MF 0015

Unit 1
International Financial Environment
Structure
1.1 Caselet
1.2 Introduction
Objectives
1.3 Globalization
1.4 Multinational Corporations and Transnational Corporations
1.5 Objectives of MNCs
1.6 International Financial Management and
Domestic Financial Management
1.7 Goals of International Financial Management
1.8 International Monetary System
1.9 Case Study
1.10 Summary
1.11 Glossary
1.12 Terminal Questions
1.13 Answers
References/e-References
1.1 Caselet
IMF cuts India's 2013 growth forecast to 6.5%
The International Monetary Fund on July 16, 2012 projected Indias
economic growth forecast as 6.5 per cent, down from its April projection of
7.2 per cent. It also stated that the global forecast has been lowered to 3.9
per cent in the financial year 2013 from 4.1 per cent indicating that there
are harder times ahead for economies around the globe. "Growth
momentum has also slowed in various emerging market economies, notably
Brazil, China, and India. This partly reflects a weaker external environment,
but domestic demand has also decelerated sharply in response to capacity
constraints and policy tightening over the past year," IMF said in an update
to its World Economic Outlook, first released in April. The growth of Indias
economy is already slowing down and it fell to 6.5 per cent for the financial
year ended March 2012, after hitting a nine-year low of 5.3 per cent in the
March quarter. However, last month, the World Bank made a forecast that
the gross domestic product of India would grow at a rate of 6.9 per cent.
"Many emerging market economies have also been hit by increase in
investor risk aversion and perceived growth uncertainty, which have led not
International Financial Management
Unit 1
only to equity price declines, but also to capital outflows and currency
depreciation," the IMF added in its statement.
In sectors such as insurance, aviation and retail, foreign direct investment
has been stalled, largely due to political opposition. Most Indian political
parties have the fear that if FDI is allowed in retail in India, the small
businessmen and traders who run the retail market of india and constitute
a sizeable vote bank will go against them in the national elections. Prime
Minister of India, who is in charge of the Finance Ministry, pointed out that
India's slower growth is a reflection of the larger slowdown in the global
economy, but conceded the economy "continues to grow at an impressive
rate".
Source: Adapted from http://profit.ndtv.com/News/Article/imf-cuts-india-s2013-growth-forecast-to-6-5307925.
Accessed on 18 July 2012
1.2 Introduction
International Financial Management is the branch of financial economics that is
broadly concerned with the macroeconomic and monetary interrelations between
two or more countries. The main objective of international financial management
is to make optimal decisions for a corporate, in terms of dividend policy, working
capital management, investment decisions, and the capital structure in
international business context. Finally, what matters is whether the goal of wealth
maximization has been achieved or not. In this unit, you will learn about the
concept of International Financial Management in contrast with Domestic
Financial Management. Along with it, you will also learn about multinational
national corporations (MNCs) and transnational corporations.
The term globalization has also been discussed in details along with its
advantages and disadvantages. The unit also presents the goals of International
Financial Management in order to discuss the concept better. You will also study
about the International Monetary System and the advantages and disadvantages
of the Gold Standard.
Objectives
After studying this unit, you should be able to:
define what is meant by globalization
identify the objectives of MNCs
Sikkim Manipal University
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discuss multinational and transnational companies

explain the goals of international financial management
discuss the international monetary system
1.3 Globalization
Globalization can be defined as the process of international integration that
arises due to increasing human connectivity as well as the interchange of
products, ideas and other aspects of culture. It includes the spread and
connectedness of communication, technologies and production across the world
and involves the interlacing of cultural and economic activity. The term
'globalization' was used by the late professor Theodore Levitt of Harvard Business
School in an article titled 'Globalization of Markets' which appeared in Harvard
Business Review in 1983. The world turning into a global market has its own
advantages and disadvantages for various countries.
During the last couple of years, there has been a rapid internationalization
of the world financial markets. The US financial investors have invested heavy
funds into overseas markets to reap the benefits of rate differentials and high
growth rates in new and budding economies. No country can now boast of selfsufficiency since the growth of population all over has a tremendous impact on
the growth in consumption, production, and investment around the globe. With
such a rise in global demands, a country has to engage itself in trade with
international markets. These opportunities have given rise to big fund houses,
financial institutions and multinational banks. The tradeoff between risk of
investing in global markets and return from these investments is focused to
achieve wealth maximization of the stakeholders. It is important to note that in
international financial management, stakeholders are spread all over the world.
Globalization affects the foreign exchange market to a great extent. According
to the theory of comparative advantage by David Ricardo, countries can benefit
by exploiting the comparative advantage that arises from specialized production
and economies of scale. Not just in goods, globalization of investments allows
a country to invest its surplus funds in other countries where the rate of return is
comparatively higher and there are better investment opportunities. This also
helps in diversification of risk. Therefore cross border investments is a good
strategy for growth. However, the downside is that if the exchange rate is volatile,
it can affect the trade and investment adversely. In this light, let us now look at
the distinct advantages and disadvantages of globalization.
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Advantages of Globalization
1. Economic growth: An open economy can have a higher GDP growth
than a closed one because of increased access to various markets and
exposure to better technology. An economy can be called a closed
economy if it has no economic transactions with any other economy. An
open economy is one that has economic interactions with other economies.
2. Lower costs: Open economies can import inputs, raw materials, and
technology at cheaper rates and, thus benefit in terms lower cost structure.
3. Improved availability of goods and services: Open economies have
access to many countries. They can use the best among all that are
available. India which is a labour-intensive country has been able to use
cheap Chinese goods due to open trade.
4. Global prosperity and flow of productive resources: Open economies
can exchange raw materials and other goods with other. This will benefit
both the producers and the customers.
5. Incentives for research and adoption of innovations: The countries
that have human resources can develop new products and technology
and use the market of less-developed countries to increase trade.
6. Raise cheaper loans: Open economies not only gain on the customerend, but also have access to financial markets of the countries in which
they do business with. They can raise cheaper loans than their home
country.
Disadvantages of Globalization
1. Open economies are interdependent that makes them prone to
unavoidable risks like trade cycles. The most recent example is that of
the American recession that had affected the whole world.
2. Import dependence can expose a country to undue political, economic
and cultural risks.
3. Large-scale increase in international capital flows has increased the
problem of heavy indebtedness of some countries and their inability to
repay their debts.
4. Problems of foreign exchange due to different currencies of different
countries.
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Self-Assessment Questions
1. ____________can be defined as the process of international integration
that arises due to increasing human connectivity as well as the interchange
of products, ideas and other aspects of culture.
2. The term 'globalization' was used by the late professor _____________of
Harvard Business School in an article titled 'Globalization of Markets'.
3. An economy can be called a__________ if it has no economic transactions
with any other economy.
Activity 1
Make a SWOT Analysis of impact of globalization on India since 1991.
Hint:
Analyze the liberalization regime in India and then find out the impact
of globalization on the Indian economy.
1.4 Multinational Corporations and Transnational Corporations

Shapiro has defined 'Multinational Corporation' as a company engaged in
producing and selling goods or services in more than one country. It ordinarily
consists of a parent company located in the home country and at least five or
six foreign subsidiaries. The business strategy of MNCs is based classical theory
of international trade developed by Adam Smith and David Ricardo. Ricardo
emphasized that each nation should specialize in the production and export of
those goods that it can produce with maximum efficiency than any other nation
(Theory of Comparative Advantage). A multinational corporation is one whose
offices or plants or operations are located mostly outside its own home country
and the majority of whose revenue is generated outside its home country, i.e.
from across the globe. An MNC is an enterprise that owns and controls production
or service facilities outside of the country in which it is based (United Nations,
1973). To qualify as an MNC, the number of countries in which the firm operates,
must be at least six (Vernon, 1971; United Nations, 1978) and at the same time,
the firm must generate a sizeable proportion of its revenue from the foreign
operations, although no exact percentage has been specified or agreed upon.
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Overview of the Multinational Financial Environment

Multinational companies across the globe form a major part of the multinational
financial environment. They function in international financial operations and
try to gain advantage from the local or customized environmental conditions of
that market. But the global multinational financial environment also consists of
the very small, small, medium and large enterprises or companies which provide
support to the overall environment, directly and indirectly.
No firm or business enterprise is free from the effects of the elements of
the global financial environment like price movements, international buffer stock,
fluctuation in interest rate or the economic or political environment. Macro and
micro level environmental issues can adversely or positively affect the
international financial environment.
The multinational financial environment of a parent company and its
subsidiary depends on the multilateral agreements, the banking system and
the multilateral agencies available in the given country.
Both the parent as well as the subsidiary companies have to consider
several environmental factors such as economic, social, legal, financial and
cultural aspects related to business.
The environment of domestically oriented organizations is quite different
from that of multinational organizations/firms. Both types of companies face
political, legal, socio-cultural, financial and physical environments but the
difference is that multinational firms/companies have to face the set of
environment in more than one country. This implies that the more the number of
countries a firm /organization operates in or conducts business in , the higherthe
risks it faces as it has to cope with the environments of different countries. The
set of environmental factors become more complex with the increase of
international business operations in more number of countries.
We will now analyse some of these factors/parameters which form a part
of the global financial environment:
1. Multiplicity and complexities of the taxation system: Every country
has its own taxation system and the corporate tax imposed on foreign
companies varies from country to country. Many countries have a very
complex tax system while some other countries deliberately keep the tax
rates high. This has a major effect on the profitability of any business
belonging to a foreign company. The multiplicity parameter means that
the number and level of taxes being charged are many. Besides, the filing
procedure, documentation and payment mechanism of corporate taxes
too can be very cumbersome.
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2. Diversity of medium of financing: Any company which wishes to go

international has different sources/means from which it can generate funds
for its new venture. At the same time, if the funding is done in a country
where the sources of funds are diverse and the company has a lot of
options to choose from, then the rate of return on investments may be
higher, as funds are easily available.
3. Political risk: For MNCs, this risk is very significant because the political
risk in every country varies depending upon several factors such as stability
of the government, support of the opposition parties, etc. Political risk
may take the form of expropriation or confiscation if the modus operandi
of the MNC is not found to be in line with the government policies. In fact,
the governments of many countries these days have to be environmentally
conscious, and do not compromise on the social well-being of the
customers and stakeholders whom they serve. Also, they have to be and
are conscious of the impact of their business on the citizens - directly or
indirectly. On the other hand, there are MNCs, which, because of their
environment friendly products and company image have been able to
establish themselves very well in foreign countries.
4. Foreign exchange risk: This is one of the most volatile factors of the
international financial environment. Foreign currency fluctuations happen
across the world because the demand for and supply of different currencies
are different in different countries at the same point of time. Some
currencies like pound (), dollar ($), euro () and Japanese yen () are
more in demand vis--vis other currencies and the supply of these four
currencies is also low in relation to their demand.
5. Diversity of physical environment: The diversity of the physical
environment can adversely affect the overall environment facing the MNCs.
These parameters can be infrastructural facilities like roads, railways,
post and telegraph, transport, communication, etc., which vary from one
country to another. For example, the road conditions in Vietnam are so
bad that it takes 12 hours to travel a distance of 350-400 hours by road.
Also, the climate and weather conditions vary from country to country.
6. Conflicts with the host country environment or government: Here,
we are talking about the host country's socio-cultural environment related
to tastes and preferences, consumer behaviour, fashion and fad and other
aspects such as traditions, etc., which continuously vary from time to
time and also within countries. The host country government may have
different economic and developmental policies, fiscal and monetary
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policies, balance of payments policies and labour and employment policies

which may clash with the overall objective of a multinational firm and
make the international financial environment more complex.
4. The diversity of financial sources enables the MNC to reduce its cost of
capital but at the same time maximizes the return on its excess cash
resources by investing funds in capital markets. (True/False)
5. Investment decisions are concerned with generating funds from
internal sources or from external sources that costs less. (True/False)
6. The diversity of the physical environment does not have any impact on
the overall environment facing the MNCs. (True/False)
1.5 Objectives of MNCs

Multinational Corporations have many objectives to fulfill and they need to ensure
that they frame their policies keeping in mind the investment policies and culture
of different companies. There are certain risks like political risk, foreign exchange
risks that can affect the performance of a global financial manager. It remains a
constant endeavour to manage these risks, use various tools and techniques
that are available to counter the risks while keeping a goal in mind goal of
wealth maximization of the shareholder.
Maximization of stockholder wealth globally is the most commonly
accepted objective of an MNC. Shareholder wealth maximization means that
the firm makes all business decisions and investments with an eye toward making
the owners of the firm the shareholders better off financially, or more wealthy,
than they were before. Thus, the objective of the management of a firm is
maximization of the current value of the wealth of the shareholder, i.e. the current
value of the equity shares.
7. Maximization of ____________globally is the most commonly accepted
objective of an MNC.
8. There are certain risks like political risk, __________ that can affect the
performance of a global financial manager.
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1.6 International Financial Management and Domestic Financial

Management
International financial management is concerned with the financial decisions
that are taken in the field of international business. The general agreement on
Trade and Tariffs were set up in the immediate post-war years in order to increase
trade. It led to the reduction of trade barriers over the years and as a result,
international trade grew manifold. It also resulted in the increase of the
involvement of the traders exporters and importers as well as the quantum of
the cross-country transactions. And these required that the international flow of
funds is properly managed for which the study of international finance
management became important.
International financial management encompasses the following areas:
1. Foreign exchange market
2. Exchange rate determination
3. Determination and management of exchange rate risk
4. MNCs' investment decisions
5. International working capital management
6. Financing decisions in international market
However, with the growth of multinational companies, a number of
complexities also arose in the area of financial decisions. Apart from taking
decisions about where and how much to invest, decisions related to the
management of working capital among the parent units and their different
subsidiaries also became more complex.
Domestic Financial management deals with the payoffs from investments
and costs of financing sources. Movements in exchange rates are significantly
ignored in the domestic arena.
The management of finance in domestic and international enterprises is
considerably different. The four major aspects which distinguish international
financial management from domestic financial management explained as follows:
Foreign exchange risks: The foreign exchange risks states the fluctuation
or variation in the prices of currency which will have a tendency to convert
a profitable deal to a loss making one. This creates a situation of additional
risk to the finance manager.
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Country risks: The political risks may include any changes that will result
in the economic environment of the country. For example, Taxation rules,
Contract Act and so on. It is pertaining to the management of the country
which can alter the rules of the game in an unanticipated manner.
Market imperfection: By the integration in the world economy, the
differences across the countries have resulted with respect to the
transportation costs and different tax rates. Inadequate markets can force
a finance manager to struggle for best opportunities across the countries
border.
Enhanced opportunities: When business is undertaken in a country
other than native country, it will help them to expand the chances in
business. In addition, it will enhance the opportunity for the business and
it diversifies the overall risk.
9. International financial management is concerned with the financial
decisions that are taken in the field of international business. (True/False)
10. Movements in exchange rates are given utmost importance in the domestic
arena. (True/False)
1.7 Goals of International Financial management

Effective financial management is not limited to the application of the latest
business techniques or functioning more efficiently but includes maximization
of wealth meaning that it aims to offer profit to the shareholder, the owners of
the businesses and to ensure that they gain benefits from the business decisions
that have been made. So, the goal of international financial management is to
increase the wealth of shareholders just like in domestic financial management.
The goals are not only limited to just the shareholders, but also to the suppliers,
customers and employees. It is also understood that any goal cannot be achieved
without achieving the welfare of the shareholders. Increasing the price of the
share would mean maximizing shareholders wealth.
Though in many countries such as Canada, the United Kingdom, Australia
and the United States, it has been accepted that the primary goal of financial
management is to maximize the wealth of the shareholders; in other countries
it is not as widely embraced. In countries such as Germany and France, the
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shareholders are generally viewed as a part of the stakeholders along with the
customers, banks, suppliers and so on. In European countries, the managers
consider the most important goal to be the overall welfare of the stakeholders
of the firm. On the other hand, in Japan, many companies come together to
form a small number of business groups known as Keiretsu, including companies
such as Mitsui, Sumitomo and Mitsubishi which were formed due to consolidation
of family-owned business empires. The growth and the prosperity of their Keiretsu
is the most critical goal for the Japanese managers.
However, it doesnt mean that the maximization of shareholders wealth
is just an alternative but it is a goal that a company seeks to fulfill along with
other goals. The maximization of shareholders wealth is a long term goal. If a
firm does not treat the employees properly or produces merchandises of poor
quality, it cannot be expected that such firms will be able to maximize the
shareholders wealth. Only those firms can stay in business for a long term and
provide opportunities for employment that efficiently produces what is demanded
from them.
However, in recent times, as capital markets are becoming more integrated
and liberalized, managers in countries such as France, Germany and Japan
have started paying serious attention to the maximization of the shareholders
wealth. For instance, in Germany, companies can now repurchase stocks, if
necessary for the shareholders benefit.
Fill in the blanks with the appropriate words.
11. The goals of International Financial Management are not only limited to
just the shareholders, but also to the suppliers, ____________.
12. The foremost goal of international financial management is maximization
of the________________________.
1.8 International Monetary System

A successful exchange rate system is needed to stabilize the international
payment system. An exchange rate system needs to fulfill three conditions:
(i) Balance of payments (BOP) deficits or surpluses by individual countries
should not be large.
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(ii) These deficits should be corrected in such a way that it does not cause
inflation on trade and payments for either the individual country or whole
of the world.
(iii) The maximum sustainable expansion of trade and other international
economic activities should be facilitated.
BOP is an accounting system that measures all economic transactions
between residents (including government) of one country and residents of all
other countries. Economic transactions include exports and imports of goods
and services, capital inflows and outflows, gifts and other transfer payments,
and changes in a country's international reserves.
The International Monetary Fund (IMF)
Since its establishment in 1944, the International Monetary Fund has been the
centerpiece of the world monetary order though its supervisory role in exchange
rate arrangements has been considerably weakened after the advent of floating
rates in 1973. The IMF was given the responsibility for collecting and allocating
reserves. The role of supervising the adjustable peg system, offering advice to
the member countries on their international monetary affairs, promoting research
in different areas of monetary and international economics were also given to
the IMF. It also offers the member countries a forum for consultation and
discussion.
Funding Facilities
As we have seen above, operation of the peg requires a country to intervene in
the foreign exchange markets to support its exchange rate when it threatens to
move out of the permissible band. If a country faces a BOP deficit, reserves are
needed for carrying out the intervention and for this; it must take the step of
selling foreign currencies and buying its own currency. In case its own reserves
are inadequate, it must borrow from other countries or from the IMF. (Note that
the country which has a surplus does not face this problem.)
International Liquidity and International Reserves
The stock of means of international payments are referred to as international
liquidity refers to the. On the other hand, the assets that the country can make
use of when settlement of payment imbalances arises in its transactions with
other countries are known as international reserves. The monetary authority of
the company takes care of the reserves and uses them while carrying out
interventions on the foreign exchange markets. In addition, liquidity can be
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provided by the private markets by lending to deficit countries out of funds that
are deposited with them by the surplus countries. This sort of private financing
of BOP deficits took place on a large scale during the post oil-crisis years and
has come to be known as recycling of petrodollars.
Gold Standard 1876-1913
From the ancient times, gold has been used as a medium of exchange as it is
durable, portable and easily tradable. Increase in the trade activity during the
free-trade period in the 19th century led to the need for a more formalized
system for settling business transactions. This made gold desirable to be used
as a standard to determine the value of currency. The rules of the game under
the gold standard were that each country would establish the rate at which its
currency could be converted to the weight of gold. Each country's government
agreed to buy or sell gold at its own fixed rate of demand. This served as a
mechanism to preserve the value of each individual currency in terms of gold.
Each country had to maintain adequate reserves of gold in order to back its
currency's value. There was a limit to the rate at which any individual country
could expand its supply of money. The growth in the money was limited to the
rate at which additional gold could be acquired by official authorities.
Advantages of Gold Standard
1. Gold standard provided stable exchange rates, which were conducive for
trade policy because this eliminates another source of price instability.
2. An efficient operating gold standard exchange rate system ensures
automatic adjustment of balance payment problem through price changes.
3. This system imposes orthodoxy on fiscal policies and restricts governments
from resorting to indiscriminate spending.
Disadvantages of Gold Standard
1. The burden of BOP adjustment shifts to domestic variables which
subordinate the domestic economy to external economic factors.
2. There is always a problem of selecting an appropriate par value which
reflects the external and internal equilibria.
3. Emergence of misaligned values might have encouraged speculations of
sufficient magnitude to effect exchange rate realignment.
4. The gold standard was dependent on an adequate supply and not excess
supply of new gold.
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5. The mining process of gold involves huge cost and is used as a reserve
only. The same purpose can be served by some other asset that has no
cost.
6. There is unequal geographic distribution of gold throughout the world.
The countries which had greater gold reserves enjoyed greater strength.
Interwar Years 1914-1944
The gold standard worked adequately till World War I. Subsequently, it broke
down during World War I but was again put to practice from 1925-1931. Under
this standard, the US and England could hold only gold reserves but other
nations could hold both gold and dollars/pounds as reserves.
The Bretton Wood System 1945-1971
In 1944, a conference was held at Bretton Woods, New Hampshire, in which
each participating government agreed to maintain a fixed exchange rate for its
currency in comparison to dollar/gold. One ounce of gold was set equal to $35.
Thus, fixing a currency's gold price was equivalent to setting its exchange rate
relative to the dollar. For example, Germany's currency was set equal to 1/140
of an ounce of gold. So, if we convert to dollar, then $ 35/140 = $0.20.1 German
Mark= $ 0.20
The Smithsonian Agreement 1971-1973
From August to December 1971, most of the major currencies were allowed to
fluctuate. The US dollar fell in value against a number of major currencies.
Several countries imposed trade and exchange controls causing a major concern.
It was feared that such protective measures may become widespread and limit
the international trade. In order to solve these problems, the world's leading
trading countries called the 'Group of ten' signed an agreement on 18 December
1971. The agreement established a new set of exchange rates. The dollar was
devalued to 1/38 of an ounce of gold and other currencies were re-valued by
agreed on amounts of dollars. Officially, in 1971 it turned to floating exchange
rates. It was proposed that the new system would reduce economic volatility
and facilitate free trade but it failed miserably. The government control on foreign
exchange did not decrease, so this agreement came to an end in March 1973.
Post-1973
The fixed rate system was replaced by the floating exchange rate system.
However, there are five different market mechanisms for establishing exchange
rates. The choice of the method of fixing the exchange rate depends on the
government of the country.
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1. Free float: In a free market, exchange rates are determined by the

interaction of currency supplies and demands. For example, in India there
are more imports from America. So there will be more demand of American
dollars. If the exports are less as compared to imports, there will be a gap
in demand and supply of dollars, leading to a fluctuation in the exchange
rate. This system is also called a clean float.
2. Managed float: When the central bank of a country intervenes in the
determination of exchange rates so as to smoothen the exchange rates
fluctuations, it is called as managed or dirty float system. The bank may
smoothen out the daily fluctuations by entering the market as a buyer or
seller to control the exchange rate variations.
3. Target-zone arrangement: Countries adjust their economic policies to
control the variations in the exchange rates within a margin agreed upon.
This system exists in Europe, the US, Japan and Germany.
4. Fixed-rate system: The governments of the countries where such a
system exists maintain the exchange rate by actively buying and selling
their currencies in the foreign exchange market whenever their exchange
rates fluctuate from the stated par value.
5. Current hybrid system: The current international monetary system is a
hybrid, with major currencies floating on a managed basis, some freely
floating and moving from a target-zone to a fixed-rate system.
Activity 2
In the present economic scenario, assess the contribution of IMF towards
India. Find news item regarding the same and paste them in a chart.
Hints:
1. Browse the internet and study the functions of IMF.
2. Collect newspapers and search for news item.
13. __________is an accounting system that measures all economic
transactions between residents (including government) of one country
and residents of all other countries.
14. The Fixed rate system was replaced by the ______________________.
15. The International Monetary Fund was established in _______________.
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16. In 1944, a conference was held at ______________________in which

each participating government agreed to maintain a fixed exchange rate
for its currency in comparison to dollar/gold.
1.9 Case Study

UnileverA Case Study
Unilever being one of the oldest and largest foreign multinationals conducting
businesses in the U.S. presents an opportunity for understanding the various
problems that are encountered by multinationals in the foreign land. Different
issues related to the multinationals can be studied through the help of the
case of Unilever.
A complex organization
Since 1929, the company has been headed by two different Dutch and British
companies having different sets of shareholders but the same boards of
directors. Two head offices were located in Rotterdam and London and had
two chairmen. The role of the "chief executive" was performed by a three
person special committee comprising two chairmen and one other director.
The complexity of the organization was further compounded by the wide
range of products offered by UniIever and the changes that took place in
these products over time. Unilever also manufactured convenience foods
such as ice cream, meat products, tea as well as frozen foods and soups.
Other than these, they also manufactured personal care products such as
shampoo, hairspray, toothpaste and deodorants. In Europe, its food business
spanned all stages of the industry, from fishing fleets to retail shops. It also
owned a trading company, the United Africa Company employing around
70,000 people in the 1970s and became the largest modern business
enterprise in West Africa. In 1981, a ranking by sales revenues in Forbes
put it in twelfth place. As an early multinational investor, Unilever had the
advantage of extensive manufacturing and trading businesses throughout
Europe, North and South America by the postwar decades, Unilever was
one of the largest and oldest foreign multinationals in the United States
and its longevity in the United States offers an opportunity to study the
issue of inward FDI in the United States.
The case of Unilever provides new empirical evidences of important issues
related to the functioning and impact of the multinationals. It also brings
into focus the issue of what is meant by "control" within multinationals.
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Questions
1. What do you think are the issues faced by Multinationals in foreign
lands?
2. What do you think were the advantages that Unilever had being an
early multinational investor?
Hint: As an early multinational investor, Unilever had the advantage of
extensive manufacturing and trading businesses throughout Europe.
Source: Adapted from http://hbswk.hbs.edu/item/3212.html
1.10 Summary
Let us recapitulate the important concepts discussed in this unit:
The term 'globalization' was used by the late professor Theodore Levitt of
Harvard Business School in an article titled 'Globalization of Markets' which
appeared in Harvard Business Review in 1983.
An open economy can have a higher GDP than a closed one because of
increased access to improved economies and exposure to better
technology that can provide an upwards thrust to economic development.
Shapiro has defined 'Multinational Corporation' as a company engaged
in producing and selling goods or services in more than one country.
The classical theory of international trade developed by Adam Smith and
David Ricardo emphasized that each nation should specialize in the
production and export of those goods that it can produce with maximum
efficiency than any other nation (Theory of Comparative Advantage).
No firm or business enterprise is free from the effects of the elements of
the global financial environment like price movements, international buffer
stock, fluctuation in interest rate or the economic or political environment.
The foremost goal of international financial management is maximization
of the wealth of the shareholder.
A successful exchange system is needed to stabilize the international
payment system.
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Unit 1
1.11 Glossary
Globalization: Processes of international integration as a result of
increase in human connectivity and the interchange of ideas, products,
worldviews as well as other aspects of culture
Open economy: Economy which is free from trade barriers and
where a large percentage of the GDP includes exports and imports
Liquidity: Flow of assets
Subsidiary: An organization that is controlled by another
due to the ownership of more than 50 percent of the voting stock
Mobilization: Make mobile or capable of moving
Buffer Stock: Supply of inputs that is kept as a reserve for facing any
kind of demands or unforeseen shortages.
Expropriation: Deprive of possession
Stockholder: One who owns a share or shares of stock in a company

1. Explain the term Globalization.
2. Discuss the advantages of Globalization.
3. Discuss what you mean by multinational corporations.
4. What do you think is the most commonly accepted objective of an MNC?
Discuss.
5. How does International Financial Management helps in maximizing the
wealth of the shareholders?
6. Discuss the disadvantages of Gold Standard.
1.13 Answers
Answers to Self-Assessment Questions
1. Globalization
2. Theodore Levitt
3. Closed economy
Page No. 18
Unit 1
4. True
5. False
6. False
7. Stockholder wealth
8. Exchange rate risks
9. True
10. False
11. Customers and employees
12. Wealth of the shareholder
13. BOP
14. Floating exchange rate system
15. 1944
16. Bretton Woods, New Hampshire
Answers to Terminal Questions

1. Globalization can be defined as the process of international integration
that arises due to increasing human connectivity as well as the interchange
of products, ideas and other aspects of culture.
For further details, refer to Section 1.3.
2. The advantages of Globalization are:
Economic growth
Lower costs
Improved availability of goods and services
3. 'Multinational Corporation' is a company engaged in producing and selling
goods or services in more than one country.
4. Maximization of stockholder wealth globally is the most commonly
accepted objective of an MNC.
Page No. 19
Unit 1
5. Effective financial management is not limited to the application of the

latest business techniques or functioning more efficiently but includes
maximization of wealth meaning that it aims to offer profit to the
shareholder, the owners of the businesses and to ensure that they gain
benefits from the business decisions that have been made.
6. The disadvantages of Gold Standard are:
The burden of BOP adjustment shifts to domestic variables which
subordinate the domestic economy to external economic factors.
There is always a problem of selecting an appropriate par value
which reflects the external and internal equilibrium.
Kaur, Dr. Harmeet. International Finance, Delhi: Vikas Publishing House.
Apte, P.G. International Financial Management. 2006. New Delhi: Tata
McGraw Hill.
Page No. 20
Unit 2
Balance of Payments
Structure
2.1 Caselet
2.2 Introduction
Objectives
2.3 Principles of BOP Accounting
2.4 Balance of Payments Statement
2.5 Current Account Deficit and Surplus
2.6 Capital Account Convertibility
2.7 Case Study
2.8 Summary
2.9 Glossary
2.11 Answers
2.1 Caselet
Tarapore Committee Recommendations
on the Capital Account Convertibility in India
Since 1991, the Indian Government thought of liberalizing both the current
and the capital accounts. After the Government attained full convertibility
on current account transactions by August 1994, a long debate on whether
to go for capital account convertibility (CAC) and also how to go about it
ensued. In February 1997, the Reserve Bank of India appointed a committee
for exploring the possibility for CAC and for suggesting important measures.
Taking into consideration issues such as the pre-conditions that are
necessary for the smooth functioning of the committee and to find out how
to phase on to the CAC, the Tarapore Committee report was tabled in June
1997. Some of the suggestions were implemented while some others could
not be implemented due to some unwarranted changes in macro-economic
variables in general and in external sector variables in particular, since late
1997. The committee suggested that the resident individuals should be
allowed to make foreign-currency denominated deposits with a bank in
India, in order to borrow from the non-residents at an interest rate not
exceeding the London Interbank Offered Rate (LIBOR). Through this, they
could also transfer financial capital abroad.
Unit 2
The committee also recommended that the limit of the Indian banks
borrowings can also be enhanced from the then existing level of US $ 10
million to 50% of their unimpaired Tier 1 capital in the first year to 100% of
such capital in the final year. It also suggested that liberal provisions should
be made for the forward cover in the foreign exchange market and also
allow the NBFCs to function as authorized dealers.
Source: Adapted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/
72250.pdf
2.2 Introduction
In the previous unit, you learnt broadly about the international financial
environment in which the world economy operates. You also understood the
concept of International Financial Management as well as Domestic Financial
Management. Along with it, you learnt about the multinational and transnational
corporations and the concept of the term globalization. The economies of the
world are interdependent one with other and in this light international trade and
flow of capital gain importance. Therefore, in order to analyse and understand
the monetary aspects of a countrys international interactions, a statement of
balance of international payments is prepared by every country. In this unit, you
will learn about the concepts and principles of balance of payments and its
various components. The Current Account Deficit and Surplus and Capital
Account Convertibility have also been discussed.
Objectives
explain the concept and principles of BOP accounting
define the Balance of Payment Statement
identify capital account, current account and the official reserve account
describe current account deficit and surplus
explain the concept of capital account convertibility
2.3 Principles of BOP Accounting

Balance of payments (BOPs) measures the payments that flow between a
country and other countries. It determines economic transactions of a country
Page No. 22
Unit 2
during a specific time period. The BOP is determined by a countrys export and
imports of goods services, and financial capital, as well as financial transfers.
The balance of payments is based on the principles of double-entry
bookkeeping, according to which two entries - credit and debit - are made for
every transaction, so that the total credits match the total debits.
BOP accounting principles regarding debits and credits are as follows:
1. Credit Transactions (+) are those that involve the receipt of payment from
foreigners. The following are some of the important credit transactions:
(i) Exports of goods or services
(ii) Unilateral transfers (gift) received from foreigners
(iii) Capital inflows
2. Debit Transactions (-) are those that involve the payment of foreign
exchange i.e., transactions that expend foreign exchange. The following
are some of the important debit transactions:
(i) Import of goods and services
(ii) Unilateral transfers (gift) given to foreigners
(iii) Capital outflows
2.3.1 Debits and Credits

Debits and credits can be defined as the two fundamental aspects of every
financial transaction in the system of double-entry bookkeeping. They are a
system of notation through which it can be determined how any financial
transaction is recorded. In order to determine whether a person should credit or
debit a specific account, the modern accounting equation approach is used that
comprises five rules or accounting elements. These elements are expenses,
liabilities, income, equity and assets.
The rules of double-entry bookkeeping show the credit and debit items
vertically in the BOP of a country. Debit can be defined as any economic
transaction that leads to a payment to foreigners and is characterized by a
negative arithmetic sign (-). Any economic transaction giving rise to a receipt
from the rest of the world is known as credit with a positive arithmetic sign (+).
Thus, it is known that every credit in the account is balanced by a corresponding
debit and vice versa.
While numbers are being recorded in accounting, a credit value is placed
on the right side of a ledger (Accounting Book) and a debit value is placed on
Page No. 23
Unit 2
the left side of a ledger. Depending on the kind of accounts, there is an increase
or a decrease in the total balance in each account. In the accounting sense, the
balance of payment always balances, since every economic transaction recorded
in BOP is represented by two entries with equal values.
2.3.2 Debit and Credit Entries

All the transactions that lead to a prospective payment or an immediate payment
from the rest of the world (ROW) to the country in question should be recorded
as credit entries in the BOP of that country. And the payments themselves should
be recorded as the offsetting debit entries.
Thus, while the sale of the product is recorded as a credit entry, the payment
made by a foreign firm is recorded as a debit entry. For instance, if an Indian
firm is purchasing machinery from a foreign firm, the machinery that is imported
is recorded as a debit entry and the payment which is made is recorded as a
credit entry.
A credit entry can be defined as an international transaction that results in
a demand for domestic currency in the foreign exchange market or a transaction
which is a source of foreign currency. On the other hand, debit entry is the
transaction that leads to a supply of the home currency in the foreign exchange
market.
The individual items that make up the BOP are categorized under five
groups of transactions:
Credit entries
Debit entries
Trade items
Visible exports
Invisible exports (payments to
the domestic countries for
services rendered abroad)
Visible imports
Invisible imports (payments
by the domestic countries for
services rendered abroad)
Non-trade
items
Gold exports (physical export of

the metal)
Unrequited receipts (gifts
received from foreigners)
Capital receipts (loans from,
capital repaid by, or assets sold
to foreign nationals)
Gold imports (physical import

of the metal)
Unrequited receipts (gifts
paid to foreigners)
Capital payments (loans to,
capital repaid to, or assets
purchased from foreign
nationals)
Total receipts
Total payments
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Unit 2
We will learn about how these transactions appear in the Balance of

Payment statements in the next section.
Activity 1
Suppose Country A supplies machinery products worth 300 million to Country
B and exports crude oil worth 300 million, what will be the credit and debit
entries? Write them down on a chart.
Hint:
While the sale of the product is recorded as a credit entry, the payment
made by a foreign firm is recorded as a debit entry.
1. The balance of payments is based on the principles of ___________,
according to which two entries-credits and debits are made for every
transaction, so that the total credits match the total debits.
2. ____________can be defined as any economic transaction that leads to
a payment to foreigners and is characterized by a negative arithmetic
sign (-).
3. While the sale of the product is recorded as a ____________, the payment
made by a foreign firm is recorded as a debit entry.
2.4 Balance of Payments Statement

The economic transactions of a countrys residents in relation to the rest of the
world are summarized by the balance of payments statement. It also presents
the transactions of movements in official reserves, the net income that has
been generated abroad and the transactions that take place in the physical and
financial assets.
The BOP consists of current account, capital account and reserve account.
The current account records flow of goods, services and unilateral transfers.
The capital account shows the transactions that involve changes in the foreign
financial assets and liabilities of a country. The reserve account records
transactions pertaining to reserve assets like monetary gold, special drawings
right (SDRs) and assets denominated in foreign currencies.
BOP is neither an income statement nor a balance sheet. It is a statement
of sources and uses of funds that reflects changes in assets, liabilities and net
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Unit 2
worth during a specified period of time. Decreases in assets and increases in

liabilities or net worth represent credits or sources of funds. Increases in assets
and decreases in liabilities or net worth represent debits or uses of funds. Sources
of funds include exports of goods and services, investment and interest earnings,
unilateral transfers received from abroad and loans from foreigners. Uses of
funds include imports of goods and services, dividends paid to foreign investors,
transfer payments abroad, loans to foreigners and increase in reserve assets.
2.4.1 The Current Account

The current account of the balance of payments refers to the monetary value of
all exports and imports of merchandise and invisibles. All international flows
associated with transactions in goods and services, investment income, and
unilateral transfers are included in this account.
It is divided into merchandise trade balance, the service balance and the
balance on unilateral transfers. All the entries that are made in these accounts
are of current value and they do not give rise to any future claim. A surplus in
the current account represents an inflow of funds while a deficit represents an
outflow of funds. The detail of these three sub-categories is presented as follows:
Merchandise trade: It includes the balance between exports or imports
of goods such as machinery, electronic goods, cars etc. A surplus balance
of merchandise trade happens when exports are greater in value than
imports. A deficit in balance of merchandise occurs when imports exceed
exports.
Invisibles: These include services like payments for legal assistance,
tourists expenditures, and shipping fees, royalty payments and interest
payments. International interest and dividend payments and the earnings
of domestically owned firms operating abroad.
Unilateral transfers: These include remittances, gifts and grants by both
government and private sector. Government transfers include money,
goods and services sent as an aid to other countries in the hour of need.
Private gifts and grants include personal gifts of all kinds.
Merchandise trade includes all of the goods a country exports or imports,
such as agricultural products, machinery, automobiles, petroleum, electronics,
textiles, and the like. The dollar value of merchandise exports is recorded as a
plus (credit), and the dollar value of merchandise imports is recorded as a minus
(debit). Combining the exports and imports of goods gives the merchandise
Page No. 26
Unit 2
trade balance. When this balance is negative, the result is a merchandise trade
deficit; a positive balance implies a merchandise trade surplus.
Exports and imports of services include a variety of items. When Indian
ships carry foreign products or foreign tourists spend money at Indian restaurants
and hotels, valuable services are being provided by Indian residents, who must
be compensated. Such services are considered as exports and are recorded
as credit items on the goods and services account. Conversely, when foreign
ships carry Indian products or when Indian tourists spend money at hotels and
restaurants abroad, foreign residents are providing services that require
compensation. Because Indian residents are, in effect, importing these services,
the services are recorded as debit items. Insurance and banking services are
explained in the same way. Services also include items such as transfers of
goods under military programmes, construction services, legal services, technical
services, and the like.
When the sum of all debits and credits is calculated, a country may have
a deficit or surplus on the merchandise trade account. This measures whether
the country is a net exporter or importer of goods. A trade surplus indicates that
the countrys exports are greater than imports and a trade deficit indicates that
a countrys imports are greater than exports. Just what does a surplus or deficit
balance on the goods and services account mean? A surplus shows how much
the country will have to lend or invest abroad. A deficit shows how much a
country will have to borrow from aboard by issuing certain financial securities
like bonds or stocks to finance its deficit.
2.4.2 Capital Account

It is an accounting measure of the total domestic currency value of financial
transactions between domestic residents and the rest of the world over a period
of time. This account consists of loans, investments and other transfers of
financial assets and the creation of liabilities. It includes financial transactions
associated with international trade as well as flows associated with portfolio
shifts involving the purchase of foreign stocks, bonds and bank deposits. It
includes three categories: direct investment, Portfolio investment and other
capital flow. The detail of these three sub-categories is presented as follows:
Direct investment: It occurs when the investor acquires shares of a
company acquires the entire firm or the establishment of new subsidiaries.
FDI takes place when the firms tend to take advantage of various market
imperfections. Firms also undertake FDI when the expected returns from
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Unit 2
foreign investment exceed the cost of capital, allowing for foreign exchange
and political risks. The expected returns from the foreign profits can be
higher than those from domestic projects due to lower material and labour
costs, subsidized financing, investment tax allowances, exclusive access
to local markets etc. An example of direct investment is an Indian firm
doing business in a foreign country.
Portfolio investment: This represents the sales and purchases of foreign
financial assets such as stocks and bonds that do not involve a transfer
of management control. A desire for return, safety and liquidity in
investments is the same for international and domestic portfolio investors.
International portfolio investments have seen a boom in the recent years
as the investors have become aware about the risk diversification that
can be reduced if they invest in various financial assets globally. The
increased returns from the foreign markets have also given a boost to
such category of investors. An example is a foreign institutional investor
buys the equity stock of an Indian company.
Capital flows: It represents the claim with a maturity of less than one
year. Such claims include bank deposits, short-term loans, short-term
securities, money market investment etc. these investments are sensitive
to both changes in relative interest rates between countries and the
anticipated change in the exchange rate. Let us understand with the help
of an example. If the interest rate increases in India then it will experience
a capital inflow as investors would like to take advantage of the situation
by buying bonds when prices are low, since interest rates on bonds and
inversely proportional to the bond prices.
2.4.3 The Official Reserve Account

The Official reserve account of BOP measures a countrys official reserves
which are in the form of liquid assets like the central banks holding of gold.
They are government owned assets. This account represents only purchases
and sales by the central bank (RBI). These reserves also include foreign
exchange in the form of balances with the foreign banks and the IMF and the
governments holding of Special drawing rights (SDRs).The changes in official
reserves are necessary to account for the deficit or surplus in the BOPs. While
an increase in the holdings of foreign currency reserves by the countrys central
bank is debited to the official reserve account, a decrease in the holdings of
foreign currency reserves by the countrys central bank is credited to the reserve
account.
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Unit 2
4. The goods account of a country includes all transactions of the visible
items. (True/False)
5. Short-term capital account follows internationally acceptable means of
settling international obligations. (True/False)
6. Unilateral transfers account is also known as a gift account, which includes
all gifts, grants, reparation receipts and payments given to foreign
countries. (True/False)
7. The official reserve account of the balance of payments refers to the
monetary value of international flows associated with transactions in goods
and services, investment income, and unilateral transfers. (True/False)
2.5 Current Account Deficit and Surplus

If the BOP is considered as a double-entry accounting record, then apart from
errors and omissions, it must always balance. Obviously, the terms deficit or
surplus cannot then refer to the entire BOP but must indicate imbalance on a
subset of accounts included in the BOP. The imbalance must be interpreted in
some sense as an economic disequilibrium.
Concerning the balance of payments, the current account and the capital
and financial account are not unrelated. They are essentially reflections of one
another. Because the balance of payments is a double-entry accounting system,
the total debits will always equal total credits. It follows that if the current
account registers a deficit (debits outweigh credits), the capital and financial
account must register a surplus, or net capital/financial inflow (credits outweigh
debits). Conversely, if the current account registers a surplus, the capital and
financial account must register a deficit, or net capital/financial outflow.
To better understand this notion, assume that in a particular year your
spending is greater than your income. How will you finance your deficit? The
answer is by borrowing or by selling some of your assets. You might liquidate
some real assets (for example, sell your personal computer) or perhaps some
financial assets. In like manner when a nation experiences a current account
deficit, its expenditures for foreign goods and services are greater than the
income received from the international sales of its own goods and services,
after making allowances for investment income flows and gifts to and from
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Unit 2
foreigners. The nation must somehow finance its current account deficit. But
how? The answer lies in selling assets and borrowing. In other words, a nations
current account deficit (debits outweigh credits) is financed essentially by a net
financial inflow (credits outweigh debits) in its capital and financial account.
The transactions that constitute the BOP are also categorized as
autonomous transactions and accommodating transactions. An autonomous
transaction is undertaken for its own purpose, i.e. to realize profits. An
accommodating transaction is undertaken to correct the imbalance in an
autonomous transaction.
Is a current account deficit a problem?
Contrary to commonly held views, a current account deficit has little to do with
foreign trade practices or any inherent inability of a country to sell its goods on
the world market. Instead, it is because of underlying macroeconomic conditions
at home requiring more imports to meet current domestic demand for goods
and services than can be paid for by export sales. In effect, the domestic economy
spends more than it produces, and this excess of demand is met by a net inflow
of foreign goods and services leading to the current account deficit. This tendency
is minimized during periods of recession but expands significantly with the rising
income associated with economic recovery and expansion.
When a nation realizes a current account deficit, it becomes a net borrower
of funds from the rest of the world. Is this a problem? Not necessarily. The
benefit of a current account deficit is the ability to push current spending beyond
current production. However, the cost is the debt service that must be paid on
the associated borrowing from the rest of the world.
Is it good or bad for a country to get into debt? The answer obviously
depends on what the country does with the money. What matters for future
incomes and living standards is whether the deficit is being used to finance
more consumption or more investment. If used exclusively to finance an increase
in domestic investment, the burden could be slight. We know that investment
spending increases the nations stock of capital and expands the economys
capacity to produce goods and services. The value of this extra output may be
sufficient to both pay foreign creditors and also augment domestic spending. In
this case, because future consumption need not fall below what it otherwise
would have been, there would be no true economic burden. If, on the other
hand, foreign borrowing is used to finance or increase domestic consumption
(private or public), there is no boost given to future productive capacity.
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Unit 2
Therefore, to meet debt service expense, future consumption must be

reduced below what it otherwise would have been. Such a reduction represents
the burden of borrowing. This is not necessarily bad; it all depends on how one
values current versus future consumption.
During the 1980s, when the United States realized current account deficits,
the rate of domestic saving decreased relative to the rate of investment. In fact,
the decline of the overall saving rate was mainly the result of a decrease of its
public saving component, caused by large and persistent federal budget deficits
in this periodbudget deficits are in effect negative savings that subtract from
the pool of savings. This indicated that the United States used foreign borrowing
to increase current consumption, not productivity-enhancing public investment.
The US current account deficits of the 1980s were thus greeted by concern by
many economists.
In the 1990s, however, US current account deficits were driven by increases
in domestic investment. This investment boom contributed to expanding
employment and output. It could not, however, have been financed by national
saving alone. Foreign lending provided the additional capital needed to finance
the boom. In the absence of foreign lending, US interest rates would have been
higher, and investment would inevitably have been constrained by the supply of
domestic saving. Therefore, the accumulation of capital and the growth of output
and employment would all have been smaller had the United States not been
able to run a current account deficit in the 1990s. Rather than choking growth
and employment, the large current account deficit allowed faster long-run growth
in the US economy, which improved economic welfare.
Balance of Payments deficit or surplus has an immediate impact on the
exchange rate. It was mentioned earlier that BOP records all transactions that
create demand for and supply of currency. Hence a current account deficit will
raise interest rates to attract short term capital inflow to prevent depreciation of
the currency. Or the monetary authorities may tighten credit and money supply
to make it difficult for domestic banks to borrow the home currency to make
investments abroad. It may force exporters to quickly realize their earnings and
bring foreign currency home. Countries suffering from chronic deficits may find
their credit ratings being downgraded because the markets interpret it as
evidence that the country may have difficulty in servicing its debts.
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Unit 2
8. A nations current account deficit (debits outweigh credits) is financed
essentially by a net financial inflow (credits outweigh debits) in its capital
and________________________.
9. The ___________ of an economy can be expressed as the sum of the
net borrowing by each of its sectors: government and the private sector
including business and households.
10. In the ___________, US current account deficits were driven by increases
in domestic investment.
2.6 Capital Account Convertibility

When free inflows and outflows are allowed abroad except for capital purposes
like loans and investments, it is referred to as Current Account Convertibility.
This really means that residents of a country can make or receive trade related
payments, for example dollars, for exporting goods and services. They can also
pay dollars for import of goods and services to make sundry remittances, access
foreign currency for studying abroad, or undergoing medical treatments, gifts
or for travel purpose. Current Account Convertibility in India was established
with the acceptance of the obligations under Article VIII of the IMFs Articles of
Agreement in August 1994.
The term capital account convertibility means relaxing control on capital
account transactions. For instance, it could mean quantitative restriction on the
movement of capital, a multiple exchange rate system suggesting different
exchange rates for commercial/financial transactions or explicit/implicit tax on
international financial transactions for discouraging the flow of capital. Thus,
CAC gives way to an absence of quantitative taxes on capital account
transactions or the presence of a market-based exchange rate system.
Capital account convertibility (CAC) permits the local currency to be
exchanged for foreign currency and no restrictions are put on the limit. Through
this, the local merchants can easily conduct transnational business without the
need for foreign currency exchanges in order to carry out small transactions.
However, questions also arise whether the monetary authorities of a
country should go for CAC or not. According to the advocates of capital control,
there are three basic advantages of control. They are:
Page No. 32
Unit 2
1. It leads to a lessening of the effects of the balance of payment crisis and

also leads to the reduction of instability in exchange rates.
2. It ensures that the requirements of investments are met by the domestic
savings and also assist in avoiding the foreign ownership of the domestic
factors of production.
3. It helps in maintaining the ability of the authorities in taxing domestic
financial activities.
For ensuring CAC, the advocates who are arguing for relaxing the control
however opine that the arguments behind control are free from flaws. Though
investments are financed by the domestic savings, they often fall short of the
requirements. Foreign capital also possesses a number of advantages that the
domestic capital does not have.
It is also important to note that the experience of capital control measures
in the developing and the developed countries states that such kinds of measures
have not been very effective. In order to make it more effective, a technically
sophisticated bureaucracy is required which is not present in the developing
countries. Moreover, firms can also transfer funds across borders through the
transfer pricing techniques. This also makes the controls ineffective.
Again, there is greater freedom for individual decision making as to how
to get necessary resources and how to use the excess reserves. The residents
are also capable of holding internationally diversified portfolio of assets, which
leads to reduction of the risks involved in investment and augments the riskadjusted returns on capital.
Due to the increased competition abroad, domestic providers of financial
services are required to be more efficient. In addition to fostering efficiency in
the domestic financial market, CAC also allows an economy to access
international financial market. It receives the desired amount of external funds
with minimal borrowing cost. However, it cannot function successfully in the
presence of domestic distortions, such as lopsided development of the domestic
financial market.
CAC finds support in both the international and the regional level. The
CAC also gains support from the IMF if the country has witnessed current account
surpluses and has also received a large inflow of capital. Many developing
countries have also received technical assistance from the IMF in the field of
the management of foreign exchange.
Page No. 33
Unit 2
Activity 2
Browse the Internet and find out how CAC is functioning in India. Make a
report.
Hint:
The authorities officially involved with CAC (Capital Account
Convertibility) for Indian Economy encourage all companies, commercial
entities and individual countrymen for investments, divestments, and
real estate transactions in India as well as abroad.
11. Capital account convertibility (CAC) permits the local currency to be
exchanged for foreign currency and no restrictions are put on the limit.
(True/False)
12. Control leads to an increase in the effects of the balance of payment
crisis and also raises instability in exchange rates. (True/False)
2.7 Case Study

Worst may be over on Balance of Payments
Indias Central bank released a data on 29 June, 2012 stating that the external
position of India is the most fragile since the country witnessed a balance of
payments crisis in the summer of 1991. However, many analysts are also of
the opinion that there is going to be an improvement in the external position
of India. The data released by the Central bank showed that Indias current
account deficit ballooned to a record high of $21.7 billion, or 4.5% of gross
domestic product (GDP), in the January-March quarter, from $6.3 billion a
year earlier. The money that crosses the borders of a country for all purposes
excepting investment and loans is counted by the current account. If the
imports as well as other external payments exceed the exports in addition to
the external receipts, it is considered to be in deficit.
As the investments made by the foreigners into India during the JanuaryMarch quarter was not enough to fulfill the shortfall of current account, the
Reserve Bank of India required to supply dollars from the foreign-exchangereserves of India for the second consecutive quarter. The data also revealed
that Indias current account deficit jumped from 2.7% to 4.2% of GDP for
the fiscal year ending on March 31 after staying below 3% since 1991.
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However, there are a number of barriers to the growth of the external position
of India. Slow growth in the developed economic markets of Europe and
the US could be a barrier to the growth of export. The price of oil may
further rise due to the rise in the European Union oil sanctions on Iran from
July 1. The Indian government also subsidizes some fuel products for the
end-consumers thus resulting in high demand of fuel. If the Government
doesnt cut down on fuel subsidies the way it has committed to do, the
pressure on the current account deficit may continue.
But still, there are many analysts who believe that the worst is over. Imports
will be highly discouraged due to the sharp fall of the Indian rupee against
the US dollar as it will result in the companies paying more rupees for the
goods that are priced in dollars. However, it will also result in the Indian
companies exporting more as their earnings will increase when converted
into Indian rupees. These simultaneous developments could lead to the
reduction of the current account gap. Its worth noting that in the past 12
months, the rupee has fallen more than 20% against the dollar. Why hasnt
the current account improved over that period? What has suddenly changed
now?
Nomura, a leading financial services group, is of the opinion that the benefit
of a weak local currency can be seen after a time period as it takes time for
the importers and the exporters to adjust. Some of the imports are also
inelastic in nature meaning that their demand does not decrease even if
there is an increase in the price. Goldman Sachs estimates that every 1%
fall in the value of the rupee, adjusted for inflation, leads to a 1.1% increase
in exports with a lag of two months and a similar fall in imports after four
months. Goldman Sachs further says that the recent fall in crude prices is
also likely to lower the current account gap. India imports three-fourths of
its crude oil requirement and, if oil costs less, India has to pay fewer dollars
for it though of course, it now needs more rupees to buy those dollars.
Nomura expects the current account deficit to fall to 3.0% to 3.5% of GDP
in the year that started April 1, while Barclays Capital estimates it at 3.6%.
Questions
1. Do you agree that India will benefit from the fall in the value of rupee?
2. What do you think are the barriers to the growth of the external position
of India?
Source: Adapted from http://blogs.wsj.com/indiarealtime/2012/07/02/worstmay-be-over-on-balance-of-payments/
Page No. 35
Unit 2
2.8 Summary
Balance of payments (BOPs) measures the payments that flow between
a country and other countries.
The balance of payments is based on the principles of double-entry
bookkeeping, according to which two entries-credits and debits are made
for every transaction, so that the total credits match the total debits.
Debits and credits can be defined as the two fundamental aspects of
every financial transaction in the system of double-entry bookkeeping.
A current account surplus means an excess of exports over imports of
goods, services, investment income, and unilateral transfers.
During the 1980s, when the United States realized current account deficits,
the rate of domestic saving decreased relative to the rate of investment.
Capital account convertibility (CAC) permits the local currency to be
2.9 Glossary
Double-entry bookkeeping: An accounting technique which records
each transaction as both a credit and a debit
Reparation: The act or process of making amends
Tangible: Material or substantial
Subsidized: Having partial financial support from public funds
Assets: Something valuable that an entity owns, benefits from, or has
use of, in generating income
Liquidate: To convert to cash
Maturity: Arrival of the time fixed for payment; termination of the period a
note, etc
Merchandise: The objects of commerce
Special drawing rights (SDRs): They are supplementary foreign
exchange reserve assets defined and maintained by the International
Monetary Fund (IMF)
Page No. 36
Unit 2

1. Define debits and credits in BOP.
2. Explain the major accounts of the balance of payments statement.
3. Discuss the three sub-categories of capital account.
4. What is official reserves account? Explain.
5. Discuss current account surplus.
6. What do you mean by capital account convertibility? Discuss.
2.11 Answers
1. Double-entry bookkeeping
2. Debit
3. Credit entry
4. True
5. False
6. True
7. False
8. Financial account
9. Net borrowing
10. 1990s
11. True
12. False

1. Debits and credits can be defined as the two fundamental aspects of
every financial transaction in the system of double-entry bookkeeping.
For further details, refer to Section 2.3.1.
2. The balance of payments statement includes six major accounts which
are as follows:
Page No. 37
Unit 2
Goods account
Services account
Unilateral transfers account
Long-term capital account
Short-term capital account
International liquidity account
3. The three sub-categories of capital account are:
Direct investment
Portfolio investment
Capital flows
4. Official reserves are government owned assets. This account represents
only purchases and sales by the RBI. The changes in official reserves are
necessary to account for the deficit or surplus in the BOPs.
5. A current account surplus means an excess of exports over imports of
goods, services, investment income, and unilateral transfers.
6. Capital account convertibility (CAC) permits the local currency to be
Apte, P.G. 2012. International Financial Management. Sixth edition. New
Delhi: Tata McGraw-Hill.
Sharan, Vyuptakesh. 2012. International Financial Management. Sixth
edition. New Delhi: PHI Learning Private Limited.
Siddaiah, Thummuluri. 2010. International Financial Management. New
Delhi: Pearson.
Kaur, Dr. Harmeet. Basics of International Finance. Delhi: Vikas Publishing
Private Limited.
Page No. 38
Unit 3
Foreign Exchange Market
Structure
3.1 Caselet
3.2 Introduction
Objectives
3.3 History of Foreign Exchange
3.4 Fixed and Floating Rates
3.5 Foreign Exchange Transactions
3.6 Foreign Exchange Quotations
3.7 Interpreting Foreign Exchange Quotation
3.8 Forward, Futures and Options Market
3.9 Case Study
3.10 Summary
3.11 Glossary
3.13 Answers
3.1 Caselet
Currency options trading in India
There are two types of options market that are found in India. One is the
rupee foreign currency (INR-FC) options and the other is the cross-currency
options. The call or put options can be purchased by the banks in order to
hedge their cross-currency proprietary trading positions. However, the banks
also need to take care that there is no initiation of the "no stand-alone"
transactions. Due to the fact that the small exporters and importers could
not use such transactions in view of large standard size, they were not
used widely in the 1990s. Such options were initially found in US dollars.
But now, they are found in other currencies as well such as Japanese yen,
euro and British pound.
It has become possible for the foreign exchange market participants to
hedge dollar-rupee risk due to the introduction of the INR-FC options. In
case an Indian economy is bidding for an international assignment where
the costs are in rupees and the bid quote in dollar, there is a risk for the
company until the contract is awarded. In cases like this, reverse positions
are created by the currency options if the company is not allotted the contract.
Unit 3
The underlying currency is US dollar and the size of the contract is US $

1000. The option premium is expressed in rupee terms and is paid on cash
on t1 day. The requirements of the margin money are dependent on the
exchange norms. The options found in the Indian market are European
options but they can be squared up early through taking offsetting positions
in the market. The settlement of the transaction takes place in rupee terms
and the maturity falls on two working days prior to the last working day of
the expiry month.
On 29 October 2010, the currency options were introduced at the National
Stock Exchange besides the OTC market. It is easier for a small currency
to hedge the currency risk on an exchange as the banks have become
strict and letter of credit as well as some form of guarantee and supplier
consignment has to be shown in the full amount. But in case of an exchange,
companies can trade by paying only the margin.
Source: Adapted from http://business-standard.com/india/prof_page.php?
search=currency+options&select=1
3.2 Introduction
In the previous unit, you learnt about the concepts and principles of balance of
payments and its various components. The Current Account Deficit and Surplus
and capital account convertibility were also discussed.
In this unit, you will learn about the origin of the concept of foreign exchange
and the difference between fixed and floating rates. You will also study foreign
exchange transactions and the types of foreign exchange transactions. You will
also learn about the derivatives instruments traded in foreign exchange market
such as forwards, futures, swaps, and options.
Objectives
discuss the history of foreign exchange
differentiate between fixed and floating rates
explain foreign exchange transactions and foreign exchange quotations
interpret foreign exchange quotation
describe forwards, futures, swaps, and options markets
Page No. 40
Unit 3
3.3 History of Foreign Exchange

The 17th century saw the start of the depositing of coins and bullion with money
changers, goldsmiths, etc. The first people to start the system of money by
book entry were the goldsmiths in England. This development further led to the
expansion of banking services and the people started gaining the confidence
that they can receive certain commodities against the bank note they possessed.
Thus, the history of foreign exchange can be traced back to the time when the
moneychangers in the Middle East would exchange money from all over the
world. In 1880, the practice of using gold as the standard of value started whose
main aim was to guarantee any currency against a set amount of gold.
Under the gold standard exchange rates, currency was backed by gold
and was measured in ounces. For this, the countries needed huge reserves of
gold in order to back the demand for currency. The foreign exchange rate was
determined by the difference of the price of gold between these two countries.
The foreign exchange history changed due to the birth of an international
standard through which foreign exchange can take place conveniently between
different countries. During the First World War, financial issues arose in Europe
which gave way to a lack of gold and this led to a historical change in foreign
exchange.
There emerged a void due to the abolishment of the Gold standard and to
discuss this concern, a convention was held in July 1944 at Bretton Woods,
New Hampshire. The new Bretton Woods monetary system led to a changed
forex market which put forward the following solutions:
A new method was to be established in order to obtain a fixed foreign
exchange rate
The US Dollar is to replace the gold standard as the new final exchange
currency
The US dollar will be the only currency which will be backed by gold
Three international authorities will be founded who would guard over all
the foreign transactions.
However, the Bretton Woods monetary system also failed after a period
of 25 years and on 15 August 1971, the US announced the end of the exchange
of gold for US dollar.
Page No. 41
Unit 3
1. The history of foreign exchange began in the year ____________ with
the establishment of the gold standard monetary system.
2. In 1880, the practice of using gold as the ____________ started whose
main aim was to guarantee any currency against a set amount of gold.
3. There emerged a void due to the abolishment of the Gold standard and to
discuss this concern, a convention was held in_________ at Bretton
Woods, New Hampshire.
3.4 Fixed and Floating Rates

The currency system in which the regulator tries to keep exchange rate constant
between domestic currency and foreign currencies is known as the fixed
exchange rate system. In this system, the government of a country determines
the value of its currency against a fixed amount of another currency.
The gold standard is the oldest fixed exchange rate regime. The gold
standard functioned till the beginning of the World War I and even few years
after that. According to the gold standard, the currency in circulation is convertible
into gold at a fixed rate. Therefore, the exchange rate between any two currencies
is determined by the value of the currencies in terms of gold.
After the fall of the gold standard, the world monetary system was in
chaos and the volume of international trade fell considerably. Thus, in place of
the gold standard, the gold exchange standard, popularly known as the Bretton
Woods System, was put up after the World War II by the victorious allies of the
war.
Advantages of fixed rates system
1. The system provides exchange rates stability by eliminating uncertainty.
2. Volatility of exchange rate is controlled as it insulates the economy from
external disturbances.
3. Foreign investors are encouraged to invest in countries without the fear
of exchange rate fluctuations.
4. Poorer nations could get foreign exchange for development purposes at
low costs.
Page No. 42
Unit 3
Disadvantages of fixed rates system

1. The system required regular rigorous control and monitoring by the
monetary authorities.
2. The system is not self equilibrating therefore over-valuation and undervaluation existed.
3. Since the realignment was to be done only when all other avenues to
correct the balance of payment were exhausted, therefore the burden
accumulated and the economies which resorted to devaluation faced a
lot of economic problems.
4. The system required regular rigorous control and monitoring by the
monetary authorities.
Floating exchange rate system
Floating exchange rates can be broadly classified into two types: clean float and dirty
float. In the clean float exchange rate system, the exchange rate is determined by
the forces of demand and supply without any intervention from the central authorities.
But when the central banks intervene to either raise or lower the exchange rate in
the floating exchange rate system, it is referred to as dirty float or managed float.
In the dirty float, there are two main reasons why the central banks and
other authorities intervene in the exchange rate system. The reasons are as follows:
To stabilize fluctuations in the exchange rate
To reverse the growth of trade deficit
In the pure float, the system is close to a free float, whereas in the dirty
float system, it is close to an adjustable peg. There are various other substitutes
between the two extremes of fixed and floating exchange rate regimes and
these substitutes try to incorporate the good features of both the regimes. The
alternate exchange rate systems are as follows:
The crawling peg system allows for modifications within the narrow band
of +1 or -1 per cent, and thus, replaces the abrupt parity changes of the
adjustable peg system. In simple words, the crawling peg is the system in
which a currency exchange rate is changed frequently, may be many
times a year, mainly to make adjustments for rapid inflation.
The wider bands system is more flexible as it has wider bands of variation
around the central parity. The parity can either be shifted as in the case of
the crawling peg and then the wider bands are referred to as gliding bands
or there may be discrete jumps as in the adjustable peg.
Page No. 43
Unit 3
The multiple exchange rate system allows for applying different exchange
rates to different transactions. For example, in 1992, India had two
exchange ratesthe 'official' exchange rate applicable to certain imports
and a 'market determined' exchange rate for other transactions.
Activity 1
Browse the Internet and find out which exchange rate system is found in
India. Also put forward your own views on whether the fixed or the floating
exchange rate is better.
Hint:
There are two types of exchange rate: Fixed and Floating.
4. Exchange rates are of two types: fixed or rigid exchange rates and flexible
or floating exchange rates. (True/False)
5. The gold standard is a new system of fixed exchange rate regime. (True/
False)
6. In the pure float, the system is close to a free float, whereas in the dirty
float system, it is close to an adjustable peg. (True/False)
3.5 Foreign Exchange Transactions

The foreign exchange market can be defined as the market where foreign
currencies are bought and sold. In case an Indian importer needs to import
goods from the USA, he has to pay in US dollars, He will take the help of the
foreign exchange market in order to buy dollars for rupees. The exporter, on the
other hand, converts the export proceeds that have been obtained in a foreign
currency to his own currency. Apart from these transactions, there are many
types of transactions that are involved in the import and export of goods.
3.5.1 Spot and Forward Transactions

Foreign exchange transactions, depending on the time gap between the
settlement and the transaction date, are classified into spot transactions and
forward transactions.
Page No. 44
Unit 3
In case of spot transactions, even though the name suggests spot

transactions, an immediate or on-the-spot transaction doesnt take place. The
settlement of spot transactions takes place within two days of the transaction
date. During the two-day period, the parties that are associated with the
transaction arrange to effect the exchange of a deposit denominated in one
currency for a deposit denominated in the other currency. In other words, during
the two-day period, the necessary crediting and debiting of banks that are situated
in different locations are carried out. In certain cases, the settlement is carried
out after the deal. In case the foreign trading centres are situated in the same
time zone, it will be possible to settle the deal on the very day the deal is carried
out. These types of transactions are known as cash transactions or short date
transactions as they can give way to immediate exchange of currencies that
are involved in the transaction.
The exchange rates in which the spot transactions are carried out are
known as the spot rate. These transactions can also be rolled over at a cost is
based on the interest rate differential between the two currencies. The trader
will earn interest in case the trader is long in the currency with a higher rate of
interest. On the contrary, the trader will pay interest in case the trader is short in
the currency with a higher rate of interest.
On the other hand, in case of forward transaction, the parties enter into a
forward contract which permits the sale or purchase of a particular amount of a
foreign currency at a future date at an exchange rate that has already been
agreed upon while entering the contract. Thus, in case of forward transaction,
there is no need for immediate settlement and the transactions are settled on
any date that has been predetermined after the transaction date. After the deal
date, the date of settlement of the forward transactions may be 30, 60, 90, 120
or 180 days. The transaction may be further referred to as a 30 day forward, 60
day forward and so on depending on the days in which a forward transaction
may be settled. The forward transactions are very important in the sense that
they increase currency risks across countries. These transactions are also very
flexible and can be customized to meet the specific needs of a trader with regard
to the amount, currency and the date of the settlement. Sometimes, a deal can
be carried out by a trader to exchange one currency for another currency
immediately, with an obligation of reversing the exchange at a specified future
date.
Page No. 45
Unit 3
7. The settlement of ____________takes place within two days of the
transaction date.
8. The exchange rates in which the spot transactions are carried out are
known as the____________.
9. In case of_________, there is no need for immediate settlement and the
transactions are settled on any date that has been predetermined after
the transaction date.
3.6 Foreign Exchange Quotations

Two - Way Quotations
Foreign exchange quotations between banks have 2 rates - one at which the
quoting bank is willing to buy (bid price) and the other at which it is willing to sell
the foreign currency (ask price). For example, on 21 June 2012, the inter-bank
rates for one $1US were `55.87 /98 indicating that the buying rate was `55.87
and the selling rate was `55.98. The difference between the two rates is called
exchange rate spread and that is the source of profit for the bank. The spread
is lower in currencies where the volume traded is large and is higher where the
volume traded is small. As the volume involved in the case of inter-bank dealings
is very high, and bankers would like to make a profit while dealing in currencies,
they have developed certain maxims to help themselves.
A foreign exchange rate is quoted as the foreign currency per unit of the
domestic currency. In an indirect quote, the foreign currency is a variable amount
and the domestic currency is fixed at one unit.
For example, in the US, an indirect quote for the Canadian dollar would
be C$1.17 = US$1. Conversely, in Canada an indirect quote for US dollars
would be US$0.85 = C$1.
For direct quotations, they 'buy low and sell high', i.e., they pay fewer
units of the home currency for buying a fixed unit of foreign currency
but receive more units of home currency while selling the same.
(a) For indirect quotations, they 'buy high and sell low', i.e., they acquire
more units of a foreign currency for a fixed unit of home currency
but part with fewer units of foreign currency while selling it.
Page No. 46
Unit 3
Banks are able to manage within this small margin. In the case of merchant
rate, however, the percentage spread is much higher as the gap between the
buying and selling rates is more.
RBI's Reference Rate
The Reserve Bank of India also publishes a rate called RBI reference rate. This
rate is based on 12 noon rates of a few select banks in Mumbai. The SDRRupee rate is based on this rate. Based on the RBI reference rate for US dollar
and middle rates of the cross currency quotes at 12 noon, the exchanges of US
dollar, Pound Sterling, EURO and yen are published.
For example, the reference rate from RBIs published data is presented
below:
The Reserve Bank of Indias Reference Rate for the US dollar is `55.1515
and the Reference Rate for Euro is `67.6030 on July 20, 2012. The corresponding
rates for the previous day (July 19, 2012) were `55.3830 and `68.0639
respectively. Based on the Reference Rate for the US dollar and middle rates of
the cross-currency quotes, the exchange rates of GBP and JPY against the
Rupee are given below:
Date
July 19, 2012
July 20, 2012
Currency
1 GBP
86.7464
86.5768
100 JPY
70.47
70.22
Note: The SDR-Rupee rate will be based on the reference rate.

Types of Exchange Rate Quotes
There is no single quote for exchange rate. A number of rates exist at the same
time between two currencies. The rates differ between currency notes and foreign
currency denominated travellers cheques. Inter-bank rates are the rates quoted
for trading in currencies between banks, and merchant rates are the rates quoted
by banks for merchants, e.g., exporters and importers.
Merchant Rates
The Reserve Bank of India has authorized some commercial banks to undertake
foreign exchange transactions with merchants. The inward/outward foreign
exchange remittances of banks include (a) Telegraphic Transfer, (b) Mail Transfer
(MT) (c) Demand Draft (DD) and (d) Bills for clearing. In recent years, electronic
transfer has become one of the most important and speedy ways of transferring
Page No. 47
Unit 3
funds from one centre to another. Telegraphic transfer of funds from one centre
to another is done by way of instructions through telex, telegram or cable. Telex
has been the most important mode of transferring funds for reasons of security
and record-keeping. Wherever facilities were available are now being replaced by
electronic transfer facilities. A mail transfer is an order in writing to pay to the
beneficiary the sum mentioned therein. A demand draft is a written order issued by
a bank on another bank (correspondent) or its own branch at a different financial
centre equivalent to the amount already received by the banker. Similarly,
there are selling and buying rates for import and export bills. TT selling rates are for
outward remittances in foreign currency and TT buying rates are meant for clean
inward remittance. In order to avoid cut-throat competition amongst its
members, the Foreign Exchange Dealers Association of India has issued guidelines
for quoting the various rates.
10. Inter-bank rates are quoted up to 4 decimal points while merchant rates
are quoted up to 2 decimal places. (True/False)
11. A mail transfer is an order in writing to pay to the beneficiary the sum
mentioned therein. (True/False)
3.7 Interpreting Foreign Exchange Quotation

Exchange Rate Quotations
In the foreign exchange market, quotations adopted by the Association Cambiste
Internationale (ACI) are used for determining the exchange rate for a currency.
ACI is an international financial market association in which foreign exchange
professionals work for market development. A quotation is represented by a pair
of three-letter SWIFT codes for currencies separated by an oblique or a hyphen.
The currency that appears before the hyphen is the base currency and the currency
after the hyphen is the quoted currency. Some examples of quotation are:
USD/JPY: In this quotation, US dollar is the base currency and Japanese
yen is the quoted currency.
EUR/GBP: In this quotation, euro is the base currency and the pound is
the quoted currency.
INR/AUD: In this quotation, Indian rupee is the base currency and
Australian dollar is the quoted currency.
Page No. 48
Unit 3
Thus, an exchange rate quotation is the representation of the number of

units of quoted currency per unit of the base currency. A quotation can also
consist of prices of two currencies separated by a hyphen. The price before the
hyphen is known as the bid price and the price after the hyphen is called the ask
or offer price. The bid price is the price at which a trader wants to buy base
currency against the quoted currency. The ask price is the price at which a
trader wants to sell the base currency against the quoted currency.
Quotations are used to indicate the exchange rate of currencies. These
contain the names of the currencies and their exchange rates. Normally, each
country has two types of quotations, direct and indirect. A direct quotation
represents the number of units of home currency of the country per unit of
foreign country.
An indirect quotation or reciprocal quotation represents the number of
units of foreign currency for per unit of home currency of a country. This type of
quotation is the inverse representation of the direct quotation, so it is also called
inverse quotation. An example of an indirect quotation is USD 2.1010 per INR
100 in India indicating that the number of units of the rupee is 100. An indirect
quotation represents the exchange rate of currency in European terms, which
represents the number of units of a currency per US dollar. A quotation that is
used to represent the exchange rate for two non-dollar currencies is known as
cross rate; for example, GBP/EUR represents non-dollar currencies pound and
euro. Sometimes, traders use short forms for the quotations; for example, INR/
JPY: 1.2940/1.2960 can be represented in the following forms:
1.2940/60, when the price of currencies is changed to decimal points.
40/60, when two traders regularly interact for trading a particular currency
pair because they know the big figure of the currency rate. Big figure
means starting digits of the rate that is 1.29 in the 1.2940/60 quotation.
All the quotations used in the foreign exchange market are divided into
three main categories. These categories are:
Spot quotation
Outright forward quotation
Swap quotation
Spot quotation
Spot quotations are used to represent the exchange rate of a currency according
to the present rate in the market. It must be in such a form that no arbitrage
situation is created in the market.
Page No. 49
Unit 3
Arbitrage situation
Sometimes, there exist market situations which help participants of the market
to make a profit without any risk. These market situations are known as arbitrage
situations. Participants of the market can gain by making some currency
transactions with such banks which have quoted different prices for the same
currency pair.
Inverse quote and two-point arbitrage
Two-point arbitrage is the condition when there is a chance to buy a currency
from one market and sell that currency in another market where the price of the
currency is higher. For example, Bank A in France has quoted USD/EUR: 1.9345/
1.9350 and Bank B in America has also quoted for the same currency pair as
EUR/USD: 0.5345/0.5360 which is the inverse or reciprocal quote of Bank A.
This means ask rate of Bank A, which is EUR/USD, is the reciprocal of the bid
rate of Bank B, that is, USD/EUR. This means reciprocal of the ask rate of Bank
A is 1/(EUR/USD) which is equal to the bid rate of Bank B. You can also say that
the EUR/USD bid rate of Bank B implies 1/(USD/EUR) ask rate of Bank A
andEUR/USD ask rate of Bank A implies 1/(USD/EUR) bid rate of Bank B. In
this way an inverse quotation is used in a two-point arbitrage situation.
The bid rate in the quotation of Bank B should be overlapped with the ask
rate in the quotation of Bank A to avoid two-point arbitrage situation.
Triangular arbitrage
Triangular arbitrage is that market situation in which a bank provides some
exchange rates that are not directly inverse of the exchange rate of another
bank but provides an indirect way to make a profit without any risk to the trader.
12. An____________ or reciprocal quotation represents the number of units
of foreign currency for per unit of home currency of a country.
13. ____________ ____________ are used to represent the exchange rate
of a currency according to the present rate in the market.
14. ____________ ____________ is that market situation in which a bank
provides some exchange rates that are not directly inverse of the exchange
rate of another bank but provides an indirect way to make a profit without
any risk to the trader.
Page No. 50
Unit 3
3.8 Forward, Futures and Options Market

3.8.1 Forward Market
In the forward market, contracts are made to buy and sell currencies for future
delivery, say, after a fortnight, one month, two months and so on. The rate of
exchange for the transaction is agreed upon on the very day the deal is finalized.
The rate of exchange for the transaction is agreed upon on the very day the
deal is finalized. The forward rates with varying maturity are quoted in the
newspapers and those rates form the basis of the contract. Both parties have to
abide by the contract at the exchange rate mentioned therein irrespective of
whether the spot rate on the maturity date resembles the forward rate or not.
The value date in case of a forward contract lies definitely beyond the value
date applicable to a spot contract.
Sometimes the value date is structured to enable one of the parties to the
transaction to have freedom to select a value date within the prescribed period.
This happens when the party does not know in advance the precise date on
which it would be able to deliver the currency, for instance, an exporter who
sells a foreign currency forward without knowing in advance the precise date of
shipment.
3.8.2 Futures Market

The foreign exchange market involving forward contracts has a long history but
the market for currency futures has a comparatively recent origin. It came into
being in 1972 when the Chicago Mercentile Exchange has set up its international
monetary market division for trading of currency futures. Currency futures are
traded only in a limited number of currencies. A forward contract is finalized on
telephone, etc. meaning that it represents an over-the-counter market. But in
case of currency futures, brokers strike the deals sitting face to face under a
trading roof, known as pits. The brokers can trade for themselves as well as on
behalf of the customers. When they trade for themselves, they are called locals
or floor traders. On the other hand, when the brokers trade on behalf of their
customers, they are known as commission brokers or floor brokers.
When a trader has to enter a currency futures contract, he informs his
agent who in turn informs the commission broker at the stock exchange. The
commission broker executes the deal in the pit for a commission/fee. After the
deal is executed, the commission broker confirms the trade with the agent of
the trader. There are different costs associated with the transactions in the
Page No. 51
Unit 3
market for currency futures. The first is the brokerage commission that is charged
by the commission brokers and covers both the opening and the reversing
trade. The second is the floor trading and clearing fee charged by the stock
exchange and its associated clearing house. Normally, this fee is included in
the brokerage commission but when the locals trade for themselves, the fee is
quite exclusively found. The third is the delivery cost that is related to the delivery
of the currencies but since actual delivery of the currencies seldom takes place,
such cost is not common.
3.8.3 Options Market

The market for currency options is the other form of the derivatives market
representing large-scale sale and purchase of currencies. This form of market
possesses some distinguishing features and also the methods of operation are
different. There are three different types of option market. They are listed currency
options market, currency futures options market and over-the-counter options
market.
Listed currency options market
Listed currency options are standardized contracts. In such contracts, the
clearinghouse is essentially a party to the contract. For the option- buyer, the
clearinghouse is a seller of options and for the seller of the options, it is a buyer.
It guarantees both sides of the contract and charges a small fee for facilitating
such contracts.
Currency futures options market
In this market, which is basically a listed currency options market, the contracts
present a mixture of currency futures and currency options. The buyer and the
seller of options have, however, to deposit margin money with the exchange
that is equal to a small function of the contract price. The options are marked to
market meaning that they undergo daily settlement as in the case of a futures
contract.
Over-the-counter options market
The second type of market for currency options is known as inet-bank currency
options market or the over-the-counter options market. Such a market is centred
in New York or London and the size of transactions is many times that of the
market in the organized exchanges.
Page No. 52
Unit 3
Activity 2
Approach a broker and find out the differences between the forward markets,
futures markets and option market. Write them down on a chart.
Hint:
Analyse what forward, future and option markets are.
15. In the options market, contracts are made to buy and sell currencies for
future delivery, say, after a fortnight, one month, two months and so on.
(True/False)
16. In listed currency options, the clearinghouse is essentially a party to the
contract. (True/False)
3.9 Case Study

Currency Futures Market in India
Rupee currency futures were started in Dubai in 2007 at the Dubai Gold
and Commodity Exchange. In India, after a green signal from the Raghuram
Rajan Committee and the Expert Group at the RBI, three Indian exchanges,
viz. BSE, NSE and MCX, applied for dealing in currency futures. RBI and
SEBI released the guidelines in this respect on 6 August 2008. Finally,
NSE started operating on the 29 August 2008. MCX and BSE followed the
suit.
The guidelines allowed only US dollar-rupee contracts with a size of $ 1,000
for a maturity not exceeding 12 months. The trading is done on Monday
through Friday excluding public holidays between 9.00 AM and 5 PM and
the settlement is done on the last working day of the month, and not earlier.
Thus, the standardized size is smaller than those at the international
exchanges. The contracts are quoted and settled in rupee.
The membership of the currency futures market would be separate from
the membership of derivatives/cash segment. Again, only a resident Indian
can participate in the deal. A bank being a member must have reserves
worth rupees 5 billion, 10 per cent CRAR, an NPA of 3 per cent at the
maximum and a profit record for at least three years. The trading limit for
Page No. 53
Unit 3
an individual client is $ 5 million or 6.0 per cent of the total open interest,
whichever is higher. For a trading member bank or broker, it is $ 25
million or 15.0 per cent of the total open interest, whichever is higher.
The hedger or the client is first registered with the trading member who
buys or sells the currency futures contract on behalf of the client. The
marking to market is based on the daily settlement price and are carried
forward to the next day. Finally, on the settlement day, the settlement is
done in cash payable in rupee.
Now the question is whether the currency futures are better than the forwards
transacted in India. First of all, while in the case of OTC forward contracts,
the banks quote different bid-ask rates for different customers, the futures
rates are shown on the screen of the exchange. Thus, the price discovery
is more transparent in the case of futures.
Second, participants such as exporters and importers can go for a forward
contract only for their underlying transactions. Their purpose cannot be
speculation. But in the case of currency futures, no underlying securities
are required.
Questions
1. How is the membership of the currency futures market separate from
the membership of derivatives/cash segment?
2. Dou you think currency futures are better than forwards transacted in
India? If yes, why?
Source: Adapted from http://www.marketswiki.com/mwiki/Dubai_Gold_
and_Commodities_Exchange
Accessed on 30 September 2012
3.10 Summary
The foreign exchange began in the year 1875 with the establishment of
the gold standard monetary system.
The term exchange rate regime refers to a set of mechanisms, procedures
and framework to determine the exchange rates at a given point of time
and changes in the exchange rates over a certain time period.
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Unit 3
Floating exchange rates can be broadly classified into two types: pure
float and dirty float.
Foreign exchange transactions depending on the time gap between the
settlement and the transaction date have been classified into spot
transactions and forward transactions.
Sometimes, there exist market situations which help participants of the
market to make a profit without any risk. These market situations are
known as arbitrage situations.
There are three different types of option market. They are listed currency
options market, currency futures options market and over-the-counter
options market.
3.11 Glossary
Monetary: Of or relating to money
Convertible: That can be converted
Intervention: Government action to influence market forces
Crawling Peg system: A system of exchange rate adjustment in which a
currency with a fixed exchange rate is allowed to fluctuate within a band
of rates
Obligation: Act of binding oneself by a social, legal or moral tie
Maxims: An established principle or proposition
Remittance: The act of transmitting money or bills especially to a distant
place, in discharge of an obligation or as in satisfaction of a demand

1. Trace the history of Foreign Exchange.
2. Define the advantages of the Fixed Rates System.
3. State the differences between pure float and dirty float.
4. Define spot and forward transactions.
5. Discuss devaluation and revaluation.
6. Discuss the three different types of option markets.
Page No. 55
Unit 3
3.13 Answers
1. 1875
2. Standard of value
3. July 1944
4. True
5. False
6. True
7. Spot transactions
8. Spot rate
9. Forward transactions
10. True
11. False
12. Indirect quotation
13. Spot quotations
14. Triangular arbitrage
15. False
16. True

1. The foreign exchange began in the year 1875 with the establishment of
the gold standard monetary system.
In earlier times, people used the barter system to fulfill his needs of different
products and commodities and the exchange was limited to food items
only
Page No. 56
Unit 3
2. The advantages of the fixed rates system are:

The system provides a measure of exchange rates stability and
eliminates the source uncertainty and price instability.
Volatility of exchange rate is controlled as it insulates the economy
towards the economic disturbances
3. The differences between pure float and dirty float are:
In the pure float exchange rate system, the exchange is determined
by the forces of demand and supply without any intervention from
the central authorities. But when the central banks intervene to either
raise or lower the exchange rate in the floating exchange rate system,
it is referred to as dirty float or managed float.
In the pure float, the system is close to a free float, whereas in the
dirty float system, it is close to an adjustable peg.
4. In case of spot transactions, the settlement of spot transactions takes
place within two days of the transaction date.
On the other hand, in case of Forward transaction, the parties enter into
a forward contract which permits the sale or purchase of a particular
amount of a foreign currency at an exchange rate that has already been
agreed upon at a future date.
For further details, refer to Section 3.5
5. Technically, the term 'devaluation' refers to the reduction in the value of
the currency made by the authorities concerned. An increase in the value
of the currency in a pegged exchange rate regime is referred to as
revaluation.
6. There are three different types of option market. They are:
listed currency options market
currency futures options market
over-the-counter options market.
Page No. 57
Unit 3
Apte, P.G. 2006. International Financial Management. New Delhi: Tata
McGraw Hill.
Kumar, Neelesh. International Finance Management. Delhi: Vikas
Publishing.
Page No. 58
Unit 4
Currency Derivatives
Structure
4.1 Caselet
4.2 Introduction
Objectives
4.3 Forward Markets
4.4 Currency Futures Market
4.5 Currency Options Market
4.6 Contingency Graphs for Currency Options
4.7 Swap
4.8 Case Study
4.9 Summary
4.10 Glossary
4.12 Answers
4.1 Caselet
Forex hedging remains geared to benefit from rupee weakness
The finance chief of Tata Consultancy Services Ltd. recently said that in
case the rupee continues its downward trend, the company will benefit
from it. He further told Dow Jones Newswires that TCS continues to use an
options-based currency hedging strategy to guard against a rise in the
rupee and gain from a fall, which indicates that the broader market is still
betting against the rupee. Over the past 12 months, rupee plunged 20 per
cent against the US dollar and this has increased the uncertainty for those
companies which have overseas exposure. If the local currency is weak, it
helps exporters such as TCS because their overseas earnings get converted
into rupees. However, a volatile market also leads to a dilemma whether to
lock in hedging contracts at the going rate, or hold out for the rupee to slide
further.
TCS also benefitted from the weak rupee which helped it to beat the
expectations of the analysts to report a 38 per cent rise in its April-June net
profit to 32.81 billion rupees ($593 million). The finance chief also said that
TCS has bought put options at 52 rupees, making it possible for them to
sell dollars and buy rupees in case the greenback falls below that level.
Unit 4
However, the company hasnt sold call options that would oblige it to sell
dollars to the holder at the contracted rate if the greenback were to rise.
Though the selling of offsetting call options would have led to reduction in
its hedging costs, it would also have limited the benefit in case the dollar
rose above the strike price of the option. He said that the gain in revenue
due to the rupee's weakness helped the company in allocating a higher
budget for its hedging costs.
Source: Adapted from http://online.wsj.com/article/BT-CO-20120713704794.html
4.2 Introduction
In the previous unit, you learnt about the history of foreign exchange, the concepts
of foreign exchange rates, transactions and quotations and also the financial
markets that function in this domain. In this unit, you will further learn about
forward markets and the different concepts associated with it. You will also
know what currency futures markets and currency options markets are. We will
also discuss the concept of a swap, which is an agreement between two or
more parties to exchange sets of cash flows over a period in future.
Objectives
define the concept of forward markets
explain the currency future and option markets
discuss currency call options and put options
interpret contingency graphs for currency options
identify the different features and types of swaps
4.3 Forward Markets

Features
In the forward market, contracts are made to buy and sell currencies for future
delivery, say, after a fortnight, one month two months, or three months. The rate
of exchange for the transaction is agreed upon on the very day the deal is
finalized. The forward rates with varying maturity are quoted in the newspapers
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Unit 4
and those rates form the basis of the contract. Both the parties have to abide by
the exchange rate mentioned in the contract irrespective of whether the spot
rate on the maturity date is more or less than that of the forward rate. In other
words, no party can back out of the deal, even if changes in the future spot rate
are not in his or her favour.
The value date in case of a forward contract lies definitely beyond the
value date applicable to a spot contract. If it is a one-month forward contract,
the value date will be the date in the next month corresponding to the spot value
date. Suppose a currency is purchased on 1 August, if it is a spot transaction,
the currency will be delivered on 3 August.
But if it is a one-month forward contract, the value date will fall on 3
September. If the value date falls on a holiday, the subsequent date will be the
value date. If the value date does not exist in the calendar, such as 29 February
(if it is not a leap year) the value date will fall on 28 February.
Sometimes, the value date is structured to enable one of the parties to
the transaction to have the freedom to select a value date within the prescribed
period. This happens when the party does not know in advance the precise
date on which it would be able to deliver the currency; for instance, an exporter
who sells a foreign currency forward without knowing in advance the precise
date of shipment.
Again, the maturity period of forward contract is normally for one month,
two months, three months, and so on but sometimes it may not be for the whole
month and a fraction of a month may also be involved. A forward contract with
a maturity period of thirty-five days is an opposite example. Naturally, in this
case, the value date falls on a date between two complete months. Such a
contract is known as broken-date contract.
Arbitrage in forward markets
It is said that the forward rate differential is approximately equal to the interest
rate differential. Sometimes, there may be marked deviation between these
two differentials. In such cases, covered interest arbitrage begins and continues
till the two differentials become equal. This is an arbitrage in forward markets.
Forward markets hedging
Forward markets are used not only by the arbitrageurs or speculators but by
the hedgers too. Changes in the exchange rates are a usual phenomenon.
Such changes entail some foreign exchange risk in terms of loss or gain to the
traders and other participants in the foreign exchange market. Risk is reduced
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Unit 4
or hedged through forward markets transactions. Under the process of hedging,

currencies are bought and sold forward. Forward buying and selling depends
upon whether the hedger finds himself in a long, or a short position. An export
billed in foreign currency creates a long position for the exporter. On the contrary,
an import billed in foreign currency leads to a short position for the importer.
Speculation in forward markets
In addition to the arbitrageur or the hedger, speculators are also very active in
the forward markets operations. Their purpose is not to reduce the risk but to
reap profits from the changes in the exchange rates. The source of profit to
them being the difference between the forward rate and the future spot rate,
they are not very concerned with the direction of the exchange rate change.
Suppose a speculator sells US $1,000 three-month forward at the rate of
`40.50/US $. If, on maturity, the US dollar depreciates to `40, the speculator
will get `40,500 under the forward contract. At the same time, he will exchange
`40,500 at the future spot rate of `40/US $ and will get US $1,012.50. Both
these activities the selling and the purchasing of the US dollars will be
simultaneous. Thus, without making any investment, the speculator will make a
profit of US $12.50 through the forward markets deal. This is an example of
speculation in the forward markets.
Speculation in the forward markets cannot extend beyond the date of
maturity of the forward contract. However, if the speculator wants to close the
speculation operation prior to maturity, say by one month, he may buy an
offsetting contract. In other words, if he has already entered into a three-month
forward contract for selling the US dollars, he would have to opt for a two-month
forward contract for selling the US dollars. The profit or loss would naturally
depend upon the exchange rate involved in the two forward contracts.
The above is a very simple example. Many other examples can be cited
about speculation in the forward markets. In fact, the type of speculation depends
upon the expected movement of the future spot rate.
1. The foreign exchange market is classified either as ____________or
as____________.
2. The electronic clearance system in New York is called the____________.
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Unit 4
3. The ____________is used not only by the arbitrageurs but by the hedgers
too.
4. Speculation in the forward markets cannot extend beyond the date of
maturity of the____________.
4.4 Currency Futures Market

Futures and options are derivative assets; that is, their values are derived
from underlying asset values. Futures derive their value from the
underlying currency, and options on currency futures derive their values
from the underlying futures contracts...
Chicago Fed Letter, November 1989

What are currency futures?
Currency futures are standardized contracts that are traded like conventional
commodity futures in the futures exchange market. Brokers or exchange
members receive orders to buy or sell a fixed amount of foreign currency. These
orders from companies, individuals, or even commercial banks are
communicated to the floor of the futures exchange. Long positions (orders to
buy a currency) are matched with the short positions (orders to sell) at the
exchange. The exchange, or more precisely, its clearing corporation, guarantees
both sides of each of the two-sided contracts, that is, the contract to buy and
the contract to sell. The willingness to buy versus the willingness to sell moves
futures prices up and down to maintain a balance between the number of buy
and sell orders. The market-clearing price is reached in the vibrant, somewhat
chaotic-appearing trading pit of the futures exchange. Currency futures began
trading in the International Money Market (IMM) of the Chicago Mercantile
Exchange in 1972. Since then many other markets have opened, including the
Commodities Exchange Inc. (COMEX) in New York, the Chicago Board of Trade,
and the London International Financial Futures Exchange (LIFFE).
It is necessary to have only a few value dates for a market to be made in
currency futures contracts. The Chicago IMM has four value dates of contracts:
the third Wednesday in the months of March, June, September and December.
In the rare event that contracts are held to maturity, delivery of the underlying
foreign currency occurs two business days after the contract matures to allow
for the normal two-day delivery of spot currency. Contracts are traded in specific
sizes, 62,500, Canadian $100,000, and so on. This keeps the contracts
sufficiently homogeneous and few in variety that there is enough depth for a
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Unit 4
market to be made. (The Case Study given at the end of this unit will help clarify
the concept better.)
Futures contracts versus forward contracts
The daily settlement of bets on futures means that a futures contract is the
same as entering a forward contract everyday and settling each forward contract
before opening another one, where the forwards and futures are for the same
future delivery date. The daily marking to market on futures means that any
losses or gains are realized as they occur, on a daily cycle. With the loser
supplementing the margins daily and in relatively modest amounts, the risk of
default is minimal. Of course, with the clearing corporation of the exchange
guaranteeing all contracts, the risk of default is faced by the clearing corporation.
Were the clearing corporation not to guarantee all contracts, the party winning
the daily bets would be at risk if the losing party did not pay.
In the forward markets there is no formal and universal arrangement for
settling up as the expected future spot rate and consequent forward contract
value move up and down. Indeed, there is no formal and universal margin
requirement.
Generally, in the case of interbank transactions and transactions with
large corporate clients, banks require no margin, make no adjustment for dayto-day movements in exchange rates, and simply wait to settle up at the originally
contracted rate. A bank will, however, generally reduce a client's existing line of
credit.
However, despite the large difference in the sizes of the two markets,
there is a mutual interdependence between them; each one is able to affect the
other. This interdependence is the result of the action of arbitrageurs who can
take offsetting positions in the two markets when prices differ. The most
straightforward type of arbitrage involves offsetting outright forward and futures
positions.
If, for example, the three-month forward buying price of pounds is $1.5000/
, while the selling price on the same date on the Chicago IMM is $1.5020/, an
arbitrager can buy forward from a bank and sell futures on the IMM. The arbitrager
will make $0.0020/, so that on each contract for 62,500, he or she can make
a profit of $125 ($0.0020/ x 62,500). However, we should remember that
since the futures markets require daily maintenance or marking to market, the
arbitrage involves risk which can allow the futures and forward rates to differ a
little. It should also be clear that the degree to which middle exchange rates on
the two markets can deviate will depend very much on the spreads between the
Page No. 64
Unit 4
buying and the selling prices. Arbitrage will ensure that the bid price of the
forward currency does not exceed the ask price of the currency futures, and
vice versa. However, the prices can differ a little beyond this due to marking-tomarket risk. We should also note that the direction of influence is not invariably
from the rate set on the larger forward markets to the smaller futures markets.
When there is a move on the Chicago IMM that results in a very large numberof
margins being called to scramble to close positions with sudden buying or selling
can spillover into the forward markets.
5. Currency futures are standardized contracts that are traded like
conventional commodity futures in the futures exchange market.
(True/False)
6. The Chicago IMM has four value dates of contracts: the third Friday in the
months of March, June, September and December. (True/False)
7. The most straightforward type of arbitrage involves offsetting outright
forward and futures positions. (True/False)
Activity 1
Talk to a broker and find out how transactions for currency future markets
are done. Write them down and analyse the transaction.
Hint:
Currency futures are standardized contracts that are traded like
4.5 Currency Options Market

What is a currency option?
Forward exchange and currency futures contracts must be exercised. It is true
that currency futures can be sold and margin gains can be withdrawn, and that
forward contracts can be offset by going into an offsetting forward agreement.
However, all forward contracts and currency futures must be honoured by both
the parties, that is, the banks and their counterparties, or those holding
outstanding futures, must settle. There is no option allowing a party to settle
only if it is to that party's advantage.
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Unit 4
Unlike forward and futures contracts, currency options give the buyer the
opportunity, but not the obligation, to buy or sell at a pre-agreed price in the
future. As the name suggests, an option contract allows the buyer who purchases
it the option or right either to trade at the rate or price stated in the contract, if
that is to the option buyer's advantage, or to let the option expire, if that is
better.
Currency options also trade on the Philadelphia Exchange. Unlike the
IMM options, which are on currency futures, the Philadelphia options are on
spot currency. These options give the buyers the right to buy or sell the currency
itself at a pre-agreed price. Therefore, options on spot currency derive their
value directly from the expected future spot value of the currency, not indirectly
via the price of futures. However, ultimately, all currency options derive their
value from movements in the underlying currency, and so we can focus on the
more direct linkage involving spot option contracts.
Quotation conventions and market organization
Option dealers quote a bid and ask a premium on each contract, with the bid
being what buyers are willing to pay and the ask being what sellers want to be
paid. Of course, a dealer must state whether a bid or an ask premium is for a
call or put, whether it is for an American or European option, the strike price,
and the month the option expires.
After the buyer has paid for an option contract, he or she has no financial
obligation. Therefore, there is no need to talk about margins for option buyers.
The person selling the option is called the writer. The writer of a call option must
be ready, when required, to sell the currency to the option buyer at the strike
price. Similarly, the writer of a put option must be ready to buy the currency from
the put option buyer at the strike price. The commitment of the writer is open
throughout the life of the option for American options, and on the maturity date
of the option for European options. The option exchange guarantees that the
option seller honours their obligations to option buyers and therefore requires
option sellers to post a margin. On the Philadelphia Exchange, there is a 10 per
cent option premium plus a lump sum to a maximum of $2500 per contract,
depending on the extent the option is in or out of money.
As in the case of futures contracts, an exchange can make a market in
currency options only by standardizing the contracts. This is why option contracts
are written for specific amounts of foreign currency, for a limited number or
maturity dates, and for a limited number of strike exchange rates. The
Page No. 66
Unit 4
standardization allows buyers to resell contracts prior to maturity. It also allows

writers to offset their risks more readily, because for example, the writer of a call
option can enter the market as a buyer of a call option to limit losses or to lock
in gains.
Determinants of market values of currency options
The factors that influence the price of an option are:
1. Spot rate
2. Exercise rate
3. Time to maturity
4. Interest rate
5. Volatility
6. Dividends
Table 4.1 Comparison of Forwards, Futures and Options
Forward
Contracts
Currency
Futures*
Currency Options#
Delivery discretion
Nothing
Nothing
Buyer's discretion.
must honour if
exercises.
Maturity date
Any date
Third
Wednesday of
March, June,
September or
December
Friday before the third

Wednesday of March, June,
September or December on
regular options. Last Friday
of the month on the end-ofmonth options.
Maximum length
Secondary market
Several years
Must offset
with bank
Informal; often
line of credit or
5-10% on
account
12 months
Can sell via
exchange
Formal fixed sum
per contract, e.g.,
$2000. Daily
marketing to
market.
Outright
9 months
Can sell via exchange
Futures clearing
corporation
Options clearing corporation
Primarily
speculators
Hedgers and speculators
Margin
requirement
Contract variety
Guarantor
Major users
Swap or
outright form
None
Primarily
hedgers
Seller
buyer
No margin for buyer who

pays for contract. Seller
posts 130% of premium plus
lump sum varying with
intrinsic value.
Outright
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Unit 4
Forwards, Futures and Options: A Comparison

While forwards, futures and options can all be used both to reduce foreign
exchange risk (that is, to hedge) and to purposely take foreign exchange risk
(that is, to speculate), the differences between forwards, futures, and options
make them suitable for different purposes. An explanation of which type of
contract would be most appropriate in different circumstances must wait until
we have dealt with many other matters, including further ways of hedging and
speculating. So at this point we can do little more than list the differences between
forwards, futures, and options as shown in Table 4.1. The table notes the primary
users of the markets, as well as the institutional differences between forwards,
futures and options. The reasons different markets have different primary users
can be explained with the pay-off profiles.
8. Unlike forward and futures contracts, ____________give the buyer the
opportunity, but not the obligation, to buy or sell at a pre-agreed price in
the future.
9. As in the case of____________, an exchange can make a market in
currency options only by standardizing the contracts.
Call Options
Currency call options can be defined as the option which allows the buyer the
right to purchase the underlying currency from the seller. The buyer expects
that the underlying foreign currency will strengthen against the home currency
during the life of the option.
It can be simply put as a financial contract between two parties, i.e. the
buyer and the seller of the option. The buyer of the call option is given the right
to buy from the seller an agreed quantity of a financial instrument or a particular
product, for a certain price at a certain time. The seller on the other hand is
compelled to sell the product or the financial instrument if the buyer so decides.
For the application of this right, the buyer pays a fee, called the premium.
While buying call options, the buyer expects that the price of the underlying
instrument will rise in the future though the seller might or might not expect it. It
is the most profitable for the buyer of call options if the price of the underlying
instrument moves up and comes closer to the strike price.
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The buyer of the call options believes that the price of the underlying
asset will rise by the exercise date. The buyer can get a large profit and this
profit is limited by the extent of the rise in the spot price of the underlying asset.
When the price of the underlying instrument is higher than the strike price, it is
said that the option is "in the money".
On the other hand, the call seller or the call writer does not gain any
benefit in case the stock rises above the strike price. The initial transaction that
takes place in the buying and selling of the call option does not include the
supplying of the underlying instrument but grants the right to buy the underlying
instrument in return of a premium or the exchange fee.
However, specifications regarding the options might differ in different
countries depending on the opinion style. While in case of an American call
option, the buyer can exercise the option anytime throughout the lifetime of the
call option, in European call option, the holder can exercise the option only on
the expiration date of the option.
10. Currency call options can be defined as the option which allows the buyer
the right to purchase the underlying currency from the seller. (True/False)
11. When the price of the underlying instrument is higher than the strike price,
it is said that the option is "in the money". (True/False)
Put Options
An option contract through which the holder gets the right to sell a certain amount
of an underlying currency to the writer of the option at a particular price up to a
particular expiration date is known as currency put option. Unlike the call options,
in case of the put options, a buyer expects that the foreign currency will weaken
against the home currency during the life of the option.
It can be further defined as a contract between two parties through which
the exchange of assets is done at a specified price by a predetermined date.
While the buyer of the put option has the right but not an obligation to sell the
underlying asset at the strike price, the seller of the option is obliged to purchase
the asset at the strike price in case the buyer exercises the option. A put option
is more like insurance in the sense that no matter what happens, losses are
limited. The Put option establishes a floor for the exchange rate, and the option
can be used to hedge foreign currency inflows.
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As far as the seller is concerned, the profit will be equal to the amount of
premium when the buyer does not exercise the option. It occurs when the spot
price is greater than the strike rate. On the other hand, the seller will face a loss
if the option is exercised. The amount of loss will vary depending upon how
much lower the spot price is.
The most important use of a put option is as a type of insurance. Under
the protective put strategy, the investor buys enough puts so that if the price of
the underlying currency decreases suddenly, the option of selling the holdings
at the strike price still remains with them. Another use of this kind of option is
speculation in the sense that an investor can take a short position in the
underlying currency without trading in it directly.
12. In case of the put options, a buyer expects that the foreign currency will
____________against the home currency during the life of the option.
13. The most important use of a put option is as a type of____________.
4.6 Contingency Graphs for Currency Options

A graph which illustrates the potential profit or loss, which a speculator dealing
in currencies will realize on his positions for various exchange rate scenarios, is
known as contingency graph. In other words, it shows how much profit/loss a
currency speculator will make if the underlying currency moves anywhere within
the graphs range.
Graphs are a simple yet powerful way to communicate the risk and reward
associated with any option call or put.
The Profit/Loss vs Price graph has Profit or (loss) of the position plotted
on the Y-axis and the underlying price plotted on the X-axis.
profit
(loss)
underlying
price
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Unit 4
The current price of the underlying is located in the center of the X-axis
underlying price range.
profit
(loss)
underlying
price
current price
Buying a call option: (a call option is: a right to buy an underlying for a specific
price and time period)
profit
(loss)
underlying
price
BUY CALL
The above graph shows the profit or loss of buying a call option for a
range of projected underlying prices at expiration day for the call option.
Buying a put option: (a put option is: a right to sell an underlying for a specific
price and time period)
profit
(loss)
underlying
price
BUY PUT
The above graph shows the profit or loss of buying a put option for a
range of projected underlying prices at expiration day for the call option.
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Unit 4
Selling call or put options

profit
(loss)
profit
(loss)
underlying
price
SELL CALL
underlying
price
SELL PUT
The above graphs show the profit and loss at options expiration for selling
a call or put.
We have already discussed currency call and put options. Now, we will
discuss various commonly used option combinations. These combinations
simultaneously use call and put options and create a unique payoff suited or
customized to the needs of the speculator or hedger. They are used for both
hedging future cash flows in other countrys currency and speculating future
exchange rate movement. For each of the combination there will be a unique
contingency graph.
Many combinations are popular and frequently used. Few of these
combinations are, Straddle (Long and Short), Strangle (Long and Short), Straps
and Strips, Bull spread, Bear Spread, Butterfly spread, and Box spread. Here,
we will discuss the combination and contingency graph of the two most commonly
used combinations, i.e. straddle and strangle in detail and few others in brief.
Straddles
This strategy is commonly used by the investors who are of the view that the
exchange rate will move significantly, but are unable to guess whether currency
will appreciate or depreciate.
To construct a long straddle the buyer take long position (buy) both a call
option and a put option for that currency i.e. holds a position in both a call and
a put. The condition in this being that both the call and the put should have the
same strike price and expiration date.
We now take an example to construct the contingency graph and show
how this strategy will work.
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Unit 4
Example:
The put and call options with the following details are available in the market:
Premium of call option: `1.5
Premium of put option: `3
Strike Price: `87/
Evaluate payoff and construct a contingency graph of a long straddle
using the above details?
Solution:
To construct a long straddle, the investor would take a long position in both call
and a put. He will have to pay a premium of `4.5 per unit. If the exchange rate
at expiration is `87/, the put option is in the money and the call option is out of
the money and vice versa for exchange rate at expiration being greater than
`87/. The payoff at various exchange rates are a shown as follows:
Exchange
Rate (`/)
Long Call
Payoff
Long put
Payoff
Net Payoff
78
-1.5
4.5
79
-1.5
3.5
81
-1.5
1.5
82
-1.5
0.5
84
-1.5
-1.5
85
-1.5
-1
-2.5
87
-1.5
-3
-4.5
89
0.5
-3
-2.5
90
1.5
-3
-1.5
92
3.5
-3
0.5
93
4.5
-3
1.5
Contingency graph for a long currency straddle

It can be seen from above contingency graph that long straddle will give positive
results only if the exchange rate moves by a substantial amount. There are two
break even points at exchange rate of `82.5 and 91.5, these values are what
we get if we subtract and add total premium to the strike price respectively.
Page No. 73
Unit 4
87
Net Payoff
91.5
82.5
Short straddle strategy involves going short (selling) both the call and the
put. Its payoff and the contingency graph will be exactly opposite to long straddle.
A general contingency graph for short straddle is given below:
Contingency graph for a short currency straddle
Short Straddle
Net
Profit
Per
Unit
Future Spot
Rate
Strangle
A long (short) strangle position is developed by going short (selling) on both a
put and a call with different strike prices with the same expiration. In this strategy
the call strike is higher than the put strike price. Investors who go this strategy
expect prices to be volatile. Compared to straddle the premium paid in this
strategy is less.
In this strategy, the upside potential is unlimited; whereas the downside
risk is limited to the net amount of premium that is paid on the two options.
Contingency graph for a long currency strangle
The contingency graph of short strangle will be exactly the mirror image of the
above graph.
Page No. 74
Net Profit
per unit
Unit 4
Long Strangle
Future Spot Rate
Currency Spreads
There are various currency spreads which exist that are used by hedgers to
either hedge against unanticipated foreign cash flows or by speculators to profit
an unanticipated foreign currency movement.
The two most commonly used are bull spread and bear spread:
Bull Spread
Investors go for this strategy if they have an expectation of a price rise. This
strategy involves:
Buying a call option with a lower strike price
Selling/writing a call option with a higher strike price
Same expiration date
This currency bull spreads can also be easily constructed using put options,
Contingency graph for a bull spread strategy
The contingency graph for Bear Spread will be the mirror image of the above
graph.
Net
Profit
Per
Unit
Page No. 75
Unit 4
14. Straddles are commonly used by the investors who are of the view that
the exchange rate will move significantly, but are unable to guess whether
currency will appreciate or depreciate. (True/False)
15. Long straddle strategy involves going short (selling) both the call and the
put. (True/False)
4.7 Swap
Swap is an agreement between two or more parties to exchange sets of cash
flows over a period in future. The parties that agree to swap are known as
counter parties. It is a combination of a purchase with a simultaneous sale for
equal amount but different dates. Swaps are used by corporate houses and
banks as an innovating financing instrument that decreases borrowing costs
and increases control over other financial instruments. It is an agreement to
exchange payments of two different kinds in the future. Financial swap is a
funding technique that permits a borrower to access one market and then
exchange the liability for another type of liability. The first swap contract was
negotiated in 1981 between Deutsche Bank and an undisclosed counter party.
The International Swap Dealers association (ISDA) was formed in 1984 to speed
up the growth in the swap market by standardizing swap documentation. In
1985, ISDA published the standardized swap code.
Features of swap
Swaps are contracts of exchanging the cash flows and are tailored to the
needs of counter parties. Swaps can meet the specific needs of customers.
Counter parties can select amount, currencies, maturity dates etc.
Exchange trading involves loss of some privacy but in the swap market
privacy exists and only the counter parties know the transactions.
There is no regulation in swap market.
There are some limitations like
(a) Each party must find a counter party which wishes to take opposite
position.
(b) Determination requires to be accepted by both parties.
(c) Since swaps are bilateral agreements the problem of potential default
exists.
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Unit 4
There are two kinds of swap, they are as follows:

1. Currency swap: It is an agreement whereby currencies are exchanged
at specified exchange rates and at specific intervals. The reason is to
lock in the exchange rate. Large commercial banks that serve as an
intermediary agree to swap currencies with a firm. Two currencies are
exchanged in the beginning and again at the maturity, they are reexchanged because one counter party is able to borrow a particular
currency at a lower interest rate than the other counter-party.
2. Interest rate swap: It is an arrangement whereby one party exchange
one set of interest rate payments for another. Most common arrangement
is an exchange of Fixed Interest rate payment for another rate of over a
period of time.
Features
The following are the features:
The principal value upon which the interest rate is to be applied should be
known
Fixed interest rate to be exchanged for another rate.
Formula type of index is used to determine the flowing rate.
Frequency of payment is agreed upon.
Life time of swap.
Various types of interest rate swap
Following are the most important types of interest rate swap:
Plain vanilla swap: This swap involves the periodic exchange of fixed
rate payments for floating rate payments. It is sometimes referred as
fixed for floating swaps.
Forward swap: This involves an exchange of interest rate payments that
does not begin until a specified future point in time. It is a swap involving
fixed for floating interest rates.
Callable swap: Another use of swap is through swap options (swaptions).
A callable swap provides a party making the fixed payments it the right to
terminate the swap prior to its maturity. It allows a fixed rate payer to
avoid exchanging future interest rate payments if its so desired.
Putable swap: It provides the party making the floating rate payments
with a right to terminate swap.
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Unit 4
Extendable swap: It contains an extendable feature that allows fixed for

floating party to extend the swap period.
Zero coupon for floating swap: In this swap, the fixed rate pair makes
a bullet payment at the end and floating rate pair makes the periodic
payment throughout the swap period.
Rate capped swaps: This involves the change of fixed rate payments for
floating rate payments whereby the floating rate payments are capped.
An upfront fee is paid by the floating rate party to fixed rate party for the
cap.
Equity swaps: An equity swap is a financial derivative contract where a
set of future cash flows are agreed to be exchanged between two
counterparties at set dates in the future.
Cost of swap
While there is no exchange risk involved in swap transactions, there is a cost
involved. The swap cost depends on the currency being in premium or discount
in the forward markets. A currency is said to be at premium against the other
currency if it is costlier in the forward and it is said to be at discount against the
other currency, if it is cheaper in the forward.
When a currency is at a premium against the other currency, then the
currency will be costlier in the forward so in the vent of swap, i.e. when the
buying and selling transaction is undertaken then the swap cost will be favourable.
Suppose, $/Rupee quote in value on 1/9/2011 = 51.87 and
$/Rupee quote in value on 31/10/2011 = 52.93
The currency is bought at 51.87 and sold at 52.93, so the swap cost will
be received. Alternatively, when swap is reversed, that is selling and buying
transaction takes place, the swap cost is to be paid.
16. The ____________was formed in 1984 to speed up the growth in the
swap market by standardizing swap documentation.
17. ____________involves the periodic exchange of fixed rate payments for
floating rate payments.
18. An arrangement whereby one party exchanges one set of interest rate
payments for another is known as________________________.
Page No. 78
Unit 4
4.8 Case Study

To check speculation, RBI seeks curbs on currency futures
The Reserve Bank of India has asked for checks on currency trading based
on the argument that it was resulting in speculation. The demand for checks
was recently made during a meeting of the Financial Stability and
Development Council (FSDC). However, it has not found favour with SEBI.
It also came at a time when the rupee is touching new lows against the
dollar and putting pressure on the overall Indian economy. However, it has
been known that SEBI has managed to get a reprieve for the currency
futures markets where trading started in 2008 after RBI agreed to the plan
after years of debate. Futures aim to help traders hedge their currency
bets. The joint regulation with SEBI was also one of the major reasons for
RBIs opposition. The FSDC, which is headed by the finance minister, is a
regulatory coordination body comprising the regulators. The RBI however,
in the recent weeks has sought to clamp down on activities that could impact
currency fluctuations. The proposal has also been made towards that
direction. In the past twelve months, the rupee has depreciated over 20 per
cent and closed at 56.80 against the dollar, compared to Wednesday's
close of 57.16.SEBI has taken the appeal that in the absence of a regulated
segment such as currency futures, traders would be forced to hedge their
risks in unregulated markets such as the non-deliverable forwards market
in Singapore, where volumes are of the order of $20 billion, compared to
$4 billion for currency futures. The over-the-counter market regulated by
the central bank where business worth around $15 billion is transacted.
"It is already a matter of worry that the largest market is not regulated by
Indian regulators. By putting in restrictions on currency futures, you will
only drive out business from the country," said a source. Action taken by
SEBI against United Stock Exchange to argue that the market was well
regulated was also pointed out by sources. Market players said that instead
of banning currency futures, the regulators could look to club position limits
and use other tools to check speculative behaviour. For instance, like the
Forward Markets Commission they can seek higher margins from buyer
along with the stipulation that cash payments be made. SEBI has also
stepped up the vigil, sources said and has sought detailed data from
exchanges so that it can crack down on errant behaviour.
Page No. 79
Unit 4
Questions
1. Why do you think RBI asked for checks on currency trading? What
was the argument against it?
2. Do you think the decision taken by RBI to curb on currency futures is
justified? If yes, why?
Source: Adapted from http://timesofindia.indiatimes.com/business/indiabusiness/To-check-speculation-RBI-seeks-curbs-on-currency-futures/
articleshow/14480326.cms
4.9 Summary
In case of forward markets, contracts are made for buying and selling
currencies for future delivery, for instance, a fortnight, one month and two
months.
The value date in case of a forward contract lies definitely beyond the
value date applicable to a spot contract.
The forward markets are used both by the arbitrageurs and the hedgers.
Changes in the exchange rates are a usual phenomenon.
In the forward markets operations, in addition to the arbitrageur or the
hedger, speculators are also very active. Their purpose is not to reduce
the risk but to reap profits from the changes in the exchange rates.
Currency futures are standardized contracts that are traded like
Currency options give the buyer the opportunity, but not the obligation, to
buy or sell at a pre-agreed price in the future.
Option dealers quote a bid and ask a premium on each contract, with the
bid being what buyers are willing to pay and the ask being what sellers
want to be paid.
Currency call options can be defined as the option which allows the buyer
the right to purchase the underlying currency from the seller.
The agreement between two or more parties for exchanging sets of cash
flows over a period in future is known as swap. The parties that agree to
swap are known as counter parties.
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Unit 4
4.10 Glossary
Arbitrageur: A person or company which practices arbitrage
Depreciation: A non cash expense that reduces the value of an asset as
a result of wear and tear, age, or obsolescence
Diminution: The act of diminishing, or of making or becoming less
Volatility: A measure of risk based on the standard deviation of the asset
return.
Hedge: It is used for reducing any substantial losses/gains suffered by
an individual or an organization

1. Define what you mean by Forward Markets.
2. Discuss the differences between futures options and spot options.
3. State the factors that influence the price of an option.
4. Define contingency graph.
5. Define various kinds of swaps.
6. Discuss the cost of swap.
4.12 Answers
1. Spot market, forward markets
2. Clearing House Interbank Payment System (CHIPS)
3. Forward markets
4. Forward contract
5. True
6. False
7. True
8. Currency options
Page No. 81
Unit 4
9. Futures contracts
10. True
11. True
12. Weaken
13. Insurance
14. True
15. False
16. International Swap Dealers association (ISDA)
17. Plain vanilla swap
18. Interest rate swap

1. In the forward markets, contracts are made to buy and sell currencies for
future delivery, say, after a fortnight, one month and two months. The rate
of exchange for the transaction is agreed upon on the very day the deal is
finalized.
2. The differences between futures options and forward options are:
Such options give the buyers the right to buy or sell currency futures
contracts at a pre-agreed price.
Options on futures derive their value from the prices of the underlying
futures
3. The factors that influence the price of an option are:
Intrinsic value
Volatility of the spot or futures exchange rate
Length of period to expiration
4. A graph which illustrates the potential profit or loss, which a speculator
dealing in currencies will realize on his positions for various exchange
rate scenarios, is known as contingency graph.
Page No. 82
Unit 4
5. There two kinds of swap. They are as follows:

Currency swap
Interest rate swap
6. Cost of Swap:
While there is no exchange risk involved in swap transactions, there
is a cost involved.
The swap cost depends on the currency being in premium or discount
in the forward markets.
Apte, P.G. 2012. International Financial Management. Sixth edition. New
Delhi : Tata Mc-graw Hill.
Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing.
Page No. 83
Unit 5
Exchange Rate Determination
Structure
5.1 Caselet
5.2 Introduction
Objectives
5.3 Measuring Exchange Rate Movements
5.4 Factors that Influence Exchange Rates
5.5 Movements in Cross Exchange Rates
5.6 Anticipation of Exchange Rate Movements
5.7 International Arbitrage
5.8 Interest Rate Parity Theory
5.9 Purchasing Power Parity
5.10 International Fisher Effect
5.11 Forecasting Foreign Exchange Rates
5.12 Case Study
5.13 Summary
5.14 Glossary
5.16 Answers
5.1 Caselet
To loosen or not to loosen policy
The Reserve Bank of India faced a similar situation that it faced at the time
of the mid-quarter review. The formulation of monetary policy by the RBI
was announced on 31 July 2012. The economic environment in India
deteriorated further due to the delayed monsoon.
Inflation, being aggravated by the steep depreciation of the rupee continues
to be a major problem for the country. However, the inter-bank exchange
rates do not reveal the plans about the future direction. The price level
reflects the impact of imported inflation through the inter-industry
transactions that are captured by the Leontief-type input-output matrix or is
revealed directly. Keeping in mind the continuation of inflation, it is needed
for the RBI to carry out research on the issue.
Unit 5
Building up reserves
The RBI is being faced with two challenges: one, to increase the flows of
foreign capital and second, to build up the reserves which have decreased
substantially in recent times because of market intervention. The Central
bank states that its aim in market intervention is to remove volatility and not
to establish any particular level or band for the exchange rate.
If the purpose of the RBI is to remove volatility, it also means that it is trying
to decrease the standard deviation to a level which is close to the mean.
However, it would then imply that the RBI is targeting the mean unless it
puts forward proper arguments that the mean is changing all the time.
It is very proper for the market to expect action from the RBI when a particular
level is reached. In the West though whenever market intervention was
practiced, it stated that its main aim was to appreciation or depreciation but
not volatility in rates. Unlike the West, the flow of foreign funds into and out
of the stock markets affects the exchange rate movements in India.
Source: Adapted from http://www.thehindubusinessline.com/opinion/
columns/a-seshan/article3682899.ece?homepage=true
Accessed on 03 August 2012
5.2 Introduction
In the earlier unit, you learnt about the various concepts associated with the
forward markets. You also studied the currency futures market and currency
options markets and understood the differences between the futures options
and the spot options. You now know that Swap is an agreement that is made
between two or more parties in order to exchange sets of cash flows over a
period in future.
In this unit, you will learn how exchange rate movements are measured.
You will also learn about the factors that influence exchange rates and study
the movements in cross exchange rates. You will study about various concepts
such as international arbitrage, interest rate parity, and purchasing power parity
and the International Fisher effect.
Objectives
explain how exchange rate movements are measured
list the factors that influence exchange rates
Page No. 86
Unit 5
describe the movements in cross exchange rates

interpret international arbitrage, interest rate parity, purchasing power parity
and fisher effect
5.3 Measuring Exchange Rate Movements

Exchange rates respond quickly to all sorts of events - both economic and noneconomic. The movement of exchange rates is the result of the combined effect
of a number of factors that are constantly at play. Economic factors, also called
fundamentals, are better guides as to how a currency moves in the long run.
Short-term changes are affected by a multitude of factors which may also have
to be examined carefully.
In recent years, global interdependence has increased to an
unprecedented degree. Changes in one nation's economy are rapidly transmitted
to that nation's trading partners. These fluctuations in economic activity are
reflected almost immediately in fluctuations of currency values. These changes
in exchange rates expose all those firms having export import operations as
also multinationals with integrated cross border production and marketing
operations. It is useful to be aware of the various factors that influence exchanges
rates. By a study of these factors and the trend of movements in the value of
particular currency, an experienced businessman may be able to forecast the
possible future movement of that currency. This will enable him to:
(i) estimate his risk and
(ii) make an informed, prudent decision as to whether it would be worthwhile for him to carry the risk or to take some appropriate steps to
reduce that risk.
The demand for foreign exchange comes from importers of goods and
services; outflow of capital through foreign direct investment and portfolio
investment; profits, interest, dividend and other incomes earned by foreigners/
corporate bodies and repatriated to their country; Indian travelers going abroad
for education, medical treatment; pleasure trips, etc.; expenditures incurred by
our embassies abroad; bilateral loans/aids granted to other countries;
subscription payment to international organizations; grants and gifts to other
friendly countries; repayment of foreign loans and interest payments; etc.
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Unit 5
All these transactions can be classified in three classes:

(1) Purchases and sales for trading purposes;
(2) Speculative deals by professional dealers;
(3) Protective movements by substantial holders.
Interest rate differentials
Foreign exchange markets and exchange rates are quite sensitive to movements
in interest rates. This is because financial markets were becoming more closely
linked due to
(i) Growing interest in international investment;
(ii) Elimination or constraints on mobility of capital to a large extent;
(iii) More rapid means of communications.
Most investors would like to move their funds from a country having lower
interest rates to a country having higher interest rates. Such funds are usually
termed as 'hot money'. If the interest rate in the UK is higher than the interest
rate in the USA, investors would find it profitable to invest funds in the UK and
would purchase pounds and sell dollars in the spot market, leading to an upward
movement in pound sterling. In fact, the UK very often uses interest rate as a
weapon to push up the 'pound'.
However, if the rise in interest rates is due to people expecting a higher
inflation rate or bigger budget deficits, there is reason to doubt the strength of
the currency. Thus it would not lead to higher investment. The role of interest
rate differences thus depends upon what is causing them.
Activity 1
Browse the Internet and make a report on how the value of currency has
fluctuated in India in recent times. Also write down how it affects the
exchange rate movements.
Hints:
The fluctuations in economic activity are reflected almost immediately
in fluctuations of currency values.
Demand and supply of a particular currency are the most important
factors affecting its exchange rate.
Page No. 88
Unit 5
1. Economic factors are also called ________
2. Most investors would like to move their funds from a country having lower
interest rates to a country having higher interest rates. Such funds are
usually termed as____________.
5.4 Factors that Influence Exchange Rates

In foreign exchange trading, technical indicators such as charts and moving
average lines are very significant in the determination of movement of the prices
of various currencies. Fundamental analysis of economic data and current events
is also helpful in the prediction of how the price of a currency will change. The
basic economic principle of supply and demand underlies the fundamental and
technical methods. Prices in the free marketplace can radically change from
the changes in the supply of a currency and the differences in the demand for a
currency.
Focus on the Demand-Supply Model
The demand factor
At the most primary level, a change in the price of a currency will occur because
of more or less demand for it. High demand signifies a higher price experience
of the currency pair. Less demand signifies fall in the price of the currency pair.
An increased demand for a currency suggests a strong economy, while a
currency's demand can go down if the central bank lowers the rates of interest.
The movement of price is based on the demand for the currency. Actually,
currencies rally when the demand for it goes up.
The supply side factor
A basic economic principle of supply says that a currency's value will change
with the rise and fall of the levels of supply. The value and price of a currency
will diminish if there is a higher supply of a currency. Similarly, the value and
price of a currency will increase when there is a lower supply of a currency.
Even though the supply side is important, the demand factor is the primary
moving force that determines the value and price of a currency.
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Unit 5
Long term vs. short term

A time period of a year or more signifies a long-term supply and demand. Shortterm is generally thirty days or less than that. The currency prices in both the
time periods can be affected by the same factors. A trader should be conscious
of the time factor in which a trade is placed. Long and short-term price movements
can happen in parallel. However, they can also deviate, which can lead to
inconsistency in price movements. Hence, a trader should always keep in mind
the trading environment and the time frame while doing foreign exchange trade.
Factors affecting Currency Trading
A number of factors affect the rates of exchange. At the end, costs of currency
result from the supply of currency. The currency markets all over the world can
be considered a huge melting pot. The supply and demand ingredients constantly
change in relation to the changing mix of current events and the cost of one
currency in relation to another change accordingly.
Economic factors
These include the economic policy of the government which is made known
through various government agencies and the central bank of the country, and
economic conditions, generally revealed through economic reports. Economic
conditions include:
Inflation levels and trends: If there is a high level of inflation in the
country, or if the inflation level seems to be rising, typically a currency will
lose value because inflation brings down the purchasing power and thus
the demand for that particular currency.
Economic growth and health: The economic growth and health of a
country can be known through a country's gross domestic product (GDP),
level of employment, capacity utilization, retail sales and other indicators.
Generally, a currency will perform better and there will be more demand
for it if the economy of the country is healthy and robust. The better the
economic performance, the higher will be the currency's demand.
Government budget deficits or surpluses: Widening government
budget deficits lead to a negative reaction in the market, whereas the
market reacts positively in case of narrowing budget deficits. The impact
of budget deficit or budget surplus is reflected in the value of the currency
of a country.
Balance of trade levels and trends: The flow of trade from a country to
other parts of the world shows the demand for goods and services of the
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Unit 5
country, which in turn indicates the demand for a country's currency for
conducting trade. The competitiveness of a country's economy is reflected
by the surpluses and deficits in trade of goods and services. Trade deficits,
for example, may negatively impact the currency of a nation.
Political conditions
Internal, regional and international political conditions and issues can profoundly
affect currency markets; for instance, political upheaval and instability can
negatively impact the economy of a nation. Similarly, the growth of a political
faction that is considered to be fiscally responsible can have a positive opposite
effect on the economy. Again, cases in one country in a region may spur positive
or negative interest in a neighbouring country, and in the process, affect its
currency.
3. High demand signifies a higher price experience of the currency pair.
(True/False)
4. A basic economic principle of supply says that a currency's value remains
constant even with the rise and fall of the levels of supply. (True/False)
5. The economic growth and health of a country can be known through a
country's gross domestic product (GDP), level of employment, capacity
utilization, retail sales and other indicators. (True/False)
5.5 Movements in Cross Exchange Rates

A cross-rate may be defined as the rate of exchange calculated from two (or
more) other rates. Thus, the rate for the euro to the Swedish krona will be
derived as the cross-rate from the US dollar to the euro and the US dollar to the
krona. Traditionally, a cross-rate denotes an exchange rate that does not involve
the home currency. Thus, to the Indian, quotes such as $ per GBP () and Yen
per are cross-rates. In contrast, a straight rate denotes a rate that involves the
home currency. To the Indian, INR per USD and INR per GBP are straight rates.
In global foreign exchange markets, currencies are quoted against the
US dollar. Unless otherwise specified, if a bank asks another bank for its Deutsch
mark rate, that rate will be quoted against the US dollar. Most dealings are done
against the US dollar. Hence, the market rate of a currency at any time is most
accurately reflected in its rate of exchange against the US dollar. A bank that
Page No. 91
Unit 5
has to quote sterling against the Swiss franc would normally do so by calculating
this rate from the /$ rate and the $/Sfr rate. It would, therefore, be using crossrates to arrive at its quotation.
The cross-rate between two currencies is obtained by getting quotes for
each currency in terms of the exchange rate with a third nation's currency. For
example the exchange rate of the U.S. dollar per euro is 1.2440 and the exchange
rate for U.S. dollar per British pound is 1.8146. The euro-to-pound cross rate
can be calculated as the euro-to-dollar rate multiplied by the dollar-to-pound
rate, which is equal to (1/1.2440) 1.8146 = 1.4587, or dollar 1.4587 per British
pound.
This result is an indirect quote from the a British entity viewpoint, however
it is a direct quote from the viewpoint of an entity whose domestic currency is
the euro.
6. A ___________may be defined as the rate of exchange calculated from
two (or more) other rates.
7. In global foreign exchange markets, currencies are quoted against
the___________.
5.6 Anticipation of Exchange Rate Movements

Foreign-exchange markets are highly competitive in nature. Participants have
excellent, up-to-the-minute information about the exchange rates between any
two currencies. As a result, currency values are determined by the unregulated
forces of supply and demand as long as central banks do not attempt to stabilize
them. The supplies and demands for a currency are those of private individuals,
corporations, banks, and government agencies other than central banks.
If we are to understand why some currencies depreciate and others
appreciate, we must investigate the factors that cause the supply and demand
schedules of currencies to change. These factors include market fundamentals
(economic variables) and market expectations
Market fundamentals
Bilateral trade balances
Real income
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Real interest rates

Inflation rates
Consumer preferences for domestic or foreign products
Productivity changes affecting production costs
Profitability and riskiness of investments
Product availability
Monetary policy and fiscal policy
Government trade policy
Market expectations
News about future market fundamentals
Speculative opinion about future exchange rates
Because economists believe that the determinants of exchange-rate
fluctuations are rather different in the short run (a few weeks or even days),
medium run (several months), and long run (one, two or even five years), we
will consider these time frames when analysing exchange rates. In the short
run, foreign-exchange transactions are dominated by transfers of financial assets
that respond to differences in real interest rates and to shifting expectations of
future exchange rates. Such transactions have a major influence on short-run
exchange rates. Over the medium run, exchange rates are governed by cyclical
factors such as cyclical fluctuations in economic activity. Over the long run,
foreign-exchange transactions are dominated by flows of goods, services and
investment capital, which respond to forces such as inflation rates, investment
profitability, consumer tastes, real income, productivity, and government trade
policy. Such transactions have the dominant impact on long-run exchange rates.
Note that day-to-day influences on foreign exchange rates can cause the
rate to move in the opposite direction from that indicated by longer-term
fundamentals. Although, today's exchange rate may be out of line with longterm fundamentals, this should not be construed as implying that it is necessarily
inconsistent with short-term determinants. Medium-run cyclical forces can induce
fluctuations of a currency above and below its long-run equilibrium path. However,
fundamental forces serve to push a currency toward its long-run equilibrium
path. Note that medium-run cyclical fluctuations from a currency's long-run
equilibrium path can be large at times, if economic disturbances induce significant
changes in either trade flows or capital movements.
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Longer-run structural forces and medium-run cyclical forces interact to

establish a currency's equilibrium path. Exchange rates may sometimes move
away from this fundamental equilibrium path if short-run forces (for example,
changing market expectations) induce fluctuations in exchange rates beyond
those based on fundamental factors. Although such overshooting behaviour
can persist for significant periods, fundamental forces generally push the currency
back into its fundamental equilibrium path.
Unfortunately, exchange-rate determination (forecasting) is a difficult job.
That is because economic forces affect exchange rates through a variety of
channelssome of which may induce negative impacts on a currency's value,
others of which may exert positive impacts on a currency's value. Some of
those channels may be more important in determining short- or medium-run
tendencies, whereas other channels may be more important in explaining the
long-run trend that a currency follows.
8. The factors that cause the supply and demand schedules of currencies
to change include ___________and___________.
9. ___________can induce fluctuations of a currency above and below its
long-run equilibrium path.
10. ______________________and medium-run cyclical forces interact to
establish a currency's equilibrium path.
5.7 International Arbitrage

An exchange rate can be defined as the price of a currency in terms of another.
It can be explained as the number of units of currency B in terms of a unit of
currency A or vice versa. Thus, the exchange rate between US dollar and British
pound can be stated as 1.7656 dollars per pound or 0.5664 pound per dollar.
When we state the price of goods in terms of money, the most common way of
doing so is by stating it in terms of units of money per unit of the good and not
vice versa. For example, rupee 10 per litre of water. The choice of unit, though,
is subject to the convenience of the user. Thus, the rupee-dollar rate is usually
stated as number of rupees per dollar while the rupee-yen rate is stated as
number of rupees per 100 yen.
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Arbitraging between Banks

It is not possible for all banks to have the same and identical quotes although
we always hear one market rate or exchange rate for any two given currencies
at any particular point of time. The exchange rate quotations may be similar to
each other for any two given banks but they cannot be exactly the same in
almost most of the cases. Therefore, it may be possible for a company to benefit
by trading or exchanging currencies through one particular bank and not through
the other. We will now discuss and try to understand the possible relationships
between the quotes offered by different banks.
1. Suppose banks A and B are quoting:
GBP/USD:
1.4550/1.4560
1.4538/1.4548
We will represent this as:
bid
bid
Bank A
ask
Bank B
ask
A situation in which the ask and bid rates overlap, it will give rise to an
arbitrage opportunity. Pounds can be bought from B at $1.4548 and sold
to A at $1.4550 for a net profit of $0.0002 per pound without any risk or
commitment of capital. One of the basic tenets of modern finance is that
markets are efficient and such arbitrage opportunities are quickly spotted
and exploited by alert traders. The result will be, bank B will have to raise
its ask rate and/or A will have to lower its bid rate. The arbitrage opportunity
will disappear very fast. An opportunity of making a huge amount of profit
from arbitrage opportunities is not going to stay for a very long time
because there will be arbitrageurs who are going to move from investing
in one market to the another and such an opportunity is going to be wiped
out very soon.
2. Now suppose the quotes are as follows:
GBP/USD:
1.4550/1.4560
1.4545/1.4555
As is evident from the quotations, there is no arbitrage opportunity because

the ask and bid rates at two different banks are overlapping in nature. We can
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conclude that in order to prevent arbitrage that two quotes must overlap. In
such a scenario, A would find itself competing with many other sellers of pound
sterling and B would find itself amidst a large number of buyers of pound sterling
and a lesser number of sellers.
Banks are always on the move for influencing the quote. Most corporate
or large scale customers run a check on the rates being offered by various
banks, but this is only when the sum involved is large. It must also be observed
that usually the customers who make frequent jumps while using such services
of various banks are not treated on the same scale as the more 'regular'
customers. 'Regular' customers usually get better rates in the routine foreign
exchange transactions.
Inverse Quotes and Two-point Arbitrage
Consider the following spot quotation:
USD/CHF: 1.4955/1.4962
Suppose this is a quote available from a bank in Zurich. At the same time,
a bank in New York is offering the following spot quote:
CHF/USD: 0.6695/0.6699
In this situation, let us explore if there is an arbitrage possibility. Suppose
we buy one million Swiss francs against dollars from the Zurich bank and sell
them to the New York bank. The Zurich Bank will give CHF 1.4955 for every
dollar it buys. It will cost us $(1,000,000/1.4955) i.e. $6,68,700 to acquire the
Swiss francs. In New York, the bank will give $0.6695 for every CHF it purchases.
Thus, CHF 1 million can be sold to the New York bank for $(0.6695 x
1000000) i.e. $6,69,500. One can make a risk-less profit of $800 with the help
of a few phone calls. Obviously, the CHF/USD rates implied by the Swiss Bank's
USD/ CHF quotes and the New York bank's CHF/USD quotes are out-of-line.
Recall that (CHF/USD) ask is the rate that applies when the bank sells
Swiss francs in exchange for dollars. But this is precisely the deal we did with
the Zurich Bank and for each Swiss franc we bought, we had to pay $(1/1.4955)
which is nothing but l/ (USD/CHF) bid. In the same way, die (CHF/USD) bid
implied by the Swiss bank's USD/CHF quotes would be the amount of US dollars
it would give when it buys one CHF. It requires CHF 1.4962 for every USD it
sells. This means that it will give USD (l/l.4962) when it buys one CHF. Thus,
the (CHF/USD) bid implied by its USD/CHF quote is l/ (USD/CHF) ask. Thus,
we have:
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Implied (CHF/USD) bid = I/ (USD/CHF) ask Implied (CHF/USD)

ask = 1/ (USD/CHF) bid
To prevent arbitrage, the New York bank's (CHF/USD) quotes must overlap
the (CHF/USD) quotes implied by the Swiss bank's quotes. The latter work out
to 0.6684/0.6687. A CHF/USD quote such as 0.6686/0.6690 will not lead to
arbitrage though it may lead to a one-way market for the banks. The rates
found in the markets will obey the above relations to a very close approximation.
The arbitrage transaction described above, viz., buying a currency in one
market and selling it at a higher price in another market is called Two-Point
Arbitrage'. Foreign exchange markets eliminate two-point arbitrage opportunities
very quickly if and when they arise.
11. The exchange rate quotations may be similar to each other for any two
given banks but they cannot be exactly the same in almost most of the
cases. (True/False)
12. An exchange rate can be defined as the price of a currency in terms of
another. (True/False)
5.8 Interest Rate Parity Theory

This theory is a link between exchange rates and interest rates.
Proposition 1: The interest rates prevailing in two countries affect the exchange
rate between the currencies of those countries. Interest rates in India and in the
US, for example, will drive the exchange rate between dollar and rupee.
Proposition 2: In an efficient market, if the interest rates in two countries are
different, the exchange rates between the two countries will move in such a way
as to bring about parity in interest rates, offsetting the apparent interest rate
differentials, thereby denying any arbitrage opportunity.
This implies that high interest rate in one country will be offset by the
depreciation of the currency of that country. If, for example, the interest rate in
India is higher than that in the US, the rupees will depreciate against the US
dollar.
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According to the Interest Rate Parity Theory, it is argued that forward rate
would reflect the interest rate. In the absence of it, arbitrage opportunities would
open up and a shrewd investor could make a lot of money. To understand further,
one needs to understand the arbitrage and then about how it works in the field
of international finance.
Arbitrage means the existence of two different prices in two markets for
the same commodity. If this happens investors would make money. Let us
understand the same with an example:
Suppose a fruit cake cost `10 in Bakery A and `12 in Bakery B. You know
a cake is eatable wherever it is brought or sold (assuming other things remain
constant). You would buy 100 pieces of cake in Bakery A and sell 100 pieces of
cake in Bakery B making a profit of `200 per day for no effort. Your action of
buying and selling pushes up the demand for cakes in Bakery A and the supply
of cakes in Bakery B. In line with the law of demand and supply, the price of
cake goes up in Bakery A and the price of cake comes down in Bakery B. Over
time, the two prices would catch up and arbitrage would dissolve. This is an
example of arbitrage over space.
We could also have an arbitrage over time. If, for example, the time value
of money is 6 per cent and a cake costs `10 today, it would have to cost `10.6
a year later. If you know that it would cost, say `11 a year later, you would
borrow `10 today at 6 per cent, buy a cake, sell it a year later at `11, pay the
interest and repay the principal amounting to `10.60 and pocket the difference
of `0.40. And if you knew that it would cost less, say `10.40 a year later, you
would sell cakes today at `10, invest the proceeds at 6 per cent, get `10.6 a
year later and buy cakes at `10.40 thus pocketing `0.20 in the bargain.
Arbitrage over space in forex refers to the price of the currency in two
countries. Arbitrage over time refers to the prices in the two markets, spot and
forward.
One can identify arbitrage opportunities in one of the two ways. One,
compute what should be the forward price (theoretical price) and compare it
with what is the forward price (actual forward rate). If the two are not equal,
there could be an arbitrage opportunity. Two, compute what should be the home
country interest rate (theoretical interest rate) for the given forward rate and
compare it with what is the actual home country rate (actual interest rate). If the
two are not equal, there could be an arbitrage opportunity.
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13. According to the______________________, it is argued that forward rate
would reflect the interest rate.
14. Arbitrage over time refers to the prices in the two markets____________
and____________.
5.9 Purchasing Power Parity

This theory presents a link between exchange rates and inflation.
Proposition 1: The inflation rates prevailing in two countries affect the exchange
rate between the currencies of those countries. For instance, the inflation rates
ruling in India and the US will determine the exchange rate between rupee and
US dollar.
Proposition 2: In an efficient market, if the inflation rates in two countries are
different, the exchange rates between the two countries will move in such a way
as to bring about parity in inflation rates, offsetting the apparent inflation rate
differentials, thereby denying any arbitrage opportunity. This implies that high
inflation rate in one country will be offset by the depreciation of the currency of
that country. If for instance, the inflation rate in India is higher than in the US,
rupee will depreciate against dollar.
A second implication is that similar to the linkage between forward
exchange rates and interest rate differentials in the Interest Rate Parity Theory,
there is a similar connection between inflation rates and the exchange rates of
currencies of two countries. This link is also called the law of one price. The law
of one price states that the price of a commodity should be the same in two
markets or else arbitrage opportunity will open up.
Relative purchasing power parity
Rather than focusing on a particular good when applying the purchasing-powerparity concept, most analysts look at market baskets consisting of many goods.
They consider a nation's, overall inflation (deflation) rate as measured by, say,
the producer price index or consumer price index.
According to the theory of relative purchasing power parity, changes in
relative national price levels determine changes in exchange rates over the
long run. The theory predicts that the foreign-exchange value of a currency
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Unit 5
tends to appreciate or depreciate at a rate equal to the difference between

foreign and domestic inflation. As an example, if US inflation exceeds
Switzerland's inflation by 4 percentage points per year, the purchasing power of
the dollar falls 4 points relative to the franc. The foreign-exchange value of the
dollar should therefore depreciate 4 percent per yet. Conversely, the US dollar
should appreciate against the franc if US inflation is less than Switzerland's
inflation.
If the US price level rises relative to the UK price level, imports become
relatively less expensive in the United States. US consumers tend to increase
their spending on imports from the United Kingdom, which leads to an increase
in the demand for pounds. At the same time, UK consumers see US goods
becoming more expensive. As they reduce their demand for exports from the
United States, the supply of pounds decreases. The result is depreciation in the
dollar's exchange value against the pound. Although the purchasing-powerparity theory can be helpful in forecasting appropriate levels to which currency
values should be adjusted, it is not an infallible guide to exchange-rate
determination. For instance, the theory overlooks the fact that exchange-rate
movements may be influenced by capital flows. The theory also faces the
problems of choosing the appropriate price index to be used in price calculations
(for example, consumer prices or producer prices) and of determining the
equilibrium period to use as a base. Moreover, government policy may interfere
with the operation of the theory (for example, trade restrictions that disrupt the
flow of exports and imports among nations).
Activity 2
Suppose the domestic price level increases rapidly in the United States
and remains constant in the United Kingdom. Will the US consumers favour
British goods? How will it affect the dollar and pound?
Hint:
The increase in the demand for pounds and the decrease in the supply
of pounds result in a depreciation of the dollar.
15. The inflation rates prevailing in two countries affect the exchange rate
between the currencies of those countries. (True/False)
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Unit 5
16. According to the theory of relative purchasing power parity, changes in

relative national price levels determine changes in exchange rates over
the long run. (True/False)
17. When applying the purchasing-power-parity concept, most analysts
consider a particular product. (True/False)
5.10 International Fisher Effect

Irving Fisher argued that, over time, money interest rates change to reflect
changes in the anticipated inflation rates. In other words, this theory states that
changes in the anticipated inflation produce corresponding changes in the rate
of interest. While some authors have provided statistical evidence to negate
this theory, there is a consensus that Fishers theory provides a useful rule of
thumb. If the inflation rate is likely to change, it is a fairly good bet that interest
rates will also change.
According to Fisher, the nominal rate of interest comprises two
components, the real rate of return and the expected rate of inflation.
The rationale is extended to substantiate a view that international
differences in the money interest rates also reflect the differences in the
anticipated inflation rates. Some countries experience a higher interest rate
than their trading partners (interest rate in Germany is less than that in India,
while in the US, interest rate is lower than even in Germany). The latter countries
expect that they would experience depreciation in their currencies. Countries
with high rates of inflation will generally have high nominal rates of interest too.
This at least partially serves to allow investors to obtain a high enough real rate
of return, where inflation is relatively high. The International Fisher Effect
suggests the following:
Changes in interest rates reflect the changes in anticipated inflation rates,
and interest rate differentials provide an unbiased predictor of future
changes in spot exchange rates.
Currency of countries with relatively high interest rates is expected to
depreciate because higher interest rates are considered necessary to
compensate for anticipated currency depreciation.
Given the free movement of capital internationally, the real rate of return
in different countries will equalize as a result of adjustments to spot
exchange rates.
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The International Fisher Effect reinforces the Interest Rate Parity and the
Purchasing Power Parity theories by highlighting the inflation element in nominal
interest rates.
Fisher formula
(1+Money rate) = (1+Real rate) (1+Inflation rate)
18. ____________argued that, over time, money interest rates change to
reflect changes in the anticipated inflation rates.
19. The ________________________reinforces the Interest Rate Parity and
the Purchasing Power Parity theories by highlighting the inflation element
in nominal interest rates.
5.11 Forecasting Foreign Exchange Rates

Corporate financial decisions include exchange rate forecasts as one of the
most important inputs. They have several usages such as making investment
decisions, hedging decisions and financing decisions. The speculative
businesses in the foreign exchange market are also benefitted by forecasts.
There are a number of models which offer explanation about the different factors
that are influencing exchange rates and they are also used for forecasting or
predicting the exchange rates of currencies.
Approaches to Forecasting
Two basic approaches to forecasting foreign exchange rates are found. They
are fundamental analysis and technical analysis. While fundamental analysis
includes the study of certain macroeconomic variables that have the possibility
of influencing exchange rates, technical analysis studies the technical
characteristics expected in major market turning points. There are different
models for analyzing the effect of macroeconomic variables on the demand
and supply of a currency. Three most popular models are discussed below.
Asset market model: This theory suggests that there will be more demand
of a currency and so will likely appreciate in value if there is an increase in
the flow of funds into other financial market of the country, such as equities
and bonds and vice versa. It is also based on the assumption that asset
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Unit 5
markets are efficient and they reflect completely all the available
information.
Monetary model: This model aims towards predicting a proportional
relationship between the relative supply of money and nominal exchange
rates between nations. According to the monetary model, three
independent variables determine the exchange rate. They are relative
interest rates, relative money supply and relative national output.
Portfolio balance model: This model suggests that depending on the
expected return and risk, people divide their total wealth between foreign
and domestic bonds and foreign and domestic money. There are three
assets that are included in this model. They are domestic bonds
denominated in the home currency (B), money (M) and foreign currency
bonds (FB).
20. Corporate financial decisions include exchange rate forecasts as one of
the most important inputs. (True/False)
21. The portfolio balance model aims towards predicting a proportional
relationship between the relative supply of money and nominal exchange
rates between nations. (True/False)
5.12 Case Study

Managed Floating Exchange Rate Regime in India
Managed float includes the intervention of the Reserve Bank of India in the
foreign exchange market either directly through the sale and purchase of
US dollars or indirectly by making changes in the repo rate and the resultant
size of liquidity in the monetary and the financial system. Though the new
system of exchange rate helped in boosting trade and investments, the
oscillations however cannot be ruled out.
It has been seen that the value of rupee has been fluctuating. Though it
depreciated in the year 2002-03, it again appreciated at a rapid pace in
2007-08. It again depreciated in 2009-10 and saw rise in the FY 20102011. The most important factors that determine the exchange rate is the
demand and supply. For instance, in FY 2007-08, the inflow of a large
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Unit 5
amount of foreign direct investments and foreign portfolio investment led

to the increase in the supply of dollar in the foreign exchange market. During
the first half of FY 2008-09 the rupee depreciated fast as foreign international
investors made disinvestment during the sub-prime crisis.
The risk of exchange rate and the resultant forward trading to hedge the
risk could not be avoided by Managed float. In the late 1990s, the issue of
financial stability achieved importance in order to reduce the effects of the
turbulence in the South-East Asian financial markets and the deepening of
the financial crisis in Russia. In June 1998, the Reserve Bank of India
announced a set of policy measures that emphasized the role of the RBI in
meeting the mismatches between the demand and supply of foreign
currency through market intervention. It further permitted the institutional
investors to manage the exposure of exchange rate by undertaking foreign
exchange cover on their incremental investment, advising the traders and
the banks to monitor their foreign currency position and allowing domestic
financial institutions to buy back their debt from the international financial
market.
From 1 June, 2000, the Foreign Exchange Management Act came into
force by replacing the Foreign Exchange Regulation Act (FERA). The aim
of FEMA was to promote an orderly development and maintenance of the
foreign exchange market in India. It also offers transparent norms related
to Reserve Bank of Indias approval for acquiring and holding of foreign
exchange and the limits to which foreign exchange is admissible to current/
capital account transactions from the viewpoint of full current account
convertibility and the growing convertibility on capital account.
Questions
1. Do you think the managed floating exchange rate regime is beneficial
for the Indian economy?
2. What was the aim of the FEMA?
Source: Compiled by Author
5.13 Summary
Exchange rates respond quickly to all sorts of events - both tangible and
psychological.
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Unit 5
The fluctuations in economic activity are reflected almost immediately in

fluctuations of currency values.
Demand and supply of a particular currency are the most important factors
affecting its exchange rate.
In foreign exchange trading, technical indicators such as charts and moving
average lines are very significant in the determination of movement of
the prices of various currencies.
Rather than focusing on a particular good when applying the purchasingpower-parity concept, most analysts look at market baskets consisting of
many goods.
The Fisher Effect theory states that changes in the anticipated inflation
produce corresponding changes in the rate of interest.
Corporate financial decisions include exchange rate forecasts as one of
the most important inputs.
5.14 Glossary
Fluctuations: A price or interest rate change
Determinants: Factor or element that limits or defines a decision or
condition
Repatriate: Capital flow from a foreign country to the country of origin
Deficits: A situation in which outflow of money exceeds inflow
Fiscal: Involving financial matters
Upheaval: A state of violent disturbance and disorder
Equilibrium: A state of stable prices brought about by the rough equality
of supply and demand

1. Discuss the primary determinants of foreign exchange rates.
2. Define the factors that determine the exchange rates.
3. Discuss what you mean by cross-rate.
4. Define Exchange rate.
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Unit 5
5. Discuss the ways in which arbitrage opportunities can be identified.

6. Money interest rates change to reflect changes in the anticipated inflation
rates. Discuss.
7. What are the various approaches to forecasting?
5.16 Answers
1. fundamentals
2. Hot money
3. True
4. False
5. True
6. Cross-rate
7. US dollar
8. Market fundamentals, market expectations
9. Medium-run cyclical forces
10. Longer-run structural forces
11. True
12. True
13. Interest Rate Parity Theory
14. Spot, forward
15. True
16. True
17. False
18. Irving Fisher
19. International Fisher Effect
20. True
21. False
Page No. 106
Unit 5

1. Demand and supply of a particular currency are the primary determinants
of foreign exchange rate.
2. The factors that determine the foreign exchange rates are:
The demand factor
The supply side
Long term vs. short term
Factors affecting Currency Trading
Economic factors
3. A cross-rate may be defined as the rate of exchange calculated from two
(or more) other rates.
4. An exchange rate can be defined as the price of a currency in terms of
another.
5. One can identify arbitrage opportunities in one of the two ways. One,
compute what should be the forward price (theoretical price) and compare
it with what is the forward price (actual forward rate).
6. Irving Fisher argued that, over time, money interest rates change to reflect
changes in the anticipated inflation rates.
7. The various approaches to forecasting are:
Asset Market Model
Monetary Model
Portfolio Balance Model
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Unit 5
References/ e-References
Kumar Neelesh. Foreign Exchange Management. Delhi: Vikas Publishing.
Page No. 108
Unit 6
International Financial Markets
Structure
6.1 Caselet
6.2 Introduction
Objectives
6.3 Foreign Exchange Market
6.4 International Money Market
6.5 International Credit Markets
6.6 International Bond Markets
6.7 International Equity Markets
6.8 Case Study
6.9 Summary
6.10 Glossary
6.12 Answers
6.1 Caselet
Foreign investors lap up SBI dollar bonds
State Bank of India, the largest lender of the country has managed to raise
$1.25 billion from investors abroad for five years at 4.125 per cent. Despite
the recent concerns expressed about the countrys economy by international
credit rating agencies, it was the largest single tranche bond sale that
received overwhelming response. The dollar-denominated bonds of SBI
were subscribed 5.4 times and they received $6.8 billion from around 350
accounts that are spread over European, Asian, and US investors. Citibank,
Deutsche Bank, Barclays, Bank of America, JP Morgan Merrill Lynch and
UBS were the lead managers of this issue.
SBI managed to raise $1 billion for five years at 4.5 per cent in 2010. Rajiv
Nayar, the head of the capital markets organization at Citi India stated that
the issuance has offered a window of opportunity to the other high quality
Indian issuers to tap the international bond markets. He further said that in
the five-year duration, the SBI notes were priced at the lowest ever coupon
achieved in the US dollar market for an Indian issuer. Since April, a number
of large Indian banks, private and government owned are waiting on the
sidelines because they had to restrain from carrying out their plans due to
Unit 6
the risk-averse investor sentiments after developments in the Euro zone. A

senior treasury official from a Mumbai-based public sector bank stated that
SBIs dollar bond pricing indicates that the interest rates are coming back
to normal.
Source: Adapted from http://www.business-standard.com/india/news/
foreign-investors-lapsbi-dollar-bonds/481572/
6.2 Introduction
In the earlier unit, you learnt about measuring exchange rate movements and
the various factors that influence exchange rates. You also studied various
concepts such as international arbitrage, interest rate parity, and purchasing
power parity and the Fisher effect. Forecasting foreign exchange rates and the
approaches to forecasting were also discussed.
In this unit, you will learn about foreign exchange markets and the
international money market. You will also study the International credit markets
which are defined as the forum where companies and governments can obtain
credit (loans in various forms) from the creditors/investors. You will also learn
about the international equity markets.
Objectives
explain foreign exchange market
define international money market
interpret international credit markets
discuss international bond markets and international equity markets
6.3 Foreign Exchange Market

The foreign exchange market is like any other over-the-counter market. This
means that the foreign exchange market is unlike an electronic or a physical
market like a stock exchange wherein traders would assemble and trade their
currencies. This market is an across-the-world network of inter-bank traders,
consisting of different players such as banks, connected by different
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Unit 6
communication tools and techniques such as telephony services, fax machines,

the internet, video conferencing, and computers.
The market functions virtually 24 hours in respect of the time differences
across the world. Inter-bank currency trading is handled largely by five major
centres of the currency trade, who handle two-thirds of the foreign currency
transactions. They are London, New York, Tokyo, Zurich, and Frankfurt.
Transactions in Hong Kong, Singapore, Paris and Sydney account for the bulk
of the transactions in rest of the market.
Functions of Foreign Exchange Market
Foreign exchange market plays a very important role in smoothing the progress
of international trade, commerce and investment transactions. It provides the
foundation and the structure through which one countrys currency is exchanged
with that of another country. The major functions of the market are as follows:
(a) The foreign exchange market provides a method by which participants
transfer purchasing power denominated in one currency into another
currency. Since each party is eager to deal its transaction in its own
currency, there is a need for a market to deal in foreign currency.
(b) The foreign exchange market provides a source of credit for facilitating
international trade and capital transactions.
(c) The foreign exchange markets help participants to reduce their foreign
exchange risk exposure by offering multiple hedging facilities, viz., forward
market hedge, money market hedge, option hedge, swaps etc.
(d) The foreign exchange market complements the primary role of the
commercial banks to help its stakeholders to carry out international trade
and exchange transactions.
Structure of Foreign Exchange Market
The foreign exchange market is a two-tiered market:
1. Interbank Market (Wholesale)
The foreign exchange market is globally dominated by about 700 banks.
Currency trading is a major source of profits for commercial banks across the
globe. Many of these banks in the United States and Europe dealing with largescale foreign currency trading. Large commercial banks retain demand deposit
accounts with one another which make possible the efficient functioning of the
FX market.
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International commercial banks communicate with one another with:

(a) The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It allows international commercial banks to
communicate information of the above type to one another. It is a
non-profit private message transfer system with headquarters in
Brussels and international switching centres at Netherlands and
Virginia.
(b) Clearing House Interbank Payments System (CHIPS): It functions
in cooperation with Fedwire, a system of US Federal Reserve Bank.
It provides clearing house for interbank settlement for over 95 percent
of US dollar payments between international banks.
(c) Exchange Clearing House Limited (ECHO): It was the first global
clearing house for settling transactions on foreign exchange among
the commercial banks. Set up in 1995, this multilateral netting system
nets a clients payments and receipts in each currency on each
settlement date. This reduces significantly the risk and inefficiency
of individual settlement.
Apart from the commercial banks, nonbank dealers large nonbank
financial institutions such as investment banks, hedge funds, mutual funds,
pension funds account for about 30 per cent of the interbank trading volume.
There are foreign exchange (FX) brokers who match buy and sell orders
but do not carry inventory. These have the expertise and knowledge of the
quotes offered by many dealers in the foreign exchange market.
2. Client Market (Retail)
Market participants include international banks, their customers, nonbank
dealers, FX brokers and central banks. Exporters and importers, international
portfolio investors, tourists, multinational enterprises and even government
participate in the foreign exchange market to facilitate international trade and
capital transactions.
Speculators and arbitragers are also essential participants in the foreign
exchange market. They seek to make money from trading in the market, mostly
by taking advantage of exchange rate differentials existing simultaneously in
different markets. Their activities are guided by self-motives, with or without
any need to serve the clients.
The central bank of a country often intervenes in the foreign exchange
market. Since 1993, Indias currency regime is said to be a managed float.
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1. Large commercial banks retain ____________with one another which
make possible the efficient functioning of the FX market.
2. Since____________, Indias currency regime is said to be a managed
float.
3. ____________provides clearing house for interbank settlement for over
95 percent of US dollar payments between international banks.
6.4 International Money Market

One of the key components of the financial system is the money market that
acts as a fulcrum of monetary operations that are carried out by the Central
bank while pursuing the objectives of monetary policy. The maturity of such
markets range from overnight to a year and involves financial instruments that
are considered as close substitute of money. There are three broad functions
that are performed by the money market.
1. For the demand and supply of short term funds, the money market provides
an equilibrating mechanism.
2. It helps the lenders and the borrowers of the short term funds in fulfilling
the borrowing and investment requirements at a competent market clearing
price.
3. It offers an avenue to the central bank to intervene in influencing the cost
of liquidity and the quantum in the financial system which in turn transmits
monetary policy impulses to the real economy.
6.4.1 Origins and Development

Over the centuries, money markets have evolved and have presented new
instruments and participants to fit the changing procedures of the monetary
policies. Various changes in the structures of the financial market,
macroeconomic objectives and economic environment have led to the demand
for shifts in the monetary regimes, necessitating refinements both in the
procedures and the operating instruments and in institutional arrangements by
the Central banks.
After the breakdown of the Bretton Woods System, a shift was witnessed
from the rule-based frameworks towards discretion in using the instruments of
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monetary policy that finally led to the abandonment of exchange rate targets.
The various changes that took place in financial innovations and financial
structures made the monetary targeting ineffective by making the money demand
functions unstable. In the same way, there has also been a shift towards greater
flexibility of exchange rate adoption of inflation targeting by some central banks
partly due to repeated instances of currency crisis, increase in capital mobility
and greater financial market integration.
Keeping in mind these changes, central banks have also distanced
themselves from the conventional instruments of monetary control and have
moved towards the use of indirect instruments such as operating through the
price channel. Also the use of direct credit controls and reserve requirements
have also been de-emphasized and to signal the monetary policy stance, they
are depending more on interest rates. The most common strategy that has
been adopted by the Central banks is to direct influence only on short-term
interest rates to allow market expectations to exert an impact on the long-term
interest rates through financial market inter-linkages. Thus, the structure of the
money market guides the choice of monetary policy instruments.
Since the early 1990s, the different financial sector reforms have offered
strong impetus to the financial market development, which also paved the way
for the introduction of market-based monetary policy instruments. With
innovations in the financial field, money demand was viewed as less stable and
the money market disequilibrium got reflected in short-term interest rates. Interest
rates have also emerged as the operational instrument of policy since the
adoption of the multiple indicator approach in 1998. For the purpose of widening
the money market, a range of new money market instruments emerged. They
were certificates of deposit and repos and commercial papers. Moreover, the
increase in the development of the financial markets also led to changes in the
risk profiles of the participants of the financial market giving way to the introduction
of derivative instruments as effective risk management tools.
6.4.2 International Interest Rates

Money market rates are interest rates used by banks for operations among
themselves. Money market enables the banks to trade their surpluses and
deficits. This rate is also commonly known as inter-bank rate. The rates for
various countries vary substantially. The reason for this substantial difference in
rates is due to the interaction of supply or availability of short term funds (bank
deposits) in a particular country versus the demand by borrowers for short term
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funds in that country. If the supply is more than the demand the interest rate will
be low. A typical case is of Japan where the short term rates are very low for the
same reason. On the other hand, if the supply of short term funds is less, than
the demand of rates will be high as in the case of Australia.
In general, the interest rates in developing countries are higher than the
other developed countries.
Let us now examine the linkages between:
1. Interest rate in the domestic and foreign market
2. Interest rate for different countries in foreign market
We examine the above two linkages considering mainly the US and
European markets. Eurocurrency market is considered to be an interbank deposit
market. LIBOR (London Inter Bank Offer Rate) is a rate which a first class bank
in London will charge from another first class bank for a short term loan. It is the
most commonly used benchmark. One more rate, (London interbank bid rate)
is a rate which a bank is willing to pay for deposits accepted from another bank.
Generally LIBOR quotations are provided for 3 to 6 months LIBORs.
However, LIBOR varies according to the term of the underlying deposit. LIBOR
also varies according to the currency in which the loan or deposit is denominated.
6.4.3 Standardized Global Market Regulations

Regulations contribute to the development of international money markets
because these impose restrictions on local markets. Local investors and
borrowers try to circumvent the restrictions in local markets. Difference in
regulations among countries puts banks in some countries to advantageous
position compared to banks in other countries. Over a period of time, international
banking regulations have been standardized, which permit competitive global
banking. Three most significant regulatory events for creating more competitive
global level playing field are given below:
1. The Single European Act
2. The Basel I Accord
3. The Basel II Accord
Single European Act
This was one of the most significant events pertaining to international banking.
It was introduced in 1992 throughout the European Union countries. The main
features of this act are:
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(i) Capital can flow freely throughout Europe.

(ii) Banks can offer a wide variety of lending, leasing and securities
activities in European Union.
(iii) Regulations regarding competition, mergers and taxes are similar
throughout the European Union.
(iv) A bank established in any one of the European Union countries has
the right to expand into any or all of the other European Union
countries.
The Basel I Accord
In July 1988, central bank governors of 12 countries agreed on standard
guidelines for banking regulation under The Basel Accord. As per the guidelines
of The Basel Accord, banks are required to maintain capital equal to minimum
of 4 per cent of their assets. For the purpose of this assessment, the banks
assets are weighted by the risk involved, i.e. more risky assets will have higher
required capital ratio. Items which are not appearing on the balance sheet are
also accounted so that banks cannot circumvent the provisions of the accord.
This applies to services which are not explicitly shown on the balance sheet.
The Basel II Accord
The banking regulators those formed the Basel Accord introduced a new accord
called The Basel II Accord. The objective of this accord is to rectify some
inconsistencies that still exist in the earlier accord. For example, banks in some
countries require better collateral to back the loans. The Basel II Accord is
aiming to resolve such differences amongst banks. Additionally, this accord will
also account for the operational risk. The operational risk is defined by the
Basel Committee as the risk of losses resulting from failure of internal processes
or systems which are inadequate. The Basel committee aims to help banks to
improve their techniques for reducing operational risk. This will in turn result in
reducing failures in the banking system. The Basel committee also wants banks
to provide more information about their exposure to different type of risks to the
existing and prospective shareholders.
Thereafter, Basel III was developed in response to the deficiencies in
financial regulation this was revealed by the occurrence of the financial
meltdown of 2008. Basel III has strengthened bank capital requirements and
imposes new regulatory requirements on bank liquidity and bank leverage.
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The regulatory barriers

Due to increasing competition, deregulation of financial barriers has increased
worldwide. Deregulation is speeded up by the process of regulatory arbitrage in
which the users of capital markets issue and trade securities in financial centres
with low regulatory standards and hence lowest costs. With a view to win back
the business, financial centres across the world are eliminating obsolete and
costly regulations.
Many countries have felt that the bank centred financial system does not
provide adequately for the credit requirements of small and medium sized firms
which are engines of growth and innovation. The combination of free markets
with widely available information has formed the basis of global growth. Fund
raising has become global with growing amount of money being raised on the
international capital markets. Treasurers are looking for international sources
of funding and are quick to exploit any attractive opportunity that appears
anywhere in the world.
Activity 1
Put on chart the aims and objectives of The Basel Accord and Basel II
Accord.
Hints:
As per the guidelines of The Basel Accord, banks are required to
maintain capital equal to minimum of 4 per cent of their assets.
4. After the breakdown of the Bretton Woods System, a shift was witnessed
from the rule-based frameworks towards discretion in using the instruments
of monetary policy that finally led to the abandonment of exchange rate
targets. (True/False)
5. Eurocurrency market is considered to be an interbank deposit market.
(True/False)
6. In September 1998, central bank governors of 12 countries agreed on
standard guidelines for banking regulation under The Basel Accord. (True/
False)
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6.5 International Credit Markets

International credit markets are the forum where companies and governments
can obtain credit (loans in various forms) from the creditors/investors. These
markets are an important part of international capital markets.
International capital market is that financial market or world financial centre
where shares, bonds, debentures, currencies, mutual funds and other long term
securities are purchased and sold. These markets provide the opportunity for
international companies and investors to deal in shares and bonds of different
companies from various countries. Two very important aspects of international
credit market are the syndicated loans and impact of credit crisis on the credit
market, which are explained below.
6.5.1 Syndicated Loans

Syndicated loans are credits granted by a group of banks, called a syndicate to
a borrower who may be a company or the government. Interest rates can be
fixed for the term of the loan or floating based on a benchmark rate such as the
London Interbank Offered Rate (LIBOR).These are hybrid instruments combining
features of relationship lending and publicly traded debt. These allow sharing of
credit risk between various financial institutions without the disclosure and
marketing burden that bond issuers face.
Syndicated credits are a very significant source of international financing,
these accounting for more than a third of all international financing, including
bonds, commercial papers and equity issues.
Two or more banks agree jointly to make a loan to a borrower. There is a
single loan agreement. Every member of the syndicate has a claim on the debtor.
The creditors can be many syndicate members led by one or several lenders,
acting as lead managers or agents.
Leading banks are selected by the borrower to form a syndicate who is
willing to lend money at specified terms. Syndicate leaders are generally
borrowers relationship banks, who provide major portion of loan and join in
with other participants for relatively smaller portions of loan. The number and
size of the syndicate member banks depends on the size of the loan, the terms
involved and concurrence of the borrower.
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6.5.2 External Commercial Borrowings (ECB)

ECBs refer to loans from commercial banks, suppliers credit, buyers credit,
fixed rate bonds, floating rate notes, credit from authorized export credit agencies,
and loans from institutions such as IFC (International Finance Corporation),
ADB (Asian Development Bank) and CDC (Commonwealth Development
Corporation). Guidelines for ECBs were first liberalized in India in 1997. Ever
since then, corporate firms have been allowed to raise capital for expanding
existing capacity, making new investments and finance working capital. All
infrastructure and Greenfield projects are allowed to make use of ECB up to 35
per cent of total project expenses. The average maturity time of ECBs ranges
from three to five to seven years. ECBs are mostly used for:
(a) Project related cost of infrastructure projects
(b) License fee payments in the telecom sector
(c) Foreign exchange cost of capital goods and services
Those corporate firms which manage to acquire ECBs with maturity time
of 10 to 20 years are able to use the capital for general corporate purposes.
However, the funds acquired through ECBs cannot be invested in stock markets
or for dabbling in real estate. How much an ECB can be mobilized depends on
the relative value of current rates of interest in India and other countries. The
cost of an ECB should ideally include the margin of depreciation/appreciation in
the value of the rupee abroad. Also, if interest rates in India are low, the demand
for the ECB would also be low. Commonly, it has been seen that when the value
of the rupee falls, the value of the ECB increases. The interest rate restrictions
on ECB acquired for project financing permit an interest spread of up to 350
basis points over the LIBOR/US treasury rate. A corporate can only opt for an
ECB only after they have obtained government approval. The government has
specifies limits on the overall ECB that can be financed in a particular year. As
happens with other types of foreign capital, the ECB actually received may be
less than the amount approved.
In a nutshell we can say that, arranging a syndicated loan meets borrowers
demand for loan requirements without the lender having to bear the market and
credit risk. The prime goal of syndicate lending is to spread out the risk of
default amongst a number of lending banks or institutional investors.
These loans are generally large in size and a single default can seriously
jeopardize the safety of a single bank. These loans are also used in the leveraged
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buyout of international companies where loan amounts are large and the risk
level is high.
7. ____________are credits granted by a group of banks, called a syndicate
to a borrower who may be a company or the government.
8. ____________is the rate at which large global banks lend to each other.
6.6 International Bond Markets

Although debt financing has always been international in nature, there is still no
unified international bond market. The international bond market is divided into
three bond market groups:
1. Domestic bonds: They are issued locally by a domestic borrower and
are usually denominated in the local currency.
2. Foreign bonds: They are issued on a local market by a foreign borrower
and are usually denominated in the local currency. Foreign bond issues
and trading are under the supervision of local market authorities.
3. Eurobonds: They are underwritten by a multinational syndicate of banks
and placed mainly in countries other than the one in whose currency the
bond is denominated. These bonds are not traded on a specific national
bond market.
6.6.1 Euro Bond Markets

This is an international market for borrowing capital by any countries government,
corporate and institutions. The centre of activity of borrowing and lending in
London and Europe is called as Euro bond market. The borrowers and lenders
can come from all over the world. A Bond market is a long term market in which
the International Banks transact. It was developed in the 1960s when there
was huge surplus of US Dollars in countries other than US.
Euro bond is defined as a debt instrument underwritten by an international
syndicate and offered for sale simultaneously in a number of countries. Therefore,
it is usually denominated in a currency that is foreign. There are different names
for particular segments of the foreign bond markets, for example, Yankee bonds
are the bonds issued by the US companies in US markets.
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It is a telephone and telex market depending upon the means of

communication for trading. The main features are as follows:
The bonds issued by the issuer range from medium to long term.
Repayment of principal amount in these instruments takes place in two
forms; one is by means of agreed amortization over a period of time and
the other is one lump sum payment at the end of the given maturity of the
bond called as bullet payment.
Bonds are issued in the form of bearer instruments that are transferable
by delivery.
Bonds are characterized by annual servicing and settlements are done
through international clearing house mechanism.
Placement of bonds
There are two ways in which issuer can issue their bonds to the investors. They
are discussed as follows:
1. Public offering: In this mode, the issue is opened to general public to
invest in the issue and the issue is placed in the market by a syndicate of
international banks that make elaborate arrangements to market the issue
to their clients. Once the public offering is over, they are listed on any of
the international stock exchanges.
2. Private placement: In this mode, the issue is made on a retail basis with
individual investors in certain markets and the investors who generally
invest in these issues are of professional in nature. Listing arrangement
is done away as the issue is to be placed privately. The instrument is
traded by leading banks on OTC market or through bank dealing rooms.
6.6.2 Development of other Bond Markets

International bonds are debt instruments issued by international agencies,
governments and companies to borrow foreign currencies for a particular period
of time. Interest to the creditor and repayment of the capital is made by the
issuer. There are various types of international bonds and the procedure of
issue of such bonds is very specific.
Types of International Bonds
International bonds are categorized into two types: foreign bonds and euro bonds.
They are discussed as follows:
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Eurobonds
These are basically debt instruments denominated in a currency issued outside
the country of that currency; for example, yen bond floated in France. The primary
attraction of these bonds is the refuge from tax and regulations, and also the
scope for arbitraging yields. These are usually bearer bonds and can take the
form of:
(i) Traditional fixed rate bonds
(ii) Floating rate notes (FRNs)
(iii) Convertible bonds
Foreign/global bonds
In 1989-90, the World Bank issued global bonds for the first time and from
1992, various companies also started issuing such bonds. Currently, global
bonds are issued in seven currencies in which such bonds are denominated,
namely euro, Japanese yen, Australian dollar, Canadian dollar and Swedish
krona.
Straight bonds
The traditional types of bonds are the straight bonds. The interest rate for straight
bonds is fixed and it is known as the coupon rate. The rate is fixed in terms of
the rates on treasury bonds for comparable maturity. The borrowers credit
standing is also taken into account for fixing the coupon rate.
There are several varieties of straight bonds. They are as follows:
Bullet redemption bond: In this type of bond, the principal amount is
repaid at the end of the maturity period and not in installments every year.
Rising-coupon bonds: In these bonds, the coupon rate rises over time.
The borrower has to pay little amount of interest payment during the early
years of debt.
Zero-coupon bond: This type of bond does not carry any interest
payment. As a result of no interest payment, this bond is issued at discount.
This discount compensates for the loss of interest of the creditors. Zerocoupon bond was issued in 1981 for the first time.
Bonds with currency options: For this type of bonds, the investor has
the right of receiving payments in a currency other than the currency of
the issue.
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Bull and bear bonds: These bonds are indexed to some particular
benchmark and are issued in two tranches. The bonds for which the
amount of redemption increases with a rise in the index are called the bull
bonds and the bonds for which the amount of redemption falls with a fall
in the index are called the bear bonds.
Debt warrant bond: This bond has a call warrant attached with it. Zerocoupon bonds are known as warrants. The creditors have the right of
purchasing another bond at a given price.
Floating rate notes
Floating rate notes (FRNs) are bonds which do not carry a fixed rate of interest.
The rate of interest is quoted as a premium or a discount to a reference rate
which is always the London Interbank Offered Rate (LIBOR). Depending upon
the period for which the interest rate is referenced to, the rate of interest is
periodically revised, say, at every three-month or every six-month period.
There are various forms of FRNs. They are as follows:
Perpetual FRNs: In this type of FRNs, the principal amount is never
repaid, which means they are like equity shares.
Minimax FRNs: These are FRNs where the minimum and maximum rates
are mentioned. The minimum rate is advantageous for the investors, while
the maximum rate is beneficial for the issuer. It is only the maximum rate
that is payable even if LIBOR rises beyond the maximum rate.
Drop-lock FRNs: Under this type of FRNs, the investor has the right of
converting the FRN into a straight bond.
Flip-flop FRNs: These FRNs were issued by the World Bank for the first
time. In the case of flip-flop FRNs, the investor has the choice to convert
a FRN into a three-month note with a flat three-month yield.
Mismatch FRNs: In case of mismatch FRNs, the rate of interest rate is
fixed on a monthly basis, but the interest is paid every six months. The
investor, in such a situation can go for arbitrage on account of the difference
in rates of interest. Such FRNs are also called rolling-rate FRNs.
Hybrid fixed rate reverse FRNs: This type of floating rate notes is a
recent innovation. They were developed in the Deutschmark segment of
the market in 1990. These FRNs pay a fixed high rate of interest for a
couple of years. The investors receive the difference between LIBOR
and even a higher fixed rate of interest. They earn profits as the LIBOR
becomes low.
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Convertible bonds
Convertible bonds are bonds that can be converted into equity shares.
International bonds are also convertible bonds. Some of the convertible bonds
have detachable warrants that involve acquisition rights while other convertible
bonds have automatic convertibility into a particular number of shares.
Cocktail bonds
Bonds that are denominated in a mixture of currencies are known as cocktail
bonds. The SDIR bonds represent a weighted average of four currencies. The
investors who purchase cocktail bonds automatically get the benefits of currency
diversification. The depreciation of any one currency on account of a change in
the foreign exchange rate is offset by appreciation of another currency.
Activity 2
Analyse the present bond market in India and find out how it is affecting the
Indian economy. Make a report.
Hint:
Browse the Internet and to gather notes on the bond market.
9. Foreign bonds are issued locally by a domestic borrower and are usually
denominated in the local currency. (True/False)
10. Bullet redemption bond the coupon rate rises over time. (True/False)
11. Bonds that are denominated in a mixture of currencies are known as
cocktail bonds. (True/False)
6.7 International Equity Markets

Equity markets are seen as an avenue by a large number of investors both
individual and institutional as an investment source. Securities market includes
the distribution of new issues of securities by new or existing companies as well
as the purchase and sale of old securities in the stock exchange markets.
A company always prefers equity to debt because debt servicing is a
compulsory commitment. Equity markets encourage savings among the
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nationals and increases the efficiency of capital allocation by channeling the

savings into productive investments.
Participants of securities market
Investors and the issuers: In every economy, the saving of individuals
reaches the business sector by circulation of money in the other sectors.
The individuals and institutional investors save their earnings and invest
in the stock market. Issuers are the corporate world that raises money
through the stock market.
Intermediaries: The merchant bankers, underwriting agents and the other
institutions like banks are an important link between the investors and the
corporate world. They are involved since the beginning when the issue is
planned and continue as the dividends are continuing affair in the securities
market.
Regulators: As more and more scams occurred in the different stock
markets across the world, the need for a regulatory body was felt. The
regulatory bodies regulate the functioning of the securities market by over
viewing the process of issue till the securities are issued. They protect
the interest of investors and ensure the companies that are operating in
the secondary market, report all the facts and figures to the investors on
timely basis.
6.7.1 Issuance of Stock in Foreign Markets

Up to the year 1980, there were hardly any equity issues of firms in international
markets. However, in the 1980s, especially between 1983 and 1987, the number
of equity issues in the international markets saw a large increase. During the
1990s, institutional investors from developed countries bought equities of
developing markets in a big way. The advantage for the issuer was to obtain low
cost funds, broaden their shareholders base, initiate steps for international
activities like acquisitions, grant stock options to foreign employees and improve
the access to large size term funding. The advantage for the investors was the
motive for diversification. Technology boom in the 1990s also attracted the
investors towards the technology stocks from emerging stocks.
Most firms who have gone for global equity markets have done so for one
or more of the following considerations:
1. The size of the stock is large and the domestic market is not large enough
to support the stock. So, the issuing companies issue stocks in another
country and often more than one country at the same time.
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2. For obtaining better price and terms for equity issue, if all the markets
had been totally integrated, there would be no change in prices of the
stock in any country except for the issue cost. However, most markets
are fragmented and segmented from each other due to constraints placed
by various countries, so that liquidity position of each market is different
and share prices will also be different.
3. For establishing their image as global companies and, thus improving the
demand for their products and services.
4. Liquidity of the stock in the secondary market: This also applies to
instruments which are based on the stocks like depository receipts, which
are listed and traded on foreign stock exchanges.
5. Regulatory issues pertaining to reporting and disclosures
Sometimes, shares of a firm are traded by indirect route in the form of
depository receipts. The shares issued by the firm are held by a depository who
is a large international bank which receives dividends, reports etc. and issues
claims against these. The claims are called depository receipts. Each receipt is
a claim on specified number of shares. The depository receipts are denominated
in a foreign currency usually US dollars. The depository receipts are listed and
traded on major stock exchanges. The issuing firm pays dividends in the home
currency of the firm and the depository converts the same to dollar and pays to
investors. This mechanism originated in the US and is called American Depository
Receipts (ADRs). Further, European Depository Receipts (EDRs) and Global
Depository Receipts (GDRs) can be used to tap multiple markets in other
countries with single instrument. Reliance Ltd. issued the first GDR in 1992 and
many Indian software and other firms have issued ADRs.
Domestic firms and MNCs generally obtain long term capital by issue of
shares in domestic markets. However, the firms can attract funds from foreign
investors by issuing stocks in foreign markets. If the size of issue is large, it can
be issued in more than one country at the same time. Such issues are called
Euro issues.
For the MNCs, the country for the issue of stock can be based on the
location of its operations. It may like to issue stocks in countries where it has
operations and expects to generate future cash flows so that dividend can be
paid out of the revenues in the local currency of that country. The stocks are
designated in the currency of the country where these are issued and also
these are listed in those countries so that the investors can sell the stocks in
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secondary market. For example, the Coca-Cola stock issued to investors in

Germany is designated in Euros and not Dollars.
For large companies, while issuing shares they tap investors in a number
of countries because domestic market may be too small for the level of operation.
For example, when KLM company which is an airline located in Holland issued
5 crore shares, it placed 70 lakh shares in Europe, 70 lakh shares in US and 10
lakh shares in Japan.
Selling stocks in foreign markets increases its demand and hence, the
stock price goes up. Since the investor base is widened, stock prices also become
more stable as the offloading of stock by any single investor or financial institution
cannot have a major impact on the prices.
Another major advantage of issuing stocks in foreign markets is that the
brand name and the product get support and the effect on sales is large. For
example, Apple computers of US issued its shares in Japan and Germany and
also listed on Tokyo and Frankfurt exchanges to raise the profile of its products
in those countries.
6.7.2 Issuance of Foreign Stock in the United States

Sometimes firm in different countries wants to issue stocks in the US with the
objective of obtaining large amount of funds due to high liquidity in US markets.
These are called Yankee stock offerings. A foreign corporation may be able to
sell an entire issue of stock in the US market.
The companies are looking for those markets where they can reach
shareholders at the lowest cost and investors are looking for good prices and
low transaction costs.
In the case of non-US firms issuing stocks in their own country, the spread
of shareholders is limited and a few large institutional investors may buy a bulk
of the shares. If any major institutional investor sells his shares, the share prices
can drop substantially. When the firm sells shares in the US, the spread of
shareholding increases and the effect of a single shareholder selling his stocks
on the price will not be much. Thus, the volatility of the firms shares will reduce.
In US, the investment bankers serve as underwriters for the shares being
issued in the US financial market and charge high underwriting fee of around 5
to 8 per cent of the value of the total stock issue. Many financial institutions in
the US buy foreign stocks purely as investments; non-US firms can sell large
stocks fully in the US.
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In many countries, there are large businesses owned by respective

governments. When the government wants to sell any business to private
shareholders, local markets are not large enough to provide necessary liquidity.
Thus, when the stocks are sold in the US, it amounts to US investors financing
the private business in foreign countries.
For the purpose of issue of stocks in US markets, the foreign firms have
to comply with stringent disclosure rules on the financial condition of the firms.
The foreign firm will be exempted from some of these rules when they qualify
for Security and Exchange Commission (SEC) guidelines (adopted the Rule
144A in 1990) through a direct placement of stock to institutional investors.
Rule 144 A permits the qualified institutional investors to trade in private
placements of unregistered firms. This rule increased the liquidity of the private
placement market and makes it attractive to foreign firms who are often unable
to enter the US market by SECs stringent disclosure and reporting rules. The
main advantage of private placement is that its total cost would be less than half
of the public offering cost, and it takes less time to make private placement.
However, the pricing for private placement is less competitive compared to a
public offering and the firm has limited access to US markets.
Many foreign companies decide to sell their initial public offerings (IPOs)
in US because they get better price, a shareholder base which understands the
business and they can in the process get publicity for their products.
A classical example is that of the Daimler-Benz, the company that
manufactures Mercedes; when it listed its shares on New York Stock exchange
in 1993, it was the first German company to do so. The company had to comply
with stringent disclosure rules and had to modify its accounting practices to
confirm to US generally accepted accounting principles. Daimler-Benz undertook
this difficult task because it wanted access to larger and liquid pool of capital in
the US market. The firm also thought that the positive image of its Mercedes
cars would help it to raise capital at lower prices. During the next six weeks,
from the announcement of its plan to issue of stock in US markets and the date
of actual listing, the share prices in US market had risen by about 30 per cent
whereas in the German market, the share prices during the same period rose
about 10 per cent.
Non-US firms also obtain equity financing by using American Depository
Receipts (ADRs). These are certificate representing bundles of stocks. The
use of ADRs circumvents some of the disclosure requirements for stock offerings
in US, but still enables the non-US firms to obtain funds from US markets. ADR
shares can be traded just like shares of the stock, the price of ADR changes
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continuously as a consequence of demand and supply conditions. In the long

run, the ADR is expected to move in tandem with the value of its shares listed in
foreign stock exchange except for adjustment of exchange rate effect.
12. The ____________regulate the functioning of the securities market by
over viewing the process of issue till the securities are issued.
13. ____________permits the qualified institutional investors to trade in private
placements of unregistered firms.
14. Selling stocks in foreign markets increases its ____________and hence,
the stock price goes up.
6.8 Case Study

Euro-issues of the Indian Firms
The Indian companies receive funds from the International market through
the euro-issues, viz., American Depository Receipt (ADRs), Global
Depository Receipts (GDRs) and Foreign Currency Convertible Bond
(FCCBs). In case the bank depository is situated in the USA, the receipt
that is issued by it is known as ADR. In the international financial market,
the ADRs and GDRs are issued and sold by the depositories depending on
the shares that are deposited by Indian companies with a custodian bank
located in India.
The flow of fund takes place from the ultimate investors to the GDs, from
the GDs to the custodian bank and from the custodian bank to the company.
Before the depository receipts are issued, the value of the depository issues,
ratio between the depository receipts and the Indian shares are agreed
upon between the foreign depository and the custodian bank in India.
An ADR/GDR issue can be sponsored by an Indian company. When a
resident shareholder gives back his shares to the company, the latter can
go for the issue of depository shares on the basis of those shares. Three
different types of ADR issues exist although an alternative approach under
Rule 144A is also found. These types depend on some factors such as the
choice of the accounting standards, profile of the company that is sought
by the investor and the amount that is to be raised. At level 1, the disclosure
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requirements to the US Securities and Exchange Commission (USSEC)

are the minimum possible and the ADRs are traded in the US over-thecounter market under the provision. The issues are also not found listed on
the National Stock Exchanges. The provisions of the Generally Accepted
Accounting Principles (GAAP) are also not applicable.
At level 2, the issue needs a greater amount of disclosures. The GAAP
provisions are also applicable and the ADRs are registered at the New
York Stock Exchange or the NASDAQ. At level 3, public offerings are raised
by the ADRs in order to raise money. They need to comply with the listing
requirement of the Stock Exchange and are needed to be registered with
the USSEC. Here, the GAAP provisions are also applicable. The issue
under the Rule 144 A, is restricted only to the qualified institutional buyers.
In the first two years, the securities being unregistered or unsponsored are
sold under very stringent processes.
In the case of FCCBs, as they are debt instruments, they include the
repayment of the principal and payment of interest in foreign currency. The
high promoter shareholding companies generally issues the FCCBs as they
do not perceive any risk that they will lose management control even after
the exercise of the conversion option. In India, the FCCBs are often
unsecured and the holder of this bond can sell a part or the entire holding
or convert it into American depository share.
Questions
1. What do you think are the differences between ADRs, GDRs and
FCCBs?
2. How do the Indian companies receive funds from the international
market?
6.9 Summary
The foreign exchange market is an across-the-world network of interbank traders, consisting of different players such as banks, connected by
different communication tools and techniques such as telephony services,
fax machines, the Internet, video conferencing, and computers.
Foreign exchange market plays a very important role in smoothing the
progress of international trade, commerce and investment transactions.
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Unit 6
One of the key components of the financial system is the money market
that acts as a fulcrum of monetary operations that are carried out by the
Central bank while pursuing the objectives of monetary policy.
Syndicated loans are credits granted by a group of banks, called a
syndicate to a borrower who may be a company or the government.
International bonds are debt instruments issued by international agencies,
governments and companies to borrow foreign currencies for a particular
period of time.
Equity markets are seen as an avenue by a large number of investors
both individual and institutional as an investment source.
6.10 Glossary
Transaction: An agreement between a buyer and a seller to exchange
an asset for payment.
Hedging: Reducing or controlling risk
Multilateral: A trading system that facilitates the exchange of financial
instruments between multiple parties
Macroeconomic: The field of economics studying the behavior of the
aggregate economy
Impetus: Incentive, stimulus
Repos: A form of short-term borrowing for dealers in government
securities
Deregulation: Reduction of governments role in controlling markets
leading to freer markets, and presumably a more efficient marketplace

1. Discuss the functions of the foreign exchange market.
2. Discuss the single european act in brief.
3. What are international credit markets? Explain.
4. Define euro bond market.
5. Explain the different forms of FRNs.
6. Discuss the process of issue of stocks by MNCs.
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6.12 Answers
1. Demand deposit accounts
2. 1993
3. Clearing House Interbank Payments System (CHIPS)
4. True
5. True
6. False
7. Syndicated loans
8. LIBOR
9. False
10. False
11. True
12. Regulatory bodies
13. Rule 144 A
14. Demand

1. The major functions of the Foreign Exchange Market are as follows:
(i) The foreign exchange market provides a method by which
participants transfer purchasing power denominated in one currency
into another currency.
(ii) The foreign exchange market provides a source of credit for
facilitating international trade and capital transactions.
2. This was one of the most significant events pertaining to international
banking. It was introduced in 1992 throughout the European Union
countries.
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3. International credit markets are the forum where companies and

governments can obtain credit (loans in various forms) from the creditors/
investors.
4. This is an international market for borrowing capital by any countries
government, corporate and institutions. The centre of activity of borrowing
and lending in London and Europe is called as Euro bond market.
5. There are various forms of FRNs. They are as follows:
Perpetual FRNs
Minimax FRNs
Drop lock FRNs
Flip-flop FRNs
Mismatch FRNs
Hybrid Fixed Rate Reverse FRNs
6. For the MNCs, the country for the issue of stock can be based on the
location of its operations.
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas
Publishing.
Page No. 133
Unit 7
Foreign Trade Finance
Structure
7.1 Caselet
7.2 Introduction
Objectives
7.3 Financing Exports
7.4 Financing Imports
7.5 Documentary Collections
7.6 Factoring and Forfeiting
7.7 Countertrade
7.8 Case Study
7.9 Summary
7.10 Glossary
7.12 Answers
7.1 Caselet
Factoring WindowNarrowed by RBI
The central bank announced on 23 July 2012 that any company who is
planning of undertaking the factoring business are needed to register itself
as an NBFC-Factor with the Reserve Bank of India (RBI). It is also required
for them to have a minimum net owned fund of `5 crore.
Factoring which is a financial transaction allows the entity to sell its
receivables at discounted prices to a third party called a factor. The direction
of RBI follows notification of the Factoring Regulation Act, 2011, whose
aim is regulating factors and assignment of receivables in favour of factors.
It has also been stated that under this Act, companies undertaking factoring
business, other than the government companies and banks would be
registered with the RBI as non-banking financial companies (NBFCs). RBI
has further said that in accordance with the Act, it had been decided that a
new category of NBFCs would be introduced and separate directions would
be provided to these.
The RBI has also said that every company who is willing to undertake
factoring business is required to put forward an application so that a
certificate of registration as an NBFC-Factor to the RBI is registered.
Unit 7
Moreover, it should also have a minimum NOF of `5 crore. However,

companies who needs registration but do not fulfill the criteria of NOF can
also approach the RBI requesting for time in order to fulfill the requirement.
It has also been stated by the Apex bank that it should be ensured by the
NBFC-Factor that the factoring business constitutes at least 75 per cent of
its total assets. It should also be taken into consideration that the income
that has been derived from the factoring business is not less than 75 per
cent of its gross income. The NBFC-Factor (Reserve Bank) Directions,
2012 come into operations with immediate effect.
Source: Adapted from http://www.business-standard.com/india/news/rbinarrows-factoring-window/481246/.
7.2 Introduction
In the previous unit, you learnt about the foreign exchange market as well as
the international money market. Topics related to money market interest rates
and standardizing global market regulations had also been discussed. You also
studied about the international bond markets and the international stock markets.
In this unit, you will learn about foreign trade finance. You will be introduced
to the concepts of financing exports and financing imports and you will also
learn about documentary collections, factoring, forfeiting and countertrade.
Objectives
discuss financing exports and imports
define documentary collections
explain factoring and forfeiting
evaluate the concept of countertrade
7.3 Financing Exports

It is very necessary to provide attractive payment terms that is customary in the
trade in order to make a sale. Many export financing options are available in the
market and the exporters should be aware of them so as to choose the most
acceptable and profitable one. Many a times, the assistance of the government
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in financing exports to small and medium-sized businesses can also increase

options for the firm.
While extending credit to foreign buyers, it should be known that they
often ask the buyers for longer payment periods. Thus, the exporters should
weigh carefully the credit or financing that they are extending to the foreign
customers. For determining the appropriate credit period, the exporters can
consult the normal commercial terms available in the exporters industry. The
normal commercial terms for products like agricultural commodities, consumer
goods, chemicals and other raw materials range from 30 to 180 days. However,
exceptions can be made for longer shipment times as foreign buyers are often
unwilling to start the credit period even before the receipt of the goods.
Government Assistance Programs
Different programs are offered by the federal government agencies to help the
exporters fulfill their financial needs. Some of these include loans or grants to
an exporter or a foreign government while others include guarantee programs.
The main aim of the government programs is to improve the access of the
exporters to credit rather than subsidizing the cost at below-market levels. With
few exceptions, banks are also allowed to charge fees and market interest
rates to the government agencies in order to cover the default risks and the
administrative costs of the agencies. Generally, the commercial banks use
government guarantee and insurance programs to lessen the risk that is
associated with loans to exporters. Lenders who are concerned with the ability
of the exporters about performing under the terms of sale uses government
programs in order to reduce the risks that would have otherwise prevented
them from providing financing.
There are different forms of credit that are provided to the exporters.
They are as follows:
1. Pre-shipment credit
2. Post-shipment credit
3. Medium-term credit
4. Credit under duty draw-back scheme
This credit is provided to the exporters meant for procuring raw material, packing
and processing of goods as well as for other processes till the goods are really
shipped. This type of credit is normally extended on the strength of letter of
credit but sometimes also on the strength of purchase order. This credit is
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extended generally in stages and not as a lump sum, depending on the needs
of the customer. It is a short-term credit normally not exceeding 180 days but in
exceptional cases may exceed up to 270 days.
2. Post-shipment credit
It is extended by the banks after the goods have been shipped and against the
submission of export documents evidencing the shipment of the goods. It is
also a short-term credit and the rate of interest is lower up to 90 days. But later,
it increases and it is still higher beyond 180 days. Post-shipment credit is
extended also in the case of deemed export or supplies that are made to
international bodies. The banks in India have also started extending the postshipment credit in foreign currency since January 1992. The process is that
Indian exporter is paid in Indian rupees and the liability of the exporter is
denominated in US dollar.
3. Medium-term Credit
The medium-term credit is used in case of certain categories of export such as
capital goods, project export and engineering items. In case of such products,
the short-term finance does not help. In case the maturity exceeds a period of
three years or less, the credits will be either suppliers credit or buyers credit.
4. Credit under Duty Drawback Scheme
Under the Duty Drawback Scheme, the duty that is paid on the imported inputs
or the excise duty that is paid on the goods produced for export are repaid to
the exporter when the export is completed. The banks provide a cash advance
for this period as the exporters cash is locked up during the period between the
payment of duty and the completion of export and this advance is given both at
the pre-shipment and the post-shipment stage. The time period necessary for
this advance is three months. In case of this scheme, the exporters bank gets
the duty drawback from the government in behalf of the exporter. No interest is
charged on this amount.
Activity 1
Make a report about what form of credit is provided to the exporters in
India.
Hint:
The different kinds of credit are pre-shipment credit, post-shipment
credit, medium-term credit and credit under duty drawback scheme.
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1. ____________is provided to the exporters meant for procuring raw
material, packing and processing of goods as well as for other processes
till the goods are really shipped.
2. The banks in India have also started extending the post-shipment credit
in foreign currency since____________.
3. Under the________________________, the duty that is paid on the
imported inputs or the excise duty that is paid on the goods produced for
export are repaid to the exporter when the export is completed.
7.4 Financing Imports

Financing imports relieves the importer of a huge burden and helps the importer
in overcoming the challenges of cash flow and leaves working capital free for
investments. Import finance can also be tailored to meet the funding needs of
different businesses. The most important way through which imports are financed
is through letters of credit (L/C).
A Letter of Credit includes four parties which are the applicant, issuing
bank, beneficiary and the advising bank. The importer who approaches the
bank for the issuance of the letter is known as the applicant. The issuing bank
is the one which issues the letter. Beneficiary is the exporter in favour of whom
the letter of credit is opened. The advising bank, on the behalf of the issuing
bank informs the exporter about the opening of the letter of credit.
There are different types of Letters of Credit. They are discussed as follows:
1. Revocable Letter of Credit: This is a type of credit which the issuing
bank can cancel or revoke at the request of the applicant, without the
beneficiarys consent.
2. Irrevocable Letter of Credit: This type of credit cannot be cancelled by
the issuing bank without the prior consent of the beneficiary.
3. Deferred Payment Letter of Credit: Through this credit, the beneficiary
receives the payment in installments from the issuing bank. The amount
of these installments and the time in which it has to be paid are
predetermined.
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4. Confirmed Letter of Credit: The confirmed letter of credit is a type of

credit that is guaranteed or confirmed by a bank in addition to the issuing
bank.
5. Unconfirmed Letter of Credit: Unlike the confirmed letter of credit, this
letter is not confirmed by any other bank other than the issuing bank.
6. Revolving Letter of Credit: This type of credit gets reinstated after having
been utilized once. However, it is might be limited by the overall credit
that is available or by the time period in which such credit may be utilized
or both.
7. Transferable Letter of Credit: A transferable letter of credit is one where
the beneficiary can transfer his rights to a third party. The third party is
usually the manufacturer of the goods utilizing the services of the
beneficiary as a marketer or a middleman.
8. Back-to-back Letter of Credit: This letter of credit is opened with the
security of another letter of credit. The letter of credit that acts as the
security is known as the principal credit or the overriding credit. A number
of parties are associated with this credit. They are the buyer and his bank,
the seller/manufacturer and his bank and the manufacturers subcontractor
and his bank.
9. Anticipatory Letter of Credit: Under this credit, the payment is made to
the beneficiary even at the pre-shipment stage. Two kinds of anticipatory
letters of credit are found, the red clause credit and the green clause
credit. Advance for the processing and or packing of goods and the
purchase of raw materials are given under the red clause credit and under
the green clause credit, advance is also given for warehousing and
insurance charges.
4. The most important way through which imports are financed is letters of
credit (L/C). (True/False)
5. Beneficiary is the one which issues the letter. (True/False)
6. Two kinds of anticipatory letters of credit are found, the red clause credit
and the green clause credit. (True/False)
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7.5 Documentary Collections

Every business needs cash for its successful operations. However, at the same
time cash and near cash assets are the least productive assets of a business.
The global financial manager will have to frame and maintain policies and
procedures that are necessary for an MNC to achieve an efficient flow of cash
for its operations. The elements of a cash system include collection system for
getting the cash into the MNC and the disbursement system for paying the
suppliers and other people who have to be paid in cash. These elements are
now discussed in detail.
Collection system
Collection system is designed to receive payments from buyers as soon as
possible. A collection system has five elements:
(i) The number of collection points
(ii) Location of collection points
(iii) Operations of collection points
(iv) Assignment of individual payers to collection points
(v) Information about payment to the user of the collection system
The collection system works on the concept of collection float. Collection
float is the total time lag between the mailing of the payment by the payer and
the availability of the cash in the bank.
An MNC has to measure float with respect to the time lag and the amount
involved and thereby calculate the cost involved. Float is usually measured in
amount days, which is calculated by multiplying the time lags in days by the
amount being delayed. MNCs can measure float either on each item that is
processed or on an average daily basis.
Types of collection systems
Over-the-counter collection: In this method, the payment is received in
a face-to-face meeting with the customer.
Mailed payment collection system: The payments are made through
the mode of cheques or the instruments of the payment are mailed by the
customer in response to an invoice. This type of system has all the three
floats
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Unit 7
Lock box system: Lock box is a post office box number of a company,
and the companys customers have to send their payments in the form of
the instrument
Netting: Netting is the elimination of counter payments as only the net
amount is paid. For example, if the parent company is to receive US$ 3.0
million from its subsidiary and if the same subsidiary is to get US$ 1.0
million from the parent company, the two transactions can be netted and
the subsidiary will pay US$ 2.0 million to the parent company. This will
lower the cost of transfer. Netting can be bilateral or multilateral.
Bilateral netting: If Company A exports goods to Company B for `1 million
and imports goods worth `1.5 million from Company B and their dates of
maturity are the same, both companies will have to bear the transaction
cost in case of normal movements of funds. But in case netting is followed,
it will save the transaction cost of both the companies as the cost will be
only borne by one company and also the amount will be less as the amount
of transaction has been reduced.
Multi-lateral netting: It involves netting of risk exposure among more
than two companies.
The total risk exposure without netting is `7,890,000. As a result of bilateral
netting, as shown in Figure 7.1, the total risk exposure gets reduced to
`1,710,000.
Parent
`3,50,000
`3,50,000
Subsidiary D
Subsidiary A
`50,000
`1,00,000
`1,00,000
Subsidiary B
Subsidiary C
`2,50,000
`1,60,000
Figure 7.1 Movements of Funds with Bilateral Netting
Source: Compled by Author
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Unit 7
Multi-lateral netting simplifies funds flow as only net amounts are

transferred. A further simplification is possible in such a manner that a company
is either paying or receiving a net sum. As a result, the total risk exposure gets
further reduced to `4,10,000 (see Figure 7.2).
Parent
`3,50,000
`3,50,000
Subsidiary D
Subsidiary A
`1,50,000
Subsidiary B
`4,10,000
Subsidiary C
Figure 7.2 Centralized International Cash Management
Source: Compiled by author

Centralization is not the control by headquarter but the concentration of
decision-making power at a sufficiently high level within the corporation. With
this, all information will be available at a centralized position and can be utilizedto
strengthen the position of a firm.
Cash Concentration Strategies
The parent MNC has cash distributed in all its subsidiaries spread across the
globe. Once the payments are received from customers, the firm has to make a
decision to ensure that cash is moved efficiently to a central place where it will
benefit the parent company the most. The process of collecting funds at a central
place is called concentration strategy. This will simplify the work for MNCs
whichhave to calculate short-term borrowings for its various subsidiaries. It can
also have the knowledge about the excess cash that can be invested in shortterm marketable securities. The parent MNC would have to accelerate the
collections from within a home country and across borders, i.e. from the host
country. Collecting cash from different subsidiaries without any delay is a key
element of international cash management.
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Disbursement system
A firm can optimize its working capital requirement by managing both its
receiptsfrom customers and payments to be made to vendors. It can reduce its
cash requirement by delaying the payments as much as possible or by matching
the dates of cash receipts with cash payments. Disbursement system includes
banks and the delivery procedures that an MNC uses to facilitate the movement
of cash from the centralized cash pool to the disbursement banks and then to
the suppliers.
Cash planning
A good reporting system between various subsidiaries and the parent company
is a must for successful coordination of cash and marketable securities. Cash
receipts at various locations must be summarized and reporting to the parent
should be done in a comprehensive and accurate manner. A multinational cash
mobilization system should be framed to optimize the use of funds by using
current and near-term cash positions.
Liquidity management
When an MNC is able to achieve efficiency in cash-flow management, it should
focus on the management of liquidity of its assets. An MNC aims to achieve the
lowest possible funding cost on debits and the highest possible return on invested
cash. A cash-flow forecast is prepared to help the MNC to have an idea about
cash balances that would have to be managed.
Cash management structures
There are four stages in a companys evolution from a decentralized organization
to a centralized cash management organization. Lesser centralized the cash
management model is, greater the gains a company can achieve.
1. Decentralized liquidity and cash-flow management: If the MNC follows
a fully decentralized cash management policy, each subsidiary would be
allowed to maintain its cash position on its own. It will not be affected and
also would not affect the cash positions of its sister concerns and even
the parent company. The cash manager will have complete independence
of managing the operations of the subsidiary.
2. Centralized liquidity and decentralized cash-flow management: If the
parent MNC follows this model, liquidity of the group will be managed
centrally by it. This model can operate with or without delegation of the
cash function to a local financial representative of the subsidiary.
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3. Decentralized liquidity and centralized cash-flow management: In

this policy, cash-flow management is managed by a transaction centre
which has a single pipeline to the bank for settlement by way of the
appropriate local clearing mechanism. Each subsidiary manages its
liquidity at its own level without being affected by the liquidity of other
subsidiaries in different countries. This policy is used in multi-currency
environments, but it is unlikely to be used in the Euro zone.
4. Centralized liquidity and centralized cash-flow management: In this
policy, all activities are centralized. The parent company acts on behalf of
the local operating companies and provides full administration of both
liquidity and cash flow to them. It agrees to specific service levels with the
individual operating companies and maintains a single pipeline to a panEuropean bank.
Degree of centralized
liquidity management
High
Degree of centralized
cash flow management
Low
1
I
II
Low
3
4
High
III
IV
Figure 7.3 Centralized Liquidity and Centralized Cash Flow Management
7. The collection system works on the concept of____________.
8. ________________________is a post office box number of a company,
and the companys customers have to send their payments in the form of
the instrument.
9. A________________________ is prepared to help the MNC to have an
idea about cash balances that would have to be managed.
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7.6 Factoring and Forfeiting

Formulation of a credit policy of an MNC has to manage the receivables in
international trade. The procedure of credit evaluation for overseas customers
and credit granting decision is a specialized field. The credit policy of MNC lays
down the parameters that will help the manager to decide whether to grant
credit to a particular party or not. It also helps in determining the length of period
for which credit can be extended to the customer and what will be the discount
and to what extent efforts are to be made for the collection of receivables.
Creditworthiness of an applicant is judged by the three Cs. For checking
the creditworthiness, a company needs to check (1) character, (2) capacity and
(3) collateral. Character represents the willingness to pay, capacity means the
ability to pay and collateral means the security offered by the firm in the form of
mortgages.
Generally, the payment is received by an exporter after a couple of days
of the shipment and during this period, the export is considered as account
receivables. There is also the possibility that the exporter might face bad debt
loss for which the exporter sells its receivables without recourse to a bank. This
helps them in avoiding collection expenses and getting immediate payment for
export. This procedure of selling receivables is known as factoring. After the
selling is done, it is the responsibility of the bank to collect the amount from the
importer. The bank usually purchases the receivables at discount and receives
a flat processing fee as the bank faces the risk of non-payment and also has to
make the payment of the collection charges.
One of the most essential credit management strategies to be evolved is
to carry out effective Forfeiting services. Forfeiting is a fund-based financial
service that provides resources to finance receivables as well as facilitates the
collection of receivables. Forfeiting is a type of finance of receivables that arise
due to international trade. In this technique, a bank or a financial institution
buys trade bills/promissory notes of a firm involved in business of export-import
without recourse to the seller. The buyer of the bills is called the forfeiter. The
forfeiter would purchase the assets by discounting the documents that cover all
the risks of non-payment in collection. It is the responsibility of the forfeiter to
cover all risks and collection problems. The forfeiter pays cash to the seller
after discounting the bills. A cross-border factoring has common features of
non-recourse and advance payment. The entire value of the note/bill is
discounted by a forfeiter. So there is 100 per cent financing arrangement of
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receivables finance. The availing bank that provides an unconditional and

irrevocable guarantee is a critical element in the Forfeiting arrangement. The
forfeiters decision to provide financing depends upon the financial standing of
the availing bank. Forfeiting is a pure financing arrangement. It includes ledger
collection, administration, etc. Forfeiting finances notes/bills arising out of
deferred credit transactions spread over three to five years.
The increase in the threshold of credit increases the sales and profits,
and the contraction of credit will lead to less sales. It will increase the
administrative costs incurred in the collection of debts from customers globally.
Now we will discuss the main highlights of Forfeiting as a form of export-linked
financing.
As per the agreement made in a commercial contract between an exporter
and an importer, goods are sold and delivered by the exporter and the importer
receives them on the deferred payment basis. Now in turn, the importer draws
a series of promissory notes in favour of the exporter for payment including the
interest charge. The other way is that the exporter draws a series of bills which
are accepted by the importer. The bills/notes are sent to the exporter. These
bills/notes are guaranteed by a bank. The bank may not necessarily be the
importers bank. The guarantee by the bank is called an Aval. An Aval is defined
as an endorsement by a bank guaranteeing payment by the buyer (importer).
The exporter enters into a forfeiting arrangement with a Forfeiter which is
usually a reputed bank including exporters bank. The exporter sells the availed
notes/bills to the forfeiter at discount recourse. The agreement between the two
parties provides for the basic terms of the arrangement such as cost of forfeiting
margin to cover risk, days of grace, commitment charges, period of forfeiting
contract, fee to compensate the forfeiter for loss of interest due to transfer and
payment delays, installment of repayment, usually bi-annual installment, and
rate of interest. The rate of interest/discount charged by the forfeiter depends
upon the terms of the note/bill, the currency in which it is denominated, the
country risk of the importer, the credit rating of the availing bank. In case of
payment to forfeiter by the exporter of the face value of the bill/note has less
discount, the forfeiter may hold these notes/bills till maturity for payment by the
importers bank. Alternatively, he can also secure them and sell the short-term
paper in the secondary market as a high-yielding unsecured paper.
Based on the features built into the Forfeiting deal to cater to the varying
needs of the trade/clients in international trade, it offers several advantages to
a client. The advantages include (1) reduction in current liabilities, (2) off-balance
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sheet financing, (3) higher credit standing, (4) progress in current ratio, (5)
improved efficiency, (6) reduction of costs, (7) additional sources of funds, and
so on.
Activity 2
Browse the Internet and find out the list of companies offering factoring in
India. Also make a report of their operation and mechanism.
Hint:
A financial transaction through which a business sells its accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount
is known as factoring.
10. The credit policy of MNC lays down the parameters that will help the
manager to decide whether to grant credit to a particular party or not.
(True/False)
11. Forfeiting finances notes/bills arising out of deferred credit transactions
spread over three to five years. (True/False)
7.7 Countertrade
Thousands of years ago, the concept of bartering between parties was prevalent,
when the concept of money had not evolved. A person could give say 100 bags
of wheat and get wood or coal, a certain quantity for cooking. These bartering
contracts were between individuals or small kingdoms. Bartering exists today
also but at different level. For example, Iran may give 100 million barrels of oil to
France and get 5000 guns of certain type in exchange. We can say that bartering
is exchange of goods between parties as per agreed terms without the use of
money.
Today, most business is transacted with money as medium. Trading
between countries is through respective currencies using international exchange
rate. Countertrade means all types of foreign trade in which the sale of goods to
another country is associated with parallel purchase of some other goods from
that country.
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The level of international trade is going up every year. All countries are
trying to export what they can in order to earn foreign exchange to be in a
position to import what they need. The prosperity and living standard of general
population of a country depends a great deal on the total exports made by the
country.
In this back drop, the industrially advanced countries are at advantage as
high technology products like computers, machines, arms, helicopters,
aeroplanes,etc,are required by all countries. The importing countries in many
cases are not in a position to make huge payments for such items. So, it is in
the interest of both parties to agree to accept an arrangement where either full
or part of the payment is made through export of some other item which the
country can supply.
In countertrade, there is exchange of goods between two parties in different
countries under two separate contracts in money terms. Delivery and payment
of the two contracts are independent transactions. Countertrade deals are mostly
negotiated and executed either at government to government level or between
organisations with approval of respective governments. Countertrade takes many
different forms as explained below:
(i) Barter: It is exchange of goods without the use of money. Typical examples
are:
(a) Oman exchange oil for airconditions with Taiwan
(b) Sri Lanka exchange fish for mobile hand sets with Germany
(ii) Buy back: In this part, the payment of the price of contract is through
supply of related products. Typical examples are:
(a) A firm in China purchases plant & technology for manufacture of
high precision bearings from Germany,and the firm in Germany
agrees to buy a part of bearings produced by the plant in China.
(b) An Indian aerospace firm sets up production facility for manufacture
of executive jets under technical collaboration from an American firm
who in turn agrees to provide a part of worldwide business of
overhauling of executive jets to the Indian firm.
(c) A firm establishes gas pipeline for another firm to transport gas and
produce electricity and in turn agrees to buy a portion of electric
power for prolonged period at predetermined terms.
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(iii) Counter purchase: In such cases, there is direct purchase of items as

exchange deals. Typical examples are:
(a) A firm in US sold soft drinks to Russian counterpart and imported
vodka in exchange.
(b) Canada sold wheat to Indonesia in exchange for import of rubber.
(c) A German firm sold machine tools to a firm in Romania in exchange
for import of hosiery items.
Examples of countertrade are many and in a variety of forms. Though
countertrade is existing to create win-win situation between parties involved, it
has its own ills; typically following issues are existing:
1. The exporting country sells high technology items at inflated prices and
the items which they import are disposed off to other countries at a
discount, using a part of high premium charged on their exports.
2. The middlemen in the countertrade agreements are usually shrewd traders
who exploit the political and social circumstances to obtain large gains for
themselves.
3. The goods that are offered in countertrade are not the required items,
because the desirable items have already been exported. For example, if
Switzerland sells high precision machines to Brazil, it may like Brazilian
coffee beans in exchange, but what it may get is only leather goods.
What in principle is a good idea to export your items to another country
and accept something else in countertrade which the other country can offer,
has been often misused. Price manipulations, routing the product imported from
one country to another country, mis-representation of facts by middlemen for
their own gains, excessive discussions/negotiations between firms / governments
with less resulting action makes the whole process inefficient. Technologically
advanced developed countries are trying to exploit weaker and less developed
countries through these trades. Time has come where weaker countries must
develop their own strength and export their own goods in the international market
based on quality and prices instead of taking the shelter of countertrade.
Notwithstanding what is said above, countertrade is there to stay and it
may take very long time before all international trades are independently handled
on their own strength.
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12. In______________________, there is direct purchase of items as
exchange deals.
13. In_____________, there is exchange of goods between two parties in
different countries under two separate contracts in money terms.
7.8 Case Study

Goodbye to Govt-to-Govt trade
A couple of years ago, it was not possible for India to sell rice due to pricing
issues. As the grain inventories touched 80 million tonnes in May-June
2012, it was expressed by the Indian authorities that they intended to
conclude Government to Government (G to G) deals in order to export
wheat to some African and West Asian countries. Though the Indian
government, through STC/PEC from FCI stocks agreed to supply three
lakh tonnes of rice and two lakh tonnes of wheat to the Government of
Bangladesh in 2010-11, no agreement on the pricing and other commercial
terms were made. This was because FCI prices needed that acute
subsidization should be carried out in order to structure the deal. GOI,
considering the sensitivity on food matters refused to offer concessional
rates to Bangladesh and bilateral negotiations were also terminated.
Bangladesh, nevertheless, sourced grains from international traders. The
Ministry of Food, GOI, initiated discussions on the criteria of government to
government trade for importing 0.5 million tonnes of pulses from Myanmar
in 2008-09. However, it was demanded by Myanmar that an advance amount
in US dollars should be paid to them before affecting supplies. They in the
meantime kept their pricing open as per their commercial convenience.
The proposition fell through. Later, pulses were imported by Indian Public
Sector Undertakings (PSUs) at market prices via Singapore traders at
market prices on government account.
Since some time, India has been approaching Iran for a wheat deal for
offsetting the import of crude oil, under rupee payment. In a similar way,
Pakistan is pursuing Iran for a wheat deal for the barter of urea. Phytosanitary
concerns related to wheat have stalled commercial activity on a G to G
basis, while from countries like US/Australia/Russia, it has contracted more
than 3 million tonnes. However, other commodities such as sugar, soy meal,
and tea are being profitably exported by India to Iran and this in turn is
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offsetting crude payments partially. Thus, the above examples suggest that
G to G deals take place when a country is not capable of selling its product
on internationally competitive terms. In todays world, when information
regarding almost everything is available on the Internet, it is not possible to
keep the pricing and contractual terms opaque. Overpriced commodities
cannot be bought and the cargoes that are priced below the market datum
cannot be sold even by state agencies. It is also known that behind the
faade of Government deals, private trade is active most of the time. This
leads to the buying nations becoming overcautious and it is not possible to
formalize deals unless it is advantageous. Since the deals are offered by
the traders on a marked to market values, they are neither cheap nor
expensive and, thus, there can be no point of questions being asked.
Many countries do not undertake any G to G business. For instance,
countries like Indonesia or South Africa do not offer coal on G to G basis.
Australia and the US do not make such unworkable propositions either.
Though Russia was the hub of socialism not too long ago, it also sells
grains at market-determined prices. There is a clear distinction between G
to G understanding and barter/counter-trade, or offset mechanism. Such
kinds of agreements were beneficial in periods such as from 1960 to 1990.
India also imported defence equipment in rupees due to the non-availability
of the NATO-compatible armaments to our armed forces. Deals were carried
out in secret and commodities such as coffee, rice, etc., could be exported
in rupees at a premium to the Soviet bloc. However, with time such deals
have ceased to exist and now due to the transparency that exists due to
the web, media and newswires, secrecy in carrying out such deals has
been demolished. Audit and vigilance are overactive and thus any statesponsored deal is not possible. Thus, the existence of government to
government mechanisms is coming to an end, whether on commercial terms
or barter of some sort.
Questions
1. Government to Government (G to G) deals take place when a country
is not capable of selling its product on internationally competitive terms.
Do you agree?
2. Why do you think countries like the US and Australia do not make
deals for import and export?
article3628083.ece?homepage=true
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7.9 Summary
The main aim of the government programs is to improve the access of
the exporters to credit rather than subsidizing the cost at below-market
levels.
Financing imports relieves the importer of a huge burden and helps the
importer in overcoming the challenges of cash flow and leaves working
capital free for investments.
A Letter of Credit includes four parties which are the applicant, issuing
bank, beneficiary and the advising bank.
The credit policy of MNC lays down the parameters that will help the
manager to decide whether to grant credit to a particular party or not.
In countertrade, there is exchange of goods between two parties in different
countries under two separate contracts in money terms.
7.10 Glossary
Subsidize: Having partial financial support from public funds
Denominated: To be expressed in terms of a particular currency unit
Disbursement: Payment of money
Float: Shares that are publicly owned and are available for trading
Invoice: A commercial document issued by a seller to the buyer
Netting: Settlement of obligations between two parties processing the
combined value of transactions
Subsidiary: A wholly or partially owned company that is part of a large
corporation
Aval: It is defined as an endorsement by a bank guaranteeing payment
by the buyer (importer)
Receivables: Money that a customer owes a company for a good or
service purchased on credit
Forfeiting: It is a fund-based financial service that provides resources to
finance receivables as well as facilitates the collection of receivables
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1. Explain the different forms of credit provided to the exporters.
2. What are the different types of letters of credit? Discuss.
3. Define a collection system.
4. Define factoring.
5. What is forfeiting? State the advantages of forfeiting.
6. Define countertrade. Discuss the different forms of countertrade.
7.12 Answers
2. January 1992
3. Duty Drawback Scheme
4. True
5. False
6. True
7. Collection float
8. Lock box
9. Cash-flow forecast
10. True
11. True
12. Counter purchase
13. Countertrade

1. There are different forms of credit that are provided to the exporters.
They are as follows:
Pre-shipment credit
Post-shipment credit
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Medium-term credit
Credit under duty draw-back scheme
2. The different types of Letters of Credit are:
Revocable letter of credit
Irrevocable letter of credit
Deferred payment letter of credit
Confirmed letter of credit
Unconfirmed letter of credit
Revolving letter of credit
Transferable letter of credit
Back-to-back letter of credit
Anticipatory letter of credit
3. Collection system is designed to receive payments from buyers as soon
as possible.
4. A financial transaction through which a business sells its accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount is
known as factoring.
5. Forfeiting is a fund-based financial service that provides resources to
finance receivables as well as facilitates the collection of receivables.
6. Countertrade means all types of foreign trade in which the sale of goods
to another country is associated with parallel purchase of some other
goods from that country.
The different forms of countertrade are:
Barter
Buy-back
Counter purchase
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Unit 7
Sharan, Vyuptakesh. 2012. International Financial Management.Sixth
Publishing.
http://www.unzco.com/basicguide/c13.html
Page No. 156
Unit 8
Nature and Measurement of Foreign

Exchange Exposure
Structure
8.1 Caselet
8.2 Introduction
Objectives
8.3 Meaning of Exposure
8.4 Types of Exposure
8.5 Measuring Economic Exposure
8.6 Translation Methods
8.7 Case Study
8.8 Summary
8.9 Glossary
8.11 Answers
8.1 Caselet
Maruti aims to cut forex exposure to $600 mn by Mar 2015
With adverse currency movements affecting margins, car market leader
Maruti Suzuki India is targeting to reduce its forex exposure by nearly 65%
to $600 million by March 2015, for which it is working with its vendors to
reduce imports. Besides, the company is looking out for new markets to
increase exports of its products to ease the impact of unfavourable foreign
exchange fluctuations. The reason given by the sources is that the adverse
currency movements are affecting their bottomline. Hence they are planning
to reduce their net forex exposure to $0.6 billion by 2014-15 fiscal from
about $1.7 billion at present. The companys current foreign currency
exposure, along with its vendors, due to import is $2.5 billion.
They have identified 14-15 vendors, whose import content is very high,
and requested them to reduce it. They are also providing them all help for
localization of their products. The aim is to bring down the import content to
$1.8 billion in the next three years. On the export front, the companys
exposure at present is around $800 million. Sources reveal that the company
is on a lookout for newer markets for expanding their exports and are aiming
to increase the exports to $1.2 billion by 2014-15.
Unit 8
Hit by rupee depreciation and higher overall expenses, MSI had reported
22.84% decline in its net profit to `423.77 crore for the quarter ended June
30 this year. Rupee devalued this year drastically and crossed `56 against
each dollar. However, on the back of robust capital inflows and persistent
dollar selling by exporters and some banks, the rupee has risen by 35
paise to over four-month high of 53.10 against the American currency in
the month of September, 2012.
The management is focused on lowering forex exposure over the next
three years and it expects at least 25-30% savings on localized components.
The key components targeted for localization are diesel engine and
transmission components. MSI has also set localization targets for the
vendors, who have very high import content, unlike in the past where it
used to compensate them for adverse forex movement. Led by higher
exports and increased localization, margins are expected to rise by about
10% by FY16.
Source: Adapted from http://www.business-standard.com/india/news/
maruti-aims-to-cut-forex-exposure-to-600-mn-by-mar-2015/188195/on
Accessed on 6 October 2012
8.2 Introduction
In the earlier unit, you learnt about foreign trade finance and the ways of exporting
and importing finance. You also learnt about documentary collections, factoring
and forfeiting and countertrade.
Michael Adler and Bernard Dumas have defined foreign exchange
exposure as the sensitivity of changes in the real domestic currency value of
assets, liabilities or operating incomes to unanticipated changes in exchange
rates. In this unit, you will learn about the nature and measurement of foreign
exchange exposure. You will also learn about the different types of exposures
and the various types of translation methods used.
Objectives
define foreign exchange exposure
discuss the types of foreign exposure
explain the measures for economic exposure
discuss the translation methods
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8.3 Meaning of Exposure

The foreign exchange exposure of a firm can be defined as a measure of the
sensitivity of its cash flows to changes in exchange rates. Due to the difficulty of
measuring cash flows, exposure is examined by most of the researchers through
the study of how a firms market value responds to the changes in the exchange
rates.
The value of a currency in a floating exchange-rate regime changes
frequently and these changes influence the value of those firms involved in
international transactions. A number of changes occur in regards to the value of
their assets and their liabilities in addition to their cash flow. This, in other words,
means that they face foreign exchange exposure.
According to Michael Adler and Bernard Dumas, foreign exchange
exposure is the measure of the sensitivity of changes in the real domestic
currency value of assets, liabilities or operating income to unanticipated changes
in exchange rates. In the case of domestic currency, a firms values of assets,
liabilities and operating incomes are exposed to the effects of the changes in
the values of other factors along with the effects of exchange rate fluctuations.
Theoretically, foreign exchange exposure is the result of the difference
between the actual change in the exchange rate and the anticipated change.
For instance, if a firm has fixed that the price of the product will be exported on
a 30-day credit keeping into account the changes that have been anticipated in
the value of its home currency relative to a foreign currency, then the exporter is
free from foreign exchange exposure. But in case there is a change in the
foreign exchange rate from what had been expected, then the exporter will
have to face foreign exchange exposure.
From this, it can be concluded that the value of assets, liabilities or
operating income needs to be denominated in the functional currency of a firm
which is also the primary currency of the firm and in which the financial statements
are published. While theoretically, the correct way of defining exposure is with
respect to the real values, due to the difficulty of dealing with an uncertain
inflation rate, this is often ignored and the exposure is estimated with reference
to changes in nominal values.
However, there are different views in regards to the exchange rate
exposure. While one section opines that any talk of exchange rate exposure is
irrelevant, other section talks in favor of the exchange rate exposure. This
argument is based on the PPP theory which explains that the movement in
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Unit 8
exchange rate is matched by the movement in the price and thus there is no
impact on the financial performance of a firm.
The other argument states that the exchange rate exposure is very relevant
as the PPP theory is not very relevant in the short term. They state that there
are many other factors other than the inflation rate differential that affect the
exchange rate. For instance, if the exchange rate changes due to some other
factors then the resulting factor will not match the changes in the inflation rate
differential which means that the exchange rate exposure does matter.
Also the instability in exchange rate will lead to instability in the growth of
a firm which might lead to bankruptcy. For this, reason, firms are very careful
with regards to the exchange rate and they apply various hedging tools to protect
themselves from the foreign rate exposure.
Activity 1
Browse the Internet and find out the difference between foreign exchange
exposure and foreign exchange risk.
Hint:
Foreign Exchange exposure is the measure of sensitivity whereas
foreign exchange risk is a variance.
1. The value of assets, liabilities or operating income needs to be
denominated in the____________ of a firm which is also the primary
currency of the firm and in which the financial statements are published.
2. The PPP theory explains that the movement in ____________is matched
by the movement in the price and thus there is no impact on the financial
performance of a firm.
8.4 Types of Exposure

There are different types of exposure to which a particular company-domestic or
internationalis exposed to. The types of exposure are related to two parameters:
1. One is related to the time of the transactions, the transactions and the
flows of money (payment and receivables) related to them and the other
one to the aspect of conducting international business in host countries.
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2. The second one is based on the analysis of how to reconcile the balance
sheet of the subsidiary company with that of the parent companys balance
sheet.
The types of exposure are broadly divided into economic and translation
exposure. Economic exposure is further divided into transaction exposure and
operating exposure.
8.4.1 Economic Exposure

The potential changes in all future cash flows of a firm resulting from
unanticipated changes in the exchange rates are referred to as economic
exposure. The monetary assets and liabilities, in addition to the future cash
flows, get influenced by the changes in foreign exchange rates.
Of all the three exposures, economic exposure is the most important, as
it has an impact on the valuation of a firm. Suppose a Japanese company imports
children toys from India. The same product is also available from China but it is
costly. If the rupee appreciates against the yen and the Chinese currency
decreases against yen, Japan will prefer to import the toys from China as it will
get at a cheaper rate.
Since economic exposure comes from unanticipated changes, its
measurement is not as precise as those of transaction and translation exposures.
There are two components of economic exposure transaction.
(a) Transaction Exposure
(b) Operating Exposure
(a) Transaction exposure
Transaction exposure is concerned with the impact of change in exchange rate
on present cash flows. Transaction exposure emerges mainly on account of
export and import of commodities on open account, borrowing and lending in a
foreign currency and intra-firm flows within an international company.
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Transaction exposure measures profits or losses that occur once the

existing financial obligations as per the terms of reference are settled. Given
that the transaction will result in a future foreign currency cash inflow or outflow,
any unanticipated changes in the exchange rate between the time the transaction
is entered into and the time it is settled in cash will lead to a change value of the
net cash flow in terms of the home currency. Examples of a transaction exposure
of an Indian company would be the account receivable associated with a sale
denominated in US dollars or the obligation of an account payable in Euro debt.
(b) Operating exposure
Operating exposure has an impact on the firms future operating costs and
cash flows. Since the firm is valued as a going concern entity, its future revenues
and costs are to be affected by the exchange rate changes. If the firm succeeds
in passing on the impact of higher input costs fully by increasing the selling
price, it does not have any operating risk exposure as its operating future cash
flows are likely to remain unaffected. In addition to supply and demand elasticity,
the firms ability to shift production and sourcing of inputs is another major factor
affecting operating risk exposure.
Sensitivity of future operating cash flows to unexpected changes in the
foreign exchange rate is known as the operating exposure. In other words, it
arises when the changes in the exchange rate in addition to the rates of inflation
changes the risk element and the amount of the companys future revenue and
cost stream. The word operating means the change in the operating cash flow
which leads to change in the value of the firm. It is not very easy to measure
real operating exposure as far as the measurement of the inflation rate differential
is not easy, more so when countries are going through a phase when they
experience a highly volatile rate of exposure.
Operating exposure analysis assesses the impact of changing exchange
rates on a firms own operations over coming months and years and on its
competitive position vis--vis other firms. The goal is to identify strategic moves
or operating techniques that the firm might wish to adopt to enhance its value in
the face of unexpected exchange rate changes.
Suppose an Indian MNC, such as Videocon, has sales in India, United
States, China and Europe and therefore, posts a continuing series of foreign
currency receivables (and payables). Sales and expenses that are already
contracted for are traditional transaction exposures. Sales that are highly
probable based on the Videocons historical business line and market share but
have no legal basis yet are anticipated transaction exposures. Let us extend
the analysis of the firms exposure to exchange rate changes even further into
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the future. The analysis of this longer term, where exchange rate changes are
unpredictable and, therefore, unexpected, is the goal of operating exposure
analysis. From a broader perspective, operating exposure is not just the
sensitivity of a firms future cash flows to unexpected changes in foreign
exchange rates, but also to its sensitivity to other key macroeconomic variables.
This factor has been labelled as macroeconomic uncertainty.
Some firms face operating exposure without even dealing in foreign
exchange. Consider an Indian perfume manufacturer who sources and sells
only in the domestic market. Since the firms product competes against imported
perfumes (say from Paris) it is subject to foreign exchange exposure. It faces
severe competition when rupee gains against other currencies (here, euro),
lowering the prices of imported perfumes.
8.4.2 Translation Exposure

Translation exposure, which is also known as accounting exposure, emerges
on account of consolidation of financial statements of different units of a
multinational firm. The parent company is normally interested in maximizing its
overall profitability and to make it possible, it consolidates the financial statements
of its subsidiaries with its own.
Whatever may be the objective of consolidation, it is done through
translating the items of the financial statements of subsidiaries denominated in
different currencies into the domestic currency of the parent company. When
the currency of any of the host countries changes its value, it is translated into
a value in the domestic currency of the parent company. The extent of this
change represents the magnitude of translation exposure. If the subsidiary
maintains its account in the reporting currency, i.e., the domestic currency of
the parent company as is sometimes done by the extended departments of a
firm abroad, the translation exposure does not emerge. Normally though, the
subsidiaries maintain their accounts in a functional currency that is normally the
currency of the host country, there is every possibility for the translation exposure
to emerge in the wake of exchange rate changes. It is sometimes argued that
the translation exposure is irrelevant, because it does not influence the cash
flow, nor is the subsidiaries earning actually converted into the parents currency.
However, since the change in the value of the currency of the host countries
has an impact on the net worth of the firm as a whole, measurement of the
accounting exposure is highly relevant.
The size of accounting exposure depends no doubt on the extent of change
in the value of related currencies, it also depends upon the extent of involvement
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of subsidiaries in the parents business on the location of the subsidiaries in

countries with stable or unstable currency and on the methods that are used in
the translation of currencies. The larger the involvement of subsidiaries in the
parents business, the greater will be the exposure. Again, if the subsidiaries
are located in countries where the currency is highly unstable, the accounting
exposure will be large.
3. Operating exposure has an impact on the firms future operating costs
and cash flows. (True/False)
4. Economic exposure is divided into translation exposure and operating
exposure. (True/False)
5. When the currency of any of the host countries changes its value, it is
translated into a value in the domestic currency of the parent company.
(True/False)
8.5 Measuring Economic Exposure

A firm involved in international business faces a higher degree of exposure to
exchange rate fluctuations than a purely domestic firm. It is also difficult to
assess the economic exposure of an MNC as there is a complex interaction
funds flowing into, out of and within an MNC. Economic exposure is very
important for the functioning of the firms in the long run. In case an MNC has
subsidiaries around the world then the fluctuations in currencies will affect the
subsidiaries.
One method of measuring the economic exposure of an MNC is through
classification of cash flows into different items on the income statement and
prediction of movement of each item in the income statement that is based on
a forecast of exchange rates. This will facilitate the development of an alternative
exchange rate scenario. It will also help in revising the forecasts of the income
statement items. Depending on the change in the forecasts for the economic
statement items, it will become possible for the firm to assess the influence of
currency movements on cash flows and earnings.
The economic exposure is further divided into transaction exposure and
real operating exposure. Transaction exposure refers to the foreign exchange
loss or gain on transactions already entered into and denominated in a foreign
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currency, as a result of changes in the exchange rate. In other words, transaction

exposure is concerned with the changes in the present cash flows. Real operating
exposure, on the other hand, is related to changes in future cash flows. It is
concerned with the impact of exchange rate changes along with the changes in
inflation rate on the cost and revenue structure of a firm.
Transaction exposure on account of trade is divided into three parts. The
first part, known as quotation exposure, is created when the exporter quotes a
price in foreign currency and exists till the importer places on order with the
exporter at that price. The second part is backlog exposure that exists between
the placement of an order by the importer and the shipping and billing by the
seller. The third part is the billing exposure and exists between the billing of the
shipment and the settlement of the trade payments (Eiteman, et al., 1995).
Borrowing and lending in a foreign currency
Transaction exposure emerges also when borrowing or lending is done in a
foreign currency. If the foreign currency appreciates, the burden of borrowing
will be greater in terms of domestic currency, while if the foreign currency
depreciates, the burden will be lower. Similarly, the receipt of the lender in case
of the foreign currency will be larger in terms of the domestic currency. If foreign
currency depreciates, there will be loss to the lenders in terms of domestic
currency. It is not only the principal but also the amount of interest that changes
owing to changes in the exchange rate.
Intra-firm flow in an international company
In case of international companies, when funds flow among the different units
that are located in different countries, any change in the exchange rate alters
the value of cash flow. Suppose, the Indian subsidiary of an American firm has
declared a dividend and it has to repatriate it to the parent company. If in the
meantime, the rupee depreciates, the amount of dividend to be received by the
parent company in dollar terms will be lower and this will amount to a loss to the
parent company. If the exchange rate moves the other way, there will be gain of
the parent company.
6. ___________ ___________ refers to the foreign exchange loss or gain
on transactions already entered into and denominated in a foreign currency,
as a result of changes in the exchange rate.
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7. Real operating exposure is related to changes in___________________.

8. ___________ ___________ is created when the exporter quotes a price
in foreign currency and exists till the importer places on order with the
exporter at that price.
8.6 Translation Methods

The methods of translation vary as they are not unanimous on the items of the
financial statement which are exposed to changes in the exchange rate. Every
method has its merits and demerits. A particular method is used depending
upon the circumstances and the legal and accounting procedures adopted in a
particular country. The methods are:
Current rate method
Current/non-current method
Monetary/non-monetary method
Temporal method
Current rate method
The current rate method is also known as the closing rate method. In this method,
all items of the income statement and the balance sheet are translated at current
rate or the post-change rate. This method is preferred in case of those host
countries where the local currency accounts are periodically adjusted for inflation.
The translation exposure in this case is simply the net worth of the affiliate as
stated in local currency.
The merit of this method is that the relative proportion of individual balance
sheet accounts remains the same and the process of translation does not distort
the various balance sheet ratios. However, the demerit is that the fixed assets are
also translated at current rate and that goes against the principles of
accounting.
Under this method, current assets and current liabilities of the subsidiary are
translated at current rate or the post-change rate. The fixed assets and longterm liabilities are translated at the historical or pre-change rate or at a rate at
which they were acquired. In fact, this approach is based on traditional accounting
that makes a clear-cut distinction between current and long-term items. The
magnitude of the exposure is measured by the difference between current assets
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and current liabilities, that is, the subsidiarys working capital. The critics of this
approach opine that the long-term debt which is also exposed to exchange rate
change is ignored by this method. This is perhaps the reason that this method
is not frequently used.
As far as the income statement items are concerned, they are translated
at the average rate of exchange - the average of the pre-change and the postchange rates. However, there are a few income statement items which by virtue
of being closely related to non-current assets and long-term liabilities are
translated at the pre-change rate.
Under the monetary/non-monetary method, the assets and liabilities are classified
as monetary and non-monetary. Items that represent a claim to receive or an
obligation to pay, a fixed amount of foreign currency, such as cash, accounts
receivable, accounts payable, etc. come under the monetary group, while the
physical assets and liabilities, such as fixed assets, inventory and long-term
investment are treated as non-monetary items. The monetary assets and
liabilities are translated at current rate, while the non-monetary items are
translated at historical rate. The translation exposure under this method is
measured by the net monetary assets or by the difference between the monetary
assets and the monetary liabilities.
As far as the income statement items are concerned, they are translated
at an average rate and those closely related to non-monetary assets and liabilities
are translated at historical rate.
Temporal method
The temporal method uses historical rate for the items that are stated at historical
cost. Fixed assets, for example, are translated at historical rate but items that
are stated at replacement cost, realizable value, and market value or expected
future value, are translated at current rate. This is done in order to preserve the
value of assets and liabilities as shown in the original financial statement. As
regards income statement items, the same norm is applied as in the monetary/
non-monetary method.
The temporal method to a great extent resembles the monetary/nonmonetary method. The main difference is that under the temporal method,
inventory is translated at current rate if it is shown at market value. In the
monetary/non-monetary method, it is translated at historical rate in all
probabilities.
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Unit 8
Let us now understand the translation methods with examples by bringing

in the income statement of a company and showing how translation would be
different for different methods.
Balance Sheet
Items
Rupee:
Local
Currency
Current Rate = `50/US $
Historical
Rate =
`30/US $
Current Rate current/non-current monetary/non- temporal

monetary
Current assetsinventory
Inventory (market
value)
Fixed assets(net
of depreciation)
2000
67
40
40
40
40
4000
133
80
80
133
80
4000
133
80
133
133
133
Goodwill
1000
33
20
33
33
33
Total assets
11000
366
220
286
339
286
Current liabilities
4000
133
80
80
80
80
Long term debit
3000
100
60
100
60
60
Share capital
Retained earnings
(asset s-liabilities)
2000
67
40
67
40
40
2000
67
40
39
159
80
Total liabilites
Translation gains
(loss)
11000
366
220
286
339
260
-27
-11
33
13
Literature on the subject often explains accounting exposure not only in

terms of the impact of exchange rate changes on the book value of assets and
liabilities, but also in terms of real balance sheet exposure that arises when a
firms real net asset position is affected by the exchange rate changes (Click
and Coval, 2002). What is real net asset position? It is the market value of total
assets net of the market value of liabilities. It shows the real value of the balance
sheet as it is based on the market value and not on the book value. For measuring
the net worth exposure, one needs to distinguish between the monetary assets
and non-monetary assets. Monetary assets earn national returns manifest in
the interest rates. The Interest Rate Parity Theory suggests, among other things,
that the depreciation in currency is matched by a rise in interest rate. So if the
value of a monetary asset of the subsidiary falls in terms of the parent country
currency in the wake of the currency depreciation in the host country, that
monetary asset will be earning higher interest to compensate the loss in the
value. If the loss in the value is exactly matched by the gain in terms of interest,
there will be no net worth exposure insofar as it does not represent a deviation
from the Interest Rate Parity Theory. Net worth exposure will arise only when
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Unit 8
there is unanticipated deviation from the interest rate parity meaning that the
loss/gain on account of exchange rate changes is not exactly matched by
changes in interest rates.
Similarly, in case of non-monetary assets, net worth exposure will arise
only when there is deviation from the PPP Theory. If inflation is higher in India
than in the USA, rupee will depreciate vis--vis US dollar. If depreciation is
matched by a rise in the market price of the asset, there is no net worth exposure.
The net worth exposure will arise only when the rise in the asset price is not
matched by the deprecation in rupee.
Activity 2
Make a chart and write down the differences between the translation
methods.
Hint:
The different types of translation methods are current rate method,
current/non-current method, monetary/non-monetary method and
temporal method.
9. A particular method is used depending upon the circumstances and the
legal an d accounting procedures adopted in a particular country. (True/
False)
10. Under the monetary/non-monetary method, current assets and current
liabilities of the subsidiary are translated at current rate or the post-change
rate. (True/False)
11. The temporal method uses historical rate for the items that are stated at
historical cost. (True/False)
8.7 Case Study

Watch Out for Currency Manipulators
The reason behind the volatility of rupee is attributed to a number of reasons
such as Indias current account deficits as well as the dwindling foreign
portfolio flows. The role of currency manipulators is hardly mentioned. There
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Unit 8
are a wide number of participants who are involved with the foreign exchange
market. Other than those who buy or sell currency in order to hedge foreign
exchange exposure, there is another group who bet on the currency volatility
in order to make money. This group is suspected of leading to exaggerated
currency movements.
While regulators can ignore the argument stating that the size of the foreign
exchange market acts as a barrier to price manipulation, the question still
remains whether it is possible for a single player to influence price
movements in currencies. However, this argument has been further affirmed
by Dr. Kaushik Basu who states in his paper The Art Of Currency
Manipulation: How Some Profiteer By Deliberately Distorting Exchange
Rates, that it is possible to do so. He writes in his paper that it is possible
for a foreign exchange player to make a profit by deliberately making the
exchange rates fluctuate.
Basu presents in his paper that in most of the countries, the foreign exchange
market consists of a few small, price-taking agents who transact in the
market without creating any impact on the market. Other than them, there
are large strategic agents having market-power and are also power driven.
In India, banks and other institutions comprising the Foreign Exchange
Dealers Association of India (FEDAI) are such agents.
The model of Dr. Basu shows that the manipulator is capable of buying
dollars and yet leaving the exchange rate unchanged The manipulator in
the next period can create a confusion for the other dealers as they raise
the price higher when they face the manipulators strategy, resulting in the
manipulator selling at a price higher than he originally purchased. In other
words, the manipulator works out how many dollars he will buy or sell at out
of equilibrium price. When faced with such kind of strategies, the dealers
functioning in isolation move the price in such a way that the manipulator
profits from it. In most of the countries, the regulators deny the presence of
the manipulators which in turn curbs the possibility of dealing with the ways
of the manipulators. If the regulators are aware of the methods that are
taken up by the manipulators then the currency fluctuations can be curbed
without disturbing the free functioning of market forces.
Recently, the RBI has also taken a step by imposing limits on overnight
open positions and intra-day open positions held by dealers in inter-bank
forex market. This is among the first acknowledgement by the central bank
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that speculation could be one of the reasons for currency volatility. While it
is easy to regulate the domestic inter-bank and the exchange-traded forex
market, it is not easy to find out what the regulator is possible of doing in
case the manipulator operates from off-shore currency market.
That said acknowledging the presence of currency manipulators is the first
step. The Government and the RBI appear to be doing that now. The next
step is to understand how it is done. The final step would be to impose
checks, as completely stopping the manipulation is next to impossible.
Questions
1. How do you think the manipulators profit from the currency volatility?
2. Do you think the steps taken by the RBI will help in reducing the activities
of the manipulators?
columns/lokeshwarri-sk/article3624422.ece?homepage=true
8.8 Summary
According to Michael Adler and Bernard Dumas, Foreign Exchange
exposure is the measure of the sensitivity of changes in the real domestic
currency value of assets, liabilities or operating income to unanticipated
changes in exchange rates.
Foreign exchange exposure is the result of the difference between the
actual change in the exchange rate and the anticipated change.
The types of exposure are broadly divided into economic and translation
exposure. Economic exposure is further divided into transaction exposure
and operating exposure.
Transaction exposure is concerned with the impact of change in exchange
rate on present cash flows.
Operating exposure has an impact on the firms future operating costs
and cash flows.
A firm involved in international business faces a higher degree of exposure
to exchange rate fluctuations than a purely domestic firm.
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8.9 Glossary
Nominal Value: A value expressed in monetary terms for a specific year
or years, without adjusting for inflation
Macroeconomic: The field of economics that studies the behaviour of
the aggregate economy
Consolidation: The combining of separate companies, functional areas,
or product lines, into a single one
Repatriate: To send back a sum of money previously invested abroad to
its country of origin

1. Discuss foreign exchange exposure.
2. What are the different types of exposure? Explain.
3. Define translation exposure.
4. State the translation methods.
5. Define the temporal method.
6. How does operating exposure have an impact on the firms future operating
costs and cash flows?
8.11 Answers
1. Functional currency
2. Exchange rate
3. True
4. False
5. True
6. Transaction exposure
7. Future cash flows
8. Quotation exposure
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Unit 8
9. True
10. False
11. True

1. The foreign exchange exposure of a firm can be defined as a measure of
the sensitivity of its cash flows to changes in exchange rates.
2. The types of exposure are broadly divided into economic and translation
exposure. Economic exposure is further divided into transaction exposure
and operating exposure.
3. Translation exposure, which is also known as accounting exposure,
emerges on account of consolidation of financial statements of different
units of a multinational firm.
4. The translation methods are
Current rate method
Temporal method
5. The temporal method uses historical rate for the items that are stated at
historical cost. Fixed assets, for example, are translated at historical rate
but items that are stated at replacement cost, realizable value, and market
value or expected future value, are translated at current rate.
6. Operating exposure has an impact on the firms future operating costs
and cash flows. Since the firm is valued as a going concern entity, its
future revenues and costs are to be affected by the exchange rate changes.
For details, refer to Section 8.4.1
Page No. 173
Unit 8
Sharan, Vyuptakesh. International Financial Management. 2012. Sixth
Publishing.
Page No. 174
Unit 9
Management of Foreign
Exchange Exposure
Structure
9.1 Caselet
9.2 Introduction
Objectives
9.3 Tools of Foreign Exchange Risk Management
9.4 Distinguishing between Functional and Reporting Currency
9.5 Currency Volatility Over Time
9.6 Risk Management Products
9.7 Techniques of Exposure Management
9.8 Case Study
9.9 Summary
9.10 Glossary
9.12 Answers
9.1 Caselet
A primer on corporate hedging
In the recent past, many instances relating to capital losses have surfaced
due to wrong decisions taken by companies in regard to the market
movements and erroneous hedging. Without hedging, a company is open
to the elements of the markets on which they have no control and in adverse
times the companies post losses due to poor market condition.
A case in point is with Hexaware Systems. The company booked a loss of
Rs 10.3 crore ($2.6 million). This was mainly because of dealing in foreign
exchange options contracts. Another example is that of Larsen and Tuobro.
It had booked a `200-crore ($51 million) loss on commodity futures on the
London Metals Exchange. Many IT companies were also mercilessly hit by
the sharp depreciation in the dollar in 2007. The reason attributed was
inadequate hedging. These instances bring out the need and importance
of having a clear-cut and guiding policy frame-work for hedging by corporate.
However, one must not confuse these situations from losses that banks
Unit 9
(such as ICICI Bank) have incurred due to taking speculative positions in

financial markets. The basic rule behind the policy of hedging is that it is a
preventive measure taken to reduce losses in a possible adverse market
situation. The etymology of the word probably comes from the fact that
hedges protect gardens from destructive visitors like stray dogs. It is a
myth that all hedging is financial; for example, constituting a bench strength
in an IT company to ensure availability of talent when required; diversification
to reduce reliance on one market or one client and decentralization and
creation of back-ups to reduce reliance on a few key employees are all
examples of non-financial or strategic hedging. Typically, the level of financial
hedging is more in companies whose main activity is trading (such as
investment banks and hedge funds) vis-a-vis brick-and-mortar companies
that produce something.
Source: Adapted from http://www.thehindubusinessline.com/todays-paper/
article1620827.ece?ref=archive
Accessed on 8 October 2012
9.2 Introduction
In the previous unit, you learnt about the concept of foreign exchange exposure.
The different types of exposure had also been discussed. You also studied how
to measure economic exposure and the various translation methods.
In this unit, we will take the concept forward and understand how foreign
exchange exposure is managed. You will learn about the various tools and
techniques of foreign risk management and the risk management products.
You will understand the differences between the functional and the reporting
currency and various techniques used for exposure management.
Objectives
discuss the tools and techniques of foreign exchange risk management
define the differences between functional and reporting currency
assess risk management products and currency volatility
discuss the techniques of exposure management
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Unit 9
9.3 Tools of Foreign Exchange Risk Management

Various financial instruments are used by companies in India and abroad in
order to hedge the exchange risk. Such kinds of instruments are available to
the company at varying costs. The various tools that hedge the different kinds
of risks are given below:
Forward contracts: A forward contract is a non-standardized contract
that takes place between two parties for the purpose of selling or buying
an asset at a specified future time at a price that has already been agreed.
The party who buys the underlying position assumes a long position and
the party who sells the asset assumes a short position. Delivery price is
the price that has been agreed upon. It is one of the most common means
of hedging transactions in foreign currencies. It offers the ability to the
users to lock in a sale price or a purchase without the involvement of any
direct cost. It is also used by speculators who use forward contracts so as
to place bets on the price movements of the underlying asset. Banks and
many multinational corporations also use it to hedge the price risk by the
elimination of uncertainty about prices.
Futures contracts: It is a standardized contract that takes place between
two parties for buying and selling a specified asset of standardized quality
and quantity for a price that has been agreed at the present date. The
payment and delivery takes place at a future specified date which is also
known as the delivery date.
Option contracts: In this type of contract, the buyer of the option has the
right but not the obligation to fulfill the transaction while the seller has the
responsibility of fulfilling the conditions stated in the contract through the
delivery of the shares to the appropriate party.
An option can be distinguished as a call option or a put option. The option
conveying the right to buy the underlying asset at a specific price is called
a call and the option conveying the right to sell the underlying asset at a
specific price is known as the put option.
Currency Swap: The agreement that takes place between two parties
through which they exchange a series of cash flows in one currency for a
series of cash flows in another currency is known as currency swap. It
takes place at agreed intervals and over an agreed period of time. Law
doesnt require it to be shown on a companys balance sheet as it is
considered to be a foreign exchange transaction.
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Unit 9
Activity 1
Select an MNC of your choice and study the hedging techniques it had
applied for foreign risk management. Make a report.
Hint:
Browse the Internet and find out the hedging techniques that are applied
in the market.
1. A ____________ is a non-standardized contract that takes place between
two parties for the purpose of selling or buying an asset at specified future
time at price that has already been agreed.
2. The option conveying the right to buy the underlying asset at a specific
price is called a ____________ .
3. ____________ is a standardized contract that takes place between two
parties for buying and selling a specified asset of standardized quality
and quantity for a price that has been agreed at the present date.
9.4 Distinguishing between Functional and Reporting Currency

In December 1981, the Financial Accounting Standards Board Statement 52
(FASB 52) was issued after which it was required of all the American MNCs to
adopt the statement for fiscal years starting on or after 15 December 1982. The
FASB 52 states that the firms must make use of the current rate method for
translating foreign currency denominated assets and liabilities into dollars. The
expense items on the income statement and all the foreign currency revenue
must be translated at either the exchange rate in effect on the date when these
items were recognized or at an appropriated weighted average exchange rate
for the period. It is also required by the FASB 52 that the translation gains and
the losses needs to be accumulated and presented in a different equity account
on the parents balance sheet and this account is known as the cumulative
translation adjustment account. A foreign affiliates functional and reporting
currency have also been differentiated by ASB 52.
The currency of the primary economic environment where the affiliate
operates and in which it generates cash flows is known as functional currency.
It is also the local currency in which most of the business of the entity is
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conducted. However, in some situations, it can also function as the home country
currency of the parent firm or some third country currency.
The reporting currency on the other hand is the one in which the financial
statements are prepared by the parent firm. It is also generally the currency in
which the parent is located and most of the business is conducted.
The management also needs to determine the nature and purpose of the
foreign operations in order to decide on the appropriate functional currency.
Generally the functional currency will become the local currency of the country
if the operations of the foreign affiliate are self-contained and integrated with a
particular country.
4. In December 1981, the Financial Accounting Standards Board Statement
52 (FASB 52) was issued. (True/False)
5. The currency of the primary economic environment where the affiliate
operates and in which it generates cash flows is known as reporting
currency. (True/False)
9.5 Currency Volatility Over Time

Currency volatility can be defined as the measure of the change in price that
takes place over a given time period. It doesnt remain constant from one time
period to another. The currency volatility keeps on changing from time to time
and thus the assessment conducted by the MNCs of the future volatility of the
currency will not be accurate. However, it can still be beneficial for the MNCs as
they can derive information even though the MNCs may not be able to predict
accurately. Currencies such as the British pound whose value is most likely to
remain constant unlike the highly volatile currencies like the South Korean Won
or the Italian Lira can be identified.
Change in the value of a company that accompanies an unanticipated
change in exchange rates is called as economic exposure risk. This is also
related to the currency volatility over time. Of all the three exposures, economic
exposure is the most important as it has an impact on the valuation of a firm.
Suppose a Japanese company imports children toys from India. The same
product is also available from China but it is costly. If the rupee appreciates
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against the yen and the Chinese currency decreases against yen, Japan will
prefer to import the toys from China as it will get at a cheaper rate.
Since economic exposure comes from unanticipated changes, its
measurement is not as precise as those of transaction and translation exposures.
Shapiro has classified economic exposure into two components, transaction
exposure and operating exposure. The changes in the value of financial
obligations incurred before a change in exchange rates but to be settled after
the change is defined as transaction exposure. Operating exposure has an
impact on the firms future operating costs and cash flows. Since the firm is
valued as a going concern entity, its future revenues and costs are to be affected
by the exchange rate changes. If the firm succeeds in passing on the impact of
higher input costs fully by increasing the selling price, it does not have any
operating risk exposure as its operating future cash flows are likely to remain
unaffected. In addition to supply and demand elasticity, the firms ability to shift
production and sourcing of inputs is another major factor affecting operating
risk exposure. High-low Position Index (HLPI) is an important tool that is used
to measure the volatility of currencies and also to describe the position of the
current exchange rate relative to its one year high and low.
6. Currency volatility can be defined as the measure of the change in price
that takes place over a given time period. (True/False)
7. Transaction exposure has an impact on the firms future operating costs
and cash flows. (True/False)
9.6 Risk Management Products

The most important products that the firms use to meet their exchange risk
management risks are through the forward, swap and options contracts. A survey
conducted by the Fortune 500 firms found that the most popular product is the
traditional forward contract. A currency option is the next most commonly used
instrument followed by options contract. In another survey conducted by
Jesswein, Kwok and Folks, it has been stated that the finance/insurance/real
estate industry is the one which uses the risk management products most
frequently. It also further stated that the corporate use of foreign exchange risk
management is also related to international involvement of a firm.
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Through a forward contract, a buyer or a seller can lock in a purchasing

or selling price for an asset with the arrangement that the transaction would
take place in the future. In this contract, the buyer or the seller arrives at a price
and date when they are obligated to buy or sell a given asset. Until the expiry or
the delivery date, there is no exchange of cash or assets and on the day of the
delivery it can be be settled either by physical delivery of the asset or the cash
settlement. It helps the buyer and the seller to reduce the fluctuation risks in the
currency markets through which businesses are affected.
Currency swap: A derivative in which cash flows of the financial instrument of
one party is exchanged for the cash flow of another partys financial instrument
is known as a swap. The type of the financial instrument involved determines
the benefits in question. The dates when the cash flows are to be paid and the
way in which they are to be calculated are defined by the swap agreement.
Various kinds of swaps are available but the most commonly used swaps are
the interest rate swaps and currency swaps. An interest rate swap can be defined
as a financial contract that takes place between two parties through which interest
payments are made on a notional amount of principal on a number of occasions
throughout a specified period. One of the parties involved in the contract make
a cash payment on each payment date during the specified period. This cash
payment depends on the differential between the fixed and the floating rates. A
currency swap on the other hand can be defined as a contract which takes
place in order to exchange interest payments in one currency for those
denominated in another currency. Back-to-back loans and parallel loans gives
way to currency swap and at present the current swap market is smaller and
less sophisticated.
Option: A derivative financial instrument through which a contract takes place
between two parties for a future transaction on a particular asset at a reference
price is known as an option. In this type of contract, the buyer gains the right but
not the obligation to engage in that transaction. There are different types of
options market. They are exchange traded option and over-the-counter option.
Exchange traded options are a class of exchange traded derivatives that are
settled through a clearing house and the fulfillment is guaranteed by the Options
Clearing Corporation (OCC). In this type of contracts, accurate pricing models
are often available as the contracts are standardized. In case of over-the-counter
options, the trade takes place between two private parties who are not listed on
an exchange. The options can also be individually tailored to meet any business
needs.
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8. Through a____________, a buyer or a seller can lock in a purchasing or
selling price for an asset with the arrangement that the transaction would
take place in the future.
9. A derivative financial instrument through which a contract takes place
between two parties for a future transaction on a particular asset at a
reference price is known as an____________.
10. ____________are a class of exchange traded derivatives that are settled
through a clearing house and the fulfillment is guaranteed by the Options
Clearing Corporation (OCC).
9.7 Techniques of Exposure Management

9.7.1 Managing Transaction Exposure
Transaction exposure calculates gains or losses which occur after the current
financial compulsions according to terms of reference are resolved. Taken that
the deal would lead to a future inflow or outflow of foreign currency cash, any
unprecedented alterations in rate of exchange amid the period in which
transaction is entered and the time taken for it to settle in cash would guide to a
change in worth of net flow of cash in terms of the home currency. For example
a transaction exposure of an Indian company will be the account receivable
which is associated with a sale denominated in US dollars or the compulsion of
an account payable in Euro debt.
Presume an Indian firm sells goods with an open account to a German
buyer for 1,800,000 payment of which is to be done in 2 months. The current
exchange rate is ` 50/, and the Indian seller expects to exchange the euros
received for ` 90,000,000 when payment is received. If euro weakens to `45/
when payment is received, the Indian seller will receive only `81,000,000, or
some `9,000,000 less than anticipated. Opposite will be the case should euro
strengthen. Thus exposure is a chance of either gain or loss.
Alternative 1: Invoice the German buyer in rupees; but the Indian firm might
not have obtained the sale in the first place.
Alternative 2: Invoice the German buyer in dollars; both the parties are exposed
should an unanticipated change in exchange rate between dollar and the
respective home currency.
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In either case, the remedy might be worse than the disease!

(i) Forward market hedge: If you might owe foreign currency in upcoming
future, be in agreement to purchase foreign currency in present by entering
into long position in a onward contract. If you might get foreign currency
in future, consent to sell it now by entering into small time position in a
forward contract.
Let us take an example of an Indian importer of readymade garments
from Britain who has just placed the order for next years stock. Payment
of amount of 100 million is pending in coming year. Question: How can
you fix outflow of cash in rupees?
Another method involves putting oneself in a situation that lets one gain
100 million a year, resulting in a long forward contract on the pound.
Suppose both the spot and one-year forward exchange rate is `80/. If
he does not hedge the 100 million payable, in one year your gain (loss)
on the unhedged position is calculated as follows. The importer will be
better off if the pound depreciates: he still buys 100 million but at an
exchange rate of only `79/, he saves `100 million relative to `80/. But
he will be worse off if the pound appreciates.
If the importer agrees to buy 100 million in one year at forward exchange
rate of `80/, his gain (loss) on the forward is as follows. If he agrees to
buy 100 million at a price of `80 per pound, he will make `50 million if
the price of a pound reaches `80.50. If he agrees to buy 100 million at a
price of `80 per pound, he will lose `50 million if the price of a pound is
only `79.50. This analysis is based on actual results as the future spot
rate cannot be predicted. However, the decision of going forward with the
hedge must be based on the predications. So the firm has to form an
expectation about future spot rate
(a) If E(ST)=F, the expected gains or losses are zero. But forward
hedging eliminates exchange exposure.
(b) If E(ST)<F, the firm expects a loss from forward hedging. Thus the
firm would be less inclined to hedge under this scenario. However,
assuming that the firm is averse to risk and the firm does go ahead
with the hedge, the reduction in the predicted proceeds (in dollars)
can also be viewed as the insurance premium. In other words, it
can be used to make necessary payments in order to avoid or
minimize the risks involved with exchange rates.
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(c) If E(ST)>F, the firm expects a positive gain from forward hedging.
Thus the firm would be more inclined to hedge under this scenario.
(ii) Money market hedge: In order to hedge the payable foreign currency, a
firm can purchase a lump sum of that foreign currency and then sit on it
for a long period of time. This can be done in following ways:
The current value of the payable foreign currency can be bought.
The amount may be invested at the foreign rate.
The amount can be converted back at maturity. This ensures that
the investment grows enough to cover the payable foreign currency.
The Indian importer of British readymade garments, owes in one year
100 million to the British supplier. The spot exchange rate is `80/. The
one-year interest rate in UK is i = 5 per cent. Borrow ` x million in India.
Translate ` x million into pounds at the spot rate S(`/) = `80/. Invest x/
80 million in the UK at i = 5 per cent for one year. In one year investment
x (1.05)/80 million will have grown to 100 million. Solving for x, we get
x=7619 (approximately), so that we have redenominated a one-year 100
million payable into a `7619 million payable due today. If the interest rate
in India is i` = 6 per cent, the Indian importer could borrow the `7619
million today and owe in one year.
`8076 million = `7619 million (1.06)
Let us suppose that a firm wishes to hedge received in the sum of y
along with a maturity of T:
(i) Borrow y/(1+ i)T at t = 0.
(ii) Exchange y/(1+ i)T for $x at the prevailing spot rate.
At the time of maturity, the firm will owe a $y which can be paid
with the receivable sum. This way, the firms exposure to the
exchange rates involving dollar and pound will be reduced
considerably.
(iii) Option hedge: One possible shortcoming of both forward and money
market hedges is that the firm has to forgo the opportunity to benefit from
favourable exchange rate changes. Keeping several options available
creates a flexible hedge against the downside. At the same time, it helps
in preserving the upside potential. The payable buys are called on the
foreign currency in order to hedge the currency. If there is an appreciation
in the value of the currency, then the call option allows the firm to purchase
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the currency at the exercise price of the call. In order to hedge a foreign
currency, receivable buy is put on the currency. In case of depreciation in
the value of the currency, the put option allows the firm to sell off the
currency at the exercise rate.
Suppose our importer buys a call option on 100 million with an exercise
price of `80 per pound. He pays ` 8 per pound for the call, so that the total
payment for the option is `800,000,000. This transaction provides Indian
importer with the right, but not the obligation, to buy upto 100 million for
`80/, regardless of the future spot rate.
Assume that the spot exchange rate turns out to be `79.50 on the expiration
date. Since the importer has the right to buy each pound at `80, he will
not exercise the option. However if the rupee depreciates to `80.50 on
the expiration date, he will surely exercise the call option by buying each
pound at a much cheaper rate of `80. The foremost benefit of option
hedging is that it allows the firm to decide if it wants to exercise this option
on the basis of the realized spot exchange rate on expiry. Recall that
Indian importer has paid `800,000,000 upfront for the option. Considering
the time value of money, this upfront cost at i` = 6 per cent is equivalent
to `848,000,000 (= `800,000,000 x 0.06) as of expiration date.
Transaction
Buy a call option on 100 million for an upfront cost of `800,000,000. In one
year, decide whether to exercise the option upon observing the prevailing spot
exchange rate.
Outcome
Assurance of not having to pay more than ` 848,000,000, in case the future
spot exchange rate is found to be more than the exercise exchange rate.
Cross-hedging minor currency exposure
In todays market, the most prominent currencies are US dollar, euro, Canadian
dollar, Swiss francs, Japanese yen and Mexican pesos. Currencies like Thai
bath, Indian rupee and Korean won are minor currencies circulating in the market.
Obtaining financial contracts for hedge exposure of these minor currencies is a
difficult task and proves to be costly. For this purpose, cross-hedging is often
used. It can be understood as the hedging of a particular position in one asset
and replacing a position in some other asset. The success and effectiveness of
cross-hedging depends on the degree of interrelatedness of the assets.
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9.7.2 Managing Operating Exposure

Operating exposure is alternatively known as economic exposure. It evaluates
the changes that occur in the current value of the firm. The change in the current
value may be a result of the change that takes place in predicted operating
cash flows on account of fluctuations in exchange rates.
They are similar in that they both deal with future cash flows. They differ
in terms of which cash flows management considers. Transaction exposure
deals with the predicted cash flows for future that have already been contracted
and hence accounted for. At the same time, the operating exposure focuses on
the predicted-but not yet contracted-cash flows in future. These future cash
flows may undergo changes in case of a major fluctuation in the exchange rate,
resulting in changes in the overall competitiveness at international level.
Suppose an Indian MNC, such as Videocon, has sales in India, United
States, China and Europe and therefore, posts a continuing series of foreign
currency receivables (and payables). Sales and expenses that are already
contracted for are traditional transaction exposures. Sales that are highly
probable based on the Videocons historical business line and market share but
have no legal basis yet are anticipated transaction exposures. Let us extend
the analysis of the firms exposure to exchange rate changes even further into
the future. The analysis of this longer term where exchange rate changes are
unpredictable and, therefore, unexpected is the goal of operating exposure
analysis. Broadly speaking, operating exposure and its implications are not limited
to the sensitivity and dependability of the future cash flows of a firm upon the
unpredictable fluctuations in foreign exchange rates. It is also directly affected
by other chaif macroeconomic variables. This phenomenon is often known as
macroeconomic uncertainty.
Some firms face operating exposure without even dealing in foreign
exchange. Consider an Indian perfume manufacturer who sources and sells
only in the domestic market. Since the firms product competes against imported
perfumes (say from Paris) it is subject to foreign exchange exposure. It faces
severe competition when rupee gains against other currencies (here, euro),
lowering the prices of imported perfumes.
Suppose that an Indian manufacturer has contracted to sell 100 pairs of
jeans per year to Britain at `1200 per pair and to buy 200 yards of denim from
Britain in this same period for 2 per yard. Suppose that 2 yards of denim are
required per pair and that the labour cost for each pair is `400. Suppose that at
the time of contracting the exchange rate is S(`/) = 80 and the rupee is then
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devalued to S(`/) = 81. Suppose also that the elasticity of demand for Indian
jeans in Britain is -2 and that after the contract expires the Indian manufacturer
raises the price of jeans to `1205 per pair. What are the gains/losses from the
devaluation on the jeans sold and on the denim bought at the pre-contracted
prices? (i.e., what are the gains/losses from transaction exposure on payables
and receivables?) What are the gains/losses from the extra competitiveness of
Indian jeans, that is, from operating exposure?
Solution: Effect of transaction exposure
Before the devaluation
Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected total
cost /year =100 pairs x 2yd/pair 2/yd x `80/ + 100 pairs x `400/pair =
`72,000. Expected profit = `120,000 `72,200 = `48,000.
After the devaluation
Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected total
cost /year =100 pairs x 2yd/pair x 2/yd x `81/ + 100 pairs x `400/pair = `72,400.
Expected profit = `120,000 `72,400 = `47,600. Exporters profit on contracted
quantities and prices of jeans supplied and denim purchased is reduced by
`400 per year because of the transaction exposure.
Solution: Effect of operating exposure
Before the devaluation
Expected profit = ` 48,000
After the contract expires
When the rupee price of jeans rises from `1200/pair to `1205/pair, the pound
price falls from 15 to 14.88, i.e., a 0.8 per cent reduction. With a demand
elasticity of -2, it will result in sales increasing by 1.6 per cent to 101 pairs per
year. Expected total revenue/year =101 pairs x `1205/pair =`121,705. Expected
total cost /year =101 pairs x 2yd/pair x 2/yd x `81/ + 101 pairs x `400/pair =
`73,124. Expected profit = `121,705 `73,124 = `48,581. We find that the
exporters profit is increased by `581 per year from the devaluation because of
operating exposure.
The operating exposure of a firm is dependent upon the following:
1. The overall market structure in terms of inputs and products
2. The level of competitiveness and monopoly existing in the market
that the firm is looking to face
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3. The capability of the firm to align its marketing strategies, product

mix, and sourcing in relation to the exchange rates and the
accompanying changes
In case, the cost or the price of a firm is directly affected by the changes
in the exchange rates, then the firm is understood to be subjected to increased
levels of operating exposure. As an extension of this, when the cost as well as
the price of the firm is being affected by the changes in exchange rates, then
firm can be said to have little or no operating exposure.
Consider a hypothetical company, Ford Indiana, a subsidiary of Ford,
which imports cars from US and distributes in India. If dollar is expected to
appreciate against the rupee, Ford Indianas expected cost goes up in rupee
terms. Whether this creates operating exposure for Ford critically depends on
the structure of the car market in India. If Ford Indiana faces competition from
India (or other foreign) car makers for whom rupee costs did not arise, raising
the rupee price of imported car is not a feasible option. In contrast, if Ford
Indiana faces competition only from other US car makers (like General Motors)
for whom rupee costs would have similarly been affected by dollar appreciation,
competitive position of Ford Indiana would not be adversely affected, leading to
a higher rupee price of imported cars.
Even if Ford Indiana faces competition from local car makers in India, it
can reduce exposure by starting to source Indian parts and materials, which
would be cheaper in dollar terms after the dollar appreciation. Ford can even
start to produce cars in India by hiring local workers and sourcing local inputs,
thereby making its costs less sensitive to changes in the dollar/rupee exchange
rate. The firms flexibility regarding production locations, sourcing, and financial
hedging strategy is an important determinant of its operating exposure to
exchange risk.
Suppose the annual inflation rate in US is 2 per cent and in India, it is 6
per cent. Recollect the relative PPP condition: the exchange rate change during
a period should equal the inflation differential for that same time period, to avoid
possibility of any arbitrage.
Case 1: dollar appreciates about 4 per cent against the rupee. Since the
rupee prices of both Ford and locally produced cars rise by the same 6 per cent
(for Ford it includes a 2 per cent increase in the dollar price of cars + a 4 per
cent appreciation of dollar against rupee), the 4 per cent appreciation of the
dollar will not affect the competitive position of Ford vis--vis local car makers.
Ford is thus not exposed to exchange risk
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Case 2: Suppose dollar appreciates by more than 4 per cent against

rupee. Ford cars will become relatively more expensive than locally produced
cars, adversely affecting Fords competitive position. Ford is thus exposed to
exchange risk.
Managing operating exposure
(i) Selecting low cost production sites: A firm may wish to diversify the
location of their production sites to mitigate the effect of exchange rate
movements. The adverse repercussions of the fluctuations in exchange
rates can be avoided, if the location of the production sites is shifted to
other countries with currencies that have depreciated in real terms. One
condition to this is that the production costs in these countries should
involve plenty of local and topical content. The Japanese car maker Nissan
has manufacturing facilities in US other than Japan. During the JanuaryMay, 1993 yen appreciated against the dollar by more than 13 per cent,
thereby affecting the competitive position of Nissan in US car market.
Nissan choose to shift production from Japan to US manufacturing facilities
in order to mitigate the negative effect of the strong yen on US sales.
Another example is of Honda Group, which constructed factories in North
America in the view of the strong position of yen in the market. However,
later when the yen began to weaken, the company decided to import
more cars from Japan than to build them in North American factories.
(ii) Flexible sourcing policy: It is found that if the inputs and raw materials
are bought in foreign markets where the local content in the production
costs is considerably high, then the fluctuations in excshange rates result
in a corresponding change in the relative cost of sourcing from alternative
sources.
Example: Facing strong yen, Japanese manufacturers in the car and
consumer electronics industries, depend heavily on parts and intermediate
products from such low-cost countries as Thailand, Malaysia and China.
Sourcing is not limited to components used in production but also extend
to hiring guest workers. For instance, Japan Airlines recruited people
from foreign countries for its crew in order to retain its competitive edge in
the wake of strong yen. Later, however, it reversed its strategy when the
yen began to weaken and there was a rise in the rate unemployment in
the local market.
(iii) Diversification of market: this can be understood in terms of sale of
products in a number of markets in order to maximize advantage on
account of diversification of the exchange rate risk. Suppose Infosys is
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outsourcing its services in US as well as in Germany. Reduced outsourcing/

sales in US, following rupee appreciation against dollar can be
compensated by increased sales in Germany due to rupee depreciation
against the euro. As a result Infosys overall cash flows will be much more
stable, than would be the case if it were to outsource in only one country.
(iv) R&D and product differentiation: This entails an effective R&D in order
to facilitate the following:
Cost reduction
Increase in productivity
Product differentiation
An effective product differentiation results in a decrease in demand
elasticity, which in turn, translates into reduced risks involving exchange
rate fluctuations.
(v) Financial hedging: Transaction exposure to currency risk is mostly shortterm in nature. In contrast operating exposure has a very long time horizon.
The four most commonly employed financial hedging policies are:
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
(a) Matching currency cash flows: Let us suppose, that an Indian
company is involved in continuous export sales in the US market. In
order to gain a competitive advantage, the firm invoices all its sales
in American dollars. This strategy leads to a continuous receipt of
dollars every month. This continuous string of transactions results in
a continuous hedging with forwards and contractual agreements.
Alternatively, the firm can match its continual inflow of American
dollars, with an equivalent outflow by acquiring debt denominated in
dollars.
Exposure:The sale of manufactured products in the US markets
results in the creation of a foreign currency exposure out of inflow of
American dollars.
Hedge: The payment of debts in American dollars serves as a
financial hedge. It requires debt service, which is an outflow of
American dollars.
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Situation 1: A predicted and constant exposure to a company can

be counterbalanced by acquiring debt dominated in the currency, by
the method of matching.
Situation 2: Alternatively, the method of currency switching can be
adopted, according to which, the company can pay the foreign
supplier/ dealers in American dollars.
(b) Risk-sharing agreements: Long-term cash flow exposure between
firms can also be managed by using the method of risk sharing. The
risk-sharing method involves a contractual agreement between the
buyer firm and the seller firm, to share or divide the impact, if any,
of the currency movements on the transaction being done between
them. This agreement serves as an ideal and co-operative way of
functioning between firms that look forward to building a long-term
relationship based on the product quality and mutual reliability. It
facilitates building a relationship that does not depend on the whims
of the unpredictable currency markets. It helps in smoothening the
impact of the changes and movements of exchange rates by dividing
the burden of the impact on the involved parties (firms).
For example, Fords operations in America involve importing the
automotive parts from Mazda in Japan every year. Major fluctuations
in the exchange rates tend to profit one firm at the expense of the
other.
The Agreement
All purchases by Ford will be made in Japanese yen at the
current exchange rate, as long as the spot exchange rate on
the date of invoice is between 115/$ and 125/$; so that
whatever transaction exposure exists is borne by Ford.
If however, the exchange rate falls outside this range on the
payment date, Ford and Mazda will share the difference equally.
Suppose Ford has an account payable of 25,000,000 for the month
of March and the spot rate on the date of invoice is 110/$, i.e., the
Japanese yen would have appreciated versus dollar increasing Fords
costs from $217,391.30 to $227,272.73. However, since the rate
falls outside the stipulated range, the difference of 5/$ would be
shared between Ford and Mazda; so that Fords total payment in
Japanese yen would be calculated using an effective exchange rate
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of 112.5/$, and saves Ford $5,050.51. This savings is a reduction

in an increased cost, not a true cost reduction.
(c) Back-to-Back loans: When two companies from two different
countries borrow each others currencies for a particular time period,
the arrangement is termed as back-to-back loan (parallel loan or
credit swap). The borrowed currencies are returned on a terminal
decided with retural consent. Suppose a British parent firm discuss
of make funds investment to invest funds in its Dutch subsidiary
locates a Dutch parent firm that wants to invest funds in the UK. The
British parent lends pounds to the Dutch subsidiary in UK, while the
Dutch parent lends euros to the British subsidiary in the Netherlands.
The two loans would be for equal values at the current spot rate and
for a specified maturity. At maturity the two separate loans would
each be repaid to the original lender, without the need to use the FX
markets.
Two primary obstacles to the extensive usage of the back-to-back
loan exist which are as follows:
It is not easy for a firm to find a partner, termed a counterparty
for the currency amount and timing desired.
One risk is that one of the parties will fail to return the borrowed
funds at the designated maturityalthough each party has 100
per cent collateral (denominated in a different currency).
These disadvantages have resulted in the rapid development and
wide use of the currency swap, where a firm and a swap dealer or
swap bank agree to exchange an equivalent amount of two different
currencies for a specified amount of time.
(d) Currency Swaps: This is already discussed in earlier subsection.
Activity 2
Find out the various alternatives that are available to the Indian corporate
for hedging risk. Put it down on a chart.
Hint:
Some of the alternatives are forward market hedge, money market
hedge, futures market hedge and options market hedge.
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11. In order to ____the payable foreign currency, a firm can purchase a lump
sum of that foreign currency and then sit on it for a long period of time.
12. Cross-hedging is the hedging of a particular position in one asset and
replacing a position in some other asset. (True/False)
9.8 Case Study

Reserve Bank of India eases hedging rules to aid volumes
For the purpose of boosting trading volumes in the over-the-counter market,
the Reserve Bank of India has liberalized the norms related to hedging. It
has imposed these restrictions for restricting speculation in the foreign
exchange market after the weakening of the rupee by over 18 per cent
between August and December 2011.
This has enabled the exporters to credit 100 percent of their foreign
exchange earnings to the EEFC (exchange earners foreign currency
account) without the need of converting 50 per cent of it in rupee terms.
EEFC is an account that is maintained in foreign currency with a bank or an
authorized dealer. The foreign exchange earners are provided this facility
to credit 100 per cent of their foreign exchange earnings to the account.
However, it is needed that the exporters convert the total accrual into rupee
terms by the end of the month.
Experts state that this measure will help the exporters in hedging their
exposures with banks in turn giving a boost to the rupee which has become
weak by 9 per cent against the dollar in the first quarter of the financial year
2013. Anil Bhansali, the vice-president of Mecklai Financial said that though
exporters might sell, it will stand to have a limited impact as the demand for
dollars is high and one-off inflows have not helped the rupee correct much
in the recent past
The exporters have also been permitted by the RBI to book and cancel
forward contracts to about 25% of their total contracts that have been booked
for hedging exposures. RBI has already stated in a circular that was issued
in July that the forward contracts that have been booked once will not be
cancelled. While getting into a forward contract, the exporters and the
importers comes to an agreement to buy or sell a currency at a pre-
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determined exchange rate at a given time. Subir Gokarn, the deputy

governor of SBI had said that the steps that have been taken by the RBI
seem to be helping in the reduction of volatility.
And having reached that situation, we felt that there was some room to
give our participants a little more flexibility in their management of their
exposures, their genuine hedging requirements and that has motivated the
actions that we took today.
RBI has also freed the net overnight open positions (NOOP) of overseas
branches of banks from the limits imposed earlier. Net open positions are
transactions which have not been squared off on an overnight basis.
This liberalizes the NOOP a bit more, said the ED, trading, UBS. These
moves are directed towards undoing the restrictions the RBI had put in
place in December. Trading volumes in the OTC market will certainly
increase, he added.
Questions
1. Do you think that the steps taken by the RBI will help in easing hedging?
2. What are the opinions of the experts in this matter?
Source: Adapted from http://articles.economictimes.indiatimes.com/201208-01/news/32981521_1_eefc-foreign-currency-exporters-and-importers
9.9 Summary
The different tools that hedge the different kinds of risks are forward
contracts, futures contracts, Option contracts and currency swap.
An option can be distinguished as a call option or a put option.
In December 1981, the Financial Accounting Standards Board Statement
52 (FASB 52) was issued after which it was required of all the American
MNCs to adopt the statement for fiscal years starting on or after 15
December 1982.
The FASB 52 states that the firms must make use of the current rate
method for translating foreign currency denominated assets and liabilities
into dollars.
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The hedge involves a money market position to cover a future payable or

receivables position.
A natural hedge is applied when the contractual hedge fails to give good
results. It may be mentioned that the contractual hedge provides only
temporary protection against exchange rate movement.
Risk-sharing is a contractual arrangement through which the buyer and
the seller agree to share the exposure.
9.10 Glossary
Hedge: To make an investment for the reduction of the risk of adverse
price movements in an asset
Underlying asset: The security or property or loan agreement through
which the option holder receives the right to buy or to sell
Cumulative: A preferred stock where the publicly-traded company must
pay all dividends
Affiliate: A corporation that is related to another corporation by one
owning shares of the other
Transaction exposure: Transaction exposure measures gains or loses
that arises from the settlement of existing financial obligations the terms
of which are stated in a foreign currency
Translation exposure: Accounting exposure, also called translation
exposure, arises because financial statements of foreign subsidiaries
which are stated in foreign currencymust be restated in the parents
reporting currency for the firm to prepare consolidated financial statements

1. Define the tools of foreign exchange risk management.
2. Discuss functional currency.
3. What is the function of a forward contract? Discuss.
4. Define reporting currency.
5. Explain the types of contractual hedges.
6. What is transaction exposure?
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Unit 9
9.12 Answers
1. Forward contract
2. Call option
3. Futures contracts
4. True
5. False
6. True
7. False
8. Forward contract
9. Option
10. Exchange traded options
11. hedge
12. True

1. The different tools of Foreign risk management are:
Forward contracts
Future contracts
Options contract
Currency swap
2. The currency of the primary economic environment where the affiliate
operates and in which it generates cash flows is known as functional
currency.
3. The reporting currency on the other hand is the one in which the financial
statements are prepared by the parent firm.
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Unit 9
4. Currency volatility can be defined as the measure of the change in price

that takes place over a given time period. It doesnt remain constant from
one time period to another.
5. Through a forward contract, a buyer or a seller can lock in a purchasing
or selling price for an asset with the arrangement that the transaction
would take place in the future. In this contract, the buyer or the seller
arrives at a price and date when they are obligated to buy or sell a given
asset.
6. Transaction exposure calculates gains or losses which occur after the
current financial compulsions according to terms of reference are resolved.
References/ e-References
Publishing.
Kuntluru, Dr. Sudarshan. International Financial Management. Delhi: Vikas
Publishing.
Page No. 197
Unit 10
International Capital Structure
Structure
10.1 Caselet
10.2 Introduction
Objectives
10.3 Cost of Capital
10.4 Capital Structure of MNCs
10.5 Cost of Capital in Segmented vs. Integrated Market
10.6 Describe Cost of Capital Across Countries
10.7 Case Study
10.8 Summary
10.9 Glossary
10.11 Answers
10.1 Caselet
Equity capital market deal value falls to 8-yr low at $7.3 billion
Dealogic, a global deal tracking firm has stated that the activity in the Indian
equity capital market has seen a significant decrease due to the fall of the
deal value by over 18 per cent to an eight year low of USD 7.3 billion this
year so far. Last year in the comparable period, almost 76 equity capital
market transactions took place that led to an increase in the capital worth
USD 9 billion. Dealogic further said that the Indian ECM volume has reached
USD 7.3 billion by way of 44 transactions till August 7 this year the
lowest year-to-date volume since 2004, when it stood at USD 5.9 billion.
Oil & Natural Gas Corps USD 2.6 billion follow-on via Citi, Bank of America
Merrill Lynch, HSBC, JM Financial Group, Morgan Stanley and Nomura
was the largest Indian ECM transaction this year so far. The Indian ECM
bookrunner ranking till August 7,2012 was led by Citi with a 39.9 per cent
share, followed by HSBC and Morgan Stanley with 8.6 per cent and 7.7 per
cent share, respectively. Meanwhile, Indian ECM convertible volume totaled
USD 130 million via just one deal Amtek Indias USD 130 million issues
via Standard Chartered Bank. This is the lowest volume since 2003 and
down 83 per cent compared with 2011 year-to-date period when USD 775
million was raised via three deals, Dealogic said. The peak year for Indian
Unit 10
convertible issuance was in 2007 YTD when USD 5.6 billion was raised via
42 deals. Issuance has subsequently failed to reach the USD 2 billion mark
in every YTD period since 2007, the report said.
Source: Adapted from http://zeenews.india.com/business/news/finance/
equity-capital-market-deal-value-falls-to-8-yr-low-at-7-3-bn_57643.html
10.2 Introduction
In the earlier unit, you learnt about the management of foreign exchange
exposure. Concepts such as tools and techniques of foreign exchange risk
management were also discussed. You also learnt about the differences between
the functional and reporting currency. It also provided detailed information about
hedging and the different ways of hedging risks.
This unit will provide information about the international capital structure.
You will also learn about the cost of capital and the capital structure of MNCs. In
addition to this, you will learn about cost of capital in segmented versus integrated
markets. You will also study the cost of capital across countries.
Objectives
define cost of capital
discuss the capital structure of MNCs
assess the cost of capital in segmented versus integrated markets
examine cost of capital across countries
10.3 Cost of Capital

Let us begin with an example. There are two projects A and B which the firm is
considering. It has to choose only one of them. It chooses project B. By taking
up project B, the firm has to forego the opportunity to undertake project A. This
means that the firm incurs an opportunity cost in terms of what it could have
earned on an alternative investment. Suppose project A yields a return of 10
per cent. So, by undertaking project B, the firm forgoes the 10 per cent return
on project A. Hence the firm should get a return of at least 10 per cent on
project B. This is the required rate of return. The higher the risk of a project, the
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Unit 10
higher is the rate of return. However, if the project risk is zero, this does not
imply that the rate of return is zero. This means that the project still requires
compensation for the passage of time. This is called risk free rate of return.
Thus, the required rate of return is a sum of risk free rate of return plus the risk
premium.
Cost of capital is another name for required rate of return. It is the minimum
rate of return required by a firm on its investment in order to provide the rate of
return required by its suppliers of capital. The suppliers of capital are equity
shareholders and debt holders. A firm may have cost of equity, cost of retained
earnings and cost of debt. The cost of capital is the combined cost of all sources
of capital. As the components are combined according to the weight of each
component of the firms capital structure, the overall cost of capital is also known
as weighted average cost of capital (WACC).
The cost of capital for foreign investment projects like domestic capital
budgeting projects should be based on the weighted average cost of long-term
sources of finance. While calculating the cost of capital, cash flows warrant
adjustment not only for corporate taxes, but also for foreign exchange risk,
withholding taxes on repatriations made, and so on. It must be added here that
in case of international project evaluation, it is important to consider the country
risk factor and therefore, the sovereign spread of the country gets added to the
cost of debt and equity. The country risk arises due to macroeconomic variable,
volatility and the inefficiencies of the capital market and the political situations.
The determination of weighted average cost of capital (WACC) requires the
calculation of specific costs of different sources of long-term funds. The
procedure of computing various sources of finance is the measurement of:
10.3.1 Cost of Debt

The cost of debt is the rate of return required by the debt holders. This rate of
return is generally designated as kd. For example, a company has issued
debentures that have value of INR 5000 and coupon rate of 10 per cent. Here,
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kd is equal to 10 per cent. As the interest on debt is tax deductible for the company
it is the interest rate on debt less than tax saving that is actually the cost of debt.
Thus, the cost of debt is defined ads kd (1-T), where T is the companys marginal
tax rate. Suppose the marginal tax rate is 30 per cent the cost of debt is 7 per
cent. Thus, the cost of debt to the company is less the rate of return required by
lenders (debt holders). When foreign debt is used to finance a foreign project,
the costs of debt in the home currency of the parent firm should incorporate the
interest on the debt, currency gains of losses and taxes.
10.3.2 Cost of Retained Earnings

There is implicit cost of retained earnings, that is, the firm is implicitly required
to earn on the retained earnings, at least equal to the rate that would have been
earned by the shareholders, if they were distributed to them. Thus, retained
earnings involve opportunity cost; the opportunity cost of retention of earnings
is the rate of return that could be earned by investing the funds retained in
investment opportunities that have the same degree of risk as that of the finances
itself. In other words, the rate of return the equity holders have been deprived of
by allowing retentions with the corporate firm is the cost of retained earnings
(k). Accordingly, the cost of retained earnings (kd) for all practical purposes is
equal to the cost of equity. Gitman has appropriately referred retained earnings
as unissued equity shares. However, since raising funds through equity involves
flotation costs, the kr is marginally lower. Apart from the adjustment for flotation
costs, the cost of retained earnings in the context of foreign firms may require
additional adjustment with respect to withholding taxes, as repatriation of
dividends in most countries is subject to such taxes. As a result ke gets reduced.
10.3.3 Cost of Equity Capital

Two possible approaches employed to calculate the cost of equity capital are:
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(i) Dividend approach: As per this approach, the cost of equity capital is
worked out on the basis of a required rate of return, in terms of the future
dividends to be paid on the shares. Accordingly, ke is defined as the discount
rate that equates the present value of all expected future dividends per
share with the net proceeds of the sale (or the current market price) of a
share.
(ii) CAPM approach: Another technique that can be used to estimate the
cost of equity is the CAPM approach. According to the CAPM approach,
k is a function of
the riskless rate of return (normally represented by the rate of return/
yield available on long-term treasury bonds of the government of
the country),
market rate of return (average rate of return on market portfolio,
represented in India by, say, the National Stock Exchange Index,
NIFTY, and so on), and
beta is the measure of systematic risk.
It is significant to note that foreign companies/MNCs, in general, may
have a lower ke than domestic companies due to the fact that they have access
to several foreign capital markets to raise funds.
Activity 1
Make a report differentiating the cost of capital, cost of debt, cost of equity
capital and cost of retained earnings.
Hint:
The procedure of computing various sources of finance is the
measurement of cost of debt, retained earnings and equity.
1. The ________________________is a sum of risk free rate of return plus
the risk premium.
2. ________________________is the minimum rate of return required by a
firm on its investment in order to provide the rate of return required by its
suppliers of capital.
3. The cost of debt is the rate of return required by the________________.
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10.4 Capital Structure of MNCs

Capital structure refers to the financing mix (mix of debt and equity capital)
used by a firm, domestic or and MNC. The capital structure of a firm has a
rearing on the cost of capital. Firms using debt capital enjoy a substantial
advantage as the interest on debt is tax deductible, however the financial risk of
the firm goes up and the cost of capital goes up as well.
The time has come for global managers to refresh their domestically
oriented concepts that have guided the choice of financial structure of their
organization. Under the present situation, MNCs would like to finance their foreign
subsidiaries with as much foreign borrowing as possible. The benefits of being
cheaper and the finances with lesser restrictions have made them a profitable
option for MNCs. Though there are many benefits but the foreign borrowing
makes it difficult for a global manager to choose the optimum financial structure.
The main difficulty in this is that financial structure norms differ from one country
to the other. The managers of these companies would have to be tactical to
benefit from the borrowing and will have to be well versed with the different
norms of different countries. This is the reason that consultancies hire MBA
graduates from different countries who do the project feasibility studies.
Most MNCs report the consolidated foreign and domestic balance sheet
and income statement as the accounting standards are different for different
countries. As the global culture is growing fast, the International Accounting
Standards will have to be followed so that the reporting should be uniform all
over the world. We will discuss this issue in later units. But foreign borrowings
also make the reporting difficult. If a country increases or decreases its foreign
borrowing, it will change the various debt ratios. There is always a struggle with
the proportion of foreign and domestic borrowing, and the MNC tries to achieve
optimal financial structure.
Irrespective of the theoretical issues, there is a similarity in the financial
structures of the firms in the same industry. This suggests that there is an optimal
financial structure for a specific industry. There is an influence of industry norms
on the financial structure, but there are some intra-industry differences due to
variables such as size, managerial risk preference and credit rating that will
make the optimal financial structure difficult to achieve. Now take the case of a
small firm; it would not be able to float bond issues as that would be a costly
proposition as the underwriters would charge them heavily. They could look for
other avenues that would be less costly.
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We have understood that industry norms influence the financial structure,

but this concept does not hold true if the firms are in the same industry but in
different countries. Country norms overshadow the industry norms. A research
study was conducted on 463 corporate financial structures in nine selected
industries of eleven developed countries. The results of the study showed that
the average proportion of debt to total assets of the sample corporations in
each of the nine industries is consistently higher in Japan, Italy, Sweden and
Germany than it is in the US or France. The paper did not explain how a countrys
financial norms influenced but it definitely played a role.
Differences in tax regulations between countries have an influence on the
comparative financial structure. Tax treatment of interest on debt is not the
same in all countries. Some countries take it as a tax deductible item whereas
others treat it as an expense. It has been proved that the depreciation policy
and use of tax-free reserves vary greatly that would affect the debt ratios because
the book value of the total assets was used. Finance theory suggests that the
lack of adequate corporate leverage can be offset by an individuals personal
leverage. High debt ratios would be considered as a good hedge in those
countries where inflation is a problem. Inflation would also increase debt ratios
based on book value because the equity would typically be undervalued relative
to the market value.
Since different countries have different financial structure norms, one has
to observe wherever the host countries permit. MNCs should guide their various
subsidiaries to adopt such a financial structure that will profit them the most
with respect to the norms of the host country. The main advantages of localized
financial structure are the environmental factors that cause different companies
to opt for such a financial structure. When a foreign subsidiary follows a localized
financial structure, it will save the subsidiary from the accusation that it is draining
the countrys fund to its parent. The MNCs subsidiaries that have too high a
proportion of debt contribute a fair share of risk capital to the host country. It
improves the image of foreign subsidiaries that use very little of the financial
resources that are available from the host country. If these subsidiaries use the
local finances they will have to be aware of the various rules and regulations of
the host countries law. The monetary and the credit policy of the host country
will have to be analysed thoroughly as they will have a deep impact on the
operations of the subsidiary. Once a foreign subsidiary borrows from the local
market, it has to abide by the rules and regulations of the host country. Also, the
sense that the subsidiary will close its operations will be reduced as it has to
stay in the market to repay the loan.
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4. The capital structure of a firm has a rearing on the cost of capital. (True/
False)
5. Differences in tax regulations between countries do not affect the
comparative financial structure. (True/ False)
6. The MNCs subsidiaries that have too high a proportion of debt contribute
a fair share of risk capital to the host country. (True/ False)
10.5 Cost of Capital in Segmented vs. Integrated Market

Multinational companies (MNCs) have the parent company in one country and
the subsidiaries in many other countries. For these companies, it is possible to
raise capital in any other country in which they operate. The option to raise
capital in different markets improves their liquidity situation and they can create
optimum capital structure to take better advantage of cheaper debt capital, easy
availability of funds and possibility of diversifying cash flows.
The value of a firm depends upon its profitability, which in turn is the
combined effect of the income generated from operations and the sources of
capital deployed to fund the operations. If cheaper funds have been used, value
of firm goes up and returns on shareholders equity increases, which is the
main goal of the organization. In order to decide the sources from where funds
are to be procured, the firm has to examine many aspects. Some of the important
aspects are given here:
1. Segmented markets: Segmentation in market is created by restriction to
free flow of capital. In such markets, inflow of international capital is
generally restricted and hence, cost of capital is higher. This is the situation
in most developing countries. A market is segmented if the required rate
of return on securities of comparable risk in that market is different from
securities traded in other countries with similar risk.
2. Integrated markets: Integrated market securities of comparable expected
returns and risks have identical values in each international market except
for adjustments of foreign exchange risk and political risk. Since the capital
can be arranged in any of the countries where the firm operates, it has
possibility of choosing a financial market which is cheapest keeping similar
risk level.
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4. Taxation rules: Tax rules in different countries are different and the firm
has to see the combined effect of basic cost of capital and the applicable
taxes.
5. Lending norms: Different countries have different rules regarding the
liquidity, proportion of foreign capital, fulfilling taxation and legal
requirements and compliance, to all the norms. All these raise the cost of
capital.
6. Disclosure norms: Disclosure norms are different in each country for
firms seeking capital. If norms are strict, fewer firms will be seeking capital
and hence, cost of capital becomes cheaper in such a situation.
7. Information barrier: The main information barriers are language,
accounting practices and quality of disclosures. In case, language is not
understood, international accounting standards are not followed, the
requisite disclosures are not made, and the required rate of return by
investor will be increased due to increase perception of risk.
8. Small country bias: Small countries have small financial markets
9. Exchange rate fluctuation: If the exchange rates are volatile, the investor
would raise the rate of return to cater for the higher risk involved.
10. Transaction cost: Imposition of higher taxes is one of the main ways to
segment the market.
11. Political risk: The possibility of political instability or disturbances
increases the risk level and the investor would raise the cost of capital as
they would be less inclined to invest in such circumstances.
The cost of capital is dependent on degree of segmentation. For fully
segmented market, the cost of capital would be higher. Sometimes, it is possible
to circumvent the situation and assess other capital markets in which case, the
cost of capital would be lower. If a financial market is fully integrated with rest of
the world, the most competitive cost of capital can be obtained.
C
D
Cost
of
capital
and
rate
of
return
in per
cent
Kc
Kb
Ka
D1
Budget in local currency
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The integrated market provides least cost of capital. It is also to be noted

that when the firm moves from domestic market to free market to fully integrated
market, the cost of capital progressively goes down and the budget size
progressively goes up.
Floatation cost and WACC
When a firm raises funds with debt or equity to finance a long term project, it
incurs flotation costs. These costs are related to issue of securities and pertain to
advertising, publicity, fees, brokerage and, underwriting charges for the merchant
banker, legal and administrative expenses and other miscellaneous expenses.
The result of these expenses is that the actual debt and equity becomes costlier
than their real cost of issue. There are two ways to recover these costs from the
project. One way is to include these in the costs of debt and equity and such
modified costs of debt and equity be used to determine the cost of capital for the
project. Another way is not to include these costs in the calculation of cost of
capital and use the flotation expenses as a part of the initial expenses for the
project. Since these are onetime expenses, it is considered better to use these as
one time initial cost of the project and not include in the WACC calculation.
Activity 2
Find out an example of segmented market and one example of integrated
market. Put them down on a chart.
Hints:
A market is segmented if the required rate of return on securities of
comparable risk in that market is different from securities traded in
other countries with similar risk.
Integrated market securities of comparable expected returns and risks
have identical values in each international market except for adjustments
of foreign exchange risk and political risk.
7. The value of a firm depends upon its____________, which in turn is the
combined effect of the income generated from operations and the sources
of capital deployed to fund the operations.
8. ____________in market is created by restriction to free flow of capital.
9. For fully segmented market, the cost of capital would be____________.
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10.6 Describe Cost of Capital Across Countries

Each country is unique in terms of technology and other resources as well as in
the cost of capital for its components like debt, preference and equity. MNCs
which have parent company in one country and subsidiaries in various other
countries would like to take advantages of the unique situation in each country.
The parent company is interested in maximizing the shareholders wealth in its
parent country. For example, if the cost of capital is high in some country, the
operations may be kept at a lower level compared to the countries where the
cost of capital is low. In the countries with high cost of capital, many projects
may not be viable as per capital budgeting analysis, whereas similar projects
may be highly profitable in countries with lower cost of capital. The most
advantageous method for the MNCs would be to receive capital in those countries
where the cost of capital is low and to expand business in markets where the
market potential is high. However, the exchange rate variations will have to be
kept in mind while taking such decisions.
Further, the difference in cost of capital of its various components may
influence the MNCs to use different capital structure in each country based on
the relative value of cost of capital for its components. If the debt is available
cheaper, more debt may be used in the capital structure and vice versa.
Effect of country difference in the cost of debt
The cost of debt in a country is based primarily on risk free rate and the risk
premium demanded by creditors. Differences in risk free rate depend upon the
rate of interest which is available on government securities at any point in time
and thus depends on the general economic conditions, financial policies, tax
laws and political stability. It also depends on the demand and supply of funds
for investment. These conditions are different in each country.
Tax laws in some countries provide high incentives for savings and
therefore, more funds will be available for investment. Further, tax laws relating
to tax rate on profits, depreciation tax provisions, investment and investment
tax incentives affect the demand of the firms for funds.
Demographical differences between countries affect their supply of funds
and hence, the interest rate; countries with higher proportion of younger
population have higher rate of interest, as the tendency today is to spend more
and save less compared to senior age group.
The central bank in each country like RBI in India implement the monetary
policies which influence the supply of funds and this in turn influences the interest
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rates. One exception to this is that European Central Bank controls the supply
of Euros and hence all the member countries using Euros as currency have
identical risk free rate.
The economic conditions of each country affect the interest rates and as
these are different in each country, the interest rates would be different. Generally,
the interest rate is higher in less developed countries due to economic conditions.
Differences in the risk premium: The risk premium must compensate the
creditors for the risk that the firm would not be able to meet its obligations to
creditors. The level of risk depends upon the general economic conditions,
relationship between the firm and its creditors, degree of financial leverage and
government intervention. If the economic condition of a country is stable and
risk for the firm of not being able to meet its obligations is less, this in turn would
lead to lower risk premium.
The cultural differences between countries result in having different
relationships between companies and creditors. This is especially true for Japan
where the creditors would come to the rescue of the firm in the case of crisis by
offering further loans to reduce the liquidity risk. Thus, there is a less chance of
bankruptcy of a Japanese firm and it leads to low risk premium. In some other
countries, the cultural position may be the other way round, i.e. the moment
creditors sense trouble with the firm, they will act relentlessly to demand their
outstanding interest dues and pull out the principal amounts as soon as possible
and stay away from the firm. In such cultures, the risk of bankruptcy is higher
and therefore, the risk premium would be more.
In some countries, the government intervenes and tries to rescue the
firms when these are in difficult times by providing subsidies and special loans
etc. and in such countries, the failure risk will be less and accordingly, the risk
premium will be lower. Such practice is common in UK, where as in US this type
of government intervention is the least.
In some countries, the firm can have borrowings because the lenders are
willing to accept high degree of financial leverage and not demand higher interest
rates. This depends upon the relationship between the firm with the lenders
and the government. For example, the firms in Japan and Germany deploy
higher financial leverage compared to the firms in US.
Country differences in cost of equity
A firms cost of equity depends upon the opportunity cost based upon alternate
investment options which the investor would have used, if he had not invested
in the firm. Return on equity consists of two parts, a risk free interest rate that
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they would have achieved by depositing their funds in government securities

and the premium to cover the risk of the firm. Since risk free interest rate is
different between the countries, accordingly the cost of equity. The cost of equity
is also dependent on the investment options in the country. If there are many
investment opportunities in a country, the cost of equity will be high and vice
versa.
Another parameter to watch is the price-earnings ratios as it reflects share
price of the firm as a multiple of its earnings. A high priceearnings ratio indicates
that for the given earnings, the firm is able to command higher prices and that
indicates low cost of equity. While comparing the price earning multiple in different
countries, it needs to be adjusted for inflation, earnings growth, exchange rate
etc.
The European countries which have common currency Euro are in an
integrated market situation, because investors can freely trade in the equity in
other European countries using the same Euro currency. This has led to
increased demands for shares and has led to increased share prices. Due to
increased liquidity in European market, MNCs can obtain equity financing at
lower cost.
Examining debt and equity cost together
The cost of debt and equity can be combined in proportion to their market value
to obtain overall cost of capital also called Weighted Average Cost of Capital
(WACC). Due to differences in the cost of debt and equity in different countries,
the cost of capital will be different. Some countries like Japan have relatively
low cost of capital. They have low risk free rate which also has reducing effect
on the cost of equity. The price earnings multiples are high and funding can be
obtained at a lower cost. MNCs can obtain such low cost funding. However, if
these funds are used to finance operations in another country, the cost of this
capital is exposed to exchange rate risk. The firms using such capital must be
careful that the ultimate cost of using such low cost capital may turn out to be
more expensive due to the exchange rate involved.
Estimating the cost of capital
MNCs can estimate the cost of debt and equity when they want to finance new
projects in order to decide about the capital structure to use for the project.
Post-tax cost of debt can be estimated relatively easily by looking at the data of
other firms with similar risk level as the project. The cost of equity is an opportunity
cost which the investors could earn while deploying their funds in other
investments with similar risk. The MNCs can try to determine the expected
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return on other stocks with similar risk level and this can be used as cost of
equity.
The cost of capital for the project which is also called discount rate or
required rate of return is the weighted average cost of the estimated debt and
equity cost.
10. The most advantageous method for the MNCs would be to receive capital
in those countries where the cost of capital is low and to expand business
in markets where the market potential is high. (True/False)
11. The cost of capital for the project is also called discount rate or required
rate of return. (True/False)
10.7 Case Study

Central Bank of India to seek `700 crore from government
The Central Bank of India has stated that it will request for `700 crore
capital from the government. It needs almost `1,200 crore in order to
increase its credit by 20 per cent in the current financial year. MV Tanksale,
the chairman and the managing director of the bank has stated that the
bank has enough headroom for raising subordinated debt or tier II capital
but no bank is keen to use this option as the imminent Basel 3 regimes
emphasizes on core capital. Indian banks will adopt Basel 3 from January
2013.
If the plea is accepted by the government, the amount will be invested in
pure equity through the subscription to preference shares issued by the
bank. The internal accruals will also provide balance which gets added to
tier I capital too. The government holds 79 per cent in the bank.
Tanksale further said that the banks are now under the compulsion to create
capital out of profit generation. He also announced that the bank aim to
seek `700-800 crore from the government. The rest of the amount will
come from the profits.
Mr. Tanksale was in Kolkata to attend a FICCI seminar and he there
announced that they are targeting an 18-20 per cent growth this fiscal year
which is more than what the Reserve Bank of India had projected. RBI had
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projected a growth of 17 per cent. However, the slow deposit growth has
also made him concerned. He said that the deposit growth is not in
commensuration with the credit growth. This was mainly because of the
fact that high inflation led the people towards physical savings instead of
the financial savings.
The Mumbai-based entity with a 31 per cent share of high cost bulk deposits
said it would not able to reduce the share to 15 per cent by March 2013 as
directed by the government.
Questions
1. Do you think the Central Bank will benefit of if their plea is granted?
2. State the plans put forward by the chairman of the bank.
Source: Adapted from an article at http://articles.economictimes.
indiatimes.com/2012-08-10/news/33137623_1_deposit-growth-creditgrowth-mv-tanksale written by Atmadip Ray
10.8 Summary
Cost of capital is another name for required rate of return. It is the minimum
rate of return required by a firm on its investment in order to provide the
rate of return required by its suppliers of capital.
The cost of capital for foreign investment projects like domestic capital
budgeting projects should be based on the weighted average cost of longterm sources of finance.
The cost of debt is the rate of return required by the debt holders.
The opportunity cost of retention of earnings is the rate of return that
could be earned by investing the funds retained in investment opportunities
that have the same degree of risk as that of the finances itself.
Two possible approaches employed to calculate the cost of equity capital
are: (i) the dividend approach and (ii) the capital asset pricing model
(CAPM) approach.
Capital structure refers to the financing mix (mix of debt and equity capital)
used by a firm, domestic or and MNC.
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The difference in cost of capital of its various components may influence

the MNCs to use different capital structure in each country based on the
relative value of cost of capital for its components.
MNCs can estimate the cost of debt and equity when they want to finance
new projects in order to decide about the capital structure to use for the
project.
10.9 Glossary
Repatriation: The act of an individual or company bringing foreign capital
into a home country and converting it to the domestic currency
Dividends: A distribution of a portion of a companys earnings, decided
by the board of directors, to a class of its shareholders
Deductible: An amount subtracted from an individuals adjusted gross
income to reduce the amount of taxable income
Optimal: An optimum return on capital
Leverage: The use of various financial instruments or borrowed
capital, such as margin, to increase the potential return of an investment.
Diversifying: Dividing investment funds among a variety of securities
with different risk, reward, and correlation statistics so as to minimize
unsystematic risk
Disclosure: A companys release of all information pertaining to the
companys business activity, regardless of how that information may
influence investors
Retained earnings: Profits generated by a company that are not
distributed to stockholders (shareholders) as dividends but are either
reinvested in the business or kept as a reserve for specific objectives

1. Define cost of capital.
2. Discuss the approaches that are employed to calculate the cost of equity
capital.
3. What do you mean by capital structure? Discuss.
4. Explain the aspects that a firm needs to examine in order to decide the
sources from where funds are to be procured.
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5. Define the effect of country difference in the cost of debt.

6. How do MNCs estimate the cost of debt and equity? Discuss.
10.11 Answers
1. Required rate of return
2. Cost of Capital
3. Debt holders
4. True
5. False
6. True
7. Profitability
8. Segmentation
9. Higher
10. True
11. True

1. Cost of capital is another name for required rate of return. It is the minimum
rate of return required by a firm on its investment in order to provide the
rate of return required by its suppliers of capital.
2. Two possible approaches employed to calculate the cost of equity capital
are: (i) the dividend approach and (ii) the capital asset pricing model
(CAPM) approach.
3. Capital structure refers to the financing mix (mix of debt and equity capital)
used by a firm, domestic or and MNC. The capital structure of a firm has
a rearing on the cost of capital.
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4. In order to decide the sources from where funds are to be procured, the
firm has to examine many aspects. Some of the important aspects are
given here:
Segmented markets
Integrated markets
Taxation rules
Lending norms
Disclosure norms
Information barrier
Small country bias
Exchange rate fluctuation
Transaction cost
Political risk
5. The cost of debt in a country is based primarily on risk free rate and the
risk premium demanded by creditors. Differences in risk free rate depend
upon the rate of interest which is available on government securities at
any point in time and thus depends on the general economic conditions,
financial policies, tax laws and political stability.
For further details, refer Section 10.6.
6. MNCs can estimate the cost of debt and equity when they want to finance
new projects in order to decide about the capital structure to use for the
project.
Publishing.
Kuntluru, Dr. Sudarshan. International Financial Management. Delhi: Vikas
Publishing.
Page No. 216
Unit 11
International Capital Budgeting
Structure
11.1 Caselet
11.2 Introduction
Objectives
11.3 Review of Domestic Capital Budgeting
11.4 Adjusted Present Value Model
11.5 Capital Budgeting from Parent Firms Perspective
11.6 Expecting the Future Expected Exchange Rate
11.7 Risk Adjustment in Capital Budgeting: Sensitivity Analysis
11.8 Case Study
11.9 Summary
11.10 Glossary
11.12 Answers
Reference/e-References
11.1 Caselet
A Vision for Tomorrow
The head of a company which sells fairness crme was once asked What
do you sell? We sell hope, she said. The same question was posed to
the head of UTV. He said, We sell happiness through entertainment. And
when a furniture business owner was asked the question, he said, We are
into furniture and furnishings business. The first two replies were from two
successful business people, whose vision of business was clear and
futuristic right from the word go. Whereas, in the furniture sellers case, it
is most unlikely that his company, however well it may be faring, would
never attain the heights of the FMCG giant or UTV. Their vision is sure to
help make them move ahead in their business as they have long term
plans; they will think in terms of leveraging themselves on to a higher plane.
For example, they may have envisioned that by year 2020 or so, they will
be at least five times the size they are today. Now, we know that if we need
to plan for anything for the future, it well means that it has to be planned
and budgeted for now. Capital budgeting is based on identifying the
opportunities, threats and internal weaknesses, setting long-term goals,
formulating action plans and strategies, and monitoring them on a
continuous basis.
Unit 11
Whenever businesses take capital budgeting decisions, they add value to

their company, which gets reflected in shareholder earnings, the priceearnings ratio, the share price, market capitalization and dividends.
Source: Adapted from http://www.thehindubusinessline.in/mentor/2003/07/
21/stories/2003072100321000.htm
11.2 Introduction
In the earlier unit, you learnt about the international capital structure. You also
learnt about the cost of capital and the capital structure of MNCs. Various
concepts related to the cost of capital such as cost of debt, cost of retained
earnings and cost of equity capital were also discussed. You also learnt about
the cost of capital in segmented versus integrated markets as well as the cost
of capital across countries and states.
Every firm is a going concern, whether domestic or an MNC. This means
that the business of that firm will go on for years on end. Over the years, every
business needs to grow profitably. To grow, the firms need capital. Capital projects
are important for firms as these generate the products which can be sold to
obtain revenue. These projects require large investments and the income accrues
over a number of years in the future.
In this unit, you will learn about different topics related to international
capital budgeting. You will learn about the adjusted present value model, capital
budgeting from parent firms perspective and expecting the future expected
exchange rate. You will also learn about the political risk and will also know
about transaction and exchange rates. In addition to these, you will also learn
about risk adjustment in capital budgeting analysis and sensitivity analysis.
Objectives
explain domestic capital budgeting
discuss the adjusted present value model
define capital budgeting from parent firms perspective
examine how to expect the future expected exchange rate
discuss risk adjustment in capital budgeting analysis and sensitivity
analysis
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11.3 Review of Domestic Capital Budgeting

Every financial manager has to deal with two main issues; how to raise funds
and how to use these funds. Funds are raised normally by equity shares,
preference shares and debt. Capital projects are important for the firm as these
generate the products which can be sold to obtain revenue. These projects
require large investments and the income accrues over a number of years in
the future. The whole process of planning and selecting a long term project on
the basis of financial analysis is called capital budgeting.
The steps involved in financial analysis or capital budgeting analysis are
assessing the cash flows, determining the opportunity cost of capital and finally
selecting and applying the techniques of capital budgeting to decide whether to
accept the project or not. Also, if only one project can be accepted, then which
project to accept in order to maximize shareholders wealth.
Techniques of Capital Budgeting
There are many techniques which can be used to analyze the projects. These
techniques can be broadly classified into discounted cash flow techniques, which
include net present value (NPV), internal rate of return (IRR), profitability index
(PI) and discounted payback methods, and non-discounted cash flow techniques
which include payback and accounting rate of return (ARR) methods. The most
commonly and most widely accepted technique is NPV method. We now describe
some of these techniques in brief and NPV method in greater detail.
Net Present Value (NPV)
In this method all future cash flows occurring in different time periods are discounted
to present value using opportunity cost of capital as discount rate. Whenever
there is a cash inflow, we take it with positive sign and cash outflow, we take it as
negative sign. If present value (PV) of cash inflows is greater than present value
(PV) of cash outflows the project can be accepted. However, if there are more
than one project and only one can be accepted then the project with highest
difference of PV of all cash inflow and PV of cash outflows is accepted. The
difference of PV of all future cash flows and initial investment is known as NPV.
So, we can say that project with positive NPV can be accepted and in case of
more than one project, the project with highest NPV will be accepted.
NPV =
C3
C1
C2
Cn
+
+
+ ................. +
C0
1
2
3
(1 + k)
(1 + k)
(1 + k)
(1 + k)n
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C1, C2, ...................., Cn are the cash flows in respective years

k = opportunity cost of capital
C0 is the initial investment (-ve sign taken since it is an outflow)
n is life of the project
Example:
The expected cash flow in respective years of a project which is under
consideration by a firm is given below. The firms opportunity cost of capital is
9 per cent. Calculate the NPV and make your recommendation of whether to
accept or reject the project.
Year
Cash
flow (`)
1,200
500
400
400
400
300
Solution:
NPV =
500
400
400
400
300
+
+
+
+
1,200
1
2
3
4
(1 + .09)
(1 + .09)
(1 + .09)
(1 + .09)
(1 + .09)5
Solving we get
NPV = 382.61
Since NPV is positive so project can be accepted.
Internal Rate of Return (IRR)
Internal rate of return is defined as that discount rate at which NPV is equal
zero. This internal rate of return is compared with opportunity cost of capital. If
IRR is greater than opportunity cost of capital the project can be accepted; if
IRR is less than opportunity cost of capital the project cannot be accepted as in
such a case, the project will not be able to generate even the opportunity cost of
capital. If IRR is equal to opportunity cost of capital the project will not generate
any extra returns so it can either be accepted or rejected. The greater the
magnitude by which IRR exceeds the opportunity cost of capital the greater will
be the profitability, so ranking of projects can be done based on the magnitude
of difference.
Profitability Index (PI)
It is defined as the ratio of present value of all cash inflows divided by the initial
cash outflow. It is similar to NPV in the sense that it also uses discounted cash
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flows and initial outflow but instead of subtracting initial cash outflow from
discounted cash flows, here we divide the discounted cash flows by initial cash
outflow. We accept the project if PI is greater than one, reject it if PI is less than
one and may or may not accept it if PI is equal to one.
Payback Period
This is a non-discounted cash flow technique. It finds out the time in years in
which the initial investment would be recovered. It is the easiest method as far
as computation is concerned but drawback being that it does not consider time
value of money. Mathematically, it is calculated by dividing initial cash outflow
by annual constant cash inflows.
Discounted payback period is a better method than payback period in the
sense that it considers the time value of money and discounts all future cash
flows.
Determining cash flows
We need to determine the incremental cash flows over the existing cash flows
which will take place by acceptance of the project under evaluation. Any expenses
which are already incurred will not be included in cash flows. Such expenses
are called sunk costs.
The step of determining cash flows with accuracy is the most important
step in capital budgeting analysis as further process is dependent on it, but it is
a difficult task due to the following reasons:
1. Future is uncertain, and uncertainty gives rise to risks
2. Accounting information which is based on various assumptions is used
as basis to determine cash flows
3. Economic conditions may change suddenly due to some event
In any capital investment project there will be three main cash flows:
Initial cash outflow
Cash flows during the project. It may be inflow or a mix of inflow and
outflow
Final period cash flow; generally referred to as terminal cash flow
Though cash flows (not profits) are used as basis for evaluation of capital
projects, both are important. These are connected by the following equation:
Cash Flow = Profit (P) + Depreciation (D) Capital Expenditure (CAPEX)
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The drawback with the use of profit as basis of the evaluation is that it is
based on past data and does not fully reflect the likelihood of future cash flows.
Projects are of two types. Independent projects are those projects which
can be accepted or rejected without the effect on any other project. Mutually
exclusive projects are those projects where out of a number of options, only
one can be accepted. When we accept one option, the other options do not
exist. For example, a firm has a plot of land and the options are to build a hotel
or to build a hospital. The moment one project is accepted, the land is utilized
and therefore, the other project cannot be accepted. Sometimes, independent
projects become mutually exclusive due to constraint on the availability of funds.
Such projects are called capital rationing projects.
The important points to be noted are:
1. Cash flows are considered only on after tax basis.
2. Financing costs are not included as these are covered under the
projects required rate of return.
3. Cash flows are assessed on an incremental basis and represent
difference in cash flows after and before the investment.
Activity 1
Browse the Internet and find out the capital budgeting practices used by
MNCs. Also make a chart and write down how they are different from a
domestic firm.
Hint:
The techniques used are NPV, IRR or APV.
1. _____________are raised normally by equity shares, preference shares
and debt.
2. The whole process of planning and selecting a long term project on the
basis of financial analysis is called_____________.
3. ____________are those projects which can be accepted or rejected
without the effect on any other project.
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11.4 Adjusted Present Value Model

Debt has an advantage over equity since the interest paid on debt is almost
always deductible from income while calculating corporate taxes, which is not
the case for dividends on equity. So, the post cost of debt is less than the pretax cost of debt. Debt creates additional value for a project. How is this so? By
reducing the taxes paid, so adjustments to the calculation of the projects present
value must be made if it supports additional debt. Therefore, the contribution to
present value of issuing debt is calculated as the present value of tax savings.
This present value (PV) can then be added to the PV of a project calculated
using the all-equity cost of capital. The method of adding the tax benefits of
debt to the separately calculated present value of the project using the allequity cost of capital is known as the adjusted present value (APV) approach.
Let us understand this from another angle. The NPV model that you studied
earlier involves discounting all cash flows at the cost of capital. You already know
that the cost of capital measures the risk and also the opportunity cost of the
money invested. The conventional NPV model assumes that the project has the
same business risk (financial and operating risk). It is also assumed that the
debt-equity ratio is unchanged over the life of a project. However, in reality all the
assumptions may prove to be untrue. Therefore a conventional model needs to
be adjusted to take care of the risks. Such an adjusted model is known as Adjusted
Present Value Model. This model considers that the project will have differing
discount rates in its evaluation process based on the risks that it bears. The APV
method also identifies the cash flows of a project by different components and
discounts each one at the appropriate risk-adjusted discount rate.
The APV model is a three step approach
Step 1: Evaluate the project as if it is financed entirely by equity, to
obtain the cash flows. The rate of discount is the required rate of return
on equity corresponding to the risk class of the project.
Step 2: Add the present value of any cash flows arising out of special
financing features of the project such as external financing. The rate
of discount used should reflect the associated risk with each of the
cash flows.
Step 3: Add cash flows of Step 1 and Step 2 to obtain APV
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Accordingly, we can say that:

Value of the levered firm = Value of the unlevered firm + Value of financing
effects.
In other words, NPV of a project has two components: all equity NPV and
the value of financing effects which includes interest tax shields that arise from
use of debt financing and subsidies. For example, the government of a country
may provide loans at subsidized rates or offer a tax holiday to promote Foreign
Direct Investment.
The value of such concessions will be added to the project evaluation.
Issue costs that arise due to issue of equity shares and debentures will also add
to the cost. This will reduce the project APV.
If you compare the NPV and the APV model, the latter is definitely a
better method as it deals with the financing effects and the operating cash flows
of the project. However, it is difficult to obtain the precise tax shield as the
shareholders and creditors are subject to diverse tax rates and regulations.
Whether it is conventional NPV or APV, the decision is to accept the project
if the NPV or APV is greater than zero. If it is less than zero, the project should
be rejected. In case the NPV and APV are zero, then at times, the project may
be accepted on the basis of consideration of certain other factors of business.
4. The contribution to present value of issuing debt is calculated as the
present value of tax savings. (True/False)
5. Debt creates additional value for a project by reducing taxes paid, so
adjustments to the calculation of the projects present value must be made
if it supports additional debt. (True/False)
11.5 Capital Budgeting from Parent Firms Perspective

In the case of MNCs, the parent firm is in one country and subsidiaries are in
various other countries. A very pertinent question arises that for capital budgeting
project analysis, it should be seen from the perspective of parent company or
from the perspective of subsidiary.
Analysis of a foreign project involves two issues in addition to the
investment and financing, and these are:
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1. Are the cash flows to be measured from the perspective of the foreign
subsidiary or from the perspective of the parent company?
2. Should the additional economic and political risks which are unique to the
foreign country where subsidiary is located, be used in adjustments of
cash flows to arrive at net present value?
The basic point is that the main firm is in the parent country and
shareholders in that country have invested their funds; so their interest must be
the foremost objective of the organization. This still does not fully answer the
question about the capital budgeting project. If a project in a foreign country is
going to be beneficial to the parent firm in the long run, it can be accepted. As
per economic theory, the value of a project is measured by net present value of
future cash flows to the investor.
Major differences can exist in the cash flows of the project and the cash
flow remittances to the parent firm due to tax laws and exchange control
regulations. Basically, the net present value of the future cash inflows in relation
to the initial outlay will determine the acceptability and profitability of the project.
However, the total effect has to be seen from the perspective of investors in the
parent country.
A three stage approach is suggested in such cases:
Carry out the project evaluation from the perspective of the subsidiary
as if it was a separate company
In this stage, the perspective shifts to the parent firm. It requires specific
forecasts regarding amount, timing and the form of transfer of funds to
the parent company and information regarding taxes and other
expenses required to be incurred in the process of transfer of funds.
In this state, the firm has to consider other indirect costs and benefits
that this project provides on the total system such as increase or
decrease of export business by another affiliated firm.
Estimating incremental cash flows

The company must estimate the projects true profitability and it involves marginal
revenues and marginal costs associated with the project from all subsidiary
operations of the world. The incremental cash flows to the parent can be found
out from the worldwide cash flow with and without this project. While doing so,
one has to take care of the following aspects:
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1. Include fees and royalties to the parent firm in the cash inflows
2. Remove overhead costs which are anyway to be incurred by the parent
firm
3. Use market value of capital resources and other services transferred
internally
4. Cannibalisation of sales of other units
5. Creation of incremental sales by other units
6. Foreign tax credits which can be separately utilised
7. Provision of a key link in the firms global services network, and providing
seamless service to customers
8. Competitors, technology, products
9. Diversification of production facilities
10. Market diversification
11. Firms reputation of being a market leader and always taking the lead in
introducing new technology / products
12. Effect on brand building
13. Considering the projects strategic purpose and its effect on future opening
up of opportunities
So, you can see that the calculation of future cash flows in the foreign
country and the remittances to the parent country with reference to the initial
outlays may be simple to calculate, the strategic considerations of investing in
a new project in a foreign country far outweigh those cash flow benefits.
Besides the above, the following aspects require special considerations:
Economic and political risk
Generally, firms want to invest in countries which have sound economy, stable
currency and healthy social and political condition involving minimal political
risk. It is essential to make an assessment of economic and political risk before
deciding about the investment projects. Three methods to include these risks in
the analysis are:
Reducing the payback period requirement
Increasing the required rate of return for the project
Adjusting cash flows to incorporate impact of specific risk
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One or more of the above methods can be used. Broadly, it implies that
when risk levels are higher, you invest in shorter duration projects and require
larger cash flows to make the project viable.
Adjusting discount rate and payback period are general approaches to
protect the firm from risky investments. Most often, the economic and political
risks are not clearly well defined but rather vaguely hidden in the circumstances
as these keep unfolding. It requires great insight to be able to assess the
magnitude of such risks one year or five years down the line. For example, if
you raise the required rate of return from 16 per cent to 18 per cent, it simply
means that you are adding some safety cushion to cover the risk. Similarly, if
you reduce the requirement of payback period from 4 years to 3.5 years, it
implies that you are keen to go for short duration projects because investments
in distant future are more risky.
Adjusting cash flows for specific periods based on expected risks on those
periods is a better approach so that you can address the specific risks in our
assessment.
However, by taking such actions, you are restricting the new projects to
those really profitable ones. In case, there is a heavy competition for our products,
you have to be careful in raising the acceptance level of the project, because
you may lose good opportunities to competition.
Exchange rate changes and inflation
Exchange rates between currencies keep fluctuating all the time and inflation in
different countries is at different rates. Present value of future cash flows from
a foreign project can be calculated in two steps. First convert nominal foreign
currency cash flows to nominal parent country cash flows and then discount
these cash flows with nominal parent country required rate of return. It is required
to analyze the effect of inflation and effect of exchange rate separately for each
component of cash flow. For example, depreciation tax shield will not change
with inflation whereas revenues and costs will be affected. So generally what is
done is to first convert the foreign currency cash flows for inflation in the foreign
country and then projecting these cash flows into parent country currency using
prevailing exchange rate.
International taxation
In addition to the taxes the subsidiary pays to the host government, there is
withholding of taxes on dividends and other income remitted to the parent. Also,
the home government may tax this income in the hands of the parent. If double
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taxation avoidance treaty is in place, the parent may get some credit for the
taxes paid abroad. However this will depend on the financial arrangements
between the countries. There is also the issue of transfer pricing which may
enable the parent to further reduce the overall tax burden.
Blocked funds
It may happen that a foreign project becomes an attractive proposal because
the parent has some funds accumulated in a foreign country which cannot be
taken out or may only be withdrawn after giving heavy penalties in the form of
taxes. Investing these funds locally in a subsidiary or a joint venture may be a
better way to use such blocked funds.
6. In the case of MNCs, the ________________________is in one country
and subsidiaries are in various other countries.
7. Major differences can exist in the cash flows of the project and the cash
flow remittances to the parent firm due to __________and_____________.
8. Adjusting__________ and payback period are general approaches to
protect the firm from risky investments.
11.6 Expecting the Future Expected Exchange Rate

For the MNCs the exchange rate between currencies is of paramount importance
due to the following reasons:
1. Most important are the capital budgeting decisions in which case the future
cash inflows would be in the currency of the foreign country and cash
flows for the parent company in home country will depend upon the
exchange rates applicable to remit the funds. Thus future cash flows are
dependent on future exchange rates.
2. In the case of financing decisions the firms generally borrow in the country
where the cost of capital is low and those currencies that are expected to
depreciate.
3. Expected future exchange rates are important in order to decide whether
to hedge the exchange rate risk or not.
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There are three forecasting methods for future exchange rates:

(1) Fundamental
(2) Technical
(3) Market Based
Fundamental forecasts
These are based on changes in the underlying economic factors that affect
exchange rates.
For example, purchasing power parity (PPP) gives a forecast of future
exchange rates based on estimates of inflation in two countries:
This is dependent on estimates of inflation rates over the next period.
PPP generally gives an unbiased estimate of long run changes in exchange
rates.
Technical forecasts
This is based on assumption of repeated patterns in exchange rate changes
over a period. An investor might find that if the exchange rate goes up three
months in a row it usually goes down the next month.
Technical forecasting may be useful on a very short term basis. However,
from the viewpoint of an MNC, longer term changes in exchange rates are
important.
Market based forecasts
These forecasts use current information from the foreign exchange market to
forecast future exchange rates. There are two market based estimates that can
be used for a forecast of future rates:
(1) The current spot rate
(2) The forward rate
Current spot rate
The exchange rate in next period generally has no correlation with exchange
rate in last period. This means that changes from period to period are random
and therefore unpredictable.
One way to forecast what next periods exchange rate will be is to simply
use todays exchange rate. That is, if you want an estimate of what next years
Dollar Yen rate will be and todays rate is 80, then using 80 as your forecast
will be the best guess.
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It has been found that the current spot rate is good estimate of the future
spot rate. However, the errors in any particular period can be very large.
Forward rate
Important place to look for a forecast of future rates is the forward rate. Forward
rate is arrived at based on the combined wisdom of competing parties and is
most likely to be right.
Forward rate = Expected spot rate at maturity of forward
Thus, looking at forward quotations may be a very good way to get an
unbiased estimate of the future spot rate. Since the forward rate is set in the
forward market, it is really a combined effect of all investors expectations (the
final rate is actually an average of each investors forecasts). Hence, it is expected
to be better forecast than any one individual could make.
According to the above discussion, the forward rate should be the best
possible forecast of future spot exchange rates. However, this is not true.
First, interest rate parity states that the forward rate is simply a reflection
of interest rate differentials between countries. This means that the forward
rate is not determined by peoples expectations of the future spot rate.
Second, there are two groups of people in the forward market: hedgers
and speculators. Hedgers are trying to get rid of exchange rate risk and the
speculators are agreeing to take on this risk in the hope that they make a profit.
In order for a speculator (i.e., a bank) to be convinced to enter a forward contract,
it must expect to make a profit. From the opposite viewpoint, this means that
the hedger must expect to lose money on the forward contract. In effect, this
expected loss by the hedger is the price that must be paid for getting rid of the
exchange rate risk.
The difference between the expected future spot rate and the forward
rate is referred to as the risk premium.
Many studies have been made to determine if a risk premium exists in
forward rates, and the result has been that it exists. Therefore, the forward rate
is not an unbiased estimate of the future spot rate; it ends up being wrong on
average.
So the question is, even if forward rates are not an unbiased forecast of
future spot rates, do they provide a reasonable forecast and/or the best forecast
available?
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This is an important question because there are a number of exchange

rate forecasting services which can be engaged.
It has been found that:
(1) Forward rates are closer to the actual spot rate.
(2) Professional forecasting services can accurately predict the direction
of change, in terms of movement of the rate up or down
To engage or not to engage a professional forecasting service for
estimating future exchange rates depends upon the purpose for which the
forecasts are required (i.e., the accuracy required) and also the cost involved.
Activity 2
Make a report stating the differences between current spot rate and forward
rate. Also state their usefulness in forecasting future exchange rate.
Hint:
Current spot rate and forwards rate are two market based estimates
that can be used for a forecast of future rates.
9. In the case of financing decisions the firms generally borrow in the country
where the cost of capital is low and those currencies that are expected to
depreciate. (True/False)
10. Technical forecasts are based on changes in underlying economic factors
that affect exchange rates. (True/False)
11. In order to justify the extra cost involved in using a professional forecasting
service it is important to know if professional forecasts outperform forward
rates in the accuracy of their predictions. (True/False)
11.7 Risk Adjustment in Capital Budgeting: Sensitivity Analysis

The problem of project risk
For now, we will define the risk of an investment project as the variability of its
cash flows from those that are expected. The greater the variability, the riskier
the project is said to be. For each project under consideration, we can make
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estimates of the future cash flows. Rather than estimate only the most likely
cash-flow outcome for each year in the future, we estimate a number of possible
outcomes. In this way we can consider the range of possible cash flows for a
particular future period rather than just the most likely cash flow.
As far as the foreign projects are concerned, their expected nominal cash
flows can be converted into nominal home currency terms and discounted at
the expected nominal domestic discount rate. If the ash flow is in foreign currency
then the foreign currency discount rate has to be used. Risk is usually measured
as by a standard deviation or variance of the expected cash flows. In estimation,
the concept of probability should be understood. Probability is a measure of the
likelihood that a particular event will occur; in this case, it is the cash flow. So, in
the process of appraisal of a project, the probability of the cash flow should also
be considered.
Risk-handling techniques
There are different techniques to handle risk in investment decisions. The
important techniques include the risk adjusted discount rate approach, the
certainty equivalent approach, sensitivity analysis, scenario analysis and the
decision tree approach. We will discuss the sensitivity analysis here.
Sensitivity analysis
It is important for international firms to forecast exchange rate variations in
order to protect themselves from the fluctuations. The firms use sensitivity
analysis for this purpose. Sensitivity analysis is a technique to find out the effect
in variation or fluctuation in one parameter on the movement of another
parameter. In fact in terms of international trade the most important aspect is
the fluctuation of foreign currency exchange rate. So, if we can identify the
factors which cause these, then through the use of sensitivity analysis we can
attempt to forecast the exchange rate changes when any one of these factors
undergo a given change. When a regression model is used for forecasting,
some factors have lagged impact on exchange rate while some other factors
have instantaneous impact on exchange rate.
Assume an MNC desires to determine the effect of change in the forecast
demand for the product or the effect of change in tax rates by the foreign
government; we attempt to answer the question like what would happen to APV
or NPV if this input variable changes. The objective is to determine how sensitive
NPV is to the alternative values of the input variable. In this technique alternative
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values of APV/NPV are calculated and examined. The advantage of sensitivity

analysis in comparison to use of simple point estimates is that it reassesses the
project on the basis of various circumstances that are likely to occur. To conduct
sensitivity analysis large number of computer software are available.
In the above discussions the focus is on how to make adjustment in each
cash flow and discount rate in case of international capital budgeting. Estimated
cash flow is used in the calculation of NPV and IRR but the point is how the
estimation of cash flow varies under different assumptions. For example if the
foreign country is having pessimistic, expected and optimistic outlook the cash
flows would be different. It is difficult to foresee the future possibilities and
accordingly equally difficult to estimate future cash flow with full certainty. Similarly
the cost of capital will have wide variations under different levels of political,
financial and business risk. The varying cash flows and varying discount rates
under different assumptions will have effect on acceptability of the project. The
sensitivity analysis determines how sensitive the NPV is to varying values of
input variables. Actually when cash flows are not known with full certainty,
probabilistic techniques are used. Magnitude of uncertainty is measured in terms
of dispersion from expected value, which can be quantified by the variance or
standard deviation of the project.
It is also important to understand the reliability of NPV or IRR or APV
depends on how accurate are we able to forecast the variables underlying the
estimates of net cash flows. To determine the reliability of NPV and IRR of any
project, we need to work out how much would be the difference in the outcome
if any of these estimates goes wrong. We can change each of the forecasts,
taking one at a time, to minimum three values pessimistic, expected, and
optimistic.
12. In the process of _____________of a project, the probability of the cash
flow should also be considered.
13. _____________is a technique to find out the effect in variation or
fluctuation in one parameter on the movement of another parameter.
14. __________________________is measured in terms of dispersion from
expected value, which can be quantified by the variance or standard
deviation of the project.
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11.8 Case Study

Interest Rate, Exchange Rate and Inflation in India
The higher interest rate regime in India is seen as one of the important
reasons for the recent economic slowdown, industrial growth and low
appetite for investment. In the present weak global market environment
where the risk appetite is low, the interest rates tend to remain high in order
to attract more risk premium.
Even with high nominal rates, if proper allowance is provided for inflation
and taxes, the real estate rates become much lower in comparison to the
return on other classes of assets such as real estate and gold. In markets
where investments move from lower currencies to higher ones, large carry
trades take place.
The US Fed signals that till the middle of 2014, there will be no increase in
the low interest rates. This provides opportunities to the operators to bring
inflows from those countries only when there is high interest arbitrage. This
further leads to exertion of pressure on interest rates. The Indian economy
is not fully market-driven and a number of elements are present that are
administered by the government and other authorities. Such elements are
minimum support prices, interest subventions and subsidies. This also
means that the interest rates are not freely determined by demand and
supply.
Factors such as a countrys balance of payments and exchange rates also
determine the exchange rates. One of the reasons leading to such high
interest rates is also the burgeoning current account deficit. The Central
banks signal in its monetary policy will also play an important role in
determining the interest rates in the market. Any stringent measure to
squeeze liquidity through monetary action and stiff policy rates will drive
interest rates northwards, as demand for liquidity outstrips supply.
It is not possible to bring down nominal rates until inflation is tamed. This is
because real interest rates will tend to move to unsustainable levels. It is
necessary to make the supply-side bottlenecks smoother in order to keep
the inflation rate in control. Sovereign rating can be improved through a
strong currency, better fiscal discipline and sustained growth. They also
help in raising the earning potential of large sections of society, increasing
savings and bringing down interest rates. Banks on their part would also do
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their best in considering rate cuts for ensuring adequate flow credit to ensure
adequate flow credit to productive and select sectors of the economy.
Questions
1. State the factors that determine the exchange rate.
2. How do you think inflation can be tamed?
Source: Adapted from http://economictimes.indiatimes.com/opinion/etdebate/interest-rate-will-stay-high-till-inflation-is-tamed/articleshow/
15398539.cms
11.9 Summary
Two main issues needed to be dealt by every financial manager are how
to raise funds and how to use these funds.
Capital projects are important for the firm as these generate the products
which can be sold to obtain revenue.
In the NPV method, all future cash flows occurring in different time periods
are discounted to present value using opportunity cost of capital as discount
rate.
Internal rate of return is defined as that rate at which NPV is zero. This
internal rate of return is compared with opportunity cost of capital.
Though cash flows (not profits) are used as basis for evaluation of capital
projects, both are important.
Expected future exchange rates are important in order to decide whether
to hedge the exchange rate risk or not.
The technique through which the variation or the fluctuation in one
parameter on the movement of another parameter is found out is known
as the sensitivity analysis.
11.10 Glossary
Capital budgeting analysis: The process in which it is determined by
the business whether projects such as building a new plant or investing in
a long-term venture are worth pursuing
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Discounted payback: The method through which the time value of money
is considered and all future cash flows are discounted
Incremental cash flow: The difference between the cash flows of a firm
with and without a project
Tax shield: The reduction in taxable income for a corporation or an
individual that is achieved through the claiming of allowable deductions
such as medical expenses, mortgage interest and depreciation
Remittance: Transfer of funds, usually from a buyer to a distant seller,
instrument of transfer (such as a check or draft), or funds so transferred
Speculator: One whose work is to predict changes in price and who
aims to make profits through buying and selling contracts

1. Discuss the techniques that are used to analyse the projects.
2. What do you mean by net present value? Discuss.
3. Define the adjusted present value approach.
4. Discuss the methods of assessing the economic and political risk.
5. Explain the forecasting methods for future exchange rates.
6. Define sensitivity analysis.
11.12 Answers
1. Funds
2. Capital budgeting
3. Independent projects
4. True
5. True
6. Parent firm
7. Tax laws, Exchange control regulations
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8. Discount rate
9. True
10. False
11. True
12. Appraisal
13. Sensitivity analysis
14. Magnitude of uncertainty

1. There are many techniques which can be used to analyze the projects.
These techniques can be broadly classified into discounted cash flow
techniques, which include net present value (NPV), internal rate of return
(IRR), profitability index (PI) and discounted payback methods, and nondiscounted cash flow techniques which include payback and accounting
rate of return (ARR) methods.
2. In the net present value (NPV), all future cash flows occurring in different
time periods are discounted to present value using opportunity cost of
capital as discount rate. Whenever there is a cash inflow, we take it with
positive sign and cash outflow, we take it as negative sign.
3. The method of adding the tax benefits of debt to the separately calculated
present value of the project using the all-equity cost of capital is known as
the adjusted present value (APV) approach.
4. The three methods of assessing the economic and political risk before
deciding about investment projects are:
Reducing the payback period requirement
Increasing the required rate of return for the project
Adjusting cash flows to incorporate impact of specific risk
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5. There are three forecasting methods for future exchange rates:

Fundamental Forecasts
Technical Forecasts
Market Based Forecasts
6. Sensitivity analysis is a technique to find out the effect in variation or
fluctuation in one parameter on the movement of another parameter. In
fact in terms of international trade the most important aspect is the
fluctuation of foreign currency exchange rate.
Reference/e-Reference
Kumar, Neelesh. International Financial Management. Delhi: Vikas
Publishing.
Page No. 238
Unit 12
Country Risk Analysis
Structure
12.1 Caselet
12.2 Introduction
Objectives
12.3 Country Risk Factors
12.4 Assessment of Risk Factors
12.5 Techniques to Assess Country Risk
12.6 Measuring Country Risk
12.7 Governance of Country Risk Assessment
12.8 Case Study
12.9 Summary
12.10 Glossary
12.12 Answers
12.1 Caselet
Q3 economic situation is found unfavourable by finance executives
A study has put forward that most of the senior finance executives are of
the opinion that the macro-economic conditions of a country are likely to
remain unchanged or unfavourable in the July-September quarter.
The Dun and Bradstreet India CFO survey states that in comparison to the
previous quarter, the optimism level for the overall macroeconomic
conditions has gone down in the third quarter of 2012. This is mainly because
of difficult domestic as well as international economic conditions.
It is considered by around 73 per cent of the surveyed CFOs that the overall
macro-economic conditions during Q3 2012 will be unfavourable or will
remain unchanged. There is an increase of around 24 per cent from Q2
2012, thus expressing a weak business sentiment.
The chief operating officer of Dun & Bradstreet India said that the overall
CFO optimism level has further declined during Q3 2012 due to tough
domestic conditions in addition to the prolonged worries about the European
debt crisis weigh on overall confidence.
Unit 12
The increasing concerns related to both global and domestic economy have
led to an increasing focus on risk management tools for the coming six
months. Around 82 per cent are of the opinion that the level of financial risk
on the companys balance sheet will either increase or will remain constant
in Q3 2012.
A large number of CFOs continue to remain focused on Risk Management
as a key priority area and implementing risk mitigation measures that will
help them minimize the impact of the volatile economic and political
environment on the companys balance sheet, he said.
Source: Adapted from http://zeenews.india.com/business/news/economy/
finance-executives-find-q3-economic-situation-unfavourable_57536.html
12.2 Introduction
In the previous unit, you learnt about the international capital structure, where
concepts such as cost of capital and capital structure of MNCs were discussed.
You also understood how to describe the cost of capital in international business
context.
Now that you understand the concept of the capital structure of an MNC,
you might want to acquire the assets of a company, for monetary gains, which
lies outside your domestic market. For this you will have to use foreign currency.
When you use foreign currency, you are subjecting yourself to two types of
risks country risk and foreign exchange risk. Country risk is the risk of investing
in a country, where a change in the business environment may adversely affect
the profits or the value of the assets in a specific country. For example, financial
factors such as devaluation or stability factors such as a civil war may jeopardize
your investment. So we need to understand the theory behind country risk before
we can think about making an investment abroad.
In this unit, you will learn about country risk analysis. You will also study
the country risk factors and the assessment of risk factors. The unit also presents
a detailed description of the techniques through which the country risks can be
assessed as well as measured. You will also learn about incorporating risk in
capital budgeting, governance of country risk assessment and preventing host
government takeovers.
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Objectives
define country risk and assess the risk factors
explain the techniques of assessing country risk and measuring country
risk
discuss incorporating country risk in capital budgeting and governance of
country risk assessment
assess how to prevent host government takeovers
12.3 Country Risk Factors

We can define country risk as the risk of losing money due to changes that can
occur in a countrys government or regulatory environment. The most common
examples are acts of war, civil wars, terrorism and military coups, etc. It comes
in various forms: for example, change in the government of a country, a new
president or prime minister, some new laws, a ruling party becoming minority,
and so on. Such changes do impact a countrys economic environment. They
have a great impact on the investors perception about a countrys prospects.
Political stability means the frequency of changes in the government of a
country, the level of violence in the country, etc. A country is called politically
stable if there are no frequent changes in the government and the level of
violence is low or nil. For example, Australia was considered a dream destination
by Indians earlier. Now the country is being avoided due to the instances of
violence against Indians. In some countries, government can expropriate either
a legal title to property or the stream of income it generates. Such countries are
said to be high political risk countries. Political risk is also said to exist if property
owners may be constrained in the way they use their property.
Host government may enact laws to prevent foreign companies from taking
money out of the country or from exchanging the host countrys currency for
any other currency. This can be called financial form of country risk.
It is difficult to calculate the exact value of country risk like any economic
or financial variables. The calculation of country risk scores is difficult, but
there are many important financial decisions that are based on the assessment
of the country risk of a country. A company will have to do its own calculations
for taking financial decisions.
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Stephen Kobrin (1982) has classified country risk as:

Macro or country-specific risk
Micro or firm-specific risk
Factors determining the extent of political risk for a country
The factors determining the extent of political risk for a country are broadly
classified into:
Country-related factors
Company-related factors
Country-related factors: These have three broad categories that have been
discussed in detail.
(a) Economic factors
Fiscal discipline: This is indicated by the ratio of the fiscal deficit of a
country to its GNP. Higher the ratio, the more government is promising
to its population relative to resources it is obtaining from them.
Controlled exchange rate system: This system increases the
problem of BOP and makes fiscal discipline difficult. Government
uses currency controls to fix exchange rates. This provides little
flexibility to respond to changing prices.
Wasteful government expenditure: This is an indicator of financial
problems.
Resource base: If a country has natural resources, it is considered
economically stable.
Countrys capacity to adjust to external shocks: If a country has
a vast resource base, it possesses greater capacity to respond to
external shocks.
(b) Geographical factors: The best example in this case would be Sri
Lanka, where due to the presence of the LTTE, there was a border
issue.
(c) Sociological factors: These include religious diversity, language
diversity, ethnic diversity, etc.
(i) Company-related factors
Nature of industry: Government of a country controls certain
critical industries that affect the economy of the country, e.g. oil
and petroleum
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Level of operations: An MNC with a global presence is safe

from government interventions.
Level of technology and research and development:
Companies using sophisticated technology and having high
degree of R&D content are difficult to be regulated.
Level of competition: Companies that have little or no
competition are not regulated by government.
Form of ownership: Local ownership is favoured by
government.
Nationality of management: Foreign management is more
vulnerable to hostile treatment from the government.
Activity 1
Find out the latest country risk ratings. Also analyse how country risks are
evaluated.
Hint:
Country risk is measured through economic, political factors and social
factors.
1. _________means the frequency of changes in the government of a
country, the level of violence in the country, etc.
2. ___________increases the problem of BOP and makes fiscal discipline
difficult.
3. Country risk is the risk of losing money due to changes that can occur in
a ___________or regulatory environment.
12.4 Assessment of Risk Factors

There are risk assessment agencies that provide country risk indices which try
to assess the political stability of a country. The factors from which the political
instability occurs can be classified into three categories:
1. Economic factors: These factors include inflation, unemployment, fiscal
deficit, trade policies, large external debt, etc.
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2. Geographic factors: These include border disputes, natural calamities,

etc.
3. Sociological factors: These include religious diversity, diversity in
language, etc.
When a firm has to do business in a foreign country, it has to be doubly
sure about the uncertainties that it can face. It has to analyse all the risks that
are theoretically said to exist. MNCs have to assess the country risk both
qualitatively and quantitatively.
Qualitative approach: This approach involves interpersonal contact. MNCs
may know influential people in a foreign country. They may know politicians,
bureaucrats, officials, etc. who might make MNCs aware about the political
environment present in their country. They might update the MNC about the
future prospects of business in their country. The entire process is based on
judgement and there is no data to support such decisions.
The MNC may send a team of experts for the on-the-spot study of the
political situation in a particular country. This is a preparatory step taken to start
talks with companys management. The qualitative approach involves
examination and interpretation of diverse secondary facts and figures. On the
past trends of events, future trends are assessed (Kramer, 1981).
Quantitative models: There are specific quantitative tools for estimating country
risk. One such tool is a computer program named Primary Risk Investment
Screening Matrix (PRISM) that has 200 variables and reduces them to general
ratings. It represents an index of economic viability as also an index of country
stability. The variables include the level of violence in a country, frequency of
changes in government, number of armed insurrections, conflict with other
nations and economic factors such as inflation rate, external balance deficit
and growth rate of the economy.
The other commonly used tool is the decision tree approach used by
Stobaugh (1969) which finds out the probability of nationalization. He has done
his analysis by taking two cases, i.e. whether the government will change or
not. If there is a change, a new government may or may not go in for
nationalization. If it goes in for nationalization, then again there are two
possibilities: whether it will pay adequate compensation or not. Thus, each
possibility has many possible sub-events. The probabilities are indicated along
tree branches. Probabilities are multiplied along the tree branches. Then they
are summed up.
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Example 12.1: There is 50 per cent probability of change in government and

50 per cent probability for no change in government. If a government changes,
there is 40 per cent probability for nationalization and 60 per cent probability for
no nationalization. Again, if there is nationalization, then there is 60 per cent
probability for adequate compensation. With these figures, the probability for
inadequate compensation can be calculated as:
0.5 x 0.4 x 0.4 = 0.08
Probability = 8%
Knudsen (1974) used comparatively measurable variables and not very
subjective ones. Notable among his variables are: the degree of urbanization,
literacy rate, degree of labour unionism, national resource endowment, infant
survival rate, calorie intake, access to civic amenities, per capita GNP, etc.
Haner (1979) used a scale from 0-7 to rate country risks. He grouped the factors
leading to country risks into two parts: internal and external. The internal factors
are fractionalization of political spectrum, fractionalization of social spectrum,
restrictive measures required to retain power, xenophobia, socio-economic
conditions and the strength of radical left government. The external factors
were dependence on a hostile major power and negative influence of regional
political forces. After adding up the rating points, if the total is 19 or below, he is
of the view that the country risk is minimal. If the total is between 20 and 34, the
risk may be acceptable, but if the total lies between 35 and 44, the risk is
supposed to be very high. Lastly, if the total exceeds 44 rating points, it is not
advisable to make any investment in that country.
The country risk index tries to incorporate all these economic, geographical
and social aspects and measures overall business climate of a country. Business
Environment Risk Information (BERI) classifies countries into different categories
on the basis of risk perception:
Low-risk countries
Medium-risk countries
High-risk countries
Prohibitive-risk countries
Another method is of capital flight. Capital flight is an indicator of the
degree of country risk. It means the export of savings by a nations citizens
because of the fears about the safety of their capital. The reasons for occurrence
of capital flight can be as follows:
Government regulations and controls
Taxes
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Unit 12
Low returns
High inflation
Political instability
4. Qualitative approach involves interpersonal contact. MNCs may know
influential people in a foreign country. (True/False)
5. Capital flight is an indicator of the degree of country risk. (True/False)
6. Economic factors include religious diversity, diversity in language, etc.
(True/False)
12.5 Techniques to Assess Country Risk

Approaches to country risk management
There are two approaches to country risk management.
1. Defensive approach: In this approach, the company tries to protect its
interest by finding those aspects of the company that are beyond the
reach of the host government. This reduces the firms dependence on
the host country and the government of the host country. The important
strategies in the functional areas of the company are discussed as follows:
Financial strategies: To protect against the hostility of the host
government, a company can take the following steps:
Maximum utilization of debt instruments.
Company does not raise all the capital through a single source but a
variety of sources are used like host government, local banks and
third parties.
Companies prefer to enter into joint venture with the host government.
The most successful example is that of Suzuki. It entered into a joint
venture with the Government of India to form Maruti Suzuki.
Company can obtain host countrys guarantees for investment.
They can minimize local retained earnings.
If possible, the company should use transfer pricing.
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Management policies: To protect the information about the companys

functioning, the following steps have to be taken:
Minimize the role of host nationals at strategic points and limit locals
to low and junior levels.
Train and educate host country nationals to inculcate loyalty.
If the host countrys nationals are at key positions, try to replace
them.
Logistics: Once the country risk has been assessed, it is necessary to:
Locate the crucial segment of the companys process outside the
country but near the country.
Concentrate on R&D in the home country, making the subsidiary
dependent on the parent company.
Balance the production of goods among several locations, thus
reducing dependence on a single location.
Marketing management: Companys marketing policies should follow
the following steps:
Control markets wherever and whenever possible.
Maintain control over distribution network including transportation of
goods.
Maintain a strong single global trademark.
Government relations: The company should assess its own strengths
and weaknesses and try to negotiate with the government to defend its
interests.
2. Integrative approach: This approach aims at integrating the company
with the host economy to make it appear local. The important strategies
adopted are as follows:
Financial strategies: The following strategies should be adopted for
financing the projects in a host country:
Raise equity from the host country and take credit from the local
parties.
Establish joint ventures with locals and the government.
Ensure that internal pricing among subsidiaries and between
headquarters and subsidiaries is fair.
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Unit 12
Management strategies: The following strategies are required to be

adopted for integrating the company with the host country:
Employ high percentage of locals in the organization
Ensure that the expatriate understood the host environment
Establish commitment among local employees
Operations management: The following steps are required to be
undertaken:
Maximize localization in terms of sourcing, employment and research
and development.
Use local sub-contractors, distributors, professionals and transport
system.
Marketing management: Marketing policies should:
Share markets with domestic players as collaborators.
Appoint local distributors and use local network
Maintain a strong single global trademark
Government relations: A company should develop good and cordial
relationships by:
Developing and maintaining channels of communication with
members of country elite
Being willing to negotiate agreements that are fair to host government
Providing expert opinion whenever asked for
Providing public services
7. In ___________approach, the company tries to protect its interest by
finding those aspects of the company that are beyond the reach of the
host government.
8. The two approaches to country risk management are _________ and
__________.
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Unit 12
12.6 Measurement of Country Risk

Risks that are faced by MNCs on an overseas direct investment are those related
to the local economy. Among these, some may be due to the possibility of
confiscation (government takeover without any compensation) and the rest may
be because of the possibility of expropriation (government takeover with
compensation). The other risks may be the political risks, risk of currency
inconvertibility and restrictions on the repatriation of income beyond those
reflected in the cash flows of an MNC.
Before a company can consider how much of its country risk is systematic,
it must be able to determine the risk in each country. One of the best-known
country-risk evaluations is prepared by Euro money, a monthly magazine that
periodically produces a ranking of country risks. It consults a cross-section of
specialists. These specialists give their opinion on each country with regard to
one or more factors used in their calculation. Three broad categories of factors
are considered. These are analytical indicators, credit indicators and market
indicators. The analytical indicators consist of economic and political-risk
evaluations. The economic evaluation is based on the actual and projected
growth in GNP. The political risk evaluation is provided by a panel of experts
comprising risk analysts, insurance brokers and bank credit officers. The credit
indicator includes measures of the ability of the country to service debts based
on debt service versus exports, the size of the current account deficit or surplus
versus GNP, and external debt versus GNP. Market indicators are based
on assessments of a countrys access to bank loans, short-term credits,
syndicated loans and the bond market as well as on the premiums occurring on
recourse loans made to the exporters.
Methods of reducing country risk
Measures of country risk do not distinguish different risks facing different
industries. They measure only the risk of countries. An MNC will have to reduce
the country risk to gain. The various techniques that can be adopted by them
are summarized as follows:
Keeping control of crucial elements of corporate operations: Some
companies making direct foreign investments try to prevent operations from
running without their cooperation. This can be achieved if the investor maintains
control of a crucial element of operations. For example, food and soft-drink
manufacturers keep their special ingredients a secret. Auto companies can
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Unit 12
produce vital parts such as engines in some other countries and can refuse to
supply these parts if their operations are seized.
Programmed stages of planned divestment: An alternative technique for
reducing the probability of expropriation is for the owner of an FDI to promise to
turnover ownership and control to local people in the future.
Joint ventures: Instead of promising shared ownership in the future, an
alternative technique for reducing the risk of expropriation is to share ownership
with foreign private or official partners from the very beginning. Such shared
ownerships are known as joint ventures.
Local debt: The risk of expropriation as well as the losses from expropriation
can be reduced by borrowing within the countries where investment occurs. If
the borrowing is denominated in the local currency, there will often also be a
reduction of foreign exchange risk.
Activity 2
Analyse the techniques used to reduce country risk. Put them down on a
chart.
Hint:
Some of the techniques are joint ventures and local debt.
9. The economic evaluation is based on the actual and projected growth in
GNP. (True/False)
10. Risk of expropriation as well as the losses from expropriation can be
reduced by borrowing within the countries where investment occurs. (True/
False)
12.7 Governance of Country Risk Assessment

The country risk management strategy depends upon the type of risk and the
degree of risk the investment will have. Investment in a country will prove to be
profitable if it is managed right from the start. An MNC should not wait for a
problem to arise but should go with a cautious approach.
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12.7.1 Incorporating Risk in Capital Budgeting

(i) Integration of risk in capital budgeting: If there is a chance of country
risk, the discount rate should be increased taking care that it is in the
starting years itself when the project may not be acceptable in a new
country. The risk can be reduced by reducing the investment flow from
parent company to subsidiary and the subsidiary can borrow from the
host country. This will create a degree of acceptability of the subsidiary in
the host country as it cannot run after using so much of funds in a project.
A trade-off has to be struck between higher financing cost and lower
country risk.
(iii) Planned divestment: The company can plan to transfer the ownership
title and control of the business to the local shareholders. This reduces
the risk of expropriation.
(iv) Insurance of risk: Investing firm can take an insurance against country
risk.
12.7.2 Preventing Host Government Takeover

Forced disinvestment: Government may put pressure on firms to disinvest.
Forced disinvestment may take place for various reasons such as:
Government may believe that it may make better use of the assets.
Takeover may improve the image of the government among the people
of the country.
Government wants to control these assets for strategic and developmental
reasons.
An example of forced disinvestment is the takeover of oil exploration. In
India, most of the oil producing companies is nationalized though a few private
players like Reliance have come up in the market. These forced disinvestments
are legal under international law as long as they are accompanied by adequate
compensation. Such takeovers do not involve the risk of total loss of assets.
Forced disinvestments are practiced in two forms.
(i) Takeover/nationalization: These are done as a matter of political
philosophy. The government announces a policy for takeover or
nationalization with a compensation package. The company owners are
asked to withdraw from the management for the announced compensation
which usually does not match with the expectation of the owners.
Takeovers and nationalizations are usually done when the ideological
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Unit 12
base of the government changes from right or centralist to socialist or to

communist ideology.
(ii) Confiscation/expropriation with or without compensation: This is
another form of forced disinvestment. In this form, the government
expropriates a legal title to the property or the stream of income the
company generates. Governments may also constrain the property owners
in the way they use their property. Confiscation may be with a minimal
compensation or even without compensation. This step may be taken by
governments because of political rivalry among nations or because of
idealistic shift in governments political philosophy.
Undesired regulations: These regulations reduce the profitability
of MNCs. In this type of risk, the government expropriates legal title
to property or the stream of income the company generates.
Governments may also constrain the property owners in the way
they use their property. Confiscation may be with a minimal
compensation or even without compensation. This step may be taken
by governments because of political rivalry among nations or of
idealistic shift in governments political philosophy.
Interface with operations: This refers to any government activity
that makes it difficult for business to operate effectively. This risk
includes things as governments encouragement of unionization,
governments expression of negative comments about foreigners
and discriminatory government support to locally owned and operated
business. Governments generally engage in these kinds of activities
when they believe that a foreign companys operation could be
detrimental to the local development or would harm the political
interest of the government.
Political risk: Political risk due to government interface with business
is difficult to assess and manage because the actions are done in a
subtle way.
Forced disinvestment and undesired regulations have identifiable
and immediate impact on foreign business but the interface with
operations may be less obvious and the effects are unclear.
Social strife: In any country, there may be social strife arising due
to ethnic, racial, religious, tribal or civil tensions. Natural calamities
such as drought and floods may also cause economic dislocation. It
means general breakdown of government machinery leading to
economic disturbance giving rise to political risk.
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Negotiating agreements with the host government: It would be advisable if

an investing company talks with the government of the host country before
starting a project so that issues that might cause hostility are dealt with in the
initial stages. It will also create a degree of acceptability among the government
as an agreement is already signed.
Joint-ventures and concession agreements: In a joint-venture
agreement, local shareholders who are influential can force the
government to take decisions to their advantage. For example, when
Maruti Suzuki entered India, they entered into a joint venture with
the Government of India, so that there would be no hindrance to the
project.
Political support: A host country will act in favour of MNCs if it gets
a strong financial backing from them.
Structure operating environment: Country risk can be reduced by
creating linkage of dependency between the operation of the firm in
a high-risk country and the operation of other units of the same firm.
Anticipatory planning: Investing company should take necessary
precautions against country risk before or after the investment has
been made by chalking out different courses of action for the possible
situations that might arise.
1. Goal conflicts with economic policies: Conflicts between the objectives
of MNC and host governments have risen over such issues as the firms
impact on economic development, perceived infringement on national
sovereignty, foreign control of key industries, sharing of ownership and
control with local interests, impact on host countrys balance of payment,
influence on the exchange rate and control over export market and the
use of domestic versus foreign executives.
Economic policies of a government aim at achieving sustainable rate of
growth in per capita, gross national product, full employment, price stability,
external balance and fair distribution of income. The policies through which
these objectives are to be achieved are as follows:
o Monetary policies and goal conflicts: Through monetary policies,
the government controls the cost and availability of domestic credit
and long-term capital as a means of achieving national economic
priorities. MNCs can circumvent the policy by turning to the parent.
If credit flow is restricted and it has become costlier, the MNC can
implement its spending plans with the help of the parent company.
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Local competitors then face the crunch, thus changing the competitive
position of the domestic companies.
o Fiscal policies and goal conflicts: To attract FDI, the government
commits tax concession and sometimes even provides subsidies.
After some time, when the government wants to achieve revenue
targets, the MNCs are insulated because of the commitments, and
therefore the achievement falls short of targets.
o Trade policies and economic protectionism: Nationalistic
economic policies are often made to protect the domestic industry.
To protect the domestic industry from competition tariff and nontariff barriers are used.
o Balance of payment problems: Repatriation by MNCs puts pressure
on the much needed foreign exchange resources. The outflow is in
the form of dividend management fees, royalty, etc. which puts
pressure on the balance of payment.
o Economic development policies and goal conflicts: The
government puts protective tariffs or restrictions on foreign investment
to protect the companies that are in the infant stage or old industries
as the case may be.
2. Corruption: Political corruption and blackmail contribute to the risk.
Corruption is endemic to developing countries. If these bribes are not
paid, the projects are either not cleared or delayed through bureaucratic
system.
11. A trade-off has to be struck between higher financing cost
and____________
12. Through__________, the government controls the cost and availability
of domestic credit and long-term capital as a means of achieving national
economic priorities.
13. ___________by MNCs puts pressure on the much needed foreign
exchange resources.
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12.8 Case Study

Cases of Political Risk in Host Countries Rich in Minerals
Political risks such as law and order problems, widespread conflict and
corruption are causing a lot of problems for a number of Indian companies
who are looking forward to invest in several African and Latin American
countries. Some of these companies are Vedanta Resources, Essar Group
and Jindal Steel & Power. Moreover, the host countries have also imposed
royalties and raised taxes in order to continue their hold over their minerals.
Most of the mining projects do not receive protection guarantees from
multilateral agencies.
Attempt is made to minimize the chances of incidents that have taken place
in the past. For instance, Jindal Steel & Power was forced to file a claim in
the International Court of Arbitration against the Bolivia Government for
not sticking to a pact that was signed between the company and the Bolivia
Government. Under this pact, the Indian majors were granted land for $ 2billion iron ore mining project. However, the Bolivian government encashed
the bank guarantee without providing the land to the Jindals.
On another occasion, Essar Group was faced with delay in the completion
of the revival programme for state-owned Zimbabwe Iron & Steel. The
company acquired the deal for an amount of $ 750 million in 2010. Through
the deal, the company was to receive an 80 per cent stake in an iron ore
mine with one of the largest deposits in the world. However, some ministers
in Zimbabwe did not accept the grant of control to the mines resulting in
delay. The Indian companies that are operating in these countries are
demanding for political risk cover but the re-insurers are not willing to provide
this or are increasing the premium.
A total of around 6-7 Indian Insurance companies offer political risk insurance
policy and in most of the companies the finance professionals carry out the
risk assessment. Mapping of risk is conducted by variables such as
exposure, threat and vulnerability. Indian companies are also better equipped
in dealing with factors such as socio-political complexity and uncertainty.
However it is also true that most of the companies do not have a structured
approach to handling risks. The issue of risk perception about investing in
resource-rich countries is making the Indian firms set up dedicated risk
management teams that can forecast potential threats and decrease the
impact.
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Questions
1. What are the risks that are faced by the Indian companies in mineralrich host countries?
2. Do you think the measures taken by the Indian companies will minimize
the risk of investing in mineral-rich countries?
12.9 Summary
Country risk can be defined as the risk of losing money due to changes
occurring in a countrys government or regulatory environment.
The frequency of changes in the government of a country, the level of
violence in the country, etc dictates the political stability of a country.
Risk assessment agencies provide country risk indices which are used to
assess the political stability of a country.
The qualitative approach involves examination and interpretation of diverse
secondary facts and figures. On the past trends of events, future trends
are assessed (Kramer, 1981).
Risks that are faced by MNCs on an overseas direct investment are those
related to the local economy.
The aim of economic policies of a government is to achieve sustainable
rate of growth in gross national product, per capita, full employment,
external balance, price stability and fair distribution of income.
12.10 Glossary
Fiscal: Of or related to government finances, especially tax revenues
Risk Assessment: The process of determination of the likelihood that a
specified negative event will occur
Calamities: An event leading to terrible loss, lasting distress, or severe
affliction;
Insurrection: The act or an instance of open revolt against civil authority
or a constituted government
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Confiscate: Seize private property for the public treasury

Currency inconvertibility: Inability of a local currency to be exchanged
for another currency
Strife: Heated, often violent dissension

1. Define political stability.
2. What are the factors that determine the political risk for a country? Discuss.
3. What is a country risk index? Explain the categories classified by the
business environment risk information (BERI).
4. Discuss the approaches to country risk management.
5. Explain the techniques adopted by MNCs to reduce country risk.
6. What is the main aim of economic policies? State the objectives through
which they are achieved.
12.12 Answers
1. Political stability
2. Controlled exchange rate system
3. Countrys government
4. True
5. True
6. False
7. Defensive
8. Defensive approach, integrative approach
9. True
10. True
11. Lower country risk
12. Monetary policies
13. Repatriation
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1. Political stability means the frequency of changes in the government of a
country, the level of violence in the country, etc. A country is called politically
stable if there are no frequent changes in the government and the level of
violence is low or nil.
2. The factors determining the extent of political risk for a country are broadly
classified into:
o Country-related factors
o Company-related factors
3. The country risk index tries to incorporate the economic, geographical
and social aspects and measures overall business climate of a country.
Business Environment Risk Information (BERI) classifies countries into
different categories on the basis of risk perception:
o Low-risk countries
o Medium-risk countries
o High-risk countries
o Prohibitive-risk countries
4. There are two approaches to Country Risk Management. They are:
o Defensive approach
o Integrative approach
5. The techniques of reducing country risk are:
o Keeping control of crucial elements of corporate operations
o Programmed stages of planned divestment
o Joint ventures
o Local debt
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6. Economic policies of a government aim at achieving sustainable rate of

growth in per capita, gross national product, full employment, price stability,
external balance and fair distribution of income.
The policies through which these objectives are to be achieved are as
follows:
o Monetary policies and goal conflicts
o Fiscal policies and goal conflicts
o Trade policies and economic protectionism
o Balance of payment problems
o Economic development policies and goal conflicts
Publishing.
Kumar, Neelesh. International Financial Management. Delhi: Vikas
Publishing.
Page No. 259
Unit 13
International Taxation
Structure
13.1 Caselet
13.2 Introduction
Objectives
13.3 Bases of International Tax System
13.4 Principles of Taxation
13.5 Double Taxation
13.6 Tax Havens
13.7 Transfer Pricing
13.8 International Tax Management Strategy
13.9 Indian Tax Environment
13.10 Case Study
13.11 Summary
13.12 Glossary
13.14 Answers
13.1 Caselet
Indian finance minister Palaniappan Chidambaram to review tax
law that landed Vodafone with $2bn bill
A review of retrospective tax laws that landed British mobile phone giant
Vodafone with a $2.2bn bill have been ordered by Indias new finance
minister Palaniappan Chidambaram. The overseas firms which use tax
havens for the completion of deals involving Indian companies have been
targeted by the controversial legislation of the country.
In the year 2007, Vodafone purchased a 67 per cent stake in Hong Kongbased Hutchison Whampoas Indian cellular unit. The deal was finalized
between the Dutch subsidiary of Vodafone and a company that is based in
the Cayman Islands, a tax haven, holding the India assets of Hutchison
Whampoa.
Under the laws that are present now, Vodafone has been hit with a $2.2bn
(1.4bn) tax bill. Chidambaram stated that any apprehension or distrust
that the investors might have should be removed as investment requires
Unit 13
faith and trust. He also stated that factors such as a stable tax regime, a
non-adversarial tax administration, clarity in tax laws and an independent
judiciary will also offer great assurance to the investors. However, Vodafone
argues that it is illegal of India to apply tax law changes. They are also
looking for international arbitration.
He also said that the government would try to lessen the cost of borrowing
for easing the strain on businesses and consumers.
We are conscious that current interest rates are high, he said. High interest
rates inhibit the investor and are a burden on every class of borrowers.
Sometimes it is necessary to take carefully calibrated risks in order to
stimulate investment and to ease the burden on consumers.
We will take appropriate steps in this regard.
Source: Adapted from http://www.telegraph.co.uk/finance/newsbysector/
mediatechnologyandtelecoms/telecoms/9457831/Indian-finance-ministerPalaniappan-Chidambaram-to-review-tax-law-that-landed-Vodafone-with2bn-bill.html
13.2 Introduction
In the previous unit, you learnt about the country risk factors and the assessment
of country risk factors. You also studied about the techniques of accessing
country risk. You understood how country risk is measured and how risk is
incorporated in capital budgeting. The topics related to the governance of country
risk assessment and preventing host government takeovers were also discussed.
Uncertainty from business cannot be undermined, but that should not be
a deterrent for being a showstopper. But in reality a business can be managed
in such a way that it transforms into a planned uncertainty. Certain risks can be
managed by hedging, tax planning and insurance. For this, we need to
understand the environment of tax system.
In this unit, you will learn about the bases of international tax system and
the principles of taxation. You will study about double taxation, tax havens and
transfer pricing. You will also learn about international tax management strategy
and Indian tax environment.
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Objectives
define the bases of international tax system and the principles of taxation
discuss double taxation, tax havens and transfer pricing
assess international tax management strategy and the Indian tax
environment
13.3 Bases of International Tax System

The international tax system is expected to be neutral and equitable. Being
neutral means it should not affect the economic efficiency. Moreover, a firm
should not be taxed twice for the same income. Let us understand these concepts
in detail.
13.3.1 Tax Neutrality

The concept of neutrality of international taxation is based on the concept of
economic efficiency. An MNC gives importance to the calculation of tax when it
is considering the distribution of capital among different countries. In case the
tax is neutral, it will not be affected either by the location where the investment
is made or by the nationality of the investor who makes the investment. An
MNC will benefit if it transfers its investment from a country with lower return to
a country with higher return, thereby increasing World welfare.
Domestic neutrality provides equal treatment to the residents and nonresidents. The key issue to be seen is whether the marginal tax burden is
equalized between home and host countries and would such equalization be
desirable. This form of neutrality involves:
Uniformity in both the applicable tax rate and determination of taxable
income
Equalization of all taxes on profits
Foreign neutrality in taxation means that the tax burden placed on the
foreign subsidiaries of a firm should equal that imposed on foreign-owned
competitors operating in the same country.
Horst (1980) has explained tax neutrality in terms of capital-export neutrality
and capital-import neutrality. Capital-export neutrality means that the rates of
taxes should be the same between domestic and foreign investment. Investors
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are indifferent to domestic and foreign investment. This is possible when pre-tax and post-tax returns on capital are the same between the capital exporting
country and the capital importing country. Capital-import neutrality occurs when
the same tax rate is applied to the income of all firms competing in the same
capital-importing country so that no firm, neither domestic nor foreign, enjoys
any competitive advantage. As tax bases are different, it is not easy to achieve
capital-import neutrality.
13.3.2 Tax Equity

The principle of tax equity is based on the fact that all the similarly situated tax
payers should participate in the cost of operating the government according to
the same rules. This can be understood in two ways.
One is that the contribution of each payer should be in conformity with the
amount of public services he or she receives. The other is that each tax payer
should pay taxes according to his or her ability to pay. It means that a person
with greater ability should pay a greater amount of tax. But when there is more
than one tax jurisdiction, it becomes difficult to define the concept of equity.
Activity 1
Make a report of the differences between tax neutrality and tax equity.
Hints:
The concept of neutrality is based on the concept of economic efficiency.
The principle of tax equity is based on the fact that all the similarly
situated tax payers should participate in the cost of operating the
government according to the same rules.
1. The concept of ____________ of international taxation is based on the
concept of economic efficiency.
2. ____________ means that the rates of taxes should be the same between
domestic and foreign investment. Investors are indifferent to domestic
and foreign investment.
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13.4 Principles of Taxation

Two common principles of international taxation are the residence principle and
the source principle. The residence principle calculates the tax liabilities by
considering the place where the tax payer resides and the source principle law
considers the source of income of the tax payer as the basis of assessing tax
liabilities.
Residence principle: Residents of a country are taxed uniformly on their
world-wide income, regardless of the source of that income whether it is
domestic or of foreign origin. Non-residents who earn in home country
are not taxed by the home country on their income originating in that
country.
Source principle: Income originating in the home country is uniformly
taxed, regardless of the residency of the receiver of the income. Residents
of the home country are not taxed by the home country on the foreign
source of income.
Countries may adopt any of the two principles in their pure form. They
may also use a mixture of these two principles. A mixture of these two principles,
either within the same country or among different countries, may involve double
taxation on the same income. Double taxation is removed by a system of
domestic tax credits for foreign taxes. If all countries stick to the same pure
principle, i.e., either residence or source principle, there will be no double taxation.
If both home country and foreign country adopt the residence principle, then all
the four categories of income will be taxed only once. The categories are follows:
Income of home country residents originating in home country is taxed
only by home country.
Income of residents of home country originating abroad is taxed only by
the home country.
Income of residents of a foreign country originating in the home country
is taxed only by the foreign country.
Income of the residents of a foreign country originating in the foreign
country is taxed only by the foreign country.
For tax purposes, countries treat individuals differently than corporations.
In most developed countries, individuals are taxed according to the residence
principle, i.e. home country taxes their foreign source income while foreign
country usually exempts non-residents or withholds tax at relatively low rates.
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The international operations of a firm have to bear three kinds of taxes:

Income tax: Major part of the tax revenue in a country is that of tax on
personal income as well as corporate income tax. This tax is levied on
income arising out of a firms operation but the rate of tax varies from one
country to another.
Value-added tax: It is a tax levied on the value added at different stages
of production of a commodity or services. VAT is an indirect tax and is
preferred to direct income tax as it discourages unnecessary consumption
and is easier to collect.
Withholding tax: It is a tax levied on passive income earned by an
individual or a corporate body. Passive means that the income arises in
some other country. Let us take an example that an MNC in India gets
dividends from its subsidiary operating in London and pays tax on the
dividend income to the Government of India. The dividend income is a
passive income. The tax on such income is called the withholding tax as
the MNC receiving the dividend withholds the tax borne by the shareholder
and passes the tax amount to the tax authorities. Passive income may be
in the form of dividend income, income from royalty and technical service
fees and income from interest.
3. Withholding tax is a tax levied on the value added at different stages
of production of a commodity or services. (True/False)
4. Two common principles of international taxation are the residence principle
and the source principle. (True/False)
13.5 Double Taxation

Double taxation is one of the risks associated with doing business outside the
home country. Business transactions may be subject to tax both in the country
of their origin as well as of their completion. An item of income can be subjected
to tax in one country on the basis of residential status and in another country on
the basis of the fact that income was earned in that country.
Corporate income tax is levied when a firm earns income but if the posttax income is remitted to foreign countries, the recipient of such income is taxed
again. Double taxation reduces the incentive of an MNC to invest. For this
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purpose, the entire income from foreign sources should be exempted from tax.
We will discuss different methods used to avoid double taxation later in the unit.
Tax burdens differ in various countries because:
Statutory tax rates differ across countries.
Differences exist in the definitions of taxable corporate income.
Interpretation of how to achieve tax neutrality differs.
Treatment of inter-company transactions.
Tax system like single tax, double tax and partial double tax.
Treatment of tax deferral privilege.
However, relief against such hardships can be provided. The following are the
two ways:
1. Bilateral relief: The two sovereign states concerned can come to a mutual
agreement through which relief against double taxation can be worked
out. This agreement can be of two kinds. One kind of agreement states
that the two countries concerned come to the conclusion that certain
incomes that are likely to be taxed in both countries will be taxed in only
one of them. It further states that only a specified portion of the income
should be taxed by each of the two countries. The other agreement states
that though the income is subjected to tax in both the countries, the
assessee is given a deduction from the tax payable by him in the other
country. It is usually the lower of the two taxes paid.
2. Unilateral relief: Unilateral relief takes place when no agreement exists
for relief against double taxation. Section 91 of the Income Tax Act provides
for such kind of relief. Bilateral relief is always not sufficient to meet all
cases. Thus, at such times, unilateral relief is provided irrespective of the
fact whether the country concerned has any agreement with the other
country or has provided for any kind of relief related to double taxation.
5. ___________is levied when a firm earns income but if the post-tax income
is remitted to foreign countries, the recipient of such income is taxed
again.
6. ____________takes place when no agreement exists for relief against
double taxation.
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13.6 Tax Havens

A tax-haven country is one that has zero rates or a very low rate of income tax
and withholding tax. MNCs are accused of (MIS) using tax havens to shield
income from the local tax collector.
R. Gordon (1981) has given the following features of tax-haven countries:
Strict rules on secrecy and confidentiality with respect of business
transactions
Relative importance of banking and other financial activities
Lack of currency controls
Governmental measures promoting tax-haven status
Alworth (1988) groups the tax havens into four types:
(i) Those having no income or corporate gain tax: The countries that can
be covered under this head are Bahamas, Bermuda, The Cayman Islands,
Nauru, New Hebrides and Turks and the Caicos Islands. Governments of
these countries do not impose any specific rate of taxes but has fixed a
small amount of tax. This ensures that MNCs get a long-term guarantee
against taxes.
(ii) Those having a very low rate of tax: The countries that can be covered
under this head are British Virgin Islands, Netherlands, Antilles, Montserrat,
Gersey, Guernsey and Isle of Man. Tax rates are low in these countries.
Also, special tax privileges are provided to shipping, aviation and holding
companies.
(iii) Those exempting from tax all income from foreign sources:
Thecountries that can be covered under this head are Costa Rica, Hong
Kong, Liberia and Panama. The governments of these countries tax only
locally generated income and not the income coming from the foreign
sources.
(iv) Those allowing special tax privileges in specific cases: The countries
that can be covered under this head are Luxembourg, Netherlands,
Switzerland, Liechtenstein, Gibraltar, Barbados and Grenada. In the first
four countries, special tax privileges are provided to qualified holding
companies, while in the latter three countries, low rates of taxes are
applicable to special-status companies or to international business
companies.
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Before selecting the type of tax haven to use, MNCs must develop a
framework to evaluate its projected needs and what benefits would it get by the
use of tax havens. Factors considered in choosing a tax haven include:
The political and economic stability of the country and the integrity of its
government
Attitude of a country towards tax-haven business
Taxes other than income tax
Tax treaties
Banking facilities
Infrastructure facilities
Liberal incorporation laws that would minimize both the cost of
incorporation and the length of time it takes to incorporate
The long-range prospects for continued freedom from taxation
It has become a practice among many companies to avoid paying taxes
to the government. But ever since the governments of different countries have
started cracking down these unlawful activities, many countries that were earlier
considered to be a tax haven have started sorting things at their ends. Take the
example of Switzerland. It has developed a negative image by helping the
corporate to avoid tax.
7. A tax-haven country is one that has zero rates or a very low rate of income
tax and withholding tax. (True/False)
8. Tax haven is a factor considered in choosing a tax treaty. (True/False)
13.7 Transfer Pricing

Transfer pricing is a method of pricing of goods and services between parent
and subsidiary or between two subsidiaries. It is a technique used to transfer
funds from one location to another. It helps in positioning the funds at a desired
location. It is a pricing technique for inter-corporate transactions. There are
different subsidiaries of an MNC that operate in some or different countries that
may be linked due to vertical or horizontal linkages.
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Example 13.1: A garment manufacturing unit may be buying the raw material
from its subsidiary. This is a vertical linkage. Raw material will be charged at a
transfer price from the subsidiary.
Determination of transfer prices
Transfer prices are set on the basis of arms length prices. These are the prices
prevailing in transactions between unrelated parties engaged in similar or the
same trade under similar conditions in the open market. There are two
components involve
(a) Market price
(b) Cost of production
When a firm can sell its output either to its subsidiary or to any other firm
in the market, it is an open market. When there is an open market, arms length
price is equal to the market price.
Figure 13.1 gives an example of an open market.
Subsidiary A
Subsidiary B
Parent
Subsidiary C
Subsidiary D
Figure 13.1 Example of Open Market

Transfer Price = Market Price

Subsidiary A will sell its product to Subsidiary B at the market price, because if
Subsidiary B does not buy from it, it can sell the product to other companies in
the market. If it sells at less than the market price, it will be decreasing its profit.
Here, we can clear the concept of the uncontrolled market price and resale
price.
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Uncontrolled market price: It is the direct way of calculating arms length

price. Uncontrolled sales are made to an unrelated party outside the firms
own network.
Resale price is the price at which the product that has been bought from
a subsidiary is resold to an independent buyer. The reseller margin (cost
+ profit) will be deducted to find the arms length price. This method is
used when a comparable uncontrolled market price does not exist or the
reseller margin is not much.
A multinational company can help achieve the goal by shifting profits from
high-tax to low-tax jurisdictions. For example, take Hungary, with a corporate
tax rate of 16 per cent, and France, with a tax rate of 35 per cent. An MNC with
divisions in these two locales will benefit by shifting more profit toward Hungary
and less to France. Each division is controlled by corporate headquarters, which
can set a transfer price to benefit the entity as a whole.
9. ____________is a technique used to transfer funds from one location to
another. It helps in positioning the funds at a desired location.
10. ____________is the price at which the product that has been bought
from a subsidiary is resold to an independent buyer.
11. When a firm can sell its output either to its subsidiary or to any other firm
in the market, it is an __________.
13.8 International Tax Management Strategy

The strategy for an international firm is to minimize overall tax burden of the
firm so that it can increase the profits. For this, an international firm has to
decide whether the profits of the subsidiaries should lie with them, thereby
delaying their repatriation to the parent in order to evade taxes at home. In this
way, the profits would be reinvested in profitable channels and the corporate
wealth of the subsidiary will increase but if the repatriation is delayed, the parent
will not get net cash inflow and this will be against the basic purpose of investment
in the subsidiary. The MNC has to trade-off between the repatriation of dividend
and retention of earning with the subsidiary.
The objective of minimization of tax burden also depends on the cost
allocation between different units of the firm. If a firm allocates more cost in a
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high-tax country and shows greater profits in a low-tax country, the total tax
burden would be reduced. But there are limits to cost allocations, for which the
firm has to adopt the transfer pricing principles.
The tax management strategy helps the firm to decide whether the foreign
operation should take the form of either a branch or a subsidiary. If it is expected
that foreign operation will incur huge losses in the near future, it would be better
to operate through branches.
Whatever strategy is adopted by a firm, it needs to consider the tax
provisions in home as well as the host country. An MNC has the flexibility to
plan international taxation in such a way so as to structure its foreign operations
and to plan remittance policy in order to maximize global after-tax cash flows.
12. The strategy for an international firm is to minimize overall tax burden of
the firm so that it can increase the profits. (True/False)
13. If a firm allocates more cost in a high-tax country and shows greater
profits in a low-tax country, the total tax burden would increase. (True/
False)
13.9 Indian Tax Environment

The Income Tax Act in India has provisions for taxation of income from foreign
sources. It provides tax incentives to those investing in India. It also has norms
for avoiding double taxation. All these have been designed to attract scarce
foreign exchange for the Indian economy.
The tax laws first determine the resident status of an individual. This status
for an individual depends on the duration of his stay in India. A company is
treated as a resident or a non-resident depending upon whether the control and
management of the company is wholly in India or outside.
The tax liability on earnings is fixed in the following manner.
Any person who was a resident in the previous year is liable to pay tax in
India on the total income it earns. The income comprises:
Income received or deemed to be received in India
Income accrued or deemed to have accrued in India
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Income that accrues outside India

Non-residents are taxed only in the first two cases, i.e. income received
or accrued or deemed to have received and accrued in India.
The Act provides tax subsidies to residents with respect to income from
foreign sources, and at the same time, provides incentives to non-resident Indians
with regard to their investments in India.
Tax incentives for residents on earnings from foreign sources
The residents get tax deductions on some forms of income as follows:
The profits of newly established industrial units in EPZ/SEZ/100 per cent
EOU are completely exempted from tax provided their export accounts
for at least 75 per cent of the total sales.
Any resident enterprise involved in infrastructure projects or in assembly/
installation of machinery and plant outside the country can claim 50 per
cent deduction while computing taxable income.
30 per cent of the profits from export made directly or through export
houses are granted tax deductions.
Taxes for foreign enterprises in India
NRIs enjoy tax exemptions on their income accrued in India. The income may
be in the form of business profit, salary, royalty, fees, interest and other payments.
The provision of the Act is that the income accruing in India from news agency,
royalty, fees, purchase of goods for export purpose and interest on bonds and
securities are exempted from tax in India.
Companies resident in India are subject to the Indian tax on their income,
generally on an accrual basis, from all sources inside or outside India and whether
or not remitted to India.
Branch income
The income of all foreign branches is taxed in India as part of the Indian
companys worldwide taxable income. Similarly, the losses of all foreign branches
are deductible in computing the worldwide taxable income. In computing the
income or loss of a foreign branch, a deduction is generally allowed for all
expenses incurred wholly and exclusively for the purpose of the business that
are not of a capital or personal nature. Income is taxed whether or not repatriated.
If the branch income incurs tax in the foreign country, credit is given in India to
the extent of the lesser of the foreign tax paid or the Indian tax on the foreign
income, either unilaterally or under treaty.
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Foreign subsidiary income

Dividends of foreign subsidiaries when declared (and interim dividends when
they are made unconditionally available) are included in the worldwide taxable
income of the Indian company. Profits not distributed by the foreign subsidiary
are not taxed in the hands of the Indian company. Treaties often provide for
lower foreign withholding tax. No credit is given for underlying tax paid by the
foreign subsidiary.
Income Tax Act, 1961 [Section 43 (5)1]
Speculative transaction refers to a transaction in which a contract for the
purchase or sale of any commodity, including stocks and shares, is periodically
or ultimately settled otherwise than by the actual delivery or transfer of the
commodity.
Provided that for the purpose of this clause:
(a) A contract in respect of raw materials or merchandise entered into by a
person in the course of his manufacturing or merchandising business to
guard against loss through future price fluctuations in respect of his
contracts for actual delivery of goods manufactured by him or merchandise
sold by him; or
(b) A contract in respect of stocks and shares entered into by a dealer or
investor therein to guard against loss in his holdings of stocks and shares
through price fluctuations.
Section 73 Losses in speculation business
1. Any loss, computed in respect of a speculation business carried on by
the assessee, shall not be set off except against profits and gains, if any,
of another speculation business.
2. Where for any assessment year any loss computed in respect of a
speculation business has not been wholly set off under sub-section (1),
so much of the loss as is not so set off or the whole loss where the
assessee had no income from any other speculation business, shall,
subject to the other provisions of this chapter, be carried forward to the
following assessment year, and:
It shall be set off against the profit and gains, if any, of any speculation
business carried forward to the following assessment year; and
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If the loss cannot be wholly set off, the amount of the loss not so set
off shall be carried forward to the following assessment year, and so
on.
3. In respect of allowance on account of depreciation or capital expenditure
on scientific research, the provisions of sub-section (2) of Section 72
shall apply in relation to speculation business as they apply in relation to
any other business.
4. No loss shall be carried forward under this Section for more than eight
assessment years immediately succeeding the assessment year for which
the loss was first computed.
Explanation: Where any part of the business of a company (other than a
company whose gross total income consists mainly of income which is
chargeable under the heads Interest on securities, Income from house property,
Capital gains and Income from other sources or a company the principal
business of which is the business of banking or the granting of loans and
advances) consists in the purchase and sale of shares of other companies,
such company shall, for the purposes of this section, be deemed to be carrying
on a speculation business to the extent to which the business consists of the
purchase and sale of such shares.
Activity 2
Examine how the Income-Tax Act 1961 has affected the tax environment in
India.
Hint:
The Income-Tax1961Act provides for levy, administration, collection and
recovery of Income.
14. The___________in India has provisions for taxation of income from foreign
sources. It provides tax incentives to those investing in India.
15. ___________refers to a transaction in which a contract for the purchase
or sale of any commodity, including stocks and shares, is periodically or
ultimately settled otherwise than by the actual delivery or transfer of the
commodity.
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Unit 13
13.10 Case Study

Indian IT industry: New Tax Rules Reduce Litigation
The PMs move of setting up a panel in order to clarify taxation policies that
are related to the IT industry has been welcomed by the IT industry, IT
sector analysts and taxation experts. This move states that a taxation regime
in line with the best international practices would lead to an improvement in
the investor confidence.
In the Finance Bill in 2010, Safe harbour provisions were announced whose
aim was to resolve disputes and provide certainty to the taxpayers. Though
the framework prepared for the safe harbour provisions have been finalized
by the Central Board of Direct Taxes (CBDT), it has still not been
operationalized.
Both the taxpayers and the tax authorities are benefited by the Safe harbour
provisions in the determination of transfer price international transactions.
Safe harbour defines circumstances where the revenue authorities would
accept the transfer pricing that has been declared by the assessee. This
generally takes place without much scrutiny. The taxpayers are also provided
with certainty and relief from compliances and associated costs. At the
same time, the tax authorities will also be relieved of much of their
administrative burden.
Senior director in Deloitte India, stated that the step taken can lead to much
needed litigation relief to the taxpayers who are faced with aggressive
transfer pricing audits in India. He also said that the move is a positive one
as it leads to an increase in the confidence of foreign companies in the
setting up or in the expansion of their operations in India.
In fact, the safe harbour regulations proposed by the industry did not see
much traction and it is important that India comes out with a clear position
on the safe harbour rules and make it attractive for companies to come
under the regime rather than litigate with the tax authorities, said the head
of tax disputes resolution, KPMG.
Activities such as analytical work, software development and product
development are conducted by a number of MNCs through captive entities
in India. In India, over 750 MNCs have such centres in India. Transfer
pricing margin is specified by safe harbour rules for such transactions which
are repetitive in nature and in case where the foreign parent company uses
India as a development centre.
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He also stated that at present, the tax authorities have an aggressive

approach to transfer pricing margins and they compare such development
centres to a fully fledged company comprising all kinds of associated risks.
Questions
1. Do you think the move taken for setting up a panel to clarify taxation
policies is a beneficial one?
2. What do you understand by safe harbour?
Source: Adapted from http://articles.timesofindia.indiatimes.com/2012-0731/software-services/32961047_1_safe-harbour-tax-authorities-transferprice
13.11 Summary
The international tax system is expected to be neutral and equitable.
The concept of economic efficiency forms the basis of the concept of
neutrality of international taxation. An MNC gives importance to the
calculation of tax when it is considering the distribution of capital among
different countries.
The principle of tax equity is based on the fact that all the similarly situated
tax payers should participate in the cost of operating the government
according to the same rules.
Residence principle and the source principle are the two common principles
of international taxation.
The difference between the residence principle and the source principle
may be viewed as the difference between taxing the net national product
(NNP) and taxing the net domestic product (NDP).
A country with a zero rate or a very low rate of income tax and withholding
tax is known as a tax-haven country.
Corporate income tax is levied when a firm earns income but if the posttax income is remitted to foreign countries, the recipient of such income
is taxed again.
Provisions for the taxation of income from foreign sources are provided
by the Income Tax Act in India.
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13.12 Glossary
Equitable: Marked by or having equity
Marginal: The total cost incurred to a company for producing one more
unit of a product
Jurisdiction: The right, power and authority of interpreting and applying
law
Arbitrary: Not restrained or limited in the exercise of power
Accrual: The adding together of interest or different investments over a
period of time

1. Define capital-export neutrality and capital-import neutrality.
2. Explain the two principles of international taxation.
3. Discuss the kinds of taxes that the international operations of a firm have
to bear.
4. What is double taxation? Discuss.
5. Explain a tax-haven country. State the features of tax-haven countries.
6. Define transfer pricing.
7. State some forms of income on which the residents receive tax deductions.
13.14 Answers
1. Neutrality
2. Capital-export neutrality
3. False
4. True
5. Corporate income tax
6. Unilateral relief
7. True
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8. False
9. Transfer pricing
10. Resale price
11. Open market
12. True
13. False
14. Income Tax Act
15. Speculative transaction

1. When the rates of taxes are the same between domestic and foreign
investment, it leads to Capital-export neutrality.
Capital-import neutrality occurs when the same tax rate is applied to the
income of all firms competing in the same capital-importing country so
that no firm, neither domestic nor foreign, enjoys any competitive
advantage.
2. Two common principles of international taxation are the residence principle
and the source principle.
3. The kinds of taxes that the international operations of a firm have to bear
are:
Income tax
Value-added tax
Withholding tax
4. Double taxation is one of the risks associated with doing business outside
the home country. It reduces the incentive of an MNC to invest.
5. A tax-haven country is one that has zero rates or a very low rate of income
tax and withholding tax.
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The features of tax-haven countries presented by R. Gordon (1981) are

as follows:
Strict rules on secrecy and confidentiality with respect of business
transactions
Relative importance of banking and other financial activities
Lack of currency controls
Governmental measures promoting tax-haven status.
6. Transfer pricing is a method of pricing of goods and services between
parent and subsidiary or between two subsidiaries.
7. The residents get tax deductions on some forms of income as follows:
The profits of newly established industrial units in EPZ/SEZ/100 per
cent EOU are completely exempted from tax provided their export
accounts for at least 75 per cent of the total sales.
Any resident enterprise involved in infrastructure projects or in
assembly/installation of machinery and plant outside the country can
claim 50 per cent deduction while computing taxable income.
Kaur, Dr. Harmeet. International Financial Management.Delhi: Vikas
Publishing.
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Unit 14
Foreign Direct Investment, International

Portfolio and Cross-Border Acquisitions
Structure
14.1 Caselet
14.2 Introduction
Objectives
14.3 Flow of Foreign Direct Investments (FDI)
14.4 Cost and Benefits of FDI
14.5 ADR and GDR
14.6 Concept of Portfolio
14.7 Cases on Cross Border Acquisitions
14.8 Case Study
14.9 Summary
14.10 Glossary
14.12 Answers
14.1 Caselet
GOI & RBI to announce GDR guidelines: UK Sinha
SEBI Chairman UK Sinha stated in an interview that SEBI has never been
influenced by politics and he further asserted this statement by saying that
the track record of the market regulator proves it. He also said that capital
market regulator SEBI is aware of its responsibility towards conducting
reforms and working towards a strong financial market.
When asked about the crucial issue of misusing global depository receipts
(GDR), it was stated by UK Sinha that the Reserve Bank of India and the
government are likely to announce GDR guidelines soon. He also informed
that the recommendations on GRD guidelines have already been presented
by the SEBI to the government.
According to Sinha, the GDR proceeds are being misused by several firms
for trading purposes. Following this, in recent times, the SEBI has also
banned many firms that were found to be manipulating share prices after
issuing GDRs.
Unit 14
There has also been a concern about the vacancies of whole-time members
in the SEBI board and addressing this issue, UK Sinha stated that the
government would be appointing members by the book.
Source: Adapted from http://www.moneycontrol.com/news/business/
govtrbi-to-announce-gdr-guidelines_741012.html
14.2 Introduction
In the previous unit, you learnt about the bases of international tax system as
well as the principles of taxation. You also learnt about double taxation, tax
havens and transfer pricing. In addition to this, you also studied about
international tax management strategy and Indian tax environment.
In this unit, you will learn about the flow, cost and benefits of Foreign
Direct Investment. You will also study about ADR and GDR as well as the concept
of portfolio. In addition to these, you will also study about cases on cross border
acquisitions.
Objectives
define the concept of FDI
describe ADR and GDR
assess the concept of portfolio
explain cases on cross border acquisitions
14.3 Flow of Foreign Direct Investments (FDI)

When an investor based in one country acquires an asset in another country so
as to manage that asset, it is known as Foreign Direct Investment (FDI). FDI
inflows into a country by a foreign investor are with long-term commitment.
Given the appropriate host-country policies and a basic level of development, it
has been shown that FDI triggers technology spillovers, assists human capital
formation, contributes to international trade integration, helps create a more
competitive business environment and enhances enterprise development. All
these contribute to a higher economic growth. Beyond the initial macro-economic
stimulus for actual investment, FDI influences growth by increasing total factor
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productivity. Technology transfers through FDI generate positive externalities in

the host country. The benefits from FDI do not accrue automatically and evenly
across countries and sectors. In order to reap the maximum benefits from FDI,
there is a need to establish a transparent, broad and effective enabling policy
environment for investment and to put in place appropriate framework for their
implementation. Such an environment must provide incentives for innovations
and improvement of skills and contribute towards improved competitiveness.
FDI is needed for promoting economic growth of the host country. It
increases the domestic savings and lowers the cost of production. The company
that comes to the country will bring technical know how to the country and
promotes employment. FDI indirectly promotes the specialization of labour and
induces the implementation of rational policies.
Factors for low FDI inflow into India
According to the latest AT Kearney report on FDI Confidence Index, some of
the most prominent deterrents for companies to invest in India are bureaucracy
(Lengthy FDI approval process), political stability and physical infrastructure
development. Also maintaining the lower cost advantage vis--vis other countries
seems to be an area of concern of companies looking at India as a destination.
Though economic reforms welcoming foreign capital were introduced in
the 1990s it does not seem so far to be really evident in the inflow of FDI. There
is a lingering perception abroad that foreign investors are still looked at with
some suspicion. Besides, the Made in India label is not conceived by the world.
Most of the problems for the investors arise because of domestic policy, rules
and procedures and not FDI policy per se or its rules and procedures. India has
one of the most transparent and liberal FDI regimes between the emerging and
developing economies.
Problems for slow growth of FDI in India
In addition to Indias poor performance in terms of competitiveness, quality of
infrastructural skills and productivity of labour, there are several other factors
that make it a far less attractive ground for direct investment than the potential it
has. Some of the major deterrents are discussed. Domestic policy framework
affects all investments, whether the investor is Indian or foreign. Among the policy
problems that have been identified by surveys as acting as additional hurdles for
FDI are laws, regulatory systems and government monopolies that do not have
contemporary relevance. Corporate tax rates in East Asia are generally in the
range of 1530 per cent, compared with a rate of 48 per cent for foreign companies
in India. This is definitely a major disincentive to foreign corporate investment.
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Taxes levied on transportation of goods from state to state (such as Octroi and
entry tax) adversely affect the economic environment for export production. Such
taxes impose both cost and time delay on movement of inputs used in production
of export products as well as in transport of the latter to the ports.
The FDI regime in India is still quite restrictive. In order to ease FDI, the
government needs to loosen the restrictions on FDI outflows so that Indian
enterprises are allowed to enter into joint ventures. The government needs to
take steps to deregulate FDI in industry and simplify the FDI procedures in
infrastructure. Many of the reforms have already been implemented and it has
yielded good result in terms of removing the entry barriers. However, the
liberalization of exit barriers is still needed. In fact, it is really because of lack of
exit barriers that large volumes are not flowing in. Export policy needs to be
revised in order to attract FDI. The export zones lack dynamism because of the
governments general lack of decision about attracting FDI.
Labour laws discourage the entry of green field FDI because of the fear
that it would not be possible to downsize if and when there is downturn in
business. In context of FDI, poor infrastructure has a greater effect on export
production than the production for the domestic market. FDI directed at the
domestic market suffers the same handicap and additional costs as domestic
manufacturers that are competing for the domestic market.
Despite India being a latecomer to the FDI scene in comparison to other
East Asian countries, its liberalized policy regime and significant market potential
has sustained its attraction as a favourable destination for foreign investors. A
transparent, investor friendly and liberal FDI policy has been drafted by the
Government of India. In India, up to 100 per cent of FDI is allowed under
automatic route for most of the sectors/activities, where the investor does not
require any prior approval.
Activity 1
Assess the problems for slow growth of FDI in India. Make a report.
Hint:
The FDI regime in India is still quite restrictive
1. _________ directly promotes the development of the financial sector.
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2. _________discourage the entry of green field FDI because of the fear

that it would not be possible to downsize if and when there is downturn in
business.
14.4 Costs and Benefits of FDI

When direct investment flows from one country to another, it creates benefits
for both the home country and the host country but at a certain cost. We will
discuss the benefits derived and the costs incurred on the FDI to both the
countries involved.
Benefits to the host country
Availability of scarce factors of production: FDI brings in capital and
supplements the domestic capital, and in return can use the factors of
productions that are cheap in comparison to the host country.
Improvement in the balance of payments: The inflow of investment is
credited to the capital account. The host country is able to produce those
items that were being imported earlier.
Building of economic and social infrastructure: Due to foreign
investment the basic economic infrastructure, social infrastructure, financial
markets and the marketing system of the host country develop fast.
Fostering of economic linkages: Foreign firms have forward and
backward linkages. They train the local labour with technical knowledge
that increases the earning capacity; but it also increases the purchasing
power.
Strengthening of government budget: Foreign firms are a source of
tax income for the government. They pay not only income tax, but also
import tariff; thus they help the government in reducing its expenditure.
Cost to the host country
The outflow of money from the host country on account of imports and
the payments of dividends, technical service fees, royalty, etc. deteriorate
the balance of payments.
Overexploitation of raw material is detrimental to the host country as in
future it may lose its advantageous position.
Parent company supplies technology to the subsidiary but does not
disseminate it to the host market so the host country remains dependent
on the MNC.
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The MNC shows reluctance to train local people and uses capital-intensive
production techniques that increase unemployment.
Since the foreign company is technologically more superior to the domestic
companies, the sales of the domestic companies decreases, thus domestic
industry fails to grow.
Foreign companies infuse foreign culture into the industrial set-up and
also into the society. They become so powerful that sometimes they may
even subvert the government.
Benefits to the home country
The home country gets supply of raw material that was not earlier available.
The balance of payment improves as the parent company gets dividend,
royalty, technical service fees and other payments.
The parent company makes an entry into new financial markets through
investment abroad.
Government of the home country generates revenue through taxing the
dividend and other earnings of the parent company.
FDI is a complement to foreign aid and helps in developing closer political
ties between the home country and the host country which is beneficial
for both the countries.
Cost to the home country
Making investment abroad takes away capital, skilled manpower and
managerial professionals from the home country. Outflow of these factors
of production may disturb the home countrys interest.
Subsidiaries of MNCs operating in different countries may adopt various
techniques that may not be in the interest of the home country.
3. The inflow of investment is credited to the capital account. (True/False)
4. Foreign firms have forward and backward linkages. (True/False)
5. Overexploitation of raw material is advantageous to the host country as
in future it may lose its advantageous position. (True/False)
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14.5 ADR and GDR

A depository receipt is a financial instrument whereby investors in one country
can buy, hold, or sell the securities issue by companies in another country. The
Depository receipt is a certificate on which is indicated the following information:
Name of the issuing company in the foreign country
Name of the Registered holder
The number of depository shares held representing ordinary shares of a
specified par value of the company
The name of the custodian and that of the local depository
A summary of the depository agreement and
The benefits and the responsibilities of the holder
Instruments
There are two types of DRs; they are discussed in detail in the following
subsections.
14.5.1 Global Depository Receipt (GDR)

They are used in Global Equity offering to international investors. It can be
considered as global finance instrument that allows an investor to raise capital
at the same time from two or more markets. Depositing receipts helps in crossborder trading and settlement helps to reduce transaction costs and increases
the investment base among the institutional investors. GDR is a negotiable
certificate that represents a companys publicly traded equity or debt. They are
created when a broker purchases the companys shares on domestic stock
market and deliver them to the depositorys local custodian bank who instructs
the depository bank to issue GDRs. They are traded on a stock exchange where
they are listed and in OTC market.
Let us understand the concept of GDR with the help of an example.
Consider an European investor who wants an exposure in Indian securities. He
can do so in two ways. The two ways are as follows:
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1. First one is to enter the Indian stock market and buy the companys stock
on one of the Indian markets. The investors get exposed to the exchange
risks and other compulsory rules and regulations that are formulated for
the purchase and sale of securities in the Indian markets.
2. Second route is through GDRs that would give the investor ownership of
the Indian Companys stock without being subject to Indian stock market
regulation.
GDRs are considered same as selling equity in the Euromarkets.
Features of GDRs
The following are the features of GDR:
GDRs can be listed on any American and European Stock exchange
One GDR can represent more than one share
The holder of the GDRs can get them converted into shares
The holder of the GDR has not right to vote in the company. However, the
shareholders do have this right. The dividend on the GDRs is quite like
the dividend on shares
GDRs are in the US dollar
Structure of GDR
When GDRs are structured with a Rule 144 (a) offering for the US and a
Regulation S offering for non-US investors, there are two possible options for
the structure. Those are as follows:
1. Unitary structures: A single class of DRs is offered both to QIBs in the
US and to off-shore purchasers outside the issuers domestic market, in
accordance with regulations. All DRs are governed by one Deposit
Agreement and all are subject to deposit, withdrawal and resale
restrictions.
2. Bifurcated structures: Under this structure, Rule 144 (a) GDRs are
offered to QIBs in the US and Regulation SDRs are offered to off-shore
investors outside the issuers domestic market.
Benefits for raising GDRs
The following are the benefits of raising GDRs:
Once the issuing company has exploited the domestic capital market, the
company will not benefit by expanding its base in domestic market. The
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company will turn to International Capital markets to expand the base of

investors.
Since there are many restrictions in the issue of shares in the domestic
market, the company can explore international markets. It will help the
company in creating an international recognition among the public.
It will bring foreign exchange to the country that will help in the development
of the economy. International capital is available at a lower cost through
the Euro equity. The funds raised through such instrument do not add to
the foreign exchange exposure. The investors would be able to diversify
their risk and return.
Disadvantages of GDR
As GDR is raised through public issues and hence, it is more expensive
in terms of administrative expenses.
GDRs have a foreign exchange risk if the currency of the issuer is different
from the currency of the GDR, i.e., normally US dollar.
14.5.2 American Depository Receipt (ADR)

It represents ownership in the shares of a non-US company and trades in the
American stock markets. ADRs enable American investors to buy shares in
foreign company without any issue of cross-border and cross-currency
transactions.
ADRs carry price in American dollar, pay dividend in the same currency
and can be traded like any other share of US-based companies. Each ADR is
issued by a US depository bank and can represent one share. The owner of
ADR has the right to obtain the foreign stock it represents, but US investors are
more interested in owning ADR as they can diversify their investments across
the globe. ADR falls within the regulatory framework of the US and requires
registration of the ADRs and the underlying shares with the SEC.
Features of ADRs
The following are the features of ADR:
ADR can be listed on American Stock Exchange.
A single ADR can represent more than one share. One ADR can be two
shares or any fraction also.
The holder of the ADRs can get them converted into shares.
The holders of ADR have no right to vote in the company.
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ADRs in US dollar
The dividend on ADRs is similar to the dividend on share that are paid in the
home currency.
Process of issue of ADR
Investors can purchase ADRs from brokers. These brokers obtain ADR s for
their clients in two ways. They can either purchase already issued ADRs on a
US exchange.
This is similar to buying a share in secondary market or they can create a
new ADR.
Let us understand this with the help of an example. To create an ADR, a
US based broker purchases shares of the issuer in the issuers home market.
The US broker then deposits those shares in a bank in that market. The bank
then issues ADRs representing those shares to the brokers custodian which
can then apply them to the clients account.
Types of ADRs
ADR facilities may be established as either unsponsored or sponsored. The
type of ADR programme employed depends on the requirements of the issuer.
It is broadly classified as follows:
Unsponsored ADR programme: This facility is created in response to a
combination of investor, broker-dealer and depository interest. It is initiated
by a third party. Depository is the principal initiator of a facility because it
perceives US investor interest in a particular foreign security and
recognizes the potential income that may be derived from a facility.
Sponsored ADR programme: This facility is established jointly by an
issuer and a depository. Sponsored ADR facilities are created in the same
manner as unsponsored facility except that the issuer of the deposited
securities enters into a deposit agreement with the depository and signs
the registration statement. The deposit agreement sets out the rights and
responsibilities of the issuer, the depository and the ADR holder. Like
unsponsored ADR facilities, sponsored ADR facilities usually involve the
use of a foreign custodian to hold the deposited securities.
Benefits of ADRs
There are different benefits to issuers and investors.
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Benefits to the issuing company

For issuers, there are several reasons for launching and managing an ADR
programme. They are as follows:
An ADR programme can make the investors interested in them. It also
increases the companies visibility, broaden its shareholder base and
increase liquidity.
It enables a company to tap US equity markets. The ADR offers a new
avenue for raising capital but at highly competitive costs.
ADRs can provide increased communications with shareholders in the US.
They provide an easy way for US employees of non-US companies to
invest in their companies employee stock purchase plan.
Did you know!
An Indian depository receipt is an instrument denominated in Indian Rupees
in the form of a depository receipt created by a domestic depository
(custodian of securities registered with the Securities and Exchange Board
of India) against the underlying equity of issuing company to enable foreign
companies to raise funds from the Indian securities markets.
Activity 2
Find out the Indian ADRs listed on USA stock exchanges. Write them down
on a chart and analyse their financial status.
Hint:
The investors in the US wishing to invest in individual Indian Stocks
usually buy Indian ADRs listed on US stock exchanges.
6. A _________ is a financial instrument whereby investors in one country
can buy, hold, or sell the securities issue by companies in another country.
7. GDRs are considered same as____________ in the Euromarkets.
8. __________ also increases the companies visibility, broaden its
shareholder base and increase liquidity.
9. __________ is created in response to a combination of investor, brokerdealer and depository interest.
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14.6 Concept of Portfolio

MNC makes two types of investment decisions that are as follows:
Portfolio investment decisions
Foreign direct investment decisions
Portfolio is the combination of assets so as to reduce the risk by
diversification.
There are two major types of risks that are as follows:
1. Systematic risk: It is also known as market risk. It is the risk common to
all securities and all companies. These risks cannot be diversified away
and some examples are interest rates, recessions and wars. Technically
speaking, it is that part of the total variability of return caused by external
variables such as factors arising out of market, nature of industry and the
state of economy. These are the uncontrollable factors thus the risk arising
out of these is undiversifiable risk.
2. Unsystematic risk: It is also called as the specific risk that is specific to
the individual asset and can be diversified away as we increase the number
of assets in our portfolio. This risk is due to the known and controllable
factors like internal variables of the company. It is also known as
diversifiable risk as we can reduce it by adding or reducing the number
of securities to the portfolio.
Diversification
It is a risk management technique that uses a wide variety of investments in
order to reduce the impact that any one security will have on the overall
performance of the portfolio. It means combining the securities into a portfolio
is such a way so as to reduce portfolio risk without the impact on the return.
Portfolio policy selecting securities and markets
Portfolio return and risk measured are specific to the currency of investment.
The return on a portfolio is a weighted sum of returns on the assets comprising
the portfolio, the weights being the initial value of the share or asset in the
portfolio. The return on the assets has two components:
Dividend
Capital gain
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Each of these components depends on certain factors which have been

summarized as follows:
1. Global-specific variables, such as global economic trends, the world
business cycle, trends in world trade, world income, and so on.
2. Nation-specific variables, such as national income, national economic
trends, business cycles, nationwide cost factors such as labour
negotiations.
3. Industry-specific factors such as labour negotiations.
4. Firm-specific factors
5. Currency in which returns are earned and the behaviour of exchange rate
and forex markets.
If the investor has an internationally diversified portfolio then the rupee
returns on security depends on world factors, national factors, investors country
factors, firm-specific factors and exchange-rate movements. If these factors
are measurable, then with econometric techniques, we can estimate the expected
returns of the portfolio. Risk-averse investors will have a preference for portfolio
that has lower variance of returns. Diversification of portfolio will lower the
variability of the portfolio. International diversification will be advantageous if
the earnings are not perfectly positively correlated.
Risk reduction and international portfolio diversification
As per the portfolio theory, the investors have to choose between lower expected
returns for lower risks. Whenever there is an imperfect correlation between
returns on different securities, the risk is reduced by diversification of portfolio.
The lower is the correlation among returns the greater benefits is in Portfolio
Diversification Solnik has shown that the internationally diversified portfolio is
less risky than a purely domestic portfolio. A risk-averse investor would hold a
well diversified portfolio than a single security in the same market. The extent
to which risk is reduced depends upon the correlation between the returns of
the securities held in the portfolio.
The less correlated are the returns on the securities included in the portfolio,
the less risky is the portfolio. Let a portfolio in which the security returns are
highly correlated and another securities is added, this also has returns correlated
to the returns of earlier held securities. In this case, the risk reduction is minimum.
If the securities return is not correlated with the earlier held securities, the risk
reduction is greater. Correlation of stock returns intra-market is high as compared
to inter markets, therefore if the securities of different national markets are held
the risk reduction is greater. We know that as an investor increases the number
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of securities in the portfolio, the risk will decrease if they are not positively
correlated. The risk in domestic market can be reduced to a minimum level by
increase in number of stocks in the portfolio.
There have been few studies that describe the benefits that a company
gets from international diversification as compared to diversification in the
domestic market.
10. Portfolio is the combination of assets so as to reduce the risk by
diversification. (True/False)
11. Unsystematic risk is the risk common to all securities and all companies.
These risks cannot be diversified away and some examples are interest
rates, recessions and wars. (True/False)
12. Diversification of portfolio will lower the variability of the portfolio. (True/
False)
14.7 Cases on Cross Border Acquisitions

Given below are few cases of international acquisitions in order to understand
the phenomenon and the principles involved:
1. Daiichi Sankyo of Japan buys 34.8 per cent stake in Ranbaxy of
India
Daiichi Sankyo is Japans century old second largest drug maker and it focuses
in the areas of cardio-vascular disease and cancer and has a strong research
and development setup. Ranbaxy was founded in 1937 and has been Indias
largest generic drug maker. Ranbaxy has presence in more than 100 countries
and in 2007; the companys sale was `7,000 crore.
On June 11, 2008, Daiichi bought the Ranbaxy promoters 34.8 per cent
stake and made an open offer to acquire another 20 per cent of the public
shareholding at a price of `737 per share.
The important question that arises is about the benefits of this acquisition
for the two companies. The main points are:
For Ranbaxy shareholders, it was a very lucrative offer to sell shares at
`737 per share where the share price had been in the range of `500 to
`550.
Page No. 294
Unit 14
In the pharmaceutical sector, giant MNCs are operating and there is fierce
competition. The joining of Daiichi and Ranbaxy strength will provide
synergy to take advantage of the market place.
Ranbaxy was in the generic drug making and in this area; huge investment
in R&D is required. The two firms together can sustain R&D effects.
Japan is a big market for generic drugs and Ranbaxy was not able to
penetrate due to regulatory constraints. Now, through Daiichi, it would be
able to exploit this market.
Daiichi will have increased share in the market of generic drugs. The
quality of these drugs can be improved by its strong R & D.
Daiichis presence will improve in the international market due to wider
international spread of Ranbaxys drugs.
Earnings per share in the combined firm will improve. This may lead to
higher market price of shares in the combined firm.
Leveraged buyout deal of Tata and Tetley
This case provides the concept of leveraged buyout and its use as a financial
tool in acquisitions with specific reference to Tata Teas takeover of global tea
major Tetley. This deal which was the biggest ever cross border acquisition,
was also first ever successful leveraged buyout by an Indian company.
In June 2000, Tata Tea acquired the UK heavyweight brand Tetley for 271
million pounds. The acquisition of Tetley pushed Tata tea to a position similar to
global big companies Unilever and Lawrie. Tata Tea became the second largest
tea company in the world, the first being Unilever owned by Brooke Bond and
Lipton.
Leveraged buyout (LBO) method of financing had never been used before.
LBO mechanism allowed Tata Tea to minimize its cash outlay on making the
purchase. In LBO, the acquiring company could float a special purpose vehicle
(SPV) which was a 100 per cent subsidiary of the acquirer, with minimum equity
capital. The SPV leveraged this equity to gear up significantly higher debt to
buyout the target company. This debt was paid off by the SPV through the
target companys cash flows. The target companys assets were pledged with
lending institutions. Once the debt was cleared, the acquiring company had the
option to merge with the SPV.
Main benefit Tetley: Good price for shareholders
Main benefit Tata Tea: Well known brand with access to international markets.
Page No. 295
Unit 14
13. Ranbaxy was founded in ____________ and has been Indias largest
generic drug maker.
14. In ____________ ____________, the acquiring company could float a
special purpose vehicle (SPV) which was a 100 per cent subsidiary of the
acquirer, with minimum equity capital.
14.8 Case Study

Tata steel of India buys Corus of UK
Corus, which was created by the merger of British Steel and Dutch Steel
Co., was Europes second largest steel producer with the revenue of 9.2
billion pounds in 2005. Tata Steel, Indias largest private sector steel
company, was established in 1907. Tata Steel falls under the Tata Sons
and is financially very strong.
Corus decides to sell
Total debt of Corus was 1.6 billion pounds
Corus needs supply of raw materials at a lower cost
Corus facilities were relatively old with high production cost
Employees cost was 15%
Tata decides to buy
Tata looking for manufactured finished products in European markets
Presently manufactures low value long and flat steel products while
Corus produces high value stripped products
A diversified product mix will reduce risk and higher end products will
improve bottom line
Corus holds a number of patents with strong R&D
Cost of acquisition is lower compared to setting up a new facility and
marketing/distribution channels
Tata known for efficient management would aim to reduce employee
cost at Corus and improving productivity
It will move from 55th position in steel manufacture to 5th position
Page No. 296
Unit 14
In April 2007, the acquisition was completed. The enterprise value of Corus
was 13.7 trillion US dollars.
Synergies: Tata steel is the lowest cost steel producer in the world and
Corus is a large player with significant presence in value added steel
segment and strong distribution network in Europe. One of the benefits for
Tata steel was that it would be able to supply semi-finished steel to Corus
for finishing at its plants which were located closer to high value markets.
The road ahead: Before the acquisition, the major market for Tata steel
was India and it accounted for about 70 per cent of companys total sales.
About half of Corus steel production was sold in Europe (other than UK).
After the acquisition, Europe (including UK) would consume about 80 per
cent of the combined entitys steel production.
Questions
1. State the benefits that Tata Steel derived from the acquisition.
2. How do you think the market for Tata Steel changed after the acquisition?
Source: Adapted from http://www.business-standard.com/india/news/tatasteel-acquires-corus-group-plc-uk/273185/
14.9 Summary
When an investor based in one country acquires an asset in another country
so as to manage that asset, it is known as foreign direct investment (FDI).
The benefits from FDI do not accrue automatically and evenly across
countries and sectors. It is necessary to establish a transparent, broad
and effective enabling policy environment for investment and to put in
place appropriate framework for their implementation to reap the maximum
benefits from FDI.
According to the latest AT Kearney report on FDI Confidence Index, some
of the most prominent deterrents for companies to invest in India are
bureaucracy (Lengthy FDI approval process), political stability and physical
infrastructure development.
While the reforms implemented so far have helped remove the entry
barriers, liberalization of exit barriers has yet to take place. This is a major
deterrent to large volumes of FDI flowing to India.
Page No. 297
Unit 14
Though India has been a latecomer to the FDI scene in comparison to

other East Asian countries, it has managed to become a favourable
destination for foreign investors due to its liberalized policy regime and
significant market potential.
GDR is a negotiable certificate that represents a companys publicly traded
equity or debt.
Through AD`, American investors can buy shares in foreign company
without the problem of cross-border and cross-currency transactions.
As per the portfolio theory, the investors have to choose between lower
expected returns for lower risks. Whenever there is an imperfect correlation
between returns on different securities, the risk is reduced by diversification
of portfolio.
14.10 Glossary
Deterrent: Something immaterial that interferes with or delays action or
progress
Deregulation: The reduction of governments role in controlling markets,
which lead to freer markets, and presumably a more efficient marketplace
Ambivalence: Simultaneous and contradictory attitudes or feelings (as
attraction and repulsion) toward an object, person, or action Tariff
Custodian: A bank, agent, trust company, or other organization
responsible for safeguarding financial assets
Formulated: To express in systematic terms or concepts
Variability: The extent to which data points in a statistical distribution or
data set diverge from the average or mean value.

1. Define the benefits of FDI.
2. State the cost of FDI to the home country.
3. What is GDR? State the ways through which an investor waning exposure
in Indian securities can attain the same.
4. Discuss ADR. What are the different types of ADR?
Page No. 298
Unit 14
5. Define diversification.
6. What are systematic risk and unsystematic risk?
14.12 Answers
1. FDI
2. Labour laws
3. True
4. True
5. False
6. Depository receipt
7. Selling equity
8. Unsponsored ADR programme
9. ADR programme
10. True
11. False
12. True
13. 1937
14. Leveraged Buyout (LBO)

1. FDI influences growth by increasing total factor productivity. Technology
transfers through FDI generate positive externalities in the host country.
The benefits from FDI do not accrue automatically and evenly across
countries and sectors. For further details, refer to Section 14.4.
2. Cost to the host country:
The outflow of money from the host country on account of imports
and the payments of dividends, technical service fees, royalty, etc.
deteriorate the balance of payments.
Page No. 299
Unit 14
Overexploitation of raw material is detrimental to the host country as

in future it may lose its advantageous position.
3. GDR is a negotiable certificate that represents a companys publicly traded
equity or debt.
4. ADRs enable American investors to buy shares in foreign company without
the problem of cross-border and cross-currency transactions.
The types of ADR are:
Unsponsored ADR programme
Sponsored ADR programme.
5. Diversification is a risk management technique that uses a wide variety
of investments in order to reduce the impact that any one security will
have on the overall performance of the portfolio.
6. Systematic risk: It is also known as market risk. It is the risk common to
all securities and all companies.
Unsystematic risk: It is also called as the specific risk that is specific to
the individual asset and can be diversified away as we increase the number
of assets in our portfolio.
Publishing.
Page No. 300
International
Financial Management

Manipal
INSPIRED BY LIFE
Directorate of Distance Education
Subject Code: MF0015 / MBF404 / IB0010

Revised Edition: Spring 2010
Book ID: B1759

Directorate of Distance Education
Department of Management Studies
Board of Studies
Chairman
HOD, Department of Management Studies
SMU DDE
Pankaj Khanna
Director
HR, Fidelity Mutual Fund
Dean
SMU DDE
Shankar Jagannathan
Former Group Treasurer
W ipro Technologies Limited
Additional Registrar
SMU DDE
Abraham Mathew
Chief Financial Officer
Infosys BPO
Deputy Registrar
Student Evaluation Examinations Branch
SMU DDE
Sadhana Dash
Senior HR Consultant
Bangalore
Dr T.V. Narasimha Rao

Adjunct Faculty and Advisor
SMU DDE
Prof. K.V. Varambally
Director
Manipal Institute of Management, Manipal
Revised Edition: Spring 2010

Print:
Printed at Manipal Technologies Ltd
Published on behalf of Sikkim Manipal University, Gangtok, Sikkim by
Vikas Publishing House Pvt Ltd
Authors: Dr Harmeet Kaur: Units (1.31.4, 1.8, 1.6, 3.3, 6.46.4.1, 6.5.16.5.2, 6.66.6.2, 6.7, 7.3
7.6, 8.38.4, 9.3, 9.5, 10.310.4, 12.312.6, 13.313.9, 14.314.6) Reserved, 2012
Neelesh Kumar: Units (2.32.5, 3.43.8, 5.3, 5.65.7, 6.3, 8.5, 9.4, 9.7, 11.4, 11.7, 12.7)
Neelesh Kumar, 2012
Subhash Chander Gulati & Sumit Gulati: Units (4.6, 6.4.26.4.3, 6.5, 6.7.16.7.2, 7.7, 8.6, 10.5
10.6, 11.3, 11.511.6, 11.8, 14.7) Reserved, 2012
Dr Sudershan Kuntluru: Units (4.34.5, 5.45.5, 5.85.11, 9.6) Reserved, 2012
All rights reserved. No part of this publication which is material protected by this copyright notice may
be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter
invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any
information storage or retrieval system, without prior written permission from the Publisher.
Information contained in this book has been pre-approved by SMU and published by VIKAS Publishing
House Pvt. Ltd. and has been obtained by its Authors (pre-approved by SMU) from sources believed to
be reliable and correct to the best of their knowledge. However, the Publisher and its Authors shall in no
event be liable for any errors, omissions or damages arising out of use of this information and specifically
disclaim any implied warranties or merchantability or fitness for any particular use.
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Authors Profile
Dr Harmeet Kaur is an Assistant Professor in Business Management Guru Nanak Institute of
Management and Technology. She is a Ph.D and an MBA and also holds a Postgraduate
Diploma in Investment Banking. She has over 12 years of teaching experience. She works with
PAMETI Punjab Agricultural University as Deputy Director.
Neelesh Kumar is an Assistant Professor at the MBA Department - Hindustan College of Science
& Technology Sharda Group of Institutions, Agra. He teaches Supply Chain Management,
Strategic Management and International Business. He has published a number of research
papers.
Subhash Chander Gulati, an ex - Executive Director Hindustan Aeronautics Limited, is a
B.Tech. (Honours) in Mechanical Engineering from Indian Institute of Technology (IIT), Kharagpur
, an M.Sc. (Technology) from Cranfield Institute of Technology (CIT), Bedford, U.K. and an MBA
from Osmania University, Hyderabad. Earlier he has worked with Sigma Microsystems Private
Ltd at Hyderabad as Vice President, Marketing. He has also been working as a Consultant and
Management Trainer in the areas of soft skills, finance and management related topics.
Sumit Gulati holds an MBA (Finance) from the ICFAI Business School, Hyderabad. He is a
B.E. (Mechanical) from Bharati Vidyapeeth College of Engineering, Pune. He possesses sound
knowledge of the prevalent Financial / Industry information and is well versed with the
fundamental analysis tools and systems. He has worked at I.T.S Ghaziabad as Assistant
Professor (Finance) and has taught PGDM/MBA students. Earlier, he has worked as an
Investment Research Analyst at Evalueserve and a Senior Sales Manager at Aviva Life Insurance
Co. (I) Ltd.
Dr Sudershan Kuntluru, Ph.D., Osmania University, Hyderabad, India, is a Post Doctoral
Fellow from the Indian School of Business, Hyderabad. Earlier he has been an Associate
Professor, Finance and Accounting Area, School of Business Management, NMIMS University
and an Academic Associate, India Institute of Management (IIM-A), Ahmedabad. He has taught
MBA students on subjects ranging from Financial Management, Mergers and Acquisitions to
Corporate Valuation and Corporate Restructuring. He has various articles published in journals
to his name on Accounting and Finance.
Peer Reviewer:
Dr P.C. Biswal is an Associate Professor, Finance at Management Development Institute, Gurgaon.
He has a Ph.D. degree from University of Hyderabad. Prior to MDI, Dr Biswal was working as
ICICI Bank BFSI Chair Professor in T. A. Pai Management Institute (TAPMI), Manipal. Dr Biswal
has about 8 years of experience in teaching and research. He has taught various courses in India
and abroad in the areas of Risk Management and Derivatives, International Financial Management,
Investment Analysis and Portfolio Management, Financial Markets and Institutions, and Open
Economy Macroeconomics. His research interest is in Risk Management and Derivatives,
Commodity Derivatives and Applied Econometrics.
In House Content Review Team
Dr G.P. Sudhakar
HOD, Department of Management Studies
SMU DDE
Arpita Agrawal
Assistant Professor
SMU DDE
Shubha Pissay
Assistant Professor
SMU DDE
Contents
Unit 1
International Financial Environment
1-20
Unit 2
Balance of Payments
21-38
Unit 3
Foreign Exchange Market
39-58
Unit 4
Currency Derivatives
59-83
Unit 5
Exchange Rate Determination
85-108
Unit 6
International Financial Markets
109-133
Unit 7
Foreign Trade Finance
135-156
Unit 8
Nature and Measurement of Foreign Exchange Exposure
157-174
Unit 9
Management of Foreign Exchange Exposure
175-197
Contents
Unit 10
International Capital Structure
199-216
Unit 11
International Capital Budgeting
217-238
Unit 12
Country Risk Analysis
239-259
Unit 13
International Taxation
261-280
Unit 14
Foreign Direct Investment, International
Portfolio and Cross-Border Acquisitions
281-300
Page No. (vi)
MF0015 / MBF404 / IB0010

Course Description
International financial management deals with the financial decisions taken in
the area of international business. The growth in international business is quite
evident in the form of highly inflated quantum of international trade. In the
immediate post-war years, the general agreement on the Trade and Tariffs
(GATT) was set up in order to boost trade. It reduced the trade barriers
significantly over the years, as a result of which international trade grew manifold.
Also, as a logical fallout, basic financial decisions now involve cross-border
complexities. Choices about raising capital, investment, risk management,
acquisition activity, restructuring, and other aspects of financial policy typically
involve international considerations. When making these choices, managers
must analyze exchange rates, differences in tax rules, country risk factors, and
variation in legal regimes.
The 1980s brought a rapid integration of international capital and financial
markets. Impetus for globalized financial markets initially came from the
governments of major countries that had begun to deregulate their foreign
exchange and capital markets. The economic integration and globalization that
began in the eighties is picking up speed in the 1990s via privatization.
Privatization is the process by which a country divests itself of the ownership
and operation of a business venture by turning it over to the free market system.
Lastly, trade liberalization and economic integration continued to proceed at
both the regional and global levels.
Ultimately, because of international borrowing and lending, economic
opportunities are expanded and households have better options to smooth their
incomes. The fundamental job of the financial manager is to maximize
shareholders wealth. These are good things. But just as the existence of banks
makes bank crises a possibility, the existence of an international financial system
makes international financial crises possible. Though this is the flip side, this is
exactly where all the interesting action of the course emanates. In order to
understand such crises we need to understand the nature of the international
financial system. This course provides the foundations for learning how finance
works in the backdrop of cross-border setting.
Course Objectives
In a world where all the major economic functions, i.e., consumption, production,
and investment, are highly globalized, it is essential for financial managers to
fully understand vital international dimensions of financial management. You
are aware that as with international trade, international macro is the result of
the fact that economic activity is affected by the existence of nations. If there
was no international trade, we would not need international macro. But countries
do trade with each other, and because countries (not all, but many) use their
own currencies we have to wonder about how these goods are paid for and
what determines the prices that currencies trade at. The two way flow of funds,
outward in the form of investment and inward in the form of repatriation divided,
royalty, technical service fees, among others, requires proper management and
so the study of International Finance Management has become a real necessity.
In fact, International Finance Management suggests the most suitable technique
to be applied at a particular moment and in a particular case in order to hedge
the risks that are involved in every international transaction.
Though this course does not require a high level of mathematical ability, a basic
understanding will help the learners.
After studying this subject, the student should be able to:
discuss multinational and transnational companies
explain the goals of international financial management
discuss the international monetary system
explain the concept and principles of BOP accounting
explain the concept of capital account convertibility
differentiate between fixed and floating rates
describe forward, futures, swaps, and option markets
discuss international bond markets and international equity markets
discuss the tools and techniques of foreign exchange risk management
examine how to expect the future expected exchange rate
define the bases of international tax system and the principles of taxation
define the concept of FDI
Page No. (ix)
Course Objectives
The Self Learning Material (SLM) for this subject is divided into 14 units. A brief
description of all the 14 units is given below:
Unit 1 - International Financial Environment: This unit explains the term
globalization and presents the goals of International Financial Management in
order to discuss the concept better.
Unit 2 - Balance of Payments: This unit examines the concepts and principles
of balance of payments and its various components. The Current Account Deficit
and Surplus and Capital Account Convertibility have also been discussed.
Unit 3 - Foreign Exchange Market: The unit elucidates the origin of the concept
of foreign exchange and the difference between fixed and floating rates. It also
explains the foreign exchange transactions and the derivatives instruments
traded in foreign exchange market such as forwards, futures, swaps, and options.
Unit 4 - Currency Derivatives: The unit elucidates the importance of forward
markets and the different concepts associated with it. You will also know what
currency futures markets and currency options markets are and how they
function.
Unit 5 - Exchange Rate Determination: This unit outlines the exchange rate
movements and you will also learn about the factors that influence exchange
rates and the movements in cross exchange rates. You will also study about
various concepts such as international arbitrage, interest rate parity, and
purchasing power parity and the International Fisher effect.
Unit 6 - International Financial Markets: This unit highlights the basic concepts
of the international money market. You will also study the International credit
markets which are defined as the forum where companies and governments
can obtain credit (loans in various forms) from the creditors/investors.
Unit 7 - Foreign Trade Finance: This unit explains the concept of foreign trade
finance. You will be introduced to the concepts of financing exports and financing
imports and you will also learn about documentary collections, factoring, forfeiting
and countertrade.
Unit 8 - Nature and Measurement of Foreign Exchange Exposure: This unit
outlines the nature and measurement of foreign exchange exposure. You will
also learn about the different types of exposures and the various types of
translation methods used.
Unit 9 - Management of Foreign Exchange Exposure: This unit will take the
concept of exposure forward and understand how foreign exchange exposure
is managed. You will learn about the various tools and techniques of foreign
risk management and the risk management products.
Page No. (x)
Course Objectives
Unit 10 - International Capital Structure: This unit will provide information

about the international capital structure. You will learn about the cost of capital
and the capital structure of MNCs. In addition to this, you will also learn about
cost of capital in segmented versus integrated markets.
Unit 11 - International Capital Budgeting: In this unit, you will understand the
different topics related to international capital budgeting. You will learn about
the adjusted present value model, capital budgeting from parent firms
perspective and expecting the future expected exchange rate analysis.
Unit 12 - Country Risk Analysis: In this unit, you will study the country risk
factors and the assessment of risk factors. The unit also presents a detailed
description of the techniques through which the country risks can be assessed
as well as measured.
Unit 13 - International Taxation: This unit examines the bases of international
tax system and the principles of taxation. You will study about double taxation,
tax havens and transfer pricing. You will also learn about international tax
management strategy and Indian tax environment.
Unit 14 - Foreign Direct Investment, International Portfolio and CrossBorder Acquisitions: In this unit, you will learn about the flow, cost and benefits
of Foreign Direct Investment. You will also study about ADR and GDR as well
as the concept of portfolio. In addition to these, you will also study about cases
on cross border acquisitions.
Page No. (xi)

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Unit 1

International Financial Environment

International Financial Management

International Financial Management

discuss multinational and transnational companies

Sikkim Manipal University

International Financial Management

Sikkim Manipal University

International Financial Management

1.4 Multinational Corporations and Transnational Corporations

Sikkim Manipal University

International Financial Management

Overview of the Multinational Financial Environment

International Financial Management

2. Diversity of medium of financing: Any company which wishes to go

International Financial Management

policies, balance of payments policies and labour and employment policies

1.5 Objectives of MNCs

International Financial Management

1.6 International Financial Management and Domestic Financial

Sikkim Manipal University

International Financial Management

1.7 Goals of International Financial management

International Financial Management

1.8 International Monetary System

Sikkim Manipal University

International Financial Management

Sikkim Manipal University

International Financial Management

Sikkim Manipal University

International Financial Management

International Financial Management

1. Free float: In a free market, exchange rates are determined by the

International Financial Management

16. In 1944, a conference was held at ______________________in which

1.9 Case Study

International Financial Management

Sikkim Manipal University

International Financial Management

1.12 Terminal Questions

International Financial Management

Answers to Terminal Questions

Sikkim Manipal University

International Financial Management

5. Effective financial management is not limited to the application of the

Sikkim Manipal University

International Financial Management

2.3 Principles of BOP Accounting

International Financial Management

2.3.1 Debits and Credits

International Financial Management

2.3.2 Debit and Credit Entries

Gold exports (physical export of

Gold imports (physical import

Sikkim Manipal University

International Financial Management

We will learn about how these transactions appear in the Balance of

2.4 Balance of Payments Statement

International Financial Management

worth during a specified period of time. Decreases in assets and increases in

2.4.1 The Current Account

Sikkim Manipal University

International Financial Management