International financial

environment
UNIT 1
 Why?
Why do we need to study international finance?
• We are living in a highly globalized and
integrated world economy
• internationalizes the consumption pattern
• globalized production
• Integrated financial markets
 WHY MNC ?
• What is MNC?
• History and Evolution of MNC
• MNC Structure.
• Organization of MNC
What is MNC?
MNC STRUCTURE
International finance
 What makes international finance
special?
• Three major dimension/features make
international finance different from purely
domestic finance:
1. Foreign exchange and political risks
2. Market imperfections
3. expanded opportunity sets
1) Foreign exchange and political risks
• Unexpected fluctuations of the exchange rates
• Exchange rate uncertainty may affect -
consumption, production, and investment
• Sovereign country can change the rules, e.g.,
-Tax rules
-Expropriation of assets
 2) Market imperfections
Such frictions/ impediments/ barriers include
• Legal restrictions
• Excessive transportation and transaction costs
• Information asymmetry
• Discriminatory taxation
 3) Expanded opportunity set
• locating production in any country/region of
the world to maximize performance
• raising fund in any capital market where the
cost capital is the lowest.
• deploying assets on a global basis to gain from
greater economies of scale.
 International finance & domestic
finance
1. Exposure to foreign exchange
2. Macro business environment
3. Legal & tax environment
4. Different group of stake holders
5. Foreign exchange derivatives
6. Different standards of reporting
7. Capital management
 INTERNATIONAL MONETARY AND
FINANCIAL SYSTEM

• Introduction
• International Monetary System: An Overview
• Evolution of International Financial System
Introduction
Monetary system is the most important
ingredient of international trade and financial
system which facilitates the process of flow of
goods and services among different countries
of the world
International Monetary System: An
Overview
International monetary system is defined as a
set of procedures, mechanisms, processes,
institutions to establish that rate at which
exchange rate is determined in respect to
other currency.

“Exchange Rate”
 1) Monetary System Before First World
War: (1880- 1914 Era of Gold Standard)
Gold Species Standard or Gold Bullion Standard-
actual content of gold
1. authorities must fix some once-for-all
conversion rate
2. free flow of Gold between countries on Gold
Standard
3. money supply should be tied with the
amount of Gold reserves kept by authorities
2) The Gold Exchange Standard (1925-
1931)
• initiated in 1925 in which US and England
• 1931, England took its foot back which
resulted in abolition of this regime
• International Monetary Fund (IMF) and the
World Bank, (WB) and the system was known
as Bretton Woods System
 Gold standard
• Pure gold standard
• Relative gold standard
• Mint par parity
 3) Purchase power parity
• Relationship between inflation, interest rate,
spot /forward exchange rate
• Spot exchange rate & inflation
Methods
A. Fisher effect
B. International fisher effect
C. Interest rate parity
 Absolute purchase power parity
• Only two currency = commodity price of two
countries
• Ex: india collection of goods cost 9625
• US collection of goods cost $195
priceofind ia 9625
spotprice 
• priceofUs 195 = 47.5128
 Relative purchase power parity
St
•  {(1  iy ) /(1  ix )}
t
Inflation
So
St = spot exchange rate end of time period
So= spot exchange rate start of time period
Y= country y inflation
X= country X inflation

Ex: india inflation 8%, US inflation 3% exchange rate is 46.550/USD

What is expected exchange rate after 6 months
St
 {(1  0.08) /(1  0.03)} 0.5
46.5500
0.5
St=46.500 + {(1.08) / (1.03)}
= 47.665
 A) Fisher effect
• Relationship between real & nominal
exchange rate
• Nominal inflation rate in economy is equal to
real rate of return & inflation rate
• (1 + r) = (1 +r) (1 + inflation rate)
 example
• Ex: bank nominal rate 3% on loan & inflation rate
is 2% so bank real rate is 1% only

• Nominal rate 10% inflation 6% so real rate is 4%

• Nominal rate 10% inflation 13% so real rate is -3%
 b) International fisher effect
• Change in exchange rate of currency is directly
proportional to difference between two
countries interest rate of a time
• % change in spot exchange rate is governed
between nominal interest rate for two
currencies
 So  St
So = interest rate of foreign country
St = interest rate of domestic country

(1  St )
Nominal interest rate in INDIA = 12%
Nominal interest rate in USA = 8%
What is the expected depreciate of India currency to USD

8  12 = 3.57% are after one year -3.57%

(1  0.12)
India Government bonds in 2010 1 year maturity with coupon rate 12%
US government bonds 2010 1 year maturity with coupon rate 8%
 c) Interest rate parity
• Spot price & forward price/ future price of
currency pair would be governed by interest
rate differently between two countries
• Interest rate paid on two countries should be
equal to the difference between spot &
forward rate
 (1  r)
spot
(1  r )
India interest rate 8%
US interest rate 3%
Spot rate 47/USD= what is forward rate

(1  .08)
47 x = 49.28
(1  .03)
 4) The Bretton Woods Era (1946 to
1971)
• One US dollar conversion rate was fixed by the
USA as one dollar = 35 ounce of Gold
• Other members agreed to fix the parities of
their currencies vis-à- vis dollar with respect
to permissible central parity with one per cent
(± 1%)
August 15, 1971 American abandoned their
commitment
 5) Post Bretton Woods Period (1971-
1991)
• oil prices were quadrupled by the
Organisational of Petroleum Exporting
Countries (OPEC)
 EVOLUTION OF INTERNATIONAL
FINANCIAL SYSTEM
• international capital markets & international money
markets
• 1945 - International Bank for Reconstruction and
Development (IBRD)
• 1956- International Finance Corporation (IFC)
• 1960-International Development Association (IDA)
• 1980 Multilateral Investment Guarantee Agency
(MIGA)

• COMBINED IFC, IBRD , MIGA & IDA – world bank group

was created
 Evolution of International financial
Institutions
• Emergence of International Banks
• Euro Banks
• Bank for International Settlements – BIS
• Asian development bank
 EXCHANGE RATE REGIME
1. Fixed exchange rate system
2. Floating exchange systems
 Fixed exchange rate system
1. Gold, as under the gold standard system that
operated prior to 1914.
2. 2. Dollars, as under the Breton woods system
1945 – 1971
3. 3. A basket of major currencies.
 Floating Exchange Rate Systems
• floating exchange rate is determined by the
private market through supply and demand
self-correcting", as any differences in supply and
demand will automatically be corrected in the
market
if demand for a currency is low, its value will
decrease - international market
a) Free Floating Exchange Rate
b) Managed Floating
 Current Exchange System
1. Dollarization;
2. Pegged rate;
3. Managed floating rate
 Exchange rate theories
Macroeconomic factors – inflation rate interest
rate
Currency – appreciate / depreciate for some
currency
1. NEER- nominal effective exchange rate
2. REER – Real effective exchange rate
 NEER
Nominal effective exchange rate
India gives rating for trading partners
Each trading partners is given weight based on
the transaction in global market

Till 2005 RBI had 36 trading partners

After 2005 it was reduced to 6 trading partners-
US, EURO, Japan, Asia, Australia, Africa
Determination of Exchange rates
What Determines Exchange Rates?
• Factors that cause the supply and demand
schedules of currencies to change
– Market fundamentals (economic variables)
• Productivity, inflation rates, real interest rates,
consumer preferences, and government trade policy
– Market expectations
• News about future market fundamentals
• Traders’ opinions about future exchange rates

45
What Determines Exchange Rates?
• Factors affecting exchange rates
– Short term: transfers of assets
• Differences in real interest rates and to the shifting
expectations of future exchange rates
– Interim: cyclical factors
• Fluctuations in economic activity
– Long term: flows of goods, services, and
investment capital
• Inflation rates, investment profitability, consumer
tastes, productivity, and government trade policy

46
 Determining Long-Term Exchange
Rates
• Exchange rate changes
– Reactions of traders in the foreign-exchange
market to changes in
• Relative price levels
• Relative productivity levels
• Consumer preferences for domestic or foreign goods
• Trade barriers

47
 Determining Long-Term Exchange
Rates
• Increase in the U.S. price level relative to price
levels in other countries
– Increase in the demand for foreign currency
– Decrease in the supply of foreign currency
– Depreciation of the dollar

48
 Determining Long-Term Exchange
Rates
• U.S. productivity growth is faster than that of
other countries
– Increase in the supply of foreign currency
– Decrease in the demand for foreign currency
– Appreciation of the dollar

49
 Determining Long-Term Exchange
Rates
• An increased demand for U.S. exports
– Appreciation of the dollar
• An increased demand for U.S. imports
– Depreciation of the dollar
• U.S. imposes trade barriers
– Appreciation of the dollar

50
Determining Short-Term Exchange Rates:
The Asset-Market Approach
• Foreign-exchange market activity
– Dominated by investors in assets
• Treasury securities, corporate bonds, bank accounts,
stocks, and real property
• Asset-market approach
– Investors deciding between domestic and foreign
investments
• Relative levels of interest rates
• Expected changes in the exchange rate itself over the
term of the investment

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FIGURE 12.4 Inflation differentials and the dollar’s exchange
value

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 Currency rate forecasting
• Investment of short term funds
• Long term investment of funds
• Financing decision
• Assessment of earnings
 Techniques of Forecasting
• Technical forecasting – charts, moving
average, linear regression
• Fundamental forecasting- macroeconomic
• Market based forecasting-international parity
conditions with market prices
 Balance of payment
balance of payments of a country is a
systematic record of all economic transactions
between the residents of the reporting and
the residents of the foreign countries during a
given period of time

Current account balance + Capital account

balance + Reserve balance = Balance of
Payments
 Components of BOP Accounts
• The Current Account

• The Capital Account-short term and the long

term
 Features of Balance of Payments
1. Systematic Record- It is a systematic record of receipts
and payments of a country with other countries.
2. Fixed Period of Time- It is a statement of account
pertaining to a give period of time,usually one year.
3. Comprehensiveness- It includes all the three items i.e.
visible, invisible and capital transfers
4. Double entry System- Receipts and payments are
recorded on the basis of double entry system.
5. Adjustment of Differences
6. All Items-Government and Non-Government.
 Causes of Unfavorable Balance of
Payments
• 1.Import of Machinery
• 2. Import of War equipments
• 3. More demand of Consumption Goods
• 4. Price disequilibrium
• 5. Expenditure on Embassies
• 6. Foreign Competition
• 7. Increase in price of Crude Oil
• 8. Payments of interest on foreign Debts
• 9. Less growth in Exports
 correct disequilibrium in the Balance
of Payments
• 1.Promotion of Exports
• 2. Increase in Production
• 3.Trade Agreements
• 4.Encouragement to Foreign Investment
• 5.Attraction to Foreign Tourists
• 6.Devaluation of Indian Currency
• 7.Deflation
• 8.Restriction on Imports
End of unit 1