BFM 414 International Finance

DEPARTMENT OF ACCOUNTING AND FINANCE
COURSE CODE: BFM 414
COURSE TITLE: INTERNATIONAL FINANCE
MANUAL COMPILED BY: Mr. MBURU PETER
Cell phone No.: 0723135375
Email address: [email protected]
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COURSE DESCRIPTION
BFM 414: INTERNATIONAL FINANCE
Contact hours: 42
Purpose: To provide learners with the requisite knowledge in international finance.
Expected learning outcomes of the course

By the end of the course unit the learners should be able to:-
 Describe foreign exchange markets and derivatives
 Discuss the management of economic exposures
 Describe international money and capital markets
Course content
Introduction; significance of international finance, international financial environment, reasons
why study international finance, foreign exchange markets and foreign exchange rates; functions
of foreign exchange market, participants of the foreign markets, factors affecting exchange rates,
foreign exchange rate regime/system, currency derivatives, balance of payments (BOPs); BOPs
accounting and accounts, Sub-accounts in the BOPs, BOPs disequilibrium, correction of
disequilibrium, financing of BOP deficit, international parity conditions; purchasing power
parity, arbitrage profit, arbitrage profit, exchange rate equilibrium, interest rate parity, covered
interest arbitrage, foreign exchange exposure ; transaction exposure, operation exposure and
accounting exposure, exposure management, international investment and international financial
institutions; foreign private investment, international monetary fund (IMF), World Bank,
Structural Adjustment Programmes (SAPs); conditions for SAPs, criticisms of SAPs,
international money and capital markets; international banking, Eurocurrency and Eurobond
markets.
Teaching / learning Methodologies: lectures and tutorials; group discussion; demonstration;
individual assignment; case studies.
Instructional materials and equipment: projector; test books; design catalogues; computer
laboratory; design software; simulators
Course Assessment
Examination -70%
Continuous Assessment Test (CAT) -20%
Assignments -10%
Total 100%
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Reference
Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the
Atrium, South Gale,.
Cherunilam, F. (2007) International Business. 4 TH Ed. New Delhi: Asoke K. Gitosh, PHI
learning private limited
Clark (2007), International Finance Management, Cengage Learning (Thompson)

Morris Levis (2007), International Finance. 5th Ed. Routledge, London.
Thomas J O’brien (2008), International finance, Oxford University Press
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CONTENTS
COURSE DESCRIPTION.................................................................................................................................. ii
Reference ........................................................................................................................................................ iii
CHAPTER ONE:-INTRODUCTION TO INTERNATIONAL FINANCE ................................................... 8
1.0 Definition of international finance ........................................................................................................... 8
1.1 Significance of international finance ....................................................................................................... 8
1.2 International financial environment ......................................................................................................... 9
1.2.1 Reasons for studying international finance ....................................................................................10
1.3 Chapter review questions .......................................................................................................................12
Reference .......................................................................................................................................................12
CHPATER TWO: FOREIGN EXCHANGE MARKET ................................................................................13
2.0 Definition of foreign exchange market ..................................................................................................13
2.0.1 Functions of foreign exchange market ...........................................................................................13
2.0.2 Characteristics and participants of the foreign exchange market .................................................14
2.1 Determinants of demand and supply of foreign currency ....................................................................15
2.2 Foreign exchange rate .............................................................................................................................16
2.2.1 Factors affecting exchange rates .....................................................................................................17
2.2.2 Spot Exchange and Forward Exchange ..........................................................................................19
2.2.3 Nominal Exchange Rate, Real Exchange Rate and Effective Exchange Rate ............................22
2.3 Foreign exchange regime/systems .........................................................................................................24
2.3.1 Fixed (stable) exchange rates ..........................................................................................................24
2.3.2 Flexible (floating) Exchange Rate ..................................................................................................26
2.4 Currency Derivatives (Futures, options and swaps) .............................................................................27
2.4.1 Reasons for rapid growth of futures and options markets .................................................................27
2.4.2 Currency futures and currency forwards ............................................................................................28
2.4.3 Currency options ..............................................................................................................................29
2.4.4 The swaps market ............................................................................................................................30
Reference .......................................................................................................................................................32
CHAPTER THREE: BALANCE OF PAYMENTS .......................................................................................33
3.6 Financing of BOP deficit ........................................................................................................................46
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Reference .......................................................................................................................................................46
CHAPTER FOUR: THE INTERNATIONAL PARITY CONDITIONS .....................................................48
4.0 The law of one price (Purchasing Power Parity i.e. PPP) ....................................................................48
4.1 Arbitrage profit........................................................................................................................................48
4.2 Transaction costs and the No- Arbitrage Conditions ............................................................................49
4.3 Exchange Rate Equilibrium....................................................................................................................50
4.3.1 Bilateral Exchange Rate and equilibrium and Locational Arbitrage............................................51
4.3.2 Interest Rate Parity and Covered Interest Arbitrage......................................................................52
4.3.3 Covered Interest Arbitrage ..............................................................................................................53
4.4 Chapter review questions.......................................................................................................................54
Reference .......................................................................................................................................................55
CHAPTER FIVE: FOREIGN EXCHANGE RISKS/EXPOSURES .............................................................56
5.0 Introduction .............................................................................................................................................56
5.1 Economic exposure .................................................................................................................................56
5.1.1 Transaction exposure.......................................................................................................................57
5.1.2 Operating exposure..........................................................................................................................57
5.2 Accounting exposure (transaction exposure) ........................................................................................58
5.3 Strategies for managing exchange rate exposure/ risks ......................................................................58
Reference .......................................................................................................................................................61
CHAPTER SIX: INTERNATIONAL INVESTMENT AND INTERNATIONAL FINANCIAL
INSTITUTION ..................................................................................................................................................62
6.0 Introduction .............................................................................................................................................62
6.1 Types of foreign private investment ......................................................................................................62
6.1.1 Foreign direct investment (FDI) .....................................................................................................63
6.1.2 Foreign Portfolio Investment (FPI) ................................................................................................63
6.2 Significance of foreign investment ........................................................................................................64
6.3 Reasons for foreign investment ..............................................................................................................64
6.4 INTERNATIONAL FINANCIAL INSTITUTIONS ...........................................................................65
6.4.1 International Monetary Fund (IMF) ...............................................................................................65
6.4.2 World Bank ......................................................................................................................................67
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Reference .......................................................................................................................................................69
CHAPTER SEVEN: STRUCTURAL ANJUSTMENT PROGRAMMES (SAPs)......................................70
7.0 Introduction .............................................................................................................................................70
7.1 What was structural adjustment programmes (SAPs) designed to do? ...............................................70
7.3 CONDITIONS FOR STRUCTURAL ADJUSTMENT PROGRAMMES (what measures are
imposed under SAPs?) ..................................................................................................................................71
7.4 Why the need for SAPs?.........................................................................................................................72
Reference .......................................................................................................................................................75
CHAPTER EIGHT: INTERNATIONAL MONEY AND CAPITAL MARKET ....................................76
8.1 International banking ..............................................................................................................................76
8.1.1 International banks assist multinational enterprises in the following ways: ................................77
8.1.2 Types of international banking offices ...............................................................................................77
8.2 Eurocurrency and Eurobond market ......................................................................................................78
8.2.1 International capital market .................................................................................................................78
8.2.2 Factors to consider when choosing between Euromarkets or Domestic Markets ...........................79
8.2.3 Participants in the Eurocurrency and Eurobond markets ..............................................................79
8.3 Chapter review questions.......................................................................................................................80
Reference .......................................................................................................................................................81
SAMPLE OF UNIT REVIEW QUESTIONS .................................................................................................82
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CHAPTER ONE:-INTRODUCTION TO INTERNATIONAL FINANCE
Objectives
At the end of this chapter, the student should be able to:
i. Define international finance and explain its significance

ii. Explain international financial environment
iii. Explain reasons for studying international finance
1.0 Definition of international finance

International finance activities help organizations to engage in cross-border transactions with
foreign business partners, such as customers, suppliers and lenders. Government agencies and
Non-profit institutions also use international finance tools to meet operating needs.
International finance is branch of economics that studies the dynamics of exchanges rates,
foreign investment and how these affect international trade. International finance covers all
procedures, techniques and tools that financial institutions, such as banks and insurance
companies provide to clients. These tools may include financing agreements and transaction
strategies on securities exchange. In other words international finance is the study of the
institutions, policies, and practices that govern global financial management and/or financial
aspects of global business.
1.1 Significance of international finance

International finance plays a significance role in modern economies. Business transactions are
not only interconnected more than ever before, but must companies engage in multinational
activities through exports or import.
Some of the benefits of international finance are:
 Access to capital markets across the world enables a country to borrow during tough
times and lend during good times.
 It promotes domestic investment and growth through capital import.
 Worldwide cash flows can exert a corrective force against bad government policies.
 It prevents excessive domestic regulation through global financial institutions.
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 International finance leads to healthy competition and, hence, a more effective banking
system.
 It provides information on the vital areas of investments and leads to effective capital
allocation.
International finance promotes the integration of economies and facilitating easy flow of capital.
The free transfer of funds would eventually result in more equality among countries that are a
part of the global financial system.
1.2 International financial environment

The economies of the world have become increasingly interdependent trading economies. The
financial services industry supports these activities by providing the means to transfer payment
for goods and services purchased internationally and by acting as an intermediary between those
nations with excess funds and those in need of funds.
As the economies of individual nations become intertwined, the role of the financial services
industry becomes more important to the world economy.
Changes are taking place in the structure of financial markets as well as the structure of the
industry and its participants. Communication and information technology have helped to make
markets that were once local or regional in character, global. Funds travel across national
boundaries with such ease that disequilibrium is offset.
Globalization which is the increasing economic integration of goods, services, and financial
markets, presents opportunities and challenges for governments, business firms, and individuals.
Although businesses operating in countries across the globe have existed for centuries, the world
has recently entered an era of unprecedented /extraordinary world-wide production and
distribution.
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1.2.1 Reasons for studying international finance
1. To understand a global economy
Three recent changes have had a profound effect on the international finance environment. These
are the end of the Cold War, The emergence of growing markets among the developing countries
East Asia and Latin America, and the increasing globalization of the international economy.
Understanding these changes should help one to see where the international economy is headed
in the future so that you can effectively respond to these challenges, fulfill your responsibilities,
and take advantage of those opportunities.
(a) The end of the Cold War.
In 1989 the Soviet Union relaxed its control over the Eastern Europe countries that had suffered
its Domination for over 40 years. These countries immediately seized the opportunity to throw
off authoritarian communist rule. Two years later the Soviet Union itself underwent a political
and ideological upheaval/ disorder, which quickly led to its breaking into independent states.
Most of these and other formally centrally planned economies are now engaged in a process of
transition from central planning and state ownership to market forces and private ownership to
market forces and private ownership.
(b) Industrialization and Growth of the Developing World.
The 2nd great change of recent years has been the rapid industrialization and economic growth of
countries in several parts of the world. The first of these emerging markets were the four Asian
tigers i.e. Hong Kong, Singapore, South Korea, and Taiwan. China and other Asian countries
have followed in their footsteps.
Having overcomed the debt crisis of the 1980, and undertaken economic and political reforms,
some of the Latin Americans countries like Argentina, Brazil, Chile, and Venezuela have also
began to experience faster and more sustained growth.
(c) Increased globalization
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The 3rd major change in the international financial environment is even more sweeping than the
first two. National economies are become more integrated. Technological barriers have fallen as
transportation and communication costs have dropped.
Government made barriers have also fallen as tariffs and non-tariffs barriers have been reduced
in a series of multilateral negotiations and trading blocs since the Second World War.
These falling technological and government-made barriers have caused trade and foreign direct
investment to increase several times faster than world output since 1985.
2. To understand the effects of global finance on business
There are many examples of the growing importance of international operations for individual
companies. Companies like coca cola earn more than half of their total operating profits through
international operations. Also companies like General motors, Sony, do business in more than
150 countries around the world. Philips electronics, Ford and IBM have more workers overseas
than in their home countries.
By the same token, global finance has also become increasingly important as it serves world
trade and foreign investment. Simply stated, each nation is economically related to other nations
through a complex network of international trade, foreign investment, and international loans.
Companies have advantage in moving their operations forward if they understand the basic
elements of international finance. Apart from career interests, persons who want to improve their
knowledge of the world would be seriously handicapped if they do not understand the economic
dynamics and policy issues of finance, and investment flows among nations.
3. To make intelligent personal decisions
For example, when looking for a job, you may have the advantage of comparing two job offers,
one from a company in home country and another from a company in foreign country.
When deciding to buy a car, your choice between the latest modes offered by various companies
(general motors $ volks wagen) may well depends on the exchange rate between the home
currency and foreign currencies of those country where the car is coming from.
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All these decisions require significant knowledge of international finance to make intelligent
decisions in all these cases, the important point is that you will participate not just in the
domestic economy but in economies around the world.
1.3 Chapter review questions

I. Define the term international finance
II. Explain significance of international finance
III. Discuss international financial environment
IV. Clearly, discuss reasons for studying international finance.
Reference

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CHPATER TWO: FOREIGN EXCHANGE MARKET
Objectives of the chapter
At the end of this chapter, the student should be able to:-
 Explain the meaning of the following terms; foreign market, foreign exchange rate, spot
exchange rate, forward exchange rate, nominal exchange rate, real exchange rate,
effective exchange rate, currency futures, currency swaps, currency options.
 Explain functions of foreign exchange market.
 Discuss characteristics and participants of foreign exchange market.
 Discuss determinants of demand and supply of foreign currency
 Explain factors affecting exchange rates
 Discuss forward exchange market and spot exchange rate.
 Discuss various foreign exchange regime/systems
 Discuss Currency derivatives, that is, futures, options and swaps.
2.0 Definition of foreign exchange market

There are different interpretations of the term foreign exchange, of which the following two are
most important and common:-
1. Foreign exchange is the system or process of converting one national currency into
another, and of transferring money from one country to another.
2. The term foreign exchange is used to refer to foreign currencies. That is, foreign
exchange is the foreign currency and includes all deposits, credits and balance payable in
any foreign currency and any drafts, traveler’s deposits, letters of credits and bill of
exchange, expressed or drawn in domestic currency, but payable in any foreign currency.
2.0.1 Functions of foreign exchange market

The foreign exchange market is a market in which foreign exchange transactions take place. In
other words, it is a market in which national currencies are bought and sold against one another.
A foreign exchange market performs three important functions:-
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i. Transferring of purchasing power – The primary function of a foreign exchange
market is the transfer of purchasing power from one country to another and from one
currency to another. The international clearing function performed by foreign
exchange markets plays a very important role in facilitating international trade and
capital market.
ii. Provision of credit – International trade depends to a great extent on credit facilities.
Exporters may get pre-shipment and post-shipment credit. Credit facilities are
available also for exporters. The Euro-dollar Market has emerged as a major
international credit market.
iii. Provision of hedging facilities – Foreign exchange market provide hedging facilities.
Hedging refers to covering of export risks, and it provides a mechanism to exporters
and importers to protect themselves against losses from fluctuation in exchange rates.
2.0.2 Characteristics and participants of the foreign exchange market

The foreign exchange market is a worldwide market and is made up primarily of commercial
banks, foreign exchange brokers and other authorized agents trading in most of the currencies of
the world. These groups are kept in close and continuous contact with one another and with
developments in the market through telephone, computer terminals, telex and fax.
The most heavily traded currency is the US dollar which is known as a vehicle currency because
it is widely used to denominate international transactions. Oil and many other important primary
products such as tin, coffee and gold all tend to be priced in dollars.
The main participants in the foreign exchange market can be categorized as follows:-
i. Retails clients – These are made up of business, international investors, multinational

corporations and the like who need foreign exchange for the purposes of operating
their business. Normally, they do not directly purchase or sell foreign currencies
themselves; rather they operate by placing buy or sell orders with commercial banks.
ii. Commercial banks – the commercial banks carry out buy/sell orders from their retail
clients and buy/sell currencies on their own account (known as proprietary trading) so
as to alter the structure of their assets and liabilities in different currencies. The banks
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deal either directly with other banks or through foreign exchange brokers. In addition
to the commercial banks other financial institutions such as merchant banks are
engaged in buying and selling of currencies both for proprietary purposes and on
behalf of their customers in finance-related transactions
iii. Foreign exchange brokers – Often banks do not trade directly with one another,
rather they offer to buy and sell currencies through such brokers. Operating through
such brokers is advantageous because they collect buy and sell quotations for most
currencies from many banks, so that the most favorable quotation is obtained quickly
and at very low cost.
One disadvantageous of dealing through a broker is that a small brokerage fee is
payable which is not incurred in a straight bank-to-bank deal.
iv. Central Banks – central banks frequently intervene to buy and sell their currencies in
a bid to influence the rate at which their currency is traded. Under a fixed exchange-
rate system the authorities are obliged to purchase their currencies when there is
excess supply and sell the currency when there is excess demand.
2.1 Determinants of demand and supply of foreign currency

The demand for foreign currency is fixed by the supply and demand curve (just like any other
commodity in an open market). The demand for foreign currency arises from the traders who
have to make up payments for imported goods i.e. demand for a currency in the foreign exchange
market is a derived demand. The supply arises from those who have exported goods and services
abroad. This depends largely on how much foreigners are willing to buy goods and services
from a particular country.
• Foreign exchange are demanded
i. to buy things denominated in it (goods, services, or assets)
ii. to hold interest-bearing accounts in that currency
iii. greater quantity demanded at lower price/exchange rate
• Non-price Determinants of Demand.
i. increased (decreased) demand for foreign goods and services
 increased (decreased) domestic income
 lower (higher) relative price levels for goods and services denominated in
currency
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ii. Increased (decreased) relative return on assets denominated in foreign currency
• Supply of foreign exchange: wanting to sell a currency
i. greater quantity supplied at higher price/exchange rate
• People wanting to sell more (less) of a currency at any given exchange rate is an increase
(decrease) in supply
i. change in foreign income
ii. change in relative price levels
iii. change in relative rate of return on domestic assets
2.2 Foreign exchange rate

Exchange rate: - this is simply the price of one currency in terms of another. There are two
methods of expressing exchange rate:-
 Foreign exchange units per unit of the domestic currency. For example, taking the Kenya
shilling as the domestic currency, we can have approximately Kshs. 85.6 required to
purchase one US dollar (Kshs. 85.6/$1)
 Foreign units per unit of domestic currency. Again taking Kenya Shillings as a domestic
currency, we can have approximately $0.01162/Kshs.1 required to obtain one pound.
Note
i. The second method is a reciprocal of the first method

ii. It is necessary to be careful when talking about a rise or a fall in the exchange rate
because the meaning will be very different depending upon which expression used. A
rise in the Kshs per dollar exchange rate from say Kshs. 85.6/$1 to Kshs. 90.0/$1
means that more Kshs. Have to be give to obtain a dollar. This means that the Kshs
has depreciated in value or equivalently the dollar has appreciated in value.
If the second definition is employed, a rise in the exchange rate from
$0.01162/Kshs.1 to $0. 01262/Kshs.1 would mean that more dollars are obtained per
Kshs, so that the Kshs has appreciated or equivalently the dollar has depreciated.
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2.2.1 Factors affecting exchange rates
a) Export/Imports
If a country exports more goods, the importing country will have a higher demand for the
currency of the exporting country so as to meet its obligation. The value of the currency of the
exporting country will therefore appreciate. The opposite is the case if a country imports more
goods than exports.
b) Political Stability
Unsuitable political climate will make the citizens lose confidence in their currency. They would
therefore wish to invest or just buy the currency of the other countries they deem to be stable. In
so doing, the demand for currency of more political stable countries will appreciate as compared
to those of politically unstable countries.
c) Inflation rate differential (purchasing power parity theorem)

Parity between the purchasing powers of two currencies establishes the rate of exchange between
the two currencies. When inflation rate differential between two countries changes, the
exchange rate also adjusts to correspond to the relative purchasing powers of the currencies.
The purchasing power theorem states that the:
% E(f) = I (h) – I (f) x 100

I (f) + 1
Where:-
% E (f) = the percentage change in the direct quote
I (h) = the inflation rate in the home market
I (f) = the inflation rate in the foreign market.
Illustration
Assume that the direct quote between the $ and £ is £1 = $ 1.5 and that the inflation rate in UK is
10% and the inflation rate in the US is 6%
Required
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Compute the % change in the direct quote and determine the new exchange rate.
% E (f) = 0.06 – 0.1 x 100 = -3.64%

0.1+ 1
The New Direct Quote
£1 = £1.5*(1 – 3.64%)
£1 = $1.4454
d) Interest Rate Parity (International Fisher Effect)

This theory states that differences in interest rate in different market can cause a flow of funds
from markets with low interest rate to markets with high interest rates.
The international fisher effect can be explained as follows:
%E (f) = I (h) – I (f) x 100

1+ I (f)
% E (f) = is the % change in direct quote.
I (h) = is the interest rate in the home market.
I (f) = is the interest rate in the foreign market.
Illustration
Assume that the direct quote is deuchemark is DM 1 - $ 0.5 while the general interest rate in US
is 6% and general interest rate in Germany is 3%.
Required:
Compute the percentage change in direct quote and the new exchange rate.
Solution
%E (f) = 0.06 – 0.03 x 100 = 2.9126%
1 + 0.03
New Direct Quote

DM 1 = $0.5* ( 1 –2.9126%)
= $0.4854
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e) Balance of Payment
The term balance of payment refers to a system of government accounts that catalogues the flow
of economic transactions between the residents of one country and the residents of other
countries. It is therefore the fund flow statement.
Continuous deficit in the balance of payments is expected to depress the value of a currency
because such deficit would increase the supply of that currency relative to its demand.
e) Government Policies
A national government may through its Central Bank intervene in the foreign exchange market,
buying and selling its currency as it sees fit to support its currency relative to others. In order to
promote cheap export, a country may maintain a policy of undervaluing its currency.
2.2.2 Spot Exchange and Forward Exchange

The term spot exchange refers to the class of foreign exchange transaction which requires the
immediate delivery or exchange of currencies on the spot. In practice, the settlement takes place
within two days in most markets. Spot exchange rate is the quotation between two currencies for
immediate delivery. In other word, the spot exchange rate is the current exchange of two
currencies vis-à-vis each other. The market for spot exchange transaction is known as the spot
market.
In addition to the spot exchange rate it is possible for economic agents to agree today to
exchange currencies to some specified time in the future, most commonly for 1 month, 3 month,
6 month, 9 month and 1 year.
Forward transactionis an agreement between two parties, requiring the delivery at some
specified amount of foreign currency by one of the parties, against payment in domestic currency
by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the
forward contact is called the forward exchange rate and the market for forward transaction is
known as the forward market.
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Forward exchange facilities, obviously, are of immense help to exporters and importers as they
can cover the risk arising out of exchange rate fluctuations by entering into an appropriate
forward exchange contract.
Note
With reference to forward rate relationship with the spot rate, the forward rate may be at par,
discount or premium.
 At par – The forward exchange rate is said to be at par if the forward exchange rate
quoted is exactly equivalent to the spot rate at the time of making the contract.
 At premium – The forward rate for a currency, say the Kshs, is said to be at premium
with respect to the spot rate when Kshs 1 buys more units of another currency say
Uganda shillings, in the forward than in the spot market. The premium is usually
expressed as a percentage deviation from the spot rate on a per annum basis.
 At discount – the forward rate for a currency, say Kshs, is said to be at discount with
respect to the spot rate when Kshs. 1 buys fewer Uganda shillings in the forward than in
the spot market. The discount is also usually expressed as a percentage deviation from
the spot rate on per annum basis.
The forward exchange rate is determined mostly by the demand for and supply of forward
exchange. When the demand for forward exchange exceeds its supply, the forward rate will be
quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand
for it, the rate will be quoted at discount. When the supply is equivalent to the demand for
forward exchange, the forward rate will tend to be at par.
Economic agents involved in the forward exchange market are divided into three groups where
classifications are distinguished by their motives for participation in the foreign exchange
market. These agents are:-
 Hedgers – these are agent, usually firms, which enter the forward exchange
market to protect themselves against exchange-rate fluctuations which entail
exchange-rate risk. By exchange rate risk we mean the risk of loss due to daverse
exchange rate movement.
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For example, consider UK importer who is due to pay for goods from the US to
the value of $15,500 in one year’s time. Let us suppose that the spot exchange
rate is $1.60/£1 while the one-year forward exchange rate is $ 1.55/£1. By buying
dollars forward at this rate the trade can be sure that he only has to pay £ 10,000.
If he does not buy forward today, he runs the risk that in one year’s time the spot
exchange rate may be worse than $ 1.55/£1, such as $1.30/£1 which would mean
him having to pay £11923 ($15,500/1.30)
 Arbitrageurs – these are agents (usually banks) that aim to make a riskless profit
out of discrepancies between interest-rate differentials and what is known as the
forward discount or forward premium. A currency is said to be forward premium
if the forward exchange rate quotation for that currency represents an appreciation
of that currency compared to the spot quotation. A currency is said to be forward
discount if the forward exchange-rate quotation for that currency represents
depreciation of that currency compared to the spot quotation. The forward
discount or premium is usually expressed as a percentage of the spot exchange
rate, that is:-
Forward discount/premium = X 100

Where:
F = forward exchange rate
S = spot exchange rate
The presence of arbitrageurs ensures that what is known as the covered interest
parity condition holds continually. Formula used by banks to calculate their forward exchange
quotation.
( ∗ )
F= +
Where:-
F = one-year forward exchange-rate quotation in foreign currency per unit of

domestic currency
S = spot exchange-rate quotation foreign currency per unit of domestic currency
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r = one-year domestic interest rate
r* = one year foreign interest rate
Example of the calculation of the forward exchange rate
Suppose that the one-year dollar interest rate is 5 per cent, and the sterling interest rate is 8 per
cent, and the spot rate of the dollar against the pound is $ 1.60/£1. Then the one year forward
exchange rate of the pound is:-
( ∗ )
F= +
. . ) .
F= .
+ 1.60 =$1.5555/£1
. .
Since X 100 = .
X 100 = -2.78 the one-year forward rate of sterling is at an
annual forward distant of 2.78 per cent.
 Speculators – Speculators are agents that hope to make a profit by accepting

exchange-rate risk. They engage in the forward exchange market because they
believe that future spot rate corresponding to the date of the quoted forward
exchange rate will be different from the quoted forward rate. Consider the
situation where the one year forward rate is quoted at $1.55/£1, and a speculator
feels that the pound will be $1.40/£1 in one year’s time. In this instance he may
sell £1000 forward at $1.55/£1 so as to obtain $1550 one year hence and hope to
change them back into pounds in one year’s time at $1.40/£1, and so obtain
£1107.14 making £107.14 profit. Of course the speculator maybe wrong and find
that in one year’s time the spot exchange rate is above $1.55/£1 which lead to a
loss.
2.2.3 Nominal Exchange Rate, Real Exchange Rate and Effective Exchange Rate
1. Nominal Exchange rateis the exchange rate that prevails at a given date i.e.it is the amount of
US dollar that will be obtained for Kshs. 1 in the foreign exchange market. The nominal
exchange rate is merely the price of one currency in terms of another with no reference made to
what this means in terms of purchasing power of goods or services. A depreciation or
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appreciation of the nominal exchange rate does not necessarily imply that the country has
become more or less competitive on international markets. For such a measure we have to look
at the real exchange rate.
2. Real Exchange Rate is the nominal exchange rate adjusted for relative prices between the
countries under consideration. It is the normally expressed in index form algebraically as:-
Sr = ∗
Where
Sr = the index of the real exchange rate
S = the nominal exchange rate (foreign currency units per unit of domestic currency) in
index form
P = the index of the domestic prices level
P* = the index of the foreign price level
Table: - Construction of nominal and real exchange-rate indices
Period Nominal Nominal Exchange- UK Price US Price Real Exchange-

Exchange Rate Rate Index Index Index Rate Index
1 $ 2.00 100 100 100 100
2 $ 2.00 100 120 100 120
3 $ 2.40 120 120 120 120
4 $ 1.80 90 130 117 100
5 $ 1.50 75 150 125 90
NOTE:- The real exchange-rate index is constructed by multiplying the nominal exchange-rate
index by the UK price and diving this by the US price index
3. Effective Exchange Rate: - since most countries of the world do not conduct all their trade
with a single foreign country, policy-maker are not so much concerned with what is happening to
their exchange rate against a single foreign currency, but rather what is happening to it against a
basket of foreign currencies with whom the country trades.
23
Effective exchange rateis a measure of whether or not the currency is appreciating or
depreciating against a weighted basket of foreign currencies.
In order to illustrate how an effective exchange rate is compiled consider the hypothetical case of
the UK conducting 30 per cent of its foreign of its foreign trade with the US and 70 percent of its
trade with Germany. This means that a weight of 0.3 will be attached to the bilateral exchange
rate index with the dollar, and 0.7 with the deutschmark.
Construction of a nominal effective exchange-rate index
Period Nominal exchange rate Nominal exchange Effective exchange rate

index of $/£ rate index of DM/£ index of £
1 100 100 100
2 100 90 93
3 120 90 99
4 90 80 83
5 75 85 83
The effective exchange-rate index is constructed by multiplying the $/£ index by 0.3 and the
DM/£ index by 0.7.
2.3 Foreign exchange regime/systems

Broadly, there are two important exchange rate systems, namely the fixed (stable) exchange rate
system and floating (flexible) exchange rate regime/system.
2.3.1 Fixed (stable) exchange rates

Fixed exchange rate is a rate not determined by the forces of supply and demand but by other
outside regulator. For example in Kenya this was done before 1992. Countries following a fixed
exchange rate system agree to keep their currencies at a fixed, pegged rate and to change their
value only at fairly infrequent intervals, when the economic situation forces them to do so.
2.3.1.1 Argument for fixed exchange rate system (merits)
The important arguments supporting the fixed rate system are as follows:-
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i. Exchange rate stability is necessary for ordinarily development and growth of foreign
trade. If exchange rate stability is not assured, exporters will be uncertain about the
amount they will have to pay. Such uncertainties and the associated risk adversely affect
foreign trade. A great advantage of a the fixed exchange rate system is that it eliminates
the possibilities of such uncertainties and risks
ii. Especially the developing countries, which have a persistent balance of payment
deficits, should necessarily adopt the fixed exchange rate system to prevent continuous
depreciation of the external value of their currencies.
iii. Exchange rate stability is necessary to attract foreign capital investment as foreigner will
not be interested to invest in a country with an unstable currency. Thus, exchange rate
stability is necessary to augment/ supplement resources and foster economic growth.
iv. Unstable exchange rates may encourage the flight of capital. Exchange rate stability is
necessary to prevent its outflows.
v. A stable exchange rate system eliminates speculation in the foreign exchange market
and enhances discipline in the market.
vi. A stable exchange rate system is necessary condition for the successful function of
region grouping and arrangements among nations
vii. A stable exchange rates system is necessary for growth of international money and
capital markets. Due to the uncertainties associated with unstable exchange rates,
individuals, firms and institutions may shy away from lending to and borrowing from
the international money and capital market.
2.3.1.2 Argument against fixed exchange rate system (demerits)
i. Expensive to defend a fixed rate because it require large sum of foreign exchange
reserves. A foreign exchange reserves are the amount of foreign currencies held by a
country’s central bank for the purpose of international payments.
ii. Defending local currencies may involve raising interest rates which could be costly and
damaging to domestic economy.
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2.3.2 Flexible (floating) Exchange Rate
Flexible (floating) exchange rate determined by forces of supply and demand. Under the floating
exchange rate system, exchange rates are freely determined in an open market primarily by
private dealing and like other market prices, vary from day to day.
2.3.2.1 Cases against floating (flexible) exchange rate (demerits)
A number of economist point out that certain serious problems are associated with the system of
floating rates. The following are demerits of floating exchange rates.
i. A flexible exchange rate presents a situation of instability, creating uncertainty and

confusion. Freidman disputes this view and argues that a flexible exchange rate need
not to an unstable exchange rate. If it is, it is primarily because there is underlying
instability in the economic conditions governing international governing international
trade. And a rigid exchange rate may, while itself remaining nominally stable,
perpetuate and accentuate/heighten other elements of instability in the economy. The
mare fact that a rigid official exchange rate does not change while flexible rate does is
no evidence that the former means greater stability in any more fundamental sense.
ii. The system of flexible exchange rates, with its associated uncertainties, makes it
impossible for exporters and importers to be certain about the price they will have to
pay or receive for foreign exchange. This will have a dampening effect on foreign
trade.
iii. The system of flexible exchange rates gives an inflationary bias to an economy. When
the currency depreciates due to payments deficit, imports become costlier and thus
stir up an inflationary spiral.
2.3.2.1 Cases for floating (flexible) exchange rate (merits)
i. Automatic stabilization: - automatic variations in the exchange rates, in accordance

with the variations in the balance of payments position, tend to automatically restore
the balance of payments equilibrium. A surplus in the balance of payments increases
the exchange rate i.e. currency appreciate. This makes foreign goods cheaper in terms
26
of the domestic currency and domestic goods more expensive in terms of the foreign
currency. This in turn, encourages imports and discourage exports, resulting in the
restoration of the balance of payments equilibrium
If there is a payments deficit, the exchange rates falls i.e. currency depreciate and this
makes domestic goods cheaper in terms of the foreign currency and foreign goods
more expensive in terms of the domestic currency. This encourages exports,
discourages imports and thus helps to establish the balance of payments equilibrium.
ii. Freeing internal policy:- floating allows government to pursue internal policy
objectives like growth and full employment without external constraints
iii. Absence of crisis i.e. with floating rates there is no pressure on the country to devalue
or revalue it currency because changes occur automatically.
iv. Low reserves i.e. there are less need to maintain large reserves to defend a currency
instead it is used for more production elsewhere.
v. Flexibility i.e. there is a lot of freedom and easy management of trade when using
floating exchange rates. Changes in trade are reflected in changes in value of
currency.
2.4 Currency Derivatives (Futures, options and swaps)

The growth of derivatives markets
The phenomenal growth of trading in these derivative instruments has been one of the most
important developments in international financial markets over the last three decades. The 1980s
witnessed an astonishing growth of futures and options markets and this trend has continued into
the 1990s.
2.4.1 Reasons for rapid growth of futures and options markets

i. The volatility of foreign exchange markets following the collapse of Bretton Wood
System of fixed exchange rates, combined with greater freedom o movement of
capital internationally, has created a large demand on part of companies, investors,
fund manager and the like for a means to cope the greater volatility and risk of
exchange rate.
27
ii. Futures and options market enables traders to take speculative position on price
movements for a low initial cash payment, known as the initial margin.
iii. Futures and options contrasts enable traders to take short positions, that is sell
something they do not own with considerable ease. This means that taking a position
on currency depreciation is as easy as taking position on currency appreciation.
iv. Unlike forward contracts, where there is a degree of counterparty risk, all futures and
options contracts are guaranteed by the exchange on which they traded.
2.4.2 Currency futures and currency forwards

A currency futures contract is an agreement between two counterparties to exchange a specified
amount of two currencies at a given date in the future at a pre determined exchange-rate.
Currency futures are basically standardized forward contracts. For example, a currency futures
contract may specify that £62500 per contract is being bought or sold. With forward contract, the
amount to be exchange is negotiable between the two parties; For example, the two parties might
agree to buy/sell, say £ 64272 forward.
Currency futures contract specifies:-
 the amount of currency to be exchanged,

 the Exchange on which on which the contract is traded
 the delivery and the process for delivery.
One party agree to sell the currency (go short), and the other to purchase it (go long). Despite
their high degree of similarity there are some practical differences between currency forward and
futures contracts.
The main differences are:-
i. a currency futures contract is a standardized notional agreement between two

counterparties to exchange a specified amount of a currency at a fixed future date for
a predetermined price, while in a forward contract the amount of currencies to be
exchanged is determined by the mutual agreement of the two parties.
28
ii. Futures contracts are traded on an Exchange while forward contracts are over-the-
counter instruments with the exchange being made directly between two parties.
iii. Futures contracts are guaranteed by the Exchange whereas forward contracts are not,
which removes the counterparty risk inherent in forward contracts. With forward
contact, each of counterparty needs to carefully consider what will happen and
whether the other is capable of seeing their commitment which may involve quite
substantial losses. This credit risk tends to limit the forward market to only very high
grade financial and commercial institutions.
iv. Futures contracts are generally regarded as having greater liquidity than forward
contracts. Their standardized nature means that they can easily be sold to other party
at any time up until maturity at the prevailing futures prices; with the trader being
credited with a profit or loss. Since forward contracts obligations cannot be
transferred to a third party, the only way for a trader to get out of a forward contract is
to take out a new offsetting forward position. For example. If a trader is committed to
buying £ 1 million of sterling forward at $1.50, then the only way out of the forward
contract is to take out another forward contract to sell £ 1 million sterling with
another party. There are two problems with this:-
 The trade is now exposed to two counterparties (double his counterparty
risk)
 The maturity date of the second forward contract may not be perfectly
match with that of the first forward contract. For example, if the origin
forward contract is for 90 days and 20 days later the trader tries to take an
offsetting position, the nearest available forward contract is 60 days
leaving 10 days of open exposure.
2.4.3 Currency options

A currency option is a contract that gives the purchase the right, but not the obligations to buy or
sell a currency at a predetermined price sometimes in the future. The currency in which the
option is granted is known as the underlying currency. The currency to be exchanged for the
underlying currency is known as the counter currency. For example, if the contact specifies the
29
right to buy £31250 at $ 1.65/£1, then the pound is the underlying currency and the dollar is the
counter currency.
An option contract involves two parties, the writer who sells the option and the holder who
purchases it. If the option contract gives the holder the right to purchase the underlying currency
at a predetermined price from the other party, the contract is known as a call option. If it gives
the owner the right to sell the underlying currency at a predetermined exchange rate from the
other party, it is known as a put option.
The price at which the underlying currency can be bought or sold is known as the strike price/
exercise price and the date at which the current express is known as expiry date or maturity date.
2.4.3.1 Differences between options and future contracts
Options are futures are both examples of derivatives instruments in that their price is derived in
relation to the spot price, and they can also both be used for hedging and speculative purposes.
However, there are some significant differences in the two contracts. The differences are:-
i. With an option contract the buyer of the option is not obliged to transact, whereas
both parties to a futures contract are obliged to transact.
ii. With a futures contracts, for every cent the future spot prices is above the futures rate
on expiry of the contract the buyer makes a cent and the seller lose a cent on the
contract. This is not the case with an option contract. The maximum loss of the option
holder is limited to the premium paid for the option, which is the maximum possible
gain for the option writer. However, there is a limited potential profit for an option
holder and likewise unlimited potential loss for the writer.
2.4.4 The swaps market

A swap is an agreement between two parties to exchange two differing forms of payment
obligations. They are basically of two kinds:-
 Interest rate swaps – this is the exchange which involves payments denominated in same
currency
 Currency swaps – the exchange involves two different currencies.
30
The first well-documented currency swap involved the World-Bank and International Business
Machines (IBM) in 1981, whereby the World Bank committed itself to financing some of IBM’s
deutschmark/ Swiss franc debt in return for a commitment by IBM to finance some of the World
Bank’s dollar debt.
Like many other financial instruments, swap agreements are used to manage risk exposure;
however, one of the main reasons for the rapid growth of the swap markethas been that they
enable parties to raise fund more cheaply than would otherwise be the case. Swap markets are
used extensively by major corporations, international financial institutions and governments and
are important part of the international bond market.

I. Give the meaning of the following terms;
 Foreign market,
 Foreign exchange rate,
 Spot exchange rate,
 Forward exchange rate,
 Nominal exchange rate,
 Real exchange rate,
 Effective exchange rate,
 Currency futures,
 Currency swaps,
 Currency options.
II. Briefly, explain functions of foreign exchange market.
III. Briefly, discuss characteristics and participants of foreign exchange market.
IV. Explain determinants of demand and supply of foreign currency
V. Discuss factors that influence exchange rates
VI. Briefly, discuss argument for, and argument against fixed exchange rate
VII. Briefly, discuss argument for, and argument against floating exchange rate
VIII. Highlight difference between currency future contacts and currency forward contracts
31
Reference

Thomas J O’brien (2008),International finance, Oxford University Press
32
CHAPTER THREE: BALANCE OF PAYMENTS
 Define balance of payments and explain what to be included in it.

 Explain collection, reporting and presentation of the balance of payments statistics.
 Discuss balance of payments accounting and accounts
 Explain sub-accounts in the balance of payments
 Explain balance of payments surplus and deficit
 Discuss factors that cause disequilibrium in the balance of payments
 To give correction measures for the balance of payment disequilibrium
Introduction
Balanceof payments is one of the most important economic indicators for policy-makers in an
open economy. A good or bad set of figures can have an influential effect on the exchange rate
and can lead policy-makers to change the content of their economic policies. Deficits may lead to
the government raising interest rates or reducing public expenditures to reduce expenditures on
imports. Alternatively, deficits may lead to calls for protection against foreign imports or capital
controls to defend the exchange rate.
3.0 Balance of Payment BOP
The Balance of Payment is a statistical record of all the economic transactions between residents
of the reporting country and residents of the rest of the world during a given period. The usual
reporting period for all the statistics included in the accounts is a year.
Balance of Payments is one of the most important statistical statements for any country. It
reveals how many goods and services the country has been exporting and importing, and whether
the country has been borrowing from or lending money to the rest of the world. In addition,
whether or not the central monetary authority (usually the central bank) has added to or reduces
its reserves of foreign currency is also reported in Balance of Payment
33
Domestic and foreign residents need to be differentiated. It is important to note that citizenship
and residency is not necessarily the same thing from the viewpoint of the Balance of Payments
statistics. The term resident comprises individuals, households, firms and the public
authorities, and there are some problems that arise with respect to the definition of a
resident. The problems are:-
1. Multinational corporations are by definition resident in more than one country. For the
purposes of Balance of Payment reporting, the subsidiaries of a multinational are treated
as being resident in the country in which they are located even if their shares are actually
owned by foreign residents
2. Another problem concerns the treatment of international organizations such as the
International Monetary Fund, the World Bank e.t.c. These institutions are treated as being
foreign residents even though they may actually be located in the reporting country. For
example, although the International Monetary Fund is located in Washington,
contributions by the US government to the fund are included in the US Balance of
Payment statistics because they are regarded as transactions with foreign residents.
3. Tourists are regarded as being foreign residents if they stay in the reporting country for
less than a year.
Note
The criterion for a transaction to be included in the Balance of Payments is that it must involve
dealings between a resident of the reporting country and a resident from the rest of the world.
Purchases and sales between residents from the same country are excluded.
3.1 Collection, Reporting and Presentation of the Balance-of-Payment Statistics
The Balance-of-Payments statistics record all of the transactions between domestics and foreign
residents, be they purchases or sales of goods, services or financial assets such as bonds, equities
and banking transactions. Reported figures are normally in domestic currency of the reporting
country. Obviously, collecting statistics on every transaction between domestic and foreign
residents is an impossible task. The authorities collect their information from the customs
authorities, surveys of tourist numbers and expenditures, and data on capital inflows and
outflows is obtained from banks, pension funds, multinational and investment house. Information
34
on government expenditures and receipts with foreign residents is obtained from local authorities
and central government agencies.
The responses from the various sources are compiled by government statistical agencies. In
Kenya, this is done by the Kenya Bureau of statistics.
There is no unique method governing presentation of Balance of Payments statistics and there
can be considerable variations in the presentations of different national authorities.
3.2 Balance of Payments Accounting and Accounts
An important point about a country’s Balance of Payments statistics is that in an accounting

sense they always balance. This is because they are based upon the principle of double-entry
book keeping. Each transaction between domestic and foreign resident has two sides to it, a
receipt and a payment, and both these sides are recorded in the balance of payments statistics.
Each receipt of currency from residents of the rest of the world is recorded as a credit item (a
plus in the account) while each payment to residents of the rest of the world is recorded as a
debit item (a minus in the accounts).
Traditionally, the statistics are divided into two main sections i.e. the current account and the
capital account, with each part being further sub-divided. The explanation for division into these
two main parts is that the current account items refer to income flows, while the capital account
records changes in assets and liabilities.
A simplified example of the annual Balance of Payments accounts for Europa is presented
in table below:-
The balance of payments of Euroland
35
Current Account
1) Exports of goods +150
2) Imports of goods -200
3) Trade balance-50 (rows 1 + 2 )
4) Exports of services +120
5) Imports of services -160
6) Interest, profits and dividends received +20
7) Interest, profits and dividends paid -10
8) Unilateral receipts +30
9) Unilateral payments -20
10) Current account balance -70 (sum rows 3 to 9 inclusive)
Capital account
11) Investment Abroad-30
12) Short-term lending -60
13) Medium-term and long-term lending -80
14) Repayments of borrowing from ROW -70
15) Inward Foreign Investment +170
16) Short-term borrowing +40
17) Medium-term and long-term borrowing +30
18) Repayments on loan received from received from ROW +50
19) Capital account balance +50 (sum rows 11 to18)
20) Statistical error +5 zero minus [(10)+(19)+(24)
21) Official statements balance -15 (10)+(19)+(20)
22) Change in reserve rise (-), fall (+) +10
23) IMF borrowing from (+) repayments to (-) +5
24) Official financing balance +15 (22)+(23)
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3.3 An Overview of the Sub-Accounts in the Balance of Payments
(a) The Trade Balance
The trade balance is sometimes referred to as the visible balance because it represents the
difference between receipts for exports of goods and expenditure on imports of goods which can
be visibly seen crossing frontiers or boundaries. The receipts for exports are recorded as a credit
in the Balance of Payments, while the Payment for exports is recorded as a debit. When the trade
balance is in surplus this means that a country has earned more from its exports of goods that it
has earned more from its exports of goods than it has paid for its imports of goods.
(b) The Current Account Balance
The current account balance is the sum of visible trade balance and the invisible balance. The
invisible balance shows the difference between revenue received for exports of services and
payments made for imports of services such as shipping, tourism, insurance and banking. In
addition, receipts and payments of interests, dividends and profits are recorded in the invisible
balance because they represent the rewards for investments in overseas companies, bonds, and
equity; while payments reflects the rewards to foreign residents for their investment in the
domestic economy. As such, they are receipts and payments for the services of capital that earn
and cost the country income just as do exports and imports.
Unilateral transfers are normally included in the balance. Unilateral transfers are payments or
receipts for which there is no corresponding quid pro quo. Examples of such transactions are
migrant workers’ remittance to their families back home, the payments of pensions to foreign
residents, and foreign aid. Such receipts and payment represent redistribution of income between
domestic and foreign residents. Unilateral payments can be viewed as a fall in domestic income
due to payments to foreigners and so are recorded as a debit; while unilateral receipts can be
viewed as an increase in income due to receipts from foreigners and consequently are recorded
as credit.
(c) The Capital Account Balance
The capital account records transactions concerning the movement of financial capital into and
out of the country. Capital comes into the country by borrowing, sales of overseas assets, and
37
investments in countryby foreigners. These items are referred to as capital inflows and are
recorded as credit items in the balance of payments. Capital inflows are in effect, a decrease in
the country’s holding of foreign assets or increase in liabilities to foreigners. Capital inflows are
recorded as credits in the balance of payments. The easier way to understand why they are pluses
(credit) is to think of foreign borrowing as the export of IOU. Similarly investment by foreign
residents is the export of equity or bonds, while sales of overseas investments is an export of
those investments to foreigners.
Conversely, capital leaves the country due to lending, buying of overseas assets, and purchases
of domestic assets owned by foreign residents. These items represent capital outflows and are
recorded as debits in the capital account. Capital outflows are in effect, an increase in the
country’s holding of foreign assets or decrease in liabilities to foreigners. These items are
recorded as debits as they represent the purchase of an IOU from foreigners, the purchase of
foreign bonds or equity, and the purchase of investments in foreign economy.
(d) Official Settlements Balance
Given the huge statistical problem involved in compiling the balance of payments statistics, there
will usually be discrepancy between the sums of all the items recorded in the current account,
capital account and the balance of official financing which in theory should sum to zero. To
ensure that the credits and debits are equal it is necessary to incorporate a statistical discrepancy
for any difference between the sum of credits and debits.
3.4 Possible source of this error (statistical discrepancy)
i. It is an impossible task to keep track of all the transactions between domestic and
foreign residents. Many of the reported statistics are based on sampling estimates
derived from separate sources, so that some error is unavoidable.
ii. Desire to avoid taxes i.e. some of transactions in the capital account are under-
reported. Moreover some dishonest firms may deliberately under-invoice their
exports and over-invoice their imports to artificially deflate their profits.
iii. Another problem is that of ‘leads and lags’ the balance of payments record receipts
and payments for a transaction between domestic and foreign residents, but it can
happen that a good is imported but the payments delayed. Since the imports is
38
recorded by the customs authorities and the payment by the banks, the time
discrepancy may mean that the two side of the transaction are not recorded in the
same set of figures.
The summation of the current balance, capital account balance and the statistical discrepancy
gives the official settlement balance. The balance on this account is important because it shows
the money available for adding to the country’s official reserves or paying off the country’s
official borrowing.
A central bank normally holds a stock of reserves made up of foreign currency assets. Such
reserves are held primarily to enable the central bank to purchase its currency should it wish to
prevent it depreciating. Any official settlements deficit has to be covered by the authorities
drawing on the reserves, or borrowing money from foreign central banks or the IMF (recorded as
a plus in the accounts). If, on the other hand, there is an official settlements surplus then this can
be reflected by the government increasing official reserves or repaying debts to the IMF or other
sources overseas (a minus since money leaves the country)
3.5 Balance of payments surplus and deficit
The balance of payments always balances since each credit in the account has corresponding
debt elsewhere. However, this does not mean that each of the individual accounts make up the
balance of payments is necessarily in balance. For instance, the current account can be in surplus
while the capital account is in deficit. When talking about a balance of payments deficit or
surplus, economists are really saying that subsets of items in the balance of payments are in
surplus or in deficit.
Autonomous or above the line items are transactions that take place independently of the balance
of payments, whilst accommodating or below the line items are transaction which finance any
difference between autonomous receipts or payments. A surplus in the balance of payments is
defined as a excess of autonomous receipts over autonomous payments. A deficit is an excess of
autonomous payments over autonomous receipts.
Autonomous receipts > autonomous payments = surplus
Autonomous receipts < autonomous payments = deficit
39
Note
There is disagreement on which items qualify as autonomous. This leads to alternative views on
what constitutes a balance of payments surplus or deficits. The difficulty arises because it is not
easy to identify the motive underlying a transaction. For example, if there is a short-term capital
inflow in response to a higher domestic interest rate, it should be classified as autonomous item.
If, however, the item is an inflow to enable the financing of imports then it should classified as
an accommodating item. The difficulty of deciding which items should be classified as
accommodating and autonomous has led to several concepts of balance of payments
disequilibrium.
3.5.1 Balance of payments disequilibrium
The balance of payment of a country is said to in equilibrium when the demand for foreign
exchange is exactly equivalent to the supply of it. The balance of payments is regarded as being
in disequilibrium when the demand for foreign exchange exceeds its supply, and there will be a
surplus when the supply of foreign exchange exceeds the demand.
(a) Factors that may cause disequilibrium in the balance of payments
i. Economic factors: - Various economic factors cause development disequilibrium,

cyclical disequilibrium, secular disequilibrium and structural disequilibrium.
 Development disequilibrium –large scale development expenditures usually
increase the purchasing power, aggregate demand and prices, resulting in
substantially large imports. Development disequilibrium is common in the
case of developing countries, because the above factors and the large scale
import of capital goods needed for carrying out the various development
programs give rise to a deficit in their balance of payment.
 Cyclical disequilibrium – cyclical fluctuation of general business actively is
one of the prominent reasons for balance of payments disequilibrium.
Depression always brings about a drastic shrinkage in world trade, while
prosperity stimulates it. A country enjoying a boom all by itself will ordinarily
experience a more rapid growth in its imports than its exports, while the
opposite will be true of other countries.
40
 Secular disequilibrium – sometimes, the balance of payments disequilibrium
persists for long period due to certain secular trends in the economy. For
instance, in a developed country, the disposable income is generally very high
and, therefore, so is the aggregate demand. At the same time, the production
costs are also very high due to the high wages. This naturally results in higher
prices. These two factors (high aggregate demand and higher domestic prices)
may result in the imports being much higher than the exports.
 Structural disequilibrium – such structural changes include development of
alternative sources of supply, development of better substitutes, exhaustion of
productive resources or changes in transport routes and costs.
ii. Political Factors:- certain political factors could also Produce a BOP disequilibrium.
For instance, a country plagued with political instability may experience large capital
outflows and inadequacy of domestic investment and production. These factors may,
sometimes, cause disequilibrium in the balance of payment.
iii. Sociological factors – for instance, changes in the tastes, preferences and fashion,
may affect imports and thereby affect the balance of payments.
(b) Correction of disequilibrium
There are a number of measures available for correcting the balance of payments disequilibrium.
They fall into two broad groups, namely, automatic measures and deliberate measures.
i. Automatic correction
The theory of automatic correction is that if the market forces of demand and supply are allowed
to have free play, in course of time, equilibrium will be automatically restored. When there is a
BOP deficit, the demand for foreign exchange exceeds it supply and this result in an increase in
the exchange rate and a fall in the external value of the domestic currency. This makes the
exports of the country cheaper and imports expensive than before. Consequently, the increase in
exports and fall in imports restore the balance of payment equilibrium.
Under the fixed exchange rate system, the automatic adjustments of the balance of payments
happen via changes in the adjustment variable such as price, interest, income and capital flows.
41
 Price adjustments – A fall in the money supply in the deficit country and increase in
money in the surplus country will result in rise in the prices in the surplus country
which will encourage imports and discourage exports, and fall in prices in the deficit
country which will encourage exports and discourage imports, leading to restorations of
BOP equilibrium in due course.
 Interest rate adjustments – A monetary effect of BOP surplus or deficit, is its impact
on the short-term interest rates. The contraction or expansion of money supply resulting
from the BOP deficit or surplus leads to a rise or fall in the interest rates. This will
encourage investors in the deficit country where the interest rate has risen to withdraw
then funds from abroad and invest in the home country. Because of the fall in interest
rate in the foreign country with BOP surplus, foreigners will be encouraged to send
money to the deficit country where the interest rate has risen. These changes will also
contribute to the restoration of BOP.
 Income adjustments – Kaynes demonstrated that under the fixed rate system, the
changes in income will help restore BOP equilibrium automatically. A nation with
persistent payment surplus will experience rising income causing increasing exports.
The opposite will happen in the deficit nation.
 Capital flows – Changes in the interest rates consequent to BOP disequilibrium will
encourage capital flows between the deficit and surplus nations, helping restoration of
the BOP.
ii. Deliberate measures
Because of the various problems associated with the policy of automatic correction, deliberate
measures are widely employed today. Deliberate measures refer to correction of disequilibrium
by means of measures taken deliberately with this end in view. Deliberate measures may be
broadly grouped into monetary measures, trade measures and miscellaneous measures.
42
(a) Monetary Measures
The important monetary measures are:
i. Monetary contraction/expansion:- the level of aggregate domestic demand, domestic

price level and the demand for imports and exports may be influenced by contraction
or expansion of money supply so that a balance of payment disequilibrium may be
corrected. For example, assume a situation of balance of payments deficit for the
correction of which a contraction of money supply is required. Contraction of money
supply is likely to reduce the purchasing power and thereby the aggregate demand. It
also reduces domestic prices. The fall in the domestic aggregate demand and
domestic prices reduces the demand for imports and encourage exports.
ii. Devaluation:- Devaluation means reduction of the official rate at which the currency
is exchanged for another currency. A country with fundamental disequilibrium in the
balance of payments may devalue its currency in order to stimulate its exports and
discourage imports to correct the disequilibrium. Devaluation makes export goods
cheaper and imports dearer/expensive
iii. Exchange control:- exchange control is a popular method employed to influence the
balance of payments positions of a country. Under exchange control, the government
or central bank assumes complete control over the foreign exchange reserves and
earnings of the country. The recipients of foreign exchange, like exporter, are
required to surrender foreign exchange to the government or central banks in
exchange for domestic currency. By virtue of its control over the use of foreign
exchange, the government can control imports.
(b)Trade measures
Trade measures include export promotion measures and measures to reduce imports. These
include:-
i. Export promotion – Exports may be encouraged by reducing or abolishing export

duties, providing export subsidies, encouraging export production and export
43
marketing by giving monetary, fiscal, physical and institutional incentives and
facilities.
ii. Import control – Imports may be controlled by imposing or enhancing import duties,
restricting imports through quotas, licensing and even prohibiting altogether the
import of certain inessential items.
(b) Miscellaneous measures
Apart from the monetary contraction/expansion and trade measures, there are a number of other
measures that can help to make the balance of payments position more favorable, like obtaining
foreign loans, encouraging foreign investment in the home country, development of tourism to
attract foreign tourist and providing incentives to enhance inward remittances
44
Figure 3.1 Correction measures balance of payment disequilibrium
CORRECTION OF BOP DISEQUILIBRIUM
Automatic correction Deliberate measures
Monetary measures Trade measures Miscellaneous measures
1. Monetary contraction/ 1. Foreign loan

expansion 2. Incentives for foreign
2. Devaluation/ revaluation investment
3. Exchange control 3. Tourism development
4. Incentives for foreign

remittances
5. Import substitution
Export promotion Import control
1. abolition/reduction of export 1. Import duties

duties
2. Import quotas
2. Export subsidies
3. Import prohibition
3. Export incentives
45
3.6 Financing of BOP deficit
When a nation has a balance of payment deficit i.e. when the total external payments obligations
exceed the total receipts, an external payments problem arises. The nation has to find out means
for meeting the payments obligation. The common methods of financing the BOP deficit are the
following:-
i. Using foreign exchange reserves – If the nation has comfortable foreign exchange
reserves, the deficit can be financed by drawing upon the reserves. The problem,
however, is that only when the BOP has a continuous surplus that a country will have
a comfortable foreign exchange reserves. If a country experiences persistent deficits,
the reserves would dry up and it will have to resort to some other method(s) to
finance deficit.
ii. External assistance – If a nation does not have enough foreign exchange reserves to
draw upon to finance the BOP deficit, it may have to take reserve to external
assistance. It very important source of assistance for countries with BOP problem is
the IMF. A nation may also resort to other sources, including commercial borrowing,
for financing the deficit.

i. Define balance of payments and explain what to be included in it.
ii. Briefly,discuss balance of payments accounting and accounts
iii. Clearly, explain sub-accounts in the balance of payments
iv. What is the meaning of balance of payments surplus and balance of payments deficit
v. Discuss factors that cause disequilibrium in the balance of payments
vi. State and explain correction measures for the balance of payment disequilibrium
Reference
46
47
CHAPTER FOUR: THE INTERNATIONAL PARITY CONDITIONS
 Explain the law of one price

 Discuss the concept of arbitrage profit
 Discuss transaction costs and no-arbitrage conditions
 Explain interest rate parity and covered interest arbitrage.
 Discuss exchange rate equilibrium
 Explain low covered interest rate arbitrage and how to undertake covered interest
arbitrage.
4.0 The law of one price (Purchasing Power Parity i.e. PPP)
The Law of One Price, also known as Purchasing Power Parity or PPP, is the single most
important concept in international finance and economics. The implication for multinational
finance is that an asset must have the same value regardless of the currency in which value is
measured. The law of one price implies that equivalent assets sell for the same price. If PPP does
not hold within the bounds of transaction costs, then there is an opportunity to profit from cross-
currency difference in prices.
4.1 Arbitrage profit

Although the term arbitrage or risk arbitrage is often used to refer to speculation positions,
arbitrage is more strictly defined as a profitable position obtained with no net investment and no
risk. Arbitrage opportunities are often exploited, and just as quickly disappear as arbitragers
drive prices back toward equilibrium.
Let Pd denote the price of an asset in domestic currency and Pt denote the price of the same asset
or an identical asset in a foreign currency. The law of one price requires that the value of an asset
be the same whether the value is measured in the foreign or in the domestic currency. This means
that the spot rate of exchange ( ), must equate the value in the foreign currency to the value in
the domestic currency.
= =
48
If this equality does not hold within the bounds, of transaction costs, then there may be an
opportunity for an arbitrage profit.
Example
Suppose gold sells for P $=$ 400/oz (i.e $ 400 per Ounces) in New York and £
=£ 250/oz (i.e.
£250 per Ounces) in London. The no-arbitrage condition requires that the value of gold in dollars
must equal the value of gold in pounds, so
$ $ /
$/£
= £ =£ /
=$ 1.6000/1£
Or
£/$ = £ /
$/£ =$ /
=£ 0.6250/1$
If this condition does not hold within the bound s of transaction costs, then there is an
opportunity to lock in a riskless arbitrage profit in cross-currency gold transactions. Transaction
costs are relatively small for actively traded financial assets, such as currencies in the interbank
market. The purchasing power parity nearly always holds in these markets, because the potential
for arbitrage ensures that prices are in equilibrium. PPP is less likely to hold in illiquid markets
where high transaction costs or financial markets controls prevent arbitrage from enforcing the
law of one price.
4.2 Transaction costs and the No- Arbitrage Conditions

For there to be no-arbitrage opportunities, PPP (Purchasing Power Parity) must hold within the
bounds of transactions costs for identical assets bought or sold simultaneously in two or more
locations. Whether the PPP holds depends on the extent to which market frictions restrain from
working magic. Some barriers to the cross-border flow of capital are generated in the normal
course of business, as fees are charged for making a market, providing information, or
transporting and delivering an asset. Other barriers are imposed by governmental Authorities,
including trade barriers, taxes and financial market controls.
49
Buying and selling real assets usually entails higher costs than trading a financial claim on the
real assets. As an example, gold is costly to transport because of its weight, but a financial asset
representing ownership of gold is easily transferred from one party to another and can be as
simple as a piece of paper or a credit in an account. Although a large amount of gold are a
nuisance to store, currency can be conveniently store in the Eurocurrency market at a
competitive interest rate. Because of this difference between financial and real assets, actively
traded financial assets are more likely to conform to the law of one price than similar real
assets.
Example (How transaction cost influence the analysis)
Suppose gold is quoted at £250.00/oz bid and £253.00/oz ask in London and $402.00/oz bid and
406.00/oz ask in New York. A forex dealer quotes pounds in the spot market as $ 1.5990/£ bid
and 1.6010/£ ask. Translated into pounds at the $1.6000/£ mid rate, the New York dealer’s mid-
$ . /
price of $ . /£
= £252.50/oz is slightly higher than the London dealer’s mid-price of
£251.50/oz, so the winning play should be to buy gold from the London dealer and sell gold to
the New York dealer.
Suppose you buy 1,000 ounces of gold for £ 253,000 at London dealer’s ask price for gold of
£253/oz. The forex dealer will sell £ 253,000 to you for a payment of
(£253,000)x($1.6010/£)=$405,053 at the $1.6010/£ ask price for pounds. Selling the gold in
New York yields only $ 402,000 at the New York dealer’s bid price for gold. This leaves you
with a net loss of $3,053.
Even though purchasing power parity does not hold exactly, it does hold within the bounds of
transaction costs in this example. Unfortunately for your dreams of wealth, the dealers bid-ask
price overlap one another and an arbitrage profit is not possible.
4.3 Exchange Rate Equilibrium

Spot exchange and forward currency contracts are traded in liquid interbank markets with few
governmental restrictions r market frictions. The potential for arbitrage using actively traded
financial contracts ensures that the following international parity conditions:
50
( )
1. (Y) = (X) ↔ =1
( )
( ) t
2. =[ ]
( )
will hold with the bounds of transaction cost in the interbank markets.
4.3.1 Bilateral Exchange Rate and equilibrium and Locational Arbitrage

In the absence of market frictions, the no-arbitrage condition for trade in spot exchange rates
between two banks X and Y is
( )
(Y) = (X) ↔ =1
( )
This ensures bilateral exchange rate equilibrium. If this relation does not hold within the bounds
of transaction costs, then there is a locational arbitrage opportunity between the banks.
An example of Locational Arbitrage
Bank X is quoting “ A $0.5838/€ bid and A $0.5841/€ ask” and bank Y is quoting “A $ 0.5842/€
bid and A $ 0.5845/€ ask”. If you buy € 1million from X at it’s A $0.5841/€ ask price and
simultaneously sell € 1million to Y at it’s A $ 0.5842/€ bid price. You can lock in an arbitrage
profit of (A$ 0.0001/€) x (1,000,000) = A$ 100 with no net investment or risk. Transaction costs
are built into the bid-ask spread, so this profit is free and clear. If this is a good deal with € 1
million, it is even better with a € billion transaction. The larger the trade, the larger is the profit.
With forex volume around $ 2 trillion par day, there is no doubt that there are plenty of
arbitrageurs looking for opportunities such as these. Dealers are just as vigilant in ensuring that
their bid and offer quotes overlap those of other forex dealers. If a bank’s bid or offer quotes drift
outside of the band defined by other dealer’s quotes, they quickly find themselves in undated
with buy (sell) orders for their low-priced (high-priced) currencies.
51
Even if banks’ quoted rates do not allow arbitrage, banks offering the lowest offer (or highest
bid) prices in a currency will attract the bulk of customer purchases (sales) in that currency.
The long and the short of it
A long position is synonymous with ownership of an asset. A short position means the holder of
the position has sold the asset with the intention of buying it back at a later date. Long positions
benefit if the price of the asset goes up, whereas short positions benefits if the price of the asset
goes down. For example, a bank is in a long Euro position and a short Dollar position when, on
balance, it has purchased Euros and sold Dollars. Conversely, a bank is short position Euros and
Long position Dollars when it has sold Euros and purchased Dollars.
Currency balances must be netted out; if a bank has bought € 100 million and sold € 120 million
in two separate transactions, then its net position is short € 20 million.
Banks try to minimize their net exposures, because currency dealers operating with large
imbalances risk big gains or losses if new information arrives and currency value unexpectedly
changes.
4.3.2 Interest Rate Parity and Covered Interest Arbitrage
Let be the t-period forward exchange rate initiated at time zero (0) for exchange at time t.
is the spot exchange rate at time zero (0). Nominal interest rates in the two currencies are
denoted if and id. Interest Rate Parity, or IRP, relates the currency and interest rate markets as
follows
( ) t
= [( )
]
According toInterest Rate Parity, the forward premium (or discount) reflects the interest rate
differential on the right-hand side of equation above. For major currencies, nominal interest rate
contracts are actively traded in the interbank Eurocurrency markets. Likewise, there are active
spot and forward markets for major currencies. Because each contract in equation above is
actively traded, interest rate parity always holds within the bounds of transaction costs in these
markets.
52
4.3.3 Covered Interest Arbitrage
Locational arbitrage takes advantage of a price discrepancy between two locations, and
triangular arbitrage takes advantage of price disequilibria across three bilateral cross rates.
Through a similar mechanism, covered interest arbitrage takes advantages of an interest rate
differential that is not fairly reflected in the forward premium. Disequilibrium in the interest rate
parity relation provides an opportunity for arbitrageurs to borrow in one currency, invest in the
other currency, and cover the difference in the spot and forward currency markets. The no-
arbitrage condition then ensures that currency and Eurocurrency markets are in equilibrium
within the bounds of transactions.
Example
Suppose you can trade at the following prices:
$ $
£ £
=$ 1.250000/£ =$ 1.200000/£
i$ = 8.15000% i£ =11.5625%
Where;
S = spot exchange rate
F = forward exchange rate
i$ = domestic interest rate
i£ = foreign interest rate
Interest Rate Parity doesn’t hold, because
$ . /£ ( ) .
= $ . /£
=0.960000 < 0.969412 = ( )
= .
53
Covered interest rate arbitrage is described below as follows
1. Borrow £ 1 million at the prevailing Eurocurrency interest rate of i£ = 11.5625 percent for
one year. Your obligation will be $ 1,115,625 in one year.
2. Exchange the £ 1 million for $ 1.25 million at as the spot exchange rate. This leaves you
with a net dollar inflow today and a pound obligation in one year.
3. Invest the $ 1.25 million at i$ = 8.15000 percent. Your pay off will be
($1,250,000)(1.0815) = $ 1,351,875 in one year. Your net position is now an inflow of
$1,351,875 and outflow of £1,115,625, both at time t=1.
4. To cover your time t=1 obligation of £ 1,115,625, sign a 1 year forward contract in which
you bag £ 1,115,625 and sell ($1.2/£)(£1,115,625) = $ 1,338,750 at the forward rate =$
1.200000/£.
The net result is an arbitrage profit of $13,125. Although this example ignores bid-ask
spreads, these could be included by using appropriate bid or offer price when trading
each contact.

i. Explain what is meant by the term Purchasing Power Parity (PPP).
ii. What is arbitrage profit and when one can make arbitrage profit.
iii. Given the following information, assess whether the interest rate parity condition
holds
$ $
£ £
=$ 2.500000/£ =$ 2.400000/£
i$ = 16.3000% i£ =23.1250%
Where S is spot exchange rate, F is forward exchange rate, i$ is domestic interest
rate, i£is foreign interest rate.
iv. If bank X is quoting “A $1.5838/€ bid and A $1.1682/€ ask” and bank Y is quoting
“A $1.1684/€ bid and A $1.1690/€ ask”. If you buy € 2million from X at it’s A
$1.1682/€ ask price and simultaneously sell € 2million to Y at it’s A $ 1.1684/€ bid
price. Calculate arbitrage profit.
54
Reference

55
CHAPTER FIVE: FOREIGN EXCHANGE RISKS/EXPOSURES
 Give the meaning of foreign exchange exposure.

 Clearly, discuss various types of foreign exchange exposure
 Explain various strategies for managing exchange rate exposure
5.0 Introduction
There are two types of foreign exchange risk or exposure. The term foreign exchange exposure
refers to the degree to which a company is affected by exchange rate changes.
 Economic exposure
 Accounting exposure (translation exposure)
5.1 Economic exposure

Economic exposure refers to the risks arising from economic transaction and other economic
activities. The economic exposures focuses on the impact of an exchange rate change on future
cash flows; that is, economic exposure is based on the extent to which the value of the firm, as
measured by the present value of its expected future cash flows, will change when exchange rate
change.
∆
Specifically, if PV is the present value of a firm then firm is exposed to risk if ∆
is not equal to
zero, where:
∆ = is the change in that firm’s present value associated with an exchange rate
change, ∆ .
Economic exposure may be divided into its two component parts; transaction exposure and real
operating exposure.
56
5.1.1 Transaction exposure
Transaction exposure arise out of the various types of transactions, such as international trade,
borrowing and lending in foreign currencies, and the local purchasing and sales activities of
foreign subsidiaries, that requires settlement in a foreign currency.
Transaction exposure measure the change in the value of outstanding nominal financial
obligations incurred prior to a change in the exchange rate but not due to be settled until after
exchange rate change.
Example
A US firm sells good to a Kenyan importer with price of $10,000, with payments due in 90 days.
The current spot exchange rate is Kshs.86/$1, so the price of the sale in foreign currency is
Kshs.860, 000. The transaction exposure arises because in all likelihood the foreign buyer will
not probably pay Kshs 860,000 because the spot rate will differ on the settlement date.
 If spot exchange rate in 90 days to come is Kshs.90/$1 the Kenyan importer pays
Kshs.900, 000.
 If spot exchange rate in 90 days to come is Kshs.80/$1 the Kenyan importer pays
Kshs.800, 000.
Thus, the foreign buyer faces an economic gain or loss on the purchase of the good depending on
how the exchange changes.
5.1.2 Operating exposure

This exposure arises because currency fluctuation can alter company’s future revenues and costs,
that is, its operating cash flows. Measuring a firm’s operating exposure requires a longer-term
perspective, viewing the firm as an ongoing concern with operations whose cost and price
competitiveness could be affected by exchange rate changes.
Example
Assume that a multinational firm has concentrated its production in one country and sells the
output across the world. If the currency of this particular country appreciates considerably, the
products from this country will be costly in terms of the currencies which have depreciated vis-à-
vis that country’s currency, making its goods good costly in foreign markets.
57
5.2 Accounting exposure (transaction exposure)
Accounting exposure arises from the need, for purposes of reporting and consolidation, to
convert the financial statements of foreign operations from the local currencies involved to the
home currency. Translation exposure measures the accounting derived exchange rate gains or
losses that result from the need to convert foreign currency financial statements of affiliates into
parent currency units. It arises from the total change in the nominal exchange rate from previous
reporting period and the particular accounting basis i.e. consolidation method used. Translation
effects do not result in a change in current cash flow.
5.3 Strategies for managing exchange rate exposure/ risks

The four most common ways of minimizing exchange risk are:-
 Exchange risk avoidance

 Changing sourcing
 Exchange risk adaptation
 Currency diversification
i. Exchange risk avoidance
This is the elimination of exchange risk by doing business locally. The adverse effects of a
devaluation of the domestic currency can be mitigated by procuring the items domestically if
devaluation has made the domestic goods cheaper than foreign goods. Devaluation often
encourages imports substitution (indigenization)
ii. Changing /diversify sourcing
Another strategy is to change the sources of purchasing. For example, if the US goods become
costlier because of dollar appreciation, change the source of purchase from US to countries
where the product is cheaper, either because of depreciation of their currencies or other reasons.
iii. Currency diversification
Currency diversification is the spreading financial assets across several currencies so that
exchange rate movements of different currencies may be evened out. This may be applicable to
change to large multinational national enterprises that have an ongoing need for those currencies;
58
however it is not feasible in respect of small firms whose international operations are not widely
spread.
iv. Exchange risk adaptation
Exchange risk adaptation is the use of hedging to provide protection against exchange rate
fluctuation. Hedging refers to covering of export risks, and it provides a mechanism to exporters
and importers to guard themselves against losses arising from fluctuations in exchange rates. In
other words, hedging a particular currency exposure means establishing an offsetting currency
position such that whatever is lost or gained on the original currency exposure is exactly offset
by a corresponding foreign exchange gain or loss on the currency hedge. Hedging can protect a
firm from unforeseen currency movements. One of the most common methods of hedging is the
purchase of forward contract, futures and currency options. Other methods include:-
 Money market hedge
Money market hedge is a technique by which transaction exposure may be hedged by

borrowing and lending in the domestic and foreign money market. A firm may
borrow or lend in foreign currency to hedge currency receivables. For example, an
American firm which has receivables in pounds may borrow the required amount in
pounds for a period which equals the maturity of the receivables, convert them into
dollars and invest them. The pound loan can be paid off when the pound receivables
are realized.
 Hedging by lead and lag
Leading and lagging the foreign currency receipts and payments is another technique
for reducing the transaction exposure. To lead means to pay or collect early and to lag
means to pay or collect late.
A firm lead soft currency (i.e. relatively weak currency,prone to depreciation)

payments and lag hard currency (strong currency which is likely to appreciate)
receivables to avoid the loss from depreciation of the soft currency and to gain from
the appreciation of the hard currency.
59
 Exposure netting
When a firm has a portfolio of currency positions i.e. both receivables and payments
in different currencies, it is unnecessary to hedge every position if the adverse effects
of exchange rate movements in some cases are likely to be offset by the favourable
movements in other cases.
Exposure netting involves offsetting exposures in one currency which exposures in

the same or other currency, where exchange rates are expected to move in such a way
that losses (gains) on the first exposed position should be offset by gains (losses) on
the second currency exposure. This portfolio approach to hedging recognizes that the
total variability or risk of a currency exposure portfolio should be less than the sum of
the individual variabilities of each currency exposure considered in isolation. The
assumption underlying exposure netting is that the net gain or loss on the entire
currency exposure portfolio is what matter, rather than the gains or loss on any
individual monetary unit.
In practice, exposure netting involves one of the 3 possibilities:-
1. A firm can offset a long-position in a currency with a short position in that some
currency.
2. If the exchange movements of two currencies are positively correlated (for
example the Swiss franc and deutsch mark), then the firm can offset a long-
position in one currency with a short position in the other.
3. If the currency movements are negatively correlated, then short (or long) positions
can be used to offset each other.

i. What do you understand is meant by the term foreign exchange exposure?
ii. Define economic exposure and discuss, by give example, two component of
economic exposure.
iii. Explain accounting (translation) exposure.
iv. Discuss any five strategies for managing exchange rate exposure
60
Reference

61
CHAPTER SIX: INTERNATIONAL INVESTMENT AND INTERNATIONAL
FINANCIAL INSTITUTION
At the end of this chapter, the student should be:-
 Explain the meaning of the term Official Development Assistance (ODA)

 Discuss types of foreign private investment
 Give significance of foreign investment
 Differentiate between IMF and world bank, and explain their purposes
6.0 Introduction
International business has been propelled/ boosted by large cross-border flows of finance. While
the private financial flows are invariably/always, commercial in nature, financial flows related to
Official Development Assistance (ODA) have also implications for business.
Official Development Assistance refers to grants and soft loans from official sources, with the
objectives of promoting economic development and social welfare. There are two channels of
aid flows:-
I. Between governments and government agencies (bilateral flows)

II. Through multilateral institutions like the World Bank and Regional Development
Banks (multilateral flows)
The poor countries are not able to raise much money on commercial terms. Official
Development Assistance (ODA) or Aid is very important for that, investments resulting from
ODA also provide opportunities for private business besides the general economic improvements
such investments may promote.
6.1 Types of foreign private investment

Broadly, there are two types of foreign private investment:-
 Foreign direct investment (FDI)

 Foreign portfolio investment (FPI)
62
6.1.1 Foreign direct investment (FDI)
Foreign direct investment refers to investment in a foreign country where the investor retains
control over the investment. It typically takes the form of starting a subsidiary, acquiring a stake
in an existing firm or starting a joint venture in the foreign country.
United Nations Conference on Trade and Development (UNCTED)’s world invest report defines
foreign direct investment (FDI) as an investment involving a long-term relationship and
reflecting a lasting interest and control by a resident entity in one economy (foreign direct
investor or parent enterprise) in an enterprise resident in an economy other than that of the
foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate).
FDI implies that the investor exerts a significant degree of influence on the management of the
enterprise resident in the other country.
Flows of FDI comprise capital provided (either directly or through other related enterprises) by a
foreign direct investor to an FDI enterprise, or capital received from an FDI enterprise by a
foreign direct investor.
Foreign domestic investment (FDI) has three components:
 Equity capital,
 Reinvested earnings and
 Intra-company loans.
FDIs are governed by long-term considerations because these investments cannot be easily
liquidated. Hence factors like long term political stability, government policy, industrial and
economic prospects, among other, influence FDI decision.
6.1.2 Foreign Portfolio Investment (FPI)

If the investor has only a sort of property interest in investing the capital in buying equities,
bonds, or other securities abroad, it is referred to as portfolio investment. That is, in the case of
portfolio investments, the investor uses his capital in order to get a return on it, but has no much
control on the use of the capital.
63
6.2 Significance of foreign investment
(a) Foreign investment is playing an increasing role in economic development. Economic
reforms and the far-reaching political changes have resulted in very substantial
changes in the international capital flows. FDI now contributes to a significant share
of the domestic investment, employment generation, exports, tax revenue e.t.c. in a
number of economies.
(b) The changes in the composition of the capital flows and the substantial increase in the
magnitude of some of the flows like FDI, have remarkably changed the balance of
payments and foreign exchange reserves position of several countries.
(c) Foreign investment has assisted and is assisting the economic growth of many
countries. As a World Bank report points out, for developing countries FDI has the
following advantages over the Official Development Assistance (ODA):-
 FDA shifts the burden of risk of an investment from domestic to foreign
investors.
 Repayments are linked to profitability of the underlying investment, whereas
under debt financing the borrowed funds must be serviced regardless of the
project costs.
 Further World Bank has also observed that FDI is the only capital inflow
that has been strongly associated with higher GDP growth since 1970.
Note
Given the limitations of domestic savings, many developing countries will have to rely on
foreign investment to accelerate economic growth.
6.3 Reasons for foreign investment

The decision to invest capital in a project abroad should be based upon consideration of expected
return and risk just like investing locally. However, these factors are different in different
countries. Some of the reasons for foreign investment are:
 Return considerations: - Domestically, competitive pressures may be such that only a

normal rate of return can be earned. A firm may invest abroad so as to produce more
efficient due to existence of cheaper factors of production.
64
 Taxation:- Tax lows are different in different countries and therefore a firm may invest
abroad to minimize tax payment to the government.
 Risk considerations:- international diversification is often more effective than domestic
diversification in reducing risk in relation to expected return. This is due to differences
in economic cycles in different countries.
6.4 INTERNATIONAL FINANCIAL INSTITUTIONS

There are several international organizations, funding and assisting the development of nations.
These include International Monetary Fund, World Bank, Regional Development Bank e.t.c. the
influence of some of them is, indeed, very profound. The economic policies and programmes of
member countries which take financial assistance from these organizations may be influenced by
policies and conditions of assistance of these organizations.
The IMF has several schemes of financial assistance for countries with balance of payment
problems. It also provides different types of technical assistance.
Assistance from the World Bank and Regional Development Banks are substantial sources of
public investments in a number of countries and such investments may help improve the general
business conditions in those countries. Many of these public projects are implemented by private
parties and it is mandatory that contracts in respect of large projects funded by these institutions
shall be award by global tendering.
Further some of the organizations also provide direct financial assistance to the private sector.
6.4.1 International Monetary Fund (IMF)

The International Monetary Fund (IMF), which was established on December 27, 1945 with 29
countries and which began financial operation on March 1, 1947, is the result of the Bretton
Woods Conference of nations held in 1944 to discuss the major international economic
problems, including reconstruction of the economies ravaged by World War II, and to evolve
practical solutions for them.
The IMF is the central institution of the international monetary system. It aims to prevent crises
in the system by encouraging countries to adopt sound economic policies. Also, as it name
65
suggests, a fund can be tapped by members needing temporary financing to address balance of
payment problems.
Membership in the IMF is open to every country that controls its foreign relations and is able and
prepared to fulfill the obligation of membership.
(a) Purpose of IMF
The IMF’s statutory purposes include promoting the balance expansion of world trade, the
stability of exchange rates, the avoidance of competitive currency devaluations, and the orderly
correction of a county’s balance of payments problems.
According to Article one of Agreement of the International Monetary Fund, the purposes of the
IMF are:
 To promote international monetary cooperation through a permanent institutions which

provide the machinery for consultation and collaboration on international monetary
problems.
 To facilitate the expansion and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income and
to the development of the productive resources of all members as primary objectives of
economic policy.
 To promote exchange stability, to maintain orderly exchange arrangements among members,
and to avoid competitive exchange depreciation.
 To assist in the establishment of a multilateral system of payments in respect of current
transactions between members and in the elimination of foreign exchange restrictions which
hamper the growth of world trade.
 To give confidence to members by making the general resources of the Fund temporarily
available to them under adequate safeguards, thus providing them with opportunity to correct
maladjustments in their balance of payments without resorting to measures destructive of
national or international prosperity.
66
 In accordance with the above, to shorten the duration and lessen the degree of
disequilibria in the international balances of payments of members.
(b) Technical Assistance
The IMF provides technical assistance in areas within its core mandate; these areas are
macroeconomic policy, monetary and foreign exchange policy and systems, fiscal policy and
management, external debt, and macroeconomic statistics.
The objective of IMF technical assistance is to contribute to the development of the productive
resources of member countries by enhancing the effectiveness of economic policy and financial
policy.
In practice, the IMF fulfills this objective by providing support to capacity building and policy
design. It helps countries strengthen their human and institutional capacity, as a means to
improve the quality of policy-making, and gives advice on how to design and implement
effective macroeconomic and structural policies.
The IMF provides technical assistance in three broad areas:-
 Designing and implementing fiscal and monetary policies.

 Drafting and receiving economic and financial legislation, regulations, and procedures,
thereby helping to resolve difficulties that often lie at the heart of macroeconomic
imbalances
 Institution and capacity building, such as in central banks, treasuries, tax and customs
departments, and statistical services.
6.4.2 World Bank

The World Bank Group, originated as a result of the Bretton Woods Conference of 1944, is one
of the World’s largest sources of development assistance and it has extended assistance to more
than 100 developing economies bringing a mix of finance and ideas to improve living standards
and eliminate the worst forms of poverty. For each of its clients, the bank works with
government agencies, non-governmental organizations, and the private sector to formulate
assistance strategies.
67
The World Bank Group consists of five closely associated institutions playing a distinct role in
the mission to fight poverty and improve living standards for people in the developing world.
The term World Bank refers specifically to two of the five, that is, The International Bank for
Reconstruction and Development (IBRD) and The International Development Association
(IDA).
The other 3 institutions are:-
 The International Finance Corporation (IFC)

 The multilateral investment guarantee agency
 The International Centre for Settlement of Investment Disputes (ICSID)
While all five specialize in different aspects of development, they use their comparative
advantages to work collaboratively towards the goal of poverty reduction.
(a) The purposes of the World Bank, as laid down in its Articles of agreement, are:-
(a) To assist in the reconstruction and development of the territories of its members
governments, by facilitating investments of capital for productive purposes, including
the restoration of economies destroyed or disrupted by war and the encouragement of
the development of productive facilities and resources in less developed countries.
(b) To promote foreign private investment by guarantees of or through participation in

loans and other investments made by private investors.
(c) Where private capital is not available on reasonable terms, to make loans for
productive purposes out of its own resources or out of the funds borrowed by it.
(d) To promote the long term growth of international trade and the maintenance of
equilibrium in balance of payments by encouraging international investment for the
resources of members.
The bank advance loans to member countries in the following three ways:
i. By making or participating in direct loans out of its own funds.
ii. Out of funds raised in the markets of a member or otherwise borrowed by the bank.
68
iii. By guaranteeing in whole or part loans made by private investors through the
investments channels.
The bank has made loans for specific development projects in the field of Agriculture,
Power, Transport, Industry and Education, Railway Rehabilitation, Highway Constructions
etc.

I. State two channels if aid flows
II. Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI)
III. State significance of foreign investment
IV. Explain 3 reasons for foreign investment
V. Highlight any four purposes of IMF
VI. Highlight 3 area in which IMF provides technical assistance
VII. Give the purposes of the World Bank as stipulated in its Articles of agreement.
VIII. Highlight 3 ways in which the world advance loans to member countries.
Reference

69
CHAPTER SEVEN: STRUCTURAL ANJUSTMENT PROGRAMMES (SAPs)
 What is meant by the term structural adjusted programme (SAPs)

 Explain what SAPs was designed to do
 Discuss conditions for structural adjustment programme
 Criticize structural adjusted programme
7.0 Introduction
Structural adjustmentprogrammes is the name given to a set of ‘free market’ economic policy
refers imposed on developing countries by the World Bank and international monetary fund
[IMF] as a condition for receipt of loans. Thus structural adjustment programmers are the
policies implemented by the international monetary fund (IMF) and the World Bank in
developing countries.
These policy changes are conditions for getting new loans from international monetary fund or
World Bank, or for obtaining lower interest rates on existing loans. The conditions are
implemented to ensure that the money lent will be spent in accordance with the overall goods of
the loan.
7.1 What wasstructural adjustment programmes (SAPs) designed to do?
SAPs are designed to:-
i. Improve a country’s foreign investment climate by eliminating trade and investment

regulations.
ii. To boost foreign exchange earnings by promoting exports.
iii. To reduce government deficits through cuts in spend.
SAPs were developed in the early 1980s as a means of gaining stronger influence over the
economies of debt-strapped governments in the south. To ensure the continued inflow of funds,
countries already devastated by debt obligations have little choose but to adhere to conditions
70
mandated by the IMF and World Bank. The structured adjustment programmers (SAPs) are
created with the goal of reducing the borrowing country’s fiscal imbalances. The SAPS are
supposed to allow the economies of the developing countries to become were market oriented.
This then forces them to concentrate more on trade and production so it can boost their economy.
Through conditionalities, structural adjustment programmes and policy these programs include;
1. Internal changes (privatization and deregulation)
2. External changes, especially the reduction of trade barriers.
Countries which fail to enact these programs may be subject to severe fiscal discipline.
7.3 CONDITIONS FOR STRUCTURAL ADJUSTMENT PROGRAMMES (what

measures are imposed under SAPs?)
1. Cutting expenditures (austerity) – that is, deep cuts to social programs usually in the areas
of health, education and housing and massive layoffs in the civil service.
2. Shift from growing diverse food crops for domestic consumption to specializing in the
production of cash crops or other commodities like rubber, cotton, coffee, copper, tin for
export.
3. Abolishing food and agricultural subsidies to reduce government expenditures
4. Devaluation of currencies –currency devaluation measures increase import costs while
reducing the value of domestically produced goods.
5. Trade liberalization, i.e. lifting import and export restrictions and high interest rates to
attract foreign investment.
6. Balancing budgets and not overspending.
7. Removing price controls and state subsidies.
8. Privatization of government held enterprises.
9. Enhancing the rights of foreign investors vis- vis national laws.
10. Improving governance and fighting corruption.
11. Increasing the stability of investments by supplemental foreign direct investment with the
opening of domestic stock markets.
12. Focusing economic output on direct export and resource extraction.
71
These conditions have also been sometimes labeled as the Washington consensus.
7.4 Why the need for SAPs?

The World Bank and the IMF argue that SAPs are necessary to bring a developing country
from crisis to economic recovery and growth. Economic growth driven by private sector
foreign investment is seen as the key to development. These agencies argue that the resulting
national wealth will eventually ‘trickle down’ or spread throughout the economy and
eventually to the poor.
7.5 Criticisms on SAPs
Multiple criticisms that focus on different elements of SAPs
1. National sovereignty- critics claim that SAPs threaten the sovereignty of national
economies because an outside organization is dictating a nation’s economic policy.
Critics argue that the creation of good policy is in a sovereign nation’s own best interest.
Thus, SAPs are unnecessary given the state is acting in its best interest. However,
supporters consider that in many developing countries the government will favor political
gain over national economic interests; that is, it will engage in rent-seeking practices to
consolidate political power rather than address crucial practices to consolidate political
power rather than address crucial economic issues.
Also some critic argue that the democratic policy process of countless countries has been
undermined by decisions formulated miles away by western economic bureaucrats and
that the implementation of such policy has solely benefited the largest donor countries
like US, UK, Canada & Japan.
2. Privatization: - A common policy in structural adjustment is the privatization of state-

owned industries and resources. This policy aims to increase efficiency and investments,
and decrease state spending. State-owned resources are to be sold whether they generate a
fiscals profit or not.
Critics argue that when resources are transferred to foreign corporation and/or national
elites, the goal of public prosperity is replaced with the goal of private accumulation.
72
Privatization makes essential needs such as water and health cure a commodity, and these
who are poor are unable to access such basic necessities. Therefore, many scholars have
argued that SAPs are not in the interest of the borrowing country, but rather caters to the
elites of the eliminating and undeveloped worlds.
The privatization of a previously social service such as health care is actually counter-
intuitive to the alleged purpose of structural adjustment.
3. Agriculture:-The agricultural, anti-land reform and food trade policies associated with
SAPs have been pointed to as a major engine in the urbanization of the developing.
In the irrigation sub-sector the trend has been towards disengagement of governments
from irrigation development and management.
There are also sources of contention for environmental activities. If large portion of SAPs
policy in agriculture focuses on the increased use of fertilizers and pesticides which harm
the health of local bodies of water and therefore fish populations
Impact- the privatization of the agricultural sector increased the inequality of good
distribution and inequality wealth in general as some farmers adapted to privatization and
flourished and others fell behind.
Farmers were introduced to fertilizers that left the hand nutrient barren and unusable.
In theory, devolution, by lowering the relative price of farm commodities on the

international market, should make a country’s agriculture exports more competitive.
However, it is by no means certain that increased exports compensate for the loss of
purchasing power of a cheaper currency.
4. Environment
Local environments can easily become casualties of pro-trade policies. Pro-trade policy
promotes an increase of industry geared toward western needs. As a result of the policy,
local industries begin the focus on producing in expensive goods to sell on the
international market.
73
Impact: - the focus on creating the least expensive product often leads to environment
exploitative industry. As these industries are often unregulated there are no laws
prohibiting this exploitation. For example, emission from factories is much less regulated
in developing nations.
SAPs call for increased exports to generate foreign exchange to service debt. The
acceleration of resource extraction and commodity production that results as countries
increase exports is not ecologically sustainable.
Deforestation, land degradation, soil erosion and sanitization, biodiversity loss, increased
production of green house gases, and air and water pollution are but a many the long-term
environmental impacts that can be traced to the imposition of SAPs.
5. Austerity
SAPS emphasized maintain a balanced budget which forces austerity programs. The
casualties of balancing a budget are often social programs.
The programs most often cut are education, public health, and other miscellaneous social
safety nets. Commonly, those are programs that are already underfunded and desperately
need monetary investment for improvement.
Impact: - if government cuts education funding, universally is impaired, and therefore
long-term economic growth.
6. Gendered effects
Poverty is a gendered issue, that is, various differences in circumstances between males
and females cause variances in the way poverty affects each. With this structural
adjustment programs fail to address poverty as a gendered issue. Thus implementation of
SAPs caused many problems which include:-
 Local health, welfare and infrastructures (especially water and sanitation) are usually
considered “women’s work” and fall directly to them. Withdrawing government support
directly affects the amount of work women are required to do, resulting in lessened health
and well-being for women and indeed the entire family.
74
 In addition, opening markets causes an upsurge of jobs in cities. As rural man leave to go
to those jobs, women and children are left behind, with increased responsibility for wives
and mothers to single handedly run the household.

I. Define Structural Adjustment Programme (SAPs)
II. What was structural adjustment programme (SAPs) designed to do?
III. Highlight 8 conditions for structural adjustment programme (SAPs)
IV. Briefly hive argument for SAPs as give by World Bank and IMF.
V. Discuss any four criticisms on SAPs.
Reference

75
CHAPTER EIGHT: INTERNATIONAL MONEY AND CAPITAL MARKET
 Explain what is international banking and be able to differentiate between domestic

banks
 Give ways in which international finance assist multinational enterprises
 Discuss various types of international banking offices
 Explain the concept of Eurocurrency and Eurobond market.
 Discuss factors to consider when choosing between Euromarkets or Domestic markets
 Factors which motivate capital flows between economic agents of different countries.
The development of international business is highly assisted by the development of international

banking and Eurocurrency market.
8.1 International banking

International banks are banks which accept foreign currency deposit, finance international
business and provide associated and ancillary/ supplementary services like hedging and advisory
services and operate internationally.
The major distinguishing features between domestic banks and international banks are the types
of deposits they accept and the loans and investments they make.
Large international banks both borrow and lend in the Eurocurrency market. Additionally, they
are frequently members of international loan syndicates, participating with other international
banks to lend large sums to multinationals corporations needing project financing and sovereign
governments needing funds for economic development.
Areas in which international banks typically have expertise to provide consulting services and
advice to their clients are:-
 foreign exchange hedging strategies,

 Interest rate and currency swap financing,
 and international cash management services.
76
Banks that provide a majority of these services are commonly known as universal banks or full
service banks. Some of the leading international banks include Bank of America, Citigroup and
Industrial and commercial Bank of China (ICBC).
8.1.1 International banks assist multinational enterprises in the following ways:

(a) financing of foreign trade
(b) financing capital project
(c) international cash management services
(d) providing full local banking services in different countries
(e) trading in foreign exchange and currency options
(f) lending and borrowing in Eurocurrency markets
(g) participating in syndicated loans facilities
(h) provisions of advice and information
(i) Underwriting of Eurobonds.
8.1.2 Types of international banking offices

There are different types of international banking offices ranging from correspondent bank
relationships, through which minimal services can be provided to a bank’s customers, to branch
offices and subsidiaries providing a full array of services.
(a) Correspondent bank:- a correspondent bank is a bank located elsewhere that provides
services on behalf of other bank, besides its normal business. The correspondent banking
system enables a bank’s foreign client to conduct business worldwide through his local
bank or its contacts.
The correspondent bank mode is ideal because of its low cost when the volume of
business is small. The possible disadvantage is that the clients may not receive the
required level of services.
(b) Representative offices:-this is a small service facility staffed b the parent bank personnel
that is designed to assist the foreign clients of the parent bank in dealings with a level of
service greater than that provided through a correspondent relationship.
(c) Foreign branches:- they provide full services, and are established when volume of
business is sufficiently large and when low of the land permits it. Foreign branches
facilitate better services to the clients and help the growth of business.
77
(d) Subsidiaries and Affiliates:-a subsidiary bank is a locally incorporated bank that is either
wholly or majority owned by a foreign parent and an affiliate bank is one that is only
partially owned but not controlled by its parent. Subsidiaries and affiliates are normally
meant to handle substantial volume of business.
8.2 Eurocurrency and Eurobond market

Eurocurrency markets are defined as banking markets which involve short-term borrowing and
lending conducted outside the legal jurisdiction of the authorities of the currency that is used. For
example, Eurodollar deposits are dollar deposits held in London and Paris.
The Eurocurrency market has two sides to it i.e. the receipt of deposits and the loaning out of
these deposits.
The most important Eurocurrency is the Eurodollar which currently accounts for approximately
65-70 per cent of all Eurocurrency activities, followed by the Euromark, Eurofrancs (Swiss),
Eurosterling and Euroyen.
The Eurocurrency markets are part of the international money market since it involves lending
and borrowing for a period of less than a year.
8.2.1 International capital market

Large companies may arrange borrowing facilities from their bank, in the form of bank loans or
bank overdrafts. Instead, however, they might prefer to borrow from private investors by issuing
Eurobonds.
The Eurobond market is part of the international capital market and involves lending and
borrowing for a period of more than a year. A Eurobond is a bond that is sold by a government,
institution or company in a currency that is different from the country the bond is issued. For
example, a dollar bond sold in London is a dollar Eurobond and a sterling bond sold in Germany
is a sterling Eurobond.
Note
An investor subscribing to a bond issue will be concerned about:-
 Security – the borrower must of high quality
78
 Marketability – investors wish to have a ready market in which bonds can be bought
and sold.
 The return on the investment as indicated by the coupon interest rate
8.2.2 Factors to consider when choosing between Euromarkets or Domestic Markets

(a) The currency that the borrower wants to obtain
Multinational companies usually want to borrow in foreign currency to reduce their foreign
exchange exposure and therefore borrow in Euromarkets rather than the domestic market.
(b) The cost
There is often a small difference in interest rate between Eurocurrency and domestic markets. On
large borrowings, however, even a small difference in interest rate result in a large difference in the
total interest charged on the loan.
(c) Timing and speed
It may be possible to raise money on the Euromarkets more quickly than in the domestic markets.
(d) Security
Euromarkets loans are usually unsecured, whereas, domestic market loans are more commonly
secured. Large borrowers may therefore prefer Euromarkets.
(e) The size of the loans
It is often easier for a large multinational to raise very large sums on the Euromarkets than in a
domestic financial market.
8.2.3 Participants in the Eurocurrency and Eurobond markets

The participants in the international money and capital markets include national governments,
local authorities, financial institutions such as banks, multinational firms, companies and
international institutions such as the World Bank, as well as private investors.
79
Most industrialized countries’ participants act as both lenders and borrowers of funds, while
many developing countries use the markets almost exclusively for borrowing purposes.
The various types of capital flows between economic agents of different countries are
motivated by various factors which include:-
 Trade financing motives: -much trade is financed by borrowing on the

international money and capital markets.
 Borrowing/lending motives:- many capital flows are simply motivated by the
desire of savers to get the best possible return on their money, while
borrowers are merely seeking to obtain the lowest possible interest rate.
 Hedging motives:- much borrowing and lending is motivated by desire to
hedge positions, that is, to reduce or eliminate losses resulting from
prospective interest-rate and exchange rate changes.
 Speculative motives:- much borrowing or lending is due to the taking of
speculative positions based on profiting from prospective interest-rate and
exchange-rate changes.
 Capital flight motives:-many movements of capital are motivated by a desire
to protect investors’ funds from penal taxation, possible seizure by the
domestic government, or to escape potential restrictions being imposed on
convertibility or to avoid political risk.

I. Explain what international banking is and differentiate between domestic banks and
international banks
II. Highlight ways in which international finance assist multinational enterprises
III. Discuss various types of international banking offices
IV. Explain the concept of Eurocurrency and Eurobond market.
V. Discuss factors to consider when choosing between Euromarkets or Domestic
markets.
VI. Factors which motivate capital flows between economic agents of different countries.
80
Reference

81
SAMPLE OF UNIT REVIEW QUESTIONS
SECTION A
1. (a) Highlight 2 ways in which the world advance loans to member countries. (2 marks)
(b) Define Structural Adjustment Programme (SAPs) (1 marks)
(c) State any factors to consider when choosing between Euromarkets or Domestic
markets. (2 marks)
2. (a) Highlight three ways in which international banks assist multinational enterprises (3
marks)
(b) Differentiate between nominal exchange rate and real exchange rate (2 marks)
3. Give the meaning of the following terms; (5 marks)
 Foreign market,
 Foreign exchange rate,
 Spot exchange rate,
 Currency options.
 Nominal exchange rate,
4. Define balance of payments and explain what to be included in it. (5 marks)
5. What is arbitrage profit and when one can make arbitrage profit. (5 marks)
6. Explain significance of international finance (5 marks)
7. Discuss international financial environment (5 marks)
8. Explain what is meant by the term Purchasing Power Parity (PPP). (5 marks)
9. (a) What do you understand is meant by the term foreign exchange exposure? (1 marks)
(b) Define economic exposure and discuss, by give example, two component of economic
exposure. (2 marks)
82
(c) Explain accounting (translation) exposure. (2 marks)
10. (a) State two channels if aid flows (1 mark)
(b) Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI) (2 marks)
(c) State significance of foreign investment (2 marks)
SECTION B
11. (a) Highlight any 3 purposes of IMF (3 marks)
(b) Highlight 3 area in which IMF provides technical assistance (3 marks)
(c) Give five purposes of the World Bank as stipulated in its Articles of agreement. (5 marks)
(d) Highlight 8 conditions for structural adjustment programme (SAPs) (8 marks)
(e) Briefly give argument for SAPs as give by World Bank and IMF. (3 marks)
12. (a) Discuss any four criticisms on SAPs. (10 marks)
(b) Discuss four types of international banking offices (10 marks)
13. (a) Explain what international banking is and differentiate between domestic banks and
international banks (6 marks)
(b) Explain the concept of Eurocurrency and Eurobond market. (6 marks)

(c) Factors which motivate capital flows between economic agents of different
countries. (8 marks)
14. Briefly, discuss argument for, and argument against floating exchange rate (20 marks)
83
15.(a) Highlight difference five between currency future contacts and currency
forward contracts (5 marks)
(b) Clearly, explain sub-accounts in the balance of payments (15 marks)
16. (a)What is the meaning of balance of payments surplus and balance of payments
deficit. (5 marks)
17. (a) Briefly, explain functions of foreign exchange market (10 marks)
(b) Briefly, discuss characteristics and participants of foreign exchange market. (10 marks)
18. (a) Explain determinants of demand and supply of foreign currency (10 marks)
(b) Discuss factors that influence exchange rates (10 marks)
19. Briefly, discuss argument for, and argument against fixed exchange rate (20 marks)
(b) Discuss factors that cause disequilibrium in the balance of payments (10 marks)
(c) State and explain two correction measures for the balance of payment
disequilibrium (5 marks)
20. (a) Given the following information, assess whether the interest rate parity condition holds
$ $
£ £
=$ 1.8750/£ =$ 1.800000/£
84
i$ = 12.2250% i£ =17.2500%
Where S is spot exchange rate, F is forward exchange rate, i$ is domestic interest
rate, i£is foreign interest rate. (7 marks)
(b) If bank X is quoting “A $1.5838/€ bid and A $1.1682/€ ask” and bank Y is quoting “A
$1.1684/€ bid and A $1.1690/€ ask”. If you buy € 2million from X at it’s A $1.1682/€
ask price and simultaneously sell € 2million to Y at it’s A $ 1.1684/€ bid price. Calculate
arbitrage profit. (7 marks)
(c) State and briefly explain any three strategies for managing exchange rate
exposure(6 marks)
85

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DEPARTMENT OF ACCOUNTING AND FINANCE

COURSE CODE: BFM 414

COURSE TITLE: INTERNATIONAL FINANCE

MANUAL COMPILED BY: Mr. MBURU PETER

Cell phone No.: 0723135375

Email address: [email protected]

Expected learning outcomes of the course

Clark (2007), International Finance Management, Cengage Learning (Thompson)

At the end of this chapter, the student should be able to:

i. Define international finance and explain its significance

1.0 Definition of international finance

1.1 Significance of international finance

Some of the benefits of international finance are:

1.2 International financial environment

(a) The end of the Cold War.

(b) Industrialization and Growth of the Developing World.

(c) Increased globalization

2. To understand the effects of global finance on business

3. To make intelligent personal decisions

1.3 Chapter review questions

Clark (2007), International Finance Management, Cengage Learning (Thompson)

At the end of this chapter, the student should be able to:-

2.0 Definition of foreign exchange market

2.0.1 Functions of foreign exchange market

A foreign exchange market performs three important functions:-

2.0.2 Characteristics and participants of the foreign exchange market

i. Retails clients – These are made up of business, international investors, multinational

2.1 Determinants of demand and supply of foreign currency

2.2 Foreign exchange rate

i. The second method is a reciprocal of the first method

c) Inflation rate differential (purchasing power parity theorem)

The purchasing power theorem states that the:

% E(f) = I (h) – I (f) x 100

% E (f) = 0.06 – 0.1 x 100 = -3.64%

d) Interest Rate Parity (International Fisher Effect)

%E (f) = I (h) – I (f) x 100

New Direct Quote

2.2.2 Spot Exchange and Forward Exchange

Forward discount/premium = X 100

F = one-year forward exchange-rate quotation in foreign currency per unit of

S = spot exchange-rate quotation foreign currency per unit of domestic currency

r* = one year foreign interest rate

Example of the calculation of the forward exchange rate

 Speculators – Speculators are agents that hope to make a profit by accepting

Sr = the index of the real exchange rate

P = the index of the domestic prices level

P* = the index of the foreign price level

Table: - Construction of nominal and real exchange-rate indices

Period Nominal Nominal Exchange- UK Price US Price Real Exchange-

Construction of a nominal effective exchange-rate index

Period Nominal exchange rate Nominal exchange Effective exchange rate

2.3 Foreign exchange regime/systems

2.3.1 Fixed (stable) exchange rates

2.3.1.1 Argument for fixed exchange rate system (merits)

2.3.1.2 Argument against fixed exchange rate system (demerits)

2.3.2.1 Cases against floating (flexible) exchange rate (demerits)

i. A flexible exchange rate presents a situation of instability, creating uncertainty and

2.3.2.1 Cases for floating (flexible) exchange rate (merits)