LECTURE NOTES

INTERNATIONAL FINANCIAL MANAGEMENT

MBA IV SEMESTER SYLLABUS

INTERNATIONAL FINANCE MANAGEMENT (IFM)

International Finance – Overview:
• Globalization and Multinational firm, (Theory)
• International Monetary System
• Balance of payment (Theory)
• Market for Foreign Exchange (Theory)
• International Parity Relationship & Forecasting Foreign Exchange rate. (Theory &Numerical)

• An Overview of International Finance Management (IFM)

International financial management is also known as ‗international finance ‘.

International finance is the set of relations for the creation and using of funds (assets), needed for foreign
economic activity of international companies and countries. Assets in the financial aspect are considered not
just as money, but money as the capital, i.e

. the value that brings added value (profit). Capital is the movement, the constant change of forms in the cycle
that passes through three stages: the monetary, the productive, and the commodity. So, finance is the monetary
capital, money flow, serving the circulation of capital. If money is the universal equivalent, whereby primarily
labor costs are measured, finance is the economic tool.

The definition of international finance is the combination of monetary relations that develop in process of
economic agreements - trade, foreign exchange, investment - between residents of the country and residents of
foreign countries.

Financial management is mainly concerned with how to optimally make various corporate financial decisions,
such as those pertaining to investment, capital structure, dividend policy, and working capital management,
with a view to achieving a set of given corporate objectives.

When a firm operates in the domestic market, both for procuring inputs as well as selling its output, it needs to
deal only in the domestic currency. When companies try to increase their international trade and establish
operations in foreign countries, they start dealing with people and firms in various nations. On this regards, as
different nations have different currencies, dealing with the currencies becomes a problem-variability in
exchange rates have a profound effect on the cost, sales and profits of the firm.

Globalization of the financial markets results in increased opportunities and risks on account of overseas
borrowing and investments by the firm.

Reason for growth in international business

International business has growth dramatically in recent years because of strategic imperatives and
environmental changes.
Strategic imperatives include the need to leverage core competencies, acquire resources, seek new markets,
and match the actions of rivals. Although strategic imperatives indicate why firms wish to internationalize their
operations, significant changes in the political and technical environment have facilitated the explosive growth
in international business activity that has since World War 2. The growth of the internet and other information
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technologies is likely to redefine global competition and ways of doing international business.
There are many reasons why international business is growing at such a rapid pace. Below are some of those
reasons:
Saturation of Domestic Markets
In most of the countries due to continuous production of similar products over the years has led to the
saturation of domestic markets. For example in Japan, 95% of people have all types of electronic appliances
and there is no growth of organization there, as a result they have to look out for new markets overseas.
Opportunities in Foreign Markets
As domestic markets in some countries have saturated, there are many developing countries where these
markets are blooming. Organizations have great opportunities to boost their sales and profits by selling their
products in these markets. Also countries that are attaining economic growth are demanding new goods and
services at unprecedented levels.
Availability of Low Cost Labor
When we compare labor cost in developed countries with respect to developing countries they are very high.
As a result, organizations find it cheaper to shift production in these countries. This leads to lower production
cost for the organization and increased profits.
Competitive Reasons
Either to stem the increased presence of foreign companies in their own domestic markets or to counter the
expansion of their domestic markets, more and more organizations are expanding their operations abroad.
International companies are using overseas market entry as a counter measure to increase competition.
Increased Demands
Consumers in counties that did not have the purchasing power to acquire high-quality products are now
purchasing them due to improved economic conditions
Diversification
To counter cyclical patterns of business in different parts of the world, most of the companies expand and diversify
their business, to attain profitability and uncover new markets. This is one of the reasons why international business
is developing at a rapid pace.
Reduction of Trade Barriers
Most of the developing economics are now relaxing their trade barriers and opening doors to foreign
multinationals and allowing their companies to set-up their organizations abroad. This has stimulated cross
border trade between countries and opened markets that were previously unavailable for international
companies.
Development of communications and Technology
Over last few years there has been a tremendous development in communication and technology, which has
enabled everyone to know about demands, products and services offered in other part of the world. Adding to
this is the reducing cost of transport and improved efficiency has also led to expansion of business.
Consumer Pressure
Innovations in transport and communication has led to development of more aware consumer. This has led to
consumers demanding new and better goods and services. The pressure has led to companies researching,
merging or entering into new zones.
Global Competition
More companies operate internationally because
3 New products quickly become known globally
4 Companies can produce in different countries
5 Domestic companies, competitors, suppliers have becomes international
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 As international companies venture into foreign markets, these companies will need managers and other
personals who understand and are exposed to the concepts and practices that govern international companies.
Therefore the study of international business may be essential to work in global environment.

Importance of IFM
All the major economic functions-consumption, production and investment-are highly globalized. Hence it is
essential for financial managers to fully understand vital international dimensions of financial management. Proper
management of international finances can help the organization in achieving same efficiency and effectiveness in
all markets. Hence without IFM, sustaining in the market can be difficult.
Important Domains of International Finance
Here are the significant domains of international finance.
1. Foreign Direct Investment (FDI)
The foundation of international finance is foreign direct investment. It includes firms or people making
investments in assets or enterprises abroad. FDI might manifest itself as joint ventures, new operations, or
acquisition of existing businesses. Economic development depends on this kind of investment as it gives host
nations wealth, knowledge, and technologies.
2. Currency Exchange Rates
A basic feature of international finance is exchange rates. They generally affect commerce, investment, and
economic growth and define the value of one currency to another. Businesses involved in international
commerce and investors looking for prospects in overseas markets both depend on an awareness of exchange
rate swings.
3. Global Capital Markets
The study of worldwide financial markets, including stock exchanges, bond markets, and derivative markets,
constitutes international finance. These marketplaces allow investors to diversify their portfolios and help
money flow across borders.
4. Payments of Balance
In international finance, a fundamental idea is the balance of payments. It is a record of a nation’s commerce
in products and services as well as income flows and financial transactions concerning the rest of the globe.
Policymakers and economists can better grasp a nation’s economic situation and global economic position by
analysing the balance of payments.
What is the Significance of International Finance?
Promoting Worldwide Trade
International financial management helps with the tools enterprises need to participate in cross-border trade. It
helps businesses manage currency rate risks, pay in several currencies, and get funding for operations abroad.
Global commerce would be more difficult and less efficient without international financial
management systems.
For instance, a corporation exporting goods from the UK to Japan must negotiate many payment methods,
control currency conversion, and maybe protect against exchange rate changes. The tools and
expertise international finance offers help to handle this complexity properly.
Advocating Financial Development
International finance greatly accelerates economic development by helping money to travel across boundaries.
It lets nations attract international capital, which may result in higher productivity, technological transfer, and
job creation.
When a global company invests in a developing nation, for example, it usually contributes not only to finance
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but also to modern technology and managerial techniques. This can increase the productivity and
competitiveness of the host nation, therefore supporting general economic growth.
Improving Economic Stability
Global money managers keep the world’s financial system stable. They address major economic issues that
affect numerous nations. The 2008 crisis demonstrated how closely connected countries’ finances are. It also
demonstrated that financial difficulties may spread swiftly. Now, countries must collaborate to manage global
economics and avoid emergencies in the future.
Encouraging Development
Supporting economic growth in developing nations requires international financing. It gives nations access to
finance and knowledge that would enable them to grow sectors, create infrastructure, and raise living standards.
Development finance organisations such as the World Bank apply ideas of international financial management
to provide loans and grants to underdeveloped nations. Therefore, supporting programmes range from
infrastructure development to education and healthcare efforts.
Facilitating Risk Management
Businesses and investors in a linked global economy run several risks, including market volatility, political
unrest, and currency changes. Tools and approaches for properly controlling these risks come from international
finance.
For example, companies can guard against exchange rate hazards by using financial products such as options
or currency futures. Comparably, international portfolio diversification lets investors distribute risk among
several markets and asset types

Top International Financial Organisations

Many important institutions are very important in determining and controlling the global financial situation:
IMF, International Monetary Fund
Comprising 189 nations, the IMF is a group committed to promoting world financial cooperation. It helps
nations experiencing balance of payments problems financially and strives to preserve world financial stability.
In international finance, the IMF plays a role in member countries’ economic monitoring, policy advice
provision, and crisis financial help offering. Its activities can have a big effect on world economic policy and
financial markets.
International Bank
Originally called the International Bank for Reconstruction and Development, the World Bank works to lower
poverty and advance low- and middle-income nations’ economic growth. To underdeveloped nations, the
World Bank offers loans, grants, and technical support. Global economic growth depends on its efforts in fields
such as infrastructure building, education, and healthcare.
Bank of International Settlements (BIS)
Acting as a bank for central banks, the BIS advances international monetary and financial cooperation. It is
quite important to determine worldwide rules and standards for Finance. Through the Basel Committee on
Finance Supervision, the BIS’s work covers concerns of financial stability, sets capital adequacy rules for
banks, and offers a venue for central bank collaboration.
World Trade Organisation (WTO)
Although it is not really a financial entity, controlling world commerce through the WTO is rather important
for international finance. Cross-border trade and investment flows are substantially influenced by its policies
and agreements.
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Problems Associated with Global Finance
International finance involves some difficulties even if it has several advantages:
Variability in Exchange Rates
For companies involved in foreign commerce and investment, changes in exchange rates can generate anxiety.
A fundamental World Financial component of international financial management is controlling this risk.
Businesses have to create plans to lower exchange rate risks by applying forward contracts, currency options,
or other hedging devices.Crises
As the 2008 global financial crisis shows, the interdependence of world financial systems allows crises to
swiftly travel across borders. Managing and reducing such risks presents a major difficulty for international
finance.
Political Risks
International finance may be much affected by political unrest or changes in government policies. For
companies and investors working overseas, controlling political risk is very vital.
Technology Disruption
Fast technical developments are changing the world finance scene. These developments provide difficulties in
terms of adaptation and risk management even as they create possibilities.
Current Trends in International Financial Management
As the global economy evolves, international finance will provide new opportunities like:
Digital Exchange Notes
Rising digital currencies, including central bank digital currencies (CBDCs) and cryptocurrencies—may
change global finance. These technologies might change cross-border payments and question established
monetary systems.
Sustainable Financial Management
In worldwide finance, sustainable and ethical investing is becoming increasingly important. Globally,
environmental, social, and governance (ESG) principles are progressively guiding financial practices and
investment decisions.
Innovations in Technology
Fintech developments are revolutionising global Finance and accelerating more effective cross-border
transactions. These developments, in the meantime, also present fresh difficulties like cybersecurity threats and
the necessity of revised laws.
Conclusion
International finance is a dynamic and difficult discipline crucial for our linked global economy. The value of
international finance cannot be emphasised from encouraging economic development and stability to
facilitating cross-border commerce. Understanding the ideas of international financial management becomes
even more important as companies and governments negotiate the possibilities and problems of the global
economy.

Nature and Scope of International Financial Management

International finance-the finance function of a multinational firm has two functions-treasury and control. The
treasurer is responsible for financial planning analysis, fund acquisition, investment financing, cash
management, investment decision and risk management. Controller deals with the functions related to external
reporting, tax planning and management, management information system, financial and management

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accounting, budget planning and control, and accounts receivables etc.

Multinational finance is multidisciplinary in nature. While an understanding of economic theories and

principles is necessary to estimate and model financial decisions, financial accounting and management
accounting help in decision making in financial management at multinational level.

Because of changing nature of environment at international level, the knowledge of latest changes in forex
rates, volatility in capital market, interest rate fluctuations, macro level changes, micro level economic
indicators, savings, consumption pattern, interest preference, investment behavior of investors, export and
import trends, competition, banking sector performance, inflationary trends, demand and supply conditions etc.
is required by the practitioners of international financial management.

Nature of the financial Management

• IFM is concerned with financial decisions taken in international business.

• IFM is an extension of corporate finance at international level.
• IFM set the standard for international tax planning and international accounting
• IFM includes management of exchange rate risk.

Scope of IFM includes

• Foreign exchange markets, international accounting, exchange rate risk management etc.
• It also includes management of finance functions of international business.
• IFM sorts out the issues relating to FDI and foreign portfolio investment.
• It manages various risks such as inflation risk, interest rate risks, credit risk and exchange rate risk.
• It manages the changes in the foreign exchange market.
• It deals with balance of payments in global transactions of nations.
• Investment and financing across the nations widen the scope of IFM to international accounting
standards.
• It widens the scope of tax laws and taxation strategy of both parent country and host country.
• It helps in taking decisions related to international business.

International Financial Management Different From Financial Management At Domestic Level

The important distinguishing features of international finance from domestic financial management are
discussed below:

Foreign exchange risk

An understanding of foreign exchange risk is essential for managers and investors in the modern day
environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally
ignored because a single national currency serves as the main medium of exchange within a country. When
different national currencies are exchanged for each other, there is a definite risk of volatility in foreign
exchange rates. The present International Monetary System set up is characterized by a mix of floating and
managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of
exchange rates is widely regarded as the most serious international financial problem facing corporate
managers and policy makers.
At present, the exchange rates among some major currencies such as the US dollar, British pound, Japanese
yen and the euro fluctuate in a totally unpredictable manner. Exchange rates have fluctuated since the 1970s
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after the fixed exchange rates were abandoned. Exchange rate variation affect the profitability of firms and all
firms must understand foreign exchange risks in order to anticipate increased competition from imports or to
value increased opportunities for exports.
Thus, changes in the exchange rates of foreign currencies results in foreign exchange risks.

Political risk
Another risk that firms may encounter in international finance is political risk. Political risk ranges from the
risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts
of terrorism to outright expropriation of assets held by foreigners. The other country may seize assets of the
company without any reimbursements by utilizing their sovereign right, and some countries may restrict
currency remittances to the parent company. MNCs must assess the political risk not only in countries where
it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political
risk is when the sovereign country changes the ‗rules of the game‘ and the affected parties have no alternatives
open to them.
Example: In 1992, Enron Development Corporation, a subsidiary of a Houston based Energy Company, signed
a contract to build India‘s longest power plant. Unfortunately, the project got cancelled in 1995 by the
politicians in Maharashtra who argued that India did not require the power plant. The company had spent nearly
$ 300 million on the project. The Enron episode highlights the problems involved in enforcing contracts in
foreign countries.
Thus, political risk associated with international operations is generally greater than that associated with
domestic operations and is generally more complicated.
Expanded opportunity sets
When firms go global, they also tend to benefit from expanded opportunities which are available now. They
can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from
greater economies of scale when they operate on a global basis.

Market imperfections
The final feature of international finance that distinguishes it from domestic finance is that world markets today
are highly imperfect. There are profound differences among nations‘ laws, tax systems, business practices and
general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which
investors can diversify their portfolio. Though there are risks and costs in dealing with these market
imperfections, they also offer managers of international firms abundant opportunities.

Tax and Legal system

Tax and legal system varies from one country to another country and this leads to complexity in their financial
implications and hence give rise to tax and legal risks.

Inflation
Inflation rate differs from country to country. Higher inflation rates in few countries denote inflation risks.

Major turmoil influencing International financial Market

Frictions on International financial market can be in the form of

Government controls
With the help of different controlling procedures, government tries to control international financial flows like
maintaining the multiple exchange rates, taxes on international flows and constructs on outflow of funds. These
slower the pace of international/foreign investment flows
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 Different tax laws
Capital gains, interest income, dividend and other financial transactions reduce the post tax returns and thus
restrict the scope of international portfolio investment.

Implicit and explicit transaction costs

Trading fees/commission, bid ark speared is a form of Implicit and explicit transaction which affects the
International financial market. The transactions costs is less in developed countries compared to newly market
economies/countries. Transactions costs per unit decreases when the size of transaction is large. However,
small investors are not benefited from this strategy.

INTERNATIONAL BUSINESS METHODS

The four types of international businesses are:
i) Exporting
ii) Licensing
iii) Franchising
iv) Foreign Direct Investment (FDI)
• Exporting
Exporting is often the first choice when manufacturers decide to expand abroad. Exporting means selling
abroad, either directly to target customers or indirectly by retaining foreign sales agents or/and distributors.
Either case, going abroad through exporting has minimal impact on the firm‘s human resource management
because only a few, if at all, of its employees are expected to be posted abroad.
Exporting is the practice of shipping goods from the domestic country to a foreign country. This term export is
derived from the conceptual meaning as to ship the goods and services out of the port of a country. In national
accounts ―exports‖ consist of transactions in goods and services (sales, barter, gifts or grants) from residents to
non-residents.
The seller of such goods and services is referred to as an ―exporter‖ who is based in the country of export
whereas the overseas based buyer is referred to as an ―importer‖. An export‘s counterpart is an import. In
international trade, exporting refers to selling goods and services produced in the home country to other
markets. Export of commercial quantities of goods normally requires the involvement of customs authorities
in both the country of export and the country of import. Data on international trade in goods is mostly obtained
through declarations to customs services. If a country applies the general trade system, all goods entering or
leaving the country are recorded.

• Licensing
Licensing is another way to expand one‘s operations internationally. In case of international licensing, there is
an agreement whereby a firm, called licensor, grants a foreign firm the right to use intangible (intellectual)
property for a specific period of time, usually in return for a royalty. Licensing of intellectual property such as
patents, copyrights, manufacturing processes, or trade names abound across the nations. The Indian basmati
(rice) is one such example.
When considering strategic entry into an international market, licensing is a low-risk and relatively fast foreign
market entry tactic.
Compared to the other potential entry models for foreign market entry, licensing is relatively low risk in terms
of time, resources, and capital requirements.
Advantages of licensing include localization through a foreign partner, adherence to strict international
business regulations, lower costs, and the ability to move quickly.
Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign
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market, and lower returns due to lower risk.
When deciding to license abroad, careful due diligence should be done to ensure that the licensee is a strong
investment for the licensor and vice versa.
A ‗licensor‘ in a licensing relationship is the owner of the produce, service, brand or technology being licensed.
And a ‗licensee‘ is the buyer of the produce, service, brand or technology being licensed.
A licensor (i.e. the firm with the technology or brand) can provide their products, services, brand and/or
technology to a licensee via an agreement. This agreement will describe the terms of the strategic alliance,
allowing the licensor affordable and low risk entry to a foreign market while the licensee can gain access to the
competitive advantages and unique assets of another firm. This is potentially a strong win-win arrangement for
both parties, and is a relatively common practice in international business.
Example: Due to food import regulations in Japan, the licensor in a company involved in energy health drinks
cannot sell the product at local wholesalers or retailers. In order to circumvent this strategic barrier, the licensor
finds a local sports drink manufacturer to license their recipe to. In exchange, the licensee sells the product
locally under a local brand name and kicks back 15% of the overall revenues to the licensor.
Licenses are signed for a variety of time periods. Depending on the investment needed to enter the market, the
foreign licenses may insist on a longer licensing period to pay on the initial investment. The license will make
all necessary capital investment such as machinery inventory and so on and market the products in the assigned
sales territories, which may consist of one or more countries. Licensing arrangements are subjected to
negotiations and tend to vary considerably from company to company and from industry to industry.
Before deciding to use licensing as an entry strategy, it‘s important to understand in which situations licensing.

Licensing affords new international entrants with a number of advantages:

Licensing is a rapid entry strategy, allowing almost instant access to the market with the right partners lined
up.
Licensing is low risk in terms of assets and capital investment. The licensee will provide the majority of the
infrastructure in most situations.
Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry. Cultural
and linguistic barriers are also significant challenges for international entries. Licensing provides critical resources
in this regard, as the licensee has local contacts, mastery of local language, and a deep understanding of the local
market.

• Franchising
Franchising is closely related to licensing and is a special form of it. Franchising is an option in which a parent
company grants another company/firm the right to do business in a prescribed manner. A
‗franchisee‘ is a holder of a franchise; a person who is granted a franchise. And a ‗franchiser‘ is a person who
grants franchises.
Franchising differs from licensing in the sense that it usually requires the franchisee to follow much stricter
guidelines in running the business than does licensing. Further, licensing tends to be confined to manufacturers,
whereas franchising is more popular with service firms such as restaurants, hotels and rental services.
Franchisee will take the majority of the risk in opening a new location (e.g. capital investments while gaining
the advantage of an already established brand name and operational process. In exchange, the franchisee
will pay a certain percentage of the profits of the venture back to the franchiser. The franchiser will also often
provide training, advertising, and assistance with products.
Franchising business is very important to companies here and abroad. At present, the prominent examples of
the franchise agreements in India are Pepsi Food Ltd., Coca-Cola, Wimpey‘s Domino, McDonald, and Nirula.

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In USA, one in 12 business establishments is a franchise.
Franchising enables organizations a low cost and localized strategy to expanding to international markets, while
offering local entrepreneurs the opportunity to run an established business.
A franchise agreement is defined as the franchiser granting an entrepreneur or local company (the franchisee)
access to its brand, trademarks, and products.
Franchising is designed to enable large organizations rapid access to new markets with relatively low barriers
to entry.
• Foreign Direct Investment (FDI)
Exporting, licensing and franchising make companies get them only so far in international business. Companies
aspiring to take full advantage of opportunities offered by foreign markets decide to make a substantial direct
investment of their own funds in another country. This is popularly known as Foreign Direct Investment (FDI).
FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other privileges
in that foreign country. FDI is the flow of investments from one company to production in a foreign nation,
with the purpose of lowering labor costs and gaining tax incentives. FDI can help the economic situations of
developing countries, as well as facilitate progressive internal policy reforms.
A major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and
participation in international trade agreements and institutions.
Foreign direct investment (FDI) is investment into production in a country by a company located in another
country, either by buying a company in the target country or by expanding operations of an existing business
in that country.
FDI is done for many reasons including to take advantage of cheaper wages in the country, special investment
privileges, such as tax exemptions, offered by the country as an incentive to gain tariff-free access to the markets
of the country or the region. FDI is in contrast to portfolio investment which is a passive investment in the
securities of another country, such as stocks and bonds.
Increase in the inward flow of FDI is a best choice for developing countries. However, identifying the
conditions that best attract such investment flow is difficult, since foreign investment varies greatly across
countries and over time. Knowing what has influenced these decisions and the resulting trends in outcomes can
be helpful for governments, non-governmental organizations, businesses, and private donors looking to invest
in developing countries.
Foreign direct investment refers to operations in one country that are controlled by entities in a foreign country.
In a sense, this FDI means building new facilities in other country. In India, a foreign direct investment means
acquiring control by more than 74% of the operation. This limit was 50% till the financial year 2001-2002.
There are two forms of direct foreign investment: joint ventures and wholly-owned subsidiaries. A joint venture
is defined as ―the participation of two or more companies jointly in an enterprise in which each party
contributes assets, owns the entity to some degree, and shares risk‖. In contrast, a wholly-owned subsidiary is
owned 100% by the foreign firm.

• Joint venture
Joint venture is a business agreement in which parties agree to develop a new entity and new assets by
contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and
assets.
When two or more persons come together to form a partnership for the purpose of carrying out a project, this
is called a joint venture. In this scenario, both parties are equally invested in the project in terms of money,
time and effort to build on the original concept. While joint ventures are generally small projects, major
corporations use this method to diversify. A joint venture can ensure the success of smaller projects for those

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 that are just starting in the business world or for established corporations. Since the cost of starting new projects
is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting
profits.
Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties
must be committed to focusing on the future of the partnership rather than just the immediate returns.
Ultimately, short term and long term successes are both important. To achieve this success, honesty, integrity
and communication within the joint venture are necessary.
A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological
expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time
contracts. The JV is dissolved when that goal is reached. Some major joint ventures include Dow Corning,
Miller Coors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

Recent Changes and Challenges in IFM

Challenges of International Financial Management

Despite its benefits, International Financial Management comes with several challenges

1. Exchange Rate Volatility : Exchange rate volatility can significantly impact the profitability of
international transactions. CA students must understand the factors influencing exchange rates and
develop strategies to mitigate risks.

2. Political and Economic Risks : Political instability and economic fluctuations in foreign countries can
pose significant risks to international investments. IFM requires assessing these risks and developing
contingency plans to protect business interests.

3. Cultural Differences : Cultural differences can affect business practices and financial decision-
making. Understanding and navigating these differences is crucial for successful international
financial management.

4. Regulatory Complexity :Navigating diverse financial regulations in different countries can be

challenging. CA students need to stay updated on global regulatory changes to ensure compliance
and avoid legal issues.

5. Technological Advancements :Technological advancements are rapidly changing the landscape of

international finance. Staying abreast of these changes and leveraging technology for efficient
financial management is essential for CA students. By mastering the concepts and challenges of IFM,
you can enhance your career prospects and contribute significantly to the success of multinational
corporations. For comprehensive CA preparation, consider enrolling in the PW CA Course, which
offers expert guidance and resources to help you crack the CA exam with confidence.

Recent changes in IFM

• Emergence of Euro market
Emergence of Euro market in 1960‘s the major cause for development and growth of IFM. This market
resulted in
i. A series of parallel money markets free from regulations
ii. led to internationalization of banking business and
iii. Emergence of innovative funding techniques and securities.
International financial markets have undergone rapid and extensive changes in the recent past.
i. Dramatic events in global financial markets, including the Asian crisis, the Russian crisis, and the
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 near-collapse of Long Term Capital Management (LTCM), in 2008, in US and other European
countries which was a highly leveraged hedge fund with enormous trading positions.
ii. Remarkable developments in stock prices around the world, and in particular in stocks in the
telecommunications and internet sectors. Many of these so-called "tech. stocks", which
experienced sharp price increases in late 1999 and early 2000.
iii. After 1980‘s the pace of change has become too fast. This period saw emergence of new financial
instruments, securities, methods of settlement and persons involved in the market. Development of
information and communication technology furthered the change process

In 1960‘s this is the major cause for development and growth of IFM This
market resulted in
• A series of parallel money markets free from regulations.
• led to internationalization of banking business and
• emergence of innovative funding techniques and securities

• Introduction of Floating Exchange Rate

Introduced in 1973, another important change, which resulted in volatility. This increased risk in exchange
rates to both borrowers and lenders. To manage risk new institutions and products emerged like futures,
swaps, options etc. Reduction in the traditional income of banks like interest, commission brokerage etc.
compelled them to introduce new products and services, which often the banks themselves cannot understood

• Integration among the different financial markets

Is another remarkable change taken place in 1980‘s is the integration among the different financial markets
in different countries. Integration resulted in
• Reducing the gap between local, regional, national and offshore financial markets led to the
creation of a unified, globalised financial markets
• Increasing the rate of growth of financial systems than that of production
• Establishment of branches of banks and financial institutions of developed and industrial
countries in other countries
• Establishment of branch banks in different countries and permission to tap the national financial
markets
• Integration among the financial markets of industrialized countries like US, Japan and Europe
• Resulted in reducing the gap between the financial markets of different advanced countries
• Functional unification
Different kinds of financial institutions serve different kinds of financial services. Financial institutions were
divided as commercial banks, investment banks, EXIM banks etc.
Recently these functional specializations became unimportant and financial institutions started to render wide
range of services instead of specializing one or two tasks.
Thus recently, there is a spatial and functional integration
Major reasons for these changes are
• Liberalization in cross boarder financial transaction
• Deregulation within the financial system of the major industrialized nations
Major liberalization steps include:
• Lifting exchange controls in UK, France and Japan (other nations like US, Germany, Switzerland etc,
which were already liberalized)
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 • Removal of tax on interest paid for non-resident
• Opening up of domestic financial markets to foreign borrowers
• Allowing domestic borrowers to borrow from foreign markets

• Liberalization and Deregulation

This helped portfolio investors to invest their funds in a wide range of assets over different parts of the world,
on their own risk, on their own estimates.
This helped the borrower in borrowing funds economically from different parts of the world at competitive
level, minimizing all costs.
Competition in international financial markets resulted in efficient and effective operations.
Emergence of international financial markets stock markets etc., resulted reducing the importance of national
markets. Another remarkable change was in the field of securitization and disintermediation.
Competition resulted financial service industry also.
Borrowers began to borrow directly by issuing new variety of securities like depository receipt etc. The
importance of intermediaries reduced and resulted in disintermediation.
Underwriting commission, brokerage etc reduced and the hegemony of US financial institutions also reduced.
One aspect of this securitization process has been the increase in corporate bond issue, which has also coincided
with a diminishing supply of government bonds in many countries, particularly in the United States.

• Emergence and development derivative markets

Is another interesting development. Rapid advances in technology, financial engineering, and risk management
are major reasons.
These helped to enhance both the supply of and the demand for more complex and sophisticated derivatives
products.
Increased use of derivatives to adjust exposure to risk in financial markets has also contributed to the rise in
speculation in securities.
The leveraged nature of derivative instruments increased risks to individual investors.
Derivatives also provide scope for a more efficient allocation of risks in the economy, which is beneficial for
the functioning of financial markets, and hence enhances the conditions for economic growth.
Conclusion: Unprecedented development in international financial markets Due to the liberalization of
markets, rapid technological progress and major advances in telecommunications
This has opened new vistas for investment and financing opportunities for businesses and people around the
world, and easier access to global financial markets for individuals and corporations
This has led to a more efficient allocation of capital, paving way to economic growth and prosperity.

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 BALANCE OF PAYMENT
Balance of Payments (BOP), fundamentals of BOP, Accounting components of BOP, factors affecting
international trade flows, agencies that facilitate international flows. Indian BOP trends, Balance Of Payments:
Fundamentals
Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country
and the rest of the world. These transactions include payments for the country's exports and imports of goods,
services, financial capital, and financial transfers.
The Bop is a collection of accounts conventionally grouped into three main categories with subdivisions in
each. The three main categories are: (a) The Current Account: Under this are included imports and exports
of goods and services and uni-lateral transfers of goods and services. (b) The Capital Account: Under this are
grouped transactions leading to changes in foreign financial assets and liabilities of the country. (c) The
Reserve Account: In principle this is no different from the capital account in as much as it also relates to
financial assets and liabilities. However, in this category only ―reserve assets‖ are included.
The IMF definition: The International Monetary Fund (IMF) use a particular set of definitions for the BOP
accounts, which is also used by the Organization for Economic Cooperation and Development (OECD), and
the United Nations System of National Accounts (SNA). The main difference in the IMF's terminology is that
it uses the term "financial account" to capture transactions that would under alternative definitions be recorded
in the capital account. The IMF uses the term capital account to designate a subset of transactions that,
according to other usage, form a small part of the overall capital account.[6] The IMF separates these
transactions out to form an additional top level division of the BOP accounts. Expressed with the IMF
definition, the BOP identity can be written:
Current account financial account capital account balancing item=0.
The IMF uses the term current account with the same meaning as that used by other organizations, although it
has its own names for its three leading subdivisions, which are:
The goods and services account (the overall trade balance)
The primary income account (factor income such as from loans and investments) The
secondary income account (transfer payments)

4.1.1 Current account of balance of Payment

The Current accounts records the transaction in merchandise and invisibles with the rest of the world. Merchandise
covers imports and exports and invisibles include travel transportation insurance, investment and other services.
The current account mainly consists of 4 types of transactions.
• Exports and imports of goods: Exports of goods are credits (+) to the current account.
Imports of goods are debits (-) to the current account.
• Exports and imports of services: Exports of services are credits (+) to the current account.
Imports of services are debits (-) to the current account.
• Interest payments on international investments
Interest, dividends and other income received on U.S. assets held abroad are credits (+).
Interest, dividends and payments made on foreign assets held in the U.S. are debits (-).
Since 1994, the U.S. has run a net debit in the investment income account: more payments
are made to foreigners than foreigners make to U.S. investors.
• Current transfers
Remittances by Americans working abroad, pensions paid by foreign countries to their
citizens living in the U.S., aid offered by foreigners to the U.S. count as credits (+).
Remittances by foreigners working in the U.S., pensions paid by the United States to its

14
 citizens living abroad, aid offered to foreigners by the U.S. count as debits (-) As expected
the U.S. runs a deficit in current transfers.
The sum of these components is known as the current account balance. A negative number
is called a current account deficit and a positive number called a current account surplus.
As expected, given that it runs a surplus only in the services component of the current
account, the U.S. runs a substantial current account deficit.

4.1.2 Capital account of Balance of payment

In the case of the capital account an increase (decrease) in the county foreign financial assets are debit (credit)
whereas any increase (decrease) in the country foreign financial liabilities are credits (debits). The transaction
under the Capital account is classified as:
i) Foreign Investment
ii) Loans
iii) Banking Capital
iv) Rupee debt services
v) Other debt capital
Loans include the concessional loans received by the government ‘or public sector bodies , long term loan and
medium term borrowings from the commercial capital market in the form of loans Bond issue and short term
credits. Disbursement received by Indian resident entities is the credit Items while payment and loans made by
the Indians are the credit items
All inflow of the foreign capital comes credit item of the Balance of payment/Banking capital covers the
changes in the foreign assets and liabilities of commercial banks whether privately owned or the comparative
and government owned. An decrease in assets and increase in liability is a credit item. The item Rupee debt
services defined as the cost of meeting inters payments and regular contractual repayments of the principal of
a loan along with the any administrate charges in rupee by India.

4.1.3 Factors affecting the components of BOP account

Exports of goods and services affected by following factors
(a) The prevailing rate of domestic currency
(b) Inflation rate
(c) Income of foreigners
(d) World price of the commodity
(e) Trade barriers.
Imports of Goods and services
(f) Level of Domestic Income
(g) International prices
(h) Inflation rate
(i) Value of Domestic Currency
(j) Trade Barriers

Impact of Government Policies:

• Restrictions on Imports: Taxes (tariffs) on imported goods increase prices and limit consumption.
Quotas limit the volume of imports.
• Subsidies for Exporters: Government subsidies help firms produce at a lower cost than their global
competitors.
• Restrictions on Piracy: A government can affect international trade flows by its lack of restrictions
15
 on piracy.
• Environmental Restrictions: Environmental restrictions impose higher costs on local firms, placing
them at a global disadvantage compared to firms in other countries that are not subject to the same
restrictions.
• Labor Laws: countries with more restrictive laws will incur higher expenses for labor, other
factors being equal.
• Business Laws: Firms in countries with more restrictive bribery laws may not be able to compete
globally in some situations.
• Tax Breaks: Though not necessarily a subsidy, but still a form of government financial support
that might benefit many firms that exports products.
• Country Security Laws: Governments may impose certain restrictions when national security is
a concern, which can affect on trade.
• Impact of Exchange Rates :when a home currency is exchanged for a foreign currency to buy foreign
goods, then the home currency faces downward pressure, leading to increased foreign demand for the
country‘s products. On the other way, Exchange rates will not automatically correct any international
trade balances when other forces are at work.

Agencies that facilitate international flows

• International Monetary fund
The IMF is an organization of 183 member countries. Established in 1946, it aims
i. to promote international monetary cooperation and exchange stability;
ii. to foster economic growth and high levels of employment; and
iii. to provide temporary financial assistance to help ease imbalances of payments.
iv. promote cooperation among countries on international monetary issues,
v. promote stability in exchange rates
vi. provide temporary funds to member countries attempting to correct imbalances of international
payments
vii. promote free mobility of capital funds across countries
viii. Promote free trade.
Its operations involve surveillance, and financial and technical assistance. In particular, its compensatory
financing facility attempts to reduce the impact of export instability on country economies. The IM F uses
a quota system, and its unit of account is the SDR (special drawing right). It is clear from these objectives
that the IMF‘s goals encourage increased internationalization of business

• World Bank Group

i) Established in 1944, the Group assists development with the primary focus of helping the poorest people
and the poorest countries.
ii) It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and ICSID.

• IBRD: International Bank for Reconstruction and Development

1. Better known as the World Bank, the IBRD provides loans and development assistance to middle-income
countries and creditworthy poorer countries.
2. In particular, its structural adjustment loans are intended to enhance a country‘s long-term economic
growth.
3. The IBRD is not a profit-maximizing organization. Nevertheless, it has earned a net income every year since
1948.

16
4. It may spread its funds by entering into cofinancing agreements with official aid agencies, export credit
agencies, as well as commercial banks.

• IDA: International Development Association

a. IDA was set up in 1960 as an agency that lends to the very poor developing nations on highly
concessional terms.
b. IDA lends only to those countries that lack the financial ability to borrow from IBRD.
c. IBRD and IDA are run on the same lines, sharing the same staff, headquarters and project evaluation
standards.
• IFC: International Finance Corporation
The IFC was set up in 1956 to promote sustainable private sector investment in developing countries, by
1. financing private sector projects;
2. helping to mobilize financing in the international financial markets; and
3. Providing advice and technical assistance to businesses and governments.

• MIGA: Multilateral Investment Guarantee Agency

The MIGA was created in 1988 to promote FDI in emerging economies, by
1. offering political risk insurance to investors and lenders; and
2. Helping developing countries attract and retain private investment.

• ICSID: International Centre for Settlement of Investment Disputes

The ICSID was created in 1966 to facilitate the settlement of investment disputes between governments and
foreign investors, thereby helping to promote increased flows of international investment.

• World Trade Organization (WTO)

1. Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT).
2. It deals with the global rules of trade between nations to ensure that trade flows smoothly, predictably and
freely.
3. At the heart of the WTO's multilateral trading system are its trade agreements.
Its functions include:
• administering WTO trade agreements;
• serving as a forum for trade negotiations;
• handling trade disputes;
• monitoring national trading policies;
• providing technical assistance and training for developing countries; and
• Cooperating with other international groups.

• Bank for International Settlements (BIS)

i. Set up in 1930, the BIS is an international organization that fosters cooperation among central banks and
other agencies in pursuit of monetary and financial stability.
ii. It is the ―central banks‘ central bank‖ and ―lender of last resort.‖ The
BIS functions as:
iii. a forum for international monetary and financial cooperation;
iv. a bank for central banks;
v. a center for monetary and economic research; and
vi. an agent or trustee in connection with international financial operations.

17
 • Regional Development Agencies
Agencies with more regional objectives relating to economic development include
i. the Inter-American Development Bank;
ii. the Asian Development Bank;
iii. the African Development Bank; and
iv. the European Bank for Reconstruction and Development.
Indian Bop trends
Balance of Payment in India: India‘s balance of payment position was quite unfavorable during the time of
country‘s entry into liberalized trade regime. Two decades of economic reforms and free trade opened several
opportunities that, of course, reflected in the balance of payments performance of the country.
The market for foreign exchange (often abbreviated as the forex or FX market) is a global marketplace
where participants buy, sell, exchange, and speculate on currencies. It is the largest and most liquid financial
market in the world, with daily trading volumes exceeding trillions of dollars.

What is Forex Exchange Market?

The foreign exchange market (also referred to as the forex or currency market) is the marketplace for
exchanging currencies between all stakeholders such as governments, central and commercial banks, firms,
forex dealers, brokers and individuals. Such players can use the market for trading, hedging and speculating in
currencies as well as obtaining credit.
What is Forex Exchange Market?
The foreign exchange market (also referred to as the forex or currency market) is the marketplace for
exchanging currencies between all stakeholders such as governments, central and commercial banks, firms,
forex dealers, brokers and individuals. Such players can use the market for trading, hedging and speculating in
currencies as well as obtaining credit.
How are exchange rates determined?
Currencies are always traded in pairs e.g.: USD-EUR, USD-INR etc. The relationship between the currencies
is given by the formula:
Base currency / Quotation Currency = Value
For example, if the base currency is USD and the quotation currency is INR then the value would be roughly
around 79 as the rupee is trading at around INR 79 per USD.
Now exchange rates are determined by various factors depending on whether the currencies in question have
“free float” or “fixed float”.
1. Free floating currencies are those whose value depends solely on the demand and supply of the currency
relative to other currencies.
2. Fixed floating currencies are those whose value is fixed by the government or the central bank, sometimes
by pegging it to a standard. For example, the Russian Ruble was recently pegged to gold at 5000 rubles per
gram of gold.

Key Features of the Forex Market:

i) Decentralized Market:
• The forex market operates over-the-counter (OTC), meaning there is no central exchange.
Instead, trading is conducted electronically between participants via computer networks.

18
 ii) 24-Hour Trading:
• Forex trading occurs 24 hours a day, five days a week, as the market follows the sun across
major financial centers like Sydney, Tokyo, London, and New York.
iii) High Liquidity:
• Due to the vast number of participants and the global nature of the market, forex is extremely
liquid. This means traders can execute large trades with minimal impact on prices.
iv) Currency Pairs:
• Currencies are traded in pairs, such as EUR/USD (Euro vs. US Dollar) or GBP/JPY (British
Pound vs. Japanese Yen). The first currency in the pair is the base currency, and the second
is the quote currency.
v) Participants:
• Central banks: Manage currency reserves and implement monetary policy.
• Commercial banks: Facilitate currency trading for clients and their own accounts.
• Corporations: Hedge against foreign exchange risks or pay for goods and services in other
currencies.
• Retail traders: Individuals speculating on currency movements through brokers.
• Investment funds: Hedge funds and asset managers trading currencies as part of broader
strategies.
vi) Key Determinants of Currency Value:
• Economic indicators (e.g., GDP growth, inflation, employment data).
• Interest rates and central bank policies.
• Political stability and geopolitical events.
• Market sentiment and speculation.
Types of Forex Market
There are 5 types of currency markets in India – spot, forward, futures, options and swaps.
1. Spot Market
The spot market is the marketplace for currency trading at real-time exchange rates.
2. Forward Market
deal in over-the-counter (OTC) forward contracts. Forward contracts are agreements between parties to
exchange a particular quantity of currency pair at a specific rate and on a given date. They help in hedging
currency risks i.e. the risk of changing values of currency assets due to fluctuations in currency exchange rates.
However, forward markets do not have a central exchange for their operations. Therefore:
1. They are highly illiquid (hard to find buyers or sellers randomly)
2. They usually do not require any collateral and thus have counterparty risk i.e. risk of parties not following
through with an agreement
3. Futures Market
The futures markets is basically the forward market, but with centralised exchanges like the NSE. Therefore,
they have higher liquidity and lower counterparty risk than forward markets. Currency futures or FX futures or
currency derivatives are available on the NSE on INR and four currencies viz. US Dollars (USD), Euro (EUR),
Japanese Yen (JPY) and Great Britain Pound (GBP). Cross Currency Futures & Options contracts on EUR-
USD, USD-JPY and GBP-USD are also available for trading in the currency derivatives segment. Since all
transactions are publicly available and settled in cash, it is easier to trade, speculate and perform arbitrage in

19
 the futures market.
4. Options Market
The options market allows traders the right to buy/sell currency at a specified price on a specified date through
a central exchange such as the NSE. The currencies available are the same as that of the NSE currency futures
market.
5. Swaps Market
Currency swaps are agreements between two parties to exchange a principal and interest amount in different
currencies only to be re-exchanged at a specific later date. At least one of the interest rates in the agreement is
fixed.
Advantages and Disadvantages of the Foreign Exchange Market
Advantages
• Facilitates International Trade: Enables businesses to convert one currency to another for cross-border
trade.
• Hedging and Speculation: Helps manage currency risks and provides opportunities for profit through
speculation.
• Economic Indicators: Forex prices often reflect the relative economic health of countries.
• There are fewer rules than in other markets, which means investors aren’t held to the strict standards or
regulations found in other markets.
• There are no clearinghouses and no central bodies that oversee the forex market.
• Most investors won’t have to pay the traditional fees or commissions that they would on another market.
• Because the market is open 24 hours a day, you can trade at any time of day, which means there’s no cutoff
time to be able to participate in the market (except if you’re heading into the weekend).
• Finally, if you’re worried about risk and reward, you can get in and out whenever you want, and you can
buy as much currency as you can afford based on your account balance and your broker’s rules for leverage.
Disadvantages
• Though the market being unregulated brings advantages, it also creates risks, as there is no significant
oversight that can ensure risk-free transactions.
• Leverage can help magnify profits but can also lead to high losses. As there are no set limits on leverage,
investors stand to lose a tremendous amount of money if their trades move in the wrong direction.
• Unlike stocks that can also provide returns through dividends and bonds through interest payments, FX
transactions solely rely on appreciation, meaning they have less residual returns than some other assets.
• Lack of transparency in the FX market can harm a trader as they do not have full control over how their
trades are filled, may not get the best price, and may have a limited view of information, such as quotes.

INTERNATIONAL PARITY RELATIONSHIP AMD FORECASTING:(theory and numerical in given link)

https://www.academia.edu/12382263/International_Parity_Relationships_and_Forecasting_Foreign_Exchange_
Rates?auto=download

FOREIGN EXCHANGE RATES

Foreign Exchange Rate

Foreign Exchange Rate is defined as the price of the domestic currency with respect to another currency. The purpose
of foreign exchange is to compare one currency with another for showing their relative values.
20
Foreign exchange rate can also be said to be the rate at which one currency is exchanged with another or it can be
said as the price of one currency that is stated in terms of another currency.
Exchange rates of a currency can be either fixed or floating. Fixed exchange rate is determined by the central bank of
the country while the floating rate is determined by the dynamics of market demand and supply.

• Factors influencing Exchange rates

Foreign Exchange rate (ForEx rate) is one of the most important means through which a country‘s relative level of
economic health is determined. A country's foreign exchange rate provides a window to its economic stability,
which is why it is constantly watched and analyzed. While sending or receiving money from overseas, there‘s a
need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may
fluctuate daily with the changing market forces of supply and demand of currencies from one country to another.
For these reasons; when sending or receiving money internationally, it is important to understand what determines
exchange rates.
a)Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than
another‘s will see an appreciation in the value of its currency. The prices of goods and services increase at a slower
rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value
while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by
higher interest rates
b) Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are
all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates
provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates
c) Country’s Current Account / Balance of Payments
A country‘s current account reflects balance of trade and earnings on foreign investment. It consists of total number
of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its
currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments
fluctuates exchange rate of its domestic currency.
d) Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt
is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market
if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange
rate will follow.
e) Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices.
A country's terms of trade improves if its exports prices raise at a greater rate than its imports prices. This results
in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value.
This results in an appreciation of exchange rate.
f) Political Stability & Performance
A country's political state and economic performance can affect its currency strength. A country with less risk for
political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries
with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value
of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty
in value of its currency. But, a country prone to political confusions may see depreciation in exchange rates.
g) Recession
21
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign
capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange
rate.
h) Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a
profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this
increase in currency value comes a rise in the exchange rate as well. All of these factors determine the foreign
exchange rate fluctuations. If you send or receive money frequently, being up-to-date on these factors will help you
better evaluate the optimal time for international money transfer. To avoid any potential falls in currency exchange
rates, opt for a locked-in exchange rate service, which will guarantee that your currency is exchanged at the same
rate despite any factors that influence an unfavorable fluctuation.

What is Foreign Exchange Rate?

The foreign exchange rate is the rate at which one country’s currency can be exchanged for another country’s
currency. Foreign exchange rates are influenced by various factors, including supply and demand dynamics in the
foreign exchange market, economic indicators, geopolitical events, and central bank policies. For example, the
Indian rupee (₹) in India, the Pound (£) in England, and the Dollar ($) in the United States of America. However,
a country’s currency cannot be used in another country; For example, the Indian rupee (₹) can not be directly
acceptable in the USA. In today’s world, countries have economic relations with each other. Thus, there is an
increase in interdependence among the countries.
Geeky Takeaways:
• Central banks often intervene in the foreign exchange market to stabilize or influence their currency’s value,
using tools like interest rates and foreign exchange reserves.
• Businesses and investors face exchange rate risk, as fluctuations can impact the value of international
transactions, investments, and profits.
• Exchange rates serve as an essential indicator of global economic conditions, reflecting economic health,
inflation rates, and political stability.

Types of Foreign Exchange Rates

There are three types of exchange rates; namely,
Fixed Exchange Rate,
Flexible Exchange Rate, and
Managed Floating Exchange Rate.

1. Fixed Exchange Rate

Under this system, the exchange rate for the currency is fixed by the government. Thus, the government is
responsible to maintain the stability of the exchange rate. Each country maintains the value of its currency in terms
of some ‘external standard’ like gold, silver, another precious metal, or another country’s currency.
• The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade and capital
flows.
• The central bank or government purchases foreign exchange when the rate of foreign currency rises and sells
foreign exchange when the rates fall to maintain the stability of the exchange rate.
• Thus, government has to maintain large reserves of foreign currencies to maintain a fixed exchange rate.
• When the value of one currency(domestic) is tied to another currency then this process is known as pegging and

22
 that’s why the fixed exchange rate system is also referred to as the Pegged Exchange Rate System.
• When the value of one currency(domestic) is fixed in terms of another currency or in terms of gold, then it is
called the Parity Value of currency.
Methods of Fixed Exchange Rate in Earlier Times
1. Gold Standard System (1870-1914): As per this system, gold was taken as the common unit of parity between
the currencies of different countries. Each country defines the value of its currency in terms of gold. Accordingly,
the value of one currency is fixed in terms of another country’s currency after considering the gold value of each
currency.
For example,
1£(UK Pound)= 5g of gold
1$(US Dollar)= 2g of gold
then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)
2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton Woods System.
This system was adopted to have clarity in the system. Even in the fixed exchange rate, it allowed some adjustments,
thus it is called the ‘adjusted peg system of exchange rate’. Under this system:
• Countries were required to fix their currency against the US Dollar($).
• US Dollar was assigned gold value at a fixed price.
• The value of one currency say £(UK Pound) was pegged in terms of the US Dollar($), which ultimately implies
the value of the currency in gold.
• Gold was considered an ultimate unit of parity.
• International Monetary Fund (IMF) worked as a central institution in controlling this system.
This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.
Devaluation and Revaluation
Devaluation includes a reduction in the value of the domestic currency in terms of foreign currencies by the
government. Under a fixed exchange rate system, the government undertakes devaluation when the exchange rate
is increased.
Revaluation refers to an increase in the value of the domestic currency by the government.
Difference between Devaluation and Depreciation
Merits of Fixed Exchange Rate System
1. It ensures stability in the exchange rate. Thus it helps in promoting foreign trade.
2. It helps the government to control inflation in the economy.
3. It stops speculating in the foreign exchange market.
4. It promotes capital movements in the domestic country as there are no uncertainties about foreign rates.
5. It helps in preventing capital outflow.
Demerits of Fixed Exchange Rate System
1. It requires high reserves of gold. Thus it hinders the movement of capital or foreign exchange.
2. It may result in the undervaluation or overvaluation of the currency.
3. It discourages the objective of having free markets.
4. The country which follows this system may find it difficult to tackle depression or recession.
Fixed Exchange Rate has been discontinued because of many demerits of the system by all leading economies,
including India.
2. Flexible Exchange Rate System
Under this system, the exchange rate for the currency is fixed by the forces of demand and supply of different
currencies in the foreign exchange market. This system is also called the Floating Rate of Exchange or Free
Exchange Rate. It is so because it is determined by the free play of supply and demand forces in the international
23
money market.
• Under the Flexible Exchange Rate system, there is no intervention by the government.
• It is called flexible because the rate changes with the change in the market forces.
• The exchange rate is determined through interactions of banks, firms, and other institutions that want to buy
and sell foreign exchange in the foreign exchange market.
• The rate at which the demand for foreign currency is equal to its supply is called the Par Rate of Exchange,
Normal Rate, or Equilibrium Rate of Foreign Exchange.
Merits of Flexible Exchange Rate System
1. With the flexible exchange rate system, there is no need for the government to hold any reserve.
2. It eliminates the problem of overvaluation or undervaluation of the currency.
3. It encourages venture capital in the form of foreign exchange.
4. It also enhances efficiency in the allocation of resources.
Demerits of the Flexible Exchange Rate System
1. It encourages speculation in the economy.
2. There is no stability in the economy as the exchange rate keeps on fluctuating as per demand and supply.
3. Under this, coordination of macro policies becomes inconvenient.
4. There is uncertainty in the economy that discourages international trade.
3. Managed Floating Exchange Rate
It is the combination of the fixed rate system (the managed part) and the flexible rate system (the floating part),
thus, it is also called a Hybrid System. It refers to the system in which the foreign exchange rate is determined by
the market forces and the central bank stabilizes the exchange rate in case of appreciation or depreciation of the
domestic currency.
• Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control the fluctuation
in the exchange rate. The central bank sells foreign exchange when the exchange rate is high to bring it down
and vice versa. It is done for the protection of the interest of importers and exporters.
• For this purpose, the central bank maintains the reserves of foreign exchange so that the exchange rate stays
within a targeted value.
• If a country manipulates the exchange rate by not following the rules and regulations, then it is known as Dirty
Floating.
• However, the central bank follows the necessary rules and regulations to influence the exchange rate.
Example of Managed Floating Exchange Rate
Suppose, India has adopted Managed Floating System and the Reserve Bank of India (Central Bank) wants to keep
the exchange rate $1 = ₹60. And, let’s assume that the Reserve Bank of India is ready to tolerate small fluctuations,
like from 59.75 to 60.25; i.e., .25.
If the value remains within the above limit, then there is no intervention. But if due to excess demand for the Indian
rupee the value of the rupee starts declining below 59.75/$. Then, in that case, RBI will start increasing the supply
of rupees by selling the rupees for dollars and acquiring holding of dollars.
Similarly, due to the excess supply of the Indian rupee, if the value of the rupee starts increasing above 60.25/$.
Then, in that case, RBI will start increasing the demand for Indian rupees by exchanging the dollars for rupees and
running down its holding of dollars.
Hence, in this way, the Reserve Bank of India maintains the exchange rate.
Other types of Exchange Rate System
Over the time period, because of the different changes in the global economic events, the exchange rate systems
have evolved. Besides, fixed, flexible, and managed floating exchange rate systems, the other types of exchange
rate systems are:
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1. Adjustable Peg System: An exchange rate system in which the member countries fix the exchange rate of
their currencies against one specific currency is known as Adjustable Peg System. This exchange rate is fixed
for a specific time period. However, in some cases, the currency can be repegged even before the expiry of the
fixed time period. The currency can be repegged at a lower rate; i.e., devaluation, or at a higher rate; i.e.,
revaluation of currency.
2. Wider Band System: An exchange rate system in which the member country can change its currency’s
exchange value within a range of 10 percent is known as Wider Band System. It means that the country is
allowed to devalue or revalue its currency by 10 percent to facilitate the adjustments in the Balance of
Payments. For example, if a country has a surplus in its Balance of Payments account, then its currency can
be appreciated by maximum of 10% from its parity value to correct the disequilibrium.
3. Crawling Peg System: An exchange rate system which lies between the dirty floating system add adjustable
peg system is known as Crawling Peg System. In this system, a country can specify the parity value for its
currency and permits a small variation around that parity value. This rate of parity is adjusted regularly based
on the requirements of the International Reserve of the country and changes in its money supply and prices.

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 MODULE 2: FORWARD EXCHANGE ARITHMETIC
II Forward Exchange Arithmetic (Theory & Numerical):
• Exchange Arithmetic
• Forward Exchange contracts, Forward Exchange rate based on Cross rates
• Interbank deals, Execution, cancellation, Extension of Forward contract

Exchange arithmetic

Forward Exchange Arithmetic (Theory & Numerical)

Forward exchange arithmetic is a method used in foreign exchange markets to determine the forward exchange rate
between two currencies. This rate is agreed upon today for an exchange that will occur at a future date. The forward
rate reflects expectations of the currency's future value and accounts for interest rate differentials between the two
currencies.

Theory of Forward Exchange Arithmetic

• Spot Rate and Forward Rate:
• The spot rate is the current exchange rate for immediate delivery.
• The forward rate is the agreed-upon exchange rate for a transaction that will take place at a
specified future date.
• Interest Rate Parity (IRP):
• Forward rates are derived using the principle of interest rate parity, which states:
F= s* (1 + int of dom. / 1+ int of foreign country)
• Id Domestic interest rate
• if_ Foreign interest rate
• F: Forward rate (domestic currency/foreign currency)
• S: Spot rate (domestic currency/foreign currency)
• Premium or Discount:
• A forward premium occurs when the forward rate is higher than the spot rate.
• A forward discount occurs when the forward rate is lower than the spot rate.
The premium or discount percentage is calculated as:
Forward Premium/Discount (%)=(F−S/S)×100

Key Factors Influencing Forward Rates:

• Interest rate differential
• Inflation rates
• Market expectations
• Demand and supply dynamics

Numerical Example
Problem:
Suppose the spot exchange rate between USD and INR is 1 USD = 75 INR. The annual interest rate in the U.S. is 2%,
and the annual interest rate in India is 6%. Calculate the 6-month forward rate.
Solution:
2 Given Data:
2.1 Spot rate (SSS): 75 INR/USD
2.2 Domestic interest rate (idi_did): 6% per annum
2.3 Foreign interest rate (ifi_fif): 2% per annum
2.4 Period (TTT): 6 months = 0.5 years
3 Formula:
F=S×(1+id×T)/(1+if×T)
4 Substitute Values:
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F=75×(1+0.06×0.5)/(1+0.02×0.5)
Simplify:
F=75×(1+0.03)/(1+0.01)
F=75×1.0198=76.485
Result: The 6-month forward rate is 1 USD = 76.485 INR.

Conclusion
Forward exchange arithmetic provides a systematic way to calculate future exchange rates by factoring in interest rate
differentials. This is crucial for businesses and investors involved in international trade and hedging currency risk.

Example: 2 of Forward Exchange Contract (FEC)

Here's a hypothetical example to show how FECs work. Let's assume that the U.S. dollar and Canadian dollar
(CAD) spot rate is $1 (CAD) buys $0.80 (USD.)
The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. In this case, the three-month
USD/CAD FEC rate would be calculated as:
Three-month forward rate
= 0.80 x (1 + 0.75% * (90 ÷ 360)) ÷ (1 + 0.25% * (90 ÷ 360))
= 0.80 x (1.0019 ÷ 1.0006) = 0.801
The difference due to the rates over 90 days is one one-hundredth of a cent.

What Is a Cross Rate?

A cross rate is a foreign currency exchange transaction between two currencies that are both valued against a third
currency. The U.S. dollar (USD) is the currency that's usually used in foreign currency exchange markets to establish
the values of the pair being exchanged.
As the base currency, the U.S. dollar always has a value of one. Some USD pairs are reciprocal and the dollar is not
the base currency.
Two transactions are involved when a cross-currency pair is traded. The trader first trades one currency for its
equivalent in U.S. dollars. The U.S. dollars are then exchanged for another currency.
Key Takeaways
• A cross rate can be any exchange of any two currencies that aren't the official currency of the country in
which the quote is published.
• Any currency exchange in which neither of the currencies is the U.S. dollar is considered a cross rate in
practice.
• One of the most common cross-currency pairs is the euro and the Japanese yen.
• Foreign exchange traders use the term cross rate to refer to price quotes between any pair of currencies in
which neither is the U.S. dollar.
Understanding the Cross Rate
The U.S. dollar is usually used to establish the value of each of the two currencies being traded. You would first
determine that the British pound was valued at maybe 1.25 to one U.S. dollar and that the euro was valued at 1.07 to
one U.S. dollar if you were calculating the cross rate of the British pound versus the euro,
The Major Currency Pair
Foreign exchange (forex) traders use the term cross rate to refer to price quotes between currencies in which neither is
the U.S. dollar.1
Most transactions on the forex are in major currency pairs. If one of the currencies being swapped is the U.S. dollar, it
would mean that one U.S. dollar is equal to 1.28 Canadian dollars if you see on a financial news site that USD/CAD
is quoted at 1.28.
A cross rate also refers to a currency pair or transaction that doesn't involve the currency of the party initiating the
transaction.
An exchange rate between the euro and the Japanese yen is considered to be a commonly quoted cross rate because it
doesn't include the U.S. dollar. But in the pure sense of the definition, it's considered a cross rate if it's referenced by a
speaker or writer who isn't in Japan or one of the countries that use the euro as its official currency.
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The pure definition of a cross rate requires that it be referenced in a place where neither currency is used but the term
is primarily used to reference a trade or quote that doesn't include the U.S. dollar.
Examples of Major Cross Rates
Any two currencies can be quoted against each other but the most actively traded cross-currency pairs are the euro
versus the British pound, or EUR/GBP, and the euro versus the Japanese yen, or EUR/JPY. These two pairs are the
only cross-rate currency pairs that appear in the top 10 most traded currency pairs.2
The euro is the base currency for the quote if it's included in the pair. The British pound is the base if the pound is
included but the euro is not.
These currencies are actively traded in the interbank spot foreign exchange market and the forward and options
markets to some extent as well.
Examples of Minor Cross Rates
Cross rates that are traded in the interbank market but are far less active include the Swiss franc versus the Japanese
yen, or CHF/JPY, and the British pound versus the Swiss franc, or GBP/CHF.
Cross rates involving the Japanese yen are usually quoted as the number of yen versus the other currency regardless
of the other currency.
Cross quotes in currencies that are similar in value and quoting convention must be posted carefully to prevent
mistakes in trading. The New Zealand dollar (NZD) was quoted at 1.08 per Australian dollar (AUD) in late December
of 2023. Both of these currencies are quoted against the U.S. dollar. The value reflects the number of U.S. dollars it
would take to buy the foreign currency.3
But the quote provides no guidance as to which is the base currency. The market convention is to use the stronger
AUD, which is also the larger economy, as the base. The two currencies trade near parity to each other, however,
creating the potential for a misquote.
What Is Reciprocal Currency?
Reciprocal currency is a term used in the foreign exchange market to denote a pair of currencies that includes the U.S.
dollar. But the U.S. dollar isn't used as the transaction's base currency or the currency that's initially quoted.
What is Bottom Line?
The major crosses have bid-offer spreads that are slightly wider than the major dollar-based pairs but they're quoted
actively in the interbank market. Spreads in the minor crosses are generally much wider. Some are not quoted directly
at all so a quote must be constructed from the bids and offers in the component currencies versus the U.S. dollar.

What is Cross Rate?

The exchange rate among two currencies that are not native to the nation where the quote is being given is known as a
cross rate in the field of foreign exchange. A cross rate would be what you would obtain, for instance, if you were in
the United States and wanted to know the exchange rate between the Euro (EUR) and Japanese yen (JPY). Knowing
the idea of cross rates will help you make wise selections whether you’re an international student paying for your
education abroad or a firm considering an overseas venture.

An exchange of foreign currencies between two currencies that are both valued against a third currency is known as a
cross rate. In foreign exchange markets, the U.S. dollar (USD) is typically used as the unit of account to determine the
value of the pair being exchanged.
The value of the U.S. dollar, as the base currency, is always one. Dollars are not the base currency in certain USD
pairs, which are reciprocal.
Trading a cross-currency pair involves two transactions. First, the dealer exchanges one currency for its U.S. dollar
equivalent. Next, another currency is exchanged for the U.S. dollar.
What is a Cross-Currency Pair? (Currency crosses)
In the foreign exchange market, trading between two currencies takes place where a currency is valued by pairing it
with another currency. Cross-currency pairs, or currency crosses, are some currency pairs that do not include the
dollar. The currencies that are traded the most often include the U.S. dollar, Canadian dollar, New Zealand dollar,
American dollar, Euro, and Japanese yen. Therefore, you would be trading cross-currency pairs when you traded any
of these currencies with each other, eliminating the U.S. dollar from the list.
Significance of Cross Rates
Cross rates are essential for:
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 1. International Transactions: When doing business across different countries, cross rates help with direct
currency conversions without involving USD, simplifying transactions.
2. Investments: Cross rates are used by investors to evaluate potential returns and risks when investing in
foreign currencies and assets.
3. Currency Risk Management: Businesses use cross rates to manage currency risk, especially when
dealing with various currencies in their operations.
4. Arbitrage Opportunities: Traders can take advantage of price discrepancies in cross rates to make risk-
free profits.
Cross rates are crucial in the forex market, enabling direct currency conversions between different foreign
currencies. They simplify international transactions, aid investors in decision-making, and provide
opportunities for traders to profit from currency price differences.
How To Calculate Cross-Rate?
Let’s examine the conversion procedure even though there isn’t a set cross-rate formula.
Let X and Y be a currency pair, and let P be the base currency. The conversion process is as follows:
Step 1: Find X’s exchange rate in relation to P. It indicates how much of X is needed to make one unit of P.
Step 2: Determine the exchange rate between P and Y. This indicates the quantity of P needed to equal one unit of Y.
These constitute the concept’s fundamental logic, and it is divided into two main categories:
1.Direct Quote
The amount of the quotation currency needed to buy one unit of the base currency is shown in a direct quote. Let’s
use the EUR/JPY exchange rate as an example, where EUR is the base currency.

2.Indirect Quote
The amount of base currency required to purchase one unit of the quotation currency is stated in an indirect quote.
Using the example of JPY/EUR, where JPY is the base currency.

Factors that Affect Cross Rates

Cross rates can be influenced by various things, such as:
• Interest rates: Shifts in interest rates have the potential to influence a nation’s currency value and,
consequently, its cross rate relative to other currencies.
• Inflation: The rates of inflation also influence the value of currencies. Increased inflation may cause a
currency’s value to decline and become less valuable in relation to other currencies.
• Political stability: Changes in a nation’s political climate can impact the value of its currency and its cross
rate against other currencies.
• Economic performance: The strength and potential for growth of a nation’s economy can have a big impact
on the value and cross rates of its currency.
Risks Associated with Cross Rates
Cross rates carry certain risks in addition to the potential for profit and portfolio diversification. Among these dangers
are:
• Exchange rate risk: Traders who need to gain knowledge or employ adequate risk management techniques
may experience losses as a result of fluctuations in exchange rates.
• Risk to liquidity: Cross rates involving minor or exotic currencies would see fewer trading volumes, which
would mean increased volatility and less liquidity.
• Political risk: As was previously indicated, political unrest can significantly affect exchange rates and
currency values.
Trading professionals need to employ risk management techniques like limit and stop orders in addition to close
observation of market circumstances in order to reduce these risks.
The Bottom Line
In the foreign exchange market, cross rate is a key idea that enables direct currency comparisons without the need for
the U.S. dollar to act as a middleman. It presents chances for financial gain and portfolio diversity, but it also has
hazards that need to be properly controlled. Traders can use this idea to make well-informed trading decisions if they
have a basic understanding of cross rates and keep an eye on market conditions. Therefore, in order to successfully
29
navigate the complicated world of foreign exchange trading, a solid understanding of cross rates is vital.
Example
Let's assume INR (Indian Rupee) as one of the currencies and calculate the cross rate between EUR (Euro) and INR
using the USD as the common currency.
Assume the exchange rates are as follows:
EUR/USD = 1.1500 (Euro to US Dollar)
USD/INR = 75.00 (US Dollar to Indian Rupee)
To find the EUR/INR cross rate, we'll use the formula:
EUR/INR = (EUR/USD / USD/INR)
First, let's calculate the value inside the parentheses:
EUR/USD = 1.1500
USD/INR = 75.00
EUR/INR = (1.1500 / 75.00)
EUR/INR ≈ 0.0153333
So, the cross rate between EUR and INR is approximately 0.0153333.

Forward exchange rate based on cross rate:

The forward exchange rate is calculated using the spot rate, the interest rates of the two currencies, and the time until
the contract expires. The formula for calculating the forward exchange rate is:

Forwardrate=Spotrate×1+foreigninterestrate/1+domesticinterestratecap
F o r w a r d r a t e equals cap S p o t r a t e cross the fraction with numerator 1 plus f o r e i g n i n t e r e s t r a t e
and denominator 1 plus d o m e s t i c i n t e r e s t r a t e end-fraction
𝐹𝑜𝑟𝑤𝑎𝑟𝑑𝑟𝑎𝑡𝑒=𝑆𝑝𝑜𝑡𝑟𝑎𝑡𝑒×1+𝑓𝑜𝑟𝑒𝑖𝑔𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑟𝑎𝑡𝑒/1+𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑟𝑎𝑡𝑒

Explanation
• The spot rate is the current exchange rate for the currency pair.
• The interest rate differential is the difference between the interest rates of the two currencies.
• The forward rate is adjusted for the time until the contract expires.
Example
If the spot rate for EUR/USD is 1.20, the interest rate for EUR is 0.5%, and the interest rate for USD is 1%, then the
forward rate for a one-year contract is
= 1.20* 1.005/1.01
= 1.1914.
Forward points
Forward points are the number of basis points added to or subtracted from the spot rate to determine the forward rate.
When points are added, it's called a forward premium, and when points are subtracted, it's called a forward discount.

30
Interbank Market
As the name suggests, the interbank market is a market where foreign currency is traded between large privately held
banks. The interbank market is what people refer to when talking about the currency market. It is built of large
currency trades above $1 million, e.g., CAD/USD or USD/JPY. However, the transactions are often much larger,
upwards of $100 million and beyond, and occur in just seconds.

Each trade comes with a previously agreed-upon amount and rate for both parties. Some of the exchanges taking
place are banks working on behalf of their clients. Many of the other transactions are proprietary, meaning the trades
are for the banks’ own accounts. It helps regulate the bank’s interest rate and exchange rate risks.
The interbank market follows a floating rate system, meaning the exchange rate “floats” or adjusts on its own time
based on the supply and demand of currency trades. It is also an unregulated and decentralized system, meaning there
is no specific location where these transactions occur, unlike trading securities that have exchanges like the New
York Stock Exchange (NYSE).
Settlements and Trade Agreements
Trades in the interbank market are often referred to as taking place in the spot market or cash market. For the most
part, the currency transactions settle in two business days; one of the major exceptions is the US dollar to Canadian
dollar transactions that settle in one business day.
As a result of the delay in settlement, financial institutions need to acquire credit with their trade partners to facilitate
the trades. The settlement delays increase the risk of the transaction, which are then countered by netting agreements
between the banks.
When the currencies are traded, there are two different prices: the bid price and the ask price. The bid price is the
value you would pay to buy the currency. The ask price is the value you like to receive if you are selling the
currency. The practice is extremely similar to the way securities are traded on the market.
The difference between the bid and ask price is called the “bid to ask spread.” The spread is the transaction cost,
minus any commissions or broker fees associated with the trade.
Market makers set the bid-ask spread. The market makers consist of the largest banks in the world. The banks
constantly trade currency between each other for themselves or on behalf of their customers. The trades form the
fundamental base for the currency exchange rates/market. As a result of the banks’ competitiveness, the market
ensures a fair and close spread.
Regulation of the Interbank Market
As was previously stated, the interbank market is unregulated and decentralized. With that in mind, there is no
specific location or exchange that the currency is traded on; instead, it is composed of thousands of interbank
exchanges of currency at agreed-upon prices and quantities. The prices come from market makers, usually the largest
banks in the world.
Central banks in many countries release spot-close prices that reflect the previously stated market makers’ prices at
the end of each day. In some countries, there are national or local banking regulations in which currency traders must
follow.
For example, many national authorities or central banks regulate foreign currency options; however, only a small part
of the trades takes place on exchanges such as the Chicago Mercantile Exchange or the International Securities
Exchange.
The interbank market is an essential aspect of the foreign exchange market. It is where the majority of large-scale
currency transactions take place and is predominantly used for trades among bankers and their large clients.
The interbank market consists of four main components:
• The spot market, which entails transactions made for the currency price at the exact time of the trade.
• The forward market, which is an agreement to exchange currency at an agreed-upon future date and price.
• A swap trade, which is a combination of both spot and forward. The banker buys the currency at the spot market
current price and then sells the equivalent amount in the forward market at a future date and price.
• Some banks also participate in the SWIFT (Society for Worldwide Interbank Financial
Telecommunications) market. SWIFT enables institutions to send and receive information regarding financial
transactions in a safe, proven, and reliable way.

Role of Interbank deals in facilitating liquidity in the financial markets:

31
Interbank deals, which occur between banks in the foreign exchange and money markets, play a crucial role in
ensuring liquidity and stability in financial markets. These transactions involve large-scale exchanges of currencies,
securities, and short-term loans between banks.
1. Liquidity Provision:
o Interbank deals ensure the continuous flow of liquidity in the market. By facilitating the exchange of
currencies between banks, they help ensure that there is always an adequate supply of currencies
available for international trade and financial transactions. This liquidity is essential for the smooth
functioning of financial markets.
2. Price Discovery:
o The transactions between banks help establish the market price or exchange rates for various currencies.
These deals enable price discovery in the Forex market, where supply and demand forces determine the
current exchange rate, based on real-time trading activity.
3. Stabilization of Currency Markets:
o When banks trade with each other in large volumes, they help stabilize the currency markets by balancing
currency fluctuations. If one currency is overvalued or undervalued, interbank deals provide a mechanism
for adjusting the supply and demand for that currency, reducing volatility.
4. Facilitating Cross-Border Transactions:
o Banks use interbank deals to settle payments for cross-border transactions, including international trade
and investments. Without such deals, banks would face challenges in providing currency conversion
services to clients engaged in international business.
5. Risk Management:
o Interbank deals also facilitate risk management strategies, such as hedging against currency risks. Banks
often enter into forward contracts or swaps to protect themselves and their clients from adverse exchange
rate movements.
6. Short-Term Borrowing and Lending:
o In addition to currency exchanges, interbank transactions also include short-term borrowing and lending,
primarily through the use of repurchase agreements (repos) and interbank loans. These instruments help
banks meet their short-term liquidity needs, ensuring the smooth flow of capital in the financial system.
Summary: Interbank deals are essential for maintaining liquidity in financial markets, stabilizing exchange rates,
providing price transparency, and facilitating international financial transactions. Without such deals, markets would
be less efficient, and the cost of borrowing and transacting globally would increase

Execution, cancellation, Extension of Forward contract

Execution cancellation and extension of forward contracts are critical topics in foreign exchange and financial
derivatives markets. Here's an overview:

Execution Cancellation of Forward Contracts

Execution cancellation refers to the process of terminating a forward contract before its maturity. This can occur due
to several reasons, including:
1. Change in Needs: The buyer or seller may no longer require the underlying asset or currency.
2. Hedging Adjustment: Changes in the hedging strategy of a company.
3. Market Movements: Market conditions may shift, making the contract less favorable.
32
4. Mutual Agreement: Both parties agree to cancel the contract.
How Cancellation Works:
• Close-out/Offsetting: Instead of outright cancellation, the party enters into an offsetting forward contract with
the same maturity and amount but opposite terms.
• Termination Payment: The parties may negotiate a termination payment reflecting the contract's fair market
value at cancellation time.
Considerations:
• Market Value: Cancellation often involves assessing the prevailing spot and forward rates to determine gains or
losses.
• Cost Implications: Cancelling a forward contract might incur additional costs or penalties, depending on the
terms.

Extension of Forward Contracts

An extension occurs when the maturity date of a forward contract is deferred to a later date, usually by mutual
agreement between the contracting parties.
Reasons for Extension:
• Delayed Requirements: The delivery or payment obligation has been delayed.
• Cash Flow Management: To align with new cash flow forecasts.
• Regulatory or Operational Delays: Unexpected delays in processes.
How Extensions Work:
1. Cancellation and New Contract: The existing forward contract is canceled, and a new one is entered into with
the revised maturity date.
2. Roll Forward: A "roll forward" mechanism adjusts the existing contract for the extended period, factoring in the
difference in forward rates.
Cost and Risk Considerations:
• Extension Cost: Adjustments reflect changes in forward rates and may include fees.
• Market Exposure: Prolonged exposure to market volatility might affect the overall risk profile.
• Interest Rate Differential: Any change in interest rates during the extended period is factored into the pricing.

Key Points to Keep in Mind

1. Contract Terms: Check for flexibility provisions regarding cancellation or extension.
2. Costs and Penalties: Be aware of potential financial implications.
3. Accounting Impact: Ensure compliance with accounting standards (e.g., IFRS or GAAP).
4. Consultation with Counterparties: Negotiate terms to minimize losses or penalties.
5. Regulatory Compliance: Adhere to relevant financial and trading regulations.

33
Module 3 International financial market and cash management
• International Banking & Money market (Theory)
• International Bond Market, LIBOR, (Theory)
• International Equity Market (ADR, GDR, EURO)
• Multinational Cash Management, (Theory)

What is International Banking?

International Banking means providing financial services across borders, allowing banks to serve clients in other
countries. Services include accepting deposits, issuing loans, and offering products like foreign investment advice or
letters of credit. International banking can involve local transactions in foreign currencies or business done across
countries in various currencies.
In India, international banking includes a mix of foreign banks like DBS Bank, with branches across cities, and
Indian banks such as SBI, which operates globally. Understanding international banking in India is crucial for
finance students, as the international banking syllabus covers risks like credit, interest rates, and currency
fluctuations. With practical examples, the syllabus helps students understand how banks manage these risks to avoid
financial losses.
Services and Functions of International Banking
International banking offers a range of services that help individuals and businesses manage finances across borders.
Below are some key functions of international banking and the services provided:
• Currency Accounts: International banks offer accounts in multiple currencies, allowing clients to hold and
manage funds in different currencies for easier global transactions.
• Foreign Exchange Services: These banks provide currency exchange services, crucial for businesses
involved in import-export activities. This service helps companies make payments in the currency of their
trading partners.
• Letters of Credit: To support trade, banks issue letters of credit, which secure payments for goods traded
internationally, building trust between buyers and sellers across borders.
• Wire Transfers: Facilitating secure and swift transfers between international accounts, international banks
ensure smooth money movement for both individuals and businesses.
• Investment Advice: International banks offer guidance on global investments, helping clients navigate
opportunities in foreign markets.
• Trade Finance and Treasury Management: For businesses, international banks provide trade financing,
such as export credit, and manage cash flow through treasury services.
International banking in India also offers these services, with both foreign banks and Indian banks (like SBI, ICICI,
and HDFC) providing options for cross-border transactions and investment, supporting the global business needs of
Indian companies.

Types of International Banking

International banking structures vary widely, each designed to meet the needs of cross-border clients and global trade.
Here are the main types of international banking structures, with examples relevant to international banking in India
and globally:
Correspondent Banks
Correspondent banks work together across countries to facilitate transactions. This setup allows banks to conduct
international business without a physical presence in each country.
These banks handle international payments, currency exchanges, and trade transactions for businesses, often serving
as intermediaries for transfers and payment processing.
For Example, Multinational corporations (MNCs) often use correspondent banking to streamline global operations,
making it easier to transfer funds across borders.
Subsidiary and Affiliate Banks
A subsidiary bank is a separate entity owned by a foreign parent bank but operates under the host country’s laws.
This allows it to provide localized services in line with the country’s regulations.
Moreover, Affiliate Banks are similar to subsidiaries but may operate more autonomously. While they’re connected
34
to a foreign parent bank, they often offer unique services tailored to the local market.
For Example, Many international banks in India, like Citibank, operate through subsidiary branches to comply
with Indian banking regulations while offering international banking services.
Edge Act Banks
Edge Act banks are U.S.-based banks authorized to conduct international business under a 1919 law. These banks
focus on facilitating international trade and finance.
Though headquartered in the U.S., these banks are permitted to handle international transactions and are regulated by
the Federal Reserve to ensure compliance.
For Example, U.S.-based banks like JPMorgan have Edge Act entities to manage their global trade services.
Offshore Banking Centres
Offshore banking centres provide services to foreign clients, usually located in low-tax or tax-exempt areas. Done of
the Offshore Banking Features are:
• They offer banking services to non-residents, such as investment accounts and wealth management.
• They are typically independent of the local country’s financial regulations.
For Example, Swiss banks are well-known offshore banking centres, popular for secure banking services with a focus
on privacy and tax benefits.
Multinational Banks
Multinational banks operate branches or subsidiaries in multiple countries, directly serving local clients.
They provide services such as loans, deposits, and foreign investment opportunities tailored to each country they
operate in.
For Example, International banking in India includes multinational banks like HSBC, which offers a full range of
international banking services through its extensive branch network across Indian cities.
Through these varied structures, international banking connects local and global financial needs, from providing
foreign exchange services to managing trade finance, enabling a cohesive global economy.
Importance of International Banking
International banking performs a crucial role in today’s globalized economy by offering businesses and individuals
access to financial services beyond their home country. Here are the main reasons why international banking is so
valuable:
1. Access to Comprehensive Financial Services: International banks offer a broader range of services than
most domestic banks, including currency exchange, international remittances, and trade finance, helping
clients manage finances across borders.
2. Ease of Global Transactions: For businesses and individuals looking to operate internationally,
international banking makes transactions simple and efficient. Clients can easily access their funds or make
payments from anywhere, which is vital in global trade.
3. Currency Diversification: By holding multiple currency accounts and accessing currency exchange
services, businesses can protect themselves against currency fluctuations. This helps reduce conversion costs
and currency-related risks.
4. Faster International Payment Processing: With advanced payment processing systems, international banks
ensure quick and secure cross-border transfers, helping businesses maintain smooth cash flows and timely
transactions.
5. Access to Global Markets: International banks provide businesses with the resources to invest in
international markets, offering insights into foreign investment opportunities and helping companies expand
globally.
6. Facilitates International Trade: Through services like trade finance and letters of credit, international
banking supports businesses in conducting overseas trade efficiently, contributing to the growth of trade and
economic development.
The international banking syllabus for students and professionals includes these functions of international banking
and the types of international banking structures, covering everything from currency management to trade finance.
Also Read: Bank for International Settlements
However, this knowledge prepares students for a career in a globally connected banking sector, particularly in
international banking in India, where understanding global finance is becoming increasingly important.

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International monetary system:
INTRODUCTION
The international monetary system is the framework within which countries borrow, lend, buy, sell and make
payments across political frontiers. The framework determines how balance of payments disequilibriam is resolved.
Numerous frameworks are possible and most have been tried in one form or another. Today’s system is a
combination of several different frameworks. The increased volatility of exchange rate is one of the main economic
developments of the past 40 years. Under the current system of partly floating and partly fixed undergo real and paper
fluctuations as a result of changes in exchange rates. Policies for forecasting and reacting to exchange rate
fluctuations are still evolving as we improve our understanding of the international monetary system, accounting and
tax rules for foreign exchange gains and losses, and the economic effect of exchange rate changes on future cash
flows and market values. Although volatile exchange rate increase risk, they also create profit opportunities for firms
and investors, given a proper understanding of exchange risk management. In order to manage foreign exchange risk,
however, management must first understand how the international monetary system functions. The international
monetary system is the structure within which foreign exchange rates are determined, international trade and capital
flows are accommodated, and balance-of-payments (BoP) adjustments made. All of the instruments, institutions, and
agreements that link together the world’s currency, money markets, securities, real estate, and commodity markets are
also encompassed within that term.

Over the ages, currencies have been defined in terms of gold and other items of value, and the international monetary
system has been the subject of a variety of international agreements. A review of these systems provides a useful
perspective from which to understand today’s system and to evaluate weakness and proposed changes in the present
system.

International Monetary System: Evolution and gold standard International

Monetary System: An Overview
International monetary system is defined as a set of procedures, mechanisms, processes, institutions to
establish that rate at which exchange rate is determined in respect to other currency. To understand the complex
procedure of international trading practices, it is pertinent to have a look at the historical perspective of the
financial and monetary system.
The whole story of monetary and financial system revolves around 'Exchange Rate' i.e. the rate at which
currency is exchanged among different countries for settlement of payments arising from trading of goods and
services. To have an understanding of historical perspectives of international monetary system, firstly one must
have a knowledge of exchange rate regimes. Various exchange rate regimes found from 1880 to till date at the
international level are described briefly as follows:
Gold Standard and Bretton Woods System: A Historical Analysis
1. The Gold Standard: An Overview
The gold standard is a monetary system in which a country's currency value is directly linked to gold. Under
this system, countries agreed to convert paper money into a fixed amount of gold. The gold standard ensured
currency stability and facilitated international trade by providing a universal standard of value.
Origins and Evolution
The gold standard has its roots in ancient civilizations, where gold was used as a medium of exchange due to
its intrinsic value. By the 19th century, the modern gold standard emerged, with the United Kingdom adopting
it officially in 1821. Other industrialized nations followed, creating a global network of currencies pegged to
gold.
The classical gold standard (1880-1914) was characterized by its stability and predictability. Countries
maintained fixed exchange rates by tying their currencies to a specific quantity of gold. Central banks held gold
reserves to back their currencies and intervene in the market if imbalances arose. This system promoted
international trade and investment by reducing exchange rate risks.

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 However, the gold standard had limitations. Economic growth was constrained by the supply of gold, and the
system was highly sensitive to gold discoveries. Moreover, countries faced difficulties in addressing economic
shocks, as the gold standard required monetary and fiscal discipline, often at the expense of domestic priorities
such as employment.
Collapse of the Gold Standard
The outbreak of World War I in 1914 disrupted the gold standard as countries suspended gold convertibility to
finance military expenditures. Efforts to restore the system in the interwar period were largely unsuccessful.
The Great Depression of the 1930s dealt a fatal blow, as countries abandoned the gold standard to adopt more
flexible monetary policies. By the end of the 1930s, the gold standard was largely obsolete.
2. Bretton Woods System: A New Monetary Framework
The Bretton Woods system, established in 1944, marked a new era in international monetary policy. Named
after the conference held in Bretton Woods, New Hampshire, this system sought to create a stable global
economic environment in the aftermath of World War II. The conference brought together 44 Allied nations,
aiming to design a framework that balanced the benefits of fixed exchange rates with the need for economic
flexibility.
Key Features of the Bretton Woods System
1. Fixed Exchange Rates: Under Bretton Woods, currencies were pegged to the U.S. dollar, which in turn
was convertible to gold at a fixed rate of $35 per ounce. This arrangement established the U.S. dollar as
the dominant global currency.
2. International Monetary Institutions: The conference led to the creation of the International Monetary
Fund (IMF) and the World Bank. The IMF was tasked with providing short-term financial assistance to
countries facing balance-of-payments issues, while the World Bank focused on long-term reconstruction
and development projects.
3. Capital Controls: To prevent destabilizing capital flows, the system allowed countries to impose controls
on international capital movements. This gave governments greater autonomy in pursuing domestic
economic policies.
4. Adjustable Peg System: While exchange rates were fixed, countries could adjust their currency values in
cases of fundamental disequilibrium, such as prolonged trade imbalances.
Successes of Bretton Woods
The Bretton Woods system ushered in a period of unprecedented economic growth and stability, often referred
to as the "Golden Age" of capitalism. Key achievements included:
• Post-War Reconstruction: The system facilitated the rebuilding of war-torn economies, particularly in
Europe and Japan.
• Economic Cooperation: Bretton Woods fostered international collaboration, reducing the risk of
competitive devaluations and trade wars.
• Stability: Fixed exchange rates minimized exchange rate volatility, promoting trade and investment.
Challenges and Collapse
Despite its successes, the Bretton Woods system faced inherent vulnerabilities:
1. Dollar-Gold Convertibility: The system's reliance on the U.S. dollar created a paradox. For global trade
and liquidity to expand, the U.S. had to run balance-of-payments deficits, which eroded confidence in the
dollar's convertibility to gold. This dilemma, known as the "Triffin Paradox," undermined the system's
stability.
2. Inflation and Imbalances: By the 1960s, rising U.S. inflation and trade deficits strained the dollar's
credibility. Countries began converting their dollar reserves into gold, depleting U.S. gold reserves.
3. Speculative Attacks: Fixed exchange rates became targets for speculation, as markets doubted the
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 sustainability of pegged values.
In 1971, U.S. President Richard Nixon suspended the dollar's convertibility to gold, effectively ending the
Bretton Woods system. This move, known as the "Nixon Shock," marked the transition to a system of floating
exchange rates.
Comparative Analysis: Gold Standard vs. Bretton Woods
While both systems aimed to promote stability in international trade and finance, they differed significantly in
structure and outcomes.
• Currency Anchor: The gold standard tied all currencies to gold, while Bretton Woods anchored them to
the U.S. dollar, indirectly linked to gold.
• Flexibility: The gold standard imposed rigid monetary discipline, limiting countries' ability to respond to
economic shocks. Bretton Woods offered greater flexibility through adjustable pegs and capital controls.
• Global Leadership: The gold standard lacked a central coordinating authority, whereas Bretton Woods
relied on U.S. leadership and international institutions like the IMF.
• Longevity: The gold standard endured for centuries in various forms, while Bretton Woods lasted only
three decades, reflecting the evolving complexity of the global economy.
Legacy and Lessons
The gold standard and Bretton Woods system have left lasting legacies in global monetary policy. They
underscore the trade-offs between stability and flexibility, as well as the challenges of maintaining international
cooperation in a dynamic economic landscape.
Modern monetary systems, characterized by floating exchange rates and fiat currencies, draw on the lessons of
these historical frameworks. While the gold standard and Bretton Woods are no longer in operation, their
principles continue to influence debates on monetary reform, global financial stability, and the role of reserve
currencies.
Conclusion
The gold standard and Bretton Woods system represent pivotal chapters in the history of international monetary
policy. Each system reflected the economic realities and priorities of its time, providing valuable insights into
the complexities of managing global trade and finance. As the world grapples with new challenges, from digital
currencies to economic globalization, the experiences of the gold standard and Bretton Woods remain relevant
in shaping the future of international monetary cooperation.

The International Monetary Fund (IMF)

The International Monetary Fund (IMF) is a global financial institution established to promote international
economic stability, facilitate global trade, and foster sustainable economic growth. Formed in the aftermath of
World War II during the Bretton Woods Conference in 1944, the IMF plays a critical role in the global economy
by providing financial assistance, policy advice, and technical support to its member countries.
Objectives of the IMF
The IMF's primary objectives are outlined in its Articles of Agreement. These objectives include:
1. Promoting International Monetary Cooperation: The IMF aims to foster collaboration among member
nations on monetary and financial issues, encouraging dialogue and reducing economic conflicts.
2. Facilitating Trade Expansion: By promoting balanced growth in international trade, the IMF seeks to
support global economic development and improve standards of living.
3. Promoting Exchange Rate Stability: A core function of the IMF is to encourage stable exchange rates,
which are crucial for fostering investor confidence and international trade.
4. Providing Resources to Members in Economic Difficulty: The IMF offers financial assistance to
countries facing balance of payments problems to help stabilize their economies and restore growth.
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5. Reducing Global Imbalances: By addressing macroeconomic disparities, the IMF aims to reduce
vulnerabilities in the global economy that can lead to crises.
Structure of the IMF
The IMF is a membership-based organization with 190 member countries (as of 2025). Its governance structure
is designed to ensure that all members have a voice, but voting power is weighted based on the financial
contributions of each country (known as quotas). The main organs of the IMF are:
1. Board of Governors:
o The highest decision-making body.
o Composed of one governor from each member country, typically a finance minister or central bank
governor.
o Meets annually to review key issues and make high-level decisions.
2. Executive Board:
o Responsible for the day-to-day operations of the IMF.
o Comprises 24 Executive Directors representing individual or groups of countries.
o Decisions are made by consensus or weighted voting.
3. Managing Director:
o The head of the IMF and chair of the Executive Board.
o Responsible for overall management and leadership of the organization.
4. Staff and Departments:
o Composed of economists, analysts, and other professionals from around the world.
o The IMF has various specialized departments, such as the Monetary and Capital Markets
Department and the Fiscal Affairs Department.
Key Functions of the IMF
The IMF fulfills its mandate through several key functions:
1. Surveillance
• The IMF monitors global, regional, and national economic developments.
• Through consultations under Article IV of its Articles of Agreement, the IMF assesses member countries'
economic policies and provides recommendations to foster stability and growth.
• The IMF publishes reports, such as the World Economic Outlook (WEO) and the Global Financial Stability
Report (GFSR), to provide insights into global economic trends.
2. Financial Assistance
• The IMF provides loans to member countries facing balance of payments crises or economic instability.
• These loans are typically conditional on the implementation of specific policy reforms designed to address
the root causes of economic problems.
• Lending programs include:
o Stand-By Arrangements (SBAs): Short-term financial support for countries with temporary
economic difficulties.
o Extended Fund Facility (EFF): Medium- to long-term assistance for structural reforms.
o Poverty Reduction and Growth Trust (PRGT): Concessional financing for low-income
countries.
o Rapid Financing Instrument (RFI) and Rapid Credit Facility (RCF): Emergency support with
minimal conditionality.
3. Capacity Development
• The IMF provides technical assistance and training to member countries to strengthen their economic
institutions and governance.
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• Areas of focus include public financial management, tax policy, central banking, and anti-corruption
measures.
• These efforts help countries build resilience and implement effective economic policies.
4. Research and Data
• The IMF conducts research on global economic issues and provides valuable data and analysis to
policymakers, academics, and the public.
• It maintains comprehensive databases on topics such as international trade, fiscal policy, and financial
markets.

Financing and Quotas

The IMF’s financial resources come primarily from its member countries through a quota system:
1. Quota System:
o Each member is assigned a quota based on its relative size in the global economy.
o Quotas determine a country’s financial contribution, voting power, and access to IMF resources.
2. Special Drawing Rights (SDRs):
o The IMF’s reserve asset created to supplement member countries' official reserves.
o SDRs can be exchanged among members and are used as a unit of account by the IMF.
3. Borrowing Arrangements:
o To supplement its resources, the IMF can borrow from member countries or other entities under
agreements like the New Arrangements to Borrow (NAB).

Successes of the IMF

The IMF has played a pivotal role in addressing global economic challenges:
1. Post-War Reconstruction:
o The IMF helped stabilize economies and rebuild trade after World War II.
2. Crisis Management:
o The IMF has provided financial assistance during major economic crises, including the Latin
American debt crisis (1980s), the Asian financial crisis (1997), and the global financial crisis
(2008).
3. Support During the COVID-19 Pandemic:
o The IMF mobilized resources to provide emergency financing to over 90 countries and allocated
$650 billion in SDRs to support global recovery.
4. Capacity Building:
o Through technical assistance and training, the IMF has strengthened institutions in many
developing and emerging economies.

Conclusion
The International Monetary Fund remains a cornerstone of the global economic system, providing critical
support to its member countries in times of need. While it has faced significant criticism, the IMF has also
demonstrated an ability to adapt and reform to meet new challenges. As the world continues to face complex
and interconnected economic issues, the IMF’s role in promoting stability, fostering growth, and addressing
global challenges will remain indispensable.

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TYPES OF FOREIGN EXCHANGE MARKET
• Retail Market
Transactions are exchange of currenct, bank draft, bank notes ordinary and traveller‘ s cheques etc. Retail
banking consists of a large number of small customers who consume personal banking and small business
services. Retail banking is largely intra-bank: the bank itself.

• Wholesale markets
The wholesale market comprises of commercial banks and investment banks. This is broadly classified as inter-
bank market and central bank market.
Wholesale banking typically involves a small number of very large customers such as large corporate and
governments, Wholesale banking is largely interbank: banks use the inter -bank markets to borrow from or
lend to other banks, to participate in large bond issues, and to engage in syndicated lending.

• Inter-bank
The interbank network consists of a global network of financial institutions that trade currencies between each
other to manage exchange rate and interest rate risk. The largest participants in this network are private banks.
Most transactions within the interbank network are for a short duration, anywhere between overnight to six
months. The interbank market is not regulated.
➢ Spot market
Spot market refers to the transactions involving sale and purchase of currencies for immediate delivery. In
practice, it may take one or two days to settle transactions. Transactions are affected at prevailing rate of
exchange at that point of time and delivery of foreign exchange is affected instantly. The exchange rate that
prevails in the spot market for foreign exchange is called Spot Rate.
➢ Forward Market
A market in which foreign exchange is bought and sold for future delivery is known as Forward Market. It
deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented
sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange
is called Forward Rate. Thus, forward rate is the rate at which a future contract for foreign currency is made.
➢ Derivatives
Within the fields of trading and finance, a derivative is considered to be an instrument used for investment via
a contract. Its value is "derived" from (or based upon) that of another asset, typically referred to as the
underlying asset or simply "the underlying." In other words, a derivative contract is an agreement that allows
for the possibility to purchase or sell some other type of financial instrument or non-financial asset. Common
types of derivative contracts include options, forwards, futures and swaps.
a. Future Market: Standardized forward contracts are called futures contracts and traded on a futures
exchange. A futures contract (more colloquially, futures) is a standardized contract between two parties to
buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures
price or strike price) with delivery and payment occurring at a specified future date.
b. Option Market: A currency option gives an investor the right, but not the obligation, to buy or sell a quantity
of currency at a pre-established price on or before the date that the option expires. The right to sell a currency
is known as a "call option" and the right to buy is known as a "put option." Options can be understood as a
type of insurance where buyers or sellers can take advantage of more favourable prices should market
conditions change after the option is purchased.
c. Swap Market: The idea of a swap by definition normally refers to a simple exchange of property or assets
between parties. A currency swap also involves the conditions determining the relative value of the assets

41
 involved. That includes the exchange rate value of each currency and the interest rate environment of the
countries that have issued them. A foreign exchange swap, forex swap, or FX swap is a simultaneous
purchase and sale of identical amounts of one currency for another with two different value dates (normally
spot to forward).

Market participates of foreign exchange Market

• Central Bank
National central banks play an important role in the foreign exchange markets. They try to control the money
supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They
can use their often substantial foreign exchange reserves to stabilize the market. They work as the lender of
the last resort and the custodian of foreign exchange of the country. The central bank has the power to regulate
and control the foreign exchange market so as to assure that it works in the orderly fashion. One of the major
functions of the central bank is to prevent the aggressive fluctuations in the foreign exchange market, if
necessary, by direct intervention. Intervention in the form of selling the currency when it is overvalued and
buying it when it tends to be undervalued.
The commercial banks are the second most important organ of the foreign exchange market. The banks dealing
in foreign exchange play a role of ―market makers‖, in the sense that they quote on a daily basis the foreign
exchange rates for buying and selling of the foreign currencies. Also, they function as clearing houses, thereby
helping in wiping out the difference between the demand for and the supply of currencies. These banks buy the
currencies from the brokers and sell it to the buyers.
The foreign exchange brokers function as a link between the central bank and the commercial banks and also
between the actual buyers and commercial banks. They are the major source of market information. These are
the persons who do not themselves buy the foreign currency, but rather strike a deal between the buyer and the
seller on a commission basis.

The foreign exchange market assists international trade and investment by enabling currency conversion. For
example, it permits a business in the United States to import goods from the European Union member states
especially Euro zone members and pay Euros, even though its income is in United States dollars. The foreign
exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of
international currencies.
The Market Participants are discussed in brief below:
• Commercial Bank
A commercial bank (or business bank) is a type of financial institution and intermediary. It is a bank that lends
money and provides transactional, savings, and money market accounts and that accepts time deposit n order
to facilitate international trade and development, commercial banks convert and trade foreign currencies. When
a company is doing business in another country it may be paid in the currency of that country. While some of
these revenues will be used to pay workers in that country and for administrative expense such as office rent,
utilities and supplies, the company may need to purchase goods from a neighboring country in that country's
currency, or convert cash to its native currency for return to the home office.
• Central bank
National central banks play an important role in the foreign exchange markets. They try to control the money
supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They
can use their often substantial foreign exchange reserves to stabilize the market.
• Foreign exchange fixing
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Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The
idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing
exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates
as a trend indicator.

• Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution
that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they
were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for
aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic
fundamentals are in the hedge funds' favor.
• Investment management firms
Investment management is the professional management of various securities (shares, bonds and other
securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the
investors. These firms (who typically manage large accounts on behalf of customers such as pension funds and
endowments) use the foreign exchange market to facilitate transactions in foreign securities
• Retail foreign exchange traders
One of the most important tools required to perform a foreign exchange transaction is the trading platform
providing retail traders and brokers with accurate currency quotes. Retail foreign exchange trading is a small
segment of the large foreign exchange market.

• Market rate Quotations-currency rate fluctuation

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in
the foreign exchange market. The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US
dollars.
Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro
zone) are known as direct quotation or price quotation (from that country's perspective)[4] and are used by
most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991
in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers
and are also common in Australia, New Zealand and the euro zone.
Fluctuation in the exchange rate
A market based exchange rate will change whenever the values of either of the two component currencies
change. A currency will tend to become more valuable whenever demand for it is greater than the available
supply. It will become less valuable whenever demand is less than available supply (this does not mean people
no longer want money, it just means they prefer holding their wealth in some other form, possibly another
currency).
Types of transactions & settlements in FOREX Market
The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign
exchange transaction is an agreement of exchange of currencies of one country for another at an agreed
exchange rate on a definite date.
• Spot Transaction
The spot transaction is when the buyer and seller of different currencies settle their payments within the two
days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-
day period, which means no contract is signed between the countries. The exchange rate at which the currencies

43
 are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market
in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.
• Forward Transaction
A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and
purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate
at which the currency is exchanged is called a ‗Forward Exchange Rate‘. The market in which the deals for the
sale and purchase of currency at some future date are made is called a ‗Forward Market‘.
• Future Transaction: The future transactions are also the forward transactions and deals with the contracts
in the same manner as that of normal forward transactions. But however, the transactions made in a future
contract differ from the transaction made in the forward contract on the following grounds:
i) The forward contracts can be customized on the client‘s request, while the future contracts are
standardized such as the features, date, and the size of the contracts is standardized.
ii) The future contracts can only be traded on the organized exchanges, while the forward contracts can
be traded anywhere depending on the client‘s convenience.
iii) No margin is required in case of the forward contracts, while the margins are required of all the
participants and an initial margin is kept as collateral so as to establish the future position.
• Swap Transactions
The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two
investors. Here one investor borrows the currency and lends another currency to the second investor. The
obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap
contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations
denominated in a different currency without suffering a foreign exchange risk.
• Option Transactions: The foreign exchange option gives an investor the right, but not the obligation to
exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date.
An option to buy the currency is called as a ‗Call Option‘ while the option to sell the currency is called as
a ‗Put Option‘.
Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency
of another country for the settlement of payments.
Settlement dates
Settlement date, as the name implies refers to the date on which the transaction is settled by the transferor of
deposits, with reference to foreign exchange transactions. In a Spot exchange transaction, though the word
"Spot" implies "immediate", it usually takes two business days for the transaction to get settled.
Though the spot rate is the rate of the day on which the transaction has taken place, the execution of the
transaction occurs within a maximum of two working days. But in certain cases of countries currencies, the
settlement may take place the very next business day, an example being currency settlement between
US Dollars and Canadian Dollars. There are two aspects involved in settlement dates: the settlement location
and dealing location. Settlement location refers to the country in which the transaction has to be settled or paid
and dealing location refers to the country in which the bank dealing with the foreign exchange transaction is
located.
Forward exchange rates are applicable for the delivery of foreign exchange at some future date, which may be
specified. There are two options in forward exchange transactions. Let us assume that Emirates in UAE is
purchasing aircrafts from the United States. Obviously, the settlement has to be made in US dollars. Suppose
if the agreement between the two countries is to settle the payment after 2 months time, there are now two
options available for Emirates, UAE: one, to remain silent now and after 2 months period, buy the US Dollars
at the spot market at the then prevailing spot rate and settle the payment to the United States. In this case, the
44
settlement date will be as per the Spot Exchange transaction. Secondly, the country can buy US dollars at the
forward exchange market at the agreed prevailing forward exchange rate, which would be valid for settlement
after two months period, irrespective of the spot rate prevailing at the time of settlement after two months. The
second option avoids uncertainty and risk and the settlement takes place at the maturity of the forward exchange
contract.

• Exchange rate quotations

These can be quoted in two ways-Direct quotation and Indirect quotation. Direct quotation is when the one
unit of foreign currency is expressed in terms of domestic currency. Similarly, the indirect quotation is when
one unit of domestic currency us expressed in terms of foreign currency.
Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are expressed against
the US dollar. However, the exchange rates can also be quoted against other countries‘ currency, which is called
as cross currency.
Now, a lower exchange rate in a direct quote implies that the domestic currency is appreciating in value.
Whereas, a lower exchange rate in an indirect quote indicates that the domestic currency is depreciating in value
as it is worth a smaller amount of foreign currency

Features of Futures Contracts-Foreign Exchange

This article throws light upon the six major features of futures contracts. The features are: 1. Organized
Exchanges 2. Standardization 3. Clearing House 4. Margins 5. Marking to Market 6. Actual Delivery is Rare.
• Organized Exchanges
Unlike forward contracts which are traded in an over-the-counter market, futures are traded on organized
exchanges with a designated physical location where trading takes place. This provides a ready, liquid market
in which futures can be bought and sold at any time like in a stock market.
• Standardization
In the case of forward currency contracts, the amount of commodity to be delivered and the maturity date are
negotiated between the buyer and seller and can be tailor-made to buyer‘s requirements. In a futures contract,
both these are standardized by the exchange on which the contract is traded. thus, for instance, one futures
contract in pound sterling on the International Monetary Market (IMM), a financial futures exchange in the
US, (part of the Chicago Board of Trade or CBT), calls for delivery of 62,500 British Pounds and contracts are
always traded in whole numbers, i.e., you cannot buy or sell fractional contracts. A three-month sterling deposit
on the London International Financial Futures Exchange (LIFFE) has March, June, September, December
delivery cycle.
The exchange also specifies the minimum size of price movement (called the ―tick‖) and, in some cases, may
also impose a ceiling on the maximum price change within a day. In the case of commodity futures, the
commodity in question is also standardized for quality in addition to quantity in a single contract.
• Clearing House
The exchange acts as a clearing house to all contracts struck on the trading floor. For instance, a contract is
struck between A and B. Upon entering into the records of the exchange, this is immediately replaced by two
contracts, one between A and the clearing house and another between B and the clearing house.
In other words, the exchange interposes itself in every contract and deal, where it is a buyer to every seller and
a seller to every buyer. The advantage of this is that A and B do not have to undertake any exercise to investigate
each other‘s creditworthiness. It also guarantees the financial integrity of the market. The exchange enforces
delivery for contracts held until maturity and protects itself from default risk by imposing margin requirements
on traders and enforcing this through a system called ―marking to market‖.

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• Margins
Like all exchanges, only members are allowed to trade in futures contracts on the exchange. Others can use the
services of the members as brokers to use this instrument. Thus, an exchange member can trade on his own
account as well as on behalf of a client. A subset of the members is the ―clearing members‖ or members of
the clearing house and non- clearing members must clear all their transactions through a clearing member.
The exchange requires that a margin must be deposited with the clearing house by a member who enters into a
futures contract. The amount of the margin is generally between 2.5% to 10% of the value of the contract but
can vary. A member acting on behalf of a client, in turn, requires a margin from the client. The margin can be
in the form of cash or securities like treasury bills or bank letters of credit.
• Marking to Market
The exchange uses a system called marking to market where, at the end of each trading session, all outstanding
contracts are reprised at the settlement price of that trading session. This would mean that some participants
would make a loss while others would stand to gain. The exchange adjusts this by debiting the margin accounts
of those members who made a loss and crediting the accounts of those members who have gained. This feature
of futures trading creates an important difference between forward contracts and futures. In a forward contract,
gains or losses arise only on maturity. There are no intermediate cash flows.
Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the accruals
is different. In other words, the total gains or loss over the entire period is broken up into a daily series of gains
and losses, which clearly has a different present value.
• Actual Delivery is Rare
In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer.
Forward contracts are entered into for acquiring or disposing off a commodity in the future for a gain at a price
known today.
In contrast to this, in most futures markets, actual delivery takes place in less than one per cent of the contracts
traded. Futures are used as a device to hedge against price risk and as a way of betting against price movements
rather than a means of physical acquisition of the underlying asset. To achieve this, most of the contracts
entered into are nullified by a matching contract in the opposite direction before maturity of the first.

• Forward Contract Vs Future Contract

BASIS FOR FORWARD CONTRACT FUTURES CONTRACT
COMPARISON
Meaning Forward Contract is an agreement A contract in which the parties agree to
between parties to buy and sell the exchange the asset for cash at a fixed price
underlying asset at a specified date and and at a future specified date, is
agreed rate in future. known as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Traded on Over the counter, i.e. there is no Organized stock exchange.
secondary market.
Settlement On maturity date. On a daily basis.
Risk High Low

46
Default As they are private agreement, the No such probability.
chances of default are relatively high.
Size of contract Depends on the contract terms. Fixed
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High

International Equity market

The stock market refers to the collection of markets and exchanges where regular activities of buying, selling,
and issuance of shares of publicly-held companies take place. Such financial activities are conducted through
institutionalized formal exchanges or over-the-counter (OTC) marketplaces which operate under a defined set
of regulations. There can be multiple stock trading venues in a country or a region which allow transactions in
stocks and other forms of securities.
While both terms - stock market and stock exchange - are used interchangeably, the latter term is generally a
subset of the former. Trading in the stock market, means buying and selling shares/equities on one (or more)
of the stock exchange(s) that are part of the overall stock market. The leading stock exchanges in the U.S.
include the New York Stock Exchange (NYSE), Nasdaq, the Better Alternative Trading System (BATS) and
the Chicago Board Options Exchange (CBOE). These leading national exchanges, along with several other
exchanges operating in the country, form the stock market of the U.S. Though it is called a stock market or
equity market and is primarily known for trading stocks/equities, other financial securities-like exchange traded
funds (ETF), corporate bonds and derivatives based on stocks, commodities, currencies, and bonds - are also
traded in the stock markets.

The international equity market refers to the platform or arena where shares of companies outside one's home
country are bought and sold. It allows investors to diversify their portfolios by gaining exposure to businesses
and economies across the globe, mitigating risks associated with over-reliance on a single market. Below is a
detailed breakdown of the international equity market:

Key Features of the International Equity Market

• Global Reach:
• Includes companies listed on stock exchanges around the world.
• Provides access to emerging markets, developed markets, and frontier markets.
• Market Players:
• Institutional investors: Pension funds, mutual funds, sovereign wealth funds, etc.
• Retail investors: Individual investors seeking international diversification.
• Corporations: Engaged in cross-border mergers, acquisitions, and funding.
• Trading Platforms:
• Stock exchanges such as the NYSE, NASDAQ, London Stock Exchange (LSE), Tokyo
Stock Exchange, and Euronext.
• Over-the-counter (OTC) markets for equities not listed on exchanges.
• International platforms like the MSCI (Morgan Stanley Capital International) indices, which
track global equity performance.
• Investment Instruments:
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 • Common shares of foreign companies.
• Exchange-Traded Funds (ETFs) representing international indices or sectors.
• American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs), which
allow trading of foreign company shares in domestic markets.
• Mutual funds focusing on international equities.

Benefits of International Equity Investing

• Portfolio Diversification:
• Spreads risk across different geographies, industries, and economic cycles.
• Reduces vulnerability to local market downturns.
• Currency Diversification:
• Exposure to foreign currencies may provide additional returns if foreign currencies
appreciate against the investor's home currency.
• Growth Opportunities:
• Access to high-growth regions and industries not prevalent in the investor's home country.
• Participation in rapidly growing economies like China, India, and Brazil.
• Hedging Against Domestic Risk:
• Protects against domestic political, economic, or market-specific issues.

Risks in the International Equity Market

• Currency Risk:
• Fluctuations in exchange rates can impact returns when converting foreign earnings into the
investor's home currency.
• Political and Economic Risk:
• Political instability, regulatory changes, and economic downturns in foreign countries can
affect investments.
• Market Volatility:
• Emerging and frontier markets tend to exhibit higher volatility compared to developed
markets.
• Information Asymmetry:
• Limited access to information about foreign companies and markets can hinder informed
decision-making.
• Liquidity Risk:
• Smaller markets may have lower trading volumes, leading to difficulty in buying or selling
shares.
• Cultural and Regulatory Differences:
• Differences in corporate governance, financial reporting standards, and regulatory
environments.

Strategies for Investing in International Equities

• Direct Investment:
• Purchasing shares directly from foreign stock exchanges.
• Requires understanding the foreign market, currency transactions, and regulations.
• Indirect Investment:

48
 • Using vehicles like ADRs, GDRs, ETFs, or mutual funds to invest in foreign equities.
• Index Investing:
• Investing in indices tracking global or regional equity performance (e.g., MSCI World Index,
FTSE All-World Index).
• Active Management:
• Using professional portfolio managers to select foreign equities with growth potential.

Recent Trends in the International Equity Market

• Shift Towards Emerging Markets:
• Emerging markets have attracted significant investment due to higher growth rates.
• Increased Role of Technology:
• Electronic trading and algorithmic strategies are becoming more prevalent in global equity
markets.
• Sustainability and ESG Investing:
• Growing focus on environmental, social, and governance (ESG) factors in international
investing.
• Globalization of Companies:
• Many multinational corporations are listed on multiple exchanges, broadening investment
opportunities.

Conclusion
The international equity market provides an essential avenue for investors to expand their horizons and seek
better returns and diversification. However, the associated risks necessitate thorough research, due diligence,
and often, the guidance of professional financial advisors.

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International Bonds
International bonds are bonds issued by a country or company that is not domestic for the investor. The
international bond market is quickly expanding as companies continue to look for the cheapest way to borrow
money. By issuing debt on an international scale, a company can reach more investors. It also potentially helps
decrease regulatory constraints.

Summary
• The three categories of international bonds are domestic bonds, Eurobonds, and foreign bonds.
• Under dollar-denominated bonds, there are Yankee bonds and Eurodollar bonds.
• Non-dollar denominated bonds are sold and traded in domestic markets, foreign markets, and Euro markets.

Three Categories of International Bonds

There are three general categories for international bonds: domestic, euro, and foreign. The categories are based
on the country (domicile) of the issuer, the country of the investor, and the currencies used.
• Domestic bonds: Issued, underwritten and then traded with the currency and regulations of the borrower’s
country.
• Eurobonds: Underwritten by an international company using domestic currency and then traded outside
of the country’s domestic market.
• Foreign bonds: Issued in a domestic country by a foreign company, using the regulations and currency of
the domestic country.
For example:
• Domestic bonds: A British company issues debt in the United Kingdom with the principal and interest
payments based or denominated in British pounds.
• Eurobonds: A British company issues debt in the United States with the principal and interest payments
denominated in pounds.
• Foreign bonds: A British company issues debt in the United States with the principal and interest payments
denominated in dollars.

Dollar-denominated Bonds
Dollar-denominated bonds are issued in US dollars and offer investors more choices to increase diversity. The
two types of dollar-denominated bonds are Eurodollar bonds and Yankee bonds. The difference between the
two bonds is that Eurodollar bonds are traded outside of the domestic market while Yankee bonds are issued
and traded in the U.S.
1. Eurodollar bonds
Eurodollar bonds are the largest component of the Eurobond market. A Eurodollar bond must be denominated
in U.S. dollars and written by an international company. Since Eurodollar bonds are not registered with the
SEC, they can not be sold to the U.S. public. However, they can be traded on the secondary market.
Even though many portfolios do include Eurodollar bonds in U.S. portfolios, U.S. investors do not participate
in the primary market for such bonds. Therefore, the primary market is dominated by foreign investors.
2. Yankee bonds
Yankee bonds are another type of dollar-denominated bonds. However, unlike the Eurodollar bonds, the
Yankee bonds’ target market is within the U.S. These bonds are issued by a foreign company or country that
has registered with the Securities and Exchange Commission (SEC). Since Yankee bonds are meant to be
purchased by U.S. citizens in the primary market, they must follow regulations set by the SEC. For example,
the company issuing the bond needs to be financially stable and capable of making payments throughout the
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period of the bond.
Non-dollar-denominated Bonds
Non-dollar-denominated international bonds are all the issues denominated in currencies other than the dollar.
Since there is currency volatility, U.S. investors face the question of whether to hedge their currency exposure.
The different types of non-dollar-denominated bonds depend on the domicile of the issuer and the location of
the primary trading market. The three major types are the domestic market, the foreign market, and the Euro
market.
1. Domestic market
The domestic market includes bonds that are issued by a borrower in their home country using that country’s
currency. Domestic markets have seen significant growth for several reasons. First of all, for companies, issuing
debt in the domestic currency allows them to better match liabilities with assets. By doing so, they also don’t
need to worry about the currency exchange risk.
Also, by issuing debt in dollar-denominated markets and the domestic market, companies gain access to more
investors. It allows them to obtain a better borrowing rate.
2. Foreign market
The foreign bond market includes the bonds that are sold in a country, using that country’s currency, but issued
by a non-domestic borrower. For example, the Yankee bond market is the U.S. dollar version of this market.
This is because they are sold in the U.S. using the dollar, but issued by a syndicate outside of the U.S.
Other examples include the Samurai market and the Bulldog market. The Samurai market is Yen-denominated
bonds issued in Japan but by non-Japanese borrowers. The Bulldog market is pound-denominated bonds issued
in the U.K. by non-Brtish groups.
3. Euro market
Securities that are issued into the international market are called Eurobonds. This market encompasses all the
bonds that are not issued in a domestic market and can be issued in any currency. Eurodollar bonds are an
example of a U.S. dollar-denominated version of a Eurobond as they are sold in the international markets.
Most of the time, the bonds are written by an international syndicate and sold in several different national
markets simultaneously. Issuers of Eurobonds include international corporations, supranational companies, and
countries

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What are American Depositary Receipts (ADR)?
American Depositary Receipts (ADR) are negotiable security instruments that are issued by a US bank that represent
a specific number of shares in a foreign company that is traded in US financial markets. ADRs pay dividends in US
dollars and trade like regular shares of stock. Companies can now purchase stocks of foreign companies in bulk and
reissue them on the US market. ADRs are listed on the NYSE, NASDAQ, AMEX and can be sold over-the-counter.

Before the introduction of ADRs in 1927, investors in the US faced numerous hurdles when attempting to invest in
stocks of foreign companies. American investors could purchase the shares on international exchanges only, and that
meant dealing with currency exchange rates and regulatory differences in foreign jurisdictions.
They needed to familiarize themselves with different rules and risks related to investing in companies without a US
presence. However, with ADRs, investors can diversify their portfolio by investing in foreign companies without
having to open a foreign brokerage account.
How American Depositary Receipts Work
Investors willing to invest in American Depositary Receipts can purchase them from brokers or dealers. The brokers
and dealers obtain ADRs by buying already-issued ADRs in the US financial markets or by creating a new ADR.
Already-issued ADR can be obtained from the NASDAQ or NYSE.
Creating a new ADR involves buying the stocks of the foreign company in the issuer’s home market and depositing
the acquired shares in a depository bank in the overseas market. The bank then issues ADRs that are equal to the
value of the shares deposited with the bank, and the dealer/broker takes the ADR to US financial markets to sell them.
The decision to create an ADR depends on the pricing, availability, and demand.
Investors who purchase the ADRs are paid dividends in US dollars. The foreign bank pays dividends in the native
currency, and the dealer/broker distributes the dividends in US dollars after factoring in currency conversion costs
and foreign taxes.
Such a practice makes it easy for US investors to invest in a foreign company without worrying about currency
exchange rates. The US banks that deal with ADRs require the foreign companies to furnish them with their financial
information, which investors use to determine the company’s financial health.

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Types of American Depositary Receipts
The ADRs that are sold in US financial markets can be categorized into sponsored and unsponsored.
1. Sponsored ADR
For a sponsored ADR, the foreign company issuing shares to the public enters into an agreement with a US
depositary bank to sell its shares in US markets. The US bank is responsible for recordkeeping, sale, and distribution
of shares to the public, distribution of dividends, etc. Sponsored ADRs can be listed on the US stock exchanges.
2. Non-Sponsored ADR
A non-sponsored ADR is created by brokers/dealers without the cooperation of the foreign company issuing the
shares. Non-sponsored ADRs are traded in US over-the-counter markets without requiring registration with the
Securities and Exchange Commission (SEC).
Before 2008, any brokers and dealers trading in ADRs were required to submit a written application before being
allowed to trade in the US. The 2008 SEC amendment provided an exemption to foreign issuers that met certain
regulatory conditions. Non-sponsored ADRs are only traded on over-the-counter markets.
Levels of American Depositary Receipts
ADRs are grouped into three levels depending on the extent of the foreign company’s access to the US trading
market.
1. Sponsored Level I
Level I is the lowest level at which sponsored ADRs can be issued. It is the most common level for foreign
companies that do not qualify for other levels or that do not want their securities listed on US exchanges. Level I
ADRs are subject to the least reporting requirements with the Securities and Exchange Commission, and they are
only traded over the counter.
The companies are not required to issue quarterly or annual reports like other publicly traded companies. However,
Level I issuers must have their stock listed on one or more exchanges in the country of origin. Level I can be
upgraded to Level II when the company is ready to sell through US exchanges.
2. Sponsored Level II ADRs
Level II ADRs have more requirements from the SEC than Level I, and the company gets an opportunity to establish
a higher trading presence on the US stock markets. The company must file a registration statement with the SEC.
Also, the company must file Form-20-F in accordance with the GAAP or IFRS standards. Form 20-F is the equivalent
of Form-10-K, which is submitted by US publicly traded companies. If the issuer fails to comply with these
requirements, it may be delisted or downgraded to Level I.
3. Sponsored Level III ADRs
Level III is the highest and most prestigious level that a foreign company can sponsor. A foreign company at this
level can float a public offering of ADRs to raise capital from American investors through US exchanges. Level III
ADRs also attract stricter regulations from the SEC.
The company must file Form F-1 (prospectus) and Form 20-F (annual reports) in accordance with GAAP or IFRS
standards. Any materials distributed to shareholders in the issuer’s home country must be submitted to the SEC as
Form 6-K.
Examples of foreign companies that have managed to enter this ADR level include Vodafone, Petrobras, and China
Information Technology.
Termination or Cancellation
ADRs are subject to cancellation at the discretion of either the foreign issuer or the depositary bank that created them.
The termination results in the cancellation of all ADRs issued and delisting from the US exchange markets where the
foreign stock was trading. Before the termination, the company must write to the owners of ADRs, giving them the
option to swap their ADR for foreign securities represented by the receipts.
If the owners take possession of the foreign securities, they can look for brokers who trade in that specific foreign
market. If the owner decides to hold onto their ADR certificates after the termination, the depositary bank will
continue holding onto the foreign securities and collect dividends but will not sell more ADR securities.

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What Is a Global Depositary Receipt (GDR)?
A global depositary receipt (GDR) is a negotiable financial instrument issued by a depositary bank. It
represents shares in a foreign company and trades on the local stock exchanges in investors' countries. GDRs make it
possible for a company (the issuer) to access investors in capital markets beyond the borders of its own country.
GDRs are commonly used by issuers to raise capital from international investors through private placement or public
stock offerings.
A global depositary receipt is very similar to an American depositary receipt (ADR) except that an ADR only lists
shares of a foreign company in U.S. markets.
Key Takeaways
• A global depositary receipt is a tradable financial security.
• It is a certificate that represents shares in a foreign company and usually trades on two or more global stock
exchanges.
• GDRs typically trade on American stock exchanges as well as Eurozone or Asian exchanges.
• GDRs and their dividends are typically priced in U.S. dollars, but could be in any currency.
• GDRs represent an easy way for U.S. and international investors to own foreign stocks.
Understanding Global Depositary Receipts (GDRs)
A global depositary receipt is a type of bank certificate that represents shares of stock in an international company.
The shares underlying the GDR remain on deposit with a depositary bank or custodial institution.
While shares of an international company trade as domestic shares in the country where the company is located,
global investors located elsewhere can invest in those shares through GDRs.
Using GDRs, companies can raise capital from investors in countries around the world. GDRs can in theory be
denominated in any currency, but are nearly always in U.S. dollars. Since GDRs are negotiable certificates, they trade
in multiple markets and can provide arbitrage opportunities to investors.
GDRs are generally referred to as European Depositary Receipts, or EDRs, when European investors wish to trade
locally the shares of companies located outside of Europe.
GDR transactions tend to have lower costs than some other mechanisms that investors use to trade in foreign
securities.
A GDR distributed by a depositary bank represents a particular number of underlying shares—anywhere from a
fraction to multiple shares—in a specific international company. The particular share makeup for a GDR depends on
how attractive an investment it will make to local investors. For instance, in the U.S., a depositary bank would want
to create GDRs with the number of shares, or fractions thereof, and associated U.S. dollar value that U.S. investors
might be most comfortable with.
The depositary bank first buys the shares of the international company (or, receives them from an investor who
already owns them). It then bundles a certain number of them. This bundle is represented by a GDR. The GDR is then
issued by the depositary bank on a local stock exchange. The underlying shares remain on deposit with the depositary
bank (or custodian bank in the international country).
The trading process involving GDRs is regulated by the exchange on which they trade. For example, in the U.S.,
global depositary receipts are quoted and trade in U.S. dollars. They also pay dividends with U.S. dollars. They're
subject to the trading and settlement process and regulations of the exchange where their transactions take place.
Typically, GDRs are offered to institutional investors via a private offer, due to the fact that they can take advantage
of exemptions from registration under the Securities Act of 1933. This makes GDRs an efficient and cost-effective
way to access cross-border capital. In fact, because of their flexibility and efficiencies, issuers from regions such as
the Middle East and Africa, Asia Pacific, Latin America as well as Europe have increased their use of GDR programs
to help them achieve the objectives they have for raising capital.

Example of a GDR
A U.S.-based company that wants its stock to be listed on the London and Hong Kong Stock Exchanges can
accomplish this via a GDR. The U.S.-based company enters into a depositary receipt agreement with the respective
foreign depositary banks. In turn, these banks package and issue shares to their respective stock exchanges. These
activities follow the regulatory compliance regulations for both of the countries.
A depositary is an independent, third-party entity such as a bank that may act as a safekeeping facility and fiduciary.
For instance, a depositary bank can provide stock related services for a depositary receipt program.
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GDR Characteristics
GDRs are exchange-traded securities that represent ownership of shares in a foreign company, where those actual
shares are traded abroad.
Different GDRs may also have specific characteristics that differ from one to the next. These may include:
• Number of shares: Each GDR represents a specific number of shares of the underlying company. This
amount can vary from one GDR to another, and it may be adjusted over time to reflect changes in the
underlying shares.
• Denomination: Although they can in theory use any currency, GDRs are nearly always denominated in U.S.
dollars. The Euro is the next most common currency. The currency used for a GDR may impact its price and
the risks associated with the investment, such as currency risk, as the price of its shares overseas are priced in
local currency.
• Sponsorship: GDRs are issued by depository banks, and the specific bank that sponsors a GDR may vary
from one GDR to another. Different banks may have different reputations, financial strength, and other
characteristics that could impact the risks and potential returns of a GDR.
• Fees: GDRs may also vary in terms of the fees that are charged for issuing, trading, or holding the GDRs.
These fees can impact the overall cost and potential returns of an investment in a GDR.

Trading GDRs
International companies issue GDRs to attract capital from foreign investors. GDRs trade on the investors' local
exchanges while offering exposure to an international marketplace. A custodian/depositary bank has possession of the
GDRs underlying shares while trades take place, ensuring a level of protection and facilitating participation for all
involved.
Brokers who represent buyers manage the purchase and sale of GDRs. Generally, the brokers are from the home
country and operate within the foreign market. The actual purchase of the assets is multi-staged, involving a broker in
the investor's country, a broker located within the market of the international company, a depositary bank
representing the buyer, and a custodian bank.
Brokers can also sell GDRs on an investor's behalf. An investor can sell them as-is on the proper exchanges, or the
investor can convert them into regular stock for the company. Additionally, they can be canceled and returned to the
issuing company.
Traders dealing in GDRs often compare the, for example, U.S. dollar price of the GDR with the U.S. dollar
equivalent price of the shares trading on the international company's domestic exchange. They'll typically buy the less
expensive security and sell the other. Eventually, this arbitrage trading activity causes the underlying shares and the
GDRs to reach parity.
Due to the trading activity called arbitrage, a GDR's price closely tracks that of the international company's stock on
its home exchange.
Advantages and Disadvantages of GDRs
Advantages
• GDRs help international companies reach a broader, more diverse audience of potential investors.
• They can potentially increase share liquidity.
• Companies can conduct an efficient and cost-effective private offering.
• Shares listed on major global exchanges can increase the status or legitimacy of an otherwise unknown
foreign company.
• For investors, GDRs provide the opportunity to diversify portfolios internationally.
• GDRs are more convenient and less expensive than opening foreign brokerage accounts and purchasing
stocks in foreign markets.
• Investors don't have to pay cross-border custody or safekeeping charges.
• GDRs trade, clear, and settle according to the exchange and its country's domestic processes and procedures.
• U.S. holders of GDRs realize any dividends and capital gains in U.S. dollars.2
Disadvantages
• GDRs may have significant administrative fees.
55
 • Dividend payments are net of currency conversion expenses and foreign taxes.
• The depositary bank automatically withholds the amount necessary to cover expenses and foreign taxes.
• U.S. investors may need to seek a credit from the Internal Revenue Service (IRS) or a refund from the foreign
government's taxing authority to avoid double taxation on capital gains realized.3
• GDRs have the potential to have low liquidity, making them difficult to sell.
• In addition to liquidity risk, they can have currency risk and political risk.
• This means that the value of GDR could fluctuate according to actual events in the foreign county, such as
recession, financial collapse, or political upheaval.
Pros
• Easy to track and trade
• Usually denominated in U.S. dollars
• Regulated by local exchanges
• Offers international portfolio diversification
Cons
• More complex taxation
• Limited selection of companies offering GDRs
• Investors exposed indirectly to currency and geopolitical risk
• Potential lack of liquidity
GDRs vs. ADRs

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Euro currency market
Europeans wished to hold their assets outside their own country or in currencies which is not locally
denominated. These investors were driven by the twin concerns of avoiding taxes in their own country and
protecting themselves against falling values of domestic currency. Dollar denominated, Euro bonds were
designed to address these issues.
These bonds were in bearer forms. Hence, there was no ownership and no tax withheld. The term Euro is used
because the transactions originated in the Europe, mainly London. But later on expanded fast to the countries
like Honk Kong and Singapore in the far East-at present more than half of the transactions in the Euro markets
take place outside the Europe.
Thus, it is evident that the term ‗Eurodollar‘ is a misnomer. ‗Foreign Currency Market‘ would be the
appropriate term to describe this expanding market. The term ‗Eurodollar‘ came to be used because the market
had its origin and earlier developments with dollar transactions in the European money markets. Despite the
emergence of other currencies and the expansion of the market to other areas, Europe and the dollar still hold
the key to the market. Today, the term Eurocurrency market is in popular use.
Now, the ‗Eurodollar Market‘ consists of Asian dollar market, Rio dollar market, Euro- yen market, etc., as
well as Euro-sterling, Euro-Swiss francs, Euro-French francs, Euro- Deutsche marks, and so on. In short, in
these markets, the commercial banks accept interest bearing deposits denominated in a currency other than the
currency of the country in which they operate and they re-lend these funds either in the same currency or in the
currency of the country in which they operate or in the currency of a third country.
Its Annual Report in 1966, the Bank for International Settlements (BIS) described the Eurodollar
phenomenon as ―The acquisition of dollars by banks located outside the United States, mostly through the taking
of deposits, but also to some extent by swapping other currencies into dollars, and the re-lending of these dollars,
often after re-depositing with other banks, to non-bank borrowers anywhere in the world.‖
The Important Characteristics of the Eurocurrency market are the following:
i) It is an International Market and it is under no National Control:
ii) The Eurocurrency market has emerged as the most important channel for mobilizing and deploying
funds on an international scale. By its very nature, the Eurodollar market is outside the direct control
of any national monetary policy. ―It is aptly said that the dollar deposits in London are outside United
States control because they are in London and outside British control because they are in dollars.‖ The
growth of the market owes a great deal to the fact that it is outside the control of any national authority.
iii) It is a Short-Term Money Market:
iv) The deposits in this market range in maturity from one day to several months and interest are paid on
all of them. Although some Eurodollar deposits have a maturity of over one year, Eurodollar deposits
are predominantly a short-term instrument. The Eurodollar market is viewed in most discussions more
as a credit market- a market in dollar bank loans-and as an important accessory to the Eurobond market.
v) The Eurodollar Loans are Generally for Short Periods:
Three months or less, Eurobonds being employed for longer-term loans. The Eurobonds developed out of the
Eurodollar market to provide longer-term loans than was usual with Eurodollars. A consortium of banks and
issuing houses usually issues these bonds.

Euro credit market

Euro credit helps the flow of capital between countries and the financing of investments at home and abroad.
A major function of banks is matching surplus units (who deposit at the bank) with deficit units (who borrow
from the bank). Being able to do this internationally, both across borders and across currencies improves both
liquidity and efficiency in the markets for financing.

57
Banks may also engage in syndicated loans in the euro credit market, where a loan is made by a group
(syndicate) of banks. Syndicated loans reduce the risk of borrower default for each individual bank loaning
funds and are often found where the size of the loan is too big for one bank to do by itself. Often, the banks in
a syndicate will be headquartered in different countries but lending in one currency-an example of how the
euro credit market can work to improve the flow of funds internationally.

Euro bond market

A Eurobond is debt instrument that's denominated in a currency other than the home currency of the country
or market in which it is issued. Eurobonds are frequently grouped together by the currency in which they are
denominated, such as eurodollar or Euro-yen bonds. Since Eurobonds are issued in an external currency, they're
often called external bonds. Eurobonds are important because they help organizations raise capital while having
the flexibility to issue them in another currency.
Issue of Eurobonds is usually handled by an international syndicate of financial institutions on behalf of the
borrower, one of which may underwrite the bond, thus guaranteeing the purchase of the entire issue. A foreign
bond may define as an international bond sold by a foreign borrower but denominated in the currency of the
country in which it is placed. It underwrites and sells by a national underwriting syndicate in the lending
country. Thus, a US company might float a bond issue in the London capital market, underwritten by a British
syndicate and denominated in sterling.
The bond issue would sell to investors in the UK capital market, where it would quote and traded. Foreign
bonds issued outside the USA call Yankee bonds, while foreign bonds issued in Japan are called Samurai
bonds. Canadian entities are the major floaters of foreign bonds in the USA.
Types Of Eurobonds:
There are three types of Eurobonds, of which two are international bonds. A domestic bond is a bond issue in
a country by a resident of that country.
There are several different types of Eurobonds.
• Straight Bond: Bond is one having a specified interest coupon and a specified maturity date. Straight
bonds may issue with a floating rate of interest. Such bonds may have their interest rate fixed at six- month
intervals of a stated margin over the LIBOR for deposits in the currency of the bond. So, in the case of a
Eurodollar bond, the interest rate may base upon LIBOR for Eurodollar deposits.
• Convertible Eurobond: The Eurobond is a bond having a specified interest coupon and maturity date.
But, it includes an option for the hold to convert its bonds into an equity share of the company at a
conversion price set at the time of issue.
• Medium-term Eurobond: Medium-term Euro notes are shorter-term Eurobonds with maturities ranging
from three to eight years. Their issuing procedure is less formal than for large bonds. Interest rates on Euro
notes can fix or variable. Medium-term Euro-notes are similar to medium-term roll-over Eurodollar credits.
The difference is that in the Eurodollar market lenders hold a claim on a bank and not directly on the
borrower.
Characteristics of Euro bonds or Features of Eurobonds
The following characteristics of euro bonds below are
i. Straight bonds: the fixed interest rate at periodic intervals, usually annually.
ii. Floating-rate notes (FRNs): rollover pricing payment usually six months interest stated in terms of a
spread over some reference rate.
iii. Zero-coupon bonds: discount securities, sold either at a fraction of face value and redeemed at face
value, or sold at face value and redeemed at a premium.
iv. Convertible bonds: can exchange for some other type of asset: stock, gold, oil, other bonds.
58
 v. Mortgage-backed Eurobonds: backed by a pool of mortgages, or other bonds Institutions which
would otherwise exclude from Eurobond market can get access.
vi. Dual-currency bonds: purchased in one currency, coupon or principal paid in a second currency.
vii. The following Eurobonds features are:
• The issuing technique takes the form of a placing rather than formal issuing; this avoids national
regulations on new issues.
• Eurobonds place simultaneously in many countries through syndicates of underwriting banks.
• Unlike foreign bonds, Eurobonds sale in countries other than that of the currency of
denomination; thus dollar-denominated Eurobonds sale outside the U.S.A.
• The interest on Eurobonds is not subject to withholding tax.

International Cash Management: A Definition

International Cash Management refers to the set of strategies employed by multinational companies to manage their
cash resources effectively across different countries.
This involves managing various currencies, anticipating currency fluctuations, optimizing banking relationships
across the globe, managing international transactions, and ensuring liquidity within the organization regardless of
geographical location.
Role of International Cash Management in Business Studies
As Business Studies encompasses various aspects of commerce, finance, and management, International Cash
Management is inherently integral to this field.
• With respect to finance, it allows for effective management of international currency, promoting financial
health and stability of the company.
• In terms of commerce, it facilitates cross-border transactions.
• From a management perspective, it encourages operational efficiency on a global scale.
Furthermore, as technology progresses and businesses become more globalized, understanding International Cash
Management in Business Studies aids students in becoming proficient strategic decision-makers in the era of
international business.
Interestingly, many multinational corporations employ specialized treasury management software to facilitate their
international cash management processes which provides real-time insights into cash positions, exposures, and risks
across multiple countries and currencies.
Basic Principles of International Cash Management
Fundamental to International Cash Management are principles that guide the practice. Let's delve into some widely
accepted principles,

Effective cash management reduces idle cash and ensures resources are utilized
Efficiency
efficiently. ROI=NetIncomeInvestment

A company must have enough cash to meet short-term obligations. The liquidity ratio is often
Liquidity
used to measure this. LiquidityRatio=CurrentAssetsCurrentLiabilities

Risk Currency exchange rate fluctuations, geopolitical instability or changes in local regulations
management can present risks. Businesses must have strategies in place to mitigate these risks.

59
For instance, if a UK-based company has significant operations in Japan and the UK Pound weakens against the
Japanese Yen, the company may find its costs increasing. In such cases, the company may use hedging strategies to
minimize the impact of currency fluctuations.
Remember, effective International Cash Management can greatly enhance the efficiency and profitability of a
business. Keep these principles at the core of international cash management strategies, thereby ensuring swift and
smooth cross-border transactions, increased financial stability, and improved global business operations.
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Benefits of International Cash Management
International Cash Management serves as the backbone for businesses with operations across different countries.
Delving into its potential advantages, efficiency in cross-border transactions stands out. Effective International
Cash Management can help a business manage its resources adeptly across different countries and therefore:
• Reduces the time and complexities related to managing multiple bank accounts in different jurisdictions.
• Facilitates "pooling" of cash, where excess cash from one location can be redirected to fund shortfalls in
another, thereby ensuring a balanced cash flow within the corporation.
• Streamlines the process of managing multiple currencies, thereby reducing exposure to foreign exchange rate
fluctuations and hedging costs.
Furthermore, businesses can take advantage of modern technology, deploying robust treasury and cash management
software that centralizes the process and presents real-time snapshots of the company's cash position across regions.
Thus, companies can actively manage their cash positions and make planned, strategic decisions about allocation and
usage.
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How International Cash Management Enhances Financial Stability?
Financial stability is a characteristic that any successful business strives to achieve. It denotes the capacity of an
enterprise to meet its obligations, finance its growth, and weather financial downturns. Effective International Cash
Management bolsters this stability in several key ways:
• A stable cash flow ensures that a company's routine financial obligations can be met on time and that the
company can finance its daily operations smoothly. This kind of stability is ensured by utilizing International
Cash Management.
• It aids in better management of the currencies across geographies, thereby reducing the risks associated with
currency fluctuations and foreign exchange losses.
• International Cash Management promotes risk management. This is achieved by diversifying the company's
cash holdings across several countries, thereby reducing the danger of losses due to political in-stability or
economic downturns in any one country.
For example, consider a company operating both in Country A and Country B. If Country A experiences economic
recession, a portion of the company's cash holdings may devalue. However, if the company has also established
operations and held cash in Country B, where the economy is performing well, the financial impact on the company
would be less severe. So, by employing a robust International Cash Management strategy, corporations can
effectively spread their risk, maintain a steady cash flow, and ensure a degree of financial stability, irrespective of
market volatility or geopolitical uncertainties.
Techniques Used in International Cash Management
Effective International Cash Management involves a range of techniques that companies use to enhance their
operational efficiency, maximise cash availability, minimise transaction costs and manage risks associated with
currency fluctuations. Let's delve further into these techniques.
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Fundamental Techniques for Effective International Cash Management
The success of International Cash Management hinges on several fundamental techniques, each serving a unique
Effective international cash management is crucial for businesses operating in multiple countries. It involves
optimizing the handling, allocation, and distribution of funds across different subsidiaries, regions, and currencies to
ensure liquidity, minimize costs, and mitigate financial risks. Here's an overview of some key techniques used in
60
international cash management:
1. Centralized Cash Management
Centralized cash management refers to the practice of consolidating all of a company’s cash flows into a single or
limited number of central accounts, often managed at the headquarters or a central treasury department. The goal is to
improve visibility over cash balances, enhance liquidity management, and reduce operational costs. This technique is
particularly useful for multinational corporations with subsidiaries across different regions or countries.
Benefits of Centralized Cash Management:
• Improved liquidity management: By pooling cash into central accounts, the company can better monitor
and manage overall liquidity.
• Cost reduction: Fewer accounts to maintain and reduced transaction fees.
• Efficiency: Cash surpluses in one region can be used to cover deficits in another region, reducing the need
for external borrowing.
Methods of Implementing Centralized Cash Management:
• Cash concentration: Moving funds from various subsidiaries' accounts to a central account.
• Zero-balance accounts (ZBAs): Each subsidiary has a separate account that is linked to the central treasury.
At the end of the day, the balance is automatically transferred to the central account.
• Sweeping: A process of transferring funds from subsidiary accounts to a central account on a regular basis
(usually daily).
2. Cash Pooling
Cash pooling is the practice of consolidating the cash balances of various accounts (typically from subsidiaries or
business units) into one centralized account or "pool." This is done to optimize the management of available funds,
reduce idle cash, and minimize borrowing costs. There are two main types of cash pooling: physical pooling and
notional pooling.
• Physical Pooling: Actual physical transfer of funds into one central account, allowing the company to
manage its overall cash position more effectively.
• Notional Pooling: No physical transfer of funds occurs, but the balances in various accounts are offset
against each other to determine a net position. Interest is calculated based on the net balances.
Benefits of Cash Pooling:
• Interest optimization: Surplus funds from subsidiaries can offset deficits in other regions, minimizing
external borrowing needs.
• Simplified accounting: Consolidated cash positions allow for easier cash reporting and accounting.
• Enhanced liquidity control: The company can better manage its short-term liquidity needs and have better
visibility over available cash.
3. Netting
Netting is a technique used to reduce the number of payments and transactions between subsidiaries and headquarters
(or among subsidiaries themselves). It involves offsetting intercompany payments so that only the net amount is
transferred. This is particularly beneficial for multinational companies that regularly make payments between
different legal entities in different countries.
Types of Netting:
• Bilateral Netting: Involves two parties (e.g., two subsidiaries) that offset their mutual debts and credits,
resulting in one payment in either direction.
• Multilateral Netting: Involves multiple entities, and all intercompany balances are offset to arrive at a single
net payment.
Benefits of Netting:
• Reduced transaction costs: Fewer transactions and cross-border payments mean lower banking fees and
exchange costs.
• Simplified cash flow management: It reduces the complexity of managing numerous payments across
different subsidiaries and currencies.
• Improved liquidity: By reducing the number of payments, it improves the overall liquidity position of the
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 group.
4. Exchange Risk Management
Exchange risk management refers to the strategies used to mitigate the risk of currency fluctuations that can impact
international operations. Businesses that operate in multiple currencies are exposed to exchange rate risk, which can
affect their financial statements, cash flows, and profitability.
Techniques for Exchange Risk Management:
• Hedging: Companies can use various financial instruments like forward contracts, options, and swaps to
hedge against unfavorable currency movements. For example, a company might enter into a forward contract
to lock in an exchange rate for future transactions.
o Forward contracts: Agreements to buy or sell a currency at a predetermined rate at a future date.
o Currency options: Give the company the right (but not the obligation) to exchange currency at a
specific rate on or before a certain date.
o Currency swaps: Involves exchanging one currency for another for a specified period.
• Natural hedging: Involves offsetting currency exposure by matching revenues and expenses in the same
currency. For instance, if a company earns revenue in euros, it could also incur expenses in euros to naturally
offset currency risk.
• Currency diversification: Spreading the company’s currency exposure across multiple currencies to
minimize the impact of fluctuations in any single currency.
• Multicurrency accounts: Companies with significant exposure to multiple currencies may choose to open
multicurrency accounts to hold cash in different currencies and reduce the need to convert currencies
frequently.
Benefits of Exchange Risk Management:
• Protection against volatility: Hedging reduces the impact of unfavorable currency movements.
• Cost predictability: By locking in exchange rates, a company can forecast costs and revenues more
accurately.
• Profit protection: Prevents potential losses from exchange rate fluctuations, particularly in volatile markets.
Summary of Key Techniques:
Technique Purpose Benefits
Centralized Cash Consolidates cash from various regions into Improved liquidity control, cost reduction,
Management central accounts efficiency
Interest optimization, simplified accounting,
Cash Pooling Consolidates cash from multiple accounts
liquidity control
Offsets intercompany balances to reduce Reduced transaction costs, simplified cash
Netting
transactions flow management
Exchange Risk Mitigates the impact of currency Protects against volatility, cost
Management fluctuations predictability, profit protection
Conclusion:
Effective international cash management is essential for optimizing liquidity, reducing costs, and minimizing risks in
a globalized business environment. Techniques like centralized cash management, pooling, netting, and exchange risk
management allow companies to streamline their cash flows, manage cross-border transactions more efficiently, and
protect themselves from the unpredictable nature of foreign exchange markets. By adopting these techniques,
multinational organizations can improve their financial stability and strategic flexibility.

62
Module 4
IV International Contract & Procedure:
• Letter of credit- Meaning & Mechanism
• Types of letter of Credit
• Operation of Letter of Credit Managing Exposure:(Theory & Numerical)
• Management of Economic Exposure
• Management of Transaction Exposure
• Management of Translation Exposure

Letter of credit- Meaning & Mechanism

‘Letters of Credit’ also known as ‘Documentary Credits’ is the most commonly accepted instrument of settling
international trade payments. A Letter of Credit is an arrangement whereby Bank acting at the request of a customer
(Importer / Buyer), undertakes to pay for the goods / services, to a third party (Exporter / Beneficiary) by a given
date, on documents being presented in compliance with the conditions laid down

A letter of credit, or a credit letter, is a letter from a bank guaranteeing that a buyer’s payment to a seller will be
received on time and for the correct amount. If the buyer is unable to make a payment on the purchase, the bank will
be required to cover the full or remaining amount of the purchase. It may be offered as a facility (financial assistance
that is essentially a loan).
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and
difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of
international trade to protect buyers and sellers.
Key Takeaways
• A letter of credit is a document sent from a bank or financial institution that guarantees that a seller will
receive a buyer’s payment on time and for the full amount.
• Letters of credit are often used within the international trade industry.
• There are many different letters of credit, including one called a revolving letter of credit.
• Banks collect a fee for issuing a letter of credit.
How a Letter of Credit Works
Buyers of major purchases may need a letter of credit to assure the seller that the payment will be made. A bank
issues a letter of credit to guarantee the payment to the seller, essentially assuming the responsibility of ensuring the
seller is paid. A buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay before
the bank will guarantee the payment to the seller.1
Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit.
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank
nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a
corporate parent or a third party, the right to draw.
The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits oversees letters
of credit used in international transactions

TYPES OF LETTERS OF CREDIT

1) REVOCABLE LETTER OF CREDIT
A revocable letter of credit is one which can be cancelled or amended by the issuing bank at any time and without
prior notice to or consent of the beneficiary. From the exporter’s point of view such LCs are not safe. Besides
exporter cannot get such LCs confirmed as no bank will add confirmation to Revocable LCs. However, if any bank
has negotiated bills before receipt of notice of revocation, opening bank is liable to honour its commitments. The LC
should clearly state that the same is revocable. As per Article-3 of UCP 600, a credit is irrevocable even if there is no
indication to that effect. Further UCP 600 does not provide for revocable LCs and therefore such credits no longer
exist.
2. IRREVOCABLE LETTER OF CREDIT
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 An Irrevocable Letter of Credit is one which cannot be cancelled or amended without the consent of all parties
concerned.
3. REVOLVING LETTER OF CREDIT A Revolving Letter of Credit is one where, under terms and conditions
thereof, the amount is renewed or reinstated without specific amendments to the credit being needed. It can revolve in
relation to time and value. This type of credit is generally used in local trade and sometimes for import also. Such
credits are opened for a stated amount and the drawings under the LC are reinstated as soon as the documents are
paid. The LC can be restricted to the individual amount of drawing at a time as well as aggregate amount of drawings.
The Issuing bank has to confirm to the negotiating bank about the acceptance / payment of the documents for
reinstatement of the amount in the LC. In revolving LC for import, the maximum drawings and the validity would be
to the extent permitted by the import license, if such imports are backed by Import License. Generally, we do not
open Revolving LCs for import.
However in exceptional cases such L/C may be opened with adequate safeguards / conditions subject to strict
compliance of Foreign Trade Policy and Exchange Control Regulations particularly with reference to aggregate
drawings under such L/C & shipment dates etc.

4. TRANSFERABLE LETTER OF CREDIT

A Transferable Credit is one that can be transferred by the original (first) beneficiary to one or more second
beneficiaries. When the sellers of goods are not the actual suppliers or manufacturers, but are dealers/middlemen,
such credits may be opened, giving the sellers the right to instruct the advising bank to make the credit available in
whole or in part to one or more second beneficiaries. The LC can be transferred to more than one second beneficiary
provided LC permits partial shipment and aggregate value of amounts so transferred does not exceed value of original
LC. The LC can be transferred only once and only on terms stated in the credit, with the exception of : - The amount
of the Credit, Any unit price stated therein, - The expiry date, - The latest shipment date or given period for
shipment, - The period for presentation of documents, any or all of which may be reduced or curtailed. The
percentage for which insurance cover must be effected may be increased to provide the amount of cover stipulated in
the credit. The LC is deemed to be transferable only if it is stated to be ‘Transferable’ in the LC. Second beneficiary
has no right to transfer to third beneficiary. However, he can retransfer to the first beneficiary. As per our Bank’s
policy, Transferable Import LCs is normally not opened. However, transferable LCs can be opened in exceptional
case, by specifying the second beneficiaries in the LC itself or by amendment, provided.
i) Second beneficiaries should be specific and limited in number,
ii) Satisfactory credit report on second beneficiary should have been received. Further the second beneficiary must be
a shipper / manufacturer or supplier of goods.
iii) Second beneficiary should normally be residing in the same country. If resident of another country, method of
payment of second beneficiary’s country should conform to Exchange Control Regulations.
iv) Underlying contract indent/order should provide for such transfers.

5 STANDBY LETTER OF CREDIT (SBLC)

A standby letter of credit, abbreviated as SBLC, refers to a legal document where a bank guarantees the payment of a
specific amount of money to a seller if the buyer defaults on the agreement.
An SBLC acts as a safety net for the payment of a shipment of physical goods or completed service to the seller, in
the event something unforeseen prevents the buyer from making the scheduled payments to the seller. In such a case,
the SBLC ensures the required payments are made to the seller after fulfillment of the required obligations.
A standby letter of credit is used in international or domestic transactions where the seller and the buyer do not know
each other, and it attempts to hedge out the risks associated with such a transaction. Some of the risks
include bankruptcy and insufficient cash flows on the part of the buyer, which prevents them from making payments
to the seller on time.
In case of an adverse event, the bank promises to make the required payment to the seller as long as they meet the
requirements of the SBLC. The bank payment to the seller is a form of credit, and the customer (buyer) is responsible
for paying the principal plus interest as agreed with the bank.
Types of Standby Letter of Credit
The two main types of SBLC are:
1. Financial SBLC
64
 The financial-based SBLC guarantees payment for goods or services, as stipulated in the agreement. For
example, if a crude oil company ships oil to a foreign buyer with an expectation that the buyer will pay
within 30 days from the date of shipment, and the payment is not made by the required date, the crude oil
seller can collect the payment for goods delivered from the buyer’s bank. Since it is a credit, the bank will
collect the principal plus interest from the buyer.
2. Performance SBLC
A performance-based SBLC guarantees the completion of a project within the scheduled timelines. If the
bank’s client is unable to complete the project outlined in the contract, then the bank promises to reimburse
the third party to the contract a specific sum of money.
Performance SBLCs are used in projects that are scheduled for completion within a specific timeline, such as
construction projects. The payment serves as a penalty for delays in the project’s completion, and it is used to
compensate the customer for the inconvenience caused or to pay another contractor to take over the project

How to Apply for a Letter of Credit

Letters of Credit are best prepared by trained professionals, as mistakes in the detailed documents required can lead to
payment delays and fees. Due to industry variations and types of letters of credit, each may be approached
differently.10
Here's an import-export example.
1. The importer's bank credit must satisfy the exporter and their bank. The exporter and importer complete a
sales agreement.
2. Using the sales agreement's terms and conditions, the importer's bank drafts the letter of credit; this letter is
sent to the exporter's bank. The exporter's bank reviews the letter of credit and sends it to the exporter after
approval.
3. The exporter ships the goods as the letter of credit describes. Any required documentation is submitted to the
exporter's bank.
4. The exporter's bank reviews documentation to ensure letter of credit terms and conditions were met. If
approved, the exporter's bank submits documents to the importer's bank.
5. The importer's bank sends payment to the exporter's bank. The importer can now claim the goods sent.
Advantages and Disadvantages of a Letter of Credit
Obtaining letters of credit may be necessary in certain situations. However, like anything else related to banking,
trade, and business, there are some pros and cons to acknowledge.
Advantages and Disadvantages of a Letter of Credit
Advantages
• Can create security and build mutual trust for buyers and sellers in trade transactions.
• Makes it easier to define the specifics of when and how transactions are to be completed between involved
parties.
• Letters of credit can be personalized with terms that are tailored to the circumstances of each transaction.
• Can make the transfer of funds more efficient and streamlined.
Disadvantages
• Buyers typically bear the costs of obtaining a letter of credit.
• Letters of credit may not cover every detail of the transaction, potentially leaving room for error.
• Establishing a letter of credit may be tedious or time-consuming for all parties involved.
• The terms of a letter of credit may not account for unexpected changes in the political or economic landscape.
How Does a Letter of Credit Work?
Often, in international trade, a letter of credit is used to signify that a payment will be made to the seller on time and
in full, as guaranteed by a bank or financial institution. After sending a letter of credit, the bank will charge a fee,
typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. Among the various
types of letters of credit are a revolving letter of credit, a commercial letter of credit, and a confirmed letter of credit.
What Is an Example of a Letter of Credit?
Consider an exporter in an unstable economic climate, where credit may be more difficult to obtain. A bank could
offer a buyer a letter of credit, available within two business days, in which the purchase would be guaranteed by the
bank's branch. Because the bank and the exporter have an existing relationship, the bank is knowledgeable of the
65
buyer's creditworthiness, assets, and financial status.
What Is the Difference Between a Commercial Letter of Credit and a Revolving Letter of Credit?
As one of the most common forms of letters of credit, commercial letters of credit are when the bank makes payment
directly to the beneficiary or seller. Revolving letters of credit, by contrast, can be used for multiple payments within
a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit
of the arrangement usually spanning one year.
When Does Payment Occur With a Letter of Credit?
A letter of credit is like an escrow account in that payment to the beneficiary only happens when the other party
performs a specific act or meets other performance criteria spelled out in the letter of credit agreement.11

How Much a Letter of Credit Costs

Banks usually charge a fee for a letter of credit, which can be a percentage of the total credit they are backing. The
cost of a letter of credit will vary by bank and the size of the letter of credit. For example, the bank may charge 0.75%
of the amount that it's guaranteeing.
Fees can also depend on the type of letter. In an import-export situation, an unconfirmed letter of credit is less costly.
A confirmed letter of credit may have higher fees attached based on the issuing bank's credit strength.

The Bottom Line

Letters of credit can play an important part in trade transactions. There are different types of letters of credit that may
be used, depending on the circumstances. If you need a letter of credit for a business transaction, your current bank
may be the best place to begin your search. However, you may need to expand the net to include larger banks if you
maintain accounts at a smaller financial institution.

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Foreign exchange risk
Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency
fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it describes the possibility that an
investment‘s value may decrease due to changes in the relative value of the involved currencies. Investors may
experience jurisdiction risk in the form of foreign exchange risk.
Understanding Foreign Exchange Risk
Foreign exchange risk arises when a company engages in financial transactions denominated in a currency
other than the currency where that company is based. Any appreciation / depreciation of the base currency or
the depreciation / appreciation of the denominated currency will affect the cash flows emanating from that
transaction. Foreign exchange risk can also affect investors, who trade in international markets, and businesses
engaged in the import / export of products or services to multiple countries.
The proceeds of a closed trade, whether its a profit or loss, will be denominated in the foreign currency and
will need to be converted back to the investor's base currency. Fluctuations in the exchange rate could adversely
affect this conversion resulting in a lower than expected amount.
An import/export business exposes itself to foreign exchange risk by having account
payables and receivables affected by currency exchange rates. This risk originates when a contract between
two parties specifies exact prices for goods or services, as well as delivery dates. If a currency‘s value fluctuates
between when the contract is signed and the delivery date, it could cause a loss for one of the parties.

Types Of Foreign Exchange Risk

Understanding Foreign Exchange Risk

The risk occurs when a company engages in financial transactions or maintains financial statements in a currency
other than where it is headquartered. For example, a company based in Canada that does business in China – i.e.,
receives financial transactions in Chinese yuan – reports its financial statements in Canadian dollars, is exposed to
foreign exchange risk.

The financial transactions, which are received in Chinese yuan, must be converted to Canadian dollars to be
reported on the company’s financial statements. Changes in the exchange rate between the Chinese yuan (foreign
currency) and Canadian dollar (domestic currency) would be the risk, hence the term foreign exchange risk.

Foreign exchange risk can be caused by appreciation/depreciation of the base currency, appreciation/depreciation
of the foreign currency, or a combination of the two. It is a major risk to consider for exporters/importers and
businesses that trade in international markets.

Types of Foreign Exchange Risk

The three types of foreign exchange risk include:

1. Transaction risk

Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk
is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction
and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and
options.

For example, a Canadian company with operations in China is looking to transfer CNY600 in earnings to its
Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate
67
subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would
instead of CAD86 (CNY600/7).

2. Economic risk

Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable
exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such
as geopolitical instability and/or government regulations.

For example, a Canadian furniture company that sells locally will face economic risk from furniture importers,
especially if the Canadian currency unexpectedly strengthens.

3. Translation risk

Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered
domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance
is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets,
liabilities, or equities in a foreign currency.

For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces
translation risk, as the subsidiary’s financial performance – which is in Chinese yuan – is translated into Canadian
dollar for reporting purposes.

Examples of Foreign Exchange Risk

Question 1: Company A, based in Canada, recently entered into an agreement to purchase 10 advanced pieces of
machinery from Company B, which is based in Europe. The price per machinery is €10,000, and the exchange rate
between the euro (€) and the Canadian dollar ($) is 1:1. A week later, when Company A commits to purchasing the
10 pieces of machinery, the exchange rate between the euro and Canadian dollar changes to 1:1.2. Is it an example
of transaction risk, economic risk, or translation risk?

Answer: The above is an example of transaction risk, as the time delay between transaction and settlement caused
Company A to need to pay more, in Canadian dollars, for the pieces of machinery.

Question 2: Company A, based in Canada, reports its financial statements in Canadian dollars but conducts business
in U.S. dollars. In other words, the company makes financial transactions in United States dollars but reports in
Canadian dollars. The exchange rate between the Canadian dollar and the US dollar was 1:1 when the company
reported its Q1 financial results. However, it is now 1:1.2 when the company reported its Q2 financial results. Is it
an example of transaction risk, economic risk, or translation risk?

Answer: The above is an example of translation risk. The company’s financial performance from Q1 to Q2 is
negatively impacted due to the translation from the U.S. dollar to the Canadian dollar.

Types of Capital risk

• Market risk
Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance
of the financial markets in which he or she is involved. Market risk, also called "systematic risk," cannot
be eliminated through diversification, though it can be hedged against in other ways.
• Industry risk
Industry Risk refers to the impact that the state's industrial policy can have on the performance of a
specific industry.
• Regulatory Risk

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 Regulatory risk is the risk that a change in regulations or legislation will affect a security, company, or industry.
Companies must abide by regulations set by governing bodies that oversee their industry. Therefore, any change
in regulations can cause a rippling effect across an industry.
Regulations can increase costs of operations, introduce legal and administrative hurdles, and sometimes even
restrict a company from doing business.
• Business Risk
Business risk can be defined as uncertainties or unexpected events, which are beyond control. In simple words,
we can say business risk means a chance of incurring losses or less profit than expected. These factors cannot
be controlled by the businessmen and these can result in a decline in profit or can also lead to a loss.
Business risk is the possibilities a company will have lower than anticipated profits or experience a loss rather
than taking a profit. Business risk is influenced by numerous factors, including sales volume, per- unit price,
input costs, competition, and the overall economic climate and government regulations.
• Interest rate risk
Interest rate risk is the danger that the value of a bond or other fixed-income investment will suffer as the result
of a change in interest rates. Investors can reduce interest rate risk by buying bonds that mature at different
dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other
instruments.
A long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of return to
compensate for the added risk of interest rate changes over time.
• Liquidity Risk
Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This
usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or
income in the process
• Product Risk
Product risk is the risk that you may not actually be able to deliver the product to market within the resources
(time, money) that you have available to you. And if you do deliver the product, the risk is also in that the
product may not work exactly as well as hoped or promised or envisioned.

Types of product market risks are:

• Credit/Default risk
• Basis risk
• Settlement risk
• Currency risk
• Foreign exchange risk
• Commodity risk
1. Credit/Default risk
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments.
In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows,
and increased collection costs. The loss may be complete or partial.
Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and
credit ratings for corporate and government debt issues. Credit ratings for debt issues are provided by
nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P), Moody's,
and Fitch Ratings.
Default risk can change as a result of broader economic changes or changes in a company's financial situation.
Economic recession can impact the revenues and earnings of many companies, influencing their ability to make
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interest payments on debt and, ultimately, repay the debt itself. Companies may face factors such as increased
competition and lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient
net income and cash flow to mitigate default risk.
2. Basis risk
Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price
changes in entirely opposite directions from each other.
3. Settlement risk
Settlement risk-also often called delivery risk - is the risk that one party will fail to deliver the terms of a
contract with another party at the time of settlement. Settlement risk can also be the risk associated with
default, along with any timing differences in a settlement between the two parties. Default risk can also be
associated with principal risk.
4. Currency risk
Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation will
negatively affect the value of one's assets, investments, and their related interest and dividend payment streams,
especially those securities denominated in foreign currency.
5. Foreign exchange risk
Foreign exchange risk refers to the losses that an international financial transaction may incur due to
currency fluctuations. Foreign exchange risk can also affect investors, who trade in international markets,
and businesses engaged in the import / export of products or services to multiple countries. They are classified
into three types:
• Transaction risks
• Translation risks
• Economic risks
6. Commodity risk
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused
by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc.
Commodity price risk to buyers stems from unexpected increases in commodity prices, which can reduce a
buyer's profit margin and make budgeting difficult. For example, automobile manufacturers face commodity
price risk because they use commodities like steel and rubber to produce cars.
In the first half of 2016, steel prices jumped 36%, while natural rubber prices rebounded by 25% after declining
for more than three years. This led many Wall Street financial analysts to conclude that auto manufacturers and
auto parts makers could see a negative impact on their profit margins.

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 Managing exchange rate risks—economic, translation, and transaction risks—is crucial for businesses
involved in international trade or operations. Here's how to handle each:
1. Transaction Exchange Risk

Definition: Transaction exchange risk (also called transactional or short-term exposure) arises when a
business is involved in actual financial transactions that are denominated in a foreign currency. This could
include exporting goods to a customer abroad, importing materials from a foreign supplier, taking out loans
in a foreign currency, or receiving or making payments in a currency different from the company’s home
currency.

These transactions are sensitive to exchange rate fluctuations. If the value of the foreign currency changes
before the transaction is completed, it could lead to unexpected losses or gains.

Management Strategies:

• Forward Contracts:
A forward contract is a binding agreement to buy or sell a foreign currency at a predetermined rate
on a specified future date. This eliminates the risk of adverse currency movements between the time
the transaction is initiated and when it is settled.
• Currency Options:
Currency options give the holder the right, but not the obligation, to exchange a currency at a
specified rate before or on a specific date. They are more flexible than forward contracts because if
the exchange rate moves favorably, the business can let the option expire and use the better market
rate.
• Natural Hedging:
This involves structuring the business’s operations in a way that inflows and outflows in the same
currency balance each other out. For example, if a company earns revenues in euros, it could also try
to incur expenses (like paying suppliers) in euros, minimizing the need for currency conversion.
• Leading and Lagging:
This is a strategic timing tactic. "Leading" means accelerating payments or receipts if the currency is
expected to weaken. "Lagging" means delaying payments or receipts if the currency is expected to
strengthen. It takes advantage of favorable currency trends.
• Money Market Hedging:
This method uses the money markets to create a synthetic forward contract. For example, a firm
might borrow in the foreign currency and invest in its home currency (or vice versa), thereby
locking in a future exchange rate.

2. Translation Exchange Risk

Definition: Translation risk (also known as accounting exposure) occurs when a company with foreign
subsidiaries has to consolidate those subsidiaries’ financial statements into its home currency for reporting
purposes. The problem arises because the exchange rate at the time of reporting may differ from the
exchange rate at the time the transactions occurred.

This type of exposure does not involve actual cash flows but can significantly affect the reported financial
position and profitability of multinational companies, impacting investor perception and stock prices.
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Management Strategies:

• Balance Sheet Hedging:

The idea is to balance foreign assets with foreign liabilities. For example, if a company has a foreign
subsidiary with assets in euros, it can finance those assets with euro-denominated debt. If the euro
depreciates, both assets and liabilities will decline similarly, offsetting the impact.
• Functional Currency Adjustments:
By designating the local currency of a foreign subsidiary as the "functional currency" (the primary
currency in which the subsidiary operates), firms can limit the frequency and volatility of currency
translation adjustments.
• Currency Swaps:
In a currency swap, two parties agree to exchange principal and interest payments in different
currencies. This can help reduce long-term translation exposure by locking in exchange rates for
future transactions.
• Equity Hedging:
Firms can use financial derivatives like forward contracts, options, or futures to hedge their net
investment in foreign subsidiaries. This protects the value of the foreign equity from unfavorable
exchange rate movements.

3. Economic Exchange Risk

Definition: Economic exchange risk (or operating exposure) refers to the long-term effect of currency
fluctuations on a company’s future cash flows, competitiveness, and overall market value. Unlike
transaction or translation risk, this risk is more strategic and arises from sustained changes in exchange rates
that affect a firm’s international operations and competitive position in global markets.

It influences pricing, cost structures, demand for products, and the relative attractiveness of the firm’s
offerings compared to international competitors.

Management Strategies:

• Diversification:
By spreading operations, production facilities, sourcing, and markets across various countries and
currencies, companies reduce their dependency on any single currency or economy. This provides a
natural hedge against long-term currency fluctuations.
• Strategic Pricing and Cost Management:
Firms can revise pricing strategies or shift sourcing to reduce the impact of exchange rate volatility.
For instance, if the local currency weakens, the firm can increase export prices or shift to lower-cost
suppliers to maintain margins.
• Reorganize Operations:
Businesses might relocate their production plants or realign their supply chains to countries with
more stable or favorable currency environments. This structural shift can mitigate the long-term
impact of currency shifts.
• Long-Term Contracts:
Entering into long-term agreements with suppliers and customers that specify prices in home

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 currency (or with built-in exchange rate adjustments) can help ensure stability and predictability in
revenue and cost forecasts.

Summary Table:
Risk Type Nature Timeframe Key Strategies
Specific foreign Forwards, options, money
Transaction Short-term
currency deals market hedging
Consolidation of Balance sheet hedging,
Translation Periodic/reporting
financials swaps
Overall business Diversification, operational
Economic Long-term
impact changes

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