international finance

INTERNATIONAL FINANCE (MCM4EF03)

SELF LEARNING MATERIAL

IV SEMESTER

M.Com. (2019 Admission)

UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION

CALICUT UNIVERSITY P.O. MALAPPURAM - 673 635, KERALA

190619

School of Distance Education University of Calicut

Self Learning Material

IV Semester

M.Com. (2019 Admission)

MCM4EF03: International Finance

Prepared by:

LAKSHMI VARMA Department of Management Studies Central University of Kerala.

Scrutinized by:

SOUMYA C MANOHARAN Department of Management Studies Central University of Kerala.

DISCLAIMER

"The author(s) shall be solely responsible

for the content and views

expressed in this book".

SYLLABUS

UNIT TOPICS

1

International Finance: Meaning, Importance- International

financial environment- Risk associated with international

finance- International Financial Markets- International Money

Markets – Money Market Instruments – International Capital

Markets – Comparison of New York, and Indian Money

Market – International Bond Market - Recent changes in

global financial markets. -International Monetary system

Multilateral financial institutions International Institutions –

Brettenwood and International Monetary Fund (IMF)-

Objectives- Role of IMF in International Liquidity-

Conditionality‘s of IMF lending-World Bank - International

Development Association (IDA)-Objectives- International

Financial Corporation (IFC)- Objectives- Asian Development

Bank (ADB)- Objectives- International trade Centre.

2

International financial markets-foreign exchange market-

foreign exchange trading- Cash and spot exchange rates-

foreign exchange rate and quotation forward markets-

Exchange rate behavior-cross rates-foreign exchange market

participants-SWIFT Mechanism-Forecasting exchange rate-

measuring exchange rate movements- Exchange rate

equilibrium-factors affecting foreign exchange forecasting

international parity relationship-interest rate parity, purchasing

power parity and Fisher effects.

3

Exchange rate definition- Spot and forward exchange-

Exchange rate determination- Theories and models of

exchange rate, Purchasing power parity theory, Asset market

model, Portfolio balancing model- Exchange rate of rupee-

recent trends in exchange rate -convertibility of Indian rupee.

Foreign Exchange exposure: Management of transaction

exposure-Management of translation exposure, Management

of economic exposure- Management of political exposure-

Management of interest rate exposure-Foreign exchange risk

management-Hedging against foreign exchange exposure-

Forward Market-Futures market-options market- swap market-

Hedging through currency of invoicing-Hedging through

selection of supplying country-Country risk analysis.

4

International capital budgeting-concept, problems associated,

evaluation of a project factors affecting risk evaluation, impact

on value-Long term asset and liability management-foreign

direct investment-foreign portfolio management.

5

Short term asset and liability management: Working capital

management - international cash management- receivables

and inventory management- management of short-term

overseas financing resources- international banking and

money market International Monetary and Financial

Environment – International Monetary Investments –

International Investments-Types of foreign investment

Significance of foreign investments- Factors affecting

international investment

MCM4EF03 / MCM4EFT03 : International Finance

School of Distance Education, University of Calicut 1

UNIT 1

INTERNATIONAL FINANCE

INTRODUCTION:

The term International Finance refers to monetary

transactions occurring in international trade. The origin of

international trade can be traced to the period of the barter

system. Every nation has certain types of resources in

abundance whereas certain other resources are scarce for them.

The need for a balance of these resources led to trading

between different countries. The development of international

trade has led to the growth of multinational companies and

global culture. The inflow and outflow of goods, services,

people, and money have also grown ever since.

The political, economical, cultural, historical, and

educational environment is diverse in different countries.

When a country is dealing with a foreign nation it has to

adhere to the rules, regulations, policies, and standards of both

countries. The transactions between these countries have hence

become quite complicated. While dealing with international

monetary transactions one has to take care of multiple

currencies, their comparative values in the international

market, the volatile environments of the respective countries,

and so on. International Financial organizations, global

monetary transaction channels, currency exchange systems,

new banking systems, etc. were established to make the

process smoother.

The study of International Finance gained momentum

due to the fluctuating environment in international trade. The

study of financial transactions has led to the improvement in

international business. Hence it is pivotal while making

business decisions. In this unit, we will deal with the meaning,



importance, and risk associated with international finance. The

various markets involved in international finance, the changes

in the global market, the financial institutions involved in it

will also be dealt with. A comparison of the New York Money

Market and the Indian Money Market is also studied in this

unit.

MEANING AND IMPORTANCE:

International finance can be defined in simple terms as

‗the study of monetary transactions that occur in International

trade and businesses‘. It is also termed as multinational finance

or international macroeconomics or international monetary

economics. It can be categorized as a branch of financial

economics. It deals with financial transmissions across

national boundaries.

An organization that is not involved in international trade

should also have an understanding of the global financial

environment. The political, legal, financial, cultural and

physical crisis and issues in another country can affect the

domestic country since the money business and money flow is

interconnected. For example the recession that happened in

USA have affected the job market In India as many MNCs

had opened customer care and technical call centers in our

country. Many NRI Indian investors also faced financial

crunch due to the global financial crunch.

The importance of the subject lays in the fact it is

impossible to conduct international business without a proper

understanding of fiscal transactions between different

countries. International trade and business has become

inevitable due to the fact that every nation requires balanced

growth. There are many factors that have influenced the

globalization of trade and money. Adam Smith in his book

―An Inquiry into the Nature and Causes of the Wealth of

Nations‖ describes about the absolute advantage and



comparative advantage theories. Every country is endowed

with certain resources which they manufacture or produce to

their advantage. Absolute advantage theory states that if a

country is able to produce a greater quantity of products and

services at the same quantity of inputs per unit time than other

countries or if it is able to produce the same quantity of

products or services at a lesser time and cost than other

countries it will give it superiority. Comparative advantage

holds a similar view but it involves the opportunity costs of

producing in comparison to the other nations. These theories

explain why nations focus on specializations of goods and

services. Countries engage in cross border trade to reach the

resources that they lack in as well as to sell the resources that

they possess in abundance. At times they import labor and

other resources from less expensive countries or move their

business to such developing countries to reduce the cost of

production. International trade occurs in different forms. The

organizations may adopt Foreign Direct Investment methods,

import, export or other indirect methods like licensing,

franchising, etc for the enlargement of their business. Another

factor that leads to the growth of international trade is the

search of new markets. Once a product is widely used in the

domestic markets and reaches a saturation point, it moves in

search of a new market away from its origin. This is explained

through the ―Product Life Cycle Theory‖ by Raymond Vernon.

This leads us to conclude that International movement of

money and resources will be ever increasing. Many developing

countries have opened their economies to promote

international trade. The inflow of money, technology and other

resources from other developed countries will enhance the

growth of these developing economies and provides them a

chance to compete with the global giants.

Differences among these world nations often create

issues. There may be difference of opinions, policies, rules and



regulations established in different countries, communication

gaps due to cultural and technologies differences etc.

Organizations like the IMF, World Bank, European

commission, International Investment bank and many other

financial institutions were established in order to smoothen the

fiscal transactions and solve the international disputes.

International Finance deals with the study of all such

institutions which gives the person adequate knowledge on

the functioning of these regulatory and financial institutions

and role they play in the development of the business and the

economy of a country. The subject is also concerned with

foreign exchange rates, foreign exchange risk, foreign direct

investment, Balance of payments, international monetary

systems and other factors that are related to trade between two

or more countries. An idea about various financial instruments

existing in the market is gained by understanding International

Finance. Information regarding the use stocks, bonds, digital

currencies, contracts, etc can be received through the study of

the subject. Hence it is essential for making decisions while

dealing with cross border investments, and trade.

The existence of national currencies leads to undesired

complications while engaging in multinational trade. The value

of these currencies in the international market is different.

Exchange rates were created to compare the relative values of

the currencies. International Finance studies foreign exchange

rate systems and calculates the rates regularly to make the

system smooth. Even a layman garners a fairly good

understanding about the transaction process and functioning of

foreign exchange market after studying International Finance.

It also deals with the risks associated with exchange rates,

credit risk, the comparison of inflation rates, and the volatility

of the global environment and provides solutions on how to

hedge against such risks. One will able to gauge the

performance of the economies and the investments made in



different countries and predict the changes that may occur all

over the world.

Financial statements should be as transparent as possible,

especially when we are dealing with international statements.

The International Accounting Standards Board has developed a

global accounting standard system known as the International

Financial Reporting Standards. This comprises of the balance

sheet, the profit and loss statement and statements on other

comprehensive incomes. Every business has to comply with

these standards while dealing in foreign trade. The study of

IFRS is an integral part of International Finance.

A sound international financial system will maintain

peace and good interpersonal relationships between the world

countries and promote stability in the global economy.

INTERNATIONAL FINANCIAL ENVIRONMENT:

International financial environment can be defined as the

set of conditions that facilitate economical activities

throughout the globe. The environment is affected by

numerous external forces like the Balance of Payments,

foreign exchange markets, International financial market,

international monetary system, the cross border investments

and the multitude of risks associated with these transactions.

Components of International Financial Environment:

a. International Financial Market: This market consists

of institutions like international banks, International Bond

Market, International stock market, commodities market,

derivatives market, Ministries of finance and the agencies that

coordinate between them. They play a pivotal role in

circulating the finances there by smoothening the process of

international trade. They also create the policies, the structure,

the rules and regulations that monitor the international

business.



b. International Monetary system: it is a set of rules and

conventions which are agreed by the countries all over the

world. A common monetary system arouse in 1944 with the establishment of IMF and World Bank who together monitor the

foreign exchange rates, cross border investments and international

payments. Their main aim is to mobilize the capital across the world,

maintain financial stability, promote the growth of the economies

worldwide, and maintain a global price level.

c. Foreign exchange market: it is the market where

currencies are traded with each other. It consists of the

interbank market as well as the client market. The central

banks of different countries, investment banks, commercial

banks, and brokers who trade on their own account constitute

the interbank market. The difference between the interbank

and client market is that the banks are trading on their account.

They do not represent the individual customer accounts of the

banks. The client market consists of the individual traders, the

brokers and the financial institutions that represent them.

d. Currency Convertibility: can be defined as the effort

with which a currency can be converted into gold or another

currency. It is essential for international trade. If a currency

has poor convertibility it forms a barrier to trade with foreign

countries who require payments in a particular international

currency or in home currencies. A convertible currency

indicates a strong economy. The stronger the economy, the

easier it is to convert the currency.

e. The Balance of Payment: The BOP of a country is a

systematic record of the financial transaction between the

residents of the country with the external world. International

business facilitates the flow of goods, people, services and

money among different countries. The BOP statement of a

country records all the receipts for the payments for the

exported goods, services and the funds received by the

residents as well as the, payments made by the residents for the



imported goods, services to the foreign countries.

Balance of Payment Deficits and Measures to Control It:

If a nation is unable to fund its import through the

earnings from its exports, then it has to depreciate its reserves

to fund it. This state of condition is known as Balance of

Payment Deficits. Balance of This situation can be corrected

through various measures which can be broadly classified as

Monetary and Non Monetary Measures.

Monetary Measures:

1. Exchange Depreciation adjustment: Exchange

depreciation refers to the decline in the exchange rate of the

domestic currency in terms of a foreign currency. When the

currency of a country is depreciated it encourages exports and

discourages imports. The exchange rate of a country varies

according to the market forces of demand and supply. When

exchange depreciation takes place the currency of one

country is depreciated in relation to another country. If Indian

Rupee is depreciated in relation with British Pounds it means

that the prices of Indian exported goods in Britain will lower

and the prices of British goods in India will increase. Indian

will purchase lesser British goods and British will purchase

more of Indian goods. Thus the deficit will be rectified and the

exchange rate will automatically adjust to equilibrium.

Limitations:

a. If other foreign countries use the same tactic the total

effect of the strategy will be nil.

b. It is suitable to a country which exercises a flexible

exchange rate. It will not work in a fixed exchange rate

system.

c. The risks involved in foreign trade will increase if this is

practiced.



d. Another risk of implementing this strategy is that it may

cause hyper inflation which will further deepen the

deficit.

2. Devaluation of the currency: Devaluation is a

calculated and willful reduction of the value of the currency

of a country which is enforced by the monetary authority of

the country. When devaluation is enforced, the value of the

foreign currency rises in terms of the home currency. As a

result the goods in the home country becomes cheaper in the

foreign country there by increasing the exports of the home

country. Simultaneously the foreign goods will become

expensive which will reduce its consumption by Indians. This

strategy will not become successful if the foreign country

reacts in the same manner.

Limitations:

a. Similar to the exchange depreciation strategy this will

also not become successful if the other countries retaliate

with the same technique.

b. This measure will succeed only if the demand and

supply of goods are elastic. An Inelastic demand and

supply will worsen the situation.

c. Devaluation may bring about inflation in the country.

d. This method is considered as a weakness of the country.

3. Deflation: Deflation means decrease in price. It can be

brought about by the monetary authorities through various

methods like higher taxation, bank rate policy, open market

operations etc. Deflation will result in the reduction of prices

of the home goods in the foreign market thus increasing the

export of the country. The fault with this strategy is that it will

work only in a fixed exchange rate system.

4. Exchange Control: It is an extreme measure where the



monetary authority of a country decided to take complete

control over the foreign exchange dealings. The Central Bank

instructs all the exporters to surrender their foreign exchange

to the authority. Thus the concentration of the foreign

exchange will solely remain with the central bank whereas; the

supply of foreign exchange is restricted only for essential

goods. This method is only a temporary one. It will only

control the situation from turning worse for the time being.

Non-Monetary Measures:

1. Imposing Tariffs: Tariffs are the taxes imposed on the

imported goods. When tariffs are imposed the prices of the

imported goods will increase which in turn reduces the demand

for the goods. The domestic producers will be able to produce

more substitutes inside the countries.

Limitation:

a. It reduces the volume of trade and hence may hinder

the prosperity and global trade opportunities.

b. It may not reduce the imports. Hence the result of

rectification of deficit may not be achieved.

2. Quotas: The government of a country may fix the

maximum quantity or value of a commodity for a particular

period. When quota system is introduced the imports to the

country are restricted and thus the balance of payment is

restored. There are different types of quotas like the tariff or

custom quota, the bilateral quota, the unilateral quota, import

licensing etc. This strategy is very effective and easy to

implement.

Limitations:

a. There are only temporary solutions. It does not work in

the long run.

b. Quota increases the corruption in trade.



3. Promotion of Exports: Various measures can be taken

by the government to promote the export of the country like

creation of SEZ zones, tax reductions, liberalizing the export

import policies, provide marketing facilities, giving adequate

credit amount and period etc.

4. Substitutes for Imports: Industries that produce

substitute products can be encouraged through various

measures. They can provide advisory services and technical

support and also liberalize tax and credit policies etc to

improve the competitiveness of the local producers. The local

industries which receive such benefits from the government

may slowly lose their competing spirit and may expect the

government to provide the facilities in the long run.

One of the main reasons for the growth of International

Financial environment is the growth of Multinational

Corporations: The MNCS that are responsible in the

development of international business. They are those

organizations that hold a headquarters generally in their home

country as well as own and manage production and service

facilities in multiple countries outside their home country.

They monitor the global business from their centralized head

quarters. Such organizations aims to utilize the resources that

are present indigenous to the country of operation. They also

coordinate with their branches in other countries which led to

the growth of International business.

RISK ASSOCIATED WITH INTERNATIONAL FINANCE:

Risk refers to an uncertainty which may result in the loss

or damage of a business. Both the domestic and international

trade faces multiple risks but a company dealing in

international business has to face additional risks than that of

the company dealing in domestic trade. The main causes of

the risk in International finance are the following.

Different countries possess different political, cultural,



legal, social and physical environment. A conflicting

environment between the trading partners may hinder the

trade. For example the recent clash between India and China

regarding the line of control of their borders had led to the

banning of many Chinese applications in India. While

operating in a foreign country an organization may be asked to

follow the cultural and social norms of the country.

The asymmetrical development of global economies can

be another hindrance to international trade. Certain under

developed economies may not be able to afford the foreign

goods that is being provided to them. The transfer of

technology may not happen efficiently in such cases. The

technological development of a country may reject other

countries products which may not be as advanced as theirs.

The existence of multiple currencies is another important

source of risk. The relative value of the currencies may be

different in the international market. The country with the

powerful currency can demand from the country with lesser

powerful currency.

The risks associated with the international market are:

1. Foreign Exchange risk: The risk of an investments

value changing due to changes in currency exchange rates is

known as foreign exchange risk. It is also known as currency

risk, FX risk and exchange-rate risk. It refers to the risk

associated with the foreign exchange rates that change

frequently and can have an adverse effect on the financial

transactions denominated in some foreign currency rather than

the domestic currency of the company. it describes the

possibility that an investment‘s value may decrease due to

changes in the relative value of the involved currencies. This risk

usually affects businesses that export and/or import but at times also

affect investors making international investments.

There are three types of risk exposure



a) Transaction risk: This is the risk that a company faces

when it's buying a product from a company located in another

country. The price of the product will be denominated in the

selling company's currency. This type of risk is primarily

associated with imports and exports.

b) Translation risk: A parent company owning a

subsidiary in another country could face losses when the

subsidiary's financial statements, which will be denominated in

that country's currency, have to be translated back to the parent

company's currency.

c) Operating risk: Also called forecast risk, refers to when

a company‘s market value is continuously impacted by an

unavoidable exposure to currency fluctuations. It is the risk

where the company‘s cash flow in the future is affected due to

the fluctuation in the foreign exchange rates.

The transaction risk and the operations risk are together

known as the Economic risk where as the translation risk is

known as also known as accounting risk.

2. Interest Rate Risk: businesses may incur losses due to

the change in interest rate. If a company has borrowed money

from bank and if the interest rate raises the company will have

to bear the losses. The value of the bonds issued by the

governments may fall if the interest rate increases.

3. Credit risk: it is common for businesses to trade in

credit. If the buyers are unable to pay the amount at the end of

the credit terms the business will suffer. Any external issues

like a political instability or war can also delay the payments.

Hence the organizations must maintain enough funds to hold

on to the business in case of such emergencies.

4. Legal risk: Different countries are run by different laws.

Legal complications like the contract enforceability, taxation

policies and other rules and regulations can be risky for the

business.



5. Political Risk: When a government changes its policies,

rules and regulations that affects not only the domestic

companies but also those foreign companies who are trading

with them. A liberal trade policy can favour international trade

where as stringent rules and hostile attitude towards foreign

companies can hinder it. Any revolution, internal conflicts, war

with other countries will destroy the economy. Certain taxation

policies adopted by the government and complicated

documentation procedures also affects the profits of the

companies.

6. Liquidity Risk: when a business is unable to pay off

short term obligations it may have to convert its assets to cash.

If the company does not have a convertible assets or they are

not able to convert it at the right moment then it will have

encounter trouble. The possibility of this situation is known as

liquidity risk.

7. Shipment risks: The business will have to bear the risk

of the goods getting damaged or lost during their

transportation.

8. Ethics Risk: The companies have to maintain their

morals and values while engaging in business. There are

chances of the public or the government misunderstanding the

company‘s intentions. At times the information provided by the

company regarding the product or the company might be

mistaken.

INTERNATIONAL FINANCIAL MARKET:

It is the place where the traders deal in purchase and sale

of financial products like bonds, stocks, currencies, derivatives

etc between different countries. The main role of financial

markets is to set prices for the trade of such products so that the

companies can raise the required funds.

The components of international financial markets



consist of

Capital Markets

Commodities market

Money markets

Insurance markets

Futures Market

Foreign exchange market

Derivatives Market

Mortgage Markets

The key segments in the market are the buyers, sellers,

the market infrastructure and the regulators. The buyers create

the demand in the market and the sellers create the supply of

goods and services. The infrastructure provides the platform

for the trade to occur and the regulatory bodies ensure that the

market is balanced.

INTERNATIONAL MONEY MARKET:

The formation of an international money market can be

traced to the Bretton Woods Conference. It can be defined as

the market where currencies or short time monetary

instruments are traded between the financial institutions,

large corporates and governments of different countries. It

consist of short term treasury bills, banker‘s acceptance,

commercial papers, Eurodollars, Certificate of deposits,

repurchase agreements, and money market mutual funds that

invest in such instruments. The development of international

trade has led to the necessity of possessing short term funds in

a different currency other than their home currency, for the

corporates as well as the governments. Organizations use these

short term funds for different purposes. The first is to pay off

the imported goods in foreign currency. If the organizations

require sudden funds to run their day to day operations they

may have to borrow money. Usually companies will prefer to



borrow money in a foreign currency if the interest rates are

lower than the home currency. They may also prefer a

currency whose value will depreciate in comparison to their

home currency so that they can gain more favorable

options due to the change in exchange rate over a period of

time. Some consider these short term funds as an investment

also. By investing in a foreign currency or market instruments

they may receive a higher interest rate or profit if they trade in

such instruments.

The interest rates in the money market depend on the

strength and development of the economies and the demand of

short term funds and the available supply of such funds in a

country. If the economy of a country is weakening, then the

organizations functioning in those countries need not borrow

short term funds. They don‘t have to raise any liquid cash in

short notice. Hence the interest rate will be lower. If a country

has a developing economy the companys and governments will

demand for such short term funds. If the supply of such

sources of funds is adequate then the interest rates will be low

in that country, but if the supply of the short term funds is not

able to meet the demand, then the interest rates will increases

according to the demand and supply.

MONEY MARKET INSTRUMENTS:

Money market instruments refer to financial assets that

mature within a year. They are a substitute for liquid cash. One

of the main reasons for the popularity of money market is that

it is safe. Since they are highly liquid it can be used to obtain

money in short notice. The funds are obtained by discounting

the trade bills through brokers, discount houses, acceptance

houses etc. Apart from providing funds it serves many

purposes. It provides opportunities to the financial institutions

to utilize the funds on. It develops the trade and commerce

across the globe. It also helps to mobilize money in the



markets there by ensuring the development of trade and

commerce. The main instruments in the money market are as

given below.

1) Promissory Note: can be defined as a financial

instrument which includes a written promise by one party who

can either be the issuer or the maker of the note, to pay to

another party who is called as the payee, a specific amount of

money on demand or at a future date mentioned beforehand.

They are also called debt instruments as they allow an

individual or corporate to borrow loans from other sources

than a bank. It contains all the details like principal amount,

the date of issuance and the place, the rate of interest, the date

of maturity, and the signature of the issuer. The difference of the

promissory note with an IOU is that the former contains the steps

required for repayment also where as the latter contains only an

acknowledgement that the party has borrowed a specified amount of

money.

2) Treasury Bills: T-Bills are the instruments issued by the

government, which are similar to promissory notes with

guaranteed repayment at a future date. In Indian the RBI also

issues such T-Bills. The main purpose of these bills is to raise

funds to meet the present commitments. It also helps to curb

the inflation level and also regulate the spending and

borrowing habits of the citizens. According to the standards set

by the RBI, a minimum of Rs.25000 has to be invested by a

person to procure a T –Bill. They are one of the most popular

instruments as they are safe. They do not hold any risks

associated with it. Hence the interest rates provided by such

bills are minimal.. They are sold at a discounted rate from the

face value of the bill. These bills can be resold by the

buyers to convert it into cash in short notice. There are many

types of bills based on the period of its maturation.

14-day treasury bill






One of the biggest disadvantages of investing in the T-

bills is the low returns. These bills are also taxed as per the

short term capital gain taxes. The tax rates are applicable as

per the income tax slab of the buyer.

3) Commercial Papers: Commercial papers are short term

instruments which are unsecured. They are issued by large

corporates to meet their short term liabilities. They are

unsecured because they are not backed by any collateral. The

maturity period can vary from a single day up to 27 days. The

average maturity period is around 30 days. The returns offered

by these instruments are higher than the ones offered by

treasury bills.

4) Certificates of Deposits: It acts as a receipt for an

amount of money deposited in a bank or another financial

institution. A Certificate of deposit is a freely negotiable

instrument which means that they are transferable in nature.

The holder of the instrument can use the cash in a method

which is suitable for the transfer. They are issued only for huge sums

of money unlike a fixed deposit receipt. The advantages of investing

in them are that it brings in higher returns as compared to T-Bills

and term deposits. They are also issued at a discounted rate. The

maturity date of these certificates range between 7 days to 365 days.

Corporations, individuals, non resident Indians and smaller

companies can purchase these instruments.

5) Repurchase Agreement: Also known as Repo or

Reverse Repo. They are a form of short term loans. The terms

of agreements are decided by the seller and the buyer. They are

usually dealt by the dealers of government securities. The

transaction is only allowed between RBI approved government

securities, treasury bills, PSU bonds etc. Usually they are sold

over night and brought up in the morning at a slightly



increased price. It is a repo agreement for the party who is

selling and agreeing to repurchase it in the coming days and it

is a reverse repo agreement for the party who is buying and

agreeing to sell in the future days. The price difference

occurring while selling and repurchasing acts as the interest

rate. This instrument is also risk free. Repos function in two

different ways. An agreement which specifies a maturity date

(like the next day or week) is called term repurchase agreement

whereas the agreement that does not specify a maturity date is

called an open repurchase agreement. If an open repo is not

closed, it automatically renews every day. The Interest is paid

on monthly basis and the rate of interest is updated periodically

as per the mutual agreement.

6) Banker’s Acceptance: A document where a commercial

guarantees the repayment of the loan on behalf of the borrower

is called a Banker‘s acceptance. It consists of all the details

like repayment date, amount to be paid, and details of the

individual who is responsible to repay the amount. The

maturity period ranges between 30 days to 180 days.

7) Bills of Exchange: They are also known as Commercial

Bills. It is a written order to an individual requiring them to

make a specific amount of payment to the signatory or to a

named payee; it is similar to a promissory note. This bill is to

be accepted by the bank of the debtor and can be drawn by the

creditor. The creditor can discount the bill of exchange with a

bank or a broker.

8) Call Money and Notice Money: The money market

facilitates call money and notice money to let banks and

primary dealers borrow and lend money. Call money is

borrowed or lent for a single day where as notice money is

borrowed for a period of 14 days. If the period exceeds 14 days

then this instrument will be called Term money. No collateral

is required to borrow money with this instrument. The



commercial and cooperative banks are involved in borrowing

and lending in this market and mutual funds and all India

financial institutions act as lenders only.

9) Inter-Bank term Market: Commercial banks and

Cooperative banks constitute this market where they borrow

and lend money for a period of 14 days up to 3 months without

any collateral security.

INTERNATIONAL CAPITAL MARKETS:

International Capital Market is a network where

individuals, governments and corporates perform financial

transfers to other individuals, governments who require

money. The difference between the Capital market and money

market lies in the maturity period. Capital market consists of

long term instruments. The study of International Capital

Markets is vital as they promote the efficiency of the economy.

The idle and unused funds are mobilized in the market to be

invested in productive purposes. On one hand it creates an

opportunity for a foreign government, corporate or individual

to earn better returns from the excess money that they possess

instead of depositing it in a savings bank account and on the

other hand government, corporate and individuals with

shortage of money can access it to develop their business. .

Venture Capitalists, Stock Exchanges, Insurance Companies,

Mutual Funds, Public Sector Undertakings, Foreign

Institutional Investors, Credit Rating agencies etc. are the main

participants in the market. The capital market can be accessed

in two different ways. The Equity money, where the investor is

offered an ownership in return for the fund and Debt money

where the borrowed money has to be repaid to the lender.

It consists of two types of markets.

1. The Primary Market consists of organizations who

issues securities to raise funds. It is also known as New Issue



Market. Securities are primarily issued when the certificates

are issued directly to investors by the organization upon

receiving the funds. Initial Public Offering, Rights Issue and

Preferential issue are the various methods of issuing in this

market. Underwriters, Debenture Trustees, Registrars to an

Issue, and Bankers to Issue etc. act as the intermediary agents

in this market.

2. The Secondary Market or the Stock market is where the

securities and purchased and sold. It is also known as

Aftermarket and the Share market. The securities which are

already issued are purchased and sold here. Stock Brokers and

Sub Brokers act as the intermediaries in this market. Some of

the main instruments that are traded in this market are Equity

shares, debentures, government securities, SEBI risk

management system, commercial papers and bonds

The Components of International Capital Market:

1. International Equity Markets: It includes all the stocks

traded by the companies outside the home country of the

issuing company. The development of global markets is one of

the key drivers for the growth of international equity market.

The development of internet and other technologies have

paved the way for easier, cheaper and quicker methods of

trading ensuring the increased participation of investors all the

world in the local economy.

2. International Bond Markets: This market consists of

those players who sell bonds outside their home country.

Bonds are the most common form of debt instruments.

Companies that do not wish to add more investors or owners

will turn to the debt market to access funds. Governments,

corporates institutional investors and individual investors are

the main participants in the bond market. The bonds in the

international market are not as liquid as in a domestic market.

Hence mutual fund organizations, pension fund organizations



and similar type of institutional investors play a prominent role

in the market.

Advantages and Limitations of investing in the

International Bond Market:

The main advantage of participating in the bond market

is that it provides an opportunity to the investor to diversify.

Concentrating the investments in one country increases the

risk. In case of a political emergency or a natural calamity the

investments may be lost. Diversifying in a foreign country will

keep those investments safe even if there are issues in the

home country. If an investor is able to speculate accurately

regarding the growth of an economy, then he can invest in

the bonds of that country which will yield him higher returns.

Further as compared to the domestic bonds, international

bonds provide higher returns.

One of the biggest disadvantages of investing in the

International bond market is the risk that is associated with it.

The economical and political conditions of a foreign country

are highly unpredictable. Even though this risk is present in the

domestic bonds also, an investor will be able to gain

awareness about his own economy faster than a foreign

economy. The international bonds are subject to fluctuations in

the exchange rate of that currency. Hence the risk of volatile

currency will is also associated with it. As compared to the

domestic bonds, international bonds are easily convertible to

liquid cash.

There are mainly three types of bonds in the International

Bond Market.

a) The Foreign Bond is a bond which is issued in the

currency of the country in which it is being sold and is

sold by an organization, government or an individual in

another country. These are known by different names

according to the country which it is sold. For example



the bonds that are issued in the U.S and denominated in

dollars is known as Yankee bonds. The bonds that are

issued in Japan and Denominated in Yen are called as

Samurai bonds. Foreign bonds should follow the rules

and regulations of the country in which they are issued

b) A Eurobond is a bond issued outside the country in

whose currency it is denominated. They are the most

popular among all the bonds as they are not regulated by

the governments of the countries in which they are issued.

c) A Global bond is sold in multiple financial centers

globally in the same currency denomination, usually in

Dollars or Euros. Large, and credit worthy corporations

with a high rating use this form of bonds.

3. Eurocurrency Market: The Eurocurrencies are

extensions of the Eurodollars which are US dollars deposited

in European banks. Hence it can be defined as the currency on

deposit outside its country of issue. The popularity of this

market rose as it does not hold any regulations which lower the

costs for the participants in this market. Very large amount of

funds are transacted in this market by governments, large

corporates or wealthy individuals. They are not only short-term

financing options for Eurocurrency loans but are also are also a

short-term investing option for players with surplus finances in

the form of Eurocurrency deposits.

4. Offshore Centers: An offshore financial center is a

country or territory where there are lesser rules and regulations

governing the financial sector as a whole and where there a

very low taxes. Hence they are called as Tax Havens. Many

large organizations invest in these territories to evade the

taxation. Such regions or countries are generally stable and

wealthy and they open such centers as their main industries.

Bermuda, Singapore, Bahrain, the Bahamas etc are some of the

main examples of Offshore Centers.



COMPARISON OF NEW YORK AND INDIAN MONEY

MARKETS:

The Money Markets in India and New York are vastly

different. The U.S money market can be said to be one of

largest money market in the world. The New York money is

concentrated in the Wall Street area. Even though the

activities of the country‘s money market are concentrated in

New York, U.S.A can be categorized as a general national

market. As compared to New York, India cannot be

categorized as a developed money market. The Indian Money

market is an interlinked web of financial institutions scattered

over Mumbai, Calcutta, Chennai etc.

The Indian market can be categorized into the Organized

and Unorganized sector. The organized sector is directly

supervised by the RBI and consists of nationalized banks,

foreign banks, scheduled commercial banks, unscheduled

commercial banks and regional rural banks. The unorganized

sector consists of non banking financial institutions like the

LIC, money lenders indigenous banks etc. The credit

institutions occupy an intermediate position between the

organized and unorganized sector. The structure of New York

money on the contrary is advanced and the presence of an

unorganized sector is negligible. One of the major features of a

developed money market is the presence of a Central Bank

which acts as the authority who controls, regulates and guides

the entire money market. The New York Money Market is

monitored by the Central Bank of America which is The

Federal Reserve System. In India the money market is not

sufficiently developed. The unorganized sector of the market

resists the control of the Reserve Bank of India.

The Governments of both the countries play an important

role in their money markets. The US government issues and

sells securities in the market so that they can raise funds to



repay the federal debt. The Local and the state government in

USA also borrow funds by trading in tax- anticipation notes.

The Central Government of India also issues Government of

India securities and Treasury bills to raise funds for the

repayment of the debt of the Central Government and to

finance the government. The RBI acts on behalf of the

government when issuing the bonds. The State Government of

India also issues medium to long term bonds to finance their

deficits.

Large business firms with a good reputation in the

market issues commercial papers in USA, but this does not

work for all the firms. Usually they seek loans from

commercial banks or other financial institutions to meet their

short term requirements. In India the companies in the private

sector also issue commercial paper and debentures when

they do not want to borrow loans from the commercial banks

to fulfill their short term financial requirements. In the New

York money market treasury bills are very important

instruments. It consists of the largest sector. They are short

term securities of maturity periods 3, 6, 9 months. The state

and the US government bear the obligation of these bills.

Compared to the U.S money market the treasury bills market is

undeveloped. The maturity period of these bills are 91, 182

and 364 days. The government of India is liable to pay for

these bills. RBI is the only dealer of treasury bills in India.

Besides them certain commercial banks, state government, and

semi government bodies also hold some bills. In New York the

commercial banks are the biggest players of these bills. The

Federal Reserve System brings the buyers and seller together.

INTERNATIONAL MONETARY SYSTEM:

International Monetary System is a combination mutually

agreed set of conventions, rules and regulations which are

followed by the participating institutions in the international



financial environment. It is a well designed system that

connects various currencies across the world. It deals with

international trade and financial transaction between different

countries. The main purpose of this system is to smooth the

path of cross border transactions of goods, services and capital.

It also contributes to the growth of the global economy and

promoting financial stability.

The Evolution of International Monetary System:

The IMS has been through many stages of evolution

namely.

The Bimetallism (before 1875):

It is a system of using two metals namely Silver and

Gold to determine the monetary unit value of a currency. This

is a fixed exchange rate system. For example, Consider 3

countries Britain, France and India. Suppose Britain used gold

as the exchange base, India used Silver and France used both

silver and gold. Both Britain and India could trade with France

directly. But in order for Britain to trade with India, they have

to go through France. The purpose of this system was to

improve the money supply in the economy, stabilise the prices

of products and services and to fix the exchange rates. The

issue of using this system was the necessity of the presence of

a bimetallic country to conduct the trade. This system

collapsed soon as the countries where not able to maintain its

bimetallic nature as per the Gresham‘s Law. Gresham‘s Law

states that Bad money drives good money away. Here the

‗Bad Money‘ means old, shabby or underweight coins. If two

coins are in circulation and if the relative face values of both

the coins are different, the preferred coin will be retained and

the other one would be removed from circulation. This led to

unimetallism, i.e., the use of only gold as a legal tender.

Gold Standards (1870s – 1914):

The classical gold standard came into existence after the



First World War. It is a monetary system in which the standard

unit of accounting is calculated based on a fixed amount of

gold. Gold had been used as medium of payment from ancient

times. It is durable, portable and easy to manage. Hence when

there was a necessity to fix a formal system of payment most

of the countries preferred gold. According to this system every

country had to follow three conditions.

1. Only gold should be used for exchange.

2. Two-way convertibility between the currency and gold

should be available.

3. Free export and import of gold should be allowed.

The main advantages of using the gold standard were

• Automatic adjustment of BOP through price changes.

• It provided stable exchange rate.

• It created a Monetary Discipline

• It promoted stability in Trade

Disadvantages of using gold standard:

• Gold was unequally distributed throughout the world

countries. The countries which had bigger deposits of gold

enjoyed more power.

• The process of obtaining the gold through mining is

an expensive one. Investing such large amounts for a product

to be used as a reserve is not advisable.

• Fixing the appropriate value of the gold to the currency is

an issue.

• If large quantities of gold were produced or sourced to

a country it would experience inflation. If the adequate

amount of gold is not available then it would result in

deflation.



• The government or financial institutions may not able

to act quickly during any emergencies to remove the shortage

of cash.

With the commencement of First World War the gold

standard crumbled. Due to the World war countries needed a

large amount currencies hence they printed excessive

currencies which led to a devaluation of currency to match the

gold reserves. After the First World War they tried to revive

the gold standard but the classical model was not followed.

The countries allowed export and import of goods but they

sterilised the gold. The countries restricted export and import

of gold and Britain suspended the convertibility into gold.

Bretton Woods: 1944-1971

Nations world wide used Gold standard for foreign

exchange. During the World War I currencies were printed to

meet the war cost which caused hyper inflation in the

economies. . The great depression that shook the world in 1929

raised the value of gold after which people began converting

their gold to currencies. The formation of an international

financial organization had become a necessity. In 1944, the

Bretton woods conference occurred to develop a monetary

system for the entire world A conference was held in

Brettonwoods, USA where 44 countries represented the

meeting during the heights of World War II. . The main aim of

the conference was to regulate the international financial order

after the World War I. Mutual cooperation between the

countries had become an essential for the growth of trade and

prosperity.

The Bretton Woods Agreement: An agreement was

signed in the conference between the member countries which

resulted in the following.

1. A fixed currency rate was established. The U.S dollar



was pegged to gold and the other currencies were fixed either

according to U.S Dollar or gold.

a) The exchange rate was fixed at 1 ounce of gold = 35

dollars.

b) The member countries had to maintain their exchange

rates at ± 1% of the par value that was adopted by

trading in foreign exchange.

c) The system adopted the dollar based exchange rate.

d) The dollar had a backing of gold so it could be said as an

indirect gold standard.

2. The two most important international institutions, IMF

and International Bank for Reconstruction and Development

(IBRD also known as World Bank) were established in this

conference. The establishment of IMF was done to stabilize

the foreign exchange rate as well as the international financial

flows. The IBRD‘s purpose was the reconstruction of the

economies which were devastated due to the Second World

War and to promote the development of those economies.

The Bretton Woods system was a flawed system. It

collapsed in 1971. The collapse of Brettonwoods can be

attributed to the following events.

1. The Triffin Paradox: Robert Triffin, an American

scientist predicted this conflict between the dual roles that the

Dollar had to play. U.S dollars served as the reserve currency

as per the system for all the other countries. To be a good

reserve currency, dollar had to increase its exchange rate. This

created issues in the financial system. To keep the global

economy running a country which issues the reserve currency

has to supply large amounts of currency into circulation. This

will lead to inflation in the issuing country. In the 1960‘s the

U.S began facing pressures of trade deficit and excessive

dollars circulated across the world. This led to a deficit in the

BOP.



2. The “Nixon Shock”: U.S Dollar was struggling during

this period. In 1971 the then U.S President Richard Nixon

announced that the convertibility of dollars to gold will be

suspended temporarily. The shift in the economic policy was

to catalyze the growth of the US economy, create better jobs

and to protect the dollars from the international speculators.

This dollar crisis marked the downfall of the system. An

effort to bring back the fixed exchange rate failed and soon all

the currencies began to float against each other.

Flexible/Floating Exchange Rate System (1971-1973):

It was a temporary agreement accepted by 10 countries

namely, Belgium, U.K, U.S.A, Italy, Canada, West Germany,

France, the Netherlands, Japan and Sweden. They modified the

fixed exchange rate system established by the Bretton woods

agreement by pegging their currencies to dollars. It terminated

the convertibility of dollar to gold. Hence dollar became a fiat

currency which means a currency not backed by a commodity

like gold.

Managed Float System (1973 onwards):

It can be defined as a flexible exchange rate system

where the Central bank of the country or its government will

intervene in the foreign exchange rate in order to reduce the

volatility of the currency. On January 1977 in Jamaica Europe

and American government met and came to an agreement to

amend the exchange rate system. The new system is based

on the demand and supply for a currency. This system is also

known as Dirty Float. If an economy is facing inflation then the

exchange rate may be appreciated. If the prices of the

imported capital or technology this method is used. To protect

the economy from deflationary recession or to rebalance the

economy from the effects of consumption of higher exports

and capital investments the government or the Central Bank



may depreciate the exchange rate. It is also known as the

Jamaica system.

INTERNATIONAL MONETARY FUND:

The IMF was established in 1944 in the Bretton Woods

Conference in Bretton Woods, New Hampshire, United States

of America. 44 countries together signed the Bretton woods

agreement. In 1945 there were 29 members which have grown

to 190 countries at present. The main purpose of the

establishment of this organization is to build a framework for

international economic cooperation. Apart from this they also

aim to Global Monetary cooperation, maintain the financial

stability, facilitate International trade, promote employment,

sustainable economic growth and reduce poverty. The

stabilization of the international monetary system is its primary

mission. The Headquarters is situated in Washington DC. The

main resource of funds is through the payment for quotas. IMF

reviews.

The Management: The head of staff and the Chairperson

of the executive board is the Managing Director. The first

Managing Director was Dr. Camille Gutt (1946-1951). The

current MD is Ms. Kristalina Georgieva (from October 2019

onwards). The Board of governors is the highest decision

making body. The Executive Board consists of 24 Directors

each representing a single country or groups of countries. The

Executive board can be renewed after 5 years.

Functions of IMF:

1. Provides financial assistance to the member countries:

IMF provides loans to those member countries who are

experiencing BOP imbalance. Different countries initiate their

individual balance adjustment programs after consulting with

IMF and with their financial assistance. It increased its

lending capacity in 2009 during the global economic crisis.



The loans are provided to countries which have low income. As the

covid pandemic hit the world IMF increased its loans.

2. Economic Surveillance: It oversees the IMS and the

economic and financial policies of the member countries. It

advices the countries on what adjustments are to be done to

avoid risks and promote stability. It also conducts of global

prospects through its published report World Economic

Outlook. It also assesses the financial markets in its report

Global Financial Stability.

3. Capital Development: IMF provides technical assistance

and trains the member countries to establish better institutions

and design effective taxation policies, and instructs on

expenditure management, legal framework, rules and

regulations.

4. Issuing Special Drawing Rights: The SDR department

maintains known as Special Drawing Rights. All members of

the IMF can access it with the approval of the Board of

Directors. 85% of the directors have to vote for the approval.

Once agreed, the funds are distributed. The members can

exchange the SDRs among themselves.

Objectives of IMF:

To boost the international monetary cooperation.

To promote the balanced growth of International trade.

To encourage the stability of the exchange rate

To correct disequilibrium of the Balance of payment.

Role of IMF and India:

India is a founder member of IMF. India‘s current quota

is Rs. 13,114.4 millions of SDR I.e. 2.76% making it the

eighth-largest shareholder in the multilateral agency. India has

gained many benefits through its membership.



1. Independence of the Indian Rupee

2. Membership of the World Bank

3. Availability of Foreign Currencies

4. Reputation in International Circle

5. Guidance and Advice and economic consultation.

6. Timely Help during Emergency

7. Sale and Purchase of Foreign Exchange

Role of IMF in the International Liquidity:

One of the main objectives of the IMF is to promote

international liquidity. International liquidity can be defined as

the total stock of assets that enables a country to settle the

international payments. The components of International

liquidity are foreign currency reserves, gold reserves, Special

Drawing Rights from IMF, and the borrowing capacity of the

country in the international money market. When there is an

imbalance between demand and supply i.e. when the demand

exceeds the supply then the liquidity issue arises. This occurs

when the international trade grows at a faster rate than the

supply of the liquid funds internationally. IMF has been trying

promoting international liquidity by increasing the quantity, by

modifying its composition, and by making sure that the

resources are equitably distributed.

Conditions of IMF Lending:

The government of a country has to agree to the

economic policies of IMF to borrow loans so that IMF can

ensure that the country is capable of repaying the loan. Many

IMF supported programmes are designed which modifies the

structural and macroeconomic policies. The country has the

main responsibility of designing, choosing, and implementing

these policies to make the programs successful. The issues in

Balance of payment of the countries can be overcome by



taking measures that are not harmful for the prosperity of the

country by agreeing to the conditionality.

WORLD BANK:

The World Bank is a global financial organization that

provides financial assistance to the countries having low and

middle-income. The assistance is provided in the form of loans

and grants to the governments for designing and implementing

various capital projects. It consists of two institutions: the

International Bank for Reconstruction and Development

(IBRD), and the International Development Association

(IDA). The World Bank is an element of the World Bank

Group. The World Bank Group is a partnership of five

financial institutions, IBRD, IDA, International Finance

Corporation (IFC), Multilateral Investment Guarantee

Agency (MIGA), and International Centre for Settlement of

Investment Disputes (ICSID). It is world‘s largest sources of

funding and knowledge for developing countries.

The Mission of World Bank:

1. To end extreme poverty: it wants to reduce the total

share of the population living under poverty to 3% by the

year 2030.

2. To promote shared prosperity: It wants to increase the

income of the poorest 40% of every country.

The Objectives of World Bank:

• To reduce poverty and promote shared prosperity and

sustainable growth.

• To help member countries for economic reconstruction

and development.

• To stimulate long-run capital investment for restoring

Balance of Payments equilibrium and thereby ensure

balanced development of international trade among the



member nations.

• To provide guarantees for loans meant for infrastructural

and industrial projects of member nations.

• To help war ravaged economies transform into peace

economies.

• To supplement foreign private investment by direct loans

out of its own funds for productive purposes.

The Functions of World Bank:

• To grant reconstruction loans to warn torn countries

and development loans to underdeveloped countries.

• Providing loans to governments for agriculture, power,

education, health etc.

• Providing loans to private concerns for specified projects.

• Providing technical economic and monetary advice to

countries for specific projects

• Encouraging industrial development of underdeveloped

countries by promoting economic reforms.

World Bank and India:

• Various projects in the area of poverty reduction,

infrastructure and rural development etc were funded by

the loans from World Bank.

• The first World Bank loan to India was in 1948 of US$

34 million for rehabilitation of railways.

• The World Bank has partnered with India to ensure

sustainable growth, create new job opportunities and

investments in human capital.

Examples for Various projects supported by World Bank:

1. Education - Sarva Shiksha Abhiyan (SSA):

Contributed 500 million in the first phase and 600 million in



the second phase. In 2012, 95 percent of the children had

access to primary education.

2. Infrastructure -The Pradhan Mantri Gram Sadak

Yojana Project: The World Bank initially started to finance

the program in 2004. The World Bank Group agreed on an

additional US$500million loan to finance the PMGSY in May

2018 and now has invested US$1.8billion into the program.

The program has converted around 35,000 km of rural roads to

all-weather roads to the benefit of 8 million people.

3. Healthcare- Uttarakhand Health Systems

Development Project: The project has a total project cost of

USD $125 million, USD$100 million of which was awarded

by the World Bank. The remaining USD$25 million was

funded by the local government

4. Tamil Nadu Health System Reform Program: It began

March 2019. The cost estimated for the total project is USD

5.515 billion. The contribution by the World bank to the

project is USD 287 million

The Components of World Bank:

1. International Bank For Reconstruction And

Development (IBRD):

It was established in 1945 and is the sister Institution of

IMF. The purpose of establishing IBRD was to convert the war

time economy to a peace time economy. IBRD is the world‘s

first multilateral development Bank. The original mission of

IBRD was the reconstruction of war torn European nations. The

first loans were provided to France and other European

countries to develop the post world war economies. It has also

granted loans to India, Chilie and Mexico to build power plants

and railways. Later aid was provided for a variety of issues

like environmental protection, pollution control, family

planning etc. The Goal of IBRD is to end extreme poverty and



to promote shared prosperity in a sustainable way. The

Headquarters is situated in Washington DC. At present 189

countries are its members. The first president of IBRD was

Eugene Meyer. The current President David R. Malpass took

charge in October 2019 and is still chairing the position. The

current representative of India, the Country Director is Mr.

Junaid Ahmad.

Objectives of I.B.R.D:

1. To aid the member countries reconstructing and

developing their economies by facilitating capital

investments for productive purposes, including the

restoration and rehabilitation of economies affected by

wars.

2. To promote the development of productive resources in

developing countries by supplying capital investment to

them.

3. To promote private foreign investment through,

guarantees and participation in loans and other

investment made by private investors and to supplement

it with direct loans out of its own capital resources.

4. To promote a balanced growth of international trade in

the long run and to maintain the equilibrium in the

balance of payments of the member countries by

promoting long term international investments.

5. To help in improving the standard of living in member

countries and boost the productivity.

2. International Development Association (IDA):

It was established in the year 1960 by the signing of 15

countries including India. It is a part of the World Bank that

helps the poorest countries of the world. The Headquarters is

situated in Washington DC. The Purpose of establish IDA is to



Reduce poverty and provide development assistance by

providing loans and grants to such countries. IDA assists 75 of

the poorest countries in the world out of which 39 are in

Africa. It donates funds for basic social services in these

countries. It also grants loans to developing countries with the

lowest Gross National Income (GNI), having troubled

creditworthiness, & having very low per capita income. It

provides loans at a very low rate of interest. Hence it is also

known as a ‗Soft-Loan Window‘. It provides 30 to 38 years for

the repayment with a grace period of 5 to 10 years. At present

173 countries are its members. Many countries donate funds to

IDA, who are called the donor countries. Approximately 52

countries act as donors to IDA. IDA lends its service to only

those countries that fall under the criteria of eligibility to

receive financial assistance from it. It evaluates a country in

terms of its Gross National Income, the performance of the

country, the volume of population, and the risk carried by to

fall into a debt distress.

Objectives of IDA:

1. To provide financial assistance for the development of

poorest countries on easy terms and conditions.

2. To develop the economy, increase the productivity, and

to improve the living standards of underdeveloped

countries.

3. International Financial Corporation (IFC):

It is the largest global development Institution in the

world. It encourages investments in the private sector of

developing countries. It is the only multilateral organization

for debt and equity financing for the private sector that has a

global reach. It was established in the year 1956. The

Headquarters is located in Washington DC. 185 countries are

its members at present. In order to join IFC a country has to be



a member of IBRD. The head of the organization is the

Executive Vice President and CEO. Mr. Philippe Le Houérou

is holding the position at present. The Purpose of

establishment of IFC is to provide loans to the private sector

but without sovereign guarantees. As a part of the World

Bank IFC also share the two major goals of it to end poverty

and to promote shared prosperity. IFC aims to generate

employment, promote gender equality, boost environmental

sustainability, and facilitate adaptation to changes in climatic

conditions.

The management of IFC is chaired by the President of

the World Bank Group. It is comprised of the Board of

Directors which includes 25 Executive Director, Governors

and a CEO who supervises the daily operations. . Every

member country is represented by a governor. The

Representative from India is Ms. Roshika Singh.

Objectives of IFC:

1. To encourage investments in the private sector. IFC

partners with private investors to provide investment in

different forms but without a government‘s guarantee of

repayment.

2. To create opportunities to eradicate poverty and raise

the living standards of the people by mobilizing the

financial resources.

3. To act as a clearing house, (which means an agency or

organization that collects and distributes something) to

connect the private investments, capital and management.

4. To create employment opportunities to support poor

countries.

5. To boost the productive investment of domestic and

foreign private capital

6. To promote Accessible and competitive markets.



4. The Multilateral Investment Guarantee Agency

(MIGA):

MIGA was established in 1988 to provide political risk

insurance and credit enhancements for cross border private

sector investors and lenders. The Headquarters is located in

Washington DC. At present 181 countries are members in this

organization. The Executive Vice President heads the

institution. At present Mr. Hiroshi Matano is holding the

position. The organization aims to protect the FDIs of the

investors from political and non commercial risks in

developing countries. The members act as the shareholders of

MIGA that provides the capital.

MIGA is governed by a Council of Governors who are

the representatives of its members. It also consists of 25 Board

of Directors.

5. The International Centre for Settlement of

Investment disputes (ICSID):

It is an International institution for arbitration of disputes

between countries and international investors. It was

established in the year 1966 and is headquartered in

Washington DC. The organization is governed by a Council of

Administration who meets once in a year and elects the

center's secretary-general and deputy secretary-general. ICSID

also conducts various case proceedings and approves the rules

and regulations and the annual budget put forward by the

Centre. The council is headed by the President of the World

Bank Group and the operations are carried out by the

secretariat. At present 163 countries are members of this

organization. ICSID does not conduct the arbitration directly

but it offers institutional support to commissions and tribunals.

ASIAN DEVELOPMENT BANK (ADB):

ADB was established in 1966. The main of ADB is to



eradicate poverty and promote sustainable growth in the Asia

and Pacific region. ADB supports its partners and members

countries, by granting loans, providing technical assistance,

grants, and equity investments to encourage the development

of the economy and the society. The first president of ADB

was Mr. Takeshi Watanabe. In the initial years AND focused

on supporting rural development and boosting food production.

Later on it began to promote the development of energy source

especially the domestic energy sources, infrastructure

development, education and health sector, promoting micro

financing. In the 2005s ADB began supporting its members to

achieve the Millennium Development Goals. ADB has also

aided the countries to fight against epidemics like SARS,

HIV/AIDS, and Avian Influenza.

The Organization is head by the President and is

governed by The Board of Governors, The Board of directors

who look after the general operations. The management team

consists of a Managing Director General and six Vice-

Presidents.

Functions of ADB:

1. Promote Social and Economic Development: It

provides loans and investments at a concessional rate to

developing countries.

2. Technical Assistance: ADB plays the role of an advisor

for its members. It also provides technical assistance for

implementing developmental projects.

3. Promote investments: ADB provides financial

assistance to its members in the form of investments.

4. Framing policies: It helps the members to frame policies

and plans internationally.

Objectives of ADB:

1. To assist the member countries in eradicating poverty



2. To promote economic growth by encouraging social and

economic development

3. To encourage Human development through education,

health and micro financing.

4. To preserve and protect environment

5. To empower women and improve their status in the

society.

INTERNATIONAL TRADE CENTRES:

It is a multilateral agency which comprises of the World

Trade Organization (WTO), and the United Nations (UN)

through United Nations Conference on Trade and

Development (UNCTAD).The headquarters is located in

Geneva. It was established in 1964. The purpose of

establishment was to foster inclusive and sustainable economic

development.

Objective of ITC:

To strengthen trade support institutions

To enhance the capacities of the organizations to export.

To raise awareness on trade intelligence and to ensure the

availability of it.

To improve the policies that will benefit the exporting

organizations.

The parent Organizations:

WTO: It is an International organization which deals with

trade among different countries. It is an intergovernmental

organization which was established in 1955 following the

Marrakesh Agreement. WTO replaced the General Agreement

on Tariffs and Trade (GATT) It plays many roles such as

acting as a dispute settling body between its members, setting

the rules of trade. It has 164 members who represent the 96%



of the world trade. The main aim of WTO is to reduce the

barriers in the international trade and remove tariffs, quotas

and other restrictions among its members.

The Structure of WTO

The highest body of the organization is the Ministerial

Conference who the decision is making body. It is composed

of all the representatives of the member countries. The

General Council manages the day to day affairs of WTO

and has to report to the Ministerial Conference. It consists of

two bodies namely The Dispute Settling Body, and The Trade

Policy Review Body. Councils for Trade in Goods, Trade in

Services and Trade- Related Aspects of Intellectual Property

are the three other major bodies to which the General Council

delegates its authority. The Ministerial Conference has also

established three other bodies, The Committee on Trade and

Development which is concerned with the countries that are

least developed among the members, The Committee on

Balance of Payments which acts a consultation body for the

members, and The Committee on Budget which deals with the

financing and budget related issues. They report to the General

Council.

Functions of WTO:

1. Provide a platform for negotiations between the member

countries.

2. Facilitate the administration, implementation and

operations of trade agreements.

3. Settle the disputes between the member countries

4. Perform the review of the trade policies periodically.

5. Provide technical assistance and training to the

developing countries

6. Cooperate with other international organizations.



United Nations:

It is an intergovernmental organization which was

established in 1945 to promote international peace and security

and maintain friendly relations among the world nations. It

was established after the World War II. The UN Charter was

signed on 26 June 1945 It began its operations on 24 October

1945. There are 193 members and 2 observer states at present.

The UN has six principle organizations which are:

The General Assembly

The Security Council

The Economic and Social Council (ECOSOC)

The Trusteeship Council

The International Court of Justice

The UN Secretariat.

It also includes specialized agencies like the World Bank

Group, the World Health Organization, the World Food

Programme, UNESCO, and UNICEF and additional non-

governmental organizations. It is governed by the Secretary

General, Deputy Secretary-General, General Assembly

President, Economic and Social Council President, Security

Council Presidency.

Objectives of UN:

1. To maintain international peace and security

2. To protect human rights

3. To deliver humanitarian aid

4. To promote sustainable development

5. To uphold international law.



UNIT II

INTERNATIONAL FINANCIAL MARKETS

FOREIGN EXCHANGE MARKET:

It is a global market which deals with the trade of

currencies. Banks which are authorized to deal in foreign

currencies can participate in this market. Large corporates,

governments and individuals make use of this market for

various purposes. It can be an over the counter or a virtual

market. The exchange of foreign currency has been happening

for ages. This system has evolved from Gold standard in 1876

to a floating exchange rate system which is continuing till date.

It is the world‘s largest financial market. Foreign exchange

plays a vital role in growth and development of international

trade and business.. It promotes international liquidity. The

main feature of this market is that it is functioning throughout

the day for 24 hours. The two main functions of Forex Markets

are converting currencies and reducing the foreign exchange

risk.

The Participants of Foreign Exchange Markets:

1. Central Banks: The Central Banks of each country aims

to control the money supply, Inflation, interest rates etc in their

country. It uses the foreign exchange reserve to bring stability

in the market. Their participation is relevant when the

currency fluctuates beyond the target rate. Every central bank

tries to defend their currency in the market.

2. Forex dealers: they are the largest participants in the

market. The Forex dealers provide the quotes for the exchange.

3. Brokers: They represent the clients. They help their

clients to negotiate to get the best quote.

4. Hedgers: Many people invest in foreign currency and



maintain it as an asset or a liability. Hence they may be subject

to the risk of foreign exchange fluctuation. In such a situation

the hedgers take a position where their action will nullify the

losses.

5. Speculators: They are people who predict the future

position of the foreign exchange market. Such people become

active in for a short period. Their only motive is profit. When

the market is improving every day, the number of speculators

playing in the market will also increase.

6. Arbitrageurs: They are those traders who take

advantage of the price difference of a currency in different

markets. It is the arbitrageurs who maintain the decentralized

nature of foreign exchange market.

7. Commercial Enterprises. There are many business

enterprises who deal in import and export. They also trade for

smaller values in short terms as compared to speculators and

banks.

8. Individual Participants: They are also called retail

market participants. They are the tourists who travel abroad

like tourists, students, etc. they are also short term participants.

They engaging in trading only when they require as this is not

their main source of income.

FOREIGN EXCHANGE TRADING:

It involves the purchase and sales of different currencies in the

foreign exchange market. It is also known as FX trading.

Usually the trading is being done in a currency pair. The first

currency is called the base currency and the second currency is

called as the quote currency. Similar to the normal markets

Forex market also is driven by the demand and supply.

Reasons for engaging in Forex trading:

1. It is the most liquid market and it functions 24 hours a



day. Hence you can trade at any time if required. There are

easy entry and exit position in the market.

2. Since there are numerous currencies being traded in the

market it is always easy to find a pair that are strong and will

give better returns.

3. You can choose to engage in trading for various time

frames. Trading can be done in swing basis i.e., hourly trading.

It can be traded in intraday time frame which can 1, 5 or 15

minutes time. It can even be weekly or even long term trading.

4. Forex market is a well coordinated market and is also

unregulated. One can trade without intermediaries also and

thus reduce the transaction cost by not paying commission or

broker fees.

5. Each currency pair is independent. The fluctuations in

one pair do affect the other pair. Hence one can focus on a

single pair or multiple pairs while trading.

FOREIGN EXCHANGE RATE:

Foreign exchange rate can be defined as the value of one

currency in comparison to the value of another currency. The

exchange rate is the price of one currency in terms of another

currency. There are two methods of expressing it.

a. Domestic currency per unit of foreign currency.

b. Foreign currency units per unit of the domestic currency.

The bid rate is the rate at which the broker buys the base

currency and sells the variable currency. The ask rate is the

rate at which the broker sells the base currency and buys the

variable currency and the difference between the two rates is

called Spread. The ask price will always be higher than the bid

rate in the forex market.

Bid – Ask spread = Ask – Bid



Bid – Ask Spread % = 100Ask

BidAsk

Example : A stock is traded at $10/10.25. Calculate the Bid-

Ask % Bid Price = $10

Ask price = $10.25

Bid Ask spread = $ (10.25-10)

= $ 0.25

The Spread % = 10.25 – 10 x 100

10

= 2.5%

CROSS EXCHANGE RATE:

Refers to the exchange rate between two currencies each

of which has an exchange rate quote of the common currency.

Cross rate can be defined as the exchange rate of any two

currencies that are not the official currency of the country in

which the quote is published. For example if one dollar is

equivalent to 73 rupees and if one pound is equivalent to 103

rupees then we can say that one dollar is equal to 0.71 pounds.

Value of dollars in pounds =

Value of dollar in rupees /Value of pounds in Rupees

= 73/103

= 0.71 pounds.

Example 2: Consider an agency that performs foreign

exchange at the below given rates 1 USD=Rs.70

1 GBP= USD 1.

Solution: To find the exchange rate of GBP/INR

INR/GBP = INR/USD x USD/GBP

=70x1.5 = 105



Cross Currency Calculations on two way quote: Bid rate

should be multiplied with bid rate and ask rate should be

multiplied with ask rate.

E.g: I USD = INR 70-71, I GBP= USD 1.5-1.6 INR/GBP =

(70x1.5) (71x1.6)

Problem : Calculate the amount of Rupees required to buy 500

GBP and the amount obtained by selling 500 GBP if I GBP if 1

USD= INR 73/73.2, I GBP= USD1.35/1.36

Solution: Cross rate (bid) = 73*1.35=98.55 Cross rate (ask) =

73.2*1.36=99.55

INR required to buy 500 GBP= 500*98.55=49275 INR

required to sell 500 GBP= 500*99.55=49755

TYPES OF MARKETS:

There are mainly five types of markets which are the

spot, forward, options, Future and Swap markets. Options,

Swaps and Future markets are derivatives markets.

1. Spot Market:

It is the market where the securities, currencies, and

goods are traded and the payment and delivery occurs on the

spot date, i.e. on an immediate date (which is usually two

business days) after the transaction happens. The spot market

is also called as cash market. In foreign exchange market this

is the most common type of market. The exchange rate at

which the transaction occurs in this market are called spot

rate. The exchange rate which is prevailing at that time is

taken as the spot rate. Most of the foreign exchange centers

offer this service. For example a tourist can exchange his

currency at an exchange centre in the airport immediately for

the domestic currency. This type trade occurs between banks

and financial institutions also. The most popular currencies

traded in the spot market are Euros, British Pounds and



Japanese Yen. The US Dollars are the generally accepted

medium of exchange in most of the countries.

The main participants in this market are commercial banks,

brokers, and individual customers.

Spot market transactions can occur in two different ways.

Over the Counter: The currency exchange market is an

over the counter market. There is no third party

supervision during the transactions. The participants

negotiate the terms and conditions of the transaction on

the spot. The princes in this market are generally private

and is not published anywhere.

The organized Market exchange: They are an organized

market where all the procedures are standardized. The

participants meet to bid and offer the securities or

commodities. The deal is completed through a broker

generally.

Advantages of Spot Market:

It is quick and simple. The transactions are completed on

the spot.

If the buyers and sellers are not satisfied with the current

rates, then they can hold the transaction and trade when

the rates improve.

The transactions are transparent. The participants are

aware of the exchange rate that is prevailing at the time

of transaction.

Disadvantages of Spot Market:

Inflation can affect the prices of the currency. The

buyer may purchase it at an inflated price if he is not

aware of the real price.

Once the transaction is completed it cannot be undone.



If the trader notices any discrepancies after the

transaction after the closure he will not be able to rectify

it.

The market is not flexible in terms of the time frame as

the transactions are completed on the spot.

2. Forward Market:

A forward contract is an agreement which states that a

specified amount of money will be paid at an exchange rate

which is already determined by both the parties signing the

agreement on a specified date in future. The parties of the

contract are generally corporations and financial institutions.

The market that deals with these forward contracts is called as

forward market. Multinational Corporations and other large

business institutions use these contracts hedge against the risk

of exchange rate fluctuation. Since it is used by MNS, the

amount o transactions are also generally very high. They make

use of such contract so that they fix the exchange rate while

purchasing or selling foreign currencies. The most widely used

contracts are for 30, 60, 90, 180 and 360 days. There are other

longer periods which are available period in the market but

they are not as popular as the earlier mentioned ones.

The forward rate can be calculated from the spot rate by

using the forward premium. Forward premium is when the

future exchange rate is predicted to be more than the spot

exchange rate of the currency. The formula to calculate the

forward exchange rate is

Hence Premium can be defined as the difference between the

forward rate and spot rate. It is also called as discount.



Example: Assume that the spot rate of rupee to dollar is

rupees70/-. The forward rate after 3 months is expected to be

Rs.75/-. Hence the dollar is said to be at premium as its value

has increased by 5 rupees. If the dollar value depreciates to

Rs.65/- then dollar is said to be at discount since its value has

reduced by 5 rupees. We can calculate the forward premium %

by using a simple formula

Where 12 is the total number of months and N is the forward

rate period which is the period for which the forward rate is

given or the number of months of the contract. This formula is

used to calculate the premium % of the first currency and when

direct quote is provided. To calculate the premium % of the

second currency the below given formula is used. It can be

used when an indirect quote is provided. A direct quotation

quotes 1 a fixed unit of foreign currency in terms of a variable

unit of domestic currency. Dollar is used as the foreign

currency usually. An indirect quotation is when one fixed unit

of domestic currency is quoted in terms ofa variable unit of

foreign currency.

Problem: From the data given below calculate the forward

premium or discount. Spot Rate is 45.5000/8000 . 3 months

forward rate is 45.7000/9000.

Solution: In the question the price is quoted directly. At spot

rate:



Bid price = 45.5000 Ask price = 45.8000

At 3 months forward rate:

Bid price = 45.7000 Ask price = 45.9000

The premium from the point of bidder= 45.9000-45.8000

= 0.1000

The premium from the point of seller = 45.7000-45.5000

= 0.2000

Advantages of Forward Market:

The risk of exchange rate fluctuation is eliminated as the

rates for a future date are fixed.

These contracts can be customized. Hence the agreement

can be written for any amount of money.

They are relatively easy to understand



These contracts also protect against the price fluctuations

Disadvantages of Forward Market:

The dates of payment are fixed beforehand through this

contract. The buyer may not be able to pay it on the same

day which creates the risk of default.

The cash flow from such trades will happen only at a

future date. Hence the seller will not be able to access

any payments before the mentioned date.

In the case of an increase in the exchange rate the

receiver of the payment will not be able to take advantage

of the price rise.

Arbitrage:

Arbitrage in currency market can be defined as the

process of taking advantage of the price difference of the same

currency. This happens when one purchases a currency at a

rate in a market and sells the same in a different market where

it is sold at a higher price. The interest rate and exchange rates

of a country is supposed to change in the same line

theoretically. But in reality it does not happen so. Hence the

currency traders make use of this opportunity to gain profits.

This is possible if the interest differential is greater than the

forward premium in the market. When the opportunity of

arbitrage arises due to the difference in the interest rate

between two countries it is called Interest Arbitrage.

It can be classified into

covered Interest arbitrage

Uncovered interest arbitrage.

In the Covered interest arbitrage the trader tries to utilize

the interest difference by protecting his trade using a forward

contract where as in uncovered interest arbitrage the trader



does not try to hedge the investment.

For example consider the exchange rate is Rs.70/$. The

interest rate in India is 8% p.a and the interest rate in USA is

10%. p.a. A trader decides to invest Rs/-70000 for one year. If

he invests the entire amount in India he will gain Rs.75600.

He can also convert the entire amount in dollars and invest in

America. He can invest $1000 for one year where he will gain

$1100. It is unlikely that the exchange rate after one year

will remain the same. If it increases then the trader will

gain higher returns but if it depreciates to Rs.68/$ he will

gain only Rs/. 74800. The trader will try to avoid this risk by

making a forward contract of a value more than Rs. 70/$.

Calculation of Arbitrage in Forward Market:

Example: Calculate the arbitrage gained by using the data

given below.

a. The interest rate of rupees is 8% per annum for 3

months and the interest rate for dollars is 10% per annum for 3

months

b. Spot rate is Rs.70/$ and 3 months forward rate is

Rs.69.85/$

Solution:

The forward discount of dollar = 70-69.85

= Rs.0.15

Here the interest differential is 10%-8% that is 2%.

Hence the interest differential is greater than the forward



discount.

Step 1: In this case the arbitrageur can borrow 1000 rupees

and purchase dollar immediately. It is given that 1 $ is 70

rupees hence he arbitrageur can purchase 1000/70 dollars=

$14.28

Step 2: This can be invested in the money market for 10%

interest for 3 months.

Future value after 3 months= P X [ 1+( r X t)] where (P=

Principal, R= rate of interest, T= time)

= 14.28 X [ 1+ ( 0.1 x 3/12)]

= 14.28 X [1+0.025]

= $ 15.305

Step 3: This $15.305 can be sold. The price per dollar at the

time would be rupees 69.85. Hence the arbitrageur earns Rs/-

1069.05.

Step 4: The arbitrageur has to pay the principal amount and

8% interest for the 1000 rupees which was borrowed before 3

months.

Value to paid = 1000 X [1+ (0.08 X 3/12)]

= 1000 X 1.02

= 1020

The profit gained = 1069.05-1020

= Rs/- 49.05

3. Future Market:

A future contract is very similar to a forward contract.

The difference is that it is a standardized contract where as a

forward contract can be customized. The contract will

determine all the details like the volume of asset, the price, the

delivery date which cannot be changed by either party.



4. Options Market:

Options are financial derivatives which gives the right to

the holder but not the obligation to purchase or sell at the

predetermined price. Options can be categorized into call-

option and put-option. When the option is chose to purchase an

asset it is called as call-option and when it is used to sell the

asset it is called as Put-option. The price specified in the

options contract is called the strike price. In order for an option

to profitable the strike price has to exceed the spot rate of the

asset. The biggest advantage of an options contract is that it is

not binding like a forward contract.

5. Swap Market:

A swap contract is an agreement where one party

exchanges or swaps the money flow or value of one asset for

another. One cash flow is exchanged at a fixed rate where as

the second cash flow is exchanged at a floating rate.

SWIFT MECHANISM:

Society for Worldwide Interbank Financial

Telecommunications (SWIFT) is a cooperative messaging

network that facilitates that provides safe and secure financial

transactions. If an individual sends money from the Bank of

America to Federal Bank in Kerala, then the Bank of America

will send a SWIFT message regarding the confirmation of the

transfer of payment. Once the Federal bank receives the

SWIFT message of the payment which is incoming, it clears

and pays the money to the individual in Kerala. This system

was established in 1973. The Telex system was used before

SWIFT to send messages regarding international funds

transfer. Telex was more complicated than SWIFT. The sender

had to right each and every detail regarding the transaction in

full sentences instead of codes. A number of errors often

happened while using this system. This system was time



consuming as well as unsecure because the description was not

in codes. Hence SWIFT system is now being used by all

financial institutions like banks, exchange agencies etc to

transfer funds from one location to another. This network uses

a system of code to transmit information and instructions or

commands.

Each financial institution is assigned a unique code

known as the SWIFT code, which consists of either 8

characters or 11 characters. The first four characters represents

the name of the institution, the next two characters represents

the country in which the institution is located. The seventh and

eighth characters represent the city or location of the

institution. The last three characters are not compulsory but the

organizations usually use these to represent the branch of the

institution. For example the SWIFT code of Allahabad Bank in

B.B.D Bag (East), Stephen House, Kolkata is coded as

ALLAINBBSTP. Banks, security dealers, clearing houses,

trading houses, brokerages, exchanges, treasuries etc uses this

system. There are certain other messaging systems like Ripple,

CHIPS, Fedwire, but none of these are as popular as SWIFT.

The negative side of this system is that its

implementation can be costly. The members of this society

have to pay a onetime joining fee and additional annual

charges which depends on the class of the members. It also

charges an amount from each user for each message. The

amount will be based on the length and type of message.

However they have introduced additional services like

business intelligence, compliance services, and various

applications for processing, clearing and settling instructions

Forex, securities etc. apart from the messaging services.

FORECASTING EXCHANGE RATE:

Forecasting refers to the estimation of a future value.

Forecasting exchange rates involves the study and analysis of



the behavior for foreign exchange to predict the future value of

currency. Every large company, government, brokers, and

financial institutions try to predict the future exchange rate.

The main reason for performing a forecast of the

exchange rate value is to understand the risks and derive the

maximum benefits out of it. Foreign currencies are considered

as investments. Companies with a significant amount of idle

cash with them may invest in multiple foreign currencies for a

short term. It is important to analyze whether the chance of an

appreciation or depreciation is possible for the currencies that

they are going to invest in. Foreign exchange market is one of

the most volatile markets in the world. The risk associated with

investing in foreign currencies is very high. Hence forecasting

is performed as a method of hedging against the risk of

exchange rate fluctuations. Many large corporations and

MNCs who are involved in international trade are subject to

this risk. When they consider a capital investment in a foreign

project or if they are engaged in import or export of

commodities and services, they deal with multiple currencies

for payments and returns. The capital budgeting analysis also

includes an estimated inflow of money in the future. This cash

flow will be affected by the exchange rate fluctuation. Hence

they forecast the future value of the currency of the country

they have invested in or are dealing in trade.

Forecasting is also done to assess the foreign subsidiary

company‘s earnings by a parent organization. If the currency

of the country where the subsidiaries are located is predicted to

depreciate more than the home country currency in the future

the parent organization can accelerate the settlement of the

earnings of the subsidiary company. Organizations also issue

bonds in foreign currencies to raise funds in the long term.

Such organizations prefer to issue the bonds in currencies that

may depreciate as compares to the currency in which they

receive the returns from the sales. Hence forecasting is used



for multiple purposes and without getting an estimate of the

future value decision making is not advisable for international

businesses.

TECHNIQUES FOR FORECASTING:

Forecasting techniques can be categorized into 4 types.

1. Technical forecasting

2. Fundamental forecasting

3. Market based forecasting

4. Mixed forecasting

Technical Forecasting:

In this method the historical data of exchange rate is used

to estimate the future value. This technique can be used if the

investments are for a short period or to study day to day

fluctuations. MNCs generally do not use this technique as it

focuses only on short term forecasts. In the case of long term

forecasts this may not give accurate prediction. It is also not

correct to say that event that happened in the past will occur

again. As the political, technological, physical and cultural

environments of the world changes the exchange rates also

may change. Hence studying the past may not be as useful as

other methods.

Fundamental Forecasting:

This technical is based on the relationship between

various economic variables and the exchange rate. An estimate

is made by assessing the factors that affect the exchange rate. It

may also make use of quantitative methods like regression

analysis. For example if we want to forecast the appreciation

or depreciation level of Indian rupees in terms of dollar, we

will have to study economic situations in U.S.A and India, like

the rate of inflation, political stability, growth of industries etc.

The conditions prevailing in USA will affect the value of



dollar which will in turn affect the relative value of rupee to

dollar. The disadvantage in this method is that unexpected

events in the economy may make the predication wrong.

The exact effect of the factors on the exchange rate is also

not easy to calculate ad understand. One may ignore certain

important factors over the others which will also generate the

wrong prediction.

Market Based Forecasting:

The market indicators like the spot rate and forward

rate are used to make estimates in this method. The spot rate

of the present day can be used to forecast the value of spot rate

in a future date. If a currency appreciates its value today, the

traders may assume that it will appreciate in the future too.

Hence they would purchase it today which will result in the

appreciation of its value. The same is the case for depreciation

also. If a currency falls today people may sell it to off

believing that the trend may continue. This would result in the

actual depreciation of the value. The forward rate quoted on a

predetermined date can be used to predict the spot rate on that

date.

Mixed Forecasting:

It is a combination of different techniques. The forecast

is prepared based on the weighted average of the different

techniques used in the prediction. The techniques which are

considered as reliable are given more weightage. The choice of

the techniques adopted will vary based on the currency, the

term of investment and the purpose of forecast.

MEASURING EXCHANGE RATE MOVEMENTS:

Exchange rate movement refers to the change in the

exchange rate. The main terms associated with the movement

of exchange rate are appreciation, depreciation, revaluation

and devaluation. The movement is said to be in upward



direction if the currency is strengthening. This is termed as

appreciation. When the currency weakens from its existing

value the downward movement occurs which is termed as

depreciation. The other two terms are mentioned in a fixed

exchange rate system. When the government of a country

appreciates the value of the currency deliberately, it is known

as revaluation and devaluation refers to the deliberate

depreciation of the currency by the government.

International trade and business and the strength of the

society is affected by the movements in the exchange rate.

Depreciation of a currency affects the home country

negatively. The exported goods will become cheaper over sees

and the imported foreign goods will become expensive for the

country. Hence the cash outflow may exceed the cash inflow.

An appreciation in the currency will have a positive effect by

making the imported goods cheaper and the exported goods

more expensive. The movement also affects every corporation,

government and individual who has invested in the foreign

currency or who has lended and borrowed in a foreign

currency. Hence the regular study of the day to day movement

is necessary to be protected from the fluctuation risk.

EXCHANGE RATE EQUILIBRIUM:

In a floating rate system the price of the currency is

affected by the demand and supply of the currency. When the

demand and supply for a currency against another currency

become equal then it is said to have attained a state of

equilibrium. When two countries are engaged in international

trade they import and export the required goods to each other

and the payments for the exported goods are preferred in the

home currency. The demand for a currency depends on the

demand for the products exported from that country. When the

exported products are in demand, the importing country will

have to pay in the currency of the exporting country hence they



will purchase the currency. The supply of a currency depends

on the demand of imported goods in a country.

Let us use an example of India and USA who are dealing

in trade with each other. India will have to pay the USA for the

goods it has imported in US dollars. India will have to

maintain a reserve of US dollars in order to do the payments.

Indian investors, corporations and government may also be

involved in capital investments in USA or invest in American

securities for better returns. It will have to purchase US dollars

from the market thus creating a demand for dollars. The

purchase will increase when the value of the US dollar is low

thus making the demand schedule a downward sloping curve.

When the exchange rate of dollar increases India will be

unwilling to import goods from them and sell of the dollar to

gain profits.

Similarly a supply schedule can also be developed which

forms and upward sloping curve. When the demand for the

dollar increases USA will supply dollar into the market. When

the value of dollars is high the USA will prefer to purchase

goods from India so that the payments can be done with lesser

amount of dollars. So they will be willing to exchange more

dollars to rupees. Hence there is a positive relationship

between the value of dollars and the supply of dollars.

FACTORS AFFECTING FOREIGN EXCHANGE

FORECASTING:

1. Change in prices of goods or services: the PPP theory

uses the prices of the goods in different countries to calculate

the exchange rate. The prices of goods can change

unexpectedly due to multiple reasons like demand of

supplementary goods, strikes in an industry, unavailability of

raw material, change in government policy etc. If there is an

unexpected change in the price the forecasted rate will be

wrong.



2. Decline of economy: Forecasting is also based on the

relative strength of the economies of different countries. The

economy of a country cn grow or decline suddenly. A global

situation like the Corona has affected the global economy. But

the rate of its affect is different in different countries. Such

unexpected movement of the economic condition can prove the

forecasting wrong.

3. Change in Political conditions: a sudden internal revolt

or war in a country can change the environment of the country

which will affect the forecasting.

4. Effects of Natural Calamities: Calamities like floods

that continue for months can put the economy on a standstill

and affect the movement of goods, services and people. This

will affect the trade and economy which will in turn affect the

exchange rate.

5. Error in assumption The forecasting of forward rate is

calculated through the spot rate. It is assumed that if the

currency appreciates today it may appreciate tomorrow also.

This may not be the scenario. The chance of fluctuation in

exchange rate is very high. Historical data is also used to

forecast assuming that a similar trend or pattern in the fluctuation

that happened in the previous years may repeat in the future too, but

is not common that historical data will be repeated.

6. Error in Quantitative calculations: The foreign

exchange rate is mathematically and statistically calculated

through different techniques. Regression analysis is used to

forecast exchange rate quantitatively. An error in the

mathematical calculation can result in a wrong forecast.

INTERNATIONAL PARITY RELATIONSHIPS:

The word parity refers to a state of being equal. In the

case of international trade it can be related to exchange rate,

purchasing power, the price of goods and services etc. the most



important concepts to be studied in the International parity

relationships are Interest Rate party, Purchasing Power parity

and the International Fischer Effect.

INTEREST RATE PARITY:

It refers to condition where the trader cannot avail an

arbitrage due to the difference in the interest rates. This

concept holds that if an investor invests in his domestic

currency or if he invests the same amount in a foreign currency

the rate of interest on the returns will be the same. This

concept holds due to the fact that the spot rate and forward of a

currency differs from each other. The Theory that explains this

concept is the Interest Rate Parity Theory. It states that the

interest rate differences between two different nations will

automatically adjust the exchange rates of those currencies.

PURCHASING POWER PARITY:

Purchasing power refers to the basket of goods that can

be bought by a unit of currency. For example if a citizen in

India is able o purchase a basket of goods consisting of 5

grocery items, 3 FMCG items and one dress for 1000 rupees.

In US the same basket of goods can be purchased for $20.

Thus we can conclude that $1 = 50 rupees. There are two

version of Purchasing power parity i.e., the Absolute form and

the Relative form.

INTERNATIONAL FISHER EFFECT:

This concept is named after the popular American

economist Irving Fisher. Fisher effect deals with the

relationship between the inflation rate and the interest rate.

For example if a money lender gives a loan of rupees 10000 to

an individual at 5% interest rate per annum for a year the total

returns that he receives at the beginning of the second year

would be rupees 10500. If the rate of inflation in the economy

is 10% then he is losing 5% as the value of rupees 10000



would have risen to rupees 11000 by the next year.

The international Fisher effect states that nominal interest

rate has an inverse relationship with inflation rate. The

increase in the nominal interest rate results in the decrease in

the inflation rate. Nominal interest rate is the interest rate

calculated without the inflation. The relationship can be

shown as below.

Where I is the inflation rate

n is the nominal rate

r is the real rate or expected rate of return.

Let us look on how it affects the international business.

An Indian investor decides to invest rupees 10 lakhs. He

considers London as one option and New York as the second

option. Suppose the interest in London is 10% and the interest

rate in New York is 5%. If the investor considers only the

interest rate then the choice would obviously be New York.

But suppose the inflation rate in London is 6% and the

inflation rate in New York is 12% then the investor will earn

4% profit from London and 3% profit from New York.

Nations use this concept while creating monetary

policies. A country which shows a deficit in the Balance of

payment would prefer to attract foreign investments into the

country. They can choose two different methods to achieve

this, either by controlling inflation or by increasing the

nominal interest rate.



UNIT III

EXCHANGE RATE DETERMINATION

EXCHANGE RATE:

Exchange rate can be defined as the price of one currency

in terms of another currency. Exchange rate of currencies

fluctuates continuously. The main factors that affect the

exchange rate is the market forces, demand and supply. The

two important categories of exchange rate are spot and forward

exchange rates. The spot rate refers to the immediate exchange

rate (which is usually 2 business days after the transaction) and

forward rate refers to the exchange rate at a future date. The

exchange rate is already determined when the forward contract

is prepared. The spot rate is used for immediate currency

exchanges, purchasing an asset etc and the forward rate are

used for protecting one‘s investment from exchange rate

fluctuations.

THEORIES AND MODELS OF EXCHANGE RATE

DETERMINATION:

The exchange rates between currencies of different

countries can be determined in different methods. Exchange

rate theories can be categorized into two parts.

Long Run Theories: these theories take into account the

fundamental changes in the economy which affects the

performance of an economy. All the random changes will

be eliminated and only the fundamental changes will

determine the exchange rate

Short Run Theories: These theories take into account the

current or immediate information of the performance of

the economy.

The main theories of exchange rate Mint Parity Theory,



Purchasing Power Parity Theory, and Interest Rate Parity

Theory, The Balance of Payment Theory, and the main models

of exchange rate determination are Monetary Approach to

Foreign Exchange, Asset Market Model or Portfolio Balance

Model.

Mint Parity Theory:

This theory is applicable to those countries which had the

same metallic standards. The price at which the standard

currency unit of the country was convertible into gold was

called as the mint price. The theory states that the rate of

exchange is determined on the basis of the parity of the mint

ratio maintained by the currencies of the country. The

countries should follow the same metallic standard (like gold

standard). For example the official price of gold in US was $80

per ounce and the official price in India is INR 200 per ounce.

$80 and INR 200 are the mint prices. The rate of exchange

determined on weight-to-weight basis of the metallic contents

of currencies of the two countries was called mint par of

exchange or the mint parity. So the mint parity between the

above currencies are $80=INR 200, i.e. $1=INR 2.5.The

method of determining currency value in terms of gold content

or mint parity is obsolete for various reasons. The first reason

is that in the present time none of the countries are following

gold standard. The second reason was that free trade of gold

and silver is not permitted by the governments so the par value

cannot be determined.

Interest Rate Parity Theory:

This theory states that the interest rate existing in two

countries will affect the foreign exchange rates of the

currencies of those countries. If the interest rates of two

countries are different then the forex rate will also move in

such a way that it will bring parity to the interest rate. It rules

out any arbitrage opportunity. As per the interest rate parity



theory.

This theory is criticized because it does not work in real

markets. When there is an increase in demand for a currency

with a high interest rate results in its appreciation against other

currencies with lower interest rates. This contradicts the key

assumptions of the theory stating that an arbitrage opportunity

does not exist. If two countries ‗b’ and ‗c’ are considered then

Where,

F is the Forward Rate

S is the Spot Rate

ic is the Interest rate in country c

ib is the Interest rate in country b

This theory holds the concept that if an investor invests

in home country or if he invests in a foreign country and

converts the earnings to his home currency it would provide

him the same value. The interest rates and the forward

exchange rate relationship will provide him with the same

value.

There are two types of interest rate parities. Covered

interest parity involves using forward contracts to cover the

exchange rate. It is protected from the foreign exchange risks.

Meanwhile the uncovered interest parity involves forecasting

rates and not covering exposure to foreign exchange risk—that

is, there are no forward rate contracts, and it uses only the

expected spot rate.

Purchasing Power Parity Theory:

This theory was proposed by the Swedish economist and



Professor Karl Gustov Cassel. Purchasing power refers to the

basket of goods that can be bought by a unit of currency.

Purchasing power parity (PPP) is a theory which states that

exchange rates between currencies are in equilibrium when

their purchasing power is the same in each of the two

countries. The rate of exchange between two countries depends

upon the relative purchasing power of their currencies. The

basis for this theory is the "law of one price". This means that

the exchange rate between two countries should equal the ratio

of the two countries' price level of a fixed basket of goods and

services. When a country's domestic price level is increasing

that country's exchange rate must depreciated in order to return

to PPP.

Gustov proposed two versions of PPP.

a. Absolute Version: the absolute Version states that the

prices of similar products should be the same in different

countries if they are expressed in the same currency. If we

divide the price level of one country with the price level of

another country, it should give the exchange rate between the

currencies of the countries.

b. Relative version: the relative version recognizes

inflation rates. It says that the rate of appreciation of a

currency is equal to difference in the inflation rate in the

country. It assumes that transportation, maintenance and other

costs are constant.

Criticisms of Purchasing Power Parity Theory:

The price of goods is determined not only by the inflation

rate. It is also affected by taxation policies, other costs,

availability of raw materials and resources etc. hence

the goods will not have the same prices when measured

in the common currency.

Many goods available for internal trade will not be



available for international trade.

This theory applies to a stationary world. It will not work

in the real world.

This theory is useful for predicting in the lesser

developed markets, but it may not be useful in advanced

economies.

This theory does not recognize the difference in demand

and price discrimination due to product differentiation

and the role of the government and central banks in the

exchange rate determination.

The Balance of Payments Theory:

The theory states the exchange rate is determined by the

market forces, demand and supply. The demand and supply are

in turn determined by the BOP. If there is a deficit in BOP, it

causes an appreciation of the foreign currency and if there is a

surplus in BOP then the domestic currency will be

strengthened. According to this theory when the demand and

supply intersect then equilibrium is created. Hence the BOP

theory can also be called as ‗Demand and Supply Theory of

Exchange‘. When the exchange rate moves to disequilibrium,

we can adjust the BOP position.

This theory does not consider the internal price levels.

There is no relation shown between the exchange rate and the

internal price of goods. But the BOP is also affected by the

internal price difference.

The Monetary Approach to Foreign Exchange Rate:

The approach was developed by economists Robert

Mundall and Harry Johnson in the 1960s -1970s. Many

economists such as D.H Robertson, Thomas M Humphrey,

Robert Barro, John Bilson, Jacob Frenkel, Michael Mussa,

have contributed to this approach. This approach considers the



most valuable factor in the economy‖ Money‖. Exchange rate

between two national currencies is determined by the current

and the prospective relative supplies and demand for those

national stocks. The BOP is essentially a monetary

phenomenon. The equilibrium in BOP signifies an imbalance

in the debit and credit. Any disequilibrium in BOP can be

corrected through monetary measures.

Assumptions of this model:

⚫ There is stable demand function in the long run.

⚫ The market operates in Perfect competition and the prices

are flexible.

⚫ The prevalence of PPP theory.

⚫ The Law of one price is assumed.

⚫ Market works in full employment.

The approach under fixed exchange rate system: The

theory states that the demand for nominal value of money is

positively related to the nominal national incomes and is stable

in the long run.

Where

Md is the demand for nominal money

k is the reciprocal velocity of circulation of money and is

assumed to be constant,

P is the domestic price level.

The velocity of circulation is noted by v which is also assumed

to be constant.

Supply function:



Where

Ms is the total supply of money

m is the money multiplier

D is the domestic component of monetary base of a country

F is the foreign component of monetary base of a country.

The money multiplier is assumed to be fixed. Monetary

Approach believes that Md=Ms. An increase in demand can

be balanced by both D and F. If the country‘s monetary

authority does increase D then Ms will be balanced by an

increase in F. An increase in D and money supply in the face

of unchanged money flows out of the country leading to a fall

in F and a deficit in the country‘s BOP. The country has no

control over its money supply under fixed exchange rate

system in the long run.

The Approach under flexible exchange rate system:

Under this system BOP disequilibrium are immediately

corrected by automatic changes in exchange rate without an

international flow of money. Country retains control over its

money supply and monetary policy. Adjustment will occur due

to the change in domestic price that accompanies the change in

the exchange rate. A deficit in the BOP resulting from an

excess money supply leads to an automatic depreciation of the

country‘s currency which causes domestic prices to increase.

Demand for money will rise sufficiently to absorb the excess

supply of money and automatically eliminate the BOP deficit.

A surplus in BOP resulting from an excess demand for money

automatically leads to an appreciation of the country‘s

currency. This leads to a reduction in the domestic prices thus

eliminating the excess demand for money and BOP surplus.

The equation for demand of money in the home country can be

depicted as



Md= kPY

The equation for demand of money in the foreign market can

be depicted by

Md*= k*P*Y*

Ms=Ms* and Md=Md* in equilibrium

Substituting the demand function equation

Ms/Ms*= kPY/K*P*Y

As per PPP theory R=P/P*, Substituting it in the above

equation

Ms/Ms*= kRY/k*Y*

The exchange rate is determined by the relative supply

and demand for the different national money stock. Increase in

the domestic money supply relative to foreign money supply

will lead to an increase in exchange rate that is depreciation in

the currency rate. An increase in the domestic income relative

to foreign income leads to a fall in exchange rate or

appreciation of home currency.

Portfolio Balance Approach or Asset Market Model:

It is an extension of Monetary Approach. It includes

financial assets apart from money. This was developed by

William Brason and Penti Kouri in the 1970s and was

subsequently modified by Allen, Kenen, Maurice Obstfeld etc.

This model is considered as more comprehensive and

satisfactory than monetary approach. This model argues that

organizations and individuals hold financial wealth in three

forms namely.



⚫ Domestic Money

⚫ Domestic bond

⚫ Foreign bond.

The investors purchase diversified portfolios. This theory

proposes that exchange rate is determined in the process of

balancing the stock or the total demand and supply of financial

assets in the country. It emphasizes the role of International

portfolio investors.

EXCHANGE RATE REGIME IN INDIA:

India followed a par value system from 1947 to 1971.

We were the members of the Bretton Woods System right for

the beginning; hence we followed their monetary policies.

The Indian Rupee was pegged by the government to gold and

pound sterling. From the year 1950 India was plagued by a

number of issues. The loans borrowed by the country from

foreign countries and the private sector were increasing to an

enormous amount. The wars between India and China that

occurred in 1962 and between India and Pakistan in 1965 took

a toll on the economy. We faced high inflation and hence In

1966 Indian rupee were devalued. This resulted in the

reduction of the par value of the Indian Rupee in terms of gold;

still it maintained a steady rate from 1966 to 1971.

With the collapse of Bretton Woods system India had to

adopt a new system of exchange rate just like the other

member countries. Indian began to follow a pegged system

where the value of Indian Rupee was pegged to US dollars

(1971-1991) and UK pound sterling (1971- 1975). The

advantage of this system was that it reduced the exchange rate

fluctuation as well as maintained the stability with its trading

partners but it also carries a disadvantage of creating

imbalances in the economies of the nations. Hence we began to

peg our currency with a basket of currencies. The weighted



average with each of the trading partners was the basis of the

fixed value.

India went through a severe crisis of Balance of Payment

in 1990. The collapse of Soviet Union who was an important

trading partner badly affected India‘s export. The Oil prices

which was an important commodity imported from the Gulf

also went high in the 1990 which increased the payments to be

done by India for its export. In order to face this issue the RBI

devalued the currency. The exchange rate was reduced twice.

The government also decided to liberalize the economy .This

led to the bankruptcy of the country and we were forced to take

loans from International Monetary Fund against its gold

reserves. With this the pegged exchange rate system in the

country came to an end.

The new system that originated was called the

Liberalized Exchange Rate Management System (LERMS)

was introduced temporarily so that the economy could

smoothly shift to a market determined exchange rate system.

During this period Indian rupee was made partially

convertible. 40% of the conversion was fixed by the

government as per the pegged regime and 60 % was based on

the market determining rate. Since 1993 India follows Market

based conversion system where RBI will intervene only during

highly volatile times.

RECENT TRENDS IN THE RUPEE EXCHANGE RATE:

India has been following an exchange rate which is

determined by the market forces of demand and supply. When

the exchange rate experiences extreme volatility the RBI will

intervene to retrieve the stability. The Reserve Bank of India

has been working relentlessly in the foreign exchange market

so that there is a steady appreciation in the real effective

exchange rate and foreign exchange reserves. Even though we

have been hit by the corona pandemic our country has been



able to maintain its strong position in the foreign exchange

market. India has received around $ 80 billion as FDI and FPI

investments during this period.

At present we are going through a confusing and

ambiguous situation due to the Pandemic. The foreign

exchange market is also affected just like all the other

industries. The market has displayed extreme volatility during

the period all over the world. The same reflects in the Indian

market too. The prices of currencies, equities, bonds, etc. have

shown the maximal variation during this period. The Indian

rupee has depreciated massively to Rs. / 75.4 in April 2021We

became one of the biggest losers in the foreign exchange

market. This depreciation is said to be an intended and willful

effort taken by the Indian Government to maintain a

competitive position in the global market. Depreciating the

rupee would make our exports cheaper which will attract

more foreign reserves as well as enhance the liquidity of the

local market.

The supply chain and trade were disrupted heavily due to

the lockdown of the country from March 2020. As the

Pandemic began to pose serious menaces to our economy RBI

undertook several measures to protect it. The Interbank foreign

exchange transaction timings were cut down which ended in

the reduction of spot transactions. The volume of spot

transactions went up above 20 lakh crores in March 2020. It

dipped to half its volume in April and slowly recovered to a

volume above 15 lakh crores by July 2020. To control the

volatility of the currency RBI sold the USD reserves which

also reduced the pressure of depreciation on the Indian

rupee.RBI also intervened when the financial securities

were purchased by investors which further reduced the

volatility.

From the period of March to September 2020 the Indian



Rupee was categorized in the middle band of volatility this

meant that the actual volatility was much lower than the

speculated volatility which shows the effectiveness of the RBI

measures. The Rupee began to stabilize by the month of May

2020. The Equity market has more or less recovered. By

December 2020 the rate of inflation was curbed and the

liquidity improved in the economy.

FOREIGN EXCHANGE EXPOSURE:

It can be defined as the risk that an organization is

exposed to while dealing in foreign exchange market.

Volatility of the currency is the main factor that creates such

risks in the market. Financial risk management is the practice

of creating economic value in a firm by using financial

instruments to manage exposure to risk.

Foreign exchange exposure can be categorized into

different types:

a) Transaction Exposure: This is the risk that a company

faces when it's buying a product from a company located in

another country. The price of the product will be denominated

in the selling company's currency. This type of risk is primarily

associated with imports and exports. While exchanging in

foreign exchange transaction both the parties agree to

exchange a certain quantity of goods for a certain amount of

money. When the exchange rate fluctuates it will affect the

value of the goods and the returns received by the seller.

The degree of exposure involved, is dependent on:

(a) The size of the transaction, is it material?

(b) The hedge period, the time period before the expected

cash flows occurs.

(c) The anticipated volatility of the exchange rates during the

hedge period.



Techniques of Managing Transaction Exposure:

Transaction exposure can be managed through 2 different

techniques.

Financial Techniques: This includes the use of Forward

contracts, Future Contracts, Money Market Hedging and

Options Contract. Money Market hedging refers to the

technique where the value of the foreign currency is locked by

using the domestic currency. In this process money is invested

in short term financial instruments like bankers‘ acceptance,

Treasury bills and commercial paper. The company which is

buying goods from a foreign company will have to pay in

foreign currency. The company can purchase the foreign

currency at the spot rate and this currency can be used in the

money market and receive the interest till the time of payment.

The deposited foreign currency can then be used for the

payment to the foreign company.

Operational Techniques: This includes techniques like risk

shifting, sharing the risk of currency fluctuation, leading and

lagging, and the use of re-invoicing centers. The company can

choose to conduct all their transactions in their home

currencies and avoid foreign exchange transaction totally. This

technique is called risk shifting. In this technique the risk is

completely transferred to the foreign company. The company

using this technique will not face a transaction risk. In the

second technique both the parties involved in the transaction

consciously decide to share the risk with each other. If a

company decides to do the payment when the currency is

appreciating is known as leading technique. If a company

delays a payment due to currency depreciation is known as

lagging. A Multi National Company can establish re-invoicing

centers which are subsidiary companies or divisions of a

company that handles transactions with in the firm in multiple

foreign currencies. This center acts as the location for billing

and invoice processing for all the branches of the company



across the world. The main purpose of these centers is to

centralize the multiple currency transaction.

b) Translation Exposure: A parent company owning a

subsidiary in another country could face losses when the

subsidiary's financial statements, which will be denominated in

that country's currency, have to be translated back to the parent

company's currency. The extent of translation risk can be

measured through different methods like the Current Rate

method, temporal method, Current and Non Current method

Monetary and Non Monetary method.

Current and Non Current method: In this method the

current assets and liabilities (maturity period is less than 1

year) are translated in the present rate of exchange and the non-current assets and liabilities are translated at an exchange rate

which existed during the time it was entered in the books.

Monetary and Non Monetary method: In this method

the monetary assets and liabilities like the accounts payables,

cash and marketable securities are of a foreign subsidiary are

converted at the present rate of exchange where as the non

monetary accounts and the equities of the share holders are

converted at a rate which existed when the accounts were

recorded in the balance sheet.

Current Rate method: In this method all the balance

sheets accounts are converted in the existing rate of exchange

except the equities of the shareholders.

Temporal Method: In this method both the current and

non current accounts are converted at the present exchange rate

and if the other balance sheet accounts are carried out at the

current value, then it will be converted at the existing exchange

rate and if they were already carried out before, then it will be

converted at the rate when they were carried out.



Managing the Translation Exposure:

Translation exposure can be managed by using currency

swaps, currency options, and Forward Contracts. When two

parties are exchanging currencies for a date which already

determined and if they pay an interest rate for the value of

these currencies for the time period, then this transaction can

be called currency swaps. Currency options provide the right

to the party to exchange the amount at predetermined date but

the parties are not obligated to do so. While trading in forward

contracts the exchange rates are predetermined for a future

date.

c) Operating Exposure: Also called forecast risk or

economic risk, refers to when a company‘s market value is

continuously impacted by an unavoidable exposure to currency

fluctuations. It is the risk where the company‘s cash flow in

the future is affected due to the fluctuation in the foreign

exchange rates.

There are two ways in which a company is exposed to

economic risk.

⚫ Directly: If your firm‘s home currency strengthens then

foreign competitors are able to gain sales at your expense

because your products have become more expensive (or you

have reduced your margins) in the eyes of customers both

abroad and at home.

⚫ Indirectly: Even if your home currency does not move

vis-a-vis your customer‘s currency you may lose competitive

position.

Managing Operational Exposure:

It is difficult to quantify but a favored strategy is to

diversify internationally, in terms of sales, location of

production facilities, raw materials and financing. Operating or

economic exposure are managed through two different



strategies.

Operational Strategies: The Company can mitigate economic

exposure through diversification of markets as well as the

production facilities for a single product itself.. The

disadvantage of this method is that the company will not be

able to make use of economies of scale while purchasing,

storing or transportation of the goods. Another strategy is

maintaining substitute source of procurement in different

countries for the important raw materials, sub parts etc so that

if the materials from a country becomes expensive due to

fluctuations, the company can purchase from the alternate

supplier. Diversification is also possible in the case of capital

markets. A company can reach out to multiple capital markets

to raise fund so that it will have options to raise the funds in

the cheapest way possible.

Currency Risk Mitigation Strategies: A simple strategy is to

match the cash inflow and outflow in the same currency, i.e.,

if a company receives a currency as its cash inflow, then it

should borrow in the same currency to raise funds. Thus even

if the exchange rate fluctuates the excessive inflow will

nullify the extra money to be paid while repaying the

loans. The two parties engaged in foreign exchange can also

make use of risk sharing technique to hedge against economic

exposure. Another strategy is to deal in currency swaps.

d) Political Exposure:

The currency rates of different countries are highly

affected by the political scenarios in the countries. A

politically unstable country where strikes, protests and revolts

against the governments or the businesses occur regularly will

have a weak economy. This in turn will affect the currency of

that country negatively. An unstable economy is not the only

factor that affects the currency exchange rate. The policies

set by the one government regarding imports and exports



may be changed by another government or it can be modified

by the same government while liberalizing the economy or due

to a change in its relationship with the trading country. If a

country faces economic crisis their government or central bank

may bring in restrictions on the conversion of their local

currency or may prevent their currency from being purchased

by other foreign countries. This can also lead to fluctuations in

their exchange rate

Managing Political Exposure:

One of the main strategies to protect against the political

risks is diversification. Investing in multiple markets will

reduce the risk of being dependent on a single currency.

HEDGING AGAINST FOREIGN EXCHANGE

EXPOSURE:

Hedging can be defined as technique of investing in

something with the purpose of minimizing the risk. Hedging

has both advantages and disadvantages. Even though it reduces

the risk, it reduces the returns also.

Advantages of Hedging:

1. It protects the trader against exchange rate fluctuations,

inflation, change in interest rate etc.

2. It can be used to lock in the gains of the assets.

3. The trader need not monitor the market changes

continuously or be bothered about the market volatility.

4. It provides an opportunity to trade in complex options

trading strategies which will help in maximizing his

profits.

Disadvantages of Hedging:

1. The cost of hedging will reduce the profits.

2. The more risk an investment has to face, the more



returns it will give. Reducing risk means reducing

returns.

3. Hedging is difficult for short term investments like day

traders.

4. If an investor wants to invest in options and futures

require more capital or balance.

5. Hedging requires experience, skill and good strategies to

be successful.

Techniques of Hedging:

Internal techniques to manage/reduce forex exposure:

1. Invoice in home currency:

Also known as Risk Shifting Strategy

An easy way is to insist that all the transaction by foreign

customers pay in your home currency and that your

company pays for all imports in your home currency.

However with this strategy the exchange-rate risk has not

been removed but it has just been passed onto the

customer. Your customer may not be too happy with

your strategy and simply look for an alternative supplier.

This strategy is achievable if you are in a monopoly

position, however in a competitive environment this is an

unrealistic approach.

2. Leading and lagging:

If an importer expects that the currency in which the

payment has to be made is will depreciate, then he may

attempt to delay the payment untill the currency appreciates.

This strategy is known as lagging. This may be achieved by

agreement or by exceeding credit terms.

If an exporter (receipt) expects that the currency it is due

to receive will depreciate over the next three months it



may try to obtain payment immediately. This may be

achieved by offering a discount for immediate payment.

The importer will also try to conduct the payment if the

currency in which the payment is to be made is

appreciating. This strategy is called leading.

The problem with these strategies is that it lies in

guessing which way the exchange rate will move.

3. Matching

When a company has receipts and payments in the same

foreign currency due at the same time, it can simply

match them against each other.

It is then only necessary to deal on the forex markets

for the unmatched portion of the total transactions.

An extension of the matching idea is setting up a foreign

currency bank account.

Bilateral and multilateral netting and matching tools are

discussed in more detail later in the chapter.

4. Decide to do nothing.

The company would choose to win some, lose some.

Theory suggests that, in the long run, gains and losses

net off to leave a similar result to that if hedged.

In the short run, however, losses may be significant.

One additional advantage of this policy is the savings in

transaction costs.

5. Netting:

Netting cancels the value of multiple positions or

payments due to be exchanged between two or more

parties.

Exposure netting is achieved within a firm where it can



find offsetting position in two or more currencies or other

risk factors within various segments of the firm.

Netting reduces a firm's cost and eases risk

management as offsetting positions do not need to

individually hedge for risk exposures.

Hedging through Derivatives:

1. The forward contract:

The forward market is where you can buy and sell a

currency, at a fixed future date for a predetermined rate,

i.e. the forward rate of exchange.

Forward cover is the most frequently used method of

hedging.

It is simple and easy to understand.

Its main disadvantage is that there is a chance of

defaulting of the payments or the payments can be

delayed.

2. Money market hedges

The main advantage of this technique is that it is a

binding contract for delivery.

The basic idea is to avoid the uncertainty of the

future exchange rate by making the exchange at today‘s

spot rate instead.

This is achieved by depositing/borrowing the foreign

currency until the actual commercial transaction cash

flows occur:

3. Futures contracts:

Futures contracts are standard sized, traded hedging

instruments. The aim of a currency futures contract is to fix an

exchange rate at some future date.



4. Currency options:

A currency option is a right, but not an obligation, to buy

or sell a currency at an exchange price on a future date.

If there is a favorable movement in rates the company

will allow the option to lapse, to take advantage of the

favorable movement. The right way will only be

exercised to protect against an adverse movement, i.e. the

worst-case scenario.

A call option gives the holder the right to buy the

underlying currency.

A put option gives the holder the right to sell the

underlying currency.

Options are more expensive than the forward contracts

and futures.

5. Forex swaps:

In a Forex swap, the parties agree to swap equivalent

amounts of currency for a period and then re-swap them at the

end of the period at an agreed swap rate. The swap rate and

amount of currency is agreed between the parties in advance.

Thus it is called a fixed rate/fixed rate swap. The main

objectives of a Forex swap are:

To hedge against Forex risk, possibly for a longer

period than is possible on the forward market.

Access to capital markets, in which it may be impossible

to borrow directly. Forex swaps are especially useful

when dealing with countries that have exchange

controls and/or volatile exchange rates.

6. Currency swaps:

A currency swap allows the two counterparties to swap

interest rate commitments on borrowings in different

currencies. In effect a currency swap has two elements:



An exchange of principal in different currencies, which

are swapped back at the original spot rate ―just like a

Forex swap.

An exchange of interest rates at ―the timing of these

depends on the individual contract.

The swap of interest rates could be fixed for fixed or

fixed for variable.

Hedging through selection of supplier country:

Firms face the risk of foreign exchange fluctuations

while purchasing materials, machines or other resources from

foreign suppliers. Hence choosing an appropriate supplier is

important. It is always better to have to multiple suppliers in

different countries so that in case the prices of the goods or

the exchange rate of currency fluctuates in one country, the

company can reduce the loss due to fluctuations. They can at

least maintain a back up supplier in case of a contingency. A

careful supplier evaluation has to be performed before

finalizing the trade. It is advisable to choose a supplier who

accepts the payment in the home currency of the customer.

This can reduce the foreign exchange fluctuation risk up to a

point. The balance of power in the customer supplier

relationship is an important factor of negotiation. Many

suppliers want to retain their loyal customers will be ready to

negotiate terms which are favorable to both of them.

Developing countries which require the payments from their

export are good options to purchase goods from. But such the

economic conditions in such countries are also volatile. The

customer company can communicate to the supplier on how

the foreign exchange fluctuation affects its cost structure. Thus

the supplier will be able to adjust their prices and still remain

price- competitive.



COUNTRY RISK ANALYSIS:

The risk that a country has to face while engaging in

trade with foreign countries is known as country risk. It

involves the study of the political, social, cultural, legal,

geographical, institutional and environmental conditions of a

country. The analysis of the ability of a country to transfer

payments is known as country risk analysis or country risk

assessment. The country risks are classified based on the source

of risk. While evaluating a country one has to consider the

different types of country risk which they have to face .

The internal and external political stability of the country.

Location risk or Neighborhood risk , which is not the

fault of the country but the influence of the neighboring

countries or the location of the country.

The social and cultural environment of a country

The economic conditions of the country

The willingness and capability of the country to transfer

their home currency for a foreign currency

The main factors that are considered as country risk are

1. Political Risk: This is concerned with the party in

power, Ideologies of the major political parties and influence

groups, the system of government such as democracy,

monarchy, military rule etc

2. Economic Risk: This is concerned with the GDP

parameters, like the per capita GDP, investment to GDP ratio,

monetary policy, fiscal deficits or revenue, taxation policies,

rate of inflation, Balance of payment, Capital inflow and

outflow etc.

3. Social Risk: This is concerned with the history, culture,

level of education, values and morals, attitude of the citizens

towards changes, foreigners etc.



UNIT IV

INTERNATIONAL CAPITAL BUDGETING

INTRODUCTION:

Capital budgeting can be defined as the process of

analyzing and evaluating the projects or investments an

organization is about to make or has already made and helps in

selecting the most appropriate opportunity to invest. Any

venture that is proposed to the organization has to be approved

after the capital budgeting. The investors make use of it to

determine the value of the investment which they have

proposed to make.

It is equally important for international and domestic

businesses. As it ensures that the investment is economically

feasible and will bring in an income which is not less than the

total investment. Capital budgeting is also called as project

evaluation or investment appraisal. Budgeting for international

business is a more complicated process as it involves

additional parameters to be considered like the economic and

political conditions of the foreign countries, the currency

exchange rates, the global trade scenario, the technological

developments of foreign countries etc. It involves a greater risk

than domestic capital budgeting.

Capital Budgeting is a step by step process as given below.

a. Identification of opportunities and alternatives.

b. Data collection

c. Strategic and economic analysis of the opportunity

d. Analysis of the alternative opportunities

e. Decision making and implantation of the investment or

its alternative opportunity



Techniques of evaluation of a project through

International Capital Budgeting:

Capital budgeting techniques can be classified into two

categories

1. The traditional method:

This method does not consider the time value of money.

The two main methods in this category are the Payback Period

Method and the Average Rate Returns (ARR) method.

2. The Discounted cash flow method:

This method considers the time value of money. The

main methods in this category are the Net Present Value

(NPV) method, the Internal Rate of Returns (IRR) method.

Profitability Index Method, Discounted Payback period,

Equivalent annualized Cost/benefit method, Modified Internal

Rate of Return method etc.

a) The Payback Period Method:

This method computes the duration of time required to

regain the initial investment. The project with a shorter

Payback period is preferred as the investment will be retrieved

is a short span of time. This method is used if the company has

only a few sources of funds. If the organization is able to

invest only a one project at time and they do not have

additional sources of cash inflow then a shorter payback period

will earn them quicker cash inflows. The payback period

calculation also makes it easy for the company to forecast the

cash inflows. The negative effect of using this method is that it

does not consider the time value of money but this error can be

removed by using a discounting payback period. The

discounted payback period method allows determining the

period of recovery on a discounted cash flow basis. Another

disadvantage is that it does not calculate the profitability of the

project. The life time of the asset is not considered in this



method. If it is a perishable asset or which has a short life span

then there may not be enough time to recover the investment

made on it.

b) The Average Rate of Return Method:

According to this method the project proposals are

evaluated on the basis of their comparative profitability. It can

be defined as the ration between the average annual earnings

after tax with the average investment multiplied by 100. Where

the average investment is the value of the original investment

after removing the scarp value and divided by 2. The project

which has an ARR above the expected level may be accepted.

In case of multiple options, the project with the highest ARR

will be chose over the others.

This method is simple and easy to understand. The

positive side of using this method is that it considers the cash

flow for through the lifetime of the project. It also considers

the net earnings after the taxes and depreciation which gives a

clear value of the profit. The negative side of using this

method is that it ignores the time value of money just like the

payback period.

c) Net Present Value Method:

This is the most accurate method to budget a project. In

this method the present value of a payment which is to be

received in the future is determined. A rupee we possess today

may have more value than a rupee that we receive tomorrow.

Calculating the discounted cash flows after tax will help to

determine whether the project is profitable or no while

comparing it with the other alternative investment

opportunities. . In this method all the projects with the positive



NPV value are accepted and those with a negative NPV value

are rejected. If the organization has a limited source of funds

the project with the higher discounted value can be accepted.

For example if there are two alternative projects which has Rs/-

200000 and Rs/- 300000 NPV values respectively. Both the

projects are accepted as per this method. In case the investment

available with the company is only Rs/-250000, then the

second project will be chose over the first one.

The biggest advantage of the NPV method is that it

measures the profitability of the business. It also provides a

comparison of the different options to choose from. A

calculation of profitability index will further improve the

estimation. The profitability index can be computed by

dividing the present value of an estimated cash flow with the

initial investment.

d) Profitability Index Method:

Profitability Index is the ratio between the present value

of the returns and earnings of a project to the amount of

investment. It can be computed by dividing the discounted

cash inflow with the discounted cash outflow. This method is

also known as the Benefit Cost Ratio method. If the

Profitability Index of the project is less than zero then it is

rejected and if it is equal to zero. The project with the highest

PI is chosen among the multiple alternatives.

The main advantages of using this method are that it

considers the time value of money. All the cash inflows and

outflows of the project are considered while computing the

index. This method also compares the profitability of the

project. This method cannot be used to calculate the

profitability or two of three projects added together.

e) The Discounted Payback period method:

The discounted payback period can be said as a



combination of NPV method and payback period method.

This method is practiced by finding out the payback period

using the estimated discounted cash inflows and outflows. The

cash inflow is added untill the value is equivalent to the initial

cash investment. If the discounted payback period is lesser

than the standard payback period, then the project will be

accepted. The project with the shortest discounted payback

period will be selected among the alternatives. The advantage

of using this method is that it considers both the time value of

money as well as profitability of the project. It is possible to

incorporate risk in capital budgeting by the adjustment of

discount rates. It is possible to compare different alternative

projects effectively by using this method as all the cash flows

are calculated in the present value. This method is fairly simple

and easy to comprehend.

This method has its drawbacks too. It is not easy to make

an accurate estimation of the cash flows. This affects the

accuracy of this method too. The method also does not

consider the cash flows after the payback period and the size of

the project.

f) Internal Rate of Return Method: IRR is the discount

rate that makes the NPV of the cash flows equal to zero in a

discounted cash flow analysis. The project with a higher IRR is

preferred. In this method if the IRR is greater than the cost of

capital then the project is accepted and if the IRR is lesser than

the cost of capital then project is rejected. The advantage of

using this method is that it helps in setting a benchmark for

every project that can be calculated by keeping the capital

structure of the company as a reference. The disadvantage of

using this method is that just like the payback period method;

this also does not provide the exact value that the project will

give to the firm. It also does not provide a comparison of the

alternative projects. hence this method can mislead the

investor. This method also uses trial and error making it a



complicated and time consuming method.

IRR can be computed by calculating the difference

between the present value of the future cash flows and the

present value of the invested amount. Another method of

calculating IRR is through the given formula.

Where:

CFt is the net after-tax cash inflow outflows during a single

period.

r is the internal rate of return that could be earned in

alternative investments.

t is the time period during which the cash flow is received

n is the number of individual cash flows

g) Modified IRR: This method removes the limitations of

the Internal rate of Return method as it does not assume cash

reinvestment. The cash flows are reinvested at the cost of

capital of the firm. This method provides results which are

consistent in nature. It provides a single solution by removing

the multiple IRRS. Even this method can result in the selection

of projects that are the not the ones to generate the maximum

value. It is a complicated process which is difficult to

understand.

h) Equivalent Annual Cost/Benefit Method: This is used

to compare projects which have different lifetimes. It

calculates the cost of possessing and operating an asset per

year. In this method, once the life spans of the projects are

equalized the benefits and limitations of investing in each of

them are compared. It assumes that when one project reaches the end



of its life another project will be replaced. It is computed by dividing

the Net Present Value of the project with the present value of the

annuity factor. Projects with the lower Equivalent Annual Cost or

higher Equivalent Annual Benefits will be chosen over the other

alternatives. The advantage of using this method is that it considers

the time value of money. It also carries the advantage of providing a

comparison of projects with unequal life spans which is absent in

NPV method. The fluctuations in external factors such as inflation

are not considered which is a huge demerit of this method.

Problems associated with Capital Budgeting:

Capital Budgeting is a process of decision making

through the firm evaluates different opportunities and decides

to invest in the most appropriate one. Capital budgeting helps

the company to allocate their resources in the best opportunity.

One of the main issues to be considered while conducting

capital budgeting is the inflows and outflows of cash which

are used while evaluating the projects. Since it is giving just an

estimate of the cash flows of the project, it may give us

erroneous conclusions. The forecast of the cost and the

revenues to be generated may be over estimated or under

estimated. An overestimation of revenue and underestimation

of cost will result in the selection a projects which will

generate losses and the underestimation of the revenue and the

overestimation of the cost will result in the rejection of a

potentially profitable project.

A factor that influences the accuracy of the budgeting is

its time horizon. A longer the time horizon makes way for

more errors. The change in external factors like the political,

legal and environmental changes will be unforeseen while

budgeting. It is inevitable as bigger projects do take longer

periods to be established. Another error that can happen while

conducting the capital budgeting is ignoring the time value of

money. The same amount of money at a different point of time

may have a different value due to the inflation in the economy.



Hence the project may actually incur losses. If the project is

selected based on the payback period, this error is common.

Another issue faced during the budgeting is to calculate the

discount rate. A wrong discount rate will result in defective

assumption based on which the project will be selected.

Risk analysis in Capital Budgeting:

Risk can be defined as the chance of resulting in an

undesirable outcome. Capital budgeting is concerned with

future cash flows. Any investments with a focus to gain returns

in future hold unforeseen risks. Hence we can say that risk and

uncertainty are inevitable parts of capital budget. Risks arise

from various sources. It can be financial risk which are caused

by fluctuation in exchange rate, defaulting of payments,

underestimation or overestimation of revenue generation or

cost of investment etc. It can be in the operational level like

poor storage and maintenance of raw material or finished

goods, loss of goods or materials, damages to machineries or

equipments, purchase of low quality materials, external factors

like natural calamities etc. It can also arise due to market

conditions like an introduction of a new product or technology

which is advanced than the existing ones in the market,

competitors marketing strategies, sudden change in fuel prices,

unavailability of certain key raw materials etc. Political

conditions like strike, change in government policies, etc can

also result in a risk to the investor. It can also be There are

different methods to analyze the risk involved in a project

while doing capital budgeting which are given below.

1. Sensitivity Analysis: This method studies the change in

the NPV or IRR of project for a given change in one of the

variables. The first step in this method is the identification of

the various variables that can influence the NPV or IRR of the

project. Once the different variables are identified one has to

define the quantitative relationship between these variables.



The last step is to study the impact of the change in each

variable on the NPV of the project. If the sensitivity of the

project is more, then the variable that caused it is more critical.

2. Scenario Analysis: In this method the viability of the

project is determined in terms of the change in the multiple

underlying variables simultaneously. Probabilities are

allocated to each variable on the basis of the risk innate in it.

The first step in this method is to prepare a base case scenario.

It is calculated by taking the NPV of the project on the basis of

the variables that are considered most accurate. The base case

is the expected scenario where all the conditions are normal.

As the second step the best case scenarios and the worst case

scenarios are formed from there. For example if the investor is

considering transportation cost then the best case scenario will

be when the fuel prices come down by 5 % and the worst case

scenario will be when the fuel prices are hiked by 10%. This

method is preferred more than sensitivity analysis as it

considers the changes in multiple variables at the same time.

However in reality the scenarios will never be limited to these

three ones. They lie in between these extreme scenarios.

3. Break-Even Analysis: Breakeven point can be called as

the minimum amount at which a product should be produced or

sold to avoid loss of money. The organizations decide the

pricing of their products in such a way that they do not incur

losses. The breakeven point can also be computed on the basis

of the NPV of the project. When the NPV attains the value

which is equal to zero, the cash flows become equal to the

initial investment of the project. It can also be calculated on

the basis of sales. The Break-Even point is the level of sales

when the firm incurring neither profit nor losses. In this case

the main issue of concern is the recovery of the initial

investment.

4. Hillier Model: This method was introduced by Mr. F.S.



Hillier. It uses standard deviation to estimate the risk of the

project. In this model two types of cases are analyzed. The first

one is when there is no correlation between the cash flows and

the second one is when there is a perfect correlation between

the cash flows. if the cash flows of different years are in

perfect correlation then It means that the amount will be

almost the same and if they are not in correlation it means that

the cash flows is one year is independent of the cash flows in

another year. The formulae to find standard the deviation are

given below.

5. Simulation Analysis: In this method unlimited number

of experiments are performed where all possible outcomes are

analyzed. This is an imitation of real life situation in an

experimental set up. Once a project is designed, it will show

the NPV value which are related to the variables. The

parameters are those variables that are determined by the

decision maker that are kept constant throughout the

simulation and the exogenous variables are those that beyond

the control of the decision maker. The first step in this method

is to recognize the variables that create an impact on the cash

flows. The values related to the parameters have to be chosen

and the probabilities for the random variables arising from the

exogenous variables have to be assigned. Calculate the NPV

values for both the parameters and the exogenous variables.

The probability computation and the NPV calculations have to

be repeated multiple times so that a large number of simulated



values are determined. The simulation analysis allows the

determiner to consider all possibilities and uncertainties.

6. Decision Tree Analysis: The decision tree is a diagram

or schematic representation that allows a decision maker to

make decisions or show the statistical probability. For example

a manufacturing company is deciding whether to invest in a

good Research and Development department or not. The two

options and its possible consequences are represented in a

graphical decision tree given below.

The first step to make a decision through the decision tree

analysis is to calculate the present values of the future cash

flows for each chance. As the second step evaluate each of the

alternatives at their final decision points. Select the branch

with the highest NPV and stop the branch with the lower ones.

Repeat the process untill a final decision point is reached. This

method also allows the decision maker to consider all possible

outcomes before choosing a decision.



Factors affecting risk evaluation:

Capital budgeting and risk analysis of projects are vital to

the company before making a decision on investments as the

sources of funds are always limited. The company must ensure

that they gain maximum returns from their investment. Once

the investment is made, it is difficult and costly to reverse the

transaction. A good budgeting involves a thorough analysis of

the risk and benefits of investing a project. A well calculated

risk analysis will protect the investors from the risks that they

are bound to face. However, Capital budgeting is a set of

calculated assumptions. Hence the chances of errors are high.

A number of factors affect the calculation of risk while

budgeting.

1. Volatility of the value of cash: one of the most

important risk that is studied in capital budgeting is volatility

of cash flows. The present value of future cash flows are

determined to understand whether the project is profitable or

not. The very nature of the cash flow being volatile cannot be

calculated accurately. The cash flow value may grow higher or

lower than the predicted value based on several factors after

beginning the project. The risk of devaluation of money may

be higher in case of an unexpected rise of revolution or mutiny

or natural calamities.

2. Change in trends and customer expectations and

introduction of a new technology. The longer the duration

the more will be the risk of the change in customer‘s demand.

The duration of a trend or style cannot be computed accurately.

It may change abruptly with the introduction of a new trend or

technology. This cannot be foreseen while calculating risk in

capital budgeting.

3. Changes in the political and legal environment: A

change in the government or its policies cannot be foreseen

before a long time. An unexpected strike within the company,



industry or in an outside industry can affect the operations

badly. For example a sudden increase in the fuel prices may

lead to a nationwide strike from bus and lorry transportations.

This will lead to the finished goods lying as idle inventory.

The company will have to face losses if the goods are

perishable or damageable.

4. The loss of a leader or a key employee: Risk

calculation in capital budgeting is only based on the monetary

terms. It does not consider other factors like the image of the

owner or a heading executive or the sister concern under the

same brand. The goodwill or efficiency of an individual will be

transferred to his organization too. The death of such a leader

or an important employee, or his resignation from the position

will reduce the trust of the public in the organization. The

uncertainty of lack of leadership or the new leader may be

considered as a risk by the public or government or other

stakeholders. In the same way an issue in a sister concern of

the brand will affect the other investments also.

LONG TERM ASSET AND LIABILITY MANAGEMENT:

Asset /Liability Management are a financial practice to

reduce or mitigate the risks arising due to the mismatch

between the assets and liabilities of an organization. An

organization faces a mismatch between the assets and liabilities

due to the changes in the interest rates or liquidity. The process

includes matching the assets against the liabilities so that the

firm does not have the risk of defaulting a liability payment on

time. The timing of the cash inflows from the assets are

managed so that it is available to pay back the debt when it is

due. The focus of Asset/Liability management is on the long

term risks. It is usually practiced by financial institutions. For

example consider a bank which pays 3% interest rate for the

fixed deposit accounts. The bank charges 4% interest on gold

loans from its customers. Hence the cash inflow generated



from the loans paid the bank is higher than the cash outflow to

be paid for the FDs. The bank generates a profit margin of 1%

from the interests after paying its liabilities. Organizations use

ALM to take decisions while buying and selling securities,

deciding the source of their investment and while lending and

borrowing money.

Long term assets can be defined as the tangible and

intangible assets like the plant, machinery, land, copyrights,

stocks, goodwill, brand image, patents, etc that will provide

advantage or benefit the company for more than a year. These

assets are recorded in the balance sheets at the price at which it

was bought. Therefore it does not reflect the current price of

these assets. Hence it is also known as Non-current assets.

These assets are not liquefiable easily. Long term liabilities

can be defined as those monetary obligations which include

debentures, loans taken to purchase land, machinery or raw

materials, bonds, payments for purchase under credit for more

than a year etc.

FOREIGN DIRECT INVESTMENT AND FOREIGN

PORTFOLIO MANAGEMENT: FDI:

An investment made by an organization in a business in a

foreign country is known as Foreign Direct investment.

Through FDIs the investor acquires assets in the foreign

company. FDIs occur in the form of mergers, joint ventures

and acquisitions or by establishing a fully owned subsidiary

company.

The investments can be done in three types.

1. Horizontally: When the investor purchases a similar

business or if he copies his production activities in his home

country in the foreign business it is defined as Horizontal

FDIs. For example Toyota motors, a vehicle manufacturing

company in Japan began production activities in Europe and



North America too.

2. Vertically: The investor can also invest in related but

different business in a foreign country when it acquires parts of

its supply chain. It is then called a vertical FDI. When Toyota

acquires a tire manufacturing company in a foreign country it

will be a vertical investment. Organizations engage in forward

and backward vertical investments.

3. Conglomerate: An investor can also invest in a

completely unrelated business forming a conglomerate.

Reasons for Direct Investments in Foreign Business:

Companies choose the option of engaging in Foreign

Direct Investment for various reasons. Some of them are

given below.

1. Organizations may invest in a country which is

abundant in natural resources which are scare in their

home country like oil, minerals cheap labor etc.

2. Companys wishing to expand their market or those who

fear a loss of their local market for their products may

invest in foreign markets.

3. Certain companies may purchase their raw material or

sub parts supplier in a foreign country or invest in a

similar business in a country where their suppliers or

assemblers are located. The reason is to improve the

efficiency of the operations, cost management and

quality enhancement.

4. Organizations will also invest in foreign in countries

whose economic conditions are stable or whose

government policies are business friendly.

Advantages and Disadvantages of FDI:

Advantages for the host country:

1. FDI is a source of capital for the host country.



2. The natural resources which are abundant can be utilized

properly in return for monetary or other developmental

benefits.

3. It provides employment to the citizens

4. It promotes the economic growth, implementation of

better technologies and facilities and improves the

competitive position of the country.

5. It helps to reduce inflation by increasing the

availability of essential goods through imports.

Disadvantages in the host country:

1. It increases the countries dependence on foreign

countries and capital.

2. The domestic industries especially the small and medium

scale industries may not be able compete with the

international giants.

3. The country may face an imbalanced growth.

4. It brings with it a risk of uncertainty. The economic,

natural and political conditions in the home country will

affect the host country to. The foreign exchange rate

fluctuations are an additional risk.

5. The host country may get exploited and the best

resources may not available to domestic industries.

Advantages in Home country:

1. The industries in the home country will be able to access

bigger markets and unavailable resources.

2. It leads to an inflow of foreign exchange in the form of

profit, interest of loans, payment for exports etc.

3. It leads to knowledge transfer to both the home and the

host countries.



Disadvantages in Home country:

1. Focusing on the subsidiaries may dilute the

management‘s concentration on the home country

operations which affects its quality.

2. The capital tied up in foreign investments may not

be easily accessed by the home country. It creates a

shortage of cash during an emergency.

3. If the company has set up the subsidiary to access

cheaper labor or if it shifts its operations to another

country, it will affect the employment in the home

countries.

FPI:

Foreign Portfolio investments can be defined as the

trading in securities such as foreign shares, bonds, debentures,

mutual funds, and other financial assets. It is different from

FDI in terms of the management and control given to the

investor. FDI provides direct control over the foreign assets to

the investor where as FPI is only a passive holding of the

securities. The holder does not have any management powers

or control over the stocks or assets. FPIs can be divided into

three categories.

1. Category I includes Investors from the government or

public sector like the Central bank, agents of the

governments, multinational organizations etc.

2. Category II includes Insurance companies, regulated

banks, asset management or portfolio management

companies, investment advisors etc.

3. Category III includes charitable societies, foundations,

corporates, individuals etc.

Reasons for Investing in FPI:

1. FPIs are comparatively more liquid than FDIs as



property; buildings, machineries etc are not involved in it.

2. FPIs provide quicker returns to the investor as most of

the investment options are for shorter terms.

3. If the investment is made in countries which provide

good dividends and the stock value, it is a good

alternative source of investment.

Advantages and Disadvantages of FPI:

Advantages:

1. It provides the investor an opportunity to diversify their

portfolio internationally.

2. The investors can access different markets which offer

different returns or has different levels of risk. Hence the

investor can adjust even if one or two of his investments

are creating loss.

3. As the FPIs are quite liquid, the investor can be assured

that he can generate cash in times of contingency quickly.

4. The investors can broaden their credit base and gain

access to credit in foreign countries.

Disadvantages:

1. FPIs are highly volatile. Hence it leads to increased risk.

2. The investor does not have any direct control or decision

making power over the companies in which he has

invested.

3. It is also affected by political risk such as change in

economic policies, taxation rules, etc.



MODULE V

SHORT TERM ASSET AND LIABILITY

MANAGEMENT

WORKING CAPITAL MANAGEMENT:

Working Capital can be defined as the liquid money or

cash equivalent, i.e. Current assets which are required for day

to day operations of a company. It is used to complete

activities like purchase of raw materials, payment of wages,

payment of bills, money invested in the inventory of raw

materials, semi finished and final end products etc. Working

Capital can be categorized into Permanent and Temporary

working capital. Permanent working capital is the amount

required to maintain a minimum level of current assets which

is required to run the operations. Temporary working capital is

those which are required to conduct fulfill periodical

requirements or seasonal demands and emergencies.

Another classification of working capital on the basis of

its is value is the Gross and Net working Capital. The Gross

working capital is the total money invested in the current

assets of the firm. Net working capital is the money invested in

the current assets after the paying off the current liabilities. If

the current assets are higher than the current liabilities it is

known as positive working capital and if the value of current

liabilities are higher than current assets then it is known as

negative working capital. Maintaining a negative working

capital will result in adverse effects for the business as it shows

the lack of liquidity.



Working capital can be raised through internal and

external sources. The internal source are the reserved capital or

accumulated earnings of the business owner, the surplus funds

after initial establishment of the business, depreciation funds

etc. The main external sources to gain working capital are

loans from individuals, banks and other financial institutions;

debentures, credits and advance payment from customers, The

requirement of working capital for a company is based on its

operating cycle. The operating cycle is the number of days

required by the business to complete the entire stage of

receiving the raw materials, converting it into finished good,

sale of the final product and collecting the payment of the sold

goods. The operating cycle goes through five stages namely.

Stage 1: The purchase of raw material and storage Stage 2:

Work in progress

Stage 3: Finished Goods

Stage 4: Collection of Payment from The debtors Stage 5:

Payment to the creditors

At each stage there is a holding period of money or

assets. The holding periods of all the stages added together is

called as the Operating Cycle period or Working Capital

FINISHED GOODS



Cycle. The last two stages are considered only if the business

has acquired funds from outside and assets on credit basis.

Components of Working Capital:

Approaches to working capital management:

An organization can follow different approaches to the

working capital management.

1. Conservative or Restrictive Approach: the policy of

maintaining a high level of working capital thereby

minimizing the risk of cash shortage and contingency

issues is termed as conservative approach. This is best

suited for products that have a fluctuating or seasonal

demand. For example organizations in tourism and

construction sector have to maintain large amounts of

working capital.

2. Moderate Approach: The policy of maintaining a

working capital that is equal to the volume of sales. A

moderate level can be maintained if the business has

fixed sales throughout the year.

3. Aggressive Approach: The policy of maintaining a low

level of working Capital and extract the maximum out of

the current assets. The risk is maximum in this approach.

Factors Affecting Working Capital:

1. Nature and Size of the Business: If the company is into

production of goods which reaches the customers quickly then

the requirement for working capital is not much. For example a



railway construction project may take months or years to

complete and the time taken to generate the revenue by

operating it will also take months. Hence they have to maintain

large amount cash for payment of expenses till they generate

the revenue. The size of the company also plays a major role

in the amount of working capital required. The bigger the

organization, the bigger the production or service the larger will

be the need for the working capital.

2. Stage of the Business Life Cycle and the extent of

growth of the business: A business flows through different

stages from product development, launching, growth, shake

out, maturity and decline. The working capital required during

the launching and growth stage is high compared to the

maturity and decline stage as they have to invest in different

strategies and pay the overhead expense without any revenue

generation. The maturity period also has its expenses but the

business would have generated enough revenue to pay off the

expenses. The business which is expanding at a fast pace will

require more capital than the business which is expanding at a

slower rate.

3. The basis of Production: If the production is based only

on the customer order lesser amount of working capital will

be required as compared to the production done on the basis

of the sales forecast. The volume of production will be

accurate in the first case hence the use of additional cash on

the unsold goods will be almost nothing. Most of the

organizations follow the sales forecast which results in bulk

production.

4. Credit Policy: If a company follows a liberal credit

policy allowing its debtors enough time to pay they will have

to maintain a larger working Capital. A business like retail

shop does not sell its products on credit terms to their

customer. Hence their requirement of working capital would be

comparatively lesser.



INTERNATIONAL CASH MANAGEMENT:

Cash management refers to procuring and managing the

cash inflows and outflow. It involves the management of short

term assets and short term liabilities. This is a crucial aspect of

running a business whether it is domestic or international. It is

vital for every individual and organization to manage their

money effectively to be stable and grow. An inefficient cash

management leads to financial crunch, failure of business,

inability to tackle emergencies and lead to bankruptcy. Cash

management is responsible for provide adequate amount of

funds for the business maintain the liquidity of the firm and to

protect from insolvency. An important aspect while managing

cash is to speed up the cash inflow to the business and slow

down the cash out flow untill the last possible moment.

Activities in Cash management:

1. Obtain funds for operations

2. Payment of bills, loans, taxes and other liabilities

3. Collect payments from sundry debtors, customers and

other sources

4. Control of foreign currency inflow and outflows.

5. Maintenance of relationships with banks and other

financial institutions

6. Reporting to the management and support to all other

departments etc.

We can look at cash management from two different

points of view. The first one being intra- country involves

money management, financial institutions, lending and

borrowing etc within a country. The second one is inter-

country approach which involves monetary transactions among

different countries. The Inter country approach is the global

perspective of cash management.



Need for International Cash Management:

Cash management involving international cash inflow

and outflow is termed as International Cash Management. At

the international level cash management is more complicated

and involves more risk than the domestic cash management

due to the presence foreign. Organization expand their

business across border for multiple purpose like market

expansion, earning better returns, access to resources, export

import friendly government policies, stable economic and

political conditions etc. Hence foreign exchange and

international monetary transactions are unavoidable. With the

growth of the global culture and international business the

importance of international cash management also grows. The

reasons which increased the importance of international cash

management are

1. International cash management broadens the availability

of the cash at a predetermined level of Operating cost and

risk of foreign exchange fluctuation so that the excess

money can be utilized efficiently.

2. Fluctuations in the rate of inflation have resulted in the

volatility of interest rate.

3. It minimizes the opportunity cost of the unutilized cash

held with the business.

4. It reduces the risk of foreign exchange fluctuations

5. It ensures higher rate of returns on the foreign

investments

Objectives of International cash Management:

1. Enhance the liquidity of the business: Adequate money in

hand is required for a lot of purposes. The business

should be able to grab a suitable opportunity whenever it

appears. The company should be able to handle



different types of emergencies like a sudden fall of raw

material availability, exchange rate fluctuations, change

in relation with partnering countries, political conditions

in countries where the investment are made, change in

trend, damage of assets due to natural calamities or

revolts etc. The liquidity gained through efficient cash

management aids an organization to survive all the

situations.

2. To control the money inflow and outflow: Timely

payments of liabilities and timely collection of payments

from debtors is vital for running the business. Cash

management aims to speed up the collections of

payment so that they do not face the burden of liabilities

or risk of defaulting their payments to the creditors or

taxes to the authority or interest and loans to the banks

and financial institutions.

3. To maximize the worth of the funds: It is an important

objective of cash management to maximize the rate of

returns of returns of the funds invested in the business.

Excess cash can be invested in an opportunity where it

provides maximum returns.

4. To minimize the cost of funds: An efficient cash

management focuses to obtain loans and investments at

the minimum interest rate by borrowing from different

money markets around the globe.

Centralized and Decentralized Cash Management:

Centralized cash management:

A system where the parent company controls the cash

management for itself as well as for its subsidiary companies is

known as centralized cash management system. It is an

organized system which helps in maximizing the returns of the

cash flows to the company. It is mostly used by Multinational



companies. A centralized system monitors the total cash flows

of all the subsidiary companies. Hence the subsidiary

companies will not able to spend inappropriate amounts for

themselves as per their judgment. It also helps the parent

company to understand where the shortage of cash rises and

manage the flow of funds to help them. For example if a parent

company X owns two subsidiary companies A and B in

different countries. ‗A‘ has $10000 excess which is lying idle

as surplus amount after forecasting the fund requirement for

the next year. ‗B‘ has a shortage of $ 8000 as per the

forecasting done for the next year. ‗X can transfer the required

amount from ‗A‘ to ‗B‘ so that ‗B‘ will not have to take a loan

to run the operations.

Advantages of centralized management system: There are 3

important advantages to a centralized cash management

system. They are.

1. Netting:

It is a technique which is used to optimize the cash flows

by minimizing the transaction cost and administrative expenses

which arises from currency conversion. It combines the flow

of cash between the subsidiary companies to arrive at a net

flow. For example The subsidiary companies A in India and B

in China and the parent company X in USA purchases its raw

materials from the same supplier in England. A has to covert

Indian rupees to pounds to conduct the payment. Similarly B

has to convert Yuan and dollars to pounds. Instead of

generating three invoices of the three different companies, the

parent company can instruct the supplier to generate a single

invoice to X. Hence all the net payment can be done by

converting dollars to pounds. This reduces the number of

transactions where the company can save money on

transaction and conversion costs. The cash flow forecasting is

made easier if all the payments are performed in a single



transaction at the end of the period which in turn improves the

decision making on investments. Leading and lagging are two

techniques followed by a company which enables a company

to practice netting. This involves payments which are done

earlier than the actual time and delaying the payment till the

last moment respectively.

2. Currency Diversification:

It is a strategy of using multiple currencies for financial

transactions to reduce the foreign exchange risk. The

exchange rates of currencies does not always move in a

balanced way. Hence the risk of foreign exchange fluctuations

can be reduced by diversifying into multiple currencies. The

net cash flows of each company are calculated in the

currencies of the subsidiary companies and a portfolio of

these cash flows can be made. The sum of the variance values

of a portfolio of different currencies is lesser when compared

to the variance value of individual currencies.

3. Pooling:

It is the technique of collecting all the cash at a central

location. It is possible only if a centralized cash management is

being followed by the company. Pooling helps in converting

idle cash into working capital. Delay in obtaining funds and

uncertainties can be minimized as pooling enhances the

liquidity of the company. It uses the cash surplus to balance

the borrowing requirements. This method allows the

company to maintain small amounts of cash in each

country as a precautionary method. It is necessary to receive

all the data which are concerned with the receipts,

disbursements and balances at the right time to practice polling

effectively.

Advantages of pooling:

Cash management is simplified



Decrease in costs occurred as bank fees and other

financial transactions

Control over the treasuries of the subsidiary companies.

Decentralized Cash Management System:

Decentralized Management allows the subsidiary

companies to hold their cash in their location. It is highly

complicated to maintain all the cash one centralized location

for various reasons. The local operations will be affected if

there is any delay in the transfer of the money from the

headquarters. The subsidiary companies have to make local

payments like taxes of the country, spot payments for purchase

of materials especially during emergencies, or a small supplier

who is unable to deal n international payments etc. hence

adequate balance in money in the subsidiary location is

necessary.

There are many advantages of having a decentralized

cash management. It improves the liquidity position of the

company by facilitating quick and unexpected payments.

However efficient a central cash management system may be,

it takes time for the cash to be transferred from one country to

another. The transfer may be delayed due to technological,

political or environmental reasons. Hence it is best to maintain

the cash inflow in the subsidiary location to offset the cash

outflow. It also removes transaction cost of transferring the

money from one country to another as well as the conversion

cost of exchanging the currency of the parent company to the

currency of the subsidiary company when local payments have

to be made.

Transfer Pricing in Cash Management:

Transfer price can be referred to the rate at which the

goods or services are traded between the subsidiaries of the

same company. It is a technique used to transfer cash from one



location to another. If a company wishes to take away an

amount of money from a country it can charge high prices for

the materials to be purchased from its subsidiary. The

technique can be used in the reverse manner if the company

wants to maintain cash in a particular location by charging

low prices for the materials. Usually a company places funds

in those countries which provide higher rate of returns.

Blocked funds:

The government can restrict the transfer of the currencies

completely or partially due to foreign exchange crisis. Such a

condition is called as Blocked Funds. In such a situation the

company transfers the blocked funds through transfer pricing.

They also use techniques like leading and lagging of payments

and unbundling of funds transfer. Unbundling of funds is a

technique where there is a transfer of cash from the subsidiary

companies to the parent company as remittances like the

dividend remittance, royalty payments, fees for consultation

etc.

INVENTORY MANAGEMENT:

Inventory is the complete list of products available for

sale by a firm and the material used for producing these

goods. It can be defined as the stock of the products utilized by

the organization for production or service which includes raw

materials, semi finished goods and final products. It is one of

the most important current assets of a business. Managing the

optimum level of inventory is crucial because it highly

influences the working capital required by the firm. More

working capital is required if higher levels of inventory are to

be maintained.

Inventory management refers to the purchasing, storing,

monitoring, controlling and using of the inventory held by a

firm. A company has to maintain the adequate level of

inventory by using various techniques. The different levels of



inventory which are fixed by a firm are

1. Minimum Stock level: it refers to the minimum quantity

of a particular item of material that must be kept in the stores

at all times. Factors like the nature of materials, rate of

consumption of the materials, the lead time of operations etc

are used to determine the minimum level of inventory.

2. Maximum Stock Level: It is the quantity of materials

beyond which a firm should not exceed its stocks. If the

quantity exceeds maximum level limit then it will be termed as

overstocking.

3. Average stock Level: it is the average level of stock

that is to be maintained by the company at a time.

4. Safety Stock Level or Danger Stock Level: Safety

stock is an additional quantity of a product held in the stock to

reduce the risk that the item will be out of stock. It acts as a

buffer stock in case sales are greater than planned and/or the

supplier is unable to deliver the additional units at the expected

time.

Benefits of maintaining Safety stocks:

⚫ It protects against sudden demand increase.

⚫ It saves lead time by protecting against unexpected delay

in supply of raw materials.

⚫ Helps during the time of sudden increase in price of raw



materials.

Techniques of Inventory Management:

An organization uses different methods for managing the

inventory based on the nature of the products or services it

offers.

1. Always Better Control Analysis:

This technique is popularly known as ABC analysis. It is

the method of controlling the inventory by categorizing them

into three groups based on the prices of the items and its

importance in manufacturing. The inventory is divided into

three categories A, B & C based on their annual consumption

value. It is also known as Selective Inventory Control Method

(SIM). The items in Category ‗A‘ are given the maximum

value and the items in Category B and C are given values in

the descending order. This method follows the Pareto Principle

also known as 80-20 rule. It assumes that the maximum

numbers of inventories (70%) fall in the lowest value

category, where as the items which carry the highest value are

only around 10% of the total inventory.

Features of ABC categories:

FEATURES CATEGORY A CATEGORY B CATEGORY C

Forecast Accurate

Forecast

Approximate

Forecast Rough Forecast

Management

involvement

in purchase

Senior Level Middle Level Junior Level

Level of

Inventory

Control

Strict Moderate Relaxed



2. Vital Essential and Desirable analysis:

This technique popularly known as VED analysis is

similar to ABC analysis. In this technique the classification is

based on the criticality of the inventories. This method is

widely used in many industries. For example the hospitals and

medical stores use it to categories the medicines as per their

use.

• Vital items – Items whose shortage may cause hinder &

stop the work in organization. Such items are to be

continuously monitored, and replenished to ensure that

they are stocked adequately.70% of the total value of

items fall under the Vital category.

• Essential items – The items that are important to the

organizations but if not available, the plant does not stop.

Even if the operations stop it can be repaired or the

situation can be brought back to its previous form. The

efficiency of operations is adversely affected due to

expediting expenses. They should be sufficiently stocked

to ensure regular flow of work. 20% of the total value of



the items fall under essential category

• Desirable items – The items whose non availability does

not stop the work are known as desirable items. They are

stocked in low quantities or not stocked because they can

be easily purchased from the market as & when needed.

They are the least important of the three. 10% of the total

value of items falls under the desirable category.

3. Economic Order Quantity Analysis:

EOQ can be defined as the ideal quantity of inventory

that an organization should order to minimize the holding or

carrying cost and ordering cost. In this technique the materials

are ordered whenever stock reaches the reorder point. It is also

known as Fixed Order Quantity system. The objective of EOQ

to ensure that the optimum level of inventory is ordered per

batch so that there is no excess of stock lying idle and the firm

does not have to perform frequent ordering. It also aims to

reduce the total cost of the stock while assuming constant

consumer demand. In this technique, the order quantity is

larger than a single period‘s requirement so that ordering costs

& holding costs balance out.

The ordering cost includes transportation cost, cost of

inspecting the received goods, cost of insurance against loss or

damage during transporting, communication cost etc which are

incurred when an order is placed untill the goods are received.

The holding or carrying cost includes, warehousing cost, cost

of damaged goods, cost of insuring against damage or loss

while under storage etc. The EOQ formula also known as the

Wilson‘s formula is given below.

The EOQ level can be graphically represented as given below.



The ordering cost is considered per order while the holding

cost is considered per unit of item. Ordering cost and carrying

cost have an inverse relationship. If a company wants to reduce

the ordering cost then it must reduce the number or order

placed. In order to reduce the carrying cost a company must

order in small quantities.

If the company orders in small quantities, then it will have to

place orders frequently which increase the ordering cost.

Hence the organization can calculate the Economic order

quantity which is the level of items to be ordered when both

the ordering cost and carrying cost are at an optimum level.

4. Fast Moving, Slow Moving Non Moving Analysis:

It is popularly known as FSN analysis. It is the technique

of classifying inventory on the basis of their rate of

consumption or the rate at which the inventory is used. The

Classification is based on the pattern of issues from shops.

This method takes into account the date of receipt or last date

of issue, whichever is later, to determine the no. of months

which have lapsed since the last transaction. The items are

usually grouped in periods of 12 months.

• Fast moving inventory: Are those who is issued more

than 10 to 15 times during the time period set for



analysis. Such items are monitored and replenished

regularly. Around 70% of the total inventory falls under

this category.

• Slow Moving Items: If the items are issued for a few

times say 10-15 issues in the period, the item is ―S‖ item.

Around 20% of the items fall under this category.

• Non Moving Items: If there are no issues of an item

during the period, it is ―N‖ item. The period of

consideration & the limiting number of issues vary from

organization to organization. Around 10% of the total

inventory falls under this category.

Benefits of FSN analysis:

• This technique helps to avoid investments in non moving

or slow items.

• It is also useful in facilitating timely control of

inventories

• It helps in improve the space control of the warehouse or

storage area.

• It is used for identifying periodical goods or goods which

have fluctuating demand.

5. Scarce Difficult and Easy to acquire Analysis:

It is popularly known as SDE analysis. This technique

classifies the inventory on the basis of their availability. This is

based on problems faced in procurement, where some

strategies are made on purchasing.

• Scarce: Items which need a lead time of more than 6

months. For example items which are exported and

shipped from foreign countries.

• Difficult: Items which need more than 15 days but less

than 6 months.

• Easy: Items which are available in less than 15 days.



6. Perpetual Inventory System:

It is the technique of computing the inventory

immediately after the buying and selling of the items with the

help of a computerized system. The decision on when to order

the inventory is based on the Economic order quantity.

Advantages of perpetual Inventory System:

• It gives an alarm when the product reaches the stock out

level.

• The inventory management system for multiple locations

can be controlled through this.

• It helps the managers to make decisions on policies

regarding the purchase, sale, pricing, discounts etc.

7. Just In Time Inventory:

It is the technique of procuring the inventory only when

it is required to be used so that it does not have to store for

longer periods. The technique was developed by Toyota

Motors in Japan and hence it is also known as Toyota

Production System.

ADVANTAGES DISADVANTAGES

It removes the lead time of

operations

The company will be

dependent on the

suppliers for timely delivery

It minimizes the holding costs

of inventory

It is difficult to manage

emergencies

It helps in eliminating

wastage of inventory and

overstocking and under

stocking.

Difficult to expand the

production based on

the demand because of the non

availability of inventory.

No money is tied up on idle

inventory

It increases the ordering cost as

inventory has

to be ordered frequently



8. Inventory Turnover Ratio:

Inventory turnover refers to the rate at which the

products are sold and replenished in the inventory. Companies

use this method for decision making on the pricing,

manufacturing, marketing etc. Having a higher inventory

turnover is considered positive for the company as it shows

that their products are fast moving. Inventory turnover can also

include the rate at which the raw materials and semi finished

goods are converted into finished goods and replaced.

RECEIVABLES MANAGEMENT:

Receivables can be defined as the money which the

customers are obliged to pay to the company as a result of

normal sales of goods or services. It forms an important part of

current assets. The main components of receivables are.

1. The debtors

2. Accounts Receivables

3. Book debts

4. Trade receivables

Receivables management can be defined as the planning,

controlling and managing the receivables. Receivables carry an

element of risk with them. The company‘s investment is

blocked in the receivables. A successful trade is the one where

the seller receives the payment for the goods that he has sold.

Any delay in the payment or the risk of bad debt can disrupt

the operations of the business or create a financial crunch on

the company. The organizations may have planned their

payments to the supplier and stake holders on the basis of

the receivables. Hence there is a chance of default of



payment which ultimately leads to unhealthy relationships with

the stake holder. Therefore it is vital for the company manage

receivables carefully. The main goal of receivables

management is to attain a balance between risk and

profitability.

Objectives of Receivables Management:

1. To control over the debtors by timely collection of

payments. The debtors can be maintained at minimum

debt as per the credit policy of the company.

2. To minimize the loss arising due to bad debts by creating

schedules for the collection of payment at the right time

and alerts the concerned departments of the company and

the customers. The close monitoring will help to reduce

the default of payments.

3. To improve the cash flow that is blocked in the

receivables. Receivables management designs credit

policies in such a way that there is a smooth flow of cash

on a regular basis.

4. To avoid unhealthy relationships with all the

stakeholders of the company a smooth cash inflow and

outflow is necessary. An accurate record of all the

transactions is maintained so that there is no chance of

confusion or disputes.

5. To improve the sales volume. Credit based trade allows

people to purchase more thereby enhancing the volume of

sale. With proper monitoring and management the

company can make decisions on how much sales should

be performed on credit terms.

6. To improve customer satisfaction. Financially backward

customers can establish their business when they receive

products on credit terms. Hence their loyalty to the

company will develop.



Costs of Receivables Maintenance:

Maintaining receivables incurs multiples costs to be

borne by the company. They are

Capital Cost: The company should maintain adequate

working capital if they are trading on credit terms. If the

company follows a liberal credit policy then they have to

reserve more capital so that their day to day operations

are not hampered.

Administrative Cost: The timely monitoring and

collection and management of debt require specialized

staffs and equipments. In most of the companies a

separate department for the collection of payments

handles the responsibilities. The cost of maintain the

staffs, their salary, cost of computers, softwares etc falls

under administrative cost.

Collection Cost: The payments from the customers will

have to be collected by the employees of the company

by travelling to their locations. The cost incurred for this

falls under the collection cost.

Defaulting Cost: Even after multiple reminders and trials

some customers may be unable to pay. These payments

are considered as bad debts and the cost has to be borne

by the company.

Advantages in maintaining receivables:

1. Increase in sales and enhancement of profit

2. Increase in customer satisfaction and loyalty

3. Establishment of good relations with all the stake holders

4. Improvement in the competitive position

Factors affecting the Amount of Receivables:

1. Volume of sales: if the business in trading on the credit



terms the volume of sales will have a positive

relationship with the size of debtors. The higher the sales

the higher will be the receivables.

2. Credit Policy of the company: A liberal credit policies

provide longer time for the credits to pay their debts and

chances of payments after the first payment is defaulted.

A company with a liberal credit policy attracts more debt.

A controlled or strict credit policy reduces the volume of

debt.

3. Terms of trade: The company can offer cash discounts

for speedy payments. They can also perform speedy

responses and quicker deliveries to those creditors who

pay on time which will reduce the chance of delayed

payments.

Fixing the optimum level of receivables:

The optimum size of receivables can be defined as the level of

receivables at which there is a tradeoff between the liquidity

and the profitability of the business. A liberal credit policy

increases the profitability by increasing the volume of sales. If

a tight credit policy is maintained the cost benefit will also be

high. The more liberal the credit policy the lesser will be the

cost benefit.



Aspects of Credit Policy:

While implementing the credit policy the business has

to consider different aspects of credit which are.

1. The level of sales: The amount of sales that generate the

optimum level of profits is to be considered. A high sale

gives the ability of the company to provide more credit.

2. The credit period: This refers to the duration of the

payment which can be anywhere in between a few days

to months. This depends on the volume of sales between

the company and customer, the amount of working

capital available for the company, capacity of the

customer to pay etc.

3. Cash discounts: This refers to the amount of discount that

can be provided to the customer. For example the

business can offer a 10% discount on the total bill if the

payment is made within 15 days.

4. Credit standard of a customer: It represents the basic

criteria which helps the business to decide whether to

give credit to a customer or not. The promptness of

payment of the customers and the volume of sales that

happen between them are important aspects while

deciding if a customer is credit worthy. . The standard of

a customer is defined by the 5Cs of credit. The 5 Cs

represents the character, the capital, the capacity, the

conditions and Collateral security.

5. Profits: The amount of money that will be generated by

keeping a strict credit policy and a liberal credit policy

are different. The level of strictness can be determined by

analyzing the level of profit required by the company.

6. Market conditions and Economic Environment

7. The collection policy: Through which methods will the



company collect the payments, how many reminders will

be sent, whether fines are to be paid for delayed

payments etc.

8. Maintenance of records, billing details etc.

9. The size of credit that is the amount of money that can be

provided on credit terms.

The Credit Evaluation Process:

The Credit worthiness can be calculated by using

different models namely the 5 Cs approach, the CAMPARI

approach and the Credit Scoring Approach.

The 5Cs models:

• Character: The willingness of the customer to pay. There

are certain customers who do not pay on time even if

they have the capacity to pay. The character also does not

depend on the social standing of the customer. The

company can check the credit history, reputation,

qualification, stability of business etc to analyze the

character.

• Capacity: The ability of the customer to pay can be

evaluated by his income. The net monthly cash flow and

the marketability of the customer will help to determine

the capacity.

• Capital: It is the net value of the liquid assets of the

customer. This determines the availability of financial

resources to do the payment. It can be determined by

checking his source of income, fixed expenses,

emergency liabilities etc.

• Conditions: The nature of the business or employment of

the customer and its ability to withstand the changes in

the political, social, cultural, legal, and environmental

conditions are also important aspects.



• Collateral security: The assets which the customer has

kept as a promise of payment allow a company to

mitigate the risk of defaults of payment. The company

will be able to recover the loss by taking over the asset

kept as collateral security.

Based on the 5 Cs the strengths and weakness of the customer

can be analyzed for example the customer has company

property worth one crore which is pledged as collateral

security.

The CAMPARI Model:

1. Character: Willingness to pay from the customer.

2. Ability to repay: The customer should have enough cash

to make repayments.

3. Margin of finance: The banks of the customer usually

do not give a 100% guarantee for payments. The

customer must contribute a percent as commitment.

4. Purpose: The purpose of taking the credit or loan must

be defined. The business should be able to analyze if the

purpose is risky and if the chance of default.

5. Amount: the amount of money that has to be given as

loan or the value of the credit.

6. Repayment Term: the terms and conditions of the

contract or agreement.

7. Insurance: Insurance should be taken for the loan so

that in the case of demise of the customer the payment

can be retrieved from it.

The Credit Scoring Approach:

Depending on the company the elements of credit

scoring can change. Points are assigned to each element. For

example possession of Current account has 40 points, Own



House 20 points; rented house 10 points, reference 20 points

etc. This provides an objective analysis of the customer. This

approach ensures that the credit application is treated fairly

without any bias. The company will not make an error of

rejecting a good customer or accept a risky customer.

SHORT TERM OVERSEAS FINANCING RESOURCES:

Arrangement of funds required for a company for a year

or lesser is known as short term financing. Organizations use

various sources of funds internationally to meet their

requirements. They are

1. Commercial Banks: Global commercial banks like

Standard Chartered Bank, Bank of America, etc provide

loans to their customers all over the world

2. International Agencies and Development Banks:

These institutions are set up by the government of

developed countries for funding projects. The EXIM

Bank, The International Financial Corporation, Asian

Development Bank, World Bank, European Investment

Bank etc are popular among these institutions.

3. International Capital Markets: Major NCs and

Corporate companies raise funds through financial

instruments like

a) American Depository Receipts: ADRS are depository

receipts issued by American companies to American

Citizens. It can be traded only in American markets.

b) Global Depository Receipts: It is a financial instrument

issued by a country in a foreign country to raise funds in

the foreign currency. The holders of these receipts can

avail the capital appreciation benefits and dividends but

does not have any voting powers.

c) Foreign Currency Convertible Bonds: they are equity



linked debt securities that are to be converted to equities

after a specified period of time. They are similar to

debentures in the Indian market. They are issued in

foreign currency and also carry a fixed interest rate

which is lower than the rate of debt instruments.

INTERNATIONAL BANKING AND INTERNATIONAL

MONEY MARKETS:

International Banking:

Financial services to other countries than the home

country existed from the early days when the kings helped

their needy neighboring kingdoms. The banking activities that

occur across the national boundaries of a country can be called

as International Banking. International banks offer banking

services to citizens of a foreign country unlike the domestic

banks. The functions of international banking is similar to

domestic banks with additional responsibilities of

• Organizing finance for overseas trade

• Facilitate foreign exchange

• Provide hedging services for foreign currency receivables

and payables through forward contracts and option

contracts

• Offering services of investment banking where it is

allowed.

HSBC Holdings, JP Morgan Chase, Deutsche Bank, Royal

Bank of Scotland etc are some of the popular international

banks.

Reasons for International Banking:

1. International banking can be performed with lower

marginal cost. The banks have already gained knowledge

in marketing and management which can be used in the

foreign country.



2. The subsidiary bank can take advantage of the parent

banks contacts, and credit investigations and make use

of it in foreign market.

3. Local agencies in the foreign countries may be able to

obtain better information and collect data on the financial

and trading markets of that country. The Multinational

bank can make use of their subsidiaries in those countries

to gather this knowledge o be used in their home country.

4. The reputation earned by large multinational banks

will attract customers even if they are new in the

market. Hence it is easier to gain clients in foreign

markets.

5. Huge Multinational banks are not subjected to the same

rules and regulations of the domestic banks. Governments

may offer attractive policies to get the services of the

international bank.

6. Banks use their foreign branches to maintain the

multinational clients abroad so that they will not lose

them.

7. The international banks also use their reach to compete

in retail services like catering to tourists, traveler‘s

checks and foreign business market.

8. International banks can use their hold to evade the

governments‘ currency control. It can also reduce the

transaction costs of currency and avoid foreign exchange

risk while converting currencies.

9. Foreign Markets are used for the growth of the banks

which may not be available in the home country.

10. Providing services in multiple countries is used as a

technique to avoid risk. Diversification always provide

alternatives if one or two markets go through a negative

phase.



Types of International Banking Offices:

1. Correspondent Bank: When two banks maintain deposits

with each other, it is called as a corresponding banking

relationship. It allows the banks multinational clients to

conduct business all over the world through its local branches.

2. Representative Offices: it is a small service facility where

the employees from the parent company that is designed to

help MNC clients of the parent bank in dealing with the bank‘s

correspondents. It also helps with the information regarding

the local business culture and credit evaluation of the local

customers.

3. Foreign Branches: The foreign branch of an international

bank operates like a domestic bank but is a legal part of the

parent company. These branches are subject to the rules and

regulations of both the home country as well as the country of

their location. It provides a fuller service than a representative

office.

4. Subsidiary and Affiliate Banks: A subsidiary is a locally

incorporated bank whose whole or part ownership and control

is with a foreign bank. An affiliate bank is one where the

ownership is partly with the foreign parent but does not enjoy

any control over it.

5. Offshore Banking Centre: Is a country whose banking

system is organized to permit external accounts beyond the

normal scope of local economic activity. The home country of

the bank grants the entire freedom to the host control

regulations. The Bahamas, Bahrain, Hong Kong, Panama etc

are some of the off shore centres identified by IMF.

6. Shell Branches: are just like post office boxes. The banks

in USA established them to compete with other banks without

spending for real operations.

7. International banking Facilities: It is a separate set of



accounts that are segregated on the parents‘ books.

International Money Market:

A money market is a part of the financial market. The

money market where international currency transactions take

place between the central banks of countries is known as

International money market. The monetary transactions are

done by using gold or US dollars as the base. It is governed by

the monetary policies of various nations. The most important

responsibility of the international money market is handling

the currency trading between the countries which are known as

Forex trading. Large financial institutions play as the

participants in the market. Some of the important players are

HSBC, UBS AG, Deutsche Bank, and Goldman Sachs etc. The

IMM monitors the exchange rates between different pairs of

currency. The most common indicators that govern the market

are exchange rate regime, fixed exchange rate, floating

exchange rate etc.

The IMM was established in May 1972 as a separate

entity of Chicago Mercantile Exchange. The main purpose of

the market is to trade in currency futures. By the year 2009 it

became the second largest future. The International Money

Market represents short and intermediate term borrowings and

investment market. The companies access markets either via

financial intermediaries like banks or through direct financial

markets. The Intermediary markets consist of Eurocurrency

Loan Market and Eurocredit Market. The Direct Market

includes Short Term and Medium Term Euro Notes Market

and Euro commercial Paper Market.

1. The Eurocurrency Market:

It is also known as Offshore. It is a freely convertible

currency that is deposited in the bank in a country outside the

home country. This market helps in lending and borrowing of



offshore currencies. Both domestic and foreign banks

functioning in the local market can accept Eurocurrency.

Examples of Eurocurrency are Euro dollars which are deposits

denominated in US dollars outside America. The bench market

rate or the reference rate used in the Eurocurrency market are

LIBOR: London Interbank Offered Rate PIBOR: Paris

Interbank Offered Rate

SIBOR: Singapore Interbank Offered Rate

EURIBOR: The rate at which interbank time deposits of Euros

are offered by one prime bank to another.

2. The Eurocredits Market:

Eurocredits are short term to medium term loans of

Eurocurrency. In this market the loans are often too large for a

single bank to underwrite. In such cases a number banks forms

together a syndicate so that the risk will shared among them

equally. The LIBOR rate is used as the base rate for the

Eurocredits originating in London. The borrowings are

denominated in the currencies other than the home currency of

the Eurobank. The Eurocredits have a roll over feature which

means that at its maturity the loan can be extended by a mutual

agreement between the lender and the borrower.

3. Euronotes Market:

Euronotes are short term promissory instrument that are

issued and sold by the corporation to individual and private

investors. The maturity of Euronotes is typically three to six

months. The international investment banks and international

commercial banks underwrite them through the Euronotes

programme. This programme identifies dealers to act of the

behalf of the borrowers. They are sold at a discount price from

their face value and the payback is done on the full face value

at maturity. Euronotes can be traded in secondary markets too.



Euronotes of medium term are issue by a corporation or a

government at fixed or floating rates to the investors. The

maturity period is between 9 months to 5 years but it may go

up to 10 years. It is not offered at once like a bond but in an

ongoing basis. These are offered through Euro Mid Term

Notes Program. These notes can also be traded in the

secondary market. It acts like a bridge between the Euro

commercial paper and Eurobonds.

4. Euro commercial Papers:

Euro commercial papers are unsecured short term notes

issued by banks and corporation in the Eurocurrency market.

The range of maturity period of the paper extends from one

month to 6 months. They are issued through the Euro

Commercial program to the dealers who act on behalf of the

investors.

INTERNATIONAL MONETARY AND FINANCIAL

ENVIRONMENT:

The International financial environment refers to the

conditions in which the activities of the financial markets and

economies take place globally. The system is manages and

overseas the international monetary trade and trade of

monetary assets. Several forces influence this environment. it

can be influenced in a positive and negative manner. When the

economical growth has already reached a mature level it

provides lot opportunities to the investors. They invest larger

capital in such attractive environments. The governments or

giant corporations may also take part n purchasing the debt of

other nations as they may find opportunities to gain profit from

them. This leads to a risky environment where the number of

sellers is more than the number of buyers. The main

components of the environment are

1. The foreign exchange market: it is the market where one



currency is traded for another currency. It is a global

market where a single physical or electronic market place

does not exist. The market consists of interbank market

and retail market. The Participants in these markets are

Central Banks, Investment Banks, Corporates,

Brokers, Individuals, and Commercial Banks etc.

2. The Currency Conversion: the Currencies in the foreign

exchange market are not easily convertible. Certain

countries restrict the conversion of their home currency

to foreign currency partially or wholly. This makes it

difficult to conduct business in the markets.

3. International Monetary System: It is the operating system

where a set of intentionally recognized rules and

regulations and institutions facilitate trade and

investments across the national borders of countries. It

came into existence in 1944.The IMF and the World

Bank are the two top institutions that govern the system.

4. International Financial Markets: It consists of

International stock market, Eurocurrency market and

Eurobond Market. It acts as commercial banks and

investment banks

5. Balance of Payments: It is the statement which records

the inflows and outflows of goods, services and funds. It

is the sum of current account, the capital account and the

change in the official reserves.

TARIFFS, EXPORT TAXES & SUBSIDIES:

Tariffs are the tax imposed on the imported goods by a

country. A tariff is generally used to bring a restriction on the

imports. A higher tariff will reduce the imports as the price of

the goods will increase. This will protect the domestic

countries and also helps to bring the Balance of payments to

equilibrium. This strategy will work only for non essential



goods. If tariffs are imposed on essential goods the consumers

in the home country may continue to use it which will worsen

the situation. Another risk of using this strategy is that if the

imported good become expensive, the consumer will opt for

domestic substitute. Over consumption of domestic goods will

affect the export of the country. They are also used to raise

revenues for the government.

Export taxes are the taxes levied on goods that are

leaving the national territory to a foreign country. They

constitute export duties, Taxes on the profit gained by

exchange rate differential and the profits made by the

monopolies in export. It plays an important role in generating

revenue for the government. Legally the export tax rests on the

exporter. But it may be shifted to the buyers also that is the

foreign consumers. It may also be borne by the domestic

producers from whom the exporter purchases the product.

Governments impose export taxes on high value goods which

are available in abundance in the home country and which are

scarce in other countries. Oil, diamonds, hard word, coffee etc

are such products which taxed.

Export subsidies are government policies which are

implemented to encourage exports in a country. The subsidies

can be in the form of tax reductions to the exporter, availability

of machinery or raw materials at lower prices, reimbursement

of the expenses borne by the exporter, loans at very low

interest rates, etc. This is applied when the country produces

more than the domestic consumption. It helps to ease the flow

of the goods instead of wasting them. When subsidies are

provided for exported goods it reduces it price than the

domestic price of the goods. Hence it reduces domestic

consumption. In certain case if the goods has high demand in

foreign countries and fetches a much larger profit than in the

domestic market such measures are taken to encourage the

export.



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