Diploma – Business Finance

Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

CHAPTER 12: OVERVIEW OF INTERNATIONAL FINANCE

Learning objectives:

Aarsheeya should be able to: -

1. Understand basic terms used in international finance and trade

2. Learn different payment methods used in international transactions
3. Identify risks involved in dealing with foreign currencies
4. Understand how to manage or reduce currency risks
5. Learn how forward contracts and options are used to hedge exchange rate risk

Section A: Theory and Concepts

1. Introduction
In this session, we will start by talking about internationalisation and the problems businesses face
when working across countries. Then, we will explain some basic words used in international trade
and how payments are made in these deals. After that, we will learn how foreign exchange rates (the
value of one currency compared to another) are shown and what things can change a country’s
exchange rate. Finally, we will look at how businesses can protect themselves from risks caused by
exchange rate changes by using tools like forwards and options.
2. Challenges of Internationalisation
International trade means buying and selling money, goods, and services between countries.
Because businesses are working more globally now, there is a lot more trading between countries.
One big challenge when trading across countries is the risk that currency values can change, which
can cause problems.
2.1 International Trade Terms
In international trade, there are two main players: the importer and the exporter.
 The importer is the buyer who brings goods or services into their country.
 The exporter is the seller who sends goods or services to another country.
Goods brought into a country are called imports, and those same goods are called exports in the
country that sent them.
Trade balance is the difference between how much a country sells to other countries (exports) and
how much it buys from them (imports).
 If a country sells more than it buys, it has a trade surplus.
 If it buys more than it sells, it has a trade deficit.
3. International Trade Finance
3.1 Letter of Credit
In international trade, one big problem is that the buyer (importer) and seller (exporter) often don’t
know each other. Because of this, they may not trust each other to pay or deliver the goods first. For
example, the importer doesn’t want to pay before getting the goods, and the exporter doesn’t want
to send the goods without payment.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

To solve this, a bank can help by acting as a middleman. One common tool banks use is called a
Letter of Credit (LC). It is a guarantee from the bank that the exporter will get paid.
a) Step 1:
The importer (buyer) agrees to buy goods from the exporter (seller) and signs a contract.
Then, the importer asks their bank to issue a Letter of Credit (LC) to the exporter.
If the bank trusts that the importer can pay (creditworthy), it agrees and sends the LC to the
exporter.
This means the bank is promising to pay the exporter on the importer’s behalf.

b) Step 2:
Now that the bank has guaranteed payment, the exporter feels safe to send the goods.
The exporter ships the goods using a transport company (called a carrier).
Once the goods are loaded, the carrier gives the exporter a Bill of Lading (BOL) — a
document that proves the goods have been received for shipping.

c) Step 3:
The exporter then gives the BOL to their bank to get paid.
The exporter’s bank works with the importer’s bank (the one that issued the LC) to collect
the money.
At the same time, the importer’s bank gives the BOL to the importer in exchange for
payment.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

d) Step 4:
With the BOL in hand, the importer can now show it to the carrier and collect the goods once
they arrive in their country.
This completes the international trade process.

3.2 Telegraphic Transfer

Sometimes, the importer and exporter trust each other enough to deal directly, without needing a
bank in the middle. In these cases, the importer usually pays the exporter using a telegraphic
transfer.
A telegraphic transfer is a safe electronic payment sent from one bank to another. It’s a fast and
secure way to move money between countries.
Usually, the exporter will only ship the goods after receiving the payment — especially if the
importer is from a country considered risky.

4. Exchange Rate
A foreign exchange rate is the price of one currency when you trade it for another.
For example, let’s look at the exchange rate between the U.S. dollar (USD) and the Singapore dollar
(SGD or S$):
 US$1.00 = S$1.3644 → This means 1 U.S. dollar is worth 1.3644 Singapore dollars.
 S$1.00 = US$0.7329 → This means 1 Singapore dollar is worth 0.7329 U.S. dollars.
In global markets, the exchange rate is usually written like this:
S$1.3644/US$ — meaning 1 U.S. dollar equals 1.3644 Singapore dollars.

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

4.1 Spot Rates vs. Forward Rates

 A spot rate is the exchange rate used right now — it’s the price for exchanging currencies
today, with payment and delivery happening immediately.
 A forward rate is an exchange rate that is agreed on today, but the actual currency exchange
will happen at a future date. It’s like a deal made in advance to buy or sell a certain amount
of foreign currency later at a fixed price.
4.2 What Affects Exchange Rates
Exchange rates can go up or down, and this can really affect businesses that deal with foreign money.
Here are the main reasons why exchange rates change:
(a) Inflation Differences
 If one country has lower inflation (prices go up slowly), its currency usually gets stronger.
 This is because its money can buy more, so people want it more.
 Countries with higher inflation usually see their currency weaken.
(b) Interest Rate Differences
 If a country has high interest rates, it gives better returns to investors, so more people want
to invest there.
 This increases demand for that country’s currency, making it stronger.
 If interest rates go down, the currency might weaken.
(c) Trade Balance
 If a country exports more than it imports, its currency tends to gain value.
 That’s because foreign buyers need to change their money into the exporter’s currency to
pay.
 If a country imports more, it may weaken its currency because it has to buy foreign money to
pay for goods.
(d) Political Uncertainty
 If a country has problems like war or unstable government, investors get scared and move
their money out.
 This causes the currency to lose value.
(e) Speculation
 When traders think a currency will go up or down, they buy or sell large amounts.
 This can quickly change the exchange rate, depending on the size and direction of their
actions.
5. Exchange Rate Risks
A business faces exchange rate risk when it buys or sells using foreign currencies.
This risk happens because the value of currencies can change between the time the deal is made and
when the payment is actually done.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

For example, if the currency gets weaker or stronger during that time, the business might lose
money.
To protect themselves, companies can use something called hedging.
Hedging means taking another position (using a financial tool) that helps reduce or cancel out the
risk of losing money in the original deal.
How much a company chooses to hedge depends on how much risk it is willing to take:
 A company that avoids risk (called risk-averse) may try to hedge most or all of the risk.
 But hedging isn’t free — it costs money, so businesses must think carefully about how much
to hedge.
In this module, you will learn about two common hedging methods:
1. Forward Hedge
2. Option Hedge

5.1 Foreign Currency Forward Hedge

A forward contract is an agreement to buy or sell a certain foreign currency at a fixed price on a
future date.
Businesses use this to lock in an exchange rate today for a payment or receipt that will happen later.
This helps protect them from the risk of currency values changing.
In short, a forward hedge lets a company fix the exchange rate in advance, so they know exactly
how much they will pay or receive in the future.
Illustration 1: Forward
Original Trade Transaction
 A Singapore company buys goods worth US$10,000 from a U.S. company on 1st Jan 20X6.
 The spot exchange rate on that day is US$1 = S$1.50.
 The payment is due on 1st Feb 20X6.

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Hedging the Transaction

To protect itself from changes in exchange rates, the Singapore company enters into a forward
contract on 1st Jan to buy US$10,000 at a fixed rate of US$1 = S$1.60.
This means the company will pay S$16,000 on 1st Feb no matter what the actual rate is on that
day.
On Settlement Date (1st Feb 20X6)
 The actual spot rate on 1st Feb is US$1 = S$1.80.
 Because of the forward contract, the company pays only S$16,000 instead of S$18,000.
 It saves S$2,000, but since the rate it locked in (S$1.60) was higher than the original spot rate
(S$1.50), it still paid S$1,000 more than it could have on Jan 1.

Cost of Hedging = (S$1.60 - S$1.50) × 10,000 = S$1,000

But without hedging, they would have lost S$3,000

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

What If the Company Didn’t Hedge?

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 On 1st Feb, they would need to buy US$10,000 at the new rate of US$1 = S$1.80.
 That means they would have to pay S$18,000 instead of S$15,000 (if they had paid back on
Jan 1).
 So, the company suffers an exchange loss of S$3,000.

Conclusion

Scenario Amount Paid Gain/Loss

With Forward Hedge S$16,000 Loss of S$1,000

Without Hedge S$18,000 Loss of S$3,000

Using a forward hedge, the company paid S$1,000 more than the earlier rate, but saved S$2,000
compared to what they would have paid at the new spot rate.
Let me know if you want the Option Hedge example explained next!
5.2 Foreign Currency Option Hedge
A foreign currency option is like an insurance policy for a company dealing in foreign money.
It gives the company:
 The right to buy or sell a foreign currency at a fixed rate (called the strike price),
 But the company is not forced to use it if it doesn’t want to.
This right is valid until a specific date (called the expiration date).

What Does the Company Get?

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

The company pays a premium (a small fee) to buy this option. In return, it gets:
1. Protection — If exchange rates move in a bad way (like becoming more expensive), the
company can use the option and save money.
2. Flexibility — If exchange rates move in a good way (like becoming cheaper), the company
can ignore the option and use the better rate.
Example (Simple Scenario)
Let’s say:
 A Singapore company needs to pay US$10,000 in the future.
 It buys a currency option that allows it to buy US$1 at S$1.60 any time before 1st Feb.
 It pays a premium of S$200 for this option.
Scenario A: If the spot rate rises to S$1.80
 The company uses the option and buys US$10,000 at S$1.60, saving money.
 It avoids paying S$18,000 (1.80 × 10,000) and pays only S$16,000.
 So, net savings = S$2,000 (but minus S$200 premium = S$1,800 total savings).
Scenario B: If the spot rate drops to S$1.40
 The company ignores the option.
 It buys at the better rate of S$1.40, paying only S$14,000.
 The option cost is lost (S$200), but the company still saves compared to S$16,000.
Illustration 2: Call Option
Original Trade Transaction
 A Singapore company buys goods worth US$10,000 from a U.S. company on 1st Jan 20X6.
 The spot rate on that day is US$1 = S$1.40.
 The payment is due on 1st Feb 20X6, so the company must pay US$10,000 then.
 The company faces risk if the US dollar becomes stronger (more expensive).

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Hedging Transaction
 To protect against this, the company buys a call option on US dollars.
 This gives it the right to buy US$10,000 at a fixed rate of S$1.40/US$ (called the strike price).
 The company can choose to use this option or ignore it, depending on which is better on the
payment date.
On Settlement Date (1st Feb 20X6)
The company must decide whether to exercise or abandon the option:
(a) Abandon the option
 If the spot rate is lower than the strike price (e.g., S$1.30/US$), USD is cheaper.
 The company ignores the option and buys USD at the cheaper rate: S$1.30 × 10,000 =
S$13,000.
 This means the company saves money compared to the strike price.
Foreign exchange gain = (S$1.40 - S$1.30) × 10,000 = S$1,000

(b) Exercise the option

 If the spot rate is higher than the strike price (e.g., S$1.60/US$), USD is more expensive.
 The company uses the option to buy USD at the lower strike price of S$1.40 × 10,000 =
S$14,000.
 This protects the company from paying more at the new spot rate of S$1.60.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Conclusion
 The call option lets the company limit losses while still benefiting if rates move in their Favor.
 The company pays a premium for this flexibility.
 This is a useful tool if the company wants protection but also a chance to gain from good
rate changes.
Illustration 3: Put Option
Original Trade Transaction
A Singapore exporter sold goods worth US$10,000 to a U.S. company on 1st Jan 20X6 when the spot
rate was US$1 = S$1.40. The payment will be received after one month, on 1st Feb 20X6. This
exposes the Singapore company to the risk of the USD depreciating against SGD during this time.
 1st Jan
Spot rate = S$1.40/US$
 1st Feb
Would receive US$10,000 for the goods sold

Hedging Transaction
The Singapore company can buy a USD put option from an option writer. The agreed exchange rate
(strike price) is S$1.40/US$, same as the spot rate.
 This contract gives the right to sell USD at S$1.40 on 1st Feb 20X6.
 This is a put-on USD and a call on SGD, called a USD/SGD PUT by market participants.

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

On Settlement Date (1st Feb 20X6)

The exporter decides whether to:
(a) Abandon the option
 If the new spot rate is higher than the strike price (e.g., S$1.70/US$), USD is stronger.
 The exporter sells USD at S$1.70 instead of the lower strike price of S$1.40, so the option is
abandoned.
 Exporter sells USD for more and records a foreign exchange gain.

Old Spot Rate New Spot Rate Difference

S$1.40/US$ S$1.70/US$ S$3,000 gain

(b) Exercise the option

 If the new spot rate is lower than the strike price (e.g., S$1.25/US$), USD is weaker.
 The exporter exercises the option and sells USD at the strike price S$1.40, which is better
than the lower spot rate.
 The company is perfectly hedged, receiving the same amount as originally expected.

Old Spot Rate Strike Price Difference

S$1.40/US$ S$1.40/US$ S$0 (no loss)

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Section B: Questions and Answers

Choose the Correct Answer

1. When goods are brought into a country, they are known as imports, while goods sent to another
country are known as exports.
2. A letter of credit is issued by a bank on behalf of an importer.
3. Exchange rate risk is the risk caused by varying exchange rates between two currencies.
4. The spot exchange rate is the rate of exchange between any two currencies on a given day while
the forward exchange rate is the rate of exchange between two currencies at some specific future
date.
5. The most important factor affecting exchange rates is the differing inflation rates between two
countries, where the currency with the higher rate will decline relative to the country with the
lower rate.
6. A foreign exchange forward contract requires participants to buy or sell a specified currency at a
specified price on a specified date.
7. A/An option provides the right, but not the obligation, to buy or sell a foreign currency, at a
defined price, on or before a specified date.
8. The importer could hedge the risk of appreciation in the foreign currency by purchasing a foreign
currency call option. The exporter could hedge the risk of depreciation in the foreign currency by
purchasing a foreign currency put option.

Multiple Choice Questions

1. The _____________________ is the rate of exchange between two currencies on any given
day.
(A) spot exchange rate
(B) forward exchange rate
(C) exercise price
(D) effective rate
2. Although a number of factors can influence exchange rate movements, by far the MOST
important influence is the ____________________.
(A) number of speculators in the market.
(B) trade gap between two countries.
(C) political situation in the two countries.
(D) differing inflation rates between two countries.
3. If the spot rate is USD1.45 per SGD and the AUD is 0.90 per USD, how much is S$1,000 worth
in AUD (to the nearest whole number)?
(A) 766
(B) 1,611
(C) 621
(D) 1,305
4. A Singapore importer just purchased goods and is required to make a USD payment in one
month’s time. Which of the following is NOT the correct hedging instrument to be used?
(A) A Forward contract to buy USD.
(B) A USD Call option.
(C) A USD Put option.
(D) A SGD Put option.
5. What is the exercise price of an option also known as?
(A) Premium.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

(B) Market price.

(C) Spot price.
(D) Strike price.

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Section C: Activities

Practice Questions – Hedging

Solution-

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

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Solution -

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BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

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BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

Practice Again before Exams

MCQs
1. Which of the following is not a primary goal of international financial management?
a) Profit maximization
b) Political dominance
c) Risk minimization
d) Efficient capital allocation

2. A major risk faced by multinational corporations when dealing with international finance is:
a) Domestic competition
b) Currency exchange fluctuations
c) Regulatory compliance in home country
d) Saturation of domestic markets

3. The term “Eurobond” refers to bonds that are:

a) Issued in Europe only
b) Denominated in the euro only
c) Denominated in a currency not native to the country where it is issued
d) Issued by the European Central Bank

4. Which of the following institutions is known for providing short-term financial assistance to
countries facing balance of payments problems?
a) World Bank
b) Asian Development Bank
c) IMF
d) WTO

5. Which financial instrument is commonly used by firms to hedge against foreign exchange
risk?
a) Equity shares
b) Debentures
c) Forward contracts
d) Preference shares

6. The term "foreign direct investment (FDI)" involves:

a) Purchase of foreign goods
b) Speculative trading in foreign exchange
c) Long-term investment in foreign enterprises
d) Holding of foreign bank accounts

Short Subjective Questions

1. Explain the key challenges faced by financial managers in a multinational corporation.
2. Discuss the role of international financial institutions in stabilizing global economic
conditions.
3. How does the foreign exchange market impact the operations of multinational companies?
4. Differentiate between foreign direct investment and foreign portfolio investment.

BF: Chapter 12: Overview of International Finance

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Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

5. Explain the importance of managing political risk in international finance.

Practical Questions

1. A company based in India expects to receive $500,000 after 3 months. The current exchange
rate is ₹83 per dollar. If the rupee is expected to depreciate to ₹86 per dollar, how much
more (or less) in INR will the company receive if it does not hedge?

2. Assume a Malaysian company imports equipment from a German supplier for €50,000 on
1/6/20X5. The spot exchange rate on this date is €1 = MYR 5.00.
The settlement date is 1/7/20X5.
To hedge against foreign exchange risk, the Malaysian company enters into a forward
contract on 1/6/20X5 to buy €50,000 at a forward rate of €1 = MYR 5.20, for delivery on
1/7/20X5.
The actual spot rate on 1/7/20X5 is €1 = MYR 4.70.

Required:

(a) What is the cost of hedging?

(b) If the company did not hedge, what would be the exchange gain or loss?

3. A Singaporean electronics retailer imports gadget from Europe and is due to pay €750,000
to the supplier on 30th November. The payment is in euros, and the current spot rate is €1
= S$1.45. To hedge against adverse exchange rate movement, the importer buys a call
option with a strike price of S$1.48/€.

Required:

(a) Will the importer be receiving or paying euros?

(b) Is the importer worried about an appreciation or depreciation of the euro?

(c) What option strategy has the importer adopted to hedge this risk?

(d) What right does this call option give the importer?

(e) Under what condition will the option not be exercised? What will the importer do?
(Hint: Use spot rate = S$1.40/€ for illustration)

(f) Under what condition will the option be exercised? What will the importer do?
(Hint: Use spot rate = S$1.55/€ for illustration)

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

QP – 2025 March
Question 4 –
(a) Identify and explain two macroeconomic factors that could influence the exchange rate between
the Euro and the Singapore Dollar (SGD). Indicate clearly how each factor could cause the SGD to
appreciate or depreciate relative to the Euro.
(4 marks)
(b) A Singapore company is evaluating whether to use a forward hedge or an option hedge to
protect against foreign currency risk. Briefly explain two key differences between these two hedging
methods.
(4 marks)
(c) Bright Vision Pte Ltd, based in Singapore, exports optical equipment to Germany. The company
just confirmed a sale of €200,000, with payment expected in 30 days. The current spot rate is €1 =
S$1.55.
FORWARD HEDGE
 (i)What is the hedging outcome if Bright Vision enters a forward contract to sell € at S$1.52
for settlement in 30 days?
(4 marks)
 (ii) If the company does not hedge, what would be the exchange gain or loss in 30 days if the
spot rate becomes €1 = S$1.50?
(5 marks)
OPTION HEDGE
Bright Vision is also considering a currency option with a strike price of €1 = S$1.54.
 (iii) Should the company exercise or let the option expire if the spot rate in 30 days is €1 =
S$1.58? Justify your answer.
(4 marks)
 (iv) Should the company exercise or let the option expire if the spot rate in 30 days is €1 =
S$1.50? Justify your answer.
(4 marks)
[25 Marks, Page Number – 5]
Solution –

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

QP – 2024 November
Question 4 –
(a) Discuss how ‘interest rate differentials’ between countries can impact currency exchange rates.
(4 marks)
(b) A Singapore firm exports handphones to Australia. The firm received an order to export A$50,000
of handphones and will receive payment in A$ in three months’ time. The current spot rate is A$1 =
S$1.05.
(i) To hedge the firm’s currency risk, the firm can purchase an option with a strike
price of A$1 = S$1.06. Should the firm buy A$ Put or A$ Call options? Explain.
(2 marks)
(ii) If the spot rate in three months is A$1 = S$1.08, should the firm exercise the
option? Justify your answer.
(4 marks)
(iii) If the spot rate in three months is A$1 = S$1.03, would you exercise the option?
Justify your answer.
(4 marks)

(c) A Singapore company bought goods from an American firm for US$200,000 on 1 January, when
the spot rate was US$1 = S$1.40. The settlement date is 1 February. To hedge the transaction, the
company entered a forward contract at US$1 = S$1.42 for delivery on 1 February.
(i) Is the Singapore company concerned about an appreciation or depreciation of
the US dollar? Explain.
(2 marks)
(ii) Calculate the cost of hedging.
(4 marks)
(iii) Assume that on 1 February the spot rate is US$1 = S$1.39. If the company did
not hedge, would it experience an exchange rate gain or loss? Calculate the
amount.
(4 marks)

[25 Marks, Page Number – 5]

Solution –

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance

Diploma – Business Finance
Chapter 12: OVERVIEW OF INTERNATIONAL FINANCE

BF: Chapter 12: Overview of International Finance