IF-Unit I CRR

International finance is the branch of economics that studies the dynamics of exchange rates, foreign investment, and how these affect international trade.   2)          Fundamentals of international finance deal with the study of foreign investments,  the changes in the foreign exchange rates, and how international trade is influenced by them.  3)            International finance also follows techniques for allocation of funds and resources in international trade. However, it faces certain hindrances regarding mobility of capital and foreign currencies, as well as the foreign exchange rates prevalent in different countries.  4)     The Specialty of International finance are    Foreign exchange risk:  E.g., an unexpected devaluation adversely affects your export market            Political risk:

The Scope of International Finance :   Currently, international finance has become more comprehensive or broader in scope and is dealing with matters related to globalization, fair trade, multinational banking, and multinational corporations. Three conceptually distinct but interrelated parts are   identifiable in 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…

o   Balance of Payments: Meaning: It is a systematic accounting record of all economic transactions during a given period of time between the residents of one country and the residents of all other countries. The word economic transaction means transfer of economic value from one country to another. The transfer may be requited i.e. The transferee gives something in return or unrequited like unilateral transfers or gifts. Example: purchase or sale of goods or services with a financial quid pro quo – cash or a promise to pay. This involves one real and one economic transaction. Deficit and surplus in BOP:  If debits exceed credits then it is BOP deficit and if the credits exceed debits then it is said to be BOP surplus.

o   The three main components of BOP are

•        The current account: this includes export and import of goods and services and unilateral transfers of goods and services. The current account is further divided into

o   Merchandise which takes care of the physical goods,

o   The Non Monetary Gold Movements (gold is both a commodity and a financial asset. It is a financial asset when the monitory authority holds it as part of international reserves. Otherwise it is a commodity asset).

o   The last is the Invisible account, which includes trade in services such as banking, insurance, transportation, travel etc.

•        The capital account: this includes transactions leading to changes in financial assets and liabilities of the country. The further classification is

o   Private sector capital flows and advances,

o   Banking transactions and

o   Official loans, amortization etc.

•        The reserve account: this account includes the reserve assets i.e. The assets that the monitory authority of the country uses to settle the deficits that arise on the other two categories taken together.

§  Importance of BOP information: The BOP statement contains useful information for financial decision makers. In the short run, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Taken in conjunction with recent past data, they may conform or indicate a reversal of perceived trends. They also signal a policy shift on the part of the monetary authorities of the country unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest to attract short term capital inflows to prevent depreciation of its currency. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties its debt. 

Credits	Debits
Current Account
Merchandise Exports (Sale of Goods)	Merchandise Imports (purchase of Goods)
Invisible Exports (Sale of Services)	Invisible Imports (Purchase of Services)
Transport services sold abroad	Transport services purchased from abroad
Insurance services sold abroad	Insurance services purchased
Foreign tourist expenditure in country	Tourist expenditure abroad
Other services sold abroad	Other services purchased from abroad
Incomes received on loans and investments abroad.	Income paid on loans and investments in the home country.
Unilateral Transfers	Unilateral Transfers
Private remittances received from abroad	Private remittances abroad
Pension payments received from abroad	Pension payments abroad
Government grants received from abroad	Government grants abroad.
Capital Account
Foreign long-term investments in the home country (less redemptions and repayments)	Long-term investments abroad (less redemptions and repayments)
Direct investments in the home country	Direct Investments abroad
Foreign investments in domestic securities	Investments in foreign securities
Other investments of foreigners in the home country	Other investments abroad
Foreign Governments’ loans to the home country.	Government loans to foreign countries
Foreign short-term investments in the home country.	Short-term investments abroad.

•        An exchange rate is the price of one currency in terms of another.  This is sometimes called the nominal exchange rate . Each country has a currency in which the prices of goods and services are quoted.  FX rates express the value of one currency in terms of another currency.  An exchange rate is the price of one currency in terms of another.  This is sometimes called the nominal exchange rate

•        An exchange rate can be quoted in two ways, Direct (American) terms and indirect (European) terms

o   Direct terms :  Price of foreign currency in terms of national currency.  How many units of national currency do we need to buy a unit of foreign currency Example $/€, $/¥.

o   Indirect terms : Price of national currency in terms of foreign currency How many units of foreign currency do we need to buy a unit of national currency Example €/$, ¥/$

}  Players in the foreign exchange market

◦       Commercial banks, large corporations, non-bank financial institutions, central banks.  Commercial banks are by far the largest players in the foreign exchange market.  However large corporations like IBM and GE also engage in significant transactions.  Another groups of important players are central banks

}  Characteristics of the market

◦       The main markets are London, New York, Tokyo

◦       Daily global value of forex trading $1.7 trillion

◦       $ vehicle currency

}  What factors might affect demand and supply?

◦       Inflation rates?

◦       Trade deficits?

◦       Demand for assets?

•        The 'spot' and 'forward' contracts are the most basics tools of Foreign exchange Management. These are contracts between end users (exporters, importers etc.) And financial institutions that specify the terms of an exchange of two currencies. In any foreign exchange contract the following have to be agreed upon:  1) The currencies to be bought and sold - in every contract there are two currencies. One that is bought and the one that is sold.  2) The amount of currency to be bought or sold
3) The date at which the contract matures  4) The rate at which the exchange of currencies will occur. In determining the rate of exchange in six months time there are two components:  1) The current spot rate  2) The forward rate adjustment The spot rate is simply the current market rate as determined by supply and demand.  The forward rate adjustment is a slightly more complicated calculation that involves the interest rates of the currencies involved.

Vehicle currency  (2004){06,07}: The currency used to invoice an international trade transaction, especially when it is not the national currency of either the importer or the exporter. At the start of every trading day, the external value of domestic currency gets established in the local foreign exchange market against a major currency. This currency of universally accepted major international currencies like USD, GBP or EUR. Such currency is called vehicle currency. In india from 1991, USD is vehicle currency.

·         Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars.  The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.

·         Currency Codes : All currencies have a 3-letter code used by SWIFT for all interbank transactions.

o   DEM : Deutsche Mark

o   CHF : Swiss Franc

o   NLG : Dutch Guilder

o   BEF : Belgian Franc

o   FRF : French Franc

o   DKK : Danish Kroner

o   ESP : Spanish Peseta

o   ITL : Italian Lira

o   USD : US Dollar

o   AUD : Australian Dollar

o   CAD : Canadian Dollar

o   JPY : Japanese Yen

o   GBP : British Pound

o   IEP : Irish Pound (punt)

o   INR : Indian Rupee

o   SAR : Saudi Riyal

o   EUR : Euro

•        A spread can be defined as an option trading strategy, in which a trader offsets the purchase of one trading unit against another. It can also be referred to as the gap or difference between the bid and ask of a financial instrument. Interbank market deals are conducted mainly over the telephone. If the price quoted is acceptable, then the deal between traders will move further in terms of amount bought/sold, price, identity of the party etc. In their respective banks’ computerised record systems. On the day of settlement, banks will settle the transaction with both the sides.

•        Classification of rates in terms of settlement (cash, tom, spot and forward),

•        Where T represents the current day when trading takes place and n represents number of days.

•        Cash – Cash rate or Ready rate is the rate when the exchange of currencies takes place on the date of the deal itself. There is no delay in payment at all, therefore represented by T + 0. When the delivery is made on the day of the contract is booked, it is called a Telegraphic Transfer or cash or value – day deal.

•        Tom – It stands for tomorrow rate, which indicates that the exchange of currencies takes place on the next working day after the date of the deal, and therefore represented by T+ 1.

•        Spot – When the exchange of currencies takes place on the second day after the date of the deal (T+2), it is called as spot rate. The spot rate is the rate quoted for current foreign – currency transactions. It applies to interbank transactions that require delivery on the purchased currency within two business days in exchange for immediate cash payment for that currency.

•        For e. G. A London bank sells yen against dollar to a Paris bank on Monday, 1^st march, the London bank will turn over yen deposit in Japan to the Paris bank on Wednesday and the Paris bank will turn over $  deposit in US to the London bank on  same day i. E. 3^rd march, Wednesday. If the 3^rd march is holiday in any bank in dealing location or settlement location deposit will takes place on next business day.

•        Forward –The forward rate is a contractual rate between a foreign – exchange trader and the trader’s client for delivery of foreign currency sometime in the future. Here rate of transaction is fixed on transaction date for transactions in future. Standard forward contract maturities are 1,2,3,6, 9, and 12 months.

o   Bid rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency.

o   Offer rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency

Bid offer spread: The difference between the ask and bid rates.