B.SRINIVASAN 1

INTERNATIONAL FINANCE

SESSION -1

16/07/2014

05/02/2023 B.SRINIVASAN 2

Course Contents of INTERNATIONAL FINANCE

A) International Finance – Introduction B) Inter-war instability, Bretton woodsC) Theories on International TradeD) Foreign Exchange exposure; transaction & operationsE) Fixed exchange rates, fluctuating exchange rates Case for fixed or

fluctuating exchange rates. The changing nature of world money.F) Exchange contracts & Exchange trading & position. Demand supply &

elasticity in foreign exchange rate determinationG) Derivatives Pricing & Analysis; foreign exchange arithmetic, foreign

exchange swaps, forward contracts, financial futures & financial swaps. Currency options fixed income analytic & interest rate options.

H) Syndication, Swaps, Options, Offshore banking, International Money, Capital & Foreign Exchange Markets with reference to New York, London, Tokyo, Hong Kong & Singapore.

I) Capital budgeting for international projects, international cash management, international asset pricing theories, Financial Aspects of International Negotiations.

J) Socio-Political Issues in Strategic International Financial Management (with special reference to multi-national corporations)

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INTERNATIONAL FINANCE

MARKETSConcerned with forex

Markets, International or Investment

instruments , int. securities

INTERNATIONAL ECONOMICS

Causes and Effects of Financial Flows

Application of Macro Economics

How Corporates across the world operating in a

global economy cope with complex financial

environment

INTERNATIONAL FINANCE

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• Globalization is taking place• Integration is across countries and Markets • Financial & Commodity markets are integrated

INTERNATIONAL FINANCE – THE NEED

• International Trade• Establishing International Operations in foreign countries • Countries have different currencies

•Settlement of trade in Domestic /Foreign countries• Rates of Exchange

Sales Costs ProfitsCorporates/Business in Indiaa) Domestic companies with Input &

Output in Local Marketb) Domestic Companies with either

input or output is from foreign market

c) Companies with both input & Output is foreign

a) Globally competitive & be a global player to survive

b) Knowledge & understanding of different countries & markets

c) Forex & Money market knowledge

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REASONSa) Development of technology for

transfer of money at extremely fast speed /considerably less cost

b) Increase in Inflation levels of various Industrial countries , so repricing of financial assets due to domestic inflation & Interest rates

INTEGRATION OF FINANCIAL MARKETS – HOW IT HAPPENED

IMPACT a) Freedom & opportunity to raise funds from

any part of the worldb) Invest in any part of the worldc) Invest in any types of instrument TRANSMISSION EFFECTEvents in any part of the world markets affect allother markets

Development of New financial instruments – Euro –Markets – Int. Rate Swap, Currency Swaps, Futures Markets, Forward contracts

Liberalization of regulations governing financial markets through directions

a) Increased cross penetration of foreign ownership

b) Helped countries international perspective while deciding issues & policies

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BENEFITS- Efficiently transfer resources from surplus units

to deficit units- Efficient allocation of capital & better working

of financial system- Smoother consumption pattern enjoyed by all

countries over a period of time- Enjoying the benefits of diversification –

different securities / Higher returns at same risk levels / same returns with lower risk levels

EFFECTS- Increase in volatility – Interest rates/Exchange

rates/ or prices of Financial Assets- With deregulation, control of the authorities on

these variables has reduced to a certain extent exposing a firm to a number of risks

- Corporate Finance executives must actively manage Exchange Risk + Interest Rates Risk

INTEGRATION OF FINANCIAL MARKETS

COSTS- Risks and Rewards go hand in hand so integration

of financial markets has brought forth A) Currency Risk – Due to exchange rates B) Country Risk - not able to disinvest at will - While markets grow together it also goes down

together

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UNDERSTANDING RELATIONSHIP

International Trade

International Financial System

International Payment System

International Credit System

International credit Guarantees

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UNDERSTANDING INTERNATIONAL TRADE

LETS ANSWER SOME OF THESE QUESTIONS

A) What is International Trade ? Why is it important?B) What is the Impact of International Trade on Finance? – Time

/Currency/ROE/Terms of Trade/Regulations of a country/Authorised dealers

C) How International Trade affects the country? – Resources/Foreign Exchange

D) What does Balance of Trade Mean? – Visible Trade – favourable/ unfavourable

E) What do you mean by Balance of Payment? Invisible Items Included F) What do you mean by Current Account and Capital Account? G) What do you mean by convertibility of a currency?H) How does Rupee grade itself on convertibility Issue?

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INTERNATIONAL TRADE - ABSOLUTE ADVANTAGE THEORY

BENEFITS• Adam Smith propounded this theory in 1776• International Trade takes place because one

country may be more efficient in producing a particular goods than another country

• This absolute advantage provides an incentive to trade

• Both the countries benefit from specialization and resultant increase productivity

ADVANTAGE-- Increase in rate of economic growth

LIMITATIONSA) This theory explains the causes of trade only

between two countries when they enjoy absolute advantage

B) It assumes that transport costs are non-existentC) Comparable prices and Stability of exchange rateD) Mobility of labour between products

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INTERNATIONAL TRADE - ABSOLUTE ADVANTAGE THEORY

CANADIAN TIMBER

BRAZILIAN COFFEE

SAUDI OIL

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• David Ricardo propounded this theory in 1817• Assumes a single factor of production – labour• Countries are operating at different levels of

efficiency giving rise to comparative advantage

a) Perfect Competition : with flexible prices and wages are prevalent in both the countries

b) Productivity of labour assumed to be constantc) Full Employment : This is assumed to calculate

the opportunity costsd) Mobility : is perfectly mobile between sectors

but perfectly immobile between countriese) Technology : No technological innovations take

place in the economy

INTERNATIONAL TRADE – COMPARATIVE ADVANTAGE THEORY

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INTERNATIONAL TRADE – COMPARATIVE ADVANTAGE THEORY

SOUTH KOREAN ELECTRONICSHOLLYWOOD MOVIES

BOLLYWOOD MOVIESGUATMALEN TEXTILES

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INTERNATIONAL TRADE – Heckscher-Ohlin Model / Factor Proportions Theory

• Developed in 1920s by Eli Heckscher and Bertil Ohlin

• Countries operating at the same level of efficiency and can still benefit from trade

A) No obstructions to trade are there – Trade controls/Transports costs

B) Commodity and factor markets are perfectly competitive

C) Constant or decreasing returns to scaleD) Both countries have same technology and operate at

the same level of efficiencyE) Two factors of production Labour & Capital and both

are perfectly immobile in inter-country transfers, but perfectly mobile in inter-sector transfers

How it works• There are two types of products Labour

Intensive and Capital Intensive• Labour rich country will produce Labour

Intensive products • Capital Rich country will produce Capital

intensive products • Both the countries will trade in these goods

and reap the benefits of international trade

Leontief Paradox a) Used input-output analysis to study the

characteristics of trade flow between the U.S. b) U.S. exports were relatively labor-intensive

when compared to U.S. importsc) This is the opposite of what one would expect,

considering the fact that the U.S.'s comparative advantage was in capital-intensive goods

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INTERNATIONAL TRADE – Purchasing Power Parity Theory • The idea originated in 16th century and was

refined by Gustav Cassel – a Swedish Economist in 1918

• The concept is based on the LAW of ONE PRICE, where in the absence of transaction costs and official trade barriers, identical goods will have same price in different markets when prices are expressed in the same currency

• The difference in the inflation rates is equal to the percentage of depreciation or appreciation of exchange rate

• The real exchange rate is equal to nominal exchange rate adjusted for inflation

• If the purchasing power parity held exactly then the real exchange rate is always equal to one

• There can be a marked differences between purchasing power incomes and those of converted via market exchange rates

• The GDP per Capita in India is USD 1708 while on PPP basis it is USD 3608 while for Denmark it is around USD 62100 while under the PPP figure it is USD 37304

UtilityA) PPP exchange rates stay fairly constant hence

comparisons between countries are usefulB) Over the year the exchange rates tend to move

towards the PPP exchange rates

LIMITATIONS

1. It is controversial because it is difficult to find comparable basket of goods to compare the purchasing power between countries

2. Likewise different price levels for different commodities. For example difference in food prices may be greater than say differences in housing or say entertainment

3. Adjustment must also be made for difference in the quality of goods and services

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INTERNATIONAL TRADE – BIG MAC INDEX

• An example of law of one price which underlies the PPP theory is the Big Mac Index popularized by the Economists

• It is based on a single consumer product relatively standardized and has inputs from across the sector in a local economy such as – Agriculture commodities – bread, beef, cheese, vegetable, Labour – Blue and White, Advertising, rent, marketing, transportation

• To take an example calculation, the local price of a Big Mac in Hong Kong when converted to U.S. dollars at the market exchange rate was $2.19 or 50% of the local price for a Big Mac in the U.S. of $4.37. Hence the Hong Kong dollar was deemed to be 50% undervalued relative to the U.S. dollar on a PPP basis. If you take this measure than according to Economist Indian currency is undervalued by 59% i.e the price level as a percentage relative to the US