International Finance Foreign

International finance

International finance is the study of foreign investment, exchange rates and the study of effects on the international trade. It is one of the branches of the economics. The present world is moving towards the higher level of the globalization. The international finance deals with the projects, investments and the flow of the capital on the international level. Future, options and currency swaps are also studied in the international finance.

Financial management of a company is a complex process, involving its own methods and procedures. It is made even more complex because of the globalization taking place, which is making the world's financial can commodity markets more and more integrated. The integration is both across countries as well as markets. Not only the markets, but even the companies are becoming international in their operations and approach.

International finance integrates different financial markets. Integration of financial markets involves the freedom and opportunity to raise funds from and to invest anywhere in the world, though any type of instrument. Though the degree of freedom differs from country to country, the trend is towards having a reducing control over these markets. As a result of this freedom, anything affecting the financial markets in one part of the world automatically and quickly affects the rest of the world also (Financial Management for Managers, 2004). This is what we may call the Transmission Effects. Higher the integration, greater is the transmission effect.

The contribution of the integration of the financial markets:

The development of new financial instruments- For example, instruments of the euro-dollar market, interest rate swap, and currency swap, future contracts, forward contracts, options etc.
Liberalization of regulations governing the financial markets- Though the extent and direction of liberalization has been different in the different countries, based on the domestic compulsions and the local perspective, it has been substantial enough to make operations in foreign markets a lucrative affair.
Increased cost penetration of foreign ownership-This has helped in the countries developing an international perspective while deciding on various factors influencing the process of globalization (Financial Management for Managers, 2004).

Effects of international finance

The most important and visible effect of international finance is the increase in volatility. Whether it is interest rates, exchange rates of prices of financial assets, all of them change quite frequently in response to various changes taking place in different segments of the financial markets all over the world. Such change gets reflected in exchange rates before getting reflected in interest rates. Further, with the deregulation of the financial markets the world, the control of the authorities on these variables has reduced to a great extent, thus exposing a firm to a number of risks, hitherto unknown to it. In this changed scenario, learning international finance (of which exchange risk management and interest risk management are an integral part) becomes essential for a finance manager (Financial Management for Managers, 2004).

Commercial bank loan and trade bills

Foreign commercial banks are one of the major sources of financing abroad. They perform essentially the same financing function as domestic commercial banks. One subtle difference is that banking practices in Europe allow longer-term loans than are available in the United States. These commercial bank loans are also a type of contract. In addition to commercial bank loans, discounting trade bills is a common method of short term financing. Although, this method of financing is not used extensively in the United States, it is widely used in Europe to finance both domestic and international trade. These contracts are happened between business and commercial banks (Horne, Wachowicz & Bhaduri, 2008).

Currency-option and multiple-currency bonds

Certain bonds provide the holder with the right to choose the currency in which payment is received, usually prior to each coupon or principle payment. Typically, this option is confined to two currencies, although it can be more. It is also a type of bond. The exchange rate between the currencies is fixed at the time of bond issue. Bonds are sometimes issued with principles and interest payments being a weighted average, or basket of multiple currencies. Known as currency cocktail bonds, these securities provide a degree of exchange-rate stability not found in any one currency. For example, a Swiss bond might call for interest payments in Swiss francs and principal payments in US dollar.

External commercial borrowing

External commercial borrowings are one of the sources of funds for corporate. ECBs are defined to include commercial bank loans, buyer's credit, supplier's credit, securitized instruments, such as floating rate notes and fixed rate bonds etc. these could also refer to credit from official export credit agencies and commercial borrowings from the private sector window of multilateral financial institution, such as International Finance Company (IFC), Asian Development Bank (ADB) etc. these policies, further reflects the concern of the government to keep maturities long, costs low and to promote infrastructure and export sector financing, which are crucial for overall growth of the economy (Horne, Wachowicz & Bhaduri, 2008).

Currency market hedges

Yet another means to hedge currency exposure is through devices of several currency markets-forward contracts, futures contracts, currency options and currency swaps. Let us see how these markets and vehicles work to protect the multinational company.

Forward exchange market- In the forward exchange market, one buys a forward contract for the exchange of one currency for another at a specific future date and at specific exchange ratio. A forward contract provides assurance of being able to convert into a desired currency at a price set in advance. A forward contract is a contract for the delivery of a commodity, foreign currency or financial instrument at a price specified now, with delivery and settlement at a specified future date. Although similar to a futures contract, it is not easily transferred or cancelled.

Currency futures- closely related to the use of a forward contract is a future contract. A currency futures market exists for the major currencies of the world. A future contract is a contract for the delivery of a commodity, foreign currency or financial instrument at a specified price on a stipulated future date. These are targeted on organized exchanges. Each day, the future contract is marked-to-market in the sense that it is valued at the closing price. Price movements affect the buyer and seller in opposite ways. Every day, there is a winner and a looser, depending upon the price of the movement (Horne, Wachowicz & Bhaduri, 2008).

Currency option- A currency that gives the holder the right to buy or sell a specific amount of a foreign currency at some specified price until a certain date. Forward and future contract provide a two-sided hedge against currency movements. That is, if the currency involved moves in one direction, the forward or futures position offsets it. Currency options, in contrast, enable the hedging of one-sided risk. Only adverse currency movements are hedged, either with a call option to buy the foreign currency or with a put option to sell it. The holder has the right, but not the obligation, to buy or sell the currency over the life of the contract.

Currency swaps- Yet another device for shifting risk is the currency swap. In a currency swap two parties exchange debt obligations denominated in different currencies. Each party agrees to pay the other's interest obligation. At maturity, principal amounts are exchanged, usually at a rate of exchange agreed to in advance. The exchange is notional in that only the cash-flow difference is paid. If one party should default, there is no loss of principal per use. There is, however, the opportunity cost associated with currency movements after the swap's initiation (Horne, Wachowicz & Bhaduri, 2008).

Eurocurrency Loans

Eurocurrency is a freely convertible currency deposited in banks outside the country of its origin. Depositors put their savings in banks for short periods. Banks that make Eurocurrency loans to international companies for a long period of time use these deposits. Thus short term deposits are converted into long term claims on borrowers. Usually the size of Eurocurrency loans is very large therefore these loans are syndicated by more than one bank. These loans are made on the basis of floating rates of interest. Interest rates are fixed as LIBOR (London Interbank Offering Rate) plus a premium based on default risk. The Eurocurrency market is a very large market (Pandey, 2007).

Euro Bonds and Foreign Bonds

Eurobonds are sold outside the country in whose currency they are dominated. They are issued directly by borrowers to investors. Eurobonds may be issued in different currencies. Eurobond market is a self-regulated market. Eurobonds are generally issued as bearer bonds. The bearer Eurobonds offer the ease of transfer. Eurobonds may be issued with the conversion feature or with warrants. A foreign bond is denominated in the currency of the country where it is issued, and is subjected to the laws and regulations of the country. In developed markets such as USA, Europe or Japan, markets for Eurobonds, foreign bonds and domestic bonds operate together.

Depository Receipts

An indirect method of raising equity capital from foreign markets is to issue depository receipts. A depository receipts represents number of foreign shares that are deposited in a bank in the foreign country. Depository receipts are of two types ADR and GDR. ADRs can be listed and traded on the USA stock exchanges. ADRs are denominated in US dollars and ADR investors receive dollar equivalent dividends. The Indian firms can also issue Global Depository Receipts in many other countries. Reliance and Grasim were the two first companies to issue GDRs in May and November 1992.After 1992 a number of Indian companies have raised funds from the international capital market by issuing ADRs and GDRs (Pandey, 2007).

References

Financial Management for Managers. (2004). Hyderabad: ICFAI Center for Management Research.

Horne, J. C., Wachowicz, J. M. & Bhaduri, S.N. (2008). Fundamentals of Financial Management, 12^th Revised Edition. New Delhi: Pearson Educational Publishers.

Pandey, I. M. (2007). Financial Management, 9^th Edition. New Delhi: Vikas Publishing House Pvt. Ltd.

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