An Introduction to International Finance

1. INTERNATIONAL FINANCE
SESSION -1
1B.SRINIVASAN16/07/2014

2. 12/26/2014 B.SRINIVASAN 2
Course Contents of INTERNATIONAL FINANCE
A) International Finance – Introduction
B) Inter-war instability, Bretton woods
C) Theories on International Trade
D) Foreign Exchange exposure; transaction & operations
E) Fixed exchange rates, fluctuating exchange rates Case for fixed or
fluctuating exchange rates. The changing nature of world money.
F) Exchange contracts & Exchange trading & position. Demand supply &
elasticity in foreign exchange rate determination
G) Derivatives Pricing & Analysis; foreign exchange arithmetic, foreign
exchange swaps, forward contracts, financial futures & financial swaps.
Currency options fixed income analytic & interest rate options.
H) Syndication, Swaps, Options, Offshore banking, International Money,
Capital & Foreign Exchange Markets with reference to New York,
London, Tokyo, Hong Kong & Singapore.
I) Capital budgeting for international projects, international cash
management, international asset pricing theories, Financial Aspects of
International Negotiations.
J) Socio-Political Issues in Strategic International Financial Management
(with special reference to multi-national corporations)

3. INTERNATIONAL FINANCE
MARKETS
Concerned with forex
Markets, International
or Investment
instruments , int.
securities
INTERNATIONAL
ECONOMICS
Causes and Effects
of Financial Flows
Application of
Macro Economics
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How Corporates across
the world operating in a
global economy cope
with complex financial
environment
INTERNATIONAL
FINANCE

4. • Globalization is taking place
• Integration is across countries and Markets
• Financial & Commodity markets are integrated
INTERNATIONAL FINANCE – THE NEED
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• International Trade
• Establishing International Operations
in foreign countries • Countries have different currencies
•Settlement of trade in Domestic
/Foreign countries
• Rates of Exchange
Sales Costs Profits
Corporates/Business in India
a) Domestic companies with Input
& Output in Local Market
b) Domestic Companies with either
input or output is from foreign
market
c) Companies with both input &
Output is foreign
a) Globally competitive & be a
global player to survive
b) Knowledge & understanding of
different countries & markets
c) Forex & Money market
knowledge

5. REASONS
a) Development of technology for
transfer of money at extremely fast
speed /considerably less cost
b) Increase in Inflation levels of various
Industrial countries , so repricing of
financial assets due to domestic
inflation & Interest rates
INTEGRATION OF FINANCIAL MARKETS – HOW IT HAPPENED
IMPACT
a) Freedom & opportunity to raise funds from
any part of the world
b) Invest in any part of the world
c) Invest in any types of instrument
TRANSMISSION EFFECT
Events in any part of the world markets affect all
other markets
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Development of New
financial instruments
– Euro –Markets – Int.
Rate Swap, Currency
Swaps, Futures
Markets, Forward
contracts
Liberalization of
regulations governing
financial markets
through directions
a) Increased cross
penetration of
foreign
ownership
b) Helped countries
international
perspective while
deciding issues &
policies

6. BENEFITS
- Efficiently transfer resources from surplus units
to deficit units
- Efficient allocation of capital & better working
of financial system
- Smoother consumption pattern enjoyed by all
countries over a period of time
- Enjoying the benefits of diversification –
different securities / Higher returns at same
risk levels / same returns with lower risk levels
EFFECTS
- Increase in volatility – Interest rates/Exchange
rates/ or prices of Financial Assets
- With deregulation, control of the authorities on
these variables has reduced to a certain extent
exposing a firm to a number of risks
- Corporate Finance executives must actively
manage Exchange Risk + Interest Rates Risk
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INTEGRATION OF FINANCIAL MARKETS
COSTS
- Risks and Rewards go hand in hand so
integration of financial markets has brought
forth
A) Currency Risk – Due to exchange rates
B) Country Risk - not able to disinvest at will
- While markets grow together it also goes down
together

7. UNDERSTANDING RELATIONSHIP
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International Trade
International Financial
System
International Payment
System
International Credit
System
International credit
Guarantees

8. UNDERSTANDING INTERNATIONAL TRADE
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LETS ANSWER SOME OF THESE QUESTIONS
A) What is International Trade ? Why is it important?
B) What is the Impact of International Trade on Finance? – Time
/Currency/ROE/Terms of Trade/Regulations of a country/Authorised
dealers
C) How International Trade affects the country? – Resources/Foreign
Exchange
D) What does Balance of Trade Mean? – Visible Trade – favourable/
unfavourable
E) What do you mean by Balance of Payment? Invisible Items Included
F) What do you mean by Current Account and Capital Account?
G) What do you mean by convertibility of a currency?
H) How does Rupee grade itself on convertibility Issue?

9. INTERNATIONAL TRADE - ABSOLUTE ADVANTAGE
THEORY
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BENEFITS
• Adam Smith propounded this theory in 1776
• International Trade takes place because one
country may be more efficient in producing a
particular goods than another country
• This absolute advantage provides an incentive
to trade
• Both the countries benefit from specialization
and resultant increase productivity
ADVANTAGE
-- Increase in rate of economic growth
LIMITATIONS
A) This theory explains the causes of trade only
between two countries when they enjoy absolute
advantage
B) It assumes that transport costs are non-existent
C) Comparable prices and Stability of exchange rate
D) Mobility of labour between products

10. 12/26/2014 B.SRINIVASAN 10
INTERNATIONAL TRADE - ABSOLUTE ADVANTAGE
THEORY
CANADIAN TIMBER
BRAZILIAN COFFEE
SAUDI OIL

11. 11B.SRINIVASAN12/26/2014
• David Ricardo propounded this theory in 1817
• Assumes a single factor of production – labour
• Countries are operating at different levels of
efficiency giving rise to comparative advantage
a) Perfect Competition : with flexible prices and
wages are prevalent in both the countries
b) Productivity of labour assumed to be constant
c) Full Employment : This is assumed to calculate
the opportunity costs
d) Mobility : is perfectly mobile between sectors
but perfectly immobile between countries
e) Technology : No technological innovations take
place in the economy
INTERNATIONAL TRADE – COMPARATIVE ADVANTAGE
THEORY

12. 12B.SRINIVASAN12/26/2014
INTERNATIONAL TRADE – COMPARATIVE ADVANTAGE
THEORY
SOUTH KOREAN ELECTRONICS
HOLLYWOOD MOVIES
BOLLYWOOD MOVIES
GUATMALEN TEXTILES

13. INTERNATIONAL TRADE – Heckscher-Ohlin Model /
Factor Proportions Theory
13B.SRINIVASAN12/26/2014
• Developed in 1920s by Eli Heckscher and Bertil
Ohlin
• Countries operating at the same level of
efficiency and can still benefit from trade
A) No obstructions to trade are there – Trade
controls/Transports costs
B) Commodity and factor markets are perfectly
competitive
C) Constant or decreasing returns to scale
D) Both countries have same technology and operate
at the same level of efficiency
E) Two factors of production Labour & Capital and
both are perfectly immobile in inter-country
transfers, but perfectly mobile in inter-sector
transfers
How it works
• There are two types of products Labour
Intensive and Capital Intensive
• Labour rich country will produce Labour
Intensive products
• Capital Rich country will produce Capital
intensive products
• Both the countries will trade in these goods
and reap the benefits of international trade
Leontief Paradox
a) Used input-output analysis to study the
characteristics of trade flow between the U.S.
b) U.S. exports were relatively labor-intensive
when compared to U.S. imports
c) This is the opposite of what one would expect,
considering the fact that the U.S.'s comparative
advantage was in capital-intensive goods

14. INTERNATIONAL TRADE – Purchasing Power Parity
Theory
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• The idea originated in 16th century and was refined
by Gustav Cassel – a Swedish Economist in 1918
• The concept is based on the LAW of ONE PRICE,
where in the absence of transaction costs and
official trade barriers, identical goods will have
same price in different markets when prices are
expressed in the same currency
• The difference in the inflation rates is equal to the
percentage of depreciation or appreciation of
exchange rate
• The real exchange rate is equal to nominal
exchange rate adjusted for inflation
• If the purchasing power parity held exactly then
the real exchange rate is always equal to one
• There can be a marked differences between
purchasing power incomes and those of converted
via market exchange rates
• The GDP per Capita in India is USD 1708 while on
PPP basis it is USD 3608 while for Denmark it is
around USD 62100 while under the PPP figure it is
USD 37304
Utility
A) PPP exchange rates stay fairly constant hence
comparisons between countries are useful
B) Over the year the exchange rates tend to move
towards the PPP exchange rates
LIMITATIONS
1. It is controversial because it is difficult to find
comparable basket of goods to compare the
purchasing power between countries
2. Likewise different price levels for different
commodities. For example difference in food
prices may be greater than say differences in
housing or say entertainment
3. Adjustment must also be made for difference in
the quality of goods and services

15. INTERNATIONAL TRADE – BIG MAC INDEX
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• An example of law of one price which
underlies the PPP theory is the Big Mac Index
popularized by the Economists
• It is based on a single consumer product
relatively standardized and has inputs from
across the sector in a local economy such as –
Agriculture commodities – bread, beef, cheese,
vegetable, Labour – Blue and White,
Advertising, rent, marketing, transportation
• To take an example calculation, the local price
of a Big Mac in Hong Kong when converted to
U.S. dollars at the market exchange rate was
$2.19 or 50% of the local price for a Big Mac in
the U.S. of $4.37. Hence the Hong Kong dollar
was deemed to be 50% undervalued relative to
the U.S. dollar on a PPP basis. If you take this
measure than according to Economist Indian
currency is undervalued by 59% i.e the price
level as a percentage relative to the US