International Business

Functions UNIT 11 INTERNATIONAL FINANCE

Objectives
After studying this unit, you should be able to understand:
 global financial system;
 basics of international monetary system;
 balance of payments;
 exchange risk management strategy and the factors affecting it;
 financing foreign trade; and
 terms of payment in international trade.
Structure
11.1 Introduction
11.2 Global Financial System
11.3 International Monetary System
11.4 International Flow of Funds
11.5 Foreign Exchange Market
11.6 Exchange Risk Management Strategy
11.7 Foreign Investment
11.8 Terms of Payment in International Trade
11.9 Summary
11.10 Key Words
11.11 Self-Assessment Questions
11.12 References/ Further Readings

11.1 INTRODUCTION
Reductions in barriers to international trade and financial flows coupled with innovations
in information and communication technology, all financial operations are becoming
“international” as these developments has blurred the national boundaries and each
financial operations whether aimed at trade financing, investment, funding, loans, and
other commercial operations have its origin to global market place.
Traditionally international finance is the branch of economics that studies the dynamics
of exchange rates, foreign investment and how these affect international trade. It also
studies international projects, international investments and capital flows and trade
deficits. It includes the study of future and forward contract, options and currency
swaps. Together with international trade theory, international finance is also a branch
of international economics.

11.2 GLOBAL FINANCIAL SYSTEM

184 First of all we need to understand as to what is global finance. Global finance is the
financial system which consists of regulators and various financial institutions that conduct International Finance

their business on an international level. Therefore, in global finance the businesses are
not conducted at the national level. The primary components of global finance are the
international institutions, like International Monetary Fund, World Bank and Asian
Development Bank along with various national institutions and government departments,
such as various Central Banks, finance ministries, and those private companies who
act on a global scale.

The most prominent international institutions which are linked with global finance are
as follows:

1) International Monetary Fund (IMF): The International Monetary Fund is

tasked with for encouraging international trade, ensuring financial stability and
economic growth and reducing global poverty. IMF oversees economic
development, lending, and capacity development at global level. The
International Monetary Fund also helps member states to address
disequilibrium in balance of payments, grants long term loans for financial
stability and act as a lender of last resort to avoid sovereign default.

2) World Bank: It is an institution which aims to offer funding for development

projects which, for most of the part, is offered to developing nations. The
World Bank assumes the credit risk of these developing nations; and tends to
provide financing to projects that otherwise would not be able to access such
funding.

3) World Trade Organization (WTO): WTO frames polices for orderly

conduct of trade, commerce and global financing. Further, it advocates rule-
based and transparent policy architecture and dispute resolution procedure.
WTO agreement on Trade-Related Investment Measures (TRIMS) recognizes
that certain investment measures can restrict and distort trade as some nation-
states can discriminate against other on the grounds of being a foreign products,
quantitative restrictions, and local content requiring which has its implications
for business firms on matters of global finance.

11.3 INTERNATIONAL MONETARY SYSTEM

The International Monetary System is primarily the set of policies, institutions, practices,
regulations and mechanism that determine the rate at which one currency is exchanged
for another (Shapiro, 2004). The year 1252 marked the minting of the very first gold
coin in Western Europe, since then, the International Monetary System has evolved
and transformed into the modern system that we use today. The modern system came
into existence in the beginning of the 19th century. Since then it has crossed many
stages. These are as follows:
- The Classic Gold Standard (1821-1914)
- The Interwar Period (1919-1939)
- The Bretton Woods Era (1944-1971)
- The Post-Bretton Woods Era or Dirty Float (1971 to present)
185
International Business Let us discuss each stage in brief.
Functions
• The Classic Gold Standard (1821-1914): In 1821 England returned to the
gold standard and this is the period when more and more countries joined the
gold standard. By 1880 most of the nations followed gold standard in one
form or the other. But this was a difficult time as adhering strictly to gold
standard resulted in lots of fluctuations. There were many bouts of inflation
and deflation. The reason for this can be owed to high cost involved in locating,
mining and minting gold. Despite lots of difficulties, this period is considered
to be the most remarkable period in the world economic history.
• The Interwar Period (1919-1939): This is the period when gold standard
broke International Finance down during World War I. The gold exchange
standard was reinstated for a short period from 1925-1931. In this period
only USA and England could keep gold reserves and other nations could
keep both gold and dollars or pounds as reserves. In 1931, England departed
from gold standard.
• The Bretton Woods Era (1944-1971): In 1944, a conference was held in
Bretton Woods, New Hampshire to chart-out a new post-war monetary
system. Two new institutions namely International Monetary Fund (IMF) and
the International Bank for Reconstruction and Development (World Bank)
were created to implement the new system. Under this system each country
pledged to maintain a fixed or pegged exchange rate for its currency with
dollars or gold. One ounce of gold was equivalent to $35. The fixed exchange
rates were maintained by official intervention in the foreign exchange markets.
The fixed exchange rate received a great deal of uncertainty from international
trade and investment transaction.
This system collapsed with the dissolution of the gold standard. The reasons for the
collapse were due to:
a) Inflation in US
b) Vietnam war in mid 60s
c) Major countries like West Germany, Japan and Switzerland refused to accept
economic costs associated with inflationary pressures of US$ depreciation.
The above reasons resulted in sharp depreciation of dollar resulting in collapse of
Bretton Woods’s system.
• The Post Bretton Woods Era or Dirty Float (1971 to present): The world
officially shifted to floating exchange rate in 1971 when dollar was devalued
to 1/38 of an ounce of gold. Post 1971 saw many events happening on the
international economic front. These are listed as follows:
OPEC and Oil Crisis: 1971-1974
US Dollar Crisis: 1977-1978
Rising Dollar: 1980-1995
Sinking Dollar: 1985-1987
Asian Financial Crisis: 1997
186
 Sub-Prime Crisis: 2008 International Finance

Euro Zone Crisis: 2012

Covid-19 Pandemic & Re-globalization debate: 2020 onwards
At the moment the international arena is witnessing lots of changes with trade and tariff
wars, pandemic induced economic shocks, and technological advancements. IMF
and other financial institutions are on toes to manage the International Monetary System.
Activity 1
Collect available literature from different sources related to Bretton Woods system.
List out the lessons which can be drawn from the Bretton Woods’s system.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

11.4 INTERNATIONAL FLOW OF FUNDS

Covid-19 pandemic has brought the global economic system to standstill affecting
economic activities, international trade, and movement of capital and labour which
affected adversely the international flows of funds. After witnessing a contraction in
2020, world trade is rebounding and has surpassed the pre-pandemic level touching
to historic level of almost $ 22 trillion but regional challenges remain. According to
WTO, global merchandise trade volume growth is more than 10.5% in 2021. Even
with rebounding of international trade, the financial challenges remain for many vulnerable
states across the world. These include:
- Loss of Services Trade,
- Ever increasing National Debts
- Depreciation of Currencies
- Loss of National Income
- Quantitative easing and Exchange Rate Instability
These challenges are intertwined and inter-linked causing problems of orderly flow of
international funds thus resulting in economic woes to many nation-states in the world.
Let us now discuss one of the major parts of international flow of funds i.e. Balance of
payments (BoPs). Now the question arises what is BoPs?
Balance of Payments (BoPs)
The BoPs is an accounting statement that summaries all the economic transactions
between the residents of the home country to that of residents of all other countries
(Shapiro, 2002).
The balance of payments (BoPs) is the economic barometer which the countries use to
monitor all international monetary transactions at a specific period of time. Usually, the 187
International Business BoPs is calculated every quarter and every calendar year. All the transactions both by
Functions
the private and public sectors are accounted for in the BoPs so as to determine the
amount of money coming-in and going-out of a country. If a country has received
money, (inflows) this is accounted as a ‘credit’ and if a country has paid or given
money (outflows), the transaction is accounted as a ‘debit’. Conceptually, the BoPs
should be zero, meaning that assets (credits) and liabilities (debits) should balance, but
practically this is a rare. Thus, the BoPs can tell the observer if a country has a ‘deficit’
or a ‘surplus’ and from which part of the BoPs account the discrepancies arise.
Categories of Balance of Payments
The BoPs has four main categories (Table 11.1): the trade account, the current account,
the capital account and the financial account.
• Trade Account which records the flow (export & import) of merchandized
goods;
• Current Account, which records the flows of services, remittances and other
invisible transfers;
• Capital Account, Which shows public and private investments and lending&
borrowing activities,
• Financial or Official Reserves Account, which measures changes in holdings
of gold, Special Drawing Rights (SDR) and foreign currencies i.e. resource
assets by official monetary institutions.
The statement of balance of payment (Table 11.1) of a country can be understood as
under:
Table 11.1: Structure of Trade Account/ Merchandise Account
Particulars Credit Debit Net
Merchandise Export -------------- --------------
Merchandise Import -------------- --------------
Balance of Trade ( – +) .…….
1. Tradable Services1 -------------- --------------
a. Travel
b. Transportation
c. Insurance
d. Government not
elsewhere classified
e. Miscellaneous
2. Unilateral Transfers -------------- --------------
a. Private Remittances
b. Officials Grants

1
According to Appendices 10 of India’s Foreign Trade Policy, there are 161 tradable services
188 classified in 12 heads. India’s Services Export Rules 2007 allow export of 118 services only.
 International Finance
3. Investment Income -------------- --------------
Current Account / Invisibles Account (– +)………
1. Loans Consist of: -------------- --------------
a. External Assistance
i. By India
ii. To India
b. Commercial
Borrowings
(MT and LT)
i. By India
ii. To India
c. Short-term
Loan to India
i. By India
ii. To India
2. Foreign Investments -------------- --------------
a. Direct Investments
i. Acquisitions
ii. Joint Ventures
iii. Green Field
Investments
b. Portfolio Investments
i. Depository Receipts
(ADR/GDR)
ii. Foreign Institutional
Investors
iii. Foreign Currency
Convertible Bonds
3. Banking Capital -------------- --------------
a. Commercial Banks
i. Assets
ii. Liabilities
iii. Non-resident
Deposits
b. Other
189
International Business
Functions 4. Rupee Debt Service -------------- --------------
5. Other Capital -------------- --------------

Capital Account Balance (– +) ……….

1. IMF Account -------------- --------------

2. SDR Account -------------- --------------
3. Reserves & -------------- --------------
Monetary Gold

Official Account Balance (– +) ……….

Source: Adapted from Reserve Bank of India.

Activity 2

List out at least two examples each of the different categories of BoPs:

a) Current Account:
................................................................................................................

................................................................................................................

................................................................................................................

b) Capital Account:

................................................................................................................
................................................................................................................

................................................................................................................

c) Financial Account:

................................................................................................................
................................................................................................................

................................................................................................................

11.5 FOREIGN EXCHANGE MARKET

Since World War II, the international transactions have grown to a large extent. This
has resulted in the growth of the foreign exchange market. The foreign exchange market
is a market where the foreign currencies are traded. The primary functions of a foreign
exchange market are to facilitate international trade and investments. There are two
types of important markets under foreign exchange market. These are:
 Spot Market, where currencies are traded for immediate delivery;
 Forward Market, where currencies are traded for future delivery (Shapiro,
190 2002).
Need of Foreign Exchange Market: This market is required because there is no International Finance

single international currency. Therefore, the main aim of such kind of market is to
facilitate the exchange and trading of one currency with another. For e.g. an Indian
exporter sells pharmaceutics to U.S. based importer for US Dollars which has to be
exchanged in equivalent INR and similarly when a Kenyan importer buys automobiles
from the US based supplier, he has to convert equivalent Kenyan Schilling into US$ to
pay. Each country of world does not have hard currency i.e. freely convertible currency.
As a result; most of such kind of exchange transaction(s) occurs through worldwide
interbank market.

Interbank Market: This market is known as the foreign exchange market. Basically
this market is an ‘Over the Counter Market’ (OTC) i.e., it is not a physical place but
exist everywhere and functions round the clock, days & nights, anywhere around the
world. Usually, the currencies traded in the foreign exchange markets are hard, stable
and convertible currencies.

The major players who participate in the foreign exchange markets are the large
commercial banks, individuals, firms, governments, and sometimes the international
agencies. There are two tiers in the foreign exchange market (Saran 2003) and these
are:

Tier I – Transactions between ultimate customer and the banks;

Tier II – Transactions between banks.

Figure 11.1 depicts various linkages between banks and their customers; this linkage is
with currency futures and options markets.

Customer
buys $ with `

Local Bank

Major Banks in
Customer sells an Inter-Bank Customer sells
$ with ` Market $ with `

Local Bank

Customer sells
$ with `

Figure 11.1: Linkages between Bank and Customers in a Foreign Exchange Market
191
International Business Transactions in the Interbank Market: Transactions in the foreign exchange market
Functions
can be executed on a spot, forward, or swap basis.
Spot Transactions: A spot transaction requires almost immediate delivery of foreign
exchange. In the interbank market, a spot transaction involves the purchase of foreign
exchange with delivery and payment between banks to take place normally, on the
‘second day’ following the business day, also known as T+2 settlement date. The date
of settlement is referred to as the “value date.” Spot transactions are the most important
single type of transaction and constitute around 45 % of all transactions.
Outright Forward Transactions: A forward transaction requires delivery at a ‘future
value date’ of a specified amount of one currency for a specified amount of another
currency. The exchange rate to prevail at the ‘value date’ is established at the time of
the agreement, but payment and delivery are not required until maturity. Forward
exchange rates are normally quoted for ‘value date(s)’ of one, two, three, six, and
twelve months. Actual contracts can also be arranged for other lengths. Outright forward
transactions only account for about 9 % of all foreign exchange transactions.
Swap Transactions: A swap transaction involves the simultaneous purchase and sale
of a given amount of foreign exchange for two different value dates. The most common
type of swap is a spot against forward, where the dealer buys a currency in the spot
market and simultaneously sells the same amount back in the forward market. Since
this agreement is executed as a single transaction, the dealer incurs no unexpected
foreign exchange risk.
Swap transactions account for about 46% of all foreign exchange transactions.
Foreign Exchange Rates and Quotations
A foreign exchange rate is the price of a foreign currency. A foreign exchange quotation
or quote is a statement of willingness to buy or sell a currency at an announced rate.
Bid and Ask Quotations
Interbank quotations are given as “bid” and “ask”.
A ‘bid’ is the exchange rate in one currency at which, a dealer will buy another currency.
An ‘ask’ is the exchange rate at which a dealer will sell the other currency.
Dealers buy at the ‘bid’ price and sell at the ‘ask’ price, profiting from the ‘spread’ or
difference between the ‘bid’ and ‘ask’ prices, concluding that ‘bid’<‘ask’.
‘Bid’ and ‘ask’ quotations are complicated by the fact that the ‘bid’ for one currency is
the ‘ask’ for another currency. Simply putting it; a forex dealer buys currency at ‘bid’
price and sell them at ‘ask’ price.
Foreign Exchange Derivatives Market
They do not have worth of their own and derive their value from the claim they give to
their owners, to own some other financial assets or securities. For instance, one takes
an insurance against his house covering all risks. This insurance is also a derivative
instrument on the house.
Major derivatives are as follows:-
a) Forward Contract: A forward contract is an agreement between two parties to
buy or sell an asset at a specified point of time in the future. In case of a forward
192
 contract; the price which is paid/ received by the parties is decided at the time of International Finance
entering into the contract. It is the simplest form of derivative contract and is
mostly entered by individuals in their day to day life. Forward contract is a cash
market transaction in which delivery of the instrument is deferred until the contract
has been made.
b) Futures Contract: Futures is a standardized forward contact to buy (long) or sell
(short) the underlying asset at a specified price and at a specified future date
through a specified exchange. Futures contracts are traded on exchanges that
work as a buyer or seller for the counterparty. Exchange sets the standardized
conditions in terms of Quality, Quantity, Price quotation, Date and Delivery place
(in case of commodity).
c) Options Contract: In case of futures contract, both parties are under obligation
to perform their respective obligations out of a contract. But in an Options Contract,
as the name suggests, is in some sense, an optional contract. An option is the right,
but not the obligation, to buy or sell something at a stated date and at a stated
price. A “call option” gives one the right to buy; a “put option” gives one the right
to sell.
d) Swaps Contract: A swap can be defined as a barter or exchange. It is a contract
whereby parties agree to exchange obligations that each of them have under their
respective underlying contracts or we can say, a swap is an agreement between
two or more parties to exchange stream of cash flows over a period of time in the
future. The parties that agree to the ‘Swap’ are known as counter parties.

11.6 EXCHANGE RISK MANAGEMENT STRATEGY

The values of major currencies keep on changing every second thus creating income
uncertainty for in international trade and investment decisions. The firms engaged in
international trade and financial transactions plan to eliminate this uncertainty by locking
in future exchange rates. In this context, the foreign exchange risk management strategy
helps manage currency risks including anticipated fluctuations in future. Hence, the risk
management strategy is based on set of procedures involving business specifics including
environmental assessment, the location of its competitors, degree of cash flow visibility,
its pricing parameters, decision criteria vis-a-vis risk and reward tolerance, familiarity
with different risk management styles, and the weight of a currency in foreign exchange
market. Figure 11.2 shows the matrix for the hedging strategy in an organization.
LOW PROFIT

HEDGING II SPECULATIVE I

RISK AVERSE III RISK TAKER IV

LOW PROFIT
Figure 11.2: Hedging Strategy in an Organization 193
International Business I - High Risk - High Reward
Functions

II - High Risk - Reasonable Reward

III – Low Risk – Low Reward

IV – High Risk – Low Reward

Developing an Hedging Approach

Companies involved in international trade and financial transactions should know various
types of exchange risk exposures and different type of hedging instruments and
techniques available to them for covering of risks. Hedging instruments are aimed at
offsetting the losses in international financial transactions and investments by taking an
opposite position in a related asset. Hedging instruments typically involve derivatives,
such as options and futures contracts. Commonly used hedging strategies are divided
into following categories:

 Full hedging (covering every exposure)

 Selective hedging (covering some selected exposures)

 Casual approach to hedging

Exchange risk management strategies will vary from organization to organization. The
International Finance strategy depends upon the risk appreciation attitude of the
organization, nature of exposure, significance of the risk on profitability and resources
available to the organization. With experience and knowledge of exchange rate system,
an organization can profit through exchange risk management. In the pandemic induced
volatile and ambiguous times; more and more exporters and importers are having
internal expertise in understanding exchange rates movements on the basis of macro-
economic fundamental and accordingly leverage hedging instruments to maintain
and earn profits.

11.7 FOREIGN INVESTMENT

Foreign investment, in its classic definition, “is defined as a company from one country
making a physical investment into building a factory in another country”. In an
era of globalisation; foreign investments definition has been broadened to include the
“acquisition” of a lasting management interest in a company or enterprise outside the
investing firm’s home country. As such, foreign investment in another country or foreign
firm may take many forms, such as a direct acquisition/ purchase of a foreign firm,
completely new construction of a facility in form of green field investments, or investment
in a joint venture with foreign firm. Furthermore; foreign investment may also be in
form of strategic alliance with a foreign firm with attendant input of technology / technical
knowhow; licensing of intellectual property, or entering into management contract or
turnkey projects. Foreign investment primarily may be of two types i.e. Foreign Direct
Investments (FDI) and Foreign Portfolio Investment (FPI) which in turn may have
several sub-constituents (Figure 11.3).
194
 International Finance
Types of Foreign Investment

Foreign Direct Investment Foreign Portfolio Investment

Green or Brown Field Investment Foreign Institutional Investors (FIIs)

Joint Ventures Foreign Depository Receipts (GDRs/ADRs)

Acquisitions Foreign Currency Convertible Bonds

Source: Shad Morris, James Oldroyd & Ram Singh (2021): International Business, Wiley India
Pvt. Ltd.
Figure 11.3: Types of Foreign Investment

Foreign direct investment is an investment by foreign investors into the assets of host
country structures, real estate; roads; ports; rail; plants and machinery; equipment,
financial institutions such as opening a new bank/ insurance company and sometimes in
host country organizations like investment in Indian Premier League (IPL) by foreign
counties. Foreign direct investment does not include foreign investment into the stock
markets of host countries that is separately treated as portfolio investment. In other
words, the term portfolio refers to any collection of financial assets such as stocks,
bonds and cash. Portfolios may be held by individual investors and/or managed by
financial professionals, hedge funds, banks and other financial institutions.

Advantages of FDI

When direct investment tends to flow from one country to another, it presents benefits
both to the home country as well as the host country but at the same time involves
some costs also. Let us see some of the advantages of the FDI to the home as well as
the host countries. The advantages to the host country are as follows:

a) Availability of scarce factor i.e. capital

b) Improvement in BoPs

c) Building of economic and social infrastructure

d) Fostering of economic linkages

e) Strengthening of government budget

The advantages to the home country are as follows:

a) Supply of required raw material

b) Improvement in BoPs through dividend, royalty, etc.

c) Enhanced employment opportunities

d) Develops closer diplomatic ties between two nations.

These advantages although; are conditional depending on the linkage of home as well
as the host country.
195
International Business Activity 3
Functions
Choose two companies of your interest from different nations which have tied up
together in terms of FDI. Now list the advantages of both the host and home
country from your understanding of the FDI strategies adopted by them.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

11.8 TERMS OF PAYMENT IN INTERNATIONAL

TRADE
Most of the MNCs along with even the small sized exporting firms, are extensively
involved in foreign trade apart from the other international activities. This section highlights
different modes of payment in international trade.
In highly competitive international markets today, the nature of payment terms offered
is often play a decisive role in obtaining export orders. One has to be very careful and
selective in negotiating the payment terms for a particular business. This decision is
affected by various factors, which can be categorized as under:
1) Nature of goods
2) Size and amount of the transaction
3) Credit-worthiness of the buyer
4) Economic and political situation of the country of exports
5) Export/import policy and exchange control regulation of importing and
exporting countries
6) Credit or payment terms offered by competitors
7) Financial strength of the exporter
Payment terms should be offered or accepted for trade transactions only after a careful
analysis of these factors. Let us now discuss different payment terms, which are used
for settlement of payments in the international trade:
1) PAYMENT-IN-ADVANCE: Payment in advance is the safest method of
payments. An exporter realizes the export proceeds in advance from an
importer (Exhibit 11.1) before the actual dispatch of goods. Payment in advance
is extremely favourable to an exporter and is the most risky for any importer.
In actual business practice, there are rare examples of payment in advance
however part payments in advance are common. Process of payment
settlement under payment in advance is exhibited in 11.1 as under:
Exhibit 11.1: Process of Payment Settlement in Payment in Advance

Step 1: Negotiate & sign a contract for exports

IMPORTER
EXPORTER Step 2: Receive in full or in part the payment from importer

Step 3: Dispatch the goods to importer as agreed

196
 2) DOCUMENTARY COLLECTIONS: Documentary collection is one of International Finance

the most preferred methods of payment settlement in international trade. It

balances the risks exposure between both the trading parties. Under this
method, an exporter manufactures or procures goods and dispatches them to
an importer through agreed mode of transport, delivery terms and cargo
insurance policy. Exporter prepares the documents and submits them to his
bank (remitting bank) as per procedure as laid down under Foreign Exchange
Management Act 2000 and regulations therein. Remitting bank process the
documents to collecting bank which ask for collection of payment from importer
against trade documents. Documentary collections are of two types namely
‘documents against payment’ (D/P) also known as ‘sight draft’ or ‘sight
bill’. Under D/P transaction; an importer pays to the collecting bank before
collecting the trade documents. Second type of documentary collections are
known as ‘documents against acceptance’ (D/A) also known as ‘time draft/
bill’ or ‘usance draft/bill’. There is credit period extended by exporter to
importer under D/A transactions. D/A transactions are risky and should be
used with due diligence. Process of payment settlement under documentary
collection is as under (exhibit 11.2).

Exhibit 11.2: Process of Execution for Payment under

Documentary Collections

Step 1: Exporter & Importer agree for trade deal IMPORTER/

EXPORTER
DRAWEE
/DRAWER
Step 2: Exporter dispatches goods but retails trade documents Goods

Step 3: Present Step 6: Makes

Documents to Payments at
Remitting Banks for sight or sign
purchase / acceptance &
discounting Step 5: Ask Importer to pay later
Step 8: Remitting Bank pay at sight or usance
pays to Exporter after against documents
deducting bank charges

Step 4: Bank handover documents to collecting banks for payment at PRESENTING/

REMITTING sight or usance COLLECTING
BANK BANK
Step 7: Collecting Bank remits payment to Remitting bank

3) OPEN ACCOUNT: Open account is most risky method of payment for an

exporter and most safe for an importer. It is just opposite of Payment in
Advance. Hence; it is extremely favourable to an importer and extremely
risky to an exporter. Under this method, exporter negotiates and signs an
export contract and ships the goods to an importer. Exporters also dispatch
the trade documents evidencing the transfer of ownership from an exporter to
an importer. This method of payment is used in cases of extreme trust between
two trading parties, established trade relationship and sister-concerns or
subsidiaries firms.
197
International Business 4) LETTER OF CREDIT: Letter of credit is widely used in high-value
Functions
business transactions. It is considered a safe payment term. Exporter(s)
prefer L/C terms in case of long duration business deals, doubt on importer
credit worthiness or lower credit rating, new & unestablished business
relationships, countries with high political or economic risks, etc. Under a
letter of credit, an importer asks his bank to make a contractual agreement
with beneficiary (exporter) for supply of agreed goods and services. As a
result; the risk of payment passes from an importer to a bank (issuing bank).
Bank undertakes a negotiable commitment for payment to an exporter
subject to documentary compliance. Issuing bank issues a contractual
agreement in favour of beneficiary (exporter) through SWIFT message at
exporter bank, which is called an advising bank. Advising bank advises to
exporter on various terms & conditions of credit and other associated risks.
After dispatch of cargo, an exporter is required to submit trade documents
to the bank as per negotiated terms and conditions of L/C. The negotiating
bank routes the documents to issuing bank under established banking
customs and procedures. Issuing Bank pays subject to fulfilment of
documentary compliance. To successfully leverage L/C as payment mode,
trading parties should be aware of process, parties involved and papers,
which is exhibited, step by step, as under:
Exhibit 11.3: Process of Execution for Payment under L/C Mode

Documentary credit transactions are guided by a set of customs and practices published
by the International Chamber of Commerce, Paris in 1993 under revised publication
number 600 (effective from July 1, 2007) and titled as ‘Uniform Customs and Practices
for Documentary Credit’ (UCPDC).
198
UCPDC defines letter of credit, explains, clarifies various situations and doubts, roles International Finance
of different parties involved and documents required, hence it is very important to
know and refer UCPDC while transacting under documentary credits. Following are
the main parties who are generally involved in such transaction:
1) Buyers/applicant/importer
2) Issuing bank
3) Advising bank
4) Confirming bank
5) Negotiating bank
6) Reimbursing bank
7) Seller/beneficiary/exporter
Different types of Letter of Credit are described as under (Table 11.2) detailing their
salient features, uses and risks for both the parties to trade transaction, i.e. exporter
and importer.
Table 11.2: Risks Assessment for Exporter and Importer with
Different Types of Letter of Credits

199
International Business
Functions

Source: Ram Singh (2020): Export- Import Management, Sage Books, 1st Edition, 2020.

It can thus be concluded that various terms of payment serves the following four
basic functions (Schapiro, 2002):

a) to understand where risks lies in a transaction;

b) to pinpoint who bears those risks that remain;

c) to facilitate the transfer risk to a third party; and

d) to facilitate financing.

Activity 4

Analyse the following documentary credits with respect to the risk associated
with the exporter and importer:

a) Revocable L/C

................................................................................................................

................................................................................................................

................................................................................................................

................................................................................................................

b) Irrevocable L/C

................................................................................................................

................................................................................................................

................................................................................................................

................................................................................................................
200
 International Finance
11.9 SUMMARY
Global finance is the financial system which consists of regulators and various financial
institutions that conduct their business on an international level. Therefore, in global
finance the businesses are not conducted at the national level. The primary components
of global finance are the international institutions, like International Monetary Fund,
World Bank and Asian Development Bank along with various national institutions.
Exchange risk management strategy depends upon a company’s attitude towards risk
and reward or profit motivation. There could be four possibilities: low risk and low
reward; high risk and low reward; high risk and reasonable reward; and high risk and
high reward. For covering exchange risks, a company has to develop a basic hedging
approach which could either be full hedging, selective hedging or casual hedging. The
technique of Risk Management Grid, based on exchange rate trends of the currencies
can help a company in maximizing its profits. There are several factors that influence
strategy on exchange risk management, and the main factors include type and size of
exposure, stability of currencies, maturity period, ability to forecast exposure, treasury
management expertise available with the firm, access to hedging instruments, etc.
Mode of payments is used to settle payments in international trade transactions. Each
payment is unique and has advantages associated with either party of trade, i.e. exporter
and importer. There are five payment terms used in international trade. These are;
Payment in Advance, Open Account, Documents against Payment, Documents against
Acceptance and Letter of Credit.

11.10 KEY WORDS

Hedging : A technique to mitigate risks arising from fluctuations in
exchange rates.
Foreign Direct : FDI is an investment by foreign investors into the assets
Investment (FDI) of host country economic system and may be in the forms
of green field investments, joint ventures and acquisitions.
International : It refers to set of policies, institutions, practices, regulations
Monetary System and mechanism that determine the rate at which one
currency is exchanged for another.
Balance of Payments : An accounting statement that summaries the economic
(BoPs) transactions between the residents of the home country
to that of residents of all other countries.
Documentary Credit : An arrangement whereby a bank issues generally an
irrevocable undertaking on behalf of its client to pay or to
accept to pay or authorize another bank to pay or to
accept to pay subject to compliance of conditions or terms
stipulated.

11.11 SELF-ASSESSMENT QUESTIONS

1) What are the two basic parameters of the exchange risk management strategy?
Based on these parameters, what could be the different possibilities or options for
a firm? 201
International Business 2) Why is it necessary for an international firm to have a hedging strategy? On what
Functions
factors would it depend upon? What benefits would ensue to the firm for developing
a suitable strategy?
3) Differentiate between forward contracts from future contracts.
4) Explain briefly the various terms of payment in international trade.
5) Write notes on the following:
- Spot market
- Forex market
- International cash flows

11.12 REFERENCES/FURTHER READINGS

 Ram Singh (2020): Export- Import Management, Sage Books, 1st Edition, 2020.
 Schapiro, C. Alan (2013). Multinational Financial Management, 10th Edition,
Wiley.
 Shad Morris, James Oldroyd & Ram Singh (2021): International Business, Wiley
India Pvt. Ltd.
 P.G. Apte , Sanjeevan Kapshe (2020): International Financial Management,
McGraw-Hill Education.
 Madhu Vij (2010): International Financial Management, Excel Books.
 MS-97, International Business, School of Management Studies, IGNOU, New
Delhi, November, 2015 (Reprint).
 David Eiteman, Arthur Stonehill, Michael Moffett, Multinational Business Finance
International Edition 11th Edition.
 Vyuptakesh Sharan (2012), International Financial Management, PHI.

202