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International Financial Management Cyryx College

Aminath Rifa MA-14

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Question One

Write a note on Capital Market and explain its impact on international finance

Ans: A Market in which individual and institution trade financial securities,

organization, institution in the public and private sectors also often sell securities on

the capital market in order to raise funds. Thus, this type of market is composed of

both the primary and secondary markets.

Capital Market is one of the significant aspect of every financial market. Hence it is

necessary to study its correct meaning. Broadly speaking the capital market is a

market for financial assets which have a long or indefinite maturity. Unlike money

market instruments the capital market instrument become mature for the period

above one year. It is an institution arrangement to borrow and lend money for a

longer period of time. It consists of financial institution like, IDB, ICICI, UTI, LIC etc.

these institution play the role lenders in the capital market. Business units and

corporate are the borrowers in the capital market. Capital market involves various

instruments which can be used for financial transactions. Capital market provides

long term debts and equity finance for the government and the corporate sectors.

Capital market can be classified into primary and secondary market. The primary

market is a market for new shares, where as in the secondary market existing

securities are traded. Capital market institutions provide rupee loans, foreign

exchange loans, consultancy service and underwriting.

The money market capital market is also very important. It plays a

significant role in the nation economy. A developed, dynamic and

vibrant capital market can immensely contribute for speedy

economic growth and development let us get acquainted with the

important faction and role of the capital market.


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1. Mobilization of savings: capital market is an important sourcefor mobilizing idle savings from the economy. It mobilizes

funds from people for further investments in the channels of

an economy. In that sense it activate the ideal monetary andputs them in proper investments

2. Capital Formation: capital market in capital formation is netaddition to the additional to the existing stock of capital in the

economy. Through mobilization of deal resources it generates

savings; the mobilized savings are made available to various

segment such as agriculture, industry etc. this help in

increasing capital formation.

3. Provision of Investment Avenue: capital market raisesresource for longer period of time. Thus it provides an

investment avenue for people who wish to invest resource for

a long period of time. It provides suitable interest rate returns

also to investors. Instrument such as bonds, equities, units of

mutual funds, insurance policies, etc. definitely provides

diverse investment for the public.

4. Speed Up Economic Growth and Development: capital marketenhances production and productivity in the national

economy. As it makes funds available for long period of time,

the financial requirement of business houses are met the

capital market. It helps in research and development. This

helps in, increasing production and productivity in economyby generation of employment and development of

infrastructure


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Proper regulation of Funds: capital market not only helps in fund

mobilization, but help in proper allocation of these resources. It can

have regulation over the resources so that it can direct funds in a

qualitative manner.

Service provision: As an Important financial set up capital provides

various types of services. It includes long term and medium term

loans to industry, underwriting services, export finance, etc. these

service help the manufacturing sectors in a large spectrum.

Continuous Availability of Funds: capital market place where the

investment avenue is consciously available for long term

investment. This is a liquid market as it makes funds available on

continues basis. Both buyers and sellers can easily buy and sell

securities as they are continuously available. Basically capital

market transaction is related to the stocks exchanges. Thus

marketability in the capital market becomes easy.

International economics is concerned with the effects upon economic activity of

international differences in productive resources and consumer preferences and the

institutions that affect them. It seeks to explain the patterns and consequences of

transactions and interactions between the inhabitants of different countries,

including trade, investment and migration.

International trade studies goods and services flows across internationalboundaries from supply and demand factors, economic integration,

international factors movement and policy variables such as tariff rates and

trade quotas.


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International Finance studies the flow of capital across internationalfinancial market, and the effects of this movement on exchange rates.

International monetary economics and macroeconomics studies moneyand macro flow across countries.

Question two

What do you mean by foreign exchange? Explain the factors influencing for

exchange rate determination.

Ans: Rate at which one currency may be converted into another.

The exchange rate is used when simply converting one currency to another (such as

for the purposes of travel to another country), or for engaging

in speculation or trading in the foreign exchange market. There are a wide variety

offactors which influence the exchange rate, such as interest rates, inflation, and the

state of politics and the economy in each country. Also called rate of

exchange or foreign exchange rate or currency exchange rate.

1. The risk of an investment's value changing due to changes in currency exchange

rates.

2. The risk that an investor will have to close out a long or short position in a foreign

currency at a loss due to an adverse movement in exchange rates. Also known as

"currency risk" or "exchange-rate risk".

This risk usually affects businesses that export and or import, but it can also affect

investors making international investments. For example, if money must be

converted to another currency to make a certain investment, then any changes in

the currency exchange rate will cause that investment's value to either decrease or

increase when the investment is sold and converted back into the original currency.
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In most financial papers, currencies are expressed in terms of U.S. dollars, while the

dollar is commonly compared to the Japanese yen, the British pound and the euro.

As of the beginning of 2006, the exchange rate of one U.S. dollar for one euro was

about 0.84, which means that one dollar can be exchanged for 0.84 Euros.

Exchange rate determination

Having endeavored to forecast exchange rates for more than half a century, I have understandably

developed significant humility about my ability in this area.

Figure 1: Exchange Rate Determination


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I. Short-Run Forecasting Tools

Short-term changes in exchange rates are the most difficult to predict and are often

determined based on bandwagon effects, overreaction to news, speculation, and

technical analysis.

Trend-Following Behavior is the tendency for the market to follow a trend. In

other words an increase in the exchange rate is more likely to be followed by

another increase.

Structural Changes three structural changes can affect long-term trends in

exchange rates: 1) an increase in investment spending, 2) fiscal stimulus, 3) a

decline in private savings. It is the net impact of structural changes that determines

if the countrys currency will rise or fall.

1) Investment spending domestic investment in a country will help tostrengthen a countrys currency. For example, the United States experienced

an investment boom in the 1990s.

2) Fiscal stimulus government investment in a country can also helpstrengthen a countrys currency. For example, Turkey has enjoyed fiscal

stimulus and government spending in recent years.

3) Private savings the citizens of a countrys tendency to save will helpstrengthen a countrys currency. For example, Japan has had a large and

persistent current-account surplus that has led to a stronger currency.

Terms of Trade is the idea that the price of a good that trades in international

markets will have an impact of the associated countrys currency. This can work in

terms of both imports and exports. For example, in countries where commodities

make up a large portion of GDP, like Australia, Canada, and New Zealand, there is a


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strong positive relationship between the price of commodities and the strength of

the associated countrys currency. On the other hand, in Europe, the higher prices

for oil, have led to a weaker currency.

Medium-Run Forecasting Tools

International Parity Conditions the key international parity conditions are 1)

purchasing power parity, 2) covered interest-rate parity, 3) uncovered interest-rate

parity, 4) the Fisher effect, and 5) forward exchange rates.

Figure 2: International Parity Conditions


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1) Purchasing power parity states that since the prices should be the sameacross countries, the exchange rate between two countries should be the ratioof the prices in each country.

: ( )

, ( )A

B

Price of a product in Country APPP Spot rate SPrice of a product in Country B

Pwhere the spot rate S is

P

Example: If a hamburger is $2.54 in the United States and 3.60 real (R$) in

Brazil, then the PPP spot rate should be:

3.60 $ 1.42 $,

$2.54 1$

R RS which reduces to

If the actual exchange rate is2.19 $

1$

RS , then according to the PPP theory the

Brazilian real is undervalued by 35%.

1.42 $ 2.19 $

1 % ( )1$ 1$

R R

PPP implied rate Actual exchange rate over or under valued

FYI McDonalds' Big Mac is produced locally in almost 120 countries!1

Long term forecasting tools

Purchasing Power Parity

The starting point of exchange rate theory is purchasing power parity (PPP), which

is also called the inflation theory of exchange rates. PPP can be traced back to

sixteen-century Spain and early seventeen century England, but Swedish economist

Cassel (1918) was the first to name the theory PPP. Cassel once argued that without


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it, there would be no meaningful way to discuss over-or-under valuation of a

currency.

Under this model, let i P and * i P denote, respectively, the price level of good i in the

home currency and foreign currency. Letter S denotes the nominal exchange rate

that expresses the price in foreign currency in terms of the domestic currency.

According to the law of one price, the price of one good should be equal at home

and abroad, say, * i i SP P = . If the prices of each good are equalized between the two

countries and if the goods baskets and their weights in the two countries are the

same, then, then absolute PPP holds: * SP P = (3.1)

Absolute PPP theory was first presented to deal with the price relationship of goods

with the value of different currencies. The theory requires very strong

preconditions. Generally, Absolute PPP holds in an integrated, competitive product

market with the implicit assumption of a risk-neutral world, in which the goods can

be traded freely without transportation costs, tariffs, export quotas, and so on.

However, it is unrealistic in a real society to assume that no costs are needed to

transport goods from one place to another. In the real world, each economy

produces and consumes tens of thousands of commodities and services, many of

which have different prices from country to country because of transport costs,

tariffs, and other trade barriers.

Structural Change

An economic condition that occurs when an industry or market changes how it

functions or operates. A structural change will shift the parameters of an entity,which can be represented by significant changes in time series data.


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3. Write a note on commodity market and currency market

Commodity market

The commodity market is a market, where commodities are bought and sold. Thecommodity market differs from a regular market by a specific organizational form of

trading according to established rules. The main function of the commodity

exchange is assurance of regular communication between buyers and sellers, when

transactions are carried out with available batches of goods. The exchange, while

developing, started establishing trade customs, commodity standards, standard

contracts, performing price quotations, resolving dispute, etc.

Items of international trade now are about 70 types of goods, having 30% of the

international commodity turnover. They include metals (precious, base, rare), 'soft

products' (coffee, cocoa, sugar, pepper), grain, seeds, livestock, energy sources (gas,

raw materials, oil products).

Commodities are not present at the exchange, but sold and bought without

presentation and examination. Transactions are concluded on the basis of standardexchange contracts, strictly regulating quality and terms of delivery. At the exchange

they sell and buy not certain batches of goods, but stock contracts, specifying

amounts of goods of certain sort, type, class, as established by the exchange. The

seller at the exchange delivers to the buyer not commodities, but a document,

confirming the title to goods. Most of the international exchange turnover takes

place at the futures and options exchange, where they trade option and futures

contracts.

Trading volume at such exchange has increased by several hundred times due to the

fact, that almost all transactions are fictitious (only 1-2% of transactions end up

with delivery of goods, all the rest - with payment of price difference). Prices at such


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exchanges are more volatile in comparison with the stock exchange, and the major

risk is associated with the direction of price movement. Quotation fluctuations are

mainly caused by speculative actions; that is why it is very difficult to maker

forecasts for such markets. Therefore, beginners are not recommended to trade atcommodity exchanges.

Currency Market

Process of internationalization of financial markets is expanding. Stock,

commodity and currency markets become more and more popular and friendly alsoincreasing their liquidity. Not only accessibility of financial instruments for foreign

capital became a serious achievement in development of modern financial markets,

but also their accessibility for investors with a small capital. Anyone now can

become a participant of trading at stock, commmodity or currency markets, even

with a small deposit - starting from several hundreds dollars! Development of the

Internet technologies and popularity of electronic stock exchanges have moved

stock trading to a new level - an integrated international electronic space, giving

anyone a chance to become its participant.

Now the investor is offered to open only one account, from which transactions can

be carried out with financial instruments on absolutely different markets - Forex

(currency market), securities (Stocks / Shares) or Commodity market

Currency market (Forex or foreign exchange) is a global market, where currency of

one country is exchanged for currency of another country. Currency market doesn't

have any fixed trading place and by the nature of trade it can be defined as an over

the counter market (OTC markets). Forex is a huge network of currency dealers,


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connected between each other with telecommunication facilities, functioning as a

single mechanism 24 hours a day.

The main currencies with the biggest share in currency market are US dollar (USD),

euro (EUR), Japanese yen (JPY), Swiss franc (CHF) and English pound sterling (GBP).

Each currency pair has its own requirements.

Currency market operates 24 hours a day, 5 days a week (except for national

holidays), since in each time zone there are institutions, which buy and sell currency

during the working day. The market opens at 00:00 (GMT) on Monday and closes at

0:00 on Saturday. Such continuous operation makes the currency market especially

attractive for investments and speculative trading.

Another important feature of Currency market is the biggest leverage:

Leverage ratio 1:100 at the currency market allows transactions with sums hundred

times higher than the deposit. Daily rate fluctuations (Volatility) at the

currency exchanges are 150-250 points. This means that every day there is a

possibility to earn 1500-2500 USD from each bought or sold contract. At thecurrency market, of course, sometimes there are stronger (intervention of central

banks, important news) and less strong (anticipation of significant events)

fluctuations, but with efficient management this market gives the maximum

profitability in combination with low margin requirements. The recent popular

service is trading of 1/10 lots, when profits and losses are reduced by 10 times

correspondingly, which provides an opportunity to study in the real market

environment, not risking with a lot of money.


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Question four

What do you mean by MNC? Explain the role of MNCs in international finance.

Ans: An enterprise operating in several countries but managed from one (home)

country. Generally, any company or group that derives a quarter of

its revenue from operations outside of its home country is considered a

multinational corporation.

There are four categories of multinational corporations:

(1) a multinational, decentralized corporation with strong home country presence,

(2) a global, centralized corporation that acquires cost advantage through

centralized production wherever cheaper resources are available,

(3) an international company thatbuilds on the parent corporation's technology or

R&D, or

(4) a transnational enterprise that combines the previous three approaches.

According to UN data, some 35,000 companies have direct investmentin foreign

countries, and the largest 100 of them control about 40 percentof world trade.

MNC means Multi National Corporation. MNC company is the company where thecompany produces the goods in any where of the world and sells the goods inanywhere of the world is called MNC

Globalization has made a tremendous impact throughout the world in past few years.

There are various reasons involved in this progression.

Globalization has accelerated in recent years, a development that has significant

implications for the regulation and governance of international business, trade and

investment. International business implies no fundamental shift in the underlying

principles of trading or business functions but simply more cross-border

transactions. In simpler terms it includes all commercial transactions private and

governmental between two or more countries. Private companies undertake such
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transaction for profit; governments may or may not do the same in their

transactions.

Global exchange

The world has seen a tremendous increase in the global transactions and foreign

trade in recent years. The main reason behind this is that now more and more

countries are getting engaged in trading with each other in order to increase their

profit or sales or protecting them from being eroded by competition. The main

objectives which are influencing the companies to engage in international business

are expansion of sales,acquiring resources, minimizing competitive risk and

diversification of sources of sales and supplies (Johnson & Turner, 2003). Besides

these there are other few factors like economic factors, cultural factors,

technological factors, and social factors which have influence to a greater extent.

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