Primer on The Art of International Finance www.finerva.

com

Prologue

This book is a dedication to the art of writing books. I would like to thank my guru
Alan Shapiro (ala eklavya style!!!) for making an electronics engineer with only sales
experience understand the idea of International finance so easily. I would unashamedly
state that most of the ideas are copied from Mr. Shapiro for the simple reason that he has
achieved the heights of simplicity with his easy style that there is no further simplicity I can
add to it.

My second thanks would be to Dan Brown, for teaching the art of writing over 450 pages
of a story spanning only a single night. Extraordinaire. I follow you to compress over a
thousand years of International Finance into less than 100 pages!

My third thanks to Leonardo Da Vinci for giving me my favourite philosophy; “simplicity

is the height of sophistication”. I am attempting to simplify International Finance for
learners who would like to move beyond the ordinary.

My fourth thanks to Life in general and University of Pune in particular for imbibing in my
mind and soul that “marks don’t matter” and to avoid books written with the syllabus in
mind and rather pursue knowledge through books which endeavour to become the
reference points of the subject under discussion.

My fifth thanks to all my students for inspiring me to take out time to write a simple book so
they could utilise it for their progress.

My sixth thanks to Tamil nadu state board for only cutting power supply for six hours each
day thus enabling me to complete the book only 5 days late. Thank your Govt of TN.

My thanks to the Microsoft guys for designing MS Word

My thanks to George for taking out time to review the book for me. PS: who’s George!

The readers would surely like to thank this page that it has decided to end at 12 inches as
most A4 sheets do. Thus sparing you the burden of any more of my humidity oops sorry
humility and thankfulness. Thank God for small things like A4 papers.

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What’s inside? ==>

Section 1. Ξ As it is
1. The idea of International Business
a. The Global Manager
2. The idea of International Finance
3. Primary- Foreign exchange and currency
a. What is the forex
b. Why currencies are the foundation of intl finance
4. How to?
a. Find exchange rates
b. Manage exchange rates
c. Use economics to find exchange rates – now and forever
5. Secondary- Finance Minister’s economics
a. Balance of Payments
b. Managing BOP

Section 2. = Hence
6. The market place – forex market
7. Menu card: Whats for sale
a. Forwards
b. Futures
c. Options
d. Swaps
e. Interest rate derivatives

Section 3. ∴ Therefore
8. Risk is constant. It’s everywhere. Thank god we know that!!!
a. Types of Exposure
b. Measuring Exposure-The accountant’s perspective
c. Protecting against risk
d. Side-stepping – managing risk
e. The Business Leader’s perspective – Economic Exposure

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Episode 1.
The idea of International Business

Why should a business leader understand International Finance is the only question that will form the
basis of this entire book? It sounds to be a simple question but is a very key issue especially in today’s
world where we are each day bombarded with more and more terms and terminologies related to
International business. Even kindergarten kids are today saying A for Asset...G for Globalisation... V
for VAT and so on…

Every student I teach have once or more told me that his/her aspiration is to join a Multinational
company during his career. With the wider choices we have today this dream is more of way of life for
college pass outs and hence the necessity to understand the environment in which any MNC has to do
its business. So what is an MNC? To put in very basic terms a Multinational Corporation or
Multinational Company is any company which as part of it business has operations (physical or
otherwise) in more than one country. The country where the first operations are started is called the
home country and the other operations are called subsidiaries.

Till say around 1990 in India an MNC meant an US company or a British or Japanese company. But
with free trade today we have companies like Reliance, Infy L&T etc which have joined the category by
their growth across physical borders and trade boundaries by expanding business by building
factories, providing service, becoming centres of outsourcing and so many other ways. The key being
that like we have grown up to think of Colgate as an Indian brand there are certain Indian companies
which have grown in other countries that people think of them as their own.

This scenario brings us to another fundamental question. Why did these companies become MNC’s?
The answer is a two fold answer – Part one being internal business aspirations and Part two being
external changes in business environment per se.

Income-Expense=Profit
Let’s take part one – business aspirations. Every business per se is fundamentally driven by one single
purpose – profits. To be even cruder by the motivation to create wealth for shareholders by earning
more money. And it’s a very logical deduction that for growing money business has to grow and
there has to be cash flow. Another major business logic we need to note here is also that the formula

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for profit is Income-Earning=Profit. Thus we can grow profit either by increasing Income or collaterally
reducing cost/expense.

Reasons why companies become MNC’s. Each firm would have one or more of the below points to
grow for the sake of the above discussion to take place.

1. Cost reduction- companies start factories or put up purchase branches in countries where the raw
material for their business is easily available or the cost of getting the inputs for business is much
lower than what it is in their home base. For example – Manufacturing costs for Nokia are so
much lesser than in Finland when it put its factory at Chennai. Or the Human resource cost
for Air Canada is lesser for it to outsource its customer care centre in Bangalore or Target
putting a merchandise office in Delhi to procure Towels from Karur. Wow!

2. Technical capabilities/requirements: Another reason for companies to expand beyond

boundaries is in need of skills or expertise which need not necessarily be available in their home base.
A most glaring example is of the Software industry in India which has not grown only because of the
cost factor but for the sheer number of skilled hands available here.

3. Demography: Population and Age characteristics are today forcing many companies to move to
countries where sufficient population to satisfy their needs is freely available. Countries like America
and the United Kingdom today are suffering under the pressure of a huge elderly population phasing
into retirement hence businesses have to move out in search of countries like China and India where
the younger population is abundant.

To put it into a very real life scenario what has been discussed in the above three point is
the entire stuff on which the worldwide debate on Outsourcing has been argued on by the
pro-outsourcing businesses. India and China have been the biggest benefactors. India from
points 2 and 3 and china from points 1 and 2

To put it in bullet points, the operations reasons why companies become MNC’s can be as below:
• To reduce labour cost (China, Brazil)
• Get skilled labour (electronics industry-Taiwan)
• Raw material requirements (special minerals etc)
• Reduce capital investments/working capital requirements (cheaper land)
• Taxation and policy issues (lower income tax etc)
• Environmental issues (asbestos issue)
• Special needs – specific requirements (weather) / skills (software) / inputs (uranium)
• Special benefits – tax holidays (Mauritius), free infrastructure (Hyundai Chennai) etc.

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The second major group of reasons for businesses to grow outside boundaries is for the sake of
business development of to put it more accurately for increasing income:

New markets: The main reason in terms of business development for which companies expand
across geographies is in search of newer markets for their product or service. This in turn could be
for two reasons – saturated markets in home base and two better margins. Some products
might not be saleable more in the home country for want of demand or lesser population.
(Example: Nokia Phones in Finland. Population of Finland is approx 52 lakhs whereas
Nokia sells close to 30 million handsets in India alone).
(http://www.thehindubusinessline.com/2007/08/24/stories/2007082451950400.htm) In other
cases the net margins might be really tempting (infosys margins in the US is close to 28% as
against 12-14% in India) (or collaterally the volumes might be big to compensate for the lower
margins (Example: McDonalds in India).
(http://www.iht.com/articles/2007/07/16/bloomberg/sxb4.php)

Special Needs: Companies might also expand to cater to special and specific needs in foreign
countries thus becoming multinationals in the process. (Example: L&T going to Afghanistan to
rebuild infrastructure after the war)

All the above discussion centred on why companies go global. Yet we have seen so many
successful companies which take a strong stand to stay put to their home base. Lets look at a few
reasons why a company could do so.

• Political uncertainty in other parts

• Lack of good global mangers
• Funding
• The will to take risk
• Inability to adapt to change and hence the perseverance not to change
• Some services or products might not be acceptable in any other country than their own.

Another external factor which is very severe in today’s environment is the effect of Dictatorships or
Embargoes on businesses in any country. And this will also have a direct impact on their aspirations to
become multinationals. A live example would be what’s happening in Zimbabwe today or in Iraq
during saddam’s rule.

On a more debatable scale there have been various schools of thought opposing the concept of
Globalisation and how it is killing local businesses and making poor countries poorer and richer ones
richer and so on and so forth. The issue is highly emotional and better avoided in the context of what
we are trying to achieve in these few pages.

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The art of progress is to preserve order amid change and to

preserve change amid order.

Now we look at Part two of why companies move out of their home countries to start businesses. This
is more of a historical perspective of what has been happening in the world the past few decades and
probably in India since the 90s.

1. The world has slowly but surely become a smaller place due to the rapid growth in
technology hence breaking barriers related to communication, travel, transport etc which
were present earlier. Hence it becomes easier for companies to think of expanding business
across political boundaries. (Globalisation)

2. Countries and companies have come to accept that staying isolated from the world can only
spell doom in today’s environment. The world has become a single marketplace and thus to
improve returns to stakeholders, companies are looking at newer pastures.

3. Political stability in terms of nations now giving more importance to commerce rather than
to differences in thought processes. This has ensured that there has been a strategic move
towards a free market policy in most nations and the urge to attract investors by opening up
previously closed doors. Governments too are being judged by economic performance
parameters rather than power they hold. (Liberalisation) (India after 1993)

4. Although some ideologies might not readily accept this, but the author (yours truly) also
personally feels that the fall of Socialism and rise of democracy has in a big way created the

right atmosphere for globalisation. Even China’s soCialism comes with a Capital C! (pun
un-intended) (democratisation)

5. Government run companies have been converting to private firms as governments have
realised that their main objective has to be run the nation and not spend time/energy and
valuable resources on running companies (Privatisation) (VSNL becoming TATA group
company)
6. Improved cash flows and general optimism in businesses has led to an increase in Mergers
and Acquisitions (politically incorrect would be the true face: Acquisition) Even smaller
companies have been able to leverage and buy financially bigger companies (Tata Buying
Corus)

From all the above discussions we can come to a one conclusion. Multinationalism (word coined by
we the people!!!) is the best way to improve efficiency, reduce costs and grow profits for any
organisation with a long term view of business. Amidst the great opportunities available today if
companies don’t capitalise then they can only be termed fools.

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In philosophical terms the previous concepts can be viewed in three diametrically different ways.
(Albeit the next few lines are only for readers with a Philosophical bent of Mind!!! Non philosophers are
welcome to applaud the author!!)

Philosophy number 1: I would like to quote wikipedia here: Holism (from ὅλος holos, a
Greek word meaning all, entire, total) is the idea that all the properties of a given system
(biological, chemical, social, economic, mental, linguistic, etc.) cannot be determined or
explained by its component parts alone. Instead, the system as a whole determines in an
important way how the parts behave.

The general principle of holism was concisely summarized by Aristotle in the Metaphysics: "The
whole is more than the sum of its parts (1045a10)."

Philosophy number 2: I quote Investopedia: Sum-Of-Parts Valuation: Valuing a company by

determining what its divisions would be worth if it was broken up and spun off or acquired by
another company. For example, you might hear that a young technology company is "worth
more than the sum of its parts". This means that the value of the tech company's divisions could
be worth more if they were sold to other companies. In most cases, larger companies have the
ability to take advantage of synergies and economies of scale that are unavailable to smaller
companies, enabling them to maximize a division's profitability and unlock unrealized value.

Philosophy number 3: I quote

http://sanatanavenkat.blogspot.com/2007/12/theory-of-
macrocosm-and-microcosm.html According to Einstein; the sum total of all energies in the
universe at any point of time is the same. Which means that, existence as it is, is subject to no
change. This means that creation is not time bound. This also satisfies law of conservation of
energy (derived from Newton's laws of motion) that energy can neither be created nor destroyed.

Our Vedanta says there was never a time when there was no creation. One of our Shanti mantras
which is the invocation mantra of Esavasya Upanishad says. This is referred in some
translations of the Bhagavad Gita too!!

Om purnamada purnamidam purnat purnamudasyate.

purnasya purnamadaya purnamevavasishyate.

Om that (supreme Brahman) is infinite, and this (conditioned Brahman) is infinite. The infinite
(conditioned Brahman) proceeds from the infinite (supreme Brahman), (Then through
knowledge), realizing the infinitude of the infinite (conditioned Brahman), it remains as the
infinite (unconditioned Brahman) alone.

From the translation of Mata Amritananadamayi's site, amritapuri.org

"That is the Whole, this is the Whole;

From the Whole, the Whole arises;
Taking away the Whole from the Whole,
The Whole alone remains…

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“Personal transformation can and does have global effects. As we go, so goes the world, for
the world is us. The revolution that will save the world is ultimately a personal one.”

As individuals we are self centred and all the above discussions (except the brilliant philosophical part)
lead us to the next idea of International business as to who will manage these businesses? This gives

rise to the concept of the Global Manager.

{(http://www.business.uiuc.edu/aguilera/Teaching/Bartlett%20Ghoshal%20What%20is%20a%20global%20mana
ger%202003.pdf) (This PDF is for sale at $6.5 on
http://harvardbusinessonline.hbsp.harvard.edu/b02/en/common/item_detail.jhtml?id=R0308F) but some smart

Alec has put a crude copy of the same on the previous link }

”To exist is to change, to change is to mature, to mature is to go on creating oneself endlessly”- Henri Bergson
This line probably summarises the one single most key factor for any company to succeed is to adjust
to change- whether it is in technology or business models or political factors or the most supreme
reason-currency changes! Thus it becomes very imperative for a manager aspiring to be a global
manager to be able to manage change.

Manager + Change management skills + study of Primer on International finance = Global manager!!!

And as previously discussed if there’s one single change agent responsible for making this subject
interesting it is the changes in exchange rates and currency prices. Hence almost most of what will
follow will have a very intrinsic relation to Currencies in general and Forex in particular.

Thus a simple definition of a good global finance manager could be as below:

• Powerful in change management
• Understands the economics of currencies and Forex
• Has a pulse on the political, geographical, cultural, managerial and economical diversity of the
world
• Be shrewd in choosing between multiple options
• Ready to convert negative change to a positive one
• Exceptional decision making skills in circumstances of rapid change
• Understands that globalisation is a two edged sword for his/her organisation

The fundamental skills required could be listed as below

• Change management
• Forex management
• Multi-dimensional thought process.
• Adaptability

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Episode 2.
The idea of International Finance
An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.

Narrowing down our discussions to the core theme of this e-book: International Finance, lets explore
what it takes to manage the financial aspects of a multinational or investor investing across borders.

A good financial manager is one who can take good decisions relating to Financing business and
creating solid investments with one single goal- Maximise Profits. Or in MBA terms Maximise
Shareholder wealth or stock value.

In fact Mr. Shapiro has quoted many economists as saying that “Maximising Shareholder Value” is the
ONLY way to maximise the economic interests of all stakeholders over a period of time.

By increasing its profits and shareholder value the company can also avoid becoming a potential take
over target for bigger companies.

The idea of International finance basically stems from domestic financial management except for
probably two distinct aspects: Forex and Multiple accounting strategies. All said a good International
financial Manager has be a good Financial Manager first as fundamental economics generally holds
true. (Can I get a Nobel Prize for making that statement!!!)

Two major issues are to be managed by a good finance manager:

1. Getting or sourcing money – technically called Financing decision. How do I get money for
my business? Where do I take a loan? How much capital from debt and how much accrued
internally? Etc etc are some questions regularly answered as part of this function.
2. Using the money efficiently – technically called Investment Decision. Where do I put my
money so it gives maximum returns? Do I put my factory in Singur or Sanand to achieve
higher profits? Etc are some question to which this function gives answers.

The funny side of finance

“Literature was formerly an art and finance a trade; today it is the reverse”

FINANCE, n. The art or science of managing revenues and resources for the best
advantage of the manager. The pronunciation of this word with the i long and the accent on
the first syllable is one of America's most precious discoveries and possessions.”

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When viewed from an International Finance Perspective the major differences that a Global Financial
Manager has as compared to his domestic counterpart are as below
1. Exchange risk – the exposure caused due to using multiple currencies for business
2. Inflation risk – the risk created to differences in Inflation rates among different countries.
3. Variable accounting and taxation norms in each country
4. Different kind of money markets with their inherent roadblocks
5. Governmental policies that are poles apart
6. Political uncertainty multiplied by the number of countries where his business has operations.
7. Economic risk faced by an MNC organisation is manifold as compared to a domestic entity

In terms of real time operations and activities the financial benefits of having businesses in more than
one country can be listed as follows:
1. Ability to lower cost of capital
2. Opportunity to diversify risk
3. Access to segmented capital markets
4. Shifting profits to reduce tax
5. Gaining advantages of multiple currencies
6. Better bargaining power both with customers as well as governments keen on increasing FDI
7. Ready access to changes happening across the globe. The subsidiaries acting as the sense
organs for the corporation.

This part is thanks to Mr. Alan Shapiro.

The evolution of International Finance from the mother subject Corporate Finance can be attributed to
3 very distinct and highly critical concepts put forth by Financial Economics.

Arbitrage: The simultaneous purchase and sale of an asset or product to gain a profit from
the differences in prices due to various factors like time zone, location, taxation etc. This
ability to gain from arbitrage is all the more applicable as ay MNC has simultaneous access
to multiple markets and if the markets provide an opportunity fro arbitrage, the company
can take benefit of it. It’s a very simple case of being at the right places at the right time.

The differences in Currencies, Exchange rates, Taxation laws, Regulations, Risks, risk management etc
among countries have provided MNC’s an opportunity to arbitrage at an even more higher level. For
example manufacture in a Country where tax is less and export to a country where import duties are
less. Buy currency when US markets are closing and Japan is opening and sell it when the Indian
markets are opening or any other permutations available due to time zones. These could be
technically called as Risk Arbitrage, Tax arbitrage, Time arbitrage etc

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Since information today is freely and cheaply available we can also decipher from the above idea that
continuous arbitrage will lead to creating an efficient market

What is an efficient market? An efficient market is one where the prices of the traded goods
are in sync with the changes happening across the globe. This can happen because each
new piece of information is immediately incorporated into the pricing due to the activities
of the arbitrageurs.

The idea of an efficient market was totally destroyed by the recent crisis happening in the United
States. Unabated greed to make higher returns has led to the entire system currently staring at an
impending recession. This also gives an idea of how arbitrage works. When people see markets
behaving contradictory to their expectations they start shifting funds and thus starts a cycle of
revamping which ultimately over a period time will ensure movement towards a new efficient market.

The third idea that has helped in the evolution of International finance has been the way in
which risk has been integrated into pricing decisions whether it is for financial products of
even more grass roots product pricing! These two concepts are called
• Capital Assed Pricing Model
• Arbitrage Price Theory

Capital Asset Pricing Model: It is a mathematical model which helps us to price various
assets/securities but considering all kinds of risks: Systemic risk (market risk) and Unsystemic
(diversifiable) risk and also keeping a reference point as the risk free returns. Mathematically it is as
given below:

• is the expected return on the capital asset

• is the risk-free rate of interest
• (the beta coefficient) is the sensitivity of the asset returns to market returns, or

also ,
• is the expected return of the market
• is sometimes known as the market premium or risk premium (the
difference between the expected market rate of return and the risk-free rate of return)

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*** In USA it’s called systematic and unsystematic. To basically mean due to the system.

To explain it in even more lay man terms. Systemic risk or the market risk in nothing but the
exposure the security or asset you are holding has because of the different happenings in the common
market place. For example if there is something common happening in the market which will in some
way or another affect the all the market constituents it is called Market risk. Political change,
Government policy etc could be called Systemic risks.

Unsystemic risk or Diversifiable is something that is inherent particularly only to the particular
asset/security. For example a strike in Bajaj factory will affect Bajaj’s shares but not TVS’s shares.
This is Unsystemic risk. In the same scenario of the government bans two wheelers then not only
Bajaj and TVS but even their ancillaries will get affected then this scenario is called Systemic risk.

The third component is Risk free returns: this is nothing but how much return will you get from the
same value of money if invested in an investment with out risks. For example a Share has risks but A
Treasury bill will not have any risk.

Thus from above discussion we can understand that before buying any asset we have to look at
Systemic risk, Unsystemic risk and also ensure that the returns in-spite of these returns are much
higher than what you would get by investing the same amount in a risk free instrument.

In the coming pages we will realise the importance of the two kinds of risk in real life.

A predecessor to the CAPM is the Asset pricing theory which basically takes into consideration each
and every factor that causes risk to the asset rather than just the overall market as in CAPM.

To put it into real basic language CAPM gives us an idea of the risk of how many goals the opponent
team will score against us whereas APT is a sum of the risk of each of the 11 players including the
opponent goal keeper to score against us!!!

If APT holds, then a risky asset can be described as satisfying the following relation:

where

• E(rj) is the risky asset's expected return,

• RPk is the risk premium of the factor,
• rf is the risk-free rate,
• Fk is the macroeconomic factor,
• bjk is the sensitivity of the asset to factor k, also called factor loading,
• and εj is the risky asset's idiosyncratic random shock with mean zero.

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The practical implication of the above discussion is for each Financial Manager to understand the
multiple risks that his business whether domestic or international faces as part of its operations and
hence gives him/her the ability to manage the risks appropriately in order to optimise/maximise
profits.

This discussion also clarifies another major point: it is not sufficient for a finance manager to only
correctly manage financial measures or manipulate accounting systems to increase profits. He has to
be supported by capital market imperfections in the capital market and also by opportunities to
arbitrage due to differences in various factors.

Thus we also realise the importance of an international finance mangers skill sets as the factors which
could vary and cause risk multiply manifold based on not only the number of countries his business
operates in but also on the number of countries that could affect the economy of all the countries his
business operates in. He will be faced with unlimited complexities and sophistications which if
managed properly can create huge growth and value for shareholders or on the other end could
become a self destructive tool towards bankruptcy.

And thus it becomes all the more important for aspiring finance managers to first read this e-book and
then probably spend a lot of their time with “Multinational Financial Management” by Mr. Alan Shapiro
and other similar good books.

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