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Master of Business Administration- MBA Semester 4 MF0015 International Financial Management - 4 Credits (Book ID: B1316) Assignment Set- 1 (60 Marks) Note: Each Question carries 10 marks. Answer all the questions. Q1. You are given the following information: Spot EUR/USD : 0.7940/0.8007 Spot USD/GBP: 1.8215/1.8240 Three months swap: 25/35 Calculate three month EUR/USD rate. Answer Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) Spot OCR = Other Currency Rate BCR = Base Currency Rate Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) 0.07940 SWAP = -0.00120 Forward rate = 0.07940 - 0.00120 = 0.0782 Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 - 0.00120). Customer wants to Buy EUR 3 Mio against USD 3 months forward. Q2. Distinguish between Eurobond and foreign bonds. What are the unique characteristics of Eurobond markets? Ans:- A Eurobond is underwritten by an international syndicate of banks and other securities firms, and is sold exclusively in countries other than the country in whose currency the issue is denominated. For example, a bond issued by a U.S. corporation, denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United States), would be a Eurobond. Eurobonds are issued by multinational corporations, large domestic corporations, sovereign governments, governmental enterprises, and international institutions. They are offered simultaneously in a number of different national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency the bond is denominated. Almost all Eurobonds are in bearer form with call provisions and sinking funds. A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country. The issuer, however, is from another country. A bond issued by a Swedish corporation, denominated in dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers, would be a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are "Yankee bonds"; those sold in Japan are "Samurai bonds"; and foreign bonds sold in the United Kingdom are "Bulldogs." Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s perspective.

Foreign currency bonds are issued by foreign governments and foreign corporations, denominated in their own currency. As with domestic bonds, such bonds are priced inversely to movements in the interest rate of the country in whose currency the issue is denominated. For example, the values of German bonds fall if German interest rates rise. In addition, values of bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates (or depreciates) relative to the denominated currency. Indeed, investing in foreign currency bonds is really a play on the dollar. If the dollar and foreign interest rates fall, investors in foreign currency bonds could make a nice return. It should be pointed out, however, that if both the dollar and foreign interest rates rise, the investors will be hit with a double whammy. Characteristics of Eurobond markets 1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed interest and has a long-term maturity. There are a number of different currencies in which Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro. (70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a country can protect its currency from being used. Japan, for example, prohibited the yen from being used for Eurobond issues of its corporations until 1984. 2. Non-registered: Eurobonds are usually issued in countries in which there is little regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer form means that the bond is unregistered, there is no record to identify the owners, and these bonds are usually kept on deposit at depository institution). While this feature provides confidentiality, it has created some problems in countries such as the U.S., where regulations require that security owners be registered on the books of issuer. 3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective covenants, making them an attractive financing instrument to corporations, but riskier to bond investors. Eurobonds differ in term of their default risk and are rated in terms of quality ratings. 4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10 years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds. There are also short-term Europaper and Euro Medium-term notes. 5. Other features: Like many securities issued today, Eurobonds often are sold with many innovative features. For example: a) Dual-currency Eurobonds pay coupon interest in one currency and principal in another.

b) Option currency Eurobond offers investors a choice of currency. For instance, a sterling/Canadian dollar bond gives the holder the right to receive interest and principal in either currency. 1. A number of Eurobonds have special conversion features. One type of convertible Eurobond is a dual-currency bond that allows the holder to convert the bond into stock or another bond that is denominated in another currency. 2. A number of Eurobonds have special warrants attached to them. Some of the warrants sold with Eurobonds include those giving the holder the right to buy stock, additional bonds, currency, or gold. Q3. What is sub-prime lending? Explain the drivers of sub-prime lending? Explain briefly the different exchange rate regime that is prevalent today. Ans: - Subprime lending is the practice of extending credit to borrowers with certain credit characteristics e.g. a FICO score of less than 620 that disqualify them from loans at the prime rate (hence the term sub-prime). Sub-prime lending covers different types of credit, including mortgages, auto loans, and credit cards. Since sub-prime borrowers often have poor or limited credit histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased risk, lenders charge sub-prime borrowers a premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for credit cards, higher over-the-limit or late fees are also common. Despite the higher costs associated with sub-prime lending, it does give access to credit to people who might otherwise be denied. For this reason, sub-prime lending is a common first step toward credit repair; by maintaining a good payment record on their sub-prime loans, borrowers can establish their creditworthiness and eventually refinance their loans at lower, prime rates. Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago. This substantial increase is attributable to industry enthusiasm: banks and other lenders discovered that they could make hefty profits from origination fees, bundling mortgages into securities, and selling these securities to investors. These banks and lenders believed that the risks of sub-prime loans could be managed, a belief that was fed by constantly rising home prices and the perceived stability of mortgagebacked securities. However, while this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the possibility of real losses. As home values declined, many borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. These borrowers began to default on their loans, which drove home prices down further and ruined the value of mortgage-backed securities (forcing companies to take write downs and write-offs because the underlying assets behind the securities were now worth less). This downward cycle created a mortgage market meltdown. The practice of sub-prime lending has widespread ramifications for many companies, with direct impact being on lenders, financial institutions and home-building concerns. In the U.S. Housing Market, property values have plummeted as the market is flooded with homes but bereft of buyers. The crisis has also had a major impact on the economy at large, as lenders are hoarding cash or investing in stable assets like Treasury securities rather than lending money for business growth and consumer spending; this has led to an overall credit crunch in 2007. The sub-prime crisis has also affected the commercial real estate market, but not as significantly as the residential market as properties used for business purposes have retained their long-term value.

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and euro zone banks only 40 percent. Drivers of sub-prime lending Home price appreciation : -Home price appreciation seemed an unstoppable trend from the mid-1990s through to today. This "assumption" that real estate would maintain its value in almost all circumstances provided a comfort level to lenders that offset the risk associated with lending in the sub-prime market. Home prices appeared to be growing at annualized rates of 5-10% from the mid-90s forward. In the event of default, a very large percentage of losses could be recouped through foreclosure as the actual value of the underlying asset (the home) would have since appreciated. Lax lending standards : - Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in lending standards can be seen as the product of many of the preceding themes. The increased acceptance of securitized products meant that lending institutions were less likely to actually hold on to the risk, thus reducing their incentive to maintain lending standards. Moreover, increasing appetite from investors not only fueled a boom in the lending industry, which had historically been capital constrained and thus unable to meet demand, but also led to increased investor demand for higher-yielding securities, which could only be created through the additional issuance of sub-prime loans. All of this was further enabled by the long-term home price appreciation trends and altered rating agency treatment, which seemed to indicate risk profiles were much lower than they actually were. As standards fell, lenders began to relax their requirements on key loan metrics. Loan-to-value ratios, an indicator of the amount of collateral backing loans, increased markedly, with many lenders even offering loans for 100% of the collateral value. More dangerously, some banks began lending to customers with little effort made to investigate their credit history or even income. Additionally, many of the largest sub-prime lenders in the recent boom were chartered by state, rather than federal, governments. States often have weaker regulations regarding lending practices and fewer resources with which to police lenders. This allowed banks relatively free rein to issue sub-prime mortgages to questionable borrowers. Adjustable-rate mortgages and interest rates : - Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market, particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting ARMs as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered low introductory, or teaser, rates aimed at attracting new borrowers. These teaser rates attracted droves of sub-prime borrowers, who took out mortgages in record numbers. While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan origination, rising interest rates can substantially increase both loan rates and monthly payments. In the subprime bust, this is precisely what happened. The target federal funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in interest rates over a three-year period left borrowers with steadily rising payments, which many found to be unaffordable. The expiration of teaser rates didnt help either; as these artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime borrowers are seeing their monthly payments jump by as much as 50%, further driving the increasing number of delinquencies and defaults. Between September of 2007 and January 2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of curbing losses. Though many sub-prime mortgages continue to reset from fixed to floating,

rates have fallen so much that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus, a boon for some sub-prime borrowers. The exchange rate is an important price in the economy and some governments like to control it, manage it or influence it. Others prefer to leave the exchange rate to be determined only by market forces. This decision is the choice of exchange rate regime. Many alternative regimes exist: Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one where the value of the currency is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market. In this system, currencies are allowed to: Appreciate when the currency becomes more valuable relative to others. Depreciate when the currency becomes less valuable relative to others. Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of the currency is set by official government policy. The exchange rate is determined by government actions designed to keep rates the same over time. The currencies are altered by the government: Revaluation Government action to increase the value of domestic currency relative to others. Devaluation Government action to decrease the value of domestic currency. After the transition period of 1971-73, the major currencies started to float. Flexible exchange rates were declared acceptable to the IMF members. Gold was abandoned as an international reserve asset. Since 1973, most major exchange rates have been floating against each other. However, there are countries which have fixed exchange rate regimes. Q.4 Explain (a) Parallel Loans (b) Back to- Back loans Ans: - Parallel loan: -The forerunner of a swap; a method of raising capital in a foreign country to finance assets there without a cross-border movement of capital. For example, a $US loan would be made to an Australian company to finance its factory in the US; at the same time the US party which made the loan would borrow $A in Australia from the Australian company's parent to finance a project in Australia. Parallel loans enjoyed considerable popularity in the 1970s in the UK when they were frequently used to circumvent strict exchange controls. Back-to-back loan: -A Back-to-back loan is a loan agreement between entities in two countries in which the currencies remain separate but the maturity dates remain fixed. The gross interest rates of the loan are separate as well and are set on the basis of the commercial rates in place when the agreement is signed. Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a way of avoiding currency regulations, the practice had, by the mid-1990s, largely been replaced by currency swaps. Q.5 Explain double taxation avoidance agreement in detail . Ans:- Double Taxation Avoidance Agreements Double taxation relief Double taxation means taxation of same income of a person in more than one country. This results due to countries following different rules for income taxation. There are two main rules of income taxation (a) source of income rule and (b) residence rule. As per source of income rule, the income may be subject to tax in the country where the source of such income exists (i.e. where the business establishment is situated or where the asset/property is located) whether the income earner is a resident in that country or not. On the other hand, the income earner may be taxed on the basis of his residential status in that country. For example if a person is resident of a country, he may have to pay tax on any income earned outside that country as well. Further some countries may follow a mixture of the above two rules. Thus problem of double taxation arises if a person is taxed in respect of any income on the basis of source of income rule in one country and on the basis of

residence in another country or on the basis of mixture of above two rules. Relief against such hardship can be provided mainly in two ways Bilateral Relief : -The governments of two countries can enter into agreement to provide relief against double taxation, worked out on the basis of mutual agreement between the two concerned sovereign states. This may be called a scheme of bilateral relief as both concerned powers agree as to the basis of the relief to be granted by either of them. Unilateral Relief : -The above procedure for granting relief will not be sufficient to meet all cases. No country will be in a position to arrive at such agreement as envisaged above with all the countries of the world for all time. The hardship of the taxpayer, however, is a crippling one in all such cases. Some relief can be provided even in such cases by home country irrespective of whether the other country concerned has any agreement with India or has otherwise provided for any relief at all in respect of such double taxation. This relief is known as unilateral relief. Q.6 What do you mean by optimum capital structure? What factors affect cost of capital across nations? Ans:- The objective of capital structure management is to mix the permanent sources of funds in a manner that will maximise the companys common stock price. This will also minimise the firms composite cost of capital. This proper mix of fund sources is referred to as the optimal capital structure. Thus, for each firm, there is a combination of debt, equity and other forms (preferred stock) which maximises the value of the firm while simultaneously minimising the cost of capital. The financial manager is continuously trying to achieve an optimal proportion of debt and equity that will achieve this objective. Cost of Capital across Countries : - Just like technological or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways: 1. Increased competitive advantage results to the MNC as a result of using low cost capital obtained from international financial markets compared to domestic firms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares. 2. MNCs have the ability to adjust international operations to capitalise on cost of capital differences among countries, something not possible for domestic firms. 3. Country differences in the use of debt or equity can be understood and capitalised on by MNCs. We now examine how the costs of each individual source of finance can differ across countries. Country differences in Cost of Debt Before tax cost of debt (Kd) = Rf + Risk Premium This is the prevailing risk free interest rate in the currency borrowed and the risk premium required by creditors. Thus the cost of debt in two countries may differ due to difference in the risk free rate or the risk premium. (a) Differences in risk free rate: Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect the risk free rate. These factors include: Tax laws: Incentives to save may influence the supply of savings and thus the interest rates. The corporate tax laws may also affect interest rates through effects on corporate demand for funds. Demographics: They affect the supply of savings available and the amount of loanable funds demanded depending on the culture and values of a given country. This may affect the interest rates in a country. Monetary policy: It affects interest rates through the supply of loanable funds. Thus a loose monetary policy results in lower interest rates if a low rate of inflation is maintained in the country.

Economic conditions: A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate. (b) Differences in risk premium: The risk premium on the debt must be large enough to compensate the creditors for the risk of default by the borrowers. The risk varies with the following: Economic conditions: Stable economic conditions result in a low risk of recession. Thus there is a lower probability of default. Relationships between creditors and corporations: If the relationships are close and the creditors would support the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium. Government intervention: If the government is willing to intervene and rescue a firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk premium. Degree of financial leverage: All other factors being the same, highly leveraged firms would have to pay a higher risk premium. Assignment Set- 2 (60 Marks) Q1. Because of its broad global environment, a number of disciplines (geography, history, political science, etc.) are useful to help explain the conduct of International Business. Elucidate with examples. Answer : -International Finance is a distinct field of study and certain features set it apart from other fields. The important distinguishing features of international finance are discussed below: Foreign exchange risk: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterized by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers. Political risk: Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political risk is when the sovereign country changes the rules of the game and the affected parties have no alternatives open to them. Expanded opportunity sets: When firms go global, they also tend to benefit from expanded opportunities which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economies of scale when they operate on a global basis. Market imperfections: The final feature of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect. There are profound differences among nations laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio. Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities. The International Monetary System,

as we have today, has evolved over the course of centuries and defines the overall financial environment in which multinational corporations operate. The International Monetary System consists of elements such as laws, rules, agreements, institutions, mechanisms and procedures which affect foreign exchange rates, balance of payments adjustments, international trade and capital flows. This system will continue to evolve in the future as the international business and political environment of the world economy continues to change. The International Monetary System plays a crucial role in the financial management of a multinational business and economic and financial policies of each country. Evolution of the International Monetary System can be analysed in four stages as follows: The Gold standard, 1876-1913 The Inter-war Years, 1914-1944 The Bretton Woods System, 1945-1973 Flexible Exchange Rate Regime since 1973 Q2. What is a credit transaction and a debit transaction? Which are the broad categories of international transactions classified as credits and as debits? Answer : - 1. Credit Transactions (+) are those that involve the receipt of payment from foreigners. The following are some of the important credit transactions: (a) Exports of goods or services (b) Unilateral transfers (gifts) received from foreigners (c) 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: (a) Import of goods and services (b) Unilateral transfers (or gifts) made to foreigners (c) Capital outflows Capital Inflows can take either of the two forms: (a) An increase in foreign assets of the nation (b) A reduction in the nations assets abroad For example, you can better understand the debit and credit transaction from the examples given below: A US resident purchases an Indian stock. When a US resident acquires a stock in an Indian company, foreign assets in India go up. This is a capital inflow to India because it involves the receipt of a payment from a foreigner. When an Indian resident sells a foreign stock, Indian assets abroad decrease. This transaction is a capital inflow to India because it involves receipt of a payment from a foreigner. Capital Outflows can also take any of the following forms: (a) An increase in the nations assets abroad (b) A reduction in the foreign assets of the nation Both the above transactions involve a payment to foreigners and are capital outflows. Q3. What is cross rates? Explain the two methods of quotations for exchange rates with examples. Answer : - Cross Rates: The exchange rate between any two non-dollar currencies is referred to as a cross rate. A relatively large number of cross rates would be required to trade every currency directly against every other currency. For example, N currencies would require N x (N-1)/2 separate cross rates. For this reason, most exchange rates are quoted in terms of dollars and by far the greatest volume of trading directly involves the dollar. This reduces the number of cross-currency quotes that dealers must keep track of and reduces the potential losses associated with mispricing currencies relative to one another (which permit Triangular Arbitrage).

Exchange rates are expressed in 2 methods: Direct Quote: The most common way in which they are expressed is called a direct quote. Generally speaking, most international countries deal with the direct quote in all their transactions and the quotes that they give are in accordance with international convention. The direct quote is when the USD is the senior currency and the local currency is expressed in terms of USD. For example USD:JPY is 83.25. This means how much Yen it must cost to buy one USD. Intuitively, you go from the back to the front. Therefore it takes 83.25 Yen to buy one US Dollar. If the rate increases to 84.00 it is known as depreciation because now it takes 84 Yen (more Yen) to buy 1 US Dollar in contrast to previous 83.25. Indirect Quote: An indirect quote is usually when the main currency, USD is in the back. The USD is quoted in terms of the local currency. In the example of the AUD:USD. If the AUD istrading at 0.95, it means it will cost 1 USD to buy 0.95 AUD. If AUD appreciates to 1.10, the indirect method means that it actually cost more in terms of USD to purchase 1 unit of the AUD. In this example, it can be seen previously while the cost was 0.95 US Dollars to purchase 1 AUD, now it cost 1.10 USD to buy 1 unit of AUD. Q4. Explain covered and uncovered interest rate arbitrage. Answer : -Covered Interest Arbitrage Interest arbitrage is usually covered as investors of short-term funds abroad generally want to avoid the foreign exchange risk. To do this, the investor exchanges the domestic currency for the foreign currency at the current spot rate so as to purchase the foreign treasury bills and at the same time he sells forward the amount of the foreign currency he is investing plus the interest he will earn so as to coincide with the maturity of his foreign investment. Thus, covered interest arbitrage refers to the spot purchase of the foreign currency to make the investment and offsetting the simultaneous forward sale (swap of the foreign currency) to cover the foreign exchange risk. When the treasury bills mature, the investor can then get the domestic currency equivalent of the foreign investment plus the interest earned without a foreign exchange risk. Since the currency with the higher interest rate is usually at a forward discount, the net return on the investment is roughly equal to the positive interest differential earned abroad minus the forward discount on the foreign currency. This reduction in earnings is the cost of insurance against the foreign exchange risk. Continuing with the earlier example where the interest rate on three-month treasury bills is 11 per cent per year in Germany and 15 per cent in London, let us also assume that the pound is at a three-month forward discount of 1 per cent per year. To engage in covered interest arbitrage, the German investor must exchange marks for pounds at the current exchange rate (to purchase the British treasury bills) and at the same time sell forward a quantity of pounds equal to the amount invested plus the interest he will earn at the prevailing forward rate. Since the pound is at a forward discount of 1 per cent per year, German investor loses 1 per cent on the foreign exchange transaction to cover his foreign exchange risk for the three month period. His net gain is thus the extra 1 per cent interest he earns for the three months minus th of the 1 per cent he loses on the foreign exchange transaction, or 3/4 of 1 per cent. Covered interest arbitrage and interest parity theory Figure 1 shows the relationship through Covered Interest Arbitrage (CIA) between the interest rate differentials between the two nations and the forward premium or discount on the foreign currency.

Figure 1: Interest Rate Differentials, Forward Exchange Rates and Covered Interest Arbitrage The horizontal axis in the diagram shows the forward premium (+) or forward discount on the foreign currency expressed in percentages per year. The vertical axis measures the interest differential in favour of the foreign country in per cent per annum. The solid line in the Figure depicts interest parity. Positive values indicate that interest rates are higher abroad. Negative values indicate that interest rates are higher domestically. And when the interest differential is zero, the foreign currency is neither at a forward discount nor at a forward premium (i.e., the forward rate on the foreign currency is equal to its spot rate). For example, when the positive interest differential is 1.5 per cent per year in favour of the foreign nation, the foreign currency is at a forward discount of 1.5 per cent per year. Similarly, a negative interest differential of 2.0 per cent is associated with a forward premium of 2.0 per cent. The Figure shows that for all points above the interest parity line, there will be a net gain from an arbitrage outflow due to two reasons. First, the positive interest differential exceeds the forward discount and second, the forward premium exceeds the negative interest differential. Uncovered Interest Arbitrage The transfer of funds abroad to take advantage of higher interest rates in foreign monetary centres usually involves the conversion of the domestic currency to the foreign currency, to make the investment. At the time of maturity, the funds (plus the interest) are reconverted from the foreign currency to the domestic currency. During the period of investment, a foreign exchange risk is involved due to the possible depreciation of the foreign currency. If such a foreign exchange risk is covered, we have covered interest arbitrage, otherwise we have uncovered interest arbitrage. Suppose that the interest rate on three-month treasury bills is 11 per cent at an annual basis in Germany and 15 per cent in London. It may then pay for a German investor to exchange marks for pounds at the current spot rate and purchase British treasury bills to earn the extra 1 per cent interest for the three months. When the British treasury bills mature, the German investor may want to exchange the pounds he invested plus the interest he earned back into marks. The situation is shown in Figure 2.

Figure 2: Arbitrage Process However, by that time, the pound may have depreciated so that he gets back fewer marks per pound than he paid.

Figure 3: Pound Depreciates of 1% Figure 3 shows if the pound depreciates by of 1 per cent during the three months of the investment, the German investor nets only about of 1 per cent from his foreign investment (the extra 1 per cent interest he earns minus the of 1 per cent that he loses from the depreciation of the pound).

Figure 4 shows the situation when the pound depreciates by 1 per cent during the three months, the German investor gains nothing, while Figure 5 shows if the pound depreciates by more than 1 per cent, the German investor lose. However, if the pound appreciates, the German investor gains both from the extra interest he earns and from the appreciation of the pound.

Figure 5: Pound Appreciated by More than 1% Q5. Explain briefly the mechanism of futures trading Answer : -Mechanism of Futures Trading The mechanics of futures trading consists of two parts. {1} . Components of Futures Trade 1. Futures players: Futures trading, which represents a less than zero sum game, can be considered beneficial if it results in utility gains. This is done by the transfer of risks between the market players. These players are: Hedgers Speculators Arbitrage 2. Clearing houses: Every organised futures exchange has a clearing house that guarantees performance to all of the participants in the market. It serves this role by adopting the position of buyer to every seller and seller to every buyer. Thus, every trading

party in the futures markets has obligations only to the clearing house. Since the clearing house matches its long and short positions exactly, it is perfectly hedged, i.e., its net futures position is zero. It is an independent corporation and its stockholders are its member clearing firms. All futures traders maintain an account with member clearing firms either directly or through a brokerage firm. 3. Margin requirements: Each trader is required to post a margin to insure the clearing house against credit risk. This margin varies across markets, contracts and the type of trading strategy involved. Upon completion of the futures contract, the margin is returned. 4. Daily resettlement: For most futures contracts, the initial margins are 5% or less of the underlying commodity's value. These margins are marked to the market on a daily basis and the traders are required to realise any losses in cash on the day they occur. Whenever the margin deposit falls below minimum maintenance margin, the trader is called upon to make it up to the initial margin amount. This resettlement is also called marked-to-themarket. Delivery terms. This includes: (a) Delivery date: Some contracts may be delivered on any business day of the delivery month while others permit delivery after the last trading day. (b) Manner of delivery: The possibilities are: Physical exchange of underlying asset. Cash settlement as in the case of stock index futures. (c) Reversing trade: This trade effectively makes a traders net futures position zero thus absolving him from further trading requirements. In futures markets, 99% of all futures positions are closed out via a reversing trade. 5. Types of orders: Besides placing a market order, the other types are: (a) Limit order: It stipulates to buy or sell at a specific price or better. (b) Fill-or-kill order: It instructs the commission broker to fill an order immediately at a specified price. (c) All-or-none-order: It allows the commission broker to fill part of an order at a specified price and remainder at another price. (d) On-the-open or on-the-close order: This represents orders to trade within a few minutes of operating or closing. (e) Stop order: Triggers a reversing trade when prices hit a prescribed limit. 6. Transaction costs: The costs incurred are: (a) Floor trading and clearing fees: These are small fees charged by the exchange and its associated clearing house. (b) Commissions: A commission broker charges a commission fees to transact a public order. (c) Bid: Ask spreads. (d) Delivery costs: Those are incurred in case of actual delivery. 7. Tax rules: The regulations include: (a) Marketing-to-the-market: The gains/losses are considered at the end of the calendar year where futures contracts are marked-to the-market. (b) Gains: The realised and unrealised gains are taxed at the ordinary personal income tax rate. (c) Losses: The realised and unrealised losses are made deductible by offsetting them against any other investment gains. (d) Commissions: Brokerage commissions are tax deductible. {2} Execution of Futures Trade For a client who wants to assume a long position in, say, a July British pound futures contract, the following steps are undertaken: 1. Phone call to the agent. 2. The agent trades through an exchange member who may be a commission broker or a local.

3. The actual trading is conducted in a past for the particular futures contract involved. Trades are conducted through the use of sophisticated hand signals. 4. The commission broker confirms the trade with the agent who then notifies the client of the completed transaction and price. 5. The client then deposits the initial margin with a member firm of the clearing house. 6. The commission broker can transact in the pit with another commission broker representing another client or with a local. Q6. Briefly explain the difference between functional currency and reporting currency. Identify the factors that help in selecting an appropriate functional currency that can be used by an organisation. Answer : -Functional Versus Reporting Currency Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December 1981, and all US MNCs were required to adopt the statement for fiscal years beginning on or after December 15, 1982. According to FASB 52, firms must use the current rate method to translate foreign currency denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items were recognized or at an appropriate weighted average exchange rate for the period. The other important part about FASB 52 is that it requires translation gains and losses to be accumulated and shown in a separate equity account on the parents balance sheet. This account is known as the cumulative translation adjustment account. ASB 52 differentiates between a foreign affiliates functional and reporting currency. Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. Generally, this is the local currency of the country in which the entity conducts most of its business. Under certain circumstances the functional currency may be the parent firms home country currency or some third country currency. The reporting currency is the currency in which the parent firm prepares its own financial statements. This currency is normally the home country currency, i.e., the currency of the country in which the parent is located and conducts most of its business. The nature and purpose of its foreign operations must be determined by the management to decide on the appropriate functional currency. Some of the economic factors that help in selecting the appropriate functional currency are listed in Table 1. Table 1: Factors indicating the Appropriate Functional Currency

In general, if the foreign affiliates operations are relatively self-contained and integrated with a particular country, its functional currency will be the local currency of that country. Thus, for example, the German affiliates of Ford and General Motors, which do most of their manufacturing in Germany and sell most of their output for Deutschmarks, use the Deutschmark as their functional currency. If the foreign affiliates operations were an extension of the US parents operations, the functional currency could be the US dollar. If the foreign affiliates functional currency is deemed to be the parents currency, translation of the affiliates statements employs the temporal method of FAS # 8. Thus, many US multinationals continue to use the temporal method for those foreign affiliates that use the dollar as their functional currency, while using the current rate method for their other affiliates. Under FAS # 52, if the temporal method is used, translation gains or losses flow through the income statement as they did under FAS # 8; they are not charged to the CTA account.