CU-MCOM-SEM-III-International Financial Management

MASTER OF COMMERCE SEMESTER-III INTERNATIONAL FINANCIAL MANAGEMENT MCM612

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:01133002345 For: CHANDIGARH UNIVERSITY 2 Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

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CONTENT Unit-1: Foundations Of International Financial Management...................................................5 Unit-2: Role Of Multinational Companies In Globalization ...................................................17 Unit-3: International Flow Of Funds .......................................................................................38 Unit-4: International Financial Markets And Institutions........................................................57 Unit-5: Foreign Exchange Exposure And Risk Management I ...............................................82 Unit-6: Foreign Exchange Exposure And Risk Management Ii ..............................................98 Unit-7: Foreign Exchange Exposure And Risk Management Iii ...........................................119 Unit-8: Multinational Financial Management .......................................................................137 Unit-9: Foreign Direct Investment.........................................................................................149 Unit-10: International Capital Structure And Cost Of Capital ..............................................174 Unit-11: International Capital Budgeting ..............................................................................191 Unit-12: Multinational Working Capital Policy ....................................................................204 Unit-13: International Tax Environment ...............................................................................219 Unit-14: Corporate Governance Around The World .............................................................238 4 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-1: FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 International Finance Management 1.2.1 Importance of International Finance Management 1.2.2 Nature and Scope of International Finance Management 1.3 Difference between domestic and international financial management 1.4 Summary 1.5 Keywords 1.6 Learning Activity 1.7 Unit End Questions 1.8 References 1.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain the scope of international finance.  Discuss importance of international finance management.  Describe the international and domestic business. 1.1 INTRODUCTION Finance is an art and science of handling and managing monetary resources of the concern efficiently and effectively. Finance is very important part of any business and hence most of the decisions are taken accordingly. International finance records and monitors not only local finance of the nation but it refers to international level or global level. In short international finance can be said to be focused on financial decisions, Allocation decisions and profit distribution or dividend decisions. All these processes are undertaken by the financial managers of the concern. Financial managers are the person who does research and takes decisions like what sort of capital should be obtained to finance the company’s assets and 5 CU IDOL SELF LEARNING MATERIAL (SLM)

also to raise the profits of the general management principles to financial resources of the enterprise. The meaning and objectives do not change in international finance management, but the dimensions and dynamics change drastically. International finance management has scope in financial decision, Investment decisions and Dividend decisions. As finance management is long term decisions making process it involves lots of planning the nature of finance management is explained briefly here. International finance management has certain distinguished feature when Compared with finance management. Finance is an art and science of handling and managing money and other assets. In today’s scenario financial managing is very well-known and has Its existence globally. It is also referred as international finance. It is nothing but managing the finance of business in international level. Finance management mainly focuses on planning, directing, controlling, monitoring the monetary resources of a business concern. It focuses on planning, Directing, controlling, monitoring the recourses of a business. Financial management is mostly based on ratios, fund flows, cash flows, debts and equity. Financial management is mainly concerned with financing the business, arranging funds which can be allocated for buying fixed assets or running the business known as working capital. Financial management in short can be said to be focused on finance decisions, allocation decisions and profit /dividend decisions. All these processes are done by financial managers of the concern. Financial managers are the person who foes research and takes decisions like what sort of capital should be obtained to finance the company’s assets and also to raise the profits for the stakeholders too. It refers to application of general management principles to financial resources of the enterprise. The meaning and objectives of finance management do not change in international finance management, but the dimensions and dynamics do change drastically. It is a practice and theory of international business management. It is connected with activities such as movement of resources internationally like (Raw materials, goods and services across the world) International trade is a type of international business 1.2 INTERNATIONAL FINANCE MANAGEMENT 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 labour costs are measured, finance is the economic tool. 6 CU IDOL SELF LEARNING MATERIAL (SLM)

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. 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 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 behaviours 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. 1.2.1 Importance of International Financial Management The rapid globalization, economic crises and continuously changing business environment together to make present financial management challenges more critical than ever. And the same forces make successful financial controls very important because international financial management (IFM) operates, with the decisions financial in nature taken, in the era of international business. The development in international business is apparent in the mode of extremely inflated volume of international trade. The history of international trade can be 7 CU IDOL SELF LEARNING MATERIAL (SLM)

traced back to World War II. When after the war years immediately, the common type of contracts on the Trade and Tariffs were established in order to increase trade. This arrangement eliminates the trade restrictions extensively over the years and as a consequence multinational trade grew largely. Moreover, the trader’s financial contribution in respect of exports and imports surged widely across the countries. Since then, this situation persists and increases over the years that compel companies of all types and sizes to think how to utilize resources when dealing in international markets. This expansion gives rise to significant variation in the position of market stability. As a result, today major financial decisions entail cross-border complications. Preferences in respect of raising capital, management of risk, investment decisions, mergers, restructuring, and all other features of financial strategy generally involve international complexities and these complications increase the need of international financial management. When financial managers take these decisions, they must examine currency exchange rates, risk factors of specific country, tax rule’s differences and deviation in legal systems. In short, the finance managers of multinational corporations need appropriate management of international flow of funds for which the international financial management came to be very important and this has been discussed in detail below. International financial management (IMF) significance cannot be exaggerated. It is, however, the core factor to successful business operations. In the absence of finance in local even in international market, no entity can achieve its full strengths for success and growth. We all know that money is a worldwide lubricant that keeps the local and multinational enterprise dynamic in developing product, keeping machines and men in working, motivating management to create values and progress. As I have discussed above that globalization open the market for major corporations to business into international markets, but it also brings corporations to a variety of risks that they can face while operating in international era and in this regard international financial management is the only solution to mitigate these risks and expose corporations to the whole world to operate in. Below are the details of risk that multinational companies face and the role international financial management play to control these risk that increase the importance of international financial management. Currency Exchange Risk and International Financial Management Operating business in international markets may result in a foreign currency exchange risk that is known as exposure of transaction. Currency exchange risk arises when an entity has receivables or payables major portion in foreign currency (FC). The risk persists in the variation of the foreign currency exchange rate. For instance, if the foreign currency increases in value before paying liability, the business has to pay extra amount to purchase the foreign currency required to clear this liability. As a consequence, the business will face a loss of foreign exchange. And when the currency value decreases the business will have foreign currency gain. On the other hand, net assets will have the reverse relationships that are denominated in a foreign currency. 8 CU IDOL SELF LEARNING MATERIAL (SLM)

In managing the risk of currency exchange, IFM approaches have gained prominence in recent years. IFM provides a variety of hedging techniques to control foreign currency transaction risks. Pricing. The basic technique offers by international financial management to manage risk or to control billing currency, is called pricing. Exchange risk currency can be controlled if the businesses invoice their clients in the company’s reporting currency or functional currency. For instance, a business can settle a price of receivable in the currency in which they are reporting and thus transfer the risk of exchange to their customer. Settlement. This technique is used where the business cannot price their customer in reporting currency, it can exercise the settlement technique to eliminate FC exchange risk. This technique needs that management continuously offer early settlement discounts for receivables or payables dealt in a foreign currency. In short, this technique of IFM pushes a business to renounce the advantage of the money time value with the intention to evade the risks of foreign currency exchange variations. Forward Contracts. The business should use the other techniques to control the cash flows if it doesn’t want to make early settlement or cannot price in reporting currency. Almost certainly in this situation the renowned hedging methods is selling and buying forward contracts in foreign currency. These are agreements between parties to sell or buy foreign currency in future time at pre-decided fixed exchange rate. It reduces the company’s exposures to variation in exchange rates, whatever the rate in future is, the transactions occur at fixed rate. This transaction involves the cost of currency exchange and the cost of purchasing a forward contract. Leading and logging. IFM also provides additional technique to mitigate the risks for centralized and large business, called leading and logging. This technique requires leading (prepaying) due amount when the currency of payer is decreasing against the payment currency and lagging (covering) those payments if the currency of payer is increasing. From business perspectives, the international financial manager can ask for leading and lagging technique so as to take benefit of the constructive consequences of exchange rate variation. Moreover, leading and lagging strategies may be exercised to move funds to cash-poor from cash-rich partners, thus enhancing liquidity in short-term. Working Capital Management and International Financial Management International financial management plays very important role in working capital management. Working capital management means taking decisions relating to short-term liquidity, and capital financing. These decisions comprise on managing the rapport between short-term asset and short liabilities of the firm. In this regard international financial 9 CU IDOL SELF LEARNING MATERIAL (SLM)

management plays very important role in maximizing the worth of the firm by spending in such projects which produce a positive net present value (NPV) by discounting with appropriate discount rate. These investments, as a result, have complexities in relation to cost of capital of cash flow. The purpose of IFM is to make sure that the business is capable of operating, and that it has positive flow of cash to support debt in long-term, and to assure both upcoming operational expenses and short-term debt. In this way the firm value is appreciated in case the return on capital investment surpasses the capital cost. Financing Decision International Financial Management also guides companies in taking financing decisions. And accomplishing the business financial objectives IFM need that any corporate investment be financed properly. As discussed above since both un-stable rate and cash flows will be influenced, the mix of the financing can influence the valuation. In this way financial manager must highlight the capital structures and optimal mix of financing that should result in maximum value. The sources to generate finance generally involve the combination of debt and equity financing. If a business decides to finance through debt, it will increase the liability that must be paid, therefore involving cash flow complications independent of the project target of success. The second option is equity financing. Equity financing is, however, less risky in relation to cash flow payment promises, but results in a reduction of control, ownership and earnings. The equity financing cost is also more than the cost incurred in debt financing, and in this way equity financing method may result in an appreciated hurdle rate that may compensate any reduction in risk of cash flow. International financial management helps management to keep balance between both options to avoid the risk of cost burden. IFM Co-ordinates Various Functional Activities International financial management offers comprehensive harmonization between varieties of functional areas such as production, marketing, etc. to accomplish the goals of organizations. If financial management is imperfect in multinational companies, the effectiveness of other business units can be maintained. For instance, it is very essential for the finance department to make available required finance for the raw material procurement and for other expense for the successful running of business. If financial department does not work properly and fails to meet obligations, the sale and production units will suffer and as a result profit and income will undergo. In short, proper financial management occupies a significant place in any business concern. Determinant of Business Success International financial management is necessary for the business success. It has been identified that the financial manger plays a very imperative role in the business success by suggesting the higher-level management the effective solutions of a range of financial problems as professional. They provide considerable figures and facts in relation to financial 10 CU IDOL SELF LEARNING MATERIAL (SLM)

position and company various functions performance in specific period before the higher management in such means that make it easier for the higher management to assess the company’s progress to adjust policies and the principles of the company properly. The international financial managers help the higher management in the process of decision making by recommending the best possible solutions out of the number of alternatives options available. Hence, international financial management assists the management at various stages in taking national and international financial decisions. IFM as Measure of Performance International financial management helps to measure the performance of business through its financial results by applying the techniques of ratio analysis. These analyses provide the position that where the firm is going over the years. Such financial decisions that appreciate risks become because to decrease the worth of the firm and on the other the hand, such international financial decisions that boost the profitability enhance the firm value. Profitability and risk are two necessary part of any business that can be managed effectively through financial management. 1.2.2 Scope of International Finance Management Investment Decisions Investments refers to utilizing and allocating your funds in assets or other projects or production whichever may be, but it should be beneficial and should be kept as an asset. Investment decisions taken by investor is backed by his decision ability. One has to decide where to invest and more important thing how much to invest. These decisions are to be taken by gut feeling and proper thinking as it may decide the faith of the concern. Financial Decisions One of the crucial scopes of the financing manager involves making finance decisions. The finance manager has to decide from where to raise funds. He can either raise funds from company’s own Money like equity, retained earnings or may lend from debentures, bank loan, bond etc. The main objective of the finance decision is to have optimum capital structure. The finance manager has to be more cautious while deciding about finance uprising. As more usage of equity may result in dilution of ownership and increase in debts will lead to more interest payment on borrowed funds Dividend Decisions The finance manager has to decide about the profits of the company, he has to choose between either to share the profits to the shareholders or to retain it for the company for future use. The dividend is a portion of profits which is to be paid to shareholders as per share purchased by them. The finance manager has to decide according to the position of the concern and shareholder’s interest as both of them are of high importance. 11 CU IDOL SELF LEARNING MATERIAL (SLM)

1.3 DIFFERENCE BETWEEN DOMESTIC AND INTERNATIONAL FINANCIAL MANAGEMENT Four major facets which differentiate international financial management from domestic financial management are an introduction of foreign currency, political risk and market imperfections and enhanced opportunity set. Foreign Exchange It’s an additional risk which a finance manager is required to cater to under an International Financial Management setting. Foreign exchange risk refers to the risk of fluctuating prices of currency which has the potential to convert a profitable deal into a loss-making one. Political Risks The political risk may include any change in the economic environment of the country viz. Taxation Rules, Contract Act etc. It is pertaining to the government of a country which can anytime change the rules of the game in an unexpected manner. Market Imperfection Having done a lot of integration in the world economy, it has got a lot of differences across the countries in terms of transportation cost, different tax rates, etc. Imperfect markets force a finance manager to strive for best opportunities across the countries. Enhanced Opportunity Set By doing business in other than native countries, a business expands its chances of reaping fruits of different taste. Not only does it enhance the opportunity for the business but also diversifies the overall risk of a business. Just like domestic financial management, the goal of International Finance is also to maximize the shareholder’s wealth. The goal is not only is limited to the ‘Shareholders’ but extends to all ‘Stakeholders’ viz. employees, suppliers, customers etc. No goal can be achieved without achieving welfare of shareholders. In other words, maximizing shareholder’s wealth would mean maximizing the price of the share. Here again comes a question, whether in which currency should the value of the share be maximized? This is an important decision to be taken by the management of the organization. International level initiatives like General Agreement on Trade and Tariffs (GATT), The North American Free Trade Agreement (NAFTA), World Trade Organization (WHO) etc. has to give promoted international trade and given it a shape. All because of liberalization and those international agreements, we have a buzz word called “MNC” i.e., Multinational 12 CU IDOL SELF LEARNING MATERIAL (SLM)

Corporations. MNCs enjoy an edge over other normal companies because of its international setting and best opportunities. International Finance has become an important wing for all big MNCs. Without the expertise in International Financial Management, it can be difficult to sustain in the market because international financial markets have totally different shape and analytics compared to the domestic financial markets. A sound management of international finances can help an organization achieve same efficiency and effectiveness in all markets. 1.4 SUMMARY  A Business grow, so does their awareness of opportunities is foreign market, initially, they may merely attempt to export a product to a particular country or import supplier from a foreign manufacturer.  An understanding of International Financial Management is crucial to not only the large MNCs with numerous foreign subsidiaries, but also to the small business engaged in Exporting or Importing. Seventy Eight percent of the 43,300 U.S. firms that Export have been then 100 employees.  International business is even important to companies that have no intention of engaging 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 technologies is likely to redefine global competition and ways of doing international business  The challenges that management is facing today is the effective and efficient working such that is internationally oriented.  The major difficulties that a business faces in international markets are, fluctuation in currency exchange rate, investing decisions, financing decision, coordination of different business unit in different geographic places, etc.  These problems can be managed through proper adaptation of international financial management methodologies. The effectiveness of these methodologies based on management’s understanding to the foreign markets and the requirements of its subsidiaries.  In short, managing business accounts and finance is crucial to the success of every multinational business because the increase in complication and importance of 13 CU IDOL SELF LEARNING MATERIAL (SLM)

financial management in international business environment poses challenges for management in international corporations. 1.5 KEYWORDS General Agreement on Trade and Tariffs (GATT): Signed on October 30, 1947, by 23 countries, was a legal agreement minimizing barriers to international trade by eliminating or reducing quotas, tariffs, and subsidies while preserving significant regulations. Multinational Corporations (MNC): It is usually a large corporation incorporated in one country which produces or sells goods or services in various countries. Two common characteristics shared by MNCs are their large size and the fact that their worldwide activities are centrally controlled by the parent companies. Dividend: It is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business. Assets: An asset is something containing economic value and/or future benefit. An asset can often generate cash flows in the future, such as a piece of machinery, a financial security, or a patent. Personal assets may include a house, car, investments, artwork, or home goods. Shareholder: Also known as stockholder, it is an individual or institution (including a corporation) that legally owns one or more shares of the share capital of a public or private corporation. Shareholders may be referred to as members of a corporation. 1.6 LEARNING ACTIVITY Mesa Co. specializes in the production of small fancy picture frames, which are exported from the United States to the United Kingdom. Mesa invoices the exports in pounds and converts the pounds to dollars when they are received. The British demand for these frames is positively related to economic conditions in the United Kingdom. Assume that British inflation and interest rates are similar to the rates in the United States. Mesa believes that the U.S. balance-of-trade deficit from trade between the United States and the United Kingdom will adjust to changing prices between the two countries, while capital flows will adjust to interest rate differentials. Mesa believes that the value of the pound is very sensitive to changing international capital flows and is moderately sensitive to changing international trade flows. Mesa is considering the following information: The U.K. inflation rate is expected to decline, while the U.S. inflation rate is expected to rise. British interest rates are expected to decline, while U.S. interest rates are expected to increase. 14 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain. ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Based on your answer to above question, how would Mesa’s cash flows be affected by the expected exchange rate movements? Explain. ……………………………………………………………………………………………… ……………………………………………………………………………………………… 1.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What factors cause some firms to become more Internationalised than others? 2. Describe the constraints that interfere with the MNC’s objective. 3. Briefly describe the motivations for International Business. 4. “The conflict between the MNCs and their environment is real and frequently very intense.” Discuss. 5. Discuss the distinguishing features of international finance. Long Questions 1. “Because of its broad global environment, a number of disciplines are useful to help explain the conduct of International Business.” Elucidate with examples. 2. Explain the possible reasons for growth in international business. 3. “Globalization has made a tremendous impact throughout the world in past few years. There are various reasons involved in this progression.’ Elaborate and discuss the reasons. 4. Do you think MNCs have greater flexibility than domestic firms in the location and timing of their investments? Elucidate. 5. ‘The job of a manager of a MNC is both challenging and risky.’ Comment. B. Multiple Choice Questions 1. Financial management is mainly concerned with a. Investment b. Capital structure c. Dividend policy 15 CU IDOL SELF LEARNING MATERIAL (SLM)

d. All of these 2. International finance-the finance function of a multinational firm has two functions a. Treasury b. Control c. Both a) and b) d. None of these 3. Currency exchange risk arises when an entity has receivables or payables major portion in a. Foreign currency b. Local Currency c. Digital Currency d. None of these 4. Foreign exchange risk refers to the risk of fluctuating prices of a. Currency b. Product c. Market d. Trade 5. The _________ may include any change in the economic environment of the country a. Political risk b. Foreign exchange c. Market risk d. None of these Answers 1-(d), 2-(c), 3-(a), 4-(a), 5-(a) 1.8 REFERENCES Textbooks:  Apte, P.G., International Financial Management, Tata McGraw Hill Publishing Company Limited, New Delhi.  Bhalla, V.K., International Financial Management, Anmol Publishers.  Eun/Resnick, International Financial Management, Tata McGraw Hill Publishing Company Limited, New Delhi.  Shapiro Allan C, Multinational Financial Management, Prentice Hall, New Delhi. 16 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-2: ROLE OF MULTINATIONAL COMPANIES IN GLOBALIZATION STRUCTURE 2.0 Learning Objectives 2.1 Introduction 2.2 Globalization Trend 2.2.1 Impact of Globalization and Influence On MNC 2.3 Rewards and Risk of International Finance 2.4 Goals of International Financial Management 2.5 Exposure to International Risk 2.5.1 Economic Exposures 2.6 International Monetary System 2.7 Summary 2.8 Keywords 2.9 Learning Activity 2.10 Unit End Questions 2.11 References 2.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain globalization trends.  Explain rewards and risk of international finance.  Explain international monetary fund. 2.1 INTRODUCTION According to Patrick H. O’Neil (2009), globalization can be defined as “a process whereby extensive and intensive webs of relationships connect people across time and space.” The term “globalization” started to feature regularly in scholarly works on the international 17 CU IDOL SELF LEARNING MATERIAL (SLM)

political economy (IPE) in the 90s. The phenomenon of globalization can also be defined in terms of the expansion of international interconnectedness, or interdependence, however its uniqueness from interdependence would derive majorly from the prominent role played by multinational corporations (MNCs) in the modern global economy (Hart, 2015). Dunning (1992) defines multinational corporations (MNCs) - which are also known as multinational enterprises (MNEs), transnational corporations (TNCs) or transnational enterprises (TNEs) - as enterprises that engage in foreign direct investment (FDI) and own or control value-added activities in a number of countries across the world. Multinational corporations can also be described as firms that produce, distribute, and market in more than one country. MNCs such as Microsoft are known to wield assets and profits far larger that the gross domestic products (GDPs) of most countries in the world and are hence able to influence politics, economic developments, and social relations through the goods and services that they produce and the wealth at their disposal (O’Neil, 2009). With the process of economic integration having accelerated considerably in the last three or so decades, the presence of subsidiaries of influential MNCs such as Microsoft in several countries across the globe is seen to be a key driver of globalization. Over the same period, trade, foreign direct investment (FDI) as well as the international transfer of knowledge and technology (the three main channels of economic globalization) have dynamically developed (Kleinert, 2001). There seems to be an obvious association between economic globalization and the emergence as well as expansion of a number of MNCs that have dominated global markets for some time now. Aided by more open markets and low costs of transportation, large firms such as Honda, IBM, Johnsons & Johnson, and McDonald’s control assets globally and make profits in billions of dollars, often rivalling the GDPs of several countries in which they operate 2.2 GLOBALIZATION TREND As the borderless economy advances throughout major economic regions, most globally minded companies are expanding their businesses across national borders in order to maintain competitiveness. The number of MNCs operating in major markets, without regard to the level of technological development, is rapidly increasing. It is desirable from the basic industrial operation point of view that end user products should be manufactured as close as possible to the local market since it permits providing products to meet local users' needs, minimizes energy use for transportation, and hence reduces air pollution, and provides jobs to local people. The role of MNCs in the global community has to increase dramatically. Since the end of the Cold War, the world economy has been strongly distorted by political intervention. Even though politically oriented trade frictions are being heightened at the government level between Japan and the United States, industrial leaders of the two countries 18 CU IDOL SELF LEARNING MATERIAL (SLM)

are aggressively forming strategic alliances and promoting friendly collaboration. This tide of corporate level competitive interdependence and global alliance activity is gradually becoming a significant element in the world economy. Indeed, it is paradoxical but relying on corporate alliances and interdependence is perhaps a better strategy for increasing industrial strength than economic nationalism. The science community has long enjoyed a favourable climate for international communications and collaboration. Unfortunately, the engineering community has experienced numerous constraints due to national economic and security reasons. These constraints may not be removed in the foreseeable future. However, without better management of international engineering and science relationships for improving R&D productivity, we cannot cope with the crucial problems that have put world peace and the survival of the human race at risk. Modern MNCs are desperately seeking many ways to ensure their own survival. They no longer can survive considering only their own and their national interests, but they need to be good citizens in their host countries as well. They have to receive full support from the engineering community and customers in order to be successful. Hence, they are establishing better engineering and science relationships in local communities. Strategic alliances in business and technological development are a step forward. R&D cooperation between Japan and the United States and further with all nations throughout the world should aim to solve global environmental problems such as acid rain, global warming, and preserving the rain forests, as well as developing a cure for AIDS, an epidemic that continues to grow rapidly on a global scale. In industrially advanced countries, the people demand highly sophisticated information products since their societies are rapidly becoming highly-information oriented societies. The application software of such products is very much dependent on local culture and is very difficult for engineers from different cultures to develop. Such software has to be developed by local engineers with knowledge of the market. This trend is not limited to information technology products but is also tree for any other product dependent on the market. Therefore, research and development have to be globalized. The paradigm of modern technological innovation is rapidly changing. It is no longer as simple as the industrial sector enjoyed decades ago. It is increasingly market driven rather than technology driven. It is more interdisciplinary, interdepartmental, interindustry, and international in nature. The innovation model is no longer explainable by a simple linear model, rather, a complex network model enjoys popularity among Japanese industrialists. In order to cope with the paradigm shift, many companies are forming strategic alliances across national borders in order to survive. The alliance network is so complex and tight that even nationalistic political pressure no longer can break such alliances. We think this trend is very 19 CU IDOL SELF LEARNING MATERIAL (SLM)

desirable for increasing international collaboration and for improving world peace. International industrial collaboration is a strong weapon for comprehensive national security. 2.2.1 Impact of Globalization and Influence on MNC Modernization perspective has been recognized as resulting from industrial and urbanized social changes. Charon revealed that these changes that are taking place represent the development of traditional societies which are becoming modern and modern societies becoming more global (pg. 290). These developments in industrialization, information technology, trade, political structures, cultures, and institution have become sources of benefit to the world’s modernized organizations and consumers. This also seems to account for individuals’ loss of personal connection between work, life and community. There is also a drift from the rural areas where there is abundance of resources to the urban areas in search of opportunities in white- and blue-collar jobs. The latter had received the most attention by industrial and market developments. This is a pattern that is becoming more prevalent and making alienation more common. There are also other hazards linked to the industrial production due to technological improvements. INFED; (the informal education homepage and encyclopaedia of informal education) a not- for profit site established in 1995 at the YMCA George Williams College, London insinuated that these risks are now global. “Modernization risks possess an inherent tendency towards globalization. A universalization of hazards accompanies industrial production, independent of the place where they are produced: food chains connect practically everyone on earth to everyone else. They dip under borders” (Infed, 2011, pg 6). Charon suggested that since the beginning of the Industrial Revolution, people have competed within societies and that with globalization of the postmodern era came a worldwide labour source that has allowed large corporations to shop the world to find the cheapest labour supply (pg. 301). This trend is as vast as the earth’s enormity and the comparative advantages resulting from this is becoming responsible for class stratification. The increased global connectedness resulting from this system has led to the questioning of modern science. Post Modernization perspective of the later centuries challenged the modern era. Operations have developed even more efficiently and become more rationalized. Charon posited that for many, it is not simply an evolution that goes back hundreds of years, but truly a new world that has changed economically, politically, socially, and culturally (pg. 289). Modern science had introduced dehumanization making challenges more unreasonable and common in occurrence. Postmodernism not only approves of the disorganized or chaotic side of society but embraces it. The result has also accounted for the human right theme in our current culture. There is also a sense of omission of individual differences and personal self-expression that are left out of the equation of the modern, rationalized system. Postmodernism recognizes the fact that this brings into focus the issues that opponents of this perspective emphasize on, and 20 CU IDOL SELF LEARNING MATERIAL (SLM)

the fact that there is a fine line between benefits of rationalized business operations and the detriments of globalization. The foregoing also accounts for the dehumanizing experiences of employees and consumers, including how this system affects the poor and other peripheral parts of our global system. There are many literatures on the various immediate benefits of the globalization system to all stakeholders, for one, because of their efficient rational lean production system the MNCs enjoy low-cost capabilities, and this low-cost benefits are passed on to consumers by way of low cost and multiple variety of products and services. Manufacturers are able to import back to the US products from low wage countries of the Global South and East. Under these circumstances Charon suggested that, globalization is thought to be good for consumers because products cost less (pg. 291). Benefits are also passed down to stakeholders, the organization itself, and states of the world at the core, such as the US and some European states, including others that have embraced the growth of an international environment, and MNCs that exceed the bounds of national politics. The search for low wage labour has left the Global North wondering its position with regards to the rate at which jobs are outsourced to the South. The foregoing underpins the structures or characteristics of MNCs’ operations, as well as some of the global risks they convey. Ritzer noted that, most important, rational systems are unreasonable systems that deny humanity; the human reasons of the people who work within them or are served by them. There is so much disparity between the relative performance of the working class in different societies, organizations, and nation-states. Global interdependence is resulting in affluence, peace, democracy and social changes in the world, especially for the Global North states located at the core of the system and for the emerging economics such as Brazil, India, and other Global South states that currently benefit from this trend. The social gaps of both absolute and relative poverty are obvious. This global structure is also indicative of class stratification of both individuals and nations, “a discussion of value, a conflict between holding onto capitalistic values and institutions versus values that seek control over capitalism values, that is, other than profit” (Charon, 2010). US participation in this international system depicts continuous dominance as a core state. Capital and corporate headquarters are located in the US while manufacturing takes place in low wage countries. This result also draws on division of labour internationally, hence increasing international social class. The unequal advantages experienced by nations at the periphery have not afforded them the opportunities as those that exist in nations such as the US at the core. They have no competitive or comparative advantages, thereby absolutely or relatively “making them socially unequal, with characteristics such as less economic power, large population, underdeveloped, unstable economy, dependent of few commodities, or a single mineral resource” (Charon, 2010). This also mirrors the postmodernist conflict of holding values and 21 CU IDOL SELF LEARNING MATERIAL (SLM)

institutions versus the values that seek some control through capitalism. This situation results in the disparities that continue to exacerbate debates between proponents and opponents of globalization. The foregoing is responsible for the shift in demographic and labour pattern in the US and abroad. The Global North have been attracting migrants from the south (sometimes with the support of institutional initiatives such as North American Free Trade Agreement (NAFTA), World Trade Organization/General Agreement on Trade and Tariffs (WTO/GATT)), to fill jobs created by the MNCs rational systems, while irrationally taking from the old era high paid high skilled jobs. These Institutional initiatives are also principal players, creating amicable business climates, while debates rage on some fronts in the US on the possibility of protectionist policies to circumvent the loss of jobs to the global south. The core state governments really have little or no control over the business environment and are hardly able to regulate, leaving MNCs to operate by their own rules. Charon suggested that modernity would eventually bring people together, depicting a global social culture. Although globalization promises interdependence and interconnections, cultural differences still exist. There is a tug between the emphases on the growing global culture and resisting national culture, another conflict that has prompted debates. Oppositions and receiving populations of the cultural incursion by core states continue to fuel market demands for growing homogenous products, while showing resistance on other fronts. Even in the mist of these interactions and discontent people are still committed to a world society. Charon suggested that, “efforts have turned to the future and the necessity for changing their ways. Global warming, environmental destruction, disrespect for human right are real issues because people feel a commitment to our world community” (Charon, 2010). This foregoing exacerbates the conflict that exists between the traditional, modern, postmodern perspectives and their effects on global economy, human right, and democracy. Postmodernity also seems to bring to light the emergence of emphasis on human right and democracy. Charon insinuated that human right transcends and penetrates US culture, limiting the government power, military, business and religion, and encouraging diversity and respect for minorities. This trend continues to supersede the growing modern global economy and traditional religious theme that came before it. This sort of highlights the discontent of Postmodernity for modern science and its accomplishments. The global system exposes the connection and advantages on one hand, and a clear line of disadvantages on the other. This also stresses the relative gains to individuals and states. Charon suggested that the globalized system connects those working at the grassroots level to protect, restore, nurture the environment, and to enhance access for the disadvantaged the basic resources they need to live a dignifying existence. The outcome of this is that each state benefiting from this system specializes in a certain area based on their comparative advantages. The connectedness also means shared risks, increased conflicts, and problems, international civil wars, the speed of the spread of diseases, etc. For example, a disease which 22 CU IDOL SELF LEARNING MATERIAL (SLM)

originated in the Far East Asia in 2003, the severe acute respiratory syndrome (SARS), spread vehemently and ended up in numerous states in such a short time. The fear of contamination by this disease was felt all over the world. The global environment has become so fluid that there are only virtual borders, no firm boundary line between States anymore. This conflict accentuates the benefits and risks that now exist. 2.3 REWARDS AND RISK OF INTERNATIONAL FINANCE Businesses involved in international trade have to deal not just with risks locally but also other business development risks such as ethics, transportation, intellectual property, credit, currency, and a lot more. These risks can obstruct the smooth running of the business, and hence, appropriate measures need to be taken to limit their effects. Here are 6 risks commonly faced by businesses involved in international trade and the effective ways to manage them. Credit Risk Counterparty or credit risk is the risk associated with not collecting an account receivable. There are numerous ways in which businesses can guard themselves against this risk while expanding to global markets. Take payment in full [or a decent percentage of money upfront] Taking 100 percent of the amount owed, or a fair percentage, before rendering the services at the time of the placement of an order can be used to cut down administrative expenses and finance charges. This eliminates the risk of non-payment. Although this may be difficult for new businesses and exporters, it can be worked out with little negotiations. Letter of credit This refers to a commitment issued by a financial institution wherein the institution agrees to pay a set amount to the service/product provider in exchange for delivery within a set timeframe. This offers protection to both the seller and the buyer. It includes a detailed description of the shipment as well as the terms of sale. Intellectual Property Risk This risk involves third parties making unauthorized use of the strategic information of a business or property that affects the value of services or products offered by a business, either directly or indirectly. These risks increase tenfold when doing business overseas because of the difficulties that exist in defeating business rights remotely. This can be avoided by registering the corporate names as well as the trademarks before signing an agreement in any country. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

It will also be beneficial to constantly modify and improve your services or products to remain ahead of the competition. Foreign Exchange Risk This usually concerns the accounts payable and receivable for contracts that are, or soon would be, in force. Foreign exchange rates are in flux constantly. Hence, businesses would be forced to make conversions of the funds generated overseas at rates lower than what is budgeted. This is the reason why it is crucial for businesses to have an appropriate exchange policy in place. This will help in –  Stabilizing profit margins over sales made  Mitigating the negative impact of fluctuating rates on sales and procurements  Enhancing cash flow control  Simplifying domestic and foreign pricing Businesses need to identify foreign exchange risks to frame an effective policy. It is also essential to recognize the tools available for hedging these risks and carry out a comparative analysis on a regular basis for selecting the best tool available. Ethics Risks It is vital to maintain a high ethical standard when offering any product or service in a global market. Companies may face certain questions pertaining to their values at any point while doing international trade. Social conditions and customs vary from country to country, and hence, it is necessary to be especially vigilant. You need to make sure that your foreign suppliers and partners adhere to your values and rules regardless of where they operate from. Shipping Risks Whether you are shipping goods abroad or locally, you may face issues such as contamination, seizure, accident, vandalism, theft, loss, and breakage. Before shipping any goods to the buyers, you need to make sure to have sufficient insurance. The International Chamber of Commerce has laid down rules for each party involved in international trade and their responsibilities with regard to shipping risk. It is best to go through the rules and take necessary precautionary steps. Country and Political Risks 24 CU IDOL SELF LEARNING MATERIAL (SLM)

These are risks such as non-tariff trade barriers, central bank exchange regulations, or ban on the sale of certain products in specific countries. For instance, several countries have banned products obtained from threatened animal species. There would be certain things that would never be under your control, such as sanctions, and you must be prepared in order to overcome them. You can find more information on such restrictions by checking the official website of the Ministry of Foreign Affairs and Trade for the specific country. Exchange Control Regulations Several developing nations operate certain exchange control regulations that are associated with the flow of money from and to their country. You need to identify if these regulations are effective in the country which you intend to trade with. This is because these can delay your payments. Prohibited Goods You need to make sure to carry out basic research on the import/export allowances offered by the country you are interested to carry out your business in. There are many products that are prohibited or restricted in some countries. For instance, what is acceptable in China may not be allowed in New Zealand. You need to make sure to check out all the rules pertaining to your target market in the country you are interested to carry out trade with. Whenever you are exporting certain products, it is essential to get them verified so that they meet the requirements of the country you would be exporting to. It is mandatory to obtain an export certificate before you actually commence trading globally. Customs will then verify the details associated with your export certificate. It is better to be familiar with all the rules that you are governed with while trading globally, rather than face hurdles at a later stage. This will help you operate your business without any hassles once you have set your roots. Some of the benefits of international finance are:  Access to capital markets across the world enables a country to borrow during tough times and lend during good times.  It promotes domestic investment and growth through capital import.  Worldwide cash flows can exert a corrective force against bad government policies.  It prevents excessive domestic regulation through global financial institutions.  International finance leads to healthy competition and, hence, a more effective banking system. 25 CU IDOL SELF LEARNING MATERIAL (SLM)

 It provides information on the vital areas of investments and leads to effective capital allocation.  International finance promotes the integration of economies, facilitating the easy flow of capital. The free transfer of funds would eventually result in more equality among countries that are a part of the global financial system. 2.4 GOALS OF INTERNATIONAL FINANCIAL MANAGEMENT International Financial Management is a well-known term in today’s world, and it is also known as international finance. It means financial management in an international business environment. It is different because of different currency of different countries, dissimilar political situations, imperfect markets, diversified opportunity sets. International Financial Management came into being when the countries of the world started opening their doors for each other. This phenomenon is well known with the name of “liberalization”. Due to the open environment and freedom to conduct business in any corner of the world, entrepreneurs started looking for opportunities even outside their country-boundaries. The spark of liberalization was further aired by swift progression in telecommunications and transportation technologies that too with increased accessibility and daily dropping prices. Apart from everything else, we cannot forget the contribution of financial innovations such as currency derivatives; cross border stock listings, multi-currency bonds and international mutual funds. The goals are not only limited to just the shareholders, but also to the suppliers, customers and employees. It is also understood that any goal cannot be achieved without achieving the welfare of the shareholders. Increasing the price of the share would mean maximizing shareholders wealth. Though in many countries such as Canada, the United Kingdom, Australia and the United States, it has been accepted that the primary goal of financial management is to maximize the wealth of the shareholders; in other countries it is not as widely embraced. In countries such as Germany and France, the shareholders are generally viewed as a part of the ‘stakeholders’ along with the customers, banks, suppliers and so on. In European countries, the managers consider the most important goal to be the overall welfare of the stakeholders of the firm. On the other hand, in Japan, many companies come together to form a small number of business groups known as Keiretsu, including companies such as Mitsui, Sumitomo and Mitsubishi which were formed due to consolidation of family-owned business empires. The growth and the prosperity of their Keiretsu is the most critical goal for the Japanese managers. However, it doesn’t mean that the maximization of shareholder’s wealth is just an alternative, but it is a goal that a company seeks to fulfil along with other goals. The maximization of shareholder’s wealth is a long-term goal. If a firm does not treat the employees properly or produces merchandises of poor quality, it cannot be expected that such firms will be able to 26 CU IDOL SELF LEARNING MATERIAL (SLM)

maximize the shareholder’s wealth. Only those firms can stay in business for a long term and provide opportunities for employment that efficiently produces what is demanded from them. 2.5 EXPOSURE TO INTERNATIONAL RISK The foreign exchange exposure of a firm can be defined as a measure of the sensitivity of its cash flows to changes in exchange rates. Due to the difficulty of measuring cash flows, exposure is examined by most of the researchers through the study of how a firm’s market value responds to the changes in the exchange rates. There are different types of exposure to which a particular company-domestic or international—is exposed to. The types of exposure are related to two parameters: One is related to the time of the transactions, the transactions and the flows of money (payment and receivables) related to them and the other one to the aspect of conducting international business in host countries. The second one is based on the analysis of how to reconcile the balance sheet of the subsidiary company with that of the parent company’s balance sheet. The types of exposure are broadly divided into economic and translation exposure. Economic exposure is further divided into transaction exposure and operating exposure. 2.5.1 Economic Exposures The potential changes in all future cash flows of a firm resulting from unanticipated changes in the exchange rates are referred to as economic exposure. The monetary assets and liabilities, in addition to the future cash flows, get influenced by the changes in foreign exchange rates. Of all the three exposures, economic exposure is the most important, as it has an impact on the valuation of a firm. Suppose a Japanese company imports children toys from India. The same product is also available from China, but it is costly. If the rupee appreciates against the yen and the Chinese currency decreases against yen, Japan will prefer to import the toys from China as it will get at a cheaper rate. Since economic exposure comes from unanticipated changes, its measurement is not as precise as those of transaction and translation exposures. There are two components of economic exposure transaction. Transaction Exposure Transaction exposure is concerned with the impact of change in exchange rate on present cash flows. Transaction exposure emerges mainly on account of export and import of commodities on open account, borrowing and lending in a foreign currency and intra-firm flows within an international company. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

Transaction exposure measures profits or losses that occur once the existing financial obligations as per the terms of reference are settled. Given that the transaction will result in a future foreign currency cash inflow or outflow, any unanticipated changes in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change value of the net cash flow in terms of the home currency. Examples of a transaction exposure of an Indian company would be the account receivable associated with a sale denominated in US dollars or the obligation of an account payable in Euro debt. Operating Exposure Operating exposure has an impact on the firm’s future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes. If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any operating risk exposure as its operating future cash flows are likely to remain unaffected. In addition to supply and demand elasticity, the firm’s ability to shift production and sourcing of inputs is another major factor affecting operating risk exposure. Sensitivity of future operating cash flows to unexpected changes in the foreign exchange rate is known as the operating exposure. In other words, it arises when the changes in the exchange rate in addition to the rates of inflation changes the risk element and the amount of the company’s future revenue and cost stream. The word “operating” means the change in the operating cash flow which leads to change in the value of the firm. It is not very easy to measure real operating exposure as far as the measurement of the inflation rate differential is not easy, more so when countries are going through a phase when they experience a highly volatile rate of exposure. Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over coming months and years and on its competitive position vis-à-vis other firms. The goal is to identify strategic moves or operating techniques that the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes. Some firms face operating exposure without even dealing in foreign exchange. Consider an Indian perfume manufacturer who sources and sells only in the domestic market. Since the firm’s product competes against imported perfumes (say from Paris) it is subject to foreign exchange exposure. It faces severe competition when rupee gains against other currencies (here, euro), lowering the prices of imported perfumes. 2.6 INTERNATIONAL MONETARY SYSTEM International monetary system refers to the system and rules that govern the use and exchange of money around the world and between countries. Each country has its own 28 CU IDOL SELF LEARNING MATERIAL (SLM)

currency as money and the international monetary system governs the rules for valuing and exchanging these currencies. Until the nineteenth century, the major global economies were regionally focused in Europe, the Americas, China, and India. These were loosely linked, and there was no formal monetary system governing their interactions. The rest of this section reviews the distinct chronological periods over the past 150 years leading to the development of the modern global financial system. Keep in mind that the system continues to evolve, and each crisis impacts it. There is not likely to be a final international monetary system, simply one that reflects the current economic and political realities. This is one main reason why understanding the historical context is so critical. As the debate about the pros and cons of the current monetary system continues, some economists are tempted to advocate a return to systems from the past. Businesses need to be mindful of these arguments and the resulting changes, as they will be impacted by new rules, regulations, and structures. Pre–World War I As mentioned earlier in this section, ancient societies started using gold as a means of economic exchange. Gradually more countries adopted gold, usually in the form of coins or bullion, and this international monetary system became known as the gold standard. This system emerged gradually, without the structural process in more recent systems. The gold standard, in essence, created a fixed exchange rate system. An exchange rate is the price of one currency in terms of a second currency. In the gold standard system, each country sets the price of its currency to gold, specifically to one ounce of gold. A fixed exchange rate stabilizes the value of one currency vis-à-vis another and makes trade and investment easier. Our modern monetary system has its roots in the early 1800s. The defeat of Napoleon in 1815, when France was beaten at the Battle of Waterloo, made Britain the strongest nation in the world, a position it held for about one hundred years. In Africa, British rule extended at one time from the Cape of Good Hope to Cairo. British dominance and influence also stretched to the Indian subcontinent, the Malaysian peninsula, Australia, New Zealand— which attracted British settlers—and Canada. Under the banner of the British government, British companies advanced globally and were the largest companies in many of the colonies, controlling trade and commerce. Throughout history, strong countries, as measured mainly in terms of military might, were able to advance the interests of companies from their countries—a fact that has continued to modern times, as seen in the global prowess of American companies. Global firms in turn have always paid close attention to the political, military, and economic policies of their and other governments. In 1821, the United Kingdom, the predominant global economy through the reaches of its colonial empire, adopted the gold standard and committed to fixing the value of the British pound. The major trading countries, including Russia, Austria-Hungary, Germany, France, 29 CU IDOL SELF LEARNING MATERIAL (SLM)

and the United States, also followed and fixed the price of their currencies to an ounce of gold. The United Kingdom officially set the price of its currency by agreeing to buy or sell an ounce of gold for the price of 4.247 pounds sterling. At that time, the United States agreed to buy or sell an ounce of gold for $20.67. This enabled the two currencies to be freely exchanged in terms of an ounce of gold. In essence, £4.247 = 1 ounce of gold = $20.67. The exchange rate between the US dollar and the British pound was then calculated by $20.67/£4.247 = $4.867 to £1. The Advantages of the Gold Standard The gold standard dramatically reduced the risk in exchange rates because it established fixed exchange rates between currencies. Any fluctuations were relatively small. This made it easier for global companies to manage costs and pricing. International trade grew throughout the world, although economists are not always in agreement as to whether the gold standard was an essential part of that trend. The second advantage is that countries were forced to observe strict monetary policies. They could not just print money to combat economic downturns. One of the key features of the gold standard was that a currency had to actually have in reserve enough gold to convert all of its currency being held by anyone into gold. Therefore, the volume of paper currency could not exceed the gold reserves. The third major advantage was that gold standard would help a country correct its trade imbalance. For example, if a country was importing more than it is exporting, (called a trade deficit), then under the gold standard the country had to pay for the imports with gold. The government of the country would have to reduce the amount of paper currency, because there could not be more currency in circulation than its gold reserves. With less money floating around, people would have less money to spend (thus causing a decrease in demand) and prices would also eventually decrease. As a result, with cheaper goods and services to offer, companies from the country could export more, changing the international trade balance gradually back to being in balance. For these three primary reasons, and as a result of the 2008 global financial crises, some modern economists are calling for the return of the gold standard or a similar system. Collapse of the Gold Standard The gold standard eventually collapsed from the impact of World War I. During the war, nations on both sides had to finance their huge military expenses and did so by printing more 30 CU IDOL SELF LEARNING MATERIAL (SLM)

paper currency. As the currency in circulation exceeded each country’s gold reserves, many countries were forced to abandon the gold standard. In the 1920s, most countries, including the United Kingdom, the United States, Russia, and France, returned to the gold standard at the same price level, despite the political instability, high unemployment, and inflation that were spread throughout Europe. However, the revival of the gold standard was short-lived due to the Great Depression, which began in the late 1920s. The Great Depression was a worldwide phenomenon. By 1928, Germany, Brazil, and the economies of Southeast Asia were depressed. By early 1929, the economies of Poland, Argentina, and Canada were contracting, and the United States economy followed in the middle of 1929. Some economists have suggested that the larger factor tying these countries together was the international gold standard, which they believe prolonged the Great Depression Post–World War II The demise of the gold standard and the rise of the Bretton Woods system pegged to the US dollar was also a changing reflection of global history and politics. The British Empire’s influence was dwindling. In the early 1800s, with the strength of both their currency and trading might, the United Kingdom had expanded its empire. At the end of World War I, the British Empire spanned more than a quarter of the world; the general sentiment was that “the sun would never set on the British empire.” British maps and globes of the time showed the empire’s expanse proudly painted in red. However, shortly after World War II, many of the colonies fought for and achieved independence. By then, the United States had clearly replaced the United Kingdom as the dominant global economic centre and as the political and military superpower as well. In the early 1940s, the United States and the United Kingdom began discussions to formulate a new international monetary system. John Maynard Keynes, a highly influential British economic thinker, and Harry Dexter White, a US Treasury official, paved the way to create a new monetary system. In July 1944, representatives from forty-four countries met in Bretton Woods, New Hampshire, to establish a new international monetary system. The resulting Bretton Woods Agreement created a new dollar-based monetary system, which incorporated some of the disciplinary advantages of the gold system while giving countries the flexibility they needed to manage temporary economic setbacks, which had led to the fall of the gold standard. The Bretton Woods Agreement lasted until 1971 and established several key features. Fixed Exchange Rates Fixed exchange rates are also sometimes called pegged rates. One of the critical factors that led to the fall of the gold standard was that after the United Kingdom abandoned its 31 CU IDOL SELF LEARNING MATERIAL (SLM)

commitment to maintaining the value of the British pound, countries sought to peg their currencies to the US dollar. With the strength of the US economy, the gold supply in the United States increased, while many countries had less gold in reserve than they did currency in circulation. The Bretton Woods system worked to fix this by tying the value of the US dollar to gold but also by tying all of the other countries to the US dollar rather than directly to gold. The par value of the US dollar was fixed at $35 to one ounce of gold. All other countries then set the value of their currencies to the US dollar. In reflection of the changing times, the British pound had undergone a substantial loss in value and by that point, its value was $2.40 to £1. Member countries had to maintain the value of their currencies within 1 percent of the fixed exchange rate. Lastly, the agreement established that only governments, rather than anyone who demanded it, could convert their US dollar holdings into gold—a major improvement over the gold standard. In fact, most businesspeople eventually ignored the technicality of pegging the US dollar to gold and simply utilized the actual exchange rates between countries (e.g., the pound to the dollar) as an economic measure for doing business. National Flexibility To enable countries to manage temporary but serious downturns, the Bretton Woods Agreement provided for a devaluation of a currency—more than 10 percent if needed. Countries could not use this tool to competitively manipulate imports and exports. Rather, the tool was intended to prevent the large-scale economic downturn that took place in the 1930s. Post–Bretton Woods Systems and Subsequent Exchange Rate Efforts When Bretton Woods was established, one of the original architects, Keynes, initially proposed creating an international currency called Bancor as the main currency for clearing. However, the Americans had an alternative proposal for the creation of a central currency called unitas. Neither gained momentum; the US dollar was the reserve currency. Reserve currency is a main currency that many countries and institutions hold as part of their foreign exchange reserves. Reserve currencies are often international pricing currencies for world products and services. Examples of current reserve currencies are the US dollar, the euro, the British pound, the Swiss franc, and the Japanese yen. Many feared that the collapse of the Bretton Woods system would bring the period of rapid growth to an end. In fact, the transition to floating exchange rates was relatively smooth, and it was certainly timely: flexible exchange rates made it easier for economies to adjust to more expensive oil, when the price suddenly started going up in October 1973. Floating rates have facilitated adjustments to external shocks ever since. The IMF responded to the challenges created by the oil price shocks of the 1970s by adapting its lending instruments. To help oil importers deal with anticipated current account deficits and inflation in the face of higher oil prices, it set up the first of two oil facilities. 32 CU IDOL SELF LEARNING MATERIAL (SLM)

Creation of the International Monetary Fund and the World Bank The IMF’s initial primary purpose was to help manage the fixed rate exchange system; it eventually evolved to help governments correct temporary trade imbalances (typically deficits) with loans. The World Bank’s purpose was to help with post–World War II European reconstruction. Both institutions continue to serve these roles but have evolved into broader institutions that serve essential global purposes, even though the system that created them is long gone 2.7 SUMMARY  Globalization is a process of rapid interdependence and interconnectedness amongst the countries of the world. The Multinational Corporations (MNCs) have played a major role in stimulating and spreading the process of globalization.  MNCs usually set up production units across the globe in places where the market is nearby, there is the availability of skilled and unskilled labour at low costs and other factors essential to the growth of production.  The setting up of production in various countries leads to the development of products globally. Sometimes, the MNCs might also set up production with the local companies of a country as a joint responsibility, thus bringing in the latest technology and foreign investment.  The MNCs also link and control the production of goods. Large MNCs in developed countries often place orders for production with small producers all around the world which are then sold by the MNCs under their brand name.  The power of control and influence of such corporations has contributed to the interlinking of such widely dispersed locations across the globe. This process, in turn, has contributed to the growth of globalization process.  There is no doubt that the relationship between economic globalization and MNCs grows stronger by the day. As Hart and Prakash (1999) rightly pointed out, economic globalization has everything to do with the increasing integration of input, factor, and final product markets, coupled with the increasing salience of MNCs in the world economy as well as their creation of cross-national value-chain networks.  It is therefore safe to conclude that MNCs are not only beneficiaries but also agents of globalization. The internationalisation strategies of MNCs wouldn’t be possible without a fair share of globalization.  In other words, globalization is accelerated as MNCs execute their options in pursuit of these strategies. However, the process of globalization isn’t complete yet perhaps never will be.  It is for this reason that scholars mostly focus on whether there is more or less globalization at any given period of time, as well as what the limitations of globalization might be. 33 CU IDOL SELF LEARNING MATERIAL (SLM)

 The international monetary system had many informal and formal stages. For more than one hundred years, the gold standard provided a stable means for countries to exchange their currencies and facilitate trade. With the Great Depression, the gold standard collapsed and gradually gave way to the Bretton Woods system.  The Bretton Woods system established a new monetary system based on the US dollar. This system incorporated some of the disciplinary advantages of the gold system while giving countries the flexibility they needed to manage temporary economic setbacks, which had led to the fall of the gold standard.  The Bretton Woods system lasted until 1971 and provided the longest formal mechanism for an exchange-rate system and forums for countries to cooperate on coordinating policy and navigating temporary economic crises.  While no new formal system has replaced Bretton Woods, some of its key elements have endured, including a modified managed float of foreign exchange, the International Monetary Fund (IMF), and the World Bank—although each has evolved to meet changing world conditions. 2.8 KEYWORDS Credit Risk: It is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Foreign Exchange Risk: It 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. Transaction Exposure: It is the risk of loss from a change in exchange rates during the course of a business transaction. This exposure is derived from changes in foreign exchange rates between the dates when a transaction is booked and when it is settled. Operating Exposure: It refers to how exchange rate changes can impact on a firm's future cash flows and consequently affect the firm's value. The cash flows may be contractual or anticipated. The idea of an exposure without contracted cash flows can prove a difficult concept to grasp. International Monetary Fund: IMF is an international financial institution, headquartered in Washington, D.C., consisting of 190 countries working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth. 34 CU IDOL SELF LEARNING MATERIAL (SLM)

2.9 LEARNING ACTIVITY Assume that the Polish currency (called zloty) is worth $.32. The U.S. dollar is worth .7 euros. A U.S. dollar can be exchanged for 8 Mexican pesos. Last year a dollar was valued at 2.9 Polish zloty, and the peso was valued at $.10. 1. Would U.S. exporters to Mexico that accept pesos as payment be favourably or unfavourably affected by the change in the Mexican peso’s value over the last year? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Would U.S. importers from Poland that pay for imports in zloty be favourably or unfavourably affected by the change in the zloty’s value over the last year? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2.10 UNIT END QUESTIONS A. Descriptive Short Questions 1. What is the international monetary system? 2. What was the gold standard, and why did it collapse? 3. What was Bretton Woods, and why did it collapse? 4. What is the current system of exchange rates? 5. Explain latest Global trend in trade. Long Questions 1. Describe impact of Globalization and its effect on MNC’s . 2. Illustrate Risk and Rewards in International Finance. 3. Explain Goals of International Financial Management. 4. Explain Exposure to international Risk. 5. Explain Economic Exposures. B. Multiple Choice Questions 35 1. Keynes, initially proposed creating an international currency called a. Bancor b. Unitas CU IDOL SELF LEARNING MATERIAL (SLM)

c. franc d. yen 2. MNE stands for a. Multinational Enterprise b. Micronational Enterprise c. Macro national Enterprise d. None of these 3. GDP stands for a. Gross domestic products b. Great domestic products c. Gross development products d. None of these 4. The first phase of globalization started around 1870 and ended with a. World War I b. World War II c. The Establishment of GATT d. In 1913 when GDP was High 5. WTO was replaced by the …………….on 1st Jan 1995 a. GATS b. GATT c. WHO d. IMF Answers 1-(a), 2-(a), 3-(a), 4-(a), 5-(b) 2.11 REFERENCES Textbooks:  Charon J.M. (2010). Ten Questions: A Sociological Perspective, 7th Edition. Australia: Wadsworth Cengage Learning.  Ritzer G., (2011). The McDonaldization of Society, 6th Edition, Los Angeles. Sage  Dunning, John H. (1992) Multinational Enterprises and the Global Economy. Reading, Mass.: Addison-Wesley.  Hillebrand, R., and P.J. Welfens (1998). Globalisierung der Wirtschaft. In D. Cassel (ed.), 50 Jahre Soziale Marktwirtschaft, Vol. 57. Stuttgart. 36 CU IDOL SELF LEARNING MATERIAL (SLM)

 Kleinert, J. (2001). The Role of Multinational Enterprises in Globalization: An Empirical Overview. Kiel Working Papers1069. The Kiel Institute of World Economics, Kiel. Journal:  UNCTAD (1997). World Investment Report 1997. New York.  UNCTAD (2000). World Investment Report 2000. New York.  Hart, J. (2015). Globalization and Multinational Corporations. Research Gate. Retrieved 23 April 2020, from https://www.researchgate.net/publication/280133867 37 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-3: INTERNATIONAL FLOW OF FUNDS STRUCTURE 3.0 Learning Objectives 3.1 Introduction 3.2 Balance of Payments 3.2.1 Fundamentals of BOP 3.3 Factors Effecting International Trade flow 3.4 Foreign Exchange Markets 3.4.1 Forecasting Foreign Exchange Rates 3.5 International Parity Conditions 3.6 Summary 3.7 Keywords 3.8 Learning Activity 3.9 Unit End Questions 3.10 References 3.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain International fund flow and balance of payments.  Explain the foreign exchange market and firms who participate in the market.  Describe factors effecting international trade flow. 3.1 INTRODUCTION International capital flows are the financial side of international trade.1 When someone imports a good or service, the buyer (the importer) gives the seller (the exporter) a monetary payment, just as in domestic transactions. If total exports were equal to total imports, these monetary transactions would balance at net zero: people in the country would receive as much in financial flows as they paid out in financial flows. But generally, the trade balance is 38 CU IDOL SELF LEARNING MATERIAL (SLM)

not zero. The most general description of a country’s balance of trade, covering its trade in goods and services, income receipts, and transfers, is called its current account balance. If the country has a surplus or deficit on its current account, there is an offsetting net financial flow consisting of currency, securities, or other real property ownership claims. This net financial flow is called its capital account balance. When a country’s imports exceed its exports, it has a current account deficit. Its foreign trading partners who hold net monetary claims can continue to hold their claims as monetary deposits or currency, or they can use the money to buy other financial assets, real property, or equities (stocks) in the trade-deficit country. Net capital flows comprise the sum of these monetary, financial, real property, and equity claims. Capital flows move in the opposite direction to the goods and services trade claims that give rise to them. Thus, a country with a current account deficit necessarily has a capital account surplus. In balance-of-payments accounting terms, the current-account balance, which is the total balance of internationally traded goods and services, is just offset by the capital-account balance, which is the total balance of claims that domestic investors and foreign investors have acquired in newly invested financial, real property, and equity assets in each other’s countries. While all the above statements are true by definition of the accounting terms, the data on international trade and financial flows are generally riddled with errors, generally because of undercounting. Therefore, the international capital and trade data contain a balancing error term called “net errors and omissions.” Because the capital account is the mirror image of the current account, one might expect total recorded world trade—exports plus imports summed over all countries—to equal financial flows—payments plus receipts. But in fact, during 1996–2001, the former was $17.3 trillion, more than three times the latter, at $5.0 trillion.2 There are three explanations for this. First, many financial transactions between international financial institutions are cleared by netting daily offsetting transactions. For example, if on a particular day, U.S. banks have claims on French banks for $10 million and French banks have claims on U.S. banks for $12 million, the transactions will be cleared through their central banks with a recorded net flow of only $2 million from the United States to France even though $22 million of exports was financed. Second, since the 1970s, there have been sustained and unexplained balance-of-payments discrepancies in both trade and financial flows; part of these balance-of-payments anomalies is almost certainly due to unrecorded capital flows. Third, a huge share of export and import trade is intrafirm transactions; that is, flows of goods, material, or semi-finished parts (especially automobiles and other nonelectronic machinery) between parent companies and their subsidiaries. Compensation for such trade is accomplished with accounting debits and credits within the firms’ books and does not require actual financial flows. Although data on such intrafirm transactions are not generally available for all industrial countries, intrafirm trade for the United States in recent years accounts for 30–40 percent of exports and 35–45 percent of imports. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

The bulk of capital flows are transactions between the richest nations. In 2003, of the more than $6.4 trillion in gross financial transactions, about $5.4 trillion (84 percent) involved the 24 industrial countries and almost $1.0 trillion (15 percent) involved the 162 less-developed countries (LDCs) or economic territories, with the rest, less than 1 percent, accounted for by international organizations.4 The shares of both industrial nations and the international organizations have been receding from their highs in 1998: 90 percent for industrial nations and 5 percent for the international organizations. In that year the combination of the Russian debt default and rubble devaluation, the south Asia financial crisis, and the lingering uncertainty about financial consequences of the return of Hong Kong to Chinese sovereignty in July 1997 drove the LDC share down to 5 percent of world capital flows.5 In the more tranquil five years following these crises, 1999–2003, LDC financial transactions involving mainland China and Hong Kong averaged 28 percent of the LDC total, and adding Taiwan, Singapore, and Korea brings the share to 53 percent of the developing-country transactions. Of the remaining forty-seven percentage points of developing-country transactions, Europe (primarily Russia, Turkey, Poland, and the Czech Republic) and the Western Hemisphere (primarily Mexico, Brazil, and Chile) each accounted for about sixteen percentage points, with the Middle East and Africa combining for the remaining sixteen percentage points. 3.2 BALANCE OF PAYMENTS Maintaining a balance of payments with the rest of the world is a macro-economic objective. In simple terms, if the balance of payments balances, then the combined receipts from selling goods and services abroad, and from the return on investments abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad. The balance of payments is also an official account of international payments, published in a document called the Pink Book. Statistics on UK imports and exports have been gathered in the UK since 1687. As an official record, the balance of payments is broken down into two basic accounts – the current account, and the capital and financial account. A country’s BOP is vital for the following reasons:  BOP of a country reveals its financial and economic status.  BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.  BOP statement helps the Government to decide on fiscal and trade policies.  It provides important information to analyse and understand the economic dealings of a country with other countries. 40 CU IDOL SELF LEARNING MATERIAL (SLM)

 By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures. 3.2.1 Elements of BOP There are three components of balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations Current Account The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they make up to a country’s Balance of Trade (BOT). There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries are referred to as visible items and import/export of services (banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This can also be personal transfers like – money sent by relatives to their family located in another country. Capital Account All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc. by migrants moving out/into a different country. The deficit or surplus in the current account is managed through the finance from capital account and vice versa. There are 3 major elements of capital account:  Loans & borrowings – It includes all types of loans from both the private and public sectors located in foreign countries.  Investments – These are funds invested in the corporate stocks by non-residents.  Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account. Financial Account The flow of funds from and to foreign countries through various investments in real estates, business ventures, foreign direct investments etc. is monitored through the financial account. 41 CU IDOL SELF LEARNING MATERIAL (SLM)

This account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. On analysing these changes, it can be understood if the country is selling or acquiring more assets (like gold, stocks, equity etc.). 3.3 FACTORS EFFECTING INTERNATIONAL TRADE FLOW Impact of Inflation A relative increase in a country’s inflation rate will decrease its current account, as imports increase, and exports decrease. Impact of National Income A relative increase in a country’s income level will decrease its current account, as imports increase. Impact of Government Restrictions A government may reduce its country’s imports by imposing a tariff on imported goods, or by enforcing a quota. Some trade restrictions may be imposed on certain products for health and safety reasons. Impact of Exchange Rates If a country’s currency begins to rise in value, its current account balance will decrease as imports increase and exports decrease. The factors interact, such that their simultaneous influence on the balance of trade is complex. 3.4 FOREIGN EXCHANGE MARKETS Most countries have their own currencies, but not all. Sometimes small economies use the currency of an economically larger neighbour. For example, Ecuador, El Salvador, and Panama have decided to dollarize—that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. The best example of a common currency is the Euro, a common currency used by 19 members of the European Union. With these exceptions duly noted, most international transactions require participants to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. The market in which people or firms use one currency to purchase another currency is called the foreign exchange market. Every exchange rate is a price—the price of one currency expressed in terms of units of another currency. The key framework for analysing prices, whether in this course, any other economics course, in public policy, or business examples, is supply and demand in markets. 42 CU IDOL SELF LEARNING MATERIAL (SLM)

The Extraordinary Size of the Foreign Exchange Markets The quantities traded in foreign exchange markets are breath-taking. A survey done in April 2013 by the Bank of International Settlements, an international organization for banks and the financial industry, found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2013 U.S. real GDP was $15.8 trillion per year. Table 1 shows the currencies most commonly traded on foreign exchange markets. The foreign exchange market is dominated by the U.S. dollar, the Euro, the Japanese yen, and the British pound. Currency % Daily Share U.S. dollar 87.60% Euro 31.30% Japanese yen 21.60% British pound 12.80% Australian dollar 6.90% Canadian dollar 5.10% Swiss franc 4.80% Chinese yuan 2.60% Table 1. Currencies Traded Most On Foreign Exchange Markets as of April, 2016 (Source: http://www.bis.org/publ/rpfx16fx.pdf) Demanders and Suppliers of Currency in Foreign Exchange Markets In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency— and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market:  firms that import or export goods and services  tourists visiting other countries  international investors buying ownership (or part-ownership) in a foreign firm  international investors making financial investments that do not involve ownership. Let’s consider these categories in turn. 43 CU IDOL SELF LEARNING MATERIAL (SLM)

Firms that sell exports or buy imports find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. So, a Chinese firm exporting abroad will earn some other currency—say, U.S. dollars—but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan. International tourists need foreign currency for expenses in the country they are visiting; they will supply their home currency to receive the foreign currency. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan. Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories. Foreign direct investment (FDI) refers to purchasing (at least ten percent) ownership in a firm in another country or starting up a new enterprise in a foreign country. For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase of a U.S. firm, InBev had to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars. The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased bonds issued by the government of the United Kingdom, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds. Portfolio investment is often linked to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing bonds issued in the United Kingdom. For simplicity, ignore any interest paid by the bond (which will be small in the short run anyway) and focus on exchange rates. Say that a British pound is currently worth $1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth $1.60 in U.S. currency. Thus, as Figure 1(a) shows, this investor would change $24,000 for 16,000 British pounds. In a month, if the pound is indeed worth $1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate and have $25,600— a nice profit. A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly. Say that an investor expects that the pound, now worth $1.50 in U.S. currency, will decline to $1.40. Then, as shown in Figure 1, that investor could start off with £20,000 in British currency (borrowing the money if necessary), convert it to $30,000 in U.S. currency, wait a month, and then convert back to approximately £21,429 in British currency—again making a nice profit. Of course, this kind 44 CU IDOL SELF LEARNING MATERIAL (SLM)

of investing comes without guarantees, and an investor may suffer losses if the exchange rates do not move as predicted. Figure 1. A Portfolio Investor Trying to Benefit from Exchange Rate Movements. Expectations of the future value of a currency can drive demand and supply of that currency in foreign exchange markets. Many portfolio investment decisions are not as simple as betting that the value of the currency will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. But you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Let’s say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against currency risk. Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. But if the value of the euro in dollars declines, then you are protected by the hedge. Financial contracts like hedging, where parties wish to be protected against exchange rate movements, 45 CU IDOL SELF LEARNING MATERIAL (SLM)

also commonly lead to a series of portfolio investments by the firm that is receiving a fee to provide the hedge. Both foreign direct investment and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency. With portfolio investment less than ten percent of a company is purchased. As such, portfolio investment is often made with a short- term focus. With foreign direct investment more than ten percent of a company is purchased and the investor typically assumes some managerial responsibility; thus, foreign direct investment tends to have a more long-run focus. As a practical matter, portfolio investments can be withdrawn from a country much more quickly than foreign direct investments. A U.S. portfolio investor who wants to buy or sell bonds issued by the government of the United Kingdom can do so with a phone call or a few clicks of a computer key. However, a U.S. firm that wants to buy or sell a company, such as one that manufactures automobile parts in the United Kingdom, will find that planning and carrying out the transaction takes a few weeks, even months. Table 2 summarizes the main categories of demanders and suppliers of currency. Demand for the U.S. Dollar Comes Supply of the U.S. Dollar Comes from… from… A U.S. exporting firm that earned A foreign firm that has sold imported goods foreign currency and is trying to pay in the United States, earned U.S. dollars, U.S.-based expenses and is trying to pay expenses incurred in its home country Foreign tourists visiting the United U.S. tourists leaving to visit other countries States Foreign investors who wish to make U.S. investors who want to make foreign direct investments in the U.S. economy direct investments in other countries Foreign investors who wish to make U.S. investors who want to make portfolio portfolio investments in the U.S. investments in other countries economy Table 2. The Demand and Supply Line-ups in Foreign Exchange Markets Following are the major foreign exchange markets −  Spot Markets  Forward Markets  Future Markets  Option Markets  Swaps Markets 46 CU IDOL SELF LEARNING MATERIAL (SLM)

Swaps, Future and Options are called the derivative because they derive their value from the underlying exchange rates. Spot Market These are the quickest transactions involving currency in the foreign exchange market. This market provides immediate payment to the buyers and sellers as per the current exchange rate. The spot market account for almost one-third of all currency exchange, and trades usually take one or two days to settle transactions. This allows the traders open to the volatility of the currency market, which can raise or lower the price, between the agreement and the trade. There is an increase in volume of spot transactions in the foreign exchange market. These transactions are primarily in forms of buying and selling of currency notes, cash-in of traveller’s cheque and transfers through banking systems. The last category accounts for almost 90 percent of all spot transactions are carried out exclusively for banks. As per the Bank of International Settlements (BIS) estimate, the daily volume of spot transaction is about 50 percent of all transactions in foreign exchange markets. London is the hub of foreign exchange market. It generates the highest volume and is diverse with the currencies traded. Forward Market In forward contract, two parties (two companies, individual or government nodal agencies) agree to do a trade at some future date, at a stated price and quantity. No security deposit is required as no money changes hands when the deal is signed. Advantages of forward markets Forward contracting is very valuable in hedging and speculation. The classic scenario of hedging application through forward contract is that of a wheat farmer forward; selling his harvest at a known fixed price in order to eliminate price risk. Similarly, a bread factory wants to buy bread forward in order to assist production planning without the risk of price fluctuations. There are speculators, who based on their knowledge or information forecast an increase in price. They then go long (buy) on the forward market instead of the cash market. Now this speculator would go long on the forward market, wait for the price to rise and then sell it at higher prices; thereby, making a profit. Disadvantages of forward markets The forward markets come with a few disadvantages. The disadvantages are described below in brief − 47 CU IDOL SELF LEARNING MATERIAL (SLM)

Lack of Centralization of Trading Illiquid (because only two parties are involved) Counterparty risk (risk of default is always there) In the first two issues, the basic problem is that there is a lot of flexibility and generality. The forward market is like two persons dealing with a real estate contract (two parties involved - the buyer and the seller) against each other. Now the contract terms of the deal are as per the convenience of the two persons involved in the deal, but the contracts may be non-tradeable if more participants are involved. Counterparty risk is always involved in forward market; when one of the two parties of the transaction chooses to declare bankruptcy, the other suffers. Another common problem in forward market is - the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter-party risk involved. Even in case of trade in forward markets, trade have standardized contracts, and hence avoid the problem of illiquidity but the counterparty risk always remains. Future Markets The future markets help with solutions to a number of problems encountered in forward markets. Future markets work on similar lines as the forward markets in terms of basic philosophy. However, contracts are standardized, and trading is centralized (on a stock exchange like NSE, BSE, KOSPI). There is no counterparty risk involved as exchanges have clearing corporation, which becomes counterparty to both sides of each transaction and guarantees the trade. Future market is highly liquid as compared to forward markets as unlimited persons can enter into the same trade (like, buy FEB NIFTY Future). Option Market An option is a contract, which gives the buyer of the options the right but not the obligation to buy or sell the underlying at a future fixed date (and time) and at a fixed price. A call option gives the right to buy and a put option gives the right to sell. As currencies are traded in pair, one currency is bought, and another sold. For example, an option to buy US Dollar ($) for Indian Rupees (INR, base currency) is a USD call and an INR put. The symbol for this will be USDINR or USD/INR. Conversely, an option to sell USD for INR is a USD put and an INR call. The symbol for this trade will be like INRUSD or INR/USD. 48 CU IDOL SELF LEARNING MATERIAL (SLM)

Currency Options Currency options is a part of the currency derivatives, which emerged as an important and interesting new asset class for investors. Currency option provides an opportunity to take call on Exchange Rate and fulfil both investment and hedging objectives. Participants in the Exchange Rate Market Commercial Banks These banks are the major players in the market. Commercial and investment banks are the main players of the foreign exchange market; they not only trade on their own behalf but also for their customers. A major chunk of the trade comes by trading in currencies indulged by the bank to gain from exchange movements. Interbank transaction is done in case the transaction volume is huge. For small volume intermediation of foreign exchange, a broker may be sought. Central Banks Central banks like RBI in India (RBI) intervene in the market to reduce currency fluctuations of the country currency (like INR, in India) and to ensure an exchange rate compatible with the requirements of the national economy. For example, if rupee shows signs of depreciation, RBI (central bank) may release (sell) a certain amount of foreign currency (like dollar). This increased supply of foreign currency will halt the depreciation of rupee. The reverse operation may be done to halt rupee from appreciating too much. Dealers, brokers, arbitrageurs and speculators Dealers are involved in buying low and selling high. The operations of these dealers are focused on wholesale and a majority of their transactions are interbank in nature. At times, the dealers may have to deal with corporates and central banks. They have low transaction costs as well as very thin spread. Wholesale transactions account for 90 percent of the overall value of the foreign exchange deals. In the world economy, roughly 2,000 firms are foreign exchange dealers. The U.S. economy has less than 100 foreign exchange dealers, but the largest 12 or so dealers carry out more than half the total transactions. The foreign exchange market has no central location, but the major dealers keep a close watch on each other at all times. The foreign exchange market is huge not because of the demands of tourists, firms, or even foreign direct investment, but instead because of portfolio investment and the actions of interlocking foreign exchange dealers. International tourism is a very large industry, involving about $1 trillion per year. Global exports are about 23% of global GDP, which is 49 CU IDOL SELF LEARNING MATERIAL (SLM)

about $18 trillion per year. Foreign direct investment totalled about $1.4 trillion in 2012. These quantities are dwarfed, however, by the $5.3 trillion per day being traded in foreign exchange markets. Most transactions in the foreign exchange market are for portfolio investment—relatively short-term movements of financial capital between currencies—and because of the actions of the large foreign exchange dealers as they constantly buy and sell with each other. 3.4.1 Forecasting Foreign Exchange Rates Economists and investors always tend to forecast the future exchange rates so that they can depend on the predictions to derive monetary value. There are different models that are used to find out the future exchange rate of a currency. However, as is the case with predictions, almost all of these models are full of complexities and none of these can claim to be 100% effective in deriving the exact future exchange rate. Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign currencies for a definite time period. There are numerous theories to predict exchange rates, but all of them have their own limitations. Exchange Rate Forecast Approaches: The two most commonly used methods for forecasting exchange rates are − Fundamental Approach − This is a forecasting technique that utilizes elementary data related to a country, such as GDP, inflation rates, productivity, balance of trade, and unemployment rate. The principle is that the ‘true worth’ of a currency will eventually be realized at some point of time. This approach is suitable for long-term investments. Technical Approach − In this approach, the investor sentiment determines the changes in the exchange rate. It makes predictions by making a chart of the patterns. In addition, positioning surveys, moving-average trend-seeking trade rules, and Forex dealers’ customer-flow data are used in this approach. Exchange Rate Forecast: Models Some important exchange rate forecast models are discussed below. Purchasing Power Parity Model The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It states that same goods in different countries should have identical prices. For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the U.S. (considering the exchange rate and excluding transaction and shipping costs). That is, there will be no arbitrage opportunity to buy cheap in one country and sell at a profit in another. 50 CU IDOL SELF LEARNING MATERIAL (SLM)