International Finances | Corporate Finance | Part 2 | Section B | Episode 25 | CMA USA

Welcome back to CMA USA exam coach. In today's episode we're diving into a topic that's becoming more and more important in the modern business world, international finance. So what is it all about? Well, international finance is simply the world of money when it crosses borders. It deals with how businesses manage financial decisions when they're operating in more than one country. Things like buying or selling in foreign markets, dealing with different currencies, or raising money from international investors. Now, international finance isn't just a buzzword. It's something that impacts real business decisions every day. On the one hand, it opens up access to global markets, new investment opportunities, and even cheaper sources of funding. But on the other hand, it also brings a fair share of challenges, like dealing with fluctuating exchange rates, unfamiliar tax rules, or political uncertainty in different countries. In this episode, we'll unpack all of this. We'll explore how international finance works, why it matters for businesses and finance professionals, and how companies can manage both the risks and the rewards of going global. So what exactly are we going to cover in this episode on international finance? Here's a quick look at the key areas we'll explore. First, we'll talk about foreign investment. This is when a business puts money into assets or companies in another country. It could be something like setting up a factory abroad, buying shares in a foreign company, or acquiring property in another country. Next, we'll look at currency exchange. Since every country has its own currency, understanding how exchange rates work and how they impact business transactions is a big part of international finance. Then, we'll move on to import and export activities. Whether a company is selling goods to other countries or buying from them, there are financial considerations involved, from payment methods to managing trade risks. And finally, we'll cover international financing. This refers to how companies raise funds from global sources, like borrowing from foreign banks or issuing bonds in international markets. We'll be breaking down each of these topics in more detail throughout the episode, so stay tuned as we explore how international finance works in real-world business settings. Let's start with the first key topic, foreign investment. Foreign investment happens when a U.S. company puts its money into a business or asset located outside the United States. This could be anything from building a new factory overseas to buying shares in a foreign company. Now, foreign investment generally falls into two main categories. The first is called foreign direct investment or FDI. This is when a company takes a direct role in the operations of a business in another country. For example, opening a subsidiary, acquiring a foreign firm, or setting up a manufacturing plan abroad. In FDI, the investor usually has some level of control or influence over the foreign business. The second type is foreign portfolio investment or FPI. This involves investing in financial assets, like stocks or bonds in another country, but without any control over the companies involved. It's more like passive investment. The goal here is earning returns, not managing operations. Both types of foreign investment play a big role in international finance, and we'll explore them further in the next slides. Now let's explore one of the most important concepts in international finance, foreign direct investment, or what we often call FDI. Foreign direct investment happens when a company from one country invests directly in the business operations of another country, not just by buying stocks or lending money, but by actually setting up or owning physical assets in that foreign country. Let's break it down. Imagine a company based in the United States. If that company decides to open a factory in India, or buy a warehouse in Brazil, or even start a retail store in the UAE, it is making a foreign direct investment. Why? Because it is investing in long-term physical assets like land, buildings, machines, in a foreign country with the intention of being part of the local business activities. So what kind of assets are we talking about? These can include land, which is the physical space needed for operations, plan and equipment like buildings or manufacturing units, and machinery, which is needed for production or services. FDI isn't just about owning the asset. It usually means the company wants to actively manage the business too. This is a major point. In foreign direct investment, the investor is not just a silent partner. The foreign company will often be involved in decision making, hiring, production planning, and overall strategy. Now, there are three common ways a company can make a foreign direct investment. From the ground up, a brand new office, a new production unit, or even new stores. This is also called a greenfield investment, because you're starting fresh, like building on a greenfield. The second method is by acquiring an existing foreign company. So instead of starting from scratch, the company simply buys another business that's already operating in that country. This saves time and allows quick access to local customers and operations. The third way is by forming a joint venture with a foreign company. In this case, the home country business teams up with a local company in the foreign country. They both contribute resources like capital, expertise, or technology, and share ownership and control of the new business. Now, why is FDI important? It gives companies a chance to expand into new markets, access cheaper resources or labor, and get closer to international customers. At the same time, for the country receiving the investment, FDI brings in new jobs, modern technology, and economic growth. But remember, unlike passive investments like buying foreign stocks, FDI involves active control and long-term commitment. That's why it's such a powerful strategy for companies that want to go global in a serious way. Now that we understand what foreign direct investment is, let's talk about the impact it can have on companies, both the benefits and the risks involved. Let's start with the positive impact of FDI. When a company invests directly in a foreign country, one of the biggest advantages is access to new customers and markets. This means the company can expand its product or service to an entirely new audience. For example, a company from the U.S., opening branches in Asia or the Middle East, can now sell directly to customers in those regions, increasing its revenue and global presence. FDI also gives companies access to labor, materials, and other key resources that may be cheaper or more readily available in the foreign country. For instance, manufacturing in a country with lower labor costs can reduce production expenses and increase profitability. Another advantage comes from what we call monopolistic advantages. When a company enters a market where competition is low or the product is unique, it might gain a dominant position and enjoy higher pricing power or market share. There can also be political advantages. Some countries offer incentives to attract foreign companies, such as easier regulatory approval or access to government support, especially if the investment helps create jobs or brings in new technologies. And finally, companies may enjoy tax advantages. Some countries offer lower corporate tax rates or tax holidays to attract foreign investment. This can help reduce the overall tax burden and increase after-tax profits. But, as with any international decision, FDI also comes with risks and potential negative impacts. One of the key risks is economic and political instability. When a company operates in another country, it becomes exposed to that country's political environment. Changes in government, trade restrictions, or even diplomatic tensions between countries can affect business operations and profitability. For example, if political relations between the investor's home country and the foreign country break down, the business might face sanctions, regulatory issues, or forced exit. Another challenge is currency exchange risk. Since the company will be earning and spending money in different currencies, exchange rates can fluctuate. These changes might impact profit margins. For example, if the foreign currency weakens, the value of revenues earned in that country could decrease when converted back to the home currency. So, while foreign direct investment offers exciting growth opportunities, it also demands a careful risk management strategy. Companies need to analyze the target country's economic conditions, political landscape, and currency situation before moving forward. Now let's shift the perspective and talk about the impact of FDI on the host nation, that is, the country receiving the foreign investment. When a foreign company enters a new country and sets up operations, it creates a ripple effect in the local economy, and that brings both benefits and challenges. Let's begin with the positive impacts. One of the most direct and visible benefits is job creation. When a foreign company builds a factory, opens an office, or starts a new retail chain, it needs local workers. This provides employment opportunities for the local population, not just in the company itself, but also in supporting industries like transport, logistics, maintenance, and even food and housing services. Along with more jobs comes higher tax revenue. As the foreign company does business, it pays taxes, and those tax payments can be used by the local government to improve infrastructure, education, health care, and other public services. This creates a cycle of economic improvement. Another important benefit is the inflow of foreign exchange. When international companies bring in capital, it adds to the country's foreign currency reserves, which is helpful for maintaining a stable exchange rate and strengthening the national economy. FDI can also help improve the standard of living. More jobs, better wages, and access to new products and technologies can raise the quality of life for the local population over time. And finally, foreign companies often bring healthy competition into the domestic market. This encourages local businesses to improve their products, reduce costs, and become more efficient, which is good for consumers. But of course, there are also negative impacts that countries must consider. One concern is the effect on domestic businesses. When large foreign companies enter the market, they may have more financial power, better technology, and global brand recognition, which can make it difficult for small local businesses to compete. This could lead to some local firms shutting down or losing market share. Another issue is sociocultural dilution. As foreign companies bring in their own corporate culture, marketing styles, or work practices, it can sometimes conflict with or weaken local traditions, languages, or cultural values. Over time, this might affect the social fabric of the host nation. And finally, there's the risk of economic dominance. If a foreign company becomes too powerful or controls a large share of a critical industry, it may start influencing national economic decisions. This can lead to a loss of control over local resources or key sectors. So, while FDI offers many economic advantages, it's important for host nations to manage the relationship carefully, to ensure that the benefits are shared broadly, and that local industries and cultures are protected. Now let's move on to another important type of international investment, foreign portfolio investment, or simply FPI. Foreign portfolio investment is very different from foreign direct investment. In FDI, as we discussed earlier, a company invests directly in business operations and takes an active role in management. But in the case of FPI, the foreign investor is simply putting money into financial assets, usually shares or bonds, of a company in another country. Here's how it works. Imagine an investor from the US buying shares of a company listed on the stock exchange in India. The investor is now a part owner of that company in terms of holding shares and will earn returns through dividends or capital gains if the share price goes up. But that investor does not participate in management decisions. They don't attend board meetings, they don't vote on strategic matters, and they don't run the company. This is what makes FPI a passive investment. The goal is purely financial return without being involved in the business itself. FPI is common among individual investors, mutual funds, hedge funds, and even pension funds. It's popular because it offers flexibility. Investors can buy or sell shares quickly, shift between countries easily, and diversify their investment across different economies. However, because FPI doesn't come with managerial control, it is often considered short-term or speculative. Investors may enter and exit markets based on interest rate changes, political news, or currency fluctuations. That's why countries receiving FPI may experience capital inflows and outflows very quickly, which can lead to volatility in the financial markets. To summarize it simply, in foreign direct investment, the investor builds or buys part of a company and helps run it. In foreign portfolio investment, the investor just buys shares or bonds, earns returns, and stays completely passive. Now, let's take a moment to understand one of the most essential concepts in international finance, the currency exchange rate. In simple terms, a currency exchange rate is the value of one country's currency when compared to another. It tells us how much of one currency you'll need to exchange in order to get another. This rate becomes very important when companies do business across borders. Whether it's selling products in another country, buying raw materials from abroad, investing internationally, or borrowing foreign funds, almost every transaction will involve converting money from one currency to another. Because different countries use different currencies, understanding how exchange rates work is a key part of making financial decisions on a global level. Let's look at a simple example to make it clearer. Suppose you're comparing everything to the U.S. dollar. If you exchange one U.S. dollar, you'll get approximately 3.67 UAE dirhams, AED. But that same one U.S. dollar will give you around 85 Indian rupees, INR, as per current rate. So, even though you're exchanging the same amount of U.S. dollars, the number of local currency units you receive changes depending on the country. This is exactly what the exchange rate tells us, how much one currency is worth in terms of another, and understanding this is crucial for any financial activity across borders. Let's now take a closer look at how exchange rates are presented and what we mean by terms like base currency, quote currency, and direct or indirect quotes. On our slide, we see an exchange rate written as INR slash USD equals 0.012. This simply means that one INR is equal to 0.012. In every exchange rate, the first currency listed, in this case INR, is called the base currency. The second currency, USD, is called the quote currency, or sometimes the counter currency. So, this quote is telling us how many units of the quote currency, which is the USD, are needed to buy one unit of the base currency, which is the INR. Now let's understand this using the From your perspective as a U.S. resident or a U.S.-based business, a quote like INR slash USD equals 0.012. That's because it expresses the value of a foreign currency, in this case USD, in terms of your domestic currency, which is the U.S. dollar. It's telling you how many USD you But suppose you come across a quote like AED slash INR equals 22.5. This means one UAE dirham is worth 22.5 Indian rupees. Now, from a U.S. perspective, this quote is showing the relationship between two foreign currencies, Indian rupees and UAE dirhams, without involving your home currency, the U.S. dollar. So, this would be considered an indirect quote from the U.S. point of view. So, how do we keep this straight? If the quote includes your home currency and it tells you how much foreign currency you get for one unit of your domestic currency, that is called a direct quote. On the other hand, if the quote involves two foreign currencies or it shows how much of your domestic currency is needed to buy one unit of a foreign currency, that is called an indirect quote. To sum it up with our earlier examples, INR slash USD equals 0.012 is a direct quote for someone in the United States because it shows how much USD you get for one INR. But INR slash AED equals 22.5 is an indirect quote because it doesn't involve the U.S. dollar and instead compares two foreign currencies. Understanding how these quotes work is very important for reading currency markets, interpreting financial news and making accurate international financial decisions. Let's now look at an important concept in international finance, currency appreciation and depreciation. Currencies are not fixed in value. They constantly move up and down based on market conditions like supply and demand, interest rates, inflation and geopolitical events. These changes are reflected in the exchange rate. So, what does it mean when we say a currency has appreciated or depreciated? Appreciation means the currency is getting stronger. In other words, the base currency can now buy more of the quote currency than before. Depreciation means the currency is getting weaker. The base currency buys less of the quote currency compared to before. Let's look at an example using the USD slash INR exchange rate. Suppose the exchange rate was 80 Indian rupees for one U.S. dollar. Later, the rate becomes 85 Indian rupees for one U.S. dollar. This change from 80 to 85 means the U.S. dollar has appreciated because now one dollar can buy more rupees than before. At the same time, the Indian rupee has depreciated because it now takes more rupees to buy the same one dollar. So, whenever the exchange rate increases, meaning the quote currency value goes up in the denominator, the base currency is appreciating. Now let's calculate how much the U.S. dollar has appreciated in percentage terms. We use a simple formula. Current value minus base value divided by base value multiplied by 100. That is, 85 minus 80 divided by 80 multiplied by 100. That gives us 5 divided by 80 which equals 0.0625. When we multiply that by 100, we get 6.25 percent. So, in this example, the U.S. dollar appreciated by 6.25 percent against the Indian rupee. Understanding currency appreciation and depreciation is very important, especially for companies dealing in imports and exports or investing in foreign markets because it directly affects the cost of goods, earnings, and overall profitability. Now that we've seen how the U.S. dollar appreciated by 6.25 percent against the Indian rupee, a common question students ask is Does that mean the Indian rupee has depreciated by the same 6.25 percent? The answer is no. The depreciation of the Indian rupee is not equal to the appreciation percentage of the U.S. dollar. And here's the key reason why. When we calculated the appreciation, we used the quote USD slash INR equals 85, where the U.S. dollar is the base currency and the Indian rupee is the quote currency. But if we want to calculate how much the Indian rupee has depreciated, we must look at the exchange rate from INR's perspective, which means we have to reverse the currency pair. So instead of USD slash INR, we now use INR slash USD. Now, how do we get this reversed rate? We take the reciprocal of the original exchange rate. This simply means we divide 1 by the value of the exchange rate. For example, if USD slash INR equals 85, then INR slash USD will be 1 divided by 85, which gives us 0.0117. Earlier, when USD slash INR was 80, INR slash USD was 1 divided by 80, which equals 0.0125. Now let's calculate the percentage of INR depreciation using these values. We use the standard formula for percentage change. Current value minus base value divided by base value multiplied by 100. That is 0.0117 minus 0.0125 divided by 0.0125 multiplied by 100. This equals negative 0.0008 divided by 0.0125, which gives us negative 0.064. And when we multiply that by 100, we get negative 6.4 percent. So the INR has depreciated by 6.4 percent. Now you might wonder, why is the depreciation percentage different from the appreciation percentage of the US dollar? That's because in both cases, the base currency is different, so the starting point or denominator in the percentage formula changes. This is a common area of confusion, but it's very important to remember. Appreciation and depreciation are not mirror images when we reverse the currency pair. You must take the reciprocal and then recalculate separately. Now let's understand how exchange rates are determined. In the international market, the value or exchange rate of a currency is primarily driven by the forces of demand and supply, just like in any other free market. When the demand for a particular currency increases, perhaps due to higher exports, foreign investments, or interest in the country's financial markets, then that currency becomes stronger. This means its value rises compared to other currencies. Let's take an example. Suppose many investors around the world want to invest in the United States. To do that, they need US dollars. So they start buying dollars in the foreign exchange market. As a result, the demand for the dollar increases, and this pushes the value of the dollar up. We call this currency appreciation. On the other hand, if the supply of a currency increases in the international market, maybe because the country is importing a lot and paying foreign suppliers in foreign currencies, it creates an oversupply of its own currency in the market. In such a case, the value of that currency falls, because there's more of it available than what is demanded. This is what we call currency depreciation. So, in summary, when demand increases, the currency appreciates, and when supply increases, the currency depreciates. These movements are all part of the dynamic forces of international trade, capital flows, and market speculation. Let's now look at one of the key factors that influences the demand and supply of currencies in the international market, trade between nations, which includes both imports and exports. Before we go into the example of India and the U.S., let's understand why the demand for a foreign currency even arises in the first place. In international trade, when one country imports goods or services from another, it must pay the seller in their local currency, not in its own. So, for example, if an Indian company is buying machinery from a company in the United States, it can't pay in Indian rupees. The U.S. supplier wants payment in U.S. dollars. Therefore, the Indian company needs to convert Indian rupees into U.S. dollars. This process creates demand for U.S. dollars in the foreign exchange market. Now think about what happens when a country imports more than it exports. It means more foreign currency is needed to pay for all those imports. And because of this, the demand for foreign currency increases. When demand increases and supply remains the same, the value of that foreign currency goes up. It gets stronger. On the other hand, the home currency gets weaker because it's being sold in large quantities to buy the foreign currency. Now, let's bring this idea to life with a specific example involving India and the U.S. Suppose India imports a large number of goods and services from the U.S., but exports much less in return. That means Indian importers will need to buy a lot of U.S. dollars to pay American suppliers. At the same time, American companies don't need as much Indian rupees because they aren't buying as many goods from India. This leads to a situation where India needs more U.S. dollars, the U.S. needs less I.N.R. As a result, the demand for U.S. dollars is higher than the demand for I.N.R. U.S. dollars become stronger and I.N.R. becomes weaker. So whenever imports exceed exports, the importing country's currency weakens and the exporting country's currency strengthens due to the shift in demand. This is one of the key reasons exchange rates fluctuate daily. They are constantly being adjusted by trade activities happening across the globe. To understand this better, let's take a simple real-world example between India and the United States. Suppose India is importing more goods from the U.S. than it is exporting to the U.S. That means Indian companies and consumers need to pay more U.S. dollars to buy American products. But since Indian companies have Indian rupees, they must convert their I.N.R. to U.S.D. in the foreign exchange market to make those payments. This increases the demand for U.S. dollars. At the same time, if the U.S. is importing less from India, there's less demand for Indian rupees from American buyers. So here's what happens. India needs more U.S.D. to pay for imports. The U.S. needs less I.N.R. because it's not importing as much from India. As a result, demand for U.S.D. goes up while demand for I.N.R. stays low or even drops. This imbalance causes the U.S. dollar to get stronger and the Indian rupee to get weaker in the foreign exchange market. In short, when one country imports more than it exports, it creates a higher demand for the foreign currency, which in turn strengthens that currency and weakens the home currency. This is why trade balances—exports versus imports—are such a powerful force in determining currency values. Now let's look at the opposite case where a country is exporting more than it is importing. Suppose India is exporting more goods and services to the United States than it is importing from the U.S. In this situation, the American buyers need to make payments to Indian exporters, and those payments must be made in Indian rupees. After all, Indian businesses prefer to receive money in their local currency, not in U.S. dollars. Because of this, American importers will have to convert their U.S. dollars into Indian rupees in the foreign exchange market. That action creates a higher demand for INR, the Indian currency, in global markets. At the same time, since India is importing less from the U.S., Indian buyers don't need as many U.S. dollars. That means the demand for U.S. dollars is lower than the demand for Indian rupees. Now, when demand for INR is greater than the demand for USD, the value of the Indian rupee begins to rise. In simple terms, the INR gets stronger while the U.S. dollar becomes relatively weaker. So we can say that whenever a country exports more than it imports, the increased demand for its currency from foreign buyers causes that currency to appreciate in value. This is a key relationship to understand. The direction of trade, whether a country is importing more or exporting more, plays a major role in determining the strength of its currency. And it all comes down to the basic forces of supply and demand. More demand for a currency means that currency gets stronger. Less demand or oversupply means it gets weaker. But remember, a stronger currency isn't always better or worse. It depends on the broader goals of the country. A strong currency can help reduce the cost of imports, but it can also make exports more expensive to foreign buyers. So countries try to find a balance based on their economic strategy. Let's now summarize what we've learned about how imports and exports affect a country's currency value. When a country is importing more than it is exporting, it creates a situation called a trade deficit. This means that more money is flowing out of the country to pay for foreign goods and services, while less money is coming in from exports. In order to make those payments, the country must buy more foreign currency, which increases the demand for that foreign currency. At the same time, there's less demand for the domestic currency in the international market. This imbalance causes the domestic currency to depreciate. In other words, its value goes down compared to other currencies. On the other hand, when a country exports more than it imports, it results in a trade surplus. In this case, more foreign buyers are purchasing goods and services from the country, and they need the domestic currency to make those payments. That creates higher demand for the home currency, while the demand for foreign currency is relatively lower. As a result, the domestic currency appreciates, meaning it becomes stronger in the foreign exchange market. So in simple terms, a trade deficit leads to currency depreciation, while a trade surplus leads to currency appreciation. These are the basic outcomes of how trade flows influence exchange rates in the global economy. Another important factor that affects exchange rates is the action of foreign investors, especially when they move their investments from one country to another. Let's say foreign investors decide to pull out their investments from India and move that money into the United States. This could happen for many reasons, maybe U.S. Interest rates are higher, or the U.S. economy is performing better, or they feel it's safer to invest in American assets. When these investors sell their Indian stocks or bonds, they receive the payment in Indian rupees. But since they want to move their money to the United States, they need to convert those Indian rupees into U.S. Dollars to invest in U.S. markets. Now what does this mean for the currency market? It means that the supply of Indian rupees increases because investors are selling INR to get out of Indian assets. At the same time, the demand for U.S. dollars increases because they are buying dollars to invest in the U.S. This shift puts pressure on the exchange rate. With more people wanting dollars and fewer people holding on to Indian rupees, the value of the U.S. dollar becomes stronger, and the value of the Indian rupee becomes weaker. So, in short, when foreign investors exit a country, they usually convert the local currency into a foreign one, and this process leads to currency depreciation in the country they're leaving, and appreciation in the country they're moving into. This is why foreign investment flows, whether it's in the form of portfolio investment or direct investment, have a direct impact on currency demand and supply in the international market. Now let's explore the reverse scenario when foreign investors move their investments from the United States to India. This usually happens when investors see better opportunities in the Indian market, maybe due to higher returns, economic growth, or favorable policy changes. So they decide to sell their investments in the U.S. and shift their funds into Indian assets like stocks, bonds, or real estate. To do this, they need to sell their U.S. assets and convert the money, which is in U.S. dollars, into Indian rupees in order to invest locally. This shift has a direct impact on the foreign exchange market. As investors buy Indian rupees, the demand for INR increases. At the same time, since they are converting out of U.S. dollars, the supply of USD increases in the market. This movement creates upward pressure on the Indian rupee and downward pressure on the U.S. dollar. As a result, the INR gets stronger and the USD becomes weaker in comparison. So once again, the actions of foreign investors have a real and immediate effect on currency values. When money flows into a country, it strengthens that country's currency. When money flows out, it weakens the currency. That's why countries that attract consistent foreign investment usually experience appreciation in their currency, as long as other factors remain stable. So now the question is, why do foreign investors shift their investments from one country to another? What drives them to move capital across borders? There are a few key reasons and understanding them will help us see how global financial flows influence exchange rates. The first major reason is the difference in interest rates between nations. Investors are always looking for better returns. If one country offers higher interest rates compared to another, it becomes more attractive for investment. So when interest rates rise in a country like India, foreign investors may move their money from low-interest countries like the U.S. or Japan into India to earn higher returns. This increases demand for the Indian rupee and strengthens it. On the other hand, if interest rates drop, the flow can reverse. The second reason is inflation. Investors prefer to put their money in countries where inflation is low and stable. High inflation erodes the real value of returns, making investments less attractive. So when one country has rising inflation, while another maintains price stability, investors often pull out from the high-inflation country and redirect their investments to the low-inflation one. This also causes currency movements as demand shifts from one currency to another. And the third factor is the stage of economic growth. Investors look at how well a country's economy is performing. Is it expanding? Are jobs increasing? Is business activity growing? If one country is in a strong growth phase while another is in a slowdown or recession, capital naturally flows toward the stronger, more promising economy. This also creates currency appreciation in the growing economy and depreciation in the weaker one. So in summary, foreign investment flows are influenced by a combination of interest rates, inflation levels, and the overall stage of economic performance. These factors drive decisions about where to invest. And in doing so, they directly impact the demand and supply of currencies in the global market. Another powerful factor that influences the demand and supply of currency is the action of a country's central bank. The central bank plays a key role in maintaining stability in the foreign exchange market. One of its major responsibilities is to intervene when currency values become too volatile or move in a direction that could harm the national economy. For example, if the domestic currency is depreciating too rapidly, the central bank may step in to support its value. It can do this by selling foreign exchange reserves, like US dollars, and buying its own currency in the international market. This increases the demand for the domestic currency, helping to strengthen it and slow down the depreciation. On the other hand, if the domestic currency is appreciating too much and hurting the country's export competitiveness, the central bank may decide to buy foreign currency and release more of its own currency into the market. This increases the supply of the domestic currency, helping to weaken it slightly and maintain a balance that supports trade. In some cases, the central bank can also use policy tools, such as import restrictions or bans, to control the outflow of foreign currency. By limiting imports, the These interventions are often used to smooth out sudden shocks, correct imbalances, or defend against speculative attacks on the currency. So, while demand and supply generally move according to market forces, the central bank acts as a stabilizing force, using its authority, foreign reserves, and policy tools to keep the currency within acceptable levels and to ensure economic Let's quickly summarize the main factors that influence the demand and supply of a currency in the international market. The first factor is trade between nations. When a country imports more than it exports, it needs more foreign currency to pay for those imports, which increases the supply of its own currency and weakens it. Conversely, if a country exports more than it imports, demand for its currency increases, making it stronger. The second factor is the actions of foreign investors. When foreign investors move their money into a country, they buy its currency, increasing demand and strengthening the currency. When they withdraw their investments, they sell the local currency, increasing its supply and causing it to weaken. The third key factor is the actions of the central bank. Central banks intervene in the foreign exchange market by buying or selling currencies to stabilize exchange rates. They can also use policy tools like import restrictions to control currency flows and support their currency's value. These factors interact constantly in the global market, driving the changes we see in exchange rates every day. When a company borrows money from a lender in another country, the loan is usually denominated in the lender's currency. This means the borrower must repay both the principal and interest in that foreign currency. The actual cost of the loan depends not only on the interest rate charged, but also on the exchange rate between the borrower's currency and the lender's currency during the loan period. If the borrower's currency weakens against the lender's currency, the borrower will have to pay more in their local currency to settle the loan. This increases the effective cost of borrowing. Conversely, if the borrower's currency strengthens, the effective cost decreases. Let's take an example to understand this better. Suppose a When the loan is taken, the exchange rate is 75 Indian rupees per US dollar. After one year, if the Indian rupee weakens to 80 rupees per US dollar, the company will need more rupees to repay the same amount of dollars plus interest. Let's now understand how exchange rate changes can affect the effective interest rate on a foreign currency loan using a real example. Here's the situation. A company in the United States needs 2 million US dollars for financing. Instead of borrowing from an American bank where the interest rate is 6%, they plan to borrow this money from a Japanese bank where the interest rate is much lower, just 1%. So they are taking a foreign currency loan and that means the amount is borrowed in Japanese yen. Now let's see how much yen they need to borrow to get 2 million dollars. At the time of borrowing, the exchange rate is 1 US. Dollar equals 121.35 Japanese yen. So to get 2 million dollars, the company needs to multiply 2 million by 121.35, which gives 242,700,000 yen. Now, since the interest rate in Japan is just 1%, the interest after 1 year will be 1% of 242,700,000 yen, which comes to 2,427,000 yen. So the total repayment amount after 1 year becomes 242,700,000 yen plus 2,427,000 yen, which gives 245,127,000 yen. Now comes the key point. This repayment amount has to be converted back into US dollars at the time of repayment. But the exchange rate has changed. At the time of repayment, the new exchange rate is 1 US. Dollar equals 117.71 Japanese yen, meaning the dollar has become a bit weaker compared to the yen. So now, to convert 245,127 into dollars, we divide by 117.71. This gives approximately 2,082,465 US dollars. So even though the original loan was for 2 million dollars, the company is now paying back around 2,082,465 dollars due to the exchange rate movement. Let's calculate the effective interest rate. The amount paid is 2,082,465 minus 2 million, which comes to 82,465 dollars. Now divide this by the original loan amount of 2 million dollars. That gives 0.04123, or in percentage terms, approximately 4.123%. So even though the Japanese interest rate was just 1%, the US company ends up paying an effective interest of 4.123%, simply because of the change in exchange rate. This example shows clearly how currency fluctuations can impact the actual cost of borrowing, and why companies need to be very careful about currency risk when borrowing from another country. Let's now understand the concept of currency cross rate. First, what exactly is a In simple terms, a currency cross rate is the exchange rate between two currencies, which is calculated using their exchange rates with a third currency, usually the US dollar. Why do we need this? Sometimes, we don't have a direct exchange rate available between two currencies. For example, we might know the rate of US dollar to Indian rupee, and the rate of US dollar to Saudi riyal, but we don't have the direct rate between Indian rupee and Saudi riyal. In that case, we use the cross rate method, which allows us to calculate the missing exchange rate using the two we already have. So, think of it like this. We have two known currency rates, but we want to calculate the exchange rate between two different currencies. Let's say, 1 US dollar equals 85 Indian rupees. 1 US dollar equals 3.76 Saudi riyals. Now we want to know, how many Indian rupees is one Saudi riyal worth? We don't have this directly, but we can find it using a cross rate. Now let's look at a simple example to understand how cross rates are calculated. We are given two exchange rates. First, USD to INR is 85. This means 1 US dollar is equal to 85 Indian rupees. We can write this as 85 divided by 1, or 85 over 1. This simply shows that for every 1 US dollar, we get 85 rupees. Next, USD to SR is 3.76. This means 1 US dollar is equal to 3.76 Saudi riyals. Again, we write this as 3.76 divided by 1, or 3.76 over 1. That means for every 1 US dollar, we get 3.76 riyals. Now, you might wonder, why do we divide by 1? Well, it's just to keep things clear. The value is for 1 US dollar in both cases, so we treat 1 dollar as the base unit. This helps us align both rates and use them in our cross rate formula. So now we have, 1 US dollar is equal to 85 Indian rupees. 1 US dollar is equal to 3.76 Saudi riyals. Now we want to find the cross rate between Saudi riyal and Indian rupee, or simply, how many Indian rupees is 1 Saudi riyal worth? To find this, we apply the cross rate method. Suppose the US dollar to Indian rupee rate is 85. That means 1 US dollar equals 85 Indian rupees. And the US dollar to Saudi riyal rate is 3.76, which means 1 US dollar equals 3.76 Saudi riyals. Now, we want to find the exchange rate between the Saudi riyal and Indian rupee. In other words, how many Indian rupees is 1 Saudi riyal worth? We write these exchange rates as fractions. The US dollar to Indian rupee rate is 85 divided by 1. The US dollar to Saudi riyal rate is 3.76 divided by 1. To find the Saudi riyal to Indian rupee rate, we divide the US dollar to Indian rupee rate by the US dollar to Saudi riyal rate. Dividing by a fraction is the same as multiplying by its reciprocal. So, this means we multiply 85 divided by 1 by 1 divided by 3.76. Next, we multiply the numerators and denominators. 85 times 1 is 85. 1 times 3.76 is 3.76. This leaves us with 85 divided by 3.76. When we divide 85 by 3.76, we get approximately 22.61. This means 1 Saudi riyal equals 22.61 Indian rupees. This is called the cross rate between the Saudi riyal and the Indian rupee. We calculated it using their exchange rates with the US dollar. Purchasing power parity, or PPP, is an economic theory that compares the relative value of currencies by examining the cost of a standard basket of goods and services in different countries. The idea is that in an ideal world, identical goods should cost the same in different countries when expressed in a common currency. However, due to differences in local prices, wages, and economic conditions, this isn't always the case. PPP helps adjust for these differences, providing a more accurate comparison of living standards and economic productivity between countries. Let me explain purchasing power parity, or PPP, in a way that's easy to understand. Imagine you have some money, say one unit of your country's currency. Now, think about what you can buy with that money in your country. That is the purchasing power of your money. Now, imagine someone in another country has one unit of their currency. They can buy things in their country with that money, but the prices there might be different. PPP compares how much one unit of money can buy in your country versus another country. For example, in India, you might need around 50,000 Indian rupees to buy a set of common things like food, rent, clothes, and other daily needs. In the United States, to buy the same set of things, you might need about 1,500 US dollars. This shows that the money goes farther in India than in the United States because prices are lower in India. Now, there are two ways to look at money values between countries. Exchange rate. This is how much your money can be exchanged for another country's money. For example, right now, one US dollar might be worth 82 Indian rupees. This rate changes every day based on the market. Purchasing power parity, PPP. This looks at what you can actually buy with that money inside each country, ignoring the daily market changes. So, even if one US dollar equals 85 Indian rupees in the exchange market, when you compare prices of everyday things, one US dollar might actually be worth about 33 Indian rupees in terms of buying power. This is because things cost less in India, so your money buys more there. Why is this important? PPP helps us understand the real value of money in different countries. It tells us how expensive or cheap things are when compared fairly, not just by the exchange rate. Economists use PPP to compare living costs and incomes between countries to see how well people can live in each place. Let's quickly go over what we learned in this episode. We started with foreign investment, which includes FDI, foreign direct investment, and FPI, foreign portfolio investment. We saw how these investments flow from one country to another and how they affect the demand and supply of currency, making it stronger or weaker. Then, we moved to currency exchange and understood that currency value is decided by demand and supply in the international market. Next, we discussed imports and exports. When a country imports more, it needs more foreign currency, which can weaken its own currency. But if it exports more, it earns more foreign currency, and that makes its own currency stronger. We also talked about international financing, where a company takes a loan from a bank in another country. We learned how exchange rate changes can impact the actual repayment in the company's home currency. Finally, we learned two important global finance concepts. Cross-currency rates, which help us convert between two currencies using a third one, like the U.S. dollar. And purchasing power parity, or PPP, which compares the buying power of money in different countries. Make sure you read your textbook thoroughly and understand the concepts clearly. Also, try to practice as many questions as you can, especially past exam questions and MCQs. The more you practice, the more confident you'll feel. And as always, all the best for your studies. Keep going strong. You've got this! See you in the next episode.