MODULE – 1

OVERVIEW

OF

INTERNATIONAL FINANCIAL MANAGEMENT

MEANING OF IFM

International financial management (IFM) deal with the financial decisions taken in the area of International Business.

The growth in International Business is, first of all, evident in the form of highly inflated size of international trade.

IMPORTANCE OF IFM

• Foreign Exchange Market• To determine the exchange rate• Exchange Rate Risk and its Management• MNCs’ Investment Decisions• International Working Capital Decisions• Financing decisions of the MNCs• International Accounting and Taxation

IFM Vs. DOMESTIC FINANCIAL MANAGEMENT

A domestic company takes up a project for investment only when the net present value of cash flows is positive and it shapes the working capital policy in a way that maximizes profitability and ensures desired liquidity.

However, IFM has a wider scope than domestic corporate finance and it is designed to cope with grater range of complexities than latter. The reasons are as follows:-

1. The MNCs operate in different economic, political, legal, cultural and tax environments.

2. They operate across and within varied range of product and factor markets which vary in regards to competition and efficiency.

3. They trade in a large no. of currencies as a result of which their dependence on the foreign exchange market is quite substantial.

ROLE OF INTERNATIONAL FINANCIAL MANAGER

• Forecasting the financial environment• Management of Assets• Management of Liabilities• Exchange Risk Management• Performance Evaluation and Control

INTERNATIONAL FINANCIAL SYSTEM

TREASURER CONTROLLER

Financial Planning Analysis

Fund Acquisition

Investment Financing

Cash Management

Investment Decisions

Risk Management

External Reporting

Financial and Management Accounting

Tax Planning and

Management

Budget Planning and

Control

Management Information

System

Accounts Receivable

INTERNATIONAL MONEYTARY SYSTEM

The earlier form of money solved the store-of-value problem by using relatively scarce metals such as gold, silver or copper. However, an International payments system based on precious metals was by no means a perfect system. For example:- the purity of the gold could be diluted with other metals making it difficult for trader to assay the precise amount of gold in the coin.

The Reserve Bank decides the volume and value of banknotes to be printed each year. The quantum of banknotes that needs to be printed, broadly depends on the requirement for meeting the demand for banknotes due to inflation, GDP growth, replacement of soiled banknotes and reserve stock requirements.

BRETTON WOODS SYSTEM An International Monetary and Financial Conference

of the United and Associated Nations was convened at Bretton Woods, New Hampshire on 1 July 1944.

The main goal of the architects of the Bretton Woods system was to establish an international economic order, that would prevent another political and economic collapse. In the issue area of International monetary relations two interests remained uppermost: First, the provision of adequate liquidity so that countries experiencing short term balance of payments would not resort to nationalistic measures;

BRETTON WOODS SYSTEM

Secondly, the creation of an adequate mechanism for international adjustment. Underlying the monetary arrangements lay a commitment to free trade and an open international economy. This new order under the leadership of the United States aimed to prevent a return to economic nationalism by fostering free trade and high level of international interaction.

INTERNATIONAL MONEYTARY FUND(IMF)

The prime goal of the IMF agreed at Bretton Woods was to assist its members in resolving short-term balance of payments problems under a regime of fixed exchange rates, thus permitting the orderly expansion of international trade. The fund was created as an international institution to supervise and promote an open and stable international monetary system. Exchange rate supervision and balance of payments surveillance (a place where a crime may be committed) presaged (warning) a movement away from sole national control of economic policy and the acceptance of a degree of international interference in domestic economies. The purposes of the International Monetary Fund are stated in Article I of the IMF’s constitutive document.

INTERNATIONAL MONEYTARY FUND(IMF)

These are:-• To promote international monetary cooperation through a

permanent institution which provides the machinery for consultation and collaboration on international monetary problems.

• To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.

• To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

INTERNATIONAL MONEYTARY FUND(IMF)

• To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of trade.

• To give confidence to members by making the general resources of the fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

• In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members.

ORGANIZATIONAL STRUCTURE OF IMF

The IMF, organizational structure is set out in its Articles of Agreement, which entered into force in December, 1945. the Articles provide for a Board of Governors, an Executive Board, a Managing Director, and a staff of international civil servants.

FUNCTIONS OF THE IMF

The fund is designed to perform three important roles in the international monetary system.

• To regulate the financial relations of its members. This regulatory function includes an element of rule supervision and law enforcement with respect to exchange rates and balance of payments restrictions.

• To provide financial assistance to members experiencing balance of payments difficulties.

• To act as a consultative organ. The IMF’s role is to create a climate in which governments are persuaded to dismantle exchange controls and to permit free trade and the free movement of capital.

DEFINITION OF BALANCE OF PAYMENT

The Balance of payments of a country is a systematic accounting record of all economic transactions during a given period of time between the residents of the country and residents of foreign countries

“Residents of foreign countries” may be replaced by “non-residents”, “foreigners” or “rest of the world (ROW)”. And Economic transactions means transfer of economic value from one economic agent (individual, business, Govt etc) to another.

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS (BOP):

• The BOP is a standard double entry accounting record and as such is subject to all the rules of double entry book keeping viz., for every transactions two entries must be made, one credit (+) and one debit (-) and leaving aside errors and omissions, the total credits must exactly match total of debits

• That is balance of payment must ‘balance’

VALUATION AND TIMING:

• IMF recommends the use of “market prices” i.e., price paid by the ‘willing buyer’ to a ‘willing seller’, where they are two independent parties

• IMF recommends FOB price for valuation• In India exports are valued on FOB and imports on

CIF basis• Theoretically exchange rates prevailing at the time

of transaction to be used, however in practice, in most cases, for transactions during a particular month, the average exchange rate for the month is used

VALUATION AND TIMING:

• The two sides of transaction are to be recorded in the same period of time

• For this purpose conventions have been established such as:

• Exports are recorded when cleared by customs• Imports are recorded when payment is made

etc.,

CALCULATION OF BOPItem Credits Debits Net (Rs. Cr.)

CURRENT ACCOUNTS

I. Merchandise i) Private ii) Government

II. Invisibles 1. Travel 2. Transportation 3. Insurance 4. Investment 5. Government, not included elsewhere 6. Miscellaneous 7. Transfer payments i) Official ii) Private

A. TOTAL CURRENT ACCOUNT (I + II)

CALCULATION OF BOP (CONTD…)

Item Credits Debits Net (Rs. Cr.)

CAPITAL ACCOUNT

I. Private i) Long – Term ii) Short - Term

II. Banking

III. Official i) Loans ii) Amortization iii) Miscellaneous

B. TOTAL CAPITAL ACCOUNT (I + II + III)

CALCULATION OF BOP (CONTD…)Item Credits Debits Net (Rs. Cr.)

C. IMF

D. Special Drawing Rights (SDR) Allocation

E. Capital Account, IMF and SDR Allocation (B + C + D )

F. Total Current Account, Capital Account, IMF and SDR Allocation (A + E)

G. ERRORS AND OMMISSIONS

H. RESERVES AND MONETARY GOLD

IMPORTANCE OF BOP STATISTICS

• In BOP deficits or surpluses may have an immediate impact on the exchange rate

• BOP records all transactions that create demand for and supply of a currency

• When exchange rates are market determined, BOP figures indicate excess demand or supply of currency and possible impact on exchange rate

• Taken in conjunction with past data they confirm or indicate a reversal of perceived trends

• They may signal a policy shift on the part of monetary authorities of the country, unilaterally or in concert with trading partners

IMPORTANCE OF BOP STATISTICS

• For instance a country facing a current account deficit may rise interest rates to attract short-term capital inflows to prevent depreciation of its currency, or tighten credit and money supply and make it difficult to borrow money to make investments abroad

• It may force exporters to realize export earnings quickly and bring home foreign currency

• Movements in a country’s reserves have implications for the stock of money and credit circulating in the economy

IMPORTANCE OF BOP STATISTICS

• Central bank’s purchases of foreign exchange in the market will add to the money supply and vice versa unless the central bank “sterilizes” the impact by compensatory actions such as open market sales and purchases

• Countries suffering from chronic deficit may find their credit ratings being down graded

• Finally BOP accounts are intimately connected with over all saving-investment balance in a country’s national account

• Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalance, which in turn will affect the exchange rates and interest rates in the country

MODULE – 2

FOREIGN EXCHANGE MARKET

INTRODUCTION

The foreign exchange market is the market in which currencies are bought and sold against each other. It is the largest market in the world.

The foreign exchange market is an over the counter market. This means that there is no single physical or electronic market place or an organized exchange (like a stock exchange) with a central trade clearing mechanism where trades meet and exchange currencies. The market itself is actually a worldwide network of inter-bank traders, consisting primarily of banks, connected by telephone lines and computers.

STRUCTURE OF FOREIGN EXCHANGE MARKET

• Retail Market:- This is the market in which travellers and tourists exchange one currency for another in the form of currency notes or travellers' cheques. The total turnover and average transaction size are very small.

• Wholesale Market:- The wholesale market often called the interbank market. The major categories of participants in this market are commercial banks, investment institutions, non-financial corporations and central banks. The average transaction size is very large.

TYPES OF TRANSACTIONS AND SETTLEMENT DATES

• Settlement Date:- The day on which these transfers are effected is called the Settlement Date.

• Settlement Locations:- The relevant countries are called Settlement Locations.

• Dealing Locations:- The locations of the two banks involved in the trade are Dealing Locations, which need not be the same as settlement locations.

TYPES OF TRANSACTIONS AND SETTLEMENT DATES

• Spot Transaction:-• Forward Transaction:- • Short Date Transactions:-• Swap Transaction:-

EXCHANGE RATE QUOTATIONS AND ARBITRAGE

The inter – bank market uses quotation conventions adopted by ACI (Association Cambiste International). These conventions are described below:

• A currency pair is denoted by the three – letter SWIFT codes for the two currencies separated by an oblique or a hyphen. Ex- USD/INR : US Dollar – Indian Rupee

• The first currency in the pair is the “base” currency; the second is the “quoted” currency. In USD/IND, US Dollar is the base currency, Indian Rupee is the quoted currency

EXCHANGE RATE QUOTATIONS AND ARBITRAGE

• The exchange rate quotation is given as number of units of the quoted currency per unit of the base currency. Thus a USD/INR quotation will be given as number of rupees per dollar.

• A quotation consists of two prices. The price shown on the left of the oblique or hyphen is the “bid” price, the one on the right is the “ask” or “offer” price.

EXCHANGE RATE DETERMINATION

Excess Demand

Excess Supply

P

P1

P2

A

DS

S

D

INTERESTRATE

DEMAND AND SUPPLY OF US $

EXCHANGE RATE DETERMINATION

From the diagram, SS is representing Supply Curve and DD is representing Demand Curve. At the point of A, demand for US $ is equal to supply for US $. This is the point of equilibrium. At P2 the demand for US $ is greater than the supply for US $. Hence the interest rate moves up from P to P2. At P1 the supply for US $ is greater than demand for US $. Hence the interest rate fall from P to P1.

CURRENCY FUTURES

Currency Future is a transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk.

A  currency future  or  foreign exchange future, is a futures contract  to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. Investors can close out the contract at any time prior to the contracts delivery date.

CURRENCY OPTIONS Currency Option is a contract that grants the holder the right, but not

the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise).

CURRENCY FORWARDS

A forward contract in the forex market that locks in the price at which an entity can buy or sell a currency on a future date. Also known as "outright forward currency transaction", "forward outright" or "Foreign Exchange forward” or “FX forward”. In currency forward contracts, the contract holders are obligated to buy or sell the currency at a specified price, at a specified quantity and on a specified future date. These contracts cannot be transferred.

SWAPS IN FOREIGN EXCHANGE MARKETS

A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange.