421 – International Financial Management

Unit – I

Introduction to International Financial management: Domestic vs international finance,

International financial market integration, currency crisis, and global recession and risk spill over.
Domestic finance and international finance are two distinct areas of finance that deal with different aspects of
financial management, investment, and capital allocation. Here's a comparison between the two:

Domestic Finance:
1. Scope: Domestic finance focuses on financial activities that occur within a single country's borders. It
deals with managing financial resources, making investment decisions, and raising capital for businesses
or individuals operating within that country.
2. Regulations: Financial activities are governed by the laws and regulations of the specific country.
Companies and individuals must adhere to domestic regulatory frameworks when issuing securities,
borrowing funds, and conducting financial transactions.
3. Currency: Transactions are typically conducted in the domestic currency of the country. Currency risk
is not a major concern as long as transactions remain within the domestic market.
4. Interest Rates: Interest rates are influenced by domestic economic factors, such as inflation rates,
central bank policies, and local market conditions.
5. Risk Factors: Risk factors are primarily associated with domestic economic conditions, political
stability, and regulatory changes within the country.
6. Market Familiarity: Individuals and companies are generally more familiar with the local market
conditions, economic indicators, and investment opportunities.

International Finance:
1. Scope: International finance deals with financial activities that involve cross-border transactions,
including investments, trade, foreign exchange, and capital flows between countries.
2. Regulations: International finance involves navigating the complexities of different legal and regulatory
systems in multiple countries. Companies must comply with various international laws and agreements.
3. Currency: Transactions often involve different currencies, leading to currency risk (exchange rate
fluctuations) that can impact the profitability of international ventures.
4. Interest Rates: Interest rates are affected by both domestic and international economic factors.
Exchange rate differentials and global market conditions can influence borrowing and lending rates.
5. Risk Factors: In addition to domestic risk factors, international finance also considers geopolitical risks,
trade barriers, cultural differences, and foreign exchange risks.
 6. Market Familiarity: Participants in international finance need to understand not only their own
domestic market but also the economic, political, and cultural nuances of foreign markets.
Key Considerations for International Finance:
1. Exchange Rate Risk: Fluctuations in exchange rates can affect the value of international investments
and transactions.
2. Political Risk: Changes in political environments, regulations, or government policies can impact
international financial activities.
3. Cultural Differences: Understanding cultural norms and business practices is crucial when operating in
foreign markets.
4. Diversification: International finance allows for diversification of investment portfolios across different
economies, potentially reducing overall risk.
5. Hedging Strategies: Companies can use financial instruments like currency swaps and options to hedge
against currency and interest rate risks.
In summary, while domestic finance focuses on financial activities within a single country, international finance
involves navigating the complexities of global financial systems, currency markets, regulatory environments,
and cross-border risks. Both areas are important for individuals, businesses, and governments seeking to
optimize their financial strategies and achieve their financial goals.

International financial market integration

International financial market integration refers to the increasing interconnectedness and interdependence of
financial markets across different countries. This integration is driven by advancements in technology,
liberalization of financial regulations, and the growing global movement of capital, goods, and services. Here
are some key aspects and implications of international financial market integration:
1. Capital Flows: Integration allows capital to flow more freely across borders, enabling investors and
borrowers to access a wider range of financial products and investment opportunities. This can lead to increased
capital mobility and improved allocation of resources.
2. Financial Products and Services: Integration facilitates the cross-border trading of financial instruments
such as stocks, bonds, derivatives, and currencies. It also allows investors to diversify their portfolios across
different markets, spreading risk and potentially enhancing returns.
3. Exchange Rates and Currency Markets: Integration impacts currency markets, affecting exchange rates
and influencing international trade and investment decisions. The ease of converting currencies and trading in
foreign exchange markets has increased significantly with integration.
4. Market Efficiency: Integration can lead to greater market efficiency as information and pricing trends are
transmitted more quickly across borders. This reduces the potential for arbitrage opportunities between markets
with different prices for the same asset.
5. Risk Sharing and Diversification: Integration allows investors to spread their investments across different
countries and regions, reducing exposure to country-specific risks. This risk diversification can help stabilize
portfolios and enhance overall returns.
6. Regulatory Challenges: While integration offers many benefits, it also presents challenges related to
regulatory coordination and oversight. Regulatory disparities between countries can lead to regulatory arbitrage,
where participants exploit differences in regulations to their advantage.
7. Contagion and Systemic Risk: Financial crises in one country can spread more rapidly to other countries
through integrated financial markets. Contagion risk increases due to interconnectedness, potentially amplifying
systemic risks.
8. International Monetary Policy Coordination: Central banks and monetary authorities often need to
coordinate their policies to manage the impact of cross-border capital flows on exchange rates, interest rates,
and inflation.
9. Investor Behavior and Speculation: Integration can lead to increased cross-border investment, including
speculative capital flows that respond to short-term market trends and sentiment.
10. Information Sharing and Technology: Advancements in communication and technology have
significantly contributed to market integration by enabling real-time trading, price discovery, and information
dissemination across different time zones.
Implications:
1. Efficiency Gains: Integration can lead to better allocation of resources and more efficient pricing of
assets.
2. Enhanced Liquidity: Integration often leads to deeper and more liquid markets, making it easier for
investors to buy and sell assets.
3. Risk Management: Access to global markets allows investors to diversify risks and create more
balanced portfolios.
4. Contagion Risk: Financial crises in one part of the world can quickly spread to other regions due to
integration.
5. Regulatory Cooperation: Regulators must work together to address challenges posed by integrated
markets while ensuring financial stability.
Examples of International Financial Markets:
1. Global stock exchanges like the New York Stock Exchange (NYSE) and London Stock Exchange (LSE)
2. Foreign exchange markets (forex) for trading currencies
 3. International bond markets where governments and corporations issue bonds to global investors
4. Commodities markets for trading goods like oil, gold, and agricultural products
Overall, international financial market integration has reshaped the global financial landscape, impacting
investment strategies, risk management practices, and the overall functioning of economies around the world.

GLOBAL RECESSION
A global recession refers to a widespread and synchronized downturn in economic activity across multiple
countries and regions. It is characterized by declining economic growth, rising unemployment, decreased
consumer and business spending, and reduced trade and investment. Risk spillover, in this context, refers to the
phenomenon where economic and financial risks in one country or region have adverse effects that spread to
other countries or regions through interconnected global markets and economic linkages. Here's how global
recessions and risk spill over are related:
1. Economic Interdependence: In today's interconnected world, economies are highly interdependent due to
global trade, investment, and financial linkages. When a significant economic shock or recession hits one major
economy, it can lead to reduced demand for goods and services from trading partners, causing negative ripple
effects that spread to other countries.
2. Trade Channels: A downturn in one country's economy can lead to reduced demand for imports, affecting
exporting countries that rely on trade for growth. Lower demand for goods and services in one country can lead
to reduced production and employment in other countries that supply components or raw materials for those
goods.
3. Financial Markets: Financial markets are globally connected, and negative economic developments can
trigger volatility and panic selling across markets. A financial crisis in one country can lead to contagion, where
financial institutions and investors in other countries become concerned about exposure to similar risks, leading
to a broader loss of confidence.
4. Capital Flows: During a global recession, capital flows can reverse as investors seek safe havens. Countries
with weaker economic fundamentals or higher levels of risk may experience capital outflows, leading to
currency depreciation, higher borrowing costs, and reduced investment.
5. Supply Chain Disruptions: Global supply chains are intricate networks that involve the movement of
goods, services, and components across borders. Disruptions in production or shipping in one country can lead
to supply chain bottlenecks that impact companies and industries in other countries that depend on those
supplies.
6. Policy Responses: In a global recession, countries often implement monetary and fiscal policies to stimulate
their economies. However, these policies can have spillover effects. For instance, if one country significantly
devalues its currency or implements protectionist trade measures, it can affect the competitiveness of other
countries' exports.
7. Confidence and Sentiment: Economic downturns can lead to decreased consumer and business confidence
globally. This reduction in sentiment can impact spending, investment, and growth prospects in multiple
countries, creating a self-reinforcing cycle.
8. Systemic Risks: Some risks, such as those associated with financial institutions, can be systemic in nature. A
crisis in one major financial institution or market can have far-reaching impacts due to counterparty exposure
and interconnectedness within the financial system.
In summary, global recessions and risk spillover underscore the complexity and interdependence of today's
global economy. Economic and financial shocks can easily transcend borders, affecting economies and markets
far beyond the origin of the crisis. Policymakers, businesses, and investors need to be vigilant about the
potential for risk spillover and consider the broader global context when making decisions. International
cooperation and coordination among countries become crucial to manage and mitigate the impacts of global
recessions and risk transmission.
Unit – II : Balance of Payments - Structure - Contents of Current, Capital, and Reserve Accounts.
Linkages and Impact on Exchange Rates, Capital Markets & Economy. Understanding BOP structure of
a country for Investment and Raising Finance. Foreign Currency – Options, Futures, Forwards, Swaps.

Balance of Payment (BOP)

The balance of payment is the statement that files all the transactions between the entities, government
anatomies, or individuals of one country to another for a given period of time. All the transaction details are
mentioned in the statement, giving the authority a clear vision of the flow of funds.
After all, if the items are included in the statement, then the inflow and the outflow of the fund should match.
For a country, the balance of payment specifies whether the country has an excess or shortage of funds. It gives
an indication of whether the country’s export is more than its import or vice versa.
Types of Balance of Payment
The balance of payment is divided into three types:
Current account: This account scans all the incoming and outgoing of goods and services between countries.
All the payments made for raw materials and constructed goods are covered under this account. Few other
deliveries that are included in this category are from tourism, engineering, stocks, business services,
transportation, and royalties from licenses and copyrights. All these combine together to make a BOP of a
country.
Capital account: Capital transactions like purchase and sale of assets (non-financial) like lands and properties
are monitored under this account. This account also records the flow of taxes, acquisition, and sale of fixed
assets by immigrants moving into the different country. The shortage or excess in the current account is
governed by the finance from the capital account and vice versa.
Finance account: The funds that flow to and from the other countries through investments like real estate,
foreign direct investments, business enterprises, etc., is recorded in this account. This account calculates the
foreign proprietor of domestic assets and domestic proprietor of foreign assets, and analyses if it is acquiring or
selling more assets like stocks, gold, equity, etc.
Importance of Balance of Payment
A balance of payment is an essential document or transaction in the finance department as it gives the status of a
country and its economy. The importance of the balance of payment can be calculated from the following
points:
1. It examines the transaction of all the exports and imports of goods and services for a given period.
2. It helps the government to analyse the potential of a particular industry export growth and formulate
policy to support that growth.
 3. It gives the government a broad perspective on a different range of import and export tariffs. The
government then takes measures to increase and decrease the tax to discourage import and encourage
export, respectively, and be self-sufficient.
4. If the economy urges support in the mode of import, the government plans according to the BOP, and
divert the cash flow and technology to the unfavourable sector of the economy, and seek future growth.
5. The balance of payment also indicates the government to detect the state of the economy, and plan
expansion. Monetary and fiscal policy are established on the basis of balance of payment status of the
country.
BOP - STRUCTURE

1. Trade Account Balance

It is the difference between exports and imports of goods, usually referred as visible or tangible items. Till
recently goods dominated international trade. Trade account balance tells as whether a country enjoys a surplus
or deficit on that account. An industrial country with its industrial products comprising consumer and capital
goods always had an advantageous position. Developing countries with its export of primary goods had most of
the time suffered from a deficit in their balance of payments. Most of the OPEC countries are in better position
on trade account balance. The Balance of Trade is also referred as the 'Balance of Visible Trade' or 'Balance of
Merchandise Trade'.
2. Current Account Balance
It is difference between the receipts and payments on account of current account which includes trade balance.
The current account includes export of services, interests, profits, dividends and unilateral receipts from abroad,
and the import of services, interests, profits, dividends and unilateral Payments to abroad. There can be either
surplus or deficit in current account. The deficit will take place when the debits are more than credits or when
payments are more than receipts and the current account surplus will take place when the credits are more than
debits.
3. Capital Account Balance
It is difference between the receipts and payments on account of capital account. The capital account involves
inflows and outflows relating to investments, short tern borrowings/lending, and medium term to long term
borrowing/lending. There can be surplus or deficit in capital account. The surplus will take place when the
credits are more than debits and the deficit will take place when the debits are more than credits.
4. Foreign Exchange Reserves
Foreign exchange reserves (Check item No.9 in above figure) shows the reserves which are held in the form of
foreign currencies usually in hard currencies like dollar, pound etc., gold and Special Drawing Rights (SDRs).
Foreign exchange reserves are analogous to an individual's holding of cash. They increase when the individual
has a surplus in his transactions and decrease when he has a deficit. When a country enjoys a net surplus both in
current account & capital account, it increases foreign exchange reserves. Whenever current account deficit
exceeds the inflow in capital account, foreign exchange from the reserve accounts is used to meet the deficit If a
country's foreign exchange reserves rise, that transaction is shown as minus in that country's balance of
payments accounts because money is been transferred to the foreign exchange reserves.
Foreign exchange reserves (forex) are used to meet the deficit in the balance of payments. The entry is in the
receipt side as we receive the forex for the particular year by reducing the balance from the reserves. When
surplus is transferred to the foreign exchange reserve, it is shown as minus in that particular year's balance of
payment account. The minus sign (-) indicates an increase in forex and plus sign (+) shows the borrowing of
foreign exchange from the forex account to meet the deficit.
5. Errors and Omission
The errors may be due to statistical discrepancies & omission may be due to certain transactions may not be
recorded. For eg: A remittance by an Indian working abroad to India may not yet recorded, or a payment of
dividend abroad by an MNC operating in India may not yet recorded or so on. The errors and omissions amount
equals to the amount necessary to balance both the sides.

DERIVATIVE IS A FINANCIAL INSTRUMENTS (FORWARD, OPTION, FUTURE, SWAPS)

A derivative is a financial instrument whose value depends on underlying assets. The underlying assets could be
prices of traded securities of gold, copper, aluminum and may even cover prices of fruits and flowers.
Derivatives have become important in India since 1995, with the amendment of the Securities Contract
Regulation Act of 1956.
Derivatives such as options and futures are traded actively on many exchanges. Forward contracts, swaps and
different types of options are regularly traded outside exchanges by financial institutions, banks and corporate
clients in over-the-counter markets. There is no single market place or an organized exchange.

Derivatives can be classified as:

1. Commodities derivatives: These are derivatives on commodities like sugar, jute, paper, gur, castor seeds.
2. Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged securities.
3. Basic Derivatives: Futures and Options are basic derivatives.
4. Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives.
5. Exchange traded derivatives are standard contracts traded according to the rules and regulations of a
stock exchange. Only members can trade in exchange traded derivatives and they are guaranteed against
counter-party default. Contracts are settled daily.
6. OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts in foreign exchange
are usually OTC derivatives and have a high risk of default.

Participants in Derivatives Market:

1. Hedgers are those who try to minimize loses of both the parties entering into a derivative contract. At
the same time, they protect themselves against price changes in the products that they deal in. They use
options and futures and hedge in both financial derivatives and commodities derivatives.
2. Speculators participate in futures and options. They take high risks for potential gains. Their gains are
unlimited but they can take positions and minimize their losses. They trade mainly in futures. They are
the major players of the derivatives market.
3. Arbitrageurs enter into two transactions into two different stock markets. They are able to make a profit
through the difference in price of the asset in different markets. They make a risk less profit but they
have to analyse the market with speed to ensure profitability.

Distinction between Futures and Options:

In a futures contract, both parties are obligated to perform. In the case of options, only the seller (writer) is
obligated to perform.
In an options contract, the buyer pays the seller (writer) a premium. In the case of futures, neither party pays a
premium.
In the case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and has the
potential for all the returns. In the case of options, the buyer is able to limit the downside risk to the option
premium but retains the upside potential.
The parties to a future contract must perform at the settlement date. They are, however, not obligated to perform
before the settlement date. The buyers of an options contract can exercise their right any time prior to that
expiration date.
Financial instruments
Financial instruments used in foreign exchange markets for various purposes such as hedging against currency
risk, speculation, and managing international business transactions. Let's delve into each of them:

1. Foreign Currency Options: Foreign currency options are derivative contracts that give the holder the
right (but not the obligation) to buy (call option) or sell (put option) a specified amount of foreign
currency at a predetermined exchange rate (strike price) on or before a specified expiration date. Options
provide flexibility, as the holder can choose whether or not to exercise the option based on market
conditions. They are commonly used for hedging against unfavorable exchange rate movements or for
speculative purposes.
2. Foreign Currency Futures: Foreign currency futures are standardized contracts traded on organized
exchanges. These contracts obligate the buyer to purchase, and the seller to sell, a specific amount of
foreign currency at a predetermined price (future price) on a specified future date. Futures contracts are
highly regulated and standardized, making them suitable for hedging purposes and speculative trading.
They offer less flexibility compared to options.
3. Foreign Currency Forwards: Foreign currency forwards are private contracts between two parties to
exchange a specified amount of foreign currency at a predetermined exchange rate on a specified future
date. Unlike futures, forwards are customizable in terms of the contract size, maturity date, and
currencies involved. They are often used for hedging to lock in future exchange rates for international
transactions, thereby mitigating currency risk.
4. Foreign Currency Swaps: Foreign currency swaps involve the simultaneous exchange of one currency
for another, followed by a reverse exchange at a future date. These transactions are commonly used to
manage currency risk and interest rate risk. Swaps can help entities obtain more favorable borrowing
terms in a foreign currency while still servicing their domestic currency obligations. Cross-currency
swaps and interest rate swaps are variations of currency swaps.

Each of these financial instruments has its advantages and risks, and their choice depends on factors such as the
specific financial goals of the parties involved, market conditions, and risk tolerance. It's important to note that
these instruments can be complex and may involve risks, so individuals and businesses should seek advice from
financial professionals before engaging in foreign currency trading or hedging activities.
Forwards:
In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated
price and quantity. The forward contract does not involve any money transaction at the time of signing the deal.
If a farmer enters into the contract, forward contract safeguards and eliminates the risk of price at a future date.
But the forward market has the problem of lack of centralization of trading, difficulty in liquidity and
counterparty risk, in case of one of the parties declaring themselves insolvent or bankrupt.
Futures:
Futures are a financial contract which derives its value from the underlying asset. For example, mango, walnut,
apples, wheat or rice farmers may wish to make a contract to sell their harvest at a future date to eliminate the
risk of any negative change in price by that date.
Transactions take place through the forward or futures market. There are commodity futures and financial
futures. In the financial futures, there are foreign currencies, interest rate and market index futures. Market
index futures are directly related with the stock market. Futures markets are standardized contracts, involve
centralized trading and settlements are made through clearing houses. This reduces risk.
The following values determine the pricing of futures.
1. Expected rate of return from investing in the asset.
2. Risk free rate of interest.
3. Price of the underlying asset in the cash market.

Index Futures:
In 1982, the stock index futures were introduced. The stock index futures contracts are made on the major stock
market index. It is an obligation, the settlement value depends on the value of stock index and the price at which
the original contract is struck and on the specified times the difference between the index value at the last
closing day of the contract and original price of the contract.
The basis of the stock index futures is the specified stock market index. No physical delivery of stock is made.
Standard and Poor contract is the most popular stock index futures. Here the obligation is to deliver cash equal
to 500 times the difference between stock index value at the close of last trading day of the contract and the
price at which the future contract was struck at the settlement date. For example, if the contract is struck at the
S&P stock index level at 500 and the stock index is 510 at the end of the settlement date, then the payment that
has to be made is equal to (510 – 500) x 500 = 5000.
Swaps:
Financial swaps are a funding technique, which permit a borrower to access one market and then exchange the
liability for another type of liability. The global financial markets present borrowers and investors with a wide
variety of financing and investment vehicles in terms of currency and type of coupon — fixed or floating.
Floating rates are tied to an index, which could be the London Inter-bank Borrowing Rate (LIBOR), US
Treasury bill rate etc. This helps investors’ exchange one type of asset for another for a preferred stream of cash
flows.
Swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing
indirectly. The borrower might otherwise have found this too expensive or even inaccessible. Swaps are used to
transform the fixed rate loan into a floating rate loan.
Swaps are popular because they work on the concept of comparative advantage. The basic principle is that some
companies have a comparative advantage when borrowing in fixed rate markets, while others have a
comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets
when the need is of floating rate loan and vice versa.
Types of Swaps:
All swaps involve exchange of a series of periodic payments between two parties. A swap transaction usually
involves an intermediary who is a large international financial institution. The two payment streams are
estimated to have identical present values at the outset when discounted at the respective cost of funds in the
relevant markets.
The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a
combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are
possible under each of these major types of swaps.
Interest Rate Swaps:
An interest rate swap involves an exchange of different payment streams, which are fixed and floating in nature.
Such an exchange is referred to as a exchange of borrowings or a coupon swap.
In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed
rate on a notional principal for a number of years. At the same time, party A agrees to pay Party B cash flows
equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of
the two sets of interest cash flows are the same.
The life of the swap can range from two years to over 15 years. This type of a standard fixed to floating rate
swap is popularly called a plain vanilla swap. London Inter-bank Offer Rate (LIBOR) is often the floating
interest rate in many of the interest rate swaps.
Currency Swaps:
Currency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency for
principal and fixed rate interest payments on an approximately equivalent loan in another currency. Suppose
that a company A and B are offered the fixed five-year rates of interest in U.S. dollars and sterling. Also
suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys better
creditworthiness than company B as it is offered better rates on both dollar and sterling.
This creates an ideal situation for a currency swap. The deal could be structured such that company B borrows
in the market in which it has a lower disadvantage and company A in which it has a higher advantage. They
swap to achieve the desired currency to the benefit of all concerned. The principal amount must be specified at
the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and the end
of the life of the swap.
Derivatives have been developed in India for the smooth flow of investments in the market and to attract foreign
capital. It is also expected the constant scams in the investment market will be reduced. The Harshad Mehta
scam and the Ketan Parekh scams have led to ensuring and bringing back discipline in the financial markets
through new aspects like eliminating the badla system and bringing about derivatives.
Unit – III
Foreign Exchange Markets: Nature, Functions, Transactions, Participants, Forex Markets in India,
Forex dealing, Foreign exchange regimes, Foreign exchange rate determination, factors affecting
foreign exchange and Foreign Exchange Rate Mathematics. Foreign Exchange Exposure: Risk,
Measurement and Management. Global Firms Foreign exchange exposure - Transaction, economic,
and translation exposures, potential currency exposure impact on global firms and investor
performance. Foreign exchange risk management strategies through Forward contracts, future
contracts, money market hedges, and options contracts.

Exchange Rate of Currencies in Foreign Exchange Market

Every country has their respective currencies which they use in their trade and businesses, but what about in the
foreign market? With the lack of versatility of the currencies, they become a hurdle in world trade. To solve this
problem, the Foreign Exchange Market was introduced. This is a type of marketplace that will fix the exchange
rate for the currencies.
Without the foreign exchange market, the world economy would suffer terribly. Thus, it becomes important for
us to consider this topic as a prior study. In this context, we will define the foreign exchange market, discuss the
types, features, and participants in the same market.
Define Foreign Exchange Market
The foreign exchange market is over a counter (OTC) global marketplace that determines the exchange rate for
currencies around the world. This foreign exchange market is also known as Forex, FX, or even the currency
market. The participants engaged in this market are able to buy, sell, exchange, and speculate on the currencies.
These foreign exchange markets are consisting of banks, forex dealers, commercial companies, central banks,
investment management firms, hedge funds, retail forex dealers, and investors. In our prevailing section, we
will widen our discussion on the ‘Foreign Exchange Market’.

Types of Foreign Exchange Market

The Foreign Exchange Market has its own varieties. We will know about the types of these markets in the
section below:
The Major Foreign Exchange Markets −
 Spot Markets
 Forward Markets
 Future Markets
 Option Markets
 Swaps Markets
Let us discuss these markets briefly:
 Spot Market
In this market, the quickest transaction of currency occurs. This foreign exchange market provides
immediate payment to the buyers and the sellers as per the current exchange rate. The spot market
accounts for almost one-third of all the currency exchange, and trades which usually take one or two
days to settle the transactions.
 Forward Market
In the forward market, there are two parties which can be either two companies, two individuals, or
government nodal agencies. In this type of market, there is an agreement to do a trade at some future
date, at a defined price and quantity.
 Future Markets
The future markets come with solutions to a number of problems that are being encountered in the
forward markets. Future markets work on similar lines and basic philosophy as the forward markets.
 Option Market
An option is a contract that allows (but is not as such required) an investor to buy or sell an instrument
that is underlying like a security, ETF, or even index at a determined price over a definite period of time.
Buying and selling ‘options’ are done in this type of market.
 Swap Market
A swap is a type of derivative contract through which two parties exchange the cash flows or the
liabilities from two different financial instruments. Most swaps involve these cash flows based on
a principal amount.

Functions of Foreign Exchange Market

The various functions of the Foreign Exchange Market are as follows:
 Transfer Function: The basic and the most obvious function of the foreign exchange market is to
transfer the funds or the foreign currencies from one country to another for settling their payments. The
market basically converts one’s currency to another.
 Credit Function: The FOREX provides short-term credit to the importers in order to facilitate the
smooth flow of goods and services from various countries. The importer can use his own credit to
finance foreign purchases.
 Hedging Function: The third function of a foreign exchange market is to hedge the foreign exchange
risks. The parties in the foreign exchange are often afraid of the fluctuations in the exchange rates,
which means the price of one currency in terms of another currency. This might result in a gain or loss
to the party concerned.
Features of Foreign Exchange Market
This kind of exchange market does have characteristics of its own, which are required to be identified. The
features of the Foreign Exchange Market are as follows:
1. High Liquidity
The foreign exchange market is the most easily liquefiable financial market in the whole world. This
involves the trading of various currencies worldwide. The traders in this market are free to buy or sell
the currencies anytime as per their own choice.
2. Market Transparency
There is much clarity in this market. The traders in the foreign exchange market have full access to all
market data and information. This will help to monitor different countries’ currency price fluctuations
through the real-time portfolio.
3. Dynamic Market
The foreign exchange market is a dynamic market structure. In these markets, the currency values
change every second and hour.
4. Operates 24 Hours
The Foreign exchange markets function 24 hours a day. This provides the traders the possibility to trade
at any time.

Who are the Participants in a Foreign Exchange Market?

The participants in a foreign exchange market are as follows:
1. Central Bank: The central bank takes care of the exchange rate of the currency of their respective
country to ensure that the fluctuations happen within the desired limit and this participant keeps control
over the money supply in the market.
2. Commercial Banks: Commercial banks are the channel of forex transactions, which facilitates
international trade and exchange to its customers. Commercial banks also provide foreign investments.
3. Traditional Users: The traditional users consist of foreign tourists, the companies who carry out
business operations across the globe.
4. Traders and Speculators: The traders and the speculators are the opportunity seekers who look
forward to making a profit through trading on short-term market trends.
5. Brokers: Brokers are considered to be the financial experts who act as a sure intermediary between the
dealers and the investors by providing the best quotations.
Advantages of Foreign Exchange Market
The whole world economy is relying upon this foreign exchange market for obvious advantageous reasons. Let
us check what are the advantages gained in the foreign exchange market-
1. There are very few restrictive rules, this allows the investors to invest in this market freely.
 2. There are no central bodies or clearinghouses that head the Foreign Exchange Market. Hence, the
intervention of the third party is less.
3. Many investors are not required to pay any commissions while entering the Foreign Exchange Market.
4. As the market is open 24 hours, the investors can trade here without any time-bound.
5. The market allows easy entry and exit to the investors if they feel unstable.

Foreign Exchange Rate

Foreign Exchange Rate is defined as the price of the domestic currency with respect to another currency. The
purpose of foreign exchange is to compare one currency with another for showing their relative values.
Foreign exchange rate can also be said to be the rate at which one currency is exchanged with another or it can
be said as the price of one currency that is stated in terms of another currency.
Exchange rates of a currency can be either fixed or floating. Fixed exchange rate is determined by the central
bank of the country while the floating rate is determined by the dynamics of market demand and supply.

Factors Affecting the Exchange Rate

Exchange rate is impacted by some factors which can be economic, political or psychological as well. The
economic factors that are known to cause variation in foreign exchange rates are inflation, trade balances, and
government policies. Political factors that can cause a change in the foreign exchange rate are political unrest or
instability in the country and any kind of political conflict. Psychological factors that impact the forex rate is the
psychology of the participants involved in foreign exchange.

What is Exchange Rate?

The exchange rate is the price of a currency in comparison to another currency. It is either fixed by the
central bank or determined by the market demand of demand and supply. When the central bank fixes the
exchange rate, it is known as the fixed exchange rate. On the other hand, when the rate is fixed by demand and
supply, it is known as a floating exchange rate.
Characteristics of Exchange Rate
An exchange rate is an indispensable tool in facilitating international trade.
1. It also shows the comparative value of the currency. By making it easier to make transactions with
international partners, exchange rates help countries to trade without any barriers. Therefore, in terms of
functions, exchange rates are invaluable.
2. By checking the exchange rates, economists also determine the economic well-being of a country. If too
much of fluctuations in the currency exchange rate occurs, the authorities must intervene to make the
 rates fixed. This helps the economy stay stable and any chance of an economic downturn could be
thwarted.
3. When a country imports goods in bulk, the demand usually pushes up the exchange rate for that country.
This makes the imported goods more expensive to consumers in that country. When the goods become
increasingly expensive, demand drops, and the country’s money becomes cheaper in comparison to
other countries’ money. Therefore, the country’s commodities become cheaper to buyers abroad,
demand goes up, and export from the country increases.
4. World trade now depends on a hybrid system of the exchange rate which can be called managed floating
exchange system. In such as system, governments intervene to stabilize their countries’ exchange rates
by stimulating exports, limiting imports, or devaluing the currencies.
Although a very important concept for international trade, the establishment of exchange rates is not a very old
phenomenon. It was established after the Second World War in the 20th century.

EXCHANGE RATE DETERMINATION

There are numerous methods of calculating the exchange rate of currencies. Some popular methods are -
 Fixed Exchange Rate
 Flexible Exchange Rate.
Types of Exchange Rate Systems
There are three types of exchange rate systems that are in effect in the foreign exchange market and these are as
follows:
1. Fixed exchange rate System or Pegged exchange rate system: The pegged exchange rate or the fixed
exchange rate system is referred to as the system where the weaker currency of the two currencies in question is
pegged or tied to the stronger currency. Fixed exchange rate is determined by the government of the country or
central bank and is not dependent on market forces.
2. Flexible Exchange Rate System: Flexible exchange rate system is also known as the floating exchange rate
system as it is dependent on the market forces of supply and [Link] is no intervention of the central
banks or the government in the floating exchange rate system.
3. Managed floating exchange rate system: Managed floating exchange rate system is the combination of the
fixed (managed) and floating exchange rate systems. Under this system the central banks intervene or
participate in the purchase or selling of the foreign currencies.

FIXED EXCHANGE RATES:

The fixed exchange rate is the system in which the monetary authority fixes the value of the domestic currency
to a foreign currency or to a basket of currencies. It is also called as hard peg or rigid peg and when one
currency is pegged to a foreign currency and its value is set at regular intervals according to some preset criteria
of the average exchange rate over the previous few months in the foreign exchange market which makes the
system more responsive to the market value of the domestic currency this system of determining the va;ue of
currency is called as crawling peg system.

ADVANTAGE OF FIXED EXCHANGE RATE SYSTEM:

1. Contribute to the strength of the domestic currency: since there is no panic of currencies
fluctuations, fixed exchange rate creates assurance in the strength of the domestic currency
2. Contributing to international economic integration: fixed exchange rate is a part of more universal
argument for national economic policies contributing to international economic integration.
3. Control of inflation: as compared to floating system, there is control on inflation as central bank
controls the money supply and therefore keeps the inflation under control.
4. Elimination of depreciation of currencies: under the fixed exchange system there is no unhealthy
practice of depreciation of currencies to capture international trade like the floating system.
5. Encourage long-term capital flows: since uncertainty and risk of exchange rate of exchange rates
volatility is rare in case of fixed exchange rates volatility is rare in case of fixed exchange rate, hence it
encourage-long term capital flows.
6. Encourages international trade : commitment to a single fixed exchange rate encourage
international trade by making prices of goods concerned in trade more predictable.
7. Monitor responsible financial policies: fixed exchange rate serve as a commentator and imposes a
discipline on monetary authorities to monitor responsible financial policies within countries.
8. No fear of unfavorable effect of speculation: since there is no-fear of currencies fluctuations, fixed
exchange rate creates confidence in the strength of the domestic currency and there is no fear of adverse
effect of speculation on the exchange rate.
9. Relatively simpler system: it is a relatively simpler system and can be relied upon as there are no
frequent fluctuations in the exchange rate.
10. Comparatively more stable: the exchange rates remain comparatively more stable than the flexible
exchange rate
DISADVANTAGE OF FIXED EXCHANGE RATE SYSTEM:
1. Affects domestic economic stability: fixed exchange rate possibly will achieve exchange rate stability
but at the cost of domestic economic stability.
2. Restriction on monetary policy formulation: monetary authorities lose the freedom of monetary
policy formulation to preserve exchange rate stability.
3. Managing foreign exchange reserve: the central bank may have to maintain adequate reserve of the
foreign currency every time leading to idle resources.
4. Misallocation of resources: fixed exchange rate system need difficult exchange control mechanism
 which may lead to misallocation of resources.
5. International trade not promoted by fixed rates: the argument that fixed exchange rates promote
international trade is not supported by historical facts of inter-war or post-war period.
6. International investment not promoted by fixed rates: the argument that long-term international
investments are encouraged under fixed exchange rate system is not valid.
7. Fixed rates not necessary for currency area: this stable exchange rates are not necessary for any
system of currency areas. The sterling block functioned smoothly during the thirties in spite of the
fluctuating rates of the member countries.
8. Speculation not prevented by fixed rates: the main weakness of the stable exchange rate system is
that in spite of the strict exchange control, currency speculation is encouraged.
9. Regular intervention of the central bank: this system requires regular intervention of central bank
to stabilize the rate; however, underlying problems of the weak economy could not be solved through
this method.

FLUCTUATING EXCHANGE RATES:

Fixed exchange rate regime is rarely practiced by any country at present. Almost all countries, at present, have
adopted some forms of flexible exchange rate policy. In spite of making several attempts, when the various
ways of stabilizing the exchange rates went futile, IMF proposed the flexible exchange rate system in 1978.
The second amendment in IMF articles and it provided the monetary authorities to introduce a new exchange
rate system which should be indented i.e. which is not based on gold valuation.
When the exchange rate of a country is determined by the market forces i.e. the demand and supply of the
currency, it is called as floating or flexible exchange rate. It is called as free float or clean float.
ADVANTAGE OF FLOATING EXCHANGE RATE:
1. Autonomy of monetary authorities: autonomy of monetary authorities preserve under floating
exchange rate system as there is no target exchange rate to maintain.
2. Boost international liquidity: the system of flexible exchange rates eradicated the need for official
foreign exchange reserve, if the individual governments do not empty stabilization funds to influence the
rate.
3. Equilibrium provider to balance of payment: fluctuation in the exchange rate can provide automatic
adjustments for countries with a large balance of payments deficit. Balance of payments on current
account disequilibrium can automatically be restored to equilibrium floating exchange rate regime and
the scarcity or surplus of any currency eliminated under floating exchange rate regime.
4. Flexible monetary policy: floating exchange rates gives the government/ monetary authorities’
flexibility in determining interest Rtes. This is because interest rates do not have to be set to keep the
value of the exchange rate within pre-determined bands.
 5. Improvement in current account positions: this system provides for an automatic mechanism to
deal with country’s current account deficits will lead to fall in the value of currency which will make
imports costlier and exports cheaper.
6. Market forces of demand and supply: under the flexible exchange rate system the foreign exchange
rates are determined by the market forces of demand and supply.
7. Optimum utilizing of monetary resources; flexible exchange rate enables quicker adjustments in
the rates depending upon the changes in the economic factors in country.
8. Protects domestic economy: a fluctuating exchange rate system protects the domestic economy from
the shocks produced by the turmoil generated in other countries.
9. Reflects the true position of a country: it reflects the true position of a country as the fluctuation in
the exchange rate is caused by the changes in the macro-economic factors and is determined by the
market forces of demand and supply of the currency.
10. Support planned economic development: the flexible exchange rate system promotes economic
development and helps to achieve full employment in the country.
DISADVANTAGE OF FLOATING EXCHANGE RATE:
1. Increases exchange rate volatility: market forces may fail to resolve the appropriate exchange
rate and hence floating exchange rate regime may not provide the desired result and may also guide to
misallocation of resources.
2. Increases the exchange rate risk: unless sound hedging mechanism is there, the importers and
exporters may face uncertain exchange rate risk.
3. Inflationary pressures: flexible exchange rate system involves greater chance of inflationary effect
of exchange depreciation on domestic price level of a country. Inflationary rise.
4. Makes the economy more vulnerable: it is unfeasible to have an exchange rate system without official
intervention. Government may not intervene, however domestic monetary policy and fiscal policy would
definitely influence the exchange rate.
5. Monetary disorder in the economy: this system though has auto-mechanism to correct current account
deficits, but for the countries where demand for certain products is inelastic, huge imports may lead to
heavy deficits which may induce inflation and monetary disorder in the economy.
6. Reduce the volume of international trade: volatile exchange rate introduces sizeable uncertainty
in export and import prices and a result to economic development.
7. Serious impact on the economic structure: the system of flexible exchange rates has serious impact on
the economic structure of the company. Fluctuating exchange rates cause changes in the price of
imported and exported goods which, in turn, destabilize the economy of the country.
8. Speculative capital movements: speculative capital movements caused by fluctuating exchange rates
because changes in the price of imported and exported goods which, in turn, destabilize the economy of
 the country.
9. Worsen the balance of payments deficit; the elasticity in the international markets is too low for
exchange rate, variations to operate effectively in bringing about automatic equilibrium.

DISTINCTION BETWEEN FIXED OR FLUCTUATING EXCHANGE RATES.

FIXED EXCHANGE RATE FLOATING EXCHANGE RATE
Value of currency was decide by central bank of Value of currency decided by market demand
the country supply
Exchange rates were fixed Exchange rates were flexible
Changes in exchange rate took place by official Change in exchange rate is by market action
action called devaluation or revaluation represented by depreciation

Due to stability, use of derivatives and risk Due to variability in exchange rate, the use of
management system did not exist derivation and risk management techniques is
critical
Stability of exchange rate promoted trade and There is no such concept in this system
investment
By implication central bank were required to There is no mandatory requirement for
parity rates through intervention central bank to Participate in market.
Value of gold was fixed i.e it was considered a Value of gold is variable, now considered as
financial commodity investments commodity.
Rates were calculate as ratio of gold content in 2 Exchange rates are calculated through a process
currencies of crossing using vehicle currency mechanism.

As basket securing the currency comprises of Current asset basket securing issue of INR
gold and USD contains gold, foreign currency asset. SDR and
government securities.

Foreign Exchange Rate Determination

Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of foreign
currency. According to Purchasing Power Parity theory, the foreign exchange rate is determined by the relative
purchasing powers of the two currencies.
Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate between
India and the USA will be (100/20=5), 1 $ = 5 Re.
 Forces Behind Exchange Rate Determination
Foreign Exchange is a price of one country currency in relation to other country currency, which like the price
of any other commodity is determined by the demand and supply factors. The demand and supply of the foreign
exchange rate come from the residents of the respective countries.
Demand for Foreign Exchange Supply of Foreign Exchange
(Foreign Money goes out) (Foreign Money Comes in)
Foreign Currency is needed to carry out transactions in The source of foreign currency available to the
foreign countries or for the purchase of foreign goods domestic country are foreigners purchasing our
and services (IMPORTS). goods and services (Exports).
Foreign currency is needed to invest in foreign country Foreigners investing in Indian Stock markets,
assets/shares/bonds etc. Assets, Bonds etc. (FPIs and FDIs)
Foreign currency is needed to make transfer payments.
Transfer payments. Example: Indian working in the
Example: Indian Parents sending Money to his/her
USA, sending money to his/her old aged parents.
son/daughter studying in the USA.
Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.
Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.
The DD curve represents the demand for
foreign exchange by India. The SS curve
represents the supply of foreign exchange to
India.
The point where both DD and SS curves
intersect is the point of equilibrium. At this
point demand for foreign exchange is exactly
equal to the supply of foreign exchange.
At equilibrium point E0, the exchange rate is
1 $ equal to 5 Re.
In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in time, the
exchange rate is at E1, then the demand for foreign exchange falls short of supply of foreign exchange,
as a result at this point Indians are demanding less foreign currency due to which Re will appreciate vis-
à-vis foreign currency. The appreciation mainly occurs due to a favourable balance of payment situation
(Surplus).
By the same token at point E2, demand for foreign exchange is greater than the supply of foreign
exchange, at this point Indians are demanding excess foreign exchange than what the foreigners are
 willing to supply, as a result, at E2 Re will depreciate vis-à-vis foreign currency. The depreciation
mainly occurs due to the unfavourable balance of payments situation (Deficits).

Exposures in International Finance

Introduction:
The exposure indicates a situation of being open or being vulnerable to risks. As soon as a firm enter into
transactions dealings involve foreign currency, it is exposed to foreign ex- change risk. The dealings may be
related to sale or purchase of goods and services, overseas investments or financing its operations in foreign
currencies by issue of shares/debentures/ loans to foreign investors.
The exposure of a firm to variations in exchange rates, may be of four types:
i. Transaction Exposure
ii. Translation Exposure
iii. Economic / Operating Exposure
(i) TRANSACTION EXPOSURE:
Transaction exposure, also known as transaction risk, refers to the potential impact of exchange rate
fluctuations on the financial results of individual transactions denominated in a foreign currency. It arises when
a company or individual engages in international trade or conducts business transactions in a currency different
from their home currency.
Transaction exposure occurs because the exchange rate between the home currency and the foreign currency
can change between the times a transaction is initiated and when it is settled. This fluctuation in exchange rates
can lead to gains or losses when the transaction is eventually converted back into the home currency.
For example, consider a U.S.-based company that imports goods from Europe and has to pay the supplier in
euros. If the euro strengthens against the U.S. dollar between the time the order is placed and the payment date,
the U.S. Company will need to pay more in dollars to purchase the euros required to settle the transaction.
Conversely, if the euro weakens, the U.S. Company may pay less in dollars.
Transaction exposure can affect both importers and exporters. Importers face the risk of a stronger foreign
currency, which increases the cost of imported goods or services. Exporters, on the other hand, face the risk of a
weaker foreign currency, which reduces the amount they receive when converting foreign currency sales back
into their home currency.
To manage transaction exposure, companies can adopt various risk management strategies, such as:
Hedging: This involves using financial instruments like forward contracts, futures contracts, options, or
currency swaps to lock in a specific exchange rate for future transactions. By doing so, companies can mitigate
the risk of adverse exchange rate movements.
Pricing and Cost Adjustments: Companies can adjust their pricing strategies or negotiate pricing terms with
customers and suppliers to reflect changes in exchange rates. This can help offset the impact of currency
fluctuations on transaction profitability.
Currency Invoicing: Invoicing transactions in the home currency or the currency of the company's choice can
help reduce transaction exposure. By avoiding direct exposure to the foreign currency, companies transfer the
risk to their customers or suppliers.
Netting: If a company has transactions in multiple currencies, it can net off the inflows and outflows
denominated in the same currency, reducing the overall exposure.
Managing transaction exposure is important to minimize the financial risks associated with exchange rate
fluctuations and ensure the profitability and competitiveness of international business transactions.

(ii) TRANSLATION EXPOSURE:

Translation exposure, also known as accounting exposure or balance sheet exposure, refers to the potential
impact of changes in exchange rates on the financial statements of a company that operates in multiple
currencies. It arises when a company consolidates its financial statements from foreign subsidiaries or converts
the financial statements of foreign operations into its reporting currency.
Translation exposure occurs because the exchange rates used to convert foreign currency financial statements
into the reporting currency can fluctuate over time. These fluctuations can affect the reported values of assets,
liabilities, equity, revenues, and expenses, resulting in gains or losses in the company's financial statements.
The primary cause of translation exposure is the use of different currencies in the financial statements of
subsidiaries or foreign operations. When the reporting currency and the subsidiary's functional currency differ,
translation exposure arises. Additionally, changes in exchange rates between the functional currency and the
reporting currency contribute to translation exposure.
The impact of translation exposure is reflected in the company's comprehensive income and equity, rather than
directly affecting cash flows or income from ongoing operations. The translation adjustments are typically
reported in the equity section of the balance sheet as a separate component of comprehensive income.
Translation exposure can have both positive and negative effects on a company's financial statements. If the
reporting currency strengthens against the functional currency, the translated values of foreign assets and
revenues increase, resulting in gains. Conversely, if the reporting currency weakens, the translated values
decrease, leading to losses.
To manage translation exposure, companies can employ several strategies:
Hedging: Companies can use financial instruments like forward contracts or currency swaps to hedge against
exchange rate movements that impact translation exposure.
Centralized Reporting: Consolidating financial statements in a single currency, whenever possible, reduces
the need for translation and minimizes translation exposure.
Diversification: Operating in multiple currencies can help offset the impact of exchange rate fluctuations. A
company with a diversified international presence may experience gains in some currencies that counterbalance
losses in others.
Disclosure and Communication: Providing clear and transparent disclosures in financial statements about the
potential impact of translation exposure helps investors and stakeholders understand the implications of
currency fluctuations.
It's important to note that translation exposure affects the reported financial results of a company but may not
necessarily impact its underlying cash flows or operational performance. It represents a financial reporting risk
that companies must manage to accurately reflect the economic impact of their foreign operations.
Differences between Translation Exposure vs. Transaction Exposure
Difference Translation Exposure Transaction Exposure
The risk involved in reporting consolidated The risk involved due to changes in the exchange
Definition financial statements due to fluctuation in rate, which affects the cash flow movement arises
exchange rates; in the company’s daily operations.

Area Legal Requirements and accounting issues; Managing daily operations;

Foreign It only occurs while consolidating financial

The parent company does not require having a
Affiliate/ statements of parent company and
foreign subsidiary for transaction exposure.
Subsidiary subsidiary or foreign affiliate.
Profit or The result of Translation exposure is The result of transaction exposure is realized
Loss notional profit or loss. profit and loss.
By the end of every quarter of the financial
It only arises at a time of transaction involving
Occurrence year while consolidating financial
foreign currency.
statements.
Value Since it Directly affects the cash flows of the
The value of the company is not affected.
Impact company, it changes the value of the company.
Translation exposure is more concept
instead of an actual impact on the value of Since Transaction exposure affects cash flows, it
the company. Hence it does not affect tax affects the tax payments of the company.
Tax
payment and does not provide any benefits Provides benefits in case of loss due to changes in
in case of loss in terms of fluctuation in the the exchange rate
exchange rate.
(iii) ECONOMIC EXPOSURE:
Economic exposure, also known as operating exposure or strategic exposure, refers to the potential impact of
exchange rate fluctuations on a company's future cash flows, profitability, and overall value. It goes beyond the
immediate effects on transaction or translation exposure and focuses on the long-term implications of exchange
rate movements on a company's competitiveness and market position.
Economic exposure arises from various factors, including a company's international operations, global supply
chains, pricing strategies, competitive landscape, and the sensitivity of its demand and cost structure to
exchange rate fluctuations. It reflects the vulnerability of a company's cash flows and profitability to changes in
exchange rates. There are two main components of economic exposure:
Competitive Effect: Exchange rate fluctuations can affect a company's competitiveness in the global market. A
depreciation of the home currency relative to foreign currencies can make a company's exports more
competitive and boost its sales and market share. Conversely, an appreciation of the home currency can make
exports more expensive and erode market share. Economic exposure considers the impact of exchange rates on
a company's ability to compete effectively in international markets.
Cash Flow Effect: Economic exposure also takes into account the impact of exchange rate fluctuations on a
company's cash flows and profitability. It considers how changes in exchange rates affect a company's revenues,
costs, and profit margins. For example, if a company's costs are denominated in a foreign currency and its
revenues are in the home currency, a depreciation of the home currency can increase costs and squeeze profit
margins.
Managing economic exposure requires proactive strategies to mitigate the risks and seize opportunities
associated with exchange rate movements. Some key strategies include:
Diversification: Expanding operations into different countries and currencies can help diversify economic
exposure. By spreading operations across multiple markets, companies reduce their dependence on a single
currency and can offset the impact of exchange rate fluctuations.
Pricing Strategies: Adjusting pricing strategies to reflect changes in exchange rates can help maintain
profitability. For example, a company may increase prices in markets where the home currency has depreciated
to protect profit margins.
Supply Chain Management: Evaluating and managing the exposure in the supply chain is crucial. This
includes considering the currencies in which inputs and raw materials are priced, hedging strategies, and
alternative sourcing options.
Financial Hedging: Using financial instruments like forward contracts, options, or currency swaps can help
mitigate the impact of exchange rate fluctuations on future cash flows and profitability.
Market Research and Analysis: Staying informed about market trends, economic indicators, and geopolitical
factors can help anticipate potential exchange rate movements and their impact on the company's business.
Economic exposure is a complex concept as it encompasses a broad range of factors that influence a company's
competitiveness, profitability, and long-term value. Managing economic exposure requires a strategic approach
that considers the unique characteristics of the company's operations, markets, and industry dynamics.

Currency Derivatives in India

What are Currency Derivatives?
Derivatives are instruments that derive their value from the underlying assets. An equity derivative will derive
its value from stocks and securities. Furthermore, it is a contract that parties enter into with a specific date for a
specific price. Now, these derivatives can be traded just like stocks on the exchange market. Otherwise, these
derivatives can be transacted privately over the counter.
Currency derivatives are a type of derivative that derives its value from the underlying asset, which is a
currency such as INR, USD, Euro, and so on. Such currency derivatives include forward, futures and options,
and swaps. Hence, currency derivatives are largely impacted by international economic factors. Currency
derivatives are largely traded by traders involved in import, export, international transactions, etc.
How Do Currency Derivatives Work?
Currency derivatives are dependent on their assets for their price and valuation. The trade on derivatives largely
depends on the asset that the trader wants to secure for. For instance, the currency exchange value of EUR/INR
on 17th December 2022 is 1/87.65. This means that 1 Euro is equal to INR 87.65. The EUR/INR futures with an
expiry of 28 days are trading at INR 87.96. This futures contract derives its value from the valuation of
EUR/INR.
What are the Types of Currency Derivatives?
1. Currency Futures
Currency futures are contracts for the purchase or sale of a specific underlying currency at a specific future date
and at a specific price. Exchange-traded contracts known as currency futures are standardized in terms of the
delivery date, contract value, and other criteria.
Investors can hedge themselves against foreign exchange risk by using currency futures contracts. Investors can
exit from their commitment to buy or sell the currency before the contract’s delivery date. This is done by
closing out their position because these contracts are marked-to-market every day.
Futures contracts are exchange-traded, with very low counterparty risk. The transaction promises that the
contract will be carried out. The exchange in turn expects the buyer and seller to keep their margins within the
limits set by the exchange. Additionally, futures contracts are marked to market. This means that the buyer and
the seller are informed of the gain or loss at the conclusion of each trading day. The calculations take into
account the closing rate at the end of trading. The exchange could ask the trader to maintain an additional
maintenance margin.

2. Currency Options
Currency options are the right (but not the duty) to purchase or sell a currency at a predetermined rate on a
certain future date. The option contract’s buyer is referred to as the contract’s holder, while the seller is referred
to as the contract’s writer. A call option contract is one that includes the opportunity to purchase a
predetermined amount of a currency at a specific rate. On the other hand, a put option contract is one that
includes the option to sell a predetermined amount of a currency at a specific rate. The strike or exercise price
refers to the price at which a call or put option contract is to be executed.
Before the option expires, the buyer has the opportunity to exercise it, and if he does, the seller must execute the
terms of the agreement. In return, the buyer gives the seller a premium. The buyer compares the spot and strike
prices before deciding whether or not to exercise his option. An option is considered to be “in the money” if the
strike price of a call option is higher than the current market price. On the other hand, a call option is said to be
“out of the money” if the strike price is less than the current market price. Additionally, the option is “at the
money” if the strike price and the spot price are identical.
3. Currency Swap
In a currency swap, the principal and interest from one currency are exchanged for the principal and interest
from another currency. The contractual parties exchange an equivalent principal amount at the spot rate at the
start of the transaction. The parties to the contract pay interest on the swap principal amount throughout the
term of the agreement. The principal amount is returned at either the spot rate or a pre-decided exchange rate at
the completion of the contract. It’s possible that this rate was the original rate for the swap of the principal
amount. In this scenario, the swap’s transaction risk is eliminated.
What are the Uses of Currency Derivatives?
Traders use currency derivatives for the following purposes:
Hedging
A trade that is made with the intention of reducing the risk of unfavourable price changes in another currency is
known as a hedge. A hedge often involves taking the opposite position in a currency. The aim of hedging is to
protect the trade from the potential risk of price fluctuations.
For instance, Ashok and Company imports batteries worth Euros 6000 from Europe at an exchange rate of
EUR/INR 87.65. Hence, for this exchange rate, the company needs to pay INR 5,25,900. However, the
company needs to pay this amount after 3 months. The company is afraid that this exchange rate might rise upto
EUR/INR 90.85 in the next 3 months. In this case, the company might end up paying INR 5,45,100 which is a
loss of INR 19,200.
The company will now enter into a hedge and buy 6 lots of EUR/INR at a rate of INR 87.85. Number of lots to
be purchased = (INR 5,45,100 / 87.85)1 lot = 1000 derivatives. After 3 months even if the exchange rate rises
up to EUR/INR 90.85, it has already secured its position against the possible loss.
Speculation
The goal of speculation is to profit from a currency’s price movement, whereas the goal of hedging is to lower
the risk or volatility related to a currency’s price change. Hence, speculation is exposed to the upside and
downside of a trader.
For instance, Miss Kajal expects the EUR/INR rate to decrease from 87.25 to 85.80 due to the ongoing war and
shortage of oil in Europe after 1 month. She takes a short position on EUR/INR at a rate of EUR/INR 87.25 for
20 lots. This means that she will sell at this rate. After 1 month the actual rate turned out to be EUR/INR 86.10.
She buys 20 lots at a rate of EUR/INR 86.10 in the intraday. Hence, she gains INR 23,000 (EUR/INR 87.25 –
EUR/INR 86.10) * 20 lots.
Arbitrage
Arbitrage involves buying and selling the same currency on different markets and exchanges to gain from the
price difference. The price difference might seem very low. However, given the lot size, the gain can be higher.
In India, currency derivatives trade on NSE, BSE, and MCX-SX. A trader will buy on one exchange and sell on
another for even a very small price difference. For instance, on NSE futures EUR/INR is traded at a rate of
EUR/INR 87.25. The same futures trade on BSE at a rate of EUR/INR 87.27. Mr Akash notices an arbitrage
opportunity between these 2 stock exchange listings. He buys 100 lots from NSE and sells these lots on BSE.
He makes a profit of INR 2,000 (EUR/INR 87.27 – EUR/INR 87.25) *100 lots.
FOREIGN EXCHANGE RISK MANAGEMENT
Foreign exchange risk management involves strategies and techniques that businesses and individuals use to
mitigate the potential negative impact of fluctuations in exchange rates on their financial transactions and
investments. Here are some common foreign exchange risk management strategies:
Hedging with Derivatives:
Forward Contracts: Enter into forward contracts to lock in a specific exchange rate for a future
transaction. This helps eliminate uncertainty about future exchange rate movements.
Currency Options: Use currency options to protect against adverse exchange rate movements while still
allowing for potential gains if rates move favorably.
Natural Hedging:
Matching Cash Flows: Align foreign currency revenue with foreign currency expenses. This reduces the
need for conversion and exposure to exchange rate fluctuations.
Netting: Consolidate receivables and payables in a particular currency to offset foreign exchange gains and
losses.
Operational Strategies:
Local Sourcing and Production: Source materials and produce goods locally to minimize exposure to
foreign exchange fluctuations in supply chain costs.
Currency Invoicing: Invoice transactions in the local currency of the customer to shift the exchange rate
risk to them.
Financial Strategies:
Diversification: Invest in assets denominated in different currencies to reduce the impact of a single
currency's depreciation.
Currency Swaps: Use currency swaps to exchange cash flows with another party to hedge against interest
rate and currency risks simultaneously.
Balance Sheet Management:
Foreign Currency Debt: Borrow in the currency of your foreign income streams to naturally hedge against
currency risk.
Translation Risk Management: Implement strategies to manage the impact of foreign currency translation
on consolidated financial statements.
Forecasting and Monitoring:
Market Analysis: Regularly monitor currency market trends and economic indicators to anticipate potential
exchange rate movements.
Scenario Analysis: Perform scenario analysis to assess the potential impact of different exchange rate
scenarios on your business or investments.
Centralized Treasury Management:
Consolidated Cash Management: Concentrate cash and manage foreign exchange exposure centrally to
optimize hedging strategies.
In-House Bank: Set up an in-house bank to manage intercompany transactions and centralize currency risk
management.
Risk-sharing Contracts:
Currency Swaps: Enter into currency swaps to exchange cash flows in different currencies with a
counterparty, sharing risk and reducing exposure.
Contractual Clauses:
Currency Adjustment Clauses: Include clauses in contracts that allow for adjustments in payments based
on currency fluctuations.
Dynamic Hedging:
Regular Adjustments: Continuously adjust hedging positions as market conditions change, aiming to
maintain an optimal risk profile.

It's important to note that each strategy has its own advantages, disadvantages, and associated costs. Businesses
and individuals should carefully evaluate their specific circumstances, risk tolerance, and financial goals when
selecting the most appropriate foreign exchange risk management strategies. Consulting with financial
professionals who specialize in foreign exchange risk management can provide valuable guidance in navigating
these strategies effectively.
Unit – IV
Fundamental Parity Relationships and Exchange Rate Forecasting– Purchasing Power Parity,
Covered and Uncovered Interest Rate Parity, International Fisher's Effect, Forward Rate
Parity. Influence of these parity relationships on Exchange Rates. Methods of Forecasting
foreign exchange rates and foreign exchange volatility.

International parity
International parity refers to the concept that in a globalized economy, exchange rates and prices of goods
should equalize across different countries, leading to a state of equilibrium. There are several types of
international parity conditions that economists study:
Purchasing Power Parity (PPP): PPP states that in the long run, the exchange rate between two countries
should adjust to ensure that a basket of goods has the same purchasing power in both countries. This means that
the price levels of goods and services should be comparable when expressed in a common currency.

Interest Rate Parity (IRP): IRP suggests that the difference in interest rates between two countries should be
equal to the expected change in exchange rates between their currencies. According to this principle, investors
should not be able to make risk-free profits by borrowing in a low-interest rate country, converting the funds to
another currency, and investing in a high-interest rate country.

Fisher Effect: The Fisher effect states that the nominal interest rates in a country are determined by the real
interest rate and the expected inflation rate. According to this theory, an increase in a country's expected
inflation rate should result in an equal increase in its nominal interest rates, maintaining the real interest rate
constant.
These parity conditions provide insights into the relationships between exchange rates, interest rates, and
inflation across different countries. However, in reality, these conditions may not always hold due to factors
such as market imperfections, transaction costs, government interventions, and investor expectations.
Consequently, deviations from parity can lead to opportunities for arbitrage and speculative activities in the
foreign exchange markets.
Purchasing Power Parity (PPP)
It is an economic theory that suggests that the exchange rate between two countries should equalize the
purchasing power of their respective currencies. In other words, PPP states that a unit of currency should have
the same purchasing power in different countries.
According to PPP, the prices of a basket of goods and services should be similar when expressed in a common
currency. For example, if the exchange rate between the US dollar and the British pound is such that one pound
is equivalent to two dollars, and a certain basket of goods costs $100 in the United States, then the same basket
of goods should cost £50 in the United Kingdom if PPP holds.

PPP can be used to compare living standards and economic conditions between countries. It suggests that if a
country's currency is overvalued, its goods and services will appear more expensive relative to other countries,
reducing its competitiveness in international trade. Conversely, an undervalued currency would make a
country's goods and services cheaper, potentially boosting its exports.
However, PPP is a theoretical concept and is often difficult to achieve in practice. Factors such as transportation
costs, trade barriers, differences in taxation, and non-tradable goods can all contribute to deviations from PPP.
Moreover, exchange rates are influenced by various factors, including interest rates, inflation, capital flows, and
market expectations, which may not always align with PPP predictions.
Despite its limitations, PPP serves as a useful tool for understanding long-term trends in exchange rates and
economic relationships between countries. It provides a framework for analyzing the relative value of
currencies and the impact of exchange rate movements on international trade and investment.

Interest Rate Parity

Interest Rate Parity (IRP) is an economic theory that establishes a relationship between exchange rates and
interest rates in different countries. It suggests that the difference in interest rates between two countries should
be equal to the expected change in exchange rates between their currencies. In other words, under IRP, there
should be no opportunity for risk-free profits through international borrowing and lending.
Here are some detailed notes on Interest Rate Parity:
Covered Interest Rate Parity (CIRP): CIRP is a version of IRP that takes into account the existence of
forward exchange markets. It states that the interest rate differential between two countries should be equal to
the difference between the spot exchange rate and the forward exchange rate for the respective currencies. This
equilibrium condition ensures that investors cannot earn arbitrage profits by borrowing in a low-interest rate
currency, converting it to a higher-interest rate currency, and simultaneously entering into a forward contract to
convert it back to the original currency.
Uncovered Interest Rate Parity (UIRP): UIRP assumes that investors do not cover their foreign exchange
exposure through forward contracts. It states that the expected change in the exchange rate between two
currencies should offset the interest rate differential. According to UIRP, investors will earn the same return
regardless of whether they invest in a domestic or foreign currency. If the interest rate in one country is higher
than another, it is expected that the higher interest rate currency will depreciate in the future, compensating for
the interest rate differential.
Deviations from IRP: In practice, IRP may not always hold due to various factors. Transaction costs, capital
controls, and market frictions can create opportunities for arbitrage and result in deviations from IRP.
Additionally, factors such as investor risk aversion, market expectations, and government interventions can
influence exchange rates and interest rates, causing deviations from the theoretical parity condition.
Covered vs. Uncovered Interest Parity
When discussing foreign exchange rates, you may often hear about “uncovered” and “covered” interest rate
parity. Uncovered interest rate parity exists when there are no contracts relating to the forward interest rate.
Instead, parity is simply based on the expected spot rate. With covered interest parity, there is a contract in place
locking in the forward interest rate.
In truth, there is often very little difference between uncovered and covered interest rate parity, because the
expected spot rate and forward spot rate are usually the same. The difference is that with covered interest parity,
you are locking in future rates today. With uncovered interest parity, you are simply forecasting what rates will
be in the future.
Empirical Testing: Economists and analysts often test IRP empirically to assess its validity. They examine the
relationship between interest rate differentials and exchange rate movements to determine if they are consistent
with IRP predictions. However, empirical studies have found mixed results, suggesting that other factors
beyond interest rate differentials play a significant role in exchange rate determination.
Interest Rate Parity provides insights into the interplay between interest rates and exchange rates, influencing
international capital flows and currency markets. While it serves as a useful theoretical framework, real-world
complexities and market dynamics often lead to deviations from the ideal parity conditions.
Fisher Effect
The Fisher Effect is an economic theory that describes the relationship between nominal interest rates, real
interest rates, and expected inflation. It suggests that changes in expected inflation will lead to corresponding
changes in nominal interest rates, while real interest rates remain relatively stable.
Here are some key points to note about the Fisher Effect:
Nominal Interest Rate: The nominal interest rate represents the stated interest rate on a financial instrument,
such as a loan or bond. It is the rate at which money invested or borrowed grows over time, without considering
the effects of inflation.
Real Interest Rate: The real interest rate is the nominal interest rate adjusted for inflation. It reflects the
purchasing power of money after accounting for changes in the general price level. The real interest rate
indicates the true return on an investment or the cost of borrowing, taking into account the erosion of value due
to inflation.
Expected Inflation: Expected inflation refers to the anticipated rate of inflation in the future. It is based on
market expectations, economic indicators, and other factors. Expectations of higher inflation imply a decrease
in the future purchasing power of money.
Fisher Equation: The Fisher Effect is derived from the Fisher Equation, which states that the nominal interest
rate is equal to the sum of the real interest rate and expected inflation. Mathematically, it can be expressed as:
Nominal Interest Rate = Real Interest Rate + Expected Inflation.

Implications of the Fisher Effect: According to the Fisher Effect, an increase in expected inflation will lead to
an increase in the nominal interest rate. This adjustment compensates lenders for the eroding value of money
and maintains the real interest rate at a relatively constant level. Similarly, if expected inflation decreases, the
nominal interest rate should decrease.
Empirical Evidence: Empirical studies have produced mixed results regarding the Fisher Effect. While some
research supports the theory, others find limited or weak evidence of a long-run relationship between nominal
interest rates and inflation. Various factors, such as financial market frictions, central bank policies, and
investor expectations, can influence the observed relationship.
The Fisher Effect provides a theoretical framework to understand the interplay between nominal interest rates,
real interest rates, and inflation. However, real-world complexities, including expectations and other market
dynamics, can lead to deviations from the idealized relationship described by the theory.

Forecast Currency Exchange Rates

If you’re a Forex trader, currency rate forecasting is a fundamental activity for you. If you fail to forecast an
exchange rate or at least a price direction, you could end up losing your funds. To minimise risks, a trader
should be equipped with various methods that will help them determine a currency price.
The question of how to forecast exchange rates is one of the most frequently asked in Forex trading. Although
many methods can be used to forecast exchange rates, not all of them are simple. Some of them require large
amounts of data or complex technical knowledge. However, the ones that a trader of any level can use are
covered in this article.
Factors That Affect a Currency Rate
There are some factors that form the basis of the different FX rate forecast methods, and these factors are:
Government Stability
Changes in government, in its policy, and even coups and wars can affect the exchange rate. Usually, wars lead
to the depreciation of a domestic currency, while presidential elections may cause increased price volatility.
Economic Reports
The economy of any country determines how strong a domestic currency will be. That is: a growing economy
indicates opportunities for appreciation. Conversely, economic problems will lead to a currency’s decline.
However, the underlying economy is influenced by many factors including inflation, unemployment rate, and
Gross Domestic Product (GDP). Therefore, to analyse the value of a currency, traders may use these metrics.
Central Bank Monetary Policy
High inflation and unemployment rates are some of the economic issues that any country may face, and
monetary policy aims to manage them.
Monetary policy includes various tools that allow a central bank to stabilise an economy. For instance, it can
foster economic growth by increasing the money supply.
An interest rate decision is a common factor for predicting exchange rates. The rule is: when the central bank
raises the interest rate, the domestic currency usually appreciates. When it cuts the rate, the country’s legal
tender usually depreciates.
Ways to Predict Exchange Rates
Many methods have been created to forecast currency price direction, check some of them below.
1. Fundamental Analysis
This forecast method includes all the factors mentioned above, such as monetary policy, domestic and foreign
government policy, and global economic and political conditions. Knowing the factors that may affect a
currency and constantly following economic releases and news, a trader has the potential to forecast its value.
2. Technical Analysis
This approach doesn’t consider the influence of external forces. Rather, it uses patterns discovered from
historical price data and statistics to forecast future movement. Indicators, trendlines, and candlestick and chart
patterns are essential instruments of technical analysis. You could use the TickTrader platform to discover
technical analysis tools.
These were common methods for currency exchange predictions. Below you will find five macroeconomic
approaches you may implement when analysing currencies.
3. Relative Economic Strength
It’s already been established that numerous economic factors make up FX rate forecasts. However, many
traders are unaware that these factors also interact with each other.
For example, a country’s inflation or unemployment rate can give traders an idea of what its monetary policy
will be like. So, traders can observe these economic factors. By doing this, they get an idea of what’s going to
happen to the domestic economy and exchange rates.
Of course, this currency projection method isn’t the most accurate out there. It won’t provide any numbers
regarding the new currency value; however, it will be possible to tell if the currency increases or decreases in
the short term.
4. Econometric Model
This FX rate forecast method is personal, as it differs between traders. Here, Forex traders select whatever
metrics they believe influence the currency market the most. Comparing economic conditions in two countries,
traders could forecast an exchange rate.
For example, considering the EUR/USD pair, a trader could compare interest rates in the EU and the US, GDPs,
and the unemployment rate. By determining differences, they may predict the direction of a pair’s rate.
5. Purchasing Power Parity (PPP)
While the relative economic strength approach gives a direction for currency movement, purchasing power
parity says what the rate is supposed to be.
This method asserts that the price of goods and services should be equal, regardless of the country. If there are
any differences in price, a trader can calculate the suitable exchange rate that will make goods or services cost
the same.
For example, a table in France costs €50, while that same table is priced at $80 in the USA. Considering the
difference in price, a trader can determine the EUR/USD pair’s value. To buy the same table in France and the
USA, the EUR/USD rate must be $1.6.
Knowing the required exchange rate, traders might determine whether a currency is overvalued or undervalued.
With this, they can make a guess at future currency values.
6. Interest Rate Parity (IRP)
The interest rate parity is quite similar to purchasing power parity. But PPP focuses on the prices of goods,
while IRP focuses on currency and interest rates.
The general concept of this model is that the differential between interest rates should equal the differential
between spot and forward exchange rates.
So, if an investor exchanges a domestic currency for a foreign one and invests it in a foreign economy or uses a
domestic currency to invest in the home country and converts the proceeds from the investment into a foreign
currency, their earnings will be the same in both cases.
The Interest Rate Parity method implies the following formula:

Where:
F0 = Future exchange rate
S0 = Current (spot) exchange rate
ia = Interest rate of the country of the quote currency
ib = Interest rate of the country of the base currency
The theory says that a trader should calculate the current currency pair rate and the interest rates of both
countries to determine the future exchange rate of a currency pair.
7. Balance Payment Theory
This foreign exchange model determines future currency values by considering a country’s rate of imports and
exports. The theory behind this method is that the domestic currency appreciates when it exports more than it
imports and depreciates when the opposite occurs.
 Unit – V

International Capital Markets - Sources of International Finance, Debt and Equity Markets,
International Equity Diversification. Short-term Vs Long-term Finance. Export Import
Finance. ADRs, GDRs, IDRs - benefits and costs of holdings for investors, benefits and costs
of issuance for corporations.
International Capital Structure – Parent Vs Subsidiary Norms. Global Capital Structure –
Factors affecting the choice of markets and structure. International Cost of Capital –
Calculation, Cost of Foreign Debt, Cost of Foreign Equity, Use of International CAPM. RBI
Guidelines.
International finance refers to the financial interactions between countries, including cross-border
investments, trade financing, foreign exchange transactions, and more. There are various sources of
international finance that countries, governments, businesses, and individuals can utilize to fund their
activities and investments across borders. Here are some common sources:
Foreign Direct Investment (FDI):
Foreign direct investment involves investing in businesses and assets located in another country. It can take
the form of equity investments, acquisitions, joint ventures, and the establishment of subsidiaries abroad.
Foreign Portfolio Investment (FPI):
Foreign portfolio investment involves investing in financial instruments such as stocks, bonds, and other
securities of foreign companies or governments. FPI provides exposure to international markets without
direct ownership or control.
International Loans and Borrowing:
Governments and businesses can borrow funds from international banks, financial institutions, and other
countries to finance projects and operations. This can include bilateral and multilateral loans.
Export Financing:
Export financing includes loans, credits, and guarantees provided by governments and financial institutions
to support international trade. It helps exporters and importers manage risks and ensure smooth transactions.
Multilateral and Bilateral Aid:
Countries provide financial assistance to other countries through multilateral institutions like the World
Bank, International Monetary Fund (IMF), and regional development banks, as well as through bilateral aid
agreements.
Eurobonds and International Bonds:
Companies and governments can issue bonds denominated in a currency other than their domestic currency.
Eurobonds are issued in international markets and are subject to international regulations.
Foreign Aid and Grants:
Countries receive financial assistance, grants, and aid from other countries and international organizations to
support development projects, humanitarian efforts, and economic growth.
Remittances:
Individuals working abroad often send money back to their home countries, known as remittances. These
inflows contribute significantly to the economies of many developing countries.
Trade Finance:
Trade finance includes various instruments such as letters of credit, export and import financing, and trade
credit insurance, which facilitate international trade transactions by providing guarantees and financing to
buyers and sellers.
 Foreign Exchange Markets:
Currency trading in the foreign exchange (forex) markets involves the exchange of one currency for another.
This is used for international trade, investment, speculation, and hedging against currency risk.
Sovereign Wealth Funds:
Some countries establish sovereign wealth funds that invest in foreign assets, such as stocks, bonds, real
estate, and other financial instruments, using surplus funds generated from commodities or foreign exchange
reserves.
Global Financial Institutions:
Multinational financial institutions like commercial banks, investment banks, and asset management firms
provide international finance services such as cross-border banking, capital raising, and asset management.

These sources of international finance play a crucial role in promoting economic growth, facilitating trade, and
enabling cross-border investment and cooperation. The choice of financing source depends on factors such as
the purpose of funding, risk tolerance, costs, terms, and the availability of resources in the global financial
markets.

MEANING OF DEPOSITORY RECEIPTS:

Depository receipts are a type of negotiable financial security representing a security, usually in the form of
equity, issued by a foreign publicly-listed company. However DRs are traded on a local stock exchange
though the foreign public listed company is not traded on the local exchange.
International capital market comprises of debt and equity market. Debt market includes international bond
market and the equity market includes international equity market. The international equity market can
further be divided into various depository receipts-ADR, GDR and IDR.

(1) ADR- American Depository Receipts:-

American depository receipts popularly known as ADRs were introduced in the American market in
1927. ADR is security issued by a company outside the U.S which physically remains in the country
of issue, usually in the custody of a bank, but is traded on U.S. stock exchange in other words, ADR
is a stock that trades in the United States but reprints a specified number of shares in a foreign
corporation.
An ADR:
 Is a negotiable certificate issued by a U.S bank
 Represents a specified number of shares of a foreign company
 ADRs are denominated in U.S dollars
 Ownership in the shares of a non-U.S company and trades in U.S financial markets
 ADRs are listed on US stock exchange: NYSE, AMEX, or NASDAQ.
Different types of ADR programs:
A sponsored ADR is approved and backed by the foreign company behind the shares. An investor looking
at an OTC ADR should verify whether the ADR shares are sponsored and may want to stay clear of
 unsponsored shares.
Sponsored ADR is an ADR issued by a bank on behalf of the foreign company whose equity serves as the
underlying asset. A sponsored ADR creates a legal relationship between the ADR and the foreign company
which absorbs the cost of issuing the security.
An unsponsored ADR an ADR issued by a depositary bank without the involvement or participation-or
even the consent -of the foreign issuer whose stock underlies the ADR the issuer therefore has no control
over an unsponsored ADR, in contrast to a sponsored ADR where it retains control. Unsponsored ADRs
are usually established by depositary banks in response to investor demand. Shareholder benefits and
voting rights may not extended to the holders of these particular securities. Unsponsored ADRs generally
trade over-the-counter (OTC) rather than on United States exchanges.

SOPONSORED ADR UNSPONSORED ADR

Issued with cooperation of the company whose Issued by a broker/dealer or depository bank
stock will underlie the ADR without the involvement of company whose stock
underlies the ADR
Comply with regulatory reporting No regulatory reporting
Listing on international Stock Exchanges allowed. Trade on OTC market

Levels of ADR:
a. Level 1 ADRs: level 1 ADRs are the lowest level of sponsored ADRs and also the simplest
methodfor companies top aces the US capital markets level 1 ADRs are traded in the over-the-
counter (OTC) market. The issuing company does not have to comply with US market.
b. Level II ADRs: level II ADRs enable companies to list their ADRs on NASDAQ, the American
stock exchange the new York stock exchange and the American stock exchange, the new York
stock exchange and the American Level II ADRs require a form 20- F and form F-6 to be filled
with the SEC, as well as meting the listing requirements and filling a listing application with the
designated stock exchange.
c. Level III ADRs:- level III ADRs enable companies to list their ADRs on NASDAQ, the Amex, the
NYSE or the OTC bulletin board and make a simultaneous public offering of ADRs in the united
states. The benefits of level III ADRs are substantial; it allows the issuer to raise capital and leads to
much greer visibility in the US market. Level III ADR programs must comply with various SEC
rules, including the full registration and reporting requirements of the SEC’s exchange Act.
 1) GDR- Global Depository Receipts:
These are similar to the ADR but are usually listed on exchanges outside the U.S, such as
Luxembourg or London Dividends are usually paid in U.S. dollars. GDR allows investors of any
country to purchase and sell shares of a company in any other country, entitling the shareholders to
partake in the dividend and capital gains of that foreign company.
A GDR is set up when a company from one country intends to list its publicly-traded shares in any
foreign country.

2) IDR-Indian Depository Receipts:

IDR is an exact reverse of the ADR/GDR issue. IDR’s allow foreign companies to mobilizing funds
from India markets these foreign companies get listed on Indian stock exchange. IDR is a financial
instruments denominated in Indian rupees in the form of a depository receipt created by a domestic
depository against the underlying equity of issuing company to enable foreign the underlying shares
would accrue to the depository receipts holders in India. Standard chartered PLC became the first
global company to file for an issue of Indian depository receipts in India in june 2010. IDR needs to
be registered with SEBI.
 SEBI has set Rs.50 crore as the lower limit for the IDRs to be issued by the Indian companies.
 Moreover, the minimum investments required in the IDR issue by the investor has been fixed at
Rs two lakh.
 Also, the IDR issuing company should have good track record with respect to securities market
regulations and companies not meeting the criteria will not be allowed to raise funds from the
domestic market.

Parties involved in ADR/GDR issue:

1) The issue company is the first party this is typically a large foreign based corporation that is already
listed on a local foreign exchange. Rather than dual list its shares on its home exchange and on a U.S
exchange.
2) Custodian bank is the second party in this process. They accept all the relevant documents from the
issuing company and keep them in custody. They accepts the shares from the company stores all of
them in its vault.
3) Depository bank:- the overseas bank by accepting the issuing company’s shares and selling
representative certificates to investors. It is a subsidiary of a commercial bank located in the country
where the DR’s are to be issued.
4) A stock exchange:- they list the bank certificate for trading allowing investors to buy and sell
 ADR/GDR units just as they would normal shares.
5) Lead manager:-they are merchant bankers for the issuing company. They help in smoothing the DR
issue process. The company has to chose a competent lead manager to managers usually charge a fee
as percent of the issue.
Advantage of ADRs/GDRs issue:
 For individuals, adrs/ GDRs are an easy and cost effective way to buy shares of a foreign company.
The individual are able to save considerable money and energy by trading in ADR’s/GDRs, as it
reduces administrative costs and avoids foreign taxex on each transaction
 It gives attractive pricing to the issuer.
 It provides diversification opportunity to the investors
 ADRs/GDRs can be listed on any of the overseas stock exchanges.
 Capital can be easily raised from foreign markets.
 It helps enhancing the image of company globally.

Distinguish between ADR and GDR:

ADR (American Depositary Receipt) and GDR (Global Depositary Receipt) are both financial instruments used to
facilitate the trading of foreign company stocks in international markets. They are issued by banks in different regions and
represent ownership of shares in foreign companies. Here's how they differ:
Point of
ADR (American Depositary Receipt) GDR (Global Depositary Receipt)
Difference
ADRs are issued by U.S. banks and GDRs are similar to ADRs but are issued by
represent shares of non-U.S. companies, banks outside the United States and traded
Definition
primarily traded on American stock in various countries, typically in Europe or
exchanges (e.g., NYSE or NASDAQ). Asia.
They are listed and traded on U.S. stock They are listed and traded on international
exchanges in U.S. dollars, providing stock exchanges, such as the London Stock
American investors with an easy way to Exchange (LSE) or Luxembourg Stock
Listing Location
invest in foreign companies without Exchange, in currencies like euros or
dealing with foreign exchanges or dollars.
currencies
Regional Primarily targeted at the American Geared towards international investors,
Availability market, ADRs are mostly available for GDRs are commonly issued for companies
companies from regions like Asia, from various regions worldwide, including
Europe, or Latin America.
 the Americas, Asia, and Europe.

Traded in U.S. dollars, and dividends Traded in various currencies based on the
are usually paid in U.S. dollars exchange where they are listed, and
Currency
dividends are typically paid in the currency
of the GDR.
Governed by the U.S. Securities and Subject to the regulations of the country in
Exchange Commission (SEC) which they are listed, which may vary
Regulation
regulations, with specific reporting and depending on the exchange
compliance requirements
Foreign companies issue ADRs to access Foreign companies issue GDRs to access
Usefulness for the U.S. capital markets, expand their international investors and diversify their
Foreign investor base, and increase their visibility shareholder base outside their home
Companies among American investors. country.

In summary, ADRs and GDRs are both mechanisms to facilitate the trading of foreign company shares in
international markets, but ADRs are specific to the U.S. market and traded in U.S. dollars, while GDRs are
issued and traded on international exchanges outside the United States in various currencies.

International capital structures

International capital structures refer to the way companies within a multinational corporation group allocate
financial resources and manage debt and equity across their various entities, including both parent and
subsidiary companies. These structures are influenced by a variety of factors, including regulatory
environments, taxation, market conditions, and the strategic goals of the corporation.
Parent Company Norms:
1. Centralized Control: The parent company typically exercises significant control over the capital structure
of its subsidiaries. Decisions related to financing, capital allocation, and debt management are often made at
the parent level.
2. Access to Capital Markets: The parent company usually has better access to international capital markets
due to its size, brand recognition, and creditworthiness. It can raise funds by issuing bonds or equity
securities directly.
3. Financial Flexibility: The parent company might structure its capital to optimize its overall financial health
and flexibility, taking into consideration its global operations and the need to maintain liquidity for potential
investments, acquisitions, or economic downturns.
Subsidiary Company Norms:
1. Local Market Dynamics: Subsidiaries often need to consider the specific market conditions, regulatory
requirements, and investor preferences of the countries in which they operate. This can influence their
capital structure decisions.
2. Currency and Interest Rate Risks: Subsidiaries might choose to match their debt and equity
denominations with the local currency to reduce currency risk. They might also consider interest rate
differences between countries when determining their debt structure.
3. Tax Considerations: Subsidiaries need to be mindful of local tax regulations, including rules on interest
deductibility and withholding taxes. Debt and equity financing choices can impact the tax liabilities of the
subsidiary and the overall multinational group.
4. Risk Management: Subsidiaries might adopt capital structures that help manage local economic and
political risks. For example, they might avoid excessive debt in regions with uncertain economic conditions.
5. Local Funding Sources: Depending on the subsidiary's financial performance and local market conditions,
it might raise capital locally through bank loans or other financial instruments to leverage local relationships
and reduce borrowing costs.
It's important to note that while these norms provide a general framework, the actual capital structure of
multinational corporations can vary widely based on the company's industry, geographical presence, financial
goals, and risk appetite. Moreover, there has been increased scrutiny and regulation related to transfer pricing
and thin capitalization, which can impact how companies allocate debt and equity across their international
operations.
Companies and their financial teams carefully analyze these factors to strike a balance between optimizing their
global capital structure and adhering to local regulations and market dynamics. Consulting with financial and
legal experts familiar with both international finance and local regulations is crucial for making informed
capital structure decisions within a multinational corporation.
INTERNATIONAL COST OF CAPITAL
The international cost of capital refers to the weighted average cost of capital (WACC) that a multinational
corporation uses to assess the attractiveness of investment opportunities in different countries. It takes into
account the costs of both debt and equity capital from various sources, such as domestic and foreign markets.
Calculating the international cost of capital involves determining the cost of foreign debt and the cost of foreign
equity.

There are different components and approaches to calculating the cost of capital:

1. Cost of Foreign Debt:

The cost of foreign debt is the rate of return required by creditors and investors who provide debt financing to a
company operating in a foreign country. This cost can be calculated using the following steps:
a. Identify the Cost of Borrowing in the Foreign Market: Determine the interest rate or yield that the
company would need to pay on debt issued in the foreign market. This can be based on prevailing interest rates
in that market and the perceived risk associated with the company.
b. Adjust for Tax Implications: Consider the tax implications of the foreign debt. Interest expenses on debt
are usually tax-deductible, which can reduce the effective cost of debt. Calculate the after-tax cost of debt by
subtracting the tax shield (tax rate multiplied by interest rate) from the pre-tax cost of debt.
2. Cost of Foreign Equity:
The cost of foreign equity is the required rate of return that investors expect in exchange for holding equity
shares of a company operating in a foreign country. The cost of foreign equity can be calculated using the
Capital Asset Pricing Model (CAPM) or other methods:
a. Capital Asset Pricing Model (CAPM) Approach: The CAPM formula is as follows:
Cost of Equity=Risk−Free Rate+Beta×(Market Risk Premium)
 Determine the risk-free rate in the foreign market (e.g., government bond yield).
 Estimate the company's beta, a measure of its volatility compared to the market.
 Determine the market risk premium, which represents the excess return investors expect from investing in
equities over the risk-free rate.
b. Other Approaches: Apart from CAPM, other methods such as the Dividend Discount Model (DDM) or the
Build-Up Method can be used to estimate the cost of equity.
3. Weighted Average Cost of Capital (WACC):
After calculating the cost of foreign debt and the cost of foreign equity, you can calculate the WACC by
combining the weighted costs of both debt and equity, taking into account the company's capital structure. The
formula for WACC is as follows:
WACC=(Weight of Debt×Cost of Debt)+(Weight of Equity×Cost of Equity)
Where:
 Weight of Debt = (Total Debt) / (Total Debt + Total Equity)
 Weight of Equity = (Total Equity) / (Total Debt + Total Equity)
Keep in mind that the cost of capital can vary based on the country's economic conditions, political stability,
currency risks, and other factors. It's also important to periodically reassess these costs as conditions change.
Consulting financial experts and considering the specific circumstances of your multinational corporation's
operations is recommended when calculating the international cost of capital, as it involves complex financial
modeling and consideration of various market and regulatory factors.

International capital structure

International capital structures refer to the way multinational corporations (MNCs) organize their financial
resources across different subsidiaries and the parent company. The choice of capital structure can have
significant implications for factors such as tax efficiency, risk management, funding costs, and regulatory
compliance. When comparing parent company norms with subsidiary norms in an international context, there
are several key considerations:
Parent Company Norms:
1. Centralized Control: The parent company often exercises a higher degree of control over its
subsidiaries. This can lead to a more unified capital structure approach, where funding decisions are
made at the headquarters level.
 2. Access to Funding: Parent companies typically have better access to diverse funding sources due to
their size, creditworthiness, and reputation. They may issue debt or equity on more favorable terms
compared to subsidiaries.
3. Risk Management: Centralized control allows the parent to manage risks more effectively, as it can
allocate resources strategically and respond to market changes quickly.
4. Tax Optimization: Parent companies might structure their capital in a way that minimizes their overall
tax liability. This could involve channeling debt to subsidiaries in regions with favorable tax regimes to
reduce the group's global tax burden.
Subsidiary Norms:
1. Local Factors: Subsidiaries often operate in different countries with varying economic conditions, legal
frameworks, and investor preferences. Their capital structure decisions may be influenced by local
market conditions.
2. Funding Restrictions: Subsidiaries might face restrictions on borrowing from external sources due to
local regulations or limited access to global financial markets. This can impact their capital structure
choices.
3. Currency Risk: Subsidiaries operating in different countries deal with currency exchange rate risks.
They might opt for a capital structure that aligns with their local currency liabilities to mitigate this risk.
4. Operational Autonomy: Subsidiaries might require autonomy in managing their own capital structure
to cater to their specific operational needs. This can lead to variations in financing decisions across
different subsidiaries.
5. Profit Repatriation: Subsidiaries might need to consider the ease of repatriating profits to the parent
company. This can influence the choice between debt and equity financing, as well as the currency
denomination of financial instruments.
In practice, MNCs often aim to strike a balance between centralized control and subsidiary autonomy when it
comes to capital structure decisions. They consider factors such as the cost of capital, risk management,
regulatory compliance, and the overall financial health of both the parent company and subsidiaries. The goal is
to optimize the allocation of financial resources while taking into account the complexities of operating in
multiple jurisdictions.

FACTORS AFFECTING THE CHOICE OF CAPITAL STRUCTURE

What is Capital Structure?
Capital structure decisions involve determining the types of securities to be issued as well as their relative share
in the capital structure. The financial decision regarding the composition of the capital structure is made after
the financial requirements have been established. It entails determining how much money should be raised from
each source of funding. In short, capital structure decisions involve determining the type of securities to be
issued and their relative capital share.

Capital Structure refers to the proportion of debt and equity used for financial business operations.
Based on ownership, sources of business finance are classified into two categories:
1. Owner’s funds (Equity): They are composed of retained earnings, preference share capital, and equity
share capital.
2. Borrowed funds (Debt): They are made up of bank deposits, loans, and debentures. Banks, other
financial institutions, holders of debentures, and the general public may all lend money for it.
Important Points about Debt and Equity:
1. Nature: Equity is the owner’s money, whereas debt represents funds that have been borrowed.
2. Cost of Debt is less than Cost of Equity: The debt involves less cost as compared to equity. First, the
interest paid on the debt is deducted while calculating tax liability. Second, the risk of lenders is less than that of
equity shareholders as they get assured returns every year. Thus, they require a lower rate of return as compared
to equity shareholders. Hence, increasing the use of debt, while maintaining the cost of equity lowers the overall
cost of capital.
3. Debt is riskier than Equity: Debt is risky because it is a legal obligation of the business to make payments
of common interest. In case of failure of payment, debt holders can claim over the assets of the business and if a
company doesn’t pay the return of principal, it may enter liquidation or another insolvency stage. On the other
hand, equity shareholders do not create a legal obligation on the business to pay a dividend if it is running at a
loss. Hence, increasing the use of debt increases the financial risk of a business.
It can be concluded that the capital structure represents the percentage of debt to equity in the capital structure.
The capital structure of the business impacts the profitability and financial risk of the business. It is very
difficult to define what kind of capital structure is best for a business. It must ultimately increase the value of
equity shares or maximize the wealth of equity shareholders.
Factors affecting the Capital Structure

1. Cash Flow Position:

The composition of the capital structure is determined by the business’s ability to create cash flow. It is
essential to consider the cash flow in the future to choose the capital structure. The company must have
sufficient funds for funding business operations, investing in fixed assets, and fulfilling debt obligations, such as
interest and capital repayments. The firm must pay dividends to preferred shareholders, fixed-rate interest to
debenture holders, and loan principal and interest. Sometimes, a company produces sufficient profit but is
unable to produce cash inflow for payments. If the company does not make its financial commitments, it may
become insolvent. Therefore, the expected cash flow must match the obligation to make payments.
If a company is confident in its ability to generate sufficient cash flow, it should use more debt securities in its
capital structure; however, if there is a cash shortage, it should use more equity securities since there
is no obligation to pay its equity owners.
2. Interest coverage ratio(ICR):
ICR signifies the number of times a company’s earnings before interest taxes (EBIT) meet its interest payment.
The ICR specifies the number of times EBIT can repay the interest obligation. A high ICR shows that
companies can have borrowed funds due to the lower risk of making interest payments whereas a lower ratio
shows that the company should use less debt.
3. Return on Investment(ROI): Return on Investment is a crucial factor in designing an appropriate capital
structure.
4. Debt Service Coverage Ratio(DSCR):
Under this, the amount of money needed to pay off debt and the capital for preferred shares is compared to the
profit generated by operations. A higher DSCR indicates a better capacity to meet cash obligations, which
implies that the company can choose more debt. However, in the case of lower DSCR, the company prefers
more equity.
5. Cost of debt: The cost of debt has a direct impact on how much debt will be used in the capital structure. The
company will prefer higher debt over equity if it can arrange borrowed funds at a reasonable rate of interest.
6. Tax Rate:
High tax rates reduce the cost of debt because interest paid to debt security holders is deducted from income
before calculating tax, whereas businesses must pay tax on dividends paid to shareholders. So, a high tax rate
implies a preference for debt, whereas a low tax rate implies a preference for equity in the capital structure.
7. Cost of equity:
The cost of equity is another aspect that influences capital structure. The usage of debt capital has an impact on
the rate of return that shareholders expect from equity. The financial risk that shareholders must deal with
increases as more debt is used. The required rate of return rises when the risk does as well. As a result, debt
should only be used sparingly. Any use beyond the amount increases the cost of equity, and even though the
EPS is higher, the share price may fall.
8. Floatation Costs:
It is the cost incurred on the issue of shares or debentures. It includes costs like advertisement, underwriting,
brokerage, stamp duty, listing charges, statutory fees, etc. Before making a decision, it is important to carefully
calculate the costs associated with raising money from various sources. There are additional formalities and
costs associated with issuing shares and debentures. However, it is less expensive to raise funds through loans
and advances.
9. Risk Consideration:
There are two categories of risk:
1. Financial risk is the state in which a business is unable to pay its set financial obligations, such as
interest, a dividend on preferred stock, payments to creditors, etc.
2. Business risk refers to the risk of the business’s inability to pay its fixed operating expenses, such as
rent, employees’ salaries, insurance premiums, etc.
Total risk refers to the sum of business and financial risk. Thus, if the company’s business risk is low, it may
suffer financial risk, implying that more borrowed capital can be utilized. But when business risk is higher, debt
should be used to lower financial risk.
10. Flexibility:
The firm’s ability to borrow more money may be limited by an excessive amount of debt. It must maintain some
borrowing capacity to be flexible and deal with uncertain events.
11. Control:
The company’s equity stockholders are regarded as its owners, and they have complete control over it. The
control of shareholders is not affected, however, by the issuance of debt. Debt should be employed if the current
shareholders desire to keep control. The company might opt for equity shares if they don’t mind giving up
control.
12. Regulatory Framework:
When choosing its capital structure, every company is required to follow the legal framework. The SEBI
guidelines must be followed when issuing shares and debentures. Loans from banks and other financial
institutions are likewise subject to several regulations. Companies may prefer to give securities as a source of
additional capital if SEBI regulations are straightforward, or they may opt for more loans if monetary policies
are more flexible.
13. Stock Market Conditions:
Market conditions can be divided into two categories: boom conditions and recession or depression conditions.
These conditions have an impact on the capital structure, particularly if the company plans to raise further
capital. Depending on the state of the market, investors might be more cautious in their dealings. People are
willing to take a risk and buy stock shares even at greater prices during a boom period. Investors favour debt,
which has a fixed rate of return, but, in a recession or depression period.
14. Capital Structure of other Companies:
Some businesses design their capital structures in accordance with industry norms. However, it must exercise
proper care as blindly following industry standards can result in financial risk. If a company cannot afford the
high risk, it should not increase debt just because other companies are doing so.
WHAT IS COST OF CAPITAL?
Cost of capital is the minimum rate of return or profit a company must earn before generating value. It’s
calculated by a business’s accounting department to determine financial risk and whether an investment is
justified.
Company leaders use cost of capital to gauge how much money new endeavors need to generate to offset
upfront costs and achieve profit. They also use it to analyze the potential risk of future business decisions.
Cost of capital is extremely important to investors and analysts. These groups use it to determine stock prices
and potential returns from acquired shares. For example, if a company’s financial statements or cost of capital
are volatile, cost of shares may plummet; as a result, investors may not provide financial backing.

HOW TO CALCULATE COST OF CAPITAL

To determine cost of capital, business leaders, accounting departments, and investors must consider three
factors: cost of debt, cost of equity, and weighted average cost of capital (WACC).
1. Cost of Debt
While debt can be detrimental to a business’s success, it’s essential to its capital structure. Cost of debt refers to
the pre-tax interest rate a company pays on its debts, such as loans, credit cards, or invoice financing. When this
kind of debt is kept at a manageable level, a company can retain more of its profits through additional tax
savings.
Companies typically calculate cost of debt to better understand cost of capital. This information is crucial in
helping investors determine if a business is too risky. Cost of debt also helps identify the overall rate being paid
to use funds acquired from financial strategies, such as debt financing, which is selling a company’s debt to
individuals or institutions who, in turn, become creditors of that debt.
There are many ways to calculate cost of debt. One common method is adding your company’s total interest
expense for each debt for the year, then dividing it by the total amount of debt.
Another formula that businesses and investors can use to calculate cost of debt is:
Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
Here’s a breakdown of this formula’s components:
1. Risk-free return: Determined from the return on US government security
2. Credit spread: Difference in yield between US Treasury bonds and other debt securities
3. Tax rate: Percentage at which a corporation is taxed
Companies in the early stages of operation may not be able to leverage debt in the same way that well-
established corporations can. Limited operating histories and assets often force smaller companies to take a
different approach, such as equity financing, which is the process of raising capital through selling company
shares.
2. Cost of Equity
Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding
debts, and it’s crucial to a company’s long-term success.
Cost of equity is the rate of return a company must pay out to equity investors. It represents the compensation
that the market demands in exchange for owning an asset and bearing the risk associated with owning it.
This number helps financial leaders assess how attractive investments are—both internally and externally. It’s
difficult to pinpoint cost of equity, however, because it’s determined by stakeholders and based on a company’s
estimates, historical information, cash flow, and comparisons to similar firms.
Cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which considers an investment’s
riskiness relative to the current market.
To calculate CAPM, investors use the following formula:
Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)
Here’s a breakdown of this formula’s components:
1. Risk-free return: Determined from the return on US government security
2. Average rate of return: Estimated by stocks, such as Dow Jones
3. Return risk: Stock’s beta, which is calculated and published by investment services for publicly held
companies
Companies that offer dividends calculate the cost of equity using the Dividend Capitalization Model. To
determine cost of equity using the Dividend Capitalization Model, use the following formula:
Cost of Equity = (Dividends per Share / Current Market Value of Stocks) + (Dividend Growth Rate)

Here’s a breakdown of this formula’s components:

1. Dividends: Amount of money a company pays regularly to its shareholders
2. Market value stocks: Fractional ownership of equity in an organization that’s value is determined by
financial markets
3. Dividend growth rate: Annual percentage rate of growth of a dividend over a period
3. Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the most common method for calculating cost of capital. It
equally averages a company’s debt and equity from all sources.
Companies use this method to determine rate of return, which indicates the return that shareholders demand to
provide capital. It also helps investors gauge the risk of cash flows and desirability for company shares,
projects, and potential acquisitions. In addition, it establishes the discount rate for future cash flows to obtain
value for a business.
WACC is calculated by multiplying the cost of each capital source (both equity and debt) by its relevant weight
by market value, then adding the products together to determine the total. The formula is:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Here’s a breakdown of this formula’s components:
 E: Market value of firm’s equity
 D: Market value of firm’s debt
 V: Total value of capital (equity + debt)
 E/V: Percentage of capital that’s equity
 D/V: Percentage of capital that’s debt
 Re: Required rate of return
 Rd: Cost of debt
 T: Tax rate
A high WACC calculation indicates that a company’s stock is volatile or its debt is too risky, meaning investors
will demand greater returns.

INTERNATIONAL CAPITAL STRUCTURE - RBI GUIDELINES

The Reserve Bank of India (RBI) sets guidelines and regulations related to various financial and capital market
activities, including those related to international capital structure for Indian companies. However, please note
that guidelines and regulations can change over time, so it's important to refer to the latest official sources for
the most up-to-date information. As of my last update, here are some key points related to international capital
structure based on RBI guidelines:
1. External Commercial Borrowings (ECBs): The RBI regulates the borrowing of funds by Indian
entities from foreign sources through ECBs. There are specific norms and limits for different sectors and
purposes of borrowing. These norms govern aspects such as eligible borrowers, recognized lenders,
permissible end uses, minimum maturity, and all-in-cost ceilings.
2. Foreign Currency Convertible Bonds (FCCBs): Indian companies are allowed to raise funds from
international markets through the issuance of FCCBs, subject to certain RBI regulations. These
regulations cover aspects such as pricing, end-use restrictions, and reporting requirements.
3. Overseas Direct Investment (ODI): Indian companies are allowed to make direct investments in
overseas joint ventures, wholly owned subsidiaries, and other business entities. The RBI sets guidelines
on the maximum amount of ODI that can be undertaken by Indian companies, reporting requirements,
and permissible investment routes.
4. Hedging and Risk Management: Indian companies with exposure to foreign currency risk are allowed
to hedge their positions through various financial instruments. The RBI has guidelines governing the use
of derivative instruments for risk management purposes.
5. Capital Account Transactions: The RBI monitors and regulates capital account transactions, which
involve movement of capital across borders. These transactions include equity investments, debt
investments, and other financial flows.
6. Reporting Requirements: Indian companies engaged in international capital transactions are required
to comply with reporting requirements set by the RBI. These reports provide the RBI with insights into
the flow of funds, compliance with regulations, and overall international financial activities of Indian
entities.
7. External Commercial Borrowings Framework: The RBI periodically reviews and updates the
framework for external commercial borrowings based on the economic and financial conditions. This
includes parameters like eligible borrowers, permissible end uses, and limits on borrowing.
It's important to note that RBI guidelines and regulations can change, and the information provided here might
not be up to date. For the most current and accurate information on international capital structure guidelines in
India, I recommend visiting the official RBI website or consulting legal and financial experts familiar with the
latest regulations.