Part 1

ECONOMIC ENVIRONMENT
AND FINANCIAL MARKETS

INTERNATIONAL FINANCIAL MANAGEMENT
PART 1
CONTENTS
➔ Economic Policy Objectives
➔ Fiscal Policy
➔ Monetary Policy
➔ Financial Markets
➔ Exchange Rates
➔ Interest Rates
➔ Money Market Instruments
➔ ESG
Understanding Economic Policy Objectives
Real Economic Growth (per Capita)
● Economic growth is a way to track how much a country's production of goods and services
increases over time. When we talk about "real" economic growth, we're focusing on actual
improvements, without considering the effect of rising prices. A good way to gauge changes in
wealth and the standard of living in a country is to look at the Real GDP per capita.
Maintaining Price Stability
● The changes in the price levels of goods and services can have a big impact on a country's economic
growth. When prices fluctuate, it can influence when and how much people choose to spend, save,
or borrow. These changes in prices can also affect the value of investments, so maintaining a stable
price level is essential.
Achieving Full Employment (It's not the same as zero unemployment!)
● A healthy economy aims to have low levels of unemployment, where most people who want to work
can find work. However, it's normal to have some level of voluntary (people choosing not to work)
and short-term involuntary unemployment (people temporarily between jobs).
Ensuring Balance of Payments Stability
● A country's financial health, its standing as a borrower, and its relationships with other countries
can all be influenced by its trade balance - that is, the difference between what it imports and what
it exports. Maintaining a balance here is important; consistently importing more than exporting can
hinder economic growth in the long run.
INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 3
Exploring Fiscal Policy
Fiscal policy involves adjusting government spending and tax policies to either
stimulate a sluggish economy or cool down an overly busy one. Here's how the
government might step in:
Kick-starting the Economy with Expansionary Fiscal Policy
● Imagine the government decides to build new hospitals, roads, and sewers but
doesn't increase taxes to fund these projects. Instead, it borrows more money.
This increased spending can give the economy a boost by raising the overall
demand for goods and services.
Cooling Down with Contractionary Fiscal Policy
● On the other hand, if the economy is running too hot or the country's debt is
getting too high, the government might choose to either increase taxes without
upping its spending, or maintain the current tax rate but reduce its spending. This
can help reduce the total demand in the economy, preventing it from overheating
and keeping the debt in check.
Fiscal Policy and Its Impact on Business
Fiscal policy has a ripple effect on various industries, including those in the service and
manufacturing sectors. Here are some ways businesses might be affected:
Navigating Changes in Demand
● Fiscal policy can shape the overall demand for goods and services. Businesses
need to anticipate these shifts to plan effectively for future sales growth. When
the government's approach is stable, it's easier for companies to plan accordingly.
Adapting to Tax Modifications
The fiscal policy can usher in changes in tax structures, influencing business
operations. For instance:
● Alterations in employer's national insurance contributions can affect labor costs.
● If taxes like sales tax or excise duty increase, businesses might need to decide
whether to absorb the extra costs or pass them onto consumers through higher
prices.
Understanding Monetary Policy
● Monetary policy refers to central bank (or other monetary authority) activities that are
directed toward influencing the money supply (the amount of money in circulation)
and credit (the amount of money available for borrowing and at what cost or interest
rate) in an economy. The ultimate goal is to influence key macroeconomic targets:
○ Price stability
○ Economic output or GDP
○ Employment
● Most central banks have a mandate of maintaining price stability (controlling inflation
while avoiding deflation), which has indirect effects on other macroeconomic targets,
such as employment and output.
● European Central Bank: “Our job is to maintain price stability. This is the best
contribution monetary policy can make to economic growth and job creation. We keep
prices stable by making sure that inflation – the rate at which the overall prices for
goods and services change over time – remains low, stable and predictable. We are
targeting an inflation rate of 2% over the medium term.”
Tools of monetary policy
Conventional
● Open Market Operations: the central bank buys and sells government securities like
notes and bonds. For instance, to spur the economy, the central bank might buy these
securities from commercial banks. This transaction infuses more cash into the banking
system, increasing the overall money supply and credit available in the economy.
● Adjusting the Central Bank Lending Rate: this is the rate at which commercial banks
borrow from the central bank. Adjusting this rate can influence both short-term and,
indirectly, long-term interest rates. When the central bank raises its lending rate,
commercial banks often follow suit, which slows down borrowing.
● Modifying Reserve Requirements for Commercial Banks: reserve requirements
dictate the fraction of deposits that banks need to hold back at their account with the
central bank, instead of lending out. By increasing these requirements, the central
bank can restrict the credit availability in the economy.

Tools of monetary policy
Unconventional
● Quantitative Easing (QE), initiated primarily post the 2008 financial crisis, QE
resembles open market operations but is conducted on a grander scale. It includes
the purchase of a variety of financial instruments, not limited to short-term
government securities. This might encompass long-term government debts and
corporate debts with differing maturities, helping to inject a large amount of
money into the economy to stimulate growth.
● Forward guidance is verbal assurance from a country’s central bank to the public
about its intended monetary policy. The central bank shares its plans and
expectations regarding future monetary policies with the public. It's a way to
influence economic behavior based on the predicted paths of interest rates and
other economic indicators, aiming to instill confidence and predictability in
financial markets.

Policy Limitations
The effectiveness of monetary and fiscal policy will vary over time and among countries. For
example, in a recession with rising unemployment, cuts in the income tax will not always
raise consumer spending because consumers may want to increase their savings in
anticipation of further deterioration. The policy effectiveness is limited by the following:
● Time Lags: policies take time to implement and to start showing effects on the
economy. Often, the economic landscape might change before the policy's impact
becomes visible, possibly requiring adjustments or new strategies.
● Unpredictable Responses: the reactions of consumers and businesses to policy shifts

can be unpredictable. For instance, despite low-interest rates intending to boost
spending, individuals and firms might hoard cash, anticipating economic slowdowns or
waiting for better buying opportunities later.
● Unintended Consequences: sometimes, policies might lead to unintended outcomes. A

rise in government spending to boost demand and GDP could, paradoxically, lead to a
spike in inflation due to increased employment and subsequent wage and price hikes.
Understanding Financial Markets
Think of financial markets as dynamic meeting places where people with extra money
come to lend to those who need funds. This process is facilitated by various
middlemen, such as banks and insurance firms. These markets can be classified into:
● Capital Markets (for long-term investments, like buying a factory) and
Money Markets (for short-term needs, such as business operating expenses)
● Primary Markets (where new securities are issued for the first time) and
Secondary Markets (where existing securities are bought and sold)
● Exchange Markets (organized platforms where securities are traded) and
OTC Markets (a decentralized market for trading directly between two parties)
Securitization is a creative financial process that converts illiquid assets, like loans,
into tradable securities. This innovative evolution has paved the way for direct
connections between those lending money and those borrowing, reducing the reliance
on middlemen. Nonetheless, it was a contributing factor to the Global Financial Crisis.
Financial Markets

Money and Capital Markets
Focusing mainly on short-term financial tenors, money markets are platforms where
short-term lending and borrowing take place. Here's how they operate:
● Trading of short-term financial instruments that will mature in one year or less.
● Banks and other financial institutions primarily operate on these markets, with
big corporations and most governments also taking part.
On the other hand, capital markets assist companies in securing the funding they need
for the long term. Here are the two primary routes through which companies can
obtain long-term financing:
● Raising Share Capital (Equity): Companies invite investors to buy new shares or
increase their current stake. It's a way to become a part-owner of the company.
● Raising Loan Capital (Debt): Companies can turn to several tools like loan notes,
corporate bonds, and debentures to secure long-term debt. These instruments
can either be secured or convertible, offering diverse options for raising capital.
Primary and Secondary Markets
Primary markets are the venues where issuers (like companies or governments) offer
their securities directly to investors. Think of this as the "birthplace" for securities.
● Each type of security has its unique primary market. For instance, there are
dedicated markets for company shares and government bonds.
● Eligibility: Typically, in most nations, only public companies can raise funds in the
primary market, ensuring transparency and accountability.
Secondary markets involve trading these securities among investors.
● Besides securities like shares and bonds, secondary markets also host trading of
derivative contracts like futures and options.
● Investors often lean on trading service providers, like brokers or dealers, to
navigate the complexities of these trades.
● Secondary markets are attractive to investors, because of their liquidity. After all,
it's comforting to know you can quickly sell an asset if the need arises.
International Financial Markets
● The eurocurrency market is the money market for currency outside of the country
where it is legal tender. It is used by banks, multinational corporations, mutual funds,
pension funds and hedge funds.
● The term eurocurrency should not be confused with the EU currency, the euro.
● There is also a eurobond market for countries, companies, and financial institutions to
borrow in currencies outside of their domestic market. Eurobonds may be the most
suitable source of finance for a large organization with an excellent credit rating, such
as a big multinational company, which requires a long-term loan to finance capital
expansion.
● Eurocurrency markets can offer better rates for both borrowers and lenders, but they
also have higher risks. A borrower who is contemplating a Eurobond issue must
consider the exchange risk of a long-term foreign currency loan. A crucial aspect to
consider, especially if revenues generated are in a different currency than the loan,
potentially leading to exchange losses.

Understanding Exchange Rates
Exchange rates dictate the value at which one currency can be exchanged for another.
Essentially, it tells you how much of one currency is needed to purchase a unit of another. FX
dealers exploit the differences in exchange rates to make profits, establishing bid (buying
price) and ask (selling price) rates in the process.
● Floating rate - the currency value fluctuates based on market forces of supply and
demand, without intervention from the central bank.
● Fixed rate – mitigates currency risk but erode the economic competitiveness of a
nation over time. A less competitive economy may face a deteriorating current account
balance due to overvaluation of its currency, making its exports pricey and imports
cheaper. If this happens, the only course of action is an official devaluation of the
currency.
● Managed (dirty) floating rate – a middle-ground approach where the central bank
occasionally intervenes using its foreign currency reserves to maintain the value of the
domestic currency within a predetermined range, ensuring stability and
competitiveness.
Exchange Rates and Business
Variable exchange rates bring a lot uncertainty upon businesses engaged in international
trade. As we delve deeper into this course, we will explore various strategies
multinational corporations employ to hedge their risk and prevent potential losses
arising from foreign exchange transactions.…
A lower exchange rate… A higher exchange rate…
Imported raw materials are more Imported raw materials are cheaper so
expensive so costs of production rise. costs of production fall.
Domestic goods are cheaper in foreign Domestic goods are more expensive in
markets so demand for exports increases. foreign markets so demand for exports
falls.
Foreign goods are more expensive so Foreign goods are cheaper so demand for
demand for imports falls. imports rises.

Understanding Interest Rates
Interest rates serve as the 'price tags' attached to borrowing funds. In simple
terms, they are the percentage of the principal amount that borrowers pay to
lenders as a fee for using their money. The fluctuation in interest rates on financial
assets is primarily influenced by:
● Risk and Return: Higher risk necessitates higher returns. Therefore,
borrowers perceived to be of higher risk are charged higher interest rates to
compensate the lenders for taking the increased risk.
● Creditworthiness: Banks gauge the ability of the borrower to repay, setting
the interest rate accordingly, often adding a markup to their base rate for
higher risk borrowers.
● Loan Term: Generally, the term of the loan influences the interest rate, with
longer-term assets potentially earning a higher yield compared to short-term
ones. However, this isn't a strict rule.

The risk-return trade-off
There is a trade-off between risk and return. Investors in riskier assets expect to be compensated
for the risk with additional return. This return can be decomposed into: current income (dividend or
interest) and expected capital gain. The main financial instruments in ascending order of risk are:
● government bills / notes / bonds - the risk of default is negligible. The only uncertainty
concerns the movement of interest rates over time, and longer dated bonds tend to carry a
higher interest.
● sovereign, supranational and agency bonds - the risk of default is small as usually there is
some explicit or implicit government or other guarantee. The interest rate risk is higher
compared to government bonds.
● corporate bonds – corporate bonds bear some risk of default, they can be secured (against
corporate assets) or unsecured. The unsecured corporate bonds are generally riskier.
● preferred shares - riskier than bonds since they rank behind debt in the event of a liquidation,
although they rank ahead of ordinary shares. The return usually takes the form of a fixed
percentage dividend based on the par value.
● ordinary / common shares – they carry the highest level of risk. Dividends are paid out of
profits after all other liabilities have been paid and can be subject to large fluctuations from
year to year. However, there is potential for significant capital appreciation in times of growth
or significant capital loss in recession.
Money Market Instruments
Money market instruments are traded over the counter between institutional investors.
They include interest-bearing instruments, discount instruments and derivatives.
Interest-bearing Discount Instruments Derivatives

Instruments
Money market deposits Treasury bills (T-bill) Forwards and Futures
Certification of deposit Banker’s acceptance Options

(CD)
Repurchase agreement Commercial paper (CP) Swaps
(Repo)
We will explore derivatives thoroughly in a later chapter of the course…

Interest-bearing Instruments
Money market deposits are short-term loans that take place between banks or other
entities including governments. These deposits come in two main forms: fixed deposits and
call deposits. Fixed deposits are characterized by predetermined interest rates and maturity
dates agreed upon at the time of the transaction. Call deposits feature variable interest
rates and allow the deposit to be terminated given prior notice, offering more flexibility
compared to their fixed counterparts.
A Certificate of Deposit (CD) is a certificate of receipt for funds deposited at a bank or other
financial institution for a specified term and paying interest at a specified rate. Certificates
of deposit can be either negotiable or non-negotiable. The holder of a negotiable CD has
two options: to hold it until maturity, receiving the interest and the principal or to sell it
before maturity at the prevalent market price.
Repurchase agreements, commonly referred to as repos, are loans that are secured by
marketable instruments, most often a treasury bill. These agreements are flexible, with
terms ranging from 1 to 180 days. A repo consists of two primary transactions: initially, the
dealer sells the security in exchange for cash, and upon reaching maturity, the dealer repays
the cash amount along with the interest, reclaiming the security in the process.
Practice Problems: Interest-bearing Instruments
Useful Formula:
Value of deposit (CD) at maturity =

Face Value x [1 + Interest Rate x ( Days to Maturity / Days in the Year)]
1. For your liquidity portfolio you consider a EUR-denominated overnight deposit with
a face value of EUR 25,000,000. The prevalent EUR O/N market interest rate is 1.08%.
Calculate the amount you expect to receive on maturity if the day count convention is
Actual/360.
2. Consider a US Dollar CD with a face value of $10,000,000 issued on 1st March 2022
maturing on 1st September 2022. The interest rate is 7% per annum. Calculate the
amount you expect to receive on maturity if the day count convention is Actual/360.
(Hint: There are 184 days between the issue date and the maturity date.)

Discount Instruments
Treasury bills are short-term debt instruments issued by the government to raise funds.
These have varying maturities ranging from a month to a year. Being backed by the
government, they are considered a safe investment choice for investors looking for
short-term investment opportunities with reliable returns.
Commercial paper is short-term unsecured corporate debt with maturity up to 1 year. The
typical term of this debt is about 30 days. Commercial paper is issued by governments,
agencies or other large organizations with high credit ratings, normally to finance
short-term expenditure. The debt is issued at a discount that reflects the prevailing market
interest rates.
Banker's acceptances are unique financial instruments issued by companies to finance
specific commercial transactions, including imports or the procurement of goods. The term
stems from the assurance given by banks that guarantee the payment to the holder,
essentially accepting the responsibility for the payment on behalf of the issuing firm, for a
specified fee. This underscores the secure nature of this financial instrument.
Practice Problems: Discount Instruments
Useful Formulae:
Yield to maturity = [(Face value - Purchase Price) / Purchase Price] x (Days in the Year / Days to Maturity )
Discount yield = [(Face value - Purchase Price) / Face Value] x ( Days in the Year / Days to Maturity )
3. A 180-day US T-Bill (US government treasury bill) with a face value of $100.00 is issued for $98.50.
What is the discount rate? (Hint: The day count convention is Actual/360.)
4. The Korean Development Bank (KDB) issues EUR-denominated commercial paper with a selling price of
EUR 100 for a purchase price of EUR 99 and 60 days to maturity. Calculate the yield to maturity.
(Hint: The day count convention is Actual/360.)
5. A Bubill (German government bill) with remaining maturity of 90 days is quoted on the market for 99.5
EUR per 100 EUR par value. An institutional investor buys the bond. (Assume Actual/360)
A. Calculate the yield to maturity.
30 days later the same bill is quoted by a market maker at yield to maturity of 1.5%.
B. Calculate the price of the bond at that moment.
C. Calculate the capital gain/loss of the investor if they sell at the price derived in B.

A Quick Glimpse Into ESG
The Environmental, Social, and Corporate Governance (ESG) criteria encompass the three
central factors that investors scrutinize to gauge a company's ethical stance and commitment
to sustainable operations.
● Environmental Criteria evaluate a company's ecological footprint, scrutinizing aspects
such as energy consumption, pollution levels, conservation of natural resources, and
humane treatment of animals. It reflects the company's dedication to minimizing its
negative impact on the environment.
● Social Criteria delve into a company's relationships with its stakeholders - including
customers and suppliers - and its contributions to the community. It assesses the firm's
initiatives in areas like volunteerism, philanthropy, and the safeguarding of employee
health and welfare. It also critically examines potentially unethical practices like the
utilization of child labor.
● Governance Criteria mandate firms to adhere to transparent and accurate accounting
methods, steering clear of conflicts of interest or unlawful activities. It ensures that
companies abstain from leveraging political contributions to secure favorable treatment,
promoting a culture of ethical business conduct.
Why ESG?
Adhering to ESG regulations or even taking a step further with voluntary initiatives can
offer several benefits to businesses. Here are some of the potential gains:
● Customer Preference: an ESG-friendly image can attract customers who prioritize
responsible and sustainable business practices, potentially boosting sales and brand
loyalty.
● Enhanced Public Relations: a proactive approach to ESG policies can foster better
relationships with the general public and local communities, building a favorable
corporate image that resonates well with stakeholders.
● Talent Attraction: Many individuals prefer to be associated with companies
demonstrating strong ESG commitments, making it easier for businesses to attract
and retain high-caliber talent.
● Investment Opportunities: Businesses with a solid ESG stance may find themselves
more appealing to responsible investment funds, possibly enhancing their stock
value and attracting more investment opportunities.
THANK YOU!

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ECONOMIC ENVIRONMENT

AND FINANCIAL MARKETS

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 7

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 8

● Unpredictable Responses: the reactions of consumers and businesses to policy shifts

● Unintended Consequences: sometimes, policies might lead to unintended outcomes. A

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 11

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 14

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 16

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 17

Interest-bearing Discount Instruments Derivatives

Money market deposits Treasury bills (T-bill) Forwards and Futures

Certiﬁcation of deposit Banker’s acceptance Options

We will explore derivatives thoroughly in a later chapter of the course…

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 19

Value of deposit (CD) at maturity =

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 21

INTERNATIONAL FINANCIAL MANAGEMENT :: LECTURE 1 :: ECONOMIC ENVIRONMENT AND FINANCIAL MARKETS 23

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