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In this notes

  • Globalization and International Business
  • Global Economy and Regional Economy
  • National Differences in Socio-cultural Environment
  • National Differences in Political Environment
  • National Differences in Economic Environment
  • International Financial Environment
  • Strategies for IB
  • Functional Management and Operation of IB

International Financial Environment

Binayak Niraula | Thu Jan 15 2026

Table of Contents

  1. Foreign Exchange Market
  2. Spot Market
  3. Spot Rate Quotations
  4. Bid Ask Spread
  5. Foreign Exchange Market Concepts
  6. Types of Exchange Rate Systems
  7. Factors Affecting Exchange Rate
  8. Modes of Payment in International Trade

Foreign Exchange Market

The Foreign Exchange Market (Forex Market) is a global marketplace where currencies of different countries are bought and sold. It determines the exchange rate between one currency and another and facilitates international trade, investment, and finance.

Main Functions of the Foreign Exchange Market:

1. Currency Conversion:

  • Helps businesses, investors, and governments convert one currency into another for international transactions
  • Example: Converting Nepali Rupees (NPR) to US Dollars (USD) for imports

2. Hedging and Risk Management:

  • Protects traders and firms from losses caused by fluctuations in exchange rates through forward, futures, and options contracts

3. Speculation:

  • Traders buy or sell currencies to profit from changes in exchange rates

4. Transfer of Funds:

  • Facilitates the movement of money between countries for trade, investment, tourism, or remittances

Participants in the Foreign Exchange Market:

  • Commercial Banks: Main players that buy and sell foreign currencies
  • Central Banks: Regulate currency value and stabilize exchange rates
  • Foreign Exchange Brokers: Link buyers and sellers of currencies
  • Corporations: Conduct international business transactions
  • Individuals/Investors: Exchange currency for travel or investment

Types of Foreign Exchange Markets:

1. Spot Market:

  • Immediate exchange of currency at the current exchange rate

2. Forward Market:

  • Agreement to buy or sell currency at a future date at a fixed rate

3. Futures Market:

  • Standardized contracts to exchange currency in the future through organized exchanges

4. Options Market:

  • Provides the right, but not the obligation, to buy or sell currency at a set price before a certain date

Importance of the Forex Market:

  • Promotes international trade and investment
  • Maintains liquidity in the global financial system
  • Helps determine fair and efficient exchange rates
  • Encourages global economic stability

The foreign exchange market is the world's largest financial market, operating 24 hours a day, enabling currency exchange for trade, investment, and speculation. It plays a vital role in global economic integration and financial stability.

On this page

  • Foreign Exchange Market
  • Spot Market
  • Spot Rate Quotations
  • Bid Ask Spread
  • Foreign Exchange Market Concepts
  • Types of Exchange Rate Systems
  • Factors Affecting Exchange Rate
  • Modes of Payment in International Trade

Spot Market

The spot market is a part of the foreign exchange market where currencies are bought and sold for immediate delivery — that is, the exchange of currency and payment occur "on the spot," usually within two business days.

Key Features:

1. Immediate Settlement:

  • The transaction is completed almost instantly (normally within two days)

2. Current Exchange Rate:

  • The currency is exchanged at the current market rate, known as the spot rate

3. Short-Term Nature:

  • It is used for short-term currency needs such as trade payments or travel expenses

4. No Contract for Future Delivery:

  • Unlike the forward market, no future obligation exists

Example: If a Nepali importer buys goods from the USA and needs to pay USD 10,000, they will go to the spot market to exchange Nepali Rupees (NPR) for US Dollars (USD) at the current spot rate.

Advantages:

  • Quick and simple transactions
  • Reflects the real market value of currencies
  • Highly liquid and transparent

Disadvantages:

  • Exposed to exchange rate fluctuations
  • Not suitable for long-term hedging or risk management

The spot market is the most basic and liquid segment of the foreign exchange market where currencies are exchanged immediately at the current rate, playing a key role in facilitating global trade and finance.

Spot Rate Quotations

A spot rate quotation is the current exchange rate at which one currency can be immediately exchanged for another in the spot market. It represents the price of one currency in terms of another for immediate delivery (usually within two business days).

Example: If the exchange rate between US Dollar (USD) and Nepali Rupee (NPR) is quoted as USD 1 = NPR 133.50, this means in the spot market, one US Dollar can be exchanged for 133.50 Nepali Rupees.

Types of Spot Rate Quotations

1. Direct Quotation:

  • The home currency is expressed per unit of foreign currency
  • Example (from Nepal's perspective): USD 1 = NPR 133.50

2. Indirect Quotation:

  • The foreign currency is expressed per unit of home currency
  • Example (from Nepal's perspective): NPR 1 = USD 0.0075

3. Bid and Ask (Offer) Rates:

  • Banks usually quote two rates:
    • Bid Rate: Rate at which the bank buys foreign currency
    • Ask/Offer Rate: Rate at which the bank sells foreign currency
  • Example: USD 1 = NPR 133.40 / 133.60. Here, NPR 133.40 is the bid, and NPR 133.60 is the ask rate.

Importance of Spot Rate Quotations:

  • Determines the value of currencies in international trade
  • Used for import/export payments, travel, and short-term investments
  • Reflects the real-time supply and demand of currencies in the global market

Spot rate quotations show the current exchange value of currencies for immediate transactions. They are essential for businesses, banks, and traders engaged in foreign exchange and global trade.

Bid Ask Spread

The Bid-Ask Spread is the difference between the bid price and the ask (offer) price quoted by a bank or foreign exchange dealer for a currency. It represents the dealer's profit and the cost of trading for the buyer or seller.

Key Terms:

1. Bid Price:

  • The price at which the dealer or bank buys foreign currency
  • Example: Bank buys USD 1 = NPR 133.40

2. Ask (Offer) Price:

  • The price at which the dealer or bank sells foreign currency
  • Example: Bank sells USD 1 = NPR 133.60

3. Bid-Ask Spread:

  • The difference between the ask price and the bid price
  • Formula: Spread = Ask Price - Bid Price
  • Example: Spread = 133.60 - 133.40 = 0.20

Interpretation:

  • The smaller the spread, the more liquid and competitive the market
  • The larger the spread, the less liquid or more volatile the market

Causes of Bid-Ask Spread:

  1. Market Liquidity: Low liquidity = higher spreads
  2. Transaction Size: Smaller trades may face larger spreads
  3. Market Volatility: Unstable markets increase spreads
  4. Dealer Costs: Covers transaction and administrative costs
Quotation TypeMeaningExample (USD/NPR)
Bid RateRate at which bank buys USDNPR 133.40
Ask RateRate at which bank sells USDNPR 133.60
Bid-Ask SpreadDealer's profit (Ask − Bid)NPR 0.20

The Bid-Ask Spread is a key concept in the foreign exchange market that reflects transaction costs, market liquidity, and dealer margins. It ensures the smooth functioning of currency trading worldwide.

Foreign Exchange Market Concepts

1. Trading in Spot Markets

The spot market is where currencies are bought and sold for immediate delivery, usually within two business days.

  • The exchange rate used is the spot rate
  • It reflects the current market value of a currency
  • Example: If USD 1 = NPR 133.50, a trader can immediately exchange at this rate

2. Cross Exchange Rates

A cross exchange rate is the exchange rate between two currencies, neither of which is the home currency. It is usually derived from their common relationship with a third currency (often the USD).

Example:

If:

  • USD 1 = NPR 133.50
  • USD 1 = INR 83.00

Then:

  • NPR/INR = 133.50 ÷ 83.00 = 1.61
  • → ₹1 = NPR 1.61

3. Forward Markets

A forward market is where participants agree today to buy or sell a currency at a fixed rate (forward rate) for delivery at a future date.

  • Used to avoid exchange rate risk
  • Settlement takes place on a future date (e.g., 30, 90, or 180 days later)

4. Forward Rate

The forward rate is the agreed exchange rate for a future transaction. It can be higher or lower than the current spot rate depending on market expectations.

Example:

  • Spot rate: USD 1 = NPR 133.50
  • 3-month forward rate: USD 1 = NPR 134.00
  • → Forward rate is at a premium

5. Long and Short Forward Positions

  • Long Forward Position: When a trader agrees to buy foreign currency in the future → expecting it to appreciate (Importer's position)
  • Short Forward Position: When a trader agrees to sell foreign currency in the future → expecting it to depreciate (Exporter's position)

6. Forward Premium and Discount

The difference between the forward rate and the spot rate shows whether a currency is at a premium or a discount.

  • Forward Premium: When Forward Rate > Spot Rate (foreign currency expected to appreciate)
  • Forward Discount: When Forward Rate < Spot Rate (foreign currency expected to depreciate)

Example:

  • Spot: USD 1 = NPR 133.50
  • Forward: USD 1 = NPR 134.00 → Premium (0.50)
  • Forward: USD 1 = NPR 133.00 → Discount (0.50)

7. Arbitrage

Arbitrage is the practice of buying a currency in one market and selling it in another to profit from price differences.

  • It ensures that exchange rates remain consistent across markets
  • Example: Buying USD cheaply in Kathmandu and selling it at a higher rate in Delhi

8. Hedging

Hedging means reducing the risk of loss due to exchange rate fluctuations by using forward or future contracts.

  • Importers/exporters often hedge to lock exchange rates
  • Example: An importer buying USD at a fixed forward rate to avoid future rate increases

9. Speculation

Speculation involves taking a risk to earn profit from expected future movements in exchange rates.

  • If a trader expects USD to appreciate, they buy USD now to sell later at a higher rate
  • It's risky but can be highly profitable

Summary of Concepts

ConceptMeaningExample / Key Point
Spot MarketImmediate currency exchangeUSD 1 = NPR 133.50
Cross RateExchange between two non-home currenciesNPR/INR = 1.61
Forward MarketFuture currency exchange3-month forward contract
Forward RateAgreed rate for future exchangeUSD 1 = NPR 134.00
Long PositionAgreeing to buy currency laterImporter
Short PositionAgreeing to sell currency laterExporter
PremiumForward > SpotAppreciation expected
DiscountForward < SpotDepreciation expected
ArbitrageProfit from rate differencesBuy low, sell high
HedgingMinimize riskForward contract
SpeculationTake risk for profitPredicting rate movement

These elements — spot and forward trading, cross rates, and financial strategies like arbitrage, hedging, and speculation — together form the backbone of the foreign exchange market, ensuring liquidity, stability, and efficiency in international trade and finance.

Types of Exchange Rate Systems

An exchange rate system is the method by which a country manages the value of its currency in relation to other currencies in the foreign exchange market. It determines how exchange rates are set and adjusted.

1. Fixed Exchange Rate System (Pegged System)

A fixed exchange rate system is one in which the value of a country's currency is tied (pegged) to another major currency (like the US Dollar) or to a basket of currencies.

Features:

  • The government or central bank maintains the exchange rate at a predetermined level
  • It intervenes in the market by buying or selling foreign currency to maintain the fixed rate

Advantages:

  • Provides stability in international prices
  • Encourages trade and investment

Disadvantages:

  • Requires large foreign reserves
  • Limits monetary policy independence

Example: Nepal's currency (NPR) is pegged to the Indian Rupee (INR) at a fixed rate of NPR 1.6 = INR 1

2. Floating Exchange Rate System

A floating exchange rate system is one where the value of a currency is determined by market forces — supply and demand — without direct government intervention.

Features:

  • Rates fluctuate freely
  • Central bank intervention is minimal

Advantages:

  • Reflects true market conditions
  • Provides monetary policy flexibility

Disadvantages:

  • Can cause exchange rate volatility
  • Uncertainty may discourage trade and investment

Example: The US Dollar, Euro, and Japanese Yen are freely floating currencies

3. Soft Peg (Conventional Peg or Semi-Fixed System)

Under a soft peg, a country's currency is tied to another currency, but limited fluctuations are allowed within a small band (e.g., ±1%). If it moves beyond the band, the central bank intervenes to restore the rate.

Example: The Chinese Yuan (CNY) was historically pegged to the US Dollar with slight flexibility

4. Crawling Peg

A crawling peg is a system where the exchange rate is adjusted gradually over time rather than suddenly. Adjustments are made periodically to reflect inflation differentials or market trends.

Advantages:

  • Avoids sharp currency shocks
  • Provides gradual stability

Example: Countries like Chile and Brazil have used crawling peg systems in the past

5. Free Float (Pure Float)

A free float means that the exchange rate is completely determined by the market, with no central bank intervention at all.

Features:

  • Exchange rates fluctuate daily
  • Based purely on demand and supply

Example: The US Dollar, Euro, and British Pound are largely free-floating currencies

6. Managed Float (Dirty Float)

A managed float system allows the currency to fluctuate freely, but the central bank occasionally intervenes to stabilize or guide the exchange rate.

Features:

  • Combines features of fixed and floating systems
  • Intervention only during high volatility or instability

Example: India and Indonesia follow a managed floating system

Summary of Exchange Rate Systems

Type of SystemMain FeatureGovernment InterventionExample
Fixed (Pegged)Currency tied to anotherHighNepal (to INR)
FloatingDetermined by market forcesNoneUSA, Eurozone
Soft PegLimited flexibility around fixed rateModerateChina (earlier)
Crawling PegGradual, periodic adjustmentsControlledChile, Brazil
Free FloatFully market-basedNoneUSA, UK
Managed FloatMarket-based with occasional controlOccasionalIndia, Indonesia

Key Takeaways:

  • Fixed systems provide stability but limit flexibility
  • Floating systems allow market efficiency but cause volatility
  • Hybrid systems like soft pegs, crawling pegs, and managed floats aim to balance both stability and flexibility

Factors Affecting Exchange Rate

The exchange rate is the price of one currency in terms of another. It fluctuates due to several economic and policy factors that influence demand and supply of currencies in the foreign exchange market.

1. Relative Inflation Rates

  • Countries with higher inflation experience currency depreciation, as their goods become more expensive internationally
  • Conversely, lower inflation leads to appreciation of the currency
  • Example: If Nepal's inflation is higher than India's, NPR will depreciate against INR

2. Interest Rates

  • Higher domestic interest rates attract foreign capital, increasing demand for that currency and causing appreciation
  • Lower interest rates cause depreciation as investors seek higher returns elsewhere

3. Relative Interest Rates

  • If one country's interest rate rises faster than others, its currency tends to appreciate relative to those currencies
  • Example: If the U.S. interest rate increases compared to Japan, the USD appreciates against the JPY

4. Relative Income Levels

  • When a country's income level rises, people import more goods, increasing demand for foreign currency and causing domestic currency depreciation
  • Conversely, low income reduces imports and strengthens the currency

5. Government Controls

  • Governments can influence exchange rates through monetary policy, foreign exchange intervention, or trade restrictions
  • Examples of control include:
    • Buying/selling foreign currency
    • Setting exchange rate bands
    • Imposing import/export limits

6. Market Expectations

  • Future expectations about inflation, interest rates, or political stability affect current exchange rates
  • If investors expect a country's economy to strengthen, they buy its currency → appreciation
  • Negative expectations → depreciation

Summary of Factors

FactorEffect on Exchange Rate
High inflationCurrency depreciates
High interest rateCurrency appreciates
High income levelCurrency depreciates
Strong government controlRate becomes stable
Positive expectationsCurrency appreciates

Modes of Payment in International Trade

When countries trade internationally, payment must be arranged securely. The method chosen depends on trust, risk, and trade relations between buyer and seller.

1. Advance Payment (Prepayment)

  • The importer pays before shipment of goods
  • Risk: High for the importer; safe for the exporter
  • Used when: Buyer's creditworthiness is uncertain

2. Open Account

  • The exporter ships goods first, and the buyer pays later after receiving them
  • Risk: High for exporter; safe for importer
  • Used when: Long-term trade relationship exists

3. Documentary Collection (Bill of Exchange)

  • The exporter's bank sends documents (invoice, bill of lading, etc.) to the importer's bank for payment
  • Payment is made when the importer accepts the bill
  • Moderate risk for both parties

4. Letter of Credit (L/C)

  • A bank guarantees payment on behalf of the importer once the exporter fulfills shipment terms
  • Safest and most popular method in international trade
  • Low risk for both buyer and seller
  • Example: Nepali exporter receives payment from the bank after sending goods to a buyer in Japan under a confirmed L/C

5. Consignment Basis

  • Exporter ships goods to the importer (agent), who sells them and later remits payment
  • Risk: High for exporter; common in trusted partnerships

6. Countertrade / Barter

  • Payment is made in goods or services instead of cash
  • Used between countries with foreign exchange shortages

Summary of Payment Modes

Mode of PaymentMain FeatureRisk for ExporterUsed When
Advance PaymentBuyer pays before shippingVery LowBuyer not trusted
Open AccountGoods shipped before paymentVery HighTrusted buyer
Documentary CollectionPayment via banksModerateMedium trust
Letter of Credit (L/C)Bank guarantees paymentVery LowCommon, safe
ConsignmentPayment after saleHighOngoing relationship
CountertradeGoods for goodsVariableFX shortage

Key Takeaways:

  • Exchange rates are mainly influenced by economic conditions and market expectations
  • In international trade, the mode of payment depends on the level of trust and risk between trading partners
  • The Letter of Credit remains the most reliable and secure method of payment globally