The objective of corporate financial management is to

maximise shareholder wealth. With the integration of

world markets, the amount of foreign exchange
transactions and the consequent risk for the international
business community has increased. Exchange rates are
determined by the forces of demand and supply. Though
forecasting is no simple task, the law of demand and
supply provide a base to forecast exchange rates and prove
how interest rates and inflation have a direct impact on the
exchange rates. The interest rate parity theorem,
purchasing power parity theorem and the international
Fischer effect theorem help us understand and predict
short-term and long-term exchange rate fluctuations. The
integration of world capital markets have opened up new
avenues for funding and have developed innovative
methods for pricing of financial instruments. Various
financial and technological innovations have helped
managers build suitable risk management systems. The use
of derivatives in risk management has substantially
increased in many parts of the world. The geographical
diversification attained by MNCs help hedge themselves
against adverse economic conditions in any one part of the
world.
The advent and growth of Eurocurrency and international bond markets in funding have
enabled corporations to borrow and invest across national borders without the hassles of
currency conversion. Innovation in technology has made international cash management
easier.
Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.
 4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.

International Monetary System: Meaning

International Monetary System (IMS) is a well-designed system that regulates the valuations
and exchange of money across countries. It is a well-governed system looking after the
cross-border payments, exchange rates, and mobility of capital. This system has rules and
regulations which help in computing the exchange rate and terms of international payments.
In other words, International Monetary System mobilizes the capital from one nation to
another by felicitating trade. There are many participants like MNCs (Multinational
Corporations), Investors, Financial Institutions, etc in the International Monetary System

The main purpose of the International Monetary System today is, to enhance high growth in
the world with stable price levels. Earlier the scope was only up to exchange rates, now the
system has a broader scope by taking financial stability into consideration. International
Monetary System has established International Monetary Fund (IMF) and the World Bank in
the year 1944.
Advantages of Current International Monetary System
Following are few advantages of the International Monetary Market

• IMS enhances financial stability and maintains the price level on a global scale.
It also boosts global growth.
• International Monetary System mobilizes money across countries and
determines the exchange rate.
• This system encourages the governments of respective countries to manage their
Balance of Payment by reducing the trade deficit.
• IMS is a well-regulated system that makes the whole process of international
trading smooth.
• This system relocates the capital from one country to another by enhancing
cross-border investments.
• International Financial Architecture provides liquidity to the countries of the
world.
• This system tries and avoids any short or long-run disruptions in the world
economy.
What is the Fisher Effect?

The Fisher Effect refers to the relationship between nominal interest rates, real interest rates,
and inflation expectations. The relationship was first described by American economist
Irving Fisher in 1930.
The relationship is described by the following equation:

(1+i) = (1+r) * (1+π)

Where:

• i = Nominal Interest Rate

• r = Real Interest Rate
• π = Expected Inflation Rate

The Fisher Effect is an important relationship in macroeconomics. It describes the causal

relationship between the nominal interest rate and inflation. It states that an increase in
nominal rates leads to a decrease in inflation. The key assumption is that the real interest rate
remains constant or changes by a small amount.

Applications

Monetary Policy

The central bank in an economy is often tasked with keeping inflation in a tight range. The
practice is to prevent the economy from overheating and inflation spiraling upwards in times
of expansion. It is also important to have a small amount of inflation to prevent a deflation
spiral, which pushes an economy into a depression in times of recession.

The main tool available to most central banks is their ability to set the nominal interest rate.
They achieve this through many mechanisms like open market operations, changing reserve
ratios, etc.

Given a fixed interest rate, we can see that an increase in the nominal interest rate will bring
down inflation expectations and prevent overheating. Similarly, a decrease in the nominal
interest rate can increase inflation expectations, and spur more investment, thereby avoiding
a deflation spiral.

The following figure illustrates how monetary policy acts through the Fisher Effect:
 Fig. 2:
Monetary Policy Mechanism using Fisher Effect
International Fisher Effect

• The International Fisher Effect (IFE) states that differences in nominal interest rates
between countries can be used to predict changes in exchange rates.
• According to the IFE, countries with higher nominal interest rates experience higher
rates of inflation, which will result in currency depreciation against other currencies.
• In practice, evidence for the IFE is mixed and in recent years direct estimation of
currency exchange movements from expected inflation is more common.
Calculating the International Fisher Effect
IFE is calculated as:

E=1+i2i1−i2 ≈ i1−i2where:

E=the percent change in the exchange ratei1=country A’s interest ratei2

=country B’s interest rate

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country
B's currency should appreciate roughly 5% compared to country A's currency. The rationale
for the IFE is that a country with a higher interest rate will also tend to have a
higher inflation rate. This increased amount of inflation should cause the currency in the
country with a higher interest rate to depreciate against a country with lower interest rates.

Application of the International Fisher Effect

Empirical research testing the IFE has shown mixed results, and it is likely that other factors
also influence movements in currency exchange rates. Historically, in times when interest
rates were adjusted by more significant magnitudes, the IFE held more validity. However, in
recent years inflation expectations and nominal interest rates around the world are generally
low, and the size of interest rate changes is correspondingly relatively small. Direct
indications of inflation rates, such as consumer price indexes (CPI), are more often used to
estimate expected changes in currency exchange rates.
Key difference: Risk is essentially the level of possibility that an action or activity will
lead to lead to a loss or to an undesired outcome. The risk may even pay off and not
lead to a loss, it may lead to a gain. Exposure is the company’s potential for damages.
In layman’s terms, risk is the probability, i.e. the chance that an event or situation will
come to pass, and mainly lead to a loss or an undesired outcome, whereas, exposure is
the extent to which the risk can have an effect.
Risk is essentially the level of possibility that an action or activity will lead to lead to a loss
or to an undesired outcome. The risk may even pay off and not lead to a loss, it may lead to a
gain.

Dictionary.com defines risk as:

• Exposure to the chance of injury or loss; a hazard or dangerous chance: It's not
worth the risk.
• The hazard or chance of loss.
• The degree of probability of such loss.
• The amount that the insurance company may lose.
• A person or thing with reference to the hazard involved in insuring him, her, or it.
• The type of loss, as life, fire, marine disaster, or earthquake, against which an
insurance policy is drawn.
There are many difference kinds of risk. Wikipedia lists six different ways that risk can be
defined:

• A probability or threat of damage, injury, liability, loss, or any other negative

occurrence that is caused by external or internal vulnerabilities, and that may be
avoided through preemptive action.
• Finance: The probability that an actual return on an investment will be lower than
the expected return.
• Food industry: The possibility that due to a certain hazard in food there will be an
negative effect to a certain magnitude.

Type # 1. Transaction Exposure:

Transaction exposure occurs when the company bills its customers in a foreign currency, say
British pounds, and the currency depreciates between the time the receivable is booked and
collected.

For example, an exporter sells £100,000 of merchandise to a British company when the
exchange rate is $1.80/£. The dollar value of this receivable when it is booked is $180,000. If
the pound depreciates to $1.60/£ by the time the receivable is collected, the dollar value of
the sale is only $160,000 and the exporter has lost $20,000 due to this exchange rate
transaction exposure.

Type # 2. Translation Exposure:

The risk that a company’s equities, assets, liabilities or income will change in value as a
result of exchange rate changes. This occurs when a firm denominates a portion of its
equities, assets, liabilities or income in a foreign currency. Also known as “accounting
exposure”.
Considering a company has borrowed dollars to finance the import of capital goods worth
USD 10,000 @ Rs. 43 per dollar. The entry was booked at this rate. The depreciation on the
asset would be provided accordingly assuming that the forex rate has not changed.

However, if at the time of finalisation of the accounts, the exchange rate has moved to say
Rs. 48, it would involve translation loss of Rs. 50,000. However, this loss cannot be written
off and has to be capitalized by increasing the book value of the fixed asset purchased. Thus,
the book value of the asset will become 480000 and consequently higher depreciation would
be provided reducing the net profit.

Type # 3. Economic Exposure to an Exchange Rate:

It is the risk that change in the rate affects the company’s competitive position in the market
and hence indirectly affects the company’s bottom line.

Accountants use various methods to insulate firms from these types of risks, such as
consolidation techniques for the firm’s financial statements and the use of the most effective
cost accounting evaluation procedures. In many cases, this exposure will be recorded in the
financial statements as an exchange rate gain (or loss).

How Do You Run a Measurement of Transaction Exposure?

The honest answer is you can't – at least not with any specificity. Exchange rates fluctuate
for all sorts of reasons, and none of them are within your control. The most you can do is
track historic exchange rates between the two currencies and use that as a baseline to
predict currency fluctuations in the future. The website XE.com has a list of current and
historical interest rates for just about every currency so you can track historical movements
versus the U.S. dollar.

The length of the transaction matters. If you have a five-year supply contract, for example,
then there's a much greater risk that the exchange rate will change – often multiple times
and perhaps dramatically – across the life of the contract than if you had a one-time deal.
For ongoing transactions, you may wish to get an automated currency feed so you can track
exchange rate movements in real time.

When reviewing currency exchange rates, watch out for significant shifts from month to
month or year to year. The exchange rate is one of the most significant determinants of a
country's economic health. Volatile exchange rates might indicate an unstable economy,
which would leave you with a large transaction exposure.

Transactions Exposure: To Manage or Not to Manage?

Once the degree of transactions exposure has been determined (by currency) with relative
certainty, the next step is to figure out: • Whether all transactions exposure should be hedged,
or • Whether transactions exposure should be hedged selectively, or • None of the
transactions exposure should be hedged at all.
Hedging in finance refers to protecting investments. A hedge is an investment status, which
aims at decreasing the possible losses suffered by an associated investment. Hedging is used
by those investors investing in market-linked instruments

Hedging is employed in the following areas:

• Securities Market: This area includes investments made in shares, equities,

indices, and so on. The risk involved in investing in the securities market is
known as equity or securities risk.
• Commodities Market: This area includes metals, energy products, farming
products, and so on. The risk entailed in investing in the commodities market is
referred to as the commodity risk.
• Interest Rate: This area includes borrowing and lending rates. The risk
associated with the interest rates is termed as the interest rate risk.
• Weather: This might seem interesting, but hedging is possible in this area as
well.
• Currencies: This area comprises foreign currencies and has various associated
risks such as volatility and currency risk.

Types of Hedging Strategies

Hedging strategies are broadly classified as follows:

1. Forward Contract: It is a contract between two parties for buying or selling

assets on a specified date, at a particular price. This covers contracts such as
forwarding exchange contracts for commodities and currencies.
2. Futures Contract: This is a standard contract between two parties for buying or
selling assets at an agreed price and quantity on a specified date. This covers
various contracts such as a currency futures contract.
3. Money Markets: These are the markets where short-term buying, selling,
lending, and borrowing happen with maturities of less than a year. This includes
various contracts such as covered calls on equities, money market operations for
interest, and currencies.

Advantages of Hedging

• Hedging limits the losses to a great extent.

• Hedging increases liquidity as it facilitates investors to invest in various asset
classes.
 • Hedging requires lower margin outlay and thereby offers a flexible price
mechanism.
the national FDI policy framework
POLICY FRAMEWORK TO PROMOTE FDI IN INDIA
2.  An investment made by a company or entity based in one country, into a
company or entity based in another country.  Foreign direct investments differ
substantially from indirect investments such as portfolio flows, wherein overseas
institutions invest in equities listed on a nation's stock exchange.  Entities making
direct investments typically have a significant degree of influence and control over the
company into which the investment is made.  Open economies with skilled
workforces and good growth prospects tend to attract larger amounts of foreign direct
investment than closed, highly regulated economies.
3.  The Government has put in place a policy framework on Foreign Direct
Investment. which is embodied in the Circular on Consolidated FDI Policy, issued
which is updated every six months, to capture and keep pace with the regulatory
changes. The Department of Industrial Policy and Promotion (DIPP), Ministry of
Commerce & Industry, Government of India makes policy pronouncements on FDI
through Press Notes/ Press Releases which are notified by the Reserve Bank of India
as amendments to the Foreign Exchange Management.  regulatory framework for
FDI consists of Acts, Regulations, Press Notes, Press Releases, Clarifications, etc. FDI
policy is reviewed on an ongoing basis and measures for its further liberalization are
taken. Change in sectoral policy/sectoral equity cap is notified from time to time
through Press Notes by the Department of Industrial Policy & Promotion. Policy
announcement by DIPP are subsequently notified by RBI under FEMA.
4. • Through financial collaborations. • Through joint ventures and technical
collaborations. • Through capital markets via Euro issues. • Through private
placements or preferential allotments. Foreign Direct Investment (FDI) is permitted as
under the following forms of investments-

Benefits of international equity and bond investing

KEY TAKEAWAYS

• An international portfolio may appeal to the investor who wants some exposure to the
stocks of economies that are growing faster than that of the U.S.
• The risks of such a strategy can be reduced by mixing emerging-market stocks with
shares in some of the solid performers of industrialized nations.
• The investor might also take a look at some of the U.S. companies that are
experiencing their fastest growth abroad.
International Portfolio Advantages

• May Reduce Risk: Having an international portfolio can be used to reduce

investment risk. If U.S. stocks underperform, gains in the investor’s international
holdings can smooth out returns
 Diversifies Currency Exposure: When investors buy stocks for an international
portfolio, they are also effectively buying the currencies in which the stocks
are quoted
Market Cycle Timing: An investor with an international portfolio can take advantage
of the market cycles of different nations.
1. Bonds Provide Income

While many investments provide some form of income, bonds tend to offer the highest and
most stable cash streams. Even at times when rates are low, there are still plenty of options
you can use to build a portfolio that meets your income needs. These methods may
include high-yield bonds or emerging market debt.

2. Bonds Offer Diversification

Almost everyone has heard the phrase: “Don’t put all your eggs in one basket.” This is very
true for investors. It may be a cliché, but it's wisdom that has stood the test of time. As time
goes on, greater diversification can provide you with better risk-adjusted returns than narrow
portfolios can. In other words, it reduces the amount of return relative to the risk.

4. Bonds Possess Tax Advantages

Certain types of bonds can also be useful for those who need to reduce their tax burdens. The
income on bank instruments, most money market funds, and equities are taxable unless they
are held in a tax-deferred account. But the interest on municipal bonds is tax-free on the
federal level. If you own a municipal bond issued by the state where you live, it's tax-free on
the state level as well

International capital asset pricing model (ICAPM)

KEY TAKEAWAYS

• The international capital asset pricing model (CAPM) is a financial model that applies
the traditional CAPM principle to international investments.
• The international CAPM helps determine the return investors seek for a given level of
risk, including foreign risks associated with different currencies.
• CAPM was formed on the premise that investors should be compensated for the
amount of time they hold investments and the risk they assume for holding
investments.
• International CAPM expands beyond the standard CAPM by compensating investors
for their exposure to foreign currencies.
International CAPM vs. Standard CAPM
To calculate the expected return of an asset given its risk in the standard CAPM, use the
following equation:

ra=rf+βa(rm−rf)
where:rf=risk-free rateβa=beta of the securityrm=expected market return
Understanding the International Capital Asset Pricing Model (CAPM)
CAPM is a method for calculating anticipated investment risks and returns. Economist and
Nobel Memorial Prize winner William Sharpe developed the model in 1990.1 The model
conveys that the return on investment should equal its cost of capital and that the only way to
earn a higher return is by taking on more risk. Investors can use CAPM to evaluate the
attractiveness of potential investments. There are several different versions of CAPM, of
which international CAPM is just one.