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International Finance - Short Notes (Theory)
International Finance - Short Notes (Theory)
International Finance - Short Notes (Theory)
NOTE: MOST DATA BELOW HAS BEEN COPY-PASTED FROM VAROUS SOURCES.
(UTILISE AT YOUR OWN DISCRETION, FOR REFERENCE PURPOSES ONLY)
Note: Only the seemingly important and relevant theoretical topics are covered here, not the
entire syllabus.
UNIT 1
International Trade
• International trade is a field in economics that applies microeconomic models to help
understand the international economy.
• It is the exchange of goods and services across international borders or territories
• Its content includes basic supply-and-demand analysis of international markets; firm
and consumer behavior; perfectly competitive, oligopolistic, and monopolistic market
structures; and the effects of market distortions
• The objective is to understand the effects of international trade on individuals and
businesses and the effects of changes in trade policies and other economic conditions.
There are two basic types of trade between countries:
1. the first in which the receiving country itself cannot produce the goods or provide the
services in question, or where they do not have enough to be a self-sufficient
economy.
2. the second, in which they have the capability of producing the goods or supplying the
services, but still import them
International Finance
• International finance applies macroeconomic models to help understand the
international economy.
• Its focus is on the interrelationships among aggregate economic variables such as
GDP, unemployment rates, inflation rates, trade balances, exchange rates, interest
rates, and so on.
• This field expands basic macroeconomics to include international exchanges. Its focus
is on the significance of trade imbalances, the determinants of exchange rates, and the
aggregate effects of government monetary and fiscal policies.
International finance plays a critical role in international trade and inter-economy exchange
of goods and services. International finance is an important tool to find the exchange rates,
compare inflation.
International Business
• International business is the term used for business conducted all over the world.
• These transactions include the transfer of goods, services, technology, managerial
knowledge, and capital to other countries. International business involves exports and
imports and business processes and channel beyond simple trade.
• International Business is also referred to as Global Business and can encompass:
- Exporting goods and services.
- Giving license to produce goods in the host country.
- Starting a joint venture with a company.
- Opening a branch for producing & distributing goods in the host country
- Providing managerial services to companies in the host country.
Assumptions:
● Trade exists between two countries
• Only two goods are produced and traded
• Assumes there is an absolute advantage balance among nations
• Labor is the only factor of production and its productivity remains the same
Assumptions
• Assumption of Perfect Competition
• Productivity of labor constant for both products and in both countries
• Labor is perfectly mobile between sectors but immobile between countries
• No technological innovation in any of the economies
Based on these postulates, the H-O model predicts that the capital surplus country specializes
in the production and export of capital-intensive goods and the labor surplus country
specializes in the production and export of labor-intensive goods
Gains from Trade: Trade leads to convergence of relative prices, which in turn has strong
effect on the relative earnings of the factors of production.
Example: the US has long been a substantial exporter of agricultural goods, reflecting in part
its unusual abundance of arable land. China exports labor-intensive manufactured goods
reflecting China’s relative abundance of low-cost labor
Leontief Paradox
Since US was relatively abundant in capital compared to other nations, the US would be an
exporter of capital-intensive goods and an importer of labor-intensive goods. However,
Leontief found that US exports were less capital intensive than US imports. This has become
known as Leontief paradox
Rational: US has a special advantage in producing new and innovative products. Such
products may be less capital intensive and heavily use skilled labor and innovative
entrepreneurship Ex: Computer software
Balance of payments and international investment position data are critical in formulating
national and international economic policy. Certain aspects of the balance of payments data,
such as payment imbalances and foreign direct investment, are key issues that a nation's
policymakers seek to address.
Trade Balance (BOT): The balance of trade is the difference between the value of a country's
imports and exports for a given period. The balance of trade is the largest component of a
country's balance of payments.
Balance of Goods & Services: This is the balance between exports and imports of goods and
services.
Current Account Balance: This is the net balance on the entire current account. Negative CA
Balance implies a deficit, when positive it is in surplus.
Before you move ahead: The Bretton Woods agreement also created two important
institutions namely the IMF & World Bank group. The purpose of IMF was to monitor
exchange rates and lend reserve currency to nations that needed it to support their currencies
and settle their debts.
The World Bank group initially called the International Bank for reconstruction and
Development was established to provide assistance to countries that had been physically and
financially devastate by World War II.
IMF
The International Monetary Fund (IMF) is based in Washington, D.C., and currently consists
of 189 member countries, each of which has representation on the IMF's executive board in
proportion to its financial importance, so that the most powerful countries in the global
economy have the most voting power. The IMF's website describes its mission as "to foster
global monetary cooperation, secure financial stability, facilitate international trade, promote
high employment and sustainable economic growth, and reduce poverty around the world."
The IMF's primary methods for achieving these goals are monitoring, capacity building, and
lending.
1. Surveillance
The IMF collects massive amounts of data on national economies, international trade, and the
global economy in aggregate, as well as providing regularly updated economic forecasts at
the national and international level. These forecasts, published in the World Economic
Outlook, are accompanied by lengthy discussions of the effect of fiscal, monetary, and trade
policies on growth prospects and financial stability.
2. Capacity Building
The IMF provides technical assistance, training, and policy advice to member countries
through its capacity building programs. These programs include training in data collection
and analysis, which feed into the IMF's project of monitoring national and global economies.
3. Lending
The IMF makes loans to countries that are experiencing economic distress in order to prevent
or mitigate financial crises. Members contribute the funds for this lending to a pool based on
a quota system.
The World Bank advances loans to the developing countries subject to the following
conditions:
(a) The overall economy of the borrowing country is soundly operated
(b) If the overall economic plans would reinforce the basic soundness of economy, and
(c) The projects which the bank is asked to finance have been carefully prepared and are
economically and financially justified.
The World Bank has become a part of a broadening stream of financial and technical
assistance to the less developed countries. Although now other sources and institutions have
also joined in the task which the Bank pioneered with such imagination and purposiveness, it
has not detracted from the importance of the part which the Bank is playing in mobilizing
international assistance to developing countries.
UNIT 2
Direct Quotation-Indirect Quotation (LQP)
Direct Quotation: A direct quote is a foreign exchange rate involving a quote in fixed units of
foreign currency against variable amounts of the domestic currency.
Format - Base/Quote
USD/INR = 70 (DQ for Indian)
Indirect Quotation: The term indirect quote is a currency quotation in the foreign exchange
market that expresses the amount of foreign currency required to buy or sell one unit of the
domestic currency.
INR/USD = 0.01428 (IDQ for Indian)
Retail Market: The market in which travellers and tourists exchange one currency for another
in the form of currency notes or traveller’s cheques. The total turnover and average
transaction size are very small. The spread between buying and selling prices is large. In
retail market, entities who quote forex rates, but don’t make a two-way market are the
secondary price makers. For instance, hotels, shops catering to tourists buy foreign currency.
(Bid-Ask spreads are much wider)
Wholesale Market: The foreign exchange market where the major participants are
commercial banks, investment institutions, non-financial corporations and central banks. The
average transaction size is very large. The primary price makers quote a two-way price – a
price to buy currency X against Y, and a price to sell X against Y. This group includes
commercial banks, some large investment dealers and a few large corporations. (Bid-Ask
spreads are narrow)
Note: Price takers simply take the prices quoted by the primary price makers, and buy/sell
currency for their own purposes, but do not make a market themselves. Don’t take an active
position in the market to profit from exchange rate fluctuations.
Settlement Dates
- In spot transaction, settlement date is two business days ahead for European/Asian
currencies traded against the dollar.
- To reduce credit risk, both transfers should take place on the same day.
- In case there is a holiday on the day of transfer, then the transfer is shifted to the next
business day
- For forward transactions, we find the date of spot transaction and add one calendar
month
- If in a forward transaction, the value date is ineligible because of some bank holiday,
then it is shifted to next available business day, however it must not take you into the
next calendar month (in that case it is shifted backward)
- Broken Date: Forward contracts for maturities which are not in whole months
- Short Date: Transactions that call for settlement before the spot date.
Extension
- Information on maturity date
- Information to bank before maturity date
Date of Delivery Before Date of Delivery
Importer Swap Out Fwd-Fwd-Out
Exporter Swap In Fwd-Fwd In
Cancellation – Just take opposite position of what you had earlier head
[If one country offers a higher risk-free rate of return in one currency than that of another, the
country that offers the higher risk-free rate of return will be exchanged at a more expensive
future price than the current spot price.]
2. Monetary Approach
The monetary model assumes a simple money demand curve. The purchasing power parity or
the law of one price holds true. The monetary model also assumes a vertical aggregate money
supply curve.
According to the absolute purchasing power parity the exchange rate is obtained by dividing
the price level of the home country with that of the foreign country.i.e. P = e x P*,
P stands for the domestic price level and P* the foreign price level. e is the exchange rate.
kPy=Ms
or, P = Ms / ky
or eP* = P = Ms / ky
or, e = Ms / P*ky
At this point external equilibrium is obtained in the economy. It is also clear from the above
equation that an increase in the money supply within an economy would lead to appreciation
of the domestic currency. Conversely, international price level as well as the output level
related inversely with the exchange rate.
UNIT 3
Standard No. 8
U.S. accounting standard that requires US firms to translate their foreign affiliates' accounts
by the temporal method; that is, reporting gains and losses from currency fluctuations in
current income. It was in effect between 1975 and 1981 and became the most controversial
accounting standard in the US. It was replaced by FASB No. 52 in 1981.
Standard No. 52
The US accounting standard that replaced FASB No. 8. US companies are required to
translate foreign accounts in terms of the current rate and report the changes
from currency fluctuations in a cumulative translation adjustment account in
the equity section of the balance sheet.
Operational Exposure: The effect of random changes in exchange rates on the firm’s
competitive position, which is not readily measurable. A good definition of operating
exposure is the extent to which the firm’s operating cash flows are affected by the exchange
rate. It has two components, the competitive effect (difficulties and increased costs of
shipping) and the conversion effect (lower dollar prices of imports due to foreign currency
and exchange rate depreciation). Operating exposure can be managed by:
- Selecting low cost production sites (Honda built north American factories due to
strong yen, later found itself importing more cars from Japan due to weak yen)
- Flexible sourcing policy (applies to workers as well)
- Diversification of the market (diversifying exchange rate risk)
- R&D & Product Differentiation (leads to less elastic demand)
-
Multi National Financial System
Financial transactions within the MNC result from internal transfer of goods, services,
technology and capital. These flows emerge from intermediate and finished goods to fewer
tangible items such as management skills and patents. Those transactions not liquidated
immediately give rise to some type of financial claim, such as royalties for the use of patent.
This forms a multinational financial system which can be broadly characterised by the
following factors:
1. Mode of Transfer: The MNC has considerable freedom in selecting the financial
channels through which funds, allocated profits or both are moved Moreover, the
MNC can move profits and cash from one unit to another by adjusting transfer prices
on inter-company sale-purchase of goods and services
2. Timing Flexibility: Some of the internally generated financial claims require a fixed
payment schedule, while others can be accelerated or delayed. This leading & lagging
is applied to inter-affiliate trade credit where a change in account terms can involve
massive shifts in liquidity.
3. Value: Value of MNC’s network of financial linkages stems from wide variations in
national tax systems and significant costs and barriers associated with international
financial transfer. These can be classified as the following arbitrage opportunities:
- Tax Arbitrage: Shifting profits from units located in high tax nations to those in low
tax nations.
- Financial Market Arbitrage: This can be done by transferring funds amongst units.
Firms can earn higher risk adjusted yields on excess funds, reduce risk adjusted cost
of borrowed funds, and tap previously unavailable capital resources.
- Regulatory System Arbitrage: When subsidiary profits are a function of government
regulations, or union pressure rather than marketplace, the ability to disguise true
profitability by reallocating profits can give the MNC negotiating advantage.
The value of leading and lagging depends on the opportunity cost of funds to both the paying
unit and the recipient.
- When an affiliate already in surplus position receives payment, it can invest the
additional funds at the prevailing local lending rate. If it requires working capital, the
payment received can be used to reduce its borrowings at the borrowing rate.
- If a paying unit has excess funds, it loses cash that it would have invested at the
lending rate. If it’s in a deficit position, it has to borrow at the borrowing rate.
Assessment of the benefits of shifting liquidity among affiliates require that these
borrowing and lending rates be calculated on an after-tax dollar basis.
GDR: A global depositary receipt (GDR) is very similar to an American depositary receipt
(ADR). It is a type of bank certificate that represents shares in a foreign company, such that a
foreign branch of an international bank then holds the shares. The shares themselves trade as
domestic shares, but, globally, various bank branches offer the shares for sale. Private
markets use GDRs to raise capital denominated in either U.S. dollars or euros. When private
markets attempt to obtain euros instead of U.S. dollars, GDRs are referred to as EDRs.
Euro Bond (LQP): A Eurobond is denominated in a currency other than the home currency
of the country or market in which it is issued. These bonds are frequently grouped together by
the currency in which they are denominated, such as Eurodollar or euro yen bonds. Issuance
is usually handled by an international syndicate of financial institutions on behalf of the
borrower, one of which may underwrite the bond, thus guaranteeing purchase of the entire
issue. The popularity of Eurobonds as a financing tool reflects their high degree of flexibility
as they offer issuers the ability to choose the country of issuance based on the regulatory
market, interest rates and depth of the market. They are also attractive to investors because
they usually have small par values and high liquidity.
Foreign Bond: A foreign bond is a bond issued in a domestic market by a foreign entity in
the domestic market's currency as a means of raising capital. For foreign firms doing a large
amount of business in the domestic market, issuing foreign bonds, such as bulldog bonds,
Matilda bonds and samurai bonds, is a common practice. Since investors in foreign bonds are
usually the residents of the domestic country, investors find the bonds attractive because they
can add foreign content to their portfolios without the added exchange rate exposure.
UNIT 4
International Portfolio Investment (IPM) (LQP – International Portfolio Diversification)
International Portfolio Investment is the investment by individuals and institutional investors
in international stocks, bond and other securities. Rapid growth in IPM, reflects globalisation
of financial markets accruing to governmental efforts around the globe to deregulate foreign
exchange.
International diversification is important because security returns are substantially less
correlated across countries than within a country, because of varying economic, political,
psychological factors. The diversification benefits are thereby achieved through the addition
of low correlation assets that serve to reduce the overall risk of the portfolio. Apart from
benefits, there are certain risks that international investors face:
1. Higher Transaction Costs: Despite globalization, transaction costs can vary greatly
depending on which foreign market you invest in. Brokerage commission are higher
in international markets. On top of that, stamp duties, taxes, clearing fees and
exchange fees can depreciate your returns.
Solutions: These costs can be countered using ADR, that trade on local exchanges and can be
bought with same transaction costs, they are denominated in dollar yet are exposed to
fluctuations in exchange rate.
2. Currency Volatility: Investment in foreign market requires exchanging your domestic
currency (say USD) for foreign currency. If you hold the asset for a year, and sell it,
you still will have to convert the foreign currency back to USD at prevailing rate.
Uncertainty of what future exchange rate will be, scares many investors, and affects
your returns.
Solution: Hedging Transaction Exposure as described in Unit 3.
3. Liquidity Risks: Risk of not being able to sell your stock quickly enough once a sell
order is entered into. Thereby caution must be exercised, else foreign investments can
become illiquid by the time the investor closes her position.
Solution: Illiquid assets have wider assets. Narrower spreads and high volume suggest higher
liquidity.
Optimal International Asset allocation (LQP): Rational investors would select portfolio by
considering returns as well as risk. They may be willing to assume additional risk if they are
sufficiently compensated by a higher expected return. The world beta measures the
sensitivity of the national market to the world market movements. National stock market
returns performance can be measured by Sharpe Performance Measure (SHP) that represents
the excess return per standard deviation risk.
IRR Method
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes
the net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
NPV=[∑Ct/(1+r) ^t] − C0 = 0
Ct=net cash inflow during the period t
C0=total initial investment costs
r=the discount rate that is IRR (higher the better)
t=the number of time periods
APV Method
Adjusted present value (APV), defined as the net present value of a project if financed solely
by equity plus the present value of financing benefits. It is very similar to NPV. The
difference is that is uses the cost of equity as the discount rate rather than WACC. And APV
includes tax shields such as those provided by deductible interests. APV analysis is effective
for highly leveraged transactions.
Country Risk Analysis (LQP): Country Risk refers to the uncertainty associated with
investing in a particular country, and the degree to which that uncertainty can lead to losses
for investors. This can come from any number of factors including political, economic,
exchange-rate etc.
- Country risk (in-general) denotes the risk that a foreign government will default on its
bonds or other financial commitments.
- In a broader sense, country risk is the degree to which political and economic unrest
affect the securities of issuers doing business in a particular country.
- Country risk is critical to consider when investing in less-developed nations. To the
degree that factors such as political instability can affect the investments in a given
country, these risks are elevated because of the great turmoil that can be created in
financial markets.
- Most investors think of the United States as the benchmark for low country risk. So, if
an investor is attracted to investments in countries with high levels of civil conflict,
like Argentina or Venezuela for instance, he or she would be wise to compare their
country risk to that of the U.S.
Political Risk (LQP): Political risk is the risk an investment's returns could suffer as a result
of political changes or instability in a country. Instability affecting investment returns could
stem from a change in government, legislative bodies, other foreign policy makers or military
control. Political risk is also known as "geopolitical risk," and becomes more of a factor as
the time horizon of an investment gets longer. Political risks are notoriously hard to quantify
because there are limited sample sizes or case studies when discussing an individual nation.
Some political risks can be insured against through international agencies or other
government bodies. The outcome of a political risk could drag down investment returns or
even go so far as to remove the ability to withdraw capital from an investment.
Netting: A multinational firm should not consider deals in isolation, but should focus on
hedging the firm as a portfolio of currency positions. Many multinational firms use a
reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once
the residual exposure is determined, then the firm implements hedging.
Pooling: The cash pooling (or cash pooling) is a centralized cash management strategy to
balance the accounts of a group’s subsidiaries. The final goal is to optimize the condition and
the management of the treasury by overcoming the imperfections of the financial markets
with less financial costs. The centralizing account of the holding is a unique account designed
to centralize every day all the account balances of the company’s subsidiaries and centralizes
the cash flow of the various accounts to improve the global management. This can be done by
transferring funds to accounts with negative balance, so that there is no higher interest
expense or transferring funds to one account, in order to reap the dividends of the credit
balance
Extra
Home Bias: Home bias is the tendency for investors to invest in a large number of domestic
equities, despite the purported benefits of diversifying into foreign equities. This bias is
believed to have arisen as a result of the extra difficulties associated with investing in foreign
equities, such as legal restrictions and additional transaction costs. Other investors may
simply exhibit home bias due to a preference for investing in what they are already familiar
with rather than moving into the unknown.
Hedge Ratio: The hedge ratio compares the value of a position protected through the use of a
hedge with the size of the entire position itself. A hedge ratio may also be a comparison of
the value of futures contracts purchased or sold to the value of the cash commodity being
hedged. Futures contracts are essentially investment vehicles that let the investor lock in a
price for a physical asset at some point in the future.
Note: The fundamental here is to gain a short brief explanation of each topic from
examination point of view. In depth knowledge lies in books, please do refer to them as well.
(Eun-Resnick, Shapiro, PPT’s and other resources all available on bit.ly/NOTES-COUNCIL)