Unit 1: Foundations and foreign exchange markets
International Financial Management notes · PTU syllabus (MCOPAF312-18)
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Unit summary
When firms cross borders, finance must deal with currencies, countries and global markets. This unit covers globalisation and the multinational firm, the importance and goals of international financial management, the structure of the foreign exchange market, exchange rate quotations, determination of exchange rates and international parity relationships.
After this unit you can
- Explain globalisation, MNCs and the goals of international financial management
- Describe the structure of the foreign exchange market and read quotations
- Explain the determination of exchange rates
- Apply international parity relationships — PPP, IRP and the Fisher effects
PTU syllabus topics
- Globalization and the multinational firm
- importance and goals of international financial management
- foreign exchange market structure
- exchange rate quotations (direct/indirect, spot/forward)
- determination of exchange rates
- international parity relationships
Purchasing power parity
Expected change in spot rate ≈ inflation difference
Interest rate parity
F / S = (1 + i home) / (1 + i foreign)
International Fisher effect
Spot change ≈ interest rate difference
Forward premium
(F − S) / S × 12/n × 100
Topic 1
Globalisation and the multinational firm
- Globalisation: integration of markets for goods, services, capital, technology and people — driven by trade liberalisation (WTO), technology, deregulation of capital flows.
- Multinational corporation (MNC): a firm with operations (production, sales) in several countries — Tata Group, Infosys, Unilever.
- Why firms go global: new markets, lower costs, access to resources and technology, diversification, following clients, tax and regulatory advantages.
Topic 2
Importance and goals of international financial management
- IFM differs from domestic FM due to foreign exchange risk, political (country) risk, market imperfections (taxes, capital controls) and expanded opportunity sets (global sourcing of funds).
- Goal: maximise shareholder wealth of the parent, considering exchange rates, country risk and global cost of capital.
Foreign exchange markets and risk management
International investment decisions
FDI, international capital budgeting
International financing
Euro markets, ADRs/GDRs, ECBs
Working capital and cash management across countries
International taxation and transfer pricing
Political risk assessment
Topic 3
Foreign exchange market and quotations
- Structure: a 24-hour, over-the-counter global market; participants — commercial banks (authorised dealers), central banks, corporates, brokers, investors; segments — retail and inter-bank; spot (settlement in two business days), forward, futures, options, swaps.
- India: regulated by RBI under FEMA; FBIL reference rate; currency derivatives on NSE/BSE; RBI intervenes to reduce volatility (managed float).
Meaning
Units of home currency per unit of foreign currency
Units of foreign currency per unit of home currency
Example in India
₹83.50 per US$
US$ 0.01198 per ₹
Used in India
Yes (since 1993)
Earlier
- Bid–ask spread: dealer buys at bid, sells at ask; spread % = (Ask − Bid) ÷ Ask × 100.
- Cross rates: derived through a common currency — ₹/€ = (₹/$) × ($/€).
- Forward premium/discount (annualised): (Forward − Spot) ÷ Spot × 12/n × 100.
Example
Spot ₹83.00/$, 3-month forward ₹83.83/$. Forward premium on dollar = (0.83 ÷ 83) × 4 × 100 = 4% p.a.
Topic 4
Determination of exchange rates
- Demand and supply: demand for foreign currency from imports, outward investment and debt repayments; supply from exports, inward FDI/FPI, remittances.
- Factors: relative inflation, interest rate differentials, income growth, current account balance, capital flows, government intervention, expectations and speculation, political stability.
- Exchange rate regimes: fixed (gold standard, Bretton Woods 1944–1971), floating, managed float, currency board, pegs.
Topic 5
International parity relationships
Purchasing power parity (relative)
S1 ÷ S0 = (1 + Ih) ÷ (1 + If)
Interest rate parity
F ÷ S = (1 + ih) ÷ (1 + if)
Fisher effect
(1 + i) = (1 + r)(1 + inflation)
International Fisher effect
Expected change in spot rate ≈ ih − if
Unbiased forward rate
Forward rate = expected future spot rate
Example
Spot ₹83/$; Indian interest 7%, US 4% for one year. IRP forward = 83 × 1.07 ÷ 1.04 = ₹85.39/$. If the actual forward is ₹84, covered interest arbitrage: borrow $, convert to ₹, invest at 7%, sell ₹ forward — earning a riskless profit until rates realign.
- Absolute PPP: the same basket costs the same everywhere (Big Mac index); deviations persist due to transport costs, tariffs, non-traded goods.
Key terms
- MNC
- Firm operating in several countries
- Direct quote
- Home currency per unit of foreign currency
- Cross rate
- Exchange rate derived through a third currency
- Interest rate parity
- Forward premium equals the interest rate differential
- Purchasing power parity
- Exchange rates adjust to inflation differences
Quick revision
- IFM adds FX risk, political risk, market imperfections, wider opportunities.
- FX market: OTC, spot and forward; RBI and FEMA in India.
- Quotes: direct, indirect, bid–ask, cross rates, forward premium.
- Determinants: inflation, interest rates, BoP, capital flows, intervention.
- Parities: PPP, IRP, Fisher, international Fisher, unbiased forward.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is an MNC?
- Q2.How does IFM differ from domestic FM?
- Q3.Distinguish direct and indirect quotation.
- Q4.What is a cross rate?
- Q5.State interest rate parity.
- Q6.What is the international Fisher effect?
Long-answer questions
- Q1.Explain globalisation, MNCs and the goals of international financial management.
- Q2.Explain the structure of the foreign exchange market and quotations.
- Q3.Explain the factors determining exchange rates.
- Q4.Explain international parity relationships with examples.
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