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International Financial Management
World as a Global village
Free flow of goods and services –seamless
Quantum jump in International trade and
New forms of trade-Internet,e-commerce
Dynamic and Complex International markets
International Financial Management
International Financial Environment
Natural sequel to International trade
Financial Management- Integral part of Trade
and commerce
Technology and its Impact
New funding techniques,Investment
Vehicles,Risk Management products etc.
Creative Financial Management
Financial Engineering!
International Financial Management
International Financial Environment-contd
Challenges before a Finance Manager
Keep up to date with the the changes in the
Economic Environment-eg exchange
rates,Banking and Tax regulations,Foreign
trade policies,credit conditions at home and
abroad,stock market trends etc.
Complex relationships between various
variables eg, impact of changes in the world
financial markets and its effects on the firm
and its bottom line and cash flows
International Financial Management
Challenges before a Finance Manager-contd
To be prepared to face adverse business
conditions affecting the Financial Position of
the Firm and minimize its adverse impactBusiness decisions going wrong due to
changes in assumptions,changes in market
conditions beyond control etc
Design and Implement effective solutions to
take advantages of the markets and advances
in Financial theories –Upgrading skills and
using new tools of Financial Management,use
of latest technology etc.
International Financial Management
Roles and Goals of MNCsRaw materials seekers-Vertical Integration
eg French,Dutch and British East Indian
Today they are large Oil and Gas companies eg
BP,Shell,Indian cos Mittal steel etc
Mineral companies like Anaconda copper
International Nickel etc
Goals-exploit availabilty-cost advantages
International Financial Management
Roles and Goals of MNCs- contd
Market seekers-Typical MNCs of Today-they
go overseas to manufacture and sell in
overseas markets eg IBM,unilever,coca
cola,Pepsi, Procter and Gamble,Nestle etc
Goals-Maximize businsess
opportunities,Maximize profits,to beat
perceived or real trade restrictions,eg Japan
investing in US to avoid export restrictions in
International Financial Management
Roles and Goals of MNCs-contd
Cost Minimisers•
Again very common today –companies seek
and invest in low cost countries,e.g.
BPO/KPO in India,Texas
Instruments.Japanese Consumer Electronic
companies in Malaysia,China etc.
Goals-To remain competitive in the Domestic
and world market,utilize Economies of scale.
International Financial Management
Exposure to International RisksExposure and Risk•
Exposure is the measure of the sensitivity of
the value of a Financial Item,viz
Asset,Liability,Cash Flow,to changes in the
risk factor
Risk is the quantifiable likelihood of loss or
less-than-expected returns. It is a measure of
the variability of the value of the item
attributable to the the risk factor.
International Financial Management
Exposure to International Risks1. Macroeconomic Environmental Risks-Value of
a Firms Assets,Liabilities and Operating
Income varies continually in response to
changes in the economic variables such as
Exchange rates,Interest rates,Inflation
rates,prices and so forth.
2. Core Business risks-Interruptions to Raw
material supplies, labor troubles,success or
failure of a new product,operational risks
International Financial Management
Exposure to International Risks
3)Systemic Risks-Collapse of a Financial system-eg
Stock market crash,Run on Banks etc
4)Currency Risks-also known as FE risk- A risk that a
Business operation or an Investment value will be
affected by exchange rates fluctuations.
5)Liquidity Risk-The risk that arises from the difficulty
of selling an asset. An investment may sometimes
need to be sold quickly. Unfortunately, an insufficient
secondary market may prevent the liquidation or limit
the funds that can be generated from the asset. Some
assets are highly liquid and have low liquidity risk eg
Shares.Some assets have low Liquidity and high
liquidity risk eg Real estate property
International Financial Management
Exposure to International Risks-contd
6)Market Risk-Risk which is common to an
entire class of assets or liabilities. The value of
investments may decline over a given time
period simply because of economic changes or
other events that impact large portions of the
7)Interest rate risk-Interest rate risk is due to
the rise or fall in the Interest rate of a Security
or Bond held as well the market value of the
fixed rate bonds
8)Political Risk-change in
government,unstable government eg Projects
in Iraq,Ethiopia etc.
International Financial Management
Transaction Exposure-arises due to exchange
differences in transactions-Unanticipated
changes in the exchange rate has an impactfavourable or adverse on its cash flows.It is
usually within the year.
Eg-An Indian company imports Raw materials from a
US company valued at usd100000,payable after 3
months.If it pays at today’s rate it would have paid
@Rs 45 to a dollar.As the rupee is weakened the rate
goes upto Rs 46 to a dollar within 3 months.It has to
pay Rs 100,000 more.
International Financial Management
Translation exposure-is the change in accounting
Income and Balance Sheet statementscaused
by by the changes in exchange rates.It results
from the need to translate foreign currency
assets /Liabilities into local currency while
preparing final accounts.
Eg-an Indian company borrows usd 1 million from a
us bank for importing a machine. When the import
materialized,the exchange rate was Rs 45 to a usd.The
value of the machine in the books as on that date
would be Rs 45 million(Rs 4.5 crores) and a
corresponding loan of Rs 4.5 crores. (contd)
International Financial Management
Assuming no change in the exchange rate,the company
while preparing the final accounts will provide for
depreciation on 4.5 cores ,say @25%=Rs1.125crores.
If the rate of exchange as on the Balance sheet date becomes
Rs 46 to a dollar,then correspondingly the figures of
Machinery value ,the loan taken and the depreciation
to be charged also get changed.It impacts both Pand L
Account and the Balance sheet.However there is no
direct impact on the Cash flows immediately.
International Financial Management
Economic exposure-refers to the change in the
value of a company that accompanies an
unanticipated change in exchange
rates.Anticipated changes are already reflected
in the market value of the company.
Eg-when an Indian company transacts business with an
American company,it has expectation that the Indian
Rupee is likely to weaken and factors this in its
transactions.If there is a weakening of the rupee it will
not affect the market value of the company.In case it is
different from the expected ,then it will have a bearing
on the Market Value of the company.
International Financial Management
Economic Exposure-has two components
Operating exposure-which captures the impact of the
unanticipated changes on the company’s
revenues,operating costs and operating net cash flows
over a medium term horizon-say 3 years-something
similar to Transaction exposure(TE) but longer than
TE. In general an exchange rate will affect both future
revenues as well as operating costs and also the
operating Income2.
Strategic exposure-In the long term,exchange rates
effects can undermine the company’s competitive
advantage by raising its costs over its
competitors.Such competitive exposure is also
referred to as Strategic exposure eg Japanese goods
becoming expensive due to yen becoming stronger
and hence strategically shifting production bases out
of Japan.
International Financial Management
Important Terms used in International Finance
Exchange control-mechanism by which the country
regulates its foreign exchange transactions.RBI in
India regulates the entire FE movement into and out of
Authorized Dealers-are those authorized to deal in FE
by RBI eg,Banks.they can buy and sell foreign
currencies,open LCs ,remit FE, open accounts abroad.
Letter of credit-is a document issued by the opening
bank (importer’s bank)to honor an exporter’s draft or
claim for payment provided the exporter has fulfilled
all the conditions stipulated in the LC.
Terms used in the operation of LC
Opening bank-The bank which opens the LC at the
request of the buyer.
International Financial Management
Beneficiary-The seller/exporter who sells goods to the buyer
and who will receive the proceeds of the LC.
Advising Bank-The correspondent Bank to whom the
opening bank sends the LC in the exporter’s country
who in turn send it to the exporter’s bank for further
process.It could be the branch of the opening bank
Confirming Bank-one who adds his confirmation to the LC
DP/DA-Drafts against payment and Drafts against
Acceptance-presents the draft on the Importer through
his bankers who in turn forward this draft along with
the documents to the importers’ bankers for payment
and releasing the documents.
International Financial Management
Balance of Payments-BOP of a country is a systematic
accounting record of all economic transactions
between the residents of A country with the Rest of
the WORLD.
BOP considers both Import and Exports of Goods and
Basic types of Economic Transactions
1)Purchase or sale of Goods or Services with a financial quid
pro quo-or a promise to pay.One financial and one
physical(one Real)
2)Purchase or sale of Goods or services in return for goods or
services-Barter system(Two Real)
3)Any exchange of Financial items,say purchase of Financial
securities and payment there for by cheque(two Financial
4)A unilateral Gift in kind(one real transfer)
5)A unilateral financial gift.(One financial transfer)
International Financial Management
Accounting Principles in BOPIs a standard double entry accounting record-Thumb rules to
All transactions which lead to an immediate or
prospective payment from the Rest of the
world(ROW) to the country should be recorded as
credit entries.The payments,actual or
prospective,should be recorded as the offsetting debit
Conversely,all transactions which result in an actual or
prospective payment from the country to the ROW
should be recorded as debits and the corresponding
payments as credits
International Financial Management
Accounting Principles in BOP-contd;
Payment received from ROW increases the
country’s foreign assets –either the payment will be
credited to a bank account held abroad by a
resident entity or a claim is acquired on a foreign
entity.Thus an increase in Foreign Assets must
appear as debit entry.
Conversely, a payment to the ROW reduces the
country’s foreign assets or increases its liabilities
owed to foreigners;a reduction in foreign assets or
an increase in foreign liabilities must therefore
appear as credit entries
International Financial Management
Accounting Principles in BOP-contd
A Transaction which results in an increase in demand
for foreign exchange is to be recorded as a debit entry
while a transaction which results in an increase in the
supply of Foreign exchange is to be recorded as a
credit entry.
Thus an increase in Foreign assets or reduction in
Foreign Liabilities ,because it uses up foreign
Exchange is a debit entry while a reduction in foreign
assets or an increase in foreign liabilities because it is
a source of foreign exchange now, is a credit
entry.Capital outflow-such as when a resident
purchases foreign securities or pays off a bank loan is
a debit entry while capital inflow such as a
disbursement of world bank loan is a credit entry
International Financial Management
Current Account-Imports and Exports of goods and
services and unilateral transfers of goods and
Capital Account-Under this are included
transactions leading to changes in foreign Financial
assets and Liabilities of the country
Reserve Account-In principle this is no different
from the capital account in as much as it also
relates to Financial Assets and Liabilities.However
in this category only “Reserve Assets” are
included.These are assets which the the monetary
authority of the country uses to settle deficits and
International Financial Management
India exports garments to USA worth
usd10000.The goods have been invoiced and will be
paid in USD.Payment will be effected by crediting the
account of India in USA.The balance in a foreign bank
is a foreign asset for India and liability for USA.India
will record the entry as;
-Good exported(current)
-Increase in claims from
Foreign bank (foreign assetcapital)
In the BOP of USA it will be the opposite.
International Financial Management
Example 2;India agrees to supply leather goods worth usd 5000 to
Saudi Arabia in return for CRUDE OIL equivalent to the
same amount .Both are current account transactions;Will be
recorded in India’s BOP as follows;
Goods Imports
Goods Export
In the BOP of Saudi Arabia it will be the opposite.
Example 3;SBI purchases securities issued by USA valued at usd
2000 and pays through its branch in the USA.Here it has
changed one foreign asset to another.The transaction is
capital in nature;
Increase in foreign Securities 2000
Decrease in Foreign bank account
International Financial Management
Structure of current Account in India’s BOPCurrent Account
Debits credits
1)Investment Income
2)employees compensation
International Financial Management
MERCHANDISE-In principle,merchandise covers all
transactions relating to movable goods where the
ownership is transferred from R to NR in the case of
exports and NR to R in the case of imports with some
Exports valued on FOB basis are credit entries.Data
for these items are obtained form the various forms
exporters fill up and submit to designated authorities
like STPI,Expocil,RBI etc.
Imports valued at CIF are the debit entries.
The difference between the total of debits and total of
credits appears in the “NET ‘column.This is the
Balance on Merchandise Trade Account,deficit or
surplus depending upon whether negative or positive.
International Financial Management
InvisiblesIncludes services such as transportation,Insurance
Payments and receipts for factor services,viz labour
and capital and unilateral transfers.
Credits under Invisibles consist of services rendered by
R to NR, Interest and Dividend Income earned by R
from their ownership of Foreign Financial Assets,cash
and gifts received in kind by R from NR.
The NET balance between the credit and debit entries
under the heads Merchandise ,Non-monetary gold
movements and Invisibles taken together as the
Current Account Balance.The Net balance is taken as
deficit if negative and surplus if positive.
International Financial Management
Structure of Capital Account IN India’s BOP1.Foreign Investments(a+b)
a)External Assistance
By India
To India
b) Commercial Borrowings(MT and LT)
By India
To India
C)Short term
To India
3.Banking Capital
a)Commercial Banks
4. Rupee Debt Service
5.Other capital
International Financial Management
Structure of ‘other Accounts”
1.Errors and Omissions
2.Overall Balance (Total of current,capital and
Errors and omissions)
3.Monetary movements
Foreign Exchange Reserves(increase /decrease)
Debit Credit
International Financial Management
Meaning of “Deficit” and “Surplus”
Deficit refers to the negative balance in the BOP after
giving effect to the various transactions and Surplus
refers to the positive balance in the BOP
It refers to the imbalance in subset of accounts
included in the BOP and also referred to as Economic
equilibrium or disequilibrium.Disequilibrium calls for
a policy Intervention,it is important to group the
various accounts in the BOP into set of Accounts
‘above the Line’ and “below the Line”.If the NET
balance is positive we say it is BOP surplus and if it is
negative then it is BOP Deficit.
BOP statistics are important for the Finance Manager.
If negative it will mean more demand for the Foreign
currency and will increase its cost and vice versa.
International Financial Management
Negative BOP can be corrected by increasing
taxes,reducing government expenditure,by increasing
savings and by reducing consumption.
BOP disequilibrium can be remedied by borrowing
from International Institutions like IMF which are
called Multilateral Borrowings or by Intergovernmental Borrowings called as Bilateral
FDI ,exchange control mechanism can also be
considered as a direct option for remedying the BOP
BOP can be classified as –Autonomous and
Accommodating.Autonomous Transaction takes place
due to Import and export of goods and
services.Accommodating transaction (compensatory
transactions) means borrowing to rectify Current
account deficit.
International Financial Management
Importance of BOP statistics
BOP statistics reflect the Economic Performance of the
country and contains useful information for financial decision
matters. Eg USA BOP statistics announcement immediately
reflects on the USD rate.
When exchange rates are market determined BOP statistics
indicate excess demand or supply for the currency and the
possible impact on exchange rate.
It may signal a policy shift on the part of the monetary
authorities of the countries unilaterally or in concert with its
trading partners.It may force exporters to realise their export
earnings quickly and bring the foreign currency home.
BOP accounts are intimately connected with the overall
saving-investment balance in a country’s national
accounts.Continuing deficits or surpluses may lead to fiscal
and monetary actions designed to correct the imbalances
which in turn will affect the Interest rates and FE rates in the
International Financial Management
International Monetary Systems-Introduction
Gold standard- Initially there was a Gold standard system which
started in 1814 in UK and 1870 in the USA.Under this each currency
derived its value from its GOLD content.Was used till the First world war
and a few years after that. Two versions-Gold Specie standard and Gold
Bullion standard.
Gold specie standard –The actual currency in circulation consisted of Gold
coins with a FIXED GOLD CONTENT.
Gold Bullion standard-The basis of money remains a fixed weight of Gold
but the currency in circulation consisted of Paper Notes with the
authorities standing ready to convert on demand,unlimited amounts of
paper currency into gold and vice versa at a fixed conversion ratio.
Under the Gold Exchange Standard the authorities stand ready to
convert,at a fixed rate, ,the paper currency issued by them into the paper
currency of another country which is operating a Gold species or Gold
Bullion standard.
The exchange rates between any pair of currencies will be determined by
their respective exchange rates against Gold.
International Financial Management
BRETTON WOODS SYSTEMFollowing the 2nd world war,the main allied powers USA and UK took up the task of
thoroughly revamping the International Monetary system.In 1944 in a place called
Bretton woods in New Hampshire,USA ,2 new supra National Institutions were
formed which are very much active today in the International Financial Arena, viz
World Bank
International Monetary Fund.
The exchange rate that was put in place can be characterized as the Gold Exchange
It had the following features;
The US govt undertook to convert the USD freely into Gold at a fixed PARITY of
usd 35 per ounce of gold.Other IMF member countries agreed to fix their currencies
vis a vis the dollar within a variation of 1% on either side of the central parity being
Under this system the USD in effect became International money.Other countries
accumulated and held USD balances with which thy could settle their international
This system was abandoned in 1973 .
International Financial Management
WORLD BANK(WB)-is a vital source of Financial & Technical assistance
developing countries around the world.WB representing a membership of 185
countries has 2 unique development InstitutionsIBRDA- International Bank for Reconstruction and Development.
IDAInternational Development Association
Aim of WB- Global Poverty Reduction
IBRDA- focuses on middle Income and creditworthy poor countries
IDA- focuses on the poorest countries upliftment and growth in projects like
drinking water,road construction, etc.
Together WB provides-Interest free loans,Interest free credits,Grants to developing
countries for education,health,infrastructure,and many other alleviation causes.
ADB- Asian development bank-was set up as an Asian version of the world bank to
provide development finance to countries in Asian Region .It’s HQ is
IFC-Is a member of the WB GROUP. It helps private sector projects in developing
countries in the form of giving direct assistance,underwriting issues,undertaking
feasibility studies for projects,.It also acts as a guarantor for any lending to PVT
sector and develops capital markets in the countries.
International Financial Management
IMF-International Monetary Fund.- mandated to exercise firm surveillance over
the exchange rate policies of its memeber.and to help assure orderly exchange
arrangements and to promote a stable exchange rate .The responsibility for
collection and allocation of reserves was given to IMF under the Bretton woods
arrangement.It was also given the responsibility of ;
supervising the adjustable Peg system
Rendering advise to member countries on their international monetary affairs
Promoting research in various areas of international economics and monetary
Providing a forum for discussion and consultations among member nations.
-The initial quantum of reserves was contributed by the members according to quotas
fixed for each.Each member country was required to contribute 25% of its quota in
Gold and the rest in its own currency.Thus the fund began with a pool of currencies
of its members.The quotas decide the the voting powers and maximum amount of
financing its member countries can get within the policy making bodies of IMF.
Since 1980,IMF has been authorized to borrow from capital markets.
-IMF established contingency reserve to tide over temporary BOP problems,while
structural Reserve was established to tide over structural BOP problems.Countries
with chronic BOP problems were allowed to depreciate their currencies. It has
played an important role in tackling the debt crisis of developing countries.
International Financial Management
Exchange rate regimes;current scenario1)Exchange arrangements with No separate legal tender-This group includes
Countries which are members of a currency union and share a common currency
eg European union., who have adopted Euro as their currency since1-1-1999 and
have fixed their currency on parity with the Euro on that date.(11 members have
adopted this)
Countries which have adopted the currency of another country as theirs.eg,East
carribean common market viz, Grenada,Antigua,,St Kitts,Nevis. And countries
belonging to the central African Economic and Monetary union eg
Cameroon,central African Republic.These countries have adopted the French
Franc as their currency.
2)Currency Board Arrangement-A regime under which there is a legislative
commitment to exchange the domestic currency against a specified foreign
currency at a fixed exchange rate.,coupled with restrictions on monetary authority
to ensure that commitments will be honoured. Eg Argentina, Hong Kong have
tied their currency with USD.( 8 members have adopted this )
3)Conventional Fixed Peg Arrangements-This is similar to Bretton woods system
where the currency is pegged to another currency or a basket of currencies with a
band of +/- 1% around the central parity.( 44 members have adopted this )
International Financial Management
Exchange rate regimes;current scenario4)Pegged Exchange rates with Horizontal bands-Here there is a peg but variation has
with wider bands.It is a compromise between a fixed peg and a floating peg.(8
countries have adopted this)
5)Crawling peg-This is another variant of a limited flexibility Regime.The currency is
pegged to another country or a basket of currencies but the peg is periodically
attached.(6 countries have adopted this)
6) Crawling Bands-The currency is maintained within certain margins around a central
parity which crawls as in the crawling peg regime(9 countries have adopted this)
7)Managed Floating-with no pre announced path for the Exchange rate-The central bank
influences or attempts to influence the exchange rate by means of active
intervention in the FE market.-buying or selling foreign currency against the home
currency without any commitment to maintain the rate at any particular level or
keep it on any pre announced trajectory(25 countries have adopted this)
8)Independently Floating-The exchange rate is market determined with central bank
intervening only to moderate the speed of change and to prevent excessive
fluctuations but not attempting to maintain it t at or drive it towards any particular
level(48 countries including India have adopted this)
It is therefore clear that post 1973 a wide variety of arrangements exist
International Financial Management
International Trade organizations=
1)GATT-General Agreement on Trade and Tariff was constituted in
1947 to facilitate free trade.The main objectives of GATT are;
Progressively reduce Tariff rates
Extend Most favoured Nation status treatment to all members
Remove quantitative restrictions and
Free exchange control on current account transactions
Several rounds of discussions were held -Geneva,Kennedy,Tokyo
and Uruguay Rounds
It did not take into consideration trade in services and Intellectual
International Financial Management
2)WTO-World Trade Organisation-was constituted in 1995.Unlike
GATT is permanent in nature.Apart from trade and services ,it also
deals with Trade related aspects of Intellectual Property
rights(TRIPS) wherein issues regarding copyright,Patents,Industrial
design Trademark are dealt with.In trade related aspects of
investment management (TRIMS),discrimination against Foreign
Investments in the form of restrictions,discriminatory taxation are
dealt with.
Various objectives of WTO include implementation
administration,and operation of all multilateral trade disputes
administration and operation of trade agreements,administration of
rules governing settlement of trade disputes,trade policy review
mechanism and providing a forum for discussion between members.
3)UNCTAD-United Nations council for Trade and Development
(UNCTAD) has been constituted to facilitate International trade.The
first meeting was held in Geneva in 1964 and attended by 120
countries.Its main aim was to reduce trade barriers in developed
countries and through increased access to their markets,improve
standard of living in developing countries
International Financial Management
Global Financial Markets
Provide a forum where the currency of one country is traded for the currency of
Deal with large volume of funds as well as a large number of currencies(of different
London,New york, and Tokyo are the nerve centres of FE
activity.Frankfurt,Bahrain,Singapore are also very active in the 24 hour activity of
the FE markets.
The large Central/ Commercial/Investment banks are the principal participants in the
FE markets.In general,business firms do not operate on their own but buy and sell
through a commercial Banks who are also called “authorised dealers”.
Commercial banks deal in FE markets for commercial reasons where as Central
banks in all countries are regulatory in nature .Central banks (RBI in India)maintain
the exchange rate of the domestic currency in tune with the requirements of the
national economy and government policy.They regulate the FE transactions in order
to avoid volatility(sudden upward or downward movement) of the domestic
Most of the trading in the FE markets take place in the major currencies like
USD,GBP,DM,YEN,EURO,FF,etc .There is an active market for these currencies as
there are a large number of buyers and sellers willing to execute FE dealings in these
currencies.Now a days,FE dealings primarily take place through using
technology,telephone,fax etc.and therefore does not have a geographical relevance. 42
International Financial Management
Global Financial Markets
Domestic and Offshore Markets•
Financial Assets and Liabilities denominated in a particular currency,say USD,are
traded in the National Financial Markets of that country.In addition,in the case of
many convertible currencies,they are traded outside the country of that currency.Thus
bank deposits loans,Promissory Notes,Bonds denominated in USD are bought and
sold in the US money and capital markets such as New York as well as the Financial
Markets in London,Paris,Singapore and Tokyo.The former is the Domestic market
while the latter is the Off shore market.
Domestic markets are usually subject to strict supervision and regulation by relevant
National Authorities.,like SEBI,Federal Reserve Board in the US,MOF in Japan,SEC
in the US . Domestic banks are also regulated by the concerned monetary authorities
and may be subject to Reserve Requirements,capital adequacy norms etc.
Off shore markets ,on the other hand,have minimal regulation,often no registration
formalities and importance of rating varies
However in the recent years with the removal of barriers and increasing
integration,authorities have realized that regulation of financial markets and
Institutions cannot have a narrow national focus-To minimize the problem of systemic
risks banks and Firms must be subject to norms and regulations that are common
across countries. eg Basel Accord.
International Financial Management
Euro markets
Prior to 1980Eurocurrncies Markets was the only International Financial Market of any
significance.It originated in the 1950s with the Russian authorities seeking dollardenominated deposits with banks in Britain and France as the erstwhile USSR thought
that the US might freeze its dollar accounts if kept in the US.
“Eurocurrency”Deposit is a deposit in the relevant currency with a bank outside the
home country of that currency.Thus a US Dollar deposit in a London Bank is a
Eurodollar Deposit and Deutschemark Deposit in a bank in Luxembourg is a Euro
mark Deposit.
Thus a dollar deposit belonging to an American company held with a Paris subsidiary
of an American Bank is still a Eurodollar deposit.
Main features of such deposits;
As these deposits are kept outside the country of the currency,monetary authorities
could not place any restrictions on the issue of such currencies like Reserve
requirements,withholding tax for foreign borrowers,deposit insurance requirements,
other restrictions placed by the monetary authorities etc were .not applicable to such
deposits as they were not under the purview of the MA.
Absence of restrictions made the deposits attractive not only to the depositors but also to
the banks.Such deposits were parked in developing countries debt at attractive returns
without paying much heed for credit risk ratings, (which ,in fact ,led to the Latin
American debt crisis).
International Financial Management
Euro deposits -contd
The prefix Euro is outdated now as such deposits and loans traded outside Europe .For
instance,in Singapore and Hong Kong.They are called Asian Dollar Markets.
Over the years markets have evolved a variety of Instruments other than Time deposits
and short term loans.Among them are(a) certificates of Deposits(COD) (b)Euro
commercial paper©Eurobonds(d)Floating Rate Notes etc.
In 1999,single currency Monetary union was formed.It is a unique integration of
currencies without political integration .It challenged the USD in as much as trading is
done in Euro as much as in USD and the EU has adopted this currency for trading and
holding deposits.
ECONOMIC IMPACT OF EURO MARKETS -Perceived Advantages of Euro Markets;
1)More efficient allocation of capital world wide(2)Smoothing out the effects of sudden
shifts in Balance of Payments,eg oil crisis in 1973and recycling of petrodollars without
which a large number of oil importing companies would have to face severe crisis.(3)The
spate of financial innovations that have been created by the market which have vastly
enhanced the ability of companies and governments.to manage their financial risks.
Perceived Disadvantages of Euro markets;(1)Market stabilization is difficult for Central
banks as the so called ‘hot Money’-Speculative capital flows is facilitated(2)National
Monetary authorities lose effective control over monetary policies as Domestic residents
can frustrate their efforts by borrowing or lending abroad.(3) Euro markets create ‘private
International Equity”and in the absence of a central coordinating authorities they could
create”too much”contributing to inflationary tendencies in the world economy.
International Financial Management
Market in which currencies are bought and sold against each other.It is the largest
Market in the world.
Largest volume of Trade-estimated over USD per day1 trillion and during peak
volume it touched USD 1.6 trillion.
FE market is an over-the –counter market.This means that there is no single physical
or electronic market or an organized exchange like a stock exchange with a central
trade clearing mechanism where traders meet and exchange currencies.
It is virtually a 24 hour market because it cuts across TIME ZONES.From Tokyo to
New York ,it works through out the day and night and hence the huge volumes.
1)Retail market- This is the market where tourists and travellers exchange one
currency for another in the form of currency notes or travellers cheques.The total
turnover and average transaction size are very small.The spread between buying and
selling is large.They are secondary Price Makers because they do not have a 2 way
transaction .eg Restaurants,Hotels ETC.
International Financial Management
FOREIGN EXCHANGE MARKETS2)Wholesale Marketoften called the Inter Bank Market.Major categories of participants are(a) Commercial
banks(b)Investment Institutions©Central Banks.
The average size of the transaction will be very large,e.g. the average size of transaction
in the US market is around USD 4 million and many transactions even larger .
Among the Participants in this are-Professional dealers or Primary price makers who
make a 2 way quote to each other and to their clients- a price to buy currency X against
currency Y and a price to sell X against Y.This Group consists of mainly commercial
banks ,large Investment Institutions,and a few large corporations and MNCs. A dealer
will sell USD against Euro to one corporate customer,carry the position for a while and
offset it by buying USD against Euro from another customer or dealer.Meanwhile,if the
price has moved against the dealer he bears the loss.
Eg,The dealer might agree to buy Euro by selling USD,at a rate of USD 0.9 per
Euro,and by the time he covers his position,the market may have moved ,so that he must
acquire the Euro at a price of USD 0..87 per Euro.if the transaction is for USD 1
Million ,the loss he will undergo will be USD 30000.
Foreign Currency Brokers act as middlemen between the two Price makers.They do not
buy or sell on their Account but act as brokers to get information about customers
willing to buy or sell and from whom they will get their commission.They tend to
possess a lot information because their of proximity to the customers regularly.
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3)Finally there are Price Takers, who take the prices quoted by Primary price makers,and buy
or sell currencies for their own purposes.eg,Large corporations buy or sell FE for their own
operations viz,Imports,Exports,payment of interest,hedging etc.Most of the companies deal in
FE only limited to their transactions.But some MNCs and trans national companies use their
knowledge and expertise to trade in FE and make profit out of the FE markets.
Central Banks intervene in the market from time to time ,to attempt to move exchange in a
particular direction or to moderate excessive fluctuations in the exchange rates.
Types of Transactions and Settlement Dates;
Value Date-A settlement of transaction takes place between two parties by transfer of
Deposits between two parties..The date on which the transfer takes place is called the
settlement date or Value date .The locations of the 2 banks involved in the Trade are called
Dealing locations which may not be the same as the settlement locations..The relevant
countries are called Settlement Locations.Obviously,to effect the transfers,banks in the
countries of the transfer ,banks in both the countries must be open for business.
For example-A London Bank can sell Swiss Francs against USD to a Paris Bank .The
settlement locations may be New York and Geneva while Dealing Locations are London and
Paris.The transaction can be settled only on a day on which both the US and Swiss banks are
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Value Dates for Spot Transactions- In a spot transaction,the Settlement or Value
Date is usually 2 business days ahead for the European currencies or the Yen traded
against Dollar.Thus if a London Bank sells yen against Dollar to Paris Bank on
MONDAY,the London Bank will turn over a Yen deposit to the Paris Bank on
WEDNESDAY and the Paris bank will transfer a dollar deposit to the London Bank
on the same day.If the value date is a bank Holiday it is considered as he next working
day.The settlement date is reduced to one day if the pairs of currencies are USD and
Canadian Dollar or Mexican Peso.
Value Dates for Forward Transactions-In a one month Forward Purchase of say
,Pounds against Dollar,the rate of Exchange is fixed on the transaction date;the value
date is arrived at as a follows-For a one -month forward value date is on say June
20,the corresponding spot Value date is June 22 and one-month forward value date
is July 22 and 2 months forward value is August 22.
A swap transaction in the Foreign Exchange market is a combination of SPOT
AND A FORWARD in the opposite direction.Thus a bank will buy Euros spot against
USD and simultaneously enter into a forward transaction with the same counterparty
to sell Euros against USD.As the term Swap implies .It is a temporary exchange of
one currency for another with an obligation to reverse it at a specific future date.
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TOM RATES-In the case of TOM rates,the value date is one day after the
transaction instead of 2 days as in spot rates.
READY RATES-In Ready rates transactions,the value date is the same as that of
the Transaction date.
CARD RATES- are rates quoted for a Retail customer,while for corporate
customers or wholesale customers, Bulk special rates are quoted.Card Rate is not
an Exchange rate but an approximate rate.
Buying Rate is called as a BID rate, and the selling rate is called as ASK rate.
currencies A and B is simply the price of one in terms of the other.
The ISO has given a 3 letter codes for all the currencies.They are as follows;
USD –US Dollar, GBP-British Pound , JPY-Japanese Yen , CAD-Canadian
DEM-Deutschmark,NLG-Dutch Guilder,FRF-French Franc,ESP-Spanish Peseta,
INR-Indian Rupee,EUR-Euro,IEP-Irish Pound,CHF-Swiss Franc,ITL-Italian Lira,
AUD-Australian Dollar,SEK-Swedish Kroner,BEF-Belgian Franc,DRK-Danish
Kroner,SAR-Saudi Riyal etc.Other Important currencies are-South Korea-Won,
Indonesia-Rupaiah, Malaysia-Ringet,Singapore-Dollars,South AfricaRand,Russia-Rouble etc
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FOREIGN EXCHANGE MARKETSExchange Rate quotations-Direct and Indirect quotations-A FE quotation can be Direct or
Direct when it is quoted/expressed in a manner that reflects the exchange of a
specified number of domestic currency vis- a-vis one unit of a foreign currency.
Eg,Rs 46=1 USD is a direct quotation in India .(European quotation)
Indirect quotation is when it is quoted to reflect the exchange of a specified number of
foreign currency vis a vis unit of a local currency
Eg usd.0.2083=Re1.IS Indirect quotation India(American quotation)
SPREAD- is the difference between the Ask Price and the Bid Price
Illustration for Spot and Forward rate contractAn exporter exports Goods valued at USD 100 Million. On 6 months credit on 1st
February 2007. And also enters into a Forward rate contract for Rs 49 to 1 USD.By
entering into such a contract the exporter is assured of receipt of INR 4900 million on
1st August on which date the amount actually becomes payable,irrespective of the spot
rate on that date.If he had not taken this forward cover,and if on that date ,the INR had
become Rs 48 to 1 USD,he would have got only INR 4800 million only where by he
would have lost INR 100 million.By taking forward cover he has saved INR 100
million .In other words he has gained INR 100 Million.If the spot rate has become INR
46 ,still the Exporter can get the agreed rate of Rs 49 to 1 usd.
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Cross Rates-When a direct/quote rate of the home currency or any other currency is not
available in the forex market, it is computes with the help of of exchange rates of
other countries,it is termed as Cross Rates.
eg An Indian Importer imports Farm eggs from New Zealand and is not able to get
a quote for purchasing NZ dollars.The transaction has to be routed through USD.It
will become INR—USD---NZD.
The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate)
INR/USD ;48.0465(buying rate)-48.211(selling rate)
Determine the exchange rates between INR and NZD ;
Steps; 1)The Indian importer has to buy USD at the rate of INR 48.2111(when
USD is bought by the Importer,the dealer(bank)is selling USD and hence 48.2111is
the relevant rate,as the dealer (bank)sells the USD to the Importer.
2)The Indian Importer then SELLS the USD to the dealer(bank).The
dealer BUYS the USD at the buying rate of USD1 =NZD 1.7908.
3)Which means,the Indian Importer get NZD1.7908 in exchange for
INR48.2111. And the Exchange rate is determined as- INR 48.2111/1.7908 which is
equal to INR 26.9215 per NZD.Thus INR26.9215 per NZD is the “Cross “Rate
derived from two sets f rates,which is the selling rate for the currency.
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To complete the quote the buying rate also needs to be established and given by the dealer
using the rate chart;.
The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate)
INR/USD ;48.0465(buying rate)-48.211(selling rate)
The buying rate for INR /NZD would be worked out as follows;
a)The dealer purchases 1 USD for INR 48.0465
b)The dealer sells 1USD in exchange for 1.8510 NZD.
c)NZD 1.8510 IS equivalent to INR 48.0465.
Therefore the buying exchange rate would be INR 48.0465/1.8510 which would be Rs
The dealer will quote INR/NZD :25.9571(buying rate)-26.9215(selling rate).
This means that the dealer would buy NZD at Rs 25.9571 and sell at Rs26.9215
Arbitrage Process as a means of Attaining Equilibrium on Spot markets;
The term Arbitrage in the context of Forex Markets refers to an act of buying currency in one
market (at lower price ) and selling it in another market(at higher price).Thus the
difference in Exchange rates (in a specified pair of currencies)in two markets provide an
opportunity to the dealers /Arbitrageurs to earn profits without risk.As a result ,Equilibrium
is restored in the exchange rates of currencies in different Forex markets.
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Gains from International capital flows;
Transfer the savings to investors worldwide so as to maximize productivity of
Investment.Savers in capital- rich counties,if confined to investment to their own
countries will not be able to get optimum returns.conversely if investment projects in
capital-poor countries must be financed only out of domestic savings,many high
yielding projects would have to be shelved due to shortage of funds.
A particular country may face temporary shortage in National income due to some
special adverse circumstances.It cannot borrow internationally and is unwilling to
curtail investment it must sharply cut down consumption expenditures.During years of
extraordinary prosperity if it cannot invest abroad,it will be under utilizing its
capital.International lending and borrowing permit people to achieve a smoother
consumption profile.Overall welfare would be greater with cross border capital flows.To
day in the era of Globalization cross border investments are so common.In fact India n
companies are investing very big in Foreign companies that the movement has become
two- way rather than one way.
FOREIGN DIRECT INVESTMENT;(FDI)One of the most important vehicle of
cross border investment has been FDI.Production and distribution of goods and services
has been globalised on an unprecedented scale during the preceding 4 decades..Along
with the emergence of of MNCs, JVs,technology licensing franchising,management
contracts,production sharing ,Rand D alliances have all made this possible.The theory
of ABC viz A for Aid ,B for Borrowing and C for Capital has come to stay.
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The Essence of the Arbitrage process is to buy currencies from Markets where prices
are lower and sell in markets where prices are higher..In operational terms the Arbitrage
process is essentially a balancing operation that does not allow the same currency to
have varying rate in different Forex markets on a sustainable basis.
1)Geographical Arbitrage;As the name suggests the ,Geographical Arbitrage consists of
buying currency for one Forex Market (say London) and where it is cheaper and sell in
another Forex Market( say Tokyo) where it is costly.Because of Technology,
geographical divide is not an issue today.
2) Triangular Arbitrage ;As the name suggests ,Triangular Arbitrage takes place when
there are currencies involving 3 markets.
The concept of the arbitrage process is equally applicable in forward markets.In the
case of Spot markets,mismatch between cross rates and quoted rates provides an
opportunity for arbitrage gains.Similar arbitrage gain possibilities exist in Forward
markets also.In case the difference between the forward rate and the spot rate (in terms
of premium or discount)is not matched by the interest rate differentials of the 2
currencies.Conceptually,interest rate differentials of the 2 currencies should be equal to
to the forward premium or discount on their exchange rates.Since the comparison is to
be made with Interest rate differentials,this is also referred to as “covered Interest
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Terms used in Foreign Exchange Market Dealings
SWIFT-Communications Pertaining to International Financial Transactions are
handled mainly by a large Network called “Society for worldwide Inter bank
Financial Telecommunication “-SWIFT. This is a non profit Belgian cooperative
organization with main and regional centers around the world connected by Data
Transmission lines.Depending on the location, a bank can access a regional
processor or a main center which then transmits to the appropriate information to
the appropriate location.
REUTERS- is a London based organization established in the year 1851.It
established the first Electronic Trading Screen which gives real time quotes based
on which trading in currencies take place.
TELRATE- is an American organization established in 1969 to deal in screen
based trading for Foreign Exchange.
CHAPS-Clearing House for Automated Payment system (chaps)is a UK based
Electronic payment System
CHIPS-Clearing House for Inter bank payment system (chips) is a US based
electronics payment system.
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Terminology used in International Trade and Finance•
Types of Lcs
a)Irrevocable LC-- Irrevocable LC is one which cannot be revoked or cancelled
without the consent of the beneficiary.This form LC is generally used by Importers
and Exporters as this gives more security to both the parties.
b)Confirmed LC-- is a LC which is confirmed by a third bank other than an
opening bank and the negotiating bank.Sometimes the beneficiary wants the LC of
buyers bank to be confirmed by a bank in his country.This process is called as
confirmation.It means that the confirming bank undertakes that in the event of
proper presentation of documents as required under the LC, it will make payment
irrespective of the fact whether the buyer’s bank reimburses the same or not.It
charges its commission for confirmation.
c)Transferable LC—In Transferable LC,the buyer can transfer a part of the value
of LC or the full value of LC in favour of one or more beneficiaries.Transferability
should be expressed specifically in the LC.Since the buyer relies on the integrity
of beneficiary,transferability in favour of someone unknown has some risks
.Normally Transferable LCs are taken by middlemen who do not want to the buyer
and seller to know each other and also want to make a margin without both the
parties being aware of the same.Usually transferability in several lots is possible
but the transferee again transferring the credit is not possible.
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Types of Lcs;
d)Back to Back LCs—In back to back Lcs,Beneficiary's banks open several LCs within
the value of the mother LC.This is also known as countervailing LCs..The terms and
conditions of the second LC are exactly the same as that of the first LC.The second LC
may be a Domestic LC.Any change is the second LC is possible only when the opener
of the original LC agrees to such a change in the mother LC.
e)Red clause LC—In Red clause LC,advance payment is provided against the supply
of certain documents like drawings and manufacturing schedule as mobilization
advance for manufacture of capital goods whose manufacturing cycle time is high.The
Advance payment details are printed in RED thereby being called Red clause LC.
f)Green clause LC—In this type of LC,advance is provided against goods,which are
manufactured and kept in a warehouse for a buyer against warehouse receipt,before the
same is shipped.
g)Sight LC or DP LC—Sight LC or Document against LC means that as soon as the BE
of seller is presented to the buyer ,he should make payment for the same. And only
then the documents would be handed over to the buyer.Thus no credit is given to the
h)Usance LC OR DA LC –Usance LC or Documents against Acceptance means that
payment can be made after a particular period from presentation of Bill of Exchange
presented to him .By DA or Usance ,credit is given to the buyer.
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Advising Bank– Many times,LC received from buyer may be a forged one.If the
same is routed through a bank,it performs the function of advising whether the LC is
genuine or not.For doing this ,the bank charges a commission.
Negotiating Bank-- Since the Buyer’s bank opens the LC,payment will be made to
the seller only when the buyer’s bank receives proper documents as per the LC.This
will involve delay like the transit time involved in transferring the necessary
documents by the seller to buyer’s bank.Negotiating bank is a bank which is in
seller’s country and negotiates the document presented by the seller against the
LC.In the event of documents being proper,the negotiating bank credits the proceeds
to seller’s Accounts immediately,thereby avoiding the delay.For doing this the
negotiating bank charges a commission known as Negotiating commission.
Correspondent Bank—While a bank has to deal with many centers around the
world,it cannot afford to have branches in all those countries.It enters into
correspondent agreement with a bank operating in the centers, detailing the scope of
responsibilities and sharing of commission.Such banks are referred to as
Correspondent Banks.
UCPDC-Uniform Customs and procedure for documentary credit or UCDPC is
prepared by the International Chamber of commerce.,defining the responsibility of
buyer’s bank,Negotiating bank,confirming bank, Advising bank.All International LC
must bear an endorsement that they adhere to UCPDC 500
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NOSTRO ACCOUNT-The Account of a local bank maintained with a foreign
branch or correspondent bank is called as Nostro Account.It is opened to facilitate
remittances or credits into the banks account.
VOSTRO ACCOUNT—The Account of a foreign bank maintained with a
local bank or branch is called as Vostro Account.In this case all remittances
relating to the foreign bank by local banks are credited to the Vostro account.
INCO TERMS—are terms issued by the International Chamber of
commerce.,defining the meaning of various terms given above.If the international
Purchase orders are subjected to INCO terms there will be uniformity in
interpretation of various commercial terms.
PACKING CREDIT ---Packing credit is given for financing exports.It can be
classified as pre shipment -credit and Post –shipment credit.Packing credit is
given against an Export order or LC.Pre-shipment credit is given for procuring
materials,manufacture of goods,while post –shipment credit is given for financing
receivables out of exports.Packing credit is extended at any time and export
receivables are NOT subject to Maximum Permissible Bank
Finance(MPBF)requirements.Post shipment is generally given in the form of
discounting of export bills..
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Terms used in IFM•
Libor-Libor means London Inter Bank offered Rate.London is the premiere Financial
center in the world.LIBOR is a benchmark floating rate at which one bank is willing to
lend to another bank in inter –bank market.It is available for various tenors.Libor being
the premier financial rate ,this rate is used as a landmark rate in many lending
transactions.The quotes are generally Libor +or Libor – a certain percentage.
Forfaiting –is Export factoring.In Forfaiting,export bills are accepted by Importer as
well as by his bankers..Acceptance of such bills is by Importers banks is known as
Avalising and bank accepted BE is called AVAL.Such avalised Bills are discounted by
Forfaiting agency on non-recourse basis and proceeds are credited to exporters
account.Non recourse basis means that in the event of importers failure to make payment
,the loss will be borne by the forfaiting agency and will not be recovered from the
exporter.In India EXIM bank offers such facilities.
Transfer Pricing(TP)—Due to increasing Globalization and Integration of world
economy and transactions between different branches of subsidiaries,Transfer Pricing is
being increasingly resorted to avoid payment of taxes.To counter these all the
governments have resorted to taxing the transactions where they find that the TP is not
being done on an Arms Length principle.Prices are determined based on various methods
as follows;(1)Comparable uncontrolled Price method(CUP method).(2)Resale
method(3)Transaction Net Margin Method(4)Profit split method.The governments have
realised that MNCs and other companies with HOs outside their country resort to this
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Transfer Pricing-contd
The general Feeling is that these companies fix the prices with their Head Offices in
such a manner that the Transfer Prices are not Loaded enough with adequate Profit
Margin so much so that the end prices are much higher compared to the TP,which
means that for products /services originating in India, the actual profit accrues outside
the country.This is the Crux of TP legislation. Therefore the Governments all over the
world have sought to devise mechanisms to ensure that no undue advantage is taken by
companies while fixing prices between HO and subsidiaries.eg IBM doing a lot of
work in India and invoicing at a price which will not get the actual profit to the Indian
Subsidiary but to the HO.In India,TP legislation came into effect the years 2003 when
the Government introduced new provisions in the Income Tax Act .It has already
triggered a lot of litigation in the assessments .
1)TARIFF BARRIER;Countries levy customs duty to create barriers for import of
Goods into the country for various reasons.Thus by having high customs duty rates,
imports are discouraged.This could be a deliberate attempt on the part of certain Govts
to reduce consumption of certain types of goods.It could be to encourage indigenous
manufacture also.
2)NON-TARIFF BARRIER;Non Tariff Barriers could be in the form of restrictions
imposed by certain Govts,eg ,by way of quotas in Licensing.Restrictive agreements
like Multi-Fiber agreements for textiles also constitute one form of Non Tariff
Barrier.Sometime countries impose severe quality and environmental restrictions which
would amount to non trade barriers.
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3)Trade Barriers-Trade Barriers are formed by entering into bilateral agreements and giving
Most Favored Nation(MFN) statues to import from certain countries.Apart from this
,Free Trade zones, Customs Union,Common Market,Economic Union,Monetary
Union,Cartels which restrict free flow of International trade aslo come under
Barrier.Extreme form of Trade Barrier is Embargo.
4)Free Trade Zone;In Free Trade Zone goods move in the member countries without payment
of customs duty..Generally Free trade zones provide a lot of incentives for investment
by outsiders so that they attract investments.Eg Jebel Ali Free Trade Zone near Dubai
where investment is encouraged and has become one of the well known FTZs.The
climate for investments,the sops provided,the concessions provided,etc make these
zones a very good destination for investments by outsiders.
Protecting Infant and Domestic Industries.Eg,India imposed very high tariff barriers for
protecting its infant industry.This is cited as the main reason for poor quality of Indian
goods and lack of competitiveness in Indian Industry.
Revenue collection through customs Duty.Customs duty is very good source of
Revenue for any Govt.
To counter adverse BOP.Till early 90 Indian strategy was to stress for import
Substitution to set right the BOP deficit.thru deficit high tariff and non tariff
barriers.This led to illegal activities like smuggling .
To protect Local employment
For political reasons-Embargo in Iraq
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Theories explaining the need for International Trade;
1)Theory of Absolute Advantage; Adam smith propounded the Theory of “Absolute
Advantage”.In this ,labor was considered the only factor of production..For example ,one
country has absolute advantage in producing software and another in producing
Hardware.Both can increase their wealth by producing goods/services in which they have
absolute advantage.
2)Theory of Comparative Advantage ;David Ricardo expounded the Theory of “Comparative
Advantage”.As per this theory if a nation has absolute advantage over another nation in
producing both Software and Hardware,still they should produce that which gives them
Comparative Advantage and trade in them thereby increasing wealth.This increases
specialization .A good example is Software development in India.Because of highly
educated and Technically skilled labor force India has made a niche place for itself and
has been generating wealth which is ever growing .China/Taiwan is good in computer
Hardware and they have captured the world market in Hardware.
3)Heckshire Ohlin Model;This model says that countries rich in capital will engage in capital
intensive industry.Thus USA which is capital-rich can produce and trade in capital –rich
goods while India which is labor rich can make use of its strengths in this area.This
theory focuses on factor endowments and the fact that production of different goods
requires the various inputs in different proportions.Thus countries like India are endowed
with human capital including knowledge workers but are poorly endowed with Physical
capital whereas countries like the US have plenty of physical capital but scarcity of
skilled labor.Each has to exploit its potential.
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Capital Account convertibility;Refers to the free movement of currency in the
CAPITAL ACCOUNT Transactions in BOP.In India ,The FEMA(Foreign Exchange
Management Act) does not permit full capital Account convertibility but only limited
capital account convertibility.As per one school of thought,India is not yet ready for a full
convertibility.In fact the GOI set up the Tarapore committee which gave its report
cautioning the govt to go slow on the full convertibility,though it has strongly
recommended partial convertibility.Dr Paul Krugman,the Nobel Laureate from US opined
that developing countries should have exchange restriction in the capital Account..This
school of thought argues that once the country achieves(1) mandated inflation rate
(around 3.5%)(2)mandated fiscal deficit(3)NPA of Banking assets falling under a
threshold level (4)adequate financial system supervision,then Capital Account
Convertibility can be undertaken.Of late the Govt has been liberalizing the Capital
Account transactions viz,increase in limits for advance remittances without Bank
Guarantee,Issuing GDRs and ADRs under automatic routes etc.
SPECIAL DRAWING RIGHTS-At the 1967 meeting of the IMF IN Rio de Janeiro,it
was decided to create such an asset,to be called Special Drawing Rights or SDRs..The
IMF would create SDRs by simply opening an account in the name of each member.and
crediting it with a certain amount of SDRs.the total volume created had to be ratified by
the governing board and its allocation among the members is proportional to the
quotas.The value of SDR was initially fixed in terms of gold with same gold content as
the 1970 USD.In 1974 the SR became equivalent to a basket of 16 currencies and then in
1981 to a basket of 5 currencies.After the birth of Euro,the SDR basket included4 major
“freely usable”currencies,viz,USD,EURO,GBP and JPY.(ALSO REFER TO THE
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Some more terms used in International FinanceGR FORMS-Guaranteed Receipt Form OR GR form is used by RBI for physical export
to ascertain the value of export goods as well as to monitor their realization.It is prepared
in duplicate and submitted to customs at the time of exports.Customs verify the value
with contract and certify the same and one copy is given back to the exporter and the
other copy is sent by customs directly to RBI.Exporter has to forward this copy to the AD
with Invoice etc ,who then verifies with invoice value.The D also monitors whether the
money is realised within 180 DAYS from the date of Shipment.
ETX FORM-ETX is filed by the exporter with the RBI for any delays in getting the
payment from the overseas buyer.Normally this is done to get approval for the delayed
remittance .The exporter has to give a certificate issued by a CA giving reasons for the
delay in getting the money.
SOFTEX FORM-Softex form performs the function as that of GR for Software
exports.It is filed with STPI by the exporting company who approves and certifies the
Invoice and the softex form which is then sent to the AD,as in the case of a GR .
EEFC Account –Exchange Earners Foreign currency Account is a facility given to
exporters to keep a part of their Foreign currency earning in the form of FC. Normally
upto 50 % is allowed and in special cases even a higher percentage is allowed.without any
Interest payment. EOUs,SEZs can keep upto 100 % of the FE earned in the EEC account
which can be used for any purpose more liberally for foreign projects,travel etc without
quantitative restrictions.
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EXPORT ORIENTED UNITS(EOUs)-EOUs can be set up in any place which is notified
as a warehousing station by the chief commissioner of Customs..There are around
300 warehousing stations at present notified throughout India. EOUs at present
operate under customs bonding and supervision.They cannot be involved in
Trading.They are allowed to sell in local market by entering into DTA(Domestic
Tariff Agreement).They can sell up to 50%FOB value of exports in domestic market
by paying CD applicable for import or excise Duty whichever is more.Even 100%
Foreign Equity can be held for items reserved for SSI. EOUs are expected to earn
only positive Net Foreign Exchange(NFE).They can import all capital goods
including second hand capital goods as well as raw
materials,components,consumables and packing materials without payment of
CD.Similarly they can make indigenous purchases without paying Excise
Duty.Many state governments have also exempted EOUs from paying sales Tax.
Acts Development commissioner is the registering authority and acts as a single
window clearance.They enjoy Income Tax benefits as well.
SPECIAL ECONOMIC ZONES-(SEZ) is a concept borrowed from China.These zones
are treated as foreign country within the country and are subjected to minimum
restrictions They are located in notified areas, eg Hassan in Karnataka,Kakinada in
AP.They are subjected to minimum NFE conditions.Foreign equity is allowed up to
100%.,other than for trading.Domestic sales can be made by paying CD equivalent
for similar goods.
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Money Market Instruments
Commercial Paper(CP)- is a corporate short –term,unsecured Promissory Note, on a
discount to yield basis.It can be regarded as a corporate equivalent of Certificate of
Deposit which is an Inter bank Instrument..CP maturities generally do not exceed 270
days.CP represents a cheap and flexible source of Funds especially for highly rated
borrowers.,cheaper than bank loans.Us has the largest and long established dollar CP
market .It is used extensively by US corporations as well as some non US
corporations.Euro Commercial papers emerged in the 1980s.Investors in CP consist of
money-market funds,insurance companies,pension funds and other financial institutions
and other corporations with short-term cash surpluses
Certificates of Deposit(CD)- is a negotiable Instrument evidencing a deposit with a
bank.Unlike a traditional Bank deposit which is not transferable a CD is a marketable
instrument so that the investor can dispose it off in the secondary market, if required. .The
final holder is paid face value on maturity along with interest .CDs are issued in large
denominations –usd 100000 or more are used by commercial banks as short term funding
instruments.Euro CDs are issued mainly in London by Banks.
Bankers Acceptances- This is an Instrument widely used in the US money market to
finance domestic as well as international trade.In a typical International trade
transaction,the seller (exporter)draws time or usance draft on the buyers bank.On
completing the shipment the exporter hands over the shipping docs and the LC issued by
the importers bank to his bank.The exporter gets paid the discounted value of draft..The
exporters bank presents the draft to the importers bank which stamps it as ‘accepted”.A
bankers acceptance is created.
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Money Market Instruments-In addition to these Securitised Instruments,short –term
bank loans are also available.The Euro currencies market is essentially an Inter bank
deposit and loans market.
REPOS-meaning repurchase obligations are used by securities dealers to finance
their holdings of securities.This is a form of collateralized short term borrowing in
which the borrower “ sells”securities to the lender with an agreement to “buy”them
back at a later date.Hence the name “Repurchase obligations”.The Repo price is the
same as original buying price ,but the seller (borrower)pays interest in addition to
buying back the securities.The duration for the borrowing may be as short as
overnight or as long as up to a year.The interest rate is determined by demand –supply
International Financial Management
Foreign Exchange Market in INDIA•
Foreign exchange Management Act (FEMA) replaced Foreign Exchange Regulations
Act(FERA) in 1999 .
FEMA gives full freedom to a person resident in India who was earlier resident
outside India to hold property outside India when he /she was resident outside India.
Similar freedom is also given to a resident who inherits such security or immovable
property from a person resident outside India.
Liberalization in Foreign exchange entitlements to people traveling abroad
Liberalization in Investments by Indian companies outside India.
LERMS- was introduced in the year 1992keeping in line with the spirit of
liberalization..in LERMS dual exchange rate mechanism was adopted .60% exchange
rate was market determined while the balance 40% was determined officially to take
care of bulk imports by the govt.In 1993 the dual rate system was abolished and the
entire rate was market determined.USD replaced GBP as the intervention currency.
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Foreign Exchange Dealings•
Direct and Indirect quotations(also known as European and American quotations
respectively)-(please see slide number 51.)The latter are also referred to as Inverse or
Reciprocal quotes.
Two way quotation /rates-In practice dealers quote two way rates,one for buying the
foreign currency(known as bid price/rate)and another for selling of foreign
currency(referred to as Ask price/rate).Since dealers expect profit in FE operations,the
2 prices cannot be the same.The dealer will buy the FE at a lower rate and sell it at a
higher rate and sell the foreign currency at a higher rate.For this reason,the Bid quote is
a lower rate and the Ask rate is a higher rate.The quotations are always with respect to
the dealer(say banker).
By convention,the buying rate follows the selling rates Eg a dealer in Mumbai quotes
Pound Sterling 1=Rs 83/83.5 implies that the dealer is prepared to buy 1 British Pound
at Rs 83 and sell it at Rs83.5.Normally the rates are at 4 decimal points .
The spread is affected by a number of factors .The currency involved,the volume of
business,and the market sentiments./rumors about the currency are the major variables
reckoned by dealers/operators in the FE market.Spread is akin to the Gross Profit in a
normal business,out of which the dealer has to meet his expenses.In percentage terms it
can be expressed as follows;
Spread(percent) =(Ask price-Bid price)/Ask pricex100.In the above instance,it works 71
out to;(Rs83.5-83)83.5x100=.05988%.Prima facie the spread appears to be very low.It
depends on the volume of business the dealer generates.
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Therefore it follows that normally the dealers buy FE from Exporters and sell Fe to
Importers.Thus if the Rupee becomes stronger,the dealers will buy FE from exporters
and pay less in Rs.
Eg An exporter has earned USD 10000and if he has to convert it into Rs he will get Rs
440000(usd 10000xRs44) and if the Re is weak he may get Rs 460000(usd 10000x46).
Conversely if an importer has to buy dollars for payment,the dealer will sell dollars and
if the Re is strong he will pay less and pay more if the Re is weak.
Therefore it follows that if the Re is weak the Exporter gains and the Importer loses and
conversely if the Re is strong the exporter loses and the importer gains.
The quotations are usually shortened as follows ;USD /INR 46.4870/90 which means
46.4870/46.4890.Remember that the offer rate must always exceed the bid rate –the
bank giving the quote will always want to make a profit in its currency dealing .Hence
if a quote is USD/INR 46.9595/.10 means 46.9595/46.9610 and a quote USD/INR
46.9595/8.10 means 46.9595/48.9610.
ARBITRAGE between Banks-Though we hear about “Market rates”it is often found
that different banks will give different quotes for a given pair of currencies.Suppose
SBI and Canara Bank are quoting as follows;
GBP/USD (SBI)1.4550/1.4560
(CAN BANK)1.4538/1.4548. This gives rise to an
arbitrage opportunity.”Arbitrage in finance refers to a set of transactions ,selling and
buying or borrowing and lending the same asset or equivalent group of assets,to profit
from price discrepancies within a market or across markets.Most often no risk is
involved and no capital has to be committed.
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Arbitrage (contd)-In the given example,GBP can be bought from Canara Bank at
USD1.4548 and sold to SBI at USD1.4550 for a net profit of usd 0.0002 per pound
without any risk or commitment of capital..One of the main characteristics of modern
finance is that they are very efficient these days and such arbitrage opportunities will be
spotted by the markets and exploited.Therefore the arbitrage opportunities will disappear
very fast.
Suppose,the quotes are as follows;
Canara Bank
(bid) 1.4550/1.4560(ask)
Here there is no arbitrage opportunity seen as earlier.The reason is that the 2 quotes
overlap..However now SBI will find that it is being “hit”on its bid side much more
often,while Canara Bank will find that it is confronted largely with buyers of GBP and
few sellers.This could lead to a position where the banks building up a position
If SBI has sold more GBP than it has bought it is said to have a NET SHORT
POSITION and if it has bought more GBP than it has sold ,it is said to have NET
LONG POSITION.Given the volatility of the exchange rates,maintaining a large NET
SHORT/LONG Positions for a long time can be a risky proposition.From time to time,a
bank may deliberately move its quote in a manner designed to discourage one type of
deal and encourage the opposite deal.Thus SBI may have built up a large NET short
Position in GBP and may now want to encourage sellers of pounds and discourage
buyers.of GBP.Canara Bank may be in a reverse position;it wants to encourage buyers
and discourage sellers of GBP.Thus regular clients of SBI wanting to to buy GBP can 73
save money by going to Canara bank and Vice versa.
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Cross-rates and three-point Arbitrage- A New York bank(N) is currently offering the
following quotes;
USD /JPY; 110.25/111.10
USD/AUD; 1.6520/1.6530
At the same time ,a bank in Sydney(S) is quoting;
AUD/JPY ; 68.3/69.00
Is there an Arbitrage opportunity?
Let us see the sequence of transactions
1)Sell JPY,buy USD.Then sell USD and then buy AUD in New York
2) sell the AUD for JPY in Sydney
The calculations are as follows;
1 JPY sold in NY gets USD {1/(USD/JPY)ask(N)}=USD(1/111.10)=USD 0.00900
USD 0.00900 to be sold to buy AUD.=.00900X1.6520= AUD 0.014868
Sell this AUD for JPY=0.014862X68.3=JPY1.0154844=Margin of .00154844.
So by doing this ,for every JPY there is a profit of JPY 0.0154844(say 0.0155) and for
100 Million JPY ,the profit would be JPY 1.55 Million.
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Forward Quotations•
Outright Forwards –are quotations for outright forward transactions given in the
same manner as spot quotations.Thus a quote like;
USD/SEK – 3 Month forward;9.1570/9.1595 means ,as in the case of a similar spot
quote,that the bank will give SEK9.1570 to buy a USD and require SEK to sell a
dollar,delivery 3 months from the corresponding SPOT VALUE DATE.
DISCOUNTS and PREMIUM in the FORWARD MARKET; Let us look at the
following pair of Spot and Forward quotes;
GBP/USD SPOT; 1.5677/1.5685
GBP/USD 1- month forward ;1.5575/1.5585.—The GBP is cheaper for delivery
one month hence compared to spot GBP..The GBP is said to be at Forward
Discount in relation to the USD or equivalently,the USD is at Forward Premium
compared to the GBP.
Options forward-A Standard forward contract calls for delivery on a specific day,the
settlement date of the contract..In the inter-bank market, banks offer what are known as
Optional Forward contracts or Options Forwards.Here the contract is entered into at
some time(T0) with the rate and quantities being fixed at this time,but the buyer has the
option to take/ make delivery on any day between T1 and T2 with T2>T1>T0.
Swaps in Foreign Exchange Markets-Swap Transactions between currencies A and B
consists of a spot purchase (sale) of A coupled with a forward sale (purchase) of both A
against B.
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Forward Forward swaps-Forward forward swaps is to do a swap for two Forward dates..For
Instance, purchase (sale) of currency A 3-Months forward and simultaneous sale(purchase)
of currency A 6-Months Forward,both against currency B.Such a transaction is called a
Forward Forward Swap. It is a combination of of two SPOT -forward swaps;
1)Sell A spot and buy 3- months forward against B. 2)Buy A spot and sell 6- months forward
against B
In such a deal,both the spot-forward swaps will be ‘done off”an identical spot so that the spot
transactions cancel out..The customer and the Bank have created what is known as a Swap
Position –matched inflow and outflow in a currency but with mismatched timing.,with an
inflow of A,three months hence and a matching outflow six months hence.The gain/loss from
such a transaction depends only on the relative sizes of the 3 month and 6 months swap
APPLICATIONS OF SWAP –(1)Banks use swaps amongst themselves to offset positions
created in outright forwards done with some customers(2)Swaps can be used to roll over
long-term exposures .For many currency pairs,forward contracts are not readily available
beyond a certain maturity.For example ,in the Indian market till a few years ago ,the tenor of
forward contracts could not exceed 6 months.Firms could handle their long term exposure
using the so called “roll –over Forward contracts”A firm could use swaps as follows;
Buy USD 1,000,000, 6- months forward at a rate known today.
6 months later,take delivery,use USD 100,000to repay the first Installment .For the remaining
USD 900,000,do a six –month swap-sell in the spot market,buy 6 months forward,Rupee
outflow 6 months later is again known with certainty.
Repeat this operation every 6 months till the loan is repaid.
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The Spot bill buying rate is calculated as
Spot bill buying rate =Inter bank forward rate for a forward tenor equal to transit plus
usance period of the bill ,if any minus the Exchange Margin..In addition the bank is
entitled to recover from the customer,interest for the transit period plus usance period.
SPOT TT SELLING RATE- is computed as follows;
TT selling rate =Base rate+exchange margin
Thus if a customer wishes to purchase a draft drawn on London for GBP 10000.Th inter
bank GBP/INR selling rate is Rs 85/GBP.The bank wants an exchange margin of
0.15%.The TT selling rate would be Rs 85(1+0.0015)=85.1275,rounded off to Rs
85.13.The customer will have to pay 85.13x10000=Rs 851300
BILL SELLING RATE-When an importer requests the bank to make a payment to a
foreign supplier against a Bill drawn on the importer,the bank has to handle documents
related to the transaction.For this the bank loads another margin over the TT SELLING
rate to arrive at the Bill Selling rate.Thus
SPOT BILL SELLING RATE =TT selling rate + exchange margin
Examples-A Bank customer wants to buy USD 1 Million for value date spot.The client contacts
the bank(corporate desk )and asks for a rate.The AD for corporate clients, asks his inter
bank for USD 1 million for value spot.The inter bank spot dealer quotes 44.92/93.The
corporate dealer in turn quotes this to the customer..If the customer wants to buy
USD,then he would buy at 44.93 plus the agreed spread for the corporate client,say
0.0050=Rs 44.9350 per one unit of USD.The customer has to pay Rs 43,95,000 to get
USD 1 million.
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Exchange Rate calculations•
Till August 2,1993,exchange rate quotations in the wholesale markets used to be given as
Indirect quotes,ie units of Foreign Currency per Rs 100..Since then the quotes are Direct
given as Rs per unit of foreign currency.The rates quoted by banks to their Non-Bank
customers are called ‘Merchant Rates’..Banks quote a variety of exchange rates.The so
called “TT” rates(the abbreviation denotes Telegraphic Rates ) are applicable for clean
forward or outward remittances,that is ,the bank undertakes only currency transfers and
does not have to perform any other function such as handling documents.
For eg,,suppose an individual purchases from Citibank in New York,a demand draft for
USD 2000 drawn on Citibank,Mumbai.The New York Bank will credit the Mumbai
Banks Account with itself immediately.When the individual sells the draft to Citibank
Mumbai,the bank will buy the USD at its TT Buying Rate .Similarly TT selling rate is
applicable when the bank sells a foreign currency draft or MT.TT buying rate also applies
when an exporter asks the bank to collect an export bill and the bank pays the exporter
only when it receives payment from the foreign buyer as well as in cancellation of
forward sale contracts.
When there is some delay between the bank paying the customer and itself getting
paid.,eg,the bank discounts export bills ,various margins are subtracted from the TT
buying rates .Similarly on the selling side when the bank has to handle documents such as
LC,shipping docs and so forth apart from effecting the payment,margins are added to the
TT selling rate.as per FEDAI(in India)
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SPOT TT BUYING RATE-is calculated as –Spot TT Buying Rate=Base rateExchange Margin, where Base rate is the Inter-bank rate Thus suppose the inter bank
USD quote rate is Rs 46.75/46.76 and the bank wants exchange margin of 0.125%,the TT
buying rate would be;(46.75)(1-0.00125)=46.6916 rounded off to Rs.46.69.Thus if a draft
is encashed by the bank where its overseas account has already been credited,it will
give Rs Usd 10000x46.69=
Rs 466900.when cashing a personal cheque or a
bankers;cheque payable overseas the Bank will not give this rate,because it has to send
the cheque overseas for collection.This means a delay which is called Transit period..The
bank will further subtract an exchange margin from the TT buying rate and also recover
Interest from the customer for the transit period.The transit periods for various countries
are specified by the FEDAI(Foreign Exchange Dealers Association of India).The Interest
rates are given By RBI..The purpose of the exchange margin is to recover the costs
involved and provide a profit margin to the bank.
SPOT BILL BUYING RATE –Exporters draw BE on their foreign customers.They can
sell these bills to an AD for immediate payment.The AD buys the bill and collects
payment from the importer .Since there is delay between the AD paying the exporter and
itself getting paid,various margins have to be subtracted from the TT buying rate to
compute the bill buying rate.Bills are of two kinds;Sight or Demand bills require
payment by the drawee on presentation .The delay involved in such a bill is the transit
period;Time or Usance bills give time to the importer to settle the payment ,i.e. ,the
exporter has agreed to give credit to the importer.In such a case the delay involved is the
Usance period plus the transit period.In addition to the exchange margin to cover costs
and provide profit ,the AD will now load the forward margin for an appropriate period..If
the bill is bought on a spot basis ,the forward period included the transit period plus
usance period if any,
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Example 2- A sight Export Bill for USD 100000-A bank purchases a demand export bill
drawn by an Indian exporter on an American company.The transit period is 15
days.The inter bank market spot buying rate is Rs 45.25.One month forward
buying rate is at a premium of 15 paise,that is the buying rate is Rs
45.40,EXCHANGE MARGIN IS 0.125%.The market for 15 day forward buying
rate would be;
Rs 45.25 plus a premium of 7.5paise(for 15 days )that is Rs 45.3250. With the
commission the rate given to the customer would be 45.3250((1-0.00125)=45.2683
rounded off to the 45.27.The customer will be debited separately to the customers
Example 3-A Usance Bill for GBP 50000.An exporter wants the bank to buy a 30-day
bill drawn on a British co for GBP 50000.Exchange margin is to be retained at .
0.15%.the transit period is 10days.The market spot buying rate is Rs 69.5.One
month discount on sterling is 20paise. And two month discount is 50paise.
Transit plus usance period adds up to 40days.Interpolating between 30and 60days,the
discount for 40 days would be {20+10/30x30}=30paise.The rate paid to the
customer w ill be 69.2(1-0.0015)=69.0962 rounded off to 69.1.The customer would
be paid Rs 34,55,000.Interest for 40days would be recovered separately.
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INTEREST ARBITRAGE-Interest rate Arbitrage refers to the International flow of shortterm liquid capital to earn higher return abroad.
UNCOVERED INTEREST ARBITRAGE-The transfer of funds abroad to take advantage
of higher interest rates in foreign monetary centers usually involves conversion of the
domestic currency to the foreign currency ,to make the investment.At the time of
maturity,the funds (plus the interest)are reconverted from the foreign currency to the
domestic currency.During the period of investment, a foreign exchange risk is involved due
to the possible depreciation of the foreign currency.If such a foreign exchange is covered
we have covered interest arbitrage,otherwise we have uncovered arbitrage.
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COVERED INTEREST ARBITRAGE -Interest Arbitrage is usually covered as investors of
short- term funds abroad generally want to avoid the foreign exchange risk.To do this
the investor exchanges the domestic currency for the foreign currency at the current spot
rate so as to purchase the foreign treasury bills or investment and at the same time he
sells forward the amount of the foreign currency he is investing plus the interest he will
earn ,so as to coincide with maturity of the foreign investment.Thus covered arbitrage
refers to the spot purchase of the foreign currency to make the investment and off
setting the simultaneous forward sale (swap of the currency) to cover the foreign
exchange risk.
.When the investment matures ,the investor can then get the domestic currency equivalent
of the foreign investment plus the interest earned without a FE risk.Since the currency
with the higher interest rate is usually at a forward discount ,the net return on the
investment is roughly equal to the positive interest differential earned abroad minus the
forward discount on the foreign currency.This reduction in earnings is the cost of
insurance against the FE risk..
In Covered Interest arbitrage,the rule is that if the interest rate differential is greater
than the premium or discount ,place the money in the currency that has a higher rate of
interest or vice versa.
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EXCHANGE RATE THEORIES AND EXCHANGE RATE FORECASTINGAre changes in exchange rates predictable?How does inflation affect exchange rates How
are Interest rates related to exchange rates?what is the proper exchange rate?.For an
answer to these questions it is essential to understand the different theories of Exchange
rate determination.A Swedish economist Gustav Cassel popularized. the PPP in the 1920s.
When many countries like Germany,Hungary and the Soviet Union experienced
hyperinflation,in those years the Purchasing Power of the currencies in these countries
sharply declined.The same currencies also depreciated sharply against the stable
currencies like the USD.The PPP theory became popular against this Historical backdrop.
the inflation exchange rate relationships.If the law of one price were true for all goods
and services, we could obtain the theory of theory of PPP.There are two forms of the PPP
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Absolute Purchasing Power Parity; Underlying the absolute version of the PPP is the “Law of
one Price”,Viz that commodity arbitrage will equate prices of a good in all countries
when prices are expressed in a single common currency. PPP postulates that the
equilibrium exchange rate between currencies of 2 countries is equal to the ratio of the
price levels in the two nations.Thus prices of similar products of two different countries
should be equal when measured in a common currency as per the absolute version of
PPP theory..Let Pa refer to the general price level in country A and Pb refer to the
general price level of country B,and Rab to the exchange rate between the currency of
country A and country B.The Absolute PPP theory postulates that ---Rab=Pa/Pb
For example if country A is USA and country B is UK the exchange rate between the USD and
the GBP is EQUAL to the ratio of US to UK prices. viz,if the general price level in the
US is twice the general price level in the UK ,the absolute PPP theory postulates the
equilibrium exchange rate to be 2USD=1GBP..In reality the exchange rate between USD
and GBP could vary considerably from USD 1 to GBP 2 due to various factors like
transportation costs, tariffs,or other trade barriers between the 2 countries..This version
of the absolute form of PPP has a number of defects..First, the existence of transportation
costs,tariffs,, quotas or other obstructions to the free flow of International trade may
prevent the absolute form of PPP.Secondly,The absolute form of PPP appears to
calculate the exchange rate that equilibrates trade in goods and services so that a country
experiencing capital outflows would have a deficit in its BOP while a country receiving
capital inflows would have a surplus. Finally, the theory does not even equilibrate trade
in goods and services because of the existence of non-traded good and services.
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Absolute PPP Theory (contd)-Non –traded goods such as cement and bricks, for which the cost
of transportation cost is too high,cannot enter international trade except perhaps in the
border areas.Also specialized services like those of doctors hairstyles etc,do not enter
international trade .International trade tend to equate the prices of traded goods and
services among nations but not the prices of non traded goods and services.The general
price level in each nation included traded and non traded goods and since the prices of
non traded goods are not equalized by international trade,the absolute PPP theory will
not lead to the exchange rate that equilibrates trade and therefore has to be rejected.
Relative Purchasing Power Parity-The relative form of PPP is an alternative version which
postulates that the change in the price levels in the two nations should be proportional
to the relative change in the inflation levels in the two nations over the same time
period.This form of PPP theory accounts for market imperfections such as transport
costs,tariffs and quotas.Relative PPP theory accepts that because of market imperfections
prices of similar products in different countries will not be the same when measured in a
common currency.What it specifically states is that the rate of change in the price of
products will be somewhat similar when measured in a common currency as long as the
trade barriers and transportation costs remain unchanged.In other words,it states that a
proportionate (or %)change in exchange rate between two currencies A and B between
2 points of time(approx)equals the difference in the inflation rates in the two countries
over the same time interval.
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The fact that some goods do not (and cannot )enter international trade means that even the
relative version of PPP can be expected to hold only for traded goods.Therefore,the
price indices used to measure inflation differentials must cover only traded goods.
REAL EFFECTIVE EXCHANGE RATE(REER)-Related to the notion of PPP is the
concept of RER.It is the exchange rate after adjusting for inflation .It is a measure of
exchange rate between 2 countries adjusted for relative purchasing power of the
currencies.Since purchasing power of money is measured with reference to a given
time period.,it is only the changes in real exchange rate that have significant
economic implications.
Eg-suppose at the end of August 2000 ,the USD /INR exchange rate was Rs
45,while at the end of August 1985 it was only Rs 18.This implies that in nominal
terms,that is,without adjusting for Inflation,the rupee depreciated by 150%.in 15
years.But if we were to answer the following question-In August 2000 how many
rupees worth of Purchasing power had to be given up to acquire one dollar worth of
Purchasing Power when both PPs are measured with reference to August 1985? The
following data are also available;The consumer price index (CPI) in India at the end
of August 2000,with March 1985 as the base stood at 375 while the CPI in the US
with reference to the same base was 180.This means that Rs 45 in August 2000 was
worth Rs(45/3.75)=Rs 12 of 1985 purchasing power.We had to give up Rs 12 worth of
1985 purchasing power in India to acquire USD 0.5556(1/180) worth of 1985
purchasing power in the US.
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The real effective exchange rate in August 2000,with reference to March 1985 was
therefore (12/0.5556)=21.6 though by definition, the real exchange rate in march 1985
was Rs 18.Thus in inflation adjusted terms the rupee depreciated by about 20%.(3.6/18)
The importance of the concept of Real Exchange Rate is in the fact that changes in it
have implications for the relative competitiveness of a 1)country’s exports and 2) import
If an exporter can raise the FE currency price in line with the foreign inflation,if his costs
increase in line with domestic inflation and if the exchange rate depreciates by an
amount equal to the excess of home inflation over foreign inflation,the exporters
competitiveness in the export market remains unchanged..we now see that the real
exchange rate must remain unchanged.
The case of a company which makes import substitutes can be analyzed along similar
lines..A real appreciation of the home currency hurts real profitability of producing
import substitutes and will channel resources into production of home goods –goods
which face no international competition because they are not traded.Thus real exchange
rate determines not only relative competitiveness of exports but also relative
attractiveness of producing for international markets versus producing for home
NOMINAL EFFECTIVE EXCHANGE RATE(NEER)-is the exchange rate before
adjusting inflation difference .
In the example given above Rs 18 is the NEER while 21.6 is the REER
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INTEREST RATE PARITY THEORY-According to Interest Rate Parity theory ,the difference
in exchange rate is explained by difference in the interest rate.Thus if one year interest
rate on dollar is 6% and one year interest rate on rupee rate is 12% and the spot rate
between rupee and usd is USD 1=INR 50.A person will borrow in dollar and invest in
Rupee..After one year he has to pay back usd1.06 and he will get Rs 56.Interest rate
parity theory suggests that the exchange rate between dollar and rupee should be usd
1.06=Rs 56 or usd 1=56/1.06=52.83.
Interest rate parity theory assumes no exchange control,absence of transaction cost and taxes and
a perfect market.Interest rate before adjusting for inflation is called as Nominal Interest
rate and interest rate after adjusting for inflation is called as Real Interest rate.
INTERNATIONAL FISCHER EFFECT(IFE)- The IFE uses interest rates rather than
inflation rate to explain the changes in exchange rates over time.IFE is closely related to
PPP because interest rates are significantly correlated with inflation rates.
The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is
known as the International Fischer effect . Under IFE ,real interest rate across the world
determines the difference in exchange rate.otherwise there will be scope for
arbitrage.Fischer effect states that real interest rates should converge ,or else there will be
scope for arbitrage.
International Financial Management
The IFE suggests that given 2 countries ,the currency in the country with the higher
interest rate will depreciate by the amount of the Interest rate differential.That
is within a country,the nominal interest rate tends to approximately equal the
real interest rate plus the expected inflation rate.A country’s nominal rate is
usually defined as the risk free interest paid on a virtually costless loan.
It is often argued that an increase in a country’s interest rates tends to
increase the exchange value of its currency by inducing capital
inflows.However the IFE argues that a rise in a country’s nominal interest
rate relative to the nominal interest rates of other countries indicates that the
exchange value of the country’s currency is expected to fall. THIS IS DUE
The IFE implies that if the nominal interest rate sufficiently does not increase to
maintain the real interest rate ,the exchange value of the country’s currency
tends to decline even further.
International Financial Management
We have seen that the 3 theories of Exchange rate determination are1)Purchasing Power Parity Theory(PPP),which links spot exchange rates to country’s
price levels.
2)The Interest Rate Parity theory (IRP) which links spot exchange rates,forward
exchange rates and nominal exchange rates.
3)The International Fischer effect(IFE) which links exchange rates to a country’s
nominal interests rate levels.
Comparison of PPP,IFE and IRP Theories-All the three relate to the determination
of exchange rates..Yet they differ in their implications;
1)The theory of Interest Rate Parity focuses on why the Forward rate differs from the
spot rate and the degree of difference that could exist.This relates to specific
point of time.
2)The PPP theory and IFE focus on how a currency’s spot rate will change over
time.While PPP theory suggests that the spot rate will change in accordance
with inflation differentials.IFE theory suggests that it will change in
accordance with interest rate differential.
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EXCHANGE RATE FORECASTING1)Forward rate can be used to predict future exchange rate though it cannot be
a perfect predictor of future spot rate .Forward rate contains all the current
factors and expected changes in exchange rate while unexpected rate cannot
be factored in.
2)Exchange rates can be predicted through relative inflation rates as per PPP
theory or through relative interest rate as per Interest rate parity theory.
3)Exchange rate can be predicted by using forces of demand and supply as per
BOP statistics.If the BOP is negative then demand for foreign currency will
increase leading to depreciation of domestic currency and vice versa ,the
domestic currency will appreciate..If the GNP of a country increases then the
demand will go up,import will increase thereby BOP will become deteriorated
leading to depreciation of currency and vice versa.
4)In monetary approach,the results are exactly opposite to BOP approach..For
example,if the real economy of country expands and money supply does not
expand, then there will be more demand for money than supply leading to its
appreciation which is diametrically opposed to the BOP .The corrective
mechanism is in the form of increase in interest rate thereby Bond prices will
drop ,due to which it will be costly to hold money and money will be spent for
purchasing Goods for consumption and thereby inflation will increase.As PPP
is assumed to be true under this theory value of currency will decrease.
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5)Dornbusch Sticky Price Model-Which states that the PPP holds only in the longrun.In the short- run,prices of goods are sticky.There is a stable demand for
money function which relates real balances to real incomes and interest
rates.It is also referred to as the “overshooting model” meaning that exchange
rates overshoot their eventual equilibrium levels.
6)Asset Approach-Since the foreign exchange market is efficient ,all the historic
news and expected news is reflected in the price.Only unexpected news which
follows random walk influences the price which cannot be predicted.
7)Exchange rate can also be predicted by using technical analysis wherein movement
in exchange rate itself can be used to predict future exchange rates as per
certain well observed patterns.Technical analysis are called as astrologers of
FE MARKETS.Fundamentalists and Economists disagree with them because
the Efficient market theory says that FE being an efficient market,all historic
costs and future expectations are reflected in the price.
International Financial Management
in the previous slides(12 to 16) that companies having International Business operations
,primarily encounter 3 types of exposures
1)Transaction Exposure
2) Translation Exposure
3) Economic exposure
1)Transaction Exposure-is inherent in all foreign currency denominated contractual
obligations/transactions.This involves gain or loss arising out of the various
types of transactions that require settlement in a foreign currency.The
transactions may relate to cross –border trade in terms of import or export of
goods,the borrowing or lending in foreign currencies ,domestic purchases and
sales of goods and services of the foreign subsidiaries and the purchase of
assets or take over the liability involving foreign currency..The actual profit
the firm earns or loss it suffers ,of course is known only at the time of
settlement of these transactions.
A firms Balance Sheet already contains several items reflecting transaction
exposure,the notable items being the debtors receivable in a foreign
currency,creditors payable in foreign currency,foreign loans and foreign
investments.While it is true that transactions exposure is applicable to all these
foreign transactions,it is usually employed in connection with foreign
trade,that is, specific imports or exports on open account credit.
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An unanticipated change in the exchange rate has an impact –favourable or adverse –on
its cash flows.Such exposures are known as Transaction exposures.In essence it is a
measure of the sensitivity of the home currency value of assets and liabilities which are
denominated in Foreign currency ,to unanticipated changes in exchange rates,when
the assets or liabilities are liquidated.The foreign currency values of these items are
contractually fixed,ie,they do not vary with the exchange rates.Hence it is also known
as contractual exposure.
Some typical exposure situations are as follows;
A currency has to be converted in order to make or receive payment for goods and
services-import payables or export receivables in a foreign currency.
A currency has to be converted to repay a loan or make an interest payment (or
conversely,receive a repayment or an interest) or
A currency has to be converted to make a dividend payment ,royalty payment and so
The Transaction exposure affects cash flow during the current accounting period.If the
foreign currency has appreciated between the day the receivable was booked and the
day the payment was received ,the company makes an exchange gain which may have
tax implications.
In other words Transaction exposures 1) usually have short time horizons and 2)operating
cash flows are effected.
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2)Translation exposure-relates to the change in accounting income and balance sheet
statements caused by the changes in exchanges rates.These changes may take place
by/at the time o finalization of accounts compared to the time when the asset was
purchased or liability was assumed .In other words ,translation exposure results from
the need to translate foreign currency assets or liabilities into the local currency at the
time of finalizing accounts.It arises due to a company having foreign branches or
subsidiaries ,which are required to be consolidated with the accounts of the parent
branch at the end of the year..These accounting statements are denominated in foreign
currency and they have to be converted to domestic currency at the time of
consolidation leading to the exchange rate exposure which is termed as Translation
exposure.or Accounting exposure since this exposure is recognized much before the
settlement is made.Translation exposure does not involve immediate cash flow.
3)Economic exposure-When a country’s economy is increasingly integrated internationally ,it
is exposed to vagaries of international market even though it may not have any
transactions in foreign currency neither in the form of imports nor in the form of
exports. Thus ,a firm may not have any transaction in foreign exchange at all but if its
competitor firm firm imports its major raw material and components,say ,for example
in Japanese Yen ,the firm is exposed to Economic exposure.If Yen depreciated against
rupee,then imports from Japan will become cheaper.This benefit can be passed on to
the customers thereby directly affecting the market share of the other firm.
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1)Using Forward Markets for Hedging Transactions Exposure-Hedging means taking a Position or
operation that offset an underlying exposure.In the normal course of business ,a firm
will have several contractual exposures in various dates.The net exposure in a given
currency at a given date is simply the difference between the total inflows and total
outflows to be settled on that date.Company A has the following items outstanding;
1)USD receivable
2)EUR payable
3)USD Interest Payable
4)USD Payable
5)USD purchased forward
6)USD loan installment due
7)EUR purchased forward
Days to Maturity
The net exposure in USD at 60days is (800,000+300,000)-(200,000+250,000)=USD +650,000.
The use of Forward contracts to hedge transaction exposure at a single date is quite
straightforward.A contractual NET inflow of foreign currency is sold forward and a
contractual NET outflow is bought forward..This removes all uncertainty regarding the
domestic currency value of the receivable or payable..Thus in the above example .to
hedge the 60day USD Exposure Company A can sell forward USD 650,000 while for
the EUR exposure it can buy EUR 1,000,000,90DAYS Forward.
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In a Forward Market Hedge, a company that is long in a foreign currency will sell the
foreign currency forward,whereas a company that is short in a foreign currency will buy
the currency forward.In this way ,the company can fix the dollar value of future foreign
currency cash flow..If funds to fulfill the forward contract are available on hand or are
due to be received by the business,the Hedge is considered ‘Covered’,’Perfect’ or
‘Square’. Because no residual foreign exchange risk exists.Funds on hand are matched
by funds to be paid.
In situations where funds to fulfill the contract are not available but have to be
purchased in the spot market at some future date, such a Hedge is considered to be ‘
open’ or ‘uncovered’. .It involves considerable risk as the Hedger purchases foreign
exchange at an uncertain future spot rate in order to fulfill the forward market.
Currency Futures-Currency Futures are closely related to Forward
contracts.These are known as Futures contracts and are traded in Futures Markets.A
Futures Contract is an agreement to buy or sell a pre-specified amount of foreign
currency in the futures market at some specified future date between the parties to the
contract.Currency Futures Contracts /markets are for the major/hard currencies of the
world namely,the USD,GBP,DM,FF, and JPY.Futures being standardized contracts in
nature are traded on organized exchanges.;The clearing house of the exchange operates
as a link between the two parties of the contract,namely the buyer and the seller.In other
words,transaction are through the clearing house and the two parties do not deal directly
between themselves.
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While it is true that futures contracts are similar to the Forward contracts in their objective of
hedging FE risk,they differ in many significant ways ;
1)NATURE AND SIZE-Future contracts are standardized and the value of the contracts are
permissible in standard-sums.The maturities are also standardized.In contrast Forward
contracts are tailor made with any size or maturity.
2)MODE OF TRADING-In the case of Forward contracts,there is a direct link between the firm
and the authorized dealer (bank) at the time of of entering the contract and at the time of
execution.On the other hand ,the clearing house interposes between the 2 parties involved
in futures contracts.
3)LIQUIDITY-The two positive features of futures contracts,namely,their standard-size and
trading at clearing house of an organized exchange ,provide them relatively more liquidity
vis a vis forward contracts,which are neither standardized nor traded through organized
futures For this reason the futures markets are more liquid. markets.
4)DEPOSITS/MARGINS-While futures contracts require guarantee deposits from the parties,no
such deposits are needed gor forward contracts.Besides ,the futures contract necessitate
valuation on a daily basis ,meaning that gains and losses are noted (the practice is known
as Marked to Market).Valuation results in one of the parties becoming a gainer and the
other a loser; while the loser has to deposit money to cover losses,the winner is entitled to
the withdrawal of excess margin..Such an exercise is conspicuous by its absence in
forward contracts as settlement between the parties concerned is made on the pre specified
date of maturity.
5)Default Risk- As a sequel to the deposit and margin requirements in the case of futures
contracts,default risk is reduced to a marked extent in such contracts compared to Forward
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ACTUAL DELIVERY-Forward contracts are normally closed,involving actual delivery of foreign
currency in exchange for home currency /or some other currency (cross currency forward
contracts).In contrast very few futures contracts involve actual delivery.
•INTEREST RATE FUTURES-Interest rate Futures can be used to hedge /reduce risk of a rise in
Interest rates in the future;
•Suppose IBM has taken a decision to build a new plant ,estimated to cost US 100 million .It has
been decided to finance it by 10 year bonds,the current coupon rate of Interest on such bonds is
7percent .IBM does not need money for about 6 months..of course,IBM can issue 7 percent bonds
now and can arrange funds.Since the money is not immediately needed,it would be invested in short
–term securities,yielding an interest of less than 7 percent entailing loss.
•Another alternative is that IBM waits for 6 months to sell the Bond issue.So far so good is the
interest remains unchanged at 7 percent..In case they move up higher than 7 percent,the company
will be required to pay higher interest on USD 100 million for the year period..Not surprisingly
,IBM may find the building –up of the new plant with higher interest costs an unprofitable
•Interest Rate futures provide a solution to the IBM dilemma./or its worry pertaining to an increase
in interest rates.IBM can have a futures contract to sell Treasury bond futures 6 months hence to
hedge its position .It is assumed that Treasury Bonds(T-bonds) CARRY A RATE OF Interest of 5
percent .Should Interest rate rise ,the value of T-Bonds will decline(there is a negative correlation
between interest rates and the rate value of bonds).As a result ,it makes profit on the futures
position.Of course it has to pay higher interest on its bond issue ,but it is partly compensated in
terms of the profit it has earned by selling T-Bonds.In the event of a a decline of Interest rates,it will
suffer losses on its future position,but it would gain as it would pay a lower interest rate for all ten99
years.Thus ,interest rates futures are useful derivatives to hedge /reduce the risk of a rise in the
Interest rates in future.
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2)Hedging with The Money Market-A Money Market Hedge involves simultaneous
borrowing and lending activities in two different currencies to lock in the home currency
value of a future foreign currency cash flow.The simultaneous borrowing and lending
activities enable a company to create a home-made forward contract.The firm seeking
the Money Market Hedge borrows in one currency and exchanges the proceeds for
another currency If the funds to repay the loan are generated from business
operations,then the money market hedge is ‘covered’.Otherwise,if the funds to repay the
loan are purchased in the foreign exchange spot market then the Hedge is ‘uncovered’ or
The steps involved are as follows;1)Determine the amount required in foreign currency ,to be
paid on specified date(say 3 months/4 months)from now.(2)From an authorized dealer
(in bank) ascertain the spot exchange rate at which it is selling the required foreign
currency in exchange for home currency.(3)Borrow home currency from the money
market at the prevailing interest rate. The quantum of borrowing should be in such a
manner that can make the required foreign currency sums available on the date of
payment (say after 3 or 4 months). (4)The borrowed funds are to be used to buy the
required foreign currency from the forex spot market;once purchased ,it is to be invested
in forex money market to yield interest in the desired foreign currency.(5)As per steps (3)
and (4),the required amount of foreign currency to be purchased can be
determined.These steps enable the firm to know the precise amount it will require to
make payments of foreign currency on the date of maturity.Money –market operations
serve as an important hedging function in that uncertainty is resolved regarding the
amount to be paid.
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Suppose an Indian importer is to make payment of USD 1.1 million after 3 months..3 months
interest are 4 per cent on the USD and 6 percent on the Indian rupee..The current spot
exchange of re/usd is Rs 48..To know the precise amount the importer has to do the
1)First of all ,the Indian Importer is to as certain the amount of borrowings so that the
borrowings along with Interest earned on such funds can accumulate to USD 1.1
million after 3 months.Let us say this amount is A..Therefore;
A(1+Rate x Time)=USD 1.1 million
A(1+.04x3/12)=1.1 million or A=usd1.1 million/1.01= USD1089108.91
2) The Indian importer has to then borrow a sum of usd 1089108.91x48 (spot
rate)=Rs52277227.68 from the local domestic market. He will invest USD
1089108.91 in the money market at 4%rate of interest for a period of 3 months ,yielding
him USD 1.1 million after 3 months(1089108.91x.04x3/12)
3)The accumulated sun of USD 1.1 million will be paid by the Indian Importer on the due date
to the American Export firm.
4)The Indian importer would refund Rs 52,277,227.68 along with 6% interest after 3 months to
the Indian lender.The sum is Rs 52,277,227.68/(1+.06x3/12)=Rs 53061386.09
5)The Indian Importer is to pay Rs 53.061386 million at the end of 3 months.To put it
differently,he knows that his home currency cash outflow is Rs 53.061386
million,irrespective of the Re /us dollar exchange rate , 3 months from now.
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3)Options Market Hedge-Many times the firm is uncertain whether the hedged foreign
currency cash inflow or outflow will materialize..In such circumstances the Firms can
use the Currency Options to Hedge the risks.Currency Option is a Financial instrument
that provides its holder a right but no obligation to buy or sell a pre-specified amount
of foreign currency at a pre- determined rate in the future (on a fixed maturity date /up
to a certain period.).while the buyer of an option wants to avoid the risk of adverse
changes ,in exchange rates ,the seller of the options is prepared to assume the risk.
In other words a currency option confers on its buyer the right either to buy or to sell a specified
amount of a currency at as et price known as the ‘strike price”.An option that gives the
right to buy is a ‘call” while one that gives the right to sell id the “put”.Depending on
the contract terms , an option may be exercisable on any date during a specified period
or it may be exercisable only on the final or expiration date covered by the option
contract.In return for guaranteeing the exercise of an option at its strike price,the options
seller or writer charges a premium which the buyer usually pays upfront.Under
favorable circumstances,the buyer may choose to exercise it.Alternatively,the buyer
may be allowed to sell it.If the option expires without being exercised ,the buyer of the
options receives no compensation for the premium paid.The situation of an option writer
is analogous to that of an Insurance seller. .Thus every Option has three different price
1)The exercise or strike price,i,e, the exchange rate at which the foreign currency can be
purchased.(call) or sold(put).
2)The premium.,i,e ,the cost price or value of the Option itself.
3)The underlying or actual spot exchange rate in the market.
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TWO TYPES OF OPTIONS-There are two types of Options1)
A PUT OPTION which gives the buyer the right to ,but not the obligation, to sell a
specified number of foreign currency units to the Option seller at a fixed price up to
the option’s expiration date.
A CALL OPTION which is a right ,but not the obligation ,to buy a foreign currency
at specified price up to the expiration date.
A call Option is valuable ,for example ,when a firm has offered to buy a foreign asset
such as another firm , at a fixed foreign currency price but is uncertain whether its bid
will be accepted
The General rules to follow when choosing between Currency Options and Forward
Contracts for hedging purposes are summarized as follows;
1)when the quantity of a foreign currency cash outflow is known ,buy the currency
forward.When the quantity is unknown ,buy a call option on the currency.
2)when the quantity of foreign currency cash inflow is known,sell the currency
forward.When the Quantity is unknown,buy a Put option on the currency.
3)when the quantity of foreign currency cash flow is partially known and partially
uncertain,use a forward contract to hedge the known portion and an option to hedge
the maximum value of the uncertain remainder..
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(B) MANAGEMENT OF TRANSLATION EXPOSURE=Exposed Assets-Exposed Liabilities
Translation methods-There are 4 methods by which foreign currency translation has been developed in
various countries.They are1)The Current Rate Method-The current rate method is the simplest and the most popular method all
over the world.This method requires translation of all assets ,liabilities and Profit and Loss
account items using the current rate .This is similar to translation of a book from one language
to another.Use of this method will result is preservation of the inter-relationships among various
elements in the financial statements..For example, relationship like Fixed Assets turnover ratio
will remain the same in the foreign currency financial statement.
2)Current-Non current Method-Under this method,current assets and current Liabilities of the foreign
operation are translated at the current exchange rates.Other assets and liabilities and share
capital are translated at the historical exchange rates.Depreciation and other amortization
charges are translated by using the rates at which the related assets and other items were
accounted.Other profit and loss account items are translated at the average rates.This method
presumes that the risk exposure is related to the timing of cash flows and hence converts assets
and liabilities based on maturity rather than the nature of the item.
3)Monetary/Non Monetary Method- This method substitutes nature of the Balance sheet item for
maturity..Under this method monetary assets and monetary liabilities are translated at the
current rates and non monetary assets and liabilities at the historical rate.Monetary items are
those that represent a claim to receive or an obligation to pay a fixed amount of foreign
currency unit.eg cash,,Accounts Receivable,current liabilities,accounts payable and long term
debt. Non Monetary items are those that do not represent a claim to receive or an obligation to
pay a fixed amount of foreign currency items,eg Inventory,Fixed Assets,long term
investments.Income statements are translated at Average exchange rates.
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14)The maturity of most forward contracts between banks and their customers in India does
not exceed six months. Prior to January 1997, dealers could offer their customers
forwards with longer maturities but only with the prior approval of the Reserve Bank
of India in each case. Since then, this requirement to obtain RBI’s prior approval has
been removed. Typically the market is quite liquid for contracts up to one year; The
problem with Forward contracts however is that since they require future performance,
sometimes one party may be unable to perform the contract..
2)FUTURES MARKET-A currency Future is the price of a particular currency for settlement
at a specified future date.Currency Futures are traded on Futures Exchanges through
brokers.The contracts are standardized with respect to the quality and quantity of the
underlying asset-buyers and sellers usually prefer to close their contract by reversing
their positions on the market.In other words ,buyers of a Futures contract buy another
futures with the same characteristics,while sellers of Futures contract buy another
Futures contract which has the same characteristics.By reversing their positions ,buyers
or sellers close their positions.Any gain or loss obtained from closing the futures
contract is used to offset losses or gains on the actual market.
MECHANISM OF FUTURES TRADE-consists of two parts
(A)Components of Futures Trade(1)FUTURES PLAYERS;Future trading ,which represents a less than Zero -sum game ,can be
considered beneficial if it results in Utility gains..This is done by transfer of risks
between the market players.
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EXPOSURE NETTING;involves offsetting exposures in one currency with exposures in the
same or another currency,where exchange rates are expected to move is such away that
losses(gains) on the second currency exposure.The assumption underlying exposure
netting is that the net gain or loss on the entire exposure portfolio is what matters ,rather
than the gian or loss on any individual monetary unit.
LEADING-If the domestic currency is expected to depreciate against foreign currency,then
payments are advanced (preponed) but the realization of the exports is postponed,and Vice
Versa is true for exports.
LAGGING.-If domestic currency is expected to appreciate against foreign currency ,payments
are postponed while receipts are advanced (preponed)
SOURCING-If sourcing of the material is shifted to a third country,the adverse effect of
exchange rate appreciation on export competitiveness is mitigated by sourcing goods from
the importing country itself or from countries whose currencies are not appreciating.
RELOCATION-means relocating the manufacturing base to another country where there is
exchange rate stability.The best examples are the Japanese companies like
Matsushita,Sony,Sharp etc which shifted their bases or expanded their bases in
Malaysia,Taiwan,Hong Kong etc which had stable and favorable rates of exchanges.
INVOICING IN THIRD CURRENCY-Indian exchange rates against all currencies are
determined through the medium of USD which is the Intervention currency.Thus there are
two fluctuations involved in any other currency against Rupee which is a multiple of
variance of rupee against USD and USD against the other currency, as opposed to a single
variance of rupee against US..Thus ,for an Indian dealing in any FE ,it is advantageous 106
Invoice in USD to minimize exchange rate fluctuations
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4) Temporal Method-Though this method is a variation of the monetary/non monetary
method,it is NOT based on strict balance sheet classification. According to this
method ,cash,receivables and payables (both current and non current items)are translated
at the current rates.Further other assets and liabilities which are carried at current value
are also translated at current rates.For example,Inventory carried at NET realizable value
will be translated at current rate though this is not a monetary item.All other assets and
liabilities which are carried at past transaction prices are translated at historical
costs.Revenue and expense items are translated at rates that prevailed when the
underlying transactions tool place.
In India Accounting Standard 11 framed by ICAI lays down the rules FOR ACCOUNTING OF
changes in Foreign Exchange rates.
C)MANAGEMENT OF ECONOMIC EXPOSURE –Economic Exposure refers to the
extent to which the economic value of a company can decline due to changes in
exchange rate.It is the overall impact of exchange rate changes on the value of the
firm.Managing economic exposure is very important for the long-run health of an
organization than manage changes caused by transaction or translation exposure.The
degree of economic exposure to exchange rate fluctuations is significantly higher for a
firm involved in International business for a purely domestic firm.Assessing the
economic exposure of an MNC is difficult due to the complex interaction of funds that
flow into ,out of and within the MNC.To assess this Exposure accurately , a firm needs to
know a great deal about its product and input markets ,competitive response,its
customers and cost structure.A cash flow at risk kind of framework needs to be
constructed which incorporates the firm’s business model which can help simulate 107
scenarios of the key risk factors.
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The following are some of the PROACTIVE Marketing and Production strategies which a
firm pursue in response to anticipated or actual exchange rate changesMARKETING MANAGEMENT OF EXCHANGE RISK1)Market selection-Major strategy considerations for an exposure are the markets in which to
sell.It is also necessary to consider the issue of market segmentation with individual
countries..A firm that sells differentiated products to more affluent customers may not be
harmed as much by a foreign currency devaluation compared to a Mass marketer.
2)Product strategy-Companies can also respond to exchange rate changes by altering their
product strategy which deals with such areas as new product introduction.If there is a
devaluation/depreciation of home currency, a firm will be able to expand its product line
and cover a wider spectrum of consumers abroad and at home.Conversely ,following
home currency appreciation,a firm may have to reorient its product line and target it to a
higher income,more quality conscious,less price sensitive consumers.
3)Pricing Strategy-In the wake of the rising USD ,a US firm selling overseas or competing at
home against foreign imports faces a Hobson’s choice;’Does it keep its dollar price
constant to preserve its profit margin and thereby lose sales volume or does it cut its
dollar price to maintain market share and thereby suffer reduced margin?Conversely.does
the firm use a weaker dollar to regain lost ground or dos it use the weak dollar to raise
prices and recoup losses incurred from the strong dollar..To begin with the firm should
follow the standard economic proposition of setting the price that maximizes dollar
profits.In making this decision,however profits should be translated using the forward
exchange rate that reflects the true expected dollar value of the receipts upon collection.
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4)Promotional strategy- should take into account anticipated exchange rates.A key issue issue
in any marketing programme is the size of the promotional budget.A firm exporting its
product after domestic devaluation may well find that the return per home currency
expenditure on advertising or selling is increased because of the product’s improve price
positioning.A foreign currency devaluation ,on the other hand,is likely to reduce the return
on marketing expenditure and may require amore fundamental shift in the firm’s product
location are the principle variables that companies manipulate to manage competitive risks
that cannot be managed through marketing changes alone;
1)Input Mix-Outright additions to facilities overseas accomplish a manufacturing shift.A more
flexible solution is to purchase more components overseas.This practice is called as
outsourcing.Outsourcing gives the companies the flexibility to shift purchases of
intermediate input towards suppliers affected by exchange rate changes.
2)Shifting Production –MNCs with worldwide production systems can allocate production among
their several plants in line with changing home currency cost of production,increasing
production in a nation whose currency has devalued and increasing production in a country
where there has been a revaluation..A strategy of production shifting presupposes that a
company has already created a portfolio of plants world wide and economies of scale are
being effected.
3)Plant Location- A firm without foreign facilities that is exporting to a competitive market whose
currency has devalued may find that sourcing components abroad is insufficient to
maintain unit profitability.Third country plant locations is a viable alternative in many
cases.Many Japanese companies built plants outside Japan to cope with the rising Yen.
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.4)Raising Productivity-Raising Productivity through closing inefficient plants ,automating
heavily and negotiating wage and benefit cutbacks is another alternative to manage
Economic Exposure.
4)POLITICAL AND COUNTRY EXPOSURE-Since the eruption of the Debt crisis in Latin
America(Mexico in 1982 and Brazil in 1987),international banks and Institutional
Investors have become increasingly concerned about ‘country risk” and “Political
Risk”(sovereign Risk).Proper assessment of country risk therefore has assumed great
significance in International lending ,over and above,the usual credit appraisal that
banks have always been doing.The essence of country risk analysis is an assessment of
factors that will affect a country’s ability and willingness to service its obligations .A
variety of political ,economic and psycho-social considerations are relevant.
ECONOMIC FACTORS-(1)-Resource base of the country including natural resources like
land ,mineral deposits and so on,HR including quality and depth of managerial and
technical skill, etc.(2)Macro economic performance and the quality of economic
management,per capita income growth,rate of capital formation.Lenders tend to to be
favorable inclined towards strong legal and ambient countries.(3) External factors like
state of the BOP, growth in exports,Debt/GDP ratio and Debt service Ratio.,Ratio of
reserves to normal imports. Access to IMF etc.
POLITICAL DIMENSIONS-Political events,stability in governments,Coups,willingness to
honor external commitments etc are factors which an International business.
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The actual need for the existence of a Forward Market is not speculation .Exporters and
Importers use this market as Receipts and Payments do not coincide time-wise.In this
way they overcome undesirable market fluctuations and take care of future cash
flows.The second group consists of people who use the Forward market to preserve the
value and nature of their assets without speculating against future trends.
1)FORWARDS CONTRACTS; “An agreement to buy or sell a specific asset at an agreedupon price on a specified future date. In contrast to a future, a forward contract is
privately negotiated and not standardized.”
A Forward contract is one where a counter party agrees to exchange a specified currency at an
agreed price for delivery on A FIXED MATURITY DATE..In this contract, while the
amount of the transaction ,the value date,the payments procedure and the exchange
rates are all determined in advance ,no exchange of money takes place until the actual
settlement date.e.g.,An Indian company having a liability in GBP due by end
December 07 may buy GBP today for the maturity date of December end .By entering
into a Forward contract the company has effectively locked itself into a rate.
A Forward contract for a customer involves a “spot “and a “swap” transaction , as the customer
cannot cover the transaction outright for the forward date.This is because the market (or
the company)will have to first buy GBP in the Spot and then enter into a Swap where
he sells spot and buys forward (December end)..Banks often tend to quote unfavorable
quotes to smaller business to cover the risk of the company defaulting..
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Forward contracts are more popular for the following reasons1)They are well established and transparent (2)They are accessible to even smaller companies.
3)Many corporates do not allow transactions in other derivative instruments as they feel it is
Terms and conditions applicable to Forward contracts(applicable to Indian companies);
1)For corporates ,Forward cover is available only for exposures arising out of genuine
Import/export transactions which are in conformity with the existing trade control
legislation or exposures arising out of servicing Foreign currency Liabilities and Assets
(like ECB etc).which have been contracted after obtaining necessary approvals.
2)Forward contracts can be entered between an authorized dealer and an entity which is resident
of India at the time the contract is booked. (also allows NRIs, partnership, individual,
3)Exchange brokers cannot act as brokers in a forward transaction. (This applies only to deals
between corporate and banks; brokers’ services can be used for deals between banks)
4)The authorized dealer must ensure that the customer is actually exposed to exchange rate risk
arising out of the underlying commercial transaction. (AD required to check genuineness
of documents).
5)The forward contract must be in writing, in the prescribed form of the authorized dealer.
6)The amount of forward cover cannot exceed the value of the underlying commercial
7)The customer must present to the authorized dealer the original commercial contract.
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8)Forward cover can be given on the basis of an irrevocable letter of credit provided the
customer gives a declaration that no other forward contract has been entered into for the
same transaction.
9)If exports are on a consignment basis, forward contract can be entered into only after shipment
is effected and the appropriate bill,if any, has been drawn in respect of the shipment.
(Some banks do not permit this as it is not a crystallized exposure.)
10)If a forward cover is booked for a particular underlying transaction, another transaction can
be substituted in its place.
11)The quality/grade/specifications of goods in an export contract can be changed provided the
overseas buyer has agreed to such a substitution.
12)Forward contracts can be cancelled. The authorized dealer will levy a cancellation charge.
Any gain made by the authorized dealer is credited to the customer,any loss is debited to
the customer’s account. The customer can leave his position open, or book a fresh
contract with the same or another authorized dealer. Early settlement and extension are
also possible. Forward contracts for imports, once cancelled cannot be rebooked for the
same underlying exposure; however they may be rolled over. No such restriction on
forward contracts for exports.
13)An exposure in say Euro can be broken up into two parts. One or both of these may be
covered. Thus suppose a firm has a payable in Euro. It can buy Euro forward against
US dollar, and US dollar forward against the rupee. Or it may leave the dollar exposure
uncovered. This is referred to as the “third currency forward” .
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The market players are•
(2) CLEARING HOUSES-Every organized Futures exchange has a clearing house that
guarantees performance to all of the participants in the market.It serves this role by
adopting the position of buyer to every seller and seller to every buyer.Thus ,every
trading party in the Futures Markets has Obligations only to the clearing house.Since the
clearing house matches its long and short positions exactly,it is perfectly hedged,which
(3)MARGIN REQUIREMENTS—Each Trader is required to post a margin to insure the clearing
house against credit risk. This margin varies across markets,contracts and the type of
trading involved.Upon completion of the Futures contract,the margin is returned.
(4)DAILY SETTLEMENT-For most Futures contracts,the initial margins are 5% or les of the
underlying commodity’s/currency's value.These margins are Marked to Market on a
daily basis and the traders are required to realize any losses in cash on the day they
occur.Whenever the margin deposit falls below minimum maintenance margin,the trader
is called upon to make it up to the initial margin amount.The resettlement is also called
Marked to market.
Delivery terms include;
4.1)Delivery Date –some contracts may be delivered on any business day of the
delivery month while others permit delivery after the last trading day.
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4.2)Manner of delivery-The possibilities are-(a)Delivery date-some contracts may be delivered
on any business day of the delivery month while others permit delivery after the last
trading day.(b)Manner of Delivery-Physical exchange of underlying Assets,cash
settlement as in the case of stock Index Futures and Reversing Trade which is the case
with 99% of the Futures Positions.The trade effectively makes a trader's net futures
position zero thus absolving him from further trading requirements.
5)TYPES OF ORDERS(a)Limit order –It stipulates to buy or sell a specific or better.(b)Fill or
Kill Order-It instructs the commissioner broker to fill an order immediately at a
specified price.( c)All or none order – It allows the commission broker to fill part of an
order at a specified price and remainder at another price.(d)on the open or on the close
order-Represents orders to trade within a few minutes of operating or closing.(e)Stop
order-triggers a reversing trade when prices hit a prescribed limit.(f)Market ordersContracts at the best available prices
6)TRANSACTION COSTS-The costs incurred are-(a) Floor trading and clearing
fee(b)commissions-charged by broker to transact a public order( c) Bid –Ask spreads.
(d) Delivery costs are incurred in case of actual delivery
(7)MARKED TO THE MARKET-Marking to Market essentially means that at the end of a
Trading session ,all outstanding contracts are repriced at the settlement price of that
session..Margin accounts of those who made losses are debited and those who gained are
credited..Suppose X buys a June delivery Pound sterling Future on April 14, at a price of
USD1.6 per pound of USD100000 per contract (62500x1.6).Next day the prices
increases and at the end of trading on April 15th the settlement price is 1.62.X has made a
gain of 2 cents per pound-100 Ticks or USD1250per contract.(obviously someone with a
Short Position lost a matching amount..This is immediately credited to X;s margin
Accounts and can be withdrawn immediately.
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X;s contract is re priced at 1.62 or USD 101250 per contract At this stage we can see an
and FUTURES .In a Forward contract ,gains or losses arise only on maturity.There are
no Intermediate cash flows;.in a Futures contract..In a Futures Contract even though the
overall gain/loss is same ,the time profile is actually different.-the total gain or loss over
the entire period is broken up into a daily series of gains and losses which clearly has a
different present value.Also note that the Marked to Market SETTLEMENTS DOES
CONTRACT.This is not the same thing as settling an outstanding forward contract and
marking it to market.
8)DELIVERY IS RARE-In most ,if not all forward contracts ,the commodity is actually
delivered by the seller and accepted by the buyer..In most Financial Future
contracts,actual delivery tales place in less than one percent of the contracts
traded..Futures are used as Hedging device against price risk and as a way of betting on
price movements rather than as a means of physical acquisition of the underlying
asset..Most of the contracts are extinguished before maturity by entering into a matching
contract in the opposite direction.
(B)Futures Trade Process-Futures contracts are traded by a system of “Open Outcry”on the
trading floor ( also called Trading Pit)of a centralized and regulated exchange.More and
more exchanges have resorted to Electronic screens .,all over the world..All traders
represent exchange members.Those who trade for their own are called Floor Traders.
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Those who trade on behalf of others are Floor Brokers and if one does both they are called Dual
Traders..The variables to be negotiated in any deal are the price and the number of
contracts.A buyer of Futures acquires a Long Position while the the seller acquires a
Short Position..As we have seen above ,when two traders agree on a deal ,it is entered as
a short and long both Vis a Vis the clearinghouse. For every contract,the exchange
specifies a “last trading Day..Those who have not liquidated their contracts at the end of
this day are obliged to make or accept delivery as the case may be.For some contracts
there is no physical delivery of the underlying asset but only a cash settlement from
losers to the gainers.Where there is a physical delivery involved the exchange specifies
the mechanism of delivery.
HEDGING WITH CURRENCY FUTURES-Corporations and Banks use Currency Futures
for Hedging against FE exposures..In principle the idea is very simple.If a corporation
has an asset ,e,g Receivable in Currency A which it would like to hedge ,it should take
Futures Position Such that Futures generate a Positive Cash flow whenever the asset
declines in Value.In this case since the firm is Long in the underlying Asset, it should
go Short in the Futures,THAT IS,it should sell Futures Contract in currency
A.Obviously ,the firm cannot gain from an appreciation of A since the gain on the
Receivable will be eaten away by the loss on Futures..The Hedger is willing to sacrifice
this profit to reduce or eliminate the uncertainty.Conversely , a firm with a liability in
Currency A , for instance, a Payable, should go long on Futures.
Hedging with Currency Futures involves the following three decisions1)Which contract should be used-choice of underlying; This decision would be straight forward
if Futures Contracts are available on the currency in which the Hedger has exposure 117
against his home currency. If not the choice is not so simple.
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Thus a Japanese firm has a Receivable in Canadian Dollars and there are no Futures on CAD in
terms of JPY.(OR VICE VERS).Which contract should it choose?It might choose a
JPY/USD contract?This is a Cross Hedge .If It had exposure exposure in USD it would
have hedged using the same contract; now it would be a direct Hedge.
2)Choosing the Maturity of the Contract—Suppose on 28th Feb, a Swiss Firm contracts a 3month USD Payable.This would mature on 1st of June..There is no CHF /USD Futures
contract maturing on that date;traded contracts mature on 3rd Wednesday of June,
September, and so forth..Our immediate response would be “sell the CHF contract.”-nearest to the maturity of the payable.But it is to be remembered that rarely does a
Hedger use Futures o actually take (or make) delivery of the underlying asset ;they are
used only as hedging devices.In this case ,the firm will lift the hedge by buying futures.It
hopes that that if the USD has appreciated in the meanwhile ,its loss on the payable will
be made up by the gain on Futures (conversely of course if USD has depreciated,its
market cash position will show a gain which will be offset by loss on its Futures
position).There is therefore no reason why it must buy the June contract.What can it do
to recoup as much of the loss as possible.?On the day the Futures Contract matures,its
price must equal the Spot Price.,this is known as ‘CONVERGENCE”..The hedging Firm
must first work out whether ‘convergence” worked in its favor or against it
3) Choosing the Number of Contracts-This is perhaps the most important decision.Once again
an easy but generally wrong answer would be that the value of the Futures position
should match as closely possible the value of the cash market position.An exact match
will generally not be possible because of the standardized size of Futures contracts.
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Interest Rate Futures-is one of the most successful financial innovations of the
1970s.The underlying asset is a debt Instrument such as a Treasury Bill,a
Bond ,aTime Deposit in Bank and so on.For instance the International Money
market(a part of Chicago Mercantile Exchange)has Futures Contracts on US
government treasury bills ,three months Euro dollar time deposits and the US
treasury Notes and Bonds.
Interest rate Futures are used by corporations,banks and financial institutions to
hedge interest rate risk..For instance,a corporation planning to issue
commercial paper can use T-bill futures to protect itself against an increase in
Interest rates.A corporate treasurer who expects some surplus cash in the near
future to be invested is short –term instruments may use the same as
insurance against a fall in Interest rates.A fixed income fund manager might
use bond futures to protect the value of his fund against interest rate
HEDGING WITH INTEREST RATE FUTURES-In an environment of volatile
interest rates ,both borrowers and investors may wish to ensure that
borrowing cost does not exceed some ceiling rate, while investors may want
to lock -in a minimum rate of return on their investments..Banks may wish to
reduce the risk arising out of maturity mismatch-borrowing short-term an
lending long-term and hedge their positions on OTC products like
FRAs.Interest rate futures can be used to reduce the risk ,though not
eliminate it..
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FUNCTIONS OF FUTURES MARKETS-The Futures market serves the needs of
Individuals and groups who may be active traders or passive traders,risk averse
or risk traders and /or profit makers.The Market can be classified as
1)Price discovery-Future prices might be treated as a consensus forecast by the
market regarding Future prices for certain commodities/currencies.Individuals
and the society needs information not only for generating wealth but also for
planning of future investment and consumption.Futures markets helps in Price
discovery .
2)Speculation-is a spillover of Futures trading that can provide comparatively less
risk averse investors with the ability to enhance their percentage returns.
3)Hedging- As we have seen Hedgers enter into Future contracts to reduce risk in the
spot position.There are three types of Hedges;
(a) Long Hedge/Anticipatory Hedge-An investor protects against adverse price
movements of an asset that will be purchased in the future,i,e,spot asset is not
currently owned but is scheduled to be purchased or otherwise held at a later
date.(b)Short Hedge-An Investor already owns a spot asset and engages in a
trade to sell its associated futures contract. (c )Cross hedge-In actual hedging
positions there may be mismatch in Time span covered,amounts of the
contract, and characteristics of the goods.
Thus when a trader writes a Future contract on another underlying asset he is said to
establish a cross hedge.
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(3) CURRENCY OPTIONS-Options are unique financial instruments that confer
upon the holder the right to do something without the obligation to do so.More
specifically,an Option is a financial contract in which the buyer of the
option has the right to buy or sell an asset,at a prespecified price ,on or
up to a specified date if he chooses to do so;however ,there is no
obligation for him to do so..In other words ,the Option buyer can simply
let his right lapse by not exercising his Option.The seller of the option
has an obligation to take the other side of the transaction if the buyer
wishes to exercise his option.Obviously the option buyer(holder) has the to
pay the option seller(Writer) a fee for receiving such a privilege.
An option that gives the right to buy is known as ‘CALL”while the one which
gives the right to sell is known as “PUT”.Depending on the contract terms ,an
option may be exercisable on any date during the specified period or it may be
exercisable only on the final or expiration date of the period covered by the
option contract.The option seller charges a premium which the buyer usually
pays upfront.Under favorable circumstances ,the buyer may choose to exercise
it.Alternatively the buyer may be allowed to sell it.If an option can be
exercised on any date during its lifetime it is called an American Style option
but if it can be exercised only on its expiration date ,it is called an European
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Advantages of using Options as Hedging instruments;
1)An option does not require any Margin money as in the case of a Futures contract
nor any bank facility as in the case of a Forward contract.An option buyer can
dispense with both depending on the specific market in which he operates.
2)The options buyer ,at the outset,judges the worst case scenario.Once the premium is
paid,no further cash is payable.When the main objective is to limit downside
risk,this is a powerful advantage.
3)As there is no obligation to exercise an option ,options are ideal for hedging
contingent cash flows which may or may not materialize,such as tenders..
4) Options provide a flexible hedge, offering a range of prices where the option can
be exercised whereas forward or future markets only deal at the forward prices
which exist at the time the deal is made.
5)Options by themselves provide major possibilities in the range of tools available to
Treasurers and traders They can be used on their own to hedge or they can be
combined with the forward and futures markets to achieve more complex
TRADING OF OPTIONS; are traded in two distinct markets.
1)OTC --meaning over the Counter options are available in a large number of
currencies .It is by far the largest market for options..It comprises banks,
American securities houses and corporates.
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There is no central marketplace as such. All transactions are conducted over
the telephone or through the Reuter’s Dealing system and is open 24 hours a
day.The market participants deal with each other directly or through an OTC
broker quoting volatility rates as the dealing price (rather than in currency
prices).The brokers act to bring counter parties together by the broker for such
deals.Trades concluded directly are commission free(so there are no fees when
a corporate deals with its bank).
2)Exchange Listed-the other market for Fx options is the exchange listed markets of
the various stock and futures exchanges around the world..The principal
centers are Philadelphia and Chicago.Access to the market is through brokers
who impose commissions for each contract traded and the market operates on
the floor of the exchange where brokers transact business.
Applications of currency Options-1)Exporters seeking to protect and maximize the
value of currency denominated revenues.(2)Importers seeking to protect and
minimize costs(3) companies holding rights to purchase foreign currency
denominated goods(4)companies that are planning investments ,acquisitions or
divestiture(5)Portfolio managers working to enhance total return through active
management of currency component.(6)Any firm facing currency denominated
obligation or revenue contingent upon other business factors.
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Comparison of OTC and Exchange traded
Exchange traded
Any value subject to minimum
Fixed by contract size
Overnight to 5 years
Fixed day each month for 3 months ;then
quarter months to 1year
Any within reason
Only those listed per schedule
Any pair that has active spot and
forward market
Only those listed
None,but credit line required
Yes on sales only
American or European
American or European Exchange
Trade with a Bank
Order placed with a broker
None,if dealt with a bank
Broker exchange fees
Inter bank in volatile terms
USD per currency or foreign currency per
currency for cross rate contracts
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Option terminology1)CALL OPTION-A call option gives the option buyer the right to purchase a
currency Y against currency X at a stated price Y/X on or before a stated
date.For exchange traded options, one contract represents a standard amount
of the currency Y.The writer of a call option must deliver the currency Y if the
option buyer chooses to exercise his option.
2)PUT OPTION-A put option gives the option buyer the right to sell a currency Y
against currency X at a specified price,on or before a specified date.The writer
of a PUT option must take delivery if the option is exercised.
in the option contract at which the option buyer can purchase the currency
(call) or sell the currency(Put)Y against X.NOTE CAREFULLY THAT THIS
the option buyer must pay the option writer “up front”;that is at the time the
contract is initiated.This fee is like an insurance premium,it is non –refundable
whether the option is exercised or not.
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5)INTRINSIC VALUE OF THE OPTION-The difference between spot price and the
strike price of an option is called as Intrinsic value.The value of an option can
never fall below Zero.Consider an American option on CHF with a strike price
of usd0.5865. If the current spot rate CHF /USD is0.6005,the holder of such an
option can realize an immediate gain of usd(0.6005-0.5865)or usd 0.0141 by
exercising the call and selling the currency in the spot market.This is the
“intrinsic value”of the call option.Therefore the market value or the premium
demanded by the seller of the call must be at least equal to this..The intrinsic
value of an option is the gain to the holder on immediate exercise.For a call
option it is defined as max [(S-X),0]where S is the current spot arte and X is
the strike price .If S >X,the call has a positive Intrinsic value.If S is< or = to
X,the Intrinsic value is zero.Similarly for a put option the intrinsic value is
6)TIME VALUE OF THE OPTION-The value of an American Option at any time
prior to expiration must be at least equal to its Intrinsic value..In general it will
be larger..This is because there is some probability that the spot price will move
further in favor of the option holder..Take the previous example of the call
option on CHF at a strike price of 0.5865when the spot rate is 0.6005
Its market value would exceed its intrinsic value of 0.014because before the
option expires,CHF may appreciate further increasing the gain to the option
holder. .The difference between the value of an option at any time T and its
intrinsic value at the time is called the Time value of the option.
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7)IN THE MONEY – For a call option-If the spot price is more than than the Strike
price, the option is said to be “in the money”
8)AT THE MONEY—For a call option,-If the spot price is equal to the Strike
price, the option is said to be “at the money”.
9)OUT OF THE MONEY-For a call option,-If the Spot price is less than the strike
price, the option is said to “out of the money.
10 )RELATIONSHIP - PRICES -The relationship between the price of the
underlying and price of the option is called as DELTA.Delta of call option can
be between 0 and +1 while Delta of Put option will be between 0 and –1.
11)RELATIONSHIP - TIME-Longer the time period greater will be the value of
the option. Relationship between Time period and value of the option is called
as THETA.THETA is also called as time decay of the option.
12)RELATIONSHIP-INTEREST RATE-Higher the Interest rate ,greater the value
of call option and vice versa.The relationship between interest and price of the
option is called RHO.This is due to the fact that if the interest rate is high then
the investor would prefer to hold call option and invest the balance money to
earn attractive returns.Thus increase in demand will cause the value of the
option to rise.Vice versa will be true for put option.
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13)RELATIONSHIP-VOLATILITY-Higher the volatility of underlying,greater will be
the value of the option.The relationship between the volatility of the underlying
and value of option is called as VEGA ,LAMBDA OR KAPPA.Because the
option writer will like to write option on low volatile underlying due to
predictability of the price,the option holder would like to purchase option only
on assets which are highly volatile.Thus higher the volatility,more will be the
value of both call and put options.
If the underlying is a Dividend paying stock ,for example,greater the chance of
getting a dividend payment, lower will be the value of call option;this is due to
the fact that dividend received will reduce the premium.
USING CURRENCY OPTIONS –As to how currency options might be used,let us
consider an example;
An importer in the US has to make a DM 64500 payment to a German exporter in
60days.The importer could purchase a European call option to have the DM
delivered to him, at the specified exchange rate.I,e,the strike price on the due
date.Let us assume that the option premium is usd.0.02 per DM and the strike
price is USD 0.70.The importer has paid USD 1290(64500x.02) for a DM 70
call option which gives it the right to buy DM 64500 AT APRICE OF USD
0.70 per DM AT THE END OF 60DAYS.Now suppose that the value of the
DM rises to usd.0.76,when the importers payment falls due..The option would
be said to be”in the money”.
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In this case ,the importer exercises its call option and purchases DM for .070.In this
scenario,the importer would earn a profit of usd 3870(64500x.06).which more
than covers the cost of premium for the option.
However if the spot rate declines to below the contracted rate,say,usd.0.66,the DM70
would be “out of the money”.Thus the importer would let the option expire and
purchase the DM in spot market .Despite losing the usd 1290 option
premium,the importer would still be usd 1290 better off than if it had locked in
a rate of usd.0.66 with a forward or futures contract.
The break even price where the gain in the option just equals the option premium is
0.72.Above 0.72 per DM,the option is sufficiently deep ‘in the money” to
cover the option premium and yield a profit.
The reverse will hold good for a PUT option.
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(4)SWAPS-Swap is a Derivative used for Hedging and Risk Management.There are
numerous types of Swaps.But Currency Swaps and Interest Rates Swaps are
the most commonly used Swaps.The expansion in the swap market has
occurred in response to the challenging phenomena which have characterized
financial markets today.-(a)arbitrage opportunities,tax regulations,capital
controls etc.as a result of market imperfection,(b)need for protection against
interest rate and exchange rate risk,( c )Improvements in computer technology
and increasing integration of world capital markets.
A swap is an agreement between two or more parties to exchange a set of
cash flows over a period of time in the future.The basic idea behind swaps is
that the parties involved get access to markets at better terms than would be
available to each one of them individually.The gains achieved by the parties are
divided amongst them depending on their relative competitive
advantage.Financial swaps are an Asset-Liability management technique which
permits a borrower to access one market and then exchange the liability for
another type of liability.Investors can exchange one type of asset for another
with a preferred income stream.Swaps are not a FUNDING/FINANCING
instrument.They are a device to obtain the desired form of financing indirectly
which otherwise might be inaccessible or too expensive.Thus swaps are a
powerful tool propelling global capital market integration.
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Swaps as the name implies are exchange /swap of debt obligations (interest and /or
Principal payments)between two parties.In general,currency swaps are
arranged between two firms /parties through a bank. As mentioned earlier
swaps are not Financing Instruments( as the firms involved in swap contracts
already have debt)they comfort the parties involved not only in terms of the
desired currency involved in debt financing but also provide logistic
convenience in making specified payment of interest and /or principal swaps.
SWAPS are of TWO types;
(1)INTEREST RATE SWAPS;A standard fixed-to-floating interest rate
swap.known in the market jargon as a plain vanilla coupon swap (also
referred to as exchange of borrowings)is an agreement between two parties,in
which each contracts to make payments to the other on particular dates in the
future till a specified termination date.One party known as the Fixed rate
payer,makes fixed payments all of which are determined at the outset.The
other party known as the Floating rate payer will make payments the size of
which depends upon the future evolution of a specified interest rate index(such
as the 6-month LIBOR).
The key features of this SWAP are;
1)NOTIONAL PRINCIPAL-The fixed and floating payments are calculated as if they
were interest payments on a specified amount borrowed or lent.
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It is Notional because the parties do not exchange this amount at any time;it is only used to
compute the sequence of payments.In a standard swap the notional principal remains
constant through the life of the swap.
2)THE FIXED RATE;-The rate applied to the notional principal to calculate the size of the fixed
payment.Banks who make the market in interest rate swaps quote the fixed rate they are
willing to pay if they are fixed rate players in a swap and the fixed rate they are willing
to receive if they are floating rate payers in a swap.These are ,respectively,their bid and
offer swap rates.
Where the transaction is a straightforward”;plain vanilla” fixed/floating interest rate swap with
the principal amount remaining constant throughout the transaction,swap dealers openly
display the rates at which they are willing to pay or to receive fixed rate payments.
A dealer might quote as follows;
US Dollar fixed/f;oating;
2 years Treasury (4.5%)+45/52
3 years Treasury(4.58%)+48/56
4 Years Treasury(4.75%)+52/60
The dealer is in fact saying – “I am willing to be the fixed rate payer in a 2 year swap at 45
basis points above the current yield on Treasury notes( which will mean 4.95%4.5%=45basis points).I am also willing to be the fixed rate receiver at 52 points above
the Treasury yield.”(equal to 5.02%)
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3)FLOATING RATE –In a standard swap at market rates,the floating rate is one of market
index such as LIBOR,prime rate,T-bill rate etc.The maturity of the underlying index
equals the interval between payment dates.
4) TRADE DATE,EFFECTIVE DATE,RESET DATES AND PAYMENT DATESa)The Trade date is the date on which the swap deal is concluded.This is the date when
both the parties have agreed for a swap.
b)The Effective date is the date from which the first fixed and floating payments start to
accrue..For instance,a 5-year swap is traded on August 30,1991,;the effective date
is September 1st 1991 and ten payment dates from March 1,1992 to September
1,1996.Floating rate payments in a standard swap are ‘set in advance- paid in
D(S)-,The setting date on which the next floating rate payment applicable for the next payment
is set.
D(1)- is the date from which the next floating starts to accrue And
D(2) is the date on which payment is due.
D(S) is usually 2 business days before D(1) .
D(1)is the day when the previous floating rate payment is made for the first floating rate
payment is made (for the first floating payment D (1) is the effective date above..If
both the fixed and floating payments are semi annual,D(2) will be the payment
dates for both payments and the interval D(1) to D(2) WOULD BE SIX MONTHS.
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QUALITY SPREAD DIFFERENTIAL-(QSD)-QSD differential occurs due to credit
rating difference due to which fixed Interest loan whose interest cannot be
repriced during the tenor of the loan, carries a higher spread depending on the
credit rating of the borrower,compared to a floating rate interest loan.In fact
swap is based on Ricardo’s theory of comparative advantage..
Example1-Consider 2 companies A and B with the following dataCOMPANY A
95 basis points
12.5 basis points
Company B has a higher credit rating than Company A and can,therefore raise funds
at lower costs in both the fixed rate and floating rate debt markets Company B
however has a greater RELATIVE cost advantage over company A in the
Fixed rate market than in the Floating rate market (95 basis points vs 12.5 basis
points).It would be therefore mutually advantageous for company A to obtain
floating rate funding and for company B to obtain fixed rate funding and then
to enter into a swap arrangement.
Company A wants to obtain medium term 4 years financing at a fixed rate.In case A
were to float fixed 4 year bonds ,it would have to pay interest @11.7%.An
alternative available to the company is to get a term loan at Libor+3/8% at
Floating rate.
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Company B simultaneously wants to borrow floating rate dollars.It can float fixed
bonds @10.75%.Alternatively it can borrow 6 months floating rate dollars in
the inter bank market market at Libor+1/4%.Company B can borrow fixed rate
dollars in the market at 95 basis points BELOW the rate that company A
would have to pay.Company B has privileged access to fixed rate funds vis a
vis company A.
The 2 companies enter into SWAP IN THE FOLLOWING MANNER.;
A borrows floating rate funds at LIBOR+3/8% and sells it to B at LIBOR.
B borrows fixed rate funds at 10.5% and sells it to A at 11 %.
In this manner both companies are able to raise funds in the market in which each
desires. A gains(.70-0.375)=32.5basis points and B
gains(0.25+0.25)=0.50Basis points..Their savings is more than what would
have been obtained had each company accessed the market directly..The
combined savings when both the firms grow simultaneously is 82.5basis
points..Such an arrangement is beneficial to both the parties concerned.
Company A which was in the market for fixed rate funds is able to obtain the funds at
11% instead of 11.7%.Company B which was seeking funds at a floating rate is
able obtain the funds at LIBOR instead of LIBOR+1/4%.
Swaps could be routed through an Intermediary in which case the Intermediary (say a
bank)would also charge for arranging the swap.The total savings would then135
shared by 3 parties.
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Example 2-Company A and B have been offered the following rates PA on a USD
10 MILLION Loan.
Fixed rate
Floating rate
Company A
LIBOR +0.2%
Company B
Company A requires a floating rate loan.Company B require a fixed rate loan.Design
swap that will have a bank acting as an intermediary ,@0.1% and that will
appear attractive to both the companies.
ANSWER-A has comparative advantage in fixed rate markets while B has a
comparative advantage in floating rate markets.However A wants to borrow
floating rate funds and B wants to borrow fixed rates funds.This provides the
basis for the Swap.There is a 1.4% pa differential between the fixed rates
offered to the 2 companies.The total gain to all the parties from the swap deal
is therefore 1.4%-0.5%=0.90%pa.Since the bank gets 0.1%pa ,the swap deal
should make company A and B 0.40% pa (each) better off.
The borrowing by the 2 companies will be Company A should borrow at
LIBOR-0.3% AND Company B should borrow at 13%.
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ADVANTAGS OF INTERST RATE SWAPS1)Does not involve principle amounts
2)Because of the smaller amounts at risk ,the number of potential participants in the
deals is larger.
3)As there is no lending involved,the documentation can be kept simple.
4)The deal is entirely off Balance Sheet.
5)Swap allows the issuers to revise their debt profile to take advantage of current or
expected future market conditions.
LIMITATIONS OF INTEREST RATE SWAPS1)Swaps are not easily tradable.
2)Default risk is high
3)Difficult to find a counter party sometimes.
4)It is not Exchange controlled and it is an OTC market.This calls for extra caution in
dealing with each other as credit risk is high.
5)Termination of deals is not possible without mutual agreement.So once done it may
be difficult to exit
International Financial Management
(2 )CURRENCY SWAPS-In a currency swap ,the two payment streams being
exchanged are denominated in two different currencies.Usually an exchange of
principal amounts at the beginning and a re exchange at termination are also a
feature of a currency swap.
A currency Swap is an exchange of payments in one currency for a stream of payments in
another currency.A typical fixed- to- fixed currency swap works as follows.One
party raises a fixed rate liability in currency X,say in USD.,while the other raises
fixed rate funding in currency Y,say in EUR..The principal amounts are
equivalent at the current market rate of exchange.At the initiation of the swap
contract,the PRINCIPAL amounts are exchanged with the first party handing
over USD to the second ,and getting EUR in return.Subsequently,the first party
makes periodic EUR payments to the second,computed as interest at a fixed rate
on the EUR principal,while it received from the second party payments in USD
again computed as interest on the dollar principal.At maturity,the USD and EUR
principals are re exchanged.
A fixed –to-floating currency swaps also known as CROSS CURRENCY COUPON
SWAP will have one payment calculated at a floating interest rate while the other
is at a Fixed rate.It is a combination of a fixed to fixed currency swap and
Fixed to floating Interest rate swap.In most cases ,an intermediary, a swap
bank, structures the deal and routes the payments from one party to another. 138
International Financial Management
RATIONALE FOR EXISTENCE OF CURRENCY SWAPS1)Cost reductions and Hedging-Used to hedge against FE risk..Hedging can lower a
firms borrowing costs because it reduces uncertainty of cash flows and the
probability of unfavorable changes in the value of assets and liabilities,thereby
making firms more creditworthy(.2)As it increases the total amount that a firm
can borrow,it facilitates economies of scale,which can reduce operating costs.
(3)A firm may be able to use their surplus funds in blocked currencies,. more
effectively (4)May be used as a way of circumventing exchange control
regulations.(5)Swaps can be used as a means of arbitrage opportunities.
(6)Swaps play an important role in integrating the world’s capital markets by
overcoming barriers to International capital movements.
Terminology used in swap1)Swap Facilitator-swaps are mutual obligations among the swap parties.But it may
not be necessary for the counter parties involved in a swap deal to be aware of
the each other because of the role assumed by a swap dealer .Collectively swap
dealers are called Swap banks .(2)Swap Broker is an economic agent who
helps in identifying the potential counter to a swap transaction.He is also called
as the market maker. (3)Basis points- A basis point is one hundredth of a
percentage point (0.01%) For example, a bond yield rise from 5.20% to 5.35%
represents an increase of 15 basis points (4) Swap coupon refers to the fixed
rate of interest on the swap.
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Ina addition to the various market-based hedging devices a firm may be able to reduce
or eliminate currency exposure by means of INTERNAL STRATEGIES or
INVOICING ARRANGEMENTS like risk sharing between the firms and its
foreign customers.
INVOICING-A firm may be able to shift the entire exchange risk to the other party
by invoicing its exports in its home currency and insisting that its imports too
be invoiced in its home currency.Of course the choice of Currency of Invoicing
is often dictated by marketing considerations and exchange control factors.An
exporter may wish to invoice in the buyer’s currency to gain competitive
edge.Invoicing in a weak currency --which may be neither the buyer’s nor
seller’s currency—may be an indirect way of offering discounts which
otherwise may be difficult to offer.In some countries,due to exchange control
the only way a company can take a position in a currency,is by invoicing a
trade transaction in that currency.
If Forward markets in a particular currency are thin or non existent it is better to avoid
invoicing in that country ‘s currency since the exposure cannot be effectively
hedged.Also in the presence of well functioning forward markets this method
will not yield any added benefit compared to a forward hedge.
International Financial Management
Empirically, in a study of the financial structure the following irregularities were
Discovered1)Trade between developed countries in manufactured products is generally invoiced
in the exporters currency.
2)Trade in primary products and capital assets is generally invoiced in the exporters
3)Trade between a developed and less developed currency tends to be invoiced in the
developed country’s currency.
4)If a country has a higher and more volatile inflation rate than its trading partners
there is a tendency NOT to use that country’s currency in trade invoicing.
Another hedging tool in this context is the use of “currency cocktails”or Mixed
currency invoicing for invoicing .Thus for instance,a British importer of
chemicals from Switzerland can negotiate with the supplier that the invoice be
partly in CHF and partly in GBP.
Basket invoicing offers the advantage of diversification and can reduce the variance
of home currency value of the payable or receivable as long as there is no
perfect correlation between the constituent currencies.The risk is reduced but
not eliminated.
SELECTING a country whose currency is less volatile is another form of Preventive
Hedging.Supplies from these countries will have a steady FE transactions.
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Important Terminology in FE –
1)Forward Rate Agreements-A Forward Rate Agreement (FRA) is
notionally an agreement between two parties in which one of them
(the seller of the FRA),contracts to lend to the other (the buyer), a
specified amount of funds ,in a specific currency , for a specified
period starting at a specified future date ,at an interest rate fixed at
the time of agreement.we say ‘notionally”,because in practice,actual
lending or borrowing of the underlying principal does not take place
but only the interest rate is locked in.The buyer of the FRA in turn
agrees to borrow (again notionally),funds for a specified
duration,starting at a specified duration,starting at a specified future
date,at a rate fixed at the time the FRA is bought.
A typical FRA quote from a bank might look like this;
USD 6/9 MONTHS;7.2-7.3%PA-Which means that the bank is willing to
accept a 3 month USD deposit,that is ,borrow funds,starting 6 months
from now,maturing nine months from now,at an interest rate of
7.20%pa (the bid rate).The bank is willing to lend dollars for a period
of 3 months,starting 6 months from now at an interest rate of
7.3%pa(the ask rate).There is no exchange of Principal amount.
International Financial Management
FRAs like Forward exchange contracts are a conservative way of hedging exposure.It
removes all uncertainty from cost of borrowing or rate of return on
investment.The relationship between FRA and an Interest Rate Futures contract
ic exactly analogous to that between a Forward currency contract and Currency
Futures contract.
International Financial Management
INTERNATIONAL CAPITAL BUDGETING-Capital Budgeting for multinational
firms uses the same framework as domestic capital budgeting
.However they face a number of complexities as follows;
1)Parents cash flows are different from project(subsidiaries)cash flows
2)All cash flows from the foreign projects must be converted into the currency of the
parent company.
3)Profits remitted to the parent company are subject to two taxing jurisdictions.
4)Anticipate the differences in the rates of national inflation as they can result in
changes in competitive position and thus in cash flow positions over a period
of time.
5)The possibility of Foreign exchange risk and its effect on the parent’s cash flows.
6)If the host country provides some concessionary financing arrangements and /or
other benefits,the profitability of the foreign project may go up
7) Host countries may impose various restrictions on the distribution of
cash.generated form foreign projects.
8)Political risks must be evaluated thoroughly as changes in political events can
drastically affect the cash flows.
9) Economic situations can affect the projects and may affect the cash flows
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Another problem in multinational capital budgeting is the problem of Blocked
funds.Accounting for blocked funds in the capital budgeting process depends
on the opportunity cost of blocked funds.I they can be used for foreign
investments ,the project costs to the investor may be below the local cost of the
project.Also if the opportunity cost of the blocked funds is zero the entire
amount released for the project should be considered as a reduction in the
initial investment.
3) TAXATION ISSUES-Both in domestic and International capital budgeting ,only
after –tax cash flows are relevant for project evaluation.However ,in
International( or multinational) capital budgeting ,the tax issue is complicated
by the existence of two taxing jurisdictions,plus a number of other factors,like
remittances to the parent,dividends, management fees royalty ,withholding tax
provisions ,tax treaties etc.The ability of the MNC to reduce its overall tax
burden through the Transfer pricing Mechanism should also be considered.If
treaties exist ,the highest tax rates of either of the countries should be
reckoned for budgeting purposes,to be on a conservative basis.
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PROBLEMS AND ISSUES IN FOREIGN INVESTMENT ANAYSIS1)FE RISK-Multinational companies investing abroad are exposed to FE risks –the
risk that the currency will appreciate or depreciate over a period of
time.understanding this is an important evaluation of cash flows generated by
the project over its life cycle.To incorporate the FE risk element in the cash
flows estimates,first an estimate is made of the inflation rate in the host country
during the life span of the project.The cash flows ,in terms of the local
currency,are then adjusted upwards for the inflation factor.Then the cash flows
are converted into the parent’s currency at the spot exchange rate multiplied by
an expected depreciation rate calculated by the PPP theory.
2)REMITTANCE RESTRICTIONS-Where there are restrictions on the
repatriation of income,substantial differences exist between project cash flows
and cash flows received by the parents firm.Only those flows that are
remittable to the parent are relevant from the MNC’s perspective.Many
countries impose a variety of restrictions on transfer of profits,depreciation and
other fees accruing to the parent company.Project cash flows consist of profits
and depreciation charges whereas parents cash flows consist of the amounts
that can be legally transferred by the project/subsidiary.
4)PROJECT VS PARENTS CASH FLOWS –substantial differences can exist
between the Project and the parent cash flows because of tax regulations and146
exchange controls.
International Financial Management
In the light of substantial differences that can exist between a parent company and
project cash flows,the important question is how to evaluate cash flows?
1)Its own cash flows
2)cash flows accruing to the parent company
Some experts have suggested a 3 stage financial analysis of foreign projects.
In the first stage,project cash flows are computed and analyzed from the point of view
of the subsidiary or the affiliate as if it were a separate entity.
The second stage involves evaluation of the profit on the basis of forecasts of cash
flows which will be transferable to the parent company.
In the third s and last stage ,the analysis from the viewpoint of the parent company is
widened to include indirect benefits or costs from the company as a
whole,which are attributable to the foreign project in question.
1)DCF technique involves the use of the time-value of money principle to project
evaluation.The two most widely used criteria of the DCF technique are the
NVP and the IRR methods.Both the techniques discounts the project’ cash flow
at an appropriate discount rate.The results are then used to evaluate the projects
based on the acceptance/rejection criteria developed by the management. 147
International Financial Management
The NPV of a project is the present value of all cash inflows ,including those at the
end of the Project's life,minus the present value of all cash outflows.
The IRR method finds the discount rate which equated the present value of the cash
flows the present value of all cash flows to zero.generated by the project with
the initial investment or the rate at which would equate the present value of all
cash flows to zero.
that can be adapted o the unique aspect of evaluating foreign projects is the
adjusted present value approach (APV).The APV format allows different
components of the project’s cash flow to be discounted separately.This allows
the required flexibility ,to be accommodated in the analysis of the foreign
project..The APV approach uses different discount rates for different segments
of the total cash flows depending upon the degree of certainty attached with
each cash flow..In addition ,the APV format helps the analyst to test the basic
viability of the foreign project before accounting for all the complexities.If the
project is acceptable in this scenario,no further evaluation based on accounting
for other cash flows is done.The APV model is a value added approach to
capital budgeting,I,e, each cash flow as a source of value is considered
individually.Also in the APV approach each cash flow is discounted at a rate
of discount consistent with the risk inherent in that cash flow.
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ADJUSTMENT-Another important dimension in Multinational capital
budgeting is whether to adjust cash flows or the discount rate for the
additional risk that arises from the foreign location of the project.Traditionally
MNC’s adjust the discount rate by moving it upwards for riskier projects to
reflect the political and FE uncertainties.A significant number of firms that use
the DCF technique in domestic projects also assign different hurdle rates for
different projects depending on their risk categories.
The other alternative is to adjust cash flows rather than the discount rate in treating
risk.The annual cash flows are discounted using the applicable rate for that
type of project. Either at the host country or at the parent
country,Probability and certainty equivalent techniques like Decision
tree analysis are used in economic and financial forecasting.Cash flows
generated by the project and remitted to the parent company during each time
period are adjusted for political risk ,exchange rate and other uncertainties by
converting the into certainty equivalent.The method of adjusting the cash flows
rather than the discount rate is generally the more popular method and is
usually recommended by Finance managers.There is generally more
information on the specific impact of a given risk on a project’s cash
flows than on its discount rate.
International Financial Management
Foreign Direct Investment is an investment made by a Transnational Corporation to
increase its international business.It generally involves the establishment of
new production facilities in foreign countries to earn extra returns..Foreign
Direct Investment is motivated by a complex set of strategic ,behavioral
economic and financial considerations. FDI has been a major factor in
stimulating economic growth and development in recent times.The
contribution that MNCs can make as agents of growth,structural change and
International integration has been made FDI a coveted tool of economic
development and a source of capital.FDI links the host economy and fosters
economic growth.
New sources of demand.-penetrate new markets-Domestic market saturation
Existence of various market imperfections-in product,factor,capital
Economies of scale-volume sales,larger facilities cater to larger markets
Use of foreign raw material and technology.
Use existing obsolete secondary technology in domestic market outside the
Exploit monopolistic advantage-- Firms becoming internationalized due to
competitive advantage.
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Diversify Internationally-hold assets internationally in many countries-capital
market imperfections may thus motivate firms to undertake FDI.
Political safety seekers
Knowledge seeking
1)Joint Venture-A Joint Venture is a coming together of two companies and
establishing an entity to do business together in the host country/location.It is a
viable form of increasing international business.
2)Mergers and Acquisitions/cross border acquisitions-Mergers and Acquisitions take
place internationally to increase market share and competitive position
3)Licensing-is a popular method used by MNCs to profit from foreign markets
without the need to commit sizable funds.Since the foreign producer is 100%
locally owned,the political risk tends to get minimized.In licensing, local firm
in the host country produces the goods to the licensing corporations specs.
When the goods are sold , a portion of the revenues, as specified by the
agreement, are sent o the licensor.
4)Franchising-Franchising is another form of expansion internationally.Here,the
Franchiser gives right to sell his product in a specified territory.There is an
upfront fee payment and Royalty payment based on sales done by the
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1)Legislative and Policy Reforms;(a)Remove unnecessary restrictions on equity
participation(b)standardize guidelines for environmental issues.
(c )Strengthened IP laws (d)Reduce the variance of FDI laws based on sectors.
(e)Increase trade openness
2)Government processes and machinery-(a)Increase areas for automatic approval
(b)Reduce the role of the FIPB(C )Streamline the number of agencies-single
window clearance
3)Center-State Dynamics-Devolve more authority in selected areas to the states to
negotiate projects.
4)Infrastructure-(a)Increase Political commitment,regulatory transparency and dispute
resolution mechanisms to attract foreign participation in infrastructure (b)
focus immediately on the infrastructure of airports,telecom ports ,roads
5)Concentrated Zones for FDI activity-(a)Expand export processing zones to provide
modern infrastructure for export oriented projects(b)Expand the issues of
technology parks and other zones to increase the opportunities of
agglomeration of industries for which India is particularly attractive(c )Allow
the private sector to set up and operate some of these sites.
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6)Engagement of Foreign Investors-(a) create a council of senior union and state
government officials and representatives of large foreign-invested companies.
(b)Use the council to deepen the insights into issues that impede FDI.(c )Use
the council to develop high impact decisions and learn from the these actions
quickly (d)use the council to build mutual respect and trust
Some of the important factors taken into consideration by foreign investors
when entering into a country are1)Reliable access to economic information
2)Level of corruption
3)Stability of political and business environment.
4)Character of local market or the distance and the access to neighboring
markets.Many MNCs invest in one country and use it as a stepping stone to
enter another country.
5)The existence of good and quality infrastructure consisting of ,among
others,advanced telecommunications and energetic network is an advantage
that may decide in the selection of a country.
6)Ability to meet and comply with internationally acceptable standards and norms.
International Financial Management
FDI permitted under the following forms of Investments•
Through financial collaborations
Through JVs and technical collaborations
Through capital markets and euro issues
Through private placements
FDI not permitted in the following industrial sectors•
Atomic energy
Railway Transport
Coal and Lignite
Mining of Iron ,manganese,chrome,gypsum,sulphur ,gold ,diamonds,copper
and zinc.
FOREIGN PORTFOLIO INVESTMENT-The twentieth century has seen massive
cross-border flows of capital.However,till the 80s,it was predominantly debt
capital in the form of bank loans and bond issues.The International new issues
equity market with globally syndicated offerings emerged during the eighties
grew rapidly till the stock market crash of 1987 .The initial thrust to crossborder flows of equity investment came from the desire on the part of
institutional investors to diversify their Portfolios
International Financial Management
Globally in search of both higher return and risk reduction
Foreign Portfolio Investment is through GDRs/ADRs .Indian companies are allowed
to raise equity capital in the International market through the issue of these
instruments.These are not subject to any ceiling on investment.
Foreign Portfolio Investment is subject to greater volatility due to shorter-term
commitments.An important point here is that private portfolio investment
inflows in emerging markets dropped sharply after the East Asian crisis.
INTERNATIONAL EQUITY MARKETThe International equity market can be divided into two categories1)Foreign Equity;If the equity issue is made in a particular domestic market (and in
the domestic currency of that market)it is known as a “Foreign Equity Issue”.
For example ,an Indian company accessing exclusively the US market through an
equity issue would be called a”foreign equity issue.”.The instrument available
for the above case is called American Depository Receipt( ADR) .if a non
European country raises funds exclusively from European countries through
International /European Depository Receipts(IDRs/EDRs),it is also referred to
as Foreign Equity Issue.
International Financial Management
2) )EURO EQUITY;If a company raises funds using equity route through Instruments
like Global Depository Receipts(GDR).or super stock Equity in more than one
foreign market except the domestic market of the issuing company and
denominated in a currency other than that of the issuer's home country is
known as Euro Equity Issue.
DEPOSITORY CERTIFICATE-A Depository certificate(DR) is a negotiable
certificate that usually represents a company’s publicly traded equity or
debt.DRs are created when a broker purchases the company’s shares on the
home market and delivers those to the Depository’s local custodian bank,which
then instructs the Depository bank to issue Depository receipts.Depository
receipts are traded in the currency of the country in which they trade and are
governed by the trading and settlement procedures of the market.
DR’s are issued for a number of reasons;
To raise capital in foreign markets
To potentially increase the liquidity of their shares by broadening shareholders
To gain visibility through financial market presence which can generate
support for and interest in potential mergers and acquisitions.
To allow employees outside the home market to participate in equity..
International Financial Management
AMERICAN DEPOSITORY RECEIPTS-is a Dollar denominated negotiable
certificate that represents a non-Us company’s publicly traded equity.It falls
within the regulatory framework of the USA and requires registration of the
ADRs and the underlying shares with the SEC.In 1990,changes in rule 144A
allowed companies to raise capital without having to register with SEC..Non
US companies have a choice of 5 types of ADR facilities1)Unsponsored ADR programme-initiated by a third party,not the issuing firm
2)Sponsored ADR programmes•
Level-1-is exempt from full compliance with the SECs reporting requirements
and cannot be listed on the national exchanges
Level –2- should be in full compliance with the SECs registration disclosure
and reporting requirements which allow ADRs to be listed on
NYSE,AMEX,or NASDAQ.However this type of ADR cannot be used to raise
capital through a public offering.
Level-3 –has the same requirements and privileges as level 2 plus it is allowed
to raise capital through a public offering provided that the issuer submits
appropriate information to the SEC.
Rule 144(a)ADRs-restricted ADRs are not required to comply with with the
full SECs registration and reporting requirements and are used for private
placement to qualified institutional buyers.
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Benefits of ADRs-For issuers,there are several reasons for launching and managing
an ADR programme1)An ADR programme can stimulate investor interest ,enhance a company’s
visibility,broaden its shareholder base and increase liquidity.
2)By enabling a company to access US capital markets ADR offers a new avenue for
raising capital at highly competitive costs.
3)ADRs provide an easy way for US employees of non –US companies to invest in
their companies employee stock purchase plans.Features such as dividend
reinvestments programme can help ensure that an issuer’s ADRs trade is in
comparable range with those of its peers in the US market.
Benefits to INVESTORS•
American Depository receipts are US securities
ADRs are easy to buy and sell
ADRs are liquid
ADRs are global
ADRs are cost effective
ADRs are convenient to own
ADRS have improved quality of disclosure
Better valuations
International Financial Management
GLOBAL DEPOSITORY RECIPT-It is a global finance vehicle that allows to raise
capital simultaneously in two or more markets through a global offering.
GDRs may be used in either public or private markets inside or outside the US. They
are marketed internationally ,mainly to financial institutions .A GDR is an
instrument to raise capital in multiple markets outside the issuer;s domestic
market through one security which is traded in a foreign stock market.
Characteristics of GDRs•
Holders of GDRs participate in the economic benefits of being ordinary
shareholders though they do not have voting rights.
GDRs are listed on the Luxemburg stock exchange
Trading takes place between professional market makers on an OTC basis
Liquidation of GDR---after 45 days
GDRs have become synonymous with selling equity in the Euro markets.This
is so because fresh shares are issued by the company which is raising money
from the markets,and transferred, to a depository which ,in turn,issues, a
receipt which is quoted at any stock exchange where it is listed.Considering
that a company does not need to be evaluated by the international rating
agency before marketing GDRs-which suits Indian companies just fine-,they
are easy to issue.
International Financial Management
Not only is the cost of selling a GDR issue comparatively low,this instrument
provides access to a broad investor base spread across various continents.And
best of all ,the time lag between concept and execution can be as short as 7
There are several variations to plain Vanilla GDRs.E.g.,there could be call
options which allow the issuer to limit the benefits to equity holders by
insisting on conversions of the GDR into more equity beyond certain limits.
Thus a GDR is a negotiable instrument denominated in dollars or some other
freely convertible currency.It is used as a funding vehicle for raising capital
simultaneously in 2 or more markets.The GDR structure allows for
simultaneous issuance of securities in multiple markets.This facilitates greater
liquidity through cross border trading.GDRs can be issued in either public or
private markets in the US or other countries.
A GDR gives its holder the right to get equity shares of the issuer company as
per the terms of Offer.Till such conversion takes place ,the GDR holder has no
voting rights.The shares represented by the a GDR are identical to other equity
shares in all respects.
Once a GDR is issued it can be traded freely among International
investors.GDRs are freely tradable in the overseas market like any other dollar
denominated security either on as foreign stock exchange or in the OTC
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Center-NYSE is the largest stock The LSE is not as large as the
exchange in the world for ADRs NYSE overall but is the global
for both value and turnover
center for international business
Instrument-No legal or technical
difference between an ADR and
GDR.Level3 suited for fund
Unlike the NYSE,the LSE makes
no demands requiring companies
to give holders the right to vote
disclosure required
Less onerous than ADR
GAAP-Must reconcile their
accounts to US GAAP
LSE satisfied with a statement of
the difference between the UK and
Indian Accounting standards
Cost-US listing could be
expensive.Initial cost 1 to 2 million inexpensive.around 200 to 400k
Liability-Legal liability of both a
company and its individual
directors increased by a full US
Legal liability of a company and its
directors is less than in the case of
an ADR
International Financial Management
International Financial InstrumentsThe Funding avenues potentially open to a borrower in the global capital marketare;
a)Straight Bonds
b)Floating Rate Notes(FRNs)
c)Zero-coupon Bonds
d)Bonds with a variety of option features embedded in them
2)Syndicated credits --These are bank loans,usually at floating rate of
Interests,arranged by one or more lead managers(banks) with a number of other
banks participating in the loan.A number of variations on the basic theme are
3)Medium –Term Notes—Initially conceived as instruments to fill the maturity gap
between short-term money market instruments like commercial paper and long
–term instruments like bonds,these subsequently evolved into very flexible
borrowing instruments for well-rated issuers,particularly in their “Euro”
Version,viz Euro-medium term Notes(EMTNS)
4)Committed underwritten Facilities—The basic structure under this is the Note
Issuance Facility.Introduced in the 1980s these instruments were popular for a
while before introduction of risk based capital adequacy norms rendered them
unattractive for banks.
International Financial Management
5)Money Market Instruments—These are short-term borrowing instruments and
include Commercial Paper,Certificates of Deposits,Bankers Acceptance among
others.(also refer to slides 68 and 69)
In addition to these ,export related credit mechanism such as buyers’ and suppliers’
credits credit,general purpose lines of credit,forfaiting are other forms of
medium/long term financing.(already discussed earlier)
BOND MARKETS-A bond is a debt security issued by the borrower,purchased by
the investor,usually through the intermediation of a Group of Intermediation of
a group of underwriters.
A straight Bond is the Traditional Bond .It is a debt instrument with a fixed maturity
period, a fixed coupon which is a fixed periodic payment usually expressed as
a percentage o the face or par value, and repayment of the face value at
maturity.-also known as Bullet payment of the principal amount.The market
price at which it bought by an investor either in the primary market (new
issue) or in the secondary market is its Purchase Price, which could be
different from its face value.When they are identical the bond is said to be
selling at Par,when the face value is less than (more than),the MARKET
PRICE,the Bond is said to be trading at a Premium(Discount).The difference
could arise because the Coupon is different from the ruling rates on bonds with
equal perceived risk and maturity or creditworthiness of the issuer is different.
International Financial Management
YIELD is a measure of return to the holder of the bond and is a combination of the
purchase price and coupon.There are many concepts of yields and the coupon
payments could be annual.semi- annual or even longer.
Variants OF Straight Bonds(A) A callable bond can be redeemed by the issuer at his choice.,prior to its
maturity..The first call date is normally some years from the date of issue e.g.
a 15 year bond may have call provision which allows the issuer to redeem the
bond at any time after 10 years.The CALL PRICE,that is the price at which the
bond will be redeemed is normally above face value with the difference
shrinking as the maturity date approaches.
(B) A Puttable Bond IS THE OPPOSITE OF callable Bond.It allows the investor
to sell it back to the issuer prior to maturity.The investor pays for this privilege
in the form of lower yield.
(C) Sinking Fund Bonds --were a device,often used by small risky companies to
assure the investors that they will get their money back
Floating Rate Notes(FRNs)-are instruments in which interest rate is floating
based on bench mark like LIBOR.There are various variants of floating rate
notes like(a) FRNs with multi currency option,(b)minimax FRN where cap and
floor are fixed for interest rates,(c )Perpetual FRN which does not have any
redemption period, (d)Flip-Flop FRN wherein the holder ha an option to treat
the FRN as perpetual after holding it for a time period.
International Financial Management
Medium Term Notes are facilities issued for more than one year up to desired level of
maturity.Insurance companies are the major investors in these funds.Interest
rates depend on credit rating, off take by pension funds,banks,MFs etc
(E)-ZERO COUPON BONDS –(called simply zeros) are similar to the cumulative
deposits schemes offered by companies in India.The Bond is purchased at a
substantial discount from the face value and redeemed at face value on
maturity.There are no interim interest payments.
(F) Deep discount bonds-do pay a coupon(annual interest rate ) but at a rate
below the market rate for a corresponding straight bond .Bulk of the return to
the investor is in the form of capital gains.
(G) Convertible Bonds– are bonds that can be exchanged for equity shares either
of the issuing company or some other company.The conversion price
determines the number of shares for which the bond will be exchanged.The
conversion value is the market value of the share s which is less than the face
value of the bond at the time of issue.As the share price rises,the conversion
value rises.It is a form of deferred equity.
(H) WARRANTS- are an option sold with a bond which gives the holder the right
to purchase a financial asset at a stated price.The warrants may be permanently
attached to the bond or detachable and separately tradable.Initially warrants
were used by speculative issues as an added incentive to the investor to keep165
the interest costs within limits
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(I)Bonds with embedded options– will be priced to include the value of the
option.If the issuer gets the option (for e.g. ,a callable bond),the yield would
have to be higher than a comparable straight bond;If the option is granted to
the Investors , for instance, a puttable bond or a convertible bond,its value will
be reflected in the lower yield.
The largest International Bond market is the Euro bond market which is s aid to have
originated in 1963 with an issue of eurodollar bonds by Autostrade ,an Italian
Borrower.Eurobond markets in all currencies ,except Yen are quite free from
any regulation by the respective governments except Euro yen which is
controlled by the Ministry of Finance ,Japan.They are listed on stock
exchanges in Europe.Secondary markets trading in eurobonds is almost
entirely OTC by telephone between dealers.
Among the national capital markets US market is largest in the world.It is
complemented by worlds largest and most active derivative markets,both OTC
and exchange traded.
(J)YANKEE BONDS—From a non -resident borrower’s point of view,the most
prestigious funding avenue is public issue of Yankee Bonds.These are Dollar
denominated Bonds issued by foreign borrowers.It is the largest and most
active in the world but potential borrowers must meet very stringent
disclosure ,dual rating and other listing requirements.
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Yankee Bonds are also offered under rule 144 A OF THE sec.These issues are exempt
from elaborate registration and disclosure requirements,but rating ,while not
mandatory is helpful.Finally low rated or unrated borrowers can make private
(K)SAMURAI BONDS– are publicly issued Yen denominated binds and like Yankee
bonds are the most prestigious funding vehicle.The Japanese Ministry of
Finance lays down the eligibility guidelines for potential foreign
borrowers.They specify the minimum rating ,size of the issue ,maturity and so
forth.Syndication and underwriting procedures are quite elaborate and so is the
documentation.Hence floatation costs tend to be high.Pricing is done with
reference to the Long term prime rate (LTPR).
(L)SHIBOSAI BONDS– are private placement bonds with distribution limited to
institutions and banks,while eligibility criteria are less stringent,the MOF still
controls the market in terms of rating,size and maturity of the issue.
(M)SHOGUN BONDS-are publicly floated bonds denominated in a foreign
(N)GEISHA BONDS- are their private placement counterparts.
(o)BUNNY BONDS-These bonds permit investors to reinvest their interest incomes
into more such bonds with the same terms and conditions.
(p)Bulldog bonds-are denominated in GBP for UK investors floated by non-UK
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(1)commercial Bank loans(2)Buyers’ credit(3)Suppliers credit(4)securitised
Instruments such as Floating Rate Notes and Fixed Rate Bonds(5)Various
forms of Euro and syndicated loans
Meet forex cost of capital goods and services
For project related rupee expenditure in infrastructure projects in
Power,telecom and railways
Corporate borrowers able to raise long- term resources with an average
maturity of 10 years and 20 years will be allowed to use the ECB proceeds up
to usd 100 million and 200 million respectively without any end use
APPROVALS REQUIRED-1)For ECB of minimum maturity of less than 3 years
approval from RBI alone is required.(2)For minimum average maturity of 3
years and above ,sanction is required from MOF and then from RBI
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COUNTRY RISK ANALYSIS-Country Risk is an indispensable tool for
asset management as it requires the assessment of economic opportunity
against political odds.The list of factors to be analyzed in a country risk varies
from forecaster to forecaster .Two important indicators emerge in this process;
A)POLITICAL RISK(PR) INDICATORS-It is very difficult to assess political risk
associated with a particular country or a borrower..Assessing a political risk is
a continuous process and it is very difficult to identify a few political risk
factors.Some of the common political risks are;
1)Stability of the local political environment--The level of PR for each nation is
analyzed here.Measures here take cognizance of changes in the
government,levels of violence in the country ,internal and external conflict and
so on. Existing political status and continuity of the government will be
2)Consensus regarding Priorities-This is a measure of the degree of agreement and
unity on the fundamental objectives of Govt policy and the extent to which this
consensus cuts across party lines.
3)Attitude of Host Government-If the host government starts imposing restrictions and
becomes unfriendly then it becomes greater risk..e,g anti MNC stand of the
left Govt always stopping FDI in certain sectors,levy of higher taxes etc.
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4)war-If war is possible for the country under ,the safety of employees and Assets
will be affected and needs to be reviewed.
5)Mechanism for expression of discontent- This is related to the ability to effect
peaceful change,provide internal continuity and to alter direction of policy
without major changes of the political system .
B)ECONOMIC RISK (ER)INDICATORS1)Inflation rate-The inflation rate is used as a measure of economic
instability,disruption and government mismanagement .Inflation also affects
the purchasing power of consumers and also the consumers demand for MNCs
2)Current and Potential state of the country’s economy-Several economic factors
have to be weighed before any conclusion about the soundness of the economy
can be arrived at-External Debt,Forex position,BOP position,GDP
growth,Current account position,Interest rates etc .
3)Resource base—The resource base of a country consists of a country consists of its
national ,human and financial resources.But it could be paradoxical in some
cases-eg Mexico with resources being worse off that Korea and Japan in terms
of risk.
4)Adjustment to external shock-The ability of the country to adapt o external shocks.
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2)Balance of Payments
3)Economic performance
4)Political instability
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WORKING CAPITAL MANAGEMENT IN MNCsOBJECTIVE1)Minimize the currency exposure risk
2)Minimize country and political risk
3)Minimize the overall cash requirements of the company as a whole without
disturbing the smooth operations of the subsidiary or its affiliate.
4)Minimize the transaction costs.
5) Full benefits of economies of scale as well as benefit of superior knowledge.
1)Maintaining minimum cash balance during the year.
2)Helping the center to generate maximum possible returns by investing all cash
resources optimally.
3)Judiciously manage the liquidity requirements of the center.
4)Helping the center to take complete advantage of multinational netting so as to
minimize transaction costs and currency exposure.
5)Optimally utilize the various hedging strategies so as to minimize the MNCs foreign
exchange exposure.
6)Achieve maximum utilization of the transfer pricing mechanism so as to enhance172
profitability.and growth of the firm.
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Techniques to Optimize cash flow1)Accelerating cash inflows
2)Managing blocked funds
3)Leading and Lagging funds
4)Using netting to reduce overall transactions costs by eliminating a number of
unnecessary conversions and transfer of currencies
5)Minimizing the tax on cash flow through International TP.
6) Cash pooling
Management of short –term Assets and Liabilities –
Cash,Investments,Receivables,Payables,-is an important part of the Finance
Mangers job.The essence of short-term financial management can be
summarized as follows1)Minimize the working capital needs consistent with other policies (eg granting
credit to boost sales,maintain inventories,to provide a desired level of customer
services etc)
2)Raise short term funds at the minimum possible cost and deploy short-term cash
surpluses at the maximum possible rate of return consistent with the firms
preferences and liquidity needs.
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Cash Management in a MNC poses more challenges than inventory or receivable
management which are more or less similar to the domestic environment.
Ways and means
ACCOUNT(Indian companies only)
3)INVESTING SURPLUS FUNDS-Short term liquid money market instruments are
available in various markets.Once the treasures has identified the cash flows
and determined how much surplus funds are available in which currencies and
for what durations,he or she must chose appropriate investment vehicles so as
to maximize the interest income while at the same time minimizing currency
and credit risks-instruments like short term bank deposits,fixed term money
market deposits etc.consideration for choosing an instrument would be(a)Yield
(b) Marketability (c )Exchange rate risk (d) Price risk (e)Transaction costs
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