INTERNATIONAL FINANCIAL MANAGEMENT
INTERNATIONAL FINANCIAL MANAGEMENT
Unit 1
Introduction to International Finance
International Finance deals with the management of finances in a global business. It explains how to trade in international markets and how to exchange foreign currency, and earn profit through such activities.
It mainly discusses the issues related with monetary interactions of at least two or more countries. International finance is concerned with subjects such as exchange rates of currencies, monetary systems of the world, foreign direct investment (FDI), and other important issues associated with international financial management.
International Finance is a section of financial economics which deals with the macroeconomic relation between two countries and their monetary transactions. The concepts like interest rate, exchange rate, FDI, FPI and currency prevailing in the trade come under this type of finance.
Definition of International Finance
The term international finance is defined on the basis of various parameters:
(a) It is a discipline of financing the international economic and commercial relations between countries. (b) It includes international markets (such as international banking, euro currency market, euro bond, international stock exchanges, American Depository Receipts, GDRs, international institutions viz., IMF, World Bank, Asian Development Bank, Brics Bank, China, WTO, UNCTAD, Letters of Credit, Bill of Lading, factoring and the like, international financial instruments foreign exchange markets, Balance of Payments and International risk management. (c) It is related to management, economic, commercial and accounting activities of MNCs, governments and private individuals. (d) It involves conversion of one currency into another. (e) It coordinates all financial and non-financial operations with the objectives of maximization of the shareholders’ wealth.
Scope of International Finance
It is important while determine the exchange rates of the
country.
• It plays a crucial role in investing in foreign debt securities to
have a clear idea about the market.
• The transaction between countries can be significant in
assessing the economic conditions of the other country.
• One can use arbitrage in tax, risk, and price to market
imperfections to book good profits while transacting in
international trade.
Significance and importance of International Finance
• In a growing world moving towards globalization, its
importance is growing in magnitude.
• It considers the world a single market instead of individual
markets and carries out the other procedures. For the same
reason, the firms and corporations doing such research
include institutions like the International Monetary fund
(IMF), International Finance Corp (IFC), and the World Bank.
Trade between two foreign countries is one factor in
developing the local economy and improving economies of
scale • Currency fluctuations, arbitrage , interest rate, trade deficit ,
and other international macroeconomic factors are crucial in
prevailing scenarios.
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Components of International finance
International financial management is subject to several
external forces, like
• foreign exchange market,
• currency convertibility,
• international monitory system,
• balance of payments, and
• international financial markets.
Components of International Finance
Introduction to International Finance
1. Foreign Exchange Market
Foreign exchange market is the market in which money
denominated in one currency is bought and sold with
money denominated in another currency. It is an over the
counter (OTC) market, because there is no single physical or
electronic market place or an organized exchange with a
central trade clearing mechanism where traders meet and
exchange currencies. It spans the globe, with prices moving
and currencies trading somewhere every hour of every
business day.
Components of International Finance
Introduction to International Finance
1. Foreign Exchange Market
World’s major trading starts each morning in Sydney and
Tokyo, and ends up in the San Francisco and Los-Angeles.
The foreign exchange market consists of two tiers: the inter
bank market or wholesale market, and retail market or
client market.
Components of International Finance
Introduction to International Finance
1. Foreign Exchange Market
The participants in the wholesale market are commercial banks,
investment banks, corporations and central banks, and brokers
who trade on their own account. On the other hand, the retail
market comprises of travelers, and tourists who exchange one
currency for another in the form of currency notes or traveler
cheques.
2. Currency Convertibility
Foreign exchange market assumes that currencies of various
countries are freely convertible into other currencies. But
this assumption is not true, because many countries restrict
the residents and non-residents to convert the local currency
into foreign currency, which makes international business
more difficult. Many international business firms use
“counter trade” practices to overcome the problem that
arises due to currency convertibility restrictions.
3. International Monetary System
Any country needs to have its own monetary system and an
authority to maintain order in the system, and facilitate trade
and investment. India has its own monetary policy, and the Reserve
Bank of India (RBI) administers it. The same is the case with
world, its needs a monetary system to promote trade and
investment across the countries. International monetary system
exists since 1944. The International Monetary Fund (IMF) and the
World Bank have been maintaining order in the international
monetary system and general economic development
respectively.
4. International Financial Markets
International financial markets comprises of international banks,
Eurocurrency market, Eurobond market, and international stock
market. International banks play a crucial role in financing
international business by acting as both commercial banks and
investment banks. Eurocurrency market originally called as
Eurodollar market, helps to deposit surplus cash efficiently
and conveniently, and it helps to raise short-term bank loans to
finance corporate working capital needs, including imports and
exports.
Eurobond market helps to MNCs to raise long-term debt by
issuing bonds. International bonds are typically classified as
either foreign bonds or eurobonds. A foreign bond is issued by
a borrower foreign to the country where the bond is placed.
On the other hand Eurobonds are sold in countries other than
the country represented by the currency denominating them.
5. Balance of Payments
All transactions relating to the flow of goods, services and
funds across national boundaries are recorded in the balance of
payments of the countries concerned. BOP is a statement that
systematically summarizes, for a specified period of time, the
monetary transactions of an economy with the rest of the
world. Put in simple words, the balance of payments of a
country is a systematic record of all transactions between the
‘residents’ of a country and the rest of the world.
The balance of payments includes both visible and invisible
transactions. It presents a classified record of:
• All receipts on account of goods exported, services rendered
and capital received by ‘residents’ and
• Payments made by then on account of goods imported and
services received from the capital transferred to ‘nonresidents’ or ‘foreigners’.
Thus the transactions include the exports and imports (by
individuals, firms and government agencies) of goods and
services, income flows, capital flows and gifts and similar onesided transfer of payments. A rule of thumb that aids in
understanding the BOP is to “follow the cash flow”. Balance of
payments for a country is the sum of the Current Account, the
Capital Account, and the change in Official Reserves.
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Methods of Payment in International Finance
1. Cash in advance 2. Letter of Credit (L/C) 3. Documentary Collections (D/C) 4. Open account (O/A) 5. Consignment
1. Cash in advance Also called ‘advance payment’ or ‘cash with order’, cash in advance means exactly what it sounds like. It is a mostly straightforward payment method where the importer (usually the buyer) pays for the goods upfront and before shipment. The payment may be completed by any means agreed between the exporter and the importer. Popular options include wire transfer, international cheque, and payment by debit card. Methods of Payment in International Finance Introduction to International Finance 1. Cash in advance (contd….) This payment term clearly favors the exporter because it means they receive payment while still in possession of the goods. A typical procedure for parties using this method is to agree that a set percentage of the price will be paid before production starts. After production, either all or most of the outstanding price will be paid before shipment. They may then agree that any amounts left will be paid upon receipt of the goods by the importer. Methods of Payment in International Finance Introduction to International Finance 1. Cash in advance (contd….) Cash in advance presents a lot of risk for the importer. This is because it puts them in a position where the exporter still has ownership and possession of the goods and has already received payment for the goods. It also creates an unfavorable cash flow situation for the importer because they have to pay all of the price upfronts and in cash – a position most buyers try to avoid. Methods of Payment in International Finance Introduction to International Finance 1. Cash in advance (contd….) This payment option will only be available in rare situations. This can include where the order size is very small, or situations where the exporter is in a very strong negotiating position (such as where the goods are scarce). It can also be an option for exporters who are not convinced of the importer’s credit-worthiness, or where the importer completely trusts the seller. Methods of Payment in International Finance Introduction to International Finance 1. Cash in advance (contd….) As a result, exporters will very rarely offer this payment term because it presents so much risk for the buyer. If you want to attract more sales or a higher caliber of buyers, you will need to be more flexible with your payment terms, except where the special circumstances mentioned above exist. Thus, exporters that insist on this method of payment as their sole method of doing business may find themselves losing out to competitors who may be willing to offer more attractive payment terms. Methods of Payment in International Finance Introduction to International Finance 2. Letter of credit (L/C) L/C is one of the most well-known terms of payment in international trade. It is also one of the most secure payment methods available. It involves a payment process that is conducted by a bank on behalf of the importer. The letter of credit is a document that operates as a guarantee by the bank saying it will pay the exporter for the goods once certain terms and conditions are fulfilled. These terms and conditions are typically included in the l/c itself, and mostly have to do with inspecting the documents accompanying the goods, rather than the goods themselves.
Before an importer can obtain a l/c , they must be able to
satisfy their bank of their credit-worthiness. When the bank
completes the payment on behalf of the importer, they will turn
towards the importer for reimbursement. This is usually based
on terms agreed between the importer and the bank. Letters of
credit are mostly applicable in situations where the exporter
and importer have a new and untested trade relationship.
Methods of Payment in International Finance
Introduction to International Finance
2. Letter of credit (L/C) (contd….)
They can also be a good option where the exporter is not
satisfied with the credit-worthiness of the importer or is unable
to confirm this. Either way, a letter of credit provides less risk
for the exporter since they have a solid guarantee of payment.
Methods of Payment in International Finance
Introduction to International Finance
2. Letter of credit (L/C) (contd….)
This payment term has its disadvantages though. For one, it is
generally considered to be very expensive, as the banks
involved will typically charge significant fees. The fees will
vary depending on the importer’s credit rating and the
complexity of the transaction. Also, the bank does not generally
inspect the goods shipped by the exporter. This means there
may be no provision to establish the quality of the goods in the
process.
Methods of Payment in International Finance
Introduction to International Finance
3. Documentary collections (D/C)
Documentary collection is a very balanced payment term that
provides almost equal risk exposure for exporter and importer. This method is completed exclusively between banks acting on
behalf of both parties. The process starts when the exporter
ships the goods and sends documents needed to claim the
goods to the importer. These documents usually include the
Bill of Lading.
Methods of Payment in International Finance
A bill of lading (BL or BoL) is
a legal document issued by a
carrier (transportation
company) to a shipper that
details the type, quantity,
and destination of the goods
being carried. A bill of lading
also serves as a shipment
receipt when the carrier
delivers the goods at a
predetermined destination.
Introduction to International Finance
3. Documentary collections (D/C) (contd….)
The importer also lodges payment with their bank with the
instruction that payment should be made upon confirmation of
the documents. Once the documents are confirmed, the
documents will be released to the importer, enabling him to
claim the documents. In this way, documentary collections
work almost like escrow (which lets you lodge payment with a
third party pending the completion of the agreement).
Methods of Payment in International Finance
Introduction to International Finance
3. Documentary collections (D/C) (contd….)
There are two major methods within this payment term. They
are documents against payment (DAP) and documents against
acceptance (DA).
DAP: Here, the agreement is that the bank will release payment
to the exporter upon sighting the documents. No delay in
payment is expected here, and once the documents are shown
(and found regular), payment must be completed.
Methods of Payment in International Finance
Introduction to International Finance
3. Documentary collections (D/C) (contd….)
DA: Here, the agreement is that the documents will be
delivered to the importer’s bank once there is a firm
commitment to pay on a fixed date. This means payment is not
received immediately, but on a date agreed between the
parties.
Methods of Payment in International Finance
Introduction to International Finance
3. Documentary collections (D/C) (contd….)
Since this payment method is relatively balanced, it does not
expose either party to too much risk. The seller only lets go of
ownership and possession of the goods once payment or a firm
commitment to pay is received. The buyer only pays when they
see the documents for the goods, or even after taking physical
delivery. This method also involves less cost overall than letter of
credit, and it can be set up in less time.
Methods of Payment in International Finance
Introduction to International Finance
3. Documentary collections (D/C) (contd….)
However, just like letter of credit, the focus of both banks is on
documents, and not necessarily the goods themselves. This
means it may be harder to discover a problem with the quality
of the goods before payment is made. The payment method
also provides very little recourse for the exporter in the event
that the importer fails to pay for the goods. Apart from these,
documentary collections present a balanced payment method
for both exporter and importer.
Methods of Payment in International Finance
Introduction to International Finance
4. Open account (O/A)
This payment term involves a trade deal where the exporter
agrees to deliver the goods to the importer without receiving
payment until a later date. Payment usually falls due after an
agreed period, typically 30, 60, or 90 days after delivery.
Therefore, the importer essentially receives the goods on credit,
with payment to follow at a later date.
Methods of Payment in International Finance
Introduction to International Finance
4. Open account (O/A) (contd….)
Clearly, this payment method favors the importer, since they
enjoy the position of taking delivery of the goods without
making payment. It can have the effect of reducing their
operating expenses, seeing as they can simply order the goods
and try to sell completely before they have to pay the exporter.
It also reduces their need for working capital, as they don’t
have to worry about freeing up funds to complete payment
before taking delivery of the goods.
Methods of Payment in International Finance
Introduction to International Finance
4. Open account (O/A) (contd….)
Due to these advantages, importers are always keen to find
exporters that provide open account payment terms. In a
buyers’ market (one where there are more goods and less
demand), you may see open account terms being the dominant
mode of payment. Exporters that also want to display trust in a
valued customer or that want to attract a valuable account may
be more willing to offer these terms.
Methods of Payment in International Finance
Introduction to International Finance
4. Open account (O/A) (contd….)
However, you should keep in mind that open account is also
very risky for exporters. The risks of non-payment, late
payment, bankruptcy, and other unexpected events are very
high in this transaction. In addition, exporters essentially have
to produce the goods and ship them without receiving
payment. This can leave them with less working capital than
they would like. Overall, this payment term has the potential to
put exporters in a very delicate position.
Methods of Payment in International Finance
Introduction to International Finance
4. Open account (O/A) (contd….)
You should only explore this option in situations where you
have a low-risk trading relationship with the importer. Another
possibility is where there is very low demand or where you are
looking to win important customers.
Methods of Payment in International Finance
Introduction to International Finance
5. Consignment
Here, the exporter produces, ships, and delivers the goods to
the buyer but only collects payment after the goods have been
sold. You can often see this payment term being used by
exporters who have distributors or third-party agents in foreign
countries.
Methods of Payment in International Finance
Introduction to International Finance
5. Consignment (contd….)
The rarity of this payment term is based on a simple reason –
the incredible risk it poses to exporters. The exporter bears all
of the costs of producing, shipping, and delivering the goods to
the importer. In addition, while the goods are in possession of
the importer, they typically continue to be the property of the
exporter. This means where there is an event like fire, theft,
storm, or other damage, it is the exporter that bears the loss.
Methods of Payment in International Finance
Introduction to International Finance
5. Consignment (contd….)
The exporter also bears the risk of non-payment or late
payment by the importer. This is in addition to the risk that the
goods may not even sell as well as the parties had hoped. As a
result, exporters are understandably reluctant to offer or accept
these terms from buyers. The payment term is most applicable
where there is an existing relationship between the exporter
and importer.
Methods of Payment in International Finance
Introduction to International Finance
5. Consignment (contd….)
The importer needs to be reputable and trustworthy, and the
goods must have been shipped to a country that is politically
and commercially secure. In addition, this payment term
simply cannot be accomplished without putting in place proper
insurance measures and taking advantage of trade financing
options where available.
Methods of Payment in International Finance
Introduction to International Finance
5. Consignment (contd….)
Where the exporter is able to protect themselves well,
consignment can also deliver advantages for them. It can be a
good opportunity for exporters to enter new markets, reduce
the costs of maintaining inventory (thereby allowing for lower
prices), or simply make goods available much faster (leading to
competitive advantages).
Risks & uncertainties in International Finance
Types of risks
The various types of risks that an international trader faces are divided into the following categories:
1. Exchange rate risk-Fluctuations in exchange rate can affect the value of asseta and liabilities denominated in foreign countries
2.Interest rate risk-Changes in interest rate can impact borrowing costs,investment returns and bond prices
3.Economic risk-Conditions such as recessions,inflation's and deflation can impact investment decisions and economic growth
4.. Political risks -These risks arise due to change in political situations in the concerned importing and exporting countries. Following are the factors, affecting the political situation: (i) Changes in the party in power in the concerned countries, followed by the head of the Government; (ii) Coups, civil wars and rebellions: (iii) Wars between the countries or among- many countries and (iv) Capture of cargo by enemies during war.
5. Credit risks - Risks are inherent in credit transactions; more so in international business. International business is invariably riskier than the domestic trade. Credit risk. is not the same whether one sells the goods in domestic market or in foreign market. Success, in international business depends, largely, on the ability of the exporters to give credit to importers on tree competitive and favourable terms. Export business has become highly risky as selling on credit has become very common.
6.Liquidity risk-The risk of not being able to sell an assetquickly enough or not at a fair price can impact investment decisions and financial stability
7.Operational risk-The risk of losses due to internal or external factors such as fraud,human errors, natural disasters etc can impact the financial health of organisation
8.Regulatory risk-changes in regulations and compliance rewuirements and legal frameworks can impact the profitability of business and investments
9.Technology risk-The risk of cyber attacks and technological disruptions and failure can impact the financial stability of organisations and investors
10.Environmental and social risk-Conditions such as climate change,natural disasters and social unrest can impact the sustainability of business and investments
Issues involved in International Finance,
The various issues involved are as follows
1.Global financial system-It is the worldwide framework of legal agreements, institutions and both formal and informal economic actors that together facilitate the international flow of financial capital for the purpose of investment and trade financing.While the global financial system is edging towards greater stability,governments must deal withdiffering regional and national needs and policies.Many nations are discontinuing with unconventional monetary policies while others are expanding their scope and scale.
2.International Monetary system-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.The major challenges faced by IMF include its governance structure, increasing level of politicisation, leadership challenges, performance evaluation difficulties, and dealing with social instability.
3.Balance of Payments-Balance of Payment is a statement that shows an economy’s transactions with the remaining world in a given duration. Sometimes also called the balance of international payments, BOP includes each and every transaction between a nation’s residents and its nonresidents . BOP data is crucial in deciding the national and international economic policy. Part of the BOP, such as current account imbalances and foreign direct investment (FDI), are very important issues which are addressed in the economic policies of a nation. Economic policies with specific objectives impact the BOP.
The balance of payments divides transactions into two accounts: the current account and the capital account.
The current account The current account records a nation's transactions with the rest of the world—specifically its net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments—over a defined period, such as a year or a quarter. The current account represents a country's imports and exports of goods and services, payments made to foreign investors, and transfers such as foreign aid.
The capital account-The capital account, is the part of the balance of payments which records all transactions made between entities in one country with entities in the rest of the world. broadly defined, includes transactions in financial instruments and central bank reserves. Narrowly defined, it includes only transactions in financial instruments.
The current account is included in calculations of national output, while the capital account is not.
4.Exchange rate-Exchange rate fluctuations affect not only multinationals and large corporations, but also small and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important subject for business owners and investors.
5.Foreign direct investment-Foreign direct investment (FDI) is an important factor in acquiring investments and grow the local market with foreign finances when local investment is unavailable. There are various formats of FDI and companies should do a good research before actually investing in a foreign country.
Introduction to International Monetary System
We may define international monetary system as "a set of arrangements, rules,
practices and institutions under which payments are made and received for
international transactions across national boundaries".
The international "system" is concerned not with the supply of international money
but with the relationships among a hundred or so currencies of individual countries
and with the pattern of balance of payments retatiorisllips and the manner in which
they are adjusted and settled.
International Monetary Fund
The formation of the IMF was initiated in 1944 at the Bretton Woods Conference. IMF came into operation on 27th December 1945 and is today an international organization that consists of 189 member countries. Headquartered in Washington, D.C., IMF focuses on fostering global monetary cooperation, securing financial stability, facilitating and promoting international trade, employment, and economic growth around the world.
IMF mainly focuses on supervising the international monetary system along with providing credits to the member countries.
Objectives of International Monetary Fund
The objectives of the International Monetary Fund are as follows:
- International Monetary Cooperation: The most important objective of the IMF was to establish monetary cooperation among the various member countries as it was considered necessary to establish international monetary cooperation to prevent the outbreak of war in future.
- To Ensure Stability in Foreign Exchange Rates: There was a lot of instability in foreign exchange rates before the Second World War, which produced adverse repercussions on international trade. So, IMF was established to eliminate this instability of foreign exchange.
- To Eliminate Exchange Control: Every country has resorted to exchange control as a device to fix its exchange rate at a particular level before the Second World War, which produced adverse effects on international trade. So IMF came up to remove or relax these exchange controls.
- To Promote International Trade: Another important objective of the IMF was to promote international trade by removing all the obstacles and hindrances, which had the effect of restricting it.
- To Promote Investment of Capital in Backward and Underdeveloped Countries: IMF exports capital from the richer to the poorer countries so that the poor countries can develop their economic resources for achieving a higher standard of living.
- To Eliminate or Reduce the Disequilibrium in the Balance of Payments: IMF helps to reduce the disequilibrium in the balance of payments by selling or lending foreign currencies to the member nations.
The functions of the International Monetary Fund can be categorized into three types:
- Regulatory functions: IMF functions as a regulatory body and as per the rules of the Articles of Agreement, it also focuses on administering a code of conduct for exchange rate policies and restrictions on payments for current account transactions.
- Financial functions: IMF provides financial support and resources to the member countries to meet short term and medium term Balance of Payments (BOP) disequilibrium.
- Consultative functions: IMF is a centre for international cooperation for the member countries. It also acts as a source of counsel and technical assistance.
1. It functions as a short-term credit institution.
2. It provides machinery for the orderly adjustments of exchange rates.
3. It is a reservoir of the currencies of all the member countries from which a borrower
nation can borrow the currency of other nations.
4. It is a sort of lending institution in foreign exchange. However, it grants loans for
financing current transactions only and not capital transactions.
5. It also provides machinery for altering sometimes the par value of the currency of a
member country. In this way, it tries to provide for an orderly adjustment of exchange
rates, which will improve the long-term balance of payments position of member
countries.
6. It also provides machinery for international consultations
Recent Developments in International Finance
Here are some recent developments in international finance
COVID-19 pandemic- The pandemic had a significant impact on global economy and finance markets.Central banks and governments around the world have taken unprecedented measures to mitigate the economic damage such as providing fiscal stimulus packages and lowering interest rates.
2.Cryptocurrencies-The rise of cryptocurrencies such as bitcoin has challenged the traditional forms of finance and raised questions about the future of global finance zystem. Some countries have embraced cryptocurrencies while others have expressed their concerns about their potential risks and drawbacks
3.Sustainable Finance-There has been a growing focus on sustainable finance which seeks
to align financial investments with environmental, social and governance considerations.This has led to the emergence of new financial products such as green bonds and sustainable funds
4. Fintech-Financial technology or fintech has been rapidly transforming the financial industry, with innovations such as mobile payments digital currencies and robo-advisors. This has led to increased competition and new business models as well as new regulatory challenges.
5.Trade Wars-The recent trade disputes between US and China as well as other countries has had significant implications for international finance.These disputes have led to increased volatility in financial markets changes in trade flows and potential shifts in global economic power.
6.Negative interest rates-Several countries including Japan and some European nations have implemented negative rate interest policies in an effort to stimulate economic growth.This has led to unusual dynamics in financial markets such as negative yields on government bonds.
7. Digitilization of finance-The digitalization of finance have been accelerated in recent years with the growth of mobile banking, online lending and other fintech innovations.This has led to increased efficiency and convenience for consumers but also raised concerns about privacy and cyber security.
8. Globalization-The trend of globalization which has been ongoing for several decades has had significant implications on international finance.It has led to increased trade flows, cross border investment,and global economic integration.
9. Central bank digital currencies-Several central banks including the Peoples bank of china and the European central bank are exploiting the possibility of issuing digital currencies.This could have significant implications on the global financial system including changes to the role of central banks and the international monetary system.
10.Brexit-The UK's decision to leave the European union has had significant implications for international finance, including changes in trade and investment flows,financial regulations, and the role of London as a global financial center
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Syllabus for unit 1
Unit 1: INTRODUCTION TO INTERNATIONAL FINANCE (12hrs) Introduction to International Finance, Components, Methods of Payment, Risks & uncertainties in International Finance, Issues involved in International Finance, Introduction to International Monetary System, Recent Developments in International Finance.
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