DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 1: Globalization and Trade 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 1
Globalization and Trade
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Understanding International Financial
1 - 5-6
Management (IFM)
3 International Business and its Modes 2 1 7-11
4 Multinational Corporations: The Key - - 11-12
Participant in if Functions
5 International Finance - - 13
6 Significance of International Finance - - 14-15
7 Nature of if Functions and The Scope of IFM - - 16-18
8 Challenges of International Finance - - 18-19
9 Globalization 3 - 19-23
10 International Trade and its Limitations - 2 23-26
11 Emerging Trends in Trade - - 26-29
12 Summary - - 29-30
13 Case-Study - - 30-31
14 Terminal Questions - - 31-32
15 Answers - - 32-37
16 Suggested Books and E-References - - 38

Unit 1: Globalization and Trade 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
Globalization has had a profound impact worldwide in recent years, marked by a significant
increase in global transactions and international trade. Multinational and transnational
corporations have become prominent players in this global landscape, dominating foreign
direct investment and actively participating in trade. Notably, approximately one-third of
global trade now occurs among these corporations, rather than between them.

The driving force behind this trend is the growing number of countries engaging in
international trade to boost profits, expand sales, and safeguard against competitive
pressures. Key objectives motivating companies to enter the international business arena
include sales expansion, resource acquisition, risk reduction in competitive markets, and
diversification of sales and supply sources. Moreover, economic, cultural, technological, and
social factors exert substantial influence on these decisions.

Transnational and multinational enterprises have significantly shaped the concept of

globalization. These corporations, given their global reach and mobility, compel countries
and regions to compete for their presence. To attract such companies, governments and
regional authorities offer incentives, such as tax incentives, promises of support,
infrastructure improvements, or relaxed environmental and labour standards. This
approach enhances the appeal of multinational corporations for foreign investment and
provides them with the necessary flexibility in marketing and distribution.

When an international corporation's financial manager operates across multiple countries,

they encounter new opportunities, as well as additional costs and risks. Primary risks facing
these corporations include variations among countries and populations, foreign exchange
fluctuations, and unique business challenges in unfamiliar environments. Furthermore,
there's the looming spectre of political risk—the potential for sovereign governments to
interfere with or even terminate corporate operations altogether.

Unit 1: Globalization and Trade 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1.1 Learning Objective

After studying this chapter, you will be able to:
❖ Comprehending the meaning of International Financial Management
❖ Work on key aspects of International Financial Management
❖ Discussed the different modes of International Business
❖ Role of MNC in being key participant in International Financial function
❖ Evaluating the meaning and challenges of International Finance
❖ Discussion on Nature of International Financial Functions and the scope of IFM
❖ Discussion on meaning and need of Globalization, its advantages, and dis-advantages.
❖ Discussion on International trade, different theories and its limitations.

Unit 1: Globalization and Trade 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. UNDERSTANDING INTERNATIONAL FINANCIAL MANAGEMENT (IFM)

International Financial Management is concerned with the management of international
business (IB)-related financial functions, commonly referred to as international financial
functions. The nature and scope of IFM will thus be clear if one tries to understand the nature
and mode of international business, the forms of financial functions carried out by those
participating in IB, and the complexities of international financial functions that differentiate
them from domestic financial functions.

International Financial Management refers to the management of financial resources and

operations in a global context. It involves the strategic management of various financial
aspects across national boundaries, considering factors such as exchange rates, international
trade, foreign investment, political and economic risks, and regulatory environments. The
primary goal of international financial management is to maximize the value of a company's
investments and operations while effectively managing the risks associated with
international business activities.

Fig 1
(https://www.onlineinterviewquestions.com/international-financial-management-mcq/)

Unit 1: Globalization and Trade 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Key aspects of international financial management include:

• Foreign Exchange Management: This involves understanding and managing currency
exchange rates, as businesses often deal with multiple currencies due to international
trade and investments. Fluctuations in exchange rates can significantly impact a
company's profitability and financial stability.
• International Capital Budgeting: Companies make decisions about allocating financial
resources for various projects or investments in different countries. The evaluation of
these projects involves considering factors such as exchange rate risk, differing tax
laws, and economic conditions.
• Global Financing and Funding: Businesses often need to raise capital from international
markets to support their operations and growth. This may involve issuing international
bonds, obtaining loans from international banks, or attracting foreign investors.
• Cross-Border Mergers and Acquisitions (M&A): Companies may engage in M&A
activities across borders to expand their market presence or acquire strategic assets.
International financial management plays a crucial role in evaluating the financial
feasibility and risks associated with such transactions.
• Hedging and Risk Management: Managing risks associated with international business
operations, including political risks, economic uncertainties, and currency fluctuations,
is a key aspect of international financial management. Businesses often use various
financial instruments and strategies to hedge against these risks.
• Global Cash Management: Efficiently managing cash flows across different countries is
important to optimize liquidity and minimize transaction costs.
• Regulatory and Legal Compliance: International financial management requires
adherence to various international financial regulations, tax laws, and accounting
standards that may vary from one country to another.
• Cultural and Ethical Considerations: Operating in different countries involves
navigating cultural differences and understanding ethical norms that might impact
financial decisions and relationships.

Unit 1: Globalization and Trade 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. INTERNATIONAL BUSINESS AND ITS MODES

IB means carrying of business activities beyond national boundary. These activities include
normally international trade of goods and services and also international production of
goods and provision of services normally under the grab of foreign direct investment (FDI).
To be precise, IB takes three modes: international trade, contractual entry modes, such as
licensing, franchising, management contracts and turn-key projects, and foreign investment,
especially FDI.

Modes of IB

International Trade Contractual entry modes Foreign

example=licensing, investments
franchising, management
contracts and turnkey projects
Exports and
Imports FDI and FPI

Fig 2: Modes of International Business

It is now evident that international trade-export and import-is an important mode of IB.
Export may be both direct and indirect. Direct export occurs when a company takes full
responsibility for making its goods available in the target market by selling directly or
through its agents. On the contrary, indirect export takes place when the exporting company
sells its products to the end-users through intermediaries such as export houses etc.

Again, international trade is primarily multilateral in character, but bilateral trade does exist
in many cases. Bilateral trade, often known as countertrade, is a sort of bartering of goods in
different ways. Sometimes we find industrial countertrade or the buy-back agreement that
involves the sale of industrial equipment or turnkey plants in exchange for the products
manufactured by the industrial plant so delivered.

Unit 1: Globalization and Trade 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Foreign investment is the other mode of IB. Foreign investment is classified as foreign
portfolio investment (FPI) and foreign direct investment (FDI). FPI occurs when firms
diversify their investment in international securities and often operate on the stock
exchange in a foreign country with the sole objective of getting high return. It is nothing to
with the production of goods and provision of services abroad. On the other hand, FDI is
much concerned with the operation and ownership of host-country firms.

FDI takes broadly three forms: one is greenfield investment, the other is mergers and
acquisitions (M&As) and the last one is brownfield investment. Greenfield investment can be
made through opening of branch in a host-country or through making investment in the
equity capital of the host-country firm. The latter is also known as financial collaboration. If
the parent holds the entire equity of the host country firm, the latter is called wholly owned
subsidiary of the parent. If it is more than half, it is known as a subsidiary. Otherwise, it is
simply an affiliate of the parent company.

M&As are either outright purchase of a running company abroad or an amalgamation with a
running foreign company. While in the former, the acquiring company maintains its
existence and the target company loses its existence; in the latter, both loses their existence
in favour of a new company. M&As are either horizontal or vertical or conglomerate.
Horizontal M&As are found in cases where two or more firms engaged in similar line of
activities combine. On the contrary, vertical M&As occur among firms involved in different
stages of production of a single final product. Merger of an oil exploration unit with a refining
unit is vertical. Conglomerate merger involves two or more firms in unrelated activities,
example a financial company managing the financial functions of other companies in a group.
Again, M&As may be either friendly or hostile. While hostile take-overs involve list of
negotiations, friendly take-overs only after lot of negotiations. Brownfield investment is a
combination of greenfield investment and M&A. It exists when a company first goes for an
international M&A and then makes huge investments for replacing plant & machinery in the
target company.

Contractual entry modes, also known as technical collaboration, require no financial

investment and encompass various forms, including franchising, licensing, management
contracts, and turn-key projects. Franchising involves permitting a foreign company to use

Unit 1: Globalization and Trade 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

a brand name for a royalty fee. Licensing entails transferring technology for a technical
service fee. Management contracts involve sharing management capabilities abroad. Turn-
key projects involve constructing a foreign plant and handing it over to the foreign partner
for operation. While no investment goes abroad in these contracts, funds flow in reverse for
using these services or facilities.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary goal of international financial management?

a) Maximizing domestic market share
b) Minimizing international trade
c) Maximizing the value of investments while managing risks
d) Minimizing cross-border transactions
2. What does "foreign exchange management" involve in international financial
management?
a) Managing different time zones for global operations
b) Managing cultural differences in cross-border transactions
c) Managing fluctuations in currency exchange rates
d) Managing international shipping and logistics
3. Which type of investment focuses on operating and owning host-country
firms?
a) Foreign Portfolio Investment (FPI)
b) Foreign Direct Investment (FDI)
c) International Capital Budgeting
d) International Trade Investment
4. What is the main difference between direct and indirect export?
a) Direct export involves exporting to multiple countries, while indirect
export focuses on a single market.
b) Direct export uses intermediaries, while indirect export involves selling
directly.
c) Direct export is multilateral, while indirect export is bilateral.
d) Direct export is less profitable, while indirect export is more profitable.

Unit 1: Globalization and Trade 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

5. What is the key focus of brownfield investment in foreign business

operations?
a) Establishing new branches in host countries
b) Transferring technology to foreign companies
c) Opening franchising opportunities
d) Upgrading plant and machinery in a foreign company
6. Which type of merger involves companies in unrelated business activities?
a) Horizontal merger
b) Vertical merger
c) Conglomerate merger
d) International merger
7. What is the main purpose of franchising in international business?
a) Transferring technology to foreign companies
b) Directly selling products to foreign consumers
c) Sharing brand name and receiving royalty
d) Investing in foreign markets through stocks
8. What type of investment does NOT involve financial investment, but rather
involves technology transfer?
a) Foreign Portfolio Investment (FPI)
b) Greenfield Investment
c) Licensing
d) Foreign Direct Investment (FDI)
9. What does "cross-border Mergers and Acquisitions (M&A)" refer to in
international financial management?
a) Merging two companies within the same country
b) Acquiring foreign assets through stock market trading
c) Merging a company with its subsidiaries
d) Combining companies from different countries

Unit 1: Globalization and Trade 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

10. Which aspect of international financial management involves managing cash flows
across different countries to optimize liquidity?
a) Foreign Exchange Management
b) Global Financing and Funding
c) Global Cash Management
d) Hedging and Risk Management

4. MULTINATIONAL CORPORATIONS: THE KEY PARTICIPANT IN

INTERNATIONAL FINANCIAL FUNCTIONS

It is true that even small trading firms and small investors participate in IB. But it is the
multinational corporations (MNCs) that are responsible for a lion’s share of world trade and
investment. An MNC is an enterprise that owns and controls production or service facilities
outside the country in which it is based. But for qualifying as an MNC, the number of
countries where the firm operates must be at least six. At the same time, the firm must
generate sizeable proportion of its revenue from the foreign operation, although no exact
percentage is agreed upon. All this means that the firm should be big enough to have its
stronghold in many countries through branches and subsidiaries. MNC’s stronghold in the
host countries is evident from the fact that in 2010, 64% of the total sales, 62% of the total
assets and 56% of the total employment in top 100 MNCs were accounted for by the host
countries (United Nations, 2011).

Something more be clear if one goes through the behavioural definition of a MNC given by
Vernon and Wells Jr (1986). According to them, MNCs represent a cluster of affiliated firms
located in different countries that: 1. Are linked through common ownership, 2. Draw upon
a common pool of resources, and 3. Respond to a common strategy. All this means a high
degree of integration among different units of the firm.

Multinational corporations (MNCs) can be categorized into three strategic types:

ethnocentric, polycentric, and geocentric. Ethnocentric firms prioritize their home market
and often treat global and domestic operations similarly. In contrast, polycentric firms focus

Unit 1: Globalization and Trade 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

on foreign markets to meet local demand, adopting a host-market-oriented approach.

Geocentric firms strike a balance between home and host market orientation, reflecting a
more realistic approach.

Punnett and Ricks differentiate between multi-domestic (host country-focused) and global
(worldwide market-focused) companies. The former concentrates on the specific markets
where it operates, while the latter views the world as a single market and integrates
operations accordingly.

Barlett and Ghoshal distinguish between multinational and transnational companies.

Multinational firms have decentralized decision-making and less coordination, while
transnational firms meticulously configure, coordinate, and control their global activities to
achieve competitiveness on a global scale.

A Multinational Corporation (MNC) is a corporation with extensive ties in international

operations in more than one foreign country. A MNC has its facilities and other assets in at
least one country other than its home country. Some examples are General Electric, Nike,
Coca-Cola, Wal-Mart, Toshiba etc. Typically, a multinational corporation develops new
products in its native country and manufactured them abroad, often in third world nations,
thus gaining trade advantages and economies of labour and materials. Such companies have
offices and/or factories in different countries and usually have a centralized head office
where they coordinate global management. It is argued that multinationals create jobs and
wealth and improve technology in countries that are in need of such development. However,
critics points to their inordinate political influences, their exploitation of developing nations,
and the loss of jobs that result in the corporation’s home countries.

A Transnational Corporation (TNC) is a MNC that operates worldwide without being

identified with the national home base. It is said to operate on a borderless basis. These
corporations originated early in the 20th century and proliferated after World War II.
Transnational Corporation are sometimes also called as multinational corporation. A typical
TNC is Unilever. It has headquartered in the UK and Netherland. It is active in two mains
areas: food and detergents/soaps. Its product are sold in supermarkets, shops, roadside stall
over the world.

Unit 1: Globalization and Trade 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. INTERNATIONAL FINANCE
It is a section of the financial economy that deals with the macroeconomic affairs and
monetary transactions between two countries. Factors that have an impact on international
finance include interest rates, exchange rates, Foreign Direct Investment (FDI), government
policies, and the current currency. We live in a world that is increasingly globalised. Each
country is dependent on the others in various ways. Developed countries seek lower-cost
labour from developing countries, while developing countries seek services and goods from
developed countries.

Many considerations come into role when a trade takes place between two countries like this
one, and they must be taken into account when conducting the trade to ensure that no
regulatory violations occur. International finance is a critical component of any economy,
and local players must adjust their policies accordingly to avoid stiff competition from non-
local players.

The following are some examples of international finance:

1. In 1944, the Bretton Woods Organization proposed the first general negotiation
monetary order to make money transfers between countries easier.
2. The Bretton Woods scheme required member states to examine their cross-border
trade transactions and agree to settle the bill with dollar bills that can be traded for
gold. As a result, these bills are referred to as "as good as gold." Every member country's
currency, such as Canada's, the European Union's, Australia's, and Japan's, is pegged to
the same global currency, the US dollar.
3. The United States completed this in 1971. The conversion of the U.S. dollar into gold
was stopped unilaterally, thereby turning the U.S. and other mixed currencies back into
floating currencies.
4. Another great real-time example is Trump's policy of raising tariffs on Chinese goods.
The 25 percent tariff targets industries that benefit from China’s unfair trade policies.
The sectors subject to the proposed tariffs include industries such as aerospace,
information and communication technology, robotics and machinery.

Unit 1: Globalization and Trade 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. SIGNIFICANCE OF INTERNATIONAL FINANCE

In a modernised, globalising world, its relevance is growing at an exponential rate. Day in
and day out, supplementary variables are included into the bilateral trade value. As opposed
to focusing on local markets, it regards the globe at large as one giant marketplace. For the
same reason, we also include such international organisations as the International Monetary
Fund (IMF), the International Finance Corporation (IFC), and the World Bank. Trade
between the two nations helps both their economies and the local ones to grow and prosper.
Factors such as currency fluctuations, arbitrage opportunities, interest rates, trade deficits,
and others have a major impact on the global economy.

Advantages:
1. To raise and manage capital for a company, there are a number of options in foreign
trade and finance.
2. Companies that rely on foreign trade have a substantially higher growth potential than
companies that do not.
3. The financial performance of the company will improve as there are more
opportunities to manage the different currencies and capital involved.
4. The introduction of international trade in the market can only improve the market
competitiveness. The quality of the offerings can be improved without affecting the
price because of the prevailing competition.
5. Foreign trade revenue will serve as a buffer for the business, and there is no need to be
concerned about domestic demand when there is still demand abroad.
6. The organisation has operations in several countries, is able to respond quickly in an
emergency, and has a BCP (Business Continuity Protocol) in place.

Disadvantages:
1. Political unrest in one country that is a trading partner in another country may have an
effect on other trading partners in the same country.
2. There is always a risk when dealing with different exchange rates, since all currencies
are subject to wild swings.
3. Foreign trade-related debt liability must be carefully handled. Otherwise, it could keep
you from making a lot of money.

Unit 1: Globalization and Trade 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. In comparison to domestic funds, sensitive data should be revealed more, and the risks
of confidential information being compromised are higher in global markets.
5. Local players are unable to compete with large multinational players that have access
to resources and research in order to provide high-quality goods and services.
6. Since there are many cultures, there will be cultural variations that, if not treated
correctly, will damage the brand's credibility.

In this era of technology and globalisation, international finance is a phenomenon that is

rapidly expanding. This idea not only provides the business with many opportunities to
better leverage resources, but it also enhances competition to manufacture and deliver high-
quality goods and services. Local players will have to contend with global giants, so output
will be more consistent.

There are several aspects, such as currency rate, inflation rate, and cultural and linguistic
diversity, that may be a gift or a burden for an international financial institution, depending
on how they are handled. Therefore, companies engaged in such funds have no choice but to
engage and ensure that they do so efficiently.

Unit 1: Globalization and Trade 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

7. NATURE OF INTERNATIONAL FINANCIAL FUNCTIONS AND THE

SCOPE OF IFM

It has already been mentioned that the entire gamut of financial functions related to IB forms
the subject matter of IFM. Let us discuss the nature of these financial functions which will
unravel the nature and scope of IFM. To begin with trade, an importer pays for the import
usually in a convertible currency. The exporter converts the foreign currency of the export
proceeds into its own currency. The exchange of currency has thus led to the emergence of
globally spread foreign exchange market. The discussion of the foreign exchange market and
the various activities there in forms are subject matter of IBM.

When currencies are exchanged in the foreign exchange market, there arises another
question as to what the exchange rate should be. In other words, the question is how many
units of foreign currency, a unit of the domestic currency would fetch. In some cases, the
exchange rate between any two currencies is fixed as per the government announcement.
But in many cases, it is floating, based on the market forces of demand and supply. In fact, it
is the International Monetary Fund (IMF) that has laid down the norms and procedures for
different types of the exchange rate regimes. The member countries follow those norms and
procedures for different types of the exchange rate regime. The IMF maintains surveillance
over the functioning of the exchange rate regime; and over and above, it helps maintain
international liquidity so as to ease the international monetary and financial transactions.
thus, the functioning of IMF and the determination of exchange rate form an integral part of
the study of IFM.

The foreign exchange market is supposed to be perfect where all information is easily
available and where nobody can influence the exchange rate. But in real life, it is not perfect.
Various exchange rates exist in different markets at the same point of time. The arbitrageurs
take advantage of this kind of disparity and make profits. Moreover, the market determined
exchange rates tends to oscillate putting in turn the traders to exchange rate exposure/risk.
The traders hedge their risks in the foreign exchange market. Again, the speculators are quite
active in the foreign exchange market in order to make profits out of exchange rate
oscillations. Hedging and speculations are frequent also in the market for derivatives, such
as the market for currency futures and the market for currency options that have evolved

Unit 1: Globalization and Trade 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

and matured over time. IFM covers all these activities concerning arbitrage, hedging and
speculations.

The IB-related financial functions are not limited to the foreign exchange market. A lot of
such functions are involved in cross-border investment. The operation of financial
companies at the stock exchange abroad with the objective of maximising gains with the
given level of risk or minimising risk with the given level of return is known as foreign
portfolio investment and is an important segment of IFM. But more important are the
financial activities of the MNCs that are related to FDI. First of all, an MNC selects a new
proposal on the basis of its viability in terms of a positive net present value. If it aims at
acquiring a running firm abroad, it finds out whether the gains are higher than the
considerable value it is paying to the target company. In all the cases, political risk is taken
into consideration. If the situation is favourable, the MNC makes actual investment. So the
FDI involving long-term investment decision, often known as International Capital
Budgeting forms a part of IFM.

International investment is possible only when the required funds are raised and are made
available for this purpose. It is true that MNCs have an easy access to the international
financial market. International financial market embraces variety of sources-beginning from
the international development banks, such as the World Bank and International Finance
Corporation and regional development banks such as Asian Development Bank, etc to the
eurocurrency market and international securities market. Whatever may be the source of
funds, the MNC is very much careful of, firstly the effective cost of funds that depends not
only on the interest rate but also on the appreciation/depreciation of the currency; and
secondly, the debt-equity norm that varies from one country to another and that does
influence the weightage average cost of capital. Sometimes borrower does not get the
desired currency. Sometimes it does not get funds at the desired type of interest rate
meaning that he/she may get the fund at fixed interest rate instead of floating rate and vice
verse. In such cases, the borrower swaps the loan. The swap can be interest rate swap and
currency swap. Again the floating interest changes more frequently with the result that the
lender/borrower is exposed to interest rate risk. In such cases, there are ways to hedge the
interest rate risk and eliminate/minimize the losses on this account. Thus the international
financial functions are related to the raising of funds from different windows of the

Unit 1: Globalization and Trade 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

international financial market and also to the related activities, such as financial swap,
interest rate risk management. The study of IFM covers all these activities.

8. CHALLENGES OF INTERNATIONAL FINANCE

We have discussed international finance and trade in the above section. Now in this section,
we are discussing some of the major challenges in International Finance. Some of the major
challenges are as follows:
1. The challenge of natural resource conservation: Increased international investment
would have an effect on natural resources. As the number of banks increases in India,
more and more air conditioners are being utilised, contributing to the country's rising
average temperature. Who is responsible for this mess? It's no surprise that foreign
financial institutions are setting up shop in India. If the bank branch continues to grow,
the open space will likely become too warm for comfort without installing an additional
five air conditioners. By planting the tree and avoiding the use of air conditioners at
work, this may be reduced to a manageable level.
2. Terrorism: The main challenge for the International Monetary Fund is terrorism. Any
country's foreign finances would suffer if it raises terrorism in another country.
Pakistan's current economic crisis is causing problems with food safety, oil shortages,
lack of foreign reserves, poverty, and joblessness.To control this situation, the Pakistani
government is struggling to get support from other countries to overcome this issue,
but other countries are not supporting it since the Pakistani government supports
terrorism.
3. Culture: International finance puts each country's culture to the test. In India,
vegetarianism is the standard followed by majority people. In the non-vegitarian food
category, pork is not encouraged for consumption. As a result, McDonald's and other
non-vegetarian food chains are not encouraged to sell pork in india.
4. Adhere to political policies and the law of the land: If traders in any country want
to develop a foreign fund, they must formulate their strategy in compliance with the
law and political policies of that country. The MNCs can not able to run the subsidary
and parent company equally since the political environment will differ from country to
country. Ploitical parties frame laws from time to time to make
betterment/development for their country. Such laws has to be forecefully followled

Unit 1: Globalization and Trade 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

by the foreign /subsidary company decisions that may affect the fund raising/ sales. of
the subsidary firm.
5. International currencies: International monetary finance has an impact on global
currencies. Foreign currency is necessary for any negotiations with a foreign nation.
When dealing with currencies, you should be informed of the current market rate. If
your currency is undervalued, you will have to wait for trade to pick up. If you don't
invest in yourself, your money will quickly lose value.

9. GLOBALIZATION
Globalization is a multifaceted and complex phenomenon that has transformed the world in
various ways over the past few decades. It refers to the increasing interconnectedness and
interdependence of countries and people around the world, driven by various factors,
including advances in technology, communication, trade, and finance. Here are some key
aspects of globalization:
• Trade and Economic Integration: Globalization has led to a significant increase in
international trade and economic integration. Countries trade not only goods but also
services, capital, and knowledge across borders. Trade agreements, such as the World
Trade Organization (WTO) and regional trade blocs, facilitate this process.
• Technology and Communication: Advances in technology, particularly the internet and
digital communication, have made it easier for people and businesses to connect across
the globe. This has revolutionized communication, information sharing, and business
operations.
• Cultural Exchange: Globalization has enabled the exchange of cultural ideas, products,
and practices. This includes the spread of music, art, fashion, cuisine, and popular
culture from one part of the world to another.
• Migration: Increased mobility and accessibility have led to greater international
migration. People move across borders for work, education, family reunification, and
other reasons, contributing to cultural diversity and labor market dynamics.
• Investment and Capital Flows: Globalization has facilitated the flow of capital across
borders, including foreign direct investment (FDI) and portfolio investment.
Multinational corporations have expanded their operations globally.

Unit 1: Globalization and Trade 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Global Supply Chains: Companies now source components and materials from various
countries, creating global supply chains. This practice enhances efficiency but also
makes businesses vulnerable to disruptions.
• Financial Markets: Globalization has connected financial markets, making it easier for
investors to access international financial instruments. It has also increased the
potential for financial contagion during economic crises.
• Environmental Challenges: The global movement of goods and people has significant
environmental implications, including carbon emissions from transportation and
deforestation due to increased demand for resources.
• Income Inequality: Globalization has contributed to income inequality within and
between countries. While it has lifted many people out of poverty, it has also
exacerbated disparities in income and wealth.
• Geopolitical Dynamics: Globalization has influenced international relations and
geopolitics. It has led to both cooperation and competition among nations, and it has
shaped foreign policy decisions.
• Challenges to National Sovereignty: Some argue that globalization has eroded the
sovereignty of nation-states, as international organizations and multinational
corporations wield significant influence.
• Global Challenges: Globalization has brought global challenges to the forefront, such as
pandemics, climate change, and terrorism. Addressing these issues often requires
international cooperation.

Fig 3
(https://www.quora.com/What-is-your-insight-in-the-relationship-of-globalization-and-
sustainability)

Unit 1: Globalization and Trade 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

It's important to note that globalization is a highly debated topic. While it has brought many
benefits, such as economic growth and cultural exchange, it has also created challenges and
disparities that need to be addressed. The impact of globalization varies widely from one
region or country to another, and it continues to evolve as new technologies and economic
shifts occur.

Globalization is a rapidly intertwined mechanism of cross-border trade of commodities,

resources, money, technology, and information. Businesses will raise income by widening
their markets and gaining access to more capital as a result of globalisation. Globalization,
on the other hand, is exposing domestic markets to competitors, reducing demand for local
goods. Instead of discussing the pros and cons of globalisation, it's better to accept that it
already exists and learn to live with its effects.

Companies achieve a comparative edge in a variety of ways as a result of globalisation. They

will lower operating costs by exporting abroad, minimise or eliminate tariffs, allowing them
to buy raw materials at a lower rate, and, most importantly, gain access to millions of new
customers.

Globalization should be seen as social, cultural, governmental, and legal phenomena.

• Socially, it encourages people to engage further. For example, greater access to modern
technologies, in the world of health care, could make the difference between life and
death. In the world of communications, it would facilitate commerce and education, and
allow access to independent media.
• Globalization is a cultural term that refers to the sharing of ideas, beliefs, and creative
expression between cultures, as well as a trend toward the growth of world culture.
• From a political perspective, globalisation has centred on intergovernmental
organisations like the United Nations (UN) and the World Trade Organization (WTO).
• According to the law, migration has changed the process of creating and applying
international law.

In the one side, the cross-border influx of commodities, money, and labour has resulted in
the creation of new employment and economic development. Employment and growth, on
the other hand, are not evenly distributed across industries or territories. International

Unit 1: Globalization and Trade 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

rivalry has caused significant disruption or obvious loss in certain sectors in certain
countries, such as garment manufacturing or corn farming in Mexico.

Globalization's goals are idealistic and opportunistic, but major companies headquartered in
the Western world have benefited from the expansion of the global free market. It has a
varied effect on jobs, cultures, and small enterprises in both developed and emerging
countries.

Advantages:
1. Proponents of globalisation say that growing productivity, diversity, economic
development, and improved living standards would allow industrialised nations to
catch up with developed nations.
2. Outsourcing gives jobs and technology to developed countries, which helps their
economies grow. Trade policies help cross-border trade by getting rid of restrictions
on the supply side and on trade.
3. Advocates say globalization has improved social justice internationally and focused on
human rights globally. Otherwise, they could be largely ignored.

Disadvantages:
1. One apparent consequence of globalisation is that a country's economic slowdown will
have a domino impact on its trade partners. The 2008 financial crisis, for example, had
a major effect on Portugal, Ireland, Greece, and Spain. Many of these nations were part
of the European Union, which was forced and intervene to bail out bankrupt countries
known as the PIGS.
2. Globalization opponents contend that it has concentrated money and influence in the
hands of small business elite, attracting smaller rivals from all over the world.
3. This is considered as a substantial factor to the economic stress experienced by the
developing counties.
4. Globalization has Increased Competition. On the one hand, competition has a positive
effect as it provides quality products and services at lower costs. Where on another
hand, it makes it very difficult to compete. Due to globalization, the competition is not
only local – it is international as such weak or low capital businesses are adversely
affected.

Unit 1: Globalization and Trade 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

10. INTERNATIONAL TRADE AND ITS LIMITATIONS

It is beneficial to have a brief perspective on the development of International Trade in
recent times and defining the “why” of trade, before understanding the “How”, “where” and
“when” components of Trade finances and services.

The principle governing international trade is that countries import commodities, which
they cannot produce more cheaply than another country provided that they can pay for them
with the sale of exports that are more cheaply produced at home. And shall see, freely traded
commodities are not produced by countries with total resource advantage, but by countries
with relative advantage.

The important widely accepted international trade theories are:

1. The Theory of Absolute Advantage=Adam Smith (1723-1790) saw the benefits of
specialization and trade. Smith’s theoretical contribution is known as the theory of
absolute advantage. For absolute advantage to apply, each party involved in trade, in
order to produce and export goods, would have to be the best in its field. This implies that
they could produce, at the lowest absolute cost, the goods they were going to export. In a
nutshell, the theory has been explained as “If a foreign country can supply us with a
commodity cheaper than we ourselves can make it, better buy it from them with some
part of the produce of our own industry, employed in a way in which we have some
advantage.”

The idea is simple and intuitive. If our country can produce some set of goods at lower
cost than a foreign country, and if the foreign country can produce some other set of goods
at lower cost than we can produce them, then clearly it would be best for us to trade our
relatively cheaper goods for their relatively cheaper goods. In this way both countries may
gain from trade.

2. The Theory of Comparative Advantage=David Ricardo (1772-1823) refined smith’s idea

into the concept of comparative advantage, where one could specialize and trade as long
as they could produce at a lower relative cost (relative in terms of other goods they could
produce). Ricardo justified his theory using labour costs, specifically in terms of the
number of labour hours needed to produce a unit of each good. In other words, a nation’s
comparative advantage depends on the productivity of the labour used to produce.

Unit 1: Globalization and Trade 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

As an example, imagine two countries, England and Portugal producing two goods, cloth
and wine, using labour as the sole input in production. Assume that the productivity of
labour (i.e., the quantity of output produced per worker) varies between industries and
across countries. However, instead of assuming, as Adam Smith did, that England is more
productive in producing one good and Portugal is more productive in the other, Ricardo
assumed that the Portugal was more productive in both goods. Based on Smith’s intuition,
then, it would seem that trade could not be advantageous, at least for England. However,
Ricardo demonstrated numerically that if England specialised in producing one of the two
goods, and if Portugal produced the other, then total world output of both goods could
rise. If an appropriate term of trade (i.e., amount of one good traded for another) were
then chosen, both countries could end up with more of both goods after specialisation and
free trade, than they each had before trade.

Specialization in any good would not suffice to guarantee the improvement in world
output. Ricardo showed that the specialization good in each country should be that good
in which the country had a comparative advantage in production. To identify a country’s
comparative advantage goods require a comparison of production costs across countries.
However, one does not compare the monetary costs of production or even the resource
costs (labour needed per unit of output) of production. Instead, one must compare the
opportunity cost of producing goods across countries.

A way to define comparative advantages is by comparing productivities across industries

and countries. Then suppose, as before, that Portugal is more productive than England in
the production of both cloth and wine. If Portugal is twice as productive in cloth
production relative to England but three times as productive in wine, then Portugal’s
comparative advantage is in wine, the good in which its productivity advantage is greatest.
Similarly, England’s comparative advantage good is cloth, the good in which its
productivity disadvantages is least.

This implies that to benefit from specialization and free trade, Portugal should specialise
and trade the good in which it is “most-best” at producing, while England should specialise
and trade the good in which it is “least-worse” at producing. Note: trade based on
“comparative advantage” does not contradict Adam Smith notion of trade based on
absolute advantage.

Unit 1: Globalization and Trade 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. The Heckscher-Ohilin Theory=A country will tend to export the commodity that uses
relatively more of the factor of production which is relatively most abundant in that
country. The theory assumes that the countries have different quantities of various factors
of production such as land, labour, capital and natural resources but have identical
production functions.

This theory is based on two propositions namely, different products require different
productive factors in different relative proportions and countries have different
endowments of factors of productions. The Heckscher-Ohilin Theory of international
trade explains productivity differences in terms of the relative factors endowment of
countries and consequently incorporates the principle of comparative advantage. A
country will tend to have a comparative advantage in those goods, which use intensively
the country’s relative abundant factors of production and will therefore, import goods,
which require the relative scarcer factor.

4. The Factor-Price Equalization theory posits that under completely unrestricted

international trade, the prices of both traded goods and factors of production (such as
land, labor, and capital) will equalize among countries. This occurs because identical
technological possibilities are assumed, leading to the equalization of factor prices and
the elimination of comparative advantage based on factor prices. While this theory
advocates for free trade as an efficient way to maximize global economic efficiency, it
acknowledges that real-world conditions may not always align with its ideal assumptions.

In practice, governments may intervene in free trade to promote specific economic

sectors through taxation, incentives, or other measures. The theory recognizes that
markets may not always be completely free, and the traditional assumption of immobility
of capital and labor across borders may no longer hold in all situations. Furthermore,
having a natural comparative advantage and engaging in international trade may not
guarantee greater social and economic development. Therefore, this theory alone may not
fully explain the development and competitiveness of a country's exports in the global
market.

Unit 1: Globalization and Trade 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. EMERGING TRENDS IN TRADE

Emerging trends in trade are continually evolving due to technological advancements, shifts
in global economic dynamics, and changes in consumer behaviour. Here are some key
emerging trends in trade that were shaping the landscape:
• E-commerce and Digital Trade: The growth of e-commerce has accelerated, driven by
the COVID-19 pandemic. Consumers increasingly turn to online shopping, and
businesses are expanding their digital presence. This trend involves not only the sale
of physical goods but also digital products and services, further blurring the lines
between industries.
• Global Supply Chain Resilience: The pandemic exposed vulnerabilities in global supply
chains, leading to a focus on supply chain resilience. Companies are diversifying their
supplier base, nearshoring, or reshoring production, and implementing digital
technologies like blockchain and IoT for improved visibility and risk management.
• Sustainability and Ethical Trade: There's a growing emphasis on sustainable and ethical
trade practices. Consumers are demanding products with lower environmental
footprints, and companies are striving to reduce their carbon emissions and ensure
ethical sourcing of materials.
• Trade Agreements and Geopolitical Shifts: Geopolitical tensions have influenced trade
policies. Countries are reevaluating trade agreements and alliances, potentially leading
to shifts in trade patterns and alliances.
• Digital Trade and Data Privacy: Cross-border data flows have become crucial in the
digital age. Regulations around data privacy and data localization are impacting the
movement of digital goods and services, and these issues are being addressed in trade
negotiations.
• Services Trade: Services trade, including sectors like IT, finance, and professional
services, is growing in importance. Advancements in technology, such as remote work
and telehealth, have expanded the scope of services trade.
• Trade Finance Innovation: The adoption of blockchain technology and fintech solutions
is streamlining trade finance, making it more efficient and accessible for businesses,
particularly small and medium-sized enterprises (SMEs).

Unit 1: Globalization and Trade 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Economic Regionalism: While globalization is still a dominant trend, there's also a rise
in regional economic integration, such as the African Continental Free Trade Area
(AfCFTA) and the Regional Comprehensive Economic Partnership (RCEP). These
agreements promote trade within specific regions.
• Trade and Health Security: The COVID-19 pandemic highlighted the intersection of
trade and health security. Countries are exploring ways to ensure the availability of
essential goods and medical supplies during health crises.
• Renewable Energy Trade: As the world shifts toward renewable energy sources, trade
in clean energy technologies, such as solar panels and wind turbines, is on the rise.

Unit 1: Globalization and Trade 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

11. What is the term used for an MNC that operates globally without being
identified with a national home base?
a) Transnational Corporation (TNC)
b) Multinational Corporation (MNC)
c) International Corporation (IC)
d) Global Corporation (GC)
12. Which international organization laid down norms and procedures for
different types of exchange rate regimes?
a) International Monetary Fund (IMF)
b) World Trade Organization (WTO)
c) World Bank
d) United Nations (UN)
13. What is one of the advantages of foreign trade for a business in the context
of international finance?
a) Increased political influence
b) Higher operating costs
c) Exposure to exchange rate risk
d) Improved market competitiveness
14. Which factor contributes to the challenge of political risk in international
finance?
a) Fixed exchange rates
b) Cultural diversity
c) Government policies
d) Natural resource availability

Unit 1: Globalization and Trade 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

15. Which organization intervened to provide financial assistance to countries

affected by the 2008 financial crisis?
a) World Trade Organization (WTO)
b) International Monetary Fund (IMF)
c) World Bank
d) United Nations (UN)
16. What is a potential disadvantage of globalization in terms of economic impact?
a) Higher job opportunities in developing countries
b) Increased access to capital for small enterprises
c) Concentration of wealth and influence in a few elites
d) Reduced dependence on global trade

12. SUMMARY
• International Financial Management (IFM) is concerned with managing international
business-related financial functions.
• Nature and scope of IFM understood through the modes of international business,
financial functions, and complexities.
• Key aspects of IFM includes foreign exchange management, international capital
budgeting, global financing and funding, cross border M&A, hedging and risk
management, global cash management, international trade.
• Foreign Exchange Management involves currency exchange rate understanding and
management. It studies currency fluctuations impact profitability and stability.
• International Business involves cross-border trade, investment, and other business
activities between countries.
• Multinational corporations (MNCs) play a major role in global trade and investment.
• MNCs own and control facilities in multiple countries, generating revenue from foreign
operations.

Unit 1: Globalization and Trade 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• International Finance (IF) deals with macroeconomic affairs and monetary

transactions between countries.
• Factors affecting international finance: interest rates, exchange rates, Foreign Direct
Investment (FDI), government policies, and more. IMF, IFC, and World Bank are
important international organizations in IF.
• Globalization involves cross-border trade, technology, information, and cultural
exchange. Offers benefits like increased market access, lower costs, and global
connectivity. Has social, cultural, political, and legal implications.
• Globalization-Advantages include improved productivity, economic growth, and social
justice. Disadvantages encompass economic vulnerability, wealth concentration, and
increased competition.

13. CASE STUDY

The recent technological advancements, financial market liberalization, and the elimination
of capital controls have ushered in a era of globalization in financial markets. This has
underscored the importance for all multinational corporations (MNCs) with international
cash flows to effectively handle the foreign exchange exposure that arises from operating
within a foreign exchange system.

In the present-day business environment, MNCs are actively seeking to craft techniques and
strategies for proficiently managing foreign exchange exposure. The choice of foreign
exchange strategy is of paramount significance for MNCs due to the heightened volatility in
exchange rates and the necessity to adapt to the evolving structure of the company.

Furthermore, as firms increasingly engage in financial and commercial agreements

denominated in foreign currencies, the prudent measurement and management of
transaction exposure have become indispensable for the success and financial stability of
MNCs.

Questions.
1. Outline the numerous challenges that a MNC faces when trying to manage exposure in
various currencies.

Unit 1: Globalization and Trade 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. Do you think currency correlation and variability are related to the political risk which
country faces? Can you give examples to illustrate your answer.

14. TERMINAL QUESTIONS

1. What is the primary objective of international financial management?
2. What are some key aspects of international financial management?
3. How does foreign exchange management impact businesses engaged in international
trade?
4. What are the three modes of international business (IB)?
5. What is the difference between direct and indirect export?
6. What is bilateral trade, and how does it differ from multilateral trade?
7. What is the difference between foreign portfolio investment (FPI) and foreign direct
investment (FDI)?
8. What are the three forms of foreign direct investment (FDI)?
9. What is a conglomerate merger in the context of cross-border M&A?
10. What is the main purpose of franchising in international business?
11. What are Multinational Corporations (MNCs) and how do they contribute to global trade
and investment? Provide examples to illustrate your answer.
12. What are the different types of Multinational Corporations based on their strategic
approach? Explain the differences between ethnocentric, polycentric, and geocentric
firms.
13. Discuss the advantages and disadvantages of international finance for businesses
engaging in global trade and investment.
14. How does globalization impact various aspects of society, economics, politics, and
culture? Provide examples to illustrate your points.
15. Discuss the major challenges that arise in the context of international finance. Provide
examples to support your points.

Unit 1: Globalization and Trade 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

15. ANSWERS
Terminal Questions
Answer 1: The primary goal of international financial management is to maximize the value
of a company's investments and operations while effectively managing the risks associated
with international business activities.

Answer 2: Key aspects of international financial management include foreign exchange

management, international capital budgeting, global financing and funding, cross-border
mergers and acquisitions, hedging and risk management, global cash management,
regulatory and legal compliance, and cultural and ethical considerations.

Answer 3: Foreign exchange management involves understanding and managing currency

exchange rates. Fluctuations in exchange rates can significantly impact a company's
profitability and financial stability in international trade.

Answer 4: The three modes of international business are international trade, contractual
entry modes (such as licensing, franchising, management contracts, and turn-key projects),
and foreign investment, especially foreign direct investment (FDI).

Answer 5: Direct export occurs when a company takes full responsibility for making its
goods available in the target market by selling directly or through its agents. Indirect export
happens when the exporting company sells its products to end-users through intermediaries
such as export houses.

Answer 6: Bilateral trade, often known as countertrade, involves bartering goods in

different ways between two countries. Multilateral trade involves trade between multiple
countries.

Answer 7: FPI involves investing in international securities on stock exchanges to achieve

high returns, while FDI involves the operation and ownership of host-country firms.

Answer 8: The three forms of FDI are greenfield investment, mergers and acquisitions
(M&As), and brownfield investment.

Unit 1: Globalization and Trade 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 9: A conglomerate merger involves the combination of two or more firms engaged
in unrelated activities.

Answer 10: Franchising involves a contract where a foreign company is permitted to use a
brand name in exchange for royalty. It allows for the expansion of a brand without the need
for substantial financial investment.

Answer 11: Multinational Corporations (MNCs) are enterprises that own and control
production or service facilities in multiple countries outside of their home country. These
corporations play a significant role in global trade and investment by expanding their
operations across borders. They often generate a substantial portion of their revenue from
foreign operations, strengthening their foothold in various host countries. For instance, in
2010, host countries accounted for a significant percentage of sales, assets, and employment
in the top 100 MNCs. Companies like General Electric, Nike, Coca-Cola, and Walmart are
examples of well-known MNCs that operate across multiple countries, contributing to
international trade and investment.

Answer 12: Multinational Corporations (MNCs) can be categorized into three types based
on their strategic approaches: ethnocentric, polycentric, and geocentric. Ethnocentric firms
prioritize their home market and often overlook differences between domestic and global
operations. Polycentric firms focus on serving the specific demands of the host country,
adopting a host-market-oriented policy. Geocentric firms aim to balance between home-
market and host-market policies, reflecting a more integrated and balanced approach.
Ethnocentric firms are home-market-oriented, polycentric firms are host-market-oriented,
and geocentric firms maintain a balance between the two.

Answer 13: International finance presents both advantages and disadvantages for
businesses involved in global trade and investment.

Advantages:
• Access to Capital: International finance offers various options for raising capital from
foreign markets.
• Growth Potential: Businesses engaged in foreign trade tend to have higher growth
potential compared to those focused only on domestic markets.

Unit 1: Globalization and Trade 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Financial Performance: Managing different currencies and capital sources can lead to
improved financial performance.
• Market Competitiveness: Exposure to international markets enhances market
competitiveness and product quality.
• Revenue Buffer: Foreign trade revenue acts as a buffer against domestic demand
fluctuations.
• Business Continuity: Multinational companies with operations in multiple countries
can respond effectively to emergencies.

Disadvantages:
• Political Risks: Political instability in a trading partner country can impact international
finance and trade.
• Exchange Rate Fluctuations: Exchange rate volatility can lead to uncertain outcomes
for currency conversion.
• Debt Liability: Managing foreign trade-related debt requires careful handling to avoid
financial issues.
• Confidentiality Risk: Global markets increase the risk of sensitive information
compromise.
• Uneven Competition: Local businesses may struggle to compete with multinational
corporations with access to more resources.
• Cultural Differences: Cultural variations can harm a brand's credibility if not managed
properly.

Answer 14: Globalization has far-reaching effects on different aspects of society:

• Social Impact: Globalization leads to increased access to modern technologies and
improved communication. For instance, advanced medical technologies can save lives,
and communication technologies facilitate global education and commerce.
• Cultural Impact: Globalization enables the exchange of ideas and creative expression
between cultures, contributing to the growth of world culture. This can lead to the
spread of global trends, but it can also threaten local cultures.
• Political Impact: Intergovernmental organizations like the United Nations (UN) and the
World Trade Organization (WTO) play a central role in managing global interactions.

Unit 1: Globalization and Trade 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

However, political conflicts and terrorism can be exacerbated by global

interconnections, affecting international relations.
• Legal Impact: Migration and cross-border activities challenge the creation and
application of international law. Laws and regulations may vary from country to
country, creating complex legal landscapes for multinational businesses.

Answer 15: International finance faces several challenges:

• Natural Resource Conservation: Increased global investment can impact natural
resources and the environment. For example, the expansion of businesses can lead to
higher energy consumption and environmental degradation.
• Terrorism: Terrorism can disrupt economic stability and foreign relations. For
instance, political instability caused by terrorism in one country can lead to economic
crises in neighboring countries.
• Cultural Considerations: Cultural differences affect business strategies. For instance,
cultural preferences impact the product offerings of fast-food chains like McDonald's in
different countries.
• Compliance with Laws: Multinational businesses must navigate the legal and political
landscapes of various countries. Different regulations and policies can impact business
operations.
• International Currency Dynamics: Exchange rate fluctuations affect global trade and
investments. Businesses need to manage the risk associated with currency volatility.
• Impact on Local Markets: Globalization can lead to competition from international
players, affecting local industries. Smaller businesses may struggle to compete against
larger multinational corporations.

Self-Assessment Questions
Answer Explanation 1: C) Maximizing the value of investments while managing risks.
International financial management aims to maximize the value of a company's investments
and operations while effectively managing the risks associated with international business
activities.

Unit 1: Globalization and Trade 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer Explanation 2: C) Managing fluctuations in currency exchange rates. Foreign

exchange management involves understanding and managing currency exchange rates, as
businesses often deal with multiple currencies due to international trade and investments.

Answer Explanation 3: B) Foreign Direct Investment (FDI). FDI is concerned with the
operation and ownership of host-country firms, whereas FPI involves diversifying
investment in international securities.

Answer Explanation 4: B) Direct export uses intermediaries, while indirect export involves
selling directly. Direct export occurs when a company sells its products directly or through
agents in the target market. Indirect export involves selling products to end-users through
intermediaries.

Answer Explanation 5: D) Upgrading plant and machinery in a foreign company.

Brownfield investment involves making investments to replace plant and machinery in a
target company after an international merger or acquisition.

Answer Explanation 6: C) Conglomerate merger. Conglomerate mergers involve two or

more firms engaged in unrelated activities, such as a financial company managing the
financial functions of other companies in a group.

Answer Explanation 7: C) Sharing brand name and receiving royalty. Franchising involves
a contract where the franchiser permits a foreign company to use its brand name in exchange
for royalty.

Answer Explanation 8: C) Licensing. Licensing is a form of contractual entry mode that

involves transferring technology to a foreign company in exchange for technical service fees.
It does not involve financial investment.

Answer Explanation 9: D) Combining companies from different countries. Cross-border

M&A involves merging or acquiring companies from different countries to expand market
presence or acquire strategic assets.

Answer Explanation 10: C) Global Cash Management. Efficiently managing cash flows
across different countries is important to optimize liquidity and minimize transaction costs
in international business operations.

Unit 1: Globalization and Trade 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 11: A) Transnational Corporation (TNC)

Explanation: A Transnational Corporation (TNC) is an MNC that operates on a borderless
basis and is not closely identified with a specific national home base.

Answer 12: A) International Monetary Fund (IMF)

Explanation: The International Monetary Fund (IMF) is responsible for laying down norms
and procedures for different types of exchange rate regimes, and it helps maintain
international liquidity to facilitate monetary and financial transactions.

Answer 13: D) Improved market competitiveness.

Explanation: Foreign trade can improve the market competitiveness of a business by
allowing it to enhance the quality of offerings without affecting prices due to prevailing
competition.

Answer 14: C) Government policies.

Explanation: Political risk arises from changes in government policies and political unrest in
different countries, which can impact international finance operations.

Answer 15: B) International Monetary Fund (IMF)

Explanation: The International Monetary Fund (IMF) intervened to provide financial
assistance to countries affected by the 2008 financial crisis, including countries like Portugal,
Ireland, Greece, and Spain.

Answer 16: C) Concentration of wealth and influence in a few elites.

Explanation: Critics of globalization argue that it can lead to the concentration of wealth and
influence in the hands of a few business elites, creating economic disparities.

Unit 1: Globalization and Trade 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

16. SUGGESTED BOOKS AND E-REFERENCES

BOOKS:
• Leamer, E. E., & Stern, R. M. (2017). Quantitative international economics. Routledge.
• Gandolfo, G., & Trionfetti, F. (2014). International trade theory and policy. Berlin,
Heidelberg, New York: Springer.
• Cavusgil, S. T., Knight, G., Riesenberger, J. R., Rammal, H. G., & Rose, E. L. (2014).
International business. Pearson Austra
• Marjit, S., & Acharyya, R. (2003). International trade, wage inequality and the
developing economy: A general equilibrium approach; with 15 tables. Springer Science
& Business Media.
• Dunn Jr., Robert M. and James C. Ingram (1996), International Economics, John Wiley &
Sons, New York.
• Yarbrough, Beth V. and Robert M. Yarbrough (1997), The World Economy: Trade and
Finance, Dryden Press, New York.

E-REFERENCES:
• International Financial Management, viewed on 6th April, 2021,
<https://www.grin.com/document/209297>
• Role of IFM, viewed on 6th April 2021,
<https://link.springer.com/content/pdf/bfm%3A978-81-322-2797-7%2F1.pdf>
• Globalization and International Trade, viewed on 6th April 2021,
<https://transportgeography.org/contents/chapter7/globalization-international-
trade/>

Unit 1: Globalization and Trade 38

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 2: Balance of Payment (BOP) 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 2
Balance of Payment (BOP)
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objective - -
2 Nature of Balance of Payment - - 5
3 Accounting Principles in Balance of Payments - 1 6-10
4 Valuation and Timing - - 10
5 Components of the Balance of Payments - -

5.1 Current Account - -

5.2 Capital Account - - 11-14

5.3 Official Reserve Account - -

5.4 Residual Items - -

6 “Surplus” and “Deficits” in Balance of Payments - 2 14-19
7 Importance of BOP Statistics - - 19
8 Limitation of BOP Statistics - - 20-23
9 Factors Affecting BOP - -

9.1 Disequilibrium in BOP - -

9.2 Cause of disequilibrium in BOP - - 23-27

9.3 Methods of Correcting Disequilibrium in - -

BOP
10 Summary - - 27-28
11 Case-Study - - 29-30
12 Terminal Questions - - 30
13 Answer - - 31-37

Unit 2: Balance of Payment (BOP) 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
Balance of payment is an extensive terminology, and the balance of trade is just a part of it.
In fact, it is more elaborate term compared to the balance of trade. The literal meaning of
balance of trade is simply exports and import records. Balance of payment is defined as the
collective conclusion made on the basis of the account of tangible and intangible goods which
are imported and exported by the nation. It helps in giving a complete report about the
entire trade with the foreign countries and depicts the real image of the standing position of
the nation in the international market. The true picture of the financial feasibility, power and
ability of a nation is revealed through the balance of payment, through assessing its import
and export proficiency in terms of goods and services along with technological knowledge.
Here the services refer to those related with shipping, insurance, and banking etc. Balance of
payment also take into account the loans given and taken by the country.

According to Kindleberger, “Balance of payment is a systematic record of all economic

transactions between the residents of the reporting country and the residents of foreign
countries during a given period of time”. This means that the balance of payments is a
complete account of the financial deals of the citizens of the country with the outside world
during a specified time frame. The objective is to reveal the description of the money paid
and received for the services provided and availed, and the goods purchased and sold by the
citizens. The balance of payment refers to a descriptive record which presents the outline of
the financial dealing with the native people and those outside the country. It quantifies the
dealing between the native and the foreign nations.

The balance of payments (BOP) is a comprehensive accounting system that tracks all
economic transactions between a country and the rest of the world within a specific time
frame, typically a year or a quarter. It is a vital tool for assessing a nation's economic health
and its interactions with the global economy. The BOP consists of three primary components:

Firstly, the Current Account encompasses trade in goods (exports and imports), services
(like tourism and financial services), income (earnings from foreign investments), and
unilateral transfers (such as foreign aid and remittances). A surplus in the current account
implies that a country exports more than it imports, while a deficit indicates the opposite.

Unit 2: Balance of Payment (BOP) 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Secondly, the Capital Account deals with non-financial assets like patents and capital
transfers between countries, although in many cases, it is relatively minor and combined
with the financial account.

Lastly, the Financial Account monitors financial asset transactions, including direct
investments (involving control over businesses), portfolio investments (in stocks and
bonds), and other investments (like loans and deposits).

Ideally, the BOP should be in equilibrium, with the sum of the current, capital, and financial
accounts totalling zero. However, discrepancies may arise due to statistical errors. The BOP
is indispensable for policymakers, economists, and businesses, offering insights into a
country's trade patterns, financial relationships, and overall economic standing in the global
arena, guiding decision-making and policy formulation.

1.1 Learning Objective

❖ Comprehending the meaning and nature of Balance of Payment.
❖ Work on double entry bookkeeping framework to understand the accounting principles
in Balance of Payment.
❖ Study the different components of Balance of Payment. Analyse the differences between
current account, capital account, official reserve account. Study the sub-components of
each account.
❖ Discussion on importance, limitations of BOP Statistics

Unit 2: Balance of Payment (BOP) 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. NATURE OF BALANCE OF PAYMENT

The nature of balance of payment is as follows:
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 an account pertaining to a given period of time,
usually a year.
3) Comprehensiveness: It includes all the three items, i.e., visible, invisible and capital
transfers. The balance of payments is a comprehensive record of economic transactions
of the resident of a country with the rest of world during a given period of time. The
aim is to present an account of all receipts and payments on account of goods exported,
services rendered and capital by resident of a country and goods imported, services
received, and capital transferred by residents of the country.
4) Double Entry System: Receipts and payments are recorded on the basis of double entry
system. The basic convention applied in constructing a balance of payment statement
is that every recorded transaction is represented by two entries with equal values. One
of these entries is designated as credit with positive arithmetic sign and the other is
designated as a debit with negative sign. In principle, the sum of all credit entries is
identical to the sum of all debit entries and the net balance of all entries in the statement
is zero.
5) Self-Balanced: From the point of view of accounting, double entry system keeps
automatically debit and credit side of the accounts in balance.
6) Adjustment of differences: Whenever there is differences in actual total receipts and
payments, need is felt for necessary adjustments.
7) All items-Government and Non-Government: Balance of payments includes receipts
and payments of all items whether government and non-government.

Unit 2: Balance of Payment (BOP) 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

The balance of payments is based on the principles of double-entry bookkeeping, according
to which two entries—credit and debit-are made for every transaction, so that the total
credit exactly matches the total debits. All the economic transactions which lead to payment,
either immediate or prospective, from foreigners to the residents of a country are recorded
as credit entries. The corresponding debit entries are the payment themselves. Conversely,
all transactions which lead to the payment by residents to foreigners are recorded as debit
entries, and the corresponding payments themselves are recorded as credits. These rules
can better understand with the help of an example.

Assume that an Indian firm sells products worth ₹1,000,000 to a firm in the United States,
and the US buyer pays for it in Indian currency. The sale of the product is recorded as a credit
entry and the payment made by the foreigner is recorded as a debit entry. Conversely,
consider an Indian firm that purchases ₹ 5 million worth of machinery from a firm in the
United States. The import of the machinery is recorded as a debit entry to indicate an
increase in purchases made, and the corresponding payment is recorded as a credit entry to
reflect an increase in liabilities to a foreigner. The following are the rules for the credit and
debit entries in the BOP:
1. Credit Entry: An international transaction that leads to a demand for domestic currency
in the foreign exchange market or a transaction that is source of foreign currency is to
be recorded as the credit entry in their balance of payments. For example, a US importer
who has purchased goods invoiced in Indian currency must purchase Indian currency.
This gives rise to the demand for Indian currency. Therefore, such transactions are
recorded as credits.
2. Debit Entry: A transaction that results in the supply of home currency in the foreign
exchange market, or a transaction that uses foreign currency is to be recorded as a debit
entry. For example, when a firm in India imports machinery from a firm in the United
States, the corresponding payment results in the supply of Indian currency, or an
increase in demand for the foreign currency. Such transactions are recorded as debits.

The IMF has suggested some principles for the valuation of transactions that enter BOP
accounting in order to ensure uniformity in the BOP accounts of different countries, which

Unit 2: Balance of Payment (BOP) 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

facilitates comparison across countries and over time. It specifies that all the transactions
should be valued at the market price. Both imports and exports should be valued on a Free
On-Board (FOB) basis. The transactions denominated in foreign currency should be
converted into home currency at the exchange rate prevailing in the market at the time the
transaction takes place. As the balance of payments of every country is prepared on the basis
of the principle of double-entry-bookkeeping, the world as a whole will have neither a trade
deficit nor surplus. Yet, the World Trade data do not show a balance. The implication of this
discrepancy is that some of the flow of income, capital or both are neither reported nor
correctly stated.

Example 1: An Indian firm exports goods worth ₹ 50 million to a firm in the United States.
The U.S firm pays from its bank account kept with the State Bank of India in Mumbai. What
will be the BOP entries for this transaction be?
Solution: The BOP entries for this transaction is shown below:

BOP Entries for this transaction

Current Account
Credit Debit
Exports of Goods (+) ₹ 50 million
Capital Account
Credit Debit
Withdrawal from SBI (-) ₹ 50 million

Exports appear as a credit entry in the current account because they are a source of foreign
currency. The importer needs to buy the home currency of the exporter to pay for the export.
The payment recorded as a debit entry in the capital account-a reduction in the foreign
liabilities.

Example 2: A firm in Indian imports equipment from a firm in the United States by paying ₹
60 million. The U.S firm deposits that amount in the Mumbai branch of American Express
bank. How would this transaction appear in the BOP?

Unit 2: Balance of Payment (BOP) 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Solution: The import of equipment results in the supply of Indian rupee and the deposit with
the bank in India increases India's foreign liabilities. This transaction would appear in the
BOP as shown in the table given below:

BOP Transaction

Current Account
Credit Debit
Import of equipment (-) ₹ 60 million
Capital Account
Credit Debit
Increase in Foreign
Assets in India (+) ₹ 60 million

Example 03: A bank in India subscribes to bonds issued by a British company in London for
GBP 5 million, by drawing on an account it has with its branch in London. What BOP entries
will this cause?
Solution: The BOP entries for this transaction will be shown as :

BOP Transaction

Current Account
Credit Debit
Increase in Foreign Assets (-) GBP 5 million
Capital Account
Credit Debit
Decrease in Foreign
Bank Deposits (+) GBP 5 million

The transactions that constitute the BOP may also be categorized into autonomous
transactions and accommodating transactions. An autonomous transaction is a
transaction undertaken for its own purpose, i.e., to realise a profit or to reduce costs. An
accommodating transaction, on the other hand, is undertaken to correct the imbalance in the
autonomous transaction. Autonomous transaction are known as above the line
transactions, and accommodating transaction are known as below the line transactions.
According to IMF, all transactions other than those involving reserve assets are to be “above
the line”. Any imbalance in the above the line transactions can be set right by drawing down

Unit 2: Balance of Payment (BOP) 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

or adding to reserve asset. A deficit/ surplus in the country's BOP may be thus refer to the
deficit or surplus on all autonomous transactions taken together.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary purpose of the balance of payments (BOP)?

a) To track a country's budget deficit
b) To measure a country's inflation rate
c) To provide insights into economic transactions with foreign nations
d) To assess a country's population growth
2. Which component of the BOP includes transactions related to goods,
services, income, and unilateral transfers?
a) Current Account
b) Capital Account
c) Financial Account
d) Trade Account
3. In the BOP, what is recorded as a credit entry?
a) Exports
b) Imports
c) Capital transfers
d) Imports of machinery
4. What principle of accounting is applied in constructing the BOP?
a) Double-entry bookkeeping
b) Single-entry bookkeeping
c) Triple-entry bookkeeping
d) Accrual accounting
5. According to the IMF, how should transactions in the BOP be valued?
a) At historical cost
b) At market price
c) At the face value of the currency
d) At the nominal value

Unit 2: Balance of Payment (BOP) 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. What is an accommodating transaction in the context of the BOP?

a) A transaction undertaken for its own purpose
b) A transaction involving the purchase of foreign assets
c) A transaction undertaken to correct imbalances in autonomous transactions
d) A transaction involving the sale of goods to foreign countries

4. VALUATION AND TIMING

The application of a uniform principle of valuation to all transactions recorded in the balance
of payment is necessary for three reasons:
1. As each transaction has two aspects, the double entry accounting rule would be violated
if credit and debit entries did not possess the same values.
2. The absence of a uniform valuation principle would make it impossible to compare the
BOP statement of the one country with the BOP statement of other countries because
the valuation of entries made by partner countries would lack symmetry.
3. Were a uniform valuation system not used, items recorded in the balance of payments
could not be compared with one another, and the serious problems of interpretation
would be created for data users.

A BOP statement is constructed on the double entry system; every transaction is represented
by a credit and a debit. Both sides of the transaction---each credit and the corresponding
debit should be recorded simultaneously, and at the same time or the date of occurrence
should be recorded by both parties to the transaction. To ensure uniformity, a principle is
required to determine the time at which the transaction is entered in the balance of
payments. The requirement for a uniform time of recording is analogous to that for a uniform
basis of valuation.

Unit 2: Balance of Payment (BOP) 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. COMPONENTS OF THE BALANCE OF PAYMENTS

The accounting contents or components of Balance of Payments are:

Current Account

Capital Account

Official Reserve Account

Residual Items

5.1 Current Account

According to Ghosh and Ramakrishnan, current account can be seen as the difference
between “the value of exports of goods and services and the value of import of goods and
services” . Generally current account is subdivided into three types, viz (1) merchandise
trade balance, (II) the service balance and (III) the balance on unilateral transfers. Only
current data is recorded under this category and there is no place for further planning.

The additional amount presents the money acquired and the arrears stands for the expenses
incurred. Following are the three types of current account: -
1) Merchandise: The merchandise trade balance represents account stability between the
imported and exported concrete objects like vehicles, PC, equipment etc. It is
favourable (additional) in case of export exceeds import. It is unfavourable or scarce in
case the import is more than exports. Merchandise account for imports and export is
the greatest element to represent the international transactions in most of the nations.
2) Invisibles: The second type of current account includes the services in the form of
shipping, interest payments, tourism, dividends, insurance charge and expense on
security. These services are at times also known as invisible trade.
3) Unilateral transfers include grant in aids and donations from the public as well as the
private sector. The donation from the private sector comprises of the different types of
gifts and charitable contributions. For example, the gifts and funds sent by those who

Unit 2: Balance of Payment (BOP) 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

working outside the country for their families are the part of private transfer. Funds,
products and services which are sent to foreign nations as relief are also the parts of
government transfers.

5.2 Capital Account

The capital account refers to a record of the complete national currency value related with
monetary dealing for a given time period, between the citizens of the country and those
outside. Investments, loans and other monetary resources as well as the associated
responsibilities are the part of it. Capital account consists of monetary deals related with
global business and cash flow related with change in the monetary pattern due to buying
international stocks, bonds as well as the money deposited.

Following are the different types of capital account:

1) Direct Investment: Direct investment takes place at the time when the shareholder
buys equity like stocks or purchase the complete organization or innovate a section of
it. Usually, the foreign direct investment (FDI) happens when the organizations are able
to make the best out of the different flaws in the marketplace. Foreign Direct
Investment is also carried out by the organisations when the prospective gains through
investing in international market seem to supersede the invested amount, which would
aid in the exchange of the currency and would also embark potential risk taking. The
chances are that the gains through the international trade exceeds that from the
national trade on account of little expense on resources and production, supportive
funding, grant on investments, complete control over the native market etc.
2) Portfolio Investment: It stand for buying and selling of international monetary
resources like bonds and stocks which are free from factors like shifting the
administration. Both domestic and international investors actually look for sumptuous
gains, security and cash flow through their invested amount. In the past few years there
has been an explosion in investment in the international market, particularly due to the
fact that the investors see the risk factor by branching out towards the international
markets. Usually, the investors have contemplated the fact that they have reduced the
factor by spreading towards the global market, instead of solely relying relying on the
domestic market. Moreover, some international markets are also expected to bring the
advantage of heavy gains to the investors.

Unit 2: Balance of Payment (BOP) 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3) Capital Flows: The third type of capital account is the capital flows. It stands for the
investment which would be fruitful within a year. Deposits in accounts, short-term
securities, short term loans, investment in the stock market, etc. are the part of it. These
types of claims are highly susceptible to associated changes in the interest rates in the
associated countries and the expected variation in the rate of exchange. For example,
in case the interest rate in India booms without bringing about any change in other
related variables, the investors would like to make best of it by investing or depositing
in India; this in turn brings about heavy cash flow in India. However, in case the hike in
interest rate also brings about an associated downfall in the value of Indian currency,
investors might shun investing here.

5.3 Official Reserve Account

It refers to government resources. It stands for buying and selling through the centrally
recognized bank (for example, India’s central bank is “The Reserve Bank of India, RBI”). In
case of arrears or excess in the balance of payments, there is necessity to bring about the
associated variations in the official reserve. For example, if the country is experiencing
shortage of BOP, the central bank has to compensate for it by giving the official resources,
like SDRs, foreign exchange or gold; it might also borrow from the global central banks. On
the other hand, in case there is excess of BOP in the country, the central bank can keep the
surplus amount for the future use or can payback the international debts.

5.4 Residual Items

The other items in the BOP are the things which could not be incorporated in any of the above
types. In order to maintain the balance in the BOP, they are included in it.

Following are the different types of residual things:

1) Errors and Omissions: In this category, the error in recording the data may happens
at the time of accounting. The reasons behind these flaws could be depicting the sample
instead of the exact data of the dealings (for example, the average export of rice is
presented rather than giving an exact record of each and every quintal), fraudulence
such as reporting lesser amount for avoiding the levied taxes, illegal transaction outside
the country and so on.

Unit 2: Balance of Payment (BOP) 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2) Official Reserve Transaction: Except this category, the remaining types are known as
“autonomous transaction” as they are carried out with autonomous intention; this
implies that they are carried out without the desire to bring about the relative effect on
the BOP or rate of exchange. On the other hand, the government or the national central
bank carries out these transactions with some particular global financial aim, and
hence, keeps these transactions under close scrutiny in order to study how they would
influence BOP and the rate of exchange. Consequently, these transactions are not
independent. The foremost under this type is the variations in the native official
reserved resources. A country keeps these resources as global currencies, or securities
for international currencies, gold, Special Drawing Right (SDR) along with the IMF. It is
quite essential that the variation in the deposits of the country be revealed in the total
worth of the BOP items. These resources are cut down to spend on the expenses in the
international market. These cutting down of the fund are reflected in the credit in BOP
(as selling them would bring flow of fund in the nation). The excess of these funds are
reflected as debit as they are procuring resources.

6. “SURPLUS” AND “DEFICITS” IN BALANCE OF PAYMENTS

BOP is based on double entry system of accounting under which ‘deficit’ and ‘surpluses’ are
the two most common words used in the context of BOP statement. When inflows exceed the
outflows, it is termed as surplus, whereas when outflows exceed the inflows, it is commonly
known as deficit. Following the double entry system (i.e., in respect of every credit entry,
one debit entry is made, and vice versa), total credit value in BOP statement is equal to its
total debit value. Due to this reason, BOP statement shows equilibrium in which total amount
of inflow matches with the total amount of outflow. The entry of inflows and outflow of funds
present in the BOP statement is done under different heads and subgroups. There are
various activities through which these inflows and outflows occurs. The surplus and deficit
is caused due to disequilibrium in the inflows and outflows of funds under each head or
subgroup of the account. Therefore, the concept of surplus and deficit is not only applied to
BOP statement but is applicable to various another segment as well. Studying the balance
between the receipts and payments under different heads of activity in the BOP statement
can be very meaningful and informative. Some of the important balances required to be

Unit 2: Balance of Payment (BOP) 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

analysed, examined and discussed in order to determine their economic impacts and to know
the implications of policy and its formulation are as follows:
1) Trade balance: The difference between the export and import of a country is known as
the trade balance. A country said to have a trade deficit when its import are greater
than its exports, and when the export exceeds imports then the situation is known as
trade surplus.
2) Balance of goods and services: The difference between the receipts and payments of
goods and services is known as the balance of goods and services. Such difference will
show either positive or a negative balance. When there is surplus in transaction of
goods and services, the difference obtained is a positive balance and vice versa. A
surplus amount shows the total amount of goods and services exported to other
countries in comparison to the amount of goods and services received from other
countries. In order to determine the GDP (gross domestic product) of a country, the
value of surplus is added to the total value of goods and services produced and
consumed by the individuals of the nation.
3) Current account balance: The difference between the receipts and payments related to
all the transactions in the current account is called current account balance. A current
account surplus is represented by positive balance, while the current account deficit is
represented by a negative balance. The excess of international receipts of a country in
comparison to the international payment is known as current account surplus and vice-
versa is known as current account deficit.
4) Basic Balance: Basic balance is referred to the balance between the credits and debits,
when the transaction of current account are combined with long-term capital
transaction in the capital account. This mean basic balance is a combination of both
current account balance as well as the capital account balance. The corresponding
position of long-term fund movements in international transactions of a nation is
represented by basic balance.
5) Overall balance: When there is a combination of current account and capital account
with the figures of errors and omissions in the BOP statement, the difference between
the inflow and outflows of the fund is known as the overall balance. The overall surplus
is indicated by positive surplus while negative surplus depicts the overall deficit.

Unit 2: Balance of Payment (BOP) 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

With the help of the monetary movements in the opposite directions, the overall surplus or
deficits can be adjusted. One of the simple ways of adjusting deficit is by borrowing funds
from IMF or by using country’s foreign exchange reserves. However, in case of surplus, it can
be used to increase the country’s foreign exchange reserve and also for repaying the loans
borrowed from IMF. The different types of transactions mentioned in the BOP statement are
either distinguished as accommodating transactions or autonomous transactions.
Accommodating transactions also known as compensatory transactions. Different activities
of the economy such as foreign direct investment in the country, export of goods, etc result
in autonomous transactions. In the BOP statement, accommodating transactions are
mentioned at the bottom, whereas the autonomous transactions are mentioned at the top.
Thus, the term ‘above the line’ is used for the autonomous transaction while the term ‘below
the line’ is used for accommodating transactions. The main objective of accommodating
transactions is to balance the deficit or surplus resulted due to autonomous transactions.
Such an imbalance can be balanced with the help of accommodating transactions.

As discussed above, the overall deficit in the BOP statement can be balanced either by
borrowing from IMF or by withdrawing from the foreign exchange reserves of the country.
By paying the IMF borrowings or transferring the surplus to the foreign exchange reserves,
the overall surplus can be compensated. The accommodating transactions are included in
the last segment of the BOP statement which is popularly known as “Monetary Movement”.

Unit 2: Balance of Payment (BOP) 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

7. Why is the application of a uniform principle of valuation necessary in the

balance of payments (BOP)?
a) To encourage speculative trading
b) To violate the double entry accounting rule
c) To facilitate comparison of BOP statements between countries
d) To create serious problems of interpretation for data users
8. What is the purpose of the double entry system in constructing a BOP
statement?
a) To encourage speculative trading
b) To ensure discrepancies between credit and debit entries
c) To record each transaction twice
d) To eliminate the need for valuation principles
9. What is the primary focus of the Current Account in the BOP?
a) Capital investments
b) Monetary flows related to stocks and bonds
c) Trade in goods and services
d) Official reserve transactions
10. Which component of the Current Account includes transactions related to
shipping, interest payments, tourism, and dividends?
a) Merchandise trade balance
b) Service balance
c) Unilateral transfers
d) Capital flows

Unit 2: Balance of Payment (BOP) 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. What is the main objective of accommodating transactions in the BOP?

a) To generate speculative trading opportunities
b) To create discrepancies between credit and debit entries
c) To balance deficits or surpluses resulting from autonomous transactions
d) To facilitate international monetary dealings
12. What term is used to describe the difference between a country's exports and
imports of goods and services?
a) Trade balance
b) Current account balance
c) Capital account balance
d) Basic balance
13. What does a current account surplus indicate?
a) The country's exports are greater than its imports
b) The country's imports are greater than its exports
c) The country's overall balance is negative
d) The country is borrowing funds from the IMF
14. 14.What is the primary function of the Official Reserve Account in the BOP?
a) To record trade in goods and services
b) To balance deficits and surpluses in the Current Account
c) To track investments in foreign stocks and bonds
d) To manage government resources like foreign exchange and gold
15. Which term is used to describe the balance between the credits and debits
when combining the current account and capital account?
a) Trade balance
b) Basic balance
c) Overall balance
d) Service balance

Unit 2: Balance of Payment (BOP) 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

16. How can an overall deficit in the BOP be balanced?

a) By increasing foreign exchange reserves
b) By paying off international debts
c) By engaging in speculative trading
d) By reducing government expenditures

7. IMPORTANCE OF BOP STATISTICS

BOP data may be important for any of the following reasons:

1) Prediction: The BOP predicts the business possibility of the nation, particularly for a
short span. The nation which is undergoing severe shortage of BOP may not able to
import to the extent it would, if there were excess flows.
2) Display pressure: The BOP displays heavy loads on the rate of exchange of the country,
and hence also adversely affects the trading capacity of the organization which wants
to trade with or invest in the country, which is undergoing profit or loss the exchange
rate in the international market. The variation in the BOP might foretell the
obligation/elimination of international exchange control.
3) Indicator of obligations: The varying BOP of a nation indicates the
obligation/elimination of international control related to the disbursement of the
interest and dividends, licensing expenses, royalty expenses, or the other payments to
the international firms/investors.
4) Evaluates the Constancy: It becomes quite simpler to assess the steadiness of the
variation in the exchange rate with the help of BOP because the accounts of deals in
occurring between countries aid in ascertaining the ones who want to keep the funds.
It also becomes easier to evaluate the steadiness in the foreign exchange rate. Through
these foreign exchange rates, it is also possible to know the degree to which the funds
are gathered among the other nations and put forth the questions related to simplicity
in shielding the rates of exchange, if in emergency arrives.

Unit 2: Balance of Payment (BOP) 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. LIMITATION OF BOP STATISTICS

Following are the limitations of BOP statistics:

1) Coverage of Transactions: It includes:

Central Banks, Government, and other Authorities: Transactions of the central banks,
governments, and international institutions pose conceptual and logical problems regarding
their inclusion. According to one opinion, BOP account should make a clear distinction
between the ‘autonomous’ or ‘market induced’ transactions and ‘accommodating’
transactions undertaken by the central banks and governments etc. The authorities are
expected to undertake only the accommodating transaction. In effect, however their
transactions cover both varieties and this poses a problem of estimating the overall BOP
surplus/deficit. Thus, for example, governments frequently enter into defence deals or deals
motivated by political considerations, and the transactions of central banks (including those
meant for ensuring an orderly working of the foreign exchange market).

II) International Institutions: Similarly, international institutions are not residents of any
specific country, but their activities generate huge volumes of inter-country transactions,
and the offices have to located somewhere.

III) Illegal Transactions: Illegal transactions like smuggling and transfer of funds through
Havana and other channels also pose their own problems. Such transactions do not find a
place in the official BOP accounts. To some extent, they are also cancelled by compensatory
movements. But they add to the problems of inadequate coverage and discrepancy in the
data.

2) Classification of items: For revealing their accounting and economic significance,

external transactions of a country should be aggregated into categories which the
authorities consider appropriate and relevant. However, there is no classification
which can be rated as an ideal one for all countries and for all times.
3) Agreements and their implementations: There is a time gap between legal agreements
which govern the international flow of goods, services and capital funds, and the actual
implementation of these agreements. Consequently, a sizable portion of the external
transactions of a country are spread over two or more BOP time intervals. And this

Unit 2: Balance of Payment (BOP) 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

poses a problem of allocating individual transactions to specific time intervals in an

unambiguous manner. Additional complications arise regarding methodological
collection of data, when the data relating to different parts of the single transaction,
such as sales of goods, their shipment and payment which are collected by different
agencies like customs authorities, the tax authorities, the banking sectors, and so on.
Loss and rejection of goods, default on payments, and so on also add to the difficulties
of identification, adjustment, and time interval to which transaction belongs.
4) Valuation: By their very nature, external transactions of a country cannot be aggregated
in physical units, they have to be converted into monetary equivalents. This poses some
problems of its own like the following: Conventionally, an import is valued c.i.f (i.e., its
value is recorded inclusive of the “cost, insurance and freight”). In contrast, an export
is valued f.o.b (i.e., free on board or at the price which the exporter receives).
Consequently, there is an inherent tendency for the value of world imports to exceed
the value of world exports. External transactions of a country involve conversion of
values from one currency to another. This entails the use of a rate of exchange between
the home currency and the “foreign currency”. Consequently, under a flexible exchange
rate system, transactions spread over the time are associated with different exchange
rates. And this creates additional problems of aggregating these transactions. Thus, in
India an overwhelming large proportion of external transactions are denominated in a
few foreign currencies and not in the Indian Rupees. Therefore, over time, the method
of estimating rupee equivalents of the foreign currency transactions has been
undergoing a revision from time to time.
5) The limitations of the existing statistical domains in providing information on trade by
different modes of supply are listed below in table. No clear distinction is made in
balance of payments statistics between the modes that are covered (cross-border
supply, consumption abroad, and presence of natural persons or commercial presence
for less than one year). Consumption abroad of a service could, in principle, come under
the balance of payment category “travel”. The travel category, however, consist of all
expenditures by travellers abroad, including expenditures on goods, and is not sub-
divided into the different categories of services.

Unit 2: Balance of Payment (BOP) 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Mode of Supply Relevant Data Source Inadequacies

Cross-border supply BOP service statistics BOP statistics do not
(categories other than distinguish between
travel) cross-border supply.
Presence of natural
persons (individuals) and
commercial presence for
less than one year.
Consumption abroad BOP statistics (mainly the 1) Travel also contains
travel category) goods and is not
subdivided into the
different categories of
services consumed by
travellers.
2) Some transactions
related to this mode of
supply are also in
other BOP categories.
Commercial Presence Production, FDI and FAT 1) Production statistics
statistics do not distinguish
between national and
foreign firms.
2) FDI statistics do not
provide data on
output( or sales).
3) The definition of FDI
does not match the
definition of
Commercial
Presence.
4) FAT statistics exist
only for the United
States.
5) Definition of basic
concepts are in the
process of being
established
internationally.
Presence of natural BOP statistics (mostly 1) BOP statistics do-not
persons (independent) categories other than distinguish cross-
Transport and Travel) border supply.
Presence of natural
persons (individuals)
and commercial
presence for less than
one year.

Unit 2: Balance of Payment (BOP) 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2) Natural persons who

are residents are not
covered.

Presence of natural Employment data from Not yet available

persons (employees) FAT statistics.

9. FACTORS AFFECTING BOP

Following factors affect the balance of payments of the country.
1) Cost of Production-The cost of production (land, labour, capital, taxes, incentives etc.)
in the exporting economy vis-à-vis those in the importing economy.
2) Demand and Supply: The demand and supply trend defines the cost of domestic
products to be in international market.
3) Cost and Availability: The cost and availability of raw materials, intermediate goods and
other inputs.
4) Exchange Rate Movements: For nations with low exchange rate values, balance of trade
tends to remain unfavourable.
5) Domestic Business: Sound, domestic policies are required to boost production and
international trade. Some countries like the U.S provide subsidies to local
manufacturers for exported goods and services.
6) Trade Agreements: Bilateral agreements govern international trade and define the
products and their prices in the global context.
7) External Pressure: Many countries export items that face heavy competition in the
international market. This results in market segmentation and low pricing. Countries
that are mostly oil exporters or IT hubs tends to generate favourable trade balance due
to less competition in the international market. External pressure also work in the form
of trade bans. These bans are enforced by either individual countries or international
organization such as WTO or IMF.
8) Prices: Prices of goods manufactured at home (influenced by the responsiveness of
supply).

Unit 2: Balance of Payment (BOP) 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9.1 Disequilibrium in BOP

The BOP of a nation is set to be stable when they equality between the demand and supply
of the international exchange rate. Any disparity leads to exchange excess or shortage of BOP.
The shortage of BOP indicates that the demand of international exchange is more than its
supply. Usually, that debt is more than credit or credit is more than debit which lead to
instability in BOP, this condition is called disequilibrium of BOP. Such disequilibrium can
occur as shortage or excess. There is a disequilibrium as dearth in case the funds received
from other nations less than those paid in the international market. This condition is known
as ‘unfavourable balance’. Disequilibrium in form of excess takes place in case the country
receives more than what it pays in the international market. This type of condition occurs
when the demand is more than the supply of international exchange. This type of instability
is called ‘favourable balance’.

9.2 Cause of disequilibrium in BOP

Various causes of disequilibrium in the balance of payments or adverse balance of payments
are as follows:
1) Growth Plans: As the major amounts are spent on the growth plans, the developing
nations often experience adversity of BOP. There is more inclination towards importing
in the developing nation in desire to acquire more funds for further industrialisation.
However, these nations are not able to expand their exports as they are conventionally
primary producers. It might also happen that these countries are not able to produce
much for export due to requirement in the native industries. All these factors together
results in the change in the structure of BOP which lead to instability of the structure.
2) Structure of Expenditure: Variations in the structure of expenditure of the exports
adversely affect the export quantity, resulting in instability of BOP. Moreover, the BOP
can also become unfavourable due to reduction in exports on account of the price hike
because of rise in salaries and rise in expenses on primary resources.
3) Variation in International Exchange Rates: The instability in BOP also springs from the
variations in the international exchange rates. If the currency is appreciated, their
imports appear to be economical and exports seems to be less profitable, this results in
the rise of imports and fall in export which makes BOP unfavourable. In the same

Unit 2: Balance of Payment (BOP) 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

manner, the depreciation of the money results in the downfall in imports and rise in
exports.
4) Decrease in demand of exports: The demand of exports of primary goods has drastically
fallen in the underdeveloped nations because of the heavy production of the primary
resources and their alternatives in the affluent nation. In the same manner the
developed countries are also experiencing downfall in export demands as they have
lost the concurred markets. Yet, this shortage of BOP is more prominent in the
underdeveloped nations than in developed nation.
5) Demonstration effect: According to Nurkse, “The people in the less developed countries
tends to follow the consumption patterns of the developed countries”. The
demonstration effect results in the rise in imports by the under-developed nations and
the resultant instability in the balance of payments.
6) Taking and giving loans in the International Market: The give and take of the loans to
the other nations is another cause for the instability of BOP. The countries which take
the loans are likely to have unfavourable BOP and the ones which give are likely to have
favourable BOP.
7) Recurring rise and fall: There is recurrent instability in the BOP due to recurrent rise
and fall. At the time of Recession, the earning of the natives of other countries
decreases. Consequently, there is less exports from these nations, resulting in
instability of the native BOP.
8) Recently autonomous nations: The nations which have become independent in the
recent past, invest heavily amounts on developing foreign embassies, international
houses etc., for strengthening their relationship with other countries. As a result, BOP
is adversely affected.
9) Uncontrolled population growth: The uncontrolled rate of population growth is the
major reason behind the adversity of BOP. For example, countries such as India
experience population explosion which results in the need for imports and diminishes
the export capability.

Unit 2: Balance of Payment (BOP) 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9.3 Methods of Correcting Disequilibrium in BOP

1. Monetary Policy: The correction in the shortage of the national BOP is possible through
the monetary policy. The reasons behind shortage of BOP is possible through the
monetary policy. The reasons behind the shortage of BOP are heavy imports and very
low exports. In order to cure this condition, there is need to turn this trend around.
Hence the country can implement deflationary monetary policy which is possible by
increasing the bank rate and delimiting the credit. The deflation brings about reduction
in the prices and consequently exports seem to be lucrative, and import appears
comparatively expensive. This trend gives rise to lower imports and higher exports.
2. Depreciation of the Exchange: Depreciation of the exchange implies downfall in the
exchange rate of one nation in comparison of another. For example, the exchange of ₹
for 30 cents of $. In case India is undergoing adverse BOP in relation to America, there
would be rise in the value of American currency in India. As a result, the worth of $ in
relation to ₹ would be appreciated, related with the external value. Hence the exchange
rate of ₹ in relation with $ varies to ₹ 1=20 cents from ₹1=30 cents. Such type of
depreciation of the worth of currency is referred as devaluation of the exchange.
3. Devaluation: It is another form of depreciation of exchange. It is the most appropriate
in the category of IMF schemes. Devaluation implies official lowering of the exchange
worth of a country in relation with goods or any international currency or SDR. For
example, if 1$=₹ 8; and if it is officially regarded in India as 1$=₹ 10 clearly indicates
that there is 25% devaluation of Indian currency in relation to American dollar. In case
a country is constantly experiencing shortage of BOP, it has to take prior permission
from IMF for the devaluation of its currency. The devaluation of a currency is reflected
through the fall in the prices of export goods and the rise in the price of imports. This
would result in decrease in imports and increase of exports. This would help in sorting
out the problems associated with the shortage of BOP.
4. Exchange Control: When the central bank of a country delimits the utility of the
international exchange, it is known as “exchange control. The implementation of the
exchange control means the exporters have to give up all the money earned through
the international trade to the central bank. The exchange of control permits the use of
international exchange solely for the purpose of vital imports and preserve the
remaining amount. It is one of the direct methods for keeping check on imports.

Unit 2: Balance of Payment (BOP) 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. Fiscal Policy: Another remedy for dealing with unfavourable BOP is fiscal policy. The
budgetary provisions involve levying of heavy import tax or duties; this makes imports
costlier and there is tendency to curb imports. Consequently, there is downfall in the
imports and the BOP becomes favourable.
6. Import Quotas: One of the best remedial measures for dealing with the unfavourable
BOP is import quotas. This involves fixation of the highest amount or worth of a product
for a given time span. The restriction on the import quotas leads to the reduction or
elimination in the shortage of BOP and hence BOP is made better.
7. Encouraging Exports: The exports have to be raised to handle the instability in the
balance of payment. The promotional plans, such as lowering of taxes for the exporters,
subsidies, marketing services, motivations on exports might be implemented by the
government in this regard.

10. SUMMARY
• The balance of payments (BOP) is a financial statement that records a country's
economic transactions with the rest of the world over a specific period, typically a year
or a quarter.
• It consists of three main components: the current account, which tracks trade in goods
and services, income, and unilateral transfers; the capital account, which monitors
capital transfers and certain financial transactions; and the financial account, which
records changes in ownership of financial assets and liabilities.
• The BOP helps assess a nation's international economic position, revealing whether it
has a surplus (exports exceeding imports) or a deficit (imports surpassing exports) and
providing insights for economic policy decisions.
• The balance of payments (BOP) is a financial report that records a country's
international economic transactions. BOP measures a nation's economic relationship
with the world.
• The fundamental accounting principle in the balance of payments is the "double-entry
accounting system." This principle ensures that every international transaction is
recorded as a debit or a credit in the BOP, ensuring that the sum of all debits equals the
sum of all credits, providing an accurate picture of a nation's economic transactions
with the world.

Unit 2: Balance of Payment (BOP) 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• The application of a uniform valuation principle in the balance of payments is crucial

for three reasons. Firstly, it ensures compliance with the double-entry accounting rule.
Secondly, it allows for meaningful comparisons between countries' BOP statements.
Lastly, it facilitates the meaningful comparison of different items within the BOP, aiding
data interpretation. This uniform valuation principle ensures consistency and accuracy
in BOP reporting.
• According to Ghosh and Ramakrishnan, the current account in balance of payments
represents the difference between a country's exports and imports of goods and
services. It consists of three types: merchandise (trade balance of tangible goods),
invisibles (services like tourism and interest payments), and unilateral transfers
(including grants, donations, and relief sent to foreign nations). These categories
capture the international financial interactions of a country, with no scope for future
planning.
• The capital account in a nation's balance of payments records the total monetary value
of financial transactions between residents and non-residents during a specific period.
It encompasses various types of capital flows: direct investment (e.g., foreign
companies buying local assets), portfolio investment (buying/selling international
stocks and bonds), and short-term capital flows influenced by factors like interest rates
and exchange rates. These flows reflect a country's financial engagement with the
global economy.
• Official reserves in a nation's balance of payments refer to government-held resources
like foreign exchange, gold, or Special Drawing Rights (SDRs). They are used to balance
deficits by supplying funds or saving surpluses and can involve borrowing or repaying
international debts as needed.
• Residual items in the balance of payments (BOP) encompass transactions that don't fit
into specific BOP categories. Two types of residual items are "Errors and Omissions,"
which include data recording errors or fraudulent reporting, and "Official Reserve
Transactions," where a country's central bank manages official reserves like foreign
currency, gold, or Special Drawing Rights (SDRs). Changes in these reserves impact the
BOP, with reductions as credits and additions as debits, reflecting their use for
international expenses or acquisition of assets.

Unit 2: Balance of Payment (BOP) 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. CASE STUDY

Fuller capital account convertibility (FAC) in India refers to the free flow of capital across the
country's borders, both inflows and outflows. This would allow Indian residents to invest in
foreign assets without any restrictions, and vice versa.

India currently has partial capital account convertibility, which means that there are some
restrictions on the movement of capital. For example, Indian residents are limited to
investing up to $250,000 per year in foreign assets under the Liberalised Remittance Scheme
(LRS).

There are a number of potential benefits to fuller capital account convertibility for India.
These include:
• Increased investment: FAC would make it easier for foreign investors to invest in India,
and for Indian companies to raise capital abroad. This could lead to increased
investment in the Indian economy, which could boost economic growth and job
creation.
• Reduced cost of capital: FAC could also lead to a reduction in the cost of capital for
Indian businesses. This is because foreign investors are typically willing to invest at
lower rates of return than domestic investors.
• Improved financial market development: FAC could also help to develop India's
financial markets by making them more attractive to foreign investors. This could lead
to deeper and more liquid markets, which would benefit all participants.

However, there are also some potential risks associated with fuller capital account
convertibility. These include:
• Increased volatility of the rupee: FAC could make the rupee more volatile, as foreign
investors could quickly move their capital in and out of the country in response to
changes in economic conditions. This could make it more difficult for businesses to plan
and invest for the future.
• Increased risk of financial crises: FAC could also increase the risk of financial crises in
India. This is because sudden outflows of capital could lead to a depreciation of the
rupee and a decline in asset prices. This could trigger a financial crisis, as banks and
other financial institutions become insolvent.

Unit 2: Balance of Payment (BOP) 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The Reserve Bank of India (RBI) has been gradually liberalizing India's capital account in
recent years. However, it has been cautious about moving too quickly, given the potential
risks. In 2022, the RBI Deputy Governor T Rabi Sankar said that India is on the cusp of a
fundamental shift in the direction of fuller capital account convertibility. However, he also
stressed that this will need to be managed carefully through a combination of measures.

Overall, the potential benefits of fuller capital account convertibility outweigh the risks.
However, it is important to proceed cautiously and to implement appropriate safeguards to
mitigate the risks.

Question to Discuss:
Do SWAT Analysis on the implementation of Fuller Capital Account convertibility in India.

12. TERMINAL QUESTIONS

Short Answer Type Terminal Questions
1. What is the nature of Balance of Payment?
2. Explain the concept of Valuation and timing in Balance of Payment?
3. What are current account and capital account in Balance of Payment?
4. What is the structure of BOP accounting?
5. State the factors affecting the balance of payment?
6. Explain balance of payment and its relationship with different economic variables?

Long Answer Type Terminal Questions

1. Explain the accounting principles in balance of payment?
2. Describe the ‘surpluses and ‘deficit’ in balance of payment?
3. Illustrate the components of balance of payment?
4. Explain the importance and limitations of BOP statistics?
5. What do you mean by BOP disequilibrium? Explain the ways of copying with deficit in
BOP?

Unit 2: Balance of Payment (BOP) 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. ANSWERS
Answer to Self-Assessment Questions
Answer 1: C) To provide insights into economic transactions with foreign nations.
Explanation: The BOP is a comprehensive statement that records all economic transactions
between a country and the rest of the world, giving insights into its international economic
relationships.

Answer 2: A) Current Account

Explanation: The Current Account encompasses transactions related to goods, services,
income, and unilateral transfers.

Answer 3: A) Exports
Explanation: Exports are recorded as credit entries in the BOP because they represent a
source of foreign currency.

Answer 4: A) Double-entry bookkeeping.

Explanation: The BOP is constructed based on the principles of double-entry bookkeeping,
where every transaction is represented by both a credit and a debit entry.

Answer 5: B) At market price

Explanation: The IMF recommends that transactions in the BOP be valued at market prices
to ensure uniformity and comparability across countries.

Answer 6: C) A transaction undertaken to correct imbalances in autonomous transactions

Explanation: Accommodating transactions are undertaken to correct imbalances in
autonomous transactions in the BOP.

Answer 7: C) To facilitate comparison of BOP statements between countries.

Explanation: A uniform principle of valuation is necessary to allow for meaningful
comparisons of BOP statements between different countries.

Answer 8: C) To record each transaction twice

Explanation: The double entry system in the BOP ensures that each transaction is
represented by both a credit and a debit entry.

Unit 2: Balance of Payment (BOP) 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 9: C) Trade in goods and services.

Explanation: The Current Account focuses on trade in goods and services, among other
transactions.

Answer 10: B) Service balance

Explanation: The Service Balance includes transactions related to services like shipping,
tourism, and dividends.

Answer 11: C) To balance deficits or surpluses resulting from autonomous transactions.

Explanation: Accommodating transactions in the BOP aim to balance deficits or surpluses
caused by autonomous transactions.

Answer 12: A) Trade balance

Explanation: The Trade Balance represents the difference between a country's exports and
imports of goods and services.

Answer 13: A) The country's exports are greater than its imports
Explanation: A current account surplus indicates that a country's exports exceed its imports.

Answer 14: D) To manage government resources like foreign exchange and gold
Explanation: The Official Reserve Account deals with government resources like foreign
exchange and gold.

Answer 15: B) Basic balance

Explanation: The Basic Balance represents the balance between the credits and debits when
combining the current account and capital account.

Answer 16: B) By paying off international debts

Explanation: An overall deficit in the BOP can be balanced by paying off international debts
or using foreign exchange reserves.

Answer to Terminal Short type Questions

Answer 1: The Balance of Payments (BOP) is a systematic record of all economic
transactions between residents of one country and the rest of the world over a specific
period, typically a year. It reflects a country's economic interactions with other nations,
encompassing trade in goods and services, financial transactions, and more. The BOP

Unit 2: Balance of Payment (BOP) 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

provides insight into a country's economic health, its trade relationships, and its ability to
pay its international obligations.

Answer 2: Valuation in Balance of Payments refers to the assignment of a monetary value to

transactions recorded in the BOP. This valuation is necessary to ensure uniformity and
comparability between countries' BOP statements. Timing, on the other hand, refers to when
a transaction is recorded in the BOP. To maintain uniformity and accuracy, transactions
should be recorded at the same time by both parties involved in the transaction. Uniform
valuation and timing are essential to maintain the double-entry accounting system and
enable meaningful comparisons between countries' BOP statements.

Answer 3: Current Account: The Current Account in the Balance of Payments records all
transactions related to the trade in goods and services, income flows, and unilateral
transfers. It is divided into three main components:

Merchandise Trade Balance: This represents the balance of trade in tangible goods, such as
imports and exports of goods like machinery, vehicles, and electronics.

Service Balance: It includes transactions related to services like shipping, tourism, interest
payments, dividends, and insurance.

Unilateral Transfers: These include gifts, grants, and donations between countries, both from
the public and private sectors.

Capital Account: The Capital Account records financial transactions that involve the
acquisition or disposal of non-produced, non-financial assets, or financial assets, excluding
those recorded in the current and financial accounts. It includes categories like Direct
Investment, Portfolio Investment, and Capital Flows.

Answer 4: The structure of BOP accounting typically consists of the following components:

Current Account: Records transactions related to trade in goods and services, income flows,
and unilateral transfers.

Capital Account: Captures financial transactions involving non-produced, non-financial

assets, and financial assets.

Unit 2: Balance of Payment (BOP) 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Financial Account: Tracks financial transactions such as foreign direct investment, portfolio
investment, and changes in official reserves.

Official Reserve Account: Deals with changes in a country's official reserve assets like foreign
exchange, Special Drawing Rights (SDRs), and gold.

Residual Items: Includes entries like "Errors and Omissions" and "Official Reserve
Transactions" to ensure the BOP accounts balance.

Answer 5: Several factors can affect a country's Balance of Payments, including:

Trade Balance: The difference between exports and imports of goods and services.

Exchange Rates: Fluctuations in exchange rates can impact the competitiveness of a

country's exports.

Economic Conditions: The overall health of a country's economy affects its trade and
investment.

Government Policies: Trade policies, tariffs, and regulations can influence trade.

Foreign Investment: The flow of foreign direct investment and portfolio investment.

Interest Rates: Differences in interest rates between countries can affect capital flows.

Speculation: Speculative trading in currency and financial markets can influence capital
flows.

Global Economic Conditions: Global economic events and crises can have widespread effects
on BOP.

Answer 6: The Balance of Payments is closely related to various economic variables and has
several implications:
• Exchange Rates: BOP influences exchange rates as trade imbalances and capital flows
impact a country's currency value.
• Economic Growth: A favorable BOP can contribute to economic growth through
increased exports and foreign investment.

Unit 2: Balance of Payment (BOP) 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Inflation: Capital inflows associated with BOP surpluses can lead to inflation, while
deficits may reduce inflationary pressures.
• Interest Rates: BOP affects interest rates as capital flows influence the demand for a
country's currency and, consequently, interest rates.
• Government Policies: BOP data can inform policymakers about trade policies, currency
interventions, and foreign exchange reserve management.
• Investment Climate: A stable BOP can improve a country's attractiveness for foreign
investment.
• Global Economic Stability: BOP imbalances in multiple countries can contribute to
global economic instability.

Overall, the Balance of Payments is a vital tool for understanding a country's economic
interactions with the world and their impact on various economic variables.

Answer to Terminal long type Questions

Answer 1: The Balance of Payments (BOP) follows several accounting principles to ensure
accurate recording of international transactions:

Double Entry Accounting: Every international transaction is recorded as both a credit and a
debit, ensuring that the BOP always balances. For every credit entry, there is a corresponding
debit entry, and vice versa.

Uniform Valuation: All transactions must be valued uniformly to enable meaningful

comparisons between countries. This principle ensures that the valuation of entries is
consistent across the BOP statement.

Uniform Timing: Transactions must be recorded at the same time or date of occurrence by
both parties involved in the transaction. This principle helps maintain symmetry and
consistency in BOP statements.

Answer 2:
Surplus: In the context of the BOP, a surplus occurs when a country's inflows of foreign
exchange (credits) exceed its outflows (debits). This typically indicates that the country is
exporting more goods and services, receiving more income from abroad, or attracting more
foreign investment than it is sending out.

Unit 2: Balance of Payment (BOP) 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Deficit: Conversely, a deficit in the BOP happens when a country's outflows (debits) exceed
its inflows (credits). This can result from importing more goods and services, paying more
income to foreign entities, or having more capital outflows than inflows.

BOP surpluses and deficits reflect a country's economic interactions with the rest of the
world and can have significant implications for its economic health.

Answer 3:
The Balance of Payments consists of several components:
• Current Account: Records transactions related to trade in goods and services, income
flows (e.g., interest, dividends), and unilateral transfers (e.g., gifts, grants).
• Capital Account: Captures financial transactions involving non-produced, non-financial
assets, and financial assets, excluding those recorded in the current and financial
accounts.
• Financial Account: Tracks financial transactions, including foreign direct investment
(FDI), portfolio investment, and changes in official reserves.
• Official Reserve Account: Deals with changes in a country's official reserve assets like
foreign exchange, Special Drawing Rights (SDRs), and gold.
• Residual Items: Includes entries like "Errors and Omissions" and "Official Reserve
Transactions" to ensure that the BOP accounts balance.

Answer 4: Importance:
• BOP statistics provide a comprehensive view of a country's economic interactions with
the world, aiding in policymaking and economic planning.
• They help identify trends in trade, investment, and financial flows, offering insights into
a nation's economic health.
• BOP data can signal potential economic imbalances and vulnerabilities.
• Policymakers use BOP statistics to make informed decisions regarding exchange rates,
trade policies, and capital controls.

Limitations:
• BOP statistics may not always be timely, making them less effective for real-time
decision-making.

Unit 2: Balance of Payment (BOP) 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Incomplete or inaccurate data can affect the reliability of BOP figures.

• The classification of certain transactions can be subjective and may vary between
countries.
• BOP statistics may not capture informal or illegal cross-border transactions.
• They do not provide a complete picture of a country's overall economic performance,
as they focus on international transactions.

Answer 5: BOP Disequilibrium: BOP disequilibrium occurs when a country consistently

experiences deficits (outflows exceeding inflows) or surpluses (inflows exceeding outflows)
in its Balance of Payments. It indicates an imbalance in a country's economic interactions
with the rest of the world.

Ways of Coping with a Deficit in BOP:

• Foreign Borrowing: Countries facing deficits can borrow funds from international
organizations like the International Monetary Fund (IMF) or issue bonds to foreign
investors to cover the gap.
• Foreign Exchange Reserves: Nations with substantial foreign exchange reserves can
use them to finance a deficit temporarily.
• Devaluation: A deliberate devaluation of the national currency can make exports
cheaper and imports more expensive, potentially improving the trade balance.
• Import Controls: Implementing import controls, such as tariffs or quotas, can reduce
the demand for foreign goods and help correct trade imbalances.
• Fiscal and Monetary Policies: Governments can use fiscal policies (e.g., reducing
government spending) and monetary policies (e.g., increasing interest rates) to manage
demand and reduce imports.
• Structural Reforms: Long-term solutions involve structural reforms to enhance
competitiveness, encourage exports, and attract foreign investment.
• Encourage Foreign Investment: Attracting foreign direct investment (FDI) can bring in
capital to offset the deficit.

Unit 2: Balance of Payment (BOP) 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTARTION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 3: Development of International Monetary System 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 3
Development of International Monetary
System
Table of Contents
SL Topic Fig No / Table SAQ / Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Specie Commodity Standard - - 5
3 Gold Standard - - 6-8
4 Suspension of Gold Standard - - 8
5 Advantages of Gold Standard - - 9
6 Disadvantages of Gold standard - - 10
7 Inter-War Years (1914-1944) - 1 10-13
8 Bretton Woods System (1945-1972) - - 14
9 Features of Bretton Woods System - 2 15-20
10 Exchange Rate Regime since 1973 - - 21-24
11 Pegging of a Currency - - 25-26
12 Target Zone Agreement - - 26
13 Creation of SDR - - 27-28
14 IMF Funding Facilities - - 29-30
15 Terminal Questions - - 30-31
16 Answers - - 32-38

Unit 3: Development of International Monetary System 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The international monetary system is a complex framework that governs economic and
financial transactions among countries, enabling the smooth settlement of payments. Its
evolution spans over a century, dating back to the era of the gold standard and even further,
when precious metals were used as a means of payment. This system has undergone
significant changes, with a key turning point occurring in the 1940s with the establishment
of the International Monetary Fund (IMF).

Before the 1940s, the gold standard prevailed, where currencies were backed by physical
gold reserves. However, the Great Depression and the economic instability it brought led to
its abandonment. The Bretton Woods Conference in 1944 laid the foundation for a new
monetary system. Under this arrangement, the US dollar became the primary global
currency, pegged to gold, and other currencies were pegged to the dollar, creating stability
in exchange rates.

The IMF was established to oversee this system, providing financial assistance to member
countries facing balance of payments issues and promoting international monetary
cooperation. However, this system also faced challenges, such as the US abandoning the gold
peg in 1971, leading to the collapse of the Bretton Woods system.

Since then, the international monetary system has transitioned into a more flexible
arrangement of floating exchange rates, where currencies fluctuate based on market forces.
Central banks manage their exchange rates independently, and global financial institutions
like the IMF continue to play a role in crisis management and promoting economic stability.
This dynamic evolution underscores the importance of adaptability in the face of changing
economic realities on the international stage.

1.1 Learning Objectives

International monetary system manifests in the arrangements that facilitate international
payments as well as international liquidity. This chapter traces the developments in this
regard and focuses on the IMF system. In particular, it attempts:
❖ To explain the earliest monetary system known as the specie commodity standard.

Unit 3: Development of International Monetary System 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

❖ To delineate the functioning of gold standard and the reasons behind its abandonment
during 1930s.
❖ To explain the IMF’s exchange rate regime during 1945-73, known as Bretton Woods
Exchange Rate Regime and the reasons behind its collapse.
❖ To explain the present system of exchange rate regime characterised with varying options.
❖ To comment on the IMF’s role in improving international liquidity.
❖ To describe the IMF’s role in dealing with the financial crisis.
❖ To show the changing faces of the European Monetary Union.

Unit 3: Development of International Monetary System 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. SPECIE COMMODITY STANDARD

In the early days, before the establishment of an international monetary system, trade
payments relied on barter, which was cumbersome and inconvenient. To address these
challenges, traders began using metals, particularly gold and silver, as a medium of exchange.
This marked the emergence of the specie commodity standard, where coins were created
with a sovereign's stamp, indicating their weight and fineness. These "full-bodied" coins had
intrinsic value equal to the metal they contained.

Over time, the practice of coin debasement emerged, where lower-value metals were mixed
with coins, reducing their intrinsic value below their face value. Debased coins were
commonly used for everyday transactions, while full-bodied coins were reserved for wealth
storage and melting to extract their gold or silver content.

In England, coin debasement in the mid-16th century led to the near disappearance of full-
bodied coins from circulation by 1560, necessitating Queen Elizabeth I to reintroduce them.
In the United States, the Coinage Act of 1792 established the dollar as the official monetary
unit, fixed in terms of gold and silver, giving rise to a bimetallic standard. France also adopted
a bimetallic standard in 1803, but differences in mint ratios (1:15 in the US and 1:15.5 in
France) led to gold exports from the US to France for silver purchases.

The dwindling gold reserves in the US eventually led to the adoption of a monometallic silver
standard. However, a change in the gold-silver mint ratio to 1:16 allowed the US to return to
a monometallic gold standard. These various currency systems facilitated trade and payment
settlements in their respective countries.

Unit 3: Development of International Monetary System 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. GOLD STANDARD
The gold standard possessed broader features than the specie commodity standard. It
originated in England in the 17th century when the pound was minted of gold but it was
officially announced in 1816 when gold became the official tender of payment of public and
private debt. By the end of 1870s, the gold standard was widely adopted. Germany adopted
it in 1871, and the United States followed suit in 1879. The last quarter of the nineteenth
century and till the outbreak of First World War, was the hey-day for the gold standard.

Different Forms
The form of gold standard was not the same in all the countries adopting it. In the UK and the
United States of America, gold coins were minted, and bank notes were also exchanged for
gold on demand. The price of gold was fixed under law. It was the price at which gold could
be bought and sold. It was the purest form of gold standard and was known as gold specie
standard. A modified version of the gold standard was known as gold bullion standard. It had
all advantages of gold standard without any compulsion to maintain old coinage. Individual
bank notes were not convertible to gold directly and for conversion, gold bar was purchased
at fixed rates.

The gold exchange standard was an even more economical form of gold standard where
neither gold coinage was required, nor the convertibility via purchase of gold bars existed. A
country on the gold exchange standard linked its currency to the currency of a country on
the gold specie standard. If a country on the gold exchange standard held the pound as its
reserves, its currency was convertible to pounds and the pound was convertible into gold.
Thus, convertibility existed but not directly. The country reaped the advantages of the gold
standard so long as it's linked currency continued to be on the gold specie standard. Many
countries maintained the gold exchange standard. The Scandinavian countries adopted it in
1885 and the Russia followed in 1894. They all had huge reserve of British treasury bills.

The Broad Rules

The essential features of the gold standard were:
• The government adopting it fixed the value of currency in terms of specific weight and
fineness of gold and guaranteed a two-way convertibility.

Unit 3: Development of International Monetary System 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Export and import of gold were allowed so that it could flow freely among the gold-
standard countries.
• The central bank acting as the apex monetary institution, held gold reserves in direct
relationship with the currency it had issued.
• The government allowed unrestricted minting of gold and melting of gold coins at the
option of the holder.

Since fixed weight of gold had formed the basis for a unit of currency and since free flow of
gold was allowed among the countries, the gold standard possessed an automatic
mechanism for domestic price stability, fixed exchange rates, and adjustment in balance of
payments.

Let us first explain the mechanism of exchange rates. The rates depended upon the content
of gold in different currencies. Suppose a pound sterling contained a half ounce of gold and
$1 contained a one-fourth ounce of gold, the exchange rate was fixed at 1 pound=$2. In
practice, one ounce of gold was then valued at 4.24 pound and the same weight of gold with
similar fineness was valued at

$20.67
$ 20.67. Naturally, one pound was exchanged for or $4.87. This rate was known as the
4.24

mint parity or the mint exchange rate.

The actual exchange rate remained close to mint parity because of free flow of gold between
two countries helped avoid any major deviation. Suppose the value of the dollar depreciated
to $ 5.25 a pound. The arbitrageurs would buy one ounce of gold in the United States for $
20.67 and sell it in United Kingdom for 4.24 pound and then they could exchange the pound
for the dollar in the foreign exchange market for $5.25 ×4.24=$22.26. This brought them at
a profit of $22.26-$20.67=$1.59. This process of arbitrage continued till the original parity
was re-established. It may be noted that this process involved a transaction cost or
transportation cost of gold that might not help equate the actual exchange rate to mint parity.
But the difference from the mint parity was limited to only that amount.

Turning to automatic adjustment in the balance of payments, one finds that any deficit was
made up through the price specie flow. Suppose that England faced a deficit on its trade
account which could lead to outflow of gold for the settlement of trade thus reducing the

Unit 3: Development of International Monetary System 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

money flow within the country. The emerging deflation in the wake of shrinkage of money
supply would make the English exports competitive and the resultant rise in the export
would wipe out any deficit on this account. There was one more explanation for automatic
adjustment in the balance of payments. Reduced money supply raised the interest rate. The
banking system restricted credit in view of the reduced money supply and to this end, the
central bank raised the bank rate. Ultimately, lured by the higher interest rate, foreign
investment moved into the economy meeting any deficit on the capital account. The currency
being backed fully by gold, money supply was constant in view of constant gold reserves and
with constant money supply, prices were constant. Any deviation could occur only after
discovery of new gold mines. That was the case in the USA when the Californian gold mines
were discovered in 1847. Prices increased and this increase was transmitted to other
countries through the flow of gold.

4. SUSPENSION OF GOLD STANDARD

The gold standard, known for its money supply constancy and price stability, faced
significant challenges during World War I. The warring nations needed to increase their
money supply to finance the war efforts, but this was difficult within the constraints of the
gold standard. Additionally, strained political relations hindered the free flow of gold
between countries, disrupting the automatic adjustment mechanism for external balance.

To finance the war, many countries suspended the convertibility of their currencies into gold,
causing a disturbance in exchange rate parity. This departure from the traditional gold
standard norms marked a significant deviation.

Furthermore, there were significant transfer of funds issues in the aftermath of the war. The
United States demanded repayment of war debts from France, which in turn demanded
reparations from Germany to meet its own war debts. This complicated financial
entanglement further shook the balance of payments.

Before the U.S. entered the war in 1917, it had been supplying goods to Europe, resulting in
a trade surplus. This surplus strengthened the U.S. dollar while weakening European
currencies. Due to these complex factors and disruptions, the gold standard was temporarily
suspended during World War I to accommodate the financial needs of the warring nations.

Unit 3: Development of International Monetary System 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. ADVANTAGES OF GOLD STANDARD

Following are the advantages of Gold Standard:
1) Useful for hedging the Inflation rates: The gold standard is useful for hedging the
increasing price. Availability of gold metal is fixed thus gold standard was useful
maintaining the price stability and reduced the involvement of central bank or to avoid
the condition of hyper- inflation.
2) Automatic Adjustment: The price specie-flow mechanism was useful for automatic
correction in the balance of payment.
3) Reduce the involvement of Government: Under gold standard system, the involvement
of government was less as it could not issue currency more than the amount of gold
reserves. Thus, the money supply would remain constant and reduce the possibilities
of inflation. It can be depicted from the period prior to the World War One as the
government could not reduce the supply of money even they encountered with the
outflow of gold.
4) Reduce the involvement of Federal Reserve: Under gold standard system, the Federal
Reserve policies formed for influencing the restricted money flow thus the inflation was
controlled in the country.
5) Fixed exchange rate: Under the gold standard system, the different countries were on
gold standard thus there was a single currency in circulation that was gold. Therefore,
there was a stability in the gold standard and further make the exchange rate fixed.

Unit 3: Development of International Monetary System 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. DISADVANTAGES OF GOLD STANDARD

Following are the disadvantages of gold standards:
1) Probable pressure of deflation: Under the system, the supply of gold was fixed, thus the
money supply in an economy was also fixed. Because of this, the increase in production
result into deflation.
2) Absence of Commitment Mechanism or Enforcement Mechanism: Under this system it
was not mandatory for all countries to continue with the gold standards while they are
independent to select their currency other than gold metal currency.
3) Adjustments were not profitable: Under the system, the automatic adjustments in
balance of payment were not admirable, particularly, when the unemployment was
rising, or when there was a decay in economic growth.
4) No separation from inflation and deflation at global level: Under the system the
inflation and deflation present all over the world control directly or indirectly affect the
functioning of the country because the country could not separate it economy from
other countries.

7. INTER-WAR YEARS (1914-1944)

By the end of World War 1, the centred countries on the traditional gold standards such as
Great Britain, France, Germany and Russia had adjourned the repayment of bank notes in
gold, and they had restricted the exports of gold. Subsequent to this war, the hyperinflation
condition was felt in the major countries, particularly in Germany, Australia, Hungary,
Poland and Russia. After the war, the countries were recovering and alleviating their
economies through the better methods. Although, they were making efforts in restoring the
gold standards. The Great Britain had been substituted by the United States and became the
principle of financial power and thus it has command to return to the gold standard.
Therefore, United State has removed all restrictions on export of gold and restored the gold
standard in 1919. In 1925, Winston Churchill as the chancellor of the Exchequer had played
important role in returning back to the gold standard in the Great Britain. Later in 1928, the
other countries had also returned back to the gold standards such as Switzerland, France
and the Scandinavian. The restored gold coins were destroyed because of the Great
Depression and its financial crisis. This further leads to stock market crash as the banks in

Unit 3: Development of International Monetary System 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

major countries in Australia, Germany and United States were not able to lift up the prices
off their portfolios.

In addition to this situation, the outflow of gold from Britian was also high which ultimately
resulted in prolong deficit in the balance of payment thus, the value of pound sterling was
reduced. Britian could not maintain the gold standard for long, in spite of coordinated
international efforts to restore the pound. Thus, the gold reserves were steadily decreased,
and it had become very difficult to restore the gold standards.

Therefore, in 1931 from the month of September, the British government had postponed the
payments in gold but, its currency, pound was floating. By the end of 1931, because the Great
Britain had abandoned the gold standard, the other centered countries, named the Canada,
Sweden, Australia and Japan has also abandoned the gold standards. Finally, the United
states has abandoned the gold standard in April 1933, subsequent to the failure of banks and
extensive outflow of gold. Later on the other major country, France has also abandoned the
gold standard in 1936 because of variability of economic and political factors. During that
time, Leon Blum was leading the socialist Popular Front government of France and the paper
standard has been accepted in place of gold standard. Therefore, on observing the complete
overview, it can be concluded that the inter war period was featured through the common
aspects such as economic nationalism, half-hearted efforts and failure to restore gold
standard, economic and political instabilities, bank failures and panicky flights of capital
across the borders. During this period, the international system was not clear, and its impact
was reflected through the condition of international trade and investment. While the US
dollar was taken the place of British pound and it is widely used currency in the world.

Unit 3: Development of International Monetary System 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

1. What was the primary motivation for the emergence of the specie commodity
standard?
a) To encourage the use of barter in trade
b) To establish a constant money supply
c) To simplify the exchange of goods and services
d) To create coins with intrinsic value
2. What led to the near disappearance of full-bodied coins from circulation in
England in the mid-16th century?
a) Coin debasement
b) Queen Elizabeth I's decision
c) Introduction of paper currency
d) Melting of coins
3. What was the major difference between the gold specie standard and the
gold bullion standard?
a) Gold specie standard allowed for the free minting of gold coins.
b) Gold bullion standard required direct conversion of banknotes into gold.
c) Gold specie standard did not require the maintenance of old coinage.
d) Gold bullion standard involved a fixed exchange rate with foreign
currencies.
4. What was the key advantage of the gold exchange standard over the gold
specie standard?
a) It allowed for the free minting of gold coins.
b) It required direct conversion of banknotes into gold.
c) It eliminated the need for gold coinage.
d) It linked a country's currency to another country's currency on the gold
specie standard.

Unit 3: Development of International Monetary System 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. What was the main mechanism for maintaining exchange rate stability in the
gold standard system?
a) Fixed exchange rates set by governments
b) Government intervention in foreign exchange markets
c) The price specie-flow mechanism
d) Bilateral trade agreements
6. Why was the gold standard temporarily suspended during World War I?
a) To encourage inflation
b) To facilitate international trade
c) To accommodate the need for increased money supply during the war
d) To stabilize exchange rates
7. Which major country abandoned the gold standard in April 1933 due to bank
failures and extensive outflow of gold?
a) France
b) Germany
c) Great Britain
d) United States

Unit 3: Development of International Monetary System 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. BRETTON WOODS SYSTEM (1945-1972)

By the end of Great Depression in 1930s, another World War was occurred, and it had
directly influenced the commercial trade, the international exchange rate and the
international flow of capital. Thus, the Bretton Woods Agreement has been developed from
the International Monetary and Financial Conference of the United and associated countries
in July 1944 at Bretton Woods in New Hampshire. This agreement was important for
reviving and reconstruction of International Monetary system because it has adversely
affected due to emergence of World War One, The Great Depression and the World War II.
Abandonment of gold standard was the obvious agreement after such destruction, but it was
important to stabilise the exchange rate. Thus, in order to stabilise the exchange rate, the
government of different countries need to have sufficient credit in convertible currencies.
While this became possible, when they had made suitable changes in the exchange rate on
the consultation of other countries. But the perception of each government was not the same.
As the British government was in favour of following point:
• to decrease the use of gold,
• to increase the flexibility of exchange rates,
• to increase the volume of lendable resources on discarding the role of proposed
international monetary organization, and
• to accept the principle under which both, the surplus and deficit countries are
responsible for correcting the disequilibrium of balance of payment.

On contrary to this, the Americans were in favour of the following point:

• to increase the use of gold,
• to greatly stabilise the exchange rate,
• to decrease the volume of lendable resources and
• to accept the principle under which only the deficit country is responsible for
correcting the disequilibrium of balance of payment.

Unit 3: Development of International Monetary System 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9. FEATURES OF BRETTON WOODS SYSTEM

In view of the unstable exchange rates during the 1930s and early 1940s, various moves
were afoot to create an orderly international monetary system. Finally, at the Bretton Woods
Conference, it was resolved to create the International Monetary Fund. The IMF, that evolved
a novel exchange rate was established in 1945. Since the new system was the outcome of the
Bretton Woods Conference, it is often termed as the Bretton Woods System.

Fixed Parity System

The IMF articles provided for an orderly exchange rate regime. Each member country was to
set a fixed value-called the par value-of its currency in terms of gold or the US Dollar. It was
the par value that determined the rate of exchange between two currencies. Minor
fluctuations in the exchange rate within a narrow band of 1% above and below the
established parities could not be ruled out and were to be corrected through active
intervention of the monetary authorities of the concerned countries. It may, however, be
mentioned that the fixed parity under the Bretton Woods system was not like that of the gold
standard of 1880-1914. It was a fixed parity with adjustable pegs meaning that any member
country could alter the value of its currency or, in other words, could devalue its currency in
case of “fundamental disequilibrium” in the balance of payments. Changes upto 5% did not
require prior approval of the IMF, but beyond it, IMF’s approval was necessary. Fundamental
disequilibrium was never formally defined; but in practice, it meant continued and chronic
balance of payments problems and colossal loss of reserves. The purpose of the adjustable
peg system was, therefore, to establish a balance between the objectives of stable exchange
rates and the macroeconomic goals of the countries going for such adjustments also to help
avoid any use of exchange control and trade-restriction measures. In other words, it brought
flexibility in the fixed exchange rate system for the purposes of attaining equilibrium in the
balance of payments. The provisions also contained cautions so that there might not be
competitive devaluation. It was maintained through supervision and scrutiny over desired
exchange rate changes.

Again, an important aspect of Bretton Woods exchange rate system was that the US Dollar
was convertible to gold at the fixed rate of $ 35 per troy ounce of gold. The other currencies
were convertible to gold via the US dollar. This currency was given the position of

Unit 3: Development of International Monetary System 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

intervention currency in the system in view of the fact that the immediate post-war period,
it was the strongest currency. This system was, therefore, likened with the gold exchange
standard where countries redeemed their currency into gold-convertible currency and not
necessarily into gold directly. In the post-war system, the US dollar came to the intervention
currency replacing the British pound which has played in the past during the early decades
of the twentieth century.

Collapse of Fixed Parity System

The Bretton Woods system stabilized the exchange rates but there were some inherent
weaknesses. The adjustable peg system was highly rigid and by the time a fundamental
disequilibrium could be manifest, colossal losses had occurred in member countries in the
form of misallocation of funds. Moreover, the fixed parity system failed to consider the fast
growing activities of the MNC s which caused large flow of funds among different countries
that necessitated changes in exchange rates. Most importantly, the element of confidence lay
at the root of the system. The moment confidence was shaken, the system was bound to
collapse. During the first decade, there was no confidence problem. The member countries
held large reserves in the form of dollar-denominated assets and the functioning of the
exchange rate system was smooth but in the late 1950s, the US balance of payment swung
into deficit because of its ambitious economic aid programme and other factors such as
expansionary domestic policies, etc. Viewing this deficit, the European countries began to
lose confidence in the US dollar and began converting their dollar denominated assets into
gold. The gold holding of US-treasury plummeted by 8 billion $ by 1960. This eroded
confidence again in US Dollar. A vicious circle emerged and was accelerated by the rapid
deterioration in the US balance of payments during 1960s in the wake of Vietnam war.
Financing the war caused large budgetary deficit and monetary expansion and inflation
followed. It led in turn to deficit on current account and the dollar stood overvalued which
resulted in preference of gold, when the gold conversion ability of the US treasury was not
beyond doubt. That US citizens were barred from buying gold further eroded confidence.
Expectation of a record deficit in 1971 in the US balance of payment resulted in resulted in
massive selling of the US Dollar in the international financial market. Gold price in the free
market rose putting thereby an adverse influence on the fixed parity between the US dollar
and gold. A speculative run on the dollar, which would have been impossible for the US

Unit 3: Development of International Monetary System 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Government to sustain, was expected. At the same time, Germany decided to float its
currency against the Dollar, the Netherland followed suit and Austria, Switzerland revalued
their currency. By August 1971, a full-blown crisis had developed against the dollar. During
the first half of that month, US-Government reserves fell by $ 1.1 billion. The Nixon
administration then suspended convertibility of the dollar gold thus dealing a serious blow
to the fixed parity system.

Following are the features of Bretton Woods system:

1. US Dollar-based system: This system was formed on the basis of a gold-based system,
where all countries were treated equally, and the International Monetary Fund was
authorized to manage this system. But it has been considered as a US-dominated
system because the US Dollar was the dominant currency of the world. Its supremacy
is also maintained even in the present time. US had hold equal relationship with the
other countries and it was a centered country that has maintained the stable price for
the products imported by the other countries. However, it had never intervened in the
currency market to fix the exchange rate, while the other countries were actively
participated and fix their exchange rates counter to the US dollar.
2. Adjustable Peg System: Under this system, the exchange rates were fixed but that were
approved for adjustment in case of particular situations. For this reason, the exchange
rates were expected to move in a systematic order. While this system was useful for
syndicating the features of exchange rates such as stability and the flexibility, provided
that there would be no mutual destructive devaluation (deflation). Under this system,
the member countries were permitted to make adjustment in parities or in exchange
rate, particularly, when they have disequilibrium balance of payments. But this system
had not explained the “fundamental disequilibrium” in an efficient manner. Practically,
the adjustments in exchange rate were executed only in certain cases, in comparison
with the expectations. For example, Germany has increased its exchange rate twice,
while the UK has decreased its exchange rate once and France has decreased its
exchange rate twice. On the other hand, Japan and Italy had not made any change in
their exchange rates.
3. Capital Control: Under this system the flow of capital was restricted and highly
managed. Thus, it made this system separate from the traditional goal standard under

Unit 3: Development of International Monetary System 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

which the flow of capital was unrestricted. Even though some countries such a US and
Germany had very less regulations for restricting the flow of capital to the other
countries.
4. Macroeconomic Performance: During the period 1950 to 1960, the macroeconomic
performance was extraordinary as it had never been observed in the past periods. More
specifically, the prices at global level were stable and high growth had been
accomplished, even though there were more restrictions on trade.

Smithsonian Arrangement
In December 1971, a conference was held at the Smithsonian Institute in Washington DC
which decided to take the following actions to restore stability of the system:
• Realignment of the par value of major currencies so as to better conform to their
realistic value. For the purpose, the gold parity of the US Dollar was changed from 35
to 38.02 per troy ounce entailing a devaluation of 8.57%. On the other hand, the
currencies of surplus countries were revalued upward by percentages ranging from 7.4
for the Canadian dollar to 16.9 for the Japanese Yen.
• The band for the fluctuation from the par values was widened from ±1% to ±2.25%
with a view to providing more leeway to member countries to manage their exchange
rates and their monetary policies.

In short, the purpose of the Smithsonian arrangement was to inject greater flexibility into
the par value system, although convertibility of the US dollar was never guaranteed.
Unfortunately, the arrangement could not go far. There was a tide of speculation against the
weak currencies, such as dollar and the pound sterling, and of a massive flow of capital
towards strong-currency countries such as Germany, Switzerland, the Netherlands, France
and Japan. The US Government was forced to devalue the dollar by 10% raising the price of
gold to $ 42.22 per troy ounce in February 1973. It could not check the currency flow in the
favour of European countries and Japan. At last the exchange markets were closed in March
1973 to avert a crisis. When they reopened, the major currencies came on to float thus
delivering a death blow to the Bretton Woods exchange rate regime.

Unit 3: Development of International Monetary System 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

8. What was the primary goal of the Bretton Woods Agreement in 1944?
a) To establish a gold-based international monetary system.
b) To stabilize exchange rates after World War I.
c) To create a fixed exchange rate system based on the US dollar.
d) To promote economic nationalism among member countries.
9. Which of the following accurately describes the Bretton Woods exchange
rate system?
a) A fully rigid fixed exchange rate system.
b) A fixed exchange rate system with adjustable pegs.
c) A floating exchange rate system.
d) A system where gold was the only reserve currency.
10. What did the par value in the Bretton Woods system determine?
a) The gold reserves of a country.
b) The exchange rate between two currencies.
c) The amount of foreign aid a country could receive.
d) The volume of lendable resources in a country.
11. What did the term "fundamental disequilibrium" refer to in the Bretton
Woods system?
a) A temporary trade imbalance.
b) A significant imbalance in a country's balance of payments.
c) A surplus in a country's current account.
d) A fixed exchange rate with no adjustment.
12. What currency became the intervention currency in the Bretton Woods
system, replacing the British pound?
a) Euro
b) Japanese Yen
c) US Dollar
d) British Pound

Unit 3: Development of International Monetary System 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. What major event triggered the collapse of the Bretton Woods fixed parity
system?
a) The creation of the International Monetary Fund.
b) A surge in global economic growth.
c) The oil crisis of the 1970s.
d) A loss of confidence in the US dollar.
14. What was the outcome of the Smithsonian Institute conference in 1971?
a) A decision to continue the Bretton Woods system without changes.
b) A widening of the fluctuation band for exchange rates.
c) The establishment of a new international monetary organization.
d) A return to the gold standard.
15. What action did the US government take in February 1973 that marked the
end of the Bretton Woods exchange rate regime?
a) A devaluation of the US dollar.
b) A revaluation of the US dollar.
c) The closure of exchange markets.
d) The return to a fully fixed exchange rate system.

Unit 3: Development of International Monetary System 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

10. EXCHANGE RATE REGIME SINCE 1973

In view of the collapse of the Bretton Woods system of exchange rate, the board of governors
of the IMF appointed committee of 20 to suggest guidelines for evolving an exchange rate
system that could be acceptable to the member countries. The report suggested various
options that were discussed at Rambouillet in November 1975 and approved at the Jamaica
meet in January 1976. They were formally incorporated into the text of the second
amendment to the Article of Agreement that came into force from April 1, 1978., The broad
options under the new exchange rate regime were:

Floating-Independent and Managed

Pegging to a currency-to a single currency, to a basket of currencies, to SDRs, crawling peg,
currency board arrangement

Target zone arrangement

The new regime conferred upon the member countries many options that could choose
according to their own convenience and depending upon their own macro-economic
variables. This way the system was more flexible than the adjustable peg system. A few
industrialist countries choose independent floating while some others including a few
developing countries went for managed floating. A few developing countries choose the
crawling peg, while the majority of the developing countries opted to peg-either to a single
currency, basket of currencies or to SDR.

Some European countries preferred to form a target zone agreement. During 1981, 92 out of
144 member countries currencies were pegged either to a single currency or to SDRs or still
a basket of currencies. The other 17 currencies were also pegged but within horizontal
bands. The value of other five currencies were adjusted as per a set of indicators. There were
only 30-member country currencies or around 1/5 of the total that were on float, 22
currencies being on managed float and the rest 8 currencies on independent float. On the
other hand, in 1991 they were 56 out of 156 currencies or 36% of the total that were on float.
In 2001, the total number of currencies coming on to float increase to 86 or 43%. At the end
of April 2010, out of 188 countries, 84 maintained fixed exchange rates, 44 had managed
float , 40 had independent float and the rest 20 had some kind of adjustability according to
the set of indicators.

Unit 3: Development of International Monetary System 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

A floating exchange rate regime, also known as a flexible exchange rate regime, allows
market forces to determine the value of a country's currency relative to other currencies.
Under this system, the exchange rate is not fixed or pegged to a specific value, and it
fluctuates based on supply and demand in the foreign exchange market. Here are the merits
or advantages of a floating exchange rate regime:

1. Exchange Rates Automatically Adjust to Macroeconomic Variables:

In a floating exchange rate system, exchange rates respond to changes in macroeconomic
variables such as inflation, interest rates, trade balances, and economic growth.

When a country experiences inflation, for example, its currency tends to depreciate because
higher inflation erodes the purchasing power of that currency. This depreciation can help
maintain the competitiveness of the country's exports.

2. Exchange Rate Stability in the Long Run:

While exchange rates in a floating system can be volatile in the short term, they tend to
stabilize around an equilibrium level in the long run. Market forces work to correct
imbalances in the trade and financial sectors, helping to bring exchange rates closer to their
fundamental values over time.

3. Insulation from Foreign Shocks:

A floating exchange rate system can provide a degree of insulation to a country's currency
from external shocks or economic disturbances in other countries. If a crisis occurs in a
trading partner's economy, a country with a floating exchange rate can let its currency
depreciate, making its exports more competitive and helping to mitigate the impact of the
external shock.

4. Stimulus for Trade and Investment:

A floating exchange rate system can encourage international trade and investment by
allowing exchange rates to adjust freely to market conditions. When a country's currency
depreciates, its exports become more affordable for foreign buyers, which can boost export-
driven economic growth. Additionally, a floating exchange rate regime can attract foreign
investment by allowing investors to take advantage of exchange rate movements to
potentially increase returns.

Unit 3: Development of International Monetary System 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

However, it's important to note that while a floating exchange rate regime has these merits,
it also has drawbacks. Exchange rate volatility can create uncertainty for businesses engaged
in international trade and investment, and it can lead to speculative activities in the foreign
exchange market. Central banks may sometimes intervene to stabilize exchange rates or
prevent excessive volatility through various policy tools. The choice of exchange rate regime
depends on a country's economic goals and its ability to manage the associated challenges
and risks.

Developing countries in particular do not find floating rates suitable for them. Since they
economy is not diversified and since they export is subject to frequent changes in demand
and supply, they face frequent changes in exchange rate. This is more, especially when
foreign demand for their products is price inelastic. When the value of their currency
depreciates, export earnings usually sag in the view of inelastic demand abroad. Again,
greater flexibility in exchange rate between a developed and developing country generates
greater exchange rate in the latter because of the low economic profile of the developing
countries and also because they have limited access to the forward market and to other risk
reducing mechanisms. In short, it is difficult to say whether flexible exchange rate regime is
better than fixed rate one or vice versa. A government adopts a particular regime which is
better suited to its macroeconomic environment.

Floating is generally managed in the sense that the system of managed floating involves
direct or indirect intervention by the monetary authorities of the country to stabilise the
exchange rate. It is different from independent floating which does not involve intervention.
This is why independent floating is often termed as clean floating, whereas managed floating
is termed as dirty floating. However, the difference is only theoretical. In practice, difference
is found also in case of independent floating. In Independent floating, the purpose of
intervention is simply to moderate the exchange rate and to prevent any undue fluctuation.
In case of managed floating, it is meant to establish a level for the exchange rate. When the
monetary authorities stabilize the exchange rate through changing the interest rate, it is
called indirect intervention. In case of direct intervention, on the other hand, the monetary
authorities purchase and sell foreign currency in the domestic market. When they sell
foreign currency, its supply increases, and domestic currency appreciates against the foreign
currency. When they purchase foreign currency, its demand increases and the domestic

Unit 3: Development of International Monetary System 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

currency tends to depreciate vis-à-vis the foreign currency. The IMF permits such
intervention. If intervention is aimed at preventing long term changes in exchange rate away
from equilibrium, it is known as leaning against the wind intervention. But if the intervention
support the currency trend in the exchange rate already moving toward the equilibrium, it
is known as leaning with the wind intervention.

Intervention helps move the value of domestic currency up or down also through the
expectations channel. When the monetary authorities begin supporting the foreign currency,
speculators begin buying it forward in the expectation that it will appreciate. It demand rises
and in turn it value appreciate via-a-vis domestic currency.

Intervention may be stabilising or destabilising. Stabilising intervention health move the

exchange rate toward equilibrium, while destabilising intervention found in cases where
rates are moving away from the equilibrium despite intervention. The former causes gain of
foreign currency while the letter causes loss of foreign exchange. Suppose the rupee
depreciate from 33 a dollar to 36 a dollar. The Reserve Bank sells $1000 and the rupee
improves to 33. The RBI will be able to replenish the lost reserve through buying the dollar
at ₹33/$. The gain will be $(36000/33-1000) or $ 91. But after the intervention, if the rupee
fall to 40 a dollar, the loss will be $(36000/40-100) or $ 100. The monetary authorities do
not normally resort to destabilizing intervention, but it is very difficult to know in advance
whether intervention is really destabilizing.

Again, intervention may be sterilised or non-sterilised. When the monetary authorities

purchase foreign currency with the help of created money, the money supply in the country
increases. It led to inflation. This is an example of non-sterilized intervention. But if
simultaneously, securities are sold in the market to mop up the exchange supply of money,
intervention does not lead to inflation. It takes the form of sterilized intervention. Finally,
the intervention may be coordinated one where the central Bank of two or more countries
are simultaneously involved in stabilising a particular currency. The G5 government attempt
for making U.S. dollar consistent with the economic indicator under the Plaza agreement of
1985 although many like Bordo and Schwartz (1991) feel, the coordinated intervention
under the Plaza agreement distorted the foreign exchange market and the central bank had
to face excessive risk of loss.

Unit 3: Development of International Monetary System 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. PEGGING OF A CURRENCY

Pegging of a currency refers to the practice of fixing or anchoring the value of a country's
currency to another currency, a basket of currencies, or a specific standard, such as the
Special Drawing Rights (SDR) issued by the International Monetary Fund (IMF). When a
currency is pegged, its exchange rate is set at a predetermined rate relative to the chosen
reference currency or standard. This means that the central bank or government of the
pegging country intervenes in the foreign exchange market to maintain the exchange rate at
or near the pegged rate.

There are different types of currency pegs:

Fixed Peg: In a fixed peg system, a country's currency is fixed at a specific exchange rate with
another currency or a standard. For example, a country might fix its currency to the U.S.
dollar at a rate of 1:1, meaning one unit of the domestic currency is equal to one U.S. dollar.

Basket Peg: In this case, a country pegs its currency to a basket of foreign currencies, typically
including major trading partners' currencies. The exchange rate is determined by the
weighted average of these currencies.

SDR Peg: Some countries peg their currencies to the IMF's Special Drawing Rights (SDR),
which is a composite currency based on a basket of major international currencies. The
exchange rate is determined by the value of the SDR.

Crawling Peg:
A crawling peg is a system that combines elements of both fixed and flexible exchange rate
systems. Under a crawling peg, a country's exchange rate is initially fixed at a certain rate
(like in a fixed peg), but it is periodically adjusted or "crawled" at pre-determined intervals
to align with market-determined rates. The adjustments are typically gradual and are
designed to allow the exchange rate to slowly catch up with changing market conditions.

For example, if a country's central bank sets a crawling peg with a fixed rate but allows for a
periodic adjustment of, say, 1% every month, and the market-determined rate is consistently
higher than the fixed rate, the exchange rate will gradually appreciate to reflect the market
rate.

Unit 3: Development of International Monetary System 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The primary purpose of a crawling peg is to strike a balance between the stability provided
by a fixed exchange rate and the flexibility offered by a floating exchange rate. It allows for
some adjustment in response to changing economic conditions without the abrupt
fluctuations associated with a pure floating exchange rate.

In summary, pegging involves fixing a currency's value to another currency or standard,

while a crawling peg is a variation that incorporates periodic adjustments to the fixed rate
to keep it in line with market-determined rates, offering a degree of flexibility within a fixed
framework.

12. TARGET ZONE AGREEMENT

In case of target-zone agreement, a group of countries either maintain fixed exchange rate
among their currency through a common currency or have a common currency instead of
their own currency. A few European countries opted for a target-zone agreement which
came to be known as European Monetary System (EMS) or later as the European Economic
and Monetary Union (EMU). Each currency in the EMU had a central rate expressed in term
of European Currency Unit (ECU) that has been substituted by the Euro since 1999. This led
to a fixed exchange rate among the member currencies, although fluctuation was allowed
within the prescribed band. When the exchange rate fluctuations moved towards the
prescribed limit and tried to cross it, the central bank intervened as in the case of managed
floating and if intervention did not succeed, realignment of the parity grid took place. This
arrangement provides stability at least to some extent in the exchange rates within the union,
but since the performance of the different member countries was not uniform, the
emergence of disparity between the values of different currencies could not be ruled out.
Even intervention was helpless on many occasions as the result of which there occurred
many realignments in the value of member’s currencies during the 1980s. However, with
greater effort toward convergence in the wake of the Delores plan and with the euro coming
into being finally as the sole currency of the EMU, the earlier problems are over. Besides EMU
target zone arrangements has been adopted also in other part of the world.

Unit 3: Development of International Monetary System 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. CREATION OF SDR

Special Drawing Rights (SDRs) were created by the International Monetary Fund (IMF) in
1969 to supplement the official reserves of its member countries. The SDR is not a currency,
but rather an international reserve asset that can be used to settle payments between IMF
members. It is defined as a basket of five major currencies: the US dollar, the euro, the
Japanese yen, the Chinese renminbi, and the British pound.

The SDR was created in response to the Bretton Woods system, which was the international
monetary system in place from 1944 to 1973. Under the Bretton Woods system, exchange
rates were fixed to the US dollar, which was in turn fixed to gold. This system worked well
as long as the US dollar remained strong. However, in the late 1960s and early 1970s, the US
dollar began to weaken, and the Bretton Woods system collapsed.

The SDR was created as a way to provide a more stable and diversified reserve asset for IMF
members. The SDR is not tied to any one currency, and its value is determined by the value
of the five currencies in its basket. This makes the SDR more resistant to fluctuations in the
value of individual currencies.

The SDR is allocated to IMF members based on their quotas. Quotas are determined by a
number of factors, including the size of a country's economy and its trade with other
countries. SDRs can be used by IMF members to settle payments with other IMF members,
or to exchange for other currencies.

The SDR has played an important role in the global financial system. It has been used to
provide liquidity to countries in times of crisis, and it has also been used to support economic
development in developing countries.

In recent years, there has been a growing interest in the SDR as a way to reduce the world's
reliance on the US dollar. The IMF allocated a record-breaking SDR 456 billion in 2021 to
help countries cope with the impact of the COVID-19 pandemic. This allocation also helped
to boost the global supply of SDRs and make them more attractive to investors.

The SDR is a complex and evolving instrument, but it has the potential to play an increasingly
important role in the global financial system.

Unit 3: Development of International Monetary System 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Fixed number of
Weight determined
Currency units of currency for
in 2015 review
5-year period

U.S Dollar 41.73 0.58252

Euro 30.93 0.38671

Chinese Yuan 10.92 1.10174

Japanese Yen 8.33 11.90

Pound Sterling 8.09 0.085946

The supply of SDR depends upon their creation and allocation. Any allocation is effected by
a minimum vote of 85%. Cancellation requires similar percentage of votes. The SDR holding
is subject to interest receipt and payment. If a member country holds SDRs in excess of the
allocation, it has to pay interest on the difference. If the holding is below the allocated
amount, it has to pay interest in line with the market rate of interest that is equal to those on
primary domestic market instruments in the five countries whose currencies form the
basket. The rate is calculated weekly. Thus, with the creation and allocation of SDR, the
position of international liquidity has been eased considerably. Moreover, to ease it further,
the IMF has created several facilities for drawing from the reserve pool.

Unit 3: Development of International Monetary System 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

14. IMF FUNDING FACILITIES

The International Monetary Fund (IMF) offers a variety of funding facilities to help member
countries address balance of payments problems and support economic growth. These
facilities are tailored to the specific needs of each country, and they can be used to finance a
variety of purposes, such as:
• Covering short-term balance of payments deficits
• Supporting medium-term economic reforms
• Providing emergency assistance in the wake of natural disasters or other crises

Here is a brief overview of some of the key IMF funding facilities:

• Stand-By Arrangement (SBA): The SBA is the IMF's most common lending facility. It
provides short-term financing to countries facing balance of payments problems. SBAs
are typically accompanied by economic programs that are designed to address the
underlying causes of the country's problems.
• Extended Fund Facility (EFF): The EFF is designed to support countries facing medium-
term balance of payments problems due to structural weaknesses. EFFs provide
longer-term financing and more flexible repayment terms than SBAs.
• Rapid Financing Instrument (RFI): The RFI provides rapid financial assistance to
countries facing an urgent balance of payments need. RFIs are typically disbursed
without prior conditionality, but borrowers are expected to implement economic
programs to address their problems once the immediate crisis has passed.
• Rapid Credit Facility (RCF): The RCF is a concessional lending facility that provides fast
financial assistance to low-income countries facing an urgent balance of payments
need. RCFs are typically disbursed without prior conditionality.
• Flexible Credit Line (FCL): The FCL is a precautionary lending facility that provides
access to financing for countries with strong track records. FCLs can be used to prevent
balance of payments problems from arising, or to mitigate their impact if they do occur.

In addition to these general-purpose lending facilities, the IMF also offers a number of
specialized facilities, such as the Poverty Reduction and Growth Trust (PRGT), which
provides concessional financing to low-income countries, and the Resilience and

Unit 3: Development of International Monetary System 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Sustainability Facility (RSF), which helps countries build resilience to climate change and
other shocks.

The IMF's funding facilities are an important tool that the IMF uses to help its member
countries maintain economic stability and promote economic growth. By providing financial
assistance and policy advice, the IMF can help countries to overcome their challenges and
build a more prosperous future for their people.

15. TERMINAL QUESTIONS

Short Answer Questions
1. Describe the transition from barter to the specie commodity standard. How did the use
of metals like gold and silver impact trade in the early days of international commerce?
2. Explain the concept of coin debasement and its historical significance. How did it affect
currency and everyday transactions?
3. Discuss the various forms of the gold standard and their differences. How did these forms
impact the monetary systems in different countries?
4. What were the advantages and disadvantages of the gold standard as an international
monetary system?
5. Explain the suspension of the gold standard during World War I. What were the factors
that led to this suspension, and how did it affect the international financial system?
6. Describe the attempts to restore the gold standard during the inter-war years (1914-
1944). Why did some countries return to it while others abandoned it?
7. Analyze the impact of the gold standard on economic nationalism and global financial
stability during the inter-war period.
8. Discuss the role of the US dollar in replacing the British pound during the inter-war years.
How did this transition affect international finance and trade?
9. Reflect on the relevance of the gold standard in today's global economy. Do you think a
return to such a system would be beneficial?
10. Examine the role of gold in the modern global economy. How does gold impact
international finance and currency markets today?

Unit 3: Development of International Monetary System 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Long-Answer Questions
1. Explain the historical context that led to the establishment of the Bretton Woods
Agreement in 1944. What were the key motivations for creating this international
monetary system?
2. Describe the features of the Bretton Woods System, particularly its fixed parity system.
How did it differ from the earlier gold standard?
3. Examine the reasons for the collapse of the Bretton Woods fixed parity system. What role
did factors like loss of confidence, changes in US balance of payments, and the Vietnam
War play in this collapse?
4. “Crawling Peg is a compromise between fixed exchange rate and floating exchange rate”.
Discuss

Unit 3: Development of International Monetary System 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

16. ANSWERS
Self-Assessment Questions
Answer 1: d. To create coins with intrinsic value
Explanation: The specie commodity standard involved using coins made of precious metals
like gold and silver, which had intrinsic value based on the metal they contained.

Answer 2: a. Coin debasement

Explanation: Coin debasement, where lower-value metals were mixed with coins, reduced
their intrinsic value and led to their decline in circulation.

Answer 3: c. Gold specie standard did not require the maintenance of old coinage.
Explanation: In the gold bullion standard, individual banknotes were not directly convertible
into gold, and there was no compulsion to maintain old coinage.

Answer 4: d. It linked a country's currency to another country's currency on the gold specie
standard.
Explanation: Under the gold exchange standard, a country's currency was convertible to
another country's currency, which was in turn convertible into gold, but not directly.

Answer 5: c. The price specie-flow mechanism

Explanation: The price specie-flow mechanism relied on the free flow of gold between
countries to help maintain exchange rate stability.

Answer 6: c. To accommodate the need for increased money supply during the war
Explanation: The warring nations needed to increase their money supply to finance the war
efforts, which was difficult under the constraints of the gold standard.

Answer 7: d. United States

Explanation: The United States abandoned the gold standard in April 1933 due to bank
failures and gold outflows during the Great Depression.

Answer 8: c) To create a fixed exchange rate system based on the US dollar.

Answer 9: b) A fixed exchange rate system with adjustable pegs.

Answer 10: b) The exchange rate between two currencies.

Unit 3: Development of International Monetary System 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 11: b) A significant imbalance in a country's balance of payments.

Answer 12: c) US Dollar

Answer 13: d) A loss of confidence in the US dollar.

Answer 14: b) A widening of the fluctuation band for exchange rates.

Answer 15: a) A devaluation of the US dollar.

Terminal Questions
Answer 1: In the early days, trade relied on barter, which was cumbersome. To address this,
traders started using metals like gold and silver as a medium of exchange, giving rise to the
specie commodity standard. Coins with a sovereign's stamp indicating weight and fineness
were created, ensuring intrinsic value equal to the metal they contained. This facilitated
trade by providing a more convenient and universally accepted means of exchange.

Answer 2: Coin debasement involved mixing lower-value metals with coins, reducing their
intrinsic value below face value. Debased coins were used for everyday transactions, while
full-bodied coins were for wealth storage or melting. Debasement led to a loss of trust in
currency and disrupted economic stability, as people had to deal with coins of uncertain
value.

Answer 3: The gold standard took various forms, including the gold specie standard, gold
bullion standard, and gold exchange standard. The UK and the US minted gold coins and
exchanged banknotes for gold. Differences existed in the extent of coinage maintenance and
direct convertibility. These forms allowed countries to link their currencies to gold, but with
varying degrees of flexibility.

Answer 4: Advantages: The gold standard offered price stability, automatic balance of
payments adjustment, reduced government and central bank intervention, control over
inflation, and fixed exchange rates.

Disadvantages: It posed deflationary pressures due to fixed gold supplies, lacked

commitment mechanisms, had unprofitable adjustment methods during economic
challenges, and couldn't isolate economies from global inflation/deflation.

Unit 3: Development of International Monetary System 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 5: During World War I, countries needed to finance the war, but the gold standard's
constraints hindered increasing money supply. Political tensions disrupted gold flows. To
accommodate war financing, many countries suspended gold convertibility, causing
exchange rate instability and complex debt-related issues.

Answer 6: After WWI, countries like the US and UK attempted to restore the gold standard.
The US succeeded, but the UK and others struggled due to declining gold reserves and
economic challenges. Ultimately, many countries, including the US, abandoned the gold
standard during the Great Depression, while France later followed suit.

Answer 7: The gold standard contributed to economic nationalism as countries prioritized

their interests over international cooperation. It also faced challenges during the inter-war
period, with many countries abandoning it due to economic instability and political factors,
leading to global financial uncertainties.

Answer 8: The US dollar replaced the British pound as the dominant currency. This shift
impacted international finance and trade as the dollar became widely accepted. The US
played a pivotal role in the global economy, leading to significant changes in international
monetary dynamics.

Answer 9: In today's global economy, a return to the gold standard faces challenges. The
system's limitations, like deflationary pressures and lack of flexibility, may not suit modern
economic dynamics. However, gold continues to play a role in international finance as a store
of value and a hedge against inflation and currency fluctuations.

Answer 10: Gold remains significant in the modern global economy. It serves as a safe haven
asset, often sought during economic uncertainties. Gold prices influence currency markets,
and central banks hold gold reserves as part of their monetary policy. Additionally, gold
continues to be used in jewelry and various industries, impacting international trade and
commerce.

Answer 11: The Bretton Woods Agreement emerged in the aftermath of the Great
Depression and World War II. The global economy was in disarray due to the economic
repercussions of World War I, the devastating effects of the Great Depression, and the

Unit 3: Development of International Monetary System 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

disruptions caused by World War II. The key motivations for creating this international
monetary system were:

Stabilizing Exchange Rates: The primary goal was to stabilize exchange rates, as the
fluctuating rates during the 1930s and early 1940s had created economic instability and
hindered international trade.

Abandonment of Gold Standard: The devastation caused by the wars and economic crises
made it evident that returning to the gold standard was impractical. A new system was
needed to facilitate international trade and monetary stability.

Sufficiency of Convertible Currencies: To maintain exchange rate stability, member countries

needed to hold sufficient credit in convertible currencies. This required countries to make
adjustments to their exchange rates in consultation with others.

Differing Perspectives: Notably, there were differing perspectives between the British and
American governments. The British favored decreasing the use of gold, increasing exchange
rate flexibility, and involving both surplus and deficit countries in correcting balance of
payments disequilibrium. In contrast, the Americans favored increasing the use of gold,
greater exchange rate stability, reducing lendable resources, and placing the responsibility
for correction on deficit countries.

Answer 12:
The Bretton Woods System had several key features, including:
US Dollar-based System: While it was established on the basis of a gold-based system where
all member countries were treated equally, it was considered a US-dominated system
because the US Dollar emerged as the dominant global currency. The US maintained stability
in the prices of products imported by other countries.

Adjustable Peg System: Exchange rates were fixed but allowed for adjustment in specific
situations. Member countries could alter the value of their currency, devaluing it in case of
"fundamental disequilibrium" in their balance of payments. Changes of up to 5% did not
require prior approval from the IMF.

Unit 3: Development of International Monetary System 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Capital Control: Unlike the traditional gold standard, the flow of capital was highly regulated
and restricted in the Bretton Woods System. Some countries, like the US and Germany, had
fewer regulations on capital flow.

Macroeconomic Performance: Between 1950 and 1960, the system exhibited extraordinary
macroeconomic performance, characterized by stable global prices and high economic
growth, despite increased trade restrictions.

The fixed parity system of Bretton Woods differed from the earlier gold standard in that it
allowed for adjustable pegs, meaning member countries could change their exchange rates
to address significant imbalances. In contrast, the gold standard of 1880-1914 had fixed
exchange rates with no such flexibility, leading to more rigid economic conditions.

Answer 13: The collapse of the Bretton Woods fixed parity system can be attributed to
several key factors:
• Loss of Confidence: Confidence was a fundamental element of the system. In the late
1950s, the US balance of payments swung into deficit due to ambitious economic aid
programs and expansionary domestic policies. European countries began losing
confidence in the US dollar and began converting their dollar-denominated assets into
gold. This eroded confidence in the US Dollar.
• Changes in US Balance of Payments: The US balance of payments deteriorated rapidly
during the 1960s, primarily due to the Vietnam War. Funding the war led to large
budgetary deficits, monetary expansion, and inflation. This, in turn, resulted in a
current account deficit and an overvalued US dollar.
• Gold Price Increase: The preference for gold surged as doubts arose about the US
Treasury's ability to convert dollars into gold at the fixed rate. The restriction on US
citizens from buying gold further eroded confidence.
• Speculation and Currency Movements: Expectations of a record deficit in the US balance
of payments in 1971 triggered massive selling of the US dollar in international financial
markets. Gold prices rose, affecting the fixed parity between the US dollar and gold. A
speculative run on the dollar became likely and unsustainable.

Unit 3: Development of International Monetary System 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Responses by Other Countries: Germany decided to float its currency against the dollar,
and other countries like the Netherlands, Austria, Switzerland, and Japan made
adjustments to their currencies.

As a result of these factors, the fixed parity system became untenable, and the Nixon
administration suspended the convertibility of the US dollar to gold in 1971, effectively
marking the end of the Bretton Woods exchange rate regime. Exchange markets were closed
in March 1973, leading to the major currencies floating and ending the Bretton Woods era.

Answer 14: A crawling peg is indeed a compromise between fixed exchange rates and
floating exchange rates. To understand this, let's first clarify what fixed and floating exchange
rate systems entail:

Fixed Exchange Rate System: In a fixed exchange rate system, a country's currency is pegged,
or fixed, to another currency or a basket of currencies. The exchange rate remains constant
and is usually maintained through central bank intervention. Changes in exchange rates do
not occur naturally in response to market forces but are managed by the central bank's
buying or selling of its own currency.

Floating Exchange Rate System: In a floating exchange rate system, exchange rates are
determined by market forces of supply and demand. Central banks typically do not intervene
to peg or control exchange rates. The exchange rate can fluctuate freely based on various
economic factors, including interest rates, inflation, trade balances, and capital flows.

Now, let's discuss how a crawling peg combines elements of both systems:

Crawling Peg: A crawling peg is a managed exchange rate system where a country's central
bank or monetary authority allows its currency's exchange rate to fluctuate within a
predetermined range or with a set of rules. The term "crawling" suggests that the exchange
rate is adjusted gradually over time, typically in response to changes in economic
fundamentals.

Unit 3: Development of International Monetary System 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Here are some key characteristics of a crawling peg and how it represents a compromise:
• Exchange Rate Flexibility: Unlike a fixed exchange rate system, a crawling peg allows
for some flexibility in the exchange rate. Instead of maintaining a constant rate, the
exchange rate is adjusted periodically, allowing it to respond to changing economic
conditions.
• Central Bank Intervention: Similar to a fixed exchange rate system, the central bank or
monetary authority actively participates in the foreign exchange market. It may buy or
sell its own currency to influence the exchange rate's direction within the
predetermined range.
• Economic Fundamentals: The adjustments in the exchange rate under a crawling peg
are typically based on specific economic factors or policies. For example, if a country's
inflation rate exceeds a certain threshold, the central bank might devalue the currency
to address the imbalance.
• Stability and Control: A crawling peg provides a degree of exchange rate stability
compared to a fully floating system. It allows the central bank to exercise some control
over the exchange rate while still letting market forces play a role.
• Gradual Adjustment: The term "crawling" implies that exchange rate adjustments are
gradual and predictable. This prevents sudden and disruptive movements in the
exchange rate, which can be detrimental to trade and investment.

In summary, a crawling peg represents a compromise because it incorporates elements of

both fixed and floating exchange rate systems. It offers greater flexibility and responsiveness
to economic conditions than a fixed system while providing more stability and control than
a fully floating system. This hybrid approach allows countries to balance their desire for
exchange rate stability with the need to adapt to changing economic realities.

Unit 3: Development of International Monetary System 38

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTARTION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 4: Exchange Rate Systems 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 4
Exchange Rate Systems
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-5
1.1 Learning Objectives - -
2 Forex Market - - 6-8
3 Direct and Indirect Quote in Currency - - 8-10
Transaction
4 Buying and Selling Rates - - 10-11
5 Forward Market Quotation - - 12-13
6 Forward Premium and Discount - - 14-15
7 Cross-Rates - 1 15-17
8 Evolution of Foreign Exchange Market - - 18-19
9 Functions and Participants of the Foreign - - 19-21
Exchange Market
10 Hedging, Speculation and Arbitration - - 21-23
11 Arbitration in Forex Market - - 23-24
12 Interest rate parity (IRP) - 2 24-27
13 Covered Interest Rate Arbitration - - 28-30
14 Uncovered Interest Rate Arbitration - - 30-32
15 Impact of Inflation - - 32-33
16 Purchasing Power Parity Model - - 33-34
17 Summary - - 35
18 Terminal Questions - - 36
19 Answers - - 37-39

Unit 4: Exchange Rate Systems 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
In last chapter, we discussed different forms of the exchange rate regime ranging from the
gold standard to the adjustable peg under the Bretton Woods system and to independent
and managed floating and target zone arrangements in recent decades. Since major
currencies dominating the international financial and foreign exchange market today are on
float, their value is subject to variations depending on changes in macroeconomic variables
and market forces. Here we will discuss the determination of exchange rate that is of utmost
significance for a floating rate regime and especially for those who deal in foreign exchange.
However, in the beginning let’s discuss the fundamentals of exchange rate quotation, so that
we may better understand the exchange rate determination process.

The foreign exchange market, known as the "forex" or "FX" market, stands as the largest and
most liquid financial market globally. Its fundamental function is to serve as the epicentre
for the trading of currencies from all corners of the world. Within this dynamic market,
participants engage in activities such as buying, selling, exchanging, and speculating on the
values of diverse currencies.

One of the forex market's distinctive features is its incessant operation, running 24 hours a
day throughout five business days each week. This continuous trading owes its existence to
the international nature of currency trading, which spans across different global time zones.
This around-the-clock accessibility empowers market participants to promptly respond to
economic, political, and geopolitical events as they unfold. Consequently, the forex market is
renowned for its real-time dynamism and rapid pace.

This market plays an indispensable role in the global economy by facilitating international
trade, investment, and speculation. It offers opportunities for a wide range of participants,
from central banks and financial institutions to multinational corporations and individual
retail traders. However, it also presents risks due to its inherent volatility and the potential
for substantial price fluctuations in currency pairs. In essence, the forex market is the
lifeblood of the global financial system, enabling the seamless exchange of currencies and
the efficient functioning of the international.

Unit 4: Exchange Rate Systems 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

International transactions, much like domestic ones, necessitate the transfer of funds.
However, in international dealings, money often needs to be converted into currencies
different from the parties' national currencies. This conversion is facilitated by the Foreign
Exchange Market, a marketplace that accommodates the currency preferences of the
involved parties.

The Foreign Exchange Market handles all transactions involving the exchange of various
currencies. Within this market, currencies are traded against each other. The majority of
trading revolves around a select few currencies, including the US dollar, Japanese yen, British
pound sterling, Swiss franc, Canadian dollar, and Australian dollar. To put things in
perspective, the forex market's daily trading volume surpasses that of the New York Stock
Exchange (NYSE) in just one day compared to over two months.

In India, the Foreign Exchange Market is relatively small, with a daily turnover of about $5-
10 billion. This turnover comprises spot transactions accounting for approximately 50%,
outright forwards constituting 25%, and the remaining portion involving swap transactions.
The forex market operates globally, with major trading centres located in Tokyo, Singapore,
New York, Frankfurt, Zurich, and San Francisco, among others. These centres maintain
continuous communication, thanks to advanced telecommunications networks.

Banks, professional dealers, and brokers access exchange rate quotes through computer
screens and communicate using various means such as telephone, computer, fax, and telex.
This interconnected network ensures that a change in exchange rates in one centre has an
almost instantaneous impact on forex trading in other centres.

Unit 4: Exchange Rate Systems 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1.1 Learning Objectives

❖ Explain the evolution of foreign exchange market.
❖ Discuss the foreign exchange rate.
❖ Describe the exchange rate determination.
❖ To discuss how exchange rates are quoted in spot and forward markets.
❖ To discuss between nominal, real and effective exchange rates.
❖ To show how macroeconomic variables such as inflation rates, interest rate influences the
exchange rate.
❖ To show how covered/uncovered interest arbitrage takes place when interest rate
differential is not equal to forward rate differential.

Unit 4: Exchange Rate Systems 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. FOREX MARKET
The forex market, also known as the FX market or currency market, is a global decentralized
or over the counter (OTC) market for the trading of currencies. This market determines
foreign exchange rates for every currency. It includes all aspects of buying, selling and
exchanging currencies at current or determined prices. In terms of trading volume, it is by
far the largest market in the world, followed by the credit market.

The forex market operates 24 hours a day, five and a half days a week, and is responsible for
trillions of dollars in daily trading activity. Participants in the forex market include banks,
institutional investors, retail traders, and governments.

Why is the forex market important?

The forex market is important because it allows businesses and individuals to trade
currencies for a variety of reasons, including:
• To import and export goods and services.
• To invest in foreign markets
• To hedge against currency risk
• To speculate on currency movements

How does the forex market work?

The forex market is a decentralized market, meaning that there is no central exchange where
currencies are traded. Instead, currencies are traded over the counter (OTC) between two
parties. This means that buyers and sellers of currencies must agree on a price before a trade
can take place.

Forex trading can be complex and risky, but it can also be a rewarding way to make money.
If you are interested in trading forex, it is important to do your research and understand the
risks involved.

The current volume of trading of OTC based currency derivatives is estimated to be in the
trillions of dollars per day. The Bank for International Settlements (BIS) estimates that the
notional amount of outstanding OTC currency derivatives was $618 trillion at the end of
December 2022. This means that the daily turnover of OTC currency derivatives is likely to
be in the trillions of dollars.

Unit 4: Exchange Rate Systems 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The OTC currency derivatives market is very large and complex, and it is difficult to get
accurate data on the volume of trading. However, the BIS data suggests that the OTC currency
derivatives market is one of the largest financial markets in the world.

OTC currency derivatives are used by a wide range of participants, including banks,
institutional investors, corporations, and individuals. They are used for a variety of purposes,
including hedging against currency risk, speculating on currency movements, and gaining
exposure to foreign currencies.

The OTC currency derivatives market is a very important part of the global financial system.
It allows businesses and individuals to manage their currency risk and gain exposure to
foreign currencies. However, it is important to remember that OTC currency derivatives are
complex financial instruments, and there is a significant risk of loss.

The bid-ask quote in a bank for a currency transaction is the price at which the bank is willing
to buy and sell a particular currency. The bid price is the highest price that the bank is willing
to pay for a currency, and the ask price is the lowest price that the bank is willing to sell a
currency for.

For example, if a bank is quoting a bid-ask quote of 1.1000/1.1002 for the EUR/USD currency
pair, this means that the bank is willing to buy euros for 1.1000 US dollars per euro and sell
euros for 1.1002 US dollars per euro.

The spread between the bid and ask price is the bank's profit margin. In this example, the
bank's profit margin is 0.02 US dollars per euro.

The bid-ask quote in a bank for a currency transaction will vary depending on a number of
factors, including the currency pair being traded, the size of the transaction, and the current
market conditions.

Here are some tips for getting the best bid-ask quote from a bank:
• Shop around and compare quotes from different banks.
• Ask for a better price, especially if you are trading a large volume of currency.
• Be prepared to negotiate.
• Be aware of the current market conditions.

Unit 4: Exchange Rate Systems 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

It is also important to note that the bid-ask quote in a bank is not the same as the exchange
rate that you will see on a currency converter website. Currency converter websites typically
display the mid-market exchange rate, which is the average of the bid and ask price.

The bid-ask quote in a bank is important because it is the price at which you will actually be
able to buy and sell currency. It is therefore important to understand how bid-ask quotes
work and how to get the best possible quote from your bank.

3. DIRECT AND INDIRECT QUOTE IN CURRENCY TRANSACTION

In a foreign exchange market where different currencies are bought and sold, it is essential
to know the ratio between different currencies; or how many units of one currency will equal
one unit of another currency. The ratio between the two currencies is known as an exchange
rate. The methods of quoting exchange rates are both direct and indirect. A direct quote
gives the home-currency price of a certain amount of foreign currency, usually one or 100
units. If India quotes the exchange rate between the ₹ and US dollar in the direct way the
quotation will be written as ₹84/$. On the other hand, in the case of indirect quoting, the
value of one unit of home currency is presented in terms of foreign currency. If India adopts
1
indirect quotation, the banks India will quote the exchange rate as = 0.011905$/₹. If the
84

quotation is published in a third country to which neither of the two currencies belongs, the
usual practice is to put the stronger currency on the numerator. For example, if US Dollar-
INR rate is published in London, it will be quoted as US $ 0.011905/₹. In practice, method of
quotation varies from one market to another. Continental European dealers normally use
direct quote, while the indirect quote is used in London. Both methods are used in United
States of America.

A direct quote in foreign exchange (forex) is the price of a unit of foreign currency in terms
of the domestic currency. For example, a direct quote for the EUR/USD currency pair would
be 1.1000, which means that it would cost 1.1000 US dollars to buy one euro.

An indirect quote in forex is the price of a unit of domestic currency in terms of the foreign
currency. For example, an indirect quote for the EUR/USD currency pair would be 0.9091,
which means that it would cost 0.9091 euros to buy one US dollar.

Unit 4: Exchange Rate Systems 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Direct quotes are more commonly used in forex trading, as they are easier to understand and
use. However, indirect quotes can be useful for certain purposes, such as calculating the cost
of goods and services in a foreign country.

Type of
Description Example
quote
Direct The price of a unit of foreign currency in 1.1000 EUR/USD means that it costs
quote terms of the domestic currency. 1.1000 US dollars to buy one euro.
Indirect The price of a unit of domestic currency 0.9091 EUR/USD means that it costs
quote in terms of the foreign currency. 0.9091 euros to buy one US dollar.

Which type of quote is used depends on the country and the specific financial institution. For
example, in the United States, direct quotes are typically used for forex trading. However, in
some other countries, such as Japan, indirect quotes are more commonly used.

Hence, we can summarize the content about direct and indirect quote.

Direct Quote:
In a direct quote, the domestic currency is the base currency, and the foreign currency is the
counter currency. It tells you how much of the foreign currency you need to buy one unit of
the domestic currency.

For example, if the EUR/USD pair is quoted at 1.1000, it means one euro (EUR) can be
exchanged for 1.1000 US dollars (USD). This format is commonly used in currency trading.

Indirect Quote:
An indirect quote is the reverse of a direct quote. Here, the foreign currency is the base
currency, and the domestic currency is the counter currency. It tells you how much of the
domestic currency you need to buy one unit of the foreign currency.

Using the same example, if EUR/USD is quoted indirectly at 0.9091, it means one US dollar
(USD) can be exchanged for 0.9091 euros (EUR).

The choice between direct and indirect quotes depends on the context and the specific needs
of the transaction or financial analysis. Direct quotes are more common and straightforward,
especially in forex trading. They show how much of the foreign currency you can get with
one unit of the domestic currency.

Unit 4: Exchange Rate Systems 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Indirect quotes are less common but can be useful in certain scenarios, such as when
calculating costs for goods and services in foreign currencies or when analysing the relative
strength of a domestic currency in global markets.

Ultimately, whether you use a direct or indirect quote, it's essential to understand the
quoting method being used to avoid confusion in currency transactions.

4. BUYING AND SELLING RATES

Normally, two rates are published-one being the buying rate and the other the selling rate.
The buying rate is also known as the bid rate. The selling rate is known as the ask rate or
offer rate. The bid rate is always given first, followed by the ask rate quote. If the rupees-US
Dollar rate is ₹ 40.00-40.30/US $, then the former is the buying rate and the latter the selling
rate. In other words, the buying rate is the rate at which the banks purchase a foreign
currency from the customer. Suppose in India, a customer exchanges the US dollar at the
buying rate, which is at ₹ 40 a dollar. The selling rate, on the other hand, is the rate at which
the banks sell foreign currency to their customers. For example, a bank in India selling one
dollar to customer, will charge the selling rate, that is ₹ 40.30 per US Dollar. Since the banks
need to make a profit in these transactions, the selling quote is higher than the buying rate.
The difference between the two quotes forms the bank’s profit and is known as spread. In
the above example, the spread is ₹ 0.30 per US Dollar. The bid-ask spread is often stated in
percentage terms, and it can be computed as follows:

𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑖𝑑 𝑃𝑟𝑖𝑐𝑒

𝑆𝑝𝑟𝑒𝑎𝑑% = × 100
𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒

40.30−40
Thus, in the above example, 𝑠𝑝𝑟𝑒𝑎𝑑% = ( ) × 100 = 0.744%
40.30

The size of spread in respect of a currency depends upon many factors, like its strength, the
type of transaction, and its supply and demand position with the transacting bank. The
spread is smaller in a widely traded currency because it is easy for the banks to transact in
such a currency. In a scarcely traded currency, the bank have to face some difficulty, and
hence the spread is large. Again , for individuals and firms, the spread is bigger than for
banks, An individual and a firm buy a foreign currency at a higher rate and sells at a rate
lower than that quoted in the newspapers, although in big transactions, they get some relief.

Unit 4: Exchange Rate Systems 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Similarly, if the bank is temporarily short of a foreign currency, the spread will be larger
particularly if the demand for that foreign currency is high. On the contrary, if the supply
position of that foreign currency is comfortable, the spread will be lower.

Find the bid rate if the ask rate is ₹ 40.50/US $ and the bid-ask spread is 1.23%?

Solution=

𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑖𝑑 𝑃𝑟𝑖𝑐𝑒

𝑆𝑝𝑟𝑒𝑎𝑑% = × 100
𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒

40.50 − 𝑥
1.23 = × 100
40.5

1.23
× 40.50 = 40.50 − 𝑥
100

0.49815 = 40.50 − 𝑥

𝑥 = 40.50 − 0.49815

𝑥 = ₹ 40.00185/$

Unit 4: Exchange Rate Systems 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. FORWARD MARKET QUOTATION

The quotes for the forward market are also published in the newspapers and periodicals.
The quoting rates may be expressed as outright quotes, or as swap quotes. The outright
quote for the US Dollar in terms of the rupee can be written for different periods of forward
contracts as follows:

Spot One-month Three months

₹40.00-40.30 ₹39.80-40.20 ₹ 39.60-40.10

The swap quote, on the other hand, expresses only the difference between the spot quote
and the forward quote. It can be written as follows:

Spot One-month Three months

₹40.00-40.30 ₹ (20)-(10) ₹ (40)-(20)

Example: A foreign exchange trader gives the following quotes for the Euro Spot, one month,
three months and six months to a US based treasurer

$0.02368/70 4/5 8/7 14/12

Calculate the outright quotes for one, three and six months forward.
Solution: 1st Month: Since first (buy quote) is less than the second (sell quote) Currency is
trading at a premium. Hence points are added to the Spot rate.

3rd Month: Since first (buy quote) is greater than the second (sell quote) Currency is trading
at a discount. Hence points are deducted from the Spot rate.

6th Month: Since first (buy quote) is greater than the second (sell quote) Currency is trading
at a discount. Hence points are deducted from the Spot rate.

In outright terms these quotes would be expressed as mentioned below:

Since for one-month forward currency is at premium, so to get the bid and ask quotes, one
month bid forward quote is 0.02368+0.00004=0.02372 and similarly, the one month ask
forward quote is 0.02370+0.00005=0.02375.

0.02375−0.02372
Spread%= × 100 =0.126316%
0.02375

Unit 4: Exchange Rate Systems 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Spot Rate= $ 0.02368-0.02370 One-month FR=$ 0.02372-0.02375

Since for three months forward currency is at discount, so to get the bid and ask quotes, three
months bid forward quote is 0.02368-0.00008=0.02360. and similarly, the three months ask
forward quote is 0.02370-0.00007=$ 0.02363.

0.02363−0.0236
Spread% = ( ) × 100 = 0.126957%
0.02363

Since for six months forward currency is at discount, so to get the bid and ask quotes, six
months bid forward quote is 0.02368-0.00014=0.02354. and similarly, the three months ask
forward quote is 0.02370-0.00012=$ 0.02358.

0.02358−0.02354
Spread% = ( ) × 100 = 0.169635%
0.02358

Unit 4: Exchange Rate Systems 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. FORWARD PREMIUM AND DISCOUNT

In the above quotes, it is found that the longer the maturity, the greater is the change in
forward rates. Again, with longer maturity, the spreads too get wider. This is because of
uncertainty in the future that increases the lengthening of maturity. The change in forward
rates may be upwards or downwards. With such movements, disparity arises between the
spot and forward rates. This is known as the swap or forward rate differential. If the forward
rate is lower than the spot rate, it will be case of forward discount. On the contrary, if the
forward rate is higher than the spot rate, it would be known as forward premium. Forward
premium or discount is expressed as an annualized percentage deviation from the spot rate.
It is computed:

(𝑛 − 𝑑𝑎𝑦 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒) − (𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒) 360

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 (𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡)% = ×
𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑛

Or

(𝑛 − 𝑑𝑎𝑦 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒) − (𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒) 12

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 (𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡)% = ×
𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑚

Here m=number of months, where n is the number of days.

Problem: Find out the forward rate differential if spot rate of US $ is ₹ 45 and one-month
forward rate is ₹ 45.80?

Solution: Since here forward rate > spot rate so we get forward rate premium%.

45.80 − 45 12
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚% = ( )× × 100 = 21.33%
45 1

Problem: Find out the forward rate differential if spot rate of US $ is ₹ 45 and the forward
premium is 12%.

Solution; Here it is mentioned that forward rate is at premium so forward rate > spot rate .

(𝑛 − 𝑑𝑎𝑦 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒) − (𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒) 360

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 (𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡)% = ×
𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑛

Unit 4: Exchange Rate Systems 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

𝑥 − 45 12
12% = ( )×
45 1

45
0.12 × ( ) = 𝑥 − 45
12

0.45 = 𝑥 − 45

𝑥 = ₹ 45.45/$

Assume the following foreign exchange quotations are given for a 90 day contract. Calculate
the premium or discount on an annualized basis.

Solution: SR= $ 0.8576/£

FR = $ 0.8500/£

. 8500 – .8576 360

Forward Discount = ( )× × 100 = 3.54%
0.8576 90

7. CROSS-RATES
Sometimes the value of a currency in terms of another one is not known directly. In such
cases, one currency is sold for a common currency; and again, the common currency is
exchanged for the desired currency. This is known as cross rate trading and the rate
established between the two currencies is known as the cross-rate. Suppose a newspaper
quotes ₹ 35-35.20/US $; and at the same time, it quotes Canadian $ 0.76-0.78/US $ but does
not quote the exchange rate between the rupees and the Canadian dollar. Thus, the rate of
exchange between the rupee and the Canadian dollar will be found through the common
currency, the US Dollar. The technique is similar for both spot and forward cross rates.

Spot Cross Rates

The selling rate of the Canadian Dollar in India can be worked out by selling the rupee for the
US dollar at ₹ 35.20/$ and then buying Canadian Dollars with the US dollar at C$ 0.76/US $.
This means ₹ 35.20/US $ x US $ 1/C$ 0.76=₹ 46.32/C$

The buying rate of the Canadian Dollar in India can be found through buying the Indian rupee
for the US Dollar at ₹ 35.00/US $ and selling the Canadian Dollar for US Dollar at C$ 0.78/US
$. This mean that ₹ 35.00/US $ 1 x US $ 1/C$ 0.78=₹ 44.87/C$

Unit 4: Exchange Rate Systems 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Combining the two, we get ₹ 44.87-46.32/C$

Forward Cross Rate

In this case too, the selling rate of one currency is divided by the buying rate of another
currency and vice versa. Suppose one month forward rate in case of the two currencies is ₹
34.50-34.80/US $ and C$ 0.79-0.83/US $. The forward rate of the Canadian dollar in terms
of the rupee can be found as

₹ 34.80/C$ 0.79=₹ 44.05/C$

₹ 34.50/C$ 0.83=₹ 41.57/C$

Combining the two, we get ₹ 41.57-44.05/C$

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary function of the forex market?

a) To buy and sell goods and services
b) To invest in stocks and bonds
c) To trade currencies
d) To speculate on commodity prices
2. What is the primary reason for businesses and individuals to participate in the
forex market?
a) To import and export goods and services
b) To invest in real estate
c) To speculate on stock prices
d) To trade cryptocurrencies
3. What is the bid-ask spread in a currency transaction?
a) The difference between the buying and selling rates
b) The average exchange rate
c) The currency's market capitalization
d) The interest rate on a currency

Unit 4: Exchange Rate Systems 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. If a currency is trading at a premium in the forward market, what does this

mean?
a) The currency is stronger in the future.
b) The currency is weaker in the future.
c) The forward rate is higher than the spot rate.
d) The forward rate is lower than the spot rate.
5. How can cross rates be calculated when the direct exchange rate is not
available?
a) By using the average exchange rate
b) By directly exchanging the two currencies
c) By using a common currency
d) By referring to the central bank's rate
6. What is the key difference between a direct and an indirect forex quote?
a) The exchange rates they represent
b) The time horizon (spot or forward)
c) The currency they quote against
d) The bid-ask spread
7. Which method of quoting exchange rates is more commonly used in forex
trading?
a) Direct quote
b) Indirect quote
c) Both are equally used
d) It depends on the specific currency pair

Unit 4: Exchange Rate Systems 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. EVOLUTION OF FOREIGN EXCHANGE MARKET

The Foreign Exchange Market underwent significant changes in the 1970s as countries
worldwide transitioned from fixed exchange rates, as per the Bretton Woods system, to
floating exchange rates. According to the Bank for International Settlements (April 2007),
the daily average turnover in the global foreign exchange markets reached an estimated
$3.98 trillion. Within this, trading in the world's major financial markets contributed to $3.21
trillion. This $3.21 trillion turnover in the primary Foreign Exchange Market can be further
broken down as follows:
• $1.005 trillion in Spot transactions
• $362 billion in outright Forwards
• $1.714 trillion in foreign exchange Swaps
• An estimated $129 billion accounted for gaps in reporting.

Out of the $3.98 trillion in daily global turnover, London played a dominant role, accounting
for approximately $1.36 trillion, or 34.1% of the total, solidifying its status as the world's
leading hub for foreign exchange. New York followed in second place with 16.6%, while
Tokyo held the third position with 6.0%. Additionally, alongside "traditional" turnover,
derivatives trading amounted to $2.1 trillion.

The table below provides a list of the Top 10 Currency traders. These ten most active traders
collectively represent nearly 80% of the total trading volume, as per the 2008 Euromoney
FX survey.

Top Ten Currency Traders (2012)

Rank Name Volume

1 Deutsche Bank 15.64%
2 Barclay’s Bank 10.75%
3 UBS AG 10.59%
4 Citi 8.88%
5 JPMorgan 6.43%
6 HSBC 6.26%
7 Royal Bank of Scotland 6.20%
8 Credit Suisse 4.8%
9 Goldman Sachs 4.13%
10 Morgan Stanley 3.64%

Unit 4: Exchange Rate Systems 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The main trading centre is London, but New York, Tokyo, Hong Kong and Singapore are all
important centres as well. Banks throughout the world participate. Currency trading
happens continuously throughout the day; as the Asian trading session ends, the European
session begins, followed by the North American session and then back to the Asian session,
excluding weekends.

Communications, pertaining to international financial transactions, are handled mainly by a

large network called Society for Worldwide Interbank Financial Telecommunications
(SWIFT). This is a non-profit Belgian cooperative with main and regional centres around the
world connected by data transmission lines. Depending on the location, a bank can access a
regional processor or main centre which then transmits the information to the appropriate
location. This computer-based communications system links banks and brokers in every
financial centre. The banks and brokers are in almost instant contact, with activity in some
financial centre or other 24 hours a day. Because of the speed of communications, significant
events have almost instantaneous impact despite huge distances separating market
participants.

9. FUNCTIONS AND PARTICIPANTS OF THE FOREIGN EXCHANGE

MARKET
The Foreign Exchange Market, also known as the Forex market, serves as a global platform
where individuals, firms, and banks engage in the buying and selling of foreign currencies or
foreign exchange. In this market, each country has its own currency, which is used as the
standard unit for pricing goods and services. For instance, the United States uses the dollar,
the United Kingdom uses the pound, Japan uses the yen, and Euro is used in European
member countries.

The primary function of the Foreign Exchange Market is to facilitate the transfer of funds
from one nation and currency to another. This transfer of purchasing power is crucial
because international trade and capital transactions often involve parties located in
countries with different national currencies. While each party prefers to trade in their own
currency, practicality dictates that they agree on a single currency for invoicing purposes,
often opting for a widely accepted currency like the US dollar. For example, if an Indian
exporter sells machinery to a UK importer, they can invoice in pounds, rupees, or even US
dollars.

Unit 4: Exchange Rate Systems 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Another important role of the Foreign Exchange Market is to mitigate Foreign Exchange Risk
by performing hedging functions, which help protect against unexpected changes in foreign
exchange rates.

Now, let's explore why individuals, firms, and banks have a need to exchange one national
currency for another. The demand for foreign currencies arises in various scenarios, such as
when tourists travel to another country and require the local currency, when domestic firms
want to import goods from other nations, when individuals wish to make foreign
investments, and so on. Conversely, a nation's supply of foreign currencies originates from
activities like foreign tourists spending money in the country, earnings from exports,
receipts from foreign investments, and similar transactions.

For instance, if a US firm exports goods to the UK and is paid in pounds sterling (the UK
currency), they will exchange these pounds for dollars at a commercial bank. The
commercial bank will then sell these pounds to a US resident who plans to visit the UK, a US
firm importing goods from the UK and paying in pounds, or a US investor looking to invest
in the UK and needing pounds for the investment.

In essence, a nation's commercial banks play a critical role in serving as intermediaries,

clearing houses, for the exchange of foreign currencies demanded and supplied by the
nation's residents in the context of foreign transactions. Without this function, transactions
requiring foreign currencies would be inefficient and time-consuming, resembling a barter
system.

Commercial banks that find themselves with an excess supply of a foreign currency will sell
these surplus funds (often through intermediary foreign exchange brokers) to commercial
banks that have a shortage of that currency and need it to fulfill their customers' demands.

In summary, a nation finances its foreign expenditures like tourism, imports, and overseas
investments using its foreign exchange earnings from activities such as tourism, exports, and
foreign investments. If a nation's total demand for foreign exchange surpasses its earnings,
exchange rates between currencies must adjust to balance the quantities demanded and
supplied. Failure to allow such adjustments could lead to commercial banks borrowing from

Unit 4: Exchange Rate Systems 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

the nation's central bank, which would then act as the lender of last resort and deplete its
foreign exchange reserves.

Conversely, if a nation generates an excess supply of foreign exchange in its international

transactions, this surplus would be exchanged for the national currency at the nation's
central bank, thereby increasing the country's foreign currency reserves.

In conclusion, the Foreign Exchange Market involves four levels of participants: immediate
users and suppliers of foreign currencies (tourists, importers, exporters, investors, etc.) at
the first level, commercial banks acting as intermediaries at the second level, foreign
exchange brokers at the third level, and the nation's central bank as the lender or buyer of
last resort at the fourth and highest level. These levels work together to facilitate the efficient
exchange of foreign currencies in international transactions while maintaining the stability
of a nation's foreign exchange reserves.

10. HEDGING, SPECULATION AND ARBITRATION

Hedging is a risk management strategy that involves taking an offsetting position in a market
in order to reduce the risk of adverse price movements in another market. For example, a
company that exports goods to Europe might hedge its currency risk by buying euro forward
contracts. This would allow the company to lock in a fixed exchange rate for its future euro
earnings, regardless of what happens to the euro exchange rate in the spot market.

Speculation is the act of buying or selling an asset in the hope of making a profit from a price
change. Speculators are willing to take on risk in order to potentially generate higher returns.
For example, a currency speculator might buy euros in the hope that the euro will appreciate
against the dollar.

Arbitrage is the act of exploiting price discrepancies between identical or similar assets in
two or more markets. Arbitrageurs buy assets in one market and sell them in another market
for a profit. For example, a forex arbitrageur might buy euros from one broker and sell them
to another broker for a slightly higher price.

Unit 4: Exchange Rate Systems 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Characteristic Hedging Speculation Arbitrage

Goal Reduce risk Make a profit Exploit price discrepancies
Risk level Low Medium to high Very low
Short-term or long-
Timeframe term Short-term or long-term Short-term

A currency speculator
A company buys buys euros in the hope A forex arbitrageur buys euros
euro forward that the euro will from one broker and sells
contracts to hedge appreciate against the them to another broker for a
Example its currency risk. dollar. slightly higher price.

Bankers and traders use currency derivatives to hedge against currency risk in a number of
ways, including:
• Forwards and futures: Forwards and futures contracts are used to lock in a fixed
exchange rate for a future transaction. This can be useful for businesses that import or
export goods or services, as it allows them to budget more effectively and avoid losses
due to unexpected changes in the exchange rate.
• Swaps: Currency swaps are used to exchange cash flows in one currency for another.
This can be used to hedge against interest rate risk or to gain exposure to a foreign
currency without having to physically buy or sell it.
• Options: Currency options give the holder the right, but not the obligation, to buy or sell
a foreign currency at a predetermined price on or before a future date. This can be used
to hedge against currency risk or to speculate on currency movements.

The specific hedging strategy that a banker or trader uses will depend on their individual
needs and risk tolerance. However, all of these strategies involve using currency derivatives
to offset the risk of adverse price movements in the foreign exchange market.

Here are some examples of how bankers and traders might use currency derivatives to hedge
against currency risk:
• A US importer of Japanese goods might buy a forward contract for Japanese yen to lock
in the exchange rate for its future payments.
• A European exporter of goods to the US might sell a currency swap to convert its future
US dollar earnings into euros.

Unit 4: Exchange Rate Systems 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• A US investor with a portfolio of Japanese stocks might buy a currency option to protect
themselves against a decline in the value of the yen.

Currency derivatives can be a complex and risky way to manage currency risk, but they can
also be very effective. Bankers and traders who use currency derivatives effectively can
protect their businesses and clients from losses due to unexpected changes in the exchange
rate.

It is important to note that hedging is not a guarantee against loss. If the exchange rate moves
against the hedger, they may still lose money. However, hedging can help to reduce the risk
of large losses.

11. ARBITRATION IN FOREX MARKET

Forex arbitrage is the act of exploiting tiny price discrepancies between identical or similar
assets in two or more markets. In the context of the forex market, this means buying and
selling currency pairs to profit from small differences in their exchange rates.

Forex arbitrage can be carried out in a number of ways, but the most common method is to
use two different forex brokers. For example, if one broker is offering a bid price of 1.1000
for the EUR/USD currency pair and another broker is offering an ask price of 1.1002, an
arbitrage trader could buy the EUR/USD from the first broker and sell it to the second broker
for a profit of 2 pips.

Another form of forex arbitrage is known as triangular arbitrage. This involves buying and
selling three different currency pairs in a specific order to profit from a mispricing in the
exchange rates. For example, an arbitrage trader could buy the EUR/USD currency pair, sell
the USD/JPY currency pair, and then buy the JPY/EUR currency pair. If the exchange rates
are mispriced, the arbitrage trader will be able to make a profit on the overall trade.

Forex arbitrage is a complex and risky trading strategy, but it can be profitable for
experienced traders. However, it is important to note that forex arbitrage opportunities are
rare and short-lived. As soon as an arbitrage opportunity is identified, it is typically exploited
by other traders and the price discrepancy disappears.

Unit 4: Exchange Rate Systems 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Here are some of the challenges of forex arbitrage:

• Transaction costs: Arbitrage traders need to be able to execute trades quickly and
efficiently in order to profit from small price discrepancies. This can be difficult to do,
especially during periods of high volatility.
• Liquidity: Arbitrage traders need to have access to deep liquidity in order to execute
their trades quickly and at the best possible prices. This can be difficult to do, especially
for less popular currency pairs.
• Risk: Arbitrage trading is a risky strategy, even for experienced traders. There is always
the risk that the price discrepancy will disappear before the trader can execute their
trade, or that the trader will lose money due to slippage or other factors.

12. INTEREST RATE PARITY (IRP)

Interest rate parity (IRP) is a theory in international finance that states that the interest rate
differential between two countries is equal to the differential between the forward exchange
rate and the spot exchange rate. This means that investors should be able to earn the same
return on comparable assets in different countries, regardless of the interest rates, by
hedging their currency exposure.

IRP can be expressed mathematically as follows:

1 + 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐼𝑅
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 = 𝑆𝑝𝑜𝑡 𝐸𝑥𝑐ℎ𝑛𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 × ( )
1 + 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝐼𝑅
where:
• F is the forward exchange rate
• S is the spot exchange rate
• Domestic IR is the domestic interest rate.
• Foreign IR is the foreign interest rate.

IRP can be used to explain the relationship between interest rates and exchange rates in a
number of ways. For example, if interest rates in one country are higher than in another, the
forward exchange rate for that currency will tend to be weaker than the spot exchange rate.
This is because investors will be willing to pay a premium to buy foreign currency in order
to invest in the higher-yielding country.

Unit 4: Exchange Rate Systems 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

IRP can also be used to identify arbitrage opportunities. If the forward exchange rate does
not equal the expected spot exchange rate, investors can profit by buying or selling the
currency. For example, if an investor believes that the dollar will appreciate against the euro,
they could buy euros in the forward market and then sell them in the spot market at a later
date.

IRP is an important theory in international finance, but it is important to note that it does not
always hold perfectly. There are a number of factors that can cause deviations from IRP, such
as transaction costs, risk premiums, and government intervention.

Here is an example of how IRP can be used to explain the relationship between interest rates
and exchange rates:
• Assume that the spot exchange rate between the US dollar and the euro is 1 USD = 1
EUR.
• Assume that the US interest rate is 2% and the euro interest rate is 1%.
• According to IRP, the forward exchange rate for the euro should be 1 USD = 1.01 EUR.

This means that investors can expect to receive a 1% return on their investment if they buy
euros at the spot exchange rate, invest them in euro-denominated assets for one year, and
then sell them back into dollars at the forward exchange rate.

However, if the forward exchange rate is different from 1 USD = 1.01 EUR, this presents an
arbitrage opportunity. For example, if the forward exchange rate is 1 USD = 1.02 EUR,
investors could profit by buying euros at the spot exchange rate, investing them in euro-
denominated assets for one year, and then selling them back into dollars at the forward
exchange rate.

In practice, there are a number of factors that can prevent arbitrage opportunities from being
exploited. For example, there are transaction costs associated with buying and selling
currencies, and there is also the risk that the exchange rate could move against the investor.
Additionally, governments may intervene in the foreign exchange market to prevent their
currency from appreciating or depreciating too sharply.

Unit 4: Exchange Rate Systems 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

8. What significant change did the Foreign Exchange Market undergo in the
1970s?
a) Transition from floating exchange rates to fixed exchange rates
b) Transition from the gold standard to the Bretton Woods system
c) Transition from floating exchange rates to fixed exchange rates
d) Transition from barter systems to currency trading
9. Which city plays a dominant role in the global foreign exchange market,
accounting for approximately 34.1% of the total daily turnover?
a) New York
b) Tokyo
c) Hong Kong
d) London
10. What is the primary function of the Foreign Exchange Market?
a) To make a profit through currency trading
b) To facilitate the transfer of funds from one currency to another
c) To set fixed exchange rates for all currencies
d) To regulate international trade
11. Which of the following is NOT one of the functions of the Foreign Exchange
Market mentioned in the text?
a) Facilitating international trade
b) Mitigating foreign exchange risk
c) Making a profit through speculation
d) Transferring purchasing power between nations
12. What is the primary goal of hedging in the context of currency trading?
a) To make a profit from currency price movements
b) To reduce the risk of adverse price movements in another market
c) To engage in arbitrage trading
d) To exploit small differences in exchange rates

Unit 4: Exchange Rate Systems 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. How does forex arbitrage typically work in the foreign exchange market?
a) By buying and selling currency pairs to profit from small differences in their
exchange rates
b) By holding onto a currency and waiting for it to appreciate
c) By investing in long-term foreign exchange options
d) By speculating on the future exchange rate direction
14. What is the concept of Interest Rate Parity (IRP) in the context of the foreign
exchange market?
a) It is the theory that interest rates in different countries are never equal.
b) It is the idea that investors can earn the same return on comparable assets
in different countries by hedging their currency exposure.
c) It is the belief that forward exchange rates are always stronger than spot
exchange rates.
d) It is a government policy to control interest rates in the foreign exchange
market.

Unit 4: Exchange Rate Systems 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. COVERED INTEREST RATE ARBITRATION

Covered interest rate arbitrage (CIRA) is a trading strategy that exploits the difference in
interest rates between two countries by hedging the currency risk involved. It is a relatively
low-risk strategy, but it can also generate relatively low returns.

To execute a CIRA trade, an investor would first borrow money in the country with the lower
interest rate and invest it in the country with the higher interest rate. The investor would
then hedge the currency risk by selling the forward contract for the currency of the
investment.

For example, suppose that the interest rate in the United States is 2% and the interest rate
in Japan is 0.1%. An investor could borrow money in the United States at 2% and invest it in
Japan at 0.1%. The investor would then sell a forward contract for the Japanese yen to hedge
the currency risk.

If the Japanese yen appreciates against the US dollar, the investor would make a profit on the
forward contract. However, the investor would still earn a positive return on the investment,
even if the Japanese yen depreciates against the US dollar. This is because the interest rate
in Japan is higher than the interest rate in the United States.

CIRA can be a profitable trading strategy, but it is important to note that it is not risk-free.
There is always the risk that the exchange rate will move against the investor, even if they
have hedged their currency risk. Additionally, there are transaction costs associated with
borrowing money, investing it in a foreign country, and hedging the currency risk.

Here are some of the advantages and disadvantages of CIRA:

Advantages:
• Relatively low-risk strategy
• Can generate positive returns, even if the exchange rate moves against the investor.

Disadvantages:
• Relatively low returns
• Transaction costs
• Currency risk, even if hedged.

Unit 4: Exchange Rate Systems 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

If the forward rate differential is not equal to the interest rate differential, covered interest
arbitrage will begin and it will continue till the two differentials become approximately
equal. In other words, a positive interest rate differential in a country is offset by annualized
forward discount. A negative interest rate differential is offset by an annualized forward
premium. Finally, the two differentials will be equal. In fact, this is the point where the
forward rate is determined. To explain the process of covered interest arbitrage, suppose the
spot rate is ₹ 40/$ and the three-month forward rate is ₹ 40.28/$ involving a forward
differential of 2.8%. The interest rate is 18% in India and 12% in the United States of America
involving interest rate differential of 5.37%. Since the two differentials are not equal, covered
interest arbitrage will begin. The successive steps shall be as follows:-
• Borrowing in the United States of America, say $ 1000 at 12% interest. Interest expect
12 3
to pay on borrowing is 1000 × 100 × 12 = 30$. Amount to pay back after 3 month is

1030 $.
• Converting the US dollar into the ₹ at spot rate to get ₹ 40,000.
• Assuming no transaction cost and no inter-country currency barrier, sell the rupee 90-
day forward at ₹ 40.28/$ or ₹ 40,000 thus obtained can be invested in India at 18% per
18 3
annum for 3 months. Interest receives on investment=40,000 × 100 × 12 = 400 × 18 ×
1
= 1800₹
4

• Thus the amount received on investment is 40,000+1800=₹ 41,800.

41800
• Selling ₹41,800 for US dollar at the rate of 40.28₹/$ to get = 1037.736 $
40.28

• 1037.736$ received on a commitment of 1030$, arbitration gain =1037.736-

1030=7.736$

So long as inequality continues between the forward rate differential and the interest rate
differential, arbitrageurs will profit, and the process of arbitrage will go on. But with this
process, the differential will be wiped out for the following reasons:
1. Borrowing in the United States of America will raise interest rates there.
2. Investing in India would increase the invested funds and thereby lower the interest rate
there.
3. Buying rupees at spot rate will increase spot rate of the rupees.
4. Selling rupees forward will depress the forward rate of the rupees.

Unit 4: Exchange Rate Systems 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The first two actions narrow the interest rate differential, while third and fourth widen the
forward rate differential. However, the real-life experience shows that the two differentials-
interest rate and forward rate- are equal only approximately and not precisely. It is because
the interest rate parity theorem assumes no transaction cost, no tax rate differences and
political stability. But the assumptions do not hold in real life. First of all, there is always
transaction cost involved in selling a currency spot and buying it forward. The transaction
cost, which is manifest in the bid-ask spread, forces forward rate differential to deviate from
the expected one. The transaction cost, which is involved also in borrowing and investing,
influences the effective interest rate and thereby the interest rate differential. Secondly,
there is disparity in the tax rate on interest income in different countries. Such a disparity
allows the interest rate differential to deviate from the expected one. Last but not the least,
if there is a political unrest in the country where the funds are invested, the cost of
investment will be greater, and this will influence the interest rate differential.

14. UNCOVERED INTEREST RATE ARBITRATION

Uncovered interest rate arbitrage (UIRA) is a trading strategy that exploits the difference in
interest rates between two countries without hedging the currency risk involved. It is a
higher-risk strategy than covered interest rate arbitrage (CIRA), but it can also generate
higher returns.

To execute a UIRA trade, an investor would simply borrow money in the country with the
lower interest rate and invest it in the country with the higher interest rate. The investor
would not hedge the currency risk, so they would be exposed to the possibility of losing
money if the exchange rate moves against them.

For example, suppose that the interest rate in the United States is 2% and the interest rate
in Japan is 0.1%. An investor could borrow money in the United States at 2% and invest it in
Japan at 0.1%. If the Japanese yen depreciates against the US dollar, the investor would lose
money on the investment, even though they are earning a higher interest rate in Japan.
However, if the Japanese yen appreciates against the US dollar, the investor would make a
significant profit.

Unit 4: Exchange Rate Systems 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

UIRA can be a profitable trading strategy, but it is important to note that it is very risky. The
investor is exposed to the full extent of the currency risk, which can be significant.
Additionally, there are transaction costs associated with borrowing money, investing it in a
foreign country, and bearing the currency risk.

Here are some of the advantages and disadvantages of UIRA:

Advantages:
• Can generate high returns.

Disadvantages:
• Very high risk
• Currency risk
• Transaction costs

UIRA is a complex and sophisticated trading strategy, and it is important to understand the
risks involved before engaging in it. Investors should also have a good understanding of the
forex market and how it works.

When one talks about interest arbitrage, it would be worthwhile to note that interest
arbitrage may not be only covered, it may also be uncovered. However, in an uncovered
interest arbitrage, the arbitrageur does not take advantage of the forward market and does
not go for any forward contract for reaping profit. Rather the decision behind profit making
depends upon the expectation about the future spot rate, in as much as the interest rate
differential between two countries leads to changes in future spot rate. If interest rate
differential is equal to the changes in the future spot rate, uncovered interest parity will exist.
This can be represented in the form of equation:

1 + 𝑅𝑎 𝑆(𝑒 + 1) − 𝑆
=
1 + 𝑅𝑏 𝑆
Where S(e+1) is the expected future spot rate, Ra and Rb are the interest rates in Country A
and Country B.

So long as equality is not reached, the arbitrageur will go for uncovered interest arbitrage
and reap profits. Suppose the interest rate on the Indian treasury bill is 7% and that on the
UK Treasury bill is 4% and so the interest rate differential is 2.88%. If the investor expects a

Unit 4: Exchange Rate Systems 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

depreciation of 4% in the future spot rate of Indian rupee, he/she will invest in the UK
Treasury bill because a fixed amount of British pound will fetch greater amount of Indian
rupee at a future date. This will go on till the two differentials are equal. This is uncovered
interest arbitrage.

15. IMPACT OF INFLATION

It is normally the inflation rate differential between the two countries that influences the
exchange rate between the two currencies. The influence of inflation rate finds a nice
explanation in the Purchasing Power Parity (PPP) theory. This theory suggests that at any
given time, the rate of exchange between the two currencies is determined by their
purchasing power. If e is the exchange rate and PA and PB are the purchasing power of two
𝑃
currencies, A and B, the equation can be written as 𝑒 = 𝑃𝐴 . Prior to 1914, the purchasing
𝐵

power of a unit of currency was reckoned in terms of gold. The principle applies even today,
but now it is reckoned in terms of tradable commodities. As a corollary, a country is
experiencing higher inflation will experience a corresponding depreciation of its currency,
while a country with lower inflation rate will experience an appreciation in the value of its
currency. In fact, this theory is based on the theory of one price in which domestic price of
any good equals its foreign price quoted in the same currency. For instance, if the exchange
rate is ₹ 2/$ , price of particular commodity if in india is ₹ 100 must be 50$ in the United
States of America. In other words, US $ price of a commodity X price of US $=Rupee price of
the commodity.

If inflation in one country causes a temporary deviation from the equilibrium, arbitrageurs
will begin operating and, as a result, equilibrium will be restored through changes in the
exchange rate. Suppose the price of a commodity soars in India to ₹ 125, the arbitrageurs
will but that commodity in the United States of America and sell it in India to earn a profit of
₹ 25. This will go on till the exchange rates moves to ₹ 2.5/US $ and the profit potential of
arbitrage is eliminated. The exchange rate adjustment as a sequel to inflation may be further
explained. Thus, if the Indian commodity turns costlier, its export will fall. At the same time,
the import price being cheaper, its import from the United States of America will expand.
Higher import will raise the raise the demand for the US Dollar in turn raising its value via-
a-vis the rupee. However, this version of the theory, which is known as the absolute version,

Unit 4: Exchange Rate Systems 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

holds good if the same commodities are included in the same proportion in the domestic
market basket and the world market basket. If it is not, PPP theory will not hold good despite
the law of one price holding good. Moreover, this theory does not cover the non-traded goods
and services where transaction cost is significant. In the view of the above limitations,
another version of this theory has evolved which is known as relative version of the PPP
theory. The relative version states that a change in exchange rate that would retain the
original level of relative price of tradable to non-tradable goods in the economy, would
establish an equilibrium exchange rate. It further states that the exchange rate between
currencies of any two countries should be a constant multiple of the general price indices
prevailing in them. In other words, percentage change in exchange rate should equal the
percentage change in the ratio of price indices in the two countries.

𝑒𝑡 (1 + 𝐼𝑎)𝑡
=( )
𝑒𝑜 (1 + 𝐼𝑏)𝑡

Where IA and IB are the rates of inflation in country A and country B, eo is the value of A’s
currency in terms of one unit of B’s currency in the beginning of the period, et is the spot
exchange rate in period t. Such an inflation adjusted rate is known as the real exchange rate.

16. PURCHASING POWER PARITY MODEL

The purchasing power parity (PPP) model is a macroeconomic theory that states that the
exchange rate between two currencies should be equal to the ratio of their purchasing
powers. In other words, a good or service should cost the same in both countries, when the
prices are converted using the PPP exchange rate.

The PPP model is based on the law of one price, which states that identical goods and services
should sell for the same price in all markets, once exchange rates and transportation costs
are taken into account. In practice, the law of one price does not always hold perfectly, but
the PPP model provides a useful benchmark for comparing the purchasing power of different
currencies.

To calculate the PPP exchange rate between two currencies, economists typically compare
the prices of a basket of goods and services in both countries. This basket of goods and

Unit 4: Exchange Rate Systems 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

services is typically designed to be representative of the consumption patterns of households

in each country.

Once the PPP exchange rate has been calculated, it can be used to compare the living
standards of different countries. For example, if the PPP exchange rate between the US dollar
and the Indian rupee is 1 USD = 100 INR, then this means that the same basket of goods and
services that costs 100 USD in the United States would cost 100 INR in India.

The PPP model is a useful tool for economists and policymakers, but it is important to note
that it is not a perfect measure of living standards. There are a number of factors that can
affect the PPP exchange rate, such as the quality of goods and services, transportation costs,
and trade barriers.

Here are some examples of how the PPP model can be used:
• A company can use the PPP model to compare the cost of labor and other inputs in
different countries when making decisions about where to locate its operations.
• A tourist can use the PPP model to get an idea of how much their money will be worth
in a foreign country.
• An economist can use the PPP model to compare the living standards of different
countries and to study the effects of economic policies.

The PPP model is a complex and sophisticated tool, but it can be a valuable resource for
anyone who wants to understand how exchange rates work and how they affect the global
economy.

Unit 4: Exchange Rate Systems 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

17. SUMMARY
• Foreign exchange is essentially about exchanging one Currency for another. The
complexity arises from three factors. Firstly, what is the foreign exchange exposure,
secondly, what will be the rate of exchange, and thirdly, when does the actual exchange
occur.
• Foreign exchange exposures arise from many different activities. A traveller going to
visit another country has the risk that if that country’s Currency appreciates against
their own, their trip will be more expensive.
• An exporter who sells his product in foreign Currency has the risk that if the value of
that foreign Currency falls then the revenues in the exporter’s home Currency will be
lower.
• An importer who buys goods priced in foreign Currency has the risk that the foreign
Currency will appreciate thereby making the local Currency cost greater than expected.
• The most, basic tools in the FX market are Spot rates and forward rates. In any FX
contract there are a number of variable that need to be agreed upon.
• A deal can be performed with a maturity of two business days ahead – a deal done on
this basis is called a Spot deal.
• In a Spot transaction the Currency that is bought will be receivable in two days whilst
the Currency that is sold will be payable in two days. This applies to all major
currencies. However most market participants want to exchange the currencies at a
time other than two days in advance but would like to know the rate of exchange now.
This rate is referred to as the forward rate.
• Interbank quotations are given a Bid and ask (offer) price. A Bid is the price in one
Currency at which a dealer will buy another Currency. An offer or ask is the price at
which a dealer will sell the other Currency. As the Bid-ask spread between leading
currencies is quite small, it allows market participants to implement sophisticated risk
management strategies.

Unit 4: Exchange Rate Systems 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

18. TERMINAL QUESTIONS

1. Why do companies involved in international trade have to hedge their foreign exchange
exposure?
2. Should an exporter use the Spot rate or forward rate for quotation?
3. Is devaluation good for exports and imports? Why is the impact of devaluation usually
not immediate?
4. What problems do you think you would face as a business trying to operate in two
foreign exchange markets?
5. What risks confront dealers in the Foreign Exchange Market? How can they cope with
those risks?
6. Assume that the Spot rate of the British pound is $1.70. The expected Spot rate one year
from now is assumed to be $1.68. What percentage depreciation does this reflect?
7. What are foreign exchange markets? What is their most important function? How is this
function performed? What are the four different levels of participants in foreign
exchange markets? What are the other functions of foreign exchange markets?
8. Differentiate between Speculation and Hedging. Also, discuss the appropriate role for
each in the equity market.
9. The Spot rate for the Deutschmark in New York is $0.41. (a) What should the Spot price
for the US dollar be in Frankfurt? (b) Should the dollar be quoted at DM 2.50 in
Frankfurt, how would the market react?
10. Who is authorised to exchange foreign Currency?

Unit 4: Exchange Rate Systems 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

19. ANSWERS
Self-Assessment Questions
1. c. To trade currencies
2. a. To import and export goods and services
3. a. The difference between the buying and selling rates
4. c. The forward rate is higher than the spot rate.
5. c. By using a common currency
6. c. The currency they quote against
7. a. Direct quote
8. c) Transition from fixed exchange rates to floating exchange rates
9. d) London
10. b) To facilitate the transfer of funds from one currency to another
11. c) Making a profit through speculation
12. b) To reduce the risk of adverse price movements in another market
13. a) By buying and selling currency pairs to profit from small differences in their exchange
rates
14. b) It is the idea that investors can earn the same return on comparable assets in different
countries by hedging their currency exposure.
Terminal Questions
Answer 1: Companies involved in international trade hedge their foreign exchange exposure
to mitigate risks associated with currency fluctuations. Fluctuations in exchange rates can
affect the profitability of international transactions, as they can impact the cost of goods,
revenues, and profits. By hedging, companies aim to protect themselves from adverse
exchange rate movements and ensure more predictable financial outcomes.

Answer 2: An exporter can use either the spot rate or forward rate for quotation, depending
on their specific needs and risk tolerance.
• Spot Rate: Using the spot rate means quoting the price of the goods or services in the
current exchange rate. This provides immediate certainty regarding the transaction
amount.
• Forward Rate: Quoting based on the forward rate involves locking in a future exchange
rate, which can protect against adverse currency movements over time. Exporters may

Unit 4: Exchange Rate Systems 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

use forward rates if they want to secure a specific exchange rate for a future
transaction.

Answer 3: Devaluation can have mixed effects on exports and imports:

• Devaluation is generally good for exports as it makes a country's goods and services
cheaper for foreign buyers, potentially increasing demand.
• Devaluation can be bad for imports as it makes foreign goods more expensive for
domestic consumers.
• The impact of devaluation is not immediate due to various factors like existing
contracts, supply chains, and the time it takes for consumers and businesses to adjust
to the new prices. It may take some time for the full impact to be felt.

Answer 4: Operating in two foreign exchange markets can pose several challenges,
including:
• Exchange Rate Risk: Managing exposure to fluctuations in multiple currencies can be
complex.
• Regulatory Compliance: Adhering to the rules and regulations of two different markets
can be burdensome.
• Accounting and Reporting: Handling multiple currencies may complicate financial
reporting and accounting.
• Operational Complexity: Dealing with different time zones, trading hours, and market
dynamics can be challenging.

Answer 5: Risks confronting dealers in the Foreign Exchange Market include market risk,
credit risk, operational risk, and liquidity risk. They can cope with these risks through risk
management strategies, including diversification, setting risk limits, using hedging
instruments, and maintaining robust internal controls and compliance procedures.

1.7−1.68 0.02
Answer 6: 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛% = ( ) × 100 = ( 1.7 ) × 100 = 1.176%
1.7

Answer 7: Foreign exchange markets are where currencies are bought and sold. Their most
important function is to facilitate international trade and investment by providing a
mechanism for exchanging one currency for another. This function is performed through a

Unit 4: Exchange Rate Systems 38

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

network of financial institutions, brokers, and electronic platforms. The four levels of
participants in foreign exchange markets are:
Level 1: Interbank Market (largest banks and financial institutions).
Level 2: Wholesale Market (smaller banks, corporations, and financial institutions).
Level 3: Retail Market (commercial entities and individual traders).
Level 4: Exchange-Traded Market (currency futures and options markets).

Other functions of foreign exchange markets include price discovery, risk management, and
speculation.

Answer 8: Differentiate between Speculation and Hedging:

Speculation involves taking positions in the financial markets with the expectation of
profiting from price movements. It is a risk-seeking strategy aimed at capitalizing on market
fluctuations.

Hedging, on the other hand, involves taking positions to protect against or reduce risk. It is a
risk-averse strategy aimed at minimizing the impact of adverse price movements. In the
equity market, investors may hedge their portfolios to limit losses during market downturns,
while speculators seek to profit from market movements.

Answer 9: (a) The Spot price for the US dollar in Frankfurt should be the reciprocal of the
spot rate in New York, which is $0.41. Therefore, the Spot price for the US dollar in Frankfurt
should be 1/0.41 = DM 2.44.

(b) If the dollar is quoted at DM 2.50 in Frankfurt, it would be overvalued in Frankfurt

compared to New York, where the spot rate is $0.41. This could create arbitrage
opportunities, leading to market participants buying dollars in New York and selling them in
Frankfurt, which would likely drive the exchange rate back towards its equilibrium level of
DM 2.44.

Answer 10: Authorized entities to exchange foreign currency can vary by country and local
regulations. Typically, banks, currency exchange bureaus, and financial institutions are
authorized to exchange foreign currency. In some places, government agencies may also play
a role in regulating and authorizing foreign currency exchange. It's important to comply with
local laws and regulations when exchanging foreign currency.

Unit 4: Exchange Rate Systems 39

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISATRION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 5: Derivatives 1
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 5
Derivatives
Table of Contents

SL Fig No / Table SAQ /

Topic Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 History of Derivatives - - 5-6
3 Forward Contract - - 7-8
4 Valuation of Forward Contract - - 8-9
5 Future Contract - - 10-11
6 Initial Margin and Maintenance Margin in - - 12-13
Future Contract
7 Difference between Forward Contract and - 1 13-16
Future Contract
8 Currency forwards and currency futures - - 17-19
9 Importance of currency future in hedging by - - 19-20
banks and corporates
10 Understanding Option Contract - - 20-21
11 American and European Option - - 22-23
12 Valuation of Option Contract - 2 23-30
13 Forward Rate Agreement (FRA) - - 31
14 SWAP Agreement - - 32-33
15 Difference between Interest Rate Swap and - - 33-35
Currency Swap
16 Summary - - 35-39
17 Terminal Questions - - 39-40
18 Answers - - 40-42

Unit 5: Derivatives 2
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
A derivative is a financial contract whose value is derived from the underlying asset, index,
or rate. The underlying asset can be a stock, bond, commodity, currency, or interest rate.
Derivatives are used to hedge against risk, speculate on prices, or gain exposure to an asset
without having to own it directly.

There are four main types of derivatives:

• Forwards: A forward contract is a private agreement between two parties to buy or sell
an asset at a predetermined price on a future date.
• Futures: A futures contract is a standardized forward contract that is traded on an
exchange.
• Options: An option contract gives the buyer the right, but not the obligation, to buy or
sell an asset at a predetermined price on or before a future date.
• Swaps: A swap contract is an agreement between two parties to exchange cash flows
based on the performance of an underlying asset.

Derivatives can be complex and risky, so it is important to understand how they work before
using them.

Here are some of the benefits of using derivatives:

• Hedging: Derivatives can be used to hedge against risk. For example, a company that
produces wheat could use a futures contract to lock in a selling price for its wheat in
the future. This would protect the company from a decline in the price of wheat.
• Speculation: Derivatives can be used to speculate on prices. For example, an investor
could buy a futures contract on oil if they believe that the price of oil is going to rise. If
the price of oil does rise, the investor will make a profit on their futures contract.
• Gaining exposure to an asset: Derivatives can be used to gain exposure to an asset
without having to own it directly. For example, an investor could buy a call option on a
stock if they believe that the price of the stock is going to rise. If the price of the stock
does rise, the investor can exercise their option and buy the stock at the strike price.

Unit 5: Derivatives 3
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

However, derivatives also have risks, including:

• Market risk: The value of a derivative can fluctuate with the value of the underlying
asset. If the value of the underlying asset declines, the value of the derivative may also
decline.
• Leverage: Derivatives are often leveraged instruments, which means that a small
investment can control a large position. This can magnify both profits and losses.
• Complexity: Derivatives can be complex instruments, and it is important to understand
how they work before using them.

Derivatives can be a useful tool for investors and traders, but it is important to understand
the risks involved before using them.

Here are some examples of how derivatives are used in the real world:
• A farmer might use a futures contract to lock in a selling price for their crops.
• A company might use a swap contract to hedge against interest rate risk.
• An investor might buy a call option on a stock if they believe that the price of the stock
is going to rise.
• A hedge fund might use a variety of derivatives to speculate on prices and hedge against
risk.

Derivatives are a powerful tool that can be used for a variety of purposes. However, it is
important to understand the risks involved before using them.

1.1 Learning Objectives

After studying this chapter, the following points will be cleared: -
❖ Relevance of continuous compounding in working on valuation of derivatives.
❖ Understanding Cost of Carry Model and how it helps in valuation of derivatives.
❖ Understanding the difference between forward contract, future contract, option contract.
❖ How forward rate agreements are different from SWAP contract.

Unit 5: Derivatives 4
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. HISTORY OF DERIVATIVES
The history of derivatives can be traced back to ancient times. Some of the earliest known
examples of derivatives were contracts for the future delivery of agricultural goods. For
example, farmers in Mesopotamia would enter into contracts with merchants to sell their
crops at a predetermined price on a future date. This protected the farmers from price
fluctuations and helped them to secure financing for their operations.

Derivatives trading became more sophisticated in the Middle Ages, as merchants began to
use them to hedge their risk from currency fluctuations and changes in the prices of goods.
For example, Italian merchants would often use derivatives contracts to protect themselves
from the risk of exchange rate movements when trading with merchants from other
countries.

The first formal derivatives exchanges were established in the 17th century. These
exchanges allowed traders to buy and sell derivatives contracts in a standardized format.
This made derivatives trading more efficient and accessible to a wider range of investors.

Derivatives markets continued to grow and evolve throughout the 18th and 19th centuries.
New types of derivatives contracts were developed, such as stock options and futures
contracts. Derivatives trading also expanded to new asset classes, such as commodities and
foreign currencies.

In the 20th century, derivatives markets experienced explosive growth. This was due to a
number of factors, including the development of new financial technologies, the globalization
of financial markets, and the increasing use of derivatives by institutional investors.

Today, derivatives markets are one of the largest and most important financial markets in
the world. Trillions of dollars worth of derivatives contracts are traded every day.
Derivatives are used by a wide range of participants, including farmers, businesses,
investors, and governments.

Here is a brief timeline of some of the key milestones in the history of derivatives:
• 3000 BC: Farmers in Mesopotamia enter into contracts for the future delivery of
agricultural goods.

Unit 5: Derivatives 5
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• 12th century: Italian merchants begin to use derivatives contracts to hedge their risk
from currency fluctuations and changes in the prices of goods.
• 17th century: The first formal derivatives exchanges are established.
• 18th century: New types of derivatives contracts are developed, such as stock options
and futures contracts. Derivatives trading also expands to new asset classes, such as
commodities and foreign currencies.
• 20th century: Derivatives markets experience explosive growth due to the
development of new financial technologies, the globalization of financial markets, and
the increasing use of derivatives by institutional investors.
• 21st century: Derivatives markets continue to grow and evolve. New types of
derivatives contracts are developed, such as weather derivatives and credit derivatives.
Derivatives trading is also increasingly moving to electronic platforms.

Derivatives play an important role in the global financial system. They provide businesses
and investors with tools to manage their risk and hedge against uncertainty. Derivatives can
also be used to speculate on future movements in asset prices. However, it is important to
note that derivatives are complex financial instruments and should be used with caution.

Unit 5: Derivatives 6
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. FORWARD CONTRACT
A forward contract is a private agreement between two parties to buy or sell an asset at a
predetermined price on a future date. Forward contracts are traded over-the-counter (OTC),
meaning that they are not traded on an exchange. This gives the parties flexibility to
customize the terms of the contract to meet their specific needs. For example, they can
choose the amount of the asset to be exchanged, the delivery date, and the exchange rate.

Forward contracts are used for a variety of purposes, including:

• Hedging: Businesses and investors can use forward contracts to hedge against the risk
of price fluctuations in an underlying asset. For example, a company that imports goods
from another country may use a forward contract to lock in the exchange rate at which
it will pay for the goods. This protects the company from unfavourable fluctuations in
the exchange rate.
• Speculation: Forward contracts can also be used to speculate on future movements in
asset prices. For example, an investor who believes that the price of a particular
commodity will rise may buy a forward contract for that commodity. If the price of the
commodity does rise, the investor will profit from the contract.

Forward contracts are complex financial instruments and should be used with caution. There
are a number of risks associated with forward contracts, including:
• Counterparty risk: The risk that one party to the contract will default on its obligations.
• Market risk: The risk that the price of the underlying asset will move in a direction that
is unfavourable to the holder of the contract.
• Liquidity risk: The risk that it may be difficult to find a buyer or seller for the contract
before the delivery date.

Overall, forward contracts can be a valuable tool for businesses and investors to manage
their risk and hedge against uncertainty. However, it is important to understand the risks
involved before entering into a forward contract.

Here is an example of how a forward contract can be used for hedging:

A farmer is expecting to harvest a crop of wheat in six months. He is concerned that the price
of wheat may fall before he is able to sell his crop. To protect himself from this risk, the

Unit 5: Derivatives 7
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

farmer enters into a forward contract to sell 100 metric tons of wheat at a price of $300 per
ton in six months.

If the price of wheat falls below $300 per ton in six months, the farmer will still be able to
sell his crop for $300 per ton thanks to the forward contract. This will protect him from any
losses due to the fall in wheat prices.

On the other hand, if the price of wheat rises above $300 per ton in six months, the farmer
will miss out on the opportunity to sell his crop for a higher price. However, he will still have
made a profit on his forward contract, as he will be able to sell the wheat for the
predetermined price of $300 per ton.

Forward contracts can be a complex topic, but they can be a valuable tool for businesses and
investors to manage their risk and hedge against uncertainty.

4. VALUATION OF FORWARD CONTRACT

The valuation of a forward contract is based on the following factors:
• The spot price of the underlying asset
• The cost of carry
• The time to maturity of the contract

The spot price is the current price of the underlying asset. The cost of carry is the cost of
holding the underlying asset until the delivery date. This includes costs such as interest,
storage, and insurance. The time to maturity of the contract is the number of days until the
delivery date.

The following formula can be used to calculate the fair value of a forward contract:
Forward price = Spot price + Cost of carry

For example, if the spot price of gold is $1,800 per ounce and the cost of carry is $10 per
ounce per year, then the fair value of a one-year forward contract on gold would be $1,810
per ounce.

It is important to note that the forward price is not always equal to the spot price. The
forward price can be higher or lower than the spot price depending on expectations about

Unit 5: Derivatives 8
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

the future price of the underlying asset. For example, if investors expect the price of gold to
rise in the next year, then the forward price of gold will be higher than the spot price.

Here are some of the factors that can affect the forward price:
• Interest rates
• Storage costs
• Insurance costs
• Expectations about the future price of the underlying asset

Interest rates and storage costs are two of the most important factors that affect the cost of
carry. Higher interest rates and storage costs will increase the cost of carry, which will lead
to a higher forward price.

Expectations about the future price of the underlying asset also play a role in determining
the forward price. If investors expect the price of the underlying asset to rise in the future,
then the forward price will be higher than the spot price. Conversely, if investors expect the
price of the underlying asset to fall in the future, then the forward price will be lower than
the spot price.

Forward contracts are a complex topic, but they can be a valuable tool for businesses and
investors to manage their risk and hedge against uncertainty.

Unit 5: Derivatives 9
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. FUTURE CONTRACT
A futures contract is a standardized derivative contract that is traded on an exchange. It is a
legally binding agreement between two parties to buy or sell an underlying asset at a
predetermined price on a specified future date. It is financial arrangement that obligates two
parties to buy or sell a specific asset, such as commodities, currencies, stock indices, or
interest rates, at a predetermined price on a specified future date. These contracts are widely
traded on organized exchanges, creating a structured and regulated marketplace.

One key characteristic of futures contracts is their standardization. The terms of each
contract are uniform, specifying the asset type, quantity, delivery date, and price. This
standardization ensures transparency and facilitates efficient trading.

Futures contracts are used for a variety of purposes, including:

• Hedging: Futures contracts can be used to hedge against risk. For example, a company
that produces wheat could use a futures contract to lock in a selling price for its wheat
in the future. This would protect the company from a decline in the price of wheat.
• Speculation: Futures contracts can be used to speculate on prices. For example, an
investor could buy a futures contract on oil if they believe that the price of oil is going
to rise. If the price of oil does rise, the investor will make a profit on their futures
contract.
• Gaining exposure to an asset: Futures contracts can be used to gain exposure to an asset
without having to own it directly. For example, an investor could buy a call option on a
stock if they believe that the price of the stock is going to rise. If the price of the stock
does rise, the investor can exercise their option and buy the stock at the strike price.

Futures contracts are traded on exchanges such as the Chicago Mercantile Exchange (CME)
and the Intercontinental Exchange (ICE). These exchanges set the trading rules and
specifications for each futures contract.

Futures contracts are typically settled in cash, meaning that the buyer and seller do not
actually exchange the underlying asset. Instead, the party with the winning position receives
a cash payment equal to the difference between the contract price and the settlement price.

Unit 5: Derivatives 10
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Futures contracts can be a complex and risky investment, so it is important to understand

how they work before trading them.

Here is an example of how a futures contract might be used:

A farmer is concerned about the possibility of a decline in the price of corn. The farmer could
use a futures contract to lock in a selling price for their corn at a future date. This would
protect the farmer from a decline in the price of corn.

The farmer would go to a futures exchange and buy a futures contract on corn. The futures
contract would specify the quantity of corn to be sold, the price at which the corn will be
sold, and the date on which the corn will be sold.

If the price of corn declines before the futures contract expires, the farmer will still be able
to sell their corn at the price specified in the futures contract. This will allow the farmer to
avoid losses due to a decline in the price of corn.

If the price of corn rises before the futures contract expires, the farmer will still be able to
sell their corn at the price specified in the futures contract. However, the farmer will miss
out on the opportunity to sell their corn at the higher market price.

Futures contracts can be a valuable tool for farmers and other businesses that are exposed
to price risk. However, it is important to understand the risks involved before trading futures
contracts.

Unit 5: Derivatives 11
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. INITIAL MARGIN AND MAINTENANCE MARGIN IN FUTURE CONTRACT

Initial margin and maintenance margin are important concepts in the context of futures
contracts. They both relate to the amount of capital that traders are required to have in their
accounts when trading futures.

1. Initial Margin:
1) Initial margin is the initial amount of money or collateral that a trader must deposit
into their futures trading account to initiate a new futures position.
2) It serves as a form of security or collateral to ensure that traders have the financial
capacity to meet their obligations, including potential losses.
3) The specific initial margin requirement varies depending on the futures contract
and is set by the exchange. It is typically a percentage of the contract's total value.
4) Initial margin is required to be deposited before a trader can enter into a futures
contract.
2. Maintenance Margin:
1) Maintenance margin is the minimum amount of capital that must be maintained in
a trader's account to keep an existing futures position open.
2) It is designed to ensure that traders can cover potential losses that may occur due
to adverse price movements.
3) If the account balance falls below the maintenance margin level because of trading
losses, the trader may receive a margin call from their broker. This means they must
deposit additional funds to bring the account back up to the initial margin level.
4) If a trader fails to meet a margin call and the account balance continues to fall, the
broker may close out the trader's position to limit further losses.

Mark-to-market settlement is a fundamental feature of futures contracts that ensures

transparency and fairness in daily trading activities. Here's how it works:

Daily Valuation: At the end of each trading day, the clearinghouse or exchange calculates the
daily settlement price for each futures contract. This price is determined based on the
current market conditions and the contract's reference asset.

Unit 5: Derivatives 12
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Profit and Loss Calculation: For each futures contract, the difference between the previous
day's settlement price and the current day's settlement price is calculated for all open
positions. This calculation results in either a profit or a loss for each trader holding those
positions.

Cash Flow Adjustment: Traders' accounts are adjusted accordingly. Those who made a profit
receive cash credited to their accounts, while those who incurred losses have cash debited
from their accounts. These adjustments ensure that traders are constantly putting up or
receiving funds based on the market's daily price changes.

Margin Maintenance: Mark-to-market settlement also impacts margin requirements. If a

trader's account balance falls below the maintenance margin level due to trading losses, they
must deposit additional funds to meet the margin requirements. Failure to do so may lead to
a margin call or position liquidation.

Risk Management: Mark-to-market settlement helps mitigate counterparty risk by ensuring

traders can cover their obligations daily. It also promotes transparency in futures markets
by providing real-time information on the value of open positions.

7. DIFFERENCE BETWEEN FORWARD CONTRACT AND FUTURE

CONTRACT
Forward contracts and futures contracts are both derivative financial instruments used for
buying or selling assets at a predetermined price on a future date, but they differ in several
keyways:
• Standardization: Forward Contract: These contracts are customizable, allowing parties
to tailor the terms to their specific needs, including the asset, quantity, price, and
settlement date. They are typically traded over the counter (OTC), directly between
parties. Futures Contract: Futures contracts are standardized and trade on organized
exchanges. The terms, including the contract size, expiration date, and delivery
procedures, are predetermined by the exchange. This standardization simplifies
trading and enhances liquidity.
• Exchange vs. OTC: Forward Contract: Traded over the counter, meaning they are
private agreements between two parties. This customization provides flexibility but
also exposes parties to counterparty risk. Futures Contract: Traded on organized

Unit 5: Derivatives 13
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

exchanges, creating a regulated and transparent marketplace. The exchange acts as the
intermediary, guaranteeing contract performance and reducing counterparty risk.
• Counterparty Risk: Forward Contract: Parties in a forward contract are exposed to
counterparty risk, meaning they rely on each other's creditworthiness to fulfil the
contract. Futures Contract: The exchange's clearinghouse acts as the counterparty to
all contracts, ensuring contract performance. This minimizes counterparty risk.
• Transferability: Forward Contract: Typically, not as easily transferable as futures
contracts, making them less liquid and harder to exit.
• Futures Contract: Highly liquid and easily transferable, allowing traders to enter and
exit positions more efficiently.
• Margin Requirements: Forward Contract: No standard margin requirements, and
payment typically occurs at contract maturity.
• Futures Contract: Margin requirements are standardized and enforced by the
exchange. Traders must deposit initial and maintenance margins, reducing the need for
large upfront payments.
• Settlement: Forward Contract: Usually settled by physical delivery of the asset or cash
settlement. Futures Contract: Most contracts are closed out before maturity, with
profits or losses settled daily through mark-to-market, often resulting in cash
settlement.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary focus of an interest rate swap?

a) Exchanging principal payments in different currencies
b) Exchanging interest rate cash flows
c) Speculating on currency price movements
d) Hedging against fluctuations in commodity prices
2. Which of the following is a key characteristic of futures contracts?
a) Customizable terms to suit individual preferences
b) Private agreements between two parties
c) Standardization of contract terms
d) Only traded over-the-counter (OTC)

Unit 5: Derivatives 14
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. What is the primary objective of mark-to-market settlement in futures

contracts?
a) To minimize counterparty risk
b) To encourage physical delivery of assets
c) To simplify trading procedures
d) To provide a fixed contract expiration date
4. Which historical period saw the establishment of the first formal derivatives
exchanges?
a) 12th century
b) 17th century
c) 20th century
d) 21st century
5. What is one of the key risks associated with forward contracts?
a) Market risk
b) Counterparty risk
c) Daily mark-to-market adjustments
d) Exchange rate risk
6. Which factor can affect the forward price of a contract?
a) Daily market conditions
b) Interest rates
c) Delivery date
d) Standardization
7. What is the primary purpose of maintenance margin in futures trading?
a) To determine the initial deposit required to initiate a futures contract
b) To provide liquidity for traders
c) To calculate the fair value of a forward contract
d) To ensure traders can cover potential losses and maintain an open
position

Unit 5: Derivatives 15
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. Which financial derivative is primarily used for hedging against fluctuations

in the price of an underlying asset?
a) Interest rate swap
b) Currency swap
c) Forward contract
d) Futures contract
9. In which century did derivatives markets experience explosive growth due to
factors like financial technology development and globalization?
a) 12th century
b) 17th century
c) 20th century
d) 21st century
10. What role does the exchange play in futures contracts?
a) It sets customized contract terms.
b) It acts as the counterparty to all contracts, reducing counterparty risk.
c) It allows direct negotiation between parties.
d) It does not influence the futures contract market.

Unit 5: Derivatives 16
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. CURRENCY FORWARDS AND CURRENCY FUTURES

Currency forwards and currency futures are both types of derivatives contracts that allow
buyers and sellers to lock in an exchange rate for a currency pair on a future date. However,
there are some key differences between the two types of contracts.

Currency forwards are private agreements between two parties to buy or sell a currency at
a predetermined price on a future date. They are traded over-the-counter (OTC), meaning
that there is no central exchange where they are traded. This gives the parties flexibility to
customize the terms of the contract to meet their specific needs. For example, they can
choose the amount of currency to be exchanged, the delivery date, and the exchange rate.

Currency futures are standardized contracts that are traded on exchanges. They have
specific terms and conditions, such as the amount of currency to be exchanged, the delivery
date, and the minimum margin requirement. Margin is a deposit that both parties to the
contract must make to cover the risk of default.

Here are some key features and details about currency futures:
• Standardization: Currency futures contracts are highly standardized. They specify the
currencies involved, the contract size (typically representing a standard amount of the
base currency), the maturity or delivery date, and the agreed-upon exchange rate. This
standardization ensures transparency and simplifies trading.
• Exchange-Traded: Unlike over-the-counter (OTC) currency forwards, currency futures
are exchange-traded instruments. They are bought and sold on established futures
exchanges, such as the Chicago Mercantile Exchange (CME) or Intercontinental
Exchange (ICE). This centralized trading platform enhances liquidity and price
discovery.
• Risk Management: Currency futures are widely used for risk management purposes.
Businesses engaged in international trade, investors with exposure to foreign assets,
and financial institutions often use currency futures to hedge against adverse exchange
rate movements. By locking in a future exchange rate, they can protect themselves from
currency fluctuations.

Unit 5: Derivatives 17
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Speculation: Currency futures also attract speculators who aim to profit from
anticipated exchange rate movements. Speculators take positions in futures contracts
based on their expectations of where currency exchange rates will move in the future.
• Margin Requirements: To trade currency futures, participants are required to deposit
an initial margin with the exchange. This margin serves as collateral and ensures that
both parties fulfill their obligations. Maintenance margins may also apply to keep
positions open.
• Settlement: Currency futures contracts can be settled in two ways: physical delivery or
cash settlement. Physical delivery involves the actual exchange of currencies on the
maturity date, while cash settlement involves settling the contract's value in cash based
on the difference between the contract's price and the prevailing spot exchange rate.
• Regulatory Oversight: Currency futures are subject to strict regulatory oversight, which
helps ensure market integrity and investor protection. Exchanges and regulatory
bodies establish and enforce rules governing trading, margin requirements, and
reporting.

Here is a table that summarizes the key differences between currency forwards and currency
futures:

Characteristic Currency forward Currency Future

Trading Venue Over-the Counter Exchange Traded
Standardization No Yes
Margin Requirement No Yes
Counterparty Risk Yes No
Liquidity Less liquid More liquid

Uses of currency forwards and currency futures

Currency forwards and currency futures are both used to hedge foreign exchange risk. For
example, a company that imports goods from another country may use a currency forward
to lock in the exchange rate at which it will pay for the goods. This protects the company
from unfavourable fluctuations in the exchange rate.

Currency forwards and currency futures can also be used to speculate on future movements
in currency exchange rates. For example, an investor who believes that the US dollar will

Unit 5: Derivatives 18
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

appreciate against the Japanese yen may buy a USD/JPY futures contract. If the US dollar
does appreciate, the investor will profit from the contract.

9. IMPORTANCE OF CURRENCY FUTURE IN HEDGING BY BANKS AND

CORPORATES

Currency futures play a significant role in hedging strategies for both banks and corporates,
offering various advantages in managing currency risk. Here are some of the key reasons
why currency futures are important in hedging for these entities:
• Predictable Exchange Rates: Currency futures provide a way to lock in exchange rates
for future transactions, creating predictability in international trade or financial
activities. This is particularly important for businesses that deal with multiple
currencies and need to plan their cash flows and budgets effectively.
• Risk Mitigation: Banks and corporates are exposed to currency risk when they engage
in cross-border trade, investments, or financing. Currency futures allow them to hedge
against adverse exchange rate movements, protecting themselves from potential losses
due to currency fluctuations. This risk mitigation is essential for maintaining financial
stability and profitability.
• Cost Efficiency: Currency futures are cost-effective hedging instruments compared to
other alternatives like currency options or forward contracts. They require lower
upfront costs because of standardized contract sizes and margin requirements, making
them accessible for businesses of various sizes.
• Liquidity and Accessibility: Currency futures are traded on organized exchanges, which
enhances liquidity and transparency. Banks and corporates can easily access these
markets to establish and unwind positions when needed, ensuring flexibility in their
hedging strategies.
• Regulatory Compliance: Currency futures are subject to regulatory oversight, providing
a structured and compliant environment for hedging activities. This regulatory
framework helps ensure the integrity of the market and offers protection against
fraudulent or unscrupulous practices.
• Diversification: Currency futures enable banks and corporates to diversify their risk
management strategies. By using futures contracts alongside other hedging tools, such

Unit 5: Derivatives 19
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

as options or spot contracts, they can create a well-rounded risk management portfolio
tailored to their specific needs.
• Operational Efficiency: Hedging with currency futures can streamline operations by
reducing the complexity associated with managing currency risk manually. This is
especially valuable for businesses with international operations that involve numerous
currency transactions.
• Credit Risk Mitigation: Banks often use currency futures to manage credit risk when
dealing with corporate clients. By requiring clients to hedge their currency exposure
with futures contracts, banks can minimize the credit risk associated with adverse
exchange rate movements.
• Financial Stability: Effective currency risk management through currency futures
contributes to the overall financial stability of banks and corporates. It helps them
avoid unexpected losses and disruptions caused by volatile exchange rates, ensuring
their long-term viability.

10. UNDERSTANDING OPTION CONTRACT

An option contract is a derivative contract that gives the buyer the right, but not the
obligation, to buy or sell an underlying asset at a predetermined price on or before a specified
future date. The underlying asset can be a stock, bond, commodity, currency, or market
index.

Option contracts are used for a variety of purposes, including:

• Hedging: Option contracts can be used to hedge against risk. For example, an investor
who owns a stock could buy a put option on the stock to protect themselves from a
decline in the price of the stock.
• Speculation: Option contracts can be used to speculate on prices. For example, an
investor who believes that the price of a stock is going to rise could buy a call option on
the stock. If the price of the stock does rise, the investor will make a profit on their call
option.
• Gaining exposure to an asset: Option contracts can be used to gain exposure to an asset
without having to own it directly. For example, an investor who believes that the price
of a stock is going to rise could buy a call option on the stock instead of buying the stock

Unit 5: Derivatives 20
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

itself. If the price of the stock does rise, the investor will make a profit on their call
option.

Option contracts are traded on exchanges such as the Chicago Board Options Exchange
(CBOE) and the International Securities Exchange (ISE). These exchanges set the trading
rules and specifications for each option contract.

Option contracts have two main types: call options and put options.
• Call options: A call option gives the buyer the right, but not the obligation, to buy the
underlying asset at the strike price on or before the expiration date.
• Put options: A put option gives the buyer the right, but not the obligation, to sell the
underlying asset at the strike price on or before the expiration date.

The strike price is the price at which the underlying asset can be bought or sold if the option
is exercised. The expiration date is the last date on which the option can be exercised.

Option contracts can be complex and risky, so it is important to understand how they work
before trading them.

Here is an example of how a call option might be used:

An investor believes that the price of a stock is going to rise. The investor could buy a call
option on the stock with a strike price of $100 and an expiration date of one month.

If the price of the stock rises above $100 before the expiration date, the investor can exercise
their option and buy the stock at $100. The investor can then sell the stock at the higher
market price and make a profit.

If the price of the stock does not rise above $100 before the expiration date, the option will
expire worthless and the investor will lose the premium they paid for the option.

Option contracts can be a valuable tool for investors and traders who are looking to hedge
risk, speculate on prices, or gain exposure to assets. However, it is important to understand
the risks involved before trading option contracts.

Unit 5: Derivatives 21
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. AMERICAN AND EUROPEAN OPTION

American options and European options are two different types of options contracts. The
main difference between the two types of options is the exercise rights of the option holder.

American options can be exercised at any time before the expiration date of the contract.
European options can only be exercised on the expiration date of the contract.

This difference in exercise rights can have a significant impact on the value of an option
contract. American options are typically more valuable than European options because the
option holder has more flexibility in when they can exercise the option.

Here are some examples of how the difference in exercise rights can affect the value of an
option contract:
• If the price of the underlying asset is rising rapidly, the American option holder will
want to exercise the option early in order to lock in the profit. The European option
holder, on the other hand, will have to wait until the expiration date to exercise the
option, which means they may miss out on some of the profit if the price of the
underlying asset continues to rise.
• If the price of the underlying asset is falling rapidly, the American option holder may
want to wait until the expiration date to exercise the option in the hope that the price
will recover. The European option holder, on the other hand, will have to exercise the
option early in order to lock in the loss, which means they may lose more money if the
price of the underlying asset continues to fall.

American options and European options are both traded on exchanges. However, American
options are more common than European options.

American options and European options can be used for a variety of purposes, including:
• Hedging: Options can be used to hedge against the risk of adverse price movements in
the underlying asset. For example, a company that owns a large inventory of a
commodity may purchase put options on that commodity to hedge against the risk of a
decline in the price of the commodity.

Unit 5: Derivatives 22
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Speculation: Options can also be used to speculate on future price movements in the
underlying asset. For example, an investor who believes that the price of a stock is going
to rise may purchase call options on that stock.

It is important to note that options are complex financial instruments and should be used
with caution. There is a risk of losing money when trading options.

12. VALUATION OF OPTION CONTRACT

The valuation of an option contract is based on a number of factors, including:
• The strike price of the option
• The spot price of the underlying asset
• The time to maturity of the contract
• The volatility of the underlying asset
• The risk-free interest rate

The strike price is the price at which the option can be exercised to buy or sell the underlying
asset. The spot price is the current price of the underlying asset. The time to maturity of the
contract is the number of days until the expiry date. The volatility of the underlying asset is
a measure of how much the price of the asset is expected to fluctuate over time. The risk-free
interest rate is the interest rate that can be earned on a risk-free investment, such as a
government bond.

There are a number of different models that can be used to value option contracts. The most
common model is the Black-Scholes model. The Black-Scholes model takes into account all
of the factors listed above to calculate the fair value of an option contract.

The following formula is a simplified version of the Black-Scholes formula:

Option value = Intrinsic value + Time value

The intrinsic value of an option is the difference between the strike price of the option and
the spot price of the underlying asset. The time value of an option is the value of the option
due to the possibility of it becoming in-the-money in the future.

Unit 5: Derivatives 23
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

For example, if a call option with a strike price of $100 has an intrinsic value of $10, then the
time value of the option is $90. This means that the option is worth $90 more than its
intrinsic value because of the possibility of it becoming more valuable in the future.

The time value of an option is affected by a number of factors, including the time to maturity
of the contract and the volatility of the underlying asset. The longer the time to maturity of
the contract, the more time there is for the option to become in-the-money. The higher the
volatility of the underlying asset, the more likely it is that the option will become in-the-
money.

Option valuation is a complex topic, but it is important to understand the basic concepts
before trading options. By understanding how to value options, traders can make more
informed decisions about which options to buy and sell.

Here are some of the benefits of valuing option contracts:

• It can help traders to identify mispriced options.
• It can help traders to develop trading strategies.
• It can help traders to manage their risk.

However, it is important to note that option valuation is not an exact science. There are a
number of factors that can affect the price of an option, and the Black-Scholes model does
not take into account all of these factors. As a result, it is important to use option valuation
models carefully and to understand the limitations of these models.

The Black-Scholes-Merton (BSM) option valuation model is a widely used mathematical

model for calculating the theoretical fair value of European-style options, including both call
and put options. Developed by economists Fischer Black and Myron Scholes in collaboration
with Robert Merton in the early 1970s, the model revolutionized the field of finance and
derivatives trading. It forms the basis for understanding options pricing and risk
management.

The key components of the Black-Scholes-Merton model are as follows:

Current Stock Price (S): The market price of the underlying asset (e.g., a stock).

Unit 5: Derivatives 24
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Strike Price (K): The price at which the option holder can buy (for call options) or sell (for
put options) the underlying asset.

Time to Expiration (T): The time remaining until the option's expiration date.

Risk-Free Interest Rate (r): The continuously compounded risk-free interest rate for the
duration of the option's life.

Volatility (σ): The annualized standard deviation of the returns of the underlying asset,
which measures the asset's price fluctuations.

The BSM model is based on the following assumptions:

• The underlying asset follows a geometric Brownian motion process.
• The market is frictionless, meaning that there are no transaction costs or taxes.
• The risk-free interest rate is constant.
• The volatility of the underlying asset is constant.

The BSM model can be used to calculate the fair value of both call and put options. The
following formula can be used to calculate the fair value of a call option:
C = S * N(d1) - K * e^(-rT) * N(d2)

where:
• C is the fair value of the call option
• S is the spot price of the underlying asset
• K is the strike price of the option
• T is the time to maturity of the contract
• r is the risk-free interest rate
• N(d1) is the cumulative normal distribution function evaluated at d1
• N(d2) is the cumulative normal distribution function evaluated at d2

The following formula can be used to calculate the fair value of a put option:
P = K * e^(-rT) * N(-d2) - S * N(-d1)

where:
• P is the fair value of the put option

Unit 5: Derivatives 25
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The BSM model is a valuable tool for pricing option contracts. It is a complex model, but it is
relatively accurate and easy to use. However, it is important to understand the limitations of
the model before using it. The BSM model is based on a number of assumptions, and these
assumptions may not always be met in the real world.

Here are some of the benefits of using the BSM model:

• It is a widely used model, which makes it easy to find data and information to use in the
model.
• It is a relatively accurate model for pricing option contracts.
• It is relatively easy to use.

However, there are also some limitations to the BSM model:

• It is based on a number of assumptions, such as the assumption that the underlying
asset follows a geometric Brownian motion process. These assumptions may not
always be met in the real world.
• It does not take into account all of the factors that can affect the price of an option
contract, such as market sentiment and supply and demand.
• It can be complex to use, especially for inexperienced traders.

Overall, the BSM model is a valuable tool for pricing option contracts. It is a widely used
model, it is relatively accurate, and it is relatively easy to use. However, it is important to
understand the limitations of the model before using it.

The binomial tree model is a discrete-time model that is used to value option contracts. The
model works by constructing a tree of possible outcomes for the price of the underlying asset
at each point in time. The probability of each outcome is determined using a risk-neutral
pricing framework.

The binomial tree model is a relatively simple model to understand and implement.
However, it can be computationally expensive to use for valuing options with long
maturities.

To value an option using the binomial tree model, we start by constructing a tree of possible
outcomes for the price of the underlying asset at each point in time. The number of nodes in

Unit 5: Derivatives 26
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

the tree is determined by the time to maturity of the option and the number of periods per
year.

The probability of each outcome is determined using a risk-neutral pricing framework. This
means that the probability of each outcome is calculated in such a way that the expected
return on all of the nodes in the tree is equal to the risk-free interest rate.

Once we have constructed the tree and determined the probability of each outcome, we can
calculate the payoff of the option at each node in the tree. We then discount the payoffs back
to the present value using the risk-free interest rate.

The value of the option is then equal to the average of the discounted payoffs at all of the
nodes in the tree.

The binomial tree model can be used to value both call and put options. The following steps
can be used to value a call option using the binomial tree model:
1. Construct a binomial tree of possible outcomes for the price of the underlying asset at
each point in time.
2. Determine the probability of each outcome using a risk-neutral pricing framework.
3. Calculate the payoff of the option at each node in the tree.
4. Discount the payoffs back to the present value using the risk-free interest rate.
5. The value of the call option is equal to the average of the discounted payoffs at all of the
nodes in the tree.

The binomial tree model is a valuable tool for valuing option contracts. It is a relatively
simple model to understand and implement. However, it can be computationally expensive
to use for valuing options with long maturities.

Here are some of the benefits of using the binomial tree model:
• It is a relatively simple model to understand and implement.
• It can be used to value both call and put options.
• It can be used to value options with different maturities.

However, there are also some limitations to the binomial tree model:
• It can be computationally expensive to use for valuing options with long maturities.

Unit 5: Derivatives 27
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• It is based on a number of assumptions, such as the assumption that the volatility of the
underlying asset is constant. These assumptions may not always be met in the real
world.
• It does not take into account all of the factors that can affect the price of an option
contract, such as market sentiment and supply and demand.

Overall, the binomial tree model is a valuable tool for valuing option contracts. It is a
relatively simple model to understand and implement, and it can be used to value both call
and put options with different maturities. However, it is important to understand the
limitations of the model before using it.

The model provides a theoretical estimate of an option's fair value based on the specified
inputs. It has been instrumental in options pricing, risk management, and the development
of financial derivatives markets. However, it assumes constant volatility, risk-free rates, and
no transaction costs, which are simplifications that may not fully capture real-world market
conditions. Adjustments and variations of the BSM model have been developed to address
some of these limitations.

The binomial tree model is versatile and can handle complex situations such as changing
volatility or dividend payments. However, it requires discretizing time into small steps,
which means that the accuracy of the valuation depends on the number of steps used; more
steps result in a closer approximation to the continuous-time Black-Scholes-Merton model.

This model is particularly valuable for American options, as it helps identify optimal exercise
strategies by comparing the intrinsic value at each node to the option's calculated value. If
the intrinsic value exceeds the calculated value, early exercise may be optimal. For European
options, the binomial tree converges to the Black-Scholes-Merton formula when a sufficient
number of steps are used.

Unit 5: Derivatives 28
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

11. What is a key difference between currency forwards and currency futures?
a) Currency forwards are exchange-traded, while currency futures are over
the counter.
b) Currency forwards are more standardized than currency futures.
c) Currency forwards do not require margin, while currency futures do.
d) Currency forwards have no counterparty risk, while currency futures do.
12. Which type of option contract allows the holder to exercise the option at any
time before the expiration date?
a) American option
b) European option
c) Asian option
d) Exotic option
13. What is the primary function of the Black-Scholes-Merton (BSM) model?
a) To calculate the fair value of American options
b) To calculate the fair value of European options
c) To determine the strike price of an option
d) To predict future stock prices
14. Which option valuation model constructs a tree of possible outcomes and
calculates option values based on risk-neutral probabilities?
a) Black-Scholes-Merton model
b) Binomial tree model
c) Option pricing formula
d) Monte Carlo simulation
15. What is the primary advantage of using currency futures for hedging by
banks and corporates?
a) Predictable exchange rates
b) High liquidity
c) No counterparty risk
d) Low cost

Unit 5: Derivatives 29
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

16. What does the term "margin" refer to in the context of currency futures?
a) The transaction fee paid to a broker
b) A deposit to cover the risk of default in a futures contract
c) The difference between the spot and forward exchange rates
d) The price at which an option can be exercised
17. Which type of option is typically more valuable, American or European?
a) American options
b) European options
c) They have equal value.
d) It depends on the underlying asset.
18. What is the primary limitation of the Black-Scholes-Merton (BSM) option
pricing model?
a) It cannot be used for European options.
b) It does not consider constant volatility.
c) It assumes risk-free interest rates.
d) It may not fully capture real-world market conditions.

Unit 5: Derivatives 30
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. FORWARD RATE AGREEMENT (FRA)

A forward rate agreement (FRA) is a contract between two parties that sets the interest rate
that will be paid on a loan or deposit at a future date. The parties agree on the interest rate,
the notional amount of the loan or deposit, and the start and end dates of the contract. FRAs
are traded over the counter (OTC), meaning that they are not traded on an exchange.

FRAs are used for a variety of purposes, including:

• Hedging: FRAs can be used to hedge against the risk of interest rate movements. For
example, a company that expects to borrow money in the future may enter into an FRA
to lock in a favourable interest rate.
• Speculation: FRAs can also be used to speculate on future interest rate movements. For
example, an investor who believes that interest rates are going to rise may purchase an
FRA contract.

FRAs are complex financial instruments and should be used with caution. There is a risk of
losing money when trading FRAs.

Here is an example of how an FRA can be used for hedging:

A company expects to borrow $10 million in six months at a fixed interest rate. The company
is concerned that interest rates may rise before it borrows the money. To protect itself from
this risk, the company enters into an FRA contract with a bank. The FRA contract sets the
interest rate that the company will pay on the loan at 5%.

If interest rates rise above 5% in the next six months, the company will benefit from the FRA
contract. The company will be able to borrow the money at a lower interest rate than it would
have to pay if it did not have the FRA contract.

If interest rates fall below 5% in the next six months, the company will lose money on the
FRA contract. The company will have to pay a higher interest rate on the loan than it would
have to pay if it did not have the FRA contract.

FRAs are a valuable tool for businesses and investors to manage their risk and hedge against
uncertainty. However, it is important to understand the risks involved before entering into
an FRA contract.

Unit 5: Derivatives 31
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

14. SWAP AGREEMENT

A swap agreement is a contract between two parties to exchange financial instruments or
cash flows at a predetermined time. Swap agreements are traded over the counter (OTC),
meaning that they are not traded on an exchange. This gives the parties flexibility to
customize the terms of the contract to meet their specific needs.

There are many different types of swap agreements, but the most common are:
• Interest rate swaps: These swaps involve exchanging interest payments on loans or
deposits. For example, a company with a variable-rate loan may swap its interest
payments with a company that has a fixed-rate loan. This allows both companies to lock
in a more favourable interest rate.
• Currency swaps: These swaps involve exchanging currency flows. For example, a
company that imports goods from another country may swap its currency payments
with a company that exports goods to that country. This allows both companies to
hedge against the risk of unfavourable currency fluctuations.
• Commodity swaps: These swaps involve exchanging commodity flows. For example, a
farmer may swap its wheat crop with a miller for a fixed amount of flour. This allows
the farmer to hedge against the risk of a decline in the price of wheat.

Swap agreements are used by a wide range of participants, including businesses, investors,
and governments. They are used for a variety of purposes, including:
• Hedging: Swap agreements can be used to hedge against the risk of adverse price
movements in financial instruments or commodities.
• Speculation: Swap agreements can also be used to speculate on future price movements
in financial instruments or commodities.
• Arbitrage: Swap agreements can be used to exploit price discrepancies between
different markets.

Swap agreements are complex financial instruments and should be used with caution. There
is a risk of losing money when trading swap agreements.

Unit 5: Derivatives 32
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Here is an example of how a swap agreement can be used for hedging:

A company with a variable-rate loan is concerned that interest rates may rise in the future.
To protect itself from this risk, the company enters into an interest rate swap with a bank.
The swap agreement sets the interest rate that the company will pay on the loan at 5%.

If interest rates rise above 5% in the future, the company will benefit from the swap
agreement. The company will be able to pay a lower interest rate on the loan than it would
have to pay if it did not have the swap agreement.

If interest rates fall below 5% in the future, the company will lose money on the swap
agreement. The company will have to pay a higher interest rate on the loan than it would
have to pay if it did not have the swap agreement.

Swap agreements can be a valuable tool for businesses and investors to manage their risk
and hedge against uncertainty. However, it is important to understand the risks involved
before entering into a swap agreement.

15. DIFFERENCE BETWEEN INTEREST RATE SWAP AND CURRENCY

SWAP

The main difference between an interest rate swap and a currency swap is the type of cash
flows that are exchanged. In an interest rate swap, the parties exchange interest payments
on loans or deposits. In a currency swap, the parties exchange currency flows.

Another difference between interest rate swaps and currency swaps is the purpose for which
they are typically used. Interest rate swaps are typically used to hedge against the risk of
interest rate movements. Currency swaps are typically used to hedge against the risk of
currency fluctuations.

Here are some examples of how interest rate swaps and currency swaps can be used:
• Interest rate swap: A company with a variable-rate loan may enter into an interest rate
swap with a bank to lock in a fixed interest rate. This would protect the company from
the risk of an increase in interest rates.

Unit 5: Derivatives 33
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Currency swap: A company that imports goods from another country may enter into a
currency swap with a company that exports goods to that country. This would allow
the two companies to hedge against the risk of unfavourable currency fluctuations.

Interest rate swaps and currency swaps are complex financial instruments and should be
used with caution. It is important to understand the risks involved before entering into either
type of swap.

Interest rate swaps and currency swaps are both financial derivatives used by individuals
and institutions to manage risks and achieve specific financial objectives, but they differ in
their primary focus and how they function:

Focus: Interest Rate Swap: The primary focus of an interest rate swap is to exchange interest
rate cash flows between two parties. It typically involves swapping fixed-rate interest
payments for floating-rate interest payments or vice versa. Interest rate swaps help manage
interest rate risk or capitalize on interest rate differentials. Currency Swap: A currency swap,
on the other hand, primarily involves exchanging principal and interest payments
denominated in one currency for another currency. Currency swaps are used to hedge
against currency risk or obtain access to lower borrowing costs in a foreign currency.

Cash Flows: Interest Rate Swap: In an interest rate swap, the cash flows are based on interest
rate payments. One party pays interest at a fixed rate, while the other pays interest at a
floating rate tied to a reference interest rate, such as LIBOR or the prime rate. Currency Swap:
In a currency swap, the cash flows consist of both interest payments and principal
repayments in two different currencies. The parties exchange cash flows based on a
predetermined exchange rate.

Objective: Interest Rate Swap: The primary objective of an interest rate swap is to manage
interest rate exposure, achieve a desired interest rate structure, or optimize borrowing costs.
Currency Swap: Currency swaps are used to manage currency risk when making
international investments, lower borrowing costs in foreign markets, or gain access to
foreign capital markets.

Market Participants: Interest Rate Swap: Common participants include corporations,

financial institutions, and investors looking to adjust their interest rate risk profile. Currency

Unit 5: Derivatives 34
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Swap: Participants often include multinational corporations, financial institutions, and

governments that need to manage currency exposure related to international trade or
financing.

Market Size: Interest Rate Swap: Interest rate swaps represent a larger and more liquid
market compared to currency swaps. Currency Swap: The currency swap market is smaller
in comparison but still significant, especially for entities engaged in international business.

In summary, while both interest rate swaps and currency swaps involve the exchange of cash
flows between parties, they differ in terms of their primary focus (interest rates vs.
currencies), the types of cash flows involved, objectives, participants, and market size. Each
serves specific financial needs and risk management requirements.

16. SUMMARY
History of Derivatives:
• Derivatives have ancient origins, with contracts for future delivery of agricultural goods
dating back to 3000 BC.
• Middle Ages saw the use of derivatives for hedging against currency fluctuations.
• Formal derivatives exchanges were established in the 17th century, enhancing
efficiency.
• 18th and 19th centuries saw the development of new types of derivatives contracts and
expansion into new asset classes.
• The 20th century witnessed explosive growth in derivatives markets, driven by
financial technologies, globalization, and institutional investor participation.
• Derivatives remain crucial in managing risk and speculation in the global financial
system.

Forward Contract:
• Private agreements to buy or sell an asset at a predetermined price on a future date.
• Customizable terms traded over the counter (OTC).
• Used for hedging against price fluctuations and speculation.
• Risks include counterparty risk, market risk, and liquidity risk.

Unit 5: Derivatives 35
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Valuation of Forward Contract:

• Valuation based on spot price, cost of carry, and time to maturity.
• Forward price = Spot price + Cost of carry.
• Forward price can be higher or lower than the spot price, influenced by factors like
interest rates and expectations.

Futures Contract:
• Standardized derivative contracts traded on exchanges.
• Legally binding agreements to buy or sell an underlying asset at a predetermined price
on a future date.
• Used for hedging, speculation, and gaining exposure to assets.
• Settlement typically in cash; contracts are highly liquid.

Initial Margin and Maintenance Margin in Future Contract:

• Initial margin: Initial collateral to initiate a futures position, set by the exchange.
• Maintenance margin: Minimum capital required to keep an open position; falling below
it triggers margin calls.
• Key for risk management and ensuring traders can cover potential losses.

Difference between Forward Contract and Future Contract:

• Forward contracts are customizable and traded OTC; futures contracts are
standardized and traded on exchanges.
• Forward contracts expose parties to counterparty risk; futures contracts are cleared by
the exchange, reducing counterparty risk.
• Futures contracts are highly transferable and have standardized margin requirements;
forward contracts lack these features.
• Settlement differs, with forwards often involving physical delivery and futures
involving daily mark-to-market settlement.

Currency Forwards and Currency Futures:

• Currency forwards are private agreements between parties to exchange currencies at
a predetermined rate on a future date.

Unit 5: Derivatives 36
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Currency futures are standardized contracts traded on exchanges, specifying currency

pair, contract size, maturity date, and margin requirements.
• Currency futures are more liquid and transparent due to exchange trading.
• Both are used for hedging against currency risk and for speculative purposes.

Importance of Currency Futures in Hedging:

• Currency futures offer predictability in exchange rates, crucial for businesses managing
multiple currencies.
• They help mitigate currency risk for banks and corporations engaged in cross-border
activities.
• Currency futures are cost-efficient, accessible, and provide regulatory compliance.
• They enable diversification and operational efficiency in risk management.

Option Contracts:
• Option contracts give the holder the right, but not the obligation, to buy (call option) or
sell (put option) an underlying asset at a predetermined price by a specified date.
• They are used for hedging and speculation.
• American options can be exercised at any time before expiration, while European
options can only be exercised at expiration.

Option Valuation:
• Option valuation considers factors like the underlying asset's price, strike price, time to
maturity, volatility, and risk-free interest rate.
• The Black-Scholes-Merton (BSM) model is a widely used tool for valuing European-
style options, considering these factors.
• BSM model simplifies valuation but makes assumptions like constant volatility and
risk-free rates.
• The binomial tree model offers an alternative approach, especially useful for American
options and handling changing parameters.
• It discretizes time into steps and provides flexibility but requires more computational
effort.

Unit 5: Derivatives 37
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Benefits and Limitations of Valuation Models:

• BSM model is widely used and relatively accurate but may not fully capture real-world
complexities.
• Binomial tree model is versatile, suitable for American options, and handles changing
parameters but depends on the number of steps for accuracy.

Forward Rate Agreement (FRA):

• FRA is a contract between two parties for setting future interest rates on loans or
deposits.
• Parties agree on interest rate, notional amount, and contract dates.
• Used for hedging against or speculating on interest rate movements.
• Traded over the counter (OTC).
• Example: A company hedges against rising interest rates with an FRA to secure a lower
future interest rate.

Swap Agreement:
• Swap agreements involve exchanging financial instruments or cash flows at
predetermined times.
• Types include interest rate swaps, currency swaps, and commodity swaps.
• Used for hedging, speculation, and arbitrage.
• Traded over the counter (OTC).
• Example: A company enters an interest rate swap to convert a variable-rate loan to a
fixed rate.

Interest Rate Swap vs. Currency Swap:

• Interest Rate Swap: Focus on interest rate cash flows, hedges interest rate risk.
• Currency Swap: Focus on exchanging principal and interest payments in different
currencies, hedges currency risk in international transactions.
• Cash Flows: Interest Rate Swap involves interest payments based on fixed or floating
rates; Currency Swap includes interest and principal payments in two currencies.
• Objectives: Interest Rate Swap aims to manage interest rate exposure or optimize
borrowing costs; Currency Swap manages currency risk in international trade or
finance.

Unit 5: Derivatives 38
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Participants: Interest Rate Swap involves corporations, financial institutions, and

investors; Currency Swap involves multinational corporations, financial institutions,
and governments.
• Market Size: Interest Rate Swap market is larger and more liquid; Currency Swap
market is smaller but significant for international business.

17. TERMINAL QUESTIONS

Short Questions
1. What are some of the earliest known examples of derivatives in history?
2. How did derivatives trading evolve in the Middle Ages?
3. When were the first formal derivatives exchanges established?
4. What factors contributed to the explosive growth of derivatives markets in the 20th
century?
5. What are some common uses of forward contracts?
6. What risks are associated with forward contracts?
7. How is the fair value of a forward contract calculated?
8. What is the key characteristic of futures contracts that distinguishes them from forward
contracts?
9. How are futures contracts settled, and what is the role of a clearinghouse?
10. What is the purpose of initial margin and maintenance margin in futures trading?
11. What is mark-to-market settlement in futures contracts, and why is it important?
12. What are the key differences between forward contracts and futures contracts?

Long Questions
1. Compare and contrast currency forwards and currency futures. What are the key
differences between these two derivative contracts?
2. Discuss the importance of currency futures in hedging for banks and corporations.
What advantages do currency futures offer in managing currency risk?
3. Explain the fundamental concepts of option contracts, including call and put options.
How are these contracts used for hedging and speculation?
4. Differentiate between American options and European options. How do the exercise
rights of these options impact their values and usage?

Unit 5: Derivatives 39
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. Describe the valuation of option contracts, focusing on the Black-Scholes-Merton

model. What are the key components and assumptions of this model?
6. Explain the binomial tree model for option valuation. What are its advantages and
limitations compared to the Black-Scholes-Merton model?

18. ANSWERS
Answers to Terminal Questions
Short Answer Types
Answer 1: Some of the earliest known examples of derivatives were contracts for the future
delivery of agricultural goods, such as those used by farmers in Mesopotamia.

Answer 2: In the Middle Ages, derivatives trading evolved as merchants began to use
derivatives to hedge their risk from currency fluctuations and changes in the prices of goods.
Italian merchants, for instance, used derivatives contracts for this purpose.

Answer 3: The first formal derivatives exchanges were established in the 17th century.

Answer 4: The growth of derivatives markets in the 20th century was driven by factors such
as the development of new financial technologies, the globalization of financial markets, and
the increasing use of derivatives by institutional investors.

Answer 5: Forward contracts are commonly used for hedging against price fluctuations in
underlying assets and for speculation on future price movements.

Answer 6: Forward contracts come with risks such as counterparty risk, market risk, and
liquidity risk.

Answer 7: The fair value of a forward contract is calculated using the spot price of the
underlying asset, the cost of carry, and the time to maturity of the contract.

Answer 8: Futures contracts are standardized and trade on organized exchanges, while
forward contracts are customizable and traded over the counter (OTC).

Answer 9: Futures contracts are typically settled in cash, and a clearinghouse acts as the
intermediary that ensures contract performance and reduces counterparty risk.

Unit 5: Derivatives 40
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 10: Initial margin is the initial deposit required to initiate a futures position, while
maintenance margin ensures that traders can cover potential losses and maintain their
positions. These margins help manage risk in futures trading.

Answer 11: Mark-to-market settlement ensures daily valuation and cash flow adjustments
for futures contracts. It helps mitigate counterparty risk and promotes transparency in
futures markets.

Answer 12: Forward contracts are customizable and traded over the counter, while futures
contracts are standardized and traded on organized exchanges. Futures contracts also
involve a clearinghouse that reduces counterparty risk, whereas forward contracts rely on
the creditworthiness of the parties involved.

Long Answer Types

Answer 1: Currency forwards and currency futures are both derivatives used for managing
foreign exchange risk, but they differ in several aspects. Currency forwards are private
agreements between two parties, while currency futures are standardized contracts traded
on exchanges. Currency forwards offer customization, while futures are highly standardized.
Margin requirements exist for futures but not for forwards. Forward contracts carry
counterparty risk, whereas futures do not. Finally, futures are typically more liquid due to
their exchange-traded nature.

Answer 2: Currency futures play a significant role in hedging strategies for banks and
corporations. They offer predictable exchange rates, risk mitigation against currency
fluctuations, cost efficiency, liquidity, regulatory compliance, diversification, operational
efficiency, credit risk mitigation, and contribute to overall financial stability. Currency
futures enable these entities to manage currency risk effectively and protect their financial
stability.

Answer 3: Option contracts provide the holder with the right but not the obligation to buy
(call option) or sell (put option) an underlying asset at a predetermined price on or before a
specified date. Call options are used for speculation on rising asset prices, while put options
are used for speculation on falling prices. Both can be used for hedging against adverse price

Unit 5: Derivatives 41
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

movements in the underlying asset. They provide flexibility to investors and traders to
manage risk or profit from price movements.

Answer 4: American options can be exercised at any time before expiration, while European
options can only be exercised on the expiration date. This exercise flexibility makes
American options typically more valuable than European options because holders can
optimize their exercise timing based on market conditions. American options are more
suitable for hedging and trading strategies that require early exercise, while European
options are simpler and often used in longer-term investment strategies.

Answer 5: Option valuation involves determining the fair value of an option based on factors
like the underlying asset's price, strike price, time to maturity, volatility, and risk-free
interest rate. The Black-Scholes-Merton (BSM) model is a widely used model for this
purpose. It incorporates current stock price, strike price, time to expiration, risk-free interest
rate, and volatility. The BSM model assumes constant volatility, risk-free rates, and no
transaction costs, simplifications that may not fully reflect real-world conditions.
Adjustments and variations have been developed to address these limitations.

Answer 6: The binomial tree model constructs a tree of possible outcomes for the underlying
asset's price at different time intervals. It calculates option values by evaluating payoffs at
each node and discounting them back to the present value. This model is versatile and can
handle changing volatility or dividend payments. Advantages include flexibility and the
ability to handle American options. However, it relies on discrete time steps, and the
accuracy depends on the number of steps used. It's also computationally expensive for long-
maturity options.

Unit 5: Derivatives 42
DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 6: Financing International Trade Market instruments 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 6
Financing International Trade Market
instruments
Table of Contents
SL Topic Fig No / Table SAQ / Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Financing International Trade - 1 5-14
3 Key market instruments used in financing - 2 15-28
international trade
4 Summary - - 29-32
5 Terminal Questions - - 33-34
6 Answers - - 34-38

Unit 6: Financing International Trade Market instruments 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
Financing international trade is a multifaceted process involving various market
instruments to facilitate capital flow and manage risks in cross-border transactions. The
Letter of Credit (L/C) serves as a crucial tool by guaranteeing payment upon specified
conditions, fostering trust between buyers and sellers. Documentary collections offer a
middle ground between open accounts and L/Cs, using commercial documents for secure
payment. Trade and Export Credit Insurance mitigate risks of non-payment due to buyer
insolvency. Forfaiting involves selling trade receivables, providing immediate cash flow to
exporters. Currency swaps and derivatives manage currency and commodity price
fluctuations, ensuring stability. Pre-Export Finance addresses exporters' financial needs
before shipment, and Factoring accelerates cash flow by selling accounts receivable. Islamic
Trade Finance Instruments offer Sharia-compliant alternatives. Collectively, these
instruments contribute to financial security, liquidity, and stability in global trade. The Letter
of Credit, a cornerstone in international trade, ensures smooth transactions and has become
a standard practice, offering security and liquidity. There are different types of L/Cs,
including Commercial, Standby, Revolving, Transferable, Back-to-Back, Red Clause, and
Green Clause, each catering to specific trade scenarios. The Bill of Lading is a crucial
document outlining terms and conditions for transporting goods, serving as a receipt and
title. Documentary Collections use commercial documents for payment, reducing risks for
both parties and providing flexibility. Each instrument plays a unique role in navigating the
complexities of cross-border commerce, offering a secure and structured framework for
financial transactions.

The key market instruments used in financing international trade encompass various
strategies aimed at mitigating risks and enhancing financial flexibility for businesses
engaged in cross-border transactions. Trade Credit Insurance provides protection against
non-payment, covering both commercial and political risks associated with international
trade. Forfaiting involves the discounted sale of trade receivables, offering immediate cash
flow to exporters and transferring credit risk to a specialized financial institution. Export
Credit Insurance, typically government-backed, mitigates the risk of non-payment by foreign
buyers, encouraging credit sales and promoting market expansion. Currency Swaps assist in
managing currency risk by exchanging specified amounts of different currencies at

Unit 6: Financing International Trade Market instruments 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

predetermined rates. Factoring involves the sale of accounts receivable to a third party at a
discount, providing immediate liquidity to exporters and transferring credit risk. Islamic
Trade Finance Instruments, adhering to Sharia principles, include Murabaha, Musharakah,
Wakalah, Istisna'a, Salam, and Tawarruq, offering alternative financing methods for
businesses involved in international trade while ensuring compliance with Islamic
principles. These instruments collectively contribute to the stability, risk management, and
financial growth of businesses in the global marketplace.

1.1 Learning Objectives

❖ Explore the market instruments that facilitate the seamless flow of capital.
❖ Understand the complexities and risks associated with cross-border transactions.
❖ Understanding Trade Credit Finance instruments like factoring, forfaiting, Export Credit
Insurance etc.
❖ Define Islamic Trade Finance Instruments and their compliance with Sharia principles.

Unit 6: Financing International Trade Market instruments 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. FINANCING INTERNATIONAL TRADE

Financing international trade is a multifaceted process that demands effective mechanisms
to facilitate the seamless flow of capital and manage the inherent risks of cross-border
transactions. A range of market instruments plays a pivotal role in this complex landscape.
One such instrument is the Letter of Credit (L/C), which provides assurance to both buyers
and sellers by guaranteeing payment upon the fulfilment of specified conditions.
Documentary collections offer a compromise between open account transactions and L/Cs,
utilizing commercial documents to ensure secure payment. Trade Credit Insurance and
Export Credit Insurance act as risk mitigation tools, protecting businesses from the
uncertainties of non-payment due to buyer insolvency or credit risks. Forfaiting involves
selling trade receivables, providing immediate cash flow to exporters and transferring credit
risk. Currency swaps and derivatives help manage currency and commodity price
fluctuations, ensuring stability in cross-border transactions. Pre-Export Finance addresses
the financial needs of exporters before shipment, while Factoring accelerates cash flow by
selling accounts receivable. Additionally, Islamic Trade Finance Instruments offer Sharia-
compliant alternatives. Collectively, these instruments contribute to the effectiveness of
international trade by fostering financial security, enhancing liquidity, and promoting
stability in the global movement of goods and services.

Here are some key market instruments used in financing international trade:

Letter of Credit (L/C):

A Letter of Credit (L/C) stands as a cornerstone in the realm of international trade, offering
a robust financial mechanism that ensures smooth transactions between buyers and sellers
across borders. This financial instrument, issued by a bank on behalf of an importer, serves
the crucial function of guaranteeing payment to the exporter, contingent upon the fulfillment
of specified conditions outlined in the letter of credit.

At its core, an L/C is a contractual agreement between the buyer and their bank, with the
bank undertaking the responsibility to pay the seller upon the successful completion of
certain predetermined criteria. This instrument acts as a form of assurance for the exporter,
mitigating the inherent risks associated with cross-border transactions. In the complex
landscape of global trade, where parties may be unfamiliar with each other and legal systems

Unit 6: Financing International Trade Market instruments 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

differ, the Letter of Credit provides a level of security that fosters trust and facilitates
commerce.

The process begins with the buyer and seller agreeing on the terms of the transaction,
including the nature and quantity of goods, price, and the conditions for payment. Once these
terms are established, the buyer's bank issues the Letter of Credit, detailing the specific
requirements that the exporter must fulfill to receive payment. These conditions often
revolve around the presentation of documents, such as invoices, bills of lading, certificates
of origin, and inspection certificates, which serve as evidence that the goods have been
shipped and meet the agreed-upon standards.

For the exporter, the L/C acts as a guarantee, assuring them that they will receive payment
as long as they adhere to the terms and conditions meticulously outlined in the document.
This mitigates the risk of non-payment, a concern that is particularly pronounced in
international trade due to the complexities and uncertainties involved. The exporter gains
confidence in shipping their products to distant markets, knowing that a reputable financial
institution is vouching for the buyer's ability and commitment to pay.

The Letter of Credit also plays a pivotal role in reducing the risk for the importer. By
stipulating the conditions under which payment will be made, the L/C provides a degree of
control, ensuring that the buyer only pays when the agreed-upon obligations are met. This
control is especially valuable in situations where the buyer and seller are unfamiliar with
each other, and the buyer may have concerns about the quality or timely delivery of the
goods.

Furthermore, the use of an L/C enhances the liquidity of the transaction. Since the buyer's
bank is essentially providing a guarantee of payment, the seller can often obtain financing
more easily, as the bank's creditworthiness stands behind the transaction. This liquidity is
crucial for businesses engaged in international trade, where upfront costs, such as
manufacturing and shipping, can be substantial.

The global acceptance of the Letter of Credit as a secure and reliable instrument has
contributed significantly to the expansion of international trade. It has become a standard
practice, particularly in transactions involving parties from different countries or regions

Unit 6: Financing International Trade Market instruments 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

with varying legal systems and business practices. Despite the rise of alternative financing
mechanisms, the L/C remains a preferred choice for many businesses due to its ability to
balance the interests of both buyers and sellers, offering a level playing field in the complex
arena of international commerce.

In conclusion, the Letter of Credit stands as a linchpin in international trade, providing a

structured and secure framework for financial transactions. Its ability to offer assurance to
both importers and exporters, mitigate risks, and facilitate smoother cross-border trade has
solidified its position as a key instrument in the global economic landscape. As businesses
continue to navigate the intricacies of international commerce, the Letter of Credit remains
a reliable ally, fostering trust and confidence in transactions that span the expanses of our
interconnected world.

Different Types of Letters of Credit

There are several types of Letters of Credit (L/C) that cater to different needs and scenarios
in international trade. These variations provide flexibility and customization to meet the
specific requirements of buyers and sellers. Here are some of the common types of Letters
of Credit:

Commercial Letter of Credit:

Description: This is the standard and most commonly used type of Letter of Credit. It is used
in commercial transactions where the buyer and seller may be unfamiliar with each other,
and it provides a guarantee of payment to the seller.

Function: The bank, on behalf of the buyer, assures the seller that payment will be made upon
the presentation of compliant documents as specified in the letter of credit.

Standby Letter of Credit (SBLC):

Description: Unlike a commercial L/C, a Standby Letter of Credit is a secondary payment
mechanism used as a backup if the buyer fails to fulfill their payment obligations.

Function: It serves as a guarantee to the seller that they will receive payment from the bank
if the buyer defaults. SBLCs are often used in construction projects, international bids, or as
a form of insurance against non-payment.

Unit 6: Financing International Trade Market instruments 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Revolving Letter of Credit:

Description: In a revolving L/C, the credit amount is automatically reinstated after it has
been used, allowing the buyer to make multiple shipments under a single credit.

Function: It provides flexibility for transactions involving ongoing business relationships

and continuous shipments.

Transferable Letter of Credit:

Description: This type of L/C allows the primary beneficiary (usually a middleman or
intermediary) to transfer all or part of the credit to a second beneficiary, who can then fulfill
the terms and conditions and receive payment.

Function: It is used when the intermediary does not want to handle the goods or when there
are multiple suppliers involved.

Back-to-Back Letter of Credit:

Description: In a back-to-back L/C, a new credit is issued based on an existing L/C. It is
commonly used when an intermediary is involved, and the supplier requires a letter of credit
to fulfill their part of the transaction.

Function: It allows for the extension of the original letter of credit to multiple suppliers in a
chain.

Red Clause Letter of Credit:

Description: This type of L/C includes a special clause (usually in red ink) that allows the
seller to receive a partial payment before shipment to cover the cost of production or other
expenses.

Function: It provides financial assistance to the seller before the goods are shipped.

Green Clause Letter of Credit:

Description: Similar to the red clause, the green clause includes a provision allowing for
partial payment before shipment. However, the green clause specifically covers warehousing
and pre-shipment storage costs.

Unit 6: Financing International Trade Market instruments 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Function: It is beneficial when there is a need for storage or additional processing of goods
before final shipment.

Understanding the nuances of these different types of Letters of Credit is essential for
businesses engaged in international trade. The choice of the appropriate type depends on
the specific needs of the parties involved, the nature of the transaction, and the level of risk
mitigation required. Each type serves as a valuable tool in navigating the complexities of
cross-border commerce, providing a secure and structured framework for financial
transaction.

Bill of Lading
A Bill of Lading (B/L) is a crucial document in international trade and shipping transactions,
serving as a receipt for goods and a document of title. It outlines the terms and conditions
under which the goods are being transported and provides evidence of the contract of
carriage. Here's a detailed explanation of the Bill of Lading:

Description:
A Bill of Lading is a legal document issued by a carrier or their agent to acknowledge the
receipt of cargo for shipment. It serves as a contract of carriage between the shipper
(seller/exporter) and the carrier. The document includes essential details about the goods
being shipped, the destination, and the conditions of transport.

Key Components:
Shipper and Consignee Information: The names and addresses of the shipper (seller) and the
consignee (buyer) are clearly mentioned.

Description of Goods: Detailed information about the nature, quantity, and packaging of the
goods being shipped is provided. This ensures that both parties have a clear understanding
of what is being transported.

Shipping Terms and Conditions: The terms of the contract of carriage, including the
responsibilities of the carrier and the shipper, are outlined. This includes details about
loading and unloading, the mode of transport, and any special instructions.

Unit 6: Financing International Trade Market instruments 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Vessel Information: Details about the vessel carrying the goods, including its name,
registration, and voyage number, are included.

Freight Charges: If applicable, the document includes information about the freight charges
paid or payable by the shipper.

Date and Place of Issuance: The date and place where the Bill of Lading is issued are clearly
stated.

Functions:
Receipt of Goods: The primary function of a Bill of Lading is to serve as a receipt,
acknowledging that the carrier has received the specified goods in the condition described.

Document of Title: The Bill of Lading is a negotiable instrument, meaning it can be

transferred to others, especially when it is used in a Letter of Credit transaction. The holder
of the document has the right to claim the goods upon arrival at the destination.

Contract of Carriage: It outlines the terms and conditions of the transportation contract
between the shipper and the carrier. This includes the agreed-upon route, mode of transport,
and other relevant details.

Customs Clearance: The Bill of Lading is a crucial document for customs clearance at the
destination. It provides authorities with the necessary information to verify the shipment
and assess applicable duties and taxes.

Types of Bills of Lading:

Straight (or Non-Negotiable) Bill of Lading: This type is not negotiable and is usually used
when the goods are consigned to a specific party, and they are not intended to be resold
during transit.

Order (or Negotiable) Bill of Lading: This type can be transferred to another party, making it
a negotiable instrument. It is often used in international trade when the goods are being sold
during transit, and ownership needs to change hands.

Bearer Bill of Lading: Similar to an order bill, but it is payable to whoever holds the original
document, making it more like a bearer instrument.

Unit 6: Financing International Trade Market instruments 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Documentary Collections:
Description:
Documentary collections are a method of trade finance that involves the use of commercial
documents, such as bills of exchange and promissory notes, to facilitate payment between
the buyer and the seller through their respective banks. Unlike open account transactions
where goods are shipped and delivered before payment, or letters of credit where banks
guarantee payment, documentary collections operate by presenting the buyer with the
necessary documents only upon payment or acceptance of a draft.

Function:
The primary function of documentary collections is to reduce the risk for both the buyer and
the seller in an international trade transaction. This method provides a compromise between
open account trading and letters of credit, offering a level of security for the seller while
allowing the buyer a certain degree of flexibility.

When using documentary collections, the process typically involves the following steps:

Agreement on Terms:
The buyer and seller agree on the terms of the sale, including the types of documents to be
used and the conditions under which these documents will be released.

Shipment of Goods:
The seller ships the goods to the buyer and prepares the necessary documents, including the
bill of exchange or draft, bill of lading, and other relevant commercial documents.

Submission to Banks:
The seller submits the commercial documents to their bank, which, in turn, forwards them
to the buyer's bank. The buyer's bank notifies the buyer of the arrival of the documents.

Payment or Acceptance:
The buyer's bank releases the documents to the buyer either upon payment or acceptance
of the draft. The payment can be made immediately or at a specified future date, depending
on the terms agreed upon.

Unit 6: Financing International Trade Market instruments 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Settlement:
Once the buyer has made the payment or accepted the draft, the banks involved settle the
transaction. The funds are transferred from the buyer's bank to the seller's bank.

Advantages:
Risk Mitigation:
Documentary collections provide a level of security for the seller since the release of
documents is linked to payment. On the other hand, the buyer can inspect the documents
before making the payment, reducing the risk of non-compliance with agreed-upon terms.

Lower Costs:
Compared to letters of credit, documentary collections are often less costly as they involve
fewer bank fees and are less complex in terms of documentation.

Flexibility:
The process offers more flexibility to both parties. Sellers can use collections for established
relationships or transactions with lower inherent risks, while buyers can inspect documents
before making payment.

Maintained Relationship:
Since documentary collections involve direct communication between banks, the buyer and
seller can maintain a relationship without the need for extensive intermediation.

Considerations:
While documentary collections provide certain advantages, it's essential for both parties to
clearly define and agree upon the terms of the collection. Ambiguities in the contract can lead
to misunderstandings or disputes. Additionally, the effectiveness of this method depends on
the level of trust between the buyer and the seller, as well as the reliability of the banking
systems involved.

Unit 6: Financing International Trade Market instruments 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary function of a Letter of Credit (L/C) in international

trade?
a) Facilitating direct payment between buyers and sellers
b) Mitigating risks associated with cross-border transactions
c) Issuing commercial invoices for goods
d) Providing insurance against currency fluctuations
2. In the process of a Letter of Credit, who issues the L/C on behalf of the
importer?
a) Exporter's bank
b) Importer's bank
c) Central government
d) International trade organization
3. What type of Letter of Credit is commonly used in commercial transactions
where the buyer and seller may be unfamiliar with each other?
a) Standby Letter of Credit (SBLC)
b) Revolving Letter of Credit
c) Commercial Letter of Credit
d) Back-to-Back Letter of Credit
4. What role does a Standby Letter of Credit (SBLC) play in international trade?
a) Secondary payment mechanism used as a backup
b) Primary guarantee for the buyer
c) Direct payment to the exporter
d) Insurance against shipment risks
5. What advantage does a Revolving Letter of Credit provide in international
trade transactions?
a) Allows for multiple shipments under a single credit
b) Ensures immediate payment upon presentation of documents
c) Provides partial payment before shipment
d) Facilitates direct communication between banks

Unit 6: Financing International Trade Market instruments 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

6. What is the main function of a Bill of Lading in international trade?

a) Negotiating payment terms
b) Acknowledging receipt of cargo for shipment
c) Issuing commercial invoices
d) Providing trade credit insurance
7. Which type of Bill of Lading is negotiable and can be transferred to another
party, making it a negotiable instrument?
a) Straight Bill of Lading
b) Order Bill of Lading
c) Bearer Bill of Lading
d) Non-Negotiable Bill of Lading
8. What is the primary function of Documentary Collections in trade finance?
a) Guaranteeing payment to the exporter
b) Providing insurance against non-payment
c) Facilitating open account transactions
d) Reducing risk for both the buyer and the seller
9. Why are Documentary Collections considered to be less costly compared to
letters of credit?
a) They involve fewer bank fees
b) They guarantee immediate payment
c) They are more complex in documentation
d) They require extensive intermediation
10. In the process of Documentary Collections, when are the documents released
to the buyer?
a) Before shipment of goods
b) Upon agreement on terms
c) Upon payment or acceptance of the draft
d) After customs clearance

Unit 6: Financing International Trade Market instruments 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. KEY MARKET INSTRUMENTS USED IN FINANCING INTERNATIONAL

TRADE

Trade Credit Insurance:

Trade Credit Insurance is a type of insurance that provides protection to businesses against
the risk of non-payment by buyers. This insurance coverage can extend to both commercial
and political risks associated with international trade transactions.

Function:
The primary function of Trade Credit Insurance is to mitigate the risk of non-payment, which
is particularly crucial for businesses engaged in cross-border trade. Here's how it works:

Risk Mitigation:
Businesses that sell goods or services on credit terms face the risk of not being paid by their
buyers. This risk can arise from various factors, including the financial instability of the
buyer, political events affecting the buyer's country, or other unforeseen circumstances.

Trade Credit Insurance steps in to mitigate this risk by providing coverage against the non-
payment of commercial debts. This means that if a buyer fails to pay, the insurer
compensates the seller for the covered amount, reducing the financial impact on the selling
business.

Enabling Credit Terms:

Trade Credit Insurance enables exporters to offer credit terms to their buyers with greater
confidence. Instead of requiring upfront payment, businesses can extend credit periods to
buyers, fostering stronger relationships and potentially increasing sales.

This flexibility in payment terms is a competitive advantage in the international market, as

buyers may prefer to defer payments while still ensuring the financial security of the
transaction through insurance.

Safeguarding Cash Flow:

For businesses, maintaining a healthy cash flow is essential for ongoing operations,
investment, and growth. Non-payment by buyers can disrupt this cash flow, leading to
financial strain.

Unit 6: Financing International Trade Market instruments 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Trade Credit Insurance acts as a safeguard for the cash flow of exporting businesses. In the
event of non-payment, the insurance payout helps ensure that the exporter still receives the
funds owed, reducing the impact on liquidity.

Coverage Types:
Trade Credit Insurance can cover both commercial risks, such as insolvency or protracted
default of the buyer, and political risks, including events like political unrest, currency
inconvertibility, or the imposition of trade sanctions.

Enhancing Confidence in International Trade:

By providing a safety net against the uncertainties of international trade, Trade Credit
Insurance enhances the confidence of businesses to explore and expand into global markets.
It encourages them to engage in trade with buyers from different countries, even in regions
with higher perceived risks.

Forfaiting:
Forfaiting is a financial arrangement in international trade that involves the sale of trade
receivables, such as promissory notes or bills of exchange, at a discount. This transaction
typically takes place between an exporter and a forfaiter, which is a specialized financial
institution. The forfaiter purchases the exporter's receivables, providing the exporter with
immediate cash flow.

Function:
The primary function of forfaiting is to offer a mechanism for exporters to convert their
credit sales into cash, thereby improving their liquidity. Here's how the process works:

Sale of Trade Receivables:

The exporter sells its trade receivables, which are essentially the amounts owed by buyers
for goods or services provided on credit. These receivables are typically in the form of
promissory notes or bills of exchange.

Discounted Sale to Forfaiter:

The exporter sells these receivables to a forfaiter at a discount. The discount represents the
cost of funds, the time value of money, and the risk associated with the receivables. The
forfaiter pays the exporter the discounted amount in cash.

Unit 6: Financing International Trade Market instruments 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Immediate Cash Flow:

For the exporter, forfaiting provides an immediate injection of cash, allowing them to meet
immediate financial needs, fund new projects, or explore business opportunities. This is
particularly beneficial when the exporter wants to avoid waiting for the original credit
period to expire.

Transfer of Risk:
By engaging in forfaiting, the exporter transfers the credit risk and responsibility for
collecting payment to the forfaiter. The forfaiter assumes the risk of non-payment by the
buyer, insulating the exporter from the uncertainties associated with international trade.

Promotes Risk Mitigation:

Forfaiting is particularly relevant in situations where the exporter is concerned about the
creditworthiness of the buyer, the political or economic stability of the buyer's country, or
other risks that could impact the timely receipt of payment.

By offloading these risks to the forfeiter, the exporter gains a more predictable and certain
cash flow, contributing to financial stability.

Fixed Interest Rates:

The discount rate applied by the forfeiter is typically fixed, providing the exporter with
certainty regarding the cost of financing. This can be advantageous in a fluctuating interest
rate environment.

Facilitates Competitive Financing:

Forfaiting can make the exporter's offerings more attractive to buyers, as it allows the
exporter to offer more favourable credit terms. This can be a competitive advantage in the
international market.

Export Credit Insurance

Export Credit Insurance is a type of insurance, typically backed by the government, that
provides protection to exporters against the risk of non-payment by foreign buyers. This
insurance coverage is designed to mitigate the financial impact on exporters when foreign
buyers fail to fulfill their payment obligations.

Unit 6: Financing International Trade Market instruments 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Function:
The primary function of Export Credit Insurance is to encourage and support international
trade by addressing the inherent risks associated with offering credit terms to foreign
buyers. Here's an explanation of how it works:

Risk Mitigation:
Export Credit Insurance serves as a risk mitigation tool for exporters. It protects them
against the risk of non-payment due to various factors, including insolvency of the foreign
buyer, political instability in the buyer's country, or default on payment.

Encouraging Credit Sales:

By providing a safety net against non-payment, Export Credit Insurance enables exporters
to offer credit terms to foreign buyers. This is crucial for competitive positioning, as it allows
exporters to attract buyers who may prefer deferred payment options.

Government Backing:
Export Credit Insurance is often backed or facilitated by government export credit agencies.
These agencies work to promote and facilitate international trade for their respective
countries. Government backing adds credibility to the insurance, instilling confidence in
exporters.

Credit Decision Support:

Exporters can use Export Credit Insurance as a tool for evaluating the creditworthiness of
potential foreign buyers. The insurance provider assesses the credit risk associated with
specific buyers and countries, providing valuable information for exporters to make
informed decisions.

Financing Support:
Some Export Credit Insurance programs may also facilitate access to financing for exporters.
Lenders may be more willing to extend credit when they know that the exporter is covered
by Export Credit Insurance, reducing their risk exposure.

Unit 6: Financing International Trade Market instruments 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Promoting Market Expansion:

Export Credit Insurance contributes to the expansion of export markets by giving exporters
the confidence to explore new markets and engage with buyers in regions where the risk of
non-payment might be perceived as higher.

Stability in International Transactions:

With Export Credit Insurance, exporters can conduct international transactions with greater
certainty and confidence. They are less vulnerable to the uncertainties of cross-border trade,
contributing to the stability of their operations.

Customized Coverage:
Export Credit Insurance can often be tailored to the specific needs of exporters. Coverage can
vary based on factors such as the creditworthiness of buyers, the countries involved, and the
nature of the goods or services being exported.

Currency Swaps:
Currency swaps are financial agreements between two parties to exchange a specified
amount of one currency for another at a predetermined exchange rate and on a future date.
These agreements are a mechanism for mitigating currency risk and are commonly used in
international business transactions.

Function:
The primary function of currency swaps is to assist businesses in managing the inherent
risks associated with transactions involving different currencies. Here's an explanation of
how currency swaps work and their key functions:

Risk Mitigation:
Currency swaps help businesses mitigate currency risk, also known as exchange rate risk.
When companies engage in international trade or investments, they are exposed to
fluctuations in exchange rates. Currency swaps provide a way to hedge against these
fluctuations.

Unit 6: Financing International Trade Market instruments 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Exchange of Currencies:
The parties involved in a currency swap agree to exchange a specified amount of one
currency for an equivalent amount of another currency. This exchange is based on an agreed-
upon exchange rate, which is predetermined at the initiation of the swap.

Future Date Settlement:

The actual exchange of currencies often takes place at a future date specified in the swap
agreement. This allows businesses to plan and execute transactions with more certainty, as
they know the exact terms at which the currency exchange will occur.

Stabilizing Cash Flows:

Currency swaps contribute to the stability of cash flows for businesses engaged in
international activities. By fixing the exchange rate in advance, companies can better forecast
their financial positions and reduce the uncertainties associated with fluctuating currency
values.

Cost Reduction:
For businesses engaged in frequent transactions involving different currencies, currency
swaps can help reduce costs. Instead of conducting individual currency exchanges for each
transaction, a currency swap allows for the consolidation of these exchanges, potentially
reducing transaction costs.

Access to Preferred Currency:

In international transactions, businesses may prefer to transact in their home currency or
another preferred currency. Currency swaps enable them to access the desired currency
without being directly exposed to the associated risks.

Facilitating International Financing:

Currency swaps are often used in international financing arrangements. For example, a
company based in one country may need financing in the currency of another country. A
currency swap can be structured to provide the necessary funds in the required currency.

Unit 6: Financing International Trade Market instruments 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Customization of Terms:
Currency swaps can be customized to meet the specific needs of the parties involved. This
includes determining the notional amount, the exchange rate, and the maturity date,
allowing for flexibility in addressing the unique requirements of each transaction.

Interest Rate Management:

In addition to managing currency risk, currency swaps can also be structured to manage
interest rate risk. The agreement may include provisions for swapping interest payments in
addition to the principal amounts.

Factoring
Factoring is a financial arrangement that involves the sale of accounts receivable, or
outstanding invoices, to a third party known as a factor. In this process, the exporter sells its
invoices to the factor at a discounted rate in exchange for immediate cash.

Function:
The primary function of factoring is to provide immediate liquidity to the exporter by
converting accounts receivable into cash. Here's an in-depth explanation of how factoring
works and its key functions:

Sale of Receivables:
The exporter, also known as the seller, sells its accounts receivable (unpaid invoices) to a
specialized financial institution called the factor. This sale is typically done at a discount,
meaning the factor pays less than the face value of the invoices.

Immediate Cash Flow:

By selling the receivables, the exporter gains immediate access to cash. This is particularly
beneficial for businesses that may experience cash flow challenges due to extended payment
terms or delays in receiving payments from buyers.

Offloading Credit Risk:

One of the significant functions of factoring is the transfer of credit risk. Once the factor
purchases the receivables, it assumes the responsibility for collecting payments from the
buyers. This offloading of credit risk can be crucial for exporters dealing with buyers who
may have uncertain creditworthiness.

Unit 6: Financing International Trade Market instruments 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Credit Assessment by the Factor:

Before entering into a factoring agreement, the factor assesses the creditworthiness of the
exporter's customers (buyers). This evaluation helps determine the risk associated with the
receivables and influences the discount rate applied to the invoices.

Improved Working Capital:

Factoring improves the exporter's working capital position. Instead of waiting for the normal
payment terms to be fulfilled, the exporter receives immediate funds, allowing for more agile
operations, investment in new projects, or meeting immediate financial obligations.

Professional Receivables Management:

Factors often provide professional receivables management services. This includes activities
such as credit checking, collection of payments, and maintaining detailed accounts of
receivables. This allows exporters to focus on their core business activities while the factor
handles administrative aspects.

Flexible Financing:
Factoring provides flexible financing options. The amount of funding is directly linked to the
value of the receivables. As the volume of sales or the value of invoices increases, the
available financing also grows, providing scalability for businesses.

Variants of Factoring:
There are different types of factoring arrangements, including recourse factoring and non-
recourse factoring. In recourse factoring, the exporter may be required to repurchase the
receivables if the buyer fails to pay. In non-recourse factoring, the factor assumes the risk of
non-payment, providing additional protection to the exporter.

Relationship with Buyers:

The relationship between the factor and the buyer depends on the type of factoring. In some
cases, the factor communicates directly with the buyers for payment collection, while in
others, the arrangement remains confidential, and the buyer may not be aware of the
factoring agreement.

Unit 6: Financing International Trade Market instruments 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Cost of Factoring:
The cost of factoring, including the discount rate applied to the receivables, is determined
based on factors such as the creditworthiness of the buyers, the volume of receivables, and
the agreed-upon terms. While factoring involves a cost, the benefits in terms of immediate
cash and risk mitigation often outweigh the expenses.

Islamic Trade Finance Instruments:

Islamic Trade Finance Instruments are financial tools designed to comply with Sharia
principles, which prohibit certain elements such as interest (usury) and uncertainty
(gharar). These instruments include Murabaha (cost-plus financing), Musharakah
(partnership), and Wakalah (agency), among others.

Function:
The primary function of Islamic Trade Finance Instruments is to enable businesses to engage
in international trade activities while adhering to the principles of Islamic finance. Here's an
explanation of the key instruments and their functions:

Murabaha (Cost-Plus Financing):

Description: In a Murabaha transaction, the financier (bank or financial institution)
purchases the goods on behalf of the client and sells them to the client at a cost-plus profit.

Function: This instrument allows businesses to acquire goods without directly involving
interest. The profit margin is agreed upon in advance, providing transparency in the
transaction.

Musharakah (Partnership):
Description: Musharakah involves a partnership between the financier and the client, where
both parties contribute capital to fund a business venture.

Function: In the context of international trade, Musharakah can be applied to joint ventures
or co-financing arrangements. Profits and losses are shared based on the agreed-upon terms.

Wakalah (Agency):
Description: Wakalah is an agency arrangement where one party (the principal) appoints
another party (the agent) to act on its behalf.

Unit 6: Financing International Trade Market instruments 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Function: In trade finance, Wakalah can be used for agency services related to the purchase
or sale of goods. The agent operates on behalf of the principal, following the principles of
Islamic finance.

Istisna'a (Contracting for Manufacture):

Description: Istisna'a involves a contractual agreement for the manufacture or construction
of goods. The buyer may request the seller to manufacture a specific product.

Function: This instrument is applicable to trade transactions involving the production of

goods. The buyer can specify the desired product, and the seller undertakes the
responsibility of manufacturing it.

Salam (Advance Payment for Deferred Delivery):

Description: Salam is a contract where the buyer makes an advance payment for goods that
will be delivered at a later date.

Function: This instrument supports businesses that need upfront financing for the
production of goods. It aligns with Islamic principles by avoiding the uncertainty associated
with conventional interest-based transactions.

Tawarruq (Monetization):
Description: Tawarruq involves buying an asset on deferred payment terms and selling it for
cash to a third party.

Function: While originally used for personal finance, Tawarruq can be adapted to trade
finance. It provides a way to obtain cash by selling assets, adhering to Islamic principles.

Application in International Trade:

These Islamic Trade Finance Instruments are utilized in various stages of international trade,
from acquiring goods to financing production and facilitating the exchange of goods.
Businesses engaged in Islamic finance, as well as banks and financial institutions adhering
to Sharia principles, can choose the instrument that best suits the specific requirements of
their trade transactions.

Unit 6: Financing International Trade Market instruments 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Considerations:
Adherence to Sharia principles is a critical consideration in the application of these
instruments. Contracts and agreements must be structured to ensure compliance, and the
involved parties should have a clear understanding of the chosen Islamic finance instrument.

SELF-ASSESSMENT QUESTIONS – 2

11. What does Trade Credit Insurance primarily protect businesses against?
a) Fire damage
b) Employee disputes
c) Non-payment by buyers
d) Natural disasters
12. How does Trade Credit Insurance mitigate the risk of non-payment for
businesses?
a) By providing coverage against commercial debts
b) By offering discounts to buyers
c) By investing in the stock market
d) By guaranteeing political stability
13. What competitive advantage does Trade Credit Insurance offer in the
international market?
a) Lowering product prices
b) Providing legal assistance
c) Enabling more favorable credit terms
d) Offering extended warranty
14. What is the primary function of forfaiting in international trade?
a) Offering insurance to buyers
b) Improving liquidity for exporters
c) Lowering interest rates
d) Providing legal representation

Unit 6: Financing International Trade Market instruments 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

15. How does forfaiting contribute to financial stability for exporters?

a) By increasing credit risk
b) By offering variable interest rates
c) By transferring credit risk to the forfaiter
d) By requiring upfront payments
16. What is a significant advantage of forfaiting for exporters in a fluctuating
interest rate environment?
a) Variable interest rates
b) Fixed interest rates
c) No interest rates
d) Interest-free financing
17. What is the primary purpose of Export Credit Insurance?
a) Lowering export taxes
b) Encouraging and supporting international trade
c) Providing subsidies to exporters
d) Managing exchange rates
18. How does Export Credit Insurance contribute to market expansion for
exporters?
a) By reducing product prices
b) By ensuring political stability
c) By offering tax exemptions
d) By providing confidence to explore new markets
19. What role does government backing play in Export Credit Insurance?
a) Lowering insurance premiums
b) Providing credibility to the insurance
c) Influencing currency exchange rates
d) Offering interest-free loans

Unit 6: Financing International Trade Market instruments 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

20. What is the primary function of currency swaps in international business

transactions?
a) Reducing transaction costs
b) Increasing interest rates
c) Managing political risks
d) Lowering export prices
21. How do currency swaps contribute to stabilizing cash flows for businesses
engaged in international activities?
a) By offering variable exchange rates
b) By fixing the exchange rate in advance
c) By involving political negotiations
d) By providing interest-free financing
22. In addition to managing currency risk, what other risk can currency swaps
be structured to manage?
a) Credit risk
b) Market risk
c) Interest rate risk
d) Political risk
23. What is the primary function of factoring in international trade?
a) Lowering export prices
b) Providing legal representation
c) Converting accounts receivable into cash
d) Managing political risks
24. How does factoring improve the working capital position for exporters?
a) By increasing credit risk
b) By providing interest-free financing
c) By waiting for normal payment terms
d) By offering immediate access to cash

Unit 6: Financing International Trade Market instruments 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

25. What is a significant advantage of factoring in terms of financing options?

a) Fixed financing amounts
b) Variable financing amounts
c) Interest-free financing
d) Flexible financing linked to the value of receivables
26. What is the primary consideration in the application of Islamic Trade Finance
Instruments?
a) Maximizing profits
b) Adherence to Sharia principles
c) Political stability
d) Interest rate fluctuations
27. Which Islamic finance instrument involves a partnership between the
financier and the client?
a) Murabaha
b) Musharakah
c) Wakalah
d) Istisna'a
28. What does Istisna'a involve in the context of trade transactions?
a) Sale of accounts receivable
b) Partnership in a business venture
c) Contractual agreement for the manufacture of goods
d) Advance payment for deferred delivery

Unit 6: Financing International Trade Market instruments 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. SUMMARY
Financing International Trade:
• Multifaceted process requiring effective mechanisms.
• Key instruments include Letter of Credit, Documentary Collections, Trade Credit
Insurance, Export Credit Insurance, Forfaiting, Currency Swaps, Derivatives, Pre-
Export Finance, Factoring, and Islamic Trade Finance Instruments.
• Contributions: Fostering financial security, enhancing liquidity, and promoting stability
in global trade.

Letter of Credit (L/C):

• Crucial in international trade for smooth transactions.
• Issued by a bank on behalf of an importer, guaranteeing payment to the exporter.
• Mitigates risks associated with cross-border transactions.
• Buyer's bank issues L/C, specifying conditions for payment.
• Conditions often involve presentation of documents as evidence of shipment and
compliance.
• Acts as a guarantee for the exporter, enhancing confidence in shipping products.
• Reduces risk for the importer, providing control over payment conditions.
• Enhances liquidity, as the bank's creditworthiness supports the transaction.
• Global acceptance contributes to the expansion of international trade.
• Despite alternatives, remains a preferred choice for balancing interests.

Types of Letters of Credit:

Commercial Letter of Credit:
• Standard and commonly used.
• Provides a guarantee of payment to the seller in commercial transactions.

Standby Letter of Credit (SBLC):

• Secondary payment mechanism.
• Acts as a guarantee to the seller in case the buyer fails to fulfill payment obligations.

Unit 6: Financing International Trade Market instruments 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Revolving Letter of Credit:

• Credit amount automatically reinstated for multiple shipments under a single credit.
• Provides flexibility for ongoing business relationships.

Transferable Letter of Credit:

• Allows the primary beneficiary to transfer all or part of the credit to a second
beneficiary.
• Used when the intermediary does not want to handle goods or multiple suppliers are
involved.

Back-to-Back Letter of Credit:

• New credit issued based on an existing L/C.
• Common in transactions involving intermediaries and multiple suppliers.

Red Clause Letter of Credit:

• Includes a special clause for partial payment before shipment.
• Provides financial assistance to the seller before goods are shipped.

Green Clause Letter of Credit:

• Similar to red clause but covers warehousing and pre-shipment storage costs.
• Beneficial when storage or additional processing of goods is needed before final
shipment.

Bill of Lading (B/L):

• Crucial document in international trade and shipping transactions.
• Serves as a receipt, document of title, and contract of carriage.
• Includes shipper and consignee information, goods description, shipping terms, vessel
details, freight charges, date, and place of issuance.
• Functions: Receipt of goods, document of title, contract of carriage, customs clearance.
• Types: Straight (Non-Negotiable), Order (Negotiable), Bearer Bill of Lading.

Documentary Collections:
• Trade finance method using commercial documents to facilitate payment.
• Compromise between open account transactions and letters of credit.

Unit 6: Financing International Trade Market instruments 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Process involves agreement on terms, shipment of goods, submission to banks,

payment or acceptance, and settlement.
• Advantages: Risk mitigation, lower costs, flexibility, maintained relationship.
• Considerations: Clear terms definition, trust between parties, and reliability of banking
systems.

Trade Credit Insurance:

• Type of insurance protecting businesses from non-payment by buyers.
• Covers commercial and political risks in international trade.
• Mitigates the risk of non-payment by compensating sellers.
• Enables offering credit terms with confidence, fostering relationships.
• Safeguards cash flow by ensuring payment in case of non-payment.
• Coverage for commercial risks (insolvency) and political risks (unrest).

Forfaiting:
• Financial arrangement involving the discounted sale of trade receivables.
• Provides immediate cash flow to exporters.
• Involves selling promissory notes or bills of exchange at a discount.
• Transfers credit risk to forfaiter, insulating exporters.
• Fixed interest rates provide certainty in financing.
• Enhances competitiveness by offering favorable credit terms.

Export Credit Insurance:

• Government-backed insurance protecting exporters from non-payment.
• Mitigates risks like insolvency, political instability in the buyer's country.
• Encourages credit sales to foreign buyers, supporting market expansion.
• Provides government backing for credibility.
• Assists in evaluating creditworthiness of foreign buyers.
• Customizable coverage based on specific needs.

Currency Swaps:
• Financial agreements to exchange specified currencies at a predetermined rate.
• Mitigates currency (exchange rate) risk in international transactions.

Unit 6: Financing International Trade Market instruments 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Exchange occurs at a future date, stabilizing cash flows.

• Reduces costs and provides access to preferred currencies.
• Customizable terms including notional amount, exchange rate, and maturity.
• Used in international financing and manages interest rate risk.

Factoring:
• Involves selling accounts receivable (invoices) to a factor for immediate cash.
• Provides immediate liquidity, improving working capital.
• Transfers credit risk to the factor, which handles payment collection.
• Factor assesses creditworthiness of buyers.
• Offers professional receivables management services.
• Flexible financing linked to the value of receivables.

Islamic Trade Finance Instruments:

• Compliant with Sharia principles prohibiting interest and uncertainty.
• Includes Murabaha, Musharakah, Wakalah, Istisna'a, Salam, and Tawarruq.
• Murabaha involves cost-plus financing, providing transparency.
• Musharakah is a partnership for co-financing arrangements.
• Wakalah is an agency arrangement for trade services.
• Istisna'a involves contracting for the manufacture of goods.
• Salam is an advance payment for deferred delivery.
• Tawarruq involves buying an asset on deferred payment terms.
• Application in various stages of international trade while adhering to Islamic principles.

Unit 6: Financing International Trade Market instruments 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. TERMINAL QUESTIONS
Q1 : Explain the significance of a Letter of Credit in international trade, and how does it
balance the interests of both buyers and sellers?

Q2: Discuss the different types of Letters of Credit and their respective functions. How does
each type cater to specific needs in international trade?

Q3: Elaborate on the functions and components of a Bill of Lading. How does it contribute to
the smooth execution of international trade and logistics?

Q4: Compare and contrast documentary collections with other trade finance mechanisms
like Letters of Credit. What advantages do documentary collections offer, and what
considerations should be taken into account?

Q5: Discuss the various market instruments used in financing international trade and how
they contribute to the effectiveness of global commerce. In what ways do these instruments
foster financial security, enhance liquidity, and promote stability?

Q6: Explore the risk mitigation tools mentioned in financing international trade, such as
Trade Credit Insurance and Export Credit Insurance. How do these tools protect businesses
from uncertainties in cross-border transactions?

Q7: Delve into the features and significance of Islamic Trade Finance Instruments in
international trade. How do they provide Sharia-compliant alternatives, and what role do
they play in fostering financial inclusivity?

Question 8: Explain the primary function of Trade Credit Insurance in international trade
and how it contributes to risk mitigation.

Question 9: Describe the process of Forfaiting in international trade and how it benefits
exporters in terms of cash flow and risk transfer.

Question 10: What role does Export Credit Insurance play in encouraging credit sales to
foreign buyers, and how does government backing add credibility to this insurance?

Unit 6: Financing International Trade Market instruments 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 11: Explain the functions of Currency Swaps in managing risks associated with
international transactions, including their role in stabilizing cash flows and reducing costs.

Question 12: Explore the functions and benefits of Factoring in international trade finance,
emphasizing its impact on working capital and credit risk.

Question 13: Discuss the key Islamic Trade Finance Instruments, their functions, and how
they enable businesses to engage in international trade while adhering to Sharia principles.

6. ANSWERS
Self-Assessment Questions
Answer 1: b. Mitigating risks associated with cross-border transactions

Answer 2: b. Importer's bank

Answer 3: c. Commercial Letter of Credit

Answer 4: a. Secondary payment mechanism used as a backup

Answer 5: a. Allows for multiple shipments under a single credit

Answer 6: b. Acknowledging receipt of cargo for shipment

Answer 7: b. Order Bill of Lading

Answer 8: d. Reducing risk for both the buyer and the seller

Answer 9: a. They involve fewer bank fees

Answer 10: c. Upon payment or acceptance of the draft

Answer 11: C. Non-payment by buyers

Answer 12: A. By providing coverage against commercial debts

Answer 13: C. Enabling more favorable credit terms

Answer 14: B. Improving liquidity for exporters

Answer 15: C. By transferring credit risk to the forfaiter

Unit 6: Financing International Trade Market instruments 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 16: B. Fixed interest rates

Answer 17: B. Encouraging and supporting international trade

Answer 18: D. By providing confidence to explore new markets

Answer 19: B. Providing credibility to the insurance

Answer 20: A. Reducing transaction costs

Answer 21: B. By fixing the exchange rate in advance

Answer 22: C. Interest rate risk

Answer 23: C. Converting accounts receivable into cash

Answer 24: D. By offering immediate access to cash

Answer 25: D. Flexible financing linked to the value of receivables

Answer 26: B. Adherence to Sharia principles

Answer 27: B. Musharakah

Answer 28: C. Contractual agreement for the manufacture of goods

Terminal Questions
A1: A Letter of Credit is a crucial financial instrument in international trade, providing
assurance to both buyers and sellers. It balances interests by guaranteeing payment to the
exporter upon meeting specified conditions, reducing risks for both parties. It enhances
liquidity, fosters trust, and is globally accepted in diverse transactions.

A2: There are various types of Letters of Credit, including Commercial L/C, Standby L/C,
Revolving L/C, Transferable L/C, Back-to-Back L/C, Red Clause L/C, and Green Clause L/C.
Each type serves distinct purposes, providing flexibility, security, and tailored solutions to
meet the diverse requirements of buyers and sellers in international transactions.

A3: A Bill of Lading serves as a receipt, document of title, and contract of carriage in
international trade. It includes shipper and consignee information, goods description,

Unit 6: Financing International Trade Market instruments 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

shipping terms, vessel details, freight charges, and issuance details. It ensures proper
documentation, aids in customs clearance, and facilitates the seamless transport of goods.

A4: Documentary collections provide a compromise between open account transactions and
Letters of Credit. They reduce risk for both buyers and sellers, offer flexibility, lower costs,
and maintain relationships. However, effective usage requires clear terms, and trust between
parties is crucial. The process involves presenting documents upon payment or acceptance,
striking a balance between security and flexibility.

A5: The financing of international trade involves instruments like Letter of Credit,
Documentary Collections, Trade Credit Insurance, Export Credit Insurance, Forfaiting,
Currency Swaps, Derivatives, Pre-Export Finance, Factoring, and Islamic Trade Finance
Instruments. Collectively, they provide financial security, enhance liquidity, and promote
stability by addressing different aspects of risk mitigation, cash flow, and adherence to
Sharia-compliant alternatives.

A6: Trade Credit Insurance and Export Credit Insurance act as risk mitigation tools by
protecting businesses from non-payment due to buyer insolvency or credit risks. They
provide a safety net, allowing businesses to navigate uncertainties in international trade
with confidence.

A7: Islamic Trade Finance Instruments offer Sharia-compliant alternatives in international

trade, ensuring adherence to Islamic principles. They contribute to financial inclusivity by
providing ethical financing options, catering to businesses that align with Islamic finance
practices. These instruments add diversity to the financial landscape of international trade.

A8: Trade Credit Insurance serves as a protective mechanism for businesses engaged in
cross-border trade. Its primary function is to mitigate the risk of non-payment by buyers. In
international transactions, businesses face uncertainties related to factors such as the
financial stability of the buyer, political events in the buyer's country, or unforeseen
circumstances. Trade Credit Insurance steps in by providing coverage against the non-
payment of commercial debts. If a buyer fails to pay, the insurer compensates the seller for
the covered amount, reducing the financial impact on the selling business. This enables
exporters to offer credit terms to buyers with confidence, fostering stronger relationships

Unit 6: Financing International Trade Market instruments 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

and potentially increasing sales. Additionally, the insurance safeguards the cash flow of
exporting businesses, ensuring they receive the funds owed even in the event of non-
payment.

A9: Forfaiting is a financial arrangement facilitating the immediate conversion of credit sales
into cash for exporters. The process involves the sale of trade receivables, such as
promissory notes or bills of exchange, to a forfaiter at a discount. The exporter sells these
receivables to the forfaiter, who pays the exporter the discounted amount in cash. The
primary function is to provide an immediate cash flow, allowing exporters to meet financial
needs, fund projects, or explore opportunities without waiting for the original credit period
to expire. Importantly, forfaiting transfers the credit risk and the responsibility for collecting
payment from the buyer to the forfaiter. This risk transfer contributes to a more predictable
and certain cash flow, enhancing the financial stability of the exporting business.

A10: Export Credit Insurance serves as a crucial tool in encouraging credit sales to foreign
buyers by providing a safety net against non-payment risks. Its primary function is to
mitigate risks associated with factors like buyer insolvency or political instability in the
buyer's country. This risk mitigation enables exporters to offer credit terms to foreign
buyers, making their offerings more competitive and attractive. Government backing, often
provided by export credit agencies, adds credibility to Export Credit Insurance. When backed
by the government, the insurance gains additional reliability, instilling confidence in
exporters. This backing demonstrates a commitment to supporting international trade,
promoting market expansion and stability in international transactions.

A11: Currency Swaps are financial agreements designed to manage risks inherent in
transactions involving different currencies. The primary function is to help businesses
mitigate currency risk or exchange rate fluctuations. Parties involved agree to exchange
specified amounts of different currencies at a predetermined rate and future date. Currency
swaps contribute to stabilizing cash flows by fixing exchange rates in advance, allowing
companies to plan transactions with more certainty. Additionally, they reduce costs by
consolidating currency exchanges, eliminating the need for individual transactions for each
international trade deal. This consolidation can potentially lead to cost savings, making

Unit 6: Financing International Trade Market instruments 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

currency swaps an efficient tool for businesses engaged in frequent transactions across
various currencies.

A12: Factoring plays a crucial role in international trade finance by providing immediate
liquidity to exporters. The process involves the sale of accounts receivable (invoices) to a
factor at a discount, giving the exporter immediate access to cash. One of its primary
functions is the transfer of credit risk, as the factor assumes the responsibility for collecting
payments from buyers. This offloading of credit risk is particularly beneficial for exporters
dealing with buyers of uncertain creditworthiness. Factoring significantly improves the
exporter's working capital position by converting receivables into cash, allowing for agile
operations, investment in projects, or meeting immediate financial obligations. Additionally,
factors often provide professional receivables management services, further streamlining
the exporter's financial processes.

A13: Islamic Trade Finance Instruments are designed to align with Sharia principles,
prohibiting elements such as interest and uncertainty. These instruments include Murabaha,
Musharakah, Wakalah, Istisna'a, Salam, and Tawarruq. Murabaha, for instance, involves a
cost-plus financing mechanism where goods are purchased on behalf of the client and sold
at a cost-plus profit. These instruments enable businesses to engage in international trade
activities while adhering to Islamic finance principles. For instance, Musharakah involves a
partnership, and profits and losses are shared based on agreed-upon terms. Adherence to
Sharia principles is crucial in the application of these instruments, and contracts must be
structured to ensure compliance. The flexibility of these instruments allows businesses and
financial institutions to choose the one that best suits the specific requirements of their trade
transactions.

Unit 6: Financing International Trade Market instruments 38

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 7: Concepts in International Finance 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 7
Concepts in International Finance
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Understanding International Finance - - 5-6
3 Forex Market - - 7-8
4 International Trade - - 9-10
5 Foreign Direct Investment (FDI) - - 10-12
6 Foreign Portfolio Investment (FPI) - 1 12-17
7 Depository Receipts - - 18-21
8 Summary - - 21-23
9 Terminal Questions - - 24
10 Answers - - 25-28

Unit 7: Concepts in International Finance 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
International finance is the branch of financial economics that deals with the monetary and
macroeconomic interrelations between two or more countries. It encompasses a wide range
of topics, including:
• Exchange rates: The relative value of two currencies.
• Balance of payments: A record of all economic transactions between a country and the
rest of the world.
• Trade finance: The financing of international trade transactions.
• Foreign direct investment (FDI): Investment by a company in another country.
• International capital markets: Markets where financial assets are traded across
borders.
• International financial institutions: Organizations that provide financial services to
member countries, such as the International Monetary Fund (IMF) and the World Bank.

International finance is important because it allows businesses and individuals to invest and
trade across borders. This can lead to economic growth and prosperity for all countries
involved. However, international finance can also be risky, as businesses and individuals are
exposed to foreign exchange risk, political risk, and other risks.

Recent developments in international finance

In recent years, there have been a number of significant developments in international
finance. These include:
• The rise of new financial technologies, such as blockchain and fintech.
• The growth of emerging markets, such as China and India.
• The increasing importance of environmental, social, and governance (ESG) factors in
investment decisions.

These developments are having a major impact on the way that international finance is
conducted. For example, blockchain is being used to develop new cross-border payment
systems, and fintech companies are providing innovative financial services to businesses and
individuals in emerging markets.

The future of international finance

Unit 7: Concepts in International Finance 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The future of international finance is likely to be shaped by a number of trends, including:

• The continued rise of new financial technologies.
• The increasing importance of ESG factors in investment decisions.
• The growing role of emerging markets in the global economy.
• The need to address climate change and other global challenges.

These trends are likely to lead to a more interconnected and sustainable global financial
system.

1.1 Learning Objectives

❖ Understand the scope of International Finance.
❖ Discuss how international finance can lead to economic growth and prosperity for
countries involved.
❖ Describe how international finance supports global trade by managing currency risk,
employing payment methods like letters of credit and open account transactions, and
utilizing trade credit insurance.
❖ Examine the concept of international portfolio investment and its importance in
diversifying investment portfolios.
❖ Analyse exchange rate’s system and their impact.
❖ Explain the concept and purpose of Depositary Receipts (ADRs and GDRs) as financial
instruments that represent ownership in the shares of foreign companies.
❖ Describe the trading of IDRs on Indian stock exchanges, such as the NSE and BSE, and the
mechanism for converting IDRs into the underlying foreign shares.

Unit 7: Concepts in International Finance 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. UNDERSTANDING INTERNATIONAL FINANCE

International finance refers to the management and analysis of financial interactions
between countries. It encompasses a wide range of activities, including trade, investments,
currency exchange, and the movement of capital across borders. Here are some key aspects
of international finance:

Foreign Exchange Market (Forex): This is where currencies are bought and sold.
International businesses, governments, and investors participate in the forex market to
exchange one currency for another. Exchange rates fluctuate based on various factors, such
as economic conditions, interest rates, political stability, and market sentiment.

International Trade: International finance plays a crucial role in facilitating global trade.
Exporters and importers need to manage currency risk and deal with various payment
methods, such as letters of credit and open account transactions. International trade finance
also involves trade credit insurance, which helps protect businesses from non-payment by
foreign buyers.

Foreign Direct Investment (FDI): Companies invest in foreign countries by establishing

subsidiaries or acquiring stakes in local businesses. International finance helps businesses
assess the risks and rewards of such investments and manage the flow of funds between
parent companies and foreign subsidiaries.

International Portfolio Investment: Investors diversify their portfolios by investing in assets

from different countries, such as stocks, bonds, and real estate. These investments require
analysis of foreign markets, economic conditions, and political stability.

Hedging and Risk Management: International businesses and investors use various financial
instruments, such as forward contracts, options, and swaps, to hedge against currency and
interest rate risks. This helps protect their assets and investments from adverse market
movements.

International Financial Institutions: Entities like the International Monetary Fund (IMF),
World Bank, and regional development banks play a significant role in providing financial
assistance to countries, stabilizing exchange rates, and promoting economic development.

Unit 7: Concepts in International Finance 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Balance of Payments: This is a key economic indicator that tracks a country's international
financial transactions over a specific period. It includes the trade balance, financial
investments, and transfers. A surplus or deficit in the balance of payments can have
economic implications.

Capital Flows: Capital flows involve the movement of money into and out of a country. These
flows can be in the form of foreign direct investment, portfolio investment, foreign aid, or
remittances from expatriates.

Exchange Rate Systems: Countries may have fixed, floating, or managed exchange rate
systems. A fixed exchange rate is pegged to a specific currency or a basket of currencies,
while a floating exchange rate is determined by market forces. A managed exchange rate
system combines elements of both.

Regulation and Compliance: International finance is subject to various regulatory

frameworks, including international agreements and national laws. Compliance with these
regulations is essential for conducting cross-border financial activities.

Global Economic Events: Economic events in one country can have far-reaching effects on
other countries. For example, a financial crisis in one nation can trigger a global economic
downturn, demonstrating the interconnected nature of international finance.

International finance is a complex field that requires an understanding of economics, finance,

politics, and global markets. It plays a critical role in shaping the global economy and is
essential for businesses, governments, and investors engaged in international activities.

Unit 7: Concepts in International Finance 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. FOREX MARKET
The foreign exchange market, often referred to as Forex or FX, is the global marketplace
where currencies are bought and sold. It is the largest and most liquid financial market in
the world. Here's a more detailed explanation of how the Forex market operates:

Currency Pairs: In the Forex market, currencies are traded in pairs. A currency pair consists
of two currencies, one being the base currency, and the other the quote currency. For
example, in the EUR/USD pair, the EUR (Euro) is the base currency, and the USD (U.S. Dollar)
is the quote currency. The exchange rate tells you how much of the quote currency you need
to buy one unit of the base currency.

Participants: Various participants engage in the Forex market, including:

Banks: Commercial banks, central banks, and investment banks play a significant role in the
Forex market. They facilitate transactions for their clients, manage their own positions, and
engage in speculative trading.

Corporations: International businesses involved in import and export use the Forex market
to convert their profits and payments from one currency to another.

Investors: Individual and institutional investors, such as hedge funds and mutual funds,
participate in Forex trading for investment and speculation.

Governments and Central Banks: Central banks may participate in the Forex market to
stabilize their currency's exchange rate or influence their country's monetary policy.

Retail Traders: Small-scale individual traders also participate in the Forex market through
online platforms offered by brokers.

Exchange Rate Determinants: Exchange rates in the Forex market are not fixed; they
fluctuate constantly due to various factors, including:

Economic Conditions: A country's economic indicators, such as GDP growth, employment

rates, and inflation, can impact its currency's value.

Unit 7: Concepts in International Finance 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Interest Rates: Differences in interest rates between two countries can influence the flow of
capital and, consequently, exchange rates. Higher interest rates can attract foreign
investment, increasing demand for the local currency.

Political Stability: Political events, such as elections, government policies, and geopolitical
tensions, can affect exchange rates. Stable political environments often lead to stronger
currencies.

Market Sentiment: Traders' perceptions and emotions can drive short-term fluctuations in
exchange rates. For example, positive news about a country's economy can lead to increased
demand for its currency.

Speculation: Traders engage in speculation by buying or selling currencies based on their

expectations of future price movements. This speculative activity can lead to short-term
market volatility.

Trading Hours: The Forex market operates 24 hours a day, five days a week, due to its global
nature and the fact that it spans multiple time zones. This continuous operation allows
traders to respond to global events and news in real-time.

Leverage: Forex trading often involves the use of leverage, which allows traders to control
larger positions with a relatively small amount of capital. While this can amplify potential
profits, it also increases the risk of significant losses.

Online Trading Platforms: Retail traders access the Forex market through online trading
platforms provided by brokers. These platforms offer various tools and charts for analysis,
as well as the ability to execute trades.

Risk Management: Risk management is crucial in Forex trading. Traders often use stop-loss
orders to limit potential losses and take-profit orders to secure profits at specific price levels.

The Forex market is essential for international businesses and investors because it allows
them to exchange currencies to conduct international trade and investment. It also serves as
a key indicator of economic conditions and can be a source of profit for speculators. However,
it's important to note that Forex trading carries risks, and individuals should have a good
understanding of the market and proper risk management strategies before participating.

Unit 7: Concepts in International Finance 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. INTERNATIONAL TRADE
International trade is a cornerstone of the global economy, allowing countries to exchange
goods and services across borders. International finance plays a vital role in facilitating and
supporting these trade activities in several ways:

Currency Risk Management:

Exchange Rate Fluctuations: When companies engage in international trade, they often deal
with multiple currencies. Exchange rates can fluctuate, which can affect the prices of goods
and the profitability of transactions. International finance helps businesses manage currency
risk through various strategies, such as hedging, forward contracts, and options. These tools
allow companies to lock in exchange rates, providing stability in their pricing and cash flow.

Payment Methods:
Letters of Credit: Letters of credit are financial instruments issued by banks on behalf of the
buyer to guarantee payment to the seller. This method offers security to both the buyer and
the seller. The bank ensures that the seller receives payment once they fulfill the terms and
conditions of the letter of credit.

Open Account Transactions: In open account transactions, the seller ships goods and
invoices the buyer, who agrees to pay at a later date, typically 30, 60, or 90 days after
receiving the goods. International finance assists in managing the credit risk associated with
open account transactions, which can be substantial.

Trade Credit Insurance:

Trade credit insurance is a risk management tool that provides protection to businesses
against the risk of non-payment by foreign buyers. It is particularly valuable for companies
engaged in international trade, where the buyer may be in a different country with different
legal systems and creditworthiness standards.

With trade credit insurance, a business can insure its accounts receivable against non-
payment due to various reasons, such as insolvency of the buyer, protracted default, or
political events in the buyer's country. In the event of non-payment, the insurance company
compensates the insured business, helping to mitigate financial losses and maintain cash
flow.

Unit 7: Concepts in International Finance 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In summary, international finance is critical for supporting and facilitating global trade by
addressing the financial and risk management aspects associated with international
transactions. Whether it's managing currency risk, using payment methods like letters of
credit and open account transactions, or securing trade credit insurance, businesses and
exporters rely on financial tools and services to navigate the complexities of international
commerce. This ensures that international trade can occur with reduced risk and greater
financial security for all parties involved.

5. FOREIGN DIRECT INVESTMENT (FDI)

Foreign Direct Investment (FDI) is a strategic approach for companies to expand their
operations and presence in foreign countries by either establishing wholly owned
subsidiaries, acquiring ownership stakes in local businesses, or forming joint ventures.
International finance plays a critical role in this process by assisting businesses in assessing
the risks and rewards associated with FDI and managing the flow of funds between parent
companies and foreign subsidiaries. Here's a more detailed explanation:

Risk Assessment and Reward Evaluation:

International finance professionals help businesses assess the risks and rewards of potential
FDI opportunities. They consider factors such as the political and economic stability of the
host country, legal and regulatory frameworks, market conditions, and competitive
dynamics.

Risk assessment also includes evaluating currency risk, as FDI often involves transactions in
foreign currencies. International finance experts analyse exchange rate fluctuations and
develop strategies to mitigate currency risk.

Cost-Benefit Analysis:
FDI typically requires a substantial initial investment. International finance specialists assist
in conducting cost-benefit analyses to determine if the potential returns from the investment
justify the upfront costs and ongoing expenses.

This analysis considers factors such as projected cash flows, revenue forecasts, and expected
returns on investment over the long term.

Unit 7: Concepts in International Finance 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Capital Allocation and Financing:

International finance professionals help businesses determine the appropriate sources of
capital for their foreign investments. This can involve equity financing, debt financing, or a
combination of both.

They also consider factors like the cost of capital, available financial instruments, and the tax
implications associated with different financing arrangements.

Currency Risk Management:

FDI often involves transactions in multiple currencies, which can expose businesses to
currency risk. International finance experts assist in developing risk management strategies
to protect the investment from adverse currency movements.

Techniques such as hedging, forward contracts, options, and currency swaps may be used to
mitigate currency risk.

Repatriation of Funds:
Businesses must plan for the repatriation of profits and capital from foreign subsidiaries
back to the parent company. International finance experts navigate the legal and regulatory
requirements of both the host country and the home country to ensure the smooth flow of
funds.

Transfer Pricing and Taxation:

In FDI scenarios, companies often engage in intra-group transactions between the parent
company and the foreign subsidiary. International finance specialists help establish
appropriate transfer pricing policies to ensure compliance with tax regulations in both the
host and home countries.

Financial Reporting and Compliance:

International finance professionals ensure that the financial reporting of the foreign
subsidiary complies with local and international accounting standards and regulations.

They also monitor compliance with tax laws and regulations in both the host and home
countries to avoid potential tax-related issues.

Unit 7: Concepts in International Finance 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Performance Evaluation:
International finance plays a role in evaluating the financial performance of foreign
subsidiaries and assessing whether the investment is meeting its objectives. This often
involves comparing actual financial results to the initial projections.

In summary, international finance is integral to the success of FDI initiatives. It assists

businesses in assessing the risks and rewards of foreign investments, allocating and
managing capital, navigating currency risks, ensuring compliance with tax and financial
reporting requirements, and evaluating the performance of foreign subsidiaries. This
expertise is crucial for making sound investment decisions and effectively managing the
financial aspects of international expansion.

6. FOREIGN PORTFOLIO INVESTMENT (FPI)

International Portfolio Investment is a key component of global finance and investment
strategies. It involves investors diversifying their portfolios by allocating capital to various
assets from different countries, such as stocks, bonds, real estate, and other financial
instruments. Here's an explanation of the concept and the considerations involved:

Diversification: Diversification is a fundamental principle of portfolio management. By

investing in assets from different countries, investors seek to spread risk and reduce the
potential impact of adverse events in any one market. Diversification can enhance the
stability and performance of a portfolio.

Types of International Portfolio Investments:

Equity Investments: Investors can purchase shares of foreign companies, either directly on
foreign stock exchanges or through investment vehicles like mutual funds or exchange-
traded funds (ETFs). These investments can provide exposure to the performance of foreign
economies and industries.

Bond Investments: International bonds, often referred to as foreign bonds, are issued by
foreign governments or corporations. Investors may choose to invest in foreign bonds for
yield, capital preservation, or currency diversification.

Unit 7: Concepts in International Finance 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Real Estate: Investing in foreign real estate can be done through direct property ownership
or indirectly via real estate investment trusts (REITs) and real estate mutual funds. It allows
investors to participate in the property market of other countries.

Foreign Currency: Investors can also hold foreign currencies directly or through foreign
exchange trading. Currency investment can be speculative or a part of a broader risk
management strategy.

Analysis of Foreign Markets:

International portfolio investment requires thorough analysis of foreign markets. Investors
assess the economic conditions, growth prospects, and market dynamics of the countries
they are considering. This analysis may involve examining factors like GDP growth, inflation
rates, and trade balances.

Economic Conditions:
Understanding the economic conditions of a country is crucial for portfolio investment
decisions. This includes evaluating fiscal and monetary policies, employment levels,
consumer spending, and overall economic stability.

Political Stability and Regulatory Environment:

Political stability and the regulatory environment in a foreign country can greatly affect
investment decisions. Investors consider factors like the legal framework, property rights,
and the overall political climate to assess the safety of their investments.

Currency Risk:
When investing internationally, investors are exposed to currency risk. Exchange rate
fluctuations can impact the value of investments denominated in foreign currencies. To
manage this risk, investors may use currency hedging strategies.

Global Events and Market Sentiment:

International portfolio investments can be influenced by global events and market
sentiment. Geopolitical events, economic crises, and changes in investor sentiment can lead
to fluctuations in the value of international assets.

Unit 7: Concepts in International Finance 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Regulatory Compliance and Taxation:

Investors must comply with the regulations of both their home country and the foreign
country in which they invest. Taxation on international investments can be complex, and
investors often seek professional guidance.

Investment Goals and Time Horizon:

Investment decisions in international portfolios should align with the investor's financial
goals and time horizon. Different assets and countries may be suitable for various objectives,
such as income generation, capital preservation, or long-term growth.

Equity Investments:
Definition: Equity investments involve purchasing shares or stocks of foreign companies.
Investors can acquire these shares directly on foreign stock exchanges or indirectly through
investment vehicles like mutual funds or exchange-traded funds (ETFs).

Exposure: Investing in foreign equities provides exposure to the performance of foreign

economies and industries. It allows investors to benefit from the growth and profitability of
international companies.

Bond Investments:
Definition: Bond investments in the context of international portfolios refer to investing in
foreign bonds, often referred to as foreign bonds. These bonds are issued by foreign
governments or corporations.

Purpose: Investors may choose to invest in foreign bonds for various purposes, including
generating yield (interest income), preserving capital, and diversifying currency exposure.

Yield: Bonds typically provide fixed or variable interest payments, making them attractive to
income-focused investors.

Real Estate:
Definition: International real estate investments involve investing in foreign real estate
assets. This can be done directly by owning physical properties or indirectly through
investments in real estate investment trusts (REITs) or real estate mutual funds.

Unit 7: Concepts in International Finance 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Benefits: Investing in foreign real estate allows investors to participate in the property
markets of other countries, diversify their real estate holdings, and potentially benefit from
rental income and property value appreciation.

Foreign Currency:
Definition: Foreign currency investments involve holding foreign currencies directly or
participating in foreign exchange (Forex) trading markets.

Purpose: Investors may hold foreign currencies for various reasons, including speculative
trading, hedging against currency risk in international investments, or managing currency
exposure in a broader risk management strategy.

Analysis of Foreign Markets:

Economic Conditions: Investors assess the economic conditions of foreign countries by
analysing factors such as GDP growth, inflation rates, unemployment rates, fiscal and
monetary policies, and overall economic stability. These factors provide insights into the
economic health of the country and the potential for growth or risks.

Market Dynamics: Investors evaluate the dynamics of foreign markets, considering factors
like market size, competitiveness, regulatory environments, and industry-specific factors.
This helps in understanding the opportunities and challenges in each market.

Growth Prospects: Understanding a country's growth prospects is crucial. High-growth

economies may present attractive investment opportunities, while stagnant or declining
economies may carry more significant risks.

Trade Balances: Analysing a country's trade balance, which includes exports and imports,
can provide insights into its economic health. A trade surplus suggests a strong economy,
while a trade deficit may raise concerns.

Overall, international portfolio investments require careful consideration and analysis of

foreign markets to make informed investment decisions. Each investment type comes with
its own set of risks and rewards, and understanding the economic and market conditions of
the target countries is essential to building a diversified and well-informed investment.

Unit 7: Concepts in International Finance 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In summary, international portfolio investment involves diversifying a portfolio by

allocating capital to assets from different countries. Investors consider various factors,
including economic conditions, political stability, regulatory environments, and currency
risks, when making investment decisions. The goal is to create a well-balanced and
diversified portfolio that aligns with the investor's objectives while managing the potential
risks associated with international investments.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary focus of international finance?

a) Management of domestic financial markets
b) Monetary policy within a single country
c) Macroeconomic interactions between countries
d) Management of local exchange rates
2. Which of the following is NOT a topic covered in international finance?
a) Exchange rates
b) Trade finance
c) Domestic fiscal policy
d) International financial institutions
3. What has been a significant recent development in international finance?
a) The decline of emerging markets
b) The increasing importance of cryptocurrency
c) The decreasing relevance of environmental factors
d) The rise of blockchain and FinTechs
4. Why is international finance important?
a) It simplifies the process of domestic trade.
b) It reduces the need for international investments.
c) It enables economic growth and prosperity across borders.
d) It eliminates all forms of financial risk.

Unit 7: Concepts in International Finance 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

5. How can international finance help manage currency risk in international

trade?
a) By eliminating exchange rate fluctuations.
b) By providing trade credit insurance.
c) By ignoring the impact of exchange rates.
d) By using hedging and forward contracts.
6. What is the primary role of trade credit insurance in international finance?
a) Guaranteeing high profits for exporters.
b) Protecting businesses from non-payment by foreign buyers.
c) Providing low-cost financing to importers.
d) Ensuring that exchange rates remain stable.
7. How does international finance assist businesses in foreign direct
investment (FDI)?
a) By eliminating the need for initial investment.
b) By minimizing all risks associated with FDI.
c) By assessing risks, managing capital, and addressing currency risk.
d) By bypassing the need for legal and regulatory compliance.
8. What do investors aim to achieve through international portfolio
investment?
a) Concentrating investments in a single country.
b) Maximizing exposure to the political climate of one country.
c) Diversifying their portfolios across different countries and assets.
d) Avoiding currency risk altogether.

Unit 7: Concepts in International Finance 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

7. DEPOSITORY RECEIPTS
Depositary Receipts, often referred to as DRs, are financial instruments that represent
ownership in the shares of foreign companies. They are created and issued by a bank or
financial institution in one country to allow investors in another country to invest in foreign
companies without the need to directly purchase the foreign company's shares. Depositary
Receipts are a way to facilitate international investment and trading in foreign stocks. There
are two primary types of Depositary Receipts:

American Depositary Receipts (ADRs):

Definition: ADRs are issued by U.S. banks and represent shares in non-U.S. companies. They
are traded on U.S. stock exchanges like regular stocks.

Purpose: ADRs enable U.S. investors to invest in foreign companies without having to engage
in international trading or deal with foreign stock markets.

Custodian Bank: A U.S. bank acts as the custodian and holds the actual foreign company
shares on behalf of ADR holders. The bank issues ADRs, which are then traded domestically.

Currency: ADRs can be denominated in U.S. dollars or the foreign company's home currency,
depending on the preference of the issuing bank.

Global Depositary Receipts (GDRs):

Definition: GDRs are similar to ADRs but are issued by banks outside the United States. They
represent shares in foreign companies and are typically listed and traded on international
stock exchanges.

Purpose: GDRs allow non-U.S. investors to access and invest in foreign companies, similar to
ADRs but with a more global focus.

Custodian Bank: A foreign bank, acting as a custodian, holds the foreign company shares and
issues GDRs to investors in multiple countries.

Currency: GDRs are usually denominated in a major global currency such as U.S. dollars,
euros, or British pounds.

Unit 7: Concepts in International Finance 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Investors, whether in the United States or other countries, find Depositary Receipts
attractive for various reasons:

Diversification: ADRs and GDRs provide opportunities to diversify portfolios by investing in

foreign companies from various industries and regions.

Liquidity: They are often more liquid and easily tradable than the foreign shares in their
home markets, making them accessible to a broader range of investors.

Currency Risk Management: Depositary Receipts can be denominated in a currency of the

investor's choice, helping to manage currency risk.

Ease of Access: They simplify access to global markets, especially for retail investors who
might find it challenging to invest directly in foreign stocks.

Transparency: ADRs and GDRs are subject to U.S. Securities and Exchange Commission (SEC)
reporting requirements, which enhance transparency for investors.

It's important for investors to research and understand the terms and conditions of specific
ADRs or GDRs, including any fees, voting rights, and the relationship between the depositary
receipt and the underlying shares. Additionally, investors should consider their investment
objectives and risk tolerance when incorporating Depositary Receipts into their portfolio.

Indian Depository Receipts

Indian Depository Receipts (IDRs) are financial instruments that allow Indian investors to
hold shares of foreign companies, similar to the concept of American Depositary Receipts
(ADRs) or Global Depositary Receipts (GDRs). IDRs are designed to enable Indian investors
to invest in global companies without the need to directly purchase foreign company shares
or engage in cross-border trading. Here are some key points about Indian Depository
Receipts (IDRs):

1. Issuance:
IDRs are typically issued by a domestic depository, which is a financial institution registered
with the Securities and Exchange Board of India (SEBI) and approved by the Reserve Bank
of India (RBI).

Unit 7: Concepts in International Finance 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The issuer (foreign company) appoints a depository bank in India, which holds the
underlying shares of the foreign company and issues IDRs to Indian investors.

2. Underlying Shares:
IDRs represent shares of a foreign company, and the depository bank holds the actual shares
on behalf of the IDR holders.

3. Purpose:
IDRs allow Indian investors to invest in foreign companies without the need for a demat
account in a foreign country or dealing with foreign stock exchanges.

These instruments are especially attractive to Indian investors looking to diversify their
portfolios by gaining exposure to international stocks and industries.

4. Trading:
IDRs are listed and traded on Indian stock exchanges, such as the National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE). Indian investors can buy and sell IDRs in the
same way they trade domestic securities.

5. Conversion:
In the case of IDRs, there is usually a mechanism that allows investors to convert their IDRs
into the underlying foreign shares and vice versa.

6. Regulatory Framework:
IDRs are regulated by the SEBI, which sets the rules and regulations for their issuance and
trading. Compliance with SEBI's guidelines ensures transparency and investor protection.

7. Benefits:
IDRs offer Indian investors the opportunity to diversify their investments internationally,
providing access to foreign companies and markets.

They also offer the convenience of trading on Indian stock exchanges, which may be more
familiar to domestic investors.

Unit 7: Concepts in International Finance 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. Currency of Denomination:
IDRs may be denominated in Indian rupees (INR) or a foreign currency, depending on the
preference of the issuer and the Indian depository bank.

9. Reporting and Disclosure:

Companies issuing IDRs are typically required to adhere to Indian accounting and financial
reporting standards, enhancing transparency and information availability to investors.

It's essential for Indian investors to conduct thorough research and due diligence before
investing in IDRs. Considerations should include the specific foreign company, its financial
health, the currency denomination of the IDRs, any associated fees, and regulatory
compliance. Furthermore, Indian investors should consider their investment objectives and
risk tolerance when incorporating IDRs into their investment portfolio.

8. SUMMARY
Introduction to International Finance:
• International finance deals with monetary and macroeconomic interactions between
multiple countries.
• Key topics include exchange rates, balance of payments, trade finance, foreign direct
investment, international capital markets, and international financial institutions.
• International finance enables cross-border investments and trade but also involves
risks.

Recent Developments in International Finance:

• Notable developments include the rise of financial technologies like blockchain and
fintech.
• Emerging markets like China and India are growing in significance.
• Environmental, social, and governance (ESG) factors are increasingly important in
investment decisions.

The Future of International Finance:

• Ongoing trends involve the continued growth of financial technologies and the
increasing relevance of ESG criteria.
• Emerging markets are playing a larger role in the global economy.

Unit 7: Concepts in International Finance 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Addressing global challenges, including climate change, is essential for the future.

Understanding International Finance:

• International finance encompasses trade, investments, currency exchange, and capital
movement across borders.
• Key elements include the foreign exchange market, international trade, foreign direct
investment, portfolio investment, risk management, and international financial
institutions.

Forex Market:
• The foreign exchange market is where currencies are bought and sold.
• It operates 24/5 and involves various participants like banks, corporations, investors,
and governments.
• Exchange rates are influenced by economic conditions, interest rates, political stability,
market sentiment, and speculation.

International Trade:
• International finance assists in managing currency risk in global trade.
• Payment methods such as letters of credit and open account transactions are used.
• Trade credit insurance helps protect against non-payment by foreign buyers.

Foreign Direct Investment (FDI):

• FDI involves expanding operations in foreign countries, and international finance aids
in risk assessment and reward evaluation.
• Cost-benefit analysis, capital allocation, currency risk management, and repatriation of
funds are crucial elements.
• Compliance with tax laws, financial reporting, and performance evaluation are also part
of FDI.

Foreign Portfolio Investment (FPI):

• FPI is about diversifying investment portfolios by allocating capital to assets from
different countries.
• Equity investments, bond investments, real estate, and currency investments are
common.

Unit 7: Concepts in International Finance 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Analysis of foreign markets, risk management, regulatory compliance, and investment

goals are important considerations.

Depositary Receipts (DRs):

• DRs represent shares of foreign companies and are issued by banks or financial
institutions.
• There are two primary types: American Depositary Receipts (ADRs) and Global
Depositary Receipts (GDRs).
• ADRs are issued by U.S. banks and traded on U.S. stock exchanges, while GDRs are
issued by banks outside the United States and traded on international stock exchanges.
• Investors are attracted to DRs for diversification, liquidity, currency risk management,
ease of access, and transparency.
• The currency denomination of DRs can vary, offering flexibility to investors.
• Investors should research and understand specific DRs, including fees, voting rights,
and the relationship with underlying shares.

Indian Depository Receipts (IDRs):

• IDRs allow Indian investors to hold shares of foreign companies without directly
purchasing foreign shares.
• They are typically issued by domestic depositories in India.
• The issuer, a foreign company, appoints a depository bank in India to hold the
underlying shares and issue IDRs.
• IDRs are listed and traded on Indian stock exchanges, providing accessibility to Indian
investors.
• The regulatory framework for IDRs is governed by the Securities and Exchange Board
of India (SEBI).
• IDRs can be denominated in Indian rupees (INR) or a foreign currency.
• Thorough research is crucial for Indian investors considering IDRs, taking into account
the foreign company, currency denomination, fees, and compliance with regulations.
• Investors should align IDRs with their investment objectives and risk tolerance to build
a well-balanced portfolio.

Unit 7: Concepts in International Finance 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9. TERMINAL QUESTIONS
Q1. What is international finance, and why is it important in today's global economy?

Q2. What are some significant recent developments in international finance, and how have
they influenced the field?

Q3. How does the foreign exchange market (Forex) function, and why is it important in
international finance?

Q4. What is the role of international trade in the global economy, and how does international
finance contribute to its success?

Q5. How does foreign direct investment (FDI) work, and what role does international finance
play in FDI initiatives?

Q6. What is foreign portfolio investment (FPI), and why do investors engage in it?

Q7. How do investors assess international markets when considering foreign portfolio
investment, and what factors are crucial in their decision-making?

Q8. How do international financial institutions like the International Monetary Fund (IMF)
and the World Bank contribute to international finance and the global economy?

Q9. What are the challenges and risks associated with international finance, and how can
businesses and investors manage them effectively?

Q10. How can international finance contribute to addressing global challenges like climate
change and economic sustainability?

Q11. Analyse the benefits of investing in ADRs and GDRs. How do these instruments provide
diversification, liquidity, currency risk management, access to global markets, and
transparency for investors?

Q12. How should investors align their investment objectives and risk tolerance when
incorporating IDRs into their investment portfolios? Discuss the importance of setting clear
investment goals.

Unit 7: Concepts in International Finance 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

10. ANSWERS
Self-Assessment Questions
Answer 1: c. Macroeconomic interactions between countries.

Answer 2: c. Domestic fiscal policy

Answer 3: d. The rise of blockchain and fintech

Answer 4: c. It enables economic growth and prosperity across borders.

Answer 5: d. By using hedging and forward contracts

Answer 6: b. Protecting businesses from non-payment by foreign buyers

Answer 7: c. By assessing risks, managing capital, and addressing currency risk

Answer 8: c. Diversifying their portfolios across different countries and asset

Terminal Questions
Answer 1: International finance is the branch of financial economics that deals with
monetary and macroeconomic interrelations between multiple countries. It is important
because it enables businesses and individuals to invest and trade across borders, leading to
economic growth and prosperity. However, it also involves risks like foreign exchange risk
and political risk.

Answer 2: Recent developments include the rise of financial technologies like blockchain
and fintech, the growth of emerging markets, and the increasing importance of
environmental, social, and governance (ESG) factors in investment decisions. These
developments have transformed international finance by enabling new cross-border
payment systems and innovative financial services.

Answer 3: The Forex market is where currencies are bought and sold, and it operates 24/5
across global time zones. It's crucial in international finance because it allows businesses and
investors to exchange currencies for international trade and investment. Exchange rates
fluctuate due to economic conditions, interest rates, political stability, and market sentiment.

Unit 7: Concepts in International Finance 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 4: International trade is vital for global economic exchange. International finance
plays a critical role by helping businesses manage currency risk, use payment methods like
letters of credit, and secure trade credit insurance, ensuring smoother and more secure
international transactions.

Answer 5: FDI involves companies investing in foreign countries by establishing

subsidiaries, acquiring ownership stakes, or forming joint ventures. International finance
assesses risks, conducts cost-benefit analysis, manages capital allocation and financing,
navigates currency risk, and ensures compliance with regulations and taxation.

Answer 6: FPI involves diversifying investment portfolios by allocating capital to various

assets from different countries. Investors use FPI to spread risk and reduce the impact of
adverse events in any one market. It includes equity investments, bond investments, real
estate, and currency investments.

Answer 7: Investors analyze factors like economic conditions, political stability, regulatory
environments, and currency risks. Economic indicators, political stability, and currency
fluctuations are among the critical factors influencing their decisions.

Answer 8: International financial institutions provide financial services, promote economic

development, and help stabilize exchange rates. They offer financial assistance to member
countries, particularly in times of economic crisis, and play a significant role in international
finance and the global economy.

Answer 9: Challenges and risks include foreign exchange risk, political risk, and regulatory
compliance. Businesses and investors can use financial instruments, risk management
strategies, and compliance measures to mitigate these risks effectively.

Answer 10: International finance can allocate resources and investments towards
sustainable initiatives, support green projects, and promote responsible investment through
ESG factors. It plays a pivotal role in addressing global challenges and building a more
interconnected and sustainable global financial system.

Answer 11: Investing in ADRs (American Depositary Receipts) and GDRs (Global Depositary
Receipts) offers several advantages to investors:

Unit 7: Concepts in International Finance 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Diversification: ADRs and GDRs provide opportunities for diversification, allowing investors
to spread risk across different industries and geographic regions. This diversification helps
reduce the impact of adverse events in any single market and enhances the overall stability
of investment portfolios.

Liquidity: ADRs and GDRs are often more liquid and easily tradable than the underlying
foreign shares in their home markets. They are listed and traded on established stock
exchanges, making it convenient for investors to buy and sell them, ensuring liquidity and
flexibility.

Currency Risk Management: These depositary receipts can be denominated in a currency of

the investor's choice, helping to manage currency risk. Investors can invest in foreign assets
while mitigating the impact of exchange rate fluctuations, safeguarding their investments
from adverse currency movements.

Access to Global Markets: ADRs and GDRs simplify access to global markets, especially for
retail investors who might find it challenging to invest directly in foreign stocks. These
instruments provide a straightforward way to invest in international companies without
dealing with the complexities of foreign stock exchanges.

Transparency: ADRs and GDRs are subject to regulatory frameworks and reporting
requirements in their respective markets. For instance, ADRs listed in the United States are
regulated by the U.S. Securities and Exchange Commission (SEC). These regulations enhance
transparency and provide investors with comprehensive information about the issuing
companies, ensuring greater transparency and investor protection.

Answer 12: Investors should carefully align their investment objectives and risk tolerance
when incorporating IDRs (Indian Depository Receipts) into their investment portfolios. This
alignment is crucial to ensure that the investment strategy is well-matched with individual
financial goals and the ability to handle risk. Here's how investors can go about it:
1. Clear Investment Goals: Setting clear investment goals is paramount. Investors need to
define what they aim to achieve with their investment in IDRs. Investment goals can
vary widely, including wealth accumulation, income generation, capital preservation,

Unit 7: Concepts in International Finance 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

or funding future expenses like education or retirement. These goals serve as the
foundation for crafting an appropriate investment strategy.
2. Risk Tolerance Assessment: Investors should evaluate their risk tolerance, which
reflects their capacity to withstand market fluctuations and the potential for financial
loss. Risk tolerance is influenced by factors such as age, income, investment timeline,
and personal preferences. It's essential to be honest about one's comfort level with risk,
as it helps determine the mix of investments within the portfolio.
3. Investment Horizon: The investment horizon, or the length of time an investor plans to
hold an investment, plays a pivotal role in risk assessment. Longer investment horizons
typically allow for a higher risk tolerance since there is more time to recover from
market downturns. Shorter horizons may require a more conservative approach to
protect capital.
4. Asset Allocation: Once investment goals and risk tolerance are established, investors
can allocate assets accordingly. IDRs should be a component of a diversified portfolio
that aligns with the determined risk tolerance and investment horizon. This allocation
can involve combining IDRs with other assets like stocks, bonds, or alternative
investments.
5. Risk Mitigation: To manage the specific risks associated with IDRs, such as currency
risk, investors can incorporate risk mitigation strategies. For example, they can use
currency hedging instruments or allocate a portion of their portfolio to assets
denominated in Indian rupees to counterbalance currency fluctuations.
6. Periodic Review: Investment portfolios should be periodically reviewed to ensure they
remain in line with the established investment goals and risk tolerance. As financial
circumstances change, so may an investor's risk appetite or objectives, necessitating
adjustments to the portfolio.

The importance of setting clear investment goals cannot be overstated. Well-defined goals
provide investors with a roadmap for making investment decisions, help them stay focused,
and guide them in selecting the most appropriate investment instruments, including IDRs.
By aligning risk tolerance with investment goals, investors can achieve a balanced and
suitable investment portfolio that aims to meet their financial aspirations while being within
their comfort level regarding potential risk.

Unit 7: Concepts in International Finance 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 8: World Bank 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 8
World Bank

Table of Contents
SL Topic Fig No / Table SAQ / Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Key Points about the World Bank - 1 5-19
3 Summary - - 20-23
4 Terminal Questions - - 23
5 Answers - - 24-26

Unit 8: World Bank 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The World Bank is a prominent international financial institution that plays a crucial role in
global development by providing financial assistance to the governments of less affluent
countries. Established in 1944, the World Bank operates as part of the World Bank Group,
which encompasses various institutions aimed at fostering economic progress and
addressing developmental challenges worldwide.

The institution's central objective is to alleviate poverty through the provision of loans and
grants for capital projects in developing nations. These projects cover a broad spectrum,
including infrastructure development, education, healthcare, and initiatives promoting
sustainable economic growth. By offering financial and technical support, the World Bank
endeavours to enhance the economic prospects and quality of life for people in recipient
countries.

The World Bank's membership comprises 189 countries, each of which is a shareholder and
contributes financially to the institution. The amount of financial contribution determines a
country's shareholding and influence within the organization. This cooperative structure
underscores the collaborative effort required to address global development challenges.

One of the distinctive features of the World Bank is its ability to raise capital on the
international capital markets. Through the issuance of bonds, the World Bank generates
funds that it then lends to member countries. These loans typically have low-interest rates
and extended repayment periods, aiming to provide countries with financial flexibility to
undertake projects that might be otherwise unattainable. Additionally, the World Bank
allocates grants, especially to the poorest countries, further supporting their developmental
needs without imposing a burden of debt.

The governance structure of the World Bank involves a Board of Governors and a Board of
Executive Directors. The former consists of representatives from each member country,
typically finance ministers or central bank governors, who meet annually to make key
decisions. The latter oversees day-to-day operations, and its composition is based on the
distribution of shareholding among member countries. The President of the World Bank is
traditionally nominated by the United States, the largest single shareholder.

Unit 8: World Bank 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The World Bank's portfolio encompasses a diverse array of projects. Infrastructure projects,
such as the construction of roads, bridges, and energy facilities, aim to lay the foundation for
economic growth. Social services projects focus on improving healthcare and education,
recognizing the pivotal role these sectors play in human development. Additionally, the
institution invests in projects promoting environmental sustainability, reflecting a growing
awareness of the interconnectedness between economic development and ecological well-
being.

Despite its significant contributions to global development, the World Bank has not been
immune to criticism. Concerns have been raised about the environmental and social impacts
of some projects, as well as the governance structure that disproportionately favors certain
member countries. Critics argue that reforms are necessary to ensure greater accountability,
transparency, and the equitable distribution of benefits from World Bank projects.

In conclusion, the World Bank stands as a key player in international development, providing
financial resources and expertise to empower governments in their pursuit of projects that
uplift the economic conditions and quality of life for their citizens. Through its multifaceted
approach, the World Bank strives to address the complex challenges facing developing
nations, acknowledging that sustainable development requires a comprehensive strategy
that encompasses economic, social, and environmental dimensions.

1.1 Learning Objectives

❖ Define the World Bank and its role in global development.
❖ Comprehending World Bank Financing Mechanisms
❖ Exploring World Bank Governance Structure:
❖ Describe the establishment of the World Bank Group and its affiliated institutions,
including the International Finance Corporation (IFC), Multilateral Investment
Guarantee Agency (MIGA), and International Centre for Settlement of Investment
Disputes (ICSID).
❖ Analysing World Bank Financing Strategies:

Unit 8: World Bank 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. KEY POINTS ABOUT THE WORLD BANK

Establishments: The establishment of the World Bank in 1944 marked a significant
milestone in the post-World War II era, reflecting a collective effort to address global
economic challenges and promote sustainable development. Headquartered in Washington,
D.C., USA, the World Bank operates as a crucial component of the broader World Bank Group,
a multifaceted institution with several entities designed to tackle various aspects of
international finance and development.

The impetus for the creation of the World Bank can be traced back to the Bretton Woods
Conference held in July 1944 in Bretton Woods, New Hampshire, USA. Delegates from 44
Allied nations gathered to design a framework for international economic cooperation and
establish institutions that would facilitate the reconstruction of war-torn Europe and foster
global economic stability. Out of this conference emerged the International Monetary Fund
(IMF) and the International Bank for Reconstruction and Development (IBRD), which later
became part of the World Bank.

The World Bank Group, as it stands today, encompasses multiple institutions, each with its
specific focus and mandate. In addition to the World Bank itself, the group includes the
International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency
(MIGA), and the International Centre for Settlement of Investment Disputes (ICSID).

World Bank:
The primary institution within the World Bank Group, the World Bank focuses on providing
financial and technical assistance to developing countries. Its core mission is to reduce
poverty and support sustainable development by offering loans and grants for various
projects, ranging from infrastructure development to social services.

International Finance Corporation (IFC):

The IFC, established in 1956, is the private sector arm of the World Bank Group. It works to
promote private sector investment in developing countries, with the aim of fostering
economic growth and improving living standards. The IFC provides loans, equity, and
advisory services to stimulate private sector development.

Unit 8: World Bank 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Multilateral Investment Guarantee Agency (MIGA):

MIGA, founded in 1988, specializes in providing political risk insurance and credit
enhancement to encourage foreign investment in developing countries. By mitigating risks
associated with non-commercial factors, such as political instability, MIGA aims to attract
investments that contribute to economic development.

International Centre for Settlement of Investment Disputes (ICSID):

ICSID, established in 1966, provides facilities for the arbitration and conciliation of
investment disputes between governments and foreign investors. It serves as a forum to
resolve disputes through international arbitration, promoting a stable and predictable
investment climate.

The World Bank's headquarters in Washington, D.C., serves as the central hub for
coordinating the activities of these institutions. The organization operates on a cooperative
model, with its 189 member countries actively participating in decision-making processes.
Each member country holds shares in the World Bank, reflecting its financial commitment
to the institution. The amount of shares determines the voting power and influence of each
member.

The establishment of the World Bank Group and its affiliated institutions underscores the
recognition of the interconnectedness of global economies and the need for collaborative
efforts to address developmental challenges. By providing financial resources, technical
expertise, and a platform for dispute resolution, the World Bank Group contributes
significantly to shaping the trajectory of international development and promoting economic
stability worldwide.

In conclusion, the establishment of the World Bank in 1944 was a pivotal moment in the
post-World War II era, reflecting a commitment to global economic cooperation and
development. The evolution of the World Bank Group, with its diverse institutions,
exemplifies a comprehensive approach to addressing the multifaceted challenges facing
developing nations. From its headquarters in Washington, D.C., the World Bank Group
continues to play a crucial role in shaping the global development landscape and fostering
economic progress.

Unit 8: World Bank 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Purpose: The World Bank, established in 1944, is a preeminent international financial

institution with a core mission: to alleviate poverty through the provision of financial and
technical assistance to developing countries. This mission reflects a global commitment to
addressing economic disparities, fostering sustainable development, and improving the
quality of life for populations in need.

At the heart of the World Bank's purpose is the overarching goal of poverty reduction. This
goal is pursued through a multifaceted approach that involves providing financial resources,
technical expertise, and strategic support to developing countries. The World Bank
recognizes that poverty is a complex and multifaceted challenge, necessitating a
comprehensive strategy that goes beyond mere economic assistance.

Financial Assistance: One of the primary tools in the World Bank's arsenal is financial
assistance. The institution raises capital through various means, including issuing bonds on
the international capital markets. These funds are then channeled to member countries in
the form of loans and grants. Importantly, the World Bank provides these financial resources
to countries that might face challenges accessing capital at reasonable terms in traditional
financial markets.

Development Projects: The World Bank focuses its assistance on a wide array of
development projects. These projects span sectors crucial for a nation's development, such
as infrastructure, education, healthcare, and sustainable economic growth. Infrastructure
projects may include the construction of roads, bridges, and energy facilities, laying the
foundation for improved connectivity and economic progress. Educational initiatives aim to
enhance access to quality education, empowering individuals and fostering human capital
development. Similarly, healthcare projects strive to improve healthcare systems, ensuring
that communities have access to essential medical services.

Sustainable Economic Growth: Promoting sustainable economic growth is a key pillar of the
World Bank's mission. Rather than focusing solely on short-term gains, the institution
emphasizes initiatives that contribute to long-term economic stability and prosperity. This
involves supporting policies and projects that encourage responsible and sustainable
resource management, environmental conservation, and the creation of economic
opportunities that can withstand the test of time.

Unit 8: World Bank 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Technical Assistance: Beyond financial aid, the World Bank provides valuable technical
assistance to recipient countries. This involves sharing expertise, knowledge, and best
practices to help countries design and implement effective development strategies.
Technical assistance can encompass a wide range of areas, from policy advice and
institutional capacity building to the transfer of technology and expertise in project
management.

Education and Healthcare: Improving education and healthcare are critical components of
the World Bank's poverty reduction strategy. Education is seen as a fundamental tool for
empowerment and economic advancement. By investing in education systems, the World
Bank aims to enhance human capital, increase literacy rates, and equip individuals with the
skills needed for meaningful participation in the workforce.

Similarly, healthcare projects address the healthcare needs of populations in developing

countries. This includes efforts to strengthen healthcare infrastructure, improve access to
essential medicines, and enhance preventive healthcare measures. A healthy population is
better equipped to contribute to economic development and break the cycle of poverty.

Challenges and Criticisms: While the World Bank plays a pivotal role in international
development, it has not been immune to criticism. Some concerns have been raised about
the environmental and social impacts of certain projects, as well as the governance structure
that disproportionately favors certain member countries. Critics argue that reforms are
necessary to ensure greater accountability, transparency, and the equitable distribution of
benefits from World Bank initiatives.

In conclusion, the primary goal of the World Bank is to reduce poverty through a
comprehensive strategy that involves financial assistance, development projects, and
technical expertise. By addressing the multifaceted challenges faced by developing countries,
the World Bank seeks to create sustainable pathways for economic growth, improved
education and healthcare, and the overall enhancement of the quality of life for people
around the world. While challenges exist, the World Bank remains a key player in the global
effort to alleviate poverty and promote inclusive and sustainable development.

Unit 8: World Bank 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Members: The World Bank, a significant international financial institution, derives its
strength and operational capacity from its diverse membership base. As of my last
knowledge update in January 2022, the World Bank consists of 189 member countries. This
expansive membership underscores the institution's global reach and the collaborative
nature of its mission to address poverty and promote sustainable development.

Each member country within the World Bank is more than just a participant; they are
shareholders in the organization. This shareholder status signifies a financial commitment
to the World Bank's capital and an investment in its mission. The ownership of shares is
determined by the financial contributions made by each member country, reflecting a
principle of financial responsibility and proportional representation.

The ownership structure of the World Bank is pivotal to its governance and decision-making
processes. The distribution of shares directly influences the voting power and influence of
each member country within the institution. Generally, countries with larger financial
contributions hold more shares and, consequently, have a greater say in the decisions made
by the World Bank. This reflects a form of weighted voting that mirrors the financial
commitment of member countries.

The financial contributions of member countries, represented by their shares, play a crucial
role in shaping the World Bank's capital base. The institution raises capital not only through
the financial contributions of its member countries but also through borrowing in
international financial markets. The combination of paid-in capital from member countries
and borrowed capital forms the financial foundation that allows the World Bank to provide
loans and grants to developing countries for various development projects.

The financial commitment of member countries goes beyond just capital contributions; it is
a manifestation of their dedication to the overarching goals of poverty reduction, sustainable
development, and the improvement of living standards globally. The collaborative effort of
these member countries enables the World Bank to act as a catalyst for positive change on a
global scale.

The diversity of the membership base is a fundamental strength of the World Bank. It brings
together countries with varying levels of economic development, political systems, and

Unit 8: World Bank 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

cultural backgrounds. This diversity reflects a recognition that global challenges, such as
poverty and environmental sustainability, require a collective and inclusive approach. The
World Bank serves as a platform for member countries to share experiences, pool resources,
and collectively address common development issues.

The World Bank's commitment to inclusivity is further emphasized by its engagement with
developing countries, recognizing their unique challenges and opportunities. The institution
tailors its financial and technical assistance to meet the specific needs of each country,
acknowledging that a one-size-fits-all approach is insufficient in the complex landscape of
global development.

While the membership structure is a source of strength, it also poses challenges. The
governance and decision-making processes of the World Bank have faced criticisms for being
disproportionately influenced by the larger shareholder countries. Some argue that this
dynamic can lead to a lack of representation for smaller or less economically powerful
nations. Efforts to address these concerns and reform the governance structure have been
ongoing within the World Bank.

In conclusion, the World Bank's membership of 189 countries is the bedrock of its existence
and operational capacity. Each member country, acting as a shareholder, contributes
financially to the institution based on their economic capacity. This financial commitment
not only shapes the World Bank's capital structure but also influences the governance and
decision-making processes within the organization. The diverse membership base reflects a
collective commitment to addressing global challenges and underscores the World Bank's
role as a collaborative force for positive change in the realm of international development.

Financing:
Financing is a critical aspect of the World Bank's operations, enabling it to fulfill its mission
of promoting economic development, poverty reduction, and sustainable growth in member
countries. The institution raises capital through various means, with a primary focus on
issuing bonds on the international capital markets. This capital is subsequently used to
provide loans and grants to member countries, particularly those in need of financial
assistance for development projects.

Unit 8: World Bank 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Capital Raising through Bond Issuance:

One of the primary mechanisms the World Bank employs to raise capital is the issuance of
bonds on the international capital markets. Bonds are debt securities that represent a loan
made by an investor to the issuer, in this case, the World Bank. Investors, which can include
governments, institutional investors, and individuals, purchase these bonds, essentially
lending money to the World Bank in exchange for fixed interest payments over a specified
period.

The World Bank's ability to issue bonds is rooted in its strong credit rating and reputation
for prudent financial management. Its bonds are considered relatively low-risk investments,
attracting a diverse range of investors globally. The World Bank issues bonds in various
currencies, allowing it to tap into international financial markets and access capital in
different denominations.

Low-Interest Loans with Long Repayment Periods:

Once the World Bank has raised capital through bond issuance, it lends these funds to
member countries at relatively low-interest rates. The concessional nature of these loans,
characterized by below-market interest rates, distinguishes them from traditional
commercial loans. The goal is to provide financial flexibility to recipient countries, enabling
them to undertake projects that might be financially challenging without World Bank
support.

Furthermore, the World Bank structures its loans with extended repayment periods, often
spanning several decades. This extended timeline for repayment is designed to ease the
financial burden on borrowing countries, allowing them to allocate resources more
efficiently and pay back the loans over an extended horizon. This aligns with the World
Bank's focus on fostering sustainable development by avoiding the imposition of undue
financial stress on member countries.

Grants for Poorest Countries:

In addition to providing loans, the World Bank allocates grants, especially to the poorest
countries. Unlike loans, grants do not require repayment, and they serve as a form of
financial assistance that does not create a debt burden for the recipient countries. These

Unit 8: World Bank 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

grants are often directed towards projects and initiatives that address critical needs, such as
healthcare, education, and basic infrastructure, in the least developed nations.

The provision of grants recognizes the economic challenges faced by the poorest countries
and aims to support their development without exacerbating their debt levels. It reflects a
commitment to addressing fundamental issues that hinder progress in these nations, with
the understanding that sustainable development requires a holistic approach encompassing
economic, social, and environmental dimensions.

Impact on Global Development:

The World Bank's financing model plays a pivotal role in shaping global development. By
issuing bonds on international capital markets, the institution mobilizes substantial financial
resources that might not be available through traditional budgetary allocations. This allows
the World Bank to act as a catalyst for large-scale development projects, including the
construction of infrastructure, the improvement of healthcare systems, and the expansion of
educational opportunities.

The low-interest loans provided by the World Bank empower member countries to
undertake projects that contribute to economic growth and poverty reduction. The extended
repayment periods enhance the feasibility of these projects and provide countries with the
necessary flexibility to allocate resources strategically. Additionally, the allocation of grants
to the poorest countries addresses urgent needs and contributes to the attainment of basic
development goals.

Challenges and Considerations:

While the World Bank's financing model has been instrumental in supporting global
development, it is not without challenges and considerations. The institution has faced
criticisms regarding the environmental and social impacts of some projects it funds.
Concerns have also been raised about the governance structure, which has been perceived
by some as favoring larger shareholder countries. Efforts to address these issues and
enhance transparency and accountability within the World Bank have led to ongoing
reforms.

Unit 8: World Bank 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In conclusion, the World Bank's financing mechanism, primarily through bond issuance on
international capital markets, is a cornerstone of its ability to provide financial assistance to
member countries. The low-interest loans and grants it offers play a pivotal role in
promoting sustainable development, poverty reduction, and economic growth on a global
scale. The strategic allocation of financial resources, coupled with the institution's
commitment to addressing the specific needs of the poorest countries, positions the World
Bank as a key player in the pursuit of a more equitable and prosperous world.

Governance:
The governance structure of the World Bank is a fundamental aspect that determines how
decisions are made, policies are formulated, and operations are conducted within the
institution. This structure is designed to ensure representation from all member countries,
transparency, and effective management of the World Bank's functions.

1. Board of Governors:
At the highest level of the governance hierarchy is the Board of Governors. This board is
composed of representatives from each of the member countries. Typically, these
representatives are the finance ministers or central bank governors of the respective
nations. The Board of Governors meets annually to make key decisions on overarching
policies, major institutional changes, and other significant matters that affect the World
Bank's operations.

Each member country within the World Bank is allotted a certain number of shares, and the
number of shares is directly related to the financial contribution of the member. This
arrangement establishes a link between financial commitment and decision-making
influence. The more shares a country holds, the greater its voting power and influence in the
decisions made by the Board of Governors.

The annual meetings of the Board of Governors serve as a forum for member countries to
discuss and decide on critical issues facing the World Bank. These decisions can range from
approving the budget to setting broad strategic priorities. It is a platform for collaboration
and cooperation among nations with diverse economic, political, and cultural backgrounds.

Unit 8: World Bank 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. Board of Executive Directors:

The Board of Governors may set the overall policies and direction, but the day-to-day
operations and decision-making are the responsibility of the Board of Executive Directors.
This board is separate from the Board of Governors and is composed of Executive Directors
who represent groups of countries or individual countries.

The composition of the Board of Executive Directors is based on the distribution of

shareholding among member countries. Countries are grouped into constituencies, and each
constituency appoints or elects an Executive Director to represent them. Larger economies
or groups of smaller economies may have their own Executive Directors.

The Executive Directors oversee the implementation of policies, approve projects, and
provide guidance on operational matters. They meet more frequently than the Board of
Governors and are actively involved in the ongoing activities of the World Bank. The
decision-making within the Board of Executive Directors is often influenced by the relative
financial contributions and interests of member countries.

3. President of the World Bank:

The President of the World Bank is a key leadership figure within the institution.
Traditionally, the President is nominated by the United States, which is the largest single
shareholder in the World Bank. While the nomination comes from the U.S., the appointment
is subject to approval by the Board of Executive Directors.

The President is responsible for the overall management of the World Bank and serves a
renewable term. They play a crucial role in shaping the strategic direction of the institution,
representing it at the international level, and overseeing the day-to-day administration.

The nomination process has historically sparked discussions about the need for a more open
and inclusive selection process, as critics argue that the U.S. nomination may not adequately
reflect the diverse interests and priorities of the entire membership. However, it's worth
noting that the World Bank has made efforts to enhance transparency and involve the
broader international community in the selection process.

Unit 8: World Bank 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Challenges and Reforms:

The governance structure of the World Bank has faced criticisms and calls for reform. One of
the main critiques is that the structure tends to disproportionately favor larger shareholder
countries, particularly the United States. Critics argue that this dynamic can lead to an
imbalance in decision-making influence, potentially sidelining the perspectives and needs of
smaller or less economically powerful nations.

In response to these concerns, there have been ongoing efforts to reform the governance
structure of the World Bank. These reforms aim to address issues of representation, equity,
and voice within the institution. Proposals have included changes to the allocation of shares
and the selection process for key leadership positions.

In conclusion, the governance structure of the World Bank is a complex framework involving
the Board of Governors, the Board of Executive Directors, and the President. This structure
aims to balance the interests of member countries, with decision-making power linked to
financial contributions. While it provides a platform for collaboration and decision-making,
ongoing efforts to reform the governance structure highlight the need for adaptability and
inclusivity in addressing the evolving challenges of global development.

Projects: The World Bank is a major player in international development, financing a diverse
array of projects aimed at fostering economic progress, improving social services, and
promoting environmental sustainability. These projects span various sectors, reflecting the
institution's commitment to addressing multifaceted challenges faced by developing nations.
Here's an exploration of the World Bank's involvement in funding projects across
infrastructure, social services, and environmental sustainability:

1. Infrastructure Development:
Infrastructure is a critical foundation for economic growth, and the World Bank actively
supports projects in this domain. Infrastructure projects encompass the construction and
improvement of physical and organizational structures that contribute to a country's
development. This includes but is not limited to:

Roads and Bridges: The construction and maintenance of roads and bridges are essential for
improving connectivity within and between regions. Enhanced transportation infrastructure

Unit 8: World Bank 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

facilitates the movement of goods and people, supporting economic activities and regional
integration.

Energy Projects: The World Bank funds initiatives related to energy development, including
the construction of power plants, renewable energy projects, and the expansion of electricity
access. Access to reliable energy is vital for economic productivity, healthcare, and
education.

These infrastructure projects not only contribute to economic development but also have
broader implications for poverty reduction and improved quality of life. By investing in
transportation and energy infrastructure, the World Bank aims to create an environment
conducive to sustainable economic growth.

2. Social Services:
The World Bank recognizes the pivotal role that social services play in human development.
Projects in the healthcare and education sectors are crucial for improving the well-being of
populations in developing countries:

Healthcare Projects: The World Bank funds projects that aim to strengthen healthcare
systems, improve access to essential medicines, and enhance public health outcomes. This
includes initiatives to build healthcare infrastructure, train healthcare professionals, and
address specific health challenges such as the control of infectious diseases.

Education Initiatives: Access to quality education is fundamental for human capital

development. The World Bank supports projects that focus on expanding educational
opportunities, improving educational infrastructure, and enhancing the overall quality of
education. This includes efforts to increase enrollment, particularly for girls, and to address
issues such as teacher training and curriculum development.

Investments in social services contribute to the development of human capital, fostering a

healthier and more educated population capable of driving economic and social progress.

3. Environmental Sustainability:
Recognizing the interconnectedness of economic development and environmental well-
being, the World Bank allocates funds to projects that promote environmental sustainability:

Unit 8: World Bank 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Environmental Conservation: The World Bank supports initiatives aimed at preserving

biodiversity, protecting natural habitats, and promoting sustainable land use practices.
Conservation projects contribute to the maintenance of ecological balance and the
protection of valuable ecosystems.

Renewable Energy and Climate Change Mitigation: In response to global environmental

challenges, the World Bank funds projects that promote renewable energy sources and
address climate change mitigation. This includes investments in solar and wind energy, as
well as initiatives to reduce greenhouse gas emissions and enhance climate resilience.

By integrating environmental considerations into its projects, the World Bank seeks to
ensure that economic development is pursued in a manner that is environmentally
sustainable and resilient to the challenges posed by climate change.

Challenges and Considerations:

While the World Bank's projects are aimed at addressing critical developmental needs,
challenges and considerations exist. Some projects have faced criticism for their
environmental and social impacts. Concerns include the displacement of communities,
ecological degradation, and the potential exacerbation of social inequalities. Additionally,
there have been discussions about the need for more inclusive decision-making processes
and greater involvement of local communities in project planning and implementation.

In conclusion, the World Bank's funding of a wide range of projects reflects its commitment
to comprehensive development. Infrastructure, social services, and environmental
sustainability are interconnected components of a strategy aimed at fostering economic
growth and improving the quality of life in developing countries. The institution's ongoing
efforts to address challenges and incorporate lessons learned from past projects underscore
its commitment to adapting and evolving in the pursuit of sustainable global development.

Unit 8: World Bank 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary objective of the World Bank?

a) Promoting global economic stability
b) Enhancing shareholder profits
c) Alleviating poverty through financial assistance
d) Facilitating international trade
2. Which conference led to the creation of the World Bank?
a) Geneva Conference
b) Bretton Woods Conference
c) United Nations Conference
d) London Economic Summit
3. What is the role of the International Finance Corporation (IFC) within the
World Bank Group?
a) Providing political risk insurance
b) Focusing on infrastructure projects
c) Promoting private sector investment
d) Resolving investment disputes
4. Which institution specializes in providing political risk insurance and credit
enhancement for foreign investment?
a) International Monetary Fund (IMF)
b) International Finance Corporation (IFC)
c) Multilateral Investment Guarantee Agency (MIGA)
d) International Centre for Settlement of Investment Disputes (ICSID)
5. Who typically nominates the President of the World Bank?
a) Board of Governors
b) Board of Executive Directors
c) United Nations
d) United States, the largest single shareholder

Unit 8: World Bank 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

6. What is the primary focus of the World Bank's financial assistance?

a) Maximizing shareholder profits
b) Providing grants to developed countries
c) Supporting projects in developing countries
d) Investing in high-risk ventures
7. How does the World Bank raise capital for its operations?
a) Issuing bonds on international capital markets
b) Borrowing from member countries
c) Selling shares to private investors
d) Printing currency
8. What distinguishes World Bank loans from traditional commercial loans?
a) Higher interest rates
b) Longer repayment periods
c) Strict eligibility criteria
d) Lack of financial flexibility
9. In addition to loans, what form of financial assistance does the World Bank
provide, especially to the poorest countries?
a) Equity investments
b) Subsidies
c) Grants
d) Bonds
10. What has been a common criticism of the World Bank?
a) Lack of financial resources
b) Overemphasis on environmental sustainability
c) Governance structure favouring certain countries
d) Excessive focus on short-term gains

Unit 8: World Bank 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. SUMMARY
Establishment and Structure:
• World Bank established in 1944 after Bretton Woods Conference.
• Part of the World Bank Group with entities like IMF, IBRD, IFC, MIGA, and ICSID.
• Headquarters in Washington, D.C., USA.

World Bank Group Institutions:

• World Bank: Focuses on financial and technical assistance for sustainable development
and poverty reduction.
• IFC: Private sector arm, promotes private sector investment in developing countries.
• MIGA: Provides political risk insurance to encourage foreign investment.
• ICSID: Facilitates arbitration of investment disputes between governments and foreign
investors.

Purpose and Mission:

• Core mission is poverty alleviation and sustainable development.
• Addresses economic disparities through a multifaceted approach.

Financial Assistance:
• Raises capital through bond issuance on international markets.
• Provides loans and grants to member countries facing challenges in traditional
markets.

Development Projects:
• Spans infrastructure, education, healthcare, and sustainable economic growth.
• Emphasizes long-term economic stability and prosperity.

Technical Assistance:
• Offers expertise, knowledge, and best practices to implement effective development
strategies.

Education and Healthcare:

• Invests in education for empowerment and economic advancement.
• Healthcare projects strengthen infrastructure and improve access to essential services.

Unit 8: World Bank 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Challenges and Criticisms:

• Criticisms include environmental and social impacts, governance structure favoring
certain countries.

Membership:
• 189 member countries.
• Shareholder status based on financial contributions, influencing voting power.

Financing:
• Raises capital through bond issuance on international markets.
• Provides low-interest loans with long repayment periods.
• Allocates grants, especially to the poorest countries, for critical needs without
repayment.

Diversity and Inclusivity:

• Diverse membership base reflects global collaboration.
• Engages with developing countries to tailor assistance to specific needs.

Impact on Global Development:

• World Bank's financing model through bond issuance catalyzes substantial financial
resources for large-scale projects.
• Low-interest loans empower member countries for economic growth and poverty
reduction.
• Extended repayment periods provide flexibility for strategic resource allocation.
• Allocation of grants to the poorest countries addresses urgent development needs.

Challenges and Considerations:

• Criticisms regarding environmental and social impacts of funded projects.
• Governance structure criticized for favoring larger shareholder countries.
• Ongoing reforms to address transparency, accountability, and inclusivity.

Unit 8: World Bank 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Governance:
Board of Governors:
• Composed of representatives from member countries.
• Allots shares based on financial contribution, influencing voting power.
• Annual meetings decide on key policies and institutional changes.

Board of Executive Directors:

• Responsible for day-to-day operations and decision-making.
• Composed of Executive Directors representing groups of countries.
• Decision-making influenced by relative financial contributions.

President of the World Bank:

• Nominated by the U.S., subject to Board of Executive Directors' approval.
• Responsible for overall management and strategic direction.
• Criticisms regarding the need for a more inclusive selection process.

Challenges and Reforms:

• Governance structure criticized for favoring larger shareholder countries.
• Ongoing efforts to reform governance, addressing representation, equity, and voice.

Projects:
Infrastructure Development:
• Includes roads, bridges, and energy projects.
• Enhances economic development and regional integration.
• Focus on creating an environment for sustainable economic growth.

Social Services:
• Healthcare projects strengthen systems and improve access.
• Education initiatives focus on expanding opportunities and improving quality.
• Investments contribute to human capital development.

Environmental Sustainability:
• Supports environmental conservation and sustainable land use.
• Funds projects for renewable energy and climate change mitigation.

Unit 8: World Bank 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Integrates environmental considerations for sustainable development.

Challenges and Considerations:

• Some projects criticized for environmental and social impacts.
• Discussions about the need for more inclusive decision-making processes.
• Emphasis on addressing challenges and involving local communities in project
planning.

4. TERMINAL QUESTIONS
1. Question: What is the main objective of the World Bank, and how does it aim to achieve
this objective?
2. Question: Describe the governance structure of the World Bank and its key decision-
making bodies.
3. Question: How does the World Bank raise capital, and what is the significance of issuing
bonds on the international capital markets?
4. Question: Explain the role of the World Bank in promoting sustainable economic
growth.
5. Question: What is the significance of the World Bank's portfolio, and how does it
address various developmental needs?
6. Question: What challenges and criticisms has the World Bank faced, and how does it
respond to calls for reform?
7. Question: Discuss the role of the World Bank in providing financial assistance,
development projects, and technical expertise to address poverty.
8. Question: How does the World Bank cater to the needs of the poorest countries, and
why is the provision of grants significant in this context?
9. Question: Explain the significance of the World Bank's membership structure and its
role in governance and decision-making.
10. Question: How does the World Bank's commitment to inclusivity manifest in its
engagement with developing countries, and what challenges does the membership
structure pose?

Unit 8: World Bank 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. ANSWERS
Self-Assessment Questions
Answer 1: C. Alleviating poverty through financial assistance

Answer 2: B. Bretton Woods Conference

Answer 3: C. Promoting private sector investment

Answer 4: C. Multilateral Investment Guarantee Agency (MIGA)

Answer 5: D. United States, the largest single shareholder

Answer 6: C. Supporting projects in developing countries

Answer 7: A. Issuing bonds on international capital markets

Answer: B. Longer repayment periods

Answer 9: C. Grants

Answer 10: C. Governance structure favouring certain countries

Terminal Questions
Answer 1: The main objective of the World Bank is to alleviate poverty through the provision
of financial and technical assistance to developing countries. This is achieved by offering
loans and grants for capital projects, covering areas such as infrastructure development,
education, healthcare, and sustainable economic growth. The World Bank aims to enhance
the economic prospects and quality of life for people in recipient countries.

Answer 2: The governance structure of the World Bank involves a Board of Governors and a
Board of Executive Directors. The Board of Governors consists of representatives from each
member country, usually finance ministers or central bank governors, making key decisions
in annual meetings. The Board of Executive Directors oversees day-to-day operations, its
composition based on the distribution of shareholding among member countries. The
President of the World Bank is traditionally nominated by the United States, the largest
single shareholder.

Unit 8: World Bank 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 3: The World Bank raises capital primarily through the issuance of bonds on the
international capital markets. Bonds are debt securities representing loans made by
investors to the World Bank. The institution's strong credit rating and prudent financial
management make its bonds attractive to a diverse range of investors globally. This capital,
raised through bond issuance, is then used to provide loans and grants to member countries
for development projects.

Answer 4: The World Bank emphasizes initiatives that contribute to long-term economic
stability and prosperity. It supports policies and projects promoting responsible and
sustainable resource management, environmental conservation, and the creation of
economic opportunities. The goal is to foster economic growth that can withstand the test of
time, contributing to the overall sustainable development of member countries.

Answer 5: The World Bank's portfolio encompasses a diverse array of projects, including
infrastructure development, social services, and environmental sustainability.
Infrastructure projects, such as roads and energy facilities, lay the foundation for economic
growth. Social services projects focus on improving healthcare and education, recognizing
their pivotal role in human development. This multifaceted approach aims to address the
complex challenges faced by developing nations.

Answer 6: The World Bank has faced criticism regarding environmental and social impacts
of projects and governance structures favoring certain member countries. Calls for reform
include demands for greater accountability and transparency. The World Bank
acknowledges these concerns and engages in ongoing efforts to address them,
demonstrating a commitment to improving its operations and ensuring equitable
distribution of benefits.

Answer 7: The World Bank utilizes financial assistance tools, such as loans and grants, to
provide resources to countries facing challenges accessing capital. It focuses on diverse
development projects spanning infrastructure, education, healthcare, and sustainable
economic growth. Additionally, the institution offers technical assistance, sharing expertise
and best practices to help countries design and implement effective development strategies,
contributing to poverty reduction.

Unit 8: World Bank 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 8: The World Bank allocates grants, especially to the poorest countries, addressing
critical needs in healthcare, education, and basic infrastructure. Unlike loans, grants do not
require repayment, supporting development without creating a debt burden. This
recognizes the economic challenges faced by the poorest nations and emphasizes a holistic
approach to sustainable development.

Answer 9: The World Bank's membership structure, comprising 189 countries, is pivotal to
its governance and decision-making processes. Each member country, acting as a
shareholder, contributes financially based on its economic capacity. This financial
commitment influences the distribution of shares, voting power, and decision-making within
the institution. The diversity of the membership base reflects a collaborative and inclusive
approach to addressing global challenges.

Answer 10: The World Bank demonstrates inclusivity by tailoring financial and technical
assistance to meet the specific needs of developing countries. The membership structure,
while a source of strength, poses challenges, with criticisms of disproportionate influence by
larger shareholder countries. Ongoing efforts to address these concerns and reform the
governance structure highlight the institution's commitment to inclusivity and equitable
representation.

Unit 8: World Bank 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 9: International Monetary Fund 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 9
International Monetary Fund
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objective - -
2 Need of IMF after World War II - - 5
3 Bretton Woods Agreement - - 6-7
4 Why IMF came in nature after Bretton Woods - - 7-9
Agreement?
5 International Monetary Fund and World Bank - - 10-11
6 Difference between IMF and World Bank - 1 11-14
7 Primary responsibility of International - - 14-15
Monetary Fund
8 IMF Funding Facilities - - 16-17
9 Special Rights of IMF - - 18-19
10 Challenges of IMF - 2 20-23
11 Summary - - 24-25
12 Terminal Questions - - 26
13 Answers - - 27-30

Unit 9: International Monetary Fund 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The International Monetary Fund (IMF) is an international financial institution that works
to ensure the stability of the international monetary system. It was founded in 1944 by 29
countries, and today has 190 member countries.

The IMF has three main functions:

• Surveillance: The IMF monitors the global economy and the economies of its member
countries to identify potential risks and vulnerabilities. It provides its members with
policy advice and technical assistance to help them avoid or mitigate these risks.
• Lending: The IMF provides loans to member countries that are facing financial
difficulties. These loans can be used to support economic reforms, stabilize the financial
system, or address other balance-of-payments problems.
• Capacity development: The IMF provides training and technical assistance to member
countries to help them strengthen their economic institutions and policies.

The IMF is governed by a Board of Governors, which is made up of one representative from
each member country. The Board of Governors meets once a year to review the IMF's work
and make decisions on major policy issues. The IMF is also managed by an Executive Board,
which is made up of 24 executive directors who represent groups of countries. The Executive
Board meets regularly to oversee the IMF's day-to-day operations.

The IMF's resources are provided by its member countries, which contribute to a quota
system. The quotas are based on the size of each country's economy. The IMF can also
borrow money from the financial markets to supplement its resources.

The IMF plays an important role in the global economy by promoting financial stability and
economic growth. It does this by providing policy advice, lending financial support, and
building capacity in its member countries.

Here are some examples of how the IMF has helped countries:
• In 2020, the IMF provided $117 billion in loans to 88 countries to help them respond to
the COVID-19 pandemic.
• In 2022, the IMF approved a $3 billion loan to Ukraine to help the country finance its
budget deficit and support its economy during the war with Russia.

Unit 9: International Monetary Fund 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• The IMF also provides technical assistance to member countries on a wide range of
issues, such as tax policy, financial sector regulation, and economic forecasting.

The IMF is an important institution in the global economy, and it plays a vital role in
promoting financial stability and economic growth.

1.1 Learning Objective

After undergoing this unit, the students will understand the following concepts: -
❖ Understand the Purpose and Functions of the International Monetary Fund (IMF) and the
World Bank:
❖ Explore the Historical Context of the IMF and the World Bank:
❖ Compare and contrast the IMF and the World Bank:
❖ Understand the Decision-Making and Governance of the IMF and the World Bank.
❖ Understand the primary responsibilities of the International Monetary Fund (IMF) in
promoting international monetary cooperation, exchange rate stability, and balanced
international trade.
❖ Describe the key functions of the IMF, including surveillance, financial assistance,
technical assistance, and research and analysis.
❖ Explain the various IMF funding facilities and financial instruments available to member
countries to address balance of payments problems and economic challenges.
❖ Discuss the special rights of the IMF associated with Special Drawing Rights (SDRs),
including their role in the international monetary system.

Unit 9: International Monetary Fund 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. NEED OF IMF AFTER WORLD WAR II

The need for the IMF after World War II was to help rebuild the global economy and promote
financial stability. The war had caused widespread destruction and economic disruption, and
many countries were struggling to recover. The IMF was created to provide these countries
with financial assistance and advice, and to help them implement economic reforms.

The IMF also played an important role in establishing the Bretton Woods system, which was
a set of rules and institutions designed to promote a stable international monetary system.
The Bretton Woods system was based on a system of fixed exchange rates, with the US dollar
pegged to gold. This system helped to promote trade and investment, and it contributed to
the global economic recovery in the postwar years.

The IMF has continued to play an important role in the global economy since World War II.
It has provided financial assistance and advice to countries facing a wide range of economic
challenges, including balance-of-payments problems, financial crises, and natural disasters.
The IMF has also played a leading role in helping countries to transition to market
economies, and in promoting economic development.

Here are some specific examples of how the IMF has helped countries after World War II:
• The IMF provided loans to help European countries rebuild their economies after the
war.
• The IMF helped to coordinate the global response to the Latin American debt crisis in
the 1980s.
• The IMF provided financial assistance to Russia and the other countries of the former
Soviet Union in the early 1990s as they transitioned to market economies.
• The IMF has provided loans to help countries recover from natural disasters, such as
the Asian tsunami in 2004 and the Haitian earthquake in 2010.

The IMF continues to play an important role in the global economy today. It is a key
institution in helping countries to address economic challenges and to promote sustainable
growth and development.

Unit 9: International Monetary Fund 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. BRETTON WOODS AGREEMENT

The Bretton Woods Agreement was an agreement reached by delegates from 44 countries at
the United Nations Monetary and Financial Conference held in Bretton Woods, New
Hampshire, in July 1944. The agreement established a system of fixed exchange rates, with
the US dollar pegged to gold, and created two new international financial institutions: the
International Monetary Fund (IMF) and the World Bank.

The Bretton Woods system was designed to promote global economic stability and growth.
It was based on the belief that fixed exchange rates would reduce uncertainty and encourage
trade and investment. The IMF was created to help maintain the Bretton Woods system and
to provide financial assistance to countries that were experiencing balance-of-payments
problems. The World Bank was created to provide loans to developing countries to help
them finance economic development projects.

The Bretton Woods system collapsed in the early 1970s due to a number of factors, including
the Vietnam War, the oil crisis, and the increasing financial integration of the global economy.
However, the IMF and the World Bank continue to play important roles in the global
economy today.

The Bretton Woods Agreement was a landmark event in the history of the global economy.
It established a system of international economic cooperation that helped to promote global
economic stability and growth for over two decades. The IMF and the World Bank, which
were created by the Bretton Woods Agreement, continue to be important institutions in the
global economy today.

Here are some of the key features of the Bretton Woods Agreement:
• Fixed exchange rates: All currencies were pegged to the US dollar, which was in turn
pegged to gold at a fixed rate of $35 per ounce.
• Free convertibility of currencies: Countries were required to convert their currencies
into other currencies at the fixed exchange rates.
• International Monetary Fund (IMF): The IMF was created to provide financial
assistance to countries that were experiencing balance-of-payments problems.

Unit 9: International Monetary Fund 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• World Bank: The World Bank was created to provide loans to developing countries to
help them finance economic development projects.

The Bretton Woods Agreement was a significant achievement in the context of its time. It
helped to promote global economic stability and growth in the postwar era. However, the
system eventually collapsed due to a number of factors, including the Vietnam War, the oil
crisis, and the increasing financial integration of the global economy.

4. WHY IMF CAME IN NATURE AFTER BRETTON WOODS AGREEMENT?

The International Monetary Fund (IMF) came into nature in the Bretton Woods Agreement
for a number of reasons.
• To promote financial stability. The Bretton Woods system was based on a system of
fixed exchange rates, with the US dollar pegged to gold. This system was designed to
promote financial stability by reducing uncertainty and encouraging trade and
investment. The IMF was created to help maintain the Bretton Woods system and to
provide financial assistance to countries that were experiencing balance-of-payments
problems.
• To promote economic growth. The IMF was also created to promote economic growth
by providing financial assistance and advice to countries that were struggling to
recover from World War II. The IMF also played a role in helping countries to develop
their economies and to integrate into the global economy.
• To promote international cooperation. The Bretton Woods Agreement was a reflection
of the belief that international cooperation was essential to promoting economic
stability and growth. The IMF was created as a forum for countries to discuss their
economic challenges and to work together to find solutions.

The IMF was also created in response to the failures of the previous international monetary
system, which was based on the gold standard. The gold standard had been abandoned
during World War I, and the interwar period was characterized by financial instability and
competitive devaluations. The Bretton Woods system was designed to address these
problems by creating a more stable and cooperative international monetary system.

Unit 9: International Monetary Fund 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The IMF has played an important role in the global economy since the Bretton Woods
Agreement. It has helped countries to address a wide range of economic challenges,
including balance-of-payments problems, financial crises, and natural disasters. The IMF has
also played a leading role in helping countries to transition to market economies, and in
promoting economic development.

The IMF continues to be an important institution in the global economy today. It is a key
instrument in helping countries to achieve their economic goals and to promote global
economic stability and prosperity.

The International Monetary Fund (IMF) was established as part of the Bretton Woods
Agreement, which was a pivotal international monetary system created in July 1944. The
Bretton Woods Conference, held in Bretton Woods, New Hampshire, was a gathering of
representatives from 44 Allied nations during World War II, with the primary goal of
designing a new international monetary order after the war. Several factors led to the
establishment of the IMF in the aftermath of the Bretton Woods Agreement:
• Post-World War II Economic Reconstruction: World War II had caused significant
economic devastation in many countries. The Bretton Woods negotiators recognized
the need for an international institution to assist in the economic reconstruction of war-
torn nations and to promote overall global economic stability.
• Exchange Rate Stability: Prior to the Bretton Woods Agreement, the world experienced
economic turmoil due to competitive devaluations and exchange rate fluctuations,
particularly during the Great Depression and between the two World Wars. Bretton
Woods sought to establish a system that would stabilize exchange rates and prevent
competitive devaluations, which were seen as contributing to economic instability.
• Promotion of Trade and Economic Growth: To encourage international trade and
economic growth, the agreement aimed to establish a stable system of exchange rates.
Stable exchange rates were seen as critical to facilitate trade and investments across
borders.
• Avoiding a Repeat of the Great Depression: The negotiators were keen on preventing a
repeat of the economic disasters of the 1930s. The IMF was designed to promote global
economic cooperation and provide a framework for dealing with economic imbalances
to prevent the types of economic downturns seen during the Depression.

Unit 9: International Monetary Fund 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Providing a Lender of Last Resort: The IMF was envisioned as a lender of last resort
that could provide financial assistance to countries facing short-term balance of
payments problems or currency crises. This would help prevent currency collapses and
economic instability.
• International Monetary Cooperation: The IMF was to serve as a forum for international
monetary cooperation and coordination of exchange rate policies. Member countries
would meet and discuss their economic and monetary policies to achieve common
goals of stability and growth.
• Alignment with the United Nations: The establishment of the IMF was also aligned with
the broader goals of international cooperation and peace, which were central to the
United Nations (UN). The Bretton Woods institutions, including the IMF, were designed
to promote global economic stability as a means of maintaining peace and preventing
future conflicts.

After the Bretton Woods Agreement was reached, the IMF was formally established in
December 1945 when its first 29 member countries signed its Articles of Agreement. The
IMF began its operations in 1947. Since then, it has played a vital role in the international
monetary system, providing financial assistance, offering policy advice, and fostering global
economic cooperation.

In summary, the IMF was created as a result of the Bretton Woods Agreement to address the
economic challenges and instability that arose during and after World War II. Its
establishment was part of a broader effort to rebuild the global economy, stabilize exchange
rates, and prevent the economic hardships that had been experienced in the preceding
decades.

Unit 9: International Monetary Fund 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. INTERNATIONAL MONETARY FUND AND WORLD BANK

The International Monetary Fund (IMF) and the World Bank are two of the most important
international financial institutions in the world. They were both created in 1944 at the
Bretton Woods Conference, which was held to establish a new international monetary
system after World War II.

The IMF and the World Bank have complementary missions. The IMF is focused on
promoting financial stability and economic growth, while the World Bank is focused on
reducing poverty and promoting sustainable development.

IMF
The IMF provides financial assistance and advice to countries that are facing economic
difficulties. This can include loans to help countries finance their balance of payments
deficits, as well as technical assistance to help countries implement economic reforms. The
IMF also plays a role in monitoring the global economy and providing early warning signs of
potential financial crises.

World Bank
The World Bank provides loans and grants to developing countries to help them finance
economic development projects, such as building infrastructure, improving education and
healthcare, and supporting small businesses. The World Bank also provides technical
assistance to help countries implement these projects and build their capacity for economic
management.

The IMF and the World Bank play important roles in the global economy by helping countries
to achieve their economic goals and promote global economic stability and prosperity.

Here are some examples of how the IMF and the World Bank have worked together:
• In 2020, the IMF and the World Bank provided over $100 billion in financial assistance
to countries to help them respond to the COVID-19 pandemic.
• The IMF and the World Bank are also working together to help countries address the
climate crisis. For example, they are providing financial assistance to countries to help
them invest in renewable energy and other climate-friendly technologies.

Unit 9: International Monetary Fund 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The IMF and the World Bank are important partners in the global effort to reduce poverty
and promote sustainable development. They play a vital role in helping countries to achieve
their economic goals and create a better future for their people.

6. DIFFERENCE BETWEEN IMF AND WORLD BANK

The International Monetary Fund (IMF) and the World Bank are two distinct entities, both
of which play critical roles in the global financial system. While they often work together on
international financial issues, they have different purposes, structures, and functions. Here
are the key differences between the IMF and the World Bank:
• Primary Purpose: International Monetary Fund (IMF): The primary purpose of the IMF
is to promote international monetary cooperation and exchange rate stability, facilitate
the balanced growth of international trade, provide resources to help member
countries in need of financial assistance, and offer policy advice to member countries
to maintain economic stability. It focuses on short-term financial stability. World Bank:
The World Bank, officially known as the International Bank for Reconstruction and
Development (IBRD), primarily focuses on long-term economic development and
poverty reduction in developing countries. Its main goal is to provide financial and
technical assistance for development projects, infrastructure, education, healthcare,
and other long-term initiatives.
• Membership and Ownership: IMF: Membership in the IMF is open to all countries.
Members contribute funds, known as quotas, which determine their voting power and
access to financial assistance. Quotas are based on a country's economic size and
importance in the global economy. World Bank: The World Bank consists of two main
institutions: the International Bank for Reconstruction and Development (IBRD) and
the International Development Association (IDA). Membership in the IBRD is open to
middle-income and creditworthy low-income countries, while the IDA provides
concessional loans and grants to the world's poorest countries.
• Functions: IMF: The IMF primarily provides financial assistance and policy advice to
countries facing balance of payments problems or economic crises. It monitors
exchange rates and offers policy recommendations to promote macroeconomic
stability. The IMF also provides technical assistance and training to member countries.
World Bank: The World Bank offers long-term loans, grants, and technical assistance to

Unit 9: International Monetary Fund 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

support projects and programs aimed at reducing poverty and promoting economic
development. It focuses on infrastructure, education, healthcare, agriculture, and other
sectors that contribute to long-term economic growth.
• Financial Assistance: IMF: The IMF provides financial assistance to countries facing
short-term balance of payments problems. This assistance is often contingent on
countries implementing specific policy measures, such as fiscal austerity or structural
reforms, to restore stability. World Bank: The World Bank provides loans and grants
for development projects that span several years or even decades. These projects are
aimed at building infrastructure, reducing poverty, and supporting long-term economic
development.
• Focus on Financial Stability: IMF: The IMF's primary focus is on the stability of the
global financial system. It intervenes to prevent or resolve financial crises, stabilize
exchange rates, and promote sound economic policies. World Bank: The World Bank is
more concerned with alleviating poverty and supporting sustainable development in
low- and middle-income countries. It emphasizes long-term economic and social
development.
• Decision-Making: IMF: Decision-making in the IMF is based on voting power
determined by member countries' quotas. Major decisions often require an 85%
majority, meaning that some key decisions can be influenced by the largest economies.
World Bank: Decision-making in the World Bank is based on voting power, but the
emphasis is more on development projects and initiatives rather than financial
stability.
• Leadership: IMF: The IMF is typically led by a Managing Director, who is responsible
for overseeing the organization's operations and representing it on the global stage.
World Bank: The World Bank is typically led by a President, who is responsible for the
overall operations and policies of the institution.

In summary, the IMF and the World Bank serve different purposes within the international
financial system. The IMF focuses on short-term financial stability and offers financial
assistance to countries in crisis, while the World Bank concentrates on long-term
development projects and reducing poverty in developing nations. Despite their differences,

Unit 9: International Monetary Fund 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

both institutions collaborate to address global economic challenges and promote

international financial stability.

SELF-ASSESSMENT QUESTIONS – 1

1. What was the primary goal of the Bretton Woods Agreement in 1944?
a) To create a global system of competitive exchange rates
b) To promote international monetary cooperation and exchange rate
stability
c) To establish a single global currency
d) To encourage countries to engage in competitive devaluations
2. Why was the International Monetary Fund (IMF) created as part of the
Bretton Woods Agreement?
a) To promote long-term economic development in developing countries
b) To provide loans and grants for infrastructure projects
c) To offer policy advice and financial assistance to countries facing short-
term balance of payments problems
d) To stabilize global exchange rates
3. What is the primary mission of the World Bank within the international
financial system?
a) To promote financial stability and macroeconomic policies
b) To provide short-term financial assistance to countries in crisis
c) To reduce poverty and support long-term economic development in
developing countries
d) To stabilize exchange rates
4. Which institution focuses on providing financial assistance and policy advice
during financial crises and balance of payments problems?
a) The World Bank
b) The United Nations
c) The International Monetary Fund (IMF)
d) The Bretton Woods Conference

Unit 9: International Monetary Fund 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

5. How is decision-making typically determined within the International Monetary

Fund (IMF)?
a) By a majority vote from member countries
b) By the largest economies' decisions
c) By the United Nations
d) By an appointed Managing Director

7. PRIMARY RESPONSIBILITY OF INTERNATIONAL MONETARY FUND

The primary responsibility of the International Monetary Fund (IMF) is to promote
international monetary cooperation, exchange rate stability, balanced growth of
international trade, and the orderly economic development of member countries. The IMF
fulfils its responsibilities through several key functions:
• Surveillance: The IMF monitors the global economy and the economic and financial
policies of its member countries. It conducts regular assessments of each member's
economic and financial situation to identify potential risks and vulnerabilities. These
assessments are used to provide policy advice to member countries.
• Financial Assistance: One of the most visible roles of the IMF is to provide temporary
financial assistance to member countries facing balance of payments problems. This
assistance helps countries stabilize their economies, restore economic growth, and
overcome short-term financial crises.
• Technical Assistance and Capacity Development: The IMF offers technical assistance
and training to member countries to help strengthen their capacity to design and
implement effective economic and financial policies. This includes areas like fiscal
management, monetary policy, exchange rate systems, and financial sector regulation.
• Research and Analysis: The IMF conducts economic research and analysis on a wide
range of global and regional economic issues. It publishes reports, studies, and
economic forecasts to provide member countries with valuable information and
insights.

Unit 9: International Monetary Fund 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Exchange Rate Stability: The IMF plays a role in promoting exchange rate stability.
While it no longer fixes exchange rates (as was the case during the Bretton Woods era),
it provides a forum for member countries to discuss and coordinate exchange rate
policies.
• Global Economic Cooperation: The IMF serves as a forum for member countries to
cooperate on international monetary and financial matters. This cooperation is critical
for addressing global economic challenges and fostering a stable and cooperative
international economic system.
• Financial Stability: The IMF monitors and assesses the stability of the international
financial system, including the soundness of banking and financial sectors in its
member countries. It provides advice and assistance on financial sector stability and
crisis management.
• Economic Policy Advice: The IMF offers policy advice to its member countries based on
its analysis and assessments. This advice covers a wide range of economic and financial
policies, such as fiscal policy, monetary policy, structural reforms, and more.
• Capacity Building: The IMF helps countries build their economic policy-making
capacity and institutions by providing technical assistance and training in various areas
of economic policy.
• Research and Policy Development: The IMF conducts research on global economic
issues and policy development. It provides valuable input into discussions on
important economic topics.

In summary, the primary responsibility of the IMF is to foster global economic stability,
prevent financial crises, provide financial assistance to countries in need, and offer policy
advice and technical assistance to member countries. By promoting international monetary
cooperation and exchange rate stability, the IMF aims to facilitate balanced economic growth
and prosperity among its member nations.

Unit 9: International Monetary Fund 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. IMF FUNDING FACILITIES

The International Monetary Fund (IMF) provides various funding facilities and financial
instruments to its member countries to help them address balance of payments problems,
stabilize their economies, and promote economic growth. These facilities are designed to
meet the diverse needs of member countries based on the nature and severity of their
economic challenges. Here are some of the main funding facilities and financial instruments
offered by the IMF:

Stand-By Arrangements (SBAs): Stand-By Arrangements are financial assistance programs

that provide short to medium-term support to member countries facing balance of payments
problems or experiencing fiscal and monetary challenges. These arrangements typically last
from 12 to 36 months and are designed to help countries implement economic policy
adjustments to restore stability.

Extended Fund Facility (EFF): The Extended Fund Facility is intended for countries with
more serious and long-term balance of payments problems. It provides financial assistance
over an extended period (usually three to four years) and allows countries to implement a
comprehensive set of structural reforms in addition to macroeconomic stabilization
measures.

Flexible Credit Line (FCL): The Flexible Credit Line is a financial instrument designed for
countries with strong economic policies and fundamentals. It offers a pre-approved financial
arrangement that countries can draw upon in case of balance of payments problems. The
FCL is designed to provide rapid and flexible financial assistance.

Precautionary and Liquidity Line (PLL): The Precautionary and Liquidity Line is designed
for countries with strong economic policies but who wish to have a precautionary financial
arrangement with the IMF. It provides a flexible line of credit that countries can draw upon
if needed.

Rapid Financing Instrument (RFI): The Rapid Financing Instrument is used to provide
emergency financial assistance to countries facing urgent balance of payments problems. It
is typically used in situations where immediate support is required and a full-fledged
program is not needed.

Unit 9: International Monetary Fund 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Emergency Financial Assistance: In response to severe crises, the IMF can provide
emergency financial assistance to help countries stabilize their economies. This assistance is
often provided through various financial instruments, including loans and grants.

Financial Sector Assessment Program (FSAP): While not a funding facility in the traditional
sense, the FSAP is a program that helps countries assess the stability and resilience of their
financial sectors. It provides policy advice on improving financial sector supervision and
regulation.

Catastrophe Containment and Relief Trust (CCRT): The CCRT is a financial instrument used
to provide debt relief to countries facing catastrophic events, such as pandemics, natural
disasters, or public health crises. It allows eligible countries to receive grants to cover their
debt service payments to the IMF.

Special Drawing Rights (SDRs): SDRs are international reserve assets that are allocated to
IMF member countries to provide liquidity. Member countries can use SDRs to bolster their
foreign exchange reserves or exchange them for freely usable currencies with other member
countries.

These are some of the main funding facilities and financial instruments offered by the IMF.
The choice of facility or instrument depends on the specific needs and circumstances of the
member country seeking assistance. The IMF works closely with member countries to design
programs that are tailored to their unique economic challenges.

Unit 9: International Monetary Fund 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9. SPECIAL RIGHTS OF IMF

Special Drawing Rights (SDRs) are a unique international monetary asset issued by the
International Monetary Fund (IMF). They are sometimes referred to as the "special rights of
the IMF" because they are a financial asset held by IMF member countries and can be used
for various purposes within the international monetary system. Here are the key special
rights of the IMF associated with SDRs:

International Reserve Asset: SDRs are an international reserve asset, like foreign exchange
reserves, that can be held and used by IMF member countries. They serve as a supplement
to the official reserves of member countries.

Liquidity and Stability: SDRs provide liquidity to member countries, helping them address
balance of payments problems and economic challenges. They contribute to global economic
and financial stability by providing an additional source of international liquidity.

Exchange Rate Stability: SDRs can be used by member countries to stabilize their exchange
rates and maintain the value of their national currencies.

Exchange for Currencies: Member countries can exchange their SDR holdings with other
member countries for freely usable currencies. This allows countries to acquire the currency
of their choice for various international transactions.

IMF Transactions: SDRs are used in IMF financial transactions. Member countries can use
their SDRs to pay charges and fees to the IMF, repay financial assistance received from the
IMF, and settle financial transactions with the IMF.

Financial Support: During global economic crises, the IMF can allocate SDRs to member
countries to help address their balance of payments problems. These allocations provide
additional resources to countries facing economic challenges.

Official IMF Accounts: SDRs are recorded in the financial accounts of the IMF and can be used
for various IMF purposes, including providing financial assistance to member countries.

Allocation: Periodically, the IMF may allocate SDRs to its member countries. These
allocations are made in proportion to a member country's IMF quota, which is based on its

Unit 9: International Monetary Fund 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

economic size within the global economy. Allocations aim to provide liquidity to all member
countries and can support the stability of the international monetary system.

Interest-Bearing Asset: SDRs are interest-bearing assets, and member countries that receive
allocations earn interest on their SDR holdings. The interest rate on SDRs is typically higher
than the yields on many other financial assets.

Potential Global Reserve: SDRs have been discussed as a potential global reserve asset that
could help stabilize the international monetary system and reduce the reliance on individual
national currencies as reserves.

SDRs play a crucial role in facilitating international trade and financial transactions,
especially for countries with limited foreign exchange reserves. They are a unique feature of
the international monetary system and are part of the IMF's efforts to promote global
monetary cooperation and stability. The allocation of SDRs and their use in the international
financial system can have significant implications for the economic and financial health of
member countries and the overall stability of the global economy.

Unit 9: International Monetary Fund 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

10. CHALLENGES OF IMF

The International Monetary Fund (IMF) faces a number of challenges, including:
• Conditionality: IMF loans are often tied to conditions, such as economic reforms or
fiscal consolidation. These conditions can be difficult for countries to meet, and they
can sometimes lead to social unrest.
• Governance: The IMF is governed by a Board of Governors, which is made up of one
representative from each member country. However, the voting power of each country
is based on its economic size, which means that the largest economies have the most
influence. This can lead to concerns that the IMF is biased in favor of wealthier
countries.
• Transparency: The IMF has been criticized for its lack of transparency. For example, the
IMF does not always publicly disclose the terms of its loans, and it does not always
consult with civil society groups when developing its programs.
• Effectiveness: The IMF has been criticized for the effectiveness of its programs. Some
critics argue that IMF programs do not always lead to economic recovery, and that they
can sometimes lead to social and economic hardship.

Despite these challenges, the IMF remains an important institution in the global economy. It
plays a vital role in helping countries to address their economic problems and promote
sustainable growth.

The IMF is working to address some of these challenges. For example, the IMF has become
more transparent in recent years, and it is now more likely to consult with civil society
groups when developing its programs. The IMF is also working to reform its governance
structure to give more voice to low-income countries.

The IMF is a complex institution, and it faces a number of challenges. However, the IMF is
also a vital institution in the global economy, and it plays a key role in helping countries to
achieve their economic goals.

Similarly further challenges can be discussed as. The International Monetary Fund (IMF)
faces several challenges in its role as a global financial institution and provider of economic
and financial stability. Some of the key challenges include:

Unit 9: International Monetary Fund 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Economic Inequality: One of the major challenges is addressing global economic inequality.
The IMF must navigate the delicate balance between stabilizing economies and addressing
issues of income inequality. Critics argue that some IMF policies may exacerbate income
disparities within countries.

Conditionalities and Austerity Measures: The IMF often attaches conditions to its financial
assistance, which can include austerity measures. These conditions can be politically
unpopular and may lead to social unrest in borrowing countries.

Democratic Deficit: The governance structure of the IMF has been criticized for lacking
democratic representation. Major decisions are often made by a few powerful member
countries, and developing countries may feel marginalized in the decision-making process.

Sovereignty and Policy Space: Some countries view IMF policy recommendations and
conditions as an infringement on their sovereignty and policy autonomy. There can be
tensions between the IMF's policy advice and the preferences of individual governments.

Effectiveness of Policy Recommendations: The IMF's policy advice and recommendations are
not always effective in achieving economic stability. The "one-size-fits-all" approach may not
consider the unique circumstances of individual countries.

Global Economic Governance: The IMF operates within a complex framework of

international institutions. Coordination and cooperation with other organizations, such as
the World Bank and the World Trade Organization, can be challenging.

Debt Crises: Managing and resolving sovereign debt crises is a significant challenge. The IMF
plays a key role in negotiating debt restructuring and sustainability, but finding equitable
solutions that benefit both debtor and creditor countries can be complex.

Geopolitical Conflicts: Geopolitical conflicts and rivalries can influence the decisions and
functioning of the IMF. These conflicts can complicate its role in stabilizing global finance
and supporting member countries.

Financial Resources: The IMF's ability to provide financial assistance during global crises
may be limited by the availability of resources. There are ongoing discussions about

Unit 9: International Monetary Fund 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

expanding the IMF's resource base to meet the growing financial needs of its member
countries.

Crisis Prevention and Early Warning: The IMF faces the challenge of effectively preventing
and detecting financial and economic crises before they escalate. Developing early warning
systems and taking timely preventive actions are complex tasks.

Climate Change and Environmental Issues: As environmental concerns grow, there is a need
to incorporate climate and environmental factors into economic and financial stability
assessments. The IMF is increasingly being called upon to address these issues in its policy
advice.

Pandemic Response: The IMF has played a role in addressing the economic impact of
pandemics, as seen during the COVID-19 pandemic. Managing such crises effectively and
coordinating with other international organizations and governments is a challenge.

Technical Capacity: Building the technical capacity and expertise within member countries
to effectively implement IMF recommendations and policies can be a challenge, particularly
in low- and middle-income countries.

Public Perception and Trust: Maintaining public trust and support for the IMF can be a
challenge, especially when its policies are associated with austerity measures and social
hardships.

The IMF continually adapts to address these challenges and evolve in response to changing
global economic conditions. Its effectiveness in meeting these challenges is essential for
promoting global economic stability and preventing financial crises.

Unit 9: International Monetary Fund 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

6. What is the primary responsibility of the International Monetary Fund

(IMF)?
a) Promoting its own financial stability
b) Fostering global economic stability and cooperation
c) Regulating international trade
d) Enforcing exchange rate policies
7. Which IMF function involves the regular assessment of member countries'
economic and financial situations to provide policy advice?
a) Financial Assistance
b) Technical Assistance
c) Surveillance
d) Research and Analysis
8. What is the primary purpose of the Extended Fund Facility (EFF) offered by
the IMF?
a) Providing rapid financial assistance
b) Supporting countries with strong economic policies
c) Addressing short-term financial crises
d) Helping countries with long-term balance of payments problems
9. Special Drawing Rights (SDRs) serve as:
a) A financial assistance program.
b) An international reserve asset
c) A forum for global economic cooperation
d) A grant for debt relief
10. What is one of the challenges faced by the IMF as mentioned in the provided
information?
a) Overwhelming transparency in operations
b) Struggling with an abundance of financial resources
c) Dealing with issues of economic inequality
d) Lack of cooperation with other international organizations

Unit 9: International Monetary Fund 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. SUMMARY
• The IMF (International Monetary Fund) is an international financial institution founded
in 1944 with 190 member countries.
• It has three main functions: surveillance, lending, and capacity development.
• The IMF provides policy advice and financial support to maintain global economic
stability.
• It is governed by a Board of Governors and managed by an Executive Board.
• IMF's resources come from member countries' contributions and the ability to borrow
from financial markets.
• It played a vital role in helping countries respond to crises, such as the COVID-19
pandemic.
• The Bretton Woods Agreement established the IMF and aimed to promote financial
stability through fixed exchange rates.
• The IMF's need after World War II was to help rebuild the global economy and promote
stability.
• It helped countries recover after WWII, coordinated responses to crises like the Latin
American debt crisis, and supported transitions to market economies.
• The Bretton Woods Agreement also led to the creation of the World Bank, focusing on
long-term development and poverty reduction.
• The IMF and the World Bank have different primary purposes and functions but often
collaborate on global financial issues.

Primary Responsibilities of IMF:

• Promote international monetary cooperation.
• Ensure exchange rate stability.
• Foster balanced growth of international trade.
• Support the orderly economic development of member countries.
• Functions include surveillance, financial assistance, technical assistance, research, and
policy development.

Unit 9: International Monetary Fund 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

IMF Funding Facilities:

• Stand-By Arrangements (SBAs) for short to medium-term support.
• Extended Fund Facility (EFF) for countries with long-term balance of payments
problems.
• Flexible Credit Line (FCL) for countries with strong economic policies.
• Precautionary and Liquidity Line (PLL) for countries seeking precautionary
arrangements.
• Rapid Financing Instrument (RFI) for emergency financial assistance.
• Various financial instruments, including grants, for emergency situations.

Special Rights of IMF (SDRs):

• Serve as an international reserve asset.
• Provide liquidity and stability to member countries.
• Can be used to stabilize exchange rates.
• Exchanged for freely usable currencies.
• Used in IMF transactions, including financial assistance.
• Allocated to member countries periodically.
• Potential global reserve asset.

Challenges of IMF:
• Conditionality and austerity measures in loans.
• Governance structure and lack of democratic representation.
• Transparency concerns.
• Effectiveness of policy recommendations.
• Addressing global economic inequality.
• Managing sovereign debt crises.
• Geopolitical conflicts affecting decision-making.
• Ensuring adequate financial resources.
• Addressing climate change and environmental issues.
• Building technical capacity in member countries.
• Maintaining public trust, especially during austerity measures.

Unit 9: International Monetary Fund 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

12. TERMINAL QUESTIONS

Question 1: Explain the functions and roles of the International Monetary Fund (IMF) in the
global economy. Provide specific examples of how the IMF has supported member countries
in various economic situations.

Question 2: Discuss the historical context and significance of the Bretton Woods Agreement.
Explain the objectives of the Bretton Woods system, including the creation of the
International Monetary Fund (IMF) and the World Bank.

Question 3: Explain the reasons for the establishment of the International Monetary Fund
(IMF) as a result of the Bretton Woods Agreement. Discuss how the IMF's functions
contribute to global economic stability and cooperation.

Question 4: Compare and contrast the roles and functions of the International Monetary
Fund (IMF) and the World Bank in the global economy. Provide examples of their
collaboration and highlight their respective areas of focus.

Question 5: Discuss the primary responsibilities and key functions of the International
Monetary Fund (IMF). How do these functions contribute to global economic stability?

Question 6: What are the various funding facilities and financial instruments offered by the
IMF? Explain their purposes and the types of economic challenges they address.

Question 7: Explain the concept of Special Drawing Rights (SDRs) and their significance in
the international monetary system. How are SDRs used, and what potential roles do they
play?

Question 8: What are the main challenges faced by the IMF in its role as a global financial
institution? Discuss how the IMF is working to address these challenges.

Question 9: How does the IMF contribute to global economic stability, and what is its role in
crisis prevention and resolution? Discuss the tools and mechanisms the IMF uses in these
efforts.

Unit 9: International Monetary Fund 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. ANSWERS
Terminal Questions
Answer 1: The International Monetary Fund (IMF) serves as a pivotal institution in the
global economy with three main functions. First, the IMF engages in surveillance by
monitoring the global economy and its member countries to identify risks and
vulnerabilities. It offers policy advice and technical assistance to mitigate these challenges.
Second, the IMF provides financial assistance, including loans, to member countries facing
financial difficulties. These funds can be employed to support economic reforms, stabilize
financial systems, or address balance-of-payments issues. Third, the IMF contributes to
capacity development by providing training and technical assistance to member countries to
enhance their economic institutions and policies.

Examples of the IMF's support include its provision of $117 billion in loans to 88 countries
in 2020 to combat the economic impacts of the COVID-19 pandemic. In 2022, the IMF
approved a $3 billion loan to Ukraine to help the country manage its budget deficit during
the war with Russia. Additionally, the IMF offers technical assistance on various economic
issues, such as tax policy, financial sector regulation, and economic forecasting.

Answer 2: The Bretton Woods Agreement was a historic international monetary system
established in 1944, following World War II. It aimed to rebuild the global economy and
promote financial stability, emphasizing several key objectives. One objective was to achieve
financial stability through fixed exchange rates, with the US dollar pegged to gold, to reduce
uncertainty and encourage trade and investment. Another goal was to promote economic
growth, supporting countries struggling to recover from the war.

The Bretton Woods Agreement created two prominent international institutions: the IMF
and the World Bank. The IMF was formed to provide financial assistance to countries with
balance-of-payments issues and to maintain the stability of the Bretton Woods system. The
World Bank's primary purpose was to provide long-term financial and technical assistance
for development projects in developing countries.

Answer 3: The establishment of the International Monetary Fund (IMF) as a result of the
Bretton Woods Agreement was driven by several factors. First, it was created to promote

Unit 9: International Monetary Fund 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

financial stability by maintaining the fixed exchange rate system, with the US dollar pegged
to gold. This system aimed to reduce financial uncertainty and encourage trade and
investment. Second, the IMF was established to promote economic growth by providing
financial assistance and advice to countries recovering from World War II and helping them
integrate into the global economy. Lastly, the IMF served as a platform for international
cooperation, addressing economic challenges collectively.

The IMF contributes to global economic stability by providing financial assistance to

countries facing balance-of-payments problems, helping prevent financial crises, and
promoting sound economic policies. It also fosters international monetary cooperation by
facilitating discussions among member countries about their economic and monetary
policies, aiming to achieve common goals of stability and growth.

Answer 4: The International Monetary Fund (IMF) and the World Bank are distinct
institutions with different roles and functions in the global economy. While they collaborate
on international financial issues, their primary purposes and areas of focus differ. The IMF
primarily focuses on short-term financial stability by providing financial assistance to
countries with balance-of-payments problems. It offers policy advice and monitors exchange
rates to promote macroeconomic stability. For example, in 2020, the IMF and the World Bank
jointly provided over $100 billion in financial assistance to countries to address the impacts
of the COVID-19 pandemic.

In contrast, the World Bank's primary objective is to reduce poverty and promote long-term
economic development in developing countries. It provides long-term loans and grants for
development projects, including infrastructure, education, healthcare, and more. These
projects aim to support sustainable growth and alleviate poverty. The World Bank also
collaborates with the IMF on issues like climate change, providing financial assistance for
renewable energy projects.

In summary, while both institutions work together, the IMF emphasizes financial stability,
short-term stability, and macroeconomic policy advice, while the World Bank focuses on
poverty reduction, long-term development, and development projects.

Unit 9: International Monetary Fund 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 5: The primary responsibilities of the IMF include promoting international

monetary cooperation, exchange rate stability, balanced growth of international trade, and
orderly economic development among its member countries. The IMF fulfills these
responsibilities through functions like surveillance, financial assistance, technical assistance,
research and analysis, exchange rate stability, and fostering global economic cooperation.
These functions help identify economic vulnerabilities, provide policy advice, offer financial
assistance to countries in need, and promote international monetary stability, ultimately
contributing to global economic stability.

Answer 6: The IMF offers a range of funding facilities and financial instruments to assist
member countries. These include Stand-By Arrangements (SBAs), Extended Fund Facility
(EFF), Flexible Credit Line (FCL), Precautionary and Liquidity Line (PLL), Rapid Financing
Instrument (RFI), Emergency Financial Assistance, Financial Sector Assessment Program
(FSAP), Catastrophe Containment and Relief Trust (CCRT), and Special Drawing Rights
(SDRs). These facilities cater to different economic challenges, such as short-term balance of
payments problems, long-term structural issues, and even emergency situations like
pandemics. SDRs, for instance, serve as international reserves.

Answer 7: Special Drawing Rights (SDRs) are international reserve assets issued by the IMF,
serving as a supplement to official reserves. They provide liquidity, contribute to exchange
rate stability, and can be exchanged for freely usable currencies. SDRs are used in IMF
transactions, financial support during crises, and are recorded in IMF accounts. SDRs have
been discussed as a potential global reserve asset that could reduce reliance on individual
national currencies, promoting stability in the international monetary system.

Answer 8: The IMF faces several challenges, including issues related to conditionality,
governance, transparency, effectiveness of its programs, and concerns about economic
inequality. It must balance stabilizing economies with addressing income disparities and
respecting countries' policy autonomy. To address these challenges, the IMF has improved
transparency, sought more representation for low-income countries, and adapted its
policies. However, ongoing challenges like addressing global economic inequality and
navigating geopolitical conflicts remain, requiring continuous adaptation and reform.

Unit 9: International Monetary Fund 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 9: The IMF contributes to global economic stability through its functions like
surveillance, financial assistance, and technical assistance. It monitors economic
vulnerabilities and provides policy advice to member countries. In times of crises, it offers
financial assistance through various funding facilities, helping countries stabilize their
economies. The IMF's role in crisis prevention includes assessing financial and economic
stability and providing early warning systems. It plays a key role in resolving sovereign debt
crises and addressing global economic challenges, promoting overall stability in the
international monetary system.

Self-Assessment Questions
Answer 1: b) To promote international monetary cooperation and exchange rate stability.

Answer 2: c) To offer policy advice and financial assistance to countries facing short-term
balance of payments problems.

Answer 3: c) To reduce poverty and support long-term economic development in developing

countries.

Answer 4: c) The International Monetary Fund (IMF)

Answer 5: b) By the largest economies' decisions.

Answer 6: B) Fostering global economic stability and cooperation.

Answer 7: C) Surveillance

Answer 8: D) Helping countries with long-term balance of payments problems.

Answer 9: B) An international reserve asset.

Answer 10: C) Dealing with issues of economic inequality.

Unit 9: International Monetary Fund 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 10: UN and Other Multilateral Organizations 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 10
UN and Other Multilateral Organizations

Table of Contents
SL Topic Fig No / Table SAQ / Page No
No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 United Nations - 1 5-17
3 Peacekeeping Operations - - 17-23
4 Summary - - 23-26
5 Terminal Questions - - 27-28
6 Answers - - 28-32

Unit 10: UN and Other Multilateral Organizations 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The United Nations (UN) and other multilateral organizations are pivotal in addressing
global challenges and promoting international cooperation. The UN, founded in 1945, strives
to maintain international peace, foster economic development, and uphold human rights. Its
Security Council plays a central role in peacekeeping, conflict resolution, and addressing
global threats. Multilateral organizations, including UN agencies like UNICEF, WHO, and
UNESCO, work tirelessly to provide humanitarian aid, enhance healthcare, and promote
education globally.

The UN serves as a diplomatic platform through the General Assembly, facilitating

discussions on pressing global issues. Multilateral organizations contribute to global
governance by establishing norms and standards, addressing economic disparities, and
fostering international cooperation. Institutions like the World Bank and IMF support
economic development, while the WTO ensures fair trade practices.

Regional organizations, such as the European Union and African Union, promote integration
for peace and prosperity. Multilateral efforts prevent conflicts, protect human rights, and
respond to crises, exemplified by the UNHCR and WFP.

The International Court of Justice resolves legal disputes between states, upholding
international law. Specialized agencies like UNICEF focus on children's well-being, WHO
addresses global health challenges, and UNESCO fosters collaboration in education, science,
and culture. These organizations play a crucial role in advancing a just, inclusive, and
sustainable world through international collaboration and shared goals.

The United Nations (UN) employs peacekeeping missions to foster stability in conflict zones,
deploying multinational forces to prevent hostilities, facilitate diplomacy, and aid in post-
conflict reconstruction. The World Bank, an international financial institution, tackles
poverty and promotes development through tailored financial assistance and policy advice.
The International Monetary Fund (IMF) ensures global economic stability by surveilling
economic trends and providing financial assistance to countries facing balance of payments
issues. The World Trade Organization (WTO) facilitates global trade negotiations and
resolves disputes, contributing to a fair and transparent international trading system. The

Unit 10: UN and Other Multilateral Organizations 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

African Union (AU) focuses on peace, political integration, economic development, and
cultural identity across the continent, collaborating with global entities. The European Union
(EU) integrates member states economically and politically, emphasizing free movement,
common governance, and shared values. The EU's multifaceted functions include
environmental standards, human rights advocacy, and collaborative research initiatives,
embodying a unique model of supranational governance for the collective benefit of its
citizens.

1.1 Learning Objectives

❖ Define the role of multilateral organizations, such as the United Nations (UN), in
addressing global challenges.
❖ Evaluate the contribution of multilateral organizations to global governance.
❖ Discuss ethical considerations in global governance, considering issues such as human
rights, democracy, and environmental sustainability.
❖ Define the African Union (AU), European Union (EU) and its establishment with a vision
of unity, cooperation, and development.
❖ Analyse the functions of the WTO in negotiating and monitoring international trade
agreements, IMF in surveillance of global economic trends and financial assistance during
balance of payments problems.

Unit 10: UN and Other Multilateral Organizations 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. UNITED NATIONS
The United Nations (UN) and other multilateral organizations are instrumental in addressing
global challenges and advancing international cooperation and development. Their roles
extend across various domains, including peace and security, humanitarian aid, economic
development, and the promotion of human rights. Here's an explanation of their crucial role:

Peace and Security:

The UN, particularly through its Security Council, plays a central role in maintaining global
peace and security. It addresses conflicts, conducts peacekeeping operations, and facilitates
diplomatic resolutions to prevent the escalation of tensions between nations.

Humanitarian Aid and Development:

Multilateral organizations, such as the UN agencies (e.g., UNICEF, WHO, UNESCO), are at the
forefront of providing humanitarian aid and promoting sustainable development. They work
to alleviate poverty, improve healthcare, ensure access to education, and foster social
progress worldwide.

International Cooperation:
These organizations serve as platforms for diplomatic dialogue and cooperation among
nations. The UN General Assembly, for instance, provides a forum where countries can
discuss global issues, share perspectives, and collaborate on solutions.

Global Governance:
Multilateral organizations contribute to global governance by establishing norms, standards,
and conventions that guide international behaviour. Treaties and agreements facilitated by
these organizations address issues like climate change, arms control, and human rights.

Economic Development and Stability:

Institutions like the World Bank and the International Monetary Fund (IMF) support
economic development by providing financial assistance, technical expertise, and policy
advice to developing countries. They contribute to stabilizing economies and reducing
poverty on a global scale.

Unit 10: UN and Other Multilateral Organizations 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Trade and Commerce:

Organizations like the World Trade Organization (WTO) foster international trade by
negotiating agreements, resolving trade disputes, and ensuring that trade practices are fair
and equitable. This helps create a more open and interconnected global economy.

Regional Integration:
Regional organizations, like the European Union (EU) and the African Union (AU), work
towards closer integration among member states. This integration aims to promote peace,
stability, and economic prosperity within specific regions.

Conflict Prevention and Resolution:

Multilateral organizations engage in conflict prevention and resolution efforts, addressing
the root causes of disputes and facilitating dialogue to prevent the outbreak of violence. This
contributes to global stability and security.

Human Rights Protection:

Organizations within the UN system, such as the UN Human Rights Council, play a crucial
role in promoting and protecting human rights globally. They monitor human rights
violations, advocate for justice, and work towards creating a world where everyone enjoys
fundamental rights and freedoms.

Here's an overview of the UN and some other key multilateral organizations:

United Nations (UN):
Formation and Purpose:
Established on October 24, 1945, in the aftermath of World War II, the United Nations (UN)
is a global organization with a primary mission to uphold international peace and security.
Originally conceived as a mechanism to prevent conflicts and encourage collaboration
among nations, the UN has evolved into a multifaceted institution addressing a spectrum of
global challenges. The UN Security Council, a key organ, plays a pivotal role in maintaining
peace by addressing threats, intervening in conflicts, and overseeing peacekeeping
operations. Beyond peace, the UN is actively engaged in promoting economic development
through agencies like the United Nations Development Programme (UNDP) and the
International Labour Organization (ILO), working to reduce poverty and address global
economic inequalities.

Unit 10: UN and Other Multilateral Organizations 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In the realm of social progress, the UN is dedicated to initiatives encompassing education,

healthcare, gender equality, and social justice. Agencies such as UNICEF and UNESCO focus
on improving child well-being and fostering education and cultural exchange. Human rights
protection is central to the UN's mission, exemplified by the Universal Declaration of Human
Rights adopted in 1948. The organization responds to humanitarian crises globally, offering
aid and assistance through agencies like the United Nations High Commissioner for Refugees
(UNHCR) and the World Food Programme (WFP).

Contributing significantly to the development and enforcement of international law, the UN

houses the International Court of Justice (ICJ), settling legal disputes and providing advisory
opinions. Environmental sustainability is a key focus, addressed through agencies like the
United Nations Environment Programme (UNEP), which tackles climate change and
biodiversity loss through international cooperation. Moreover, the UN actively promotes
democracy and good governance, urging member states to uphold democratic principles, the
rule of law, and transparent, accountable governance. In essence, the UN has become an
indispensable global institution, championing collaboration among nations to tackle shared
challenges and advance common goal.

Key Organs:
The General Assembly is a fundamental organ within the structure of the United Nations
(UN). Comprising representation from all member states, it stands as a global forum that
facilitates discussions, deliberations, and policymaking on a wide array of international
issues. Each member state, regardless of its size or geopolitical influence, has the opportunity
to participate in the General Assembly, making it a democratic platform for diplomatic
engagement.

The primary function of the General Assembly is to provide a space for member states to
express their perspectives, share concerns, and engage in dialogue on matters of global
significance. The discussions within the assembly cover a diverse range of topics, including
but not limited to international peace and security, economic development, human rights,
and humanitarian affairs. Member states use this platform to articulate their positions, build
consensus, and collectively address the multifaceted challenges that confront the
international community.

Unit 10: UN and Other Multilateral Organizations 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

While the General Assembly's resolutions are non-binding, they hold considerable moral and
political weight. The assembly's decisions reflect the collective will of the UN's diverse
membership, embodying a commitment to cooperative and collaborative approaches to
global problem-solving. Additionally, the General Assembly plays a crucial role in the
budgetary process, approving the UN's budget and financial matters.

In essence, the General Assembly serves as a democratic hub within the UN, fostering
inclusive dialogue and cooperation among nations. It symbolizes the principle of sovereign
equality among member states and emphasizes the importance of collective efforts in
addressing shared challenges on the world stage.

Security Council
The United Nations Security Council is a pivotal organ entrusted with the paramount
responsibility of maintaining international peace and security. Established as a response to
the devastating consequences of World War II, the Security Council operates as a central
mechanism for addressing threats to global stability. Its composition reflects a balance
between permanence and rotation, consisting of five permanent members with veto power
and ten non-permanent members.

The five permanent members of the Security Council, often referred to as the P5, are the
United States, China, Russia, France, and the United Kingdom. These nations hold a unique
position with the authority to wield a veto, providing them the capability to block any
substantive resolution, regardless of the level of support from other Council members. This
arrangement is intended to ensure that major global powers are actively engaged in
decisions related to international peace and security.

In addition to the P5, the Security Council includes ten non-permanent members elected by
the General Assembly for two-year terms. These non-permanent members contribute to the
Council's diversity and represent various regions of the world. Unlike the permanent
members, non-permanent members do not possess veto power, but they actively participate
in discussions, contribute to policymaking, and play a vital role in the Council's decision-
making processes.

Unit 10: UN and Other Multilateral Organizations 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The primary functions of the Security Council encompass conflict prevention, peacekeeping,
and the authorization of the use of force when necessary. It has the authority to establish
peacekeeping missions, impose sanctions, and, in extreme cases, endorse military actions to
address threats to international peace. The Council's decisions are binding on all UN member
states, underscoring its pivotal role in responding to global security challenges.

In summary, the Security Council stands as a critical organ within the United Nations
framework, dedicated to preserving international peace and security. The combination of
permanent and rotating members reflects a commitment to inclusivity and ensures that
major powers collaborate in addressing the complex and dynamic nature of global security
threats.

The International Court of Justice (ICJ)

It is a principal judicial organ of the United Nations, established to facilitate the peaceful
resolution of legal disputes between states. Created under the UN Charter, the ICJ began its
operations in 1946, succeeding the Permanent Court of International Justice. The Court is
headquartered in The Hague, Netherlands, and its role is integral to promoting international
justice and maintaining the rule of law in the realm of international relations.

The ICJ serves as a venue for states to bring legal disputes before an impartial and
independent judicial body. States voluntarily submit to the jurisdiction of the ICJ, indicating
their commitment to abide by the Court's decisions. While participation is typically
consensual, there are instances where states may be compelled to appear before the ICJ
through special agreements, treaties, or provisions in the UN Charter.

The Court's composition reflects a diverse and representative membership, consisting of 15

judges elected by the UN General Assembly and the Security Council. These judges serve
nine-year terms and are eligible for re-election. The ICJ's composition aims to ensure a broad
representation of different legal systems and cultures, contributing to the Court's credibility
and legitimacy.

The jurisdiction of the ICJ extends to a wide array of legal issues, including disputes related
to territorial boundaries, maritime delimitation, human rights, and violations of
international law. The Court also provides advisory opinions on legal questions referred to

Unit 10: UN and Other Multilateral Organizations 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

it by UN organs, specialized agencies, and related organizations. While its primary function
is to settle disputes between states, the ICJ's decisions often carry significant legal weight
and contribute to the development of international law.

The Court's proceedings involve a rigorous legal process, with states presenting arguments
and evidence to support their positions. The ICJ issues binding judgments that parties are
obligated to follow, contributing to the peaceful resolution of conflicts and fostering a rules-
based international order.

In essence, the International Court of Justice plays a crucial role in promoting the peaceful
settlement of disputes between states, upholding the principles of justice and the rule of law
in the international arena. It stands as a cornerstone in the architecture of international
governance, offering a legal framework for resolving conflicts and advancing the cause of
global peace and stability.

Specialized Agencies:
UNICEF (United Nations International Children's Emergency Fund)
UNICEF, which stands for the United Nations International Children's Emergency Fund, is
one of the specialized agencies of the United Nations system. It was established on December
11, 1946, by the United Nations General Assembly to address the immediate needs of
children and mothers in post-World War II Europe, China, and the Middle East. Over time,
UNICEF's mandate expanded, and it evolved into a permanent UN agency working globally
to improve the well-being of children and mothers.

Mission and Mandate:

UNICEF's mission is to ensure that every child has a fair chance in life, regardless of their
background or circumstances. The agency focuses on providing assistance to children in the
areas of health care, nutrition, education, protection, and overall development. UNICEF
operates based on the principles outlined in the Convention on the Rights of the Child,
striving to uphold the rights and dignity of every child.

Unit 10: UN and Other Multilateral Organizations 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Key Areas of Work:

Health and Nutrition: UNICEF works to improve access to essential healthcare services,
vaccinations, and proper nutrition for children. This includes efforts to prevent and treat
diseases, reduce child mortality, and ensure maternal health.

Education: UNICEF is dedicated to ensuring that every child has access to quality education.
This involves initiatives to enhance school infrastructure, provide learning materials, and
promote inclusive and equitable education for all.

Child Protection: UNICEF works to protect children from violence, exploitation, abuse, and
discrimination. This includes efforts to prevent child labor, trafficking, and recruitment into
armed forces.

Water, Sanitation, and Hygiene (WASH): UNICEF focuses on improving access to clean water,
sanitation facilities, and hygiene education to prevent waterborne diseases and promote
overall well-being.

Emergency Response: UNICEF is often at the forefront of emergency response efforts,

providing rapid assistance to children and families affected by conflicts, natural disasters,
and other humanitarian crises.

Funding and Governance:

UNICEF is funded through voluntary contributions from governments, foundations,
businesses, and individuals. It operates under the governance of an Executive Board, with
representation from member states. The Executive Director, appointed by the UN Secretary-
General, leads the organization's day-to-day activities.

Advocacy and Partnerships:

UNICEF engages in advocacy to raise awareness about children's issues globally. It
collaborates with governments, non-governmental organizations (NGOs), and other UN
agencies to implement programs and policies aimed at improving the lives of children.

World Health Organization (WHO)

The World Health Organization (WHO) is a specialized agency of the United Nations
established on April 7, 1948. It serves as the leading international organization focused on

Unit 10: UN and Other Multilateral Organizations 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

global public health. The WHO's constitution came into force on April 7, 1948, and since then,
it has played a crucial role in addressing and coordinating efforts to tackle various health
challenges worldwide. Here's an explanation of the key aspects of WHO:

Mission and Objectives:

The primary mission of the World Health Organization is to promote and protect global
health. Its constitution outlines several objectives, including the attainment of the highest
possible level of health for all people, the prevention and control of diseases, and the
collaboration in health research.

Leadership and Governance:

The WHO is led by the Director-General, who is appointed by the World Health Assembly.
The World Health Assembly, consisting of representatives from all member states, serves as
the highest decision-making body. It meets annually to set policies, approve the budget, and
appoint the Director-General. The Executive Board, composed of health experts nominated
by member states, implements the decisions and policies of the World Health Assembly.

Key Functions and Focus Areas:

Disease Prevention and Control: The WHO plays a crucial role in preventing and controlling
the spread of diseases globally. This includes initiatives to combat infectious diseases, such
as malaria, tuberculosis, HIV/AIDS, and emerging health threats like pandemics.

Health Systems Strengthening: The organization works to strengthen health systems in

member countries, aiming to improve access to essential healthcare services, enhance
infrastructure, and build sustainable health systems.

Emergency Response: The WHO is often at the forefront of responding to health emergencies
and outbreaks. It provides technical expertise, coordinates international response efforts,
and supports countries in managing and containing health crises.

Research and Innovation: The WHO promotes and coordinates health research to advance
scientific knowledge and innovation. This includes efforts to develop vaccines, treatments,
and technologies to address global health challenges.

Unit 10: UN and Other Multilateral Organizations 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Health Policy and Advocacy: The organization sets global health policies and provides
evidence-based guidance to member states. It advocates for health as a fundamental human
right and addresses social determinants of health.

Capacity Building: The WHO engages in capacity-building activities to strengthen the

capabilities of health systems, healthcare professionals, and public health institutions
worldwide.

Global Health Initiatives:

The WHO leads and participates in various global health initiatives and campaigns. These
include efforts to eradicate diseases (such as polio), promote vaccination, and address
specific health challenges like maternal and child health, mental health, and non-
communicable diseases.

Collaboration with Partners:

The WHO collaborates with governments, non-governmental organizations (NGOs),
international agencies, and the private sector to leverage resources and expertise in
addressing global health issues collaboratively.

UNESCO (United Nations Educational, Scientific and Cultural Organization)

The United Nations Educational, Scientific and Cultural Organization (UNESCO) is a
specialized agency of the United Nations that was established on November 16, 1945.
UNESCO operates with the overarching goal of promoting international collaboration in the
fields of education, science, culture, and communication. Here's an explanation of the key
aspects of UNESCO:

Mission and Objectives:

UNESCO's primary mission is to contribute to the building of a just, inclusive, peaceful, and
sustainable world through education, the sciences, culture, and communication. Its
objectives include fostering universal access to quality education, advancing scientific
knowledge, promoting cultural diversity and heritage, and facilitating freedom of expression.

Focus Areas:
Education: UNESCO works to ensure inclusive and equitable quality education for all. It
supports initiatives to improve literacy, enhance teacher training, and promote education

Unit 10: UN and Other Multilateral Organizations 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

for sustainable development. UNESCO also coordinates the Education for Sustainable
Development (ESD) program, emphasizing the role of education in addressing global
challenges.

Natural Sciences: The organization promotes international cooperation in scientific research

and capacity-building. It addresses issues such as climate change, biodiversity conservation,
and sustainable development through scientific initiatives and partnerships.

Social/Human Sciences: UNESCO focuses on understanding and addressing social

transformations and challenges. It promotes research and policies related to ethics, human
rights, social inclusion, and the ethical implications of scientific advancements.

Culture: UNESCO is committed to preserving and promoting cultural diversity, heritage, and
creativity. It designates and protects World Heritage Sites, supports cultural expressions,
and fosters intercultural dialogue to promote mutual understanding.

Communication and Information: In the digital age, UNESCO plays a key role in promoting
access to information, media development, and freedom of expression. It works to ensure
that information and communication technologies benefit all and contribute to sustainable
development.

World Heritage Sites:

One of UNESCO's notable contributions is the identification and protection of cultural and
natural heritage sites of outstanding value. These World Heritage Sites, ranging from
historical monuments to natural landscapes, are recognized for their significance and are
preserved for future generations.

International Collaboration:
UNESCO acts as a platform for international collaboration, bringing together experts,
policymakers, and stakeholders from member states. It facilitates the exchange of
knowledge, expertise, and best practices to address global challenges collectively.

Unit 10: UN and Other Multilateral Organizations 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Advocacy for Press Freedom:

UNESCO advocates for freedom of the press and the safety of journalists worldwide. It
promotes media literacy and works to counter disinformation, supporting the fundamental
role of free and independent media in democratic societies.

Capacity Building and Research:

The organization engages in capacity-building activities, research initiatives, and the
development of guidelines and standards in its various focus areas. UNESCO's work
contributes to the advancement of knowledge, policies, and practices that align with its
mission.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary mission of the United Nations (UN)?

a) Promoting economic development
b) Upholding international peace and security
c) Fostering regional integration
d) Advocating for global trade
2. Which UN organ is responsible for maintaining global peace and security,
addressing conflicts, and conducting peacekeeping operations?
a) UN General Assembly
b) UN Security Council
c) International Court of Justice (ICJ)
d) UNICEF
3. What is the key function of the International Court of Justice (ICJ)?
a) Providing humanitarian aid.
b) Settling legal disputes between states.
c) Promoting economic development.
d) Conducting peacekeeping operations

Unit 10: UN and Other Multilateral Organizations 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

4. Which specialized UN agency focuses on improving the well-being of children

and mothers globally?
a) World Health Organization (WHO)
b) UNESCO
c) International Court of Justice (ICJ)
d) UNICEF
5. What are the key areas of work for UNICEF?
a) Disease prevention and control
b) Preservation of cultural heritage
c) Child protection, education, and health
d) International trade negotiations
6. When was the World Health Organization (WHO) established, and what is its
primary mission?
a) Established in 1945, mission is economic development
b) Established in 1948, mission is global public health
c) Established in 1950, mission is cultural diversity
d) Established in 1955, mission is peacekeeping
7. Which focus area does UNESCO NOT cover among the following?
a) Education
b) Natural Sciences
c) Agriculture
d) Communication and Information
8. What is one of UNESCO's notable contributions mentioned in the text?
a) World Trade Organization negotiations
b) Designation and protection of World Heritage Sites
c) Conflict prevention and resolution
d) Economic stability programs

Unit 10: UN and Other Multilateral Organizations 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

9. How does the UN General Assembly contribute to global governance?

a) By conducting peacekeeping operations
b) By establishing norms, standards, and conventions
c) By providing financial assistance to developing countries
d) By negotiating international trade agreements
10. Which organ within the UN structure serves as a democratic platform for
diplomatic engagement and policymaking involving all member states?
a) UN Security Council
b) International Court of Justice (ICJ)
c) UN General Assembly
d) UNESCO

3. PEACEKEEPING OPERATIONS
The United Nations (UN) undertakes peacekeeping missions as a crucial tool to foster peace
and stability in areas grappling with conflicts. These missions typically involve the
deployment of multinational forces to regions where there is a threat to international peace
and security. The primary purpose is to prevent the escalation of hostilities, facilitate
diplomatic resolutions, and create conditions conducive to sustainable peace. Peacekeepers
monitor ceasefires, oversee disarmament processes, and contribute to the protection of
civilians, particularly vulnerable groups. Humanitarian aid is often an integral component,
ensuring that affected populations receive essential assistance. Furthermore, peacekeeping
operations extend beyond immediate conflict resolution, encompassing efforts to support
post-conflict reconstruction, rebuild institutions, and promote political and social
reconciliation. By addressing the root causes of conflicts and fostering stability, these
operations contribute significantly to global peace and security.

World Bank:
The World Bank, established as an international financial institution, has a twofold mission:
to reduce poverty and promote development in developing countries. At the core of its

Unit 10: UN and Other Multilateral Organizations 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

functions is the provision of financial and technical assistance to support a wide array of
development projects. The World Bank offers loans and grants to facilitate projects ranging
from infrastructure development to social services. This financial assistance is often tailored
to meet the specific needs and circumstances of recipient countries, with concessional
financing available for the world's poorest nations. Beyond financial support, the World
Bank plays a vital role in policy advice, offering guidance on economic and development
policies. It leverages its technical expertise to help countries design and implement effective
development strategies. Additionally, the institution engages in capacity-building efforts,
enhancing the skills and capabilities of institutions within developing countries. By
addressing both the financial and knowledge-based needs of nations, the World Bank aims
to create sustainable development pathways, ultimately lifting populations out of poverty
and fostering broader economic and social progress.

International Monetary Fund (IMF):

The International Monetary Fund (IMF) serves as a cornerstone in the architecture of the
international financial system, with a primary purpose centered around promoting global
economic stability and cooperation. Established in 1944, the IMF operates with the
overarching goal of facilitating international monetary cooperation and ensuring exchange
rate stability. Its mission extends beyond individual countries to encompass the collective
well-being of the global economy.

Key Functions:
Surveillance of Global Economic Trends:
One of the pivotal functions of the IMF is the surveillance of global economic trends. The
organization continually monitors the economic policies and performance of its member
countries. Through regular assessments and reports, the IMF provides valuable insights into
the state of the world economy, identifying potential risks, challenges, and areas for
improvement. This surveillance function helps member countries make informed policy
decisions, fosters transparency, and contributes to the prevention or mitigation of economic
crises.

Unit 10: UN and Other Multilateral Organizations 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Financial Assistance to Member Countries Facing Balance of Payments Problems:

The IMF serves as a financial safety net for member countries experiencing balance of
payments problems. When a nation faces challenges in meeting its international financial
obligations, such as a shortage of foreign exchange reserves, the IMF can step in to provide
financial assistance. This assistance comes with conditions aimed at restoring economic
stability, often involving policy adjustments and reforms. The IMF's financial support helps
countries stabilize their currencies, rebuild foreign exchange reserves, and implement
necessary economic adjustments, preventing the spread of financial contagion and
contributing to the overall stability of the international monetary system.

World Trade Organization (WTO):

The World Trade Organization (WTO) stands as a crucial international institution dedicated
to fostering an open, fair, and predictable global trading system. Formed in 1995, the WTO
replaced the General Agreement on Tariffs and Trade (GATT) and expanded its scope to
cover not just goods but also services and intellectual property. The primary purpose of the
WTO is to facilitate global trade negotiations, enforce trade agreements, and provide a
platform for member countries to engage in discussions on trade-related matters.

Key Functions:
Negotiates and Monitors Trade Agreements:
A fundamental function of the WTO is to negotiate and monitor international trade
agreements. Member countries engage in rounds of negotiations to address various trade
issues, including tariff reductions, subsidies, and market access. The WTO provides a
structured framework for these negotiations, allowing countries to work towards mutually
beneficial outcomes. The agreements reached cover a wide range of trade-related topics,
promoting fairness and transparency in global trade. The WTO's role in negotiating
agreements contributes to the creation of a more open and interconnected global economy.

Resolves Trade Disputes through the Dispute Settlement Body:

The Dispute Settlement Body (DSB) of the WTO serves as a crucial mechanism for resolving
trade disputes among member countries. When disagreements arise regarding the
interpretation or implementation of WTO agreements, countries can bring their cases to the
DSB. The dispute resolution process involves consultations, adjudication, and, if necessary,

Unit 10: UN and Other Multilateral Organizations 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

the imposition of sanctions. By providing a fair and impartial forum for dispute settlement,
the WTO ensures that trade conflicts are addressed through established rules and
procedures. This contributes to the stability of the global trading system and prevents
unilateral actions that could lead to trade tensions.

In essence, the WTO plays a central role in shaping the rules of international trade, fostering
cooperation among member countries, and providing mechanisms for dispute resolution.
Through its functions, the organization promotes a rules-based trading system that benefits
all participants and contributes to global economic stability.

African Union (AU):

The African Union (AU) is a continental union consisting of 55 member states across the
African continent, established with the aim of promoting unity, cooperation, and
development among African nations. It builds on the foundation of its predecessor, the
Organization of African Unity (OAU), and was officially launched in Durban, South Africa, in
2002. The AU operates with a comprehensive vision that encompasses political, economic,
and social integration, reflecting the collective aspirations of African countries.

Key Functions:
Promotion of Peace and Security:
The AU is actively involved in conflict prevention, management, and resolution across the
continent. It deploys peacekeeping missions, mediates conflicts, and works towards the
peaceful resolution of disputes. The Peace and Security Council (PSC) is a key organ within
the AU dedicated to addressing issues related to peace and security.

Political Integration and Governance:

The AU seeks to enhance political integration among member states, promoting democratic
governance, the rule of law, and respect for human rights. It encourages good governance
practices and works to prevent unconstitutional changes of government.

Economic Integration and Development:

Economic integration is a crucial aspect of the AU's agenda. The organization aims to create
a common market, facilitate the free movement of people and goods, and promote economic

Unit 10: UN and Other Multilateral Organizations 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

cooperation among member states. Initiatives such as the African Continental Free Trade
Area (AfCFTA) reflect the AU's commitment to fostering economic integration.

Social and Cultural Development:

The AU recognizes the importance of social and cultural development in fostering a united
African identity. Efforts include the promotion of cultural exchange, education, and the
preservation of Africa's rich cultural heritage.

Humanitarian Action and Sustainable Development:

The AU is actively engaged in addressing humanitarian challenges and supporting
sustainable development initiatives. It works to eradicate poverty, improve healthcare, and
promote education across the continent.

Partnerships and Collaboration:

The AU collaborates with regional economic communities, international organizations, and
the global community to address common challenges. Partnerships with organizations like
the United Nations and the European Union contribute to the effectiveness of the AU's
initiatives.

European Union (EU):

Purpose:
The European Union (EU) is a political and economic union of 27 member states primarily
located in Europe. Its foundational purpose is to promote economic and political integration
among its member states with the overarching goal of ensuring peace and stability on the
European continent. The EU emerged from the aftermath of World War II, with the belief
that closer economic ties and shared governance would contribute to lasting peace.

Key Functions:
Common Market for Goods and Services:
One of the fundamental functions of the EU is the establishment of a common market. This
facilitates the free movement of goods, services, capital, and people across member states,
fostering economic integration and cooperation.

Unit 10: UN and Other Multilateral Organizations 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Common Currency (Euro) in Many Member States:

The EU introduced the euro (€) as the official currency in several member states. This
common currency aims to promote further economic integration by eliminating exchange
rate fluctuations and simplifying cross-border transactions.

Political Integration and Governance:

The EU has institutions that contribute to political integration, including the European
Parliament and the European Council. These institutions work towards common policies,
laws, and regulations that apply across member states, promoting a unified approach to
governance.

Schengen Area and Free Movement:

The EU, through the Schengen Agreement, established an area where internal border checks
are largely abolished, allowing for the free movement of people within the Schengen Area.
This enhances cultural exchange and economic cooperation.

Common Foreign and Security Policy (CFSP):

The EU has developed a Common Foreign and Security Policy to coordinate diplomatic
efforts and promote a united stance on international issues. This allows member states to
present a cohesive front in matters of global significance.

Economic and Social Cohesion:

The EU operates structural and cohesion funds to reduce economic disparities among
member states. These funds support regions with lower economic development,
contributing to overall economic and social cohesion.

Environmental and Regulatory Standards:

The EU plays a significant role in setting common standards, particularly in areas such as
environmental protection, consumer rights, and product safety. This ensures a high level of
protection for citizens and contributes to the harmonization of regulations.

Human Rights and Rule of Law:

The EU places a strong emphasis on human rights, democracy, and the rule of law. Adherence
to these principles is a condition for EU membership, and the union actively promotes these
values both internally and in its external relations.

Unit 10: UN and Other Multilateral Organizations 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Research and Innovation:

The EU supports collaborative research and innovation initiatives across member states.
Programs like Horizon Europe aim to advance scientific knowledge, technological
innovation, and competitiveness on a global scale.

In essence, the European Union represents a unique model of supranational governance,

where member states voluntarily pool sovereignty to achieve common goals. The EU's
functions span economic, political, and social dimensions, reflecting a commitment to shared
values and objectives for the collective benefit of its citizens.

4. SUMMARY
United Nations (UN) Overview:
• Established on October 24, 1945, after World War II.
• Primary mission: Uphold international peace, security, and collaboration.
• Evolved into a multifaceted institution addressing global challenges.

UN's Key Roles:

Peace and Security:
• Security Council central in maintaining global peace.
• Addresses conflicts, conducts peacekeeping, facilitates diplomatic resolutions.

Humanitarian Aid and Development:

• UN agencies (UNICEF, WHO, UNESCO) forefront in providing aid.
• Focus on poverty alleviation, healthcare, education, and social progress.

International Cooperation:
• UN General Assembly serves as a diplomatic forum for global issues.
• Facilitates dialogue, collaboration, and consensus-building among nations.

Global Governance:
• Establishes norms, standards, and conventions guiding international behaviour.
• Addresses climate change, arms control, and human rights through treaties.

Unit 10: UN and Other Multilateral Organizations 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Economic Development and Stability:

• World Bank and IMF support economic development.
• Provide financial assistance, technical expertise, and policy advice.

Trade and Commerce:

• WTO fosters international trade through agreements and dispute resolution.

Regional Integration:
• Regional organizations (EU, AU) promote integration for peace and prosperity.

Conflict Prevention and Resolution:

• Engages in efforts to prevent conflicts and facilitate dialogue.

Human Rights Protection:

• UN Human Rights Council monitors and advocates for global human rights.

UN Key Organs:
General Assembly:
• Global forum for diplomatic engagement.
• Inclusive dialogue on peace, security, development, and human rights.

Security Council:
• Ensures international peace with permanent and non-permanent members.
• Authorizes peacekeeping missions, sanctions, and military actions.

International Court of Justice (ICJ):

• Principal judicial organ for peaceful resolution of legal disputes between states.
• Composed of 15 judges elected by the General Assembly and Security Council.

Specialized Agencies:
UNICEF:
• Established in 1946 to aid children and mothers post-WWII.
• Focus areas: health, education, child protection, water and sanitation.

Unit 10: UN and Other Multilateral Organizations 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

WHO:
• Established on April 7, 1948, focusing on global public health.
• Key areas: disease prevention, health systems strengthening, emergency response.

UNESCO:
• Established on November 16, 1945, promoting collaboration in education, science,
culture, and communication.
• Focus areas: education, natural and social sciences, culture, communication.

International Collaboration and Initiatives:

• UNESCO promotes international collaboration in education, science, culture, and
communication.
• Advocates for press freedom and safety of journalists worldwide.
• Identifies and protects World Heritage Sites of cultural and natural significance.

Peacekeeping Operations:
• UN conducts peacekeeping missions to foster peace and stability.
• Involves multinational forces deployed to conflict zones.
• Aims to prevent hostilities, facilitate diplomatic resolutions, and protect civilians.
• Includes humanitarian aid and post-conflict reconstruction efforts.

World Bank:
• International financial institution with a mission to reduce poverty and promote
development.
• Provides financial and technical assistance to developing countries.
• Offers loans and grants for diverse development projects.
• Plays a role in policy advice, technical expertise, and capacity-building support.

International Monetary Fund (IMF):

• Promotes global economic stability and cooperation.
• Facilitates international monetary cooperation and exchange rate stability.
• Conducts surveillance of global economic trends.
• Provides financial assistance to member countries facing balance of payments
problems.

Unit 10: UN and Other Multilateral Organizations 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

World Trade Organization (WTO):

• Facilitates global trade negotiations and enforces trade agreements.
• Provides a forum for resolving trade disputes through the Dispute Settlement Body.
• Negotiates and monitors trade agreements for a fair and open global trading system.

African Union (AU):

• Continental union of 55 African member states.
• Promotes peace, security, and conflict resolution.
• Aims for economic integration, social and cultural development.
• Engages in humanitarian action and sustainable development initiatives.

European Union (EU):

• Political and economic union of 27 European member states.
• Establishes a common market for goods and services.
• Introduces the euro as a common currency in several member states.
• Promotes political integration, common foreign policy, and human rights.
• Operates cohesion funds to reduce economic disparities among member states.
• Emphasizes environmental standards, rule of law, and research/innovation initiatives.

Unit 10: UN and Other Multilateral Organizations 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. TERMINAL QUESTIONS
Question 1: What is the primary mission of the United Nations (UN)?

Question 2: How does the UN Security Council contribute to global peace and security?

Question 3: What role do multilateral organizations play in economic development and

stability?

Question 4: Explain the functions of the United Nations General Assembly.

Question 5: What is the composition of the United Nations Security Council, and what is the
significance of the veto power?

Question 6: How does the International Court of Justice (ICJ) contribute to international
relations?

Question 7: What is UNICEF, and what are its key areas of work?

Question 8: How does the World Health Organization (WHO) contribute to global health?

Question 9: What is the mission of UNESCO, and what are its focus areas?

Question 10: What is the significance of UNESCO's designation of World Heritage Sites?

Question 11: Describe the multifaceted role of the United Nations in peacekeeping
operations. Highlight the key objectives, tasks, and contributions of UN peacekeepers in
fostering global peace and security.

Question 12: Examine the dual mission of the World Bank and its functions in reducing
poverty and promoting development in developing countries. Provide insights into the
financial and knowledge-based assistance the World Bank offers, and explain its role in
creating sustainable development pathways.

Question 13: Explain the foundational purpose of the International Monetary Fund (IMF) and
its key functions. Provide insights into how the IMF conducts surveillance of global economic
trends and its role in providing financial assistance to member countries facing balance of
payments problems.

Unit 10: UN and Other Multilateral Organizations 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 14: Explore the key functions of the World Trade Organization (WTO) in fostering
a global trading system. Discuss how the WTO negotiates and monitors international trade
agreements, contributing to a more open and interconnected global economy. Additionally,
explain the role of the Dispute Settlement Body in resolving trade conflicts.

Question 15 Examine the African Union's (AU) comprehensive vision and key functions in
promoting peace, security, political integration, economic development, and cultural identity
across the continent. Discuss the AU's role in humanitarian action, sustainable development,
and collaboration with international organizations.

Question 16: Analyse the European Union's (EU) unique governance model and its key
functions in promoting economic and political integration, peace, and stability. Explore the
EU's role in establishing a common market, adopting a common currency, and implementing
political and security policies. Discuss the EU's commitment to environmental standards,
human rights, and research and innovation.

6. ANSWERS
Terminal Questions
Answer 1: The primary mission of the United Nations is to uphold international peace and
security, prevent conflicts, and encourage collaboration among nations to address global
challenges.

Answer 2: The UN Security Council plays a central role by addressing conflicts, conducting
peacekeeping operations, and facilitating diplomatic resolutions to prevent the escalation of
tensions between nations.

Answer 3: Multilateral organizations, such as the World Bank and the International
Monetary Fund (IMF), support economic development by providing financial assistance,
technical expertise, and policy advice to developing countries, contributing to stabilizing
economies and reducing poverty globally.

Answer 4: The General Assembly serves as a global forum for member states to discuss and
deliberate on international issues, express their perspectives, and collaborate on solutions.

Unit 10: UN and Other Multilateral Organizations 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

It plays a crucial role in policymaking, reflecting the collective will of the diverse UN
membership.

Answer 5: The Security Council consists of five permanent members (P5) with veto power
(United States, China, Russia, France, and the United Kingdom) and ten non-permanent
members. Veto power allows the P5 to block substantive resolutions, emphasizing the active
involvement of major global powers in decisions related to international peace and security.

Answer 6: The ICJ facilitates the peaceful resolution of legal disputes between states by
providing an impartial and independent judicial body. It issues binding judgments that
contribute to the development of international law, promoting justice and the rule of law in
the international arena.

Answer 7: UNICEF, the United Nations International Children's Emergency Fund, is a

specialized agency focusing on improving the well-being of children and mothers globally.
Its key areas of work include health and nutrition, education, child protection, water,
sanitation, hygiene, and emergency response.

Answer 8: The WHO promotes and protects global health by addressing and coordinating
efforts to prevent and control diseases, strengthen health systems, respond to emergencies,
conduct research and innovation, and advocate for health as a fundamental human right.

Answer 9: UNESCO's mission is to contribute to a just, inclusive, peaceful, and sustainable

world through education, sciences, culture, and communication. Its focus areas include
education, natural sciences, social/human sciences, culture, and communication and
information.

Answer 10: UNESCO designates and protects World Heritage Sites, recognizing their
outstanding cultural and natural value. These sites are preserved for future generations,
contributing to the appreciation of cultural diversity and the conservation of important
landmarks.

Answer 11: The United Nations (UN) plays a crucial role in peacekeeping operations,
deploying multinational forces to regions facing threats to international peace and security.
The primary objectives include preventing hostilities, facilitating diplomatic resolutions, and

Unit 10: UN and Other Multilateral Organizations 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

creating conditions for sustainable peace. UN peacekeepers monitor ceasefires, oversee

disarmament, and protect civilians, including vulnerable groups. Humanitarian aid is
integral, addressing the immediate needs of affected populations. Beyond conflict resolution,
peacekeeping extends to post-conflict reconstruction, institution rebuilding, and fostering
political and social reconciliation. By addressing root causes and fostering stability, UN
peacekeeping significantly contributes to global peace and security.

Answer 12: The World Bank, as an international financial institution, has a dual mission of
reducing poverty and promoting development in developing countries. Its core functions
involve providing financial and technical assistance for diverse development projects. This
includes tailored loans and grants for projects ranging from infrastructure to social services.
The World Bank also offers policy advice, guiding economic and development policies.
Leveraging technical expertise, it assists countries in designing and implementing effective
development strategies. Additionally, the institution engages in capacity-building efforts,
enhancing skills and capabilities in developing countries. Through a comprehensive
approach addressing financial and knowledge-based needs, the World Bank aims to create
sustainable development pathways, lifting populations out of poverty and fostering broader
economic and social progress.

Answer 13: The International Monetary Fund (IMF) serves as a cornerstone in the
international financial system, aiming to promote global economic stability and cooperation.
Established in 1944, the IMF's key functions include the surveillance of global economic
trends. It continually monitors economic policies and performance, providing valuable
insights and contributing to informed policy decisions, transparency, and crisis prevention.
The IMF also serves as a financial safety net, offering assistance to member countries facing
balance of payments problems. This assistance comes with conditions aimed at restoring
economic stability, involving policy adjustments and reforms. Financial support from the
IMF helps stabilize currencies, rebuild foreign exchange reserves, and implement necessary
economic adjustments, preventing the spread of financial contagion and contributing to
overall international monetary system stability.

Answer 14: The World Trade Organization (WTO) is a crucial institution fostering a fair and
predictable global trading system. One of its fundamental functions is negotiating and

Unit 10: UN and Other Multilateral Organizations 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

monitoring international trade agreements. Member countries engage in negotiations

addressing various trade issues, promoting fairness and transparency. The WTO provides a
structured framework for these negotiations, contributing to a more open and
interconnected global economy. The Dispute Settlement Body (DSB) is a vital mechanism
within the WTO for resolving trade conflicts. When disagreements arise, countries bring
their cases to the DSB, involving consultations, adjudication, and potential sanctions. This
fair and impartial dispute resolution process ensures that trade conflicts are addressed
through established rules and procedures, contributing to the stability of the global trading
system.

Answer 15: The African Union (AU) operates with a comprehensive vision, promoting unity,
cooperation, and development across 55 member states. Key functions include active
involvement in conflict prevention, management, and resolution, deploying peacekeeping
missions, and mediating conflicts. The Peace and Security Council (PSC) plays a crucial role
in addressing peace and security issues. The AU also focuses on political integration,
democratic governance, economic integration through initiatives like the African
Continental Free Trade Area (AfCFTA), and fostering a united African identity through
cultural development. Additionally, the AU is engaged in humanitarian action, supporting
sustainable development, eradicating poverty, improving healthcare, and promoting
education. Collaborations with regional economic communities and international
organizations enhance the effectiveness of the AU's initiatives.

Answer 16: The European Union (EU) represents a unique model of supranational
governance among its 27 member states. Foundational purposes include promoting
economic and political integration for lasting peace and stability. Key functions encompass
establishing a common market for the free movement of goods, services, capital, and people.
The EU introduced the euro (€) to promote economic integration, and institutions like the
European Parliament and the European Council contribute to political integration. The
Schengen Area facilitates free movement, and the Common Foreign and Security Policy
(CFSP) ensures a united stance on international issues. Economic and social cohesion is
supported through structural and cohesion funds, while the EU actively promotes
environmental standards, human rights, and research and innovation through programs like

Unit 10: UN and Other Multilateral Organizations 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Horizon Europe. Adherence to these principles is a condition for EU membership, reflecting

a commitment to shared values and objectives for the collective benefit of its citizens.

Self-Assessment Questions
Answer 1: b. Upholding international peace and security

Answer 2: b. UN Security Council

Answer3: b. Settling legal disputes between states

Answer4: d. UNICEF

Answer5: c. Child protection, education, and health

Answer 6: b. Established in 1948, mission is global public health

Answer 7: c. Agriculture

Answer 8: b. Designation and protection of World Heritage Sites

Answer 9: b. By establishing norms, standards, and conventions

Answer 10: c. UN General Assembly.

Unit 10: UN and Other Multilateral Organizations 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 11: From GATT to WTO 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 11
From GATT to WTO
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 GATT (General Agreement on Tariffs and - - 5-7
Trade)
3 Uruguay Round of GATT (General Agreement - - 7-8
on Tariffs and Trade)
4 WTO Establishment - - 9-10
5 Doha Round (Doha Agenda): 2001-Present - 1 11-13
6 Functions of WTO - - 14-15
7 Principles of the Trading Systems - - 15-16
8 Challenges and Criticisms of WTO - - 17-19
9 Consensus on international trade practices - - 19-21
10 Summary - - 21-23
11 Terminal Questions - - 23-24
12 Answer - - 24-26

Unit 11: From GATT to WTO 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The World Trade Organization (WTO) is an international organization that deals with the
global rules of trade between nations. It was established on January 1, 1995, but its history
can be traced back to earlier trade agreements and organizations. Here is a brief history of
the WTO:

GATT: The roots of the WTO can be traced back to the General Agreement on Tariffs and
Trade (GATT), which was established in 1947. GATT was a multilateral trade agreement
aimed at reducing tariffs and trade barriers among its member countries. It served as the
framework for international trade for nearly five decades.

Uruguay Round: The Uruguay Round of GATT negotiations, which began in 1986 and
concluded in 1994, marked a significant turning point. During this round, member countries
negotiated a broad range of trade-related issues, including services, intellectual property,
and agricultural subsidies. The result was the creation of the World Trade Organization
(WTO) as a successor to GATT.

WTO Establishment: The WTO officially came into existence on January 1, 1995, replacing
GATT as the principal international organization governing global trade. The WTO is
headquartered in Geneva, Switzerland, and is responsible for overseeing trade agreements,
resolving trade disputes, and promoting international trade.

Principles and Agreements: The WTO is built on several core principles, including non-
discrimination (the most-favoured-nation principle and national treatment), transparency,
and reciprocity. It has numerous trade agreements and accords, such as the General
Agreement on Trade in Services (GATS) and the Agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPS), which member countries are required to follow.

Trade Rounds: The WTO conducts trade negotiations in rounds, with the Doha Development
Round being one of the most recent and long-running rounds, launched in 2001. These
rounds aim to address various trade issues and challenges, but progress has often been slow
due to differences between member countries.

Unit 11: From GATT to WTO 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Dispute Settlement: The WTO has a dispute settlement mechanism to resolve trade disputes
between member countries. It provides a forum for resolving conflicts through a structured
process, including panels and the Appellate Body.

Challenges and Criticisms: The WTO has faced numerous challenges, including criticism from
some groups and countries that it promotes inequality and places the interests of developed
nations over developing ones. There have been protests and debates surrounding WTO
meetings and policies.

Trade Facilitation Agreement: In 2013, the WTO members reached an agreement on trade
facilitation, aimed at simplifying and harmonizing customs procedures and reducing trade
costs.

Current Status: The WTO continues to play a crucial role in regulating international trade
and promoting economic cooperation. However, it faces ongoing challenges, such as the rise
of protectionism and trade tensions between major economies.

The history of the World Trade Organization is one of evolving international trade
governance and ongoing efforts to balance the interests of its diverse member countries.

1.1 Learning Objectives

❖ Understand the historical development of the World Trade Organization (WTO) and its
predecessor, the General Agreement on Tariffs and Trade (GATT), and how they have
shaped global trade governance.
❖ Examine the functions and responsibilities of the WTO, such as overseeing trade
agreements, resolving trade disputes, and facilitating trade negotiations, as well as its
role in providing technical assistance and promoting transparency in global trade.
❖ Recognize the significance of trade facilitation agreements in simplifying customs
procedures and reducing trade costs.
❖ Understand the current status and continued importance of the WTO in regulating
international trade and promoting economic cooperation on a global scale.
❖ Understand the primary functions of WTO, recognizing the WTO’s responsibilities,
appreciate the role of WTO in the global economy.

Unit 11: From GATT to WTO 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. GATT (GENERAL AGREEMENT ON TARIFFS AND TRADE)

The General Agreement on Tariffs and Trade (GATT) was a multilateral trade agreement that
aimed to promote free trade by reducing tariffs and other trade barriers. It was signed by 23
countries in October 1947 and became law on January 1, 1948.

The GATT was the forerunner of the World Trade Organization (WTO), which was
established in 1995. The GATT was absorbed into the WTO, and its principles and rules
continue to be the foundation of the WTO's trading system.

Establishment of GATT (1947): GATT was created in 1947 during the United Nations
Conference on Trade and Employment in Havana, Cuba. At this conference, 23 countries
signed the GATT agreement, which aimed to promote international trade by reducing trade
barriers, such as tariffs and quotas. GATT officially came into force on January 1, 1948.

The GATT was based on four key principles:

• Non-discrimination: GATT members agreed to treat all other GATT members equally,
without discrimination. This principle is known as non-discrimination or most-
favoured-nation (MFN) treatment.
• National treatment: GATT members agreed to treat imported goods the same as
domestically produced goods. This principle is known as national treatment.
• Tariff bindings: GATT members agreed to bind their tariffs at a certain level, and not to
raise them without negotiating compensation from other members.
• Dispute settlement: GATT members agreed to a binding dispute settlement mechanism
to resolve trade disputes.

Key Objectives: The primary objective of GATT was to promote economic recovery and
growth after World War II by facilitating international trade. It did so by reducing and
eliminating various trade barriers that hindered the flow of goods and services between
member countries. The core idea was to promote free trade by reducing protectionist
measures.

Unit 11: From GATT to WTO 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Principles of GATT: GATT was based on several key principles:

Most-Favoured-Nation (MFN) Principle: Member countries agreed to treat each other
equally and not discriminate in trade. Any advantage granted to one country in terms of trade
would be extended to all members.

National Treatment: GATT members agreed to treat foreign goods and services no less
favourably than their own domestic products.

Reduction of Tariffs: GATT aimed to lower and eventually eliminate tariffs on a wide range
of goods.

Trade Rounds: GATT conducted a series of trade negotiation rounds to address various trade
issues. The most famous of these was the Uruguay Round, which concluded in 1994 and
paved the way for the establishment of the WTO.

Successes and Challenges: GATT contributed to a significant reduction in global trade

barriers and played a vital role in the post-World War II economic recovery. It facilitated
trade negotiations and dispute resolution among member countries. However, GATT also
faced challenges, as trade issues became more complex and comprehensive, leading to the
need for a more robust and encompassing organization.

Transition to WTO: The GATT framework was ultimately deemed insufficient to address the
changing landscape of international trade. The Uruguay Round negotiations led to the
creation of the World Trade Organization (WTO) to replace GATT. The WTO expanded its
scope beyond trade in goods to include services, intellectual property, and dispute
settlement mechanisms.

The GATT held eight rounds of negotiations over the course of its existence. Each round
resulted in further reductions in tariffs and other trade barriers. The GATT also helped to
establish a number of important trade rules, such as the prohibition on quantitative
restrictions on imports.

The GATT was a major success in promoting international trade. Between 1948 and 1994,
the average world tariff rate fell from 40% to 5%. This led to a significant increase in the
volume of international trade.

Unit 11: From GATT to WTO 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The GATT was also successful in reducing trade disputes. The GATT's dispute settlement
mechanism was used to resolve hundreds of trade disputes over the years. The vast majority
of these disputes were resolved without resorting to retaliation or other protectionist
measures.

The GATT was a landmark agreement that helped to create the open and liberal trading
system that we enjoy today. It is a testament to the power of international cooperation to
promote economic growth and prosperity.

3. URUGUAY ROUND OF GATT (GENERAL AGREEMENT ON TARIFFS AND

TRADE)

The Uruguay Round of GATT (General Agreement on Tariffs and Trade) negotiations, which
took place from 1986 to 1994, was a landmark event in the history of international trade. It
marked a significant turning point in global trade relations by addressing and negotiating a
wide range of trade-related issues. Here are some key aspects of the Uruguay Round and its
outcomes:

Expansion of Topics: Unlike previous GATT rounds, which mainly focused on reducing tariffs
on goods, the Uruguay Round expanded the scope of negotiations to include various new
topics. These topics included services, intellectual property, trade-related investment
measures, and agricultural subsidies. This expansion recognized the growing importance of
these areas in international trade.

Services: The negotiations on services led to the creation of the General Agreement on Trade
in Services (GATS), which established rules and commitments for trade in services. GATS
aimed to liberalize trade in services, such as banking, telecommunications, and
transportation, by reducing barriers to market access and prohibiting discriminatory
practices.

Intellectual Property: The Uruguay Round resulted in the Agreement on Trade-Related

Aspects of Intellectual Property Rights (TRIPS). TRIPS established global standards for the
protection of intellectual property rights, including patents, copyrights, trademarks, and

Unit 11: From GATT to WTO 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

trade secrets. This was a significant step in protecting the intellectual property of individuals
and businesses on an international scale.

Agricultural Subsidies: Negotiations on agriculture were particularly contentious. The

Agreement on Agriculture aimed to reduce trade-distorting agricultural subsidies and
promote fair competition in the agricultural sector. This was crucial for addressing trade
imbalances and supporting the interests of developing countries.

Establishment of the WTO: Perhaps the most significant outcome of the Uruguay Round was
the creation of the World Trade Organization (WTO) in 1995. The WTO replaced GATT and
is a more comprehensive and powerful organization, overseeing the multilateral trading
system. The WTO is responsible for monitoring and enforcing trade agreements, resolving
trade disputes, and facilitating further negotiations.

Dispute Settlement Mechanism: The Uruguay Round also established a more effective and
binding dispute settlement mechanism within the WTO. This mechanism allows member
countries to bring trade disputes before a neutral panel and provides a structured process
for resolving disagreements.

Trade Liberalization: The Uruguay Round led to significant reductions in tariffs and trade
barriers in many sectors, promoting trade liberalization and economic integration on a
global scale. These tariff reductions helped to stimulate international trade and economic
growth.

In summary, the Uruguay Round of GATT negotiations represented a pivotal moment in the
evolution of the global trading system. It expanded the scope of trade agreements to
encompass a broader range of issues and resulted in the creation of the World Trade
Organization (WTO), which continues to play a central role in regulating and facilitating
international trade while addressing a wide array of trade-related concerns. The outcomes
of the Uruguay Round had a lasting impact on the rules and norms that govern international
trade, contributing to increased globalization and economic interdependence.

Unit 11: From GATT to WTO 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. WTO ESTABLISHMENT
The World Trade Organization (WTO) officially came into existence on January 1, 1995,
marking a significant shift in the international governance of global trade. Here's an
explanation of the establishment and key functions of the WTO:

Establishment and Background:

The WTO was established as a successor to the General Agreement on Tariffs and Trade
(GATT). GATT had been in operation since 1947 and was primarily focused on reducing
tariffs and trade barriers for goods.

The decision to create the WTO was made as a result of the Uruguay Round of GATT
negotiations, which concluded in 1994. These negotiations expanded the scope of trade
agreements to cover a wider range of trade-related issues beyond goods, such as services,
intellectual property, and agriculture.

The Uruguay Round negotiations resulted in various agreements, including the Agreement
on Trade-Related Aspects of Intellectual Property Rights (TRIPS), the General Agreement on
Trade in Services (GATS), and the Agreement on Agriculture. These agreements, along with
the establishment of the WTO, laid the foundation for modern international trade rules and
governance.

Headquarters and Structure:

The WTO is headquartered in Geneva, Switzerland. Its location in a neutral and
internationally respected city reflects its role as a global organization focused on
international trade.

The WTO operates as a member-driven organization, with member countries making

decisions and setting the organization's rules and policies. As of my knowledge cutoff date in
January 2022, there were over 160 member countries in the WTO.

Functions and Responsibilities:

Trade Agreements: The WTO administers and enforces trade agreements negotiated by its
member countries. These agreements cover a wide range of issues, from tariffs and trade in

Unit 11: From GATT to WTO 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

goods to services, intellectual property, and trade-related investment measures. The WTO
ensures that member countries comply with their commitments under these agreements.

Trade Dispute Resolution: The WTO has a well-defined dispute settlement mechanism that
allows member countries to bring trade disputes before a neutral panel of experts. This
process helps resolve conflicts and ensures that international trade rules are upheld.
Decisions made by the WTO's dispute settlement body are binding on member countries.

Trade Negotiations: The WTO provides a platform for ongoing trade negotiations among its
member countries. It convenes trade talks to address emerging issues and promote further
liberalization of trade. These negotiations can lead to new trade agreements and
amendments to existing ones.

Technical Assistance and Capacity Building: The WTO also offers technical assistance and
capacity-building programs to help developing countries participate effectively in the global
trading system. This support is aimed at helping these countries benefit from trade
opportunities and comply with international trade rules.

Transparency and Information Sharing: The WTO promotes transparency by making

information about trade policies, regulations, and disputes available to the public. This
transparency helps create a more predictable and open global trading environment.

In summary, the establishment of the World Trade Organization in 1995 was a significant
development in the governance of global trade. It replaced GATT as the principal
international organization responsible for overseeing trade agreements, resolving trade
disputes, and promoting international trade. The WTO plays a central role in regulating and
facilitating international trade, while its functions contribute to maintaining a rules-based,
predictable, and open global trading system.

Unit 11: From GATT to WTO 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. DOHA ROUND (DOHA AGENDA): 2001-PRESENT

The Doha Development Round, launched by the World Trade Organization (WTO) at its
fourth ministerial conference in Doha, Qatar in November 2001, was an ambitious effort
aimed at making globalization more inclusive and benefiting the world's poor. The primary
goals were to reduce trade barriers and subsidies in the agricultural sector, with a focus on
assisting developing countries. The agenda included both further trade liberalization and the
establishment of new trade rules, coupled with commitments to provide substantial support
to developing nations.

However, progress in the Doha Round stalled due to disagreements between developed
nations and major developing countries on various issues, such as industrial tariffs and non-
tariff barriers to trade. One of the significant points of contention was the clash between the
European Union (EU) and the United States over their maintenance of agricultural subsidies,
which were viewed as effective trade barriers. Despite multiple attempts to revive the
negotiations, no breakthrough was achieved.

In 2013, the adoption of the Bali Ministerial Declaration addressed certain bureaucratic
obstacles to commerce, but the core issues remained unresolved.

As of June 2012, the future of the Doha Round remained uncertain, with 21 subjects listed in
the work program where the original deadline of January 1, 2005, had been missed. The
major stumbling block was the conflict between developed countries advocating for free
trade in industrial goods and services while retaining protectionist measures, particularly in
the form of farm subsidies. On the other hand, developing countries emphasized the
importance of fair trade in agricultural products. This impasse made it impossible to launch
new WTO negotiations beyond the Doha Development Round.

As a result of the impasse, there was a growing trend of bilateral free trade agreements
between governments. Various negotiation groups within the WTO continued to work on
resolving the issues in agricultural trade negotiations, but significant progress remained
elusive.

Unit 11: From GATT to WTO 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

1. When was the World Trade Organization (WTO) officially established?

a) 1947
b) 1986
c) 1994
d) 1995
2. What was the primary focus of the General Agreement on Tariffs and Trade
(GATT)?
a) Reducing trade barriers in agriculture
b) Promoting intellectual property rights
c) Reducing tariffs and trade barriers
d) Facilitating trade in services
3. What was the key objective of GATT after World War II?
a) Promoting global inequality
b) Reducing agricultural subsidies
c) Facilitating international trade and economic recovery
d) Establishing bilateral trade agreements
4. Which round of GATT negotiations resulted in the establishment of the
World Trade Organization (WTO)?
a) Havana Round
b) Doha Round
c) Uruguay Round
d) Geneva Round
5. What key area of trade did the Uruguay Round of GATT negotiations focus
on?
a) Agriculture
b) Industrial tariffs
c) Trade in goods
d) Trade in services

Unit 11: From GATT to WTO 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

6. The General Agreement on Trade in Services (GATS) aimed to:

a) Reduce trade subsidies in agriculture
b) Liberalize trade in intellectual property
c) Promote trade in goods
d) Liberalize trade in services
7. Which agreement established global standards for the protection of
intellectual property rights?
a) Agreement on Agriculture
b) TRIPS
c) GATT
d) GATS
8. What was the most significant outcome of the Uruguay Round of GATT
negotiations?
a) Formation of the European Union (EU)
b) Reduction of global agricultural subsidies
c) Creation of the World Trade Organization (WTO)
d) Establishment of non-tariff barriers to trade
9. Where is the World Trade Organization (WTO) headquartered?
a) New York, USA
b) Geneva, Switzerland
c) Paris, France
d) Tokyo, Japan
10. The Doha Development Round primarily aimed to:
a) Reduce global trade liberalization
b) Benefit developed countries through subsidies
c) Promote fair trade in agricultural products
d) Eliminate the role of the WTO

Unit 11: From GATT to WTO 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

6. FUNCTIONS OF WTO
Promoting economic growth by facilitating international trade stands as the paramount
function of the World Trade Organization (WTO). Alongside this primary role, the WTO has
several other vital functions:

Supervision of Agreements: The WTO oversees the implementation, administration, and

operation of covered agreements. It ensures that these agreements are upheld and
functioning as intended. Notably, it does not enforce any agreements when China became a
member of the WTO in December 2001.

Negotiation and Dispute Resolution: The WTO provides a platform for member countries to
engage in negotiations and settle trade disputes. This function is essential for resolving
conflicts and advancing global trade relations.

Trade Policy Review and Surveillance: The WTO conducts the review and dissemination of
national trade policies. It aims to maintain transparency and consistency in trade policies
while playing a role in shaping global economic policy.

Assistance to Developing Countries: The organization is committed to helping to develop,

least-developed, and low-income countries transition into the WTO system. It offers
technical cooperation and training to assist these nations in adjusting to WTO rules and
disciplines.

To achieve these functions effectively, the WTO has specific responsibilities:

• Facilitating the operation of the Multilateral Trade Agreements and promoting their
objectives.
• Providing a negotiation forum for multilateral trade matters outlined in the
Agreement's annexes.
• Administering the Understanding on Rules and Procedures Governing the Settlement
of Disputes.
• Managing the Trade Policy Review Mechanism, which evaluates trade policies of
member countries.

Unit 11: From GATT to WTO 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Collaborating with international financial institutions, such as the International

Monetary Fund (IMF) and the International Bank for Reconstruction and Development
(IBRD), to enhance coherence in global economic policymaking.

These additional functions are pivotal to managing the complexities of today's globalized
society. As globalization expands, issues like protectionism, trade barriers, subsidies, and
intellectual property violations arise due to differences in national trade rules. The WTO acts
as a mediator between nations when these issues emerge. It is not only a product of
globalization but also one of the most indispensable organizations in our interconnected
global community.

Furthermore, the WTO serves as a hub for economic research and analysis. It regularly
produces assessments of the global trade landscape in its annual publications and conducts
research on specific topics. Lastly, the organization maintains close cooperation with the
other two components of the Bretton Woods system, the IMF and the World Bank, ensuring
a coordinated approach to global economic stability and development.

7. PRINCIPLES OF THE TRADING SYSTEMS

The World Trade Organization (WTO) establishes a framework for trade policies without
prescribing specific outcomes. To comprehend the principles underlying both the pre-1994
General Agreement on Tariffs and Trade (GATT) and the WTO, five key principles are of
utmost importance:
• Non-discrimination: Non-discrimination comprises two significant components: the
Most Favoured Nation (MFN) rule and the principle of national treatment. These
principles are fundamental in WTO rules concerning goods, services, and intellectual
property. The MFN rule mandates that all WTO members apply the same trade
conditions to one another. In other words, any advantageous trade terms granted to
one member must be extended to all. National treatment ensures that imported goods
should receive no less favourable treatment than domestically produced goods once
they have entered the market. This principle is vital for addressing non-tariff barriers
like discriminatory technical and security standards.
• Reciprocity: Reciprocity serves to limit free-riding, which can occur due to the MFN
rule. It also aims to secure improved access to foreign markets. Reciprocal concessions

Unit 11: From GATT to WTO 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

are essential because nations engage in negotiations when the benefits outweigh those
of unilateral liberalization. Reciprocity is the mechanism through which these benefits
become a reality.
• Binding and Enforceable Commitments: Tariff commitments made during multilateral
trade negotiations and accession are documented in legal schedules known as lists of
concessions. These schedules establish "ceiling bindings," meaning a country can
modify its commitments, but only after negotiations with trade partners, which may
include compensating them for potential trade losses. In case of dissatisfaction, the
aggrieved country can initiate the WTO's dispute settlement procedures.
• Transparency: WTO members must disclose their trade regulations, maintain
institutions for reviewing administrative decisions that affect trade, respond to
information requests from other members, and notify the WTO of changes in trade
policies. These internal transparency requirements are complemented by periodic,
country-specific trade policy reviews conducted through the Trade Policy Review
Mechanism (TPRM). The WTO also strives to promote predictability and stability by
discouraging the use of quotas and other trade-limiting measures.
• Safety Valves: Governments can, under certain circumstances, restrict trade. The
WTO's agreements allow members to take trade measures to protect not only economic
interests but also public health, animal health, and plant health. These provisions
encompass:

Provisions allowing trade interventions for economic reasons.

The MFN principle also includes exceptions that permit preferential treatment for
developing countries, regional free trade areas, and customs unions. This underscores the
WTO's commitment to promoting fairness and addressing the unique circumstances of
various members.

Unit 11: From GATT to WTO 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. CHALLENGES AND CRITICISMS OF WTO

The World Trade Organization (WTO) has encountered several challenges and criticisms,
which revolve around concerns that it promotes inequality and prioritizes the interests of
developed nations over those of developing countries. These challenges and criticisms have
led to protests and debates about the role and policies of the WTO. Here's a more detailed
explanation of these issues:

Inequality in Trade Rules: One major criticism is that the WTO's trade rules are perceived as
favoring developed countries. Some argue that these rules, which were often established
during previous negotiations like the Uruguay Round, are designed to benefit economically
advanced nations. This can result in unequal access to global markets, potentially
disadvantaging developing countries.

Dispute Settlement Mechanism: The WTO's dispute settlement mechanism has been
criticized for favoring powerful nations. Critics argue that it may be skewed in favor of
wealthy countries, making it difficult for developing nations to assert their rights and protect
their interests effectively.

Agricultural Subsidies: Developing countries have expressed concerns about the continued
existence of agricultural subsidies in developed countries, which can distort international
trade by making it difficult for farmers in less developed nations to compete in the global
market. The WTO's ability to address these imbalances is a point of contention.

Access to Essential Medicines: There have been disputes related to intellectual property
rights, particularly in the context of access to essential medicines. Some argue that stringent
patent protection can limit the affordability of life-saving drugs in developing countries,
which raises public health concerns.

Critique of Transparency: Some critics argue that the WTO's decision-making processes are
not as transparent as they should be. This can lead to a lack of inclusivity in negotiations and
decisions, potentially excluding the voices of smaller and less powerful nations.

Social and Environmental Concerns: Critics also raise concerns about the WTO's impact on
social and environmental issues. They argue that the pursuit of trade liberalization

Unit 11: From GATT to WTO 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

sometimes takes precedence over broader societal and environmental goals. This can lead
to concerns about labour rights, environmental protection, and sustainable development.

Protests and Demonstrations: As a response to these concerns, the WTO has faced protests
and demonstrations during its meetings. These events often attract a wide range of groups,
including non-governmental organizations, activists, and representatives from developing
nations. They aim to draw attention to these criticisms and advocate for changes in WTO
policies.

Debate on the Role of the WTO: These challenges have prompted ongoing debates about the
role and function of the WTO. Some argue for reforms to make the organization more
inclusive, while others believe that it should play a less dominant role in shaping global trade
policies.

While tariffs and trade barriers have seen significant reductions due to the efforts of GATT
and the WTO, the belief that free trade alone can spur economic growth, poverty reduction,
and income increases has faced scrutiny from critics. El Salvador serves as an example
where, in the early 1990s, all quantitative import barriers were removed, and tariffs were
cut. However, this did not lead to substantial economic growth. In contrast, Vietnam, which
began economic reforms in the late 1980s and followed a gradual approach to liberalization,
experienced success, much like China, by implementing safeguards for domestic trade.
Vietnam achieved notable economic growth and poverty reduction without immediately
eliminating significant trade barriers.

Economist Ha-Joon Chang points out a "paradox" in neoliberal free trade beliefs. He notes
that the economic growth of developing countries was stronger in the 1960-1980 period
compared to the 1980-2000 period, even though trade policies have become more liberal.
Research findings indicate that many countries tend to reduce trade barriers only after
achieving significant economic growth. Critics of the WTO argue that trade liberalization
does not guarantee economic growth or poverty alleviation.

Critics also contend that the benefits of WTO-facilitated free trade are not distributed
equitably. This criticism is often supported by historical records and data showing that the
wealth gap continues to widen, particularly in countries like China and India, where

Unit 11: From GATT to WTO 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

economic inequality has grown alongside high economic growth. Moreover, WTO
approaches to reduce trade barriers can potentially harm developing countries. Premature
trade liberalization, in the absence of well-established domestic industries, can lock
developing economies into the primary sector, which typically requires less skilled labour.
When these countries later seek to advance their economies through industrialization, their
domestic industries may struggle to compete with more advanced industries in other
nations, causing setbacks in their development.

In summary, the WTO faces criticism and challenges related to perceptions of inequality, a
lack of transparency, and concerns about the impact of trade policies on social and
environmental issues. The protests and debates surrounding the WTO reflect the complex
and evolving nature of international trade governance and the need to balance the interests
of both developed and developing nations in the global trading system.

9. CONSENSUS ON INTERNATIONAL TRADE PRACTICES

Consensus on international trade practices refers to a general agreement or widespread
acceptance among countries and stakeholders regarding the norms, rules, and principles
that govern international trade. Achieving consensus on trade practices is essential for
promoting global economic cooperation, reducing trade barriers, and ensuring the smooth
flow of goods and services across borders. Here are some key aspects related to consensus
on international trade practices:

Establishing International Rules: One of the primary objectives of achieving consensus in

international trade is the establishment of a set of rules and regulations that govern trade
between countries. These rules cover areas such as tariffs, non-tariff barriers, intellectual
property rights, trade in services, and dispute resolution.

Multilateral Trade Agreements: Multilateral trade agreements, negotiated within

organizations like the World Trade Organization (WTO), are a common way to achieve
consensus on trade practices. These agreements involve negotiations among a large number
of countries to create a framework for trade that is acceptable to all parties.

Non-Discrimination: Consensus often revolves around the principles of non-discrimination,

particularly the Most-Favoured-Nation (MFN) principle and national treatment. These

Unit 11: From GATT to WTO 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

principles stipulate that countries should treat all trading partners equally and not
discriminate in Favor of one nation over another.

Bilateral and Regional Agreements: In addition to multilateral agreements, countries also

engage in bilateral and regional trade agreements. These agreements are reached between
two or more countries and reflect a consensus on trade practices specific to the parties
involved.

Trade Facilitation: Achieving consensus on trade practices includes agreements on trade

facilitation measures, which aim to streamline customs procedures, reduce red tape, and
simplify the movement of goods across borders. These measures help lower trade costs and
enhance efficiency.

Intellectual Property Protection: International consensus is crucial in defining the standards

for intellectual property protection. Agreement on issues like patents, copyrights,
trademarks, and trade secrets is necessary to protect the rights of creators and inventors
globally.

Dispute Resolution: Consensus is also reached on mechanisms for resolving trade disputes.
International organizations like the WTO have established procedures that provide a
framework for settling disagreements between countries.

Transparency and Information Sharing: Transparency in trade policies and regulations is

essential for consensus. Countries often agree to share information about their trade
measures and policies to ensure predictability and openness in the trading system.

Development and Special Provisions: Consensus may include provisions to address the
specific needs of developing countries. Special and differential treatment for these nations is
often part of the consensus to ensure that trade practices promote development and reduce
economic disparities.

Trade Promotion and Cooperation: Consensus can extend to cooperation and assistance
programs to help countries, especially developing ones, adapt to international trade rules
and practices. This includes technical cooperation and capacity-building initiatives.

Unit 11: From GATT to WTO 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Environmental and Social Considerations: Achieving consensus on international trade

practices may involve considerations related to environmental protection, labor standards,
and social issues. Balancing economic interests with environmental and social concerns is an
ongoing part of trade discussions.

Consensus on international trade practices is an ongoing and evolving process. It requires

negotiations, dialogue, and cooperation among countries and stakeholders to adapt to
changing economic realities and global challenges while ensuring that international trade
remains fair, equitable, and mutually beneficial.

10. SUMMARY
• The Doha Development Round of WTO negotiations was initiated in 2001 with the goal
of making globalization more inclusive and benefiting the world's poor.
• The key objectives of the Doha Round included reducing trade barriers and subsidies
in the agricultural sector, promoting further trade liberalization, and establishing new
trade rules while providing substantial support to developing countries.
• Progress in the Doha Round faced challenges, including disagreements between
developed and major developing countries on issues like industrial tariffs and non-
tariff trade barriers.
• Agricultural subsidies were a major point of contention, with the EU and the US
maintaining subsidies that acted as trade barriers, which clashed with developing
countries' calls for fair trade in agricultural products.
• Despite multiple attempts to revive the negotiations, the Doha Round remained
incomplete, with 21 subjects in the work program missing their original deadline.
• Bilateral free trade agreements between governments became more prevalent as a
result of the impasse in the Doha Round.
• Various negotiation groups within the WTO continued to address issues in agricultural
trade negotiations, but significant progress remained elusive.

Functions of the WTO:

• Promotion of Economic Growth: Facilitating international trade is its primary function.
• Supervision of Agreements: Ensures covered agreements are implemented and
operated.

Unit 11: From GATT to WTO 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Negotiation and Dispute Resolution: Provides a platform for negotiations and conflict
resolution.
• Trade Policy Review and Surveillance: Reviews and promotes national trade policies
for global economic consistency.
• Assistance to Developing Countries: Helps developing nations adjust to WTO rules
through training and cooperation.

WTO's Responsibilities:
• Facilitating Agreements: Supports the objectives of the Multilateral Trade Agreements.
• Providing a Negotiation Forum: Offers a platform for trade negotiations among
members.
• Administering Dispute Settlement: Manages dispute resolution procedures.
• Trade Policy Review: Evaluates the trade policies of member countries.
• Collaboration with International Institutions: Cooperates with IMF and World Bank for
global economic policymaking.

Principles of Trading Systems:

• Non-discrimination: MFN and national treatment principles ensure equal treatment.
• Reciprocity: Balances trade concessions to ensure benefits materialize.
• Binding and Enforceable Commitments: Countries make tariff commitments, subject to
negotiation and dispute resolution.
• Transparency: Members disclose trade regulations, review decisions, and notify policy
changes.
• Safety Valves: Allows trade restrictions for non-economic objectives, fair competition,
and economic reasons.

Challenges and Criticisms of WTO:

• Inequality in Trade Rules: Perception that WTO rules Favor developed countries.
• Dispute Settlement Mechanism: Criticized for favouring powerful nations.
• Agricultural Subsidies: Concerns about subsidies in developed countries affecting
global trade.
• Access to Essential Medicines: Disputes related to intellectual property rights and
access to medicines.

Unit 11: From GATT to WTO 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Critique of Transparency: Claims that decision-making lacks transparency.

• Social and Environmental Concerns: Debate over trade policies' impact on labour,
environment, and development.
• Protests and Demonstrations: Criticism has led to protests and calls for WTO reform.
• Debate on the Role of the WTO: Ongoing discussions on the organization's role and
policies.

Consensus on International Trade Practices:

• Involves global agreement on trade norms, rules, and principles.
• Multilateral, bilateral, and regional trade agreements help achieve consensus.
• Focuses on non-discrimination, trade facilitation, intellectual property, and dispute
resolution.
• Considers development, environmental, and social factors.
• Aims to balance economic interests with global challenges while promoting fairness
and mutual benefit.

11. TERMINAL QUESTIONS

Question 1: Discuss the objectives of the Doha Development Round and the major challenges
that led to its stalled progress. Why did the conflict between developed and developing
countries play a central role in hindering the negotiations?

Question 2: Explain the significance of the Bali Ministerial Declaration in the context of the
Doha Development Round. How did this declaration address certain obstacles to trade, and
what were the broader issues that remained unresolved?

Question 3: Analyse the role of the World Trade Organization (WTO) in the Doha
Development Round and its efforts to bridge the gap between developed and developing
countries. What were the WTO's functions in the context of the Doha Round negotiations?

Question 4: Explain the primary functions of the World Trade Organization (WTO) and its
responsibilities in the global trade landscape. How has the WTO contributed to promoting
economic growth and resolving trade disputes?

Unit 11: From GATT to WTO 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 5: Describe the five key principles that underlie the World Trade Organization's
(WTO) trading system. Explain the significance of principles like non-discrimination,
reciprocity, and transparency in international trade governance.

Question 6: What are the main challenges and criticisms faced by the World Trade
Organization (WTO), and how have these issues influenced its role and policies? Discuss
specific concerns related to inequality in trade rules, dispute settlement mechanisms, and
agricultural subsidies.

Question 7: Discuss the role of consensus in international trade practices. Explain how
achieving consensus is essential for global economic cooperation and reducing trade
barriers. Provide examples of multilateral, bilateral, and regional trade agreements that
reflect consensus on trade practices.

12. ANSWERS
Self-Assessment Questions
Answer 1: D. 1995

Answer 2: C. Reducing tariffs and trade barriers

Answer 3: C. Facilitating international trade and economic recovery

Answer4: C. Uruguay Round

Answer 5: A. Agriculture

Answer 6: D. Liberalize trade in services

Answer 7: B. TRIPS

Answer 8: C. Creation of the World Trade Organization (WTO)

Answer 9: B. Geneva, Switzerland

Answer 10: C. Promote fair trade in agricultural products.

Unit 11: From GATT to WTO 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Terminal Questions
Answer 1: The Doha Development Round, launched in 2001 by the World Trade
Organization (WTO), aimed to promote trade liberalization and inclusivity, especially for
developing countries. The key objectives were to reduce trade barriers, particularly in
agriculture, and establish new trade rules. However, the round-faced numerous challenges.
The conflict between developed and developing countries, particularly regarding issues like
agricultural subsidies and industrial tariffs, was a major stumbling block. Developed
countries sought to maintain protectionist measures, while developing countries
emphasized the importance of fair trade in agricultural products. This conflict played a
central role in hindering progress, as both sides had divergent interests.

Answer 2: The Bali Ministerial Declaration, adopted in 2013, was a crucial development
within the context of the Doha Development Round. It addressed bureaucratic obstacles to
trade by streamlining customs procedures and reducing trade costs. This was significant as
it aimed to facilitate the movement of goods across borders. However, it's important to note
that while the declaration resolved some administrative issues, it did not tackle the core
challenges of the Doha Round. Major issues, such as agricultural subsidies, industrial tariffs,
and the broader conflict between developed and developing countries, remained unresolved.

Answer 3: The World Trade Organization (WTO) played a central role in the Doha
Development Round negotiations. Its functions included providing a platform for trade talks,
facilitating negotiations, and overseeing the trade agreements. The WTO also offered
technical assistance and capacity-building programs to help developing countries
participate effectively. However, the WTO faced significant challenges in bridging the gap
between developed and developing countries, particularly due to differences in trade
priorities. While the WTO sought to promote fair trade and inclusivity, the complex and
multifaceted issues, such as agricultural subsidies and industrial tariffs, made it difficult to
achieve a consensus among member countries, leading to stalled progress in the Doha
Round.

Answer 4: The primary functions of the WTO include promoting economic growth by
facilitating international trade, overseeing the implementation of trade agreements,
providing a platform for negotiations and dispute resolution, conducting trade policy

Unit 11: From GATT to WTO 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

reviews, and offering assistance to developing countries. The WTO has played a pivotal role
in reducing trade barriers and ensuring that trade agreements are upheld. It has contributed
to global economic growth by fostering open markets and providing a mechanism for
countries to resolve trade conflicts through negotiation and dispute settlement procedures.

Answer 5: The five key principles of the WTO's trading system are non-discrimination,
reciprocity, binding and enforceable commitments, transparency, and safety valves. Non-
discrimination is crucial as it ensures that all WTO members are treated equally through the
Most-Favoured-Nation (MFN) rule and national treatment. Reciprocity encourages countries
to engage in negotiations to secure improved access to foreign markets. Binding
commitments provide stability in trade relations. Transparency ensures openness and
predictability in trade policies. Safety valves allow governments to restrict trade under
specific circumstances. These principles are essential for establishing a fair and consistent
international trade framework.

Answer 6: The WTO has encountered challenges and criticisms, including perceived
inequality in trade rules favouring developed nations, criticism of dispute settlement
mechanisms as biased, and concerns about agricultural subsidies distorting international
trade. These issues have led to protests and debates about the WTO's role. Critics argue that
it needs to be more inclusive and consider the interests of developing countries. The WTO is
under pressure to address these concerns and ensure a more equitable global trading
system.

Answer 7: Consensus in international trade practices is crucial for establishing common

norms, rules, and principles that govern global trade. It fosters global economic cooperation
and helps reduce trade barriers. Multilateral agreements, such as those negotiated within
the WTO, reflect consensus among a large number of countries. Bilateral and regional trade
agreements, like NAFTA (North American Free Trade Agreement) and the European Union,
show consensus among specific groups of countries. Achieving consensus in these
agreements ensures that international trade remains fair, equitable, and mutually beneficial,
benefiting both developed and developing nations.

Unit 11: From GATT to WTO 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 12: Regional Development Banks 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 12
Regional Development Banks
Table of Contents
SL Topic Fig No / Table SAQ / Page No
No / Graph Activity
1 Introduction - -
3-5
1.1 Learning Objectives - -
2 Origin of Regional Development Bank - - 6-7
3 Functions and Objectives of Regional - 1 8-12
Development Bank
4 Asian Development Bank - - 13-14
5 The African Development Bank (AfDB) - - 14-16
6 Council of European Development Bank - - 16-17
7 Inter-American Development Bank - 2 17-20
8 Summary - - 21-24
9 Terminal Questions - - 24-25
10 Answers - - 25-28

Unit 12: Regional Development Banks 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
A regional development bank is a financial institution that provides funding and resources
to support economic development and infrastructure projects within a specific region or
group of countries. These banks focus on addressing the unique development challenges and
needs of the region they serve. Regional development banks play a crucial role in promoting
sustainable economic growth, reducing poverty, and enhancing the overall well-being of the
population in their respective regions. Here are some key features and examples of regional
development banks:

Key Features of Regional Development Banks:

• Regional Focus: These banks operate within a specific geographic region, such as a
continent, subcontinent, or group of neighbouring countries. They are dedicated to
addressing the economic and development issues particular to that region.
• Economic Development: The primary mission of regional development banks is to
stimulate economic development. They provide financial resources, technical
assistance, and expertise to support projects that create jobs, improve infrastructure,
and enhance the overall economic environment.
• Infrastructure Investment: Regional development banks often focus on funding
infrastructure projects, including transportation, energy, water supply, sanitation, and
telecommunications. These investments are critical for improving the region's
competitiveness and quality of life.
• Poverty Reduction: Many regional development banks have a specific mandate to
reduce poverty and promote social inclusion. They invest in projects that have a direct
and positive impact on low-income communities.
• Technical Assistance: In addition to financial support, these banks offer technical
assistance and capacity-building services to help countries plan, implement, and
manage development projects effectively.
• Long-Term Investment: Regional development banks provide long-term financing,
which is essential for large-scale infrastructure projects that have extended payback
periods. This long-term perspective contributes to the sustainable development of the
region.

Unit 12: Regional Development Banks 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Examples of Regional Development Banks:

African Development Bank (AfDB): The AfDB is a multilateral regional development bank
that serves African countries. It provides financing and technical assistance for a wide range
of development projects, including infrastructure, agriculture, health, and education, with a
focus on reducing poverty and promoting economic growth in Africa.

Asian Development Bank (ADB): ADB is a regional development bank dedicated to the Asia
and Pacific region. It finances projects related to infrastructure development, environmental
sustainability, and social progress in its member countries.

Inter-American Development Bank (IDB): The IDB is the largest source of development
financing for Latin America and the Caribbean. It supports projects aimed at reducing
poverty, improving infrastructure, and promoting economic and social development in the
region.

European Bank for Reconstruction and Development (EBRD): While not geographically
limited to a single continent, the EBRD focuses on fostering the transition to market-oriented
economies in countries across Europe, Asia, and Northern Africa. It supports private and
public sector development initiatives.

East African Development Bank (EADB): EADB is a smaller regional development bank that
serves the East African Community member states, including Kenya, Uganda, Tanzania,
Rwanda, and Burundi. It provides financial assistance for projects that contribute to
economic development and poverty reduction in the region.

These are just a few examples of regional development banks that operate in different parts
of the world. Each bank has its unique focus and priorities based on the development
challenges and opportunities in its respective region.

Unit 12: Regional Development Banks 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1.1 Learning Objectives

❖ Define the concept of a regional development bank and explain its primary role in
supporting economic development and infrastructure projects within specific regions.
❖ Identify the key features of regional development banks, including their regional focus,
emphasis on economic development, and commitment to addressing poverty and social
inclusion.
❖ Recognize the importance of infrastructure investment in regional development and
understand the sectors typically funded by regional development banks.
❖ Describe the specific examples of regional development banks, such as the African
Development Bank, Asian Development Bank, Inter-American Development Bank,
European Bank for Reconstruction and Development, and East African Development
Bank, and their unique regional focuses.
❖ Trace the historical origins of regional development banks and their evolution as financial
institutions dedicated to addressing the economic and developmental needs of specific
regions and countries.

Unit 12: Regional Development Banks 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. ORIGIN OF REGIONAL DEVELOPMENT BANK

The concept of regional development banks has evolved over time in response to the specific
economic, social, and developmental needs of various regions and groups of countries. These
institutions were established to address the challenges associated with regional
development, infrastructure investment, poverty reduction, and economic growth within a
defined geographic area. Here's a brief overview of the origins and development of regional
development banks:

Early Initiatives: The idea of regional development banks can be traced back to the early 20th
century when countries and regions began recognizing the need for financial institutions
that could provide targeted support for development projects. Some early examples include
the "Colonial Development Fund" created in the British Empire in the 1920s and regional
agricultural banks in India.

World Bank and Regional Development: The establishment of the International Bank for
Reconstruction and Development (IBRD), now part of the World Bank Group, in 1944,
marked a significant step in the development of international financial institutions. The
World Bank was created to provide post-World War II reconstruction assistance to
European countries. Over time, the World Bank expanded its focus to include development
assistance for countries worldwide.

Asian Development Bank (ADB): The Asian Development Bank, founded in 1966, is one of
the earliest regional development banks. It was established in response to the unique
economic and developmental needs of countries in Asia and the Pacific. The ADB has played
a vital role in supporting infrastructure development and economic growth in the region.

African Development Bank (AfDB): The African Development Bank, established in 1964,
emerged from the desire to address the specific challenges faced by African countries in their
quest for development. The AfDB focuses on financing projects and programs that contribute
to reducing poverty and promoting economic development in Africa.

Inter-American Development Bank (IDB): The Inter-American Development Bank was

established in 1959 to provide financial and technical assistance to countries in Latin

Unit 12: Regional Development Banks 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

America and the Caribbean. It was created to support economic and social development
efforts in the Western Hemisphere.

European Regional Development Banks: In Europe, there are various regional development
banks that predate the establishment of the European Bank for Reconstruction and
Development (EBRD). These regional banks aim to address the developmental needs of
specific sub-regions or groups of countries within Europe. The EBRD was founded in 1991
to support the transition to market-oriented economies in Eastern and Central Europe, as
well as countries in Northern Africa and the Middle East.

Sub-Regional and National Banks: In addition to international and continental regional

development banks, there are sub-regional and national development banks that focus on
the unique needs of smaller geographic areas. These institutions are often created to address
specific developmental challenges within a country or a sub-region.

The establishment of these regional development banks was driven by the recognition that
traditional international financial institutions, such as the World Bank, might not fully
address the diverse needs and priorities of distinct regions. These banks have played a
crucial role in channelling financial resources, technical expertise, and knowledge to support
projects and initiatives that contribute to regional development, economic growth, and
poverty reduction.

Over the years, regional development banks have become essential components of the global
development architecture, working alongside international organizations to promote
sustainable development and address the unique challenges faced by different regions
around the world.

Unit 12: Regional Development Banks 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. FUNCTIONS AND OBJECTIVES OF REGIONAL DEVELOPMENT BANK

Regional development banks serve specific geographic areas and have distinct functions and
objectives that are tailored to the economic, social, and developmental needs of the regions
they serve. These banks play a crucial role in promoting sustainable development and
addressing the challenges unique to their respective regions. Here are the primary functions
and objectives of regional development banks:

Functions of Regional Development Banks:

Financial Intermediation: Regional development banks act as financial intermediaries,
providing loans, grants, and other financial instruments to member countries or regions.
They mobilize financial resources, both internally and externally, to finance development
projects and programs.

Project Financing: These banks finance a wide range of development projects, including
infrastructure development (e.g., roads, bridges, energy, and water supply), social projects
(e.g., education and healthcare facilities), and initiatives to promote economic growth (e.g.,
agriculture and industry).

Technical Assistance: Regional development banks offer technical expertise and knowledge
to help member countries design and implement development projects effectively. This can
include project planning, capacity building, and knowledge sharing.

Policy Advice: They provide policy advice to member countries to support sound economic
and development policies. This advice can help nations make informed decisions about
economic reforms, governance, and development strategies.

Risk Mitigation: Regional development banks often help member countries manage risks
associated with development projects, including those related to financing, technology, and
environmental impact. They may offer risk guarantees and insurance to attract private
investment.

Research and Data Analysis: Many regional development banks conduct research and
analysis to better understand regional development challenges. They provide valuable data
and research findings to inform policy decisions.

Unit 12: Regional Development Banks 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Promotion of Regional Integration: Some regional development banks work to promote

regional economic integration, trade, and cooperation among member countries. They aim
to create economic synergies and strengthen regional stability.

Objectives of Regional Development Banks:

Poverty Reduction: One of the primary objectives of regional development banks is to reduce
poverty and improve the living standards of the population in the regions they serve. They
achieve this by investing in projects that generate jobs, improve access to essential services,
and increase income levels.

Infrastructure Development: Regional development banks focus on building and

maintaining infrastructure in areas like transportation, energy, water supply, and
telecommunications. By improving infrastructure, they aim to enhance regional connectivity
and promote economic growth.

Environmental Sustainability: Many regional development banks prioritize environmental

sustainability by financing projects that incorporate green and environmentally friendly
practices. They seek to address environmental challenges and promote sustainable
development.

Economic Diversification: These banks often work to diversify regional economies by

supporting projects that encourage the growth of various sectors, reducing dependence on
a single industry or source of income.

Human Capital Development: Regional development banks invest in human capital by

supporting education, healthcare, and social development projects. They aim to improve
access to quality education and healthcare services.

Private Sector Development: Some regional development banks support private sector
growth and entrepreneurship. They provide funding and technical assistance to help small
and medium-sized enterprises (SMEs) and businesses thrive.

Inclusive Development: Promoting inclusive development is a core objective. These banks

work to ensure that the benefits of development reach marginalized and vulnerable
populations, reducing disparities and promoting social inclusion.

Unit 12: Regional Development Banks 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Strengthening Governance and Institutions: Regional development banks often work to

strengthen governance and institutions in their member countries. They promote good
governance, transparency, and accountability.

Economic Stability: Another objective is to promote economic stability within the region by
addressing macroeconomic imbalances and helping countries navigate financial crises.

Regional Cooperation: Many regional development banks aim to foster cooperation among
member countries, creating a sense of shared purpose and working together to address
common challenges and opportunities.

The specific functions and objectives of regional development banks may vary depending on
the bank's charter, the regions it serves, and the unique needs and priorities of its member
countries. However, the overarching goal is to support sustainable development, reduce
poverty, and promote economic growth within the region.

SELF-ASSESSMENT QUESTIONS – 1

1. What is the primary focus of regional development banks?

a) Providing international aid
b) Addressing global development challenges
c) Supporting economic development and infrastructure projects within
specific regions
d) Enhancing the well-being of populations worldwide
2. Which of the following is NOT a key feature of regional development banks?
a) Regional Focus
b) Infrastructure Investment
c) Poverty Reduction Worldwide
d) Technical Assistance

Unit 12: Regional Development Banks 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

3. Which regional development bank serves African countries with a focus on

reducing poverty and promoting economic growth in Africa?
a) European Bank for Reconstruction and Development (EBRD)
b) Asian Development Bank (ADB)
c) Inter-American Development Bank (IDB)
d) African Development Bank (AfDB)
4. The Asian Development Bank (ADB) primarily serves which region?
a) Europe
b) Africa
c) Asia and the Pacific
d) Latin America
5. What is one of the primary functions of regional development banks?
a) Climate change research
b) Marketing of consumer goods
c) Providing long-term financing for development projects
d) Sports event management.
6. What key objective do regional development banks share to improve living
standards within their regions?
a) Enhancing corporate profits
b) Reducing global income inequality
c) Promoting social inclusion and poverty reduction
d) Strengthening international relations

Unit 12: Regional Development Banks 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

7. In which region does the Inter-American Development Bank (IDB) primarily

focus its efforts?
a) Africa
b) Asia and the Pacific
c) Europe
d) Latin America and the Caribbean
8. Why were regional development banks established?
a) To primarily focus on national development
b) To address the specific economic, social, and developmental needs of
various regions
c) To provide global banking services
d) To enforce international trade agreements
9. Which early initiative contributed to the concept of regional development
banks?
a) Development of global space exploration programs
b) Creation of the United Nations
c) "Colonial Development Fund" in the British Empire
d) Formation of the World Trade Organization (WTO)
10. What is one of the key objectives of regional development banks related to
infrastructure development?
a) Promoting the growth of a single industry
b) Supporting economic diversification
c) Encouraging environmental degradation
d) Reducing access to essential services

Unit 12: Regional Development Banks 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. ASIAN DEVELOPMENT BANK

The Asian Development Bank (ADB) is a regional development institution that was founded
in 1966. It was established to address the specific economic and developmental needs of
countries in Asia and the Pacific. The ADB's primary mission is to promote social and
economic progress in the region by providing financial and technical assistance for a wide
range of development projects. Here's an explanation of its key roles and functions:

Infrastructure Development: One of the primary functions of the ADB is to support the
development of infrastructure in its member countries. This includes projects related to
transportation (such as roads, bridges, and ports), energy (power generation and
distribution), water supply and sanitation, and telecommunications. These infrastructure
projects are crucial for improving connectivity, facilitating trade, and enhancing the quality
of life for people in the region.

Economic Growth: The ADB plays a vital role in fostering economic growth in Asia and the
Pacific. By providing financial resources and technical expertise to member countries, it
helps boost economic activities and create job opportunities. This, in turn, contributes to
poverty reduction and an overall improvement in living standards.

Poverty Reduction: ADB's projects and initiatives are designed to reduce poverty and
promote social inclusion. They often target marginalized and vulnerable populations, aiming
to provide them with better access to basic services, education, and healthcare. By
addressing the root causes of poverty, the ADB helps enhance the well-being of communities
across the region.

Environmental Sustainability: The ADB recognizes the importance of sustainable

development. It supports environmentally friendly projects that promote renewable energy,
resource conservation, and climate resilience. This commitment to environmental
sustainability helps member countries address the challenges of climate change and protect
their natural resources.

Capacity Building and Technical Assistance: In addition to providing financial resources, the
ADB offers technical assistance and knowledge-sharing to member countries. This helps
them build the capacity needed to plan, implement, and manage development projects

Unit 12: Regional Development Banks 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

effectively. Capacity building contributes to the long-term sustainability of development

efforts.

Regional Cooperation: ADB fosters regional cooperation and integration among its member
countries. By facilitating cross-border infrastructure projects and policy coordination, it
helps promote economic cooperation, trade, and stability within the region.

Research and Policy Advocacy: ADB conducts research and analysis to better understand the
economic and developmental challenges facing the region. It uses this research to advocate
for policies and reforms that can enhance economic growth and development outcomes in
member countries.

Overall, the Asian Development Bank is an important financial institution in the Asia-Pacific
region, dedicated to improving the quality of life for people in its member countries. Its
support for infrastructure development, economic growth, poverty reduction, and
sustainable development contributes to the overall well-being and prosperity of the region.

5. THE AFRICAN DEVELOPMENT BANK (AFDB)

The African Development Bank (AfDB) is a regional multilateral financial institution
established in 1964 to address the unique challenges faced by African countries in their
pursuit of economic and social development. The AfDB plays a critical role in supporting the
continent's development through financing and promoting projects and programs aimed at
reducing poverty and fostering economic growth. Here's an explanation of the key roles and
functions of the AfDB:

Economic Development and Poverty Reduction: The primary mission of the AfDB is to
promote economic development and reduce poverty in African countries. It achieves this by
providing financial resources and technical expertise to support a wide range of
development projects, including infrastructure, agriculture, healthcare, education, and more.
These projects aim to create jobs, improve living conditions, and enhance economic
opportunities for the people of Africa.

Infrastructure Development: The AfDB plays a crucial role in financing infrastructure

projects across the continent. This includes investments in transportation (such as roads,

Unit 12: Regional Development Banks 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

railways, and airports), energy (including electricity generation and distribution), water
supply and sanitation, and telecommunications. Infrastructure development is vital for
improving connectivity, promoting trade, and driving economic growth.

Private Sector Development: The AfDB also supports the growth and development of the
private sector in Africa. This involves providing funding and technical assistance to
businesses, entrepreneurs, and industries. A strong private sector can drive economic
growth, create jobs, and stimulate innovation and competitiveness.

Regional Integration: The AfDB promotes regional integration and cooperation among
African countries. By funding and facilitating projects that enhance cross-border trade,
infrastructure, and policy harmonization, the bank contributes to economic collaboration
and stability within the continent. This can lead to increased economic opportunities and
improved living standards.

Capacity Building and Technical Assistance: In addition to financial support, the AfDB offers
technical assistance and knowledge-sharing to its member countries. This capacity-building
support helps strengthen their ability to plan, implement, and manage development
initiatives effectively. It also includes sharing best practices and expertise to improve
governance and policy formulation.

Research and Policy Advocacy: The AfDB conducts research and analysis to gain a deeper
understanding of the economic and developmental challenges specific to African countries.
It uses this research to advocate for policies, reforms, and strategies that can foster economic
growth, reduce inequality, and promote sustainable development across the continent.

Climate Change and Environmental Sustainability: The AfDB recognizes the importance of
addressing environmental and climate-related challenges. It supports initiatives that
promote sustainability, including projects related to renewable energy, environmental
conservation, and climate resilience. This commitment is crucial for Africa, a region
particularly vulnerable to the impacts of climate change.

The African Development Bank serves as a critical partner in the development efforts of
African countries. By providing financial resources and expertise, it contributes to improving
the quality of life for people on the continent, fostering economic growth, and helping to

Unit 12: Regional Development Banks 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

alleviate poverty. Its role in infrastructure development, private sector support, and regional
integration also bolsters the continent's potential for sustainable development and
prosperity.

6. COUNCIL OF EUROPEAN DEVELOPMENT BANK

The Council of Europe Development Bank (CEB) is a multilateral development bank with an
exclusively social mandate. It was founded in 1956 and has 43 member states, all of which
are members of the Council of Europe. The CEB provides loans and technical expertise for
social projects in its member states, with a focus on promoting social cohesion and
strengthening social integration.

The CEB's lending priorities are:

• Refugees and migrants
• Health and social care
• Education and vocational training
• Administrative and judicial infrastructure
• Protection and rehabilitation of historic and cultural heritage
• Social and affordable housing
• Urban, rural, and regional development
• Natural or ecological disasters
• Protection of the environment
• MSME financing
• Microfinance

In 2022, the CEB approved €2.2 billion in new financing for projects in its member states.
These projects included:
• Construction of a new hospital in Ukraine
• Renovation of schools in Albania
• Support for refugees and migrants in Greece
• Development of social housing in Bulgaria
• Financing for small businesses in Moldova

Unit 12: Regional Development Banks 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The CEB is a major instrument of the policy of solidarity in Europe. It plays a vital role in
helping to improve the living conditions of the most disadvantaged population groups and
promoting a more just and equitable society.

7. INTER-AMERICAN DEVELOPMENT BANK

The Inter-American Development Bank (IDB), or Banco Interamericano de Desarrollo (BID)
in Spanish, is the largest source of development financing for Latin America and the
Caribbean. It was established in 1959 and is headquartered in Washington, D.C. The IDB is
an international financial institution that supports economic and social development in the
region through various means:

Financial Support: The IDB provides loans and grants to its member countries for a wide
range of projects and programs, including those related to infrastructure, education,
healthcare, and environmental sustainability. These funds help address the development
challenges in the region.

Technical Assistance: In addition to financial assistance, the IDB offers technical expertise to
help member countries design and implement effective development projects. This can
include knowledge sharing, policy advice, and capacity building.

Private Sector Development: The IDB also promotes the growth and development of the
private sector in Latin America and the Caribbean. It works to stimulate private investment,
support entrepreneurship, and improve the business environment.

Poverty Reduction: A significant focus of the IDB's work is poverty reduction. It supports
programs and projects that aim to lift people out of poverty and enhance social inclusion.

Environmental Sustainability: The IDB is committed to environmental sustainability and

supports projects that promote clean energy, natural resource conservation, and climate
resilience in the region.

Regional Integration: The IDB works to foster regional integration and cooperation among
its member countries. This can include initiatives to improve trade, transportation, and
infrastructure across borders.

Unit 12: Regional Development Banks 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Research and Knowledge Sharing: The IDB conducts research and analysis to better
understand the challenges and opportunities in the region. It shares its findings with
member countries and stakeholders to inform policy and decision-making.

The IDB comprises 48 member countries, including both Latin American and Caribbean
nations and non-regional members. It plays a vital role in promoting economic development,
reducing poverty, and enhancing the quality of life in the region. Its projects and initiatives
address a wide range of development needs and challenges across Latin America and the
Caribbean.

SELF-ASSESSMENT QUESTIONS – 2

11. What is the primary mission of the Asian Development Bank (ADB)?
a) Supporting cultural projects in the Asia-Pacific region.
b) Promoting social and economic progress in Asia and the Pacific.
c) Providing military aid to member countries.
d) Advocating for trade policies in the region.
12. What is one of the key functions of the ADB related to infrastructure?
a) Funding art installations in member countries.
b) Supporting renewable energy projects.
c) Promoting scientific research in the region.
d) Financing transportation and energy projects.
13. How does the ADB contribute to poverty reduction?
a) By organizing cultural events.
b) By promoting trade and business ventures.
c) By targeting marginalized populations and providing better access to
services.
d) By focusing on tourism development.

Unit 12: Regional Development Banks 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

14. What is the primary focus of the African Development Bank (AfDB)?
a) Promoting cultural heritage preservation.
b) Supporting European development projects.
c) Reducing poverty and fostering economic growth in African countries.
d) Funding infrastructure projects in Europe.
15. What does the AfDB prioritize in terms of its lending activities?
a) Supporting education and healthcare exclusively.
b) Promoting agricultural projects.
c) Reducing inequality among African countries.
d) Infrastructure development, including transportation and energy.
16. Why is the promotion of regional integration important for the AfDB?
a) To encourage conflict among African nations.
b) To increase competition among African businesses.
c) To enhance economic collaboration and stability in Africa.
d) To isolate African countries from global trade.
17. What is the main focus of the Council of Europe Development Bank (CEB)?
a) Supporting arts and cultural projects.
b) Promoting economic growth in Asia.
c) Exclusively financing urban development.
d) Promoting social cohesion and strengthening social integration in
member states.
18. What is one of the lending priorities of the CEB?
a) Funding space exploration projects.
b) Providing loans for small and medium-sized enterprises (MSMEs).
c) Focusing on administrative and judicial infrastructure.
d) Exclusively supporting refugee and migrant initiatives.

Unit 12: Regional Development Banks 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

19. What is the primary function of the Inter-American Development Bank (IDB)?
a) Focusing on Asia-Pacific development projects.
b) Promoting economic development in Latin America and the Caribbean.
c) Supporting exclusively environmental conservation efforts.
d) Advancing trade policies in Africa.
20. How does the IDB contribute to poverty reduction in the region?
a) By providing funding for art exhibitions.
b) By focusing on healthcare exclusively.
c) By supporting programs that lift people out of poverty and enhance social
inclusion.
d) By emphasizing tourism development.

Unit 12: Regional Development Banks 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. SUMMARY
Key Features of Regional Development Banks:
• Regional Focus: Operating within a specific geographic region, such as a continent or
group of neighbouring countries.
• Economic Development: Dedicated to stimulating economic growth and development
within their regions.
• Infrastructure Investment: Focusing on funding crucial infrastructure projects (e.g.,
transportation, energy, and water supply).
• Poverty Reduction: Many regional development banks aim to reduce poverty and
promote social inclusion.
• Technical Assistance: Offering expertise and capacity-building to support effective
project implementation.
• Long-Term Investment: Providing long-term financing for sustainable development.

Examples of Regional Development Banks:

• African Development Bank (AfDB): Serving African countries, focusing on reducing
poverty and promoting economic growth.
• Asian Development Bank (ADB): Dedicated to Asia and the Pacific, financing
infrastructure, sustainability, and social progress.
• Inter-American Development Bank (IDB): Supporting Latin America and the Caribbean
in infrastructure, development, and social progress.
• European Bank for Reconstruction and Development (EBRD): Fostering market-
oriented economies in Europe, Asia, and Northern Africa.
• East African Development Bank (EADB): Serving East African Community member
states to promote economic development and poverty reduction.

Origin of Regional Development Banks:

• Evolved to address specific economic, social, and developmental needs of regions and
countries.
• Emerged as a response to challenges related to regional development, infrastructure
investment, and economic growth.

Unit 12: Regional Development Banks 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Functions of Regional Development Banks:

• Financial Intermediation: Providing loans, grants, and financial resources for
development projects.
• Project Financing: Funding diverse projects, including infrastructure, social, and
economic initiatives.
• Technical Assistance: Offering expertise and capacity building for project success.
• Policy Advice: Providing guidance on economic and development policies.
• Risk Mitigation: Assisting countries in managing risks associated with development
projects.
• Research and Data Analysis: Conducting research to understand regional development
challenges.
• Promotion of Regional Integration: Fostering economic cooperation and trade among
member countries.

Objectives of Regional Development Banks:

• Poverty Reduction: Primary objective, improving living standards and reducing
poverty.
• Infrastructure Development: Focusing on enhancing regional infrastructure and
connectivity.
• Environmental Sustainability: Prioritizing green and sustainable practices.
• Economic Diversification: Encouraging growth in various sectors to reduce economic
dependence.
• Human Capital Development: Supporting education, healthcare, and social
development.
• Private Sector Development: Promoting entrepreneurship and SME growth.
• Inclusive Development: Ensuring benefits reach marginalized populations.
• Strengthening Governance and Institutions: Promoting good governance and
transparency.
• Economic Stability: Addressing economic imbalances and financial crises.
• Regional Cooperation: Fostering collaboration among member countries to address
shared challenges.

Unit 12: Regional Development Banks 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Asian Development Bank (ADB):

• Founded in 1966 to address Asia and the Pacific's economic and developmental needs.
• Supports infrastructure development in member countries (e.g., transportation,
energy, water).
• Aims to foster economic growth by providing financial resources and expertise.
• Focuses on reducing poverty and promoting social inclusion.
• Commits to environmental sustainability through renewable energy and climate
resilience.
• Offers technical assistance for capacity building and knowledge sharing.
• Promotes regional cooperation and advocates for policies based on research.

African Development Bank (AfDB):

• Established in 1964 to address challenges in African countries' economic development.
• Focuses on reducing poverty and promoting economic growth.
• Supports infrastructure development (e.g., transportation, energy) to boost
connectivity.
• Promotes private sector development and entrepreneurship.
• Encourages regional integration and cross-border cooperation.
• Provides technical assistance for capacity building.
• Conducts research to understand regional challenges and advocates for policy reforms.
• Addresses environmental sustainability and climate change.

Council of Europe Development Bank (CEB):

• Founded in 1956 with a social mandate.
• Provides loans and technical expertise for social projects in member states.
• Priorities include health, education, social housing, and environmental protection.
• Supports projects to aid refugees, migrants, and disadvantaged groups.
• Promotes social cohesion and integration.
• Enhances living conditions and social equity in Europe.

Inter-American Development Bank (IDB):

• Established in 1959 as the largest development financing source for Latin America and
the Caribbean.

Unit 12: Regional Development Banks 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Offers financial support for various projects, including infrastructure, education, and
healthcare.
• Provides technical assistance and expertise to member countries.
• Promotes private sector development, entrepreneurship, and poverty reduction.
• Commits to environmental sustainability, clean energy, and climate resilience.
• Fosters regional integration and cooperation in the region.
• Conducts research and knowledge sharing to inform policies and decision-making.

9. TERMINAL QUESTIONS
Question 1: What is the primary mission of regional development banks, and how do they
contribute to economic development within their specific regions?

Question 2: Can you provide examples of regional development banks and their unique
regional focuses? How do these banks address the specific challenges faced by their
respective regions?

Question 3: How have regional development banks evolved over time, and what were some
early initiatives in the development of these institutions?

Question 4: What functions do regional development banks serve, and what are their
primary objectives in promoting sustainable development?

Question 5: How do regional development banks contribute to inclusive development and

ensure that the benefits of development reach marginalized and vulnerable populations
within their regions?

Question 6: In what ways do regional development banks support environmental

sustainability and green practices in their development projects?

Question 7: How do regional development banks contribute to the economic stability of their
regions, and what measures do they take to help member countries navigate financial crises?

Question 8: What distinguishes regional development banks from international financial

institutions like the World Bank, and why are these regional institutions essential for
addressing the diverse needs of distinct regions?

Unit 12: Regional Development Banks 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 9: How have regional development banks become essential components of the
global development architecture, and how do they work alongside international
organizations to promote sustainable development?

Question 10: In summary, what is the overarching goal of regional development banks, and
how do they contribute to the overall well-being of the population in their respective
regions?

Question 11: What are the primary functions of the Inter-American Development Bank (IDB)
in promoting economic and social development in Latin America and the Caribbean?

Question 12: What is the primary mission of the Asian Development Bank (ADB), and how
does it contribute to infrastructure development in the Asia-Pacific region?

10. ANSWERS
Self-Assessment Questions
Answer 1: c) Supporting economic development and infrastructure projects within specific
regions

Answer 2: c) Poverty Reduction Worldwide

Answer 3: d) African Development Bank (AfDB)

Answer 4: c) Asia and the Pacific

Answer 5: c) Providing long-term financing for development projects.

Answer 6: c) Promoting social inclusion and poverty reduction.

Answer 7: d) Latin America and the Caribbean

Answer 8: b) To address the specific economic, social, and developmental needs of various
regions.

Answer 9: c) "Colonial Development Fund" in the British Empire

Answer 10: b) Supporting economic diversification.

Answer 11: b. Promoting social and economic progress in Asia and the Pacific.

Unit 12: Regional Development Banks 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 12: d. Financing transportation and energy projects.

Answer 13: c. By targeting marginalized populations and providing better access to services.

Answer 14: c. Reducing poverty and fostering economic growth in African countries.

Answer 15: d. Infrastructure development, including transportation and energy.

Answer 16: c. To enhance economic collaboration and stability in Africa.

Answer 17: d. Promoting social cohesion and strengthening social integration in member
states.

Answer 18: c. Focusing on administrative and judicial infrastructure.

Answer 19: b. Promoting economic development in Latin America and the Caribbean.

Answer 20: c. By supporting programs that lift people out of poverty and enhance social
inclusion.

Terminal Questions
Answer 1: The primary mission of regional development banks is to stimulate economic
development within their designated regions. They achieve this by providing financial
resources, technical assistance, and expertise to support projects that create jobs, improve
infrastructure, and enhance the overall economic environment. Through long-term
investments and a focus on infrastructure development, regional development banks play a
crucial role in promoting sustainable economic growth.

Answer 2: Regional development banks include institutions like the African Development
Bank (AfDB), Asian Development Bank (ADB), Inter-American Development Bank (IDB),
European Bank for Reconstruction and Development (EBRD), and East African Development
Bank (EADB). Each of these banks serves distinct regions and addresses region-specific
challenges. For instance, AfDB focuses on reducing poverty and promoting economic growth
in Africa, while ADB dedicates its efforts to the Asia and Pacific region, addressing unique
developmental needs in that area.

Unit 12: Regional Development Banks 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 3: The concept of regional development banks has evolved in response to the specific
economic and developmental needs of different regions. Early initiatives include the
"Colonial Development Fund" in the British Empire during the 1920s and the establishment
of regional agricultural banks in India. These early efforts laid the groundwork for the
development of modern regional development banks, which play a critical role in addressing
region-specific challenges.

Answer 4: Regional development banks have various functions, including financial

intermediation, project financing, technical assistance, policy advice, risk mitigation,
research, and promoting regional integration. Their primary objectives revolve around
reducing poverty, infrastructure development, environmental sustainability, economic
diversification, human capital development, private sector support, inclusive development,
strengthening governance and institutions, economic stability, and regional cooperation.
These objectives collectively contribute to sustainable development within their regions.

Answer 5: Regional development banks are committed to promoting inclusive development.

They achieve this by investing in projects that improve access to essential services and
generate jobs, thereby increasing income levels for marginalized communities. Additionally,
these banks often support social development projects, such as education and healthcare,
which benefit vulnerable populations and reduce disparities.

Answer 6: Regional development banks prioritize environmental sustainability by financing

projects that incorporate green and environmentally friendly practices. This includes
funding projects that address environmental challenges, promote energy efficiency, reduce
pollution, and contribute to overall sustainable development. These efforts align with global
environmental goals and regulations.

Answer 7: Regional development banks play a role in economic stability by offering policy
advice to member countries. They assist in addressing macroeconomic imbalances and
support countries in navigating financial crises. Additionally, these banks may provide risk
mitigation measures, such as risk guarantees and insurance, to attract private investment
and stabilize regional economies during turbulent times.

Unit 12: Regional Development Banks 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 8: Regional development banks are distinct from international financial institutions
like the World Bank due to their exclusive focus on specific regions or groups of countries.
These regional institutions are essential because they are better equipped to address the
diverse and unique needs of their respective regions. They can provide targeted support and
resources to tackle region-specific challenges effectively. International institutions, while
valuable, may not fully address the nuances of regional development.

Answer 9: Regional development banks have become integral parts of the global
development landscape by working in tandem with international organizations. They
provide region-specific expertise, targeted support, and a deep understanding of local
challenges. These banks collaborate with international organizations to collectively promote
sustainable development and address the unique challenges faced by different regions
worldwide.

Answer 10: The overarching goal of regional development banks is to support sustainable
development within their designated regions. They do this by reducing poverty, improving
infrastructure, supporting economic growth, promoting environmental sustainability,
fostering inclusive development, and strengthening governance. In doing so, they enhance
the overall well-being of the population in their respective regions, elevating living standards
and economic opportunities.

Answer 11: The primary functions of the IDB include providing financial support, technical
assistance, and promoting private sector development. These efforts contribute to economic
growth and social development in Latin America and the Caribbean.

Answer 12: The primary mission of the Asian Development Bank (ADB) is to promote social
and economic progress in the region. ADB contributes to infrastructure development by
supporting projects related to transportation, energy, water supply, and
telecommunications. These projects are vital for improving connectivity and enhancing the
quality of life in the Asia-Pacific region.

Unit 12: Regional Development Banks 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 13: Global Financial Regulations 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 13
Global Financial Regulations
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-4
1.1 Learning Objectives - -
2 Sub-prime Crisis - - 5
3 The Global Financial Crisis 2007 - - 6
4 Causes of Global Financial Crisis 2007 - - 7-9
5 Why US subprime crisis 2007 spread to all parts - - 10-11
of world?
6 Regulatory changes made by US government - - 11-13
after Global Financial Crisis 2007
7 Dodd-Frank Reform Act - - 13-14
8 The Volcker Rule - 1 15-18
9 Basel III - - 19-21
10 Role of Insurance Sector firms like AIG, Freddie - -
Mae and Freddie Mac etc in Global Financial 21-22
Crisis
11 Regulations after global financial crisis over the - 2 23-26
functioning of financial institutions
12 Summary - - 26-28
13 Terminal Questions - - 29-30
14 Answer - - 30-33

Unit 13: Global Financial Regulations 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
The global financial crisis of 2007-2008, triggered by the collapse of the U.S. subprime
mortgage market, had far-reaching consequences that spread across the world due to several
interconnected factors. A key element was the high level of global financial
interconnectedness, as financial institutions worldwide held complex and often opaque
assets linked to U.S. subprime mortgages. Losses and uncertainties related to these assets
caused a crisis of confidence in international financial institutions. Furthermore, a credit
freeze emerged as banks became reluctant to lend to each other, hindering economic activity
and creating a financial stress cycle. Investor panic exacerbated the situation as withdrawals
and fear of financial instability spread globally. The contagious nature of concerns about the
health of financial institutions resulted in the withdrawal of funds from banks in various
countries, propagating financial insecurity. The globalization of finance meant that
vulnerabilities in one part of the world could swiftly impact others. The crisis also disrupted
currency markets and international trade, causing challenges for multinational corporations.
In response to these events, the U.S. government implemented a series of regulatory changes
through the Dodd-Frank Act, Basel III, and other measures to enhance oversight,
transparency, and consumer protection in the financial system and to mitigate the risk of a
similar crisis in the future, emphasizing the need for prudent financial practices and
comprehensive regulatory oversight to safeguard the global economy. The Volcker Rule, a
part of Dodd-Frank, specifically aimed to prevent banks from engaging in risky proprietary
trading and high-risk investments in hedge funds and private equity funds to reduce
excessive risk-taking.

The Basel Accords, comprising Basel I, Basel II, and Basel III, represent a series of
international banking regulations and standards developed by the Basel Committee on
Banking Supervision (BCBS) to promote prudent and consistent banking supervision across
the globe. Basel I, introduced in 1988, established the first international capital standards for
banks, albeit with limitations. Basel II, in 2004, addressed these limitations with a more risk-
sensitive framework, focusing on minimum capital requirements, supervisory review
processes, and market discipline. However, it was Basel III, implemented after the 2007-
2008 global financial crisis, that made substantial strides in enhancing the stability and
resilience of the global banking system. Basel III emphasized higher capital standards,

Unit 13: Global Financial Regulations 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

introducing Common Equity Tier 1 (CET1) capital and a leverage ratio to prevent
overborrowing. It also imposed liquidity coverage and net stable funding ratios to ensure
banks can meet their obligations even during financial stress. Moreover, it addressed
counterparty credit risk and emphasized robust risk management practices within banks.
These reforms aimed to minimize the risk of financial crises by preparing banks to withstand
economic downturns, reduce the likelihood of insolvency, and safeguard the broader
financial system. Furthermore, the crisis underscored the pivotal roles of insurance sector
firms like AIG, heavily involved in credit default swaps, and government-sponsored entities
(GSEs) Fannie Mae and Freddie Mac, which amplified the proliferation of risky mortgages.
The crisis prompted a wave of post-crisis regulatory changes, including the Dodd-Frank Wall
Street Reform and Consumer Protection Act, which established the Consumer Financial
Protection Bureau and introduced the Volcker Rule, among other reforms. These changes,
along with Basel III, improved transparency, oversight, and capital and liquidity
requirements, ensuring that financial institutions are better prepared to weather economic
challenges and protect consumers, while minimizing systemic risks.

1.1 Learning Objectives

❖ Define and explain the Global Financial Crisis of 2007-2008, including its primary causes
and key consequences.
❖ Explain how the crisis spread from the United States to impact financial institutions and
markets worldwide, highlighting factors like financial interconnectedness, the credit
freeze, investor panic, contagion effects, and the globalization of finance.
❖ Analyse the fiscal costs associated with government bailouts and the implications of
increased government debt in the aftermath of the crisis.
❖ Understand the Basel Accords: Define the Basel Accords and their significance in
providing a framework for international banking regulations and risk management.
❖ Evaluate Post-Crisis Regulatory Reforms: Investigate the regulatory changes and reforms
that were implemented after the 2007-2008 financial crisis, including the Dodd-Frank
Wall Street Reform and Consumer Protection Act, Basel III, stress tests, and enhanced
capital and liquidity requirements.

Unit 13: Global Financial Regulations 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. SUB-PRIME CRISIS
The subprime mortgage crisis of 2007 was a catastrophic event that unfolded in the United
States and sent shockwaves throughout the global financial system. At its core, the crisis
stemmed from a housing bubble that had been inflating for years, driven by relaxed lending
standards. Lenders issued an abundance of subprime mortgages to borrowers with poor
credit histories, many of which had adjustable interest rates that later skyrocketed, causing
borrowers to default on their loans. These subprime mortgages were bundled into complex
financial products known as mortgage-backed securities (MBS), which were often
considered safe investments. However, when housing prices began to decline, the value of
these MBS plummeted. Financial institutions worldwide, including major banks and
insurance companies, found themselves laden with toxic assets, leading to substantial losses
and even bankruptcy. The ensuing panic and credit freeze reverberated through the global
financial system, with governments and central banks stepping in with massive bailouts to
avert a complete meltdown. The crisis exposed the vulnerabilities of a highly interconnected
financial system, leading to regulatory reforms and changes aimed at preventing a similar
catastrophe in the future, including the Dodd-Frank Act and the Volcker Rule.

Unit 13: Global Financial Regulations 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. THE GLOBAL FINANCIAL CRISIS 2007

The global financial crisis of 2007-2008 unleashed a tidal wave of bank failures and near-
collapses, sending shockwaves throughout the world's financial markets. One of the most
iconic casualties was Lehman Brothers, which succumbed to its substantial exposure to the
subprime mortgage market and severe liquidity shortages, ultimately filing for bankruptcy
in September 2008. However, Lehman Brothers was far from alone in its struggle. Numerous
other financial institutions, including major investment banks, commercial banks, and
insurance companies, found themselves grappling with significant losses and liquidity
challenges.

In response to the growing financial turmoil, governments and central banks initiated a
series of massive bailouts to prevent further collapses. These bailouts aimed to stabilize the
financial system, rebuild eroding confidence, and ward off the looming specter of an
economic catastrophe. Governments injected substantial capital into struggling financial
institutions, fortifying their balance sheets and enhancing their capacity to absorb losses.
Troublesome assets, such as toxic mortgage-backed securities, were purchased from these
institutions to cleanse their books. Loan guarantees were offered to reassure creditors and
depositors, effectively averting bank runs. In some cases, governments temporarily
nationalized or assumed significant ownership stakes in troubled banks to ensure their
stability. Furthermore, international coordination among central banks was crucial, given
the global footprint of many affected institutions.

While these government bailouts were instrumental in preventing a complete meltdown of

the financial system, they came at a significant fiscal cost, burdening governments with
massive debts. The crisis and its aftermath prompted a heightened focus on regulatory
scrutiny and the implementation of reforms to mitigate the risk of a similar catastrophe in
the future. One of the prominent responses in the United States was the Troubled Asset Relief
Program (TARP), which provided crucial capital injections to banks and other financial
institutions. The legacy of the 2007-2008 financial crisis underscores the importance of
vigilance, prudent financial practices, and comprehensive regulatory oversight to safeguard
the global economy from the perils of unchecked financial excesses.

Unit 13: Global Financial Regulations 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

4. CAUSES OF GLOBAL FINANCIAL CRISIS 2007

The global financial crisis of 2007 had multiple interconnected causes, which combined to
create a perfect storm in the financial system. Some of the key factors that contributed to the
crisis include:

Subprime Mortgage Crisis: One of the primary triggers was the collapse of the subprime
mortgage market in the United States. Lenders had issued a significant number of high-risk
mortgage loans to homebuyers with poor credit histories. When many of these borrowers
began to default on their mortgage payments, it led to a sharp decline in the value of
mortgage-backed securities (MBS) that were based on these loans.

Housing Bubble: A housing bubble had been developing for several years, causing home
prices to soar to unsustainable levels. When the bubble burst, it resulted in a glut of unsold
homes and a rapid decline in housing prices, causing many homeowners to owe more on
their mortgages than their homes were worth.

Complex Financial Products: The widespread use of complex financial products like
collateralized debt obligations (CDOs) and credit default swaps (CDS) added to the crisis.
These products were designed to spread and manage risk but had the unintended
consequence of amplifying the crisis when the underlying assets (such as subprime
mortgages) started to fail.

Lax Regulatory Oversight: Regulatory agencies failed to effectively oversee and regulate
financial institutions. The lack of transparency in financial products and inadequate risk
management practices allowed risky lending to continue unchecked.

Excessive Leverage: Many financial institutions were highly leveraged, meaning they had
borrowed large sums of money to invest in various assets. When the value of these assets
declined, it eroded their capital and left them vulnerable to insolvency.

Global Interconnectedness: The global nature of financial markets meant that problems in
one part of the world quickly spread to others. Many large financial institutions had exposure
to risky assets and complex products that spanned international borders.

Unit 13: Global Financial Regulations 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Bank Failures and Panic: As prominent financial institutions like Lehman Brothers faced
insolvency and collapsed, it led to widespread panic and a loss of confidence in the broader
financial system. This panic made it increasingly difficult for financial institutions to access
short-term funding, exacerbating the crisis.

Credit Freeze: A freeze in the credit markets occurred as banks became reluctant to lend to
each other. This reluctance was driven by concerns about the financial health of
counterparties, making it challenging for businesses and consumers to obtain credit.

Global Economic Factors: The crisis was also influenced by broader economic factors,
including rising oil prices, a slowdown in economic growth, and increasing global
imbalances.

Psychological Factors: Investor sentiment and confidence played a significant role. Once
panic and fear took hold, markets reacted with extreme volatility and sharp declines.

These multiple and interconnected factors combined to create a financial crisis that had far-
reaching consequences, including the collapse of major financial institutions, severe
economic downturns, and widespread loss of jobs and homes. It also led to a series of
government interventions and regulatory changes to prevent a similar crisis in the future.

The U.S. subprime crisis of 2007 had profound and far-reaching implications that rippled
across the globe due to several key interconnected factors. First and foremost was the high
level of global financial interconnectedness. Financial institutions worldwide held complex
and often opaque financial products tied to U.S. subprime mortgages, such as mortgage-
backed securities (MBS) and collateralized debt obligations (CDOs). As housing prices in the
United States began to decline, and subprime mortgage defaults surged, the value and quality
of these assets came into question. This uncertainty reverberated through the
interconnected web of the global financial system.

Global banks had substantial exposure to U.S. housing and mortgage-related securities.
Major European and Asian financial institutions had invested heavily in these assets. As
losses mounted, this exposure caused a crisis of confidence in financial institutions
worldwide, contributing to the spread of the crisis.

Unit 13: Global Financial Regulations 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Another pivotal factor was the credit freeze. As the crisis deepened, banks and financial
institutions became increasingly reluctant to lend to each other. This freeze in interbank
lending further exacerbated the situation by making it difficult for businesses and consumers
around the world to access credit. It hindered economic activities and created a vicious cycle
of financial stress.

The crisis triggered widespread investor panic. As financial institutions faced insolvency or
uncertainty, investors started to withdraw their investments, setting off a domino effect that
reverberated globally. The fear of financial instability quickly spread across international
markets, adding to the turmoil.

The contagion effect played a crucial role in transmitting the crisis. Fears and concerns about
the health of financial institutions were highly contagious. Investors and depositors in
various countries began withdrawing their funds from their own banks, spreading financial
insecurity to other parts of the world.

Moreover, the globalization of finance played a significant role. Financial institutions

operated across borders, and capital flowed globally, as did financial products. This meant
that vulnerabilities in one part of the world could swiftly impact others.

The U.S. subprime crisis also had a profound impact on currency markets and international
trade. Exchange rate fluctuations added challenges for multinational corporations, and the
weakening of economies worldwide led to a decline in demand for goods and services,
impacting global trade.

Ultimately, the U.S. subprime crisis spread to all parts of the world due to the complex web
of financial interconnections, the vulnerability of major global banks, the credit freeze,
investor panic, contagion effects, the globalization of finance, and its impact on currency and
trade. It underscored the challenges and risks inherent in a highly interconnected and
globalized financial system.

Unit 13: Global Financial Regulations 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

5. WHY US SUBPRIME CRISIS 2007 SPREAD TO ALL PARTS OF WORLD?

The U.S. subprime crisis of 2007 had profound and far-reaching implications that rippled
across the globe due to several key interconnected factors. First and foremost was the high
level of global financial interconnectedness. Financial institutions worldwide held complex
and often opaque financial products tied to U.S. subprime mortgages, such as mortgage-
backed securities (MBS) and collateralized debt obligations (CDOs). As housing prices in the
United States began to decline, and subprime mortgage defaults surged, the value and quality
of these assets came into question. This uncertainty reverberated through the
interconnected web of the global financial system.

Global banks had substantial exposure to U.S. housing and mortgage-related securities.
Major European and Asian financial institutions had invested heavily in these assets. As
losses mounted, this exposure caused a crisis of confidence in financial institutions
worldwide, contributing to the spread of the crisis.

Another pivotal factor was the credit freeze. As the crisis deepened, banks and financial
institutions became increasingly reluctant to lend to each other. This freeze in interbank
lending further exacerbated the situation by making it difficult for businesses and consumers
around the world to access credit. It hindered economic activities and created a vicious cycle
of financial stress.

The crisis triggered widespread investor panic. As financial institutions faced insolvency or
uncertainty, investors started to withdraw their investments, setting off a domino effect that
reverberated globally. The fear of financial instability quickly spread across international
markets, adding to the turmoil.

The contagion effect played a crucial role in transmitting the crisis. Fears and concerns about
the health of financial institutions were highly contagious. Investors and depositors in
various countries began withdrawing their funds from their own banks, spreading financial
insecurity to other parts of the world.

Moreover, the globalization of finance played a significant role. Financial institutions

operated across borders, and capital flowed globally, as did financial products. This meant
that vulnerabilities in one part of the world could swiftly impact others.

Unit 13: Global Financial Regulations 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

The U.S. subprime crisis also had a profound impact on currency markets and international
trade. Exchange rate fluctuations added challenges for multinational corporations, and the
weakening of economies worldwide led to a decline in demand for goods and services,
impacting global trade.

Ultimately, the U.S. subprime crisis spread to all parts of the world due to the complex web
of financial interconnections, the vulnerability of major global banks, the credit freeze,
investor panic, contagion effects, the globalization of finance, and its impact on currency and
trade. It underscored the challenges and risks inherent in a highly interconnected and
globalized financial system.

6. REGULATORY CHANGES MADE BY US GOVERNMENT AFTER GLOBAL

FINANCIAL CRISIS 2007

In response to the global financial crisis of 2007-2008, the U.S. government introduced
significant regulatory changes aimed at preventing a similar crisis and enhancing the
stability of the financial system. Some of the key regulatory changes and legislative actions
include:

Dodd-Frank Wall Street Reform and Consumer Protection Act: This comprehensive financial
reform legislation, signed into law in July 2010, introduced a wide range of regulatory
changes. Some key provisions of Dodd-Frank include:

Creation of the Consumer Financial Protection Bureau (CFPB): The CFPB was established to
protect consumers from abusive financial practices and ensure transparency in financial
products and services.

Volcker Rule: Named after former Federal Reserve Chairman Paul Volcker, this rule restricts
the ability of banks to engage in proprietary trading and limits their investments in hedge
funds and private equity funds.

Financial Stability Oversight Council (FSOC): FSOC was formed to monitor and address risks
to the stability of the U.S. financial system, with the authority to designate certain non-bank
financial companies as systemically important.

Unit 13: Global Financial Regulations 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Increased Oversight of Derivatives Markets: Dodd-Frank introduced regulations to bring

transparency and oversight to the derivatives markets, including the requirement for
standardized derivatives to be cleared through central counterparties.

Enhanced Capital and Liquidity Requirements: The law required stricter capital and liquidity
requirements for banks, reducing their leverage and increasing their resilience.

Resolution Authority for Large Financial Firms: The law established a framework for the
orderly resolution of large, failing financial institutions to prevent taxpayer-funded bailouts.

Volcker Rule: This rule, a part of the Dodd-Frank Act, aimed to prevent banks from engaging
in proprietary trading and imposed limits on their investments in hedge funds and private
equity funds. It was intended to reduce excessive risk-taking by banks.

Basel III: The United States, in line with international efforts, implemented the Basel III
framework for banking regulation. Basel III introduced stricter capital and liquidity
requirements, along with enhanced risk management practices.

Stress Tests and Capital Adequacy: U.S. regulators, including the Federal Reserve,
implemented regular stress tests for banks to assess their capital adequacy and ability to
withstand economic downturns. These stress tests have become a key tool for supervising
and regulating large financial institutions.

Creation of the Financial Stability Oversight Council (FSOC): This council was established to
identify and respond to emerging risks to the stability of the U.S. financial system. It has the
authority to designate certain non-bank financial firms as systemically important, subjecting
them to enhanced regulatory oversight.

Consumer Protection: The establishment of the Consumer Financial Protection Bureau

(CFPB) was a significant regulatory change aimed at protecting consumers from predatory
lending practices and ensuring transparency in financial products.

Regulation of Mortgage Markets: Regulatory changes focused on the mortgage market,

including requirements for better underwriting standards, more transparency, and greater
borrower protections.

Unit 13: Global Financial Regulations 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Resolution Planning: Financial institutions were required to create "living wills" or

resolution plans to facilitate their orderly resolution in the event of a financial crisis. This
was designed to prevent the "too big to fail" problem.

These regulatory changes were implemented to address the weaknesses and gaps that
became apparent during the financial crisis and to enhance the overall stability and
transparency of the financial system. They have had a lasting impact on the financial industry
and continue to shape the regulatory environment in the United States

7. DODD-FRANK REFORM ACT

The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as
the Dodd-Frank Act, is a significant piece of financial regulation passed in the United States
in response to the 2007-2008 global financial crisis. This comprehensive legislation
introduced a range of reforms aimed at addressing various shortcomings in the financial
system and enhancing consumer protection. Here are the key components and objectives of
the Dodd-Frank Act:

Financial Stability Oversight Council (FSOC): The Dodd-Frank Act created the FSOC, which is
responsible for monitoring and addressing systemic risks in the U.S. financial system. The
council consists of representatives from different federal regulatory agencies and is chaired
by the Secretary of the Treasury. Its role is to identify emerging threats to financial stability
and take action to mitigate them.

Consumer Financial Protection Bureau (CFPB): The CFPB is an independent agency

established by the Dodd-Frank Act with the primary mission of protecting consumers in
financial markets. It consolidates consumer protection responsibilities that were previously
scattered across various agencies. The CFPB enforces laws related to consumer financial
products and services, such as mortgages, credit cards, and student loans, to ensure that
consumers are treated fairly and transparently.

Enhanced Regulatory Oversight: The Dodd-Frank Act introduced measures to strengthen

regulatory oversight of financial institutions, particularly large banks and non-bank financial
entities. It granted regulatory authorities the power to monitor these institutions more

Unit 13: Global Financial Regulations 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

closely, subject them to higher capital and liquidity requirements, and conduct stress tests
to assess their ability to withstand economic downturns.

Volcker Rule: Named after former Federal Reserve Chairman Paul Volcker, this rule restricts
banks from engaging in proprietary trading, which involves making speculative trades for
their profit. It also limits their investments in hedge funds and private equity funds. The
Volcker Rule was implemented to reduce the risk-taking behavior of banks and prevent them
from making bets that could endanger their stability.

Resolution Authority: The Dodd-Frank Act established a framework for resolving large
financial institutions that face insolvency. This framework provides a structured process for
winding down or "unwinding" failing financial firms to prevent a repeat of the massive
taxpayer-funded bailouts seen during the financial crisis.

Increased Transparency: The act introduced measures to enhance transparency in financial

markets. It mandated greater disclosure of financial information and required financial
institutions to provide more information to regulators and the public.

Credit Rating Agency Reforms: The act addressed issues related to credit rating agencies,
aiming to reduce conflicts of interest and improve the accuracy of credit ratings. This was in
response to concerns that inflated credit ratings had contributed to the financial crisis.

Derivatives Regulation: The Dodd-Frank Act aimed to increase oversight of the derivatives
market, particularly by regulating over the counter (OTC) derivatives. It required
standardized derivatives to be cleared through central clearinghouses and traded on
organized exchanges, enhancing transparency, and reducing risk.

The Dodd-Frank Act represents a comprehensive effort to reform the U.S. financial system,
prevent a recurrence of the 2007-2008 financial crisis, and protect consumers from abusive
financial practices. While it has been subject to debate and some modifications since its
enactment, it remains a cornerstone of financial regulation in the United States.

Unit 13: Global Financial Regulations 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. THE VOLCKER RULE

This was named after former Federal Reserve Chairman Paul Volcker, is a crucial component
of financial regulation introduced in the United States as part of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, following the 2007-2008 global financial crisis. This
rule was implemented to address and reduce risky behaviour by banks, particularly in the
areas of proprietary trading and investments in hedge funds and private equity funds.

Proprietary Trading: One of the primary aspects of the Volcker Rule is its restriction on
proprietary trading. Proprietary trading refers to a bank's practice of engaging in speculative
trading activities for its profit, rather than on behalf of its clients. This can involve making
high-risk bets in financial markets. The rule limits the ability of banks to make these
speculative trades, as such activities were seen as contributing to excessive risk-taking that
could threaten the financial stability of banks.

Investments in Hedge Funds and Private Equity Funds: The Volcker Rule also places
restrictions on banks' investments in hedge funds and private equity funds. Banks are
limited in the amount of ownership interest they can hold in these types of investment
vehicles. This is aimed at reducing conflicts of interest and preventing banks from taking
undue risks in these areas, which could potentially lead to significant losses.

The underlying philosophy of the Volcker Rule is to separate traditional banking activities,
such as accepting deposits and providing loans, from riskier trading and investment
activities. By doing so, the rule aims to protect the financial system from the potential fallout
of speculative trading losses and investments in higher-risk assets.

The implementation of the Volcker Rule required affected banks to establish compliance
programs, monitor and report on their trading activities, and make structural changes to
ensure they comply with the rule's requirements. These structural changes often involve
creating separate entities or divisions within the bank for proprietary trading and
investments in hedge funds and private equity funds.

Overall, the Volcker Rule is designed to enhance the stability of the financial system by
curbing excessive risk-taking by banks. It helps to prevent a situation where taxpayer-
funded bailouts may be required to rescue banks that engage in high-risk trading activities

Unit 13: Global Financial Regulations 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

or investments. While it has been a subject of debate and some revisions since its
introduction, the rule remains an important element of financial regulation in the United
States.

SELF-ASSESSMENT QUESTIONS – 1

1. What major event marked the onset of the global financial crisis of 2007-
2008?
a) Lehman Brothers bankruptcy
b) Passage of Dodd-Frank Act
c) Housing market boom
d) Rise in consumer spending
2. What was one of the key factors contributing to the global financial crisis?
a) Strong regulatory oversight
b) Decreasing housing prices
c) Reduced complexity of financial products.
d) Stable global economic growth
3. Which regulatory change aimed to prevent banks from engaging in
proprietary trading and investing in hedge funds and private equity funds?
a) Basel III
b) Dodd-Frank Act
c) The Volcker Rule
d) Consumer Financial Protection Bureau (CFPB)
4. What international regulatory framework imposed stricter capital and
liquidity requirements on banks to enhance resilience and reduce the risk of
a banking crisis?
a) Basel III
b) Volcker Rule
c) Dodd-Frank Act
d) Troubled Asset Relief Program (TARP)

Unit 13: Global Financial Regulations 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

5. Which agency was created by the Dodd-Frank Act to protect consumers from
abusive financial practices and ensure transparency in financial products
and services?
a) Financial Stability Oversight Council (FSOC)
b) Consumer Financial Protection Bureau (CFPB)
c) Federal Reserve
d) Office of the Comptroller of the Currency (OCC)
6. The freezing of credit markets during the global financial crisis made it
challenging for businesses and consumers to access credit. What term
describes this situation?
a) Credit expansion
b) Credit boom
c) Credit freeze
d) Credit liquidity
7. What international body played a crucial role in introducing reforms to
address the weaknesses in the global financial system after the 2007-2008
crisis?
a) United Nations (UN)
b) International Monetary Fund (IMF)
c) Basel Committee on Banking Supervision
d) World Trade Organization (WTO)
8. What key aspect of the Volcker Rule aims to protect the financial system from
the potential fallout of speculative trading losses?
a) Restricting investments in hedge funds
b) Limiting proprietary trading.
c) Increasing bank ownership of private equity funds.
d) Encouraging risk-taking behaviour by banks.

Unit 13: Global Financial Regulations 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

9. Which piece of legislation was instrumental in providing capital injections to

banks and other financial institutions during the financial crisis in the United
States?
a) Basel III
b) Dodd-Frank Act
c) Volcker Rule
d) Troubled Asset Relief Program (TARP)
10. What primary objective of the Dodd-Frank Act was aimed at preventing
taxpayer-funded bailouts of large failing financial institutions?
a) Enhancing consumer protection.
b) Promoting transparency in financial markets.
c) Establishing the Consumer Financial Protection Bureau (CFPB)
d) Creating a framework for the orderly resolution of financial firms

Unit 13: Global Financial Regulations 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

9. BASEL III
The Basel norms, also known as the Basel Accords, are a set of international banking
regulations and standards that provide a framework for prudent and consistent banking
supervision and regulation across the world. They are developed by the Basel Committee on
Banking Supervision (BCBS), which is a committee of banking supervisory authorities from
different countries. The Basel norms aim to enhance the stability and integrity of the global
financial system by promoting sound banking practices and risk management. There are
three main sets of Basel Accords:

Basel I (1988): Basel I, also known as the 1988 Basel Accord, introduced the first
international capital standards for banks. It established a minimum capital requirement,
commonly known as the "8-4-4" framework, which required banks to maintain a minimum
capital adequacy ratio of 8% of risk-weighted assets. This framework classified assets into
three risk categories: 0%, 20%, and 100%, based on the perceived credit risk of borrowers.
Basel I was a crucial step in standardizing capital requirements, but it had limitations,
especially in addressing the complexity of modern financial markets.

Basel II (2004): Basel II, also known as the 2004 Basel Accord, was developed to address the
shortcomings of Basel I. It introduced a more risk-sensitive framework, which aimed to align
capital requirements more closely with a bank's actual risk profile. Basel II included three
pillars: minimum capital requirements (similar to Basel I), supervisory review processes
(allowing regulators to assess a bank's internal risk management systems), and market
discipline (enhancing transparency and disclosure). This accord provided more flexibility
and sophistication in assessing and managing risks.

Basel III is a crucial international regulatory framework introduced by the Basel Committee
on Banking Supervision to enhance the stability and resilience of the global banking system
in the aftermath of the 2007-2008 financial crisis. It implements stricter capital and liquidity
requirements for banks to reduce the risk of financial shocks and potential banking crises.
Here's a detailed explanation of Basel III's key components and objectives:

Capital Adequacy: Basel III sets higher standards for the amount and quality of capital that
banks must hold as a buffer against losses. The framework introduces the concept of

Unit 13: Global Financial Regulations 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Common Equity Tier 1 (CET1) capital, which consists of the most reliable and highest-quality
capital, including common equity. Banks are required to maintain a minimum CET1 capital
ratio to ensure they can absorb losses without becoming insolvent.

Leverage Ratio: Basel III introduces a leverage ratio that limits a bank's borrowing relative
to its capital. This is designed to prevent excessive borrowing and leverage, which played a
significant role in the 2007-2008 crisis. It serves as a safeguard against banks taking on too
much debt and becoming overleveraged.

Liquidity Coverage Ratio (LCR): The LCR requires banks to hold sufficient high-quality liquid
assets to cover their short-term liquidity needs during times of financial stress. This helps
ensure that banks can meet their obligations even when sources of funding dry up.

Net Stable Funding Ratio (NSFR): The NSFR is designed to promote more stable and longer-
term sources of funding for banks. It encourages banks to rely less on short-term, potentially
volatile funding sources. This reduces the risk of a bank being unable to roll over its debt in
a crisis.

Counterparty Credit Risk: Basel III addresses counterparty credit risk in derivatives and
other financial contracts by requiring banks to hold capital to cover potential losses. This
reduces the risk of financial contagion resulting from counterparty failures.

Risk Management and Governance: The framework places an emphasis on enhanced risk
management practices and governance within banks. It encourages banks to implement
more robust risk assessment, monitoring, and control measures to prevent excessive risk-
taking.

The primary objective of Basel III is to ensure that banks are better prepared to withstand
economic and financial downturns, making them less susceptible to crises like the one
witnessed in 2007-2008. By demanding higher levels of capital and more prudent liquidity
management, Basel III reduces the likelihood that banks will face insolvency during
turbulent times, minimizing the need for government bailouts and protecting the broader
financial system.

Unit 13: Global Financial Regulations 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

However, it's important to note that the implementation of Basel III has faced some
challenges and variations across different countries and regions. Nevertheless, it represents
a critical step toward improving the stability of the global banking system and reducing
systemic risks.

10. ROLE OF INSURANCE SECTOR FIRMS LIKE AIG, FREDDIE MAE AND
FREDDIE MAC ETC IN GLOBAL FINANCIAL CRISIS

Insurance sector firms like AIG and government-sponsored entities (GSEs) like Fannie Mae
and Freddie Mac played significant roles in the global financial crisis of 2007-2008. Here's
an overview of their roles in the crisis:

AIG (American International Group):

Credit Default Swaps (CDS): AIG's major role in the crisis was its extensive involvement in
the market for credit default swaps (CDS). A CDS is a financial contract that offers protection
against the default of a financial security or borrower. AIG had issued a substantial amount
of CDS, primarily insuring mortgage-backed securities (MBS) and collateralized debt
obligations (CDOs).

Massive Exposure to Subprime Mortgages: AIG's financial products division had sold large
volumes of CDS to investors holding MBS and CDOs backed by subprime mortgages. As the
subprime market deteriorated and mortgage defaults surged, the value of these securities
declined, causing AIG substantial losses.

Liquidity Crisis: AIG's inability to cover the losses stemming from the CDS it had issued
created a severe liquidity crisis. Credit rating agencies downgraded AIG's credit rating,
making it difficult to raise funds or meet its obligations. The fear of AIG's insolvency sent
shockwaves through the financial system.

Fannie Mae and Freddie Mac:

Secondary Mortgage Market: Fannie Mae and Freddie Mac were government-sponsored
enterprises that played a central role in the U.S. housing market. They purchased mortgages
from banks and other lenders, providing liquidity to the mortgage market and enabling
banks to originate more loans.

Unit 13: Global Financial Regulations 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Proliferation of Risky Mortgages: Fannie Mae and Freddie Mac played a role in the
proliferation of risky mortgages because they bought and securitized large volumes of
subprime and Alt-A mortgages. This contributed to the housing bubble and the eventual
burst, which had a cascading effect on the broader financial system.

Government Bailout: In September 2008, as Fannie Mae and Freddie Mac faced insolvency,
the U.S. government took them into conservatorship. This involved a government bailout and
the commitment to provide capital to keep them solvent. The potential failure of these GSEs
would have caused further distress in the housing market and financial system.

The combined effect of AIG's near-collapse, fuelled by its exposure to CDS tied to subprime
mortgages, and the insolvency of Fannie Mae and Freddie Mac, which had bought and
securitized risky mortgages, had a profound impact on the global financial crisis. It
undermined confidence in the financial markets, caused significant losses for institutions
holding their securities, and created a sense of crisis that contributed to the broader
economic downturn.

These events highlighted the systemic risks associated with large, interconnected financial
institutions, leading to calls for improved regulation and oversight of both insurance sector
firms and GSEs. It also demonstrated the need for more stringent risk management practices
and a greater focus on the quality of assets held by these entities.

Unit 13: Global Financial Regulations 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

11. REGULATIONS AFTER GLOBAL FINANCIAL CRISIS OVER THE

FUNCTIONING OF FINANCIAL INSTITUTIONS

The global financial crisis of 2007-2008 led to a series of regulatory changes and reforms
aimed at enhancing the functioning of financial institutions and mitigating the risk of a
similar crisis in the future. Some of the key regulations and reforms that came into effect
after the crisis include:

Dodd-Frank Wall Street Reform and Consumer Protection Act: This comprehensive piece of
legislation, signed into law in 2010, introduced a wide range of regulatory changes. Some of
the key provisions of Dodd-Frank include:

Consumer Financial Protection Bureau (CFPB): The creation of CFPB aimed to protect
consumers from abusive financial practices and ensure transparency in financial products
and services.

Volcker Rule: Named after former Federal Reserve Chairman Paul Volcker, this rule restricts
banks from engaging in proprietary trading and limits their investments in hedge funds and
private equity funds.

Financial Stability Oversight Council (FSOC): FSOC was formed to monitor and address risks
to the stability of the U.S. financial system, with the authority to designate certain non-bank
financial companies as systemically important.

Increased Oversight of Derivatives Markets: Dodd-Frank introduced regulations to bring

transparency and oversight to the derivatives markets.

Enhanced Capital and Liquidity Requirements: The law required stricter capital and liquidity
requirements for banks, reducing their leverage and increasing their resilience.

Basel III: The Basel III framework for banking regulation was implemented in the United
States, in line with international efforts. Basel III introduced stricter capital and liquidity
requirements, along with enhanced risk management practices for banks.

Stress Tests and Capital Adequacy: U.S. regulators, including the Federal Reserve,
implemented regular stress tests for banks to assess their capital adequacy and ability to

Unit 13: Global Financial Regulations 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

withstand economic downturns. These stress tests have become a key tool for supervising
and regulating large financial institutions.

Resolution Authority: The U.S. government established a framework for the orderly
resolution of large, failing financial institutions to prevent taxpayer-funded bailouts.

Increased Transparency and Reporting: Financial institutions were required to enhance

transparency in their operations and improve reporting standards, allowing regulators and
the public to better understand their risk exposure.

Regulation of Credit Rating Agencies: The regulation of credit rating agencies was
strengthened to reduce conflicts of interest and enhance the accuracy of credit ratings.

Mortgage Market Reforms: Regulations were put in place to promote better underwriting
standards, transparency, and borrower protections in the mortgage market.

Living Wills (Resolution Plans): Financial institutions were required to create "living wills"
or resolution plans to facilitate their orderly resolution in the event of a financial crisis,
preventing the "too big to fail" problem.

These regulatory changes were aimed at addressing the weaknesses and gaps exposed by
the financial crisis and at enhancing the overall stability and transparency of the financial
system. They have had a lasting impact on the financial industry and continue to shape the
regulatory environment in the United States and globally. The key objectives include
safeguarding against systemic risk, protecting consumers, and ensuring that financial
institutions are better equipped to weather economic downturns.

Unit 13: Global Financial Regulations 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

11. What is the primary objective of Basel III?

a) To promote risky financial products
b) To reduce the stability and integrity of the global financial system
c) To enhance the stability and resilience of the global banking system
d) To facilitate excessive borrowing by banks
12. Which of the following was the first international capital standards for
banks?
a) Basel II
b) Basel III
c) Basel I
d) Basel IV
13. What is the key component of Basel III that limits a bank's borrowing relative
to its capital?
a) Common Equity Tier 1 (CET1) capital
b) Liquidity Coverage Ratio (LCR)
c) Leverage Ratio
d) Net Stable Funding Ratio (NSFR)
14. How did AIG's involvement in the global financial crisis primarily impact the
financial system?
a) By promoting transparency and disclosure
b) By enhancing risk management within banks
c) By creating a severe liquidity crisis
d) By preventing the crisis from spreading
15. What were the roles of Fannie Mae and Freddie Mac in the global financial
crisis?
a) They primarily helped stabilize the housing market.
b) They bought and securitized large volumes of risky mortgages.
c) They were not involved in the crisis.
d) They promoted responsible lending practices.

Unit 13: Global Financial Regulations 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

16. Which regulatory reform introduced the Volcker Rule and established the
Consumer Financial Protection Bureau (CFPB)?
a) Basel III
b) The Financial Stability Oversight Council (FSOC)
c) The Dodd-Frank Wall Street Reform and Consumer Protection Act
d) The Resolution Authority
17. What is the purpose of living wills (resolution plans) required by regulatory
reforms after the global financial crisis?
a) To promote excessive risk-taking by financial institutions
b) To facilitate the orderly resolution of large, failing financial institutions
c) To protect consumers from abusive financial practices
d) To enhance transparency in financial products and services

12. SUMMARY
Global Financial Crisis 2007:
• Lehman Brothers' bankruptcy was an iconic event during the crisis.
• Government bailouts aimed to stabilize the financial system.
• Measures included capital injections, asset purchases, loan guarantees, and temporary
nationalizations.
• International coordination among central banks was crucial.
• The crisis led to increased regulatory scrutiny and reforms.

Causes of Global Financial Crisis 2007:

• Subprime mortgage crisis and the collapse of the subprime mortgage market.
• Housing bubble and unsustainable home prices.
• Complex financial products like CDOs and CDS amplified the crisis.
• Lax regulatory oversight and inadequate risk management.
• Excessive leverage and global interconnectedness.

Unit 13: Global Financial Regulations 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Bank failures, panic, and a credit freeze.

• Global economic factors and psychological factors.

Why US Subprime Crisis 2007 Spread Globally:

• High global financial interconnectedness.
• Global banks had substantial exposure to U.S. housing and mortgage-related securities.
• The credit freeze hindered interbank lending and credit access.
• Widespread investor panic and contagion effects.
• The globalization of finance allowed vulnerabilities to spread.
• Impact on currency markets and international trade.

Regulatory Changes After Global Financial Crisis 2007:

• Dodd-Frank Wall Street Reform and Consumer Protection Act.
• Creation of the Consumer Financial Protection Bureau (CFPB).
• Volcker Rule to restrict proprietary trading and fund investments.
• Financial Stability Oversight Council (FSOC) for monitoring systemic risks.
• Enhanced oversight of derivatives markets.
• Increased capital and liquidity requirements.
• Resolution authority for large financial firms.
• Stress tests for assessing bank resilience.
• Improved consumer protection and mortgage market regulation.

Dodd-Frank Reform Act:

• Established the FSOC to monitor systemic risks.
• Created the CFPB for consumer protection.
• Enhanced regulatory oversight, including stress tests.
• Volcker Rule to restrict proprietary trading and fund investments.
• Resolution authority for failing financial firms.
• Increased transparency and credit rating agency reforms.
• Derivatives market regulation.

The Volcker Rule:

• Part of the Dodd-Frank Act to limit proprietary trading by banks.

Unit 13: Global Financial Regulations 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Restricts investments in hedge funds and private equity funds.

• Aims to separate traditional banking from riskier trading activities.
• Requires structural changes within banks to ensure compliance.

Basel III
• Basel Accords are international banking regulations for global financial stability.
• Basel I (1988) introduced minimum capital requirements but had limitations.
• Basel II (2004) aimed for risk-sensitive capital requirements and included three pillars.
• Basel III focuses on capital adequacy, introducing Common Equity Tier 1 (CET1) capital.
• It includes a leverage ratio, liquidity coverage ratio (LCR), net stable funding ratio
(NSFR), and counterparty credit risk.
• Emphasizes risk management and governance to prevent excessive risk-taking.

Role of Insurance Sector and GSEs

• AIG played a significant role through credit default swaps (CDS) on subprime
mortgages.
• AIG's liquidity crisis created financial system shockwaves.
• Fannie Mae and Freddie Mac contributed to the housing bubble through risky
mortgages.
• The U.S. government provided a bailout to prevent their insolvency.

Regulations After the Global Financial Crisis

• Dodd-Frank Act introduced comprehensive regulatory changes in 2010.
• Consumer Financial Protection Bureau (CFPB) aimed to protect consumers.
• Volcker Rule restricted proprietary trading and investments in hedge funds.
• Financial Stability Oversight Council (FSOC) monitored systemic risks.
• Increased oversight of derivatives markets and enhanced capital and liquidity
requirements.
• Basel III framework introduced stricter capital and liquidity requirements.
• Stress tests assessed banks' capital adequacy.
• Resolution authority established for orderly resolution of failing institutions.
• Increased transparency, regulation of credit rating agencies, and mortgage market
reforms.

Unit 13: Global Financial Regulations 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• "Living wills" required for orderly resolution of financial institutions.

13. TERMINAL QUESTIONS

Question 1: What were the key factors that contributed to the global financial crisis of 2007-
2008, and how did they lead to the collapse of major financial institutions?

Question 2: How did the U.S. subprime crisis of 2007 spread to affect financial institutions
worldwide, and what were the key reasons behind its global impact?

Question 3: What were the major regulatory changes introduced by the U.S. government in
response to the 2007-2008 global financial crisis, and how did these changes aim to prevent
a similar crisis in the future?

Question 4: Explain the key components and objectives of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, and how it aimed to address the shortcomings of the
financial system exposed by the 2007-2008 crisis.

Question 5: What is the Volcker Rule, and why was it implemented as part of the Dodd-Frank
Act? How does it address risky behaviour by banks?

Question 6: What are the key components of Basel III, and how does it aim to enhance the
stability of the global banking system?

Question 7: What was the role of insurance sector firms like AIG and government-sponsored
entities like Fannie Mae and Freddie Mac in the global financial crisis?

Question 8: What were the major regulatory changes introduced after the global financial
crisis to improve the functioning of financial institutions?

Question 9: How did the Basel Accords evolve from Basel I to Basel III, and what were the
reasons for these changes?

Question 10: In what ways did the global financial crisis of 2007-2008 impact the regulation
of financial institutions and their risk management practices?

Question 11: What are the key components of Basel III, and how does it aim to enhance the
stability of the global banking system?

Unit 13: Global Financial Regulations 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 12: What was the role of insurance sector firms like AIG and government-
sponsored entities like Fannie Mae and Freddie Mac in the global financial crisis?

Question 13: What were the major regulatory changes introduced after the global financial
crisis to improve the functioning of financial institutions?

Question 14: How did the Basel Accords evolve from Basel I to Basel III, and what were the
reasons for these changes?

Question 15: In what ways did the global financial crisis of 2007-2008 impact the regulation
of financial institutions and their risk management practices?

14. ANSWERS
Self-Assessment Questions
Answer 1: a. Lehman Brothers bankruptcy.

Answer 2: b. Decreasing housing prices.

Answer 3: c. The Volcker Rule

Answer 4: a. Basel III

Answer 5: b. Consumer Financial Protection Bureau (CFPB)

Answer 6: c. Credit freeze.

Answer 7: c. Basel Committee on Banking Supervision

Answer 8: b. Limiting proprietary trading.

Answer 9: d. Troubled Asset Relief Program (TARP)

Answer 10: d. Creating a framework for the orderly resolution of financial firms.

Answer 11: C) To enhance the stability and resilience of the global banking system.

Answer 12: C) Basel I

Answer 13: C) Leverage Ratio

Unit 13: Global Financial Regulations 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 14: C) By creating a severe liquidity crisis.

Answer 15: B) They bought and securitized large volumes of risky mortgages.

Answer1 6: C) The Dodd-Frank Wall Street Reform and Consumer Protection Act

Answer 17: B) To facilitate the orderly resolution of large, failing financial institutions.

Terminal Questions
Answer 1: The global financial crisis of 2007-2008 resulted from various factors, including
the subprime mortgage crisis, the housing bubble, complex financial products, lax regulatory
oversight, excessive leverage, global interconnectedness, bank failures, and investor panic.
These factors combined to create a perfect storm, leading to the collapse of major financial
institutions like Lehman Brothers.

Answer 2: The U.S. subprime crisis spread globally due to factors like financial
interconnectedness, a credit freeze, investor panic, the contagion effect, globalization of
finance, and its impact on currency and trade. Financial institutions worldwide held complex
financial products tied to U.S. subprime mortgages, leading to a crisis of confidence and a
global ripple effect.

Answer 3: The U.S. government introduced significant regulatory changes, including the
Dodd-Frank Wall Street Reform and Consumer Protection Act, Basel III, stress tests, and the
creation of the Consumer Financial Protection Bureau. These changes aimed to enhance
transparency, consumer protection, oversight of financial institutions, and the stability of the
financial system.

Answer 4: The Dodd-Frank Act introduced components such as the Consumer Financial
Protection Bureau, Financial Stability Oversight Council, Volcker Rule, resolution authority,
increased transparency, credit rating agency reforms, and derivatives regulation. Its
objectives were to protect consumers, enhance regulatory oversight, prevent proprietary
trading, and address conflicts of interest, among other goals.

Answer 5: The Volcker Rule is a regulation within the Dodd-Frank Act aimed at restricting
proprietary trading and limiting banks' investments in hedge funds and private equity funds.
It separates traditional banking activities from high-risk trading, reducing the potential for

Unit 13: Global Financial Regulations 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

speculative losses and conflicts of interest, thus enhancing the stability of the financial
system.

Answer 6: Basel III introduces higher capital and liquidity requirements, a leverage ratio,
and focuses on risk management and governance within banks. Its primary goal is to ensure
banks are better prepared to withstand economic and financial downturns, making them less
susceptible to crises like the one witnessed in 2007-2008.

Answer 7: AIG's extensive involvement in credit default swaps tied to subprime mortgages
and the exposure of Fannie Mae and Freddie Mac to risky mortgages contributed
significantly to the global financial crisis. AIG's near-collapse and the insolvency of the GSEs
undermined confidence in financial markets and added to the broader economic downturn.

Answer 8: Regulatory changes included the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Basel III, stress tests, resolution authority, and regulations for derivatives
markets and credit rating agencies. These reforms aimed to enhance transparency, reduce
risk, and improve risk management within financial institutions.

Answer 9: Basel Accords evolved to address the limitations of previous versions. Basel I
established basic capital requirements, while Basel II introduced a more risk-sensitive
framework. Basel III, in response to the 2007-2008 crisis, implemented stricter capital and
liquidity requirements and placed a greater emphasis on risk management and governance
within banks.

Answer 10: The crisis led to the introduction of comprehensive regulatory reforms, such as
Dodd-Frank and Basel III, which imposed stricter capital, liquidity, and transparency
requirements. Financial institutions were required to enhance risk management and
governance, conduct stress tests, and establish resolution plans to mitigate the risk of future
crises.

Answer 11: Basel III introduces higher capital and liquidity requirements, a leverage ratio,
and focuses on risk management and governance within banks. Its primary goal is to ensure
banks are better prepared to withstand economic and financial downturns, making them less
susceptible to crises like the one witnessed in 2007-2008.

Unit 13: Global Financial Regulations 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 12: AIG's extensive involvement in credit default swaps tied to subprime mortgages
and the exposure of Fannie Mae and Freddie Mac to risky mortgages contributed
significantly to the global financial crisis. AIG's near-collapse and the insolvency of the GSEs
undermined confidence in financial markets and added to the broader economic downturn.

Answer 13: Regulatory changes included the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Basel III, stress tests, resolution authority, and regulations for derivatives
markets and credit rating agencies. These reforms aimed to enhance transparency, reduce
risk, and improve risk management within financial institutions.

Answer 14: Basel Accords evolved to address the limitations of previous versions. Basel I
established basic capital requirements, while Basel II introduced a more risk-sensitive
framework. Basel III, in response to the 2007-2008 crisis, implemented stricter capital and
liquidity requirements and placed a greater emphasis on risk management and governance
within banks.

Answer 15: The crisis led to the introduction of comprehensive regulatory reforms, such as
Dodd-Frank and Basel III, which imposed stricter capital, liquidity, and transparency
requirements. Financial institutions were required to enhance risk management and
governance, conduct stress tests, and establish resolution plans to mitigate the risk of future
crises.

Unit 13: Global Financial Regulations 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 6

DBB3313
ROLE OF INTERNATIONAL
FINANCIAL MANAGEMENT

Unit 14: Contemporary Issues in International Finance 1

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Unit 14
Contemporary Issues in International Finance
Table of Contents

SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction - -
3-5
1.1 Learning Objectives - -
2 Euro-Zone Crises - - 6-7
3 Dominance of China in International Economy - - 8-9
4 Exchange rate volatility - - 9-11
5 Trade Wars and Protectionism - - 11-13
6 Cross-Border Investment and Capital Flows - 1 13-16
7 Global Economic Imbalances - - 17-18
8 Digital Currency and Central Bank Digital - - 19-21
Currencies (CBDCs)
9 Economic Impact of Pandemics - - 21-23
10 Geopolitical Risks - - 23-25
11 Multilateral Organizations - - 25-27
12 Future of PIIGS Economies - - 27-28
13 Growth of BRICS - 29-30
14 Future of PIIGS Economies - 2 31-34
15 Summary - - 34-38
16 Terminal Questions - - 38-40
17 Answers - - 40-45

Unit 14: Contemporary Issues in International Finance 2

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1. INTRODUCTION
Contemporary issues in international finance are subject to change over time, several key
topics and challenges were prominent in the field. Keep in mind that new issues may have
emerged since then. Some of the major contemporary issues in international finance include:

The Eurozone crisis, which emerged in the late 2000s, was driven by fiscal imbalances, a
weak banking sector, and economic disparities among member states. Greece's fiscal
problems triggered the crisis, leading to bailouts and austerity measures. The European
Central Bank's interventions and long-term reforms aimed to stabilize the Eurozone, but
economic disparities and integration challenges persist.

China's push for the yuan (CNY) to become a global reserve currency stem from its economic
prowess, internationalization efforts, and the Belt and Road Initiative. Challenges include
transparency and competition with the U.S. dollar. The yuan's progress depends on
addressing these issues while gaining international trust and acceptance.

Exchange Rate Volatility: Fluctuations in exchange rates can significantly impact

international trade, investment, and financial markets. Uncertainty in exchange rates can
pose challenges for businesses and investors in managing their currency risk.

Trade Wars and Protectionism: Trade tensions and protectionist policies among major
economies, such as the U.S.-China trade dispute, have disrupted global supply chains and
international trade flows, affecting financial markets and investments.

Global Economic Imbalances: Persistent trade imbalances and current account deficits in
some countries can lead to financial instability and raise concerns about the sustainability of
these imbalances.

Digital Currency and Central Bank Digital Currencies (CBDCs): The rise of cryptocurrencies
like Bitcoin and the potential issuance of CBDCs by central banks have raised questions about
the future of international payments and the role of traditional currencies.

Cross-Border Investment and Capital Flows: Changes in global investment patterns and
capital flows, including foreign direct investment, portfolio investments, and sovereign
wealth funds, have important implications for international finance.

Unit 14: Contemporary Issues in International Finance 3

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Financial Regulation and Compliance: International financial regulations, such as Basel III,
FATCA, and the Common Reporting Standard (CRS), continue to evolve and impact the
operations of financial institutions and the flow of capital across borders.

Global Financial Crises: Ongoing concerns about the resilience of the global financial system
and the potential for financial crises, such as the 2008 global financial crisis, remain relevant
in international finance.

Climate Finance: Climate change and sustainability considerations are increasingly

integrated into international financial decision-making, with a growing emphasis on green
finance and the management of climate-related risks.

Economic Impact of Pandemics: The COVID-19 pandemic highlighted the vulnerability of

global financial systems to health crises. International financial institutions have played a
critical role in responding to the economic fallout.

Geopolitical Risks: Geopolitical tensions and conflicts, such as those involving Russia,
Ukraine, North Korea, and the South China Sea, can have significant implications for
international financial markets and investor sentiment.

Multilateral Organizations: The roles and effectiveness of multilateral organizations, such as

the International Monetary Fund (IMF), World Bank, and World Trade Organization (WTO),
have been subjects of debate and reform discussions.

These contemporary issues in international finance are interconnected and have wide-
ranging effects on the global economy. Practitioners, policymakers, and academics in the
field continuously monitor and adapt to these challenges as they evolve. It's essential to stay
updated on the latest developments to understand how they may impact international
financial markets and economic conditions.

Unit 14: Contemporary Issues in International Finance 4

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

1.1 Learning Objectives

❖ Understand the Causes and Impact of the Eurozone Crisis:
❖ Understand the concept of exchange rate volatility and its effects on international trade
and investment.
❖ Explore the rise of cryptocurrencies like Bitcoin and their implications for international
payments.
❖ Understand the Evolution of Financial Regulation and Compliance:
❖ Explore Multilateral Organizations and Their Roles in International Finance
❖ Examine the implications of trade wars for international investments and geopolitical
relations.

Unit 14: Contemporary Issues in International Finance 5

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

2. EURO-ZONE CRISES
The Eurozone crisis, often referred to as the Eurozone debt crisis or European sovereign
debt crisis, was a significant financial and economic crisis that emerged in the late 2000s and
continued through the early 2010s. It primarily affected several countries within the
Eurozone, which is a group of European Union (EU) member states that share the euro as
their common currency. The crisis had a profound impact on the European economy and led
to various measures and reforms to address the underlying issues. Here are some key
aspects of the Eurozone crisis:

Root Causes:
a. Fiscal Imbalances: Some Eurozone countries, including Greece, Portugal, Ireland, and
Spain, had accumulated large budget deficits and public debts, which were
unsustainable in the long run.
b. Weak Banking Sector: Many European banks were exposed to the debt of these
struggling countries, which created financial instability and contagion risks.
c. Lack of Economic Convergence: Economic disparities among Eurozone members and
differences in competitiveness made it challenging for some countries to maintain their
fiscal and economic health within the currency union.

Key Events:
a. Greek Crisis: The crisis began in late 2009 when Greece revealed the extent of its fiscal
problems. This led to concerns about its ability to meet its debt obligations and
potential default.
b. Bailouts: Over the following years, several Eurozone countries, including Greece,
Portugal, Ireland, and Cyprus, received financial assistance packages and bailout loans
from the European Central Bank (ECB), the International Monetary Fund (IMF), and the
EU to prevent sovereign defaults.
c. Banking Sector Stress Tests: Efforts were made to address vulnerabilities in the
European banking sector by conducting stress tests and recapitalizing weak banks.
d. European Stability Mechanism (ESM): The ESM, a permanent rescue fund, was
established to provide financial assistance to Eurozone countries in crisis.

Unit 14: Contemporary Issues in International Finance 6

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Austerity Measures: In exchange for bailout funds, the affected countries were required to
implement austerity measures, such as cutting public spending, raising taxes, and
implementing structural reforms, to reduce their budget deficits and restore economic
stability.

ECB Interventions: The European Central Bank (ECB) played a crucial role in calming
financial markets by announcing its readiness to buy government bonds of struggling
countries in the secondary market, which helped lower borrowing costs for those countries.

Long-Term Reforms: The Eurozone crisis prompted discussions about the need for closer
fiscal integration, banking union, and enhanced economic governance within the Eurozone.
Measures were taken to improve economic coordination and surveillance among member
states.

Ongoing Challenges: While the Eurozone has made progress in addressing some of the
immediate crisis issues, challenges remain. Economic disparities persist, and there is
ongoing debate about the future direction of the Eurozone, including further integration and
risk-sharing mechanisms.

It's worth noting that the Eurozone crisis had a profound impact on the global economy and
prompted significant policy changes within the Eurozone itself. However, the crisis also
underscored the complexities of managing a currency union and balancing the needs of
individual member states with the broader interests of the Eurozone as a whole. The
situation has evolved since my last update in January 2022, so I recommend consulting more
recent sources for the latest developments in the Eurozone.

Unit 14: Contemporary Issues in International Finance 7

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

3. DOMINANCE OF CHINA IN INTERNATIONAL ECONOMY

The race for the yuan (Chinese Renminbi, CNY) to become a global reserve currency is a
complex and long-term process driven by China's economic rise and its desire for
internationalizing its currency. Several factors contribute to this race:

Economic Power: China has become the world's second-largest economy, and its economic
influence continues to grow. As its trade and financial interactions expand globally, there's a
natural push for its currency to play a more prominent role in international finance.

Renminbi Internationalization: China has taken deliberate steps to internationalize the yuan.
This includes allowing its use in trade settlements, establishing currency swap agreements
with other central banks, and opening up its domestic financial markets to foreign investors.

Belt and Road Initiative: China's Belt and Road Initiative (BRI) involves massive
infrastructure projects in numerous countries. These projects often require trade and
investment in yuan, which further promotes the currency's use in international transactions.

Reserve Currency Status: To become a global reserve currency, the yuan needs to gain the
trust of central banks and international institutions. This requires stability, convertibility,
and depth in yuan-denominated financial markets.

Challenges: Challenges include concerns about the Chinese government's control over its
financial system, lack of transparency, and a controlled exchange rate. These factors can limit
the yuan's adoption.

Competition: The U.S. dollar (USD) has traditionally been the world's primary reserve
currency. Other currencies like the euro (EUR) and Japanese yen (JPY) also play significant
roles. The yuan competes with these currencies for international use.

Sino-U.S. Relations: Political and trade tensions between the U.S. and China can influence the
yuan's progress. Efforts by the U.S. to maintain the dollar's dominance and Chinese policies
to promote the yuan are part of this geopolitical competition.

Unit 14: Contemporary Issues in International Finance 8

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Internationalization Measures: China has continued to implement measures to encourage

the use of the yuan, including the launch of the digital yuan (e-CNY), which could facilitate its
international use.

Financial Infrastructure: Expanding the yuan's financial infrastructure, including the

establishment of offshore yuan centres and yuan-denominated bonds, has been a key part of
China's strategy.

Global Acceptance: Wider acceptance of the yuan by international businesses and investors
is essential for its reserve currency status.

While the yuan's internationalization has made significant strides, there are still challenges
to overcome, and the dominance of the U.S. dollar remains a formidable obstacle. The race
for the yuan to become a global reserve currency is ongoing, and the outcome will depend
on China's ability to address these challenges while the international community gains
confidence in the yuan as a stable and reliable currency for global transactions and reserve.

4. EXCHANGE RATE VOLATILITY

Exchange rate volatility refers to the extent to which the value of one currency fluctuates in
relation to another over a given period of time. These fluctuations can have a significant
impact on various aspects of the global economy, including international trade, investment,
and financial markets. Here's how exchange rate volatility can affect each of these areas:

International Trade:
a. Exporters and Importers: Exchange rate fluctuations can affect the competitiveness of
a country's exports and imports. When a currency depreciates, the products and
services of the exporting country become cheaper for foreign buyers, potentially
boosting exports. Conversely, a stronger currency can make imports more affordable
but may hurt a country's exports.
b. Pricing Strategies: Businesses engaged in international trade often face uncertainty in
pricing their goods and services due to exchange rate volatility. Rapid and
unpredictable currency movements can disrupt pricing strategies, leading to potential
profit margins and market share challenges.

Unit 14: Contemporary Issues in International Finance 9

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Investment:
a. Foreign Direct Investment (FDI): Exchange rate volatility can impact the attractiveness
of investing in a foreign country. Investors may be concerned that currency
depreciation could erode the value of their investments, while currency appreciation
might lead to higher returns.
b. Portfolio Investment: Investors in global financial markets, including stocks and bonds,
are exposed to exchange rate risk. Exchange rate fluctuations can affect the returns and
risk profiles of international investments. Investors often need to factor in currency
risk when making investment decisions.

Financial Markets:
a. Hedging and Risk Management: Exchange rate volatility creates uncertainty for
businesses and investors, making it essential to employ risk management strategies.
These strategies often involve the use of financial instruments like forwards, futures,
options, and currency swaps to hedge against potential currency losses.
b. Impact on Asset Prices: Exchange rate movements can influence the prices of financial
assets. For example, a depreciating currency can lead to higher inflation expectations,
impacting interest rates and stock market performance. Traders and investors closely
monitor exchange rate trends for insights into potential market movements.

Economic Stability:
a. Economic Stability: Excessive exchange rate volatility can have broader
macroeconomic consequences. Sudden and extreme currency movements can
destabilize economies by affecting price levels (inflation), interest rates, and trade
balances.
b. Policy Responses: Central banks and governments may intervene in currency markets
to mitigate excessive exchange rate volatility. They may use monetary policy tools or
impose capital controls to stabilize their currencies and protect their economies from
the negative effects of extreme fluctuations.

In summary, exchange rate volatility can pose challenges for businesses and investors by
introducing uncertainty into their decision-making processes. It can impact the
competitiveness of goods and services in international markets, affect the returns on

Unit 14: Contemporary Issues in International Finance 10

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

investments, influence asset prices, and potentially disrupt economic stability. As a result,
understanding and managing currency risk are crucial for those engaged in international
trade, investment, and financial markets.

5. TRADE WARS AND PROTECTIONISM

Trade tensions and protectionist policies among major economies, such as the U.S.-China
trade dispute, have disrupted global supply chains and international trade flows, affecting
financial markets and investments.

Trade tensions and protectionist policies, like the U.S.-China trade dispute, have indeed
disrupted global supply chains and international trade flows, with significant repercussions
for financial markets and investments. Here's a more detailed explanation of these effects:

Global Supply Chain Disruptions:

The imposition of tariffs and trade barriers disrupts the smooth functioning of global supply
chains. Many products today are manufactured using components and raw materials
sourced from various countries. When tariffs are applied to these inputs, businesses may
need to reconfigure their supply chains to avoid higher costs or find alternative sources. This
can lead to delays in production and increased complexity in managing supply chains.

Increased Costs for Businesses:

Tariffs and trade barriers raise the cost of imported goods, affecting businesses that rely on
these inputs. This leads to increased production costs, which can erode profit margins and
make businesses less competitive in the global market.

Reduced International Trade Flows:

Trade tensions can lead to a decline in international trade. When countries impose tariffs on
each other's products, it becomes more expensive and less attractive to engage in cross-
border trade. This reduction in trade flows can have a negative impact on economic growth
in both the countries directly involved in the dispute and those indirectly affected.

Market Volatility:
The uncertainty created by trade tensions can significantly impact financial markets.
Investors become more risk-averse, which can result in increased market volatility. Stock

Unit 14: Contemporary Issues in International Finance 11

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

markets may experience swings, and currency values can become more unpredictable as
investors seek safe-haven assets.

Investment Uncertainty:
Trade disputes can create an atmosphere of uncertainty that affects investment decisions.
Businesses may postpone or cancel planned investments due to concerns about the
unpredictable trade environment, which can slow down economic growth.

Sector-specific Effects:
Certain industries are more vulnerable to the effects of trade tensions. For instance,
industries that are heavily reliant on international markets or global supply chains, such as
technology and automotive, are particularly impacted.

Global Economic Consequences:

Trade disputes can have a cascading effect on the global economy. Reduced international
trade and investment can lead to lower economic growth, impacting job markets, consumer
spending, and overall economic stability.

Geopolitical Implications:
Trade disputes can have geopolitical ramifications. They can strain diplomatic relations,
complicate international negotiations, and even lead to broader geopolitical tensions. The
U.S.-China trade dispute, for example, has been intertwined with broader geopolitical
concerns.

Long-term Reshaping:
Trade tensions can lead to long-term changes in trade patterns and global economic
relationships. Businesses may hesitate to rebuild disrupted supply chains even after tensions
ease, and some countries may seek to diversify their trade partners to reduce dependency
on a single market.

Policy and Regulation Changes:

Trade tensions can lead to changes in government policies and regulations, with potential
long-term consequences. Governments may introduce new trade agreements, strengthen
domestic industries, and adopt protectionist measures to protect their economies.

Unit 14: Contemporary Issues in International Finance 12

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In summary, trade tensions and protectionist policies have significant and far-reaching
effects on global supply chains, international trade flows, financial markets, and investments.
They create uncertainty, raise costs, and can have negative impacts on economic growth and
market stability. Finding resolutions to these tensions and promoting a more stable and
predictable international trade environment is essential for global economic stability.

6. CROSS-BORDER INVESTMENT AND CAPITAL FLOWS

Cross-border investment and capital flows are critical components of international finance,
and changes in global investment patterns and capital flows have far-reaching implications.
Let's explore these concepts and their significance for international finance:

1. Foreign Direct Investment (FDI):

Foreign Direct Investment involves the acquisition of assets in a foreign country, such as
establishing subsidiaries or acquiring ownership in companies. It has several implications
for international finance:
a. Capital Allocation: FDI allows businesses to diversify their operations internationally,
affecting how capital is allocated globally. Companies strategically invest in foreign
markets to access resources, expand their customer base, or reduce risks related to
economic and political factors.
b. Economic Growth: FDI can contribute to economic growth in both the host and home
countries. The host country benefits from increased employment, technology
transfer, and capital inflows, while the home country's businesses expand and may
gain access to new markets.
c. Exchange Rates: FDI exposes businesses to exchange rate risk. Changes in currency
values can impact the profitability of foreign investments, and companies must
manage this risk through various strategies.
2. Portfolio Investments:
Portfolio investments involve the purchase of financial assets like stocks, bonds, and other
securities in foreign markets. They are more liquid than FDI and can have significant
implications for international finance:

Unit 14: Contemporary Issues in International Finance 13

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

a. Capital Flows: Portfolio investments result in substantial capital flows between

countries. Changes in investor sentiment, market conditions, and interest rates can
influence the direction and magnitude of these flows.
b. Risk Management: Investors use portfolio diversification to manage risk. By
investing in various asset classes and countries, they aim to spread risk and reduce
potential losses due to economic downturns or market shocks.
c. Exchange Rates: Large portfolio investments, especially in currencies, can affect
exchange rates. Capital inflows and outflows can lead to currency appreciation or
depreciation, influencing international trade.
3. Sovereign Wealth Funds (SWFs):
Sovereign Wealth Funds are state-owned investment pools funded by a country's reserves
or surpluses. They invest in various asset classes, including foreign equities, bonds, real
estate, and infrastructure, and have implications for international finance:
a. Stabilizing Financial Markets: SWFs often act as stabilizing forces in financial markets.
They take a long-term view in their investments, which can help mitigate market
volatility and uncertainty, especially during economic crises.
b. Economic Diversification: Some countries use SWFs as tools for diversifying their
economies. By investing in foreign assets, they aim to reduce their dependence on
domestic industries, particularly those reliant on commodities like oil.
c. Geopolitical Considerations: SWFs are state-owned, and their investments can have
geopolitical implications. Concerns may arise about potential political influence in
foreign markets or strategic sectors.
4. Capital Flows and Global Imbalances:
Changes in cross-border investment patterns can contribute to global economic imbalances.
For example, an influx of FDI or portfolio investments into a specific country can lead to
currency appreciation, potentially affecting its trade balance. These imbalances can
influence exchange rates and trade relationships, potentially leading to trade tensions.

5. Regulatory and Policy Implications:

Governments and central banks often introduce regulations and policies to manage cross-
border investments. These measures can affect the ease of capital mobility, the cost of

Unit 14: Contemporary Issues in International Finance 14

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

investing abroad, and the level of foreign investment inflows and outflows. Regulatory
changes can impact investor behaviour and investment strategies.

In summary, changes in global investment patterns and capital flows are integral to
international finance and have important implications for the global economy. They affect
capital allocation, economic growth, exchange rates, and risk management. Moreover, these
changes can contribute to global economic imbalances, influencing trade relations and
leading to regulatory and policy responses by governments and central banks.
Understanding these dynamics is crucial for investors, policymakers, and businesses
involved in international finance.

SELF-ASSESSMENT QUESTIONS – 1

1. How do trade tensions and protectionist policies affect global supply chains?
a) They have no impact on supply chains.
b) They make supply chains more efficient.
c) They disrupt global supply chains.
d) They reduce production costs for businesses.
2. What is the primary impact of tariffs and trade barriers on businesses?
a) Lower profit margins
b) Increased global competitiveness.
c) Streamlined supply chains.
d) Enhanced international trade flows.
3. What is one of the consequences of reduced international trade flows due to
trade tensions?
a) Accelerated economic growth.
b) Stable job markets
c) Increased consumer spending
d) Lower economic growth

Unit 14: Contemporary Issues in International Finance 15

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 1

4. How does trade-related uncertainty affect financial markets?

a) It reduces market volatility.
b) It has no impact on investor behavior.
c) It makes investors less risk-averse.
d) It increases market volatility.
5. Which industries are particularly vulnerable to the effects of trade tensions
and protectionism?
a) Healthcare and pharmaceuticals
b) Agriculture and farming
c) Technology and automotive
d) Energy and utilities
6. What are the potential geopolitical implications of trade disputes?
a) Enhanced diplomatic relations
b) Simplified international negotiations
c) Broader geopolitical tensions
d) Greater international cooperation
7. How might trade tensions lead to long-term changes in global trade patterns?
a) They have no long-term effects.
b) Businesses quickly rebuild disrupted supply chains.
c) Countries diversify their trade partners.
d) Trade disputes encourage trade specialization.
8. Which of the following is not a potential impact of trade tensions on financial
markets and investments?
a) Increased market volatility
b) Delayed or cancelled investments
c) Enhanced economic growth
d) Changes in asset allocation and investment strategies

Unit 14: Contemporary Issues in International Finance 16

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

7. GLOBAL ECONOMIC IMBALANCES

Persistent trade imbalances and current account deficits in some countries can lead to
financial instability and raise concerns about the sustainability of these imbalances.

Global economic imbalances refer to disparities in a country's international trade and

financial flows, particularly concerning trade surpluses and deficits and current account
balances. These imbalances can lead to financial instability and raise concerns about their
sustainability for several reasons:

Trade Imbalances: When a country consistently exports more goods and services than it
imports, it runs a trade surplus. Conversely, if a country imports more than it exports, it has
a trade deficit. Persistent trade imbalances can lead to concerns.

Current Account Deficits: The current account of a country's balance of payments includes
not only the trade balance but also income from abroad and net transfers. If a country
consistently runs a current account deficit, it means that it is spending more on imports,
foreign investment, and other international transactions than it is earning. This could
indicate an imbalance.

Foreign Debt Accumulation: A current account deficit implies that a country is borrowing
from the rest of the world to finance its spending. To sustain a current account deficit, a
country needs to accumulate foreign debt. If this debt becomes too large, it may raise
concerns about the country's ability to repay, leading to financial instability.

Exchange Rate Effects: Persistent trade and current account imbalances can affect a
country's exchange rate. For example, a chronic trade deficit can lead to a depreciation of the
country's currency, which may impact inflation and interest rates. This can create
uncertainty in financial markets and destabilize economic conditions.

Dependence on External Financing: Countries running persistent trade deficits rely on

external financing to sustain their consumption and investment levels. Depending on foreign
capital inflows can be risky, as these inflows may not be sustainable in the long run,
particularly if foreign investors lose confidence in the country's economic prospects.

Unit 14: Contemporary Issues in International Finance 17

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Reduced Economic Sovereignty: Countries with substantial trade deficits may find
themselves beholden to foreign investors, governments, or international institutions. This
can compromise a nation's economic sovereignty and its ability to pursue its own economic
policies.

Financial Market Vulnerability: The accumulation of foreign debt and the reliance on
external financing can make a country vulnerable to shifts in investor sentiment. If foreign
investors decide to withdraw capital from the country, it can lead to financial crises, currency
depreciation, and rising interest rates.

Impact on Economic Growth: While trade deficits can sometimes be normal and necessary,
if they persist at excessive levels, they can undermine a country's long-term economic
growth. Heavy borrowing to finance trade imbalances can crowd out productive investment
and potentially lead to stagnation.

Concerns About Economic Resilience: Persistent imbalances can raise questions about a
country's economic resilience and its ability to withstand external shocks. These imbalances
may weaken a country's position to respond to economic crises or downturns.

To address these issues and ensure the sustainability of global economic imbalances,
countries often need to implement policies that promote balanced trade, encourage
domestic savings and investment, and manage their external debt. International
coordination and cooperation may also be necessary to address imbalances, as they can have
spillover effects on the global economy. The management of global economic imbalances
remains a key challenge for international policymakers and financial institutions.

Unit 14: Contemporary Issues in International Finance 18

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

8. DIGITAL CURRENCY AND CENTRAL BANK DIGITAL CURRENCIES

(CBDCS)

The rise of digital currencies, including cryptocurrencies like Bitcoin and the potential
issuance of Central Bank Digital Currencies (CBDCs), has significant implications for
international payments and the role of traditional currencies. Here's an explanation of these
developments:

Cryptocurrencies:
Decentralization: Cryptocurrencies are digital or virtual currencies that operate on
decentralized blockchain technology. They are not controlled by any central authority, such
as a government or central bank. This decentralization can offer certain advantages,
including reduced reliance on intermediaries, enhanced security, and increased accessibility.

Global Transactions: Cryptocurrencies can be used for cross-border transactions without the
need for traditional financial intermediaries like banks or payment processors. This can lead
to faster and potentially cheaper international payments.

Volatility: Cryptocurrencies, like Bitcoin, are known for their price volatility. This can pose
challenges for international trade and finance as businesses and individuals may be exposed
to significant currency risk when dealing with cryptocurrencies.

Regulatory Challenges: The decentralized nature of cryptocurrencies has raised concerns

about their potential use in illegal activities, such as money laundering and tax evasion. As a
result, many governments are working on regulations to oversee and control the use of
cryptocurrencies.

Central Bank Digital Currencies (CBDCs):

Government-Issued: CBDCs are digital currencies issued by central banks, making them a
digital form of a country's official currency (e.g., digital US dollars or digital euros). Unlike
cryptocurrencies, CBDCs are centralized and issued by a trusted government authority.

Enhanced Control: CBDCs give central banks greater control over the money supply, enabling
them to implement monetary policy more effectively. They can also have regulatory, and

Unit 14: Contemporary Issues in International Finance 19

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

compliance features built-in, reducing the risk of illicit activities associated with
cryptocurrencies.

International Payments: CBDCs could facilitate cross-border transactions, potentially

making international payments more efficient and secure. They might be used to settle
transactions between central banks or financial institutions.

Stable Value: CBDCs are typically designed to be stable in value, unlike cryptocurrencies that
are known for their price fluctuations. This stability can make CBDCs more suitable for
everyday transactions and international trade.

Interoperability: For CBDCs to have a meaningful impact on international payments, they

would need to be interoperable with other CBDCs and existing payment systems. Achieving
such interoperability requires international coordination and standardization.

The Future of International Payments:

The rise of cryptocurrencies and the potential issuance of CBDCs raise several questions and
considerations for international payments:
• Competition with Traditional Currencies: As more individuals and businesses adopt
cryptocurrencies and CBDCs, it may challenge the role of traditional currencies in
international trade and finance. The extent of this challenge depends on factors like
regulatory developments and market adoption.
• Regulatory Frameworks: Governments and regulatory bodies are working on
establishing regulatory frameworks for cryptocurrencies and CBDCs. These
frameworks will influence how these digital currencies can be used in international
transactions and what compliance measures are required.
• Risk and Stability: The volatility of cryptocurrencies can present risks for those who
use them in international transactions. In contrast, CBDCs, designed for stability, may
become a preferred choice for businesses and individuals seeking reliability in their
payments.
• Interoperability and Standardization: Achieving interoperability between different
CBDCs and existing payment systems is a complex challenge. International cooperation
is crucial to create compatible networks for cross-border transactions.

Unit 14: Contemporary Issues in International Finance 20

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

In summary, the rise of cryptocurrencies and the potential issuance of CBDCs are reshaping
the landscape of international payments. While cryptocurrencies offer decentralized and
borderless transactions, they also introduce volatility and regulatory challenges. CBDCs, on
the other hand, promise stability and enhanced control but require international
coordination and interoperability. The future of international payments will likely involve a
mix of traditional currencies, cryptocurrencies, and CBDCs, with their roles evolving over
time as the technology and regulatory environment continue to develop.

9. ECONOMIC IMPACT OF PANDEMICS

The economic impact of pandemics, such as the COVID-19 pandemic, can be profound and
far-reaching. Here's an explanation of how pandemics affect global financial systems and the
role of international financial institutions in responding to the economic fallout:

Disruption of Economic Activity: Pandemics can disrupt economic activity on multiple fronts.
Lockdowns, travel restrictions, and social distancing measures can lead to the closure of
businesses, reduced consumer spending, and disruptions in global supply chains. Many
industries, particularly those relying on physical presence or international trade, experience
significant economic setbacks.

Loss of Jobs and Income: The economic impact of pandemics often leads to job losses and
income reductions for individuals and households. People may lose their jobs due to
business closures or reduced demand for certain services. This can result in decreased
consumer spending, which further affects economic growth.

Market Volatility: Financial markets can experience increased volatility during pandemics.
Investors may become risk-averse, leading to fluctuations in stock prices, bond yields, and
currency exchange rates. The uncertainty surrounding the duration and severity of the
pandemic can create challenges for investors and market stability.

Fiscal and Monetary Responses: Governments and central banks may implement fiscal and
monetary policies to mitigate the economic impact of pandemics. These policies can include
stimulus packages, interest rate cuts, and measures to support financial institutions. These
actions aim to stabilize financial markets, boost economic activity, and prevent a financial
crisis.

Unit 14: Contemporary Issues in International Finance 21

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Need for International Coordination: The global nature of pandemics necessitates

international coordination and cooperation. As economies around the world are
interconnected, actions taken by one country can affect others. It is essential to collaborate
on measures that promote economic recovery, trade, and financial stability.

Role of International Financial Institutions: International financial institutions like the

International Monetary Fund (IMF), the World Bank, and regional development banks play
a critical role in responding to the economic fallout of pandemics. These institutions provide
financial assistance, policy advice, and technical support to affected countries.

Financial Assistance: International financial institutions can offer financial support to

countries facing economic challenges during a pandemic. This support can include loans,
grants, and debt relief to help countries address urgent fiscal and healthcare needs.

Policy Advice: These institutions provide guidance on effective economic and public health
policies. They offer recommendations for managing fiscal resources, strengthening
healthcare systems, and implementing measures to support economic recovery.

Technical Assistance: International financial institutions offer technical expertise to help

countries enhance their healthcare infrastructure and improve financial and economic
management. This includes support for data collection, financial planning, and capacity
building.

Multilateral Cooperation: These institutions facilitate cooperation and dialogue among

countries to address common challenges. They can also work on debt relief initiatives to
reduce the financial burdens on heavily impacted nations.

Long-Term Economic Impact: The economic impact of pandemics can have lasting effects.
Countries may experience changes in consumer behavior, shifts in economic priorities, and
structural changes in industries. Long-term recovery may require strategic planning,
investment in healthcare infrastructure, and international collaboration.

In summary, pandemics like COVID-19 can expose the vulnerability of global financial
systems to health crises. The economic fallout, including job losses, market volatility, and
disruptions in economic activity, necessitates the intervention of international financial

Unit 14: Contemporary Issues in International Finance 22

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

institutions. These institutions provide financial assistance, policy advice, and technical
support to help countries navigate the economic challenges posed by pandemics and
facilitate global economic recovery.

10. GEOPOLITICAL RISKS

Geopolitical risks refer to the potential for political disputes, conflicts, or tensions between
countries or regions to impact international financial markets and investor sentiment. These
risks can have significant implications for various aspects of the global economy. Here's an
explanation of how geopolitical risks, such as those involving Russia, Ukraine, North Korea,
and the South China Sea, can affect international financial markets and investor sentiment:

Market Volatility: Geopolitical events can lead to increased market volatility. News of
conflicts or tensions in sensitive regions can cause investors to become more risk-averse,
resulting in fluctuations in stock prices, bond yields, and currency exchange rates.
Uncertainty about the outcome and duration of geopolitical disputes can further amplify
market volatility.

Safe-Haven Assets: During times of geopolitical uncertainty, investors often seek safe-haven
assets. These are investments considered to be relatively stable and low risk. Traditional
safe-haven assets include gold, U.S. Treasury bonds, and certain currencies like the Swiss
Franc and Japanese Yen. The demand for these assets can drive up their prices and influence
currency markets.

Energy and Commodity Markets: Geopolitical tensions can affect energy and commodity
markets, particularly when they involve major oil or gas-producing regions. Disruptions in
the supply of these resources can lead to higher prices, which can impact industries and
consumer costs.

Impact on Specific Industries: Certain industries can be more directly affected by geopolitical
risks. For example, defence and aerospace companies may experience increased demand for
their products during times of conflict, while companies with significant exposure to regions
in turmoil may face business disruptions and financial losses.

Unit 14: Contemporary Issues in International Finance 23

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Investor Sentiment: Geopolitical risks can significantly impact investor sentiment. Negative
developments in global hotspots can lead to pessimism among investors and reduce their
willingness to take risks. This can influence investment decisions, portfolio allocations, and
overall market behaviour.

Currency Exchange Rates: Geopolitical events can have a substantial impact on currency
exchange rates. A country's perceived stability and its ability to navigate geopolitical
challenges can affect the value of its currency. Major geopolitical events can result in sudden
fluctuations in exchange rates.

Trade Disruptions: Geopolitical conflicts can disrupt international trade, which can affect
global supply chains and economic growth. Tariffs, sanctions, or trade restrictions imposed
as a result of geopolitical tensions can lead to challenges for businesses that rely on global
markets.

Long-Term Economic Effects: Geopolitical risks can have long-term economic consequences.
Prolonged conflicts or tensions can deter foreign investment, disrupt economic
development, and lead to structural changes in affected regions. The rebuilding and recovery
process can be protracted, impacting long-term economic prospects.

Policy Responses: Governments and international organizations may respond to geopolitical

risks by implementing new policies and sanctions. These policy changes can impact
international trade, financial transactions, and market dynamics.

Opportunities and Risks: While geopolitical risks are typically associated with challenges,
they can also create opportunities for investors. For example, defence and cybersecurity
companies may benefit from increased defence spending during times of geopolitical
conflict. Investors who can identify and capitalize on these opportunities may find ways to
navigate the associated risks.

In summary, geopolitical risks, such as those involving Russia, Ukraine, North Korea, and the
South China Sea, have the potential to significantly impact international financial markets
and investor sentiment. The key factors to watch for include market volatility, the demand
for safe-haven assets, effects on specific industries, currency exchange rates, trade
disruptions, long-term economic consequences, and government policy responses. These

Unit 14: Contemporary Issues in International Finance 24

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

risks require careful monitoring and assessment by investors and financial institutions to
make informed decisions in an ever-changing geopolitical landscape.

11. MULTILATERAL ORGANIZATIONS

Multilateral organizations, including the International Monetary Fund (IMF), World Bank,
and World Trade Organization (WTO), are crucial institutions in the realm of international
economics, finance, and trade. They play significant roles in promoting global economic
stability, development, and trade. However, the roles and effectiveness of these
organizations have been subjects of ongoing debate and reform discussions for several
reasons. Here's an explanation:

1. International Monetary Fund (IMF):

Role: The IMF is an international financial institution tasked with maintaining global
monetary cooperation, ensuring exchange rate stability, facilitating the balanced growth of
international trade, providing resources to help members in financial trouble, and offering
policy advice and technical assistance to support economic stability.

Debate and Reform Discussions:

Conditionality: The IMF's policy conditionality, which requires countries to implement
specific economic policies in exchange for financial assistance, has been a subject of debate.
Critics argue that the conditions often involve austerity measures that may negatively impact
vulnerable populations. Reform discussions aim to make conditionality more tailored to
individual countries' needs and reduce potential adverse social effects.

Governance and Representation: There have been calls for reforms to enhance the
governance structure of the IMF, making it more representative of the changing global
economic landscape. This includes reforms related to voting rights and quotas to give
emerging economies more influence within the institution.

2. World Bank:
Role: The World Bank is an international financial institution focused on providing financial
and technical assistance for development projects in middle-income and low-income
countries. Its mission is to reduce poverty and promote economic development and
sustainable growth.

Unit 14: Contemporary Issues in International Finance 25

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Debate and Reform Discussions:

Impact of Projects: Concerns have been raised about the environmental and social impacts
of some World Bank projects, as well as the institution's influence in setting development
priorities in recipient countries. Reform discussions aim to ensure that projects are more
responsive to local needs and aligned with sustainable development goals.

Governance and Representation: Similar to the IMF, there is a push for reforms related to
governance and representation in the World Bank to better reflect the interests of its
member countries.

3. World Trade Organization (WTO):

Role: The WTO is a global organization that deals with the global rules of trade between
nations. It provides a forum for negotiating trade agreements, settling trade disputes, and
overseeing international trade rules.

Debate and Reform Discussions:

Stalled Trade Negotiations: The WTO has faced challenges in advancing global trade
negotiations. Issues such as agricultural subsidies, non-tariff barriers, and trade imbalances
have proven difficult to address through the consensus-based decision-making process.
Reform discussions seek to make the WTO more agile in addressing emerging trade issues.

Modernizing Trade Rules: The organization is also working on modernizing trade rules to
address new challenges, such as e-commerce, intellectual property, and sustainability. These
reforms aim to reflect the changing nature of the global economy.

Common Themes in Reform Discussions:

Governance and Representation: A common theme across these organizations is the need for
governance reforms that enhance the participation and influence of emerging economies and
reflect the shifting global economic landscape.

Transparency and Accountability: Reform discussions often include mechanisms to improve

the transparency and accountability of these organizations in their decision-making
processes and project evaluations.

Unit 14: Contemporary Issues in International Finance 26

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Addressing Emerging Challenges: Multilateral organizations are tasked with addressing new
and evolving global challenges, such as climate change, cybersecurity, and health crises.
Reform efforts aim to equip these organizations to effectively tackle these issues.

In summary, the roles and effectiveness of multilateral organizations, such as the IMF, World
Bank, and WTO, have been subjects of ongoing debate and reform discussions. These
discussions focus on improving governance and representation, making policies and projects
more responsive to local needs, and addressing emerging global challenges. The goal is to
ensure that these organizations can effectively fulfil their missions in a rapidly changing
global landscape.

12. FUTURE OF PIIGS ECONOMIES

The term "PIIGS" is an acronym that refers to five European countries: Portugal, Ireland,
Italy, Greece, and Spain. These countries were often associated with economic challenges in
the aftermath of the global financial crisis that began in 2008. The economic situations of
these countries have evolved over time, and while I can't provide predictions, I can offer
some insights into the general trends and challenges that these economies have faced and
might continue to face in the future:

Economic Recovery: Since the financial crisis, many of the PIIGS countries have made efforts
to recover from the economic downturn. A few of them have shown signs of improvement in
terms of economic growth and stability. However, the pace and extent of recovery have
varied among these nations.

Structural Reforms: Some of these countries, like Spain and Portugal, have implemented
structural reforms to improve their economic competitiveness, labour markets, and public
finances. These reforms were aimed at increasing their resilience to economic shocks.

Debt Levels: High levels of public debt have been a significant concern for some of the PIIGS
countries, notably Greece and Italy. Reducing these debt levels and maintaining fiscal
discipline are ongoing challenges.

Unit 14: Contemporary Issues in International Finance 27

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Political Factors: Political stability and government policies play a crucial role in the
economic fortunes of these countries. Political changes can have a significant impact on
economic policies and reforms.

European Union Support: The PIIGS countries are members of the European Union and have
received financial assistance and support from EU institutions during the economic crises.
Their continued integration with the EU can be a stabilizing factor.

Competitiveness: Improving competitiveness through measures like education, innovation,

and labor market reforms is essential for the long-term success of these economies.

External Factors: External factors, such as global economic trends, international trade, and
the stability of financial markets, can also influence the future of these economies.

It's important to note that the economic situations of these countries are dynamic and
subject to change. The future of the PIIGS economies will depend on various factors,
including their ability to manage their fiscal and structural challenges, political stability,
global economic conditions, and their commitment to reforms and growth-oriented policies.

For the most up-to-date information and analysis on the future of these economies, it's
recommended to refer to reliable sources and economic forecasts.

Unit 14: Contemporary Issues in International Finance 28

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

13. GROWTH OF BRICS

The term "BRICS" refers to a group of five major emerging economies: Brazil, Russia, India,
China, and South Africa. These countries are known for their significant influence on regional
and global affairs, and they have been working together on various economic, political, and
strategic initiatives. The growth of BRICS economies has been a subject of interest and
discussion over the years. Here are some key points regarding the growth of BRICS
economies:

Economic Growth: The BRICS countries have experienced significant economic growth over
the past few decades. China and India, in particular, have seen remarkable economic
expansion, contributing significantly to global GDP growth.

Structural Transformation: These economies have been undergoing structural changes,

transitioning from agriculture and traditional industries to more service-oriented and
technology-driven sectors. This transition has led to increased productivity and economic
diversification.

Trade and Investment: BRICS nations have increased their trade and investment ties, both
within the group and with the rest of the world. They have also initiated various trade
agreements and forums to promote economic cooperation, such as the BRICS New
Development Bank.

Challenges: Despite their growth, the BRICS countries have faced challenges, including
income inequality, infrastructure gaps, corruption, political instability, and economic
volatility. Addressing these issues is crucial for sustained growth.

Political Cooperation: BRICS countries have engaged in political and strategic cooperation,
discussing issues such as global governance, climate change, and regional security. They
often take collective positions on international matters.

Foreign Policy: Each BRICS nation pursues its foreign policy objectives, but they often
cooperate on common interests. They aim to reform global institutions, like the United
Nations and the International Monetary Fund, to better reflect the realities of the 21st
century.

Unit 14: Contemporary Issues in International Finance 29

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Geopolitical Significance: As a group, BRICS countries have become more influential in

international geopolitics and have challenged the dominance of Western powers in global
affairs. Their combined economic and political clout has made them important players in the
international arena.

Varied Performance: It's important to note that the growth trajectories of these economies
have been variable. China and India, in particular, have seen faster growth rates, while Russia
and Brazil have faced economic challenges in recent years. South Africa's economy is
relatively smaller compared to the other BRICS members.

The future growth of BRICS economies will depend on various factors, including their ability
to address domestic challenges, promote reforms, and adapt to changing global economic
conditions. While these countries collectively represent significant economic potential, their
individual trajectories and prospects will differ.

It's essential to consult current economic data and forecasts for the most up-to-date
information on the growth and performance of BRICS economies.

Unit 14: Contemporary Issues in International Finance 30

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

14. FUTURE OF PIIGS ECONOMIES

The term "PIIGS" is an acronym that refers to five European countries: Portugal, Ireland,
Italy, Greece, and Spain. These countries were often associated with economic challenges in
the aftermath of the global financial crisis that began in 2008. The economic situations of
these countries have evolved over time, and while I can't provide predictions, I can offer
some insights into the general trends and challenges that these economies have faced and
might continue to face in the future:

Economic Recovery: Since the financial crisis, many of the PIIGS countries have made efforts
to recover from the economic downturn. A few of them have shown signs of improvement in
terms of economic growth and stability. However, the pace and extent of recovery have
varied among these nations.

Structural Reforms: Some of these countries, like Spain and Portugal, have implemented
structural reforms to improve their economic competitiveness, labour markets, and public
finances. These reforms were aimed at increasing their resilience to economic shocks.

Debt Levels: High levels of public debt have been a significant concern for some of the PIIGS
countries, notably Greece and Italy. Reducing these debt levels and maintaining fiscal
discipline are ongoing challenges.

Political Factors: Political stability and government policies play a crucial role in the
economic fortunes of these countries. Political changes can have a significant impact on
economic policies and reforms.

European Union Support: The PIIGS countries are members of the European Union and have
received financial assistance and support from EU institutions during the economic crises.
Their continued integration with the EU can be a stabilizing factor.

Competitiveness: Improving competitiveness through measures like education, innovation,

and labour market reforms is essential for the long-term success of these economies.

External Factors: External factors, such as global economic trends, international trade, and
the stability of financial markets, can also influence the future of these economies.

Unit 14: Contemporary Issues in International Finance 31

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

It's important to note that the economic situations of these countries are dynamic and
subject to change. The future of the PIIGS economies will depend on various factors,
including their ability to manage their fiscal and structural challenges, political stability,
global economic conditions, and their commitment to reforms and growth-oriented policies.

For the most up-to-date information and analysis on the future of these economies, it's
recommended to refer to reliable sources and economic forecasts.

SELF-ASSESSMENT QUESTIONS – 2

9. What are the potential consequences of persistent trade imbalances and

current account deficits in some countries?
a) Reduced global trade
b) Increased economic stability
c) Financial instability and sustainability concerns
d) Lower inflation rates
10. What is a key issue associated with countries running persistent trade
deficits?
a) Accumulation of foreign debt
b) Reduced reliance on external financing
c) Currency appreciation
d) Increased economic sovereignty
11. Which of the following is a characteristic of cryptocurrencies like Bitcoin?
a) Centralized control by governments
b) Stable value with minimal price fluctuations
c) Dependence on traditional financial intermediaries
d) Decentralization and blockchain technology

Unit 14: Contemporary Issues in International Finance 32

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

12. How do Central Bank Digital Currencies (CBDCs) differ from

cryptocurrencies like Bitcoin?
a) They are decentralized
b) They are issued by central banks
c) They have high price volatility
d) They are not recognized by international organizations.
13. Which of the following is a potential advantage of Central Bank Digital
Currencies (CBDCs)?
a) High price volatility
b) Enhanced control over the money supply
c) Decentralization
d) Limited use for international transactions
14. In the future of international payments, what factor may influence the role of
traditional currencies?
a) Increased use of cryptocurrencies
b) Limited government regulations
c) Lack of interoperability of CBDCs
d) Reduced market volatility
15. How do geopolitical risks impact international financial markets and
investor sentiment?
a) They reduce market volatility
b) They have no influence on market behavior
c) They increase investor risk-taking
d) They can lead to increased market volatility and risk aversion

Unit 14: Contemporary Issues in International Finance 33

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

SELF-ASSESSMENT QUESTIONS – 2

16. What is the primary goal of the International Monetary Fund (IMF)?
a) Promoting global monetary cooperation
b) Reducing global poverty
c) Overseeing global trade rules
d) Regulating digital currencies
17. What is a common theme in reform discussions related to multilateral
organizations such as the IMF, World Bank, and WTO?
a) Encouraging less government involvement
b) Enhancing governance and representation
c) Reducing the role of emerging economies
d) Promoting environmental sustainability

15. SUMMARY
Euro-Zone Crisis:
• Root causes: Fiscal imbalances, weak banking sector, and economic disparities.
• Impact: Affected several Eurozone countries, leading to bailouts, austerity measures,
and economic reforms.
• Ongoing challenges: Economic disparities and integration challenges persist.

China's Yuan Internationalization:

• Economic power and internationalization efforts drive China's push for the yuan.
• Challenges include transparency, competition with the U.S. dollar, and political
tensions.
• Progress depends on international trust and acceptance.

Exchange Rate Volatility:

• Fluctuations impact international trade, investment, and financial markets.
• Uncertainty poses challenges for businesses and investors.
• Hedging strategies are used to manage currency risk.

Unit 14: Contemporary Issues in International Finance 34

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Trade Wars and Protectionism:

• Trade tensions disrupt global supply chains and international trade flows.
• Impose increased costs on businesses.
• Lead to reduced international trade, market volatility, and investment uncertainty.

Global Economic Imbalances:

• Persistent trade imbalances and deficits can lead to financial instability.
• Require coordinated international efforts and policy adjustments.

Digital Currency and CBDCs:

• Rise of cryptocurrencies and potential issuance of CBDCs raises questions about
international payments and traditional currencies.

Cross-Border Investment and Capital Flows:

• Changes in global investment patterns and capital flows impact asset prices and
investment strategies.

Financial Regulation and Compliance:

• International financial regulations like Basel III, FATCA, and CRS impact financial
institutions and capital flows.

Global Financial Crises:

• Ongoing concerns about the resilience of the global financial system persist.

Climate Finance:
• Climate change and sustainability are integrated into international financial decision-
making.
• Emphasis on green finance and managing climate-related risks.

Economic Impact of Pandemics:

• The COVID-19 pandemic highlighted vulnerabilities in global financial systems.
• International financial institutions respond to economic fallout.

Unit 14: Contemporary Issues in International Finance 35

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Geopolitical Risks:
• Tensions in regions like Russia, Ukraine, North Korea, and the South China Sea impact
international financial markets and investor sentiment.

Multilateral Organizations:
• IMF, World Bank, and WTO roles and effectiveness are subjects of debate and reform
discussions.

Global Economic Imbalances:

• Trade imbalances and current account deficits can lead to financial instability and raise
sustainability concerns.
• Trade surpluses and deficits reflect international trade disparities.
• Current account deficits indicate a country is spending more than it earns.
• Accumulating foreign debt to sustain deficits can be risky.
• Imbalances can affect exchange rates, financial markets, and economic sovereignty.
• Dependence on external financing can lead to vulnerability.
• Long-term imbalances may hinder economic growth and resilience.
• Addressing imbalances requires policies, international coordination, and cooperation.

Digital Currency and Central Bank Digital Currencies (CBDCs):

• Cryptocurrencies operate on decentralized blockchain technology.
• They offer advantages like reduced reliance on intermediaries.
• Cryptocurrencies enable global transactions, but are known for volatility.
• Central Bank Digital Currencies (CBDCs) are government-issued and centralized.
• CBDCs provide stability, regulatory control, and potential for efficient cross-border
transactions.
• Interoperability is key for CBDCs' success in international payments.
• The rise of digital currencies raises questions about competition, regulations, and risk.
• The future of international payments will involve a mix of currencies and digital assets.

Economic Impact of Pandemics:

• Pandemics disrupt economic activity through lockdowns and restrictions.
• Job losses, income reductions, and market volatility result.

Unit 14: Contemporary Issues in International Finance 36

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Fiscal and monetary policies are used to mitigate economic impact.

• International coordination is essential due to global interconnectedness.
• Multilateral organizations like the IMF and World Bank play key roles.
• Long-term recovery requires planning and addressing emerging challenges.

Geopolitical Risks:
• Geopolitical risks can lead to market volatility and impact investor sentiment.
• Safe-haven assets are sought during uncertain times.
• Energy and commodity markets can be affected by conflicts.
• Specific industries may be directly influenced.
• Geopolitical risks can impact currency exchange rates and international trade.
• Long-term consequences can deter foreign investment and lead to structural changes.
• Government policies may change in response to geopolitical risks.

Multilateral Organizations:
• The IMF focuses on monetary cooperation and financial stability.
• The World Bank aims to reduce poverty and promote development.
• The WTO deals with global trade rules and dispute resolution.
• Debate and reform discussions center around conditionality, governance,
representation, and effectiveness.
• Common themes in reform discussions include transparency, accountability, and
addressing emerging challenges.

Future of PIIGS Economies:

• PIIGS refers to Portugal, Ireland, Italy, Greece, and Spain.
• These countries have faced economic challenges in the past.
• Economic recovery varies among them.
• Structural reforms and debt reduction are ongoing concerns.
• Political stability and EU support play crucial roles.
• Competitiveness and external factors affect their future.
• Economic situations are dynamic and subject to change.
• Future prospects depend on various factors and policies.

Unit 14: Contemporary Issues in International Finance 37

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Growth of BRICS:
• BRICS includes Brazil, Russia, India, China, and South Africa.
• These countries have experienced significant economic growth.
• They are undergoing structural transformations.
• Increased trade and investment cooperation.
• Challenges include income inequality and political instability.
• They cooperate on global issues and seek reforms.
• Future growth depends on addressing challenges and global economic conditions.
• Varied performance among the member countries.

16. TERMINAL QUESTIONS

Question 1: What were the root causes of the Eurozone crisis, and how did it impact the
European economy?

Question 2: How is China working to promote the international use of the yuan (CNY) as a
global reserve currency, and what challenges does it face in achieving this goal?

Question 3: Explain the impact of exchange rate volatility on international trade, investment,
and financial markets. What strategies can businesses and investors employ to manage
currency risk?

Question 4: Discuss the effects of trade wars and protectionist policies on global supply
chains, international trade flows, financial markets, and investments. How have these issues
disrupted the global economy?

Question 5: What are the major challenges associated with addressing global economic
imbalances, and why are they a concern for the international financial system?

Question 6: How have digital currencies and Central Bank Digital Currencies (CBDCs)
impacted international finance? What questions and challenges have arisen regarding their
role in international payments and financial systems?

Question 7: Discuss the changing patterns of cross-border investment and capital flows in
the context of international finance. How do these changes affect global financial markets
and investment strategies?

Unit 14: Contemporary Issues in International Finance 38

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 8: How have international financial regulations, such as Basel III, FATCA, and the
Common Reporting Standard (CRS), evolved and impacted the operations of financial
institutions and the flow of capital across borders?

Question 9: Describe the ongoing concerns about the resilience of the global financial system
and the potential for financial crises. How have lessons from past crises influenced
regulatory and policy responses in international finance?

Question 10: How has climate finance become integrated into international financial
decision-making, and what is the emphasis on green finance and managing climate-related
risks?

Question 11: In what ways has the economic impact of pandemics, exemplified by the COVID-
19 pandemic, highlighted vulnerabilities in global financial systems? How have international
financial institutions responded to the economic fallout?

Question 12: Discuss the significance of geopolitical risks, such as tensions involving Russia,
Ukraine, North Korea, and the South China Sea, in the context of international financial
markets and investor sentiment.

Question 13: How have multilateral organizations like the International Monetary Fund
(IMF), World Bank, and World Trade Organization (WTO) been subjects of debate and
reform discussions in the field of international finance? What roles do these organizations
play in the global financial system?

Question 14: What are global economic imbalances, and why are they a cause for concern?

Question 15: What is the difference between cryptocurrencies and Central Bank Digital
Currencies (CBDCs), and how can they impact international payments?

Question 16: What is the economic impact of pandemics, and how do international financial
institutions respond to the fallout?

Question 17: How do geopolitical risks, such as conflicts in Russia, Ukraine, North Korea, and
the South China Sea, affect international financial markets and investor sentiment?

Unit 14: Contemporary Issues in International Finance 39

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Question 18: What are some common themes in the reform discussions related to
multilateral organizations like the IMF, World Bank, and WTO?

Question 19: What have been the general trends and challenges in the economic situations
of the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain) since the global financial
crisis?

Question 20: How have the BRICS economies (Brazil, Russia, India, China, and South Africa)
performed in terms of economic growth and influence in the global landscape?

17. ANSWERS
Self-Assessment Questions
Answer 1: c. They disrupt global supply chains.

Answer 2: a. Lower profit margins.

Answer 3: d. Lower economic growth.

Answer 4: d. It increases market volatility.

Answer 5: c. Technology and automotive.

Answer 6: c. Broader geopolitical tensions.

Answer 7: c. Countries diversify their trade partners.

Answer 8: c. Enhanced economic growth.

Answer 9: c. Financial instability and sustainability concerns

Answer 10: a. Accumulation of foreign debt

Answer 11: d. Decentralization and blockchain technology

Answer 12: b. They are issued by central banks

Answer 13: b. Enhanced control over the money supply

Answer 14: a. Increased use of cryptocurrencies

Unit 14: Contemporary Issues in International Finance 40

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

Answer 15: d. They can lead to increased market volatility and risk aversion

Answer 16: d. China

Answer 17: a. Promoting global monetary cooperation

Answer 18: b. Enhancing governance and representation

Terminal Questions
Answer 1: The Eurozone crisis, which began in the late 2000s, had its roots in fiscal
imbalances among member states, a weak banking sector, and economic disparities. Some
countries, including Greece, had accumulated large budget deficits and unsustainable public
debts. The crisis significantly impacted the European economy, leading to bailouts and
austerity measures in several countries. Weak banking sectors and economic disparities
made it challenging for some countries to maintain their fiscal and economic health within
the currency union.

Answer 2: China's push for the yuan to become a global reserve currency is driven by its
economic prowess, internationalization efforts, and initiatives like the Belt and Road
Initiative. China has taken measures to internationalize the yuan, including allowing its use
in trade settlements, establishing currency swap agreements, and opening its financial
markets. However, challenges include concerns about transparency, the controlled exchange
rate, competition with the U.S. dollar, and the need to gain international trust and acceptance.
Political and trade tensions with the U.S. can also influence the yuan's progress.

Answer 3: Exchange rate volatility significantly impacts international trade by affecting the
competitiveness of exports and imports. It can disrupt pricing strategies and lead to
uncertainty for businesses. Investors are exposed to currency risk in global financial
markets, which can affect returns and risk profiles. Businesses and investors can manage
currency risk through hedging strategies using financial instruments like forwards, futures,
options, and currency swaps. Central banks may also intervene in currency markets to
stabilize their currencies and protect their economies.

Answer 4: Trade wars and protectionist policies disrupt global supply chains by imposing
tariffs and trade barriers, making it more expensive and complex to source materials

Unit 14: Contemporary Issues in International Finance 41

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

globally. This can lead to delays in production and increased costs. Reduced international
trade flows can impact economic growth, while uncertainty from trade tensions can increase
market volatility and affect investment decisions. These issues have disrupted the global
economy by straining diplomatic relations and causing broader economic consequences.

Answer 5: Persistent trade imbalances and current account deficits in some countries can
lead to financial instability and raise concerns about the sustainability of these imbalances.
Challenges in addressing these imbalances include the need for coordinated international
efforts, policy adjustments in deficit and surplus countries, and addressing underlying
economic disparities. They are a concern for the international financial system as they can
lead to market distortions, protectionism, and economic instability.

Answer 6: The rise of digital currencies like Bitcoin and the potential issuance of CBDCs have
raised questions about the future of international payments and the role of traditional
currencies. Digital currencies offer new possibilities for cross-border payments, but
questions about regulation, security, and interoperability with existing financial systems
persist. CBDCs may have a significant impact on international finance and require careful
consideration of their design and implications.

Answer 7: Changes in global investment patterns and capital flows, including foreign direct
investment, portfolio investments, and sovereign wealth funds, have significant implications
for international finance. These changes can impact asset prices, market dynamics, and
investment strategies. Investors and businesses must adapt to evolving patterns and
consider the potential risks and opportunities associated with these changes.

Answer 8: International financial regulations have evolved to address risks and improve
transparency. Basel III aims to strengthen banking sector resilience, while FATCA and CRS
focus on tax compliance and information sharing. These regulations have impacted financial
institutions' operations by requiring increased capital and reporting standards. They have
also influenced the flow of capital across borders by promoting transparency and reducing
tax evasion.

Answer 9: Ongoing concerns about the resilience of the global financial system stem from
past crises, including the 2008 global financial crisis. Lessons from these crises have led to

Unit 14: Contemporary Issues in International Finance 42

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

regulatory and policy responses, including increased capital requirements for banks and
improved risk management practices. International cooperation and coordination among
central banks and financial institutions are critical to prevent and respond to financial crises.

Answer 10: Climate finance has gained importance in international financial decision-
making as environmental sustainability concerns grow. There is a growing emphasis on
green finance, which involves investments in environmentally friendly projects and
technologies. Managing climate-related risks is crucial for businesses and investors, as
climate change can impact asset values, supply chains, and overall financial stability.

Answer 11: The COVID-19 pandemic exposed vulnerabilities in global financial systems,
including the impact of health crises on economic stability. International financial
institutions, such as the International Monetary Fund (IMF) and the World Bank, played
critical roles in responding to the economic fallout by providing financial assistance, policy
guidance, and support for recovery efforts.

Answer 12: Geopolitical risks, including conflicts and tensions in regions like Russia,
Ukraine, North Korea, and the South China Sea, can have significant implications for
international financial markets and investor sentiment. These tensions can lead to increased
uncertainty, affect market stability, and influence investment decisions as investors assess
the potential geopolitical impacts on global economic conditions.

Answer 13: Multilateral organizations, such as the IMF, World Bank, and WTO, have been
subjects of debate and reform discussions in international finance. They play key roles in
providing financial assistance, promoting economic stability, and facilitating international
trade. Debates often revolve around their effectiveness, governance structures, and their
roles in addressing contemporary global challenges.

Answer 14: Global economic imbalances refer to disparities in a country's international

trade and financial flows, particularly trade surpluses, deficits, and current account balances.
These imbalances can be concerning because they can lead to financial instability for several
reasons:
• Trade imbalances can affect a country's exchange rate, leading to uncertainty in
financial markets.

Unit 14: Contemporary Issues in International Finance 43

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Current account deficits indicate reliance on foreign financing, which may not be
sustainable.
• Accumulating foreign debt to sustain deficits can raise repayment concerns.
• Excessive imbalances can hinder long-term economic growth and economic resilience.

Answer 15: Cryptocurrencies and CBDCs have distinct characteristics and impacts on
international payments:
• Cryptocurrencies are decentralized and can offer faster cross-border transactions but
are known for price volatility and regulatory challenges.
• CBDCs are government-issued, stable, and controlled, making them suitable for
international transactions.
• The future of international payments will likely involve a mix of traditional currencies,
cryptocurrencies, and CBDCs.

Answer 16: Pandemics can profoundly impact the global financial system. The economic
consequences include disruptions to economic activity, job losses, market volatility, and
fiscal and monetary responses. International financial institutions, like the IMF and World
Bank, provide financial assistance, policy advice, and technical support to affected countries
to address the economic challenges posed by pandemics.

Answer 17: Geopolitical risks can have significant implications for international financial
markets and investor sentiment, including:
• Increased market volatility due to investor risk aversion.
• A demand for safe-haven assets like gold and U.S. Treasury bonds.
• Effects on energy and commodity markets, as well as specific industries.
• Impacts on currency exchange rates and trade disruptions.
• Long-term economic consequences and government policy responses.

Answer 18: Reform discussions for multilateral organizations often revolve around several
common themes:
• Governance and representation to better reflect the changing global economic
landscape.

Unit 14: Contemporary Issues in International Finance 44

DBB3313: Role of International Financial Management Manipal University Jaipur (MUJ)

• Improving transparency and accountability in decision-making and project

evaluations.
• Addressing emerging global challenges, such as climate change, cybersecurity, and
health crises.

Answer 19: The economic situations of PIIGS countries have seen varying trends and
challenges, including:
• Ongoing efforts at economic recovery and structural reforms.
• Concerns over high levels of public debt and fiscal discipline.
• The role of political stability and government policies.
• Integration with the European Union and competitiveness measures.
• The influence of external factors, such as global economic trends and financial market
stability.

Answer 20: The BRICS economies have shown significant economic growth and increased
influence. Notably, China and India have experienced remarkable economic expansion, and
these countries have worked together on political and economic initiatives. However,
challenges such as income inequality, infrastructure gaps, and political instability exist and
need to be addressed for sustained growth.

Unit 14: Contemporary Issues in International Finance 45