Financial Management for Analysts

•  Adam smith proposed the theory of absolute advantage in  1776. The theory states that -- international trade takes place because one country may be more efficient in producing a particular good than another country,  and that other country may be capable of producing some other good more efficiently than  the first one.
• According to the theory of Comparative Advantage, propounded by the English economist David Ricardo in 1817, trade is possible as long as the country experiencing the disadvantage is not equally less efficient in producing all the products, i.e., both the countries enjoy comparative advantage in at least one of the products. The theory states that each country should produce that good, in which it has a comparative advantage.
• According to the Heckscher-Ohlin model, developed by Eli Heckscher and Bertil  ohlin, there are two types of products - labour intensive and capital intensive. The model says that two differences in their factor endowments. The labour-rich country is more likely to produce labour-intensive goods and the country rich in capital will most probably produce capital-intensive goods.
• According to the Imitation Gap theory, propounded by Posner, improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between such countries.
• Demand lag  is the difference between the time a new product  is introduced in one country, and the time when consumers in the other country start demanding it.
• Imitation lag is the difference between the time of introduction of the product in one country, and the time when the producers in country start producing it.
• According to the International Product Life Cycle theory, innovations are generally concentrated in the richer, more developed countries.
• The BoP Account is the summary of the flow of economic transactions between the residents of a country and the Rest of the World (ROW) during a given time period.
• BoP of a country measures the flow of international payments and receipts. As it measures flows and not stocks, it  records only the changes in the levels (and not the absolute level) of international assets and liabilities.
• The BoP Account has three components: The current account, the capital account and official account.
• The current account records all the income-related flows. These flows could arise on account of trade in goods and services and transfer payments among the countries. A net inflow on account of merchandise  trade results in a trade surplus while a net outflow results in a trade deficit. A net inflow after taking all entries in the current account into consideration is referred to as the current account surplus and a net outflow as current account deficit.
• The capital account records movements on account of international purchase or sale of assets. The excess of credits over debits in the capital account over a particular period is referred  to as the capital account surplus. The excess of debits over credits is known as capital account surplus.
• Official reserves include gold, reserves of convertible foreign currencies, SDRs and balances with the IMF, which are the means of international payments. The official reserves account  reflects the amount of these 'means of international payment' acquired or lost during the period for which the BoP account is constructed.
• If there is net surplus in the current account and the capital account taken together (generally referred to as BoP surplus), there will be an increase in the official reserves as the inflows will exceed the outflows. This will appear as a debit entry in the BoP account. A BoP deficit will appear as a credit entry due to its effect on the official reserves.
• The BoP account has to balance because of the double-entry system, but an imbalance may creep into the BoP account, which can be removed by adding the heading "Errors and Omissions" to it.
• Exports of goods and services, imports of goods and services income on investments, transfer payments are some of the factors that affect the components of BoP accounts..
• Globalisation has led to the integration of both financial and commodity markets. This has increased the need to study international finance.
• Studying international finance  helps a finance manager to understand the complexities of the various economies and also various activities that affect the operations of his firm. It helps him to identify and exploit opportunities and also to prevent harmful effects of the international events. Thus, he can maximize his profits and minimize his losses.
• The market players try to profit from the arbitrage opportunities in the international markets and so the events affecting one market also affect other markets directly or indirectly.
• Integration of markets involves freedom and opportunity to raise funds from and to invest anywhere in the world through any type of instrument. Therefore, control over these markets is significantly reduced.
• Because of the freedom, any event affecting the financial market in one part of the world automatically and quickly affects other part of the world also. This is called "Transmission Effect".
• Development of technology, new financial instruments, liberalization of regulations governing the financial markets, and increased cross penetration of foreign ownership are some factors, which contributed to the process of globalisation.
• Integration of markets leads to efficient allocation of capital and a better working financial system, smoother consumption patterns enjoyed by all the countries over a period of time and also give benefits of diversification.
• Currency risk denotes the risk of the value of an investment denominated in some other country's currency, coming down in terms of the domestic currency. It also denotes the risk of the value of a foreign liability increasing in terms of the domestic currency.
• Currency risk is the risk of not being able to disinvest at will due to countries suddenly changing their attitude towards foreign investment or due to some other factors like war, revolution, etc.
• The exchange rate is formally defined as the value of one currency in terms of another.
• Exchange rates may be fixed, floating, or with limited flexibility.
• Under a fixed (or pegged) exchange rate system the value of a currency in terms of another is fixed. These rates are determined by governments or the central banks of the respective countries. The fixed exchange rates result from countries pegging their currencies to either some common commodity or to some particular currency.
• Under a currency board system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged.
• The biggest advantage of a currency board system is that it offers stable exchange rates, which acts as an incentive for international trade and investment.
• Among the drawbacks, the foremost is the loss of control over interest rates.  The equilibrium in the Forex markets is established at the point where the domestic interest rates in the economy are in accordance with the underlying economic fundamentals of the domestic and the anchor currency economy and the fixed exchange rate.
• A good example of a currency board is that of Hong Kong.
• A group of countries sometimes get together, and agree to maintain the exchange rates between their currencies within a certain band around fixed  central exchange rates. This system is called a target zone arrangement.
• Monetary union is the next logical step of target zone arrangement.Under this system, a group of countries agree to use a common currency, instead of their individual currencies.This eliminates the variability of exchange rates and the attendant inefficiencies completely.
• Under this system, the exchange rates between  currencies are variable. These rates are determined by the demand and supply for the currencies in the international markets.
• The exchange rate is said to be freely floating when its movements are totally determined by the market. There is no intervention at all either by the government or by the central bank.
• When the central banks generally intervene in the currency markets to smoothen the fluctuations, such a system is referred to as a  managed float or a dirty float.
• A crawling peg system is a hybrid of fixed and flexible exchange rate systems. Under this system, while the value of a currency is fixed in terms of a reference currency, this peg itself keeps changing in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the exchange rate.
• The  exchange rate between two currencies was determined on the basis of the rates at which the respective currencies could be converted into gold, i.e., the price of gold in the two countries.
• The Process of correction of imbalance in international receipts and payments is known as the price-specie-flow mechanism.
• Under the system of the gold-exchange standard, some of the countries committed themselves to convert their currencies into the currency of some other country on the gold as a reserve asset, they started holding reserves of that currency.
• Sterilization, or neutralization, is the policy of not letting a change in the reserves have any  effect on the money supply. This may be done either by directly breaking the link between the reserves and the notes printed, or by increasing or reducing the ability of banks to create money.
• In 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, USA, and signed an agreement to establish a new monetary system which would address all these needs. This system came to be known as the Bretton Woods System.
• Two new institutions were established, namely, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD, also called the World Bank).
• The main players in the foreign exchange market are large commercial banks, forex brokers, large corporations and the central banks.
• Large commercial banks act as the market makers in the forex markets i.e., they stand ready to buy or sell various currencies at specific prices at all points of time.
• The foreign exchange brokers do not actually buy or sell any currency. They bring buyers and sellers together.
• The market in which the commercial banks deal with their customers (both individuals and corporates) is called the retail market, while that in which the banks deal with each other is called the wholesale or the Interbank market.
• Nostro account is the overseas account held by a domestic bank with a foreign bank or with its own foreign branch, in that foreign country's currency. The same account is called vostro account from the point of view of the holding bank.
• A currency's settlement always takes place in the country of origin of the currency. The term "currency" includes coins, bank notes, postal notes, postal orders and money orders.
• An exchange rate quotation is the price of a currency stated in terms of another.
• A quote can be classified as European or American if one of the currencies is dollar. An American quote is the number of dollars expressed per unit of any other currency, while a European quote is the number of units of any other currency expressed per dollar.
• A direct quote is the quote where the exchange rate is expressed in terms of  number of units of the domestic currency per unit of foreign currency.
• An indirect quote is where the exchange rate is expressed in terms of number of units of the foreign currency for a fixed number of units of the domestic currency.
• The rate at which a bank is ready to buy a currency is called bid rate and the rate at which a bank is ready to sell a currency is called ask rate. The difference between the bid rate and the ask rate is called the bid-ask spread. The bid rate is always lower than the ask rate.
• Merchant quote is the quote given by a bank to its retail customers. Interbank quote is the quote given by one bank to another.
• For every quote (A/B) between two currencies, there exists an inverse quote (B/A), where currency A is bought and sold, with its price expressed in terms of currency B.

 Implied inverse (B/A) quote =                               1                                                             1

                                                                 _____________            /                           _____________

                                                                     (A/B)ask                                                           (A/B)bid

• The arbitrage activity involving buying and selling in another in termed as two-way arbitrage.
• If the synthetic rate is less than the actual bid rate, then arbitrageurs  have a chance to make a profit by three-point arbitrage.
• Spot transactions are those, which are settled after two business days from the date of the contract.
• Forward contract  (also called an outright forward) is one where the parties to the transaction agree to buy or sell a currency at a predetermined future date at a particular price.
• A currency is said to be in premium against other currency if it is more expensive in the forward market than in the spot market. A currency is said to be discount if it is cheaper in the forward market than in the spot market.
• The difference between the spot rates and the forward rates can be expressed in terms of swap points. The bid side swap points are to be added to or subtracted from the spot bid depending upon whether the currency is at premium or at discount to arrive at the forward bid rate. Similarly, the ask side swap points should be added to or subtracted from the spot ask rate to give the forward ask rate.
•  A broken-date contract is a forward contract for maturity, which is not a whole month. The rate for a broken date contract is calculated by interpolating between the available quotes for the preceding  and succeeding maturities.
• Option forward contracts can be used when the customer knows the estimated time when the need to deal in a foreign currency may arise, but may not be sure about the exact timing.

         -  When the bank is buying a currency,  it will add on the minimum premium possible and deduct the maximum discount possible from the spot rate, resulting in the bank  quoting the rate applicable to the beginning of the option period when the currency is at premium, and the rate applicable to the end of the option period when the currency is at a discount.

        -    When  the bank is selling a currency, it will add on the maximum premium possible and deduct the minimum  discount possible from the spot rate, resulting in the bank  quoting the rate applicable to the end of the option period when the currency is at premium, and the rate applicable to the beginning of the option period when the   currency is at a discount.

•  A transaction whereby two currencies are exchanged by the parties involved, only to be exchanged back is called a currency swap.
• The settlement date for a spot transaction is the second business day from the date of the transaction.
• In cases of contracts where the settlement date is less than two business days after the date of transaction are referred to as short-date transactions.
• In  India, the foreign exchange markets are regulated by the Foreign Exchange Management Act. The FEDAI provides for the early delivery/extension/cancellation of forward exchange contracts.
• Management of exchange risk essentially means reduction or elimination of exchange rate risk through hedging. It involves taking a position in the Forex and/or the money market, which cancels out the outstanding position.
• Exchange risk can be managed using internal and external hedging techniques. Internal techniques are those, which are part of day-to-day operations of a company, while the external techniques are the ones, which are not part of the day-to-day activities and are specially undertaken for the purpose of hedging exchange risk.
• Exposure Netting involves creating exposures in the normal course of business, which offset the existing exposures. It can be achieved by  creating an opposite exposure in the same currency or a  currency, which moves in tandem with the currency or original exposure.
• Leading involves advancing a payment and Laffing involves postponing a payment. A company can lead payment required to be made in a currency that is likely to appreciate, and lag payments that it needs to make in a currency that is likely to depreciate.
• Transaction and Translation exposures can be hedged by invoicing all receivables and payables in the domestic currency. But only one party can hedge itself in this manner. It will still leave the other party exposed, as it will be dealing in a foreign currency.
• In order to hedge the transaction exposure, a company having a long position in a currency (having a receivable) will sell the currency in the forward market, and a company having a short position in the currency(having a payable) will buy the currency forward. The cost of a forward hedge can be measured by the opportunity cost, which depends on the expected spot rate at which the currency needs to be bought or sold in the absence of the forward contract.
• The company can also hedge through the future market. Hedging through the futures market has a similar effect of hedging through the forward market. The gain/loss on the futures contract gets cancelled by the loss/gain on the underlying transaction and therefore the exposure gets eliminated completely.
• Transaction and Translation exposure can also be hedged using options. A firm having a foreign currency receivable can buy a put option on the currency, having the same maturity as the receivable.  Conversely, a firm having a foreign currency payable can buy a call option on the currency with the same maturity.
• The major financial strategy is to create liabilities in the currency to which a firm's earnings are exposed to a large extent, thus creating a  natural hedge.