Tag: International Finance Mumbai University BMS Notes

Forex quotations can be quite complex for the average person. It takes some training and knowledge to understand that these quotations can be provided in more than one way! Also, it takes a little getting used to before a person can quickly comprehend these quotes and take quick decisions based on the same. In this article, we will explain the two types of Forex quotations as well as the abbreviations which are used in them.

Nomenclature

Any Foreign exchange market quotation always uses the abbreviation of the currency under question. There are standard currency keys or currency codes that have been created by International Standards Organization (ISO). These keys are used for transactions worldwide.

The key is made up of 3 alphabets. The first two alphabets of the key denote the country to which the currency belongs whereas the third alphabet of the key is the first alphabet of the currency. Hence, United States dollar is referred to as the USD, Indian Rupee is referred to as INR, Great Britain Pound is referred to as GBP and the Japanese Yen is abbreviated as JPY.

The exceptions to this rule would be currencies like Euro which is abbreviated as EUR and most importantly the Swiss Franc which is abbreviated as CHF.

Direct Quotation

Under this method, the quote is expressed in terms of domestic currency. This means that the rate expresses how one unit of domestic currency relates to the foreign currency. Therefore, if unit of the domestic currency were to be exchanged, how many units of the foreign currency would it beget? This method is also alternatively referred to as the price quotation method.

Therefore, if the value of the domestic currency increases, a smaller amount of it would have to be exchanged. Conversely a decline in value would create a situation where a large amount of the domestic currency would have to be exchanged. Hence, it can be said that the quotation rate has an inverse relationship with the value of the domestic currency.

The value of the domestic currency is assumed to be 1 in case of a direct quotation. The price being quoted explains the number of units of foreign currency that can be exchanged for a single unit of domestic currency.

Example: An example of direct quotation would be

USD/JPY: 113.15/18

This quote suggests that roughly 113.15 units of Japanese Yen can be exchanged for 1 unit of United States Dollar. The two rates provided are bid and ask rates i.e. the different rates at which the market maker is willing to buy and sell the currency.

Usage: The direct quote method is one of the most widely used quotation methods across the world. This is the norm for quoting Forex prices and is assumed de facto until another method has been explicitly mentioned.

Indirect Quotation

This method is the opposite of the direct quotation method. Under this method, the quote is expressed in terms of foreign currency. Therefore this rate assumes one unit of foreign currency. It then expresses how many units of domestic currency are required to obtain a single unit of a foreign currency. Sometimes this quote is also expressed in terms of 100 units of foreign currency. This method is often referred to as the quantity quotation method.

Since this method is quoted in terms of foreign currency, the quoted rate has a direct correlation with the domestic rate. If the quote goes up, so does the value of the domestic currency and vice versa.

Example: An example of indirect quotation would be:

EUR/USD: 1.275/79

In this case, the first currency i.e. EUR is the domestic currency. Therefore, the indirect quote refers to approximately 0.875 EUR being exchanged for 1 unit of USD. Once again the two rates provided are the bid ask rate i.e. the two different rates at which market makers are willing to buy and sell the currency.

Usage: The usage of indirect currency quotation is extremely rare. It is only in the Commonwealth countries like United Kingdom and Australia that the indirect quotation method is used as a result of convention.

Direct Quote and Indirect Quote

The direct quote and indirect quote can be expressed in relation to each other, as follows:

Direct Quote = 1 / Indirect Quote

Spread & Spread

In forex trading, the spread is the difference between the bid (sell) price and the ask (buy) price of a currency pair. There are always two prices given in a currency pair, the bid and the ask price. The bid price is the price at which you can sell the base currency, whereas the ask price is the price you would use to buy the base currency.

The base currency is shown on the left of the currency pair, and the variable, quote or counter currency, on the right. The pairing tells you how much of the variable currency equals one unit of the base currency. The buy price quoted will always be higher than the sell price quoted, with the underlying market price being somewhere in-between.

There are two types of spreads:

• Fixed
• Variable (also known as “floating”)

Fixed spreads are usually offered by brokers that operate as a market maker or “dealing desk” model while variable spreads are offered by brokers operating a “non-dealing desk” model.

Advantages

Fixed spreads have smaller capital requirements, so trading with fixed spreads offers a cheaper alternative for traders who don’t have a lot of money to start trading with.

Trading with fixed spreads also makes calculating transaction costs more predictable. Since spreads never change, you’re always sure of what you can expect to pay when you open a trade.

Disadvantages

Requotes can occur frequently when trading with fixed spreads since pricing is coming from just one source (your broker).

There will be times when the forex market is volatile and prices are rapidly changing. Since spreads are fixed, the broker won’t be able to widen the spread to adjust for current market conditions.

So if you try to enter a trade at a specific price, the broker will “block” the trade and ask you to accept a new price. You will be “re-quoted” with a new price.

The requote message will appear on your trading platform letting you know that price has moved and asks you whether or not you are willing to accept that price. It’s almost always a price that is worse than the one you ordered.

Slippage is another problem. When prices are moving fast, the broker is unable to consistently maintain a fixed spread and the price that you finally end up after entering a trade will be totally different than the intended entry price.

Slippage is similar to when you swipe right on Tinder and agree to meet up with that hot gal or guy for coffee and realize the actual person in front of you looks nothing like the photo.

A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.

Every currency area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible however some take heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional currency pegs are described as “fixed-rate regimes”; horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; and managed and independent floats are described as flexible regimes. All monetary regimes except for the permanently fixed regime experience the time inconsistency problem and exchange rate volatility, albeit to different degrees.

Flexible exchange rate

These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility.

A crawling peg attempts to combine flexibility and stability using a rule-based system for gradually altering the currency’s par value, typically at a predetermined rate or as a function of inflation differentials. A crawling peg is similar to a fixed peg; however, it can be adjusted based on clearly defined rules. A crawling peg is often used by (initially) high-inflation countries or developing nations who peg to low inflation countries in attempt to avoid currency appreciation. At the margin a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.

Exchange rate bands allow markets to set rates within a specified range; edges of the band are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the intervention requirement.

Managed float exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. They are often accompanied by a separate nominal anchor, such as an inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it does not place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency.

In a pure float, the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy.

Fixed exchange rate regime

A fixed exchange rate regime, sometimes called a pegged exchange rate regime, is one in which a monetary authority pegs its currency’s exchange rate to another currency, a basket of other currencies or to another measure of value (such as gold), and may allow the rate to fluctuate within a narrow range. To maintain the exchange rate within that range, a country’s monetary authority usually needs to intervenes in the foreign exchange market. A movement in the peg rate is called either revaluation or devaluation.

Currency board

Currency board is an exchange rate regime in which a country’s exchange rate maintain a fixed exchange rate with a foreign currency, based on an explicit legislative commitment. It is a type of fixed regime that has special legal and procedural rules designed to make the peg “Harder that is, more durable”. Examples include the Hong Kong dollar against the U.S dollar and Bulgarian lev against the Euro.

Dollarisation

Dollarisation, also currency substitution, means a country unilaterally adopts the currency of another country.

Most of the adopting countries are too small to afford the cost of running its own central bank or issuing its own currency. Most of these economies use the U.S dollar, but other popular choices include the euro, and the Australian and New Zealand dollars.

Currency union

A currency union, also known as monetary union, is an exchange regime where two or more countries use the same currency. Under a currency union, there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member states.

Examples of currency unions are the Eurozone, CFA and CFP franc zones. One of the first known examples is the Latin Monetary Union that existed between 1865 and 1927. The Scandinavian Monetary Union existed between 1873 and 1905.

History:

The Bretton Woods Conference, which established a gold standard for currencies, took place in July 1944. A total of 44 countries met, with attendees limited to the Allies in World War II. The Conference established the International Monetary Fund (IMF) and the World Bank, and it set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, with participating countries pegging their currency to the dollar. Adjustments of plus or minus one percent were permitted. The U.S. dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates.

The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon took the United States off the gold standard in 1971.

By late 1973, the system had collapsed, and participating currencies were allowed to float freely.

Failed Attempt to Intervene in a Currency

In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate. This can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions to increase the impact.

An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in 1992 when financier George Soros spearheaded an attack on the British pound. The currency had entered the European Exchange Rate Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion. Soros, on the other hand, made over $1 billion.

Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors’ funds into the country. Since attempts to control prices within tight bands have historically failed, many nations opt to free float their currency and then use economic tools to help nudge it one direction or the other if it moves too far for their comfort.

India was the one of the largest economies in the world, for about two and a half millennia starting around the end of 1st millennium BC and ending around the beginning of British rule in India.

Around 500 BC, the Mahajanapadas minted punch-marked silver coins. The period was marked by intensive trade activity and urban development. By 300 BC, the Maurya Empire had united most of the Indian subcontinent except Tamilakam, which was ruled by Three Crowned Kings, who were allies of Mauryas. The resulting political unity and military security allowed for a common economic system and enhanced trade and commerce, with increased agricultural productivity.

The Maurya Empire was followed by classical and early medieval kingdoms, including the Cholas, Pandyas, Cheras, Guptas, Western Gangas, Harsha, Palas, Rashtrakutas and Hoysalas. The Indian subcontinent had the largest economy of any region in the world for most of the interval between the 1st century and 18th century. Though it is to be noted that, up until 1000 AD,its GDP per capita was higher than subsistence level.

India experienced per-capita GDP growth in the high medieval era during the gupta empire and, during the Delhi Sultanate in the north and Vijayanagara Empire in the south, but was not as productive as Ming China until the 16th century. By the late 17th century, most of the Indian subcontinent had been reunited under the Mughal Empire, which became the largest economy and manufacturing power in the world, producing about a quarter of global GDP, before fragmenting and being conquered over the next century. Bengal Subah, the empire’s wealthiest province, that solely accounted for 40% of Dutch imports outside the west, had an advanced, productive agriculture, textile manufacturing and shipbuilding, in a period of proto-industrialization.

By the 18th century, the Mysoreans had embarked on an ambitious economic development program that established the Kingdom of Mysore as a major economic power. Sivramkrishna analyzing agricultural surveys conducted in Mysore by Francis Buchanan in 1800-1801, arrived at estimates, using “subsistence basket”, that aggregated millet income could be almost five times subsistence level. The Maratha Empire also managed an effective administration and tax collection policy throughout the core areas under its control and extracted chauth from vassal states.

The Indus Valley Civilisation, the first known permanent and predominantly urban settlement, flourished between 3500 BCE and 1800 BCE. It featured an advanced and thriving economic system. Its citizens practised agriculture, domesticated animals, made sharp tools and weapons from copper, bronze and tin, and traded with other cities. Evidence of well-laid streets, drainage systems and water supply in the valley’s major cities, Dholavira, Harappa, Lothal, Mohenjo-daro and Rakhigarhi, reveals their knowledge of urban planning.

Along with the family- and individually-owned businesses, ancient India possessed other forms of engaging in collective activity, including the gana, pani, puga, vrata, sangha, nigama and Shreni. Nigama, pani and Shreni refer most often to economic organisations of merchants, craftspeople and artisans, and perhaps even para-military entities. In particular, the Shreni shared many similarities with modern corporations, which were used in India from around the 8th century BCE until around the 10th century CE. The use of such entities in ancient India was widespread, including in virtually every kind of business, political and municipal activity.

The Shreni was a separate legal entity that had the ability to hold property separately from its owners, construct its own rules for governing the behaviour of its members and for it to contract, sue and be sued in its own name. Ancient sources such as Laws of Manu VIII and Chanakya’s Arthashastra provided rules for lawsuits between two or more Shreni and some sources make reference to a government official (Bhandagarika) who worked as an arbitrator for disputes amongst Shreni from at least the 6th century BCE onwards. Between 18 and 150 Shreni at various times in ancient India covered both trading and craft activities. This level of specialisation is indicative of a developed economy in which the Shreni played a critical role. Some Shreni had over 1,000 members.

The Shreni had a considerable degree of centralised management. The headman of the Shreni represented the interests of the Shreni in the king’s court and in many business matters. The headman could bind the Shreni in contracts, set work conditions, often received higher compensation and was the administrative authority. The headman was often selected via an election by the members of the Shreni, and could also be removed from power by the general assembly. The headman often ran the enterprise with two to five executive officers, also elected by the assembly.

India experienced deindustrialisation and cessation of various craft industries under British rule, which along with fast economic and population growth in the Western world, resulted in India’s share of the world economy declining from 24.4% in 1700 to 4.2% in 1950, and its share of global industrial output declining from 25% in 1750 to 2% in 1900. Due to its ancient history as a trading zone and later its colonial status, colonial India remained economically integrated with the world, with high levels of trade, investment and migration.

The Republic of India, founded in 1947, adopted central planning for most of its independent history, with extensive public ownership, regulation, red tape and trade barriers. After the 1991 economic crisis, the central government began policy of economic liberalisation. While this has made it one of the world’s fastest growing large economies.

Economy in the Indian Subcontinent performed just as it did in ancient times, though now it would face the stress of extensive regional tensions. Like earlier, the economy of Indian Subcontinent in medieval era was also performing in disparate units, limits of which were determined by multiple political entities which existed during this period. India during this era had multiple and divergent political units in form of Mughal Empire, Maratha Empire, Vijayanagara Empire, Ahom kingdom and several others which were all prosperous in the early 18th century. Parthasarathi estimated that 28,000 tonnes of bullion (mainly from the New World) flowed into the Indian subcontinent between 1600 and 1800, equating to 30% of the world’s production in the period.

An estimate of the annual income of Emperor Akbar’s treasury, in 1600, is $90 million (in contrast to the tax take of Great Britain two hundred years later, in 1800, totaled $90 million). The South Asia region, in 1600, was estimated to be the largest in the world followed by China.

During the time of Akbar, the Mughal Empire was at its peak as it controlled vast region of North India and had entered into alliances with Deccan States. It enforced a uniform customs and tax-administration system. In 1700, the exchequer of the Emperor Aurangzeb reported an annual revenue of more than £100 million, or $450 million, more than ten times that of his contemporary Louis XIV of France, while controlling just 7 times the population.

By 1700, the Indian Subcontinent had become the world’s largest economy, ahead of Qing China and Western Europe, containing approximately 24.2% of the World’s population, and producing about a quarter of world output. India produced about 25% of global industrial output into the early 18th century. India’s GDP growth increased under the Mughal Empire, exceeding growth in the prior 1,500 years. The Mughals were responsible for building an extensive road system, creating a uniform currency, and the unification of the country. The Mughals adopted and standardized the rupee currency introduced by Sur Emperor Sher Shah Suri. The Mughals minted tens of millions of coins, with purity of at least 96%, without debasement until the 1720s. The empire met global demand for Indian agricultural and industrial products.

Manufacturing

Until the 18th century, Mughal India was the most important manufacturing center for international trade. Key industries included textiles, shipbuilding and steel. Processed products included cotton textiles, yarns, thread, silk, jute products, metalware, and foods such as sugar, oils and butter. This growth of manufacturing has been referred to as a form of proto-industrialization, similar to 18th-century Western Europe prior to the Industrial Revolution.

Early modern Europe imported products from Mughal India, particularly cotton textiles, spices, peppers, indigo, silks and saltpeter (for use in munitions). European fashion, for example, became increasingly dependent on Indian textiles and silks. From the late 17th century to the early 18th century, Mughal India accounted for 95% of British imports from Asia, and the Bengal Subah province alone accounted for 40% of Dutch imports from Asia.[8] In contrast, demand for European goods in Mughal India was light. Exports were limited to some woolens, ingots, glassware, mechanical clocks, weapons, particularly blades for Firangi swords, and a few luxury items. The trade imbalance caused Europeans to export large quantities of gold and silver to Mughal India to pay for South Asian imports. Indian goods, especially those from Bengal, were also exported in large quantities to other Asian markets, such as Indonesia and Japan.

The largest manufacturing industry was cotton textile manufacturing, which included the production of piece goods, calicos and muslins, available unbleached in a variety of colours. The cotton textile industry was responsible for a large part of the empire’s international trade. The most important center of cotton production was the Bengal Subah province, particularly around Dhaka. Bengal alone accounted for more than 50% of textiles and around 80% of silks imported by the Dutch. Bengali silk and cotton textiles were exported in large quantities to Europe, Indonesia Japan, and Africa, where they formed a significant element in the exchange of goods for slaves, and treasure. In Britain protectionist policies, such as 1685-1774 Calico Acts, imposed tariffs on imported Indian textiles.

Mughal India had a large shipbuilding industry, particularly in the Bengal Subah province. Economic historian Indrajit Ray estimates shipbuilding output of Bengal during the sixteenth and seventeenth centuries at 223,250 tons annually, compared with 23,061 tons produced in nineteen colonies in North America from 1769 to 1771.

A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate. As of 2010, the average daily turnover of global FX spot transactions reached nearly US$1.5 trillion, counting 37.4% of all foreign exchange transactions. FX spot transactions increased by 38% to US$2.0 trillion from April 2010 to April 2013.

The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.

Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading.

Execution methods

Common methods of executing a spot foreign exchange transaction include the following:

• Direct: Executed between two parties directly and not intermediated by a third party. For example, a transaction executed via direct telephone communication or direct electronic dealing systems such as Reuters Conversational Dealing
• Electronic broking systems: Executed via automated order matching system for foreign exchange dealers. Examples of such systems are EBS and Reuters Matching 2000/2
• Electronic trading systems: Executed via a single-bank proprietary platform or a multibank dealing system. These systems are generally geared towards customers. Examples of multibank systems include Fortex Technologies, Inc., 360TGTX, FXSpotStream LLC, Integral, FXall, HotSpotFX, Currenex, LMAX Exchange, FX Connect, Prime Trade, Globalink, Seamless FX, and eSpeed
• Voice broker: Executed via telephone with a foreign exchange voice broker.

The forex rate is the rate at which a currency is exchanged. For example, if the Indian rupee trades at Rs 74.46 to one dollar, the forex rate for the US dollar for the Indian rupee is 74.46. This rate can change depending on many factors. Therefore, forex rates are closely watched by currency traders and governments, who take steps to keep the rate advantageous to the country’s economic health. These exchange rates can have a tangible impact on investor portfolios on a granular level in terms of genuine returns.

Factors affecting

Speculation

If a country’s currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.

Inflation Rates

Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another’s will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates

Political Stability & Performance

A country’s political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

Government Debt

Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

Interest Rates

Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country’s currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates.

Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

Terms of Trade

Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country’s terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country’s currency and an increase in its currency’s value. This results in an appreciation of exchange rate.

Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

Globalization of the World Economy

Economic globalization is one of the three main dimensions of globalization commonly found in academic literature, with the two others being political globalization and cultural globalization, as well as the general term of globalization. Economic globalization refers to the widespread international movement of goods, capital, services, technology and information. It is the increasing economic integration and interdependence of national, regional, and local economies across the world through an intensification of cross-border movement of goods, services, technologies and capital. Economic globalization primarily comprises the globalization of production, finance, markets, technology, organizational regimes, institutions, corporations, and people.

While economic globalization has been expanding since the emergence of trans-national trade, it has grown at an increased rate due to improvements in the efficiency of long-distance transportation, advances in telecommunication, the importance of information rather than physical capital in the modern economy, and by developments in science and technology. The rate of globalization has also increased under the framework of the General Agreement on Tariffs and Trade and the World Trade Organization, in which countries gradually cut down trade barriers and opened up their current accounts and capital accounts. This recent boom has been largely supported by developed economies integrating with developing countries through foreign direct investment, lowering costs of doing business, the reduction of trade barriers, and in many cases cross-border migration.

Global actors

International governmental organizations

An intergovernmental organization or international governmental organization (IGO) refers to an entity created by treaty, involving two or more nations, to work in good faith, on issues of common interest. IGO’s strive for peace, security and deal with economic and social questions. Examples include: The United Nations, The World Bank and on a regional level The North Atlantic Treaty Organization among others.

International non-governmental organizations (NGOs)

International non-governmental organizations include charities, non-profit advocacy groups, business associations, and cultural associations. International charitable activities increased after World War II and on the whole NGOs provide more economic aid to developing countries than developed country governments.

Businesses

Since the 1970s, multinational businesses have increasingly relied on outsourcing and subcontracting across vast geographical spaces, as supply chains are global and intermediate products are produced. Firms also engage in inter-firm alliances and rely on foreign research and development. This in contrast to past periods where firms kept production internalized or within a localized geography. Innovations in communications and transportation technology, as well as greater economic openness and less government intervention have made a shift away from internalization more feasible. Additionally, businesses going global learn the tools to effectively interact in a culturally agile way with people of many diverse cultural backgrounds.

Migrants

International migrants transfer significant amounts of money through remittances to lower-income relatives. Communities of migrants in the destination country often provide new arrivals with information and ideas about how to earn money. In some cases, this has resulted in disproportionately high representation of some ethnic groups in certain industries, especially if economy success encourages more people to move from the source country. Movement of people also spreads technology and aspects of business culture, and moves accumulated financial assets.

Goals of International Finance

Profit Maximization

International financial management aims to maximize the profits of the organization by making correct investment decisions. It promotes investments that are safe and will generate good returns. Also, the utilization of funds should be such that the activities of the company go on without interruption. This will result in an increase in turnover and thus, profits.

Wealth Maximization of Shareholders

Wealth maximization of shareholders is one of the most important goals of international financial management. It is a long-term goal that a company cannot achieve just in a few days or even months. A company can achieve this objective by an excellent overall performance consistently year on year. By this, we mean that the managers should manage the funds such that it is always adequate as per the requirement of the company. Separate budgets for separate functions within the organization need to be made and implemented. Working capital management should be effective, production and other allied activities should go on uninterrupted and employee welfare should also be a priority.

Maximization of Shareholder Value

International financial management aims to maximize shareholder value by ensuring the maximum possible dividend payout. This can happen by ensuring that the company performs well. The managers have to manage the company’s finances in the most effective and efficient manner so as to increase the net profits of the company.

Effective Inflation Risk Management

Another goal of international financial management is to effectively manage the inflation risk that may arise in different countries at different times. Inflation or the continuous rise in prices of inputs can cause a major financial strain on any company. The output price or the selling price may not increase immediately due to market constraints, resulting in lower profits or even losses.

Foreign Exchange Risk Management

As we all know foreign exchange risk is an essential and important part of international trade. Hence, managers have no choice but to manage foreign exchange rate risk timely and effectively. Exchange rates are volatile and unpredictable. They can result in gains as well as heavy losses in case they are not favorable for the company.

Proper Tax Planning

International financial management aims to promote tax planning in the best possible way. Different countries have different tax slabs, liabilities, and exemptions. Managers should be efficient enough to study in detail the taxation policies of all of the countries wherever they operate.

Effectively Use Expanded Sets of Opportunities

International financial management aims to make the best possible use of opportunities that arise from investing in different countries. Interest rates and the cost of capital can be very low in some countries. Or labor can be inexpensive in some other country. Some foreign markets may have the extra potential for a particular line of product. The managers should be dynamic and flexible in this fast-changing business environment.

Political Risk Management

Effective political risk management is one of the important goals of international financial management. The management should take into account cases of political unrest or instability in countries before they invest there. Political risk can arise in the domestic market too, and hence they should be cautious about it.

Optimum Rate of Interest

International financial management aims to achieve an optimum rate of interest on the funds that a company borrows. The managers should check and compare all the possible options of finance that a company has. They should choose the source that is reliable, safe, and with the least possible rate of interest. Lower interest or lower financing costs will boost the profits in turn.

The Emerging Challenges in International Finance

Banking Regulations

Unlike financial management in a single country, global financial management must deal with many other banking institutions that have problems of their own. Some multilateral development banks, such as the International Monetary Fund and World Bank, have been set up to regulate international economic affairs in emerging economies and typically give conditions to various countries and their banks. This can be a challenge when doing business in a country where these institutions have influence, since they advise banks in such countries to avoid testing waters in the riskier markets in its structural adjustment programs.

Culture

International finance has also challenge of culture of each country. India is veg. country. So, McDonnell and other non-veg. country should ban to produce the non-veg. in India.

Risk Management Challenges

Risk management is a major challenge of global financial management. For example, if you’re buying supplies or selling products overseas, your business may face the risk of high prices caused by inflation in emerging economies. Although vulnerability to financial crises in many emerging markets has been reduced significantly due to stronger balance sheets, better fiscal policies and more flexible exchange rate regimes, other factors still pose risks. Potential threats to energy supplies, imbalances in the world economy and other fiscal sustainability issues call for prudent financial planning and management of those risks that most affect your particular business.

Challenge of Protection of Natural Resources

When there is more international finance, its growth will affect the natural resources. For example, after increasing the number of banks in India, ACs are used at large scale due to this, there is increasing the temperature of India. Who is responsible for this? Surely international banks are responsible who are opening the branches in India. Every increase in the number of bank branch means, 4 new installations of ACs which increases open environmental temperature. So, this is big challenge of international finance. It has to reduce by planting the tree and not to use ACs in office.

Diverse Economic Environment

Operating in a globalized environment means being answerable to different countries with different political environments and cultural norms, as well as trade procedures and tax conditions to comply with. In addition, the credit conditions may be totally different from what they are domestically. Anticipate day-to-day financial management challenges when operating internationally and devise ways to maintain healthy equilibrium within this economic framework to ensure your business’s continued growth and survival.

Dynamic Foreign Exchange Rates

In a globalized economy, the cash that goes in and out of the various countries is subject to fluctuations in exchange rates. This creates uncertainty for financial managers when it comes to the value of the home currency in relation to foreign currencies. Continuous fluctuations in the foreign exchange market could mean slow business for global organizations. If you need part of your financing for projects in emerging economies where you conduct your business, fluctuating exchange rates can subject you to higher interest rates. You have to monitor the foreign exchange market closely for suitable rates that benefit your organization.

The balance of payments (also known as balance of international payments and abbreviated BOP or BoP) of a country is the difference between all money flowing into the country in a particular period of time (e.g., a quarter or a year) and the outflow of money to the rest of the world. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services.

The balance of payments consists of two components: the current account and the capital account. The current account reflects a country’s net income, while the capital account reflects the net change in ownership of national assets.

Important

The BoP statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood BoP and its components, let’s look at why it is important.

To begin with, the BoP statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s BoP determines its potential as a constructive economic partner. In addition, a country’s BoP indicates its position in international economic growth.

By studying its BoP statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.

The International Monetary Fund (IMF) use a particular set of definitions for the BoP accounts, which is also used by the Organisation for Economic Co-operation and Development (OECD), and the United Nations System of National Accounts (SNA).

The main difference in the IMF’s terminology is that it uses the term “financial account” to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, previously formed a small part of the overall current account. The IMF separates these transactions out to form an additional top-level division of the BoP accounts. Expressed with the IMF definition, the BoP identity can be written:

Current account + Financial account + Capital account + Balancing item =0

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:

• The goods and services account (the overall trade balance)
• The primary income account (factor income such as from loans and investments)
• The secondary income account (transfer payments)

Imbalances

While the BoP has to balance overall, surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account. Countries with deficits in their current accounts will build up increasing debt or see increased foreign ownership of their assets. The types of deficits that typically raise concern are

• A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.)
• An overall current account deficit.
• A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.)

Accounting Principles in Balance of Payment

The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting in one respect.

In business accounting, debits (-) are shown on the left side and credits (+) on the right side of the balance sheet. But in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.

The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official reserve assets account.

Three main elements of actual process of measuring international economic activity are:

• Identifying what is/is not an international economic transaction,
• Understanding how the flow of goods, services, assets, money create debits and credits, and
• Understanding the bookkeeping procedures for BoP accounting.

The following some simple rules of thumb help to the reader to understand the application of accounting principles for balance of payments accounting.

• Any individual or corporate transaction that leads to increase in demand for foreign currency (exchange) is to be recorded as debit, because if is cash outflow, while a transaction which results in increase the supply of foreign currency (exchange) is to be recorded as a credit entry.
• All transactions, which result an immediate or prospective payment from the rest of the world (RoW) to the country should be recorded as credit entry. On the other hand, the transactions, which result in an actual or prospective payment from the country to the RoW should be recorded as debits.

Current Account:

The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable donations, etc. received from foreign individuals and governments to foreigners.

In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item and are calculated c.i.f. (costs, insurance and freight) and included.

The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.

It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade.

The invisible items along with the visible items determine the actual current account position. If exports of goods and services exceed imports of goods and services, the balance of payments is said to be favourable. In the opposite case, it is unfavourable.

In the current account, the exports of goods and services arid the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.

Capital Account:

The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lending’s and borrowings and private and official investments. In other words, the capital account shows international flows of loans and investments, and represents a change in the country’s foreign assets and liabilities.

Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks and international loans. On the other hand, short- term international capital transactions are for a period ranging between three months and less than one year.

There are two types of transactions in the capital account; private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.

In the capital account, borrowings from foreign countries and direct investment by foreign countries represent capital inflows. They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries represent capital outflows.

They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of current account and capital account is known as the basic balance.

The Official Settlements Account:

The official settlements account or official reserve assets account is, in fact, a part of the capital account. But the U.K. and U.S. balance of payments accounts show it as a separate account. “The official settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year.

The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets.

Errors and Omissions:

Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.