Master of Business Administration -MBA Semester 4 MF0015 - International Financial Management Assignment Set- 1 Q1. What is meant by BOP?

How are capital account convertibility and current acc ount convertibility different? What is the current scenario in India? Ans:-The b alance of payments (or BOP) of a country is a record of international transactio ns between residents of one country and the rest of the world over a specified p eriod, usually a year. Thus, Indias balance of payments accounts record transacti ons between Indian residents and the rest of the world. International transactio ns include exchanges of goods, services or assets. The term residents means busine sses, individuals and government agencies and includes citizens temporarily livi ng abroad but excludes local subsidiaries of foreign corporations. The balance o f payments is a sources-and-uses-of-funds statement. Transactions such as export s of goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows (sources). Transactions such as imports of goods and services t hat expend foreign exchange are recorded as debit, minus, or cash outflows (uses ). The Balance of Payments for a country is the sum of the Current Account, the Capital Account and the change in Official Reserves. The current account is that balance of payments account in which all short-term flows of payments are liste d. It is the sum of net sales from trade in goods and services, net investment i ncome (interest and dividend), and net unilateral transfers (private transfer pa yments and government transfers) from abroad. Investment income for a country is the payment made to its residents who are holders of foreign financial assets ( includes interest on bonds and loans, dividends and other claims on profits) and payments made to its citizens who are temporary workers abroad. Unilateral tran sfers are official government grants-in-aid to foreign governments, charitable g iving (e.g., famine relief) and migrant workers transfers to families in their ho me countries. Net investment income and net transfers are small relative to impo rts and exports. Therefore a current account surplus indicates positive net expo rts or a trade surplus and a current account deficit indicates negative net expo rts or a trade deficit. The capital (or financial) account is that balance of pa yments account in which all cross-border transactions involving financial assets are listed. All purchases or sales of assets, including direct investment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in the capital account. When Indian citizens buy foreign securities or when foreig ners buy Indian securities, they are listed here as outflows and inflows, respec tively. When domestic residents purchase more financial assets in foreign econom ies than what foreigners purchase of domestic assets, there is a net capital out flow. If foreigners purchase more Indian financial assets than domestic resident s spend on foreign financial assets, then there will be a net capital inflow. A capital account surplus indicates net capital inflows or negative net foreign in vestment. A capital account deficit indicates net capital outflows or positive n et foreign investment. Current scenario in India The official reserves account ( ORA) records the total reserves held by the official monetary authorities (centr al banks) within the country. These reserves are normally composed of the major currencies used in international trade and financial transactions. The reserves consist of hard currencies (such as US dollar, British Pound, Euro, Yen), official gold reserve and IMF Special Drawing Rights (SDR). The reserves are

held by central banks to cushion against instability in international markets. T he level of reserves changes because of the central banks intervention in the for eign exchange markets. Countries that try to control the price of their currency (set the exchange rate) have large net changes in their Official Reserve Accoun ts. In general, a net decrease in the Official Reserve Account indicates that a country is buying its currency in exchange for foreign exchange reserves, to try to keep the value of the domestic currency high with respect to foreign currenc ies. Countries with net increases in the Official Reserve Account are usually at tempting to keep the price of the domestic currency cheap relative to foreign cu rrencies, by selling their currencies and buying the foreign exchange reserves. When a central bank sells its reserves (foreign currencies) for the domestic cur rency in the foreign exchange market, it is a credit item in the balance of paym ent accounts as it makes available foreign currencies. Similarly, when a central bank buys reserves (foreign currency), it is a debit item in the balance of pay ment accounts. The Balance of Payments identity states that: Current Account + C apital Account = Change in Official Reserve Account. If a country runs a current account deficit and it does not run down its official reserve to cover this def icit (there is no change in official reserve), then the current account deficit must be balanced by a capital account surplus. Typically, in countries with floa ting exchange rate system, the change in official reserves in a given year is sm all relative to the Current Account and the Capital Account. Therefore, it can b e approximated by zero. Thus, such a country can only consume more than it produ ces (or imports are greater than exports; a current account deficit) only if it has a capital account surplus (foreign residents are willing to invest in the co untry). Even in a fixed exchange rate system, the size of the official reserve a ccount is small compared to the transactions in the current and capital account. Thus the residents of a country cannot have a current account deficit (imports exceeding exports) unless the foreigners are willing to invest in that country ( capital account surplus). Q2. What is arbitrage? Explain with the help of suitable example a tow-way and a three-way arbitrage. Ans:-Arbitrage is the activity of exploiting imbalances be tween two or more markets. Foreign money exchangers operate their entire busines ses on this principle. They find tourists who need the convenience of a quick ca sh exchange. Tourists exchange cash for less than the market rate and then the m oney exchanger converts those foreign funds into the local currency at a higher rate. The difference between the two rates is the spread or profit. There are pl enty of other instances where one can engage in the practice arbitrage. In some cases, one market does not know about or have access to the other market. Altern atively, arbitrageurs can take advantage of varying liquidities between markets. The term arbitrage is usually reserved for money and other investments as opp osed to imbalances in the price of goods. The presence of arbitrageurs typically causes the prices in different markets to converge: the prices in the more expe nsive market will tend to decline and the opposite will ensue for the cheaper ma rket. The the efficiency of the market refers to the speed at which the disparat e prices converge. Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk is the potential for rapid fluctuations i n market prices. For example, the spread between two markets can fluctuate durin g the time required for the transactions themselves. In cases where prices fluct uate rapidly, would-be arbitrageurs can actually lose money. There are basically two types of arbitrage. One is two-way arbitrage and the other is three-way arb itrage. The more popular of the two is the two-way forex arbitrage. In the inter national market the currency is expressed in the form AAA/BBB. AAA denotes the p rice of one unit of the currency which the trader wishes to trade and it refers the base currency. While BBB is international three-letter code 0f the counter c urrency. For instance, when the value of EUR/USD is 1.4015, it means 1 euro = 1. 4015 dollar.

If the speculator is shrewd and has a deeper understanding of the forex market, then he can make use of this opportunity to make big profits. Forex arbitrage tr ansactions are quite easy once you understand the method by which the business i s conducted. For instance, the exchange rates of EUR/USD = 0.652, EUR/GBP = 1.31 2 and USD/GBP = 2.012. You can buy around 326100 Euros with $500,000. Using the Euros you buy approximately 248420 Pounds which is sold for approximately $500,0 43 and thereby earning a small profit of $43. To make a large profit on triangul ar arbitrage you should be ready to invest a large amount and deal with trustwor thy brokers. Arbitrage is one of the strategies of forex trading. To make a subs tantial income out of this strategy you need to make an enormous amount of inves tment. Though theoretically it is considered to be risk free, in reality it is n ot the case. You should enter into this transaction only if you have deeper unde rstanding of forex market. Hence, it would be wise not to devote much time in lo oking out for arbitrage opportunities. However, forex arbitrage is a rare opport unity and if it comes your way, then grab it without any hesitation. Three Way ( Triangular) Arbitrage The three way arbitrate inefficiency now arises when we co nsider a case in which the EUR/JPY exchange rate is NOT equivalent to the EUR/US D/USD/JPY case so there must be something going on in the market that is causing a temporary inconsistency. If this inconsistency becomes large enough one can e nter trades on the cross and the other pairs in opposite directions so that the discrepancy is corrected. Let us consider the following example : EUR/JPY=107.86 EUR/USD=1.2713 USD/JPY = 84.75 The exchange rate inferred from the above would be 1.2713*84.75 which would be 107.74 and the actual rate is 107.86. What we can do now is short the EUR/JPY and go long EUR/USD and USD/JPY until the correlati on is reestablished. Sounds easy, right ? The fact is that there are many import ant problems that make the exploitation of this three way arbitrage almost impos sible. Q3. You are given the following information: Spot EUR/US: 0.7940/0.8007 Spot USD /GBP:1.8215/1.8240 Three months swap: 25/35 Calculate three month EUR/USD rate. Ans:-1stMethod: Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) -Spot OCR = Other Currency Rate BCR = Base Currency Rate Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) 0.0 7940 SWAP = -0.00120 Forward rate = 0.07940 -0.00120 = 0.0782 Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 -0.00120). Customer wants to Bu y EUR 3 Mio against USD 3 months forward.

Q.4 Explain various methods of Capital budgeting of MNCs. Ans:- Methods of Capit al Budgeting Discounted Cash Flow Analysis (DCF) DCF technique involves the use of the time-v alue of money principle to project evaluation. The two most widely used criteria of the DCF technique are the Net Present Value (NPV) and the Internal Rate of R eturn (IRR). Both the techniques discount the projects cash flow at an appropriat e discount rate. The results are then used to evaluate the projects based on the acceptance/rejection criteria developed by management. NPV is the most popular method and is defined as the present value of future cash flows discounted at an appropriate rate minus the initial net cash outlay for the projects. The discou nt rate used here is known as the cost of capital. The decision criteria is to a ccept projects with a positive NPV and reject projects which have a negative NPV . The NPV can be defined as follows: NPV = Where, I0 = initial cash investment CFt = expected after-tax cash flows in year t. k = the weighted average cost of capital n = the life span of the proje ct. The NPV of a project is the present value of all cash inflows, including tho se at the end of the projects life, minus the present value of all cash outflows. The decision criteri a is to accept a project if NPV o and to reject if NPV < o. IRR is calculated by solving for r in the following equation. where r is the internal rate of return of the project. The IRR method finds the discount rate which equates the present value of the cash flows generated by the project with the initial investment or the rate which would equate the present value of all cash flows to zero.

Adjusted Present Value Approach (APV) A DCF technique that can be adapted to the unique aspect of evaluating foreign projects is the Adjusted Present Value appr oach. The APV format allows different components of the projects 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 fo r all the complexities. If the project is acceptable in this scenario, no furthe r evaluation based on accounting for other cash flows is done. If not, then an a dditional evaluation is done taking into account the other complexities. As mentioned earlier, foreign projects face a number of complexities not encount ered in domestic capital budgeting, for example, the issue of remittance, foreig n exchange regulation, lost exports, restriction on transfer of cash flows, bloc ked funds, etc. The APV model is a value additivity approach to capital budgetin g, i.e., each cash flow as a source of value is considered individually. Also, i n the APV approach each cash flow is discounted at a rate of discount consistent with the risk inherent in that cash flow. In equation form the APV approach can be written as: APV = Where the term Io = Present value of investment outlay = Present value of operat ing cash flows = Present value of interest tax shields = Present value of interest subsidies The various symbols denote Tt = Tax saving s in year t due to the financial mix adopted St = Before-tax value of interest s ubsidies (on the home currency) in year t due to project specific

financing id = Before-tax cost of dollar debt (home currency) The last two terms in the APV equation are discounted at the before-tax cost of dollar debt to ref lect the relative certain value of the cash flows due to tax savings and interes t savings. Q.5 a. What are depository receipts? Ans:-Depository Receipt (DR) is a negotiable certificate that usually represents a companys publicly traded equity or debt. When companies make a public offering in a market other than their home market, they must launch a depository receipt program. Depository receipts represent shares of company held in a depository i n the issuing companys country. They are quoted in the host country currency and treated in the same way as host country shares for clearance, settlement, transf er and ownership purposes. These features make it easier for international inves tors to evaluate the shares than if they were traded in the issuers home market. There are two types of depository receipts GDRs and ADRs. Both ADRs and GDRs hav e to meet the listing requirements of the exchange on which they are traded. Q.5 b. Boeing commercial Airplane Co. manufactures all its planes in United States and prices them in dollars, even the 50% of its sales destined for overseas mark ets. Assess Boeings currency risk. How can it cope with this risk? Ans:-Boeing fa ces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for these planes depends on the foreign exchange value of the do llar, and (2) Boeing faces stiff competition from Airbus Industrie, a European c onsortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to finance a p ortion of its assets in foreign currencies in proportion to its sales in those c ountries. However, this tactic ignores the fact that Boeing is competing with Ai rbus. Absent a more detailed analysis, another suggestion is for Boeing to finan ce at least half of its assets with ECU bonds as a hedge against depreciation of the currencies of its European competitors. ECU bonds would also provide a hedg e against appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to move up and down together against th e dollar (albeit imperfectly). Q6. Distinguish between Eurobond and foreign bonds? What are the unique characte ristics of Eurobond markets? Ans:- A Eurobond is underwritten by an internationa l syndicate of banks and other securities firms, and is sold exclusively in coun tries other than the country in whose currency the issue is denominated. For exa mple, a bond issued by a U.S. corporation, denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United States), would be a Eurobond. Eurobonds are issued by multinational corporations, large domest ic corporations, sovereign governments, governmental enterprises, and internatio nal institutions. They are offered simultaneously in a number of different natio nal capital markets, but not in the capital market of the country, nor to reside nts of the country, in whose currency the bond is denominated. Almost all Eurobo nds are in bearer form with call provisions and sinking funds. A foreign bond is underwritten by a syndicate composed of members from a single country, sold pri ncipally within that country, and denominated in the currency of that country. T he issuer, however, is from another country. A bond issued by a Swedish corporat ion, denominated in dollars, and sold in the U.S. to U.S.

investors by U.S. investment bankers, would be a foreign bond. Foreign bonds hav e nicknames: foreign bonds sold in the U.S. are "Yankee bonds"; those sold in Ja pan are "Samurai bonds"; and foreign bonds sold in the United Kingdom are "Bulld ogs." Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s pe rspective. FIGURE 4 FOREIGN BONDS TO U.S. INVESTORS Foreign currency bonds are issued by foreign governments and foreign corporation s, denominated in their own currency. As with domestic bonds, such bonds are pri ced inversely to movements in the interest rate of the country in whose currency the issue is denominated. For example, the values of German bonds fall if Germa n interest rates rise. In addition, values of bonds denominated in foreign curre ncies will fall (or rise) if the dollar appreciates (or depreciates) relative to the denominated currency. Indeed, investing in foreign currency bonds is really a play on the dollar. If the dollar and foreign interest rates fall, investors in foreign currency bonds could make a nice return. It should be pointed out, ho wever, that if both the dollar and foreign interest rates rise, the investors wi ll be hit with a double whammy. Characteristics of Eurobond markets 1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed interest and has a long-term maturity. There are a number of different currencies in whic h Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro. (70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) T he central bank of a country can protect its currency from being used. Japan, fo r example, prohibited the yen from being used for Eurobond issues of its corpora tions until 1984. 2. Non-registered: Eurobonds are usually issued in countries i n which there is little regulation. As a result, many Eurobonds are unregistered , issued as bearer bonds. (Bearer form means that the bond is unregistered, ther e is no record to identify the owners, and these bonds are usually kept on depos it at depository institution). While this feature provides confidentiality, it h as created some problems in countries such as the U.S., where regulations requir e that security owners be registered on the books of issuer. 3. Credit risk: Com pared to domestic corporate bonds, Eurobonds have fewer protective covenants, ma king them an attractive financing instrument to corporations, but riskier to bon d investors. Eurobonds differ in term of their default risk and are rated in ter ms of quality ratings. 4. Maturities: The maturities on Eurobonds vary. Many hav e intermediate terms (2 to 10 years), referred to as Euronotes, and long terms ( 10-30 years), and called Eurobonds. There are also short-term Europaper and Euro Medium-term notes. 5. Other features: Like many securities issued today, Eurobon ds often are sold with many innovative features. For example: a) Dual-currency E urobonds pay coupon interest in one currency and principal in another. b) Option currency Eurobond offers investors a choice of currency. For instance, a sterli ng/Canadian dollar bond gives the holder the right to receive interest and princ ipal in either currency.

1 A number of Eurobonds have special conversion features. One type of convertibl e Eurobond is a dual-currency bond that allows the holder to convert the bond in to stock or another bond that is denominated in another currency. 2 A number of Eurobonds have special warrants attached to them. Some of the warrants sold with Eurobonds include those giving the holder the right to buy stock, additional bo nds, currency, or gold.

Master of Business Administration -MBA Semester 4 MF0015 International Financial Management Assignment Set- 2 Q.1 What do you mean by optimum capital structure? What factors affect cost of capital across nations? Ans:-The objective of capit al structure management is to mix the permanent sources of funds in a manner tha t will maximise the companys common stock price. This will also minimise the firms composite cost of capital. This proper mix of fund sources is referred to as th e optimal capital structure. Thus, for each firm, there is a combination of debt , equity and other forms (preferred stock) which maximises the value of the firm while simultaneously minimising the cost of capital. The financial manager is c ontinuously trying to achieve an optimal proportion of debt and equity that will achieve this objective. Cost of Capital across Countries Just like technologica l or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways: 1 Increased competitive advantage results to the MNC as a result of using low co st capital obtained from international financial markets compared to domestic fi rms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares. 2 MNCs have the ability to adjust inter national operations to capitalise on cost of capital differences among countries , something not possible for domestic firms. 3 Country differences in the use of debt or equity can be understood and capitalised on by MNCs. We now examine how the costs of each individual source of finance can differ acr oss countries. Country differences in Cost of Debt Before tax cost of debt (Kd) = Rf + Risk Premium This is the prevailing risk free interest rate in the curren cy borrowed and the risk premium required by creditors. Thus the cost of debt in two countries may differ due to difference in the risk free rate or the risk pr emium. (a) Differences in risk free rate: Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect t he risk free rate. These factors include: Tax laws: Incentives to save may influ ence the supply of savings and thus the interest rates. The corporate tax laws m ay also affect interest rates through effects on corporate demand for funds. Dem ographics: They affect the supply of savings available and the amount of loanabl e funds demanded depending on the culture and values of a given country. This ma y affect the interest rates in a country. Monetary policy: It affects interest r ates through the supply of loanable funds. Thus a loose monetary policy results in lower interest rates if a low rate of inflation is maintained in the country. Economic conditions: A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate. (b) Diffe rences in risk premium: The risk premium on the debt must be large enough to com pensate the creditors for the risk of default by the borrowers. The risk varies with the following:

 Economic conditions: Stable economic conditions result in a low risk of recessio n. Thus there is a lower probability of default. Relationships between creditors and corporations: If the relationships are close and the creditors would suppor t the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium. Government intervention: If the government is willing to intervene and rescue a firm, the risk of bankruptcy and thus, def ault is very low, resulting in a low risk premium. Degree of financial leverage: All other factors being the same, highly leveraged firms would have to pay a hi gher risk premium. Q.2 What is sub-prime lending? Explain the drivers of sub-prime lending? Explain briefly the different exchange rate regime that is prevalent today. Ans:- Subpr ime lending is the practice of extending credit to borrowers with certain credit characteristics e.g. a FICO score of less than 620 that disqualify them from lo ans at the prime rate (hence the term sub-prime). Sub-prime lending covers differe nt types of credit, including mortgages, auto loans, and credit cards. Since sub -prime borrowers often have poor or limited credit histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased ris k, lenders charge sub-prime borrowers a premium. For mortgages and other fixed-t erm loans, this is usually a higher interest rate; for credit cards, higher over -the-limit or late fees are also common. Despite the higher costs associated wit h sub-prime lending, it does give access to credit to people who might otherwise be denied. For this reason, sub-prime lending is a common first step toward cred it repair; by maintaining a good payment record on their sub-prime loans, borrowe rs can establish their creditworthiness and eventually refinance their loans at lower, prime rates. Sub-prime lending became popular in the U.S. in the mid-1990 s, with outstanding debt increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was an estimated $1.3 trillion in sub-prime mor tgages outstanding.20% of all mortgages originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago. This substantial increase is attributable to industry enthusiasm: banks and other lenders discovered that the y could make hefty profits from origination fees, bundling mortgages into securi ties, and selling these securities to investors. These banks and lenders believe d that the risks of sub-prime loans could be managed, a belief that was fed by c onstantly rising home prices and the perceived stability of mortgage-backed secu rities. However, while this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the possibility of real losses. As home va lues declined, many borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. These borrowers began to default on their loans, which drove home prices down further and ruined the value of mortga ge-backed securities (forcing companies to take write downs and write-offs becau se the underlying assets behind the securities were now worth less). This downwa rd cycle created a mortgage market meltdown. The practice of sub-prime lending h as widespread ramifications for many companies, with direct impact being on lend ers, financial institutions and home-building concerns. In the U.S. Housing Mark et, property values have plummeted as the market is flooded with homes but beref t of buyers. The crisis has also had a major impact on the economy at large, as lenders are hoarding cash or investing in stable assets like Treasury securities rather than lending money for business growth and consumer spending; this has l ed to an overall credit crunch in 2007. The sub-prime crisis has also affected t he commercial real estate market, but not as significantly as the residential ma rket as properties used for business purposes have retained their long-term valu e. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent th rough their losses, but British and

euro zone banks only 40 percent. Drivers of sub-prime lending Home price appreci ation Home price appreciation seemed an unstoppable trend from the mid-1990s thro ugh to today. This "assumption" that real estate would maintain its value in alm ost all circumstances provided a comfort level to lenders that offset the risk a ssociated with lending in the sub-prime market. Home prices appeared to be growi ng at annualized rates of 5-10% from the mid-90s forward. In the event of defaul t, a very large percentage of losses could be recouped through foreclosure as th e actual value of the underlying asset (the home) would have since appreciated. Lax lending standards Outstanding mortgages and foreclosure starts in 1Q08, by l oan type. The reduced rigor in lending standards can be seen as the product of m any of the preceding themes. The increased acceptance of securitized products me ant that lending institutions were less likely to actually hold on to the risk, thus reducing their incentive to maintain lending standards. Moreover, increasin g appetite from investors not only fueled a boom in the lending industry, which had historically been capital constrained and thus unable to meet demand, but al so led to increased investor demand for higher-yielding securities, which could only be created through the additional issuance of sub-prime loans. All of this was further enabled by the long-term home price appreciation trends and altered rating agency treatment, which seemed to indicate risk profiles were much lower than they actually were. As standards fell, lenders began to relax their require ments on key loan metrics. Loan-to-value ratios, an indicator of the amount of c ollateral backing loans, increased markedly, with many lenders even offering loa ns for 100% of the collateral value. More dangerously, some banks began lending to customers with little effort made to investigate their credit history or even income. Additionally, many of the largest sub-prime lenders in the recent boom were chartered by state, rather than federal, governments. States often have wea ker regulations regarding lending practices and fewer resources with which to po lice lenders. This allowed banks relatively free rein to issue sub-prime mortgag es to questionable borrowers. Adjustable-rate mortgages and interest rates Adjus table-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market , particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rat e that is linked to current prevailing interest rates. In the recent sub-prime b oom, lenders began heavily promoting ARMs as alternatives to traditional fixed-r ate mortgages. Additionally, many lenders offered low introductory, or teaser, rat es aimed at attracting new borrowers. These teaser rates attracted droves of sub -prime borrowers, who took out mortgages in record numbers. While ARMs can be be neficial for borrowers if prevailing interest rates fall after the loan originat ion, rising interest rates can substantially increase both loan rates and monthl y payments. In the sub-prime bust, this is precisely what happened. The target f ederal funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadi ly upward in 2004. As of mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in interest rates over a three-year peri od left borrowers with steadily rising payments, which many found to be unafford able. The expiration of teaser rates didnt help either; as these artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime borr owers are seeing their monthly payments jump by as much as 50%, further driving the increasing number of delinquencies and defaults. Between September of 2007 a nd January 2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0 -.25% in hopes of curbing losses. Though many sub-prime mortgages continue to re set from fixed to floating, rates have fallen so much that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus, a boon for some sub-prime borrowers.

The exchange rate is an important price in the economy and some governments like to control it, manage it or influence it. Others prefer to leave the exchange r ate to be determined only by market forces. This decision is the choice of excha nge rate regime. Many alternative regimes exist: Floating Exchange Rate (Flexibl e) Regimes: A flexible exchange rate system is one where the value of the curren cy is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market. In this system, currencies are allowed to: Appreciate when the currency becomes more valuable relative to others. Depr eciate when the currency becomes less valuable relative to others. Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of the currency is set by official government policy. The exchange rate is dete rmined by government actions designed to keep rates the same over time. The curr encies are altered by the government: Revaluation Government action to increase the value of domestic currency relative to others. Devaluation Government action to decrease the value of domestic currency. After the transition period of 1971-73, the major currencies started to float. F lexible exchange rates were declared acceptable to the IMF members. Gold was aba ndoned as an international reserve asset. Since 1973, most major exchange rates have been floating against each other. However, there are countries which have fix ed exchange rate regimes. Q.3 What is covered interest rate arbitrage? Assume spot rate of = $ 1.60 180 da y forward rate = $ 1.56 180 day interest rate in U.K. = 4% 180 day U.S interest rate = 3% Is covered interest arbitrage by U.S investor feasible? YES Q.4 Explain double taxation avoidance agreement in detail . Ans:-Double Taxation Avoidance Agreements Double taxation relief Double taxation means taxation of s ame income of a person in more than one country. This results due to countries f ollowing different rules for income taxation. There are two main rules of income taxation (a) source of income rule and (b) residence rule. As per source of inc ome rule, the income may be subject to tax in the country where the source of su ch income exists (i.e. where the business establishment is situated or where the asset/property is located) whether the income earner is a resident in that coun try or not. On the other hand, the income earner may be taxed on the basis of hi s residential status in that country. For example if a person is resident of a c ountry, he may have to pay tax on any income earned outside that country as well . Further some countries may follow a mixture of the above two rules. Thus probl em of double taxation arises if a person is taxed in respect of any income on th e basis of source of

income rule in one country and on the basis of residence in another country or o n the basis of mixture of above two rules. Relief against such hardship can be p rovided mainly in two ways Bilateral relief Unilateral relief. Bilateral Relief The governments of two countries can enter into agreement to pr ovide relief against double taxation, worked out on the basis of mutual agreemen t between the two concerned sovereign states. This may be called a scheme of bila teral relief as both concerned powers agree as to the basis of the relief to be g ranted by either of them. Unilateral Relief The above procedure for granting rel ief will not be sufficient to meet all cases. No country will be in a position t o arrive at such agreement as envisaged above with all the countries of the worl d for all time. The hardship of the taxpayer, however, is a crippling one in all such cases. Some relief can be provided even in such cases by home country irre spective of whether the other country concerned has any agreement with India or has otherwise provided for any relief at all in respect of such double taxation. This relief is known as unilateral relief. Types of Agreements Agreements can be divided into two main categories: 1 2 Limi ted agreements Comprehensive agreements Limited agreements are generally entered into to avoid double taxation relating to income derived from operation of aircraft, ships, carriage of cargo and freig ht. Comprehensive agreements, on the other hand, are very elaborate documents wh ich lay down in detail how incomes under various heads may be dealt with. Countr ies with which no agreement exists [section 91] [unilateral relief] If any perso n who is resident in India in any previous year proves that, in respect of his i ncome which accrued or arose during that previous year outside India (and which is not deemed to accrue or arise in India), he has paid in any country with whic h there is no agreement under section 90 for the relief or avoidance of double t axation, income-tax, by deduction or otherwise, under the law in force in that c ountry, he shall be entitled to the deduction from the Indian income-tax payable by him of a sum calculated on such doubly taxed income at the Indian rate of tax or the rate of tax of the said country, whichever is the lower, or at the India n rate of tax if both the rates are equal. In other words, unilateral relief will be available, if the following conditions are satisfied: 1 The assessee in ques tion must have been resident in the taxable territories. 2 That some income must have accrued or arisen to him outside the taxable territory during the previous year and it should also be received outside India. 3 In respect of that income, the assessee must have paid by deduction or otherwise tax under the law in

force in the foreign country in question in which the income outside India has a risen. 4 There should be no reciprocal arrangement for relief or avoidance from double taxation with the country where income has accrued or arisen. India has a greements for avoidance of double taxation with over 60 countries. If all the ab ove conditions are satisfied, such person shall be entitled to deduction from th e Indian income-tax payable by him of a sum calculated on such doubly taxed inco me or At the average Indian rate of tax or the average rate of tax of the said c ountry, whichever is the lower, At the Indian rate of tax if both the rates are equal. Average rate of tax means the tax payable on total income divided by the total i ncome. Steps for calculating relief under this section: Step I: Calculate tax on total income inclusive of the foreign income on which relief is available. Claim relie f if available under sections 88, 88B and 88C. Step II: Calculate average rate o f tax by dividing the tax computed under Step I with the total income (inclusive of such foreign income). Step III: Calculate average rate of tax of the foreign country by dividing income-tax actually paid in the said country after deductio n of all relief due but before deduction of any relief due in the said country i n respect of double taxation by the whole amount of the income as assessed in th e said country. Step IV: Claim the relief from the tax payable in India at the r ate calculated at Step II or Step III whichever is less Q.5 Explain American depository receipt sponsored programme and unsponsored prog ramme. Ans:-When a company establishes an American Depositary Receipt program, i t must decide what exactly it wants out of the program, and how much time, effor t and resources they are willing to commit. For this reason, there are different types of programs that a company can choose. ADRs may be sponsored or unsponsor ed; however, unsponsored ADRs are increasingly rare and cannot be listed on the major American stock exchanges because they are not registered with the SEC, and lack other necessary qualifications. An unsponsored ADR is created by a U.S. in vestment bank or brokerage that buys the shares in the country where the shares trade, deposits them in a local bankthe custodian bank, which is often a branch o f a U.S. bank, called the depositary bank (aka depository bank). The depositary bank then issues shares that represent an interest in the stocks and handles mos t of the transactions with the American investors, serving both as transfer agen t and registrar for the ADR. The shares of the foreign stock that are held in th e custodian bank are called American Depositary Shares (ADS), although this term is sometimes used as a synonym for ADRs. Most often, the company will sponsor t he creation of its own ADR, in which case it is a sponsored ADR. There are 3 lev els of sponsorship. A Level 1 sponsored ADR is created by the company to extend the market for its securities to this country,

but without needing to register with the SEC, or conforming to generally accepte d accounting principles (GAAP). Consequently, this ADR can only be traded in the OTC Bulletin Board or Pink Sheets trading systems, usually by institutional inv estors. These ADRs have more risk, and it is more difficult to compare a Level I ADR with other investments, because of the differences in accounting. Level 2 and Level 3 sponsored ADRs must register with the SEC, and financial sta tements must be reconciled to generally accepted accounting principles. A Level 2 ADR requires partial compliance with GAAP, while a Level 3 ADR requires comple te compliance. A Level 3 sponsorship is required, if the ADR is a primary offeri ng and is used to raise capital for the company. Only Level 2 and Level 3 sponso red ADRs can be listed on the New York Stock Exchange, the American Stock Exchan ge, or NASDAQ. Q.6 Explain (a) Parallel Loans (b) Back to- Back loans Ans;- Para llel loan The forerunner of a swap; a method of raising capital in a foreign cou ntry to finance assets there without a cross-border movement of capital. For exa mple, a $US loan would be made to an Australian company to finance its factory i n the US; at the same time the US party which made the loan would borrow $A in A ustralia from the Australian company s parent to finance a project in Australia. Parallel loans enjoyed considerable popularity in the 1970s in the UK when they were frequently used to circumvent strict exchange controls. Back-to-back loan A Back-to-back loan is a loan agreement between entities in two countries in whi ch the currencies remain separate but the maturity dates remain fixed. The gross interest rates of the loan are separate as well and are set on the basis of the commercial rates in place when the agreement is signed. Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a way of av oiding currency regulations, the practice had, by the mid-1990s, largely been re placed by currency swaps.