International Finance MBA 309

Module1: International Financial Environment

Agenda

Finance function in global business scenario, International Monetary System, International Financial Markets and Instruments, Balance of Payments, Recent Developments

FINANCE FUNCTION IN GLOBAL BUSINESS SCENARIO

Globalization : Meaning
IMF defines globalization as: the growing economic interdependence of countries worldwide through increasing volume and variety of cross-border transactions in goods and services, freer international capital flows, and more rapid and widespread diffusion of technology Globalization is the movement towards the expansion of economic and social ties between countries through the spread of corporate institutions and the capitalist philosophy that leads to the shrinking of the world in economic terms It is characterized by growing economic, financial, trade, and communications integration.

Integration of Economies

Made possible by:

Technology Communication networks Internet access Growth of economic cooperation trading blocs (EU, NAFTA, etc.) Movement to free trade

International Finance
Concerned with how individual economic units, especially MNCs, cope with the complex financial environment of international business. How is it different from domestic financial management?

Foreign currency and exchange rate fluctuations Legal environments and taxation policies Enhanced opportunity sets Political risks

Scope of International Financial Management

Acquiring funds
Financing with International Bonds, Equity and Hybrids, Cost of Capital International capital markets

Using funds
International Capital Budgeting, Capital Structure decisions, Project Financing and Acquisition Decisions Exchange rate risk and risk management techniques

Distribution
International Taxation and transfer pricing Dividend decisions

Scope of International Finance

Knowledge of international finance is crucial for MNCs in two important ways:

It help the companies & financial managers to decide how international events will affects the firm & what steps can be taken to gain from positive developments & insulate from harmful ones It helps companies to recognize how the firm will be affected by movement in exchange rate and interest rate

The consequences of events affecting the stock markets & interest rate of one country immediately show up around the world this is due to the integral & independent financial environment which exists around the world All this makes it necessary for every MNC & aspiring manager to take a close look at the ever changing & dynamic field of international finance

Scope of International Finance

Three interrelated parts of international finance International Financial Economics: Concerned with causes and effects of financial flows among nations -application of macroeconomic theory and policy to the global economy. International Financial Management: Concerned with how individual economic units, especially MNCs, cope with the complex financial environment of international business. Focuses on issues most relevant for making sound business decision in a global economy International Financial Markets: Concerned with international financial/investment instruments, foreign exchange markets, international banking, international securities markets, financial derivatives, etc

Significance of International Finance

Access to capital market across the world enables a country to borrow during tough times & lend during good times IF promotes domestic investment & growth through capital import Worldwide cash flows can exerts a corrective force against bad government policies IF prevent excessive domestic regulation through global financial institutions IF leads to healthy competition & hence more effective banking system IF promotes the integration of economies ,facilitating the easy flow of capital. The free transfer of funds would eventually result in more equality among countries that are a part of the global financial system It provides information on vital areas of investment & leads to effective capital allocation

INTERNATIONAL MONETARY SYSTEM

IMS
The rules and procedures for exchanging national currencies are collectively known as the international monetary system. There are physical institutions like the international monetary fund and exchange rate policies / systems framed by policy makers in different countries that comprise the international monetary system. International monetary systems are sets of internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. They provide means of payment acceptable between buyers and sellers of different nationality.

Historical Framework

Gold Standard (IMF Reference, Gold.org)

The gold standard was a system under which nearly all countries fixed the value of their currencies in terms of a specified amount of gold, or linked their currency to that of a country which did so There was an explicit link between gold and paper money, with paper being exchangeable for gold on demand. The classical gold standard existed from the 1870s to the outbreak of World War I in 1914. The gold standard broke down at the outset of World War I, as countries resorted to inflationary policies to finance the war and, later, the reconstruction efforts.

Bretton Woods system (Out of the ashes)

In July 1944, representatives from 45 nations met in Bretton Woods, New Hampshire to discuss the recovery of Europe from World War II and to resolve international trade and monetary issues. The resulting Bretton Woods Agreement established the International Bank for Reconstruction and Development (the World Bank) to provide long-term loans to assist Europe's recovery. It also established the International Monetary Fund (IMF) to manage the international monetary system of fixed exchange rates, which was also developed at the conference. The new monetary system established more stable exchange rates than those of the 1930s, a decade characterized by restrictive trade policies. Under the Bretton Woods Agreement, IMF member nations agreed to a system of exchange rates that pegged the value of the dollar to the price of gold and pegged other currencies to the dollar. This system remained in place until 1972. In 1972, the Bretton Woods system of pegged exchange rates broke down forever and was replaced by the system of managed floating exchange rates that we have today.

End of Fixed/Pegged Exchange Rate System

Towards the end of the Bretton Woods era, the central role of the dollar became a problem as international demand eventually forced the US to run a persistent trade deficit, which undermined confidence in the dollar. This, together with the emergence of a parallel market for gold where the price soared above the official US mandated price, led to speculators running down the US gold reserves. Even when convertibility was restricted to nations only, some, notably France, continued building up hoards of gold at the expense of the US. Eventually these pressures caused President Nixon to end all convertibility into gold on 15 August 1971. This event marked the effective end of the Bretton Woods systems; attempts were made to find other mechanisms to preserve the fixed exchange rates over the next few years, but they were not successful, resulting in a system of floating exchange rates.

Post Bretton Woods System: Floating Exchange Rate System

The transition away from Bretton Woods was marked by a switch from a state led to a market led system. Reference

INTERNATIONAL FINANCIAL MARKETS AND INSTRUMENTS

Terms

Indirect Finance: An institution stands between lender and borrower.

We get a loan from a bank or finance company to buy a car.

Direct Finance: Borrowers sell securities directly to lenders in the financial markets.
Direct finance provides financing for governments and corporations.

Asset: Something of value that you own. Liability: Something you owe.

Funds Flowing through the Financial System

Financial Markets
A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible (freely exchangeable) items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods. Financial Markets facilitate:

The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) Price discovery Global transactions with integration of financial markets The transfer of liquidity (in the money markets) International trade (in the currency markets)

Classification of Financial Markets

1. Classification by nature of Claim:

Debt market Bonds, CDs Equity market Common stocks

2. Classification by maturity of Claim:

Money Market Short-term (maturity 1 year) Capital Market Long-term (maturity > 1 year)

3. Classification by seasoning of Claim:

Primary Market New security issues sold to initial buyers Secondary Market Securities previously issued are bought and sold

4. Classification by organizational structure:

Exchanges Market Trades conducted in central locations (e.g. stock exchange) Over-the-Counter Market Dealers at different locations buy and sell

5. Classification by immediate delivery or future delivery:

Cash or Spot Market assets or financial services are traded for immediate delivery (usually within two business days). Derivative Market Contracts calling for the future delivery of financial instruments are traded in the futures or forward market.

Intl. Financial Markets include

Foreign Exchange Market International Capital Markets

International Equity Markets International Debt Markets (Intl. Bank loans, Syndicated loans) International Bond Markets (Euro bonds, Foreign bonds)

Eurocurrency Markets

Capital Market
System that allocates financial resources according to their most efficient uses

Debt: Repay principal plus interest

Bond has timed principal & interest payments

Equity: Part ownership of a company

Stock shares in financial gains or losses

International Capital Market

Network of people, firms, financial institutions, and governments borrowing and investing internationally

Borrowers Expands money supply Reduces cost of money

Lenders Spread / reduce risk Offset gains / losses

International Bond Market

Market of bonds sold by issuing companies, governments, and others outside their own countries

Eurobond Bond that is issued outside the country in whose currency the bond is denominated

Foreign bond Bond sold outside a borrowers country and denominated in the currency of the country in which it is sold

Interest rates Driving growth are differential interest rates between developed and developing nations

International Equity Market

Market of stocks bought and sold outside the issuers home country

Privatization

Developing nations

Investment banks

Electronic markets

Eurocurrency Market
The Eurocurrency market is the money market for borrowing and lending currencies that are held in the form of deposits in banks located outside the countries where the currencies are issued as legal tender Eurodollars are dollar-denominated deposits that are placed in foreign banks or foreign branches of US banks outside the US Eurocurrencies are deposits denominated in a currency different from the domestic currency of where deposits are placed. Domestic currencies of one country on deposit in a second country. Any convertible currency can exist in Euro form (not to be confused with the European currency called the euro). For example: Eurodollar, Eurosterling, Euroyen The Eurocurrency market consists of Eurobanks who bid for time deposits and simultaneously make loans in foreign currencies (currencies other than that of the domestic currency in which banks are located). Eurobanks, i.e. banks in which Eurocurrencies are deposits, are financial intermediaries who transform these short-term deposits into longer-term loans. Unregulated market of currencies banked outside their countries of origin. Participants include Governments, Commercial banks, International companies, Wealthy individuals, etc. Reference

Foreign Exchange Market

Market in which currencies are bought and sold and their prices are determined

Conversion: To facilitate sale or purchase, or invest directly abroad

Hedging: Insure against potential losses from adverse exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit

24-Hour Trading in Forex Markets

Key Market Institutions

Interbank market Securities exchange Over-the-Counter (OTC) market

Market in which the worlds largest banks exchange currencies at spot and forward rates

Exchange that specializes in currency futures and options transactions

Global computer network of foreign exchange traders and other market participants

Uses of Financial Market Instruments

Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth that are larger than from holding money. Financial instruments can be used to transfer purchasing power into the future. Financial instruments allow for the transfer of risk (unlike money). Futures and insurance contracts allows one person to transfer risk to another.

Characteristics of Financial Instruments

These contracts are very complex. This complexity is costly, and people do not want to bear these costs. Standardization of financial instruments overcomes potential costs of complexity.
Most mortgages feature a standard application with standardized terms

Financial instruments also communicate information, summarizing certain details about the issuer.
Continuous monitoring of an issuer is costly and difficult.

Mechanisms exist to reduce the cost of monitoring the behavior of counterparties.

A counterparty is the person or institution on the other side of the contract.

The solution to high cost of obtaining information is to standardize both the instrument and the information about the issuer. Financial instruments are designed to handle the problem of asymmetric information

Underlying vs Derivative Instruments

Two fundamental classes of financial instruments. Underlying instruments are used by savers/lenders to transfer resources directly to investors/borrowers.
This improves the efficient allocation of resources. Examples: stocks and bonds

Derivative instruments are those where their value and payoffs are derived from the behavior of the underlying instruments.
Examples are futures and options. The primary use is to shift risk among investors

Instruments primarily used as stores of value

Bank loans
Borrower obtains resources from a lender to be repaid in the future.

Bonds
A form of a loan issued by a corporation or government Can be bought and sold in financial markets.

Home mortgages
Home buyers usually need to borrow using the home as collateral for the loan.

A specific asset the borrower pledges to protect the lenders interests.

Stocks
The holder owns a small piece of the firm and entitled to part of its profits. Firms sell stocks to raise money. Primarily used as a stores of wealth

Asset-backed securities
Shares in the returns or payments arising from specific assets, such as home mortgages and student loans. Mortgage backed securities bundle a large number of mortgages together into a pool in which shares are sold.
Securities backed by sub-prime mortgages played an important role in the financial crisis of 2007-2009.

Instruments primarily used to Transfer Risk

Insurance contracts.

Primary purpose is to assure that payments will be made under particular, and often rare, circumstances.
Futures contracts.

An agreement between two parties to exchange a fixed quantity of a commodity or an asset at a fixed price on a set future date. A price is always specified. This is a type of derivative instrument.
Options

Derivative instruments whose prices are based on the value of an underlying asset. Give the holder the right, not obligation, to buy or sell a fixed quantity of the asset at a pre-determined price on either a specific date or at any time during a specified period. These offer an opportunity to store value and trade risk in almost any way one would like

Financial Market Instruments

Money Market maturity 1year e.g., interbank loan market (LIBOR), Eurocurrency market Capital Market maturity > 1year e.g., credit market, securities market (bond and equity markets)

Financial Market Instruments

Equities are ownership shares that might or might not pay the holder a dividend, whose values rise and fall with the perceived value of the issuing enterprise. Debt securities are fixed-income securities due to their fixed financial obligations of issuers to lenders Debt securities include government bonds, corporate bonds, certificates of deposit (CDs), preferred stock, collateralized securities and zero-coupon securities Derivatives: futures, options, swaps

BALANCE OF PAYMENTS

Balance of payments
Balance of payments (BoP) of a country is a systematic record of all economic transactions during a given period of time between the residents of the country and residents of foreign countries. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. Operates as a nominal account:

Debit all losses and expenses Credit all incomes and gains

Components of BOP : Current Account

Current Account
Goods exports (credits) Goods are tangibles. In this case, sold to overseas nations and produced in India Goods imports (debits) Goods are tangibles. In this case, produced overseas and purchased by Indians. = Net goods (X-M) Service exports (credits) Services include transport, travel, insurance charges, telephone calls, tourist accommodation, education, computer information services, etc. In this case, provided by Indians and sold to overseas nations. Service imports (debits) As above, but provided by other nations and purchased by Indians. = Net services (X-M)

Balance of Trade = net goods + net services

Components of BOP : Current Account

Factor income credits

Incomes paid to Indians from overseas sources, Earnings on investment i.e. income (rent, profits, dividends), Royalties, Interest

Factor income debits

As above, but incomes paid by Indians to overseas sources Net factor income = credits debits

Current transfer credits

Transfers of funds into India for things such as:
payouts on insurance claims, aid from overseas governments/nations, pensions received from foreign governments to Indian residents, money sent from overseas relatives, gifts from charities in other countries, work remittances from people working overseas.

Current transfer debits

As above, but transfers of funds out of India.
Net current transfers = credits debits

Balance on Current Account = Balance of trade + Net income + Net transfers

Components of BOP : Capital Account

Capital transfers, direct / portfolio investments credits

Money coming in to India for things like:
people migrating and bringing money with them aid from overseas where addition is made to the capital stock of the recipient purchase and sale of intellectual property rights, including patents, copyrights, trademarks, franchises, works of art movements of government savings offshore (into Indian reserves).

Capital transfers, direct / portfolio investmentsdebits

As for credits, but money going out of India

Reserve Assets (Money moved by RBI)

Includes: monetary gold, Special Drawing Rights (paper gold. Created by the IMF to improve the foreign reserves of member nations), IMF transactions.

Total on capital account = credits debits

Components of BOP: Reserve Account

Above the line (autonomous transactions) Below the line (accommodating transactions: undertaken to settle imbalances arising due to other transactions) If credit- debit (above the line) = positive figure (surplus) and If credit- debit (above the line) = negative figure (deficit) Only reserve assets are included Reserve assets are financial assets which are acceptable means of payment in international transactions and are held by and exchanged between the monetary authorities of a trading countries. They consist of monetary gold, assets denominated in foreign currencies, special drawing rights and reserve positions in the IMF. The monetary authority of a country uses these assets to settle the deficits and surpluses that arise on the other two categories taken together.

BOT vs BOP
Basis Balance of Trade (BOT) Balance of Payment (BOP)

Definition

Balance of trade may be defined as difference between export and import of goods and services.

Balance of payment is flow of cash between domestic country and all other foreign countries. It includes not only import and export of goods and services but also includes financial capital transfer. BOP = BOT + (Net Earning on foreign investment - payment made to foreign investors) + Cash Transfer + Capital Account +or - Balancing Item or BOP = Current Account + Capital Account + or - Balancing item ( Errors and omissions)

Formula

BOT = Net Earning on Export - Net payment for imports

BOT vs BOP
Basis Balance of Trade (BOT) Balance of Payment (BOP)

Favorable or unfavorable

If export is more than import, at that time, BOT will be favourable. If import is more than export, at that time, BOT will be unfavourable.

Balance of Payment will be favourable, if you have surplus in current account for paying your all past loans in your capital account. Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to pay high interest on extra loan and this will make your BOP unfavourable.

Solution of unfavorable problem

To buy goods and services from domestic country

To stop taking of loan from foreign countries.

BOT vs BOP
Basis Balance of Trade (BOT) Balance of Payment (BOP)

Factors

Following are main factors which affect BOT a) cost of production b) availability of raw materials c) Exchange rate d) Prices of goods manufactured at home

Following are main factors which affect BOP a) Conditions of foreign lenders. b) Economic policy of Govt. c) all the factors of BOT

RECENT DEVELOPMENTS

Recent Develpoments
Liberated FDI regime in emerging economies Outward/overseas direct investment Increasing financial integration Greater frequency of financial crisis

Shadow institutions do not accept deposits like a depository bank, they are not subject to similar capital requirements and regulatory oversight. Usually, such institutions tend to use a very high level of leverage. Driven by excessive liquidity and light- touch regulation, shadow banking system expanded dramatically in the years leading up to the crisis. In 2008, shadow banking system had as much as $20 trillion worth of liabilities, significantly larger than the liabilities of the traditional banking system at about $13 trillion. Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac are some of the prominent examples of shadow banking institutions.

Growth of financial conglomerates

In the US, for instance, the top ten financial conglomerates were holding more than 60 percent of financial assets in 2008, as compared to merely 10 percent in 1990

Growth of shadow banking institutions Reference

Readings for the Module

In addition to reading references listed on various slides in this ppt, the following are required: BSE listing requirements LIBOR Scandal/MIBOR Balance of payment of India Crisis of credit visualized (YouTube) Rupee convertibility on current and capital account Article on Made outside India from The Economist