UNITII: Foreign exchange market

The International Financial Environment- International Financial Management and the multinational firm, geo-political events
importance and its impact on international business. Foreign exchange market- Foreign exchange rate determination Spot and
forward markets- foreign currency options.

Introduction
An international financial environment represents the conditions for activity in the economy or in the financial markets around
the world. It can be influenced by something major, such as the credit worthiness of one country's debt. Governments,
corporations, and other investors around the world participate in purchasing the debt of other nations as profit opportunities
arise. A downgrade of a country's debt by a rating's agency could damage the value of that country's debt and suggest that a
default might be imminent. These conditions have the potential to trigger a sell-off, which is when there are more sellers than
buyers of risky debt in the markets.
Components of International Financial Environment
• Foreign Exchange Market
• Currency Convertibility
• International Monetary System
• International Financial Markets
• Balance of Payments
1. Foreign Exchange Market:
Foreign exchange market is the market in which money denominated in one currency is bought and sold with
money denominated in another currency. It is an over the counter market, because there is no single physical or electronic
market place or an organized exchange with a central trade clearing mechanism where traders meet and exchange
currencies. It spans the globe, with prices moving and currencies trading somewhere every hour of every business day.
World’s major trading starts each morning in Sydney and Tokyo, and ends up in the San Francisco and Los-Angeles.

The foreign exchange market consists of two tiers: the inter bank market or wholesale market, and retail market or client
market. The participants in the wholesale market are commercial banks, investment banks, corporations and central banks,
and brokers who trade on their own account. On the other hand, the retail market comprises of travelers, and tourists who
exchange one currency for another in the form of currency notes or traveler cheques.

2. Currency Convertibility:
Foreign exchange market assumes that currencies of various countries are freely convertible into other currencies. But this
assumption is not true, because many countries restrict the residents and non-residents to convert the local currency into
foreign currency, which makes international business more difficult. Many international business firms use “counter trade”
practices to overcome the problem that arises due to currency convertibility restrictions.
3. International Monetary System
Any country needs to have its own monetary system and an authority to maintain order in the system, and facilitate trade and
investment. India has its own monetary policy, and the Reserve Bank of India (RBI) administers it. The same is the case with world, its needs a
monetary system to promote trade and investment across the countries. International monetary system exists since 1944. The International
Monetary Fund (IMF) and the World Bank have been maintaining order in the international monetary system and general economic
development respectively.
4. International Financial Markets
International financial market born in mid-fifties and gradually grown in size and scope. International financial
markets comprises of international banks, Eurocurrency market, Eurobond market, and international stock market. International banks play a
crucial role in financing international business by acting as both commercial banks and investment banks. Most international banking is
undertaken through reciprocal correspondent relationships between banks located in different countries. But now a days large bank have
internationalized their operations they have their own overseas operations so as to improve their ability to compete internationally.
Eurocurrency market originally called as Eurodollar market, which helps to deposit surplus cash efficiently and conveniently, and it helps to
raise short-term bank loans to finance corporate working capital needs, including imports and exports. Eurobond market helps to MNCs to
raise long-term debt by issuing bonds. International bonds are typically classified as either foreign bonds or eurobonds. A foreign bond is
issued by a borrower foreign to the country where the bond is placed. On the other hand Eurobonds are sold in countries other than the
country represented by the currency denominating them.
5. Balance of Payments
International trade and other international transactions result in a flow of funds between countries. All transactions relating to the
flow of goods, services and funds across national boundaries are recorded in the balance of payments of the countries concerned.
Balance of payments (BoPs) is systematic statement that systematically summarizes, for a specified period of time, the monetary transactions
of an economy with the rest of the world. Put in simple words, the balance of payments of a country is a systematic record of all transactions
between the ‘residents’ of a country and the rest of the world. The balance of payments includes both visible and invisible transactions. It
presents a classified record of:
• All receipts on account of goods exported, services rendered and capital received by ‘residents’ and
• Payments made by then on account of goods imported and services received from the capital transferred to ‘non-residents’ or ‘foreigners’.
International Financial Management and the multinational firm
The main goals of international Financial Management include ensuring an uninterrupted supply of funds for the
business activities of the organization and its optimum utilization so as to generate the highest possible returns for
the business.

What is Geo political events:

Geopolitics can be defined as a policy involving political, geographical, and economic factors or influences between at least
two nations or groups. The term is usually associated with international and/or diplomatic relations and foreign policy, and its
overall purpose is to benefit the interests of one's people and/or country. The general concepts of geopolitics have existed as
long as humans have existed but have no clear origin point. Multitudes of geopolitical policies have been implemented
throughout human history, and they have varied over central issues in policy as befitting the nations or peoples involved.
How Geopolitics Works
Geography plays a key role in the development of geopolitical policies, as well as countries acting in their own best interest.
While some geopolitical policies are based on common good for all involved, others are enacted to bring more power to one
group over another. A few key factors of geopolitics involve power and influence of nations, territorial or border unity and
resolutions, and agreements or treaties between nations to harness peace or a common goal. Countries make geopolitical
agreements and policies over issues of trade, pollution, business, education, cultural or media influences, war, balancing
power over regions, travel, immigration, and more.

The foundations of geopolitics revolve around various relationships certain groups have with others. The more powerful a
nation, the more likely it will heavily influence geopolitical efforts with other nations or groups. In order for nations to keep
considerable power, they must interact with outside groups over various issues, like the ones mentioned above. Some of the
first geopolitical issues were likely over boundaries and borders, as peace depended on recognition of borders by outside
groups. In addition, many geopolitical policies have been enacted when two or more groups enter into alliances with one
another, including in the event of war. Oftentimes, alliances between certain nations or regions allow for peace if other
alliances are evenly matched. Maintenance of positive working relationships between political entities is essential for
geopolitical policies to keep hold.

Cultural spheres, or regions that share common language, interests, ethnic ties, and general culture, often enter into alliances
with one another and can affect geopolitics.
The world is entering an era of change to the global order. Populations are growing, technology is allowing civilians to become
increasingly connected and, despite much political unrest and division, governments are now being asked to unite to face
threats such as climate change.
An understanding of geopolitics has always been important for business; perhaps because, at the most
basic level, international law allows governments to stop foreign firms from operating in their countries. Areas of geopolitical
interest for companies range from differences in international trade and legal requirements to the threat of war or terrorism,
or specific events. The latter includes the growing momentum of the so-called 16+1 initiative: China’s mechanism for engaging
with countries in Central and Eastern Europe.

The most recent gathering of 16 states which endorse China’s ambitious ‘Belt and Road’ investment project took place in the
Croatian city of Dubrovnik, and has unsettled European Union (EU) leaders, who are watching the growth of China’s political
and economic influence in the region closely.

Chinese-led infrastructure projects, including a high-speed railway from Budapest in Hungary to Belgrade in Serbia, promise
European countries that are most in need of support a financial boost. However, China would also benefit significantly from
the overall plan of linking up this railway line with its port in Piraeus, Greece, the entry point for Chinese goods to Central and
Eastern Europe. State-owned Chinese banks will provide the finance for these projects and Chinese companies will supply the
technology and construction.

Yet, although many European businesses have developed plans to deal with the moderate change factor of Brexit, barely any
are focusing on (arguably) more dramatic geopolitical events and associations, such as this alliance. A preoccupation with
creating plans for all Brexit outcomes – including the improbable – has dominated many businesses, fuelled by the European
media. Despite the UK failing to leave the EU in March 2019, eyes are still firmly fixed on micro-changes in the debate,
meaning that other important events and geopolitical shifts are largely passing unnoticed.
One such issue is that the population of Africa is expected to more than double, to 2.4 billion before 2050. Despite such a huge
projected growth figure, companies are still not devoting enough – or, in some cases, any – attention to this demographic,
which is likely to become highly relevant to them. China, however, has recently pledged $60bn USD of investment in major
capital projects which aim to develop the local African economy.
In many respects, global political and cultural goalposts are moving and managers are having to deal with totally
new perspectives and situations when they work internationally. C-suites are increasingly investing in diversity management
and the most advanced businesses are taking further measures to ensure they are aware of the geopolitical stance of countries
in which they work, trade or are interested. But are they doing enough?
How businesses can cope
Geopolitical changes in areas of operation can be significant for companies, and I’ve observed many that react to change in
precisely the wrong way. One problem is the duality of the relationship between a large number of organisations’ headquarters
(HQ) and their individual branches. Although it is absolutely necessary to be close to customers in order to understand their
needs, build authentic relationships and have a tangible point of contact, I would argue that these offshoots often operate with
far less autonomy than they deserve. Deciding and controlling everything at HQ is not always the best option when dealing
with cultural, organizational and strategic hurdles.
For these reasons, many businesses would find their operations much improved if they modified their
basic organisational structure. Scrapping the one-way mechanism of knowledge sharing and implementing a bilateral dialogue
for information exchange can greatly influence and improve strategic decisions. Jointly deciding what action a company should
take in the face of a geopolitical incident is far more likely to provide a successful outcome. It’s important, in these cases, not
only to use the experience and wisdom of the C-suite but also the regional branch’s specific understanding of the local market.
The best method for ensuring this – and one that increasing numbers of international businesses are adopting – is
implementing local research and development units.
This helps companies grow country-specific innovations and produce relevant services for a customer base they have invested
in understanding.
Foreign exchange market- Foreign exchange rate determination
Foreign exchange rate determination:

Exchange rate refers to the price of one currency in relation to other currencies in the International money market.
It means, exchange rate is the price of one currency expressed in terms of another currency. Foreign exchange rate
is determined in Foreign exchange market where exchange of curencies between two or more than two countries
takes place. There are many types of exchange rates. For example- forward, spot, favourable, adverse, fixed and
flexible exchange rate. Determination of exchange rate : Economists have developed various theories to determine
the exchange rate. Major ones among them are Demand Supply Theory, Purchasing Power Theory (PPT), Balance
of Payment theory and Mint Par theory. Demand and supply theory : As prices in the market are determined
through the forces of demand and supply, so is the case for determination of exchange rate in foreign exchange
market.
It can be explained with the help of a simple example
In the above figure, equilibrium point is E. Here, demand for foreign exchange is equal to the supply of foreign exchange.
Demand and supply of foreign exchange is OYa and exchange rate is OR0, i.e. 1$ = Rs. 68. If exchange rate is OR2 it means that
the supply of foreign exchange is greater than the demand for it. As a consequence, exchange rate will come down and
equilibrium will be again at E. On the other hand, if exchange rate is OR1; it means that demand for foreign exchange is greater
than its supply. It will push the exchange rate upward and equilibrium will again be’established at point E. In this way, change in
exchange rate bring change in demand and supply. For this, so many other economic factors are also responsible. For example,
quantity of imports and exports, flow of countries’ capital, bank rate, uncertainty of international money market and political
environment, etc.
How Exchange Rates are Determined
To determine its currency's exchange rate, every country has its own methodology. Several methods can be used to decide the
exchange rate, including fixed exchange rate, managed floating exchange rate, and flexible exchange rate.

Flexible Exchange Rate

It is sometimes referred to as a pegged exchange rate system since governments tend to keep an eye on exchange rates. The
currency value is pegged either to certain currencies- either individually or collectively- or to its reserves of gold and foreign
currencies.
As far as fixed exchange regimes are concerned, China is probably the most famous example. There was also a fixed rate regime
under the former Soviet Union. The exchange rate is not solely determined by market forces under this regime. When the
foreign exchange market fluctuates widely, the central banks will sell or buy reserves.

Floating Exchange Rate

An exchange rate that fluctuates or is flexible is called a floating exchange rate. The market determines whether it moves or not.
The term "floating currency" refers to any currency subject to a floating regime. The US dollar is an example of a floating
exchange currency.
Floating exchange rates are popular among economists. Those who believe in a free market believe that currency value should
be determined by the market. USD prices tend to decline when crude oil prices rise, for example. The two are inversely related.
The USD value fluctuates freely since oil prices vary daily.
Economists claim that markets correct themselves frequently. Most major economies are largely dependent on floating
exchanges thanks to little government intervention. In popular parlance, these are countries commonly called 'First World
Countries’.

Speculation
Every nation has money as an asset. Indians will care more about the British pound's value than they would about the rupees if
they believe the rupee will go up in value. As a result, when people hold foreign exchange hoping to reap the benefits of rising
currency values, the exchange rates are also affected.
Exchange Rate and Interest Rates

Furthermore, the difference between interest rates between nations plays a role in determining the exchange rate. In search of
the highest percentage interest rate, banks, MNCs, and affluent individuals move billions of dollars around the globe.
Exchange Rates in the Long Run
Purchasing power parity or PPP can be used to make long-term predictions on the exchange rate in an exchange rate structure
which is flexible. As per the theory, if a business has no frontiers to cross such as taxation (tariffs on business) and quotas
(quantitative controls on imports), then exchange rates must gradually adjust so that the same products cost the same price
regardless of whether you're translating into rupees in India, yen in Japan, or dollars in the US, apart from the different modes
of transportation.
Pegged Float Exchange Rate
There are three hybrid regimes in this system. Governments and Central Banks can control foreign exchange rates by
intervening in the markets. However, exchange rates are mostly determined by existing market forces.
There are 3 types:
1.Crawling Bands:
A central bank will allow fluctuations in a currency until a specific range that is usually set in advance. The authorities will
intervene once the range is breached. These ranges are determined by monetary and economic policies.
2.Crawling Pegs:
As a result of the system, the Central Bank allows its currency to appreciate or depreciate gradually on international markets.
The currency will have the capability to float if there are any market uncertainties. However, the authorities will intervene if
appreciation or depreciation are swiftly followed by one another. This has already happened in Argentina, Vietnam, and Costa
Rica.
3.Horizontally Pegged Bands:
It resembles crawling bands a bit. Nevertheless, Central Banks allow their currencies to fluctuate much more freely, provided
that the exchange rate does not exceed 1% of the gross value of its currency
Spot and forward markets

Spot Market and the Forwards and Futures Markets

There are three ways through which the financial institutions, corporations, corporate companies and individuals trade
currencies
• Spot market
• Forwards market
• Futures market.
The foreign exchange trading in the spot market always has been the major market as the forwards and futures
markets are based on the "underlying" asset. In the olden days, the futures market was the most common venue for traders
since it was available to individual investors for a longer period of time. Later with the initiation of electronic trading, the spot
market has observed a huge surge in activity and now outshines the futures market in terms of trading by individual investors
and speculators. When people mention the forex market, they generally refer to the spot market. The forwards and futures
markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the
future.
Spot market
The spot market is where buying and selling of foreign currencies takes place according to the current price, determined by
supply and demand. It is a reflection of many parameters such as economic performance, current interest rates, sentiment
towards on-going political situations (both international and local), as well as the perception of the future performance of one
currency against another. The finalized deal is known as a "spot deal". It is a two-sided transaction by which one party delivers
an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon
exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is generally known as one
that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
Forwards and Futures market

The forwards and futures markets do not trade actual currencies. Instead they deal with contracts that represent claims to a
certain currency, a specific price per unit and a future agreed date for settlement.
In the forwards market, contracts are bought and sold Over the Counter (OTC) between two parties. The terms and
conditions of the agreement are determined by themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public
commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the
futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement
dates, and minimum price increments that cannot be modified. The exchange acts as a counterpart to the trader, providing
clearance and settlement.
Both the contracts are binding and are usually settled for cash for the exchange in question upon expiry, although contracts can
also be traded before expiration. When trading currencies, the forwards and futures markets offer protection against risk.
Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but
speculators take part in these markets as well.
foreign currency options

The buyer of an option is termed the holder, while the seller of the option is referred to as the writer or
grantor.
The buyer of an option is termed the holder, while the seller of the option is referred to as the writer or
grantor.
Every option has three different price elements:
1.The exercise or strike price – the exchange rate at which the foreign currency can be purchased (call) or sold
(put)
2.The premium – the price, or value of the option itself
3.The underlying or actual spot exchange rate in the market
Essentials terminology of FX options trading
• Strike price – the predetermined price of the options contract that you can either buy
or sell the contract for at or before expiry
• Expiry date – the date at which your options contract will need to be settled, but it can
be closed before the expiry date arrives
• Premium – the fee that the writer receives from the holder for taking on the obligation
to buy or sell the underlying
• Implied volatility (IV) – is a measure of the implied risk in an options contract, relative
to the price of the underlying market. Implied volatility will affect the price of an
options contract
• In the money – an options contract is in the money when it can be exercised for a profit
• At the money – an options contract is at the money when its strike price is the same or
similar to the price of the underlying market – meaning it could expire with value, or
worthless
• Out of the money – an options contract is out of the money when it cannot be
exercised for a profit