(1) INTERNATIONAL VS. DOMESTIC FINANCE.

ANSWER. In international vs domestic finance, the term international finance is different from domestic
finance in many aspects. And the first and the most significant of them is foreign currency exposure. Other
aspects include the different political, cultural, legal, economic, and taxation environment. International
financial management involves a lot of currency derivatives, whereas such derivatives are very less used in
domestic financial management. The term ‘International Finance’ has not come from Mars. It is similar to
domestic finance in many aspects. If we talk on a macro level, the most significant difference between
international finance and domestic finance is a foreign currency or, to be more precise, the exchange rates. In
domestic financial management, we aim to minimize the cost of capital while raising funds and optimize the
returns from investments to create wealth for shareholders. We do not do anything different in international
finance. So, the objective of financial management remains the same for both domestic and international
finance, i.e., wealth maximization of shareholders. Still, the analytics of international finance is different from
domestic finance.
EXPOSURE TO FOREIGN EXCHANGE
The most significant difference between international and domestic finance is foreign currency exposure.
Currency exposure impacts almost all the areas of an international business, starting from your purchases
from suppliers, selling to customers, investing in plant and machinery, fundraising, etc. Wherever you need
money, currency exposure will come into play. And as we know well that there is no business transaction
without cash.
 3) INTERNATIONAL MONETARY SYSTEM, THE GOLD STANDARD.
ANSWER. What Is the Gold Standard?
The gold standard is a fixed monetary regime under which the government's currency is fixed and may be freely
converted into gold. It can also refer to a freely competitive monetary system in which gold or bank receipts for gold act
as the principal medium of exchange; or to a standard of international trade, wherein some or all countries fix
their exchange rate based on the relative gold parity values between individual currencies.

How the Gold Standard Works

The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold.
With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the
gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the
value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be
1/500th of an ounce of gold.

The gold standard developed a nebulous definition over time, but is generally used to describe any commodity-based
monetary regime that does not rely on un-backed fiat money, or money that is only valuable because the government
forces people to use it

4) ADVANTAGES AND DISADVANTAGES OF THE GOLD STANDARD

ANSWER. There are many advantages to using the gold standard, including price stability. This is a long-term advantage
that makes it harder for governments to inflate prices by expanding the money supply. Inflation is rare and
hyperinflation doesn't happen because the money supply can only grow if the supply of gold reserves increases.
Similarly, the gold standard can provide fixed international rates between countries that participate and can also reduce
the uncertainty in international trade. 

But it may cause an imbalance between countries that participate in the gold standard. Gold-producing nations may be
at an advantage over those that don't produce the precious metal, thereby increasing their own reserves. The gold
standard may also, according to some economists, prevent the mitigation of economic recessions because it hinders the
ability of a government to increase its money supply—a tool many central banks have to help boost economic growth. 

5) ALTERNATIVE EXCHANGE RATE SYSTEMS

ANSWER. Countries have three basic choices in determining the monetary linkage between their economy and the rest
of the world, assuming that they maintain a currency of their own as most do: (1) they can let their currency float freely
in the exchange markets against all other currencies; (2) they can fix the price of their currency against a specific foreign
currency or a basket of foreign currencies; (3) or they can pursue intermediate approaches, letting rates float to some
extent but intervening to limit those fluctuations either ad hoc ("managed floating") or pursuant to some pre-
determined parameters ("target zones," "crawling bands," etc.)

There is increasing intellectual and policy consensus that "fixed but adjustable" pegs, the traditional means of "fixing"
the exchange rate, do not work well for either industrial economies or emerging market economies.1 Hence they must
either float to some extensive degree or fix permanently and thus credibly. Both courses have clear costs as well as
benefits.

Floating permits a country to maintain a degree of national control over its monetary policy (and other national
macroeconomic policies) because it does not have to use them so often to defend the exchange rate. However, markets
can substantially overshoot the economic fundamentals; they can thus push a currency far below its underlying
economic value, generating inflation and large debt servicing costs, or far above that level, hurting the country's
competitiveness and throwing its trade balance into large deficit.
Fixed exchange rates can avoid those costs if the authorities can successfully set the rate at a sustainable level and
convince the markets of both their ability and will to keep it there. Moreover, fixed rates reduce the transactions costs
of international trade and investment. In addition, a fixed rate can provide a useful anchor for price stability by linking a
small country to the world economy (and especially to a large country with relatively stable prices, like the United States
or Germany). The option of adjusting the "fixed" rate also provides a country with an additional policy tool that can be
used to correct an excessive external deficit or surplus.

However, governments may set or try to sustain a rate at unsustainable levels and private capital flows will eventually
then force devaluations or revaluations that can be extremely costly. Successful defense of a fixed rate can often be
costly too, requiring a country to raise interest rates and/or otherwise slow its economy to avoid speculative attack.
Because of these costs, there is thus a clear trend away from fixed rates. This is true especially in emerging market
economies, in the wake of the Asian/global crisis where a number of relatively fixed-rate countries were forced to
abandon their pegs and countries with various types of floating rates generally fared better.

6) WHAT IS THE BALANCE OF PAYMENTS (BOP)?

ANSWER. The balance of payments (BOP), also known as the balance of international payments, is a statement
of all transactions made between entities in one country and the rest of the world over a defined period, such
as a quarter or a year. It summarizes all transactions that a country's individuals, companies, and government
bodies complete with individuals, companies, and government bodies outside the country.
The balance of payments (BOP) transactions consist of imports and exports of goods, services, and capital, as
well as transfer payments, such as foreign aid and remittances. A country's balance of payments and its net
international investment position together constitute its international accounts.
The balance of payments divides transactions into two accounts: the current account and the capital
account. Sometimes the capital account is called the financial account, with a separate, usually very small,
capital account listed separately. The current account includes transactions in goods, services, investment
income, and current transfers.
The capital account, broadly defined, includes transactions in financial instruments and central bank reserves.
Narrowly defined, it includes only transactions in financial instruments. The current account is included in
calculations of national output, while the capital account is not. 
If a country exports an item (a current account transaction), it effectively imports foreign capital when that
item is paid for (a capital account transaction). If a country cannot fund its imports through exports of capital,
it must do so by running down its reserves. This situation is often referred to as a balance of payments deficit,
using the narrow definition of the capital account that excludes central bank reserves. In reality, however, the
broadly defined balance of payments must add up to zero by definition.
In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction
between an economy and the rest of the world, including discrepancies caused by foreign currency
translations.
7) THE FOREIGN EXCHANGE MARKET, DEFINITION, TYPES, FUTURES, ADVANTAGES.
ANSWER. DEFINE FOREIGN EXCHANGE MARKET
The foreign exchange market is over a counter (otc) global marketplace that determines the exchange rate for
currencies around the world. This foreign exchange market is also known as forex, fx, or even the currency market. The
participants engaged in this market are able to buy, sell, exchange, and speculate on the currencies. These foreign
exchange markets are consisting of banks, forex dealers, commercial companies, central banks, investment
management firms, hedge funds, retail forex dealers, and investors. In our prevailing section, we will widen our
discussion on the ‘foreign exchange market’.

TYPES OF FOREIGN EXCHANGE MARKET

The Foreign Exchange Market has its own varieties. We will know about the types of these markets in the section below:

The Major Foreign Exchange Markets – 1) Spot Markets. 2) Forward Markets. 3) Future Markets. 4) Option Markets. 5)
Swaps Markets Let us discuss these markets briefly:

SPOT MARKET:- In this market, the quickest transaction of currency occurs. This foreign exchange market provides
immediate payment to the buyers and the sellers as per the current exchange rate. The spot market accounts for almost
one-third of all the currency exchange, and trades which usually take one or two days to settle the transactions. 

FORWARD MARKET:- In the forward market, there are two parties which can be either two companies, two individuals,
or government nodal agencies. In this type of market, there is an agreement to do a trade at some future date, at a
defined price and quantity.

FUTURE MARKETS:- The future markets come with solutions to a number of problems that are being encountered in the
forward markets. Future markets work on similar lines and basic philosophy as the forward markets. 

OPTION MARKET:- An option is a contract that allows (but is not as such required) an investor to buy or sell an
instrument that is underlying like a security, ETF, or even index at a determined price over a definite period of time.
Buying and selling ‘options’ are done in this type of market. 

SWAP MARKET:- A swap is a type of derivative contract through which two parties exchange the cash flows or the
liabilities from two different financial instruments. Most swaps involve these cash flows based on a principal amount.

FUNCTIONS OF FOREIGN EXCHANGE MARKET :- The various functions of the Foreign Exchange Market are as
follows: 

TRANSFER FUNCTION: The basic and the most obvious function of the foreign exchange market is to transfer the funds
or the foreign currencies from one country to another for settling their payments. The market basically converts one’s
currency to another.

CREDIT FUNCTION: The FOREX provides short-term credit to the importers in order to facilitate the smooth flow of
goods and services from various countries. The importer can use his own credit to finance foreign purchases.

HEDGING FUNCTION: The third function of a foreign exchange market is to hedge the foreign exchange risks. The parties
in the foreign exchange are often afraid of the fluctuations in the exchange rates, which means the price of one currency
in terms of another currency. This might result in a gain or loss to the party concerned.

FEATURES OF FOREIGN EXCHANGE MARKET 

This kind of exchange market does have characteristics of its own, which are required to be identified. The features of
the Foreign Exchange Market are as follows:

HIGH LIQUIDITY:- The foreign exchange market is the most easily liquefiable financial market in the whole world. This
involves the trading of various currencies worldwide. The traders in this market are free to buy or sell the currencies
anytime as per their own choice.

MARKET TRANSPARENCY:-There is much clarity in this market. The traders in the foreign exchange market have full
access to all market data and information. This will help to monitor different countries’ currency price fluctuations
through the real-time portfolio. 
DYNAMIC MARKET:- The foreign exchange market is a dynamic market structure. In these markets, the currency values
change every second and hour.

OPERATES 24 HOURS:- The Foreign exchange markets function 24 hours a day. This provides the traders the possibility
to trade at any time.

WHO ARE THE PARTICIPANTS IN A FOREIGN EXCHANGE MARKET?

The participants in a foreign exchange market are as follows:

CENTRAL BANK: The central bank takes care of the exchange rate of the currency of their respective country to ensure
that the fluctuations happen within the desired limit and this participant keeps control over the money supply in the
market.

COMMERCIAL BANKS: Commercial banks are the channel of forex transactions, which facilitates international trade and
exchange to its customers. Commercial banks also provide foreign investments. 

TRADITIONAL USERS: The traditional users consist of foreign tourists, the companies who carry out business operations
across the globe.

TRADERS AND SPECULATORS: The traders and the speculators are the opportunity seekers who look forward to making
a profit through trading on short-term market trends.

BROKERS: Brokers are considered to be the financial experts who act as a sure intermediary between the dealers and
the investors by providing the best quotations.

ADVANTAGES OF FOREIGN EXCHANGE MARKET

The whole world economy is relying upon this foreign exchange market for obvious advantageous reasons. Let us check
what are the advantages gained in the foreign exchange market-

1) There are very few restrictive rules, this allows the investors to invest in this market freely.
2) There are no central bodies or clearinghouses that head the Foreign Exchange Market. Hence, the intervention
of the third party is less.
3) Many investors are not required to pay any commissions while entering the Foreign Exchange Market.
4) As the market is open 24 hours, the investors can trade here without any time-bound.
5) The market allows easy entry and exit to the investors if they feel unstable.

8) DIFFERENCE BETWEEN SPOT MARKET AND FORWARD MARKET!

ANSWER:- Foreign exchange markets are sometimes classified into spot market and forward market on the basis of the
period of transaction carried out. It is explained below:

(a) SPOT MARKET: If the operation is of daily nature, it is called spot market or current market. It handles only spot
transactions or current transactions in foreign exchange.

Transactions are affected at prevailing rate of exchange at that point of time and delivery of foreign exchange is affected
instantly. The exchange rate that prevails in the spot market for foreign exchange is called Spot Rate. Expressed
alternatively, spot rate of exchange refers to the rate at which foreign currency is available on the spot.

For instance, if one US dollar can be purchased for Rs 40 at the point of time in the foreign exchange market, it will be
called spot rate of foreign exchange. No doubt, spot rate of foreign exchange is very useful for current transactions but it
is also necessary to find what the spot rate is. In addition, it is also significant to find the strength of the domestic
currency with respect to all of home country’s trading partners. Note that the measure of average relative strength of a
given currency is called Effective Exchange Rate (EER).
(b) FORWARD MARKET: A market in which foreign exchange is bought and sold for future delivery is known as Forward
Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented
sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called
Forward Rate. Thus, forward rate is the rate at which a future contract for foreign currency is made.

This rate is settled now but actual transaction of foreign exchange takes place in future. The forward rate is quoted at a
premium or discount over the spot rate. Forward Market for foreign exchange covers transactions which occur at a
future date. Forward exchange rate helps both the parties involved.

9) THEORIES OF EXCHANGE RATE DETERMINATION | INTERNATIONAL ECONOMICS

ANSWER:- For the determination of the par values of different currencies, alternative theoretical explanations have been
given.

Some of the prominent explanations or theories include: 1. Mint Parity Theory 2. The Purchasing Power Parity Theory 3.
The Balance of Payments Theory 4. The Monetary Approach to Foreign Exchange 5. Portfolio Balance Approach.

1. THE MINT PARITY THEORY: The earliest theory of foreign exchange has been the mint parity theory. This theory was
applicable for those countries which had the same metallic standard (gold or silver). Under the gold standard, countries
had their standard currency unit either of gold or it was freely convertible into gold of a given purity.

The value of currency unit under gold standard was defined in terms of weight of gold of a specified purity contained in
it. The central bank of the country was always willing to buy and sell gold upto an unlimited extent at the given price.
The price at which the standard currency unit of the country was convertible into gold was called as the mint price.

2. THE PURCHASING POWER PARITY THEORY:

The purchasing power parity theory enunciates the determination of the rate of exchange between two inconvertible
paper currencies. Although this theory can be traced back to Wheatley and Ricardo, yet the credit for developing it in a
systematic way has gone to the Swedish economist Gustav Cassel.

This theory states that the equilibrium rate of exchange is determined by the equality of the purchasing power of two
inconvertible paper currencies. It implies that the rate of exchange between two inconvertible paper currencies is
determined by the internal price levels in two countries.

There are two versions of the purchasing power parity theory: (i) The Absolute Version and (ii) The Relative Version.

3. THE BALANCE OF PAYMENTS THEORY:

The balance of payments theory of exchange rate maintains that rate of exchange of the currency of one country with
the other is determined by the factors which are autonomous of internal price level and money supply. It emphasises
that the rate of exchange is influenced, in a significant way, by the balance of payments position of a country.

A deficit in the balance of payments of a country signifies a situation in which the demand for foreign exchange
(currency) exceeds the supply of it at a given rate of exchange. The demand for foreign exchange arises from the
demand for foreign goods and services. The supply of foreign exchange, on the contrary, arises from the supply of goods
and services by the home country to the foreign country.

In other words, the excess of demand for foreign exchange over the supply of foreign exchange is coincidental to the
BOP deficit. The demand pressure results in an appreciation in the exchange value of foreign currency. As a
consequence, the exchange rate of home currency to the foreign currency undergoes depreciation.

4. THE MONETARY APPROACH TO RATE OF EXCHANGE:

In contrast with the BOP theory of foreign exchange, in which the rate of exchange is determined by the flow of funds in
the foreign exchange market, the monetary approach postulates that the rates of exchange are determined through the
balancing of the total demand and supply of the national currency in each country.

According to this approach, the demand for money depends upon the level of real income, the general price level and
the rate of interest. The demand for money is the direct function of the real income and the level of prices. On the other
hand, it is an inverse function of the rate of interest. As regards, the supply of money, it is determined autonomously by
the monetary authorities of different countries.

It is assumed that initially the foreign exchange market is in equilibrium or at interest parity. It is further supposed that
the monetary authority in the home country increases the supply of money. This will lead to a proportionate increase in
price level in the home country in the long run. It will also cause depreciation in the home currency as explained by the
PPP theory.

5. THE PORTFOLIO BALANCE APPROACH:

In view of the deficiencies in the monetary approach, some writers have attempted to explain the determination of
exchange rate through the portfolio balance approach which is more realistic than the monetary approach.

The portfolio balance approach brings trade explicitly into the analysis for determining the rate of exchange. It considers
the domestic and foreign financial assets such as bonds to be imperfect substitutes. The essence of this approach is that
the exchange rate is determined in the process of equilibrating or balancing the demand for and supply of financial
assets out of which money is only one form of asset.

To start with, this approach postulates that an increase in the supply of money by the home country causes an
immediate fall in the rate of interest. It leads to a shift in the asset portfolio from domestic bonds to home currency and
foreign bonds. The substitution of foreign bonds for domestic bonds results in an immediate depreciation of home
currency. This depreciation, over time, causes an expansion in exports and reduction in imports.

It leads to the appearance of a trade surplus and consequent appreciation of home currency, which offsets part of the
original depreciation. Thus the portfolio balance approach explains also exchange over-shooting. This explanation, in
contrast to the monetary approach, brings in trade explicitly into the adjustment process in the long run.

10) FOREIGN EXCHANGE (CURRENCY) EXPOSURE

ANSWER:- Foreign exchange exposure is classified into three types, viz. translation, transaction, and economic exposure.
Transaction exposure deals with actual foreign currency transactions. Translation exposure deals with the accounting
representation, and economic exposure deals with little macro-level exposure, which may be true for the whole industry
rather than just the firm under concern. Let us see in detail the Types of Foreign Exchange Exposure.

Foreign exchange exposure exists for a business or a firm when the value of its future cash flows is dependent on the
value of foreign currency/currencies. If a British firm sells products to a US Firm, the cash inflow of the British firm is
exposed to foreign exchange. And in the case of the US-based firm, cash outflow exposes to foreign exchange. Why are
we so skeptical about this exposure? Simple! It is because the exchange rates tend to change or fluctuate.

In the above situation, we saw how a firm directly involved in foreign currency dealing is exposed to foreign exchange
risk. It may be surprising to know that a firm with no such direct connection may also be found exposed to foreign
currency risk. For example, if a company producing small electronics products in Sri Lanka competes against the
products imported from China.

Now, if the price of the Chinese Yuan per Sri Lankan Rupee decreases, there will be a decrease in cost advantage to the
importers over that Sri Lankan company. It is evident from the example that the firm that has no direct access to forex
can also face the impact.
Transaction vs Translation Exposure
Let us understand the difference between Transaction and Translation exposure
covering the following points of difference.

POINTS OF TRANSACTION EXPOSURE TRANSLATION EXPOSURE

DIFFERENCE

ACCOUNTIN Transaction exposure impacts the cash flow Translation exposure is not a cash flow
G movement and arises while conducting change and arises as a result of
purchase and sale transactions in different consolidating the results of a foreign
currencies. subsidiary. Translation exposure is
usually driven by legal requirements
asking the parent company to consolidate
financials.
NEED OF For a transaction exposure to arise, the parent Translation exposure can arise only when
FOREIGN company doesn’t necessarily need to have a a parent company is consolidating the
AFFILIATES foreign affiliate or a subsidiary. financials of a foreign affiliate or
subsidiary.

GAIN / Transaction exposure results in realized gains Translation exposure results in notional /
LOSS or losses book gain or losses

TIMING Transaction exposure arises when a company Translation exposure arises on the
IMPACT enters into a transaction involving foreign balance sheet consolidation date and is
currency and commits to make or receive at the end of a given financial period
payment in a currency other than its domestic (quarter or year)
currency.

FIRM Because a transaction exposure has an actual Since the translation exposure doesn’t
VALUE cash flow impact, it impacts the value of a create any cash flow impact, the
IMPACT company. company’s value doesn’t change due to
this type of exposure.
TAX Transaction exposure measures gain or loss to Translation exposure is a measurement
the cash flow on account of forex movements. concept rather than dealing with actual
In case of loss, the cash flows reduce, and cash flow impact on a forex account.
hence you get tax benefit on the loss and vice Hence, no tax exemption or benefit is
versa. available on losses due to translation
 exposure.

11) TYPES OF FOREIGN EXCHANGE (CURRENCY) EXPOSURE

ANSWER:- Commonly, the exposure is classified into three types of foreign currency exposure:

TRANSACTION EXPOSURE:- The most superficial foreign currency exposure that anybody can easily think of is transaction
exposure. As the name itself suggests, this exposure pertains to the exposure due to an actual transaction taking place in
business involving foreign currency. All monetary transactions aim for profits as their end results in a business. There are
all the chances of that final objective to get hamper if it is a foreign currency transaction. And the currency market
moves in an unfavorable direction.

If you have bought goods from a foreign country and payables are in foreign currency payable after three months. Then,
you may end up paying much higher on the due date as currency value may increase. This will increase your purchase
price. And therefore, the overall cost of the product compels the profit percentage to go down or even convert to loss.

Transaction exposure occurs typically due to foreign currency debtors of sale, payment for imported goods or services,
receipt/payment of dividend, payment towards the EMIs of debts, etc.

TRANSLATION EXPOSURE:- The other name for this exposure is accounting exposure. It is because the exposure is due to
the translation of books of accounts into the home currency. Translation activity is carried out on account of reporting
the books to the shareholders or legal bodies. It also makes sense as the translated financial statements show the
company’s position as on a date in its home currency.

Gains or losses arising from translation exposure do not have more meaning over and above the reporting requirements.

Such exposure can even get reversed in the next year’s translation if the currency market moves in a favorable direction.
This kind of exposure does not require too much management attention.

ECONOMIC EXPOSURE:- This type of exposure’s impact and importance is much higher than the other two.  Economic
exposure directly impacts the value of a firm. That means the foreign exchange influences the value of the firm.

The value of a firm is the function of operating cash flows and its assets. The economic exposure can have bearings on
assets and operating cash flows. Identification and measuring this exposure is a difficult task. Although the asset
exposure is still measurable and visible in books, the operating exposure has links to various factors such as
competitiveness, entry barriers, etc. Which are pretty subjective, and the interpretation of different experts may be
different.

These three types of foreign currency exposures are very important for an international finance manager. Analyzing the
exposure to foreign exchange helps have the correct view of the firm’s business and therefore make informed decisions.