By Ashok Bhansali,

B.Com (Hons),F.C.A
Learning Objectives of the Course - International
Finance

 Financial Management in a Global context : Why study

International Financial Management ? ( INR,$,EURO,GBP)
 International Macroeconomic concepts
 Foreign Exchange Markets, Commodity markets
 The Balance of payments
 International Monetary System
 International Banking
 Foreign exchange exposure
 Derivatives, Forward swaps & Interest parity
 Exchange rate determination & forecasting
 International payment settlements
 By Ashok Bhansali,
B.Com (Hons),F.C.A
The Basic Goal of a Manager
To enhance shareholder value. The objective of the
firm is to maximize the current value of shareholder’s
wealth.
 When is value created ?
Value is created by managers when any organization
acquires physical and financial resources from the
environment earns a return on its investment in
excess of the cost of capital.
What’s special about
International Finance ?
Three major dimensions set international finance
apart from domestic finance :
Foreign Exchange & political risks
Market Imperfections
Expanded opportunity sets
This enables firms to locate products, services or
capital anywhere in the Globe
Why study International
Finance ?
To obtain foreign capital in addition to domestic
capital.
Technology up gradation
Increase recourse to Borrowings & FDI.FPI
To diversify exports & provide Long term financing to
buyers
Strategic partnerships
Challenges a Contemporary
Finance Manager faces !
1.To keep update with contemporary & significant
environmental changes & it’s impact on the
industry/firm.
e.g. Among the variables to be monitored are exchange
rates, credit conditions at home and abroad, changes in
industrial tax & foreign trade policies, stock market trends.
Fiscal & monetary developments, emergence of new
financial instruments & products.
Challenges a Contemporary
Finance Manager faces !
How will a takeover of a major competitor by an outsider
affect competition within the industry ? (Thums UP) If a
hitherto publicly owned financial institution is privatised
how will its policies change and how will that change affect
the firm ?
Financial complications resulting from cross border
transactions :
Multiple currencies
Multiple Governments
Challenges a Contemporary
Finance Manager faces !
2.To understand & analyze the complex inter-
relationships between relevant environmental
variables & corporate responses (own & Competitive)
to the changes in them.e.g What would be the impact of
stock market crash on credit conditions in the International
Financial markets ?What opportunities will emerge if
infrastructural sectors are opened up to private
investment ?What are the potential threats from
liberalization of foreign investments ?
Challenges a Contemporary
Finance Manager faces !
 3.To be able to adapt the finance function to the significant
changes in the firm’s own strategic plans and competitive
positioning. e.g.. A major change in the firm’s product-mix,
opening up of a sector or an industry so far prohibited to the firm,
increased pace of diversification. a significant change in operating
results, substantial reorientation in a major competitor’s strategic
stance are some of the factors which demand a major financial
restructuring, exploration of innovative funding strategies ,changes
in dividend policies, asset sale to overcome temporary cash
shortages and a variety of other responses.
Challenges a Contemporary
Finance Manager faces !
4.To take in stride past failures and mistakes to
minimize their adverse impact. e.g.. a wrong takeover
decision, a large foreign loan in a currency obtained when
interest was low & that has since been rising rapidly, a fix-
price contract which becomes uneconomical under current
conditions and a host of other errors of judgment which are
inevitable in the face of enormous uncertainties.
Challenges a Contemporary
Finance Manager faces !
5.To design & implement effective solutions to take
advantage of the opportunities offered by the market
& advances in financial theory. e.g. uses of
option,swaps,futures for effective risk
management,securitisation of assets to increase liquidity,
innovative funding techniques etc.
Recent Changes In the Global Financial Markets
The outstanding feature of the changes during the eighties was
Integration.
The driving force behind Integration was :
> Liberalization w.r.t cross-border financial
transactions.
> Deregulation which led to :
1.Segementation of financial services market.
2. Permitting Foreign Financial Institutions to enter
national markets
 Why do Nations Trade ?
( Barter)
 Doctrine of comparative advantage by David
Ricardo. i.e. Liberalization of international trade will
enhance the welfare of the world’s citizens.( e.g.
England produces textiles and France wine and both
benefit)
Free trade initiatives to reduce the barriers :
General Agreement on Tariffs & trade (GATT),World
Trade Organisation (WTO)
The European Union (EU)
Foreign Exchange Markets
193 Countries ! 164 different types of currencies.
Globalization & Economic expansion create a need
for a mechanism to convert one currency to another.
One currency is exchanged for another currency in
the foreign exchange market
Foreign Exchange Markets
(OTC)
Market changed fundamentally when the Bretton
woods system broke down.USD was convertible to
gold and all other currencies were convertible to USD.
1971 US suspended convertibility of Dollar to Gold
1973 onwards the advent of floating exchange rate
took place. (demand/supply)
Paradigm Shifts
The advent of the EURO

Introduction of electronic brokering systems.

FEMA (The Foreign Exchange Management

Act,1999 )replaces FERA ( The Foreign Exchange
Regulation Act,1973)
 What is an Exchange Rate ?
An exchange rate is the rate at which one currency is
exchanged for another.
Exchange rate quotes :direct /indirect
Exchange rate quotes in USD equivalent are called
direct quote. i.e. how many USD it costs to get an unit
of the foreign currency.
Rates listed as “ Currency per USD ” are indirect
quote. i.e. the price of 1 USD in foreign currency.
Exchange Rates ….
Cross Exchange rates : Exchange rates expressed in
two non –US Dollar currencies.
Bid/Ask Spread (Bid quote is bank’s “buy “price and
“ask” quote is bank’s “sell” price)
Spread = Ask rate – bid rate/Ask rate
Currency appreciation & Depreciation
The Balance of payments (BOP)
All modern economies prepare & publish detailed
statistics about their transactions with the rest of the
world.
BOP is precisely defined as “ 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 & the rest of the
world”
Foreign Exchange Markets
Location (OTC)
Size of the market (Above 3 trillion per day)
24 hours market
Efficiency
Currencies traded ( USD is the vehicle currency)
Physical market( Paris & Brussels)
 Participants

Corporate
Commercial Banks
Exchange brokers
Central Banks
Types of transactions
Purchase/sale of goods & services with a financial
quid pro quo.(1 Real & 1 financial)
Purchase/sale of goods in return for goods or services
or a barter transaction (2 real)
Purchase of foreign securities (2 financial)
A unilateral gift(real)
A unilateral financial gift(1 financial)
 Settlement of transactions

SWIFT (Society for Worldwide Interbank

Telecommunications) at Brussels,Belgium.

CHIPS (Clearing House Interbank Payment System)

Foreign Exchange
Transactions ..
The daily exchange rates are “spot rates”
Transactions in the future are “ forward transactions
” & the ex rate is “forward rate”.
Premium if the currency is expected to appreciate or
discount if the currency is expected to depreciate.
Forward contract is an agreement between a buyer &
seller to trade at a particular future date at a agreed
fixed price. (1,2,3 or 6 months)
Foreign Exchange Transactions
Spot
Forwards
Swaps
Futures
Options
Factors determining spot rates
Balance of payments
Inflation
Interest rates
Money supply
National Income
Resource Discoveries (Oil,minerals etc)
Capital movement
Political Factors (Stability,Corruption Index)
Psychological Factors & Speculation
Technical & Market factors ( Demand pull/drive)
Factors determining forward
margin
Rate of interest
Demand & Supply
Speculation about Spot rates
Exchange Regulations
Purchasing Power Parity (PPP)
P P P is derived from the Law of One price.
Goods that are traded freely should cost the same
everywhere measured in the same currency.
The exchange rates between currencies should be
such that the currencies have equivalent purchasing
power.Therefore exchange rates change,over the long
term as PP changes.
Global Fin Markets
Eurocurrencies market : wherein a borrower from country
A could raise(place) funds in currency of Country B
from(with) financial institutions located in country C.
Domestic & off shore markets
Financial assets & liabilities denominated in a particular
currency say the GBP are tarded primarily in the national
financial markets of that country(Domestic)
Financial markets where trade happens NY,Paris,Singapore
and other centres outside London are Offshore markets.
Nature of regulation distinguishes the domestic from the
offshore markets.
Recent Changes in Global Fin Markets
The outstanding feature of the eighties was Integratin
The boundaries between the national & offshore markets was
becoming blurred., leading to the emergence of a global
unified financial market.
The trend was towards geographical & functional unification.
The driving force behind this spatial & functional integration
were first ,liberalization with regard to cross border financial
transactions & second
Deregulation within the financial systems of major
industrial nations.
Global Fin Markets
Euromarkets : A Eurocurrency Deposit is a deposit in the
relevant currency with a bank outside the home country of
that currency . Thus a USD Deposit with a bank in London
is a Eurodollar deposit,a sterling deposit with a bank in
Hongkong is a Eurosterling deposit.Ironically this market
originated from Russian demand of dollars
.Note that what matters is the location of the bank –
neither the ownership of the bank nor ownership of
the deposit.
Similarly a Eurodollar loan is a dollar loan made by a
bank outside the USA to a customer or another bank.
Global Fin Markets
The early part of the eighties saw the process of
disintermediation getting underway. Highly rated
issuers began approaching the invetsors directly
rather than going through the bank route.
Taken together,these developments have given rise to
a globally integrated financial marketplace in which
entities needing short-term or long term funding have
a much wider choice than before.
Impact of Offshore markets
This market facilitates short term speculative capital
flows also hot money. Creating difficulties for the
Central bank to intervene & stabilize exchange rates.
Monetary control is lost.
The market is based on a tremendously large volume
of interbank lending.
Such markets create private international liquidity
contributing to inflationary tendencies.
Central banks of deficit countries are allowed to
borrow for Balance of payments.
Useful terms
Arbitrage means Attempting to profit by exploiting price
differences of identical or similar financial Instruments ,
on different markets or in different forms.. The ideal
version is riskless arbitrage.
Settlement date or value date is the date when the
transaction takes place by transfer of deposits.
Settlement locations means the banks of the countries of
the two currencies.
Dealing locations is the location of the banks involved
which may not be the same as settlement locations
Arbitrage
The act of simultaneously buying & selling the same
or equivalent assets or commodities for the purpose
of making certain guaranteed profits.
As long as there is arbitrage markets cannot be in
equilibrium. The market can be said to be in
equilibrium when no profitable arbitrage
opportunities exist.
Types of Transactions & settlement dates
Spot transactions : usually two days ahead for
European currecies,or the yen traded against USD.
If London sells on Monday,deposit takes place on
Wednesday.
Deals on Friday are settled on Tuesday next week.
To reduce credit risk both transactions have to be
done simultaneously.
Value date shifted if either country has a bank holiday.
Same holds good for dealing locations.
Types of Transactions & settlement dates
Forward transactions ,e.g.30 day,Settlement = 30+2
Standard Forward contract tenures are 1
week,2weeks,1,2,3,6,9,12 months.
Rolling forward must not take you in the next month.
“ Broken date “ or odd date contracts entered into by
Corporate or Individuals to settle their needs.
Swap transaction is a combination of spot & a forward
in a opposite direction or when both transactions are
at a forward date i.e. known as a forward-forward
contract.
Interest Rate Parity
Interest Rate Parity Defined
Covered Interest Arbitrage
Interest Rate Parity & Exchange Rate Determination
Reasons for Deviations from Interest Rate Parity
Interest Rate Parity Carefully
Defined
Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£
while eliminating any exchange rate risk by selling the future value
of the British investment forward.
Future value = $100,000(1 + i£)×F$/£ / S$/£

Since these investments have the same risk, they must have the same
future value (otherwise an arbitrage would exist)
Interest Rate Parity Defined
IRP is an arbitrage condition.IRP must hold good
when International markets are in equilibrium.
If IRP did not hold, then it would be possible for an
astute trader to make unlimited amounts of money
exploiting the arbitrage opportunity.
Since we don’t typically observe persistent arbitrage
conditions, we can safely assume that IRP holds.
Interest Rate Parity Carefully
Defined
Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while
eliminating any exchange rate risk by selling the future value of the British
investment forward.
F$/£
Future value = $100,000(1 + i£)×
S$/£

Since these investments have the same risk, they must have the same future value (otherwis
an arbitrage would exist)

(1 + i£) ×
F $/£
= (1 + i$)
S $/£
Covered Interest Arbitrage
Depositors who hold Sterling deposits would
liquidate them buy JPY in the spot market &
simulataneuosly enter into forward contarcts to
convert the deposit proceeds back into Sterling.This
activity is known as Covered Interest Arbitage.
 Alternative 2: $1,000
Send your $ IRP
S$/£
on a round trip
Step 2:
to Britain
Invest those
pounds at i£
$1,000 Future Value =
$1,000
 (1+ i£)
S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000×(1 + i$) =  (1+ i£) × F$/£
S$/£
IRP

Since both of these investments have the same risk, they must have the same future
value—otherwise an arbitrage would exist
Interest Rate Parity Defined
The scale of the project is unimportant

$1,000
$1,000×(1 + i$)=  (1+ i£) × F$/£
S$/£

F$/£
(1 + i$) = × (1+ i£)
S$/£
Interest Rate Parity Defined
Formally,
1+i F $
=
$/¥

1+i S ¥ $/¥

IRP is sometimes approximated as

i$ – i F–S
¥ ≈
S
Forward Premium
It’s just the interest rate differential implied by forward
premium or discount.
For example, suppose the € is appreciating from S($/€)
= 1.25 to F180($/€) = 1.30
The forward premium is given by:

F180($/€) – S($/€) 360 $1.30 – $1.25

f180,€v$ = × = × 2 = 0.08
S($/€) 180 $1.25
Interest Rate Parity Carefully
Defined
Depending upon how you quote the exchange rate ($
per ¥ or ¥ per $) we have:

1 + i¥ F 1+i $F
= =
¥/$ $/¥
or
1 + i$ S ¥/$
1+i ¥S $/¥

…so be a bit careful about that

IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. It’s
easiest to see this in the form of an example.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange rates.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%
IRP and Covered Interest Arbitrage
A trader with $1,000 could invest in the U.S. at 7.1%, in
one year his investment will be worth
$1,071 = $1,000  (1+ i$) = $1,000  (1,071)
Alternatively, this trader could
1. Exchange $1,000 for £800 at the prevailing spot rate,
2. Invest £800 for one year at i£ = 11,56%; earn £892,48.
3. Translate £892,48 back into dollars at the forward
rate F360($/£) = $1,20/£, the £892,48 will be exactly
$1,071.
Alternative 2:
buy pounds Arbitrage I
£800
£1 Step 2:
£800 =
$1,000× $1.25 Invest £800
at i£ =
$1,000 £892.48 In one year
11.56%
£800 will be
Step 3: worth
repatriate to the £800 (1+=i£)
£892.48
U.S.A. at F360($/£)
= $1.20/£
Alternative 1:
invest $1,071 F£(360)
$1,000 at $1,071 = £892.48 ×
£1
7.1%
FV = $1,071
Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360($/£), can exist. It must be the case that

F360($/£) = $1.20/£
Why?
If F360($/£)  $1.20/£, an astute trader could make money
with one of the following strategies:
Arbitrage Strategy I
If F360($/£) > $1.20/£
i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for £800 at the prevailing spot rate,
(note that £800 = $1,000÷$1.25/£) invest £800 at 11.56%
(i£) for one year to achieve £892.48
iii. Translate £892.48 back into dollars, if
F360($/£) > $1.20/£, then £892.48 will be more than
enough to repay your debt of $1,071.
Step 2: Arbitrage I
buy pounds
£800
£1 Step 3:
£800 =
$1,000× $1.25 Invest £800 at i£
= 11.56%

$1,000 £892.48 In one year £800 will

be worth
£892.48 =

£800 (1+ i£)

Step 4:
repatriate to
Step 1: the U.S.A.
borrow $1,000
Step 5: Repay your More F£(360)
dollar loan with than $1,071 $1,071 < £892.48 ×
£1
$1,071.

If F£(360) > $1.20/£ , £892.48 will be more than enough to repay

your dollar obligation of $1,071. The excess is your profit.
Arbitrage Strategy II
If F360($/£) < $1.20/£
i. Borrow £800 at t = 0 at i£= 11.56% .
ii. Exchange £800 for $1,000 at the prevailing spot rate,
invest $1,000 at 7.1% for one year to achieve $1,071.
iii. Translate $1,071 back into pounds, if
F360($/£) < $1.20/£, then $1,071 will be more than enough
to repay your debt of £892.48.
Step 2:
buy dollars Arbitrage II
£800
$1.25
$1,000 = Step 1:
£800× £1
borrow £800
$1,000
More Step 5: Repay
Step 3: your pound
Invest than
£892.48 loan with
$1,000 at i$
£892.48
Step 4:.
repatriate to
the U.K.
In one year
F£(360)
$1,000 will be $1,071 $1,071 > £892.48 ×
worth £1

If F£(360) < $1.20/£ , $1,071 will be more than enough to

repay your dollar obligation of £892.48. Keep the rest as
IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just ordered
next year’s inventory. Payment of £100M is due in one year.
Spot exchange rate S($/£) = $1.25/£
360-day forward rate F360($/£) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%
IRP implies that there are two ways that you fix the cash outflow
to a certain U.S. dollar amount:
a) Put yourself in a position that delivers £100M in one year—a
long forward contract on the pound.
You will pay (£100M)(1.2/£) = $120M in one year.
b) Form a forward market hedge as shown below.
IRP and a Forward Market Hedge
To form a forward market hedge:
Borrow $112.05 million in the U.S. (in one year you will
owe $120 million).
Translate $112.05 million into pounds at the spot rate
S($/£) = $1.25/£ to receive £89.64 million.
Invest £89.64 million in the UK at i£ = 11.56% for one
year.
In one year your investment will be worth £100 million
—exactly enough to pay your supplier.
Forward Market Hedge
Where do the numbers come from? We owe our
supplier £100 million in one year—so we know that
we need to have an investment with a future value of
£100 million. Since i£ = 11.56% we need to invest
£89.64 million at the start of the year.
£100
£89.64 =
1.1156

How many dollars will it take to acquire £89.64 million at the start of the year if
S($/£) = $1.25/£?

$1.00
$112.05 = £89.64 ×
£1.25
Reasons for Deviations from
IRP
Transactions Costs
The interest rate available to an arbitrageur for
borrowing, ib,may exceed the rate he can lend at, il.
There may be bid-ask spreads to overcome, Fb/Sa < F/S
Thus

(Fb/Sa)(1 + i¥l)  (1 + i¥ b)  0
Capital Controls
Governments sometimes restrict import and export of
money through taxes or outright bans.
Transactions Costs Example
Will an arbitrageur facing the following prices be able
to make money?
  Borrowing Lending 1+i F
$
=
$/ €

$ 5% 4.50%
1+i S
€ $/ €

€ 6% 5.50%
  Bid Ask
Spot $1.00=€1.0 $1,01=€1,00
0
Forward $0.99=€1.0 $1.00=€1.00
0
 Transactions Costs Example
Try borrowing $1.000 at 5%:
Trade for € at the ask spot rate $1.01 = €1.00
Invest €990.10 at 5.5%
Hedge this with a forward contract on
€1,044.55 at $0.99 = €1.00

Now try this backwards

Receive $1.034.11
Owe $1,050 on your dollar-based borrowing
Suffer loss of $15.89
Purchasing Power Parity
Purchasing Power Parity and Exchange Rate
Determination
PPP Deviations and the Real Exchange Rate
Evidence on PPP
Purchasing Power Parity and
Exchange Rate Determination
The exchange rate between two currencies should equal
the ratio of the countries’ price levels:
P$
S($/£) =
P
 For example, if an ounce
£ of gold costs
$300 in the U.S. and £150 in the U.K., then
the price of one pound in terms of dollars
should be: P$ $300
S($/£) = = = $2/£
P £15
Purchasing Power Parity and
Exchange Rate Determination
Suppose the spot exchange rate is $1.25 = €1.00
If the inflation rate in the U.S. is expected to be 3% in
the next year and 5% in the euro zone,
Then the expected exchange rate in one year should
be $1.25×(1.03) = €1.00×(1.05)

F($/€) = $1.25×(1.03) = $1.23

€1.00×(1.05) €1.00
Purchasing Power Parity and
Exchange Rate Determination
The euro will trade at a 1.90% discount in the forward
market:
$1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00

Relative PPP states that the rate of change in

the exchange rate is equal to differences in the
rates of inflation—roughly 2%
Purchasing Power Parity
and Interest Rate Parity
Notice that our two big equations today equal each
other:

PPP IRP
F($/€) 1 + $ 1 + i$ F($/€)
= = =
S($/€) 1 + € 1 + i€ S($/€)
Quick and Dirty Short Cut
Given the difficulty in measuring expected inflation,
managers often use
$ – € ≈ i$ – i€
Evidence on PPP
PPP probably doesn’t hold precisely in the real world
for a variety of reasons.
Haircuts cost 10 times as much in the developed world
as in the developing world.
Film, on the other hand, is a highly standardized
commodity that is actively traded across borders.
Shipping costs, as well as tariffs and quotas can lead to
deviations from PPP.
PPP-determined exchange rates still provide a
valuable benchmark.
Approximate Equilibrium Exchange
Rate Relationships
E(e
≈ IFE ) ≈ FEP

≈ PPP
F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP

E($ – £)
The Exact Fisher Effects
An increase (decrease) in the expected rate of
inflation will cause a proportionate increase
(decrease) in the interest rate in the country.
For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where
$ is the equilibrium expected “real” U.S. interest rate
E($) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest
rate
International Fisher Effect
If the Fisher effect holds in the U.S.
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country
$ =  ¥
then we get the
International Fisher Effect:
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
International Fisher Effect
If the International Fisher Effect holds,

1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)

and if IRP also holds

1 + i¥ F
=
¥/$

1 + i$ S ¥/$

F E(1 + ¥)
then forward rate PPP =
¥/$

S E(1 + $)
holds: ¥/$
Exact Equilibrium Exchange Rate
Relationships
E (S ¥ / $ )
IFE S¥ /$ FEP

PPP
1 + i¥ IRP
F¥ / $
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
Forecasting Exchange Rates
Efficient Markets Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters
Efficient Markets Approach
Financial Markets are efficient if prices reflect all
available and relevant information.
If this is so, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient markets
approach is affordable and is hard to beat.
Fundamental Approach
Involves econometrics to develop models that use a
variety of explanatory variables. This involves three
steps:
step 1: Estimate the structural model.
step 2: Estimate future parameter values.
step 3: Use the model to develop forecasts.
The downside is that fundamental models do not work
any better than the forward rate model or the random
walk model.
Technical Approach
Technical analysis looks for patterns in the past
behavior of exchange rates.
Clearly it is based upon the premise that history
repeats itself.
Thus it is at odds with the EMH
Performance of the Forecasters
Forecasting is difficult, especially with regard to the
future.
As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the forward
rate.
The founder of Forbes Magazine once said:
“You can make more money selling financial advice
than following it.”
What is a futures contract
A futures contract is an agreement for future delivery
of a specified quantity of a commodity at a specified
price.
Futures contracts in commodities have existed for a
long time.
Futures in financial assets such as currencies, interest
bearing instruments like T-Bills & Bonds are relatively
new.
We will discuss financial futures that too only
currency & interest rate futures.
Major features of a futures Contract
Organized exchanges. ( Either designated physical
locations or electronic screen based trading )
Standardization .( Amount/Maturity )
Clearing House.
Initial Margin.
Marking to market
Actual delivery is rare
Some important terms
Mark to market means that at the end of a trading
session all outstanding contracts are re-priced at the
settlement price of that session.
This feature is what creates the major difference
between a forward contract & futures.In a forward
contract,gains or losses arise only at maturity.There are
no intermediate cash flows;In a futures contract,even
though the overall gain/loss is same,the time profile of
its accrual is different –the total gain or loss over the
entire period is broken up into a series of daily gains or
losses which has a different present value.
Actual Delivery is rare
In most financial future contracts, actual delivery
takes place in less than one percent of the contracts
traded. Futures are used as a hedging device against
price risk and as a way of betting on price movements
rather than as a means of physical acquisition of the
underlying asset.
The futures trading process
Floor traders (own)
Floor brokers (others)
Dual traders ( Both own & others)
Buyer acquires a long position
Seller acquires a short position
Initial margin ( both long & short traders give)
Variation margins ( gains/losses)
If the result is a loss there is maintenance margins
The futures trading process
Market orders ; a client may ask his broker to buy or
sell a certain no of contracts at the best available
price.
Limit orders ( upper limit for buy, lower limit for
sale)
Stop-loss orders
Stop-limit orders
Time of the day orders
Forecasting : approaches
Efficient market approach ( ideal or paradise ; does
not exist in reality)

Fundamental approach ( forecasting using various

models )

Technical approach ( analyse past behavior or

patterns, based on the premise that history repeats
itself)
Efficient market approach
This means that the market has already reflected all
relevant information.,such as money
supplies,inflation rates,trade balances and output
growth.
The exchange rate will only change if the market
receives any new information
Fundamental approach
Uses various models
E.g. monetary approach to exchange rate
determination suggests that exchange rate is
determined by :
1. Relative money supplies.
2.Relative velocity of monies.
3. National output
Technical analysis
While academic studies discredits the validity of
technical analysis,many traders depend on this.
SMA ( short-term moving average)
LMA ( long-term moving average)
Short term management
The essence of short term management entails :
1. Minimise the Working Capital needs consistent with
other policies.( credit policy,inventory levels)
2. Raise short-term funds at the minimum possible
cost & deploy short-term surpluses at the maximum
possible rate of return consistent with the firm’s risk
preferences & liquidity needs.
In a multinational context the added dimensions are
the multiplicity of currencies & a much wider array
of instruments for raising & deploying funds.
International dimensions
Instrument ( availability )
Currency
Location of the financial centre
Regulatory
Tax related issues.
Cost /Return dimensions
Liquidity
Political Risks
Investing surplus funds
Yield ( Return /Price)
Marketability ( Liquidity)
Exchange Rate Risk
Price Risk
Transaction Costs
Investing surplus funds
> The break even size is given by
M x ‘ i ’ – ( M – S *) X B = S * x ‘ d ’
S * =M(b – i) / ( b – d) where :
S= Surplus funds, ‘ i ’ = interest,d = interest rate on bank deposit & b= the int
rate on borrowing/overdraft

A treasurer has 180,000 surplus for 90 days.900day USD CDs are an attractive
instrument offerimng 10 % but the denomination is 100,000 per CD.The
treasurer can purchase one CD & invest 80000 @ 6 % in bank fixed deposit or
borrow USD 20000 @ 13 % vide overdraft facility.

e.g. M=100,000 , ‘ i ’ = 10 % (0.10) d= 6 % (.06),b= 0.13

Break even size = 10000 [0.13-0.1]/(0.13-0.06]=42857
Financing Short Term Deficits
Internal accruals
Centralised Cash pooling
> Cross border transactions have certain complications .
They are certainly a complex area .
Issues are :
* Differences in tax regimes
* Existence of double tax aviodance treaties.
* Differences in accounting norms
* Exchange risk
Centralised v/s Decentralised Cash
Management
Netting
Exposure Management
Cash pooling
Centralised Cash Management
Netting is possible in a Centralised Cash
Management Environment where there are a large
number of intra-corporate transactions between
subsidiaries and between subsidiaries & the parent.
The Cash Management Center (CMC ) nets out
receivables with payables and only net cash flows are
settled amongst the different units of the corporate
family.
Exposure Management
If individual subsidiaries are left to manage their
currency exposures ,each will have to access the
forward market ( or other appropriate devices) once
again increasing costs. The CMC can adopt a
corporate perspective and look at the overall
currency composition of receivables & payables.
Since the overall portfolio will be fairly diversified,
currency risk is considerably reduced. The CMC can
match & pair receivables with payables and exploit
the close correlations.
Disadvantages OF Centralised
Cash Management
Local Cash Requirements
Short-term needs
Prohibition on rapid transfers by the local banking
system.
Volatility & Uncertainty

Therefore each Corporation must evolve its own

optimal degree of Centralisation depending upon its
overall Business Plan.
A Country’s scorecard !
The Balance of payments (BOP)
All modern economies prepare & publish detailed
statistics about their transactions with the rest of the
world.
BOP is precisely defined as “ 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 & the rest of the
world”
Types of transactions
Purchase/sale of goods & services with a financial
quid pro quo.(1 Real & 1 financial)
Purchase/sale of goods in return for goods or services
or a barter transaction (2 real)
Purchase of foreign securities (2 financial)
A unilateral gift(real)
A unilateral financial gift(1 financial)
Balance of Payments : Meaning ?
BOP of a country records its economic transactions
with the ROW (Rest of the world) using a well
defined set if accounting conventions.
These transactions can be grouped in sub-groups
such as current account, capital account, autonomous
transactions & so on depending upon the economic
significance.
Balance of Payments :
Meaning ?..
The phrase Bop deficit or surplus normally refers to
the balance between credits & debits on the current
account.
Corporate finance managers must monitor the Bop
data being put by the Govt agencies on a regular basis
because they have both short-term & long-term
implications for a host of economic & financial
variables affecting the fortunes of the Company.
Accounting principles in BOP
All transactions which lead to an immediate or
expected payment from ROW (rest of the world) to
the country are recorded as credit entries.(payment
themselves are debits)
Conversely, all transactions which result in an actual
or expected payment from the country to the ROW.
Should be recorded as debits and corresponding
payments as credits.
BOP : significance thereof
In the short-run BOP deficits or surpluses have an
immediate impact on the exchange rate. Basically
BOP records all transactions that create demand &
supply for the currency. When exchange rates are
market determined, BOP figures indicate excess
demand or supply of the currency & the possible
impact on the exchange rate.
Components of the BOP
The Current account : includes imports of goods and
services and the unilateral transfers of goods &
services
The Capital account : Under this are grouped
transactions leading to changes in foreign financial
assets & liabilities of the country,
The Reserve account : No different from Capital
account but includes “ reserve assets”
Components of the BOP ..
These are assets which the monetary authority of the
country uses to settle deficits & surpluses that arise on
the other two categories taken together.
The BOP :Surplus or deficit.

In the language of accountants the entire BOP is

divided as “below the line “& above the line.
If the net balance (credits-debits) is Positive above
the line we say the Bop is surplus.
If it is negative we say there is a BOP deficit.
The items below the line are “compensatory” i.e.. they
finance or settle the imbalance above the line.
Several Concepts :evolved by
practice
Balance of Trade or trade balance is the merchandise
trade account.
Balance of Goods & Services
Current account balance
Financing International Trade
Massive Growth of International Trade possible due to
efficient payment mechanism.
Important considerations are :
* The nature of the goods in question.ST/LT
* The nature of the market
* The nature of relationship between Exporter & Importer
* The availability of various forms of financing
Various Forms of Financing
Open account ( Default recovery difficult)
Consignment (Usually to a Branch)
Advance payment
Documentary drafts (D/P Documents against payment,
Documents against acceptance D/A)
Letters of Credit (BASED SOLELY ON DOCS)
Forfaiting
Cross border leasing ( aviation/ships/oil drigging rigs/high
value capital goods)
Buyer’s credit and Lines of Credit from Banks/FI’s
Letters of Credit
A L/C is a written guarantee given by the importer’s bank
to honour an exporter’s draft or any other claims for
payment provided the exporter has fulfilled all the
conditions specified in the L/C
Issuing bank
Correspondent bank
Opening of L/C
Utilisation of L/C
Uniform Customs And Practices for Documentary Credit
( International Chamber of Commerce)
Country rating ?
Balance on Current Account & Long Term Capital.
This is also termed as “basic balance "the idea being
that while ST capital flows are highly volatile,LT cap
flows are of a more permanent nature & indicative of
the underlying strengths or weaknesses of the
economy.
Why should How are we as Finance managers know
about a country’s stability ?
Nature & measurement of
exposure & risk
Macroeconomic environmental risks. (Exchange rates,
interest rates & inflation)
Core Business risks
Exposure is a measure of sensitivity of the value of a
financial item(asset,liability,cash flow)
Risk is the measure of variability of the value.
Thus the magnitude of risk is determined by the
magnitude of exposure & the degree of variability in
the relevant risk factor.
E.g. Indo –US trade between April 1993 to July 1995
Types of L/C
Revocable
Irrevocable (cannot be cancelled without Exporter’s
consent)
Confirmed, Irrevocable L/C
A revolving L/C (many shipments)
A transferable L/C
Back-to-Back L/C ( Close relationship )
Exposure & Risk : a formal
approach
Exposure of a firm to a risk factor is the sensitivity of
the real value of a firm’s assets, liabilities or operating
income, expressed in its functional currency, to
anticipated changes in the risk factor.
Values in functional currency i.e. the primary
currency in which it publishes its financial statements
Exposure & Risk : a formal
approach
Functional currency
The real values
Unanticipated changes,usualy measured by the
forward rate of the currency.
Anticipated and Unanticipated risks.
Classification of FOREX Exposure &
Risk
Long Term : Operating & Strategic
Short Term are further divided into :
(a)Translation (Accounting)

(b) Cash flow which is :

(i) Contractual (transactions)
(ii) Unanticipated
Purchasing Power Parity (PPP)
P P P is derived from the Law of One price.
Goods that are traded freely should cost the same
everywhere measured in the same currency.
The exchange rates between currencies should be
such that the currencies have equivalent purchasing
power. Therefore exchange rates changeover the long
term as PP changes.
Typical examples of transaction
exposures
Payment for goods or services
Repay a foreign currency loan or make interest
payments as per contract
Dividends, royalty
BOP : Inference
BOP of a country records its economic transactions
with ROW using a well defined set of accounting
conventions.
Difference between Transaction &
Translation exposure
Transaction has impact on cash flows.
Translation has no impact on cash flows,
Foreign Exchange Transactions ..
The daily exchange rates are “spot rates”
Transactions in the future are “ forward transactions
” & the ex rate is “forward rate”.
Premium if the currency is expected to appreciate or
discount if the currency is expected to depreciate.
Forward contract is an agreement between a buyer &
seller to trade at a particular future date at a agreed
fixed price. (1,2,3 or 6 months)
The International Monetary system
The institutional framework within which
international payments are made, movement of
capital are accommodated and exchange rates among
currencies are determined.
The complex international monetary arrangements
imply for adroit financial decision making. Therefore
it is essential for managers to understand in detail the
working of the International monetary system.
 Relevant websites
www.rbi.org.in = This is the official website of our
Central Bank i.e. Reserve Bank of India

www.imf.com = This is the official website of The

International Monetary Fund

www.dailyfx.com or www.oanda.com This website

enables the current foreign exchange conversion rates
and the trend of forward premia.
Classification of exchange rate
exposures & risk.
Since the advent of floating rates in 1973,firms around
the world have become acutely aware of the fact that
fluctuations in exchange rates expose their
revenues,costs,operating cash flows and hence their
market value to substantial fluctuations.Firms have
cross border transactions –exports & imports of goods
& services, foreign borrowing & lending, foreign
portfolio & direct investment and so on.
Currency exposure
Accounting exposure :
Transaction
Translation
Operating exposure
Contingent
Competitive
Transaction exposures
An unanticipated change in the exchange rate has an
impact –favorable or adverse –on its cash flows.
In essence it is the measure of the sensitivity of home
currency value of assets & liabilities which are
denominated in foreign currency, to unanticipated
changes in exchange rates., when the assets or
liabilities are liquidated.
Examples of transaction exposure
A currency has to be converted in order to make or
receive payment for goods or services.i.e exports or
imports denominated in foreign currency:
A currency has to be converted to repay a loan or
make an interest payment (or conversely receive a
repayment or an interest payment)
Payment or receipt of dividends, royalty
Translation exposure
The other kind of exposure is called a Translation
exposure also called as Balance Sheet exposure.
It is the exposure on assets & liabilities appearing in
the Balance sheet which are not going to be liquidated
in the foreseeable future.
Transaction exposures
Short term horizon

Affect Cash flows