Ifm Lecture 01 Bps

8/20/2019 Ifm Lecture 01 Bps

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INTERNATIONAL FINANCE

IAME – International Academy of Management &Entrepreneurship

Shashank BP

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About me: Shashank BP• BE (Mechanical) – Delhi College of Engineering (now DelhiTechnological University), 1989-93• Masters in Business Management, Asian Institute ofManagement, Manila, Philippines, 1995-97• Worked for Life Insurance and Mutual Fund MNC – Sun Lifeof Canada, Asia Pacific Regional Headquarters, Manila,Philippines, as Business Planner.• Worked for TVS Electronics Limited, as Business Planner.• 18 years experience as a freelance Business Planning.• Have also taught management to a number of students.• Email ID: [email protected] • Will reply to every subject related question by email..

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mailto:[email protected]:[email protected]


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Name Email ID PGDM, MBA orMIB?

Bachelors Degree(BE / B.Com. etc.)

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Your Introduction• Please take a single white paper and fill out these details in theformat shown:


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International Finance Syllabus• Module 1

International Finance – Issues and Dimensions The Internationalization process Structure of foreign exchange market

International financial flows and the balance of paymentsframework

International monetary system – IMF The nature of global capital flows – FDI, FII, Private equity

and hedge funds

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Foreign exchange: Empirical evidence on exchange ratedetermination

Exchange rate determination: Structural models ofexchange rate determination

Interest Rate Parity (IRP) and Purchasing Power Parity(PPP)

Exchange rate forecasting

Transfer pricing Netting

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The foreign exchange market: Structure, types oftransactions and arbitrage

Foreign exchange derivatives markets

Exchange rate regimes – foreign exchange market in India

• Module 4 Measurement of exposure and risk – Financial accounting

and foreign exchange Classification, transaction, translation and operating

exposures Management of exposures

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International Finance Syllabus• Module 4 (Contd.)

Managing accounting exposure Measuring economic exposure Managing economic exposure

Hedging, forwards, currency futures, options, swaps andhedging with money market.

Management of interest rate exposure: Forward RateAgreements (FRA) interest rate caps and floors.

Financial swaps – types – motivation Application of swaps GDR, ADR

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International capital budgeting International portfolio investment Capital budgeting for the MNC

Cost of capital for foreign investments Managing political risk

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Multinational working capital management – short termfinancing

Financing foreign trade Current asset management for multinational Multinational financial system

• Question Paper review

Review of question papers of PGDM & MBA (minimum 3years), as practice. [MIB 2008, 2009, 2010, 2013 available,AIMA PGDM papers also available, MBA not available]

Learning the art of answering questions acceptable to

examiners 9


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International Finance References• Adrian Buckley – Multinational Finance (online versionavailable)• Suk Kim and Seung Kim – Global Corporate Finance: Textand Cases (online version available)• Alan C. Shapiro – Multinational Financial Management(IAME Library)• PG Apte – International Financial Management (IAMELibrary)• Jeff Madura – International Financial Management (onlineversion available)• AIMA study material (IAME Library)

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International Finance• International Finance (IF) is a branch of Economics /Financial Management.• Deals with the dynamics of Foreign Exchange Rates, ForeignInvestment, International Trade etc.• Is a vast field.• Most crucial for MNCs.• Companies need to insulate from adverse ForeignExchange, Inflation and Interest rates.•

Companies also need to benefit from large markets,economies of scale and unprecedented global activity.• Risk management includes strategies to insulate fromForeign Exchange risk, political risk and market variations.

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Role of Finance Manager in MNCs• Understanding and forecasting financial environment.• Capital budgeting and funding strategies.• Exchange risk management.• Meeting tax authorities requirements in various countries.•

Understanding legal aspects of financial managementacross countries.• Understanding challenges/differences between domesticfinance management and international finance management.

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Keywords so far..• Capital Budgeting – Capital budgeting, or investment

appraisal, is the planning process used to determine whetheran organization’s long term investments such as newmachinery, replacement machinery, new plants, newproducts, and research development projects are worth the

funding of cash through the firm’s capital structure (debt,equity or retained earnings). It is the process of allocatingresources for major capital, or investment, expenditures. Oneof the primary goals of capital budgeting investments is toincrease the value of the firm to the shareholders.

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Domestic finance vs. International finance• Exposure to Foreign Exchange: Currency exposure impacts

almost all the areas of an international business starting frompurchase from suppliers, selling to customers, investing inplant and machinery, fund raising etc.

• Macro Business Environment: All trade policies are different in

different countries. Financial manager has to critically analyzethe policies to understand the feasibility and profitability ofbusiness propositions. One country may have businessfriendly policies and another may not.

• Legal and Tax Environment: Tax impacts directly to the net

profits. International finance manager has to look at thetaxation structure to find out whether the business that isfeasible in his home country is workable in the foreign countryor not.

14Contd..


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Domestic finance vs. International finance• Different group of Stakeholders: Money apart, keeping all

stakeholders (suppliers, customers, lenders, shareholders,interest groups) happy is important especially in a new placewith a different culture, values, language and belief system.

• Foreign Exchange Derivatives: Since it is inevitable to beexposed to the risk of foreign exchange in a multinationalbusiness, knowledge of forwards, futures, options and swapsis required. A financial manager has to be strong enough tocalculate the cost impact of hedging the risk with the help of

different derivative instruments while taking any financialdecisions.

15Contd..


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Domestic finance vs. International finance• Different Standards of Reporting: If the business has presence

in, say, US and India, the books of accounts need to bemaintained in US GAAP and IGAAP. It is not surprising to knowthat the booking of assets has a different treatment in onecountry compared to another. Managing the reporting task is

another big difference. The financial manager or his teamneeds to be familiar with accounting standards of differentcountries.

• Capital Management: In an MNC, the financial managers have

ample ways to raise capital. More number of ways createsmore challenge with respect to selection of right source ofcapital to ensure the lowest possible cost of capital.

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Birds’ Eye View of Global Trade Growth • World exports grew from US$334 Billion in 1971 toUS$16000 Billion in 2008.• Of this, developing countries exports’ grew from paltryUS$19 Billion in 1971 to US$2500 Billion in 2008.• GDP growth in developing countries was in the range of 6%to 8% from year 2000.• Capital flow growth was also on the same lines.• FDI in India grew to over US$35000 million by 2008-09 fromUS$4000 million in 2000-01.• Indian companies like Tata Steel, Dr.Reddy’s Labs, Videoconand Suzlon made foreign acquisitions of total deal value overUS$25000 million.

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Birds’ Eye View of Global Trade Growth • Last 25 years, veritable revolution has taken place in moneyand capital markets.• Bewildering menu of funding techniques, investing vehicles,risk management products are there in the market.• Accounting as well as Treasury functions in corporates arefacing new challenges.• Responsibilities of Finance Managers taking a new turn – challenging, demanding, and exciting.• New world financial structures are emerging, due toderegulation and innovation.

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Case 1

The globalization of financial markets brought about by recent

technological changes, financial market liberalization and theremoval of capital controls has impressed upon all MNCs withinternational cash flows the necessity to manage foreignexchange exposure that a floating exchange system creates.Today MNCs are trying to develop techniques and strategiesfor effective foreign exchange exposure management. Theforeign exchange strategy adopted is critical to an MNC in thepresent day environment due to the high variability in theexchange rates and needs to evolve with the changing

structure of the company. Further, in view of the fact thatfirms are now more frequently entering into financial andcommercial contracts denominated in foreign currencies, judicious measurement and management of transactionexposure has become critical to the success of MNCs.

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Case 1 (Contd.)

Q1) Outline the numerous challenges that a MNC faces whentrying to manage exposure in various currencies.

Q2) Do you think currency correlation and variability arerelated to the political risk which a currency faces? Can yougive examples to illustrate your answer?

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Answer to Case 1• Movement of men and capital is very high in the globalizedworld.• Exchange rate fluctuations, Trade balance, Balance ofPayments, government rules, regulations and governmentpolicies affect businesses.• There has to be a close watch on the socio-politicaldevelopments in countries where MNCs are investing.• What happens in Greece is affecting capital markets andcurrencies all over.• Integrated, inter-dependent financial environment exists allover.• Enron USA had to windup its Indian expansion plans due topolitical developments in Maharashtra.

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Enron’s India debacle • Enron tried to bully Maharashtra government in India to get into

power development.• Enron’s investment was $3 billion, in a 10 -year liquefied natural gas

power plant development project, the largest development projectand the single largest direct foreign investment in India’s history.

• Begun in 1992, the Dabhol power plant near India’s financial capital

of Bombay in Maharashtra state was to have gone online by 1997. Itwas supposed to supply energy-hungry India with more than 2,000megawatts of electricity, about one-fifth the new energy needed byIndia each year.

• But endless disputes over prices and terms of the deal turned the

venture into a symbol of what can go wrong in large-scaledevelopment projects when cultures collide.• In June 2001, with the project about 90 percent complete,

development was again put on hold amid disagreements over theprice of energy. Work has not resumed since.

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Keywords in Case 1• Floating exchange rate – A country's exchange rate regime

where its currency is set by the foreign-exchange marketthrough supply and demand for that particular currencyrelative to other currencies. Thus, floating exchange rateschange freely and are determined by trading in the forexmarket. This is in contrast to a "fixed exchange rate" regime.

• Exchange exposure – Foreign exchange exposure is the riskassociated with activities that involve a global firm incurrencies other than its home currency. Essentially, it is therisk that a foreign currency may move in a direction which isfinancially detrimental to the global firm.

(Contd..)

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Keywords in Case 1• Transaction exposure - The risk, faced by companies involved

in international trade, that currency exchange rates willchange after the companies have already entered intofinancial obligations. Such exposure to fluctuating exchangerates can lead to major losses for firms.

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Balance of payments - The balance of payments (BOP) of acountry is the record of all economic transactions betweenthe residents of a country and the rest of the world in aparticular period (over a quarter of a year or more commonlyover a year). These transactions are made by individuals, firmsand government bodies.

(Contd..)

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Keywords in Case 1• Trade Balance – Balance of Trade is simply the difference

between the value of exports and value of imports. Thus,the Balance of Trade denotes the differences of imports andexports of a merchandise of a country during the course ofyear.

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Evolution of World Monetary Systems

1. Gold Standard till 19132. Interwar period till 19443. Bretton Woods system till 19724. European Monetary system

5. Flexible Exchange Rate system (1973 onwards)

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1. Gold Standard 1876-1913: Each country is required to linkcurrency value to Gold. For example, US$20.67 per ounceof gold and UK£4.2474 per ounce of gold. This could notrun too long because countries could not always ensureflow of gold as gold is a scarce commodity.

2. The Interwar Years 1914-1944 (including first and secondworld wars): During this period, stability of exchangerates of all currencies was disturbed and the systemtotally crumbled.

3. The Bretton Woods System 1945-1972:Negotiators felt the need for a monetary system thatwould recognize that exchange rates were both anational and international concern.

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3. The Bretton Woods System 1945-1972 (Continued):Established a dollar based International MonetarySystem and created IMF and IBRD (World Bank).Decided to facilitate expansion of new world tradeand use US dollar as a standard of value.Fixed and adjustable rates formula was adapted.Adjustable rates of par value only on IMF’s approval. All nations maintain their foreign exchange reserves

principally in the form of US dollars or British Pound.The Bretton Woods system also failed as it suffered from anumber of inherent structural problems like (a) imbalance inthe roles and responsibilities of the surplus and deficitnations, and…

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(b) rigid approach of the IMF to the Balance of Paymentsequilibrium situation – countries with adverse Balance ofPayments position have to exercise tight control over theirinternal economic policies, inflation and employment issues.• By Aug – Dec 1971, most of the major currencies wereallowed to fluctuate.• Most leading countries were unwilling to subordinatedomestic policies to maintenance of the exchange rate.• Most country governments began to intervene and the floatwas no longer clean. This is called “dirty float”.

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European Monetary System (EMS)• European countries started EMS.• EMS is essentially the IMF’s adjustable peg system. • EMS has a wider band for adjustment within the currenciesof Euro nations and for nations outside Euro as well.• EMS also had Smithsonian Agreement signed in December1971 and was also known as “snake”, which is a narrowerband of float within EU countries’ currencies. This is tomaintain “monetary stability” within EU countries. • The following systems are working even today:

ERM (Exchange rate mechanism), ECU (European currency unit), EMCF (European monetary cooperation fund).

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Flexible Exchange Rate System• From 1973 onwards till now..

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Currency Pegged to

US Dollar French Franc Other Currency

Special Drawing

Rights (SDR) basket

Other

compositeAntigua Benin Bhutan (Indian Rupee) Jordan Bangladesh

and Burkina Faso Bosnia and Herzegovina (Deutsche Mark) Lavita BotswanaBarbuda Cameroon Brunei Darussalam (Singapore Dollar) Libya Burundi

Argentina C.Africa Bulgaria (Deutsche Mark) Myanmar CyprusThe Bahamas Chad Cape Verde (Port Escudo) Fiji

Barbados Comoros Estonia (Deutsche Mark) IcelandBelize Congo Kiribati (Australian Dollar) Kuwait

Djibouti Cote d'Ivoire Lesotho (South African Rand) MaltaDominica Equatorial Guinea Namibia (South African Rand) MoroccoGrenada Gabon Nepal (Indian Rupee) Samoa

Iraq Guinea-Bissau San Marino (Italian Lira) SeychellesLithuania Mali Swaziland (South African Rand) TongaMalaysia Senegal Vanuatu

Micronesia TogoNigeriaOman

PalauPanamaSt.KittsNevis

St.LuciaSt.Vincent

GrenadinesSyria


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Flexible Exchange Rate System

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Limited Flexibility More Effective

Single currencyCooperativearrangments Other Managed Listing Independent Floating

Bahrain Austria Algeria, Angola Malawi, Mauritania Afghanistan, Albania New ZealandQatar Belgium Azerbaijan, Belarus Mauritius, Nicaragua Armenia, Australia Papua New Guinea

Saudi Arabia Denmark Bolivia, Brazil Nigeria, Norway Canada, Congo Peru, Philippines

UAE Finland Cambodia, Chile Pakistan, Paraguay Entrea, Gambia Rwanda, Sao Tome

France China, Colombia Piland, Romania Ghana, Gautemala Principe, Sierra Leone

Germany Costa Rica, Croatia Rissoa, Singapore Guinea, Guyana Somalia, South Africa

Greece Czech Republic Slovak Rep, Slovenia Haiti, India Sweden, SwitzerlandIreland Dominican Rep Solomon Islands Indonesia, Jamaica Tamzamoa, Thailand

Italy Ecuador, Egypt Sri Lanka, Sudan Japan, Korea Trinidad & Tobago

Luxembourg El Salvador, Ethopia Suriname, Tajikistan Lebanon, Liberia Uganda, United Kingdom

Netherlands Georgia, Honduras Rep. Tunisa, Turkey Madagascar, Mexico United States

Portugal Hungary, Iran Turkmenistan Moldava, Mongolia Yemen, Zambia

Spain Israel, Kazaksthan Ukraine, Uruguay Mozambique ZimababweKenya, Kyrgyu Rep Uzbekistan, Venezuela

Lao PDR, Macedonia Vietnam

• Tables show how many currencies are pegged to another.• India is following a “limited flexible exchange rate” system

partially backed by gold reserves and pegged currencies.


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The Internationalization Process• Some start as International firms.• Some successful firms enter global scene after domesticsuccess.• International marketing starts with “segmentation” – Geographical, Behavioral, Benefit – and then choose whereto enter and when to enter.• Entry modes are through various ways – Product exports,service exports, turnkey projects, licensing, franchising, jointventuring.• Each has its own advantages and disadvantages.• Greenfield venture (acquisitions) and strategic alliances areother ways to enter a foreign country.

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Keywords in Internationalization process• Geographical segmentation: We can geographically segment a

market by area, such as cities, counties, regions, countries, andinternational regions. We can also break a market down intorural, suburban and urban areas. And, you can break down amarket by size and climate.• Behavioural segmentation: Behavioural segmentation dividesa population based on their behaviour, the way the populationrespond to, use or know a product. E.g. Hotels doing massmarketing by clubbing “Christmas and New Year” together. • Benefit segmentation: Benefit segmentation is dividing the

market based upon the perceived value, benefit or advantageconsumers perceive that they receive from a product or service.We can segment the market based upon quality, performance,customer service, special features or other benefits.

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Keywords in Internationalization process• Acquisition: A corporate action in which a company buys most, ifnot all, of the target company’s ownership stakes in order toassume control of the target firm. Acquisitions are often made aspart of a company’s growth strategy whereby it is more beneficialto take over an existing firm’s operations and niche compared toexpanding on its own. Acquisitions are often paid in cash, the

acquiring company’s stock or a combination of both. • Strategic Alliance: An arrangement between two companies thathave decided to share resources to undertake a specific, mutuallybeneficial project. A strategic alliance is less involved and lesspermanent than a joint venture, in which two companies typically

pool resources to create a separate business entity. In a strategicalliance, each company maintains its autonomy while gaining anew opportunity. A strategic alliance could help a companydevelop a more effective process, expand into a new market ordevelop an advantage over a competitor.

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The Internationalization Process

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Entry Mode Advantages DisadvantagesExporting Can understand location. High transport costs, trade barriers,

problems with local marketing agents.Turnkey Contracts Can earn returns using technology

skills.Efficient competitors get created, lack

of long term market penetration.Licensing Low development costs and risks. No control over technology, cannot

understand location, cannot experienceeconomies, cannot do global strategy

coordination.Fanchising Low development costs and risks. No control over quality, cannot do

global strategy coordination.Joint Ventures Access to local partners'

knowledge, sharing ofdevelopment costs and risks,

politically acceptable.

No control over technology, cannotunderstand location, cannot experienceeconomies, cannot do global strategy

coordination.Wholly Owned Subsidiaries Protection of technology, can do

global strategy coordination, canunderstand location, canexperience economies.

High cost, high risk.


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Case 2

We want to sell carpets to the foreign markets. This can onlybe done through exports. When profits from exportsincrease, we go in for international marketing, which leads tointernational trade and international business. How does ithappen? This happens only when our company becomes

international, multinational and transnational.The carpet industry, at present, is passing through theinternational marketing stage. The carpets that are exportedfollow the concept of ethnocentricity. In order to make the

carpet industry a MNC, the export of carpets has to increaseto more than $100 million turnover per annum. This can onlyhappen if this industry is properly organized and given moreincentives by the government, it being a labor intensiveindustry.

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Case 2 (Contd.)The question of becoming transnational cannot arise unless

this industry falls in the hands of a MNC itself and a largenumber of carpet weavers are trained on a large scalethrough Carpet Management Schools which is a far offdream. However, efforts should be made to provide moreincentives to the carpet weavers so that child labor in thisindustry is completely abolished and the objection ofimporters on the use of child labor is removed.

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Keywords in Case 2International Marketing – is the process of focusingresources and objectives of a company on marketingopportunities at the international level.


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Keywords in Case 2 (Contd.)Transnational – A Transnational corporation (TNC) is anincorporated or unincorporated enterprise comprising ofparent enterprise and its foreign affiliates.

Parent enterprise – A parent enterprise is defined as an

enterprise that controls assets of other entities in countriesother than its home country, usually by owning a 10% ormore equity capital stake.

Ethnocentricity – An ethnocentric orientation in domesticand international companies means that they pursuemarketing opportunities outside their home market byextending various elements of the marketing mix.


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Foreign Exchange Market Structure• Unlike stock market which is centralized, Foreign Exchange

market is decentralized. Trading Spot FX (or foreign exchange) isdecentralized. Thus called Over The Counter (OTC) market. Nocentral market.• Made up of price makers and price takers.• In Foreign Exchange market, there is no single price for a givencurrency at any time, which means quotes from differentcurrency dealers vary.• The Foreign Exchange market is huge (more than $4 trilliontrading volume daily) and competition between dealers is

fierce. Thus buyers get best prices.• There are 100’s of mini exchanges (ECNs). ECN stands forElectronic Communication Network.• Even though Foreign Exchange market is decentralized, thereis a hierarchy as shown in next slide.


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Foreign Exchange Market StructureCentral Banks

Interbank Market

Reuters & ElectronicBrokering Services (EBS)

Institutional ElectronicCommunication Networks

(ECN) and Aggregators

Commercial Firms

Retail Foreign Exchange Dealers / ECNs

Speculators, Traders and Hedge Funds


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Foreign Exchange Market Structure• Central banks (a major participant) role is to control money

supply, inflation and interest rates. They have official orunofficial target rates for currencies.• Interbank Market has major banks like Deutsche Bank, JPMorgan, Morgan Stanley, Goldman Sachs, Citigroup. They areprice makers. Everyone else is a price taker. Banks motive is tocollect spreads and commission on trades.• Institutional ECNs aggregate liquidity from banks. They collectinformation. They act as a mini exchange for the foreignexchange markets. Motive is commissions.•

EBS handles 60% of trading volume while Reuters handles therest.• Commercial firms trade small amounts compared to banks.• Last in the chain are Retail Foreign Exchange dealers, RetailECNs, and finally speculators, traders and hedge funds.


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Foreign Exchange Market Structure• Foreign Exchange Market has no central clearing authority.• Two types of market exist – (a) Spot market, (b) Forwardmarket.• Spot market is of daily nature. The spot rate of exchange isthat which prevails when transactions are incurred.•

Forward market is meant for future delivery. It determinesthe forward exchange rate at which forward transactions areto be honoured.• Foreign Exchange market is in continuous operationglobally.• Works 24 hours a day except weekends. Trading is from20:15 GMT on Sunday right up to 22:00 GMT on Friday.


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Top 10 Currency Traders% of overall volume, May 2012

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Rank Name Market share

1 Deutsche Bank 14.57%

2 Citigroup 12.26%

3 Barclays Investment Bank 10.95%

4 UBS AG 10.48%

5 HSBC 6.72%

6 JPMorgan 6.6%

7 Royal Bank of Scotland 5.86%

8 Credit Suisse 4.68%

9 Morgan Stanley 3.52%

10 Goldman Sachs 3.12%


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Measures to Develop Foreign ExchangeMarket in India

• In India, Institutional framework is in place.• Foreign Exchange Regulation Act (FERA) 1973 was replacedin 1999 by Foreign Exchange Management Act (FEMA).• Money and Securities Markets set up by Reserve Bank of

India in 1999 was expanded in 2004 to include ForeignExchange markets.• The Indian foreign exchange market is made up ofAuthorised Dealers (generally banks), some intermediarieswith limited authorisation and end users viz., individuals,corporates, institutional investors and others. Market makingbanks (generally foreign banks and new private sector banks)account for a significant percentage of the overall turnover inthe market.


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Measures to Develop Foreign ExchangeMarket in India

• In India, the average monthly turnover in the merchantsegment of the foreign exchange market increased toUS$40.5 billion in 2003-2004 from US$27.0 billion in 2002-2003. In the inter-bank segment, the turnover has moved up

from US$103 billion in 2002-2003 to US$134.2 billion in2003-2004. Consequently, the average monthly totalturnover increased sharply to US$174.7 billion in 2003-2004from US$130 billion in the previous year.• India’s daily average foreign exchange market turnover was$34 billion in 2007.

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