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WELCOME TO

INTERNATIONAL

FINANCE

• In previous finance courses you have been taught about

general finance concepts that apply to domestic or local

settings, BUT we live in an international world.

• Companies (and individuals) can raise funds, invest money,

buy inputs, produce goods and sell products and services

overseas.

• With these increased opportunities comes additional risks.

We need to know how to identify these risks and then how

to control or remove them.

American consumers routinely purchase

• Oil imported from Saudi Arabia and Nigeria.

• TV sets and camcorders from Japan

• Automobiles from Germany

• Garments from China

• Shoes from Indonesia

• Pasta from Italy

• Wine from France

• Foreigners in return purchase

• American-made aircrafts, Software, Movies,

Jeans, and other products.

• Continued liberalization of International trade

is certain to further internationalize

consumption patterns around the world.

• Like consumption, production of goods and

services has also become highly globalized.

• MNCs efforts to source inputs and locate

production anywhere in the world where costs

are lower and profits are higher.

• E.g. IBM

• Financial Markets have also become Highly

Integrated. e.g. Diversified Investment Portfolios.

• E.g. Japanese investors are investing heavily in

U.S. and other Foreign financial Markets in

efforts to recycle their enormous trade surpluses.

• Other examples-IBM, Sony etc.

• Dr. Reddy (A)

• GAIL (G)

• GRASIM Inds (G)

• ICICI Bank (A)

• Infosys Tech (A)

• ITC (G)

• L& T (G)

• M&M (G)

• SBI (G)

• Tata Comm (A)

Foreign exchange riskE.g., an unexpected devaluation adversely affects your export

market…

Political riskE.g., an unexpected overturn of the government that jeopardizes

existing negotiated contracts…

Market imperfectionsE.g., trade barriers and tax incentives may affect location of

production…

Expanded opportunity setsE.g., raise funds in global markets, gains from economies of

scale…

Rapidly integrating markets have stretched firms across

borders and increased the importance of foreign

operations to firms around the world.

What do finance practitioners need to know

to operate in a global setting?

• Finance practitioners are faced with numerous

questions that require well-developed intuitions from a

domestic setting to be reinvented in an international

setting.

• Rather than simply considering how to make aggregate

capital structure and dividend decisions, CFOs must

also wrestle with decisions regarding the capitalization

and repatriation policies of their many subsidiaries.

• Capital budgeting decisions must not only reflect divisional

differences but the complications introduced by currency, tax

and country risks.

• Valuation decisions must now take into account how to value

assets that are exposed to different country risks and

currencies. Incentive compensations systems must consider

how to measure and reward managers who are operating in

very different economic and financial settings.

• How should subsidiaries be financed?

• How should repatriation policies be designed?

• How should investment opportunities in different

countries be analyzed

• How should financial information be communicated

inside the firm?

• When should ownership be shared? With whom

InternationalFinancial

Management

ForeignExchange & Derivatives

Markets

SourcingCapital in

Global Markets

ManagingFOREX

Exposure

ForeignInvestmentDecisions

Multinational WCM

• Direct Quote

• Indirect Quote

• Devaluation

• Revaluation

• Depreciation

• Appreciation

The Foreign Exchange Market

• The Foreign Exchange Market provides:

– The physical and institutional structure through which the money of one country is exchanged for that of another country

– The determination rate of exchange between currencies

– Is where foreign exchange transactions are physically completed

The Foreign Exchange Market

• Foreign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks and drafts.

• A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.

Geography

• The foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day.

• As the next exhibit will illustrate, the volume of currency transactions ebbs and flows across the globe as the major currency trading centers open and close throughout the day.

Exhibit 4.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversations Per Hour

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn Tokyo

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.

Functions of the Foreign Exchange Market

• The foreign exchange Market is the mechanism by which participants:

– Transfer purchasing power between countries

– Obtain or provide credit for international trade transactions

– Minimize exposure to the risks of exchange rate changes

25

Market Participants

• The foreign exchange market consists of two tiers:– The interbank or wholesale market (multiples of

$1MM US or equivalent in transaction size)

– The client or retail market (specific, smaller amounts)

• Five broad categories of participants operate within these two tiers; bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Bank and Nonbank Foreign Exchange Dealers

• Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.

• The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

• Dealers in the foreign exchange department of large international banks often function as “market makers.”

• These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

Individuals and Firms

• Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.

• Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose.

• Some of the participants use the market to “hedge” foreign exchange risk.

Speculators and Arbitragers

• Speculators and arbitragers seek to profit from trading in the market itself.

• They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.

• While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Central Banks and Treasuries• Central banks and treasuries use the market to acquire or spend

their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

• They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.

• The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citicizens.

• As willing loss takers, central banks and treasuries differ in motive from all other market participants.

Foreign Exchange Brokers

• Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction.

• For this service, they charge a commission.

• It is a brokers business to know at any moment exactly which dealers want to buy or sell any currency.

• Dealers use brokers for their speed, and because they want to remain anonymous since the identity of the participants may influence short term quotes.

Transactions in the Interbank Market

• A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day.

• The date of settlement is referred to as the value date.


• An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

• The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

• Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

• Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)


• A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

• Both purchase and sale are conducted with the same counterparty.

• Some different types of swaps are:– Spot against forward

– Forward-Forward

– Nondeliverable Forwards (NDF)

Market Size

• In April 2001, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1,210 billion.

• This was the first decline observed by the BIS since it began surveying banks on foreign currency trading in the 1980s.

Foreign Exchange Rates and Quotations

• A foreign exchange rate is the price of one currency expressed in terms of another currency.

• A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.


• Most foreign exchange transactions involve the US dollar.

• Professional dealers and brokers may state foreign exchange quotations in one of two ways:– The foreign currency price of one dollar

– The dollar price of a unit of foreign currency

• Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.


• For example, the exchange rate between US dollars and the Swiss franc is normally stated:

– SF 1.6000/$ (European terms)

• However, this rate can also be stated as:

– $0.6250/SF (American terms)

• Excluding two important exceptions, most interbank quotations around the world are stated in European terms.


• As mentioned, several exceptions exist to the use of European terms quotes.

• The two most important are quotes for the euro and U.K. pound sterling which are both normally quoted in American terms.

• American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with toursists.


• Foreign exchange quotes are at times described as either direct or indirect.

• In this pair of definitions, the home or base country of the currencies being discussed is critical.

• A direct quote is a home currency price of a unit of foreign currency.

• An indirect quote is a foreign currency price of a unit of home currency.

• The form of the quote depends on what the speaker regard as “home.”


• Interbank quotations are given as a bid and ask (also referred to as offer).

• A bid is the price (i.e. exchange rate) in one currency at which a dealer will buy another currency.

• An ask is the price (i.e. exchange rate) at which a dealer will sell the other currency.

• Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.

• A bid for one currency is also the offer for the opposite currency.

Foreign Exchange Rates and Quotes

• Forward rates are typically quoted in terms of points.

• A forward quotation is expressed in points is not a foreign exchange rate as such.

• Rather, it is the difference between the forward rate and the spot rate.

Foreign Exchange Rates and Quotes

• Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.

• This method of quotation facilitates comparing premiums or discounts in the forward market with interest rate differentials.

Business

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