Functional Environment

Complex: The unpredictability of international events, conditions and influences provides complexity. The accounting standards of various countries differ. This constrains the development of financial information system. Foreign complexities need to be accommodated.

Risky: Dealing is required in a variety of foreign currencies. Changing currency rates pose foreign exchange risks. Such risks can increase the cost of capital. Leveraging through debt-equity ratio is affected.

Exchange Controls: Many developing countries have exchange controls. They affect convertibility of currencies. They also affect repatriation of profits.

Instruments: International financial management has to deal with a variety of instruments such as spot, forward, Fx swap, currency options, futures, currency swaps and letters of credit etc.

International Monetary System (International Financial System)

Every country has its own monetary system to facilitate trade and investment. The Central Bank of the country administers monetary policy. In Nepal, it is Nepal Rastra Bank

International business needs an efficient international monetary system. International monetary system aims to promote trade and investment across countries. Its concern is the system of exchange rate of any two countries.

In ancient times, the value of the metal contained in coins determined exchange rates. Gold standard was in wide use in the 19^th century. Free flow of gold was allowed among countries. The demise of gold standard created large variations in exchange rates.

Money Management Decisions

Money Management Decisions: Decisions about efficient management of resources, especially foreign exchange risk management, cost reduction, minimizing tax liabilities and distribution of profits.

The forces in the financial environment of international business consist of:

• International Financial System represented by IMF.
• Foreign Exchange Market
• Financial Institutions
• Exchange Policies and Controls

Foreign Exchange Market Terminology

Bid: The rate at which traders buy foreign exchange (buying rate).

Offer: The rate at which traders sell foreign exchange (selling rate)

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Spread: The difference between bid and offer rates. It is profit margin.

American Terms (Direct quote): The number of dollars per unit of foreign currency.

European Terms: The number of units of foreign currency per unit of dollar.

Cross Rate: The relationship between two nondollar currencies.

Multiple Exchange Rate system: Different exchange rates for different types of transactions.

Arbitrage: Buying and selling of foreign currencies at a profit due to price discrepancies.

Speculators: Trader’s position in foreign exchange market for earning a profit.

Hard Currency: A fully convertible currency which is relatively strong and stable in value.

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Convertible currency: A currency that can be freely traded for other currencies.

Exotic currency: Currency of a developing country which is weak, unstable and unpredictable.

Foreign Exchange Rate: Price of a currency.

Discount: It exists when forward rate is less than spot rate.

Premium: It exists when forward rate exceeds the spot rate.

Black Market: Price of currency based on supply and demand conditions instead of government controls.

Futures

It is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date. A contact is entered. It guarantees a future price for the trading of foreign exchange.

• Spot, forward and Fx swap are known as traditional foreign exchange market.

Options

They are the right to trade foreign currency in future. They are not obligations. It can be traded over-the-counter or security exchange.

Currency Swaps

They deal with interest-bearing bonds. They involve the exchange of principal and interest payments. They are over-the-counter instruments.

Fx Swap Transactions

They involve simultaneous spot and forward transaction. One currency is swapped for another on one date and then swapped back on a future date. Swap transactions account for about 30%of foreign exchange market.

Forward Transactions (Outright Forward)

They involve exchange of currencies three or more days after the date of deal. It is transaction for future delivery. The rate of transaction is known as Forward Rate. The forward rate is used to settle the forward transaction. Forward transactions account for 10%of foreign exchange market.

Spot Transactions

They involve exchange of currencies two days after the date of deal. The rate of transaction is known as Spot Rate. Spot transactions account for 60% of foreign exchange market.

Foreign Exchange Instruments (Types of Transactions)

There are six types of transactions that take place in the foreign exchange market. They are the instruments of foreign exchange market. They are:

• Spot Transactions
• Forward Transactions (Outright forward)
• Fx Swap Transactions
• Currency swaps
• Options
• Futures