International Financial Management-1

International Financial Management
Introduction

World as a Global village Free flow of goods and services seamless Quantum jump in International trade and commerce New forms of trade-Internet,e-commerce Dynamic and Complex International markets
International Financial Environment Natural sequel to International trade Financial Management- Integral part of Trade and commerce Technology and its Impact New funding techniques,Investment Vehicles,Risk Management products etc. Creative Financial Management Financial Engineering!
International Financial Environment-contd Challenges before a Finance Manager Keep up to date with the the changes in the Economic Environment-eg exchange rates,Banking and Tax regulations,Foreign trade policies,credit conditions at home and abroad,stock market trends etc. Complex relationships between various variables eg, impact of changes in the world financial markets and its effects on the firm and its bottom line and cash flows
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Challenges before a Finance Manager-contd To be prepared to face adverse business conditions affecting the Financial Position of the Firm and minimize its adverse impactBusiness decisions going wrong due to changes in assumptions,changes in market conditions beyond control etc Design and Implement effective solutions to take advantages of the markets and advances in Financial theories Upgrading skills and using new tools of Financial Management,use of latest technology etc.
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Roles and Goals of MNCsRaw materials seekers-Vertical Integration eg French,Dutch and British East Indian companies Today they are large Oil and Gas companies eg BP,Shell,Indian cos Mittal steel etc Mineral companies like Anaconda copper International Nickel etc Goals-exploit availabilty-cost advantages
Roles and Goals of MNCs- contd Market seekers-Typical MNCs of Todaythey go overseas to manufacture and sell in overseas markets eg IBM,unilever,coca cola,Pepsi, Procter and Gamble,Nestle etc Goals-Maximize businsess opportunities,Maximize profits,to beat perceived or real trade restrictions,eg Japan investing in US to avoid export restrictions in US
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Roles and Goals of MNCs-contd Cost Minimisers Again very common today companies seek and invest in low cost countries,e.g. BPO/KPO in India,Texas Instruments.Japanese Consumer Electronic companies in Malaysia,China etc. Goals-To remain competitive in the Domestic and world market,utilize Economies of scale.
Exposure to International RisksExposure and Risk Exposure is the measure of the sensitivity of the value of a Financial Item,viz Asset,Liability,Cash Flow,to changes in the risk factor Risk is the quantifiable likelihood of loss or less-than-expected returns. It is a measure of the variability of the value of the item attributable to the the risk factor.
Exposure to International Risks1. Macroeconomic Environmental Risks-Value of a Firms Assets,Liabilities and Operating Income varies continually in response to changes in the economic variables such as Exchange rates,Interest rates,Inflation rates,prices and so forth. 2. Core Business risks-Interruptions to Raw material supplies, labor troubles,success or failure of a new product,operational risks
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Exposure to International Risks
3)Systemic Risks-Collapse of a Financial system-eg Stock market crash,Run on Banks etc 4)Currency Risks-also known as FE risk- A risk that a Business operation or an Investment value will be affected by exchange rates fluctuations. 5)Liquidity Risk-The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk eg Shares.Some assets have low Liquidity and high liquidity risk eg Real estate property
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Exposure to International Risks-contd 6)Market Risk-Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. 7)Interest rate risk-Interest rate risk is due to the rise or fall in the Interest rate of a Security or Bond held as well the market value of the fixed rate bonds 8)Political Risk-change in government,unstable government eg Projects in Iraq,Ethiopia etc.
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Exposures;
Transaction Exposure-arises due to exchange differences in transactions-Unanticipated changes in the exchange rate has an impactfavourable or adverse on its cash flows.It is usually within the year.
Eg-An Indian company imports Raw materials from a US company valued at usd100000,payable after 3 months.If it pays at todays rate it would have paid @Rs 45 to a dollar.As the rupee is weakened the rate goes upto Rs 46 to a dollar within 3 months.It has to pay Rs 100,000 more.
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Translation exposure-is the change in accounting Income and Balance Sheet statementscaused by by the changes in exchange rates.It results from the need to translate foreign currency assets /Liabilities into local currency while preparing final accounts.
Eg-an Indian company borrows usd 1 million from a us bank for importing a machine. When the import materialized,the exchange rate was Rs 45 to a usd.The value of the machine in the books as on that date would be Rs 45 million(Rs 4.5 crores) and a corresponding loan of Rs 4.5 crores. (contd)
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Assuming no change in the exchange rate,the company while preparing the final accounts will provide for depreciation on 4.5 cores ,say @25%=Rs1.125crores.
If the rate of exchange as on the Balance sheet date becomes Rs 46 to a dollar,then correspondingly the figures of Machinery value ,the loan taken and the depreciation to be charged also get changed.It impacts both Pand L Account and the Balance sheet.However there is no direct impact on the Cash flows immediately.
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Economic exposure-refers to the change in the value of a company that accompanies an unanticipated change in exchange rates.Anticipated changes are already reflected in the market value of the company. Eg-when an Indian company transacts business with an
American company,it has expectation that the Indian Rupee is likely to weaken and factors this in its transactions.If there is a weakening of the rupee it will not affect the market value of the company.In case it is different from the expected ,then it will have a bearing on the Market Value of the company.
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International Financial Management Economic Exposure-has two components 1. Operating exposure-which captures the impact of the unanticipated changes on the companys revenues,operating costs and operating net cash flows over a medium term horizon-say 3 years-something similar to Transaction exposure(TE) but longer than TE. In general an exchange rate will affect both future revenues as well as operating costs and also the operating Income2. Strategic exposure-In the long term,exchange rates effects can undermine the companys competitive advantage by raising its costs over its competitors.Such competitive exposure is also referred to as Strategic exposure eg Japanese goods becoming expensive due to yen becoming stronger and hence strategically shifting production bases out of Japan.
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International Financial Management Important Terms used in International Finance Exchange control-mechanism by which the country regulates its foreign exchange transactions.RBI in India regulates the entire FE movement into and out of India. Authorized Dealers-are those authorized to deal in FE by RBI eg,Banks.they can buy and sell foreign currencies,open LCs ,remit FE, open accounts abroad. Letter of credit-is a document issued by the opening bank (importers bank)to honor an exporters draft or claim for payment provided the exporter has fulfilled all the conditions stipulated in the LC. Terms used in the operation of LC Opening bank-The bank which opens the LC at the request of the buyer. (contd)
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International Financial Management Beneficiary-The seller/exporter who sells goods to the buyer and who will receive the proceeds of the LC. Advising Bank-The correspondent Bank to whom the opening bank sends the LC in the exporters country who in turn send it to the exporters bank for further process.It could be the branch of the opening bank also. Confirming Bank-one who adds his confirmation to the LC DP/DA-Drafts against payment and Drafts against Acceptance-presents the draft on the Importer through his bankers who in turn forward this draft along with the documents to the importers bankers for payment and releasing the documents.
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International Financial Management Balance of Payments-BOP of a country is a systematic accounting record of all economic transactions between the residents of A country with the Rest of the WORLD. BOP considers both Import and Exports of Goods and Services Basic types of Economic Transactions
1)Purchase or sale of Goods or Services with a financial quid pro quo-or a promise to pay.One financial and one physical(one Real) 2)Purchase or sale of Goods or services in return for goods or services-Barter system(Two Real) 3)Any exchange of Financial items,say purchase of Financial securities and payment there for by cheque(two Financial transactions) 4)A unilateral Gift in kind(one real transfer) 5)A unilateral financial gift.(One financial transfer)
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International Financial Management Accounting Principles in BOPIs a standard double entry accounting record-Thumb rules to remember; 1. All transactions which lead to an immediate or prospective payment from the Rest of the world(ROW) to the country should be recorded as credit entries.The payments,actual or prospective,should be recorded as the offsetting debit entries. Conversely,all transactions which result in an actual or prospective payment from the country to the ROW should be recorded as debits and the corresponding payments as credits
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International Financial Management Accounting Principles in BOP-contd; Payment received from ROW increases the countrys foreign assets either the payment will be credited to a bank account held abroad by a resident entity or a claim is acquired on a foreign entity.Thus an increase in Foreign Assets must appear as debit entry. Conversely, a payment to the ROW reduces the countrys foreign assets or increases its liabilities owed to foreigners;a reduction in foreign assets or an increase in foreign liabilities must therefore appear as credit entries
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International Financial Management Accounting Principles in BOP-contd 2 A Transaction which results in an increase in demand for foreign exchange is to be recorded as a debit entry while a transaction which results in an increase in the supply of Foreign exchange is to be recorded as a credit entry. Thus an increase in Foreign assets or reduction in Foreign Liabilities ,because it uses up foreign Exchange is a debit entry while a reduction in foreign assets or an increase in foreign liabilities because it is a source of foreign exchange now, is a credit entry.Capital outflow-such as when a resident purchases foreign securities or pays off a bank loan is a debit entry while capital inflow such as a disbursement of world bank loan is a credit entry
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International Financial Management COMPONENTS OF BOP1. Current Account-Imports and Exports of goods and services and unilateral transfers of goods and services 2. Capital Account-Under this are included transactions leading to changes in foreign Financial assets and Liabilities of the country 3. Reserve Account-In principle this is no different from the capital account in as much as it also relates to Financial Assets and Liabilities.However in this category only Reserve Assets are included.These are assets which the the monetary authority of the country uses to settle deficits and surpluses
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International Financial Management Examples; India exports garments to USA worth usd10000.The goods have been invoiced and will be paid in USD.Payment will be effected by crediting the account of India in USA.The balance in a foreign bank is a foreign asset for India and liability for USA.India will record the entry as; Transaction Debit credit -Good exported(current) 10000 -Increase in claims from Foreign bank (foreign assetcapital) 10000
In the BOP of USA it will be the opposite.
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Example 2;India agrees to supply leather goods worth usd 5000 to Saudi Arabia in return for CRUDE OIL equivalent to the same amount .Both are current account transactions;Will be recorded in Indias BOP as follows; Transactions Debit credit Goods Imports 5000 Goods Export 50000 In the BOP of Saudi Arabia it will be the opposite. Example 3;SBI purchases securities issued by USA valued at usd 2000 and pays through its branch in the USA.Here it has changed one foreign asset to another.The transaction is capital in nature; Transaction Debit Credit Increase in foreign Securities 2000 Decrease in Foreign bank account 2000
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International Financial Management Structure of current Account in Indias BOPCurrent Account Debits credits Merchandise(goods) Invisibles(a+b+c)
a)services 1.Travel 2.Transportation 3.Insurance 4.Misc b)Transfers 1)official 2)Private c)Income 1)Investment Income 2)employees compensation TOTAL CURRENT ACCOUNT
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Net
International Financial Management MERCHANDISE-In principle,merchandise covers all transactions relating to movable goods where the ownership is transferred from R to NR in the case of exports and NR to R in the case of imports with some exceptions. Exports valued on FOB basis are credit entries.Data for these items are obtained form the various forms exporters fill up and submit to designated authorities like STPI,Expocil,RBI etc. Imports valued at CIF are the debit entries. The difference between the total of debits and total of credits appears in the NET column.This is the Balance on Merchandise Trade Account,deficit or surplus depending upon whether negative or positive.
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International Financial Management InvisiblesIncludes services such as transportation,Insurance Income, Payments and receipts for factor services,viz labour and capital and unilateral transfers. Credits under Invisibles consist of services rendered by R to NR, Interest and Dividend Income earned by R from their ownership of Foreign Financial Assets,cash and gifts received in kind by R from NR. The NET balance between the credit and debit entries under the heads Merchandise ,Non-monetary gold movements and Invisibles taken together as the Current Account Balance.The Net balance is taken as deficit if negative and surplus if positive.
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International Financial Management Structure of Capital Account IN Indias BOP1.Foreign Investments(a+b) a.)India b)Portfolio 2.Loans a)External Assistance By India To India b) Commercial Borrowings(MT and LT) By India To India C)Short term To India 3.Banking Capital a)Commercial Banks Assets Liabilities Non-Residents b)others 4. Rupee Debt Service 5.Other capital TOTAL CAPITAL ACCOUNT(1 TO 5) Debit credit Net
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International Financial Management Structure of other Accounts Net 1.Errors and Omissions 2.Overall Balance (Total of current,capital and Errors and omissions) 3.Monetary movements IMF Foreign Exchange Reserves(increase /decrease) Debit Credit
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International Financial Management Meaning of Deficit and Surplus Deficit refers to the negative balance in the BOP after giving effect to the various transactions and Surplus refers to the positive balance in the BOP It refers to the imbalance in subset of accounts included in the BOP and also referred to as Economic equilibrium or disequilibrium.Disequilibrium calls for a policy Intervention,it is important to group the various accounts in the BOP into set of Accounts above the Line and below the Line.If the NET balance is positive we say it is BOP surplus and if it is negative then it is BOP Deficit. BOP statistics are important for the Finance Manager. If negative it will mean more demand for the Foreign currency and will increase its cost and vice versa.
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International Financial Management Negative BOP can be corrected by increasing taxes,reducing government expenditure,by increasing savings and by reducing consumption. BOP disequilibrium can be remedied by borrowing from International Institutions like IMF which are called Multilateral Borrowings or by Intergovernmental Borrowings called as Bilateral borrowings. FDI ,exchange control mechanism can also be considered as a direct option for remedying the BOP position. BOP can be classified as Autonomous and Accommodating.Autonomous Transaction takes place due to Import and export of goods and services.Accommodating transaction (compensatory transactions) means borrowing to rectify Current account deficit.
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Importance of BOP statistics

BOP statistics reflect the Economic Performance of the country and contains useful information for financial decision matters. Eg USA BOP statistics announcement immediately reflects on the USD rate. When exchange rates are market determined BOP statistics indicate excess demand or supply for the currency and the possible impact on exchange rate. It may signal a policy shift on the part of the monetary authorities of the countries unilaterally or in concert with its trading partners.It may force exporters to realise their export earnings quickly and bring the foreign currency home. BOP accounts are intimately connected with the overall saving-investment balance in a countrys national accounts.Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalances which in turn will affect the Interest rates and FE rates in the country.
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International Monetary Systems-Introduction

Gold standard- Initially there was a Gold standard system which
started in 1814 in UK and 1870 in the USA.Under this each currency derived its value from its GOLD content.Was used till the First world war and a few years after that. Two versions-Gold Specie standard and Gold Bullion standard. Gold specie standard The actual currency in circulation consisted of Gold coins with a FIXED GOLD CONTENT. Gold Bullion standard-The basis of money remains a fixed weight of Gold but the currency in circulation consisted of Paper Notes with the authorities standing ready to convert on demand,unlimited amounts of paper currency into gold and vice versa at a fixed conversion ratio. Under the Gold Exchange Standard the authorities stand ready to convert,at a fixed rate, ,the paper currency issued by them into the paper currency of another country which is operating a Gold species or Gold Bullion standard. The exchange rates between any pair of currencies will be determined by their respective exchange rates against Gold.
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International Financial Management BRETTON WOODS SYSTEMFollowing the 2nd world war,the main allied powers USA and UK took up the task of thoroughly revamping the International Monetary system.In 1944 in a place called Bretton woods in New Hampshire,USA ,2 new supra National Institutions were formed which are very much active today in the International Financial Arena, viz World Bank International Monetary Fund. The exchange rate that was put in place can be characterized as the Gold Exchange standard. It had the following features; The US govt undertook to convert the USD freely into Gold at a fixed PARITY of usd 35 per ounce of gold.Other IMF member countries agreed to fix their currencies vis a vis the dollar within a variation of 1% on either side of the central parity being permissible. Under this system the USD in effect became International money.Other countries accumulated and held USD balances with which thy could settle their international payments. This system was abandoned in 1973 .
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International Financial Management WORLD BANK(WB)-is a vital source of Financial & Technical assistance
to developing countries around the world.WB representing a membership of 185 countries has 2 unique development InstitutionsIBRDA- International Bank for Reconstruction and Development. IDAInternational Development Association Aim of WB- Global Poverty Reduction IBRDA- focuses on middle Income and creditworthy poor countries IDA- focuses on the poorest countries upliftment and growth in projects like drinking water,road construction, etc. Together WB provides-Interest free loans,Interest free credits,Grants to developing countries for education,health,infrastructure,and many other alleviation causes. ADB- Asian development bank-was set up as an Asian version of the world bank to provide development finance to countries in Asian Region .Its HQ is Manila,Phillipines. IFC-Is a member of the WB GROUP. It helps private sector projects in developing countries in the form of giving direct assistance,underwriting issues,undertaking feasibility studies for projects,.It also acts as a guarantor for any lending to PVT sector and develops capital markets in the countries.
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International Financial Management IMF-International Monetary Fund.- mandated to exercise firm surveillance over
the exchange rate policies of its memeber.and to help assure orderly exchange arrangements and to promote a stable exchange rate .The responsibility for collection and allocation of reserves was given to IMF under the Bretton woods arrangement.It was also given the responsibility of ; supervising the adjustable Peg system Rendering advise to member countries on their international monetary affairs Promoting research in various areas of international economics and monetary economics Providing a forum for discussion and consultations among member nations. -The initial quantum of reserves was contributed by the members according to quotas fixed for each.Each member country was required to contribute 25% of its quota in Gold and the rest in its own currency.Thus the fund began with a pool of currencies of its members.The quotas decide the the voting powers and maximum amount of financing its member countries can get within the policy making bodies of IMF. Since 1980,IMF has been authorized to borrow from capital markets. -IMF established contingency reserve to tide over temporary BOP problems,while structural Reserve was established to tide over structural BOP problems.Countries with chronic BOP problems were allowed to depreciate their currencies. It has played an important role in tackling the debt crisis of developing 37 countries.
International Financial Management Exchange rate regimes;current scenario1)Exchange arrangements with No separate legal tender-This group includes
a) Countries which are members of a currency union and share a common currency eg European union., who have adopted Euro as their currency since1-1-1999 and have fixed their currency on parity with the Euro on that date.(11 members have adopted this) b) Countries which have adopted the currency of another country as theirs.eg,East carribean common market viz, Grenada,Antigua,,St Kitts,Nevis. And countries belonging to the central African Economic and Monetary union eg Cameroon,central African Republic.These countries have adopted the French Franc as their currency. 2)Currency Board Arrangement-A regime under which there is a legislative commitment to exchange the domestic currency against a specified foreign currency at a fixed exchange rate.,coupled with restrictions on monetary authority to ensure that commitments will be honoured. Eg Argentina, Hong Kong have tied their currency with USD.( 8 members have adopted this ) 3)Conventional Fixed Peg Arrangements-This is similar to Bretton woods system where the currency is pegged to another currency or a basket of currencies with a band of +/- 1% around the central parity.( 44 members have adopted this )
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International Financial Management Exchange rate regimes;current scenario4)Pegged Exchange rates with Horizontal bands-Here there is a peg but variation
has with wider bands.It is a compromise between a fixed peg and a floating peg.(8 countries have adopted this)
5)Crawling peg-This is another variant of a limited flexibility Regime.The currency is

pegged to another country or a basket of currencies but the peg is periodically attached.(6 countries have adopted this)
6) Crawling Bands-The currency is maintained within certain margins around a central

parity which crawls as in the crawling peg regime(9 countries have adopted this) 7)Managed Floating-with no pre announced path for the Exchange rate-The central bank influences or attempts to influence the exchange rate by means of active intervention in the FE market.-buying or selling foreign currency against the home currency without any commitment to maintain the rate at any particular level or keep it on any pre announced trajectory(25 countries have adopted this)
8)Independently Floating-The exchange rate is market determined with central bank

intervening only to moderate the speed of change and to prevent excessive fluctuations but not attempting to maintain it t at or drive it towards any particular level(48 countries including India have adopted this) It is therefore clear that post 1973 a wide variety of arrangements exist
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International Financial Management International Trade organizations= 1)GATT-General Agreement on Trade and Tariff was constituted
in 1947 to facilitate free trade.The main objectives of GATT are; Progressively reduce Tariff rates Extend Most favoured Nation status treatment to all members Remove quantitative restrictions and Free exchange control on current account transactions Several rounds of discussions were held -Geneva,Kennedy,Tokyo and Uruguay Rounds It did not take into consideration trade in services and Intellectual properties.
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2)WTO-World Trade Organisation-was constituted in 1995.Unlike
GATT is permanent in nature.Apart from trade and services ,it also deals with Trade related aspects of Intellectual Property rights(TRIPS) wherein issues regarding copyright,Patents,Industrial design Trademark are dealt with.In trade related aspects of investment management (TRIMS),discrimination against Foreign Investments in the form of restrictions,discriminatory taxation are dealt with. Various objectives of WTO include implementation administration,and operation of all multilateral trade disputes administration and operation of trade agreements,administration of rules governing settlement of trade disputes,trade policy review mechanism and providing a forum for discussion between members. 3)UNCTAD-United Nations council for Trade and Development (UNCTAD) has been constituted to facilitate International trade.The first meeting was held in Geneva in 1964 and attended by 120 countries.Its main aim was to reduce trade barriers in developed countries and through increased access to their markets,improve standard of living in developing countries
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Global Financial Markets

Provide a forum where the currency of one country is traded for the currency of another Deal with large volume of funds as well as a large number of currencies(of different countries) London,New york, and Tokyo are the nerve centres of FE activity.Frankfurt,Bahrain,Singapore are also very active in the 24 hour activity of the FE markets. The large Central/ Commercial/Investment banks are the principal participants in the FE markets.In general,business firms do not operate on their own but buy and sell through a commercial Banks who are also called authorised dealers. Commercial banks deal in FE markets for commercial reasons where as Central banks in all countries are regulatory in nature .Central banks (RBI in India)maintain the exchange rate of the domestic currency in tune with the requirements of the national economy and government policy.They regulate the FE transactions in order to avoid volatility(sudden upward or downward movement) of the domestic currency. Most of the trading in the FE markets take place in the major currencies like USD,GBP,DM,YEN,EURO,FF,etc .There is an active market for these currencies as there are a large number of buyers and sellers willing to execute FE dealings in these currencies.Now a days,FE dealings primarily take place through using technology,telephone,fax etc.and therefore does not have a geographical relevance.42
International Financial Management Global Financial Markets

Domestic and Offshore Markets Financial Assets and Liabilities denominated in a particular currency,say USD,are traded in the National Financial Markets of that country.In addition,in the case of many convertible currencies,they are traded outside the country of that currency.Thus bank deposits loans,Promissory Notes,Bonds denominated in USD are bought and sold in the US money and capital markets such as New York as well as the Financial Markets in London,Paris,Singapore and Tokyo.The former is the Domestic market while the latter is the Off shore market. Domestic markets are usually subject to strict supervision and regulation by relevant National Authorities.,like SEBI,Federal Reserve Board in the US,MOF in Japan,SEC in the US . Domestic banks are also regulated by the concerned monetary authorities and may be subject to Reserve Requirements,capital adequacy norms etc. Off shore markets ,on the other hand,have minimal regulation,often no registration formalities and importance of rating varies
However in the recent years with the removal of barriers and increasing integration,authorities have realized that regulation of financial markets and Institutions cannot have a narrow national focus-To minimize the problem of systemic risks banks and Firms must be subject to norms and regulations that are common across countries. eg Basel Accord.
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Euro markets
Prior to 1980Eurocurrncies Markets was the only International Financial Market of any significance.It originated in the 1950s with the Russian authorities seeking dollardenominated deposits with banks in Britain and France as the erstwhile USSR thought that the US might freeze its dollar accounts if kept in the US. EurocurrencyDeposit is a deposit in the relevant currency with a bank outside the home country of that currency.Thus a US Dollar deposit in a London Bank is a Eurodollar Deposit and Deutschemark Deposit in a bank in Luxembourg is a Euro mark Deposit. Thus a dollar deposit belonging to an American company held with a Paris subsidiary of an American Bank is still a Eurodollar deposit. Main features of such deposits; As these deposits are kept outside the country of the currency,monetary authorities could not place any restrictions on the issue of such currencies like Reserve requirements,withholding tax for foreign borrowers,deposit insurance requirements, other restrictions placed by the monetary authorities etc were .not applicable to such deposits as they were not under the purview of the MA. Absence of restrictions made the deposits attractive not only to the depositors but also to the banks.Such deposits were parked in developing countries debt at attractive returns without paying much heed for credit risk ratings, (which ,in fact ,led to the Latin American debt crisis).
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Euro deposits -contd The prefix Euro is outdated now as such deposits and loans traded outside Europe .For instance,in Singapore and Hong Kong.They are called Asian Dollar Markets. Over the years markets have evolved a variety of Instruments other than Time deposits and short term loans.Among them are(a) certificates of Deposits(COD) (b)Euro commercial paperEurobonds(d)Floating Rate Notes etc. In 1999,single currency Monetary union was formed.It is a unique integration of currencies without political integration .It challenged the USD in as much as trading is done in Euro as much as in USD and the EU has adopted this currency for trading and holding deposits. ECONOMIC IMPACT OF EURO MARKETS -Perceived Advantages of Euro Markets; 1)More efficient allocation of capital world wide(2)Smoothing out the effects of sudden shifts in Balance of Payments,eg oil crisis in 1973and recycling of petrodollars without which a large number of oil importing companies would have to face severe crisis.(3)The spate of financial innovations that have been created by the market which have vastly enhanced the ability of companies and governments.to manage their financial risks. Perceived Disadvantages of Euro markets;(1)Market stabilization is difficult for Central banks as the so called hot Money-Speculative capital flows is facilitated(2)National Monetary authorities lose effective control over monetary policies as Domestic residents can frustrate their efforts by borrowing or lending abroad.(3) Euro markets create private International Equityand in the absence of a central coordinating 45 authorities they could createtoo muchcontributing to inflationary tendencies in the world economy.

FOREIGN EXCHANGE MARKETS Market in which currencies are bought and sold against each other.It is the largest Market in the world. Largest volume of Trade-estimated over USD per day1 trillion and during peak volume it touched USD 1.6 trillion. FE market is an over-the counter market.This means that there is no single physical or electronic market or an organized exchange like a stock exchange with a central trade clearing mechanism where traders meet and exchange currencies. THE MARKET ITSELF IS ACTUALLY A WORLD WIDE NETWORK OF INTER-BANK TRADERS,CONSISTING PRIMARILY OF BANKS CONNECTED BY TELEPHONE LINES AND COMPUTERS. It is virtually a 24 hour market because it cuts across TIME ZONES.From Tokyo to New York ,it works through out the day and night and hence the huge volumes. STRUCTURE;
1)Retail market- This is the market where tourists and travellers exchange one currency for another in the form of currency notes or travellers cheques.The total turnover and average transaction size are very small.The spread between buying and selling is large.They are secondary Price Makers because they do not have a 2 way transaction .eg Restaurants,Hotels ETC.
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International Financial Management FOREIGN EXCHANGE MARKETS2)Wholesale Marketoften called the Inter Bank Market.Major categories of participants are(a) Commercial banks(b)Investment InstitutionsCentral Banks. The average size of the transaction will be very large,e.g. the average size of transaction in the US market is around USD 4 million and many transactions even larger . Among the Participants in this are-Professional dealers or Primary price makers who make a 2 way quote to each other and to their clients- a price to buy currency X against currency Y and a price to sell X against Y.This Group consists of mainly commercial banks ,large Investment Institutions,and a few large corporations and MNCs. A dealer will sell USD against Euro to one corporate customer,carry the position for a while and offset it by buying USD against Euro from another customer or dealer.Meanwhile,if the price has moved against the dealer he bears the loss. Eg,The dealer might agree to buy Euro by selling USD,at a rate of USD 0.9 per Euro,and by the time he covers his position,the market may have moved ,so that he must acquire the Euro at a price of USD 0..87 per Euro.if the transaction is for USD 1 Million ,the loss he will undergo will be USD 30000. Foreign Currency Brokers act as middlemen between the two Price makers.They do not buy or sell on their Account but act as brokers to get information about customers willing to buy or sell and from whom they will get their commission.They tend to 47 possess a lot information because their of proximity to the customers regularly.
International Financial Management FOREIGN EXCHANGE MARKETS 3)Finally there are Price Takers, who take the prices quoted by Primary price makers,and
buy or sell currencies for their own purposes.eg,Large corporations buy or sell FE for their own operations viz,Imports,Exports,payment of interest,hedging etc.Most of the companies deal in FE only limited to their transactions.But some MNCs and trans national companies use their knowledge and expertise to trade in FE and make profit out of the FE markets. Central Banks intervene in the market from time to time ,to attempt to move exchange in a particular direction or to moderate excessive fluctuations in the exchange rates. Types of Transactions and Settlement Dates; Value Date-A settlement of transaction takes place between two parties by transfer of Deposits between two parties..The date on which the transfer takes place is called the settlement date or Value date .The locations of the 2 banks involved in the Trade are called Dealing locations which may not be the same as the settlement locations..The relevant countries are called Settlement Locations.Obviously,to effect the transfers,banks in the countries of the transfer ,banks in both the countries must be open for business. For example-A London Bank can sell Swiss Francs against USD to a Paris Bank .The settlement locations may be New York and Geneva while Dealing Locations are London and Paris.The transaction can be settled only on a day on which both the US and Swiss banks are open.
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International Financial Management FOREIGN EXCHANGE MARKETS Value Dates for Spot Transactions- In a spot transaction,the Settlement or Value Date is usually 2 business days ahead for the European currencies or the Yen traded against Dollar.Thus if a London Bank sells yen against Dollar to Paris Bank on MONDAY,the London Bank will turn over a Yen deposit to the Paris Bank on WEDNESDAY and the Paris bank will transfer a dollar deposit to the London Bank on the same day.If the value date is a bank Holiday it is considered as he next working day.The settlement date is reduced to one day if the pairs of currencies are USD and Canadian Dollar or Mexican Peso. Value Dates for Forward Transactions-In a one month Forward Purchase of say ,Pounds against Dollar,the rate of Exchange is fixed on the transaction date;the value date is arrived at as a follows-For a one -month forward value date is on say June 20,the corresponding spot Value date is June 22 and one-month forward value date is July 22 and 2 months forward value is August 22. A swap transaction in the Foreign Exchange market is a combination of SPOT AND A FORWARD in the opposite direction.Thus a bank will buy Euros spot against USD and simultaneously enter into a forward transaction with the same counterparty to sell Euros against USD.As the term Swap implies .It is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date.
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International Financial Management FOREIGN EXCHANGE MARKETS TOM RATES-In the case of TOM rates,the value date is one day after the transaction instead of 2 days as in spot rates. READY RATES-In Ready rates transactions,the value date is the same as that of the Transaction date. CARD RATES- are rates quoted for a Retail customer,while for corporate customers or wholesale customers, Bulk special rates are quoted.Card Rate is not an Exchange rate but an approximate rate. Buying Rate is called as a BID rate, and the selling rate is called as ASK rate. EXCHANGE RATE QUOTATIONS AND ARBITRAGEAn exchange rate between currencies A and B is simply the price of one in terms of the other. The ISO has given a 3 letter codes for all the currencies.They are as follows; USD US Dollar, GBP-British Pound , JPY-Japanese Yen , CAD-Canadian Dollar, DEM-Deutschmark,NLG-Dutch Guilder,FRF-French Franc,ESP-Spanish Peseta, INR-Indian Rupee,EUR-Euro,IEP-Irish Pound,CHF-Swiss Franc,ITL-Italian Lira, AUD-Australian Dollar,SEK-Swedish Kroner,BEF-Belgian Franc,DRK-Danish Kroner,SAR-Saudi Riyal etc.Other Important currencies are-South Korea-Won, Indonesia-Rupaiah, Malaysia-Ringet,Singapore-Dollars,South AfricaRand,Russia-Rouble etc 50
International Financial Management FOREIGN EXCHANGE MARKETSExchange Rate quotations-Direct and Indirect quotations-A FE quotation can be Direct or Indirect Direct when it is quoted/expressed in a manner that reflects the exchange of a specified number of domestic currency vis- a-vis one unit of a foreign currency. Eg,Rs 46=1 USD is a direct quotation in India .(European quotation) Indirect quotation is when it is quoted to reflect the exchange of a specified number of foreign currency vis a vis unit of a local currency Eg usd.0.2083=Re1.IS Indirect quotation India(American quotation) SPREAD- is the difference between the Ask Price and the Bid Price Illustration for Spot and Forward rate contractAn exporter exports Goods valued at USD 100 Million. On 6 months credit on 1 st February 2007. And also enters into a Forward rate contract for Rs 49 to 1 USD.By entering into such a contract the exporter is assured of receipt of INR 4900 million on 1st August on which date the amount actually becomes payable,irrespective of the spot rate on that date.If he had not taken this forward cover,and if on that date ,the INR had become Rs 48 to 1 USD,he would have got only INR 4800 million only where by he would have lost INR 100 million.By taking forward cover he has saved INR 100 million .In other words he has gained INR 100 Million.If the spot rate has become INR 46 ,still the Exporter can get the agreed rate of Rs 49 to 1 usd.
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International Financial Management FOREIGN EXCHANGE MARKETS AND DEALINGS;

Cross Rates-When a direct/quote rate of the home currency or any other currency is not
available in the forex market, it is computes with the help of of exchange rates of other countries,it is termed as Cross Rates. eg An Indian Importer imports Farm eggs from New Zealand and is not able to get a quote for purchasing NZ dollars.The transaction has to be routed through USD.It will become INRUSD---NZD. The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate) INR/USD ;48.0465(buying rate)-48.211(selling rate) Determine the exchange rates between INR and NZD ; Steps; 1)The Indian importer has to buy USD at the rate of INR 48.2111(when USD is bought by the Importer,the dealer(bank)is selling USD and hence 48.2111is the relevant rate,as the dealer (bank)sells the USD to the Importer. 2)The Indian Importer then SELLS the USD to the dealer(bank).The dealer BUYS the USD at the buying rate of USD1 =NZD 1.7908. 3)Which means,the Indian Importer get NZD1.7908 in exchange for INR48.2111. And the Exchange rate is determined as- INR 48.2111/1.7908 which is equal to INR 26.9215 per NZD.Thus INR26.9215 per NZD is the Cross Rate derived from two sets f rates,which is the selling rate for the currency.
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International Financial Management FOREIGN EXCHANGE MARKETS AND DEALINGS

To complete the quote the buying rate also needs to be established and given by the dealer using the rate chart;. The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate) INR/USD ;48.0465(buying rate)-48.211(selling rate) The buying rate for INR /NZD would be worked out as follows; a)The dealer purchases 1 USD for INR 48.0465 b)The dealer sells 1USD in exchange for 1.8510 NZD. c)NZD 1.8510 IS equivalent to INR 48.0465. Therefore the buying exchange rate would be INR 48.0465/1.8510 which would be Rs 25.9571. The dealer will quote INR/NZD :25.9571(buying rate)-26.9215(selling rate). This means that the dealer would buy NZD at Rs 25.9571 and sell at Rs26.9215 Arbitrage Process as a means of Attaining Equilibrium on Spot markets; The term Arbitrage in the context of Forex Markets refers to an act of buying currency in one market (at lower price ) and selling it in another market(at higher price).Thus the difference in Exchange rates (in a specified pair of currencies)in two markets provide an opportunity to the dealers /Arbitrageurs to earn profits without risk.As a result ,Equilibrium is restored in the exchange rates of currencies in different Forex markets.
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Gains from International capital flows;
Transfer the savings to investors worldwide so as to maximize productivity of Investment.Savers in capital- rich counties,if confined to investment to their own countries will not be able to get optimum returns.conversely if investment projects in capital-poor countries must be financed only out of domestic savings,many high yielding projects would have to be shelved due to shortage of funds. A particular country may face temporary shortage in National income due to some special adverse circumstances.It cannot borrow internationally and is unwilling to curtail investment it must sharply cut down consumption expenditures.During years of extraordinary prosperity if it cannot invest abroad,it will be under utilizing its capital.International lending and borrowing permit people to achieve a smoother consumption profile.Overall welfare would be greater with cross border capital flows.To day in the era of Globalization cross border investments are so common.In fact India n companies are investing very big in Foreign companies that the movement has become two- way rather than one way. FOREIGN DIRECT INVESTMENT;(FDI)One of the most important vehicle of cross border investment has been FDI.Production and distribution of goods and services has been globalised on an unprecedented scale during the preceding 4 decades..Along with the emergence of of MNCs, JVs,technology licensing franchising,management contracts,production sharing ,Rand D alliances have all made this possible.The theory of ABC viz A for Aid ,B for Borrowing and C for Capital has come to stay. 54
International Financial Management FOREIGN EXCHANGE MARKETS AND DEALINGSThe Essence of the Arbitrage process is to buy currencies from Markets where prices are lower and sell in markets where prices are higher..In operational terms the Arbitrage process is essentially a balancing operation that does not allow the same currency to have varying rate in different Forex markets on a sustainable basis. TYPES OF ARBITRAGE IN SPOT MARKETS 1)Geographical Arbitrage;As the name suggests the ,Geographical Arbitrage consists of buying currency for one Forex Market (say London) and where it is cheaper and sell in another Forex Market( say Tokyo) where it is costly.Because of Technology, geographical divide is not an issue today. 2) Triangular Arbitrage ;As the name suggests ,Triangular Arbitrage takes place when there are currencies involving 3 markets. ARBITRAGE IN FORWARD MARKETS The concept of the arbitrage process is equally applicable in forward markets.In the case of Spot markets,mismatch between cross rates and quoted rates provides an opportunity for arbitrage gains.Similar arbitrage gain possibilities exist in Forward markets also.In case the difference between the forward rate and the spot rate (in terms of premium or discount)is not matched by the interest rate differentials of the 2 currencies.Conceptually,interest rate differentials of the 2 currencies should be equal to to the forward premium or discount on their exchange rates.Since the comparison is to be made with Interest rate differentials,this is also referred to as covered Interest 55 Arbitrage.

Terms used in Foreign Exchange Market Dealings SWIFT-Communications Pertaining to International Financial Transactions are
handled mainly by a large Network called Society for worldwide Inter bank Financial Telecommunication -SWIFT. This is a non profit Belgian cooperative organization with main and regional centers around the world connected by Data Transmission lines.Depending on the location, a bank can access a regional processor or a main center which then transmits to the appropriate information to the appropriate location.
REUTERS- is a London based organization established in the year 1851.It

established the first Electronic Trading Screen which gives real time quotes based on which trading in currencies take place.
TELRATE- is an American organization established in 1969 to deal in screen

based trading for Foreign Exchange.
CHAPS-Clearing House for Automated Payment system (chaps)is a UK based

Electronic payment System
CHIPS-Clearing House for Inter bank payment system (chips) is a US based

electronics payment system.
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Terminology used in International Trade and Finance Types of Lcs
a)Irrevocable LC-- Irrevocable LC is one which cannot be revoked or cancelled without the consent of the beneficiary.This form LC is generally used by Importers and Exporters as this gives more security to both the parties. b)Confirmed LC-- is a LC which is confirmed by a third bank other than an opening bank and the negotiating bank.Sometimes the beneficiary wants the LC of buyers bank to be confirmed by a bank in his country.This process is called as confirmation.It means that the confirming bank undertakes that in the event of proper presentation of documents as required under the LC, it will make payment irrespective of the fact whether the buyers bank reimburses the same or not.It charges its commission for confirmation. c)Transferable LCIn Transferable LC,the buyer can transfer a part of the value of LC or the full value of LC in favour of one or more beneficiaries.Transferability should be expressed specifically in the LC.Since the buyer relies on the integrity of beneficiary,transferability in favour of someone unknown has some risks .Normally Transferable LCs are taken by middlemen who do not want to the buyer and seller to know each other and also want to make a margin without both the parties being aware of the same.Usually transferability in several lots is possible but the transferee again transferring the credit is not possible.
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Types of Lcs; d)Back to Back LCsIn back to back Lcs,Beneficiary's banks open several LCs within the value of the mother LC.This is also known as countervailing LCs..The terms and conditions of the second LC are exactly the same as that of the first LC.The second LC may be a Domestic LC.Any change is the second LC is possible only when the opener of the original LC agrees to such a change in the mother LC. e)Red clause LCIn Red clause LC,advance payment is provided against the supply of certain documents like drawings and manufacturing schedule as mobilization advance for manufacture of capital goods whose manufacturing cycle time is high.The Advance payment details are printed in RED thereby being called Red clause LC. f)Green clause LCIn this type of LC,advance is provided against goods,which are manufactured and kept in a warehouse for a buyer against warehouse receipt,before the same is shipped. g)Sight LC or DP LCSight LC or Document against LC means that as soon as the BE of seller is presented to the buyer ,he should make payment for the same. And only then the documents would be handed over to the buyer.Thus no credit is given to the buyer. h)Usance LC OR DA LC Usance LC or Documents against Acceptance means that payment can be made after a particular period from presentation of Bill of Exchange presented to him .By DA or Usance ,credit is given to the buyer.
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Advising Bank Many times,LC received from buyer may be a forged one.If the
same is routed through a bank,it performs the function of advising whether the LC is genuine or not.For doing this ,the bank charges a commission. Negotiating Bank-- Since the Buyers bank opens the LC,payment will be made to the seller only when the buyers bank receives proper documents as per the LC.This will involve delay like the transit time involved in transferring the necessary documents by the seller to buyers bank.Negotiating bank is a bank which is in sellers country and negotiates the document presented by the seller against the LC.In the event of documents being proper,the negotiating bank credits the proceeds to sellers Accounts immediately,thereby avoiding the delay.For doing this the negotiating bank charges a commission known as Negotiating commission. Correspondent BankWhile a bank has to deal with many centers around the world,it cannot afford to have branches in all those countries.It enters into correspondent agreement with a bank operating in the centers, detailing the scope of responsibilities and sharing of commission.Such banks are referred to as Correspondent Banks. UCPDC-Uniform Customs and procedure for documentary credit or UCDPC is prepared by the International Chamber of commerce.,defining the responsibility of buyers bank,Negotiating bank,confirming bank, Advising bank.All International LC must bear an endorsement that they adhere to UCPDC 500
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NOSTRO ACCOUNT-The Account of a local bank maintained with a
foreign branch or correspondent bank is called as Nostro Account.It is opened to facilitate remittances or credits into the banks account.
VOSTRO ACCOUNTThe Account of a foreign bank maintained with a

local bank or branch is called as Vostro Account.In this case all remittances relating to the foreign bank by local banks are credited to the Vostro account.
INCO TERMSare terms issued by the International Chamber of

commerce.,defining the meaning of various terms given above.If the international Purchase orders are subjected to INCO terms there will be uniformity in interpretation of various commercial terms.
PACKING CREDIT ---Packing credit is given for financing exports.It can

be classified as pre shipment -credit and Post shipment credit.Packing credit is given against an Export order or LC.Pre-shipment credit is given for procuring materials,manufacture of goods,while post shipment credit is given for financing receivables out of exports.Packing credit is extended at any time and export receivables are NOT subject to Maximum Permissible Bank Finance(MPBF)requirements.Post shipment is generally given in the form of discounting of export bills..
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Terms used in IFM Libor-Libor means London Inter Bank offered Rate.London is the premiere Financial
center in the world.LIBOR is a benchmark floating rate at which one bank is willing to lend to another bank in inter bank market.It is available for various tenors.Libor being the premier financial rate ,this rate is used as a landmark rate in many lending transactions.The quotes are generally Libor +or Libor a certain percentage.
Forfaiting is Export factoring.In Forfaiting,export bills are accepted by Importer as

well as by his bankers..Acceptance of such bills is by Importers banks is known as Avalising and bank accepted BE is called AVAL.Such avalised Bills are discounted by Forfaiting agency on non-recourse basis and proceeds are credited to exporters account.Non recourse basis means that in the event of importers failure to make payment ,the loss will be borne by the forfaiting agency and will not be recovered from the exporter.In India EXIM bank offers such facilities.
Transfer Pricing(TP)Due to increasing Globalization and Integration of world

economy and transactions between different branches of subsidiaries,Transfer Pricing is being increasingly resorted to avoid payment of taxes.To counter these all the governments have resorted to taxing the transactions where they find that the TP is not being done on an Arms Length principle.Prices are determined based on various methods as follows;(1)Comparable uncontrolled Price method(CUP method).(2)Resale method(3)Transaction Net Margin Method(4)Profit split method.The governments have realised that MNCs and other companies with HOs outside their country resort to this method.(contd) 61

Transfer Pricing-contd
The general Feeling is that these companies fix the prices with their Head Offices in such a manner that the Transfer Prices are not Loaded enough with adequate Profit Margin so much so that the end prices are much higher compared to the TP,which means that for products /services originating in India, the actual profit accrues outside the country.This is the Crux of TP legislation. Therefore the Governments all over the world have sought to devise mechanisms to ensure that no undue advantage is taken by companies while fixing prices between HO and subsidiaries.eg IBM doing a lot of work in India and invoicing at a price which will not get the actual profit to the Indian Subsidiary but to the HO.In India,TP legislation came into effect the years 2003 when the Government introduced new provisions in the Income Tax Act .It has already triggered a lot of litigation in the assessments . BARRIERS TO INTERNATIONAL TRADE; 1)TARIFF BARRIER;Countries levy customs duty to create barriers for import of Goods into the country for various reasons.Thus by having high customs duty rates, imports are discouraged.This could be a deliberate attempt on the part of certain Govts to reduce consumption of certain types of goods.It could be to encourage indigenous manufacture also. 2)NON-TARIFF BARRIER;Non Tariff Barriers could be in the form of restrictions imposed by certain Govts,eg ,by way of quotas in Licensing.Restrictive agreements like Multi-Fiber agreements for textiles also constitute one form of Non Tariff Barrier.Sometime countries impose severe quality and environmental restrictions 62 which would amount to non trade barriers.

3)Trade Barriers-Trade Barriers are formed by entering into bilateral agreements and
giving Most Favored Nation(MFN) statues to import from certain countries.Apart from this ,Free Trade zones, Customs Union,Common Market,Economic Union,Monetary Union,Cartels which restrict free flow of International trade aslo come under Barrier.Extreme form of Trade Barrier is Embargo. 4)Free Trade Zone;In Free Trade Zone goods move in the member countries without payment of customs duty..Generally Free trade zones provide a lot of incentives for investment by outsiders so that they attract investments.Eg Jebel Ali Free Trade Zone near Dubai where investment is encouraged and has become one of the well known FTZs.The climate for investments,the sops provided,the concessions provided,etc make these zones a very good destination for investments by outsiders. NEED FOR ERECTING BARRIERS Protecting Infant and Domestic Industries.Eg,India imposed very high tariff barriers for protecting its infant industry.This is cited as the main reason for poor quality of Indian goods and lack of competitiveness in Indian Industry. Revenue collection through customs Duty.Customs duty is very good source of Revenue for any Govt. To counter adverse BOP.Till early 90 Indian strategy was to stress for import Substitution to set right the BOP deficit.thru deficit high tariff and non tariff barriers.This led to illegal activities like smuggling . To protect Local employment For political reasons-Embargo in Iraq
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Theories explaining the need for International Trade;
1)Theory of Absolute Advantage; Adam smith propounded the Theory of Absolute Advantage.In this ,labor was considered the only factor of production..For example ,one country has absolute advantage in producing software and another in producing Hardware.Both can increase their wealth by producing goods/services in which they have absolute advantage. 2)Theory of Comparative Advantage ;David Ricardo expounded the Theory of Comparative Advantage.As per this theory if a nation has absolute advantage over another nation in producing both Software and Hardware,still they should produce that which gives them Comparative Advantage and trade in them thereby increasing wealth.This increases specialization .A good example is Software development in India.Because of highly educated and Technically skilled labor force India has made a niche place for itself and has been generating wealth which is ever growing .China/Taiwan is good in computer Hardware and they have captured the world market in Hardware. 3)Heckshire Ohlin Model;This model says that countries rich in capital will engage in capital intensive industry.Thus USA which is capital-rich can produce and trade in capital rich goods while India which is labor rich can make use of its strengths in this area.This theory focuses on factor endowments and the fact that production of different goods requires the various inputs in different proportions.Thus countries like India are endowed with human capital including knowledge workers but are poorly endowed with Physical capital whereas countries like the US have plenty of physical capital but scarcity of skilled labor.Each has to exploit its potential. 64

Capital Account convertibility;Refers to the free movement of currency in the CAPITAL ACCOUNT Transactions in BOP.In India ,The FEMA(Foreign Exchange Management Act) does not permit full capital Account convertibility but only limited capital account convertibility.As per one school of thought,India is not yet ready for a full convertibility.In fact the GOI set up the Tarapore committee which gave its report cautioning the govt to go slow on the full convertibility,though it has strongly recommended partial convertibility.Dr Paul Krugman,the Nobel Laureate from US opined that developing countries should have exchange restriction in the capital Account..This school of thought argues that once the country achieves(1) mandated inflation rate (around 3.5%)(2)mandated fiscal deficit(3)NPA of Banking assets falling under a threshold level (4)adequate financial system supervision,then Capital Account Convertibility can be undertaken.Of late the Govt has been liberalizing the Capital Account transactions viz,increase in limits for advance remittances without Bank Guarantee,Issuing GDRs and ADRs under automatic routes etc. SPECIAL DRAWING RIGHTS-At the 1967 meeting of the IMF IN Rio de Janeiro,it was decided to create such an asset,to be called Special Drawing Rights or SDRs..The IMF would create SDRs by simply opening an account in the name of each member.and crediting it with a certain amount of SDRs.the total volume created had to be ratified by the governing board and its allocation among the members is proportional to the quotas.The value of SDR was initially fixed in terms of gold with same gold content as the 1970 USD.In 1974 the SR became equivalent to a basket of 16 currencies and then in 1981 to a basket of 5 currencies.After the birth of Euro,the SDR basket included4 major freely usablecurrencies,viz,USD,EURO,GBP and JPY.(ALSO REFER TO 65 THE ATTACHED NOTE IN WORD DOC ON SDRs FOR MORE DETAILS)
Some more terms used in International FinanceGR FORMS-Guaranteed Receipt Form OR GR form is used by RBI for physical
export to ascertain the value of export goods as well as to monitor their realization.It is prepared in duplicate and submitted to customs at the time of exports.Customs verify the value with contract and certify the same and one copy is given back to the exporter and the other copy is sent by customs directly to RBI.Exporter has to forward this copy to the AD with Invoice etc ,who then verifies with invoice value.The D also monitors whether the money is realised within 180 DAYS from the date of Shipment. ETX FORM-ETX is filed by the exporter with the RBI for any delays in getting the payment from the overseas buyer.Normally this is done to get approval for the delayed remittance .The exporter has to give a certificate issued by a CA giving reasons for the delay in getting the money. SOFTEX FORM-Softex form performs the function as that of GR for Software exports.It is filed with STPI by the exporting company who approves and certifies the Invoice and the softex form which is then sent to the AD,as in the case of a GR . EEFC Account Exchange Earners Foreign currency Account is a facility given to exporters to keep a part of their Foreign currency earning in the form of FC. Normally upto 50 % is allowed and in special cases even a higher percentage is allowed.without any Interest payment. EOUs,SEZs can keep upto 100 % of the FE earned in the EEC account which can be used for any purpose more liberally for foreign projects,travel etc without quantitative restrictions.
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EXPORT ORIENTED UNITS(EOUs)-EOUs can be set up in any place which is notified as a warehousing station by the chief commissioner of Customs..There are around 300 warehousing stations at present notified throughout India. EOUs at present operate under customs bonding and supervision.They cannot be involved in Trading.They are allowed to sell in local market by entering into DTA(Domestic Tariff Agreement).They can sell up to 50%FOB value of exports in domestic market by paying CD applicable for import or excise Duty whichever is more.Even 100% Foreign Equity can be held for items reserved for SSI. EOUs are expected to earn only positive Net Foreign Exchange(NFE).They can import all capital goods including second hand capital goods as well as raw materials,components,consumables and packing materials without payment of CD.Similarly they can make indigenous purchases without paying Excise Duty.Many state governments have also exempted EOUs from paying sales Tax. Acts Development commissioner is the registering authority and acts as a single window clearance.They enjoy Income Tax benefits as well. SPECIAL ECONOMIC ZONES-(SEZ) is a concept borrowed from China.These zones are treated as foreign country within the country and are subjected to minimum restrictions They are located in notified areas, eg Hassan in Karnataka,Kakinada in AP.They are subjected to minimum NFE conditions.Foreign equity is allowed up to 100%.,other than for trading.Domestic sales can be made by paying CD equivalent for similar goods.
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Money Market Instruments Commercial Paper(CP)- is a corporate short term,unsecured Promissory Note, on a
discount to yield basis.It can be regarded as a corporate equivalent of Certificate of Deposit which is an Inter bank Instrument..CP maturities generally do not exceed 270 days.CP represents a cheap and flexible source of Funds especially for highly rated borrowers.,cheaper than bank loans.Us has the largest and long established dollar CP market .It is used extensively by US corporations as well as some non US corporations.Euro Commercial papers emerged in the 1980s.Investors in CP consist of money-market funds,insurance companies,pension funds and other financial institutions and other corporations with short-term cash surpluses Certificates of Deposit(CD)- is a negotiable Instrument evidencing a deposit with a bank.Unlike a traditional Bank deposit which is not transferable a CD is a marketable instrument so that the investor can dispose it off in the secondary market, if required. .The final holder is paid face value on maturity along with interest .CDs are issued in large denominations usd 100000 or more are used by commercial banks as short term funding instruments.Euro CDs are issued mainly in London by Banks. Bankers Acceptances- This is an Instrument widely used in the US money market to finance domestic as well as international trade.In a typical International trade transaction,the seller (exporter)draws time or usance draft on the buyers bank.On completing the shipment the exporter hands over the shipping docs and the LC issued by the importers bank to his bank.The exporter gets paid the discounted value of draft..The exporters bank presents the draft to the importers bank which stamps it as 68 accepted.A bankers acceptance is created.

Money Market Instruments-In addition to these Securitised Instruments,short term
bank loans are also available.The Euro currencies market is essentially an Inter bank deposit and loans market.
q. +0
REPOS-meaning repurchase obligations are used by securities dealers to finance

their holdings of securities.This is a form of collateralized short term borrowing in which the borrower sellssecurities to the lender with an agreement to buythem back at a later date.Hence the name Repurchase obligations.The Repo price is the same as original buying price ,but the seller (borrower)pays interest in addition to buying back the securities.The duration for the borrowing may be as short as overnight or as long as up to a year.The interest rate is determined by demand supply conditions.
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Foreign Exchange Market in INDIA Foreign exchange Management Act (FEMA) replaced Foreign Exchange Regulations Act(FERA) in 1999 . FEMA gives full freedom to a person resident in India who was earlier resident outside India to hold property outside India when he /she was resident outside India. Similar freedom is also given to a resident who inherits such security or immovable property from a person resident outside India. Liberalization in Foreign exchange entitlements to people traveling abroad Liberalization in Investments by Indian companies outside India. LERMS- was introduced in the year 1992keeping in line with the spirit of liberalization..in LERMS dual exchange rate mechanism was adopted .60% exchange rate was market determined while the balance 40% was determined officially to take care of bulk imports by the govt.In 1993 the dual rate system was abolished and the entire rate was market determined.USD replaced GBP as the intervention currency.
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Foreign Exchange Dealings Direct and Indirect quotations(also known as European and American quotations respectively)-(please see slide number 51.)The latter are also referred to as Inverse or Reciprocal quotes. Two way quotation /rates-In practice dealers quote two way rates,one for buying the foreign currency(known as bid price/rate)and another for selling of foreign currency(referred to as Ask price/rate).Since dealers expect profit in FE operations,the 2 prices cannot be the same.The dealer will buy the FE at a lower rate and sell it at a higher rate and sell the foreign currency at a higher rate.For this reason,the Bid quote is a lower rate and the Ask rate is a higher rate.The quotations are always with respect to the dealer(say banker). By convention,the buying rate follows the selling rates Eg a dealer in Mumbai quotes Pound Sterling 1=Rs 83/83.5 implies that the dealer is prepared to buy 1 British Pound at Rs 83 and sell it at Rs83.5.Normally the rates are at 4 decimal points . SPREAD-IS THE DIFFERENCE BETWEEN ASK PRICE AND THE BID PRICE. The spread is affected by a number of factors .The currency involved,the volume of business,and the market sentiments./rumors about the currency are the major variables reckoned by dealers/operators in the FE market.Spread is akin to the Gross Profit in a normal business,out of which the dealer has to meet his expenses.In percentage terms it can be expressed as follows; Spread(percent) =(Ask price-Bid price)/Ask pricex100.In the above instance,it works 71 out to;(Rs83.5-83)83.5x100=.05988%.Prima facie the spread appears to be very low.It depends on the volume of business the dealer generates.

Therefore it follows that normally the dealers buy FE from Exporters and sell Fe to Importers.Thus if the Rupee becomes stronger,the dealers will buy FE from exporters and pay less in Rs. Eg An exporter has earned USD 10000and if he has to convert it into Rs he will get Rs 440000(usd 10000xRs44) and if the Re is weak he may get Rs 460000(usd 10000x46). Conversely if an importer has to buy dollars for payment,the dealer will sell dollars and if the Re is strong he will pay less and pay more if the Re is weak. Therefore it follows that if the Re is weak the Exporter gains and the Importer loses and conversely if the Re is strong the exporter loses and the importer gains. The quotations are usually shortened as follows ;USD /INR 46.4870/90 which means 46.4870/46.4890.Remember that the offer rate must always exceed the bid rate the bank giving the quote will always want to make a profit in its currency dealing .Hence if a quote is USD/INR 46.9595/.10 means 46.9595/46.9610 and a quote USD/INR 46.9595/8.10 means 46.9595/48.9610. ARBITRAGE between Banks-Though we hear about Market ratesit is often found that different banks will give different quotes for a given pair of currencies.Suppose SBI and Canara Bank are quoting as follows;
GBP/USD (SBI)1.4550/1.4560 (CAN BANK)1.4538/1.4548. This gives rise to an
arbitrage opportunity.Arbitrage in finance refers to a set of transactions ,selling and buying or borrowing and lending the same asset or equivalent group of assets,to 72 profit from price discrepancies within a market or across markets.Most often no risk is involved and no capital has to be committed.

Arbitrage (contd)-In the given example,GBP can be bought from Canara Bank at
USD1.4548 and sold to SBI at USD1.4550 for a net profit of usd 0.0002 per pound without any risk or commitment of capital..One of the main characteristics of modern finance is that they are very efficient these days and such arbitrage opportunities will be spotted by the markets and exploited.Therefore the arbitrage opportunities will disappear very fast. Suppose,the quotes are as follows; SBI Canara Bank GBP/USD (bid) 1.4550/1.4560(ask) 1.4545/1.4555 Here there is no arbitrage opportunity seen as earlier.The reason is that the 2 quotes overlap..However now SBI will find that it is being hiton its bid side much more often,while Canara Bank will find that it is confronted largely with buyers of GBP and few sellers.This could lead to a position where the banks building up a position If SBI has sold more GBP than it has bought it is said to have a NET SHORT POSITION and if it has bought more GBP than it has sold ,it is said to have NET LONG POSITION.Given the volatility of the exchange rates,maintaining a large NET SHORT/LONG Positions for a long time can be a risky proposition.From time to time,a bank may deliberately move its quote in a manner designed to discourage one type of deal and encourage the opposite deal.Thus SBI may have built up a large NET short Position in GBP and may now want to encourage sellers of pounds and discourage buyers.of GBP.Canara Bank may be in a reverse position;it wants to encourage buyers and discourage sellers of GBP.Thus regular clients of SBI wanting73 to to buy GBP can save money by going to Canara bank and Vice versa.

Cross-rates and three-point Arbitrage- A New York bank(N) is currently offering the following quotes; USD /JPY; 110.25/111.10 USD/AUD; 1.6520/1.6530 At the same time ,a bank in Sydney(S) is quoting; AUD/JPY ; 68.3/69.00 Is there an Arbitrage opportunity? Let us see the sequence of transactions 1)Sell JPY,buy USD.Then sell USD and then buy AUD in New York and 2) sell the AUD for JPY in Sydney The calculations are as follows; 1 JPY sold in NY gets USD {1/(USD/JPY)ask(N)}=USD(1/111.10)=USD 0.00900 USD 0.00900 to be sold to buy AUD.=.00900X1.6520= AUD 0.014868 Sell this AUD for JPY=0.014862X68.3=JPY1.0154844=Margin of .00154844. So by doing this ,for every JPY there is a profit of JPY 0.0154844(say 0.0155) and for 100 Million JPY ,the profit would be JPY 1.55 Million.
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Forward Quotations Outright Forwards are quotations for outright forward transactions given in the same manner as spot quotations.Thus a quote like; USD/SEK 3 Month forward;9.1570/9.1595 means ,as in the case of a similar spot quote,that the bank will give SEK9.1570 to buy a USD and require SEK to sell a dollar,delivery 3 months from the corresponding SPOT VALUE DATE. DISCOUNTS and PREMIUM in the FORWARD MARKET; Let us look at the following pair of Spot and Forward quotes; GBP/USD SPOT; 1.5677/1.5685 GBP/USD 1- month forward ;1.5575/1.5585.The GBP is cheaper for delivery one month hence compared to spot GBP..The GBP is said to be at Forward Discount in relation to the USD or equivalently,the USD is at Forward Premium compared to the GBP. settlement date of the contract..In the inter-bank market, banks offer what are known as Optional Forward contracts or Options Forwards.Here the contract is entered into at some time(T0) with the rate and quantities being fixed at this time,but the buyer has the option to take/ make delivery on any day between T1 and T2 with T2>T1>T0.
Options forward-A Standard forward contract calls for delivery on a specific day,the
Swaps in Foreign Exchange Markets-Swap Transactions between currencies A and B

consists of a spot purchase (sale) of A coupled with a forward sale (purchase) of both A against B.
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Forward Forward swaps-Forward forward swaps is to do a swap for two Forward dates..For Instance, purchase (sale) of currency A 3-Months forward and simultaneous sale(purchase) of currency A 6-Months Forward,both against currency B.Such a transaction is called a Forward Forward Swap. It is a combination of of two SPOT -forward swaps; 1)Sell A spot and buy 3- months forward against B. 2)Buy A spot and sell 6- months forward against B In such a deal,both the spot-forward swaps will be done offan identical spot so that the spot transactions cancel out..The customer and the Bank have created what is known as a Swap Position matched inflow and outflow in a currency but with mismatched timing.,with an inflow of A,three months hence and a matching outflow six months hence.The gain/loss from such a transaction depends only on the relative sizes of the 3 month and 6 months swap margins. APPLICATIONS OF SWAP (1)Banks use swaps amongst themselves to offset positions created in outright forwards done with some customers(2)Swaps can be used to roll over long-term exposures .For many currency pairs,forward contracts are not readily available beyond a certain maturity.For example ,in the Indian market till a few years ago ,the tenor of forward contracts could not exceed 6 months.Firms could handle their long term exposure using the so called roll over Forward contractsA firm could use swaps as follows; Buy USD 1,000,000, 6- months forward at a rate known today. 6 months later,take delivery,use USD 100,000to repay the first Installment .For the remaining USD 900,000,do a six month swap-sell in the spot market,buy 6 months 76 forward,Rupee outflow 6 months later is again known with certainty. Repeat this operation every 6 months till the loan is repaid.

The Spot bill buying rate is calculated as Spot bill buying rate =Inter bank forward rate for a forward tenor equal to transit plus usance period of the bill ,if any minus the Exchange Margin..In addition the bank is entitled to recover from the customer,interest for the transit period plus usance period. SPOT TT SELLING RATE- is computed as follows; TT selling rate =Base rate+exchange margin Thus if a customer wishes to purchase a draft drawn on London for GBP 10000.Th inter bank GBP/INR selling rate is Rs 85/GBP.The bank wants an exchange margin of 0.15%.The TT selling rate would be Rs 85(1+0.0015)=85.1275,rounded off to Rs 85.13.The customer will have to pay 85.13x10000=Rs 851300 BILL SELLING RATE-When an importer requests the bank to make a payment to a foreign supplier against a Bill drawn on the importer,the bank has to handle documents related to the transaction.For this the bank loads another margin over the TT SELLING rate to arrive at the Bill Selling rate.Thus SPOT BILL SELLING RATE =TT selling rate + exchange margin Examples-A Bank customer wants to buy USD 1 Million for value date spot.The client contacts the bank(corporate desk )and asks for a rate.The AD for corporate clients, asks his inter bank for USD 1 million for value spot.The inter bank spot dealer quotes 44.92/93.The corporate dealer in turn quotes this to the customer..If the customer wants to buy USD,then he would buy at 44.93 plus the agreed spread for the corporate client,say 0.0050=Rs 44.9350 per one unit of USD.The customer has to pay Rs 43,95,000 to get USD 1 million. 77

Exchange Rate calculations Till August 2,1993,exchange rate quotations in the wholesale markets used to be given as Indirect quotes,ie units of Foreign Currency per Rs 100..Since then the quotes are Direct given as Rs per unit of foreign currency.The rates quoted by banks to their NonBank customers are called Merchant Rates..Banks quote a variety of exchange rates.The so called TT rates(the abbreviation denotes Telegraphic Rates ) are applicable for clean forward or outward remittances,that is ,the bank undertakes only currency transfers and does not have to perform any other function such as handling documents. For eg,,suppose an individual purchases from Citibank in New York,a demand draft for USD 2000 drawn on Citibank,Mumbai.The New York Bank will credit the Mumbai Banks Account with itself immediately.When the individual sells the draft to Citibank Mumbai,the bank will buy the USD at its TT Buying Rate .Similarly TT selling rate is applicable when the bank sells a foreign currency draft or MT.TT buying rate also applies when an exporter asks the bank to collect an export bill and the bank pays the exporter only when it receives payment from the foreign buyer as well as in cancellation of forward sale contracts. When there is some delay between the bank paying the customer and itself getting paid.,eg,the bank discounts export bills ,various margins are subtracted from the TT buying rates .Similarly on the selling side when the bank has to handle documents such as LC,shipping docs and so forth apart from effecting the payment,margins are added to the TT selling rate.as per FEDAI(in India)
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SPOT TT BUYING RATE-is calculated as Spot TT Buying Rate=Base rateExchange Margin, where Base rate is the Inter-bank rate Thus suppose the inter bank USD quote rate is Rs 46.75/46.76 and the bank wants exchange margin of 0.125%,the TT buying rate would be;(46.75)(1-0.00125)=46.6916 rounded off to Rs.46.69.Thus if a draft is encashed by the bank where its overseas account has already been credited,it will give Rs Usd 10000x46.69= Rs 466900.when cashing a personal cheque or a bankers;cheque payable overseas the Bank will not give this rate,because it has to send the cheque overseas for collection.This means a delay which is called Transit period..The bank will further subtract an exchange margin from the TT buying rate and also recover Interest from the customer for the transit period.The transit periods for various countries are specified by the FEDAI(Foreign Exchange Dealers Association of India).The Interest rates are given By RBI..The purpose of the exchange margin is to recover the costs involved and provide a profit margin to the bank. SPOT BILL BUYING RATE Exporters draw BE on their foreign customers.They can sell these bills to an AD for immediate payment.The AD buys the bill and collects payment from the importer .Since there is delay between the AD paying the exporter and itself getting paid,various margins have to be subtracted from the TT buying rate to compute the bill buying rate.Bills are of two kinds;Sight or Demand bills require payment by the drawee on presentation .The delay involved in such a bill is the transit period;Time or Usance bills give time to the importer to settle the payment ,i.e. ,the exporter has agreed to give credit to the importer.In such a case the delay involved is the Usance period plus the transit period.In addition to the exchange margin to cover costs and provide profit ,the AD will now load the forward margin for an appropriate 79 period..If the bill is bought on a spot basis ,the forward period included the transit period plus usance period if any,

Example 2- A sight Export Bill for USD 100000-A bank purchases a demand export
bill drawn by an Indian exporter on an American company.The transit period is 15 days.The inter bank market spot buying rate is Rs 45.25.One month forward buying rate is at a premium of 15 paise,that is the buying rate is Rs 45.40,EXCHANGE MARGIN IS 0.125%.The market for 15 day forward buying rate would be; Rs 45.25 plus a premium of 7.5paise(for 15 days )that is Rs 45.3250. With the commission the rate given to the customer would be 45.3250((10.00125)=45.2683 rounded off to the 45.27.The customer will be debited separately to the customers account. Example 3-A Usance Bill for GBP 50000.An exporter wants the bank to buy a 30-day bill drawn on a British co for GBP 50000.Exchange margin is to be retained at .0.15%.the transit period is 10days.The market spot buying rate is Rs 69.5.One month discount on sterling is 20paise. And two month discount is 50paise. Transit plus usance period adds up to 40days.Interpolating between 30and 60days,the discount for 40 days would be {20+10/30x30}=30paise.The rate paid to the customer w ill be 69.2(1-0.0015)=69.0962 rounded off to 69.1.The customer would be paid Rs 34,55,000.Interest for 40days would be recovered separately.
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INTEREST ARBITRAGE-Interest rate Arbitrage refers to the International flow of short-term liquid capital to earn higher return abroad. UNCOVERED INTEREST ARBITRAGE-The transfer of funds abroad to take advantage of higher interest rates in foreign monetary centers usually involves conversion of the domestic currency to the foreign currency ,to make the investment.At the time of maturity,the funds (plus the interest)are reconverted from the foreign currency to the domestic currency.During the period of investment, a foreign exchange risk is involved due to the possible depreciation of the foreign currency.If such a foreign exchange is covered we have covered interest arbitrage,otherwise we have uncovered arbitrage.
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COVERED INTEREST ARBITRAGE -Interest Arbitrage is usually covered as investors of short- term funds abroad generally want to avoid the foreign exchange risk.To do this the investor exchanges the domestic currency for the foreign currency at the current spot rate so as to purchase the foreign treasury bills or investment and at the same time he sells forward the amount of the foreign currency he is investing plus the interest he will earn ,so as to coincide with maturity of the foreign investment.Thus covered arbitrage refers to the spot purchase of the foreign currency to make the investment and off setting the simultaneous forward sale (swap of the currency) to cover the foreign exchange risk. .When the investment matures ,the investor can then get the domestic currency equivalent of the foreign investment plus the interest earned without a FE risk.Since the currency with the higher interest rate is usually at a forward discount ,the net return on the investment is roughly equal to the positive interest differential earned abroad minus the forward discount on the foreign currency.This reduction in earnings is the cost of insurance against the FE risk.. In Covered Interest arbitrage,the rule is that if the interest rate differential is greater than the premium or discount ,place the money in the currency that has a higher rate of interest or vice versa.
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EXCHANGE RATE THEORIES AND EXCHANGE RATE FORECASTINGAre changes in exchange rates predictable?How does inflation affect exchange rates How are Interest rates related to exchange rates?what is the proper exchange rate?.For an answer to these questions it is essential to understand the different theories of Exchange rate determination.A Swedish economist Gustav Cassel popularized. the PPP in the 1920s. When many countries like Germany,Hungary and the Soviet Union experienced hyperinflation,in those years the Purchasing Power of the currencies in these countries sharply declined.The same currencies also depreciated sharply against the stable currencies like the USD.The PPP theory became popular against this Historical backdrop. PURCHASING POWER PARITY THEORY-PPP Theory-The PPP theory focuses on the inflation exchange rate relationships.If the law of one price were true for all goods and services, we could obtain the theory of theory of PPP.There are two forms of the PPP theory;
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Absolute Purchasing Power Parity; Underlying the absolute version of the PPP is the Law of one Price,Viz that commodity arbitrage will equate prices of a good in all countries when prices are expressed in a single common currency. PPP postulates that the equilibrium exchange rate between currencies of 2 countries is equal to the ratio of the price levels in the two nations.Thus prices of similar products of two different countries should be equal when measured in a common currency as per the absolute version of PPP theory..Let Pa refer to the general price level in country A and Pb refer to the general price level of country B,and Rab to the exchange rate between the currency of country A and country B.The Absolute PPP theory postulates that --Rab=Pa/Pb For example if country A is USA and country B is UK the exchange rate between the USD and the GBP is EQUAL to the ratio of US to UK prices. viz,if the general price level in the US is twice the general price level in the UK ,the absolute PPP theory postulates the equilibrium exchange rate to be 2USD=1GBP..In reality the exchange rate between USD and GBP could vary considerably from USD 1 to GBP 2 due to various factors like transportation costs, tariffs,or other trade barriers between the 2 countries..This version of the absolute form of PPP has a number of defects..First, the existence of transportation costs,tariffs,, quotas or other obstructions to the free flow of International trade may prevent the absolute form of PPP.Secondly,The absolute form of PPP appears to calculate the exchange rate that equilibrates trade in goods and services so that a country experiencing capital outflows would have a deficit in its BOP while a country receiving capital inflows would have a surplus. Finally, the theory does not even equilibrate trade in goods and services because of the existence of non84 traded good and services.

Absolute PPP Theory (contd)-Non traded goods such as cement and bricks, for which the cost of transportation cost is too high,cannot enter international trade except perhaps in the border areas.Also specialized services like those of doctors hairstyles etc,do not enter international trade .International trade tend to equate the prices of traded goods and services among nations but not the prices of non traded goods and services.The general price level in each nation included traded and non traded goods and since the prices of non traded goods are not equalized by international trade,the absolute PPP theory will not lead to the exchange rate that equilibrates trade and therefore has to be rejected. Relative Purchasing Power Parity-The relative form of PPP is an alternative version which postulates that the change in the price levels in the two nations should be proportional to the relative change in the inflation levels in the two nations over the same time period.This form of PPP theory accounts for market imperfections such as transport costs,tariffs and quotas.Relative PPP theory accepts that because of market imperfections prices of similar products in different countries will not be the same when measured in a common currency.What it specifically states is that the rate of change in the price of products will be somewhat similar when measured in a common currency as long as the trade barriers and transportation costs remain unchanged.In other words,it states that a proportionate (or %)change in exchange rate between two currencies A and B between 2 points of time(approx)equals the difference in the inflation rates in the two countries over the same time interval.
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The fact that some goods do not (and cannot )enter international trade means that even the relative version of PPP can be expected to hold only for traded goods.Therefore,the price indices used to measure inflation differentials must cover only traded goods. REAL EFFECTIVE EXCHANGE RATE(REER)-Related to the notion of PPP is the concept of RER.It is the exchange rate after adjusting for inflation .It is a measure of exchange rate between 2 countries adjusted for relative purchasing power of the currencies.Since purchasing power of money is measured with reference to a given time period.,it is only the changes in real exchange rate that have significant economic implications. Eg-suppose at the end of August 2000 ,the USD /INR exchange rate was Rs 45,while at the end of August 1985 it was only Rs 18.This implies that in nominal terms,that is,without adjusting for Inflation,the rupee depreciated by 150%.in 15 years.But if we were to answer the following question-In August 2000 how many rupees worth of Purchasing power had to be given up to acquire one dollar worth of Purchasing Power when both PPs are measured with reference to August 1985? The following data are also available;The consumer price index (CPI) in India at the end of August 2000,with March 1985 as the base stood at 375 while the CPI in the US with reference to the same base was 180.This means that Rs 45 in August 2000 was worth Rs(45/3.75)=Rs 12 of 1985 purchasing power.We had to give up Rs 12 worth of 1985 purchasing power in India to acquire USD 0.5556(1/180) worth of 1985 purchasing power in the US.
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The real effective exchange rate in August 2000,with reference to March 1985 was therefore (12/0.5556)=21.6 though by definition, the real exchange rate in march 1985 was Rs 18.Thus in inflation adjusted terms the rupee depreciated by about 20%.(3.6/18) The importance of the concept of Real Exchange Rate is in the fact that changes in it have implications for the relative competitiveness of a 1)countrys exports and 2) import substitutes. If an exporter can raise the FE currency price in line with the foreign inflation,if his costs increase in line with domestic inflation and if the exchange rate depreciates by an amount equal to the excess of home inflation over foreign inflation,the exporters competitiveness in the export market remains unchanged..we now see that the real exchange rate must remain unchanged. The case of a company which makes import substitutes can be analyzed along similar lines..A real appreciation of the home currency hurts real profitability of producing import substitutes and will channel resources into production of home goods goods which face no international competition because they are not traded.Thus real exchange rate determines not only relative competitiveness of exports but also relative attractiveness of producing for international markets versus producing for home markets. NOMINAL EFFECTIVE EXCHANGE RATE(NEER)-is the exchange rate before adjusting inflation difference . In the example given above Rs 18 is the NEER while 21.6 is the REER 87

INTEREST RATE PARITY THEORY-According to Interest Rate Parity theory ,the difference in exchange rate is explained by difference in the interest rate.Thus if one year interest rate on dollar is 6% and one year interest rate on rupee rate is 12% and the spot rate between rupee and usd is USD 1=INR 50.A person will borrow in dollar and invest in Rupee..After one year he has to pay back usd1.06 and he will get Rs 56.Interest rate parity theory suggests that the exchange rate between dollar and rupee should be usd 1.06=Rs 56 or usd 1=56/1.06=52.83. Interest rate parity theory assumes no exchange control,absence of transaction cost and taxes and a perfect market.Interest rate before adjusting for inflation is called as Nominal Interest rate and interest rate after adjusting for inflation is called as Real Interest rate. INTERNATIONAL FISCHER EFFECT(IFE)- The IFE uses interest rates rather than inflation rate to explain the changes in exchange rates over time.IFE is closely related to PPP because interest rates are significantly correlated with inflation rates. The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the International Fischer effect . Under IFE ,real interest rate across the world determines the difference in exchange rate.otherwise there will be scope for arbitrage.Fischer effect states that real interest rates should converge ,or else there will be scope for arbitrage.
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The IFE suggests that given 2 countries ,the currency in the country with the higher interest rate will depreciate by the amount of the Interest rate differential.That is within a country,the nominal interest rate tends to approximately equal the real interest rate plus the expected inflation rate.A countrys nominal rate is usually defined as the risk free interest paid on a virtually costless loan. It is often argued that an increase in a countrys interest rates tends to increase the exchange value of its currency by inducing capital inflows.However the IFE argues that a rise in a countrys nominal interest rate relative to the nominal interest rates of other countries indicates that the exchange value of the countrys currency is expected to fall. THIS IS DUE TO THE INCREASE IN THE COUNTRYS EXPECTED INFLATION AND NOT DUE TO THE INCREASE IN NOMINAL INTEREST RATE. The IFE implies that if the nominal interest rate sufficiently does not increase to maintain the real interest rate ,the exchange value of the countrys currency tends to decline even further.
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We have seen that the 3 theories of Exchange rate determination are1)Purchasing Power Parity Theory(PPP),which links spot exchange rates to countrys price levels. 2)The Interest Rate Parity theory (IRP) which links spot exchange rates,forward exchange rates and nominal exchange rates. 3)The International Fischer effect(IFE) which links exchange rates to a countrys nominal interests rate levels.
Comparison of PPP,IFE and IRP Theories-All the three relate to the determination of exchange rates..Yet they differ in their implications; 1)The theory of Interest Rate Parity focuses on why the Forward rate differs from the spot rate and the degree of difference that could exist.This relates to specific point of time. 2)The PPP theory and IFE focus on how a currencys spot rate will change over time.While PPP theory suggests that the spot rate will change in accordance with inflation differentials.IFE theory suggests that it will change in accordance with interest rate differential. 90

EXCHANGE RATE FORECASTING1)Forward rate can be used to predict future exchange rate though it cannot be a perfect predictor of future spot rate .Forward rate contains all the current factors and expected changes in exchange rate while unexpected rate cannot be factored in. 2)Exchange rates can be predicted through relative inflation rates as per PPP theory or through relative interest rate as per Interest rate parity theory. 3)Exchange rate can be predicted by using forces of demand and supply as per BOP statistics.If the BOP is negative then demand for foreign currency will increase leading to depreciation of domestic currency and vice versa ,the domestic currency will appreciate..If the GNP of a country increases then the demand will go up,import will increase thereby BOP will become deteriorated leading to depreciation of currency and vice versa. 4)In monetary approach,the results are exactly opposite to BOP approach..For example,if the real economy of country expands and money supply does not expand, then there will be more demand for money than supply leading to its appreciation which is diametrically opposed to the BOP .The corrective mechanism is in the form of increase in interest rate thereby Bond prices will drop ,due to which it will be costly to hold money and money will be spent for purchasing Goods for consumption and thereby 91 inflation will increase.As PPP is assumed to be true under this theory value of currency will decrease.
International Financial Management EXCHANGE RATE FORECASTING-(contd)

5)Dornbusch Sticky Price Model-Which states that the PPP holds only in the longrun.In the short- run,prices of goods are sticky.There is a stable demand for money function which relates real balances to real incomes and interest rates.It is also referred to as the overshooting model meaning that exchange rates overshoot their eventual equilibrium levels. 6)Asset Approach-Since the foreign exchange market is efficient ,all the historic news and expected news is reflected in the price.Only unexpected news which follows random walk influences the price which cannot be predicted. 7)Exchange rate can also be predicted by using technical analysis wherein movement in exchange rate itself can be used to predict future exchange rates as per certain well observed patterns.Technical analysis are called as astrologers of FE MARKETS.Fundamentalists and Economists disagree with them because the Efficient market theory says that FE being an efficient market,all historic costs and future expectations are reflected in the price.
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FOREIGN EXCHANGE EXPOSURES AND RISK MANAGEMENT- We have briefly seen in the previous slides(12 to 16) that companies having International Business operations ,primarily encounter 3 types of exposures 1)Transaction Exposure 2) Translation Exposure 3) Economic exposure
1)Transaction Exposure-is inherent in all foreign currency denominated
contractual obligations/transactions.This involves gain or loss arising out of the various types of transactions that require settlement in a foreign currency.The transactions may relate to cross border trade in terms of import or export of goods,the borrowing or lending in foreign currencies ,domestic purchases and sales of goods and services of the foreign subsidiaries and the purchase of assets or take over the liability involving foreign currency..The actual profit the firm earns or loss it suffers ,of course is known only at the time of settlement of these transactions. A firms Balance Sheet already contains several items reflecting transaction exposure,the notable items being the debtors receivable in a foreign currency,creditors payable in foreign currency,foreign loans and foreign investments.While it is true that transactions exposure is applicable to all these foreign transactions,it is usually employed in connection with foreign 93 trade,that is, specific imports or exports on open account credit.

An unanticipated change in the exchange rate has an impact favourable or adverse on its cash flows.Such exposures are known as Transaction exposures.In essence it is a measure of the sensitivity of the home currency value of assets and liabilities which are denominated in Foreign currency ,to unanticipated changes in exchange rates,when the assets or liabilities are liquidated.The foreign currency values of these items are contractually fixed,ie,they do not vary with the exchange rates.Hence it is also known as contractual exposure. Some typical exposure situations are as follows; a) A currency has to be converted in order to make or receive payment for goods and services-import payables or export receivables in a foreign currency. b) A currency has to be converted to repay a loan or make an interest payment (or conversely,receive a repayment or an interest) or c) A currency has to be converted to make a dividend payment ,royalty payment and so forth. The Transaction exposure affects cash flow during the current accounting period.If the foreign currency has appreciated between the day the receivable was booked and the day the payment was received ,the company makes an exchange gain which may have tax implications. In other words Transaction exposures 1) usually have short time horizons and 2)operating cash flows are effected.
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2)Translation exposure-relates to the change in accounting income and balance sheet statements caused by the changes in exchanges rates.These changes may take place by/at the time o finalization of accounts compared to the time when the asset was purchased or liability was assumed .In other words ,translation exposure results from the need to translate foreign currency assets or liabilities into the local currency at the time of finalizing accounts.It arises due to a company having foreign branches or subsidiaries ,which are required to be consolidated with the accounts of the parent branch at the end of the year..These accounting statements are denominated in foreign currency and they have to be converted to domestic currency at the time of consolidation leading to the exchange rate exposure which is termed as Translation exposure.or Accounting exposure since this exposure is recognized much before the settlement is made.Translation exposure does not involve immediate cash flow. 3)Economic exposure-When a countrys economy is increasingly integrated internationally ,it is exposed to vagaries of international market even though it may not have any transactions in foreign currency neither in the form of imports nor in the form of exports. Thus ,a firm may not have any transaction in foreign exchange at all but if its competitor firm firm imports its major raw material and components,say ,for example in Japanese Yen ,the firm is exposed to Economic exposure.If Yen depreciated against rupee,then imports from Japan will become cheaper.This benefit can be passed on to the customers thereby directly affecting the market share of the other firm.
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(A)MANAGEMENT OF TRANSACTION XPOSURE
1)Using Forward Markets for Hedging Transactions Exposure-Hedging means taking a Position
or operation that offset an underlying exposure.In the normal course of business ,a firm will have several contractual exposures in various dates.The net exposure in a given currency at a given date is simply the difference between the total inflows and total outflows to be settled on that date.Company A has the following items outstanding;
Item 1)USD receivable 2)EUR payable 3)USD Interest Payable 4)USD Payable 5)USD purchased forward 6)USD loan installment due 7)EUR purchased forward Value 800,000 2,000,000 100,000 200,000 300,000 250,000 1,000,000 Days to Maturity 60 90 180 60 60 60 90
The net exposure in USD at 60days is (800,000+300,000)-(200,000+250,000)=USD +650,000. The use of Forward contracts to hedge transaction exposure at a single date is quite straightforward.A contractual NET inflow of foreign currency is sold forward and a contractual NET outflow is bought forward..This removes all uncertainty regarding the domestic currency value of the receivable or payable..Thus in the above example .to hedge the 60day USD Exposure Company A can sell forward USD 650,000 while 96 for the EUR exposure it can buy EUR 1,000,000,90DAYS Forward.

In a Forward Market Hedge, a company that is long in a foreign currency will sell the foreign currency forward,whereas a company that is short in a foreign currency will buy the currency forward.In this way ,the company can fix the dollar value of future foreign currency cash flow..If funds to fulfill the forward contract are available on hand or are due to be received by the business,the Hedge is considered Covered,Perfect or Square. Because no residual foreign exchange risk exists.Funds on hand are matched by funds to be paid. In situations where funds to fulfill the contract are not available but have to be purchased in the spot market at some future date, such a Hedge is considered to be open or uncovered. .It involves considerable risk as the Hedger purchases foreign exchange at an uncertain future spot rate in order to fulfill the forward market.
Currency Futures-Currency Futures are closely related to Forward

contracts.These are known as Futures contracts and are traded in Futures Markets.A Futures Contract is an agreement to buy or sell a pre-specified amount of foreign currency in the futures market at some specified future date between the parties to the contract.Currency Futures Contracts /markets are for the major/hard currencies of the world namely,the USD,GBP,DM,FF, and JPY.Futures being standardized contracts in nature are traded on organized exchanges.;The clearing house of the exchange operates as a link between the two parties of the contract,namely the buyer and the seller.In other words,transaction are through the clearing house and the two parties do not deal directly between themselves. .
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While it is true that futures contracts are similar to the Forward contracts in their objective of hedging FE risk,they differ in many significant ways ; 1)NATURE AND SIZE-Future contracts are standardized and the value of the contracts are permissible in standard-sums.The maturities are also standardized.In contrast Forward contracts are tailor made with any size or maturity. 2)MODE OF TRADING-In the case of Forward contracts,there is a direct link between the firm and the authorized dealer (bank) at the time of of entering the contract and at the time of execution.On the other hand ,the clearing house interposes between the 2 parties involved in futures contracts. 3)LIQUIDITY-The two positive features of futures contracts,namely,their standard-size and trading at clearing house of an organized exchange ,provide them relatively more liquidity vis a vis forward contracts,which are neither standardized nor traded through organized futures For this reason the futures markets are more liquid. markets. 4)DEPOSITS/MARGINS-While futures contracts require guarantee deposits from the parties,no such deposits are needed gor forward contracts.Besides ,the futures contract necessitate valuation on a daily basis ,meaning that gains and losses are noted (the practice is known as Marked to Market).Valuation results in one of the parties becoming a gainer and the other a loser; while the loser has to deposit money to cover losses,the winner is entitled to the withdrawal of excess margin..Such an exercise is conspicuous by its absence in forward contracts as settlement between the parties concerned is made on the pre specified date of maturity. 5)Default Risk- As a sequel to the deposit and margin requirements in the case of futures 98 contracts,default risk is reduced to a marked extent in such contracts compared to Forward contracts.

ACTUAL DELIVERY-Forward contracts are normally closed,involving actual delivery of foreign currency in exchange for home currency /or some other currency (cross currency forward contracts).In contrast very few futures contracts involve actual delivery. INTEREST RATE FUTURES-Interest rate Futures can be used to hedge /reduce risk of a rise in Interest rates in the future; Suppose IBM has taken a decision to build a new plant ,estimated to cost US 100 million .It has been decided to finance it by 10 year bonds,the current coupon rate of Interest on such bonds is 7percent .IBM does not need money for about 6 months..of course,IBM can issue 7 percent bonds now and can arrange funds.Since the money is not immediately needed,it would be invested in short term securities,yielding an interest of less than 7 percent entailing loss. Another alternative is that IBM waits for 6 months to sell the Bond issue.So far so good is the interest remains unchanged at 7 percent..In case they move up higher than 7 percent,the company will be required to pay higher interest on USD 100 million for the year period..Not surprisingly ,IBM may find the building up of the new plant with higher interest costs an unprofitable proposition. Interest Rate futures provide a solution to the IBM dilemma./or its worry pertaining to an increase in interest rates.IBM can have a futures contract to sell Treasury bond futures 6 months hence to hedge its position .It is assumed that Treasury Bonds(T-bonds) CARRY A RATE OF Interest of 5 percent .Should Interest rate rise ,the value of T-Bonds will decline(there is a negative correlation between interest rates and the rate value of bonds).As a result ,it makes profit on the futures position.Of course it has to pay higher interest on its bond issue ,but it is partly compensated in terms of the profit it has earned by selling T-Bonds.In the event of a a decline of Interest rates,it will suffer losses on its future position,but it would gain as it would pay a lower 99 interest rate for all ten years.Thus ,interest rates futures are useful derivatives to hedge /reduce the risk of a rise in the Interest rates in future.

2)Hedging with The Money Market-A Money Market Hedge involves simultaneous
borrowing and lending activities in two different currencies to lock in the home currency value of a future foreign currency cash flow.The simultaneous borrowing and lending activities enable a company to create a home-made forward contract.The firm seeking the Money Market Hedge borrows in one currency and exchanges the proceeds for another currency If the funds to repay the loan are generated from business operations,then the money market hedge is covered.Otherwise,if the funds to repay the loan are purchased in the foreign exchange spot market then the Hedge is uncovered or open. The steps involved are as follows;1)Determine the amount required in foreign currency ,to be paid on specified date(say 3 months/4 months)from now.(2)From an authorized dealer (in bank) ascertain the spot exchange rate at which it is selling the required foreign currency in exchange for home currency.(3)Borrow home currency from the money market at the prevailing interest rate. The quantum of borrowing should be in such a manner that can make the required foreign currency sums available on the date of payment (say after 3 or 4 months). (4)The borrowed funds are to be used to buy the required foreign currency from the forex spot market;once purchased ,it is to be invested in forex money market to yield interest in the desired foreign currency.(5)As per steps (3) and (4),the required amount of foreign currency to be purchased can be determined.These steps enable the firm to know the precise amount it will require to make payments of foreign currency on the date of maturity.Money market operations serve as an important hedging function in that uncertainty is resolved regarding the amount to be paid. 100

Suppose an Indian importer is to make payment of USD 1.1 million after 3 months..3 months interest are 4 per cent on the USD and 6 percent on the Indian rupee..The current spot exchange of re/usd is Rs 48..To know the precise amount the importer has to do the following 1)First of all ,the Indian Importer is to as certain the amount of borrowings so that the borrowings along with Interest earned on such funds can accumulate to USD 1.1 million after 3 months.Let us say this amount is A..Therefore; A(1+Rate x Time)=USD 1.1 million A(1+.04x3/12)=1.1 million or A=usd1.1 million/1.01= USD1089108.91 2) The Indian importer has to then borrow a sum of usd 1089108.91x48 (spot rate)=Rs52277227.68 from the local domestic market. He will invest USD 1089108.91 in the money market at 4%rate of interest for a period of 3 months ,yielding him USD 1.1 million after 3 months(1089108.91x.04x3/12) 3)The accumulated sun of USD 1.1 million will be paid by the Indian Importer on the due date to the American Export firm.
4)The Indian importer would refund Rs 52,277,227.68 along with 6% interest after 3 months to the Indian lender.The sum is Rs 52,277,227.68/(1+.06x3/12)=Rs 53061386.09 5)The Indian Importer is to pay Rs 53.061386 million at the end of 3 months.To put it differently,he knows that his home currency cash outflow is Rs 53.061386 million,irrespective of the Re /us dollar exchange rate , 3 months from now.
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3)Options Market Hedge-Many times the firm is uncertain whether the hedged foreign currency cash inflow or outflow will materialize..In such circumstances the Firms can use the Currency Options to Hedge the risks.Currency Option is a Financial instrument that provides its holder a right but no obligation to buy or sell a prespecified amount of foreign currency at a pre- determined rate in the future (on a fixed maturity date /up to a certain period.).while the buyer of an option wants to avoid the risk of adverse changes ,in exchange rates ,the seller of the options is prepared to assume the risk. In other words a currency option confers on its buyer the right either to buy or to sell a specified amount of a currency at as et price known as the strike price.An option that gives the right to buy is a call while one that gives the right to sell id the put.Depending on the contract terms , an option may be exercisable on any date during a specified period or it may be exercisable only on the final or expiration date covered by the option contract.In return for guaranteeing the exercise of an option at its strike price,the options seller or writer charges a premium which the buyer usually pays upfront.Under favorable circumstances,the buyer may choose to exercise it.Alternatively,the buyer may be allowed to sell it.If the option expires without being exercised ,the buyer of the options receives no compensation for the premium paid.The situation of an option writer is analogous to that of an Insurance seller. .Thus every Option has three different price elements; 1)The exercise or strike price,i,e, the exchange rate at which the foreign currency can be purchased.(call) or sold(put). 102 2)The premium.,i,e ,the cost price or value of the Option itself. 3)The underlying or actual spot exchange rate in the market.

TWO TYPES OF OPTIONS-There are two types of Options1) A PUT OPTION which gives the buyer the right to ,but not the obligation, to sell a specified number of foreign currency units to the Option seller at a fixed price up to the options expiration date. 2) A CALL OPTION which is a right ,but not the obligation ,to buy a foreign currency at specified price up to the expiration date. 3) A call Option is valuable ,for example ,when a firm has offered to buy a foreign asset such as another firm , at a fixed foreign currency price but is uncertain whether its bid will be accepted The General rules to follow when choosing between Currency Options and Forward Contracts for hedging purposes are summarized as follows; 1)when the quantity of a foreign currency cash outflow is known ,buy the currency forward.When the quantity is unknown ,buy a call option on the currency. 2)when the quantity of foreign currency cash inflow is known,sell the currency forward.When the Quantity is unknown,buy a Put option on the currency. 3)when the quantity of foreign currency cash flow is partially known and partially uncertain,use a forward contract to hedge the known portion and an option to hedge the maximum value of the uncertain remainder..
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(B) MANAGEMENT OF TRANSLATION EXPOSURE=Exposed Assets-Exposed Liabilities Translation methods-There are 4 methods by which foreign currency translation has been developed in various countries.They are1)The Current Rate Method-The current rate method is the simplest and the most popular method all over the world.This method requires translation of all assets ,liabilities and Profit and Loss account items using the current rate .This is similar to translation of a book from one language to another.Use of this method will result is preservation of the inter-relationships among various elements in the financial statements..For example, relationship like Fixed Assets turnover ratio will remain the same in the foreign currency financial statement. 2)Current-Non current Method-Under this method,current assets and current Liabilities of the foreign operation are translated at the current exchange rates.Other assets and liabilities and share capital are translated at the historical exchange rates.Depreciation and other amortization charges are translated by using the rates at which the related assets and other items were accounted.Other profit and loss account items are translated at the average rates.This method presumes that the risk exposure is related to the timing of cash flows and hence converts assets and liabilities based on maturity rather than the nature of the item. 3)Monetary/Non Monetary Method- This method substitutes nature of the Balance sheet item for maturity..Under this method monetary assets and monetary liabilities are translated at the current rates and non monetary assets and liabilities at the historical rate.Monetary items are those that represent a claim to receive or an obligation to pay a fixed amount of foreign currency unit.eg cash,,Accounts Receivable,current liabilities,accounts payable and long term debt. Non Monetary items are those that do not represent a claim to receive or an 104 obligation to pay a fixed amount of foreign currency items,eg Inventory,Fixed Assets,long term investments.Income statements are translated at Average exchange rates.

14)The maturity of most forward contracts between banks and their customers in India does not exceed six months. Prior to January 1997, dealers could offer their customers forwards with longer maturities but only with the prior approval of the Reserve Bank of India in each case. Since then, this requirement to obtain RBIs prior approval has been removed. Typically the market is quite liquid for contracts up to one year; The problem with Forward contracts however is that since they require future performance, sometimes one party may be unable to perform the contract.. 2)FUTURES MARKET-A currency Future is the price of a particular currency for settlement at a specified future date.Currency Futures are traded on Futures Exchanges through brokers.The contracts are standardized with respect to the quality and quantity of the underlying asset-buyers and sellers usually prefer to close their contract by reversing their positions on the market.In other words ,buyers of a Futures contract buy another futures with the same characteristics,while sellers of Futures contract buy another Futures contract which has the same characteristics.By reversing their positions ,buyers or sellers close their positions.Any gain or loss obtained from closing the futures contract is used to offset losses or gains on the actual market. MECHANISM OF FUTURES TRADE-consists of two parts (A)Components of Futures Trade(1)FUTURES PLAYERS;Future trading ,which represents a less than Zero -sum game ,can be considered beneficial if it results in Utility gains..This is done by transfer of risks between the market players.
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EXPOSURE NETTING;involves offsetting exposures in one currency with exposures in the same or another currency,where exchange rates are expected to move is such away that losses(gains) on the second currency exposure.The assumption underlying exposure netting is that the net gain or loss on the entire exposure portfolio is what matters ,rather than the gian or loss on any individual monetary unit. LEADING-If the domestic currency is expected to depreciate against foreign currency,then payments are advanced (preponed) but the realization of the exports is postponed,and Vice Versa is true for exports. LAGGING.-If domestic currency is expected to appreciate against foreign currency ,payments are postponed while receipts are advanced (preponed) SOURCING-If sourcing of the material is shifted to a third country,the adverse effect of exchange rate appreciation on export competitiveness is mitigated by sourcing goods from the importing country itself or from countries whose currencies are not appreciating. RELOCATION-means relocating the manufacturing base to another country where there is exchange rate stability.The best examples are the Japanese companies like Matsushita,Sony,Sharp etc which shifted their bases or expanded their bases in Malaysia,Taiwan,Hong Kong etc which had stable and favorable rates of exchanges. INVOICING IN THIRD CURRENCY-Indian exchange rates against all currencies are determined through the medium of USD which is the Intervention currency.Thus there are two fluctuations involved in any other currency against Rupee which is a multiple of variance of rupee against USD and USD against the other currency, as opposed to a 106 single variance of rupee against US..Thus ,for an Indian dealing in any FE ,it is advantageous to Invoice in USD to minimize exchange rate fluctuations

4) Temporal Method-Though this method is a variation of the monetary/non monetary method,it is NOT based on strict balance sheet classification. According to this method ,cash,receivables and payables (both current and non current items)are translated at the current rates.Further other assets and liabilities which are carried at current value are also translated at current rates.For example,Inventory carried at NET realizable value will be translated at current rate though this is not a monetary item.All other assets and liabilities which are carried at past transaction prices are translated at historical costs.Revenue and expense items are translated at rates that prevailed when the underlying transactions tool place. In India Accounting Standard 11 framed by ICAI lays down the rules FOR ACCOUNTING OF changes in Foreign Exchange rates.
C)MANAGEMENT OF ECONOMIC EXPOSURE Economic Exposure refers to the

extent to which the economic value of a company can decline due to changes in exchange rate.It is the overall impact of exchange rate changes on the value of the firm.Managing economic exposure is very important for the long-run health of an organization than manage changes caused by transaction or translation exposure.The degree of economic exposure to exchange rate fluctuations is significantly higher for a firm involved in International business for a purely domestic firm.Assessing the economic exposure of an MNC is difficult due to the complex interaction of funds that flow into ,out of and within the MNC.To assess this Exposure accurately , a firm needs to know a great deal about its product and input markets ,competitive response,its customers and cost structure.A cash flow at risk kind of framework needs to be constructed which incorporates the firms business model which can help simulate 107 scenarios of the key risk factors.

The following are some of the PROACTIVE Marketing and Production strategies which a firm pursue in response to anticipated or actual exchange rate changesMARKETING MANAGEMENT OF EXCHANGE RISK1)Market selection-Major strategy considerations for an exposure are the markets in which to sell.It is also necessary to consider the issue of market segmentation with individual countries..A firm that sells differentiated products to more affluent customers may not be harmed as much by a foreign currency devaluation compared to a Mass marketer. 2)Product strategy-Companies can also respond to exchange rate changes by altering their product strategy which deals with such areas as new product introduction.If there is a devaluation/depreciation of home currency, a firm will be able to expand its product line and cover a wider spectrum of consumers abroad and at home.Conversely ,following home currency appreciation,a firm may have to reorient its product line and target it to a higher income,more quality conscious,less price sensitive consumers. 3)Pricing Strategy-In the wake of the rising USD ,a US firm selling overseas or competing at home against foreign imports faces a Hobsons choice;Does it keep its dollar price constant to preserve its profit margin and thereby lose sales volume or does it cut its dollar price to maintain market share and thereby suffer reduced margin?Conversely.does the firm use a weaker dollar to regain lost ground or dos it use the weak dollar to raise prices and recoup losses incurred from the strong dollar..To begin with the firm should follow the standard economic proposition of setting the price that maximizes dollar profits.In making this decision,however profits should be translated using the forward exchange rate that reflects the true expected 108 dollar value of the receipts upon collection.

4)Promotional strategy- should take into account anticipated exchange rates.A key issue
issue in any marketing programme is the size of the promotional budget.A firm exporting its product after domestic devaluation may well find that the return per home currency expenditure on advertising or selling is increased because of the products improve price positioning.A foreign currency devaluation ,on the other hand,is likely to reduce the return on marketing expenditure and may require amore fundamental shift in the firms product policy. PRODUCTION MANAGEMENT OF EXCHANGE RISK-Product sourcing and plant location are the principle variables that companies manipulate to manage competitive risks that cannot be managed through marketing changes alone; 1)Input Mix-Outright additions to facilities overseas accomplish a manufacturing shift.A more flexible solution is to purchase more components overseas.This practice is called as outsourcing.Outsourcing gives the companies the flexibility to shift purchases of intermediate input towards suppliers affected by exchange rate changes. 2)Shifting Production MNCs with worldwide production systems can allocate production among their several plants in line with changing home currency cost of production,increasing production in a nation whose currency has devalued and increasing production in a country where there has been a revaluation..A strategy of production shifting presupposes that a company has already created a portfolio of plants world wide and economies of scale are being effected. 3)Plant Location- A firm without foreign facilities that is exporting to a competitive market whose currency has devalued may find that sourcing components abroad is insufficient to maintain unit profitability.Third country plant locations is a viable alternative in109 many cases.Many Japanese companies built plants outside Japan to cope with the rising Yen.

.4)Raising Productivity-Raising Productivity through closing inefficient plants ,automating heavily and negotiating wage and benefit cutbacks is another alternative to manage Economic Exposure. 4)POLITICAL AND COUNTRY EXPOSURE-Since the eruption of the Debt crisis in Latin America(Mexico in 1982 and Brazil in 1987),international banks and Institutional Investors have become increasingly concerned about country risk and Political Risk(sovereign Risk).Proper assessment of country risk therefore has assumed great significance in International lending ,over and above,the usual credit appraisal that banks have always been doing.The essence of country risk analysis is an assessment of factors that will affect a countrys ability and willingness to service its obligations .A variety of political ,economic and psycho-social considerations are relevant. ECONOMIC FACTORS-(1)-Resource base of the country including natural resources like land ,mineral deposits and so on,HR including quality and depth of managerial and technical skill, etc.(2)Macro economic performance and the quality of economic management,per capita income growth,rate of capital formation.Lenders tend to to be favorable inclined towards strong legal and ambient countries.(3) External factors like state of the BOP, growth in exports,Debt/GDP ratio and Debt service Ratio.,Ratio of reserves to normal imports. Access to IMF etc. POLITICAL DIMENSIONS-Political events,stability in governments,Coups,willingness to honor external commitments etc are factors which an International business.
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FOREIGN EXCHANGE RISK MANAGEMENT HEDGING AGAINST FOREIGN EXCHANGE EXPOSURE The actual need for the existence of a Forward Market is not speculation .Exporters and Importers use this market as Receipts and Payments do not coincide time-wise.In this way they overcome undesirable market fluctuations and take care of future cash flows.The second group consists of people who use the Forward market to preserve the value and nature of their assets without speculating against future trends. 1)FORWARDS CONTRACTS; An agreement to buy or sell a specific asset at an agreedupon price on a specified future date. In contrast to a future, a forward contract is privately negotiated and not standardized. A Forward contract is one where a counter party agrees to exchange a specified currency at an agreed price for delivery on A FIXED MATURITY DATE..In this contract, while the amount of the transaction ,the value date,the payments procedure and the exchange rates are all determined in advance ,no exchange of money takes place until the actual settlement date.e.g.,An Indian company having a liability in GBP due by end December 07 may buy GBP today for the maturity date of December end .By entering into a Forward contract the company has effectively locked itself into a rate. A Forward contract for a customer involves a spot and a swap transaction , as the customer cannot cover the transaction outright for the forward date.This is because the market (or the company)will have to first buy GBP in the Spot and then enter into a Swap where he sells spot and buys forward (December end)..Banks often tend to quote unfavorable quotes to smaller business to cover the risk of the company 111 defaulting..

Forward contracts are more popular for the following reasons1)They are well established and transparent (2)They are accessible to even smaller companies. 3)Many corporates do not allow transactions in other derivative instruments as they feel it is risky. Terms and conditions applicable to Forward contracts(applicable to Indian companies); 1)For corporates ,Forward cover is available only for exposures arising out of genuine Import/export transactions which are in conformity with the existing trade control legislation or exposures arising out of servicing Foreign currency Liabilities and Assets (like ECB etc).which have been contracted after obtaining necessary approvals. 2)Forward contracts can be entered between an authorized dealer and an entity which is resident of India at the time the contract is booked. (also allows NRIs, partnership, individual, FIIs) 3)Exchange brokers cannot act as brokers in a forward transaction. (This applies only to deals between corporate and banks; brokers services can be used for deals between banks) 4)The authorized dealer must ensure that the customer is actually exposed to exchange rate risk arising out of the underlying commercial transaction. (AD required to check genuineness of documents). 5)The forward contract must be in writing, in the prescribed form of the authorized dealer. 6)The amount of forward cover cannot exceed the value of the underlying commercial transaction. 7)The customer must present to the authorized dealer the original commercial contract. 112

8)Forward cover can be given on the basis of an irrevocable letter of credit provided the customer gives a declaration that no other forward contract has been entered into for the same transaction. 9)If exports are on a consignment basis, forward contract can be entered into only after shipment is effected and the appropriate bill,if any, has been drawn in respect of the shipment. (Some banks do not permit this as it is not a crystallized exposure.) 10)If a forward cover is booked for a particular underlying transaction, another transaction can be substituted in its place. 11)The quality/grade/specifications of goods in an export contract can be changed provided the overseas buyer has agreed to such a substitution. 12)Forward contracts can be cancelled. The authorized dealer will levy a cancellation charge. Any gain made by the authorized dealer is credited to the customer,any loss is debited to the customers account. The customer can leave his position open, or book a fresh contract with the same or another authorized dealer. Early settlement and extension are also possible. Forward contracts for imports, once cancelled cannot be rebooked for the same underlying exposure; however they may be rolled over. No such restriction on forward contracts for exports. 13)An exposure in say Euro can be broken up into two parts. One or both of these may be covered. Thus suppose a firm has a payable in Euro. It can buy Euro forward against US dollar, and US dollar forward against the rupee. Or it may leave the dollar exposure uncovered. This is referred to as the third currency forward .
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The market players are Hedgers Speculators Arbitrageurs (2) CLEARING HOUSES-Every organized Futures exchange has a clearing house that guarantees performance to all of the participants in the market.It serves this role by adopting the position of buyer to every seller and seller to every buyer.Thus ,every trading party in the Futures Markets has Obligations only to the clearing house.Since the clearing house matches its long and short positions exactly,it is perfectly hedged,which means that the NET FUTURES POSITION IS ZERO. (3)MARGIN REQUIREMENTSEach Trader is required to post a margin to insure the clearing house against credit risk. This margin varies across markets,contracts and the type of trading involved.Upon completion of the Futures contract,the margin is returned. (4)DAILY SETTLEMENT-For most Futures contracts,the initial margins are 5% or les of the underlying commoditys/currency's value.These margins are Marked to Market on a daily basis and the traders are required to realize any losses in cash on the day they occur.Whenever the margin deposit falls below minimum maintenance margin,the trader is called upon to make it up to the initial margin amount.The resettlement is also called Marked to market. Delivery terms include; 4.1)Delivery Date some contracts may be delivered on any business day of the 114 delivery month while others permit delivery after the last trading day.
4.2)Manner of delivery-The possibilities are-(a)Delivery date-some contracts may be delivered on any business day of the delivery month while others permit delivery after the last trading day.(b)Manner of Delivery-Physical exchange of underlying Assets,cash settlement as in the case of stock Index Futures and Reversing Trade which is the case with 99% of the Futures Positions.The trade effectively makes a trader's net futures position zero thus absolving him from further trading requirements. 5)TYPES OF ORDERS(a)Limit order It stipulates to buy or sell a specific or better.(b)Fill or Kill Order-It instructs the commissioner broker to fill an order immediately at a specified price.( c)All or none order It allows the commission broker to fill part of an order at a specified price and remainder at another price.(d)on the open or on the close order-Represents orders to trade within a few minutes of operating or closing.(e)Stop order-triggers a reversing trade when prices hit a prescribed limit.(f)Market orders-Contracts at the best available prices 6)TRANSACTION COSTS-The costs incurred are-(a) Floor trading and clearing fee(b)commissions-charged by broker to transact a public order( c) Bid Ask spreads. (d) Delivery costs are incurred in case of actual delivery (7)MARKED TO THE MARKET-Marking to Market essentially means that at the end of a Trading session ,all outstanding contracts are repriced at the settlement price of that session..Margin accounts of those who made losses are debited and those who gained are credited..Suppose X buys a June delivery Pound sterling Future on April 14, at a price of USD1.6 per pound of USD100000 per contract (62500x1.6).Next day the prices increases and at the end of trading on April 15th the settlement price is 1.62.X has made a gain of 2 cents per pound-100 Ticks or USD1250per contract.(obviously 115 someone with a Short Position lost a matching amount..This is immediately credited to X;s margin Accounts and can be withdrawn immediately.

X;s contract is re priced at 1.62 or USD 101250 per contract At this stage we can see an IMPORTANT DIFFERENCE MARKING TO MARKETcreates between FORARDS and FUTURES .In a Forward contract ,gains or losses arise only on maturity.There are no Intermediate cash flows;.in a Futures contract..In a Futures Contract even though the overall gain/loss is same ,the time profile is actually different.-the total gain or loss over the entire period is broken up into a daily series of gains and losses which clearly has a different present value.Also note that the Marked to Market SETTLEMENTS DOES NOT INVOLVE DISCOUNTING ,THAT IS ,THE GAINER RECEIVES AND THE LOSER PAYS THE UNDISCOUNTED CHANGE IS THE VALUE OF THE FUTURES CONTRACT.This is not the same thing as settling an outstanding forward contract and marking it to market. 8)DELIVERY IS RARE-In most ,if not all forward contracts ,the commodity is actually delivered by the seller and accepted by the buyer..In most Financial Future contracts,actual delivery tales place in less than one percent of the contracts traded..Futures are used as Hedging device against price risk and as a way of betting on price movements rather than as a means of physical acquisition of the underlying asset..Most of the contracts are extinguished before maturity by entering into a matching contract in the opposite direction. (B)Futures Trade Process-Futures contracts are traded by a system of Open Outcryon the trading floor ( also called Trading Pit)of a centralized and regulated exchange.More and more exchanges have resorted to Electronic screens .,all over the world..All traders represent exchange members.Those who trade for their own are called Floor Traders.
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Those who trade on behalf of others are Floor Brokers and if one does both they are called Dual Traders..The variables to be negotiated in any deal are the price and the number of contracts.A buyer of Futures acquires a Long Position while the the seller acquires a Short Position..As we have seen above ,when two traders agree on a deal ,it is entered as a short and long both Vis a Vis the clearinghouse. For every contract,the exchange specifies a last trading Day..Those who have not liquidated their contracts at the end of this day are obliged to make or accept delivery as the case may be.For some contracts there is no physical delivery of the underlying asset but only a cash settlement from losers to the gainers.Where there is a physical delivery involved the exchange specifies the mechanism of delivery. HEDGING WITH CURRENCY FUTURES-Corporations and Banks use Currency Futures for Hedging against FE exposures..In principle the idea is very simple.If a corporation has an asset ,e,g Receivable in Currency A which it would like to hedge ,it should take Futures Position Such that Futures generate a Positive Cash flow whenever the asset declines in Value.In this case since the firm is Long in the underlying Asset, it should go Short in the Futures,THAT IS,it should sell Futures Contract in currency A.Obviously ,the firm cannot gain from an appreciation of A since the gain on the Receivable will be eaten away by the loss on Futures..The Hedger is willing to sacrifice this profit to reduce or eliminate the uncertainty.Conversely , a firm with a liability in Currency A , for instance, a Payable, should go long on Futures. Hedging with Currency Futures involves the following three decisions1)Which contract should be used-choice of underlying; This decision would be straight forward if Futures Contracts are available on the currency in which the Hedger has117 exposure against his home currency. If not the choice is not so simple.

Thus a Japanese firm has a Receivable in Canadian Dollars and there are no Futures on CAD in terms of JPY.(OR VICE VERS).Which contract should it choose?It might choose a JPY/USD contract?This is a Cross Hedge .If It had exposure exposure in USD it would have hedged using the same contract; now it would be a direct Hedge. 2)Choosing the Maturity of the ContractSuppose on 28th Feb, a Swiss Firm contracts a 3month USD Payable.This would mature on 1st of June..There is no CHF /USD Futures contract maturing on that date;traded contracts mature on 3rd Wednesday of June, September, and so forth..Our immediate response would be sell the CHF contract.-nearest to the maturity of the payable.But it is to be remembered that rarely does a Hedger use Futures o actually take (or make) delivery of the underlying asset ;they are used only as hedging devices.In this case ,the firm will lift the hedge by buying futures.It hopes that that if the USD has appreciated in the meanwhile ,its loss on the payable will be made up by the gain on Futures (conversely of course if USD has depreciated,its market cash position will show a gain which will be offset by loss on its Futures position).There is therefore no reason why it must buy the June contract.What can it do to recoup as much of the loss as possible.?On the day the Futures Contract matures,its price must equal the Spot Price.,this is known as CONVERGENCE..The hedging Firm must first work out whether convergence worked in its favor or against it 3) Choosing the Number of Contracts-This is perhaps the most important decision.Once again an easy but generally wrong answer would be that the value of the Futures position should match as closely possible the value of the cash market position.An exact match will generally not be possible because of the standardized size of Futures contracts. 118

Interest Rate Futures-is one of the most successful financial innovations of the 1970s.The underlying asset is a debt Instrument such as a Treasury Bill,a Bond ,aTime Deposit in Bank and so on.For instance the International Money market(a part of Chicago Mercantile Exchange)has Futures Contracts on US government treasury bills ,three months Euro dollar time deposits and the US treasury Notes and Bonds. Interest rate Futures are used by corporations,banks and financial institutions to hedge interest rate risk..For instance,a corporation planning to issue commercial paper can use T-bill futures to protect itself against an increase in Interest rates.A corporate treasurer who expects some surplus cash in the near future to be invested is short term instruments may use the same as insurance against a fall in Interest rates.A fixed income fund manager might use bond futures to protect the value of his fund against interest rate fluctuations. HEDGING WITH INTEREST RATE FUTURES-In an environment of volatile interest rates ,both borrowers and investors may wish to ensure that borrowing cost does not exceed some ceiling rate, while investors may want to lock -in a minimum rate of return on their investments..Banks may wish to reduce the risk arising out of maturity mismatch-borrowing shortterm an lending long-term and hedge their positions on OTC products like 119 FRAs.Interest rate futures can be used to reduce the risk ,though not eliminate it..

FUNCTIONS OF FUTURES MARKETS-The Futures market serves the needs of Individuals and groups who may be active traders or passive traders,risk averse or risk traders and /or profit makers.The Market can be classified as 1)Price discovery-Future prices might be treated as a consensus forecast by the market regarding Future prices for certain commodities/currencies.Individuals and the society needs information not only for generating wealth but also for planning of future investment and consumption.Futures markets helps in Price discovery . 2)Speculation-is a spillover of Futures trading that can provide comparatively less risk averse investors with the ability to enhance their percentage returns. 3)Hedging- As we have seen Hedgers enter into Future contracts to reduce risk in the spot position.There are three types of Hedges; (a) Long Hedge/Anticipatory Hedge-An investor protects against adverse price movements of an asset that will be purchased in the future,i,e,spot asset is not currently owned but is scheduled to be purchased or otherwise held at a later date.(b)Short Hedge-An Investor already owns a spot asset and engages in a trade to sell its associated futures contract. (c )Cross hedge-In actual hedging positions there may be mismatch in Time span covered,amounts of the contract, and characteristics of the goods. 120 Thus when a trader writes a Future contract on another underlying asset he is said to establish a cross hedge.

(3) CURRENCY OPTIONS-Options are unique financial instruments that confer upon the holder the right to do something without the obligation to do so.More specifically,an Option is a financial contract in which the buyer of the option has the right to buy or sell an asset,at a prespecified price ,on or up to a specified date if he chooses to do so;however ,there is no obligation for him to do so..In other words ,the Option buyer can simply let his right lapse by not exercising his Option.The seller of the option has an obligation to take the other side of the transaction if the buyer wishes to exercise his option.Obviously the option buyer(holder) has the to pay the option seller(Writer) a fee for receiving such a privilege. An option that gives the right to buy is known as CALLwhile the one which gives the right to sell is known as PUT.Depending on the contract terms ,an option may be exercisable on any date during the specified period or it may be exercisable only on the final or expiration date of the period covered by the option contract.The option seller charges a premium which the buyer usually pays upfront.Under favorable circumstances ,the buyer may choose to exercise it.Alternatively the buyer may be allowed to sell it.If an option can be exercised on any date during its lifetime it is called an American Style option but if it can be exercised only on its expiration date ,it is called an European option.
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Advantages of using Options as Hedging instruments;
1)An option does not require any Margin money as in the case of a Futures contract nor any bank facility as in the case of a Forward contract.An option buyer can dispense with both depending on the specific market in which he operates. 2)The options buyer ,at the outset,judges the worst case scenario.Once the premium is paid,no further cash is payable.When the main objective is to limit downside risk,this is a powerful advantage. 3)As there is no obligation to exercise an option ,options are ideal for hedging contingent cash flows which may or may not materialize,such as tenders.. 4) Options provide a flexible hedge, offering a range of prices where the option can be exercised whereas forward or future markets only deal at the forward prices which exist at the time the deal is made. 5)Options by themselves provide major possibilities in the range of tools available to Treasurers and traders They can be used on their own to hedge or they can be combined with the forward and futures markets to achieve more complex hedges TRADING OF OPTIONS; are traded in two distinct markets. 1)OTC --meaning over the Counter options are available in a large number of 122 currencies .It is by far the largest market for options..It comprises banks, American securities houses and corporates.

There is no central marketplace as such. All transactions are conducted over the telephone or through the Reuters Dealing system and is open 24 hours a day.The market participants deal with each other directly or through an OTC broker quoting volatility rates as the dealing price (rather than in currency prices).The brokers act to bring counter parties together by the broker for such deals.Trades concluded directly are commission free(so there are no fees when a corporate deals with its bank). 2)Exchange Listed-the other market for Fx options is the exchange listed markets of the various stock and futures exchanges around the world..The principal centers are Philadelphia and Chicago.Access to the market is through brokers who impose commissions for each contract traded and the market operates on the floor of the exchange where brokers transact business. Applications of currency Options-1)Exporters seeking to protect and maximize the value of currency denominated revenues.(2)Importers seeking to protect and minimize costs(3) companies holding rights to purchase foreign currency denominated goods(4)companies that are planning investments ,acquisitions or divestiture(5)Portfolio managers working to enhance total return through active management of currency component.(6)Any firm facing currency denominated obligation or revenue contingent upon other business factors.
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Comparison of OTC and Exchange traded
Feature
VALUE MATURITY
OTC
Any value subject to minimum Overnight to 5 years
Exchange traded
Fixed by contract size Fixed day each month for 3 months ;then quarter months to 1year Only those listed per schedule Only those listed
STRIKE CURRENCY
Any within reason Any pair that has active spot and forward market
MARGINS
STYLE
None,but credit line required

American or European
Yes on sales only

American or European Exchange
ACCESS
COMMISSION
PRICE QUOTES
Trade with a Bank

None,if dealt with a bank Inter bank in volatile terms
Order placed with a broker

Broker exchange fees USD per currency or foreign currency per currency for cross rate contracts
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Option terminology1)CALL OPTION-A call option gives the option buyer the right to purchase a currency Y against currency X at a stated price Y/X on or before a stated date.For exchange traded options, one contract represents a standard amount of the currency Y.The writer of a call option must deliver the currency Y if the option buyer chooses to exercise his option. 2)PUT OPTION-A put option gives the option buyer the right to sell a currency Y against currency X at a specified price,on or before a specified date.The writer of a PUT option must take delivery if the option is exercised. 3)STRIKE PRICE (ALSO CALLED EXERCISE PRICE)The price specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency(Put)Y against X.NOTE CAREFULLY THAT THIS IS NOT THE PRICE OF THE OPTION ;IT IS THE RATE OF EXCHANGE BETWEEN X AND Y THAT APPLIES TO THE TRANSACTION IF THE OPTION BUYER DECIDED TO EXERCISE HIS OPTION. 4)OPTION PREMIUM(OPTION PRICE OR OPTION VALUE) The fee that the option buyer must pay the option writer up front;that is at the time the contract is initiated.This fee is like an insurance premium,it is non refundable whether the option is exercised or not. 125

5)INTRINSIC VALUE OF THE OPTION-The difference between spot price and the strike price of an option is called as Intrinsic value.The value of an option can
never fall below Zero.Consider an American option on CHF with a strike price of usd0.5865. If the current spot rate CHF /USD is0.6005,the holder of such an option can realize an immediate gain of usd(0.6005-0.5865)or usd 0.0141 by exercising the call and selling the currency in the spot market.This is the intrinsic valueof the call option.Therefore the market value or the premium demanded by the seller of the call must be at least equal to this..The intrinsic value of an option is the gain to the holder on immediate exercise.For a call option it is defined as max [(S-X),0]where S is the current spot arte and X is the strike price .If S >X,the call has a positive Intrinsic value.If S is< or = to X,the Intrinsic value is zero.Similarly for a put option the intrinsic value is max[(X-S),0]. 6)TIME VALUE OF THE OPTION-The value of an American Option at any time prior to expiration must be at least equal to its Intrinsic value..In general it will be larger..This is because there is some probability that the spot price will move further in favor of the option holder..Take the previous example of the call option on CHF at a strike price of 0.5865when the spot rate is 0.6005 . Its market value would exceed its intrinsic value of 0.014because before the option expires,CHF may appreciate further increasing the gain to the option 126 holder. .The difference between the value of an option at any time T and its intrinsic value at the time is called the Time value of the option.

7)IN THE MONEY For a call option-If the spot price is more than than the Strike
price, the option is said to be in the money 8)AT THE MONEYFor a call option,-If the spot price is equal to the Strike price, the option is said to be at the money. 9)OUT OF THE MONEY-For a call option,-If the Spot price is less than the strike price, the option is said to out of the money. 10 )RELATIONSHIP - PRICES -The relationship between the price of the underlying and price of the option is called as DELTA.Delta of call option can be between 0 and +1 while Delta of Put option will be between 0 and 1. 11)RELATIONSHIP - TIME-Longer the time period greater will be the value of the option. Relationship between Time period and value of the option is called as THETA.THETA is also called as time decay of the option. 12)RELATIONSHIP-INTEREST RATE-Higher the Interest rate ,greater the value of call option and vice versa.The relationship between interest and price of the option is called RHO.This is due to the fact that if the interest rate is high then the investor would prefer to hold call option and invest the balance money to earn attractive returns.Thus increase in demand will cause the value of the option to rise.Vice versa will be true for put option.
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13)RELATIONSHIP-VOLATILITY-Higher the volatility of underlying,greater will
be the value of the option.The relationship between the volatility of the underlying and value of option is called as VEGA ,LAMBDA OR KAPPA.Because the option writer will like to write option on low volatile underlying due to predictability of the price,the option holder would like to purchase option only on assets which are highly volatile.Thus higher the volatility,more will be the value of both call and put options. If the underlying is a Dividend paying stock ,for example,greater the chance of getting a dividend payment, lower will be the value of call option;this is due to the fact that dividend received will reduce the premium. USING CURRENCY OPTIONS As to how currency options might be used,let us consider an example; An importer in the US has to make a DM 64500 payment to a German exporter in 60days.The importer could purchase a European call option to have the DM delivered to him, at the specified exchange rate.I,e,the strike price on the due date.Let us assume that the option premium is usd.0.02 per DM and the strike price is USD 0.70.The importer has paid USD 1290(64500x.02) for a DM 70 call option which gives it the right to buy DM 64500 AT APRICE OF USD 0.70 per DM AT THE END OF 60DAYS.Now suppose that the value of the DM rises to usd.0.76,when the importers payment falls due..The option 128 would be said to bein the money.

In this case ,the importer exercises its call option and purchases DM for .070.In this scenario,the importer would earn a profit of usd 3870(64500x.06).which more than covers the cost of premium for the option. However if the spot rate declines to below the contracted rate,say,usd.0.66,the DM70 would be out of the money.Thus the importer would let the option expire and purchase the DM in spot market .Despite losing the usd 1290 option premium,the importer would still be usd 1290 better off than if it had locked in a rate of usd.0.66 with a forward or futures contract. The break even price where the gain in the option just equals the option premium is 0.72.Above 0.72 per DM,the option is sufficiently deep in the money to cover the option premium and yield a profit. The reverse will hold good for a PUT option.
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(4)SWAPS-Swap is a Derivative used for Hedging and Risk Management.There are numerous types of Swaps.But Currency Swaps and Interest Rates Swaps are the most commonly used Swaps.The expansion in the swap market has occurred in response to the challenging phenomena which have characterized financial markets today.-(a)arbitrage opportunities,tax regulations,capital controls etc.as a result of market imperfection,(b)need for protection against interest rate and exchange rate risk,( c )Improvements in computer technology and increasing integration of world capital markets. A swap is an agreement between two or more parties to exchange a set of cash flows over a period of time in the future.The basic idea behind swaps is that the parties involved get access to markets at better terms than would be available to each one of them individually.The gains achieved by the parties are divided amongst them depending on their relative competitive advantage.Financial swaps are an Asset-Liability management technique which permits a borrower to access one market and then exchange the liability for another type of liability.Investors can exchange one type of asset for another with a preferred income stream.Swaps are not a FUNDING/FINANCING instrument.They are a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive.Thus swaps are a powerful tool propelling global capital market 130 integration.

Swaps as the name implies are exchange /swap of debt obligations (interest and /or Principal payments)between two parties.In general,currency swaps are arranged between two firms /parties through a bank. As mentioned earlier swaps are not Financing Instruments( as the firms involved in swap contracts already have debt)they comfort the parties involved not only in terms of the desired currency involved in debt financing but also provide logistic convenience in making specified payment of interest and /or principal swaps. SWAPS are of TWO types; (1)INTEREST RATE SWAPS;A standard fixed-to-floating interest rate swap.known in the market jargon as a plain vanilla coupon swap (also referred to as exchange of borrowings)is an agreement between two parties,in which each contracts to make payments to the other on particular dates in the future till a specified termination date.One party known as the Fixed rate payer,makes fixed payments all of which are determined at the outset.The other party known as the Floating rate payer will make payments the size of which depends upon the future evolution of a specified interest rate index(such as the 6-month LIBOR). The key features of this SWAP are; 1)NOTIONAL PRINCIPAL-The fixed and floating payments are calculated as if they were interest payments on a specified amount borrowed or lent. 131

It is Notional because the parties do not exchange this amount at any time;it is only used to compute the sequence of payments.In a standard swap the notional principal remains constant through the life of the swap. 2)THE FIXED RATE;-The rate applied to the notional principal to calculate the size of the fixed payment.Banks who make the market in interest rate swaps quote the fixed rate they are willing to pay if they are fixed rate players in a swap and the fixed rate they are willing to receive if they are floating rate payers in a swap.These are ,respectively,their bid and offer swap rates. Where the transaction is a straightforward;plain vanilla fixed/floating interest rate swap with the principal amount remaining constant throughout the transaction,swap dealers openly display the rates at which they are willing to pay or to receive fixed rate payments. A dealer might quote as follows; US Dollar fixed/f;oating; 2 years Treasury (4.5%)+45/52 3 years Treasury(4.58%)+48/56 4 Years Treasury(4.75%)+52/60 AND SO ON UPTO 10 YEARS. The dealer is in fact saying I am willing to be the fixed rate payer in a 2 year swap at 45 basis points above the current yield on Treasury notes( which will mean 4.95%4.5%=45basis points).I am also willing to be the fixed rate receiver at 52 points above 132 the Treasury yield.(equal to 5.02%)

3)FLOATING RATE In a standard swap at market rates,the floating rate is one of market index such as LIBOR,prime rate,T-bill rate etc.The maturity of the underlying index equals the interval between payment dates. 4) TRADE DATE,EFFECTIVE DATE,RESET DATES AND PAYMENT DATESa)The Trade date is the date on which the swap deal is concluded.This is the date when both the parties have agreed for a swap. b)The Effective date is the date from which the first fixed and floating payments start to accrue..For instance,a 5-year swap is traded on August 30,1991,;the effective date is September 1st 1991 and ten payment dates from March 1,1992 to September 1,1996.Floating rate payments in a standard swap are set in advance- paid in arrears. Each Floating RATE HAS THREE DATES ASSOCIATED WITH IT. D(S)-,The setting date on which the next floating rate payment applicable for the next payment is set. D(1)- is the date from which the next floating starts to accrue And D(2) is the date on which payment is due. D(S) is usually 2 business days before D(1) . D(1)is the day when the previous floating rate payment is made for the first floating rate payment is made (for the first floating payment D (1) is the effective date above..If both the fixed and floating payments are semi annual,D(2) will be the payment dates for both payments and the interval D(1) to D(2) WOULD BE SIX 133 MONTHS.

QUALITY SPREAD DIFFERENTIAL-(QSD)-QSD differential occurs due to credit rating difference due to which fixed Interest loan whose interest cannot be repriced during the tenor of the loan, carries a higher spread depending on the credit rating of the borrower,compared to a floating rate interest loan.In fact swap is based on Ricardos theory of comparative advantage.. Example1-Consider 2 companies A and B with the following dataCOMPANY A COMPANY B DIFFERENTIAL FIXED RATE. 11.7% 10.75% 95 basis points FLOATING RATE Libor+3/8% Libor+1/4% 12.5 basis points Company B has a higher credit rating than Company A and can,therefore raise funds at lower costs in both the fixed rate and floating rate debt markets Company B however has a greater RELATIVE cost advantage over company A in the Fixed rate market than in the Floating rate market (95 basis points vs 12.5 basis points).It would be therefore mutually advantageous for company A to obtain floating rate funding and for company B to obtain fixed rate funding and then to enter into a swap arrangement. Company A wants to obtain medium term 4 years financing at a fixed rate.In case A were to float fixed 4 year bonds ,it would have to pay interest @11.7%.An alternative available to the company is to get a term loan at Libor+3/8% at 134 Floating rate.

Company B simultaneously wants to borrow floating rate dollars.It can float fixed bonds @10.75%.Alternatively it can borrow 6 months floating rate dollars in the inter bank market market at Libor+1/4%.Company B can borrow fixed rate dollars in the market at 95 basis points BELOW the rate that company A would have to pay.Company B has privileged access to fixed rate funds vis a vis company A. The 2 companies enter into SWAP IN THE FOLLOWING MANNER.; A borrows floating rate funds at LIBOR+3/8% and sells it to B at LIBOR. B borrows fixed rate funds at 10.5% and sells it to A at 11 %. In this manner both companies are able to raise funds in the market in which each desires. A gains(.70-0.375)=32.5basis points and B gains(0.25+0.25)=0.50Basis points..Their savings is more than what would have been obtained had each company accessed the market directly..The combined savings when both the firms grow simultaneously is 82.5basis points..Such an arrangement is beneficial to both the parties concerned. Company A which was in the market for fixed rate funds is able to obtain the funds at 11% instead of 11.7%.Company B which was seeking funds at a floating rate is able obtain the funds at LIBOR instead of LIBOR+1/4%. Swaps could be routed through an Intermediary in which case the Intermediary (say a bank)would also charge for arranging the swap.The total savings would 135 then be shared by 3 parties.

Example 2-Company A and B have been offered the following rates PA on a USD 10 MILLION Loan. Fixed rate Floating rate Company A 13.0% LIBOR +0.2% Company B 14.4% LIBOR+.0.7% Company A requires a floating rate loan.Company B require a fixed rate loan.Design swap that will have a bank acting as an intermediary ,@0.1% and that will appear attractive to both the companies. ANSWER-A has comparative advantage in fixed rate markets while B has a comparative advantage in floating rate markets.However A wants to borrow floating rate funds and B wants to borrow fixed rates funds.This provides the basis for the Swap.There is a 1.4% pa differential between the fixed rates offered to the 2 companies.The total gain to all the parties from the swap deal is therefore 1.4%-0.5%=0.90%pa.Since the bank gets 0.1%pa ,the swap deal should make company A and B 0.40% pa (each) better off. The borrowing by the 2 companies will be Company A should borrow at LIBOR-0.3% AND Company B should borrow at 13%.
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ADVANTAGS OF INTERST RATE SWAPS1)Does not involve principle amounts 2)Because of the smaller amounts at risk ,the number of potential participants in the deals is larger. 3)As there is no lending involved,the documentation can be kept simple. 4)The deal is entirely off Balance Sheet. 5)Swap allows the issuers to revise their debt profile to take advantage of current or expected future market conditions. LIMITATIONS OF INTEREST RATE SWAPS1)Swaps are not easily tradable. 2)Default risk is high 3)Difficult to find a counter party sometimes. 4)It is not Exchange controlled and it is an OTC market.This calls for extra caution in dealing with each other as credit risk is high. 5)Termination of deals is not possible without mutual agreement.So once done it may be difficult to exit
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(2 )CURRENCY SWAPS-In a currency swap ,the two payment streams being exchanged are denominated in two different currencies.Usually an exchange of principal amounts at the beginning and a re exchange at termination are also a feature of a currency swap. A currency Swap is an exchange of payments in one currency for a stream of payments in another currency.A typical fixed- to- fixed currency swap works as follows.One party raises a fixed rate liability in currency X,say in USD.,while the other raises fixed rate funding in currency Y,say in EUR..The principal amounts are equivalent at the current market rate of exchange.At the initiation of the swap contract,the PRINCIPAL amounts are exchanged with the first party handing over USD to the second ,and getting EUR in return.Subsequently,the first party makes periodic EUR payments to the second,computed as interest at a fixed rate on the EUR principal,while it received from the second party payments in USD again computed as interest on the dollar principal.At maturity,the USD and EUR principals are re exchanged. A fixed to-floating currency swaps also known as CROSS CURRENCY COUPON SWAP will have one payment calculated at a floating interest rate while the other is at a Fixed rate.It is a combination of a fixed to fixed currency swap and Fixed to floating Interest rate swap.In most cases ,an intermediary, a swap bank, structures the deal and routes the payments from one party to 138 another.

RATIONALE FOR EXISTENCE OF CURRENCY SWAPS1)Cost reductions and Hedging-Used to hedge against FE risk..Hedging can lower a firms borrowing costs because it reduces uncertainty of cash flows and the probability of unfavorable changes in the value of assets and liabilities,thereby making firms more creditworthy(.2)As it increases the total amount that a firm can borrow,it facilitates economies of scale,which can reduce operating costs.(3)A firm may be able to use their surplus funds in blocked currencies,. more effectively (4)May be used as a way of circumventing exchange control regulations.(5)Swaps can be used as a means of arbitrage opportunities.(6)Swaps play an important role in integrating the worlds capital markets by overcoming barriers to International capital movements. Terminology used in swap1)Swap Facilitator-swaps are mutual obligations among the swap parties.But it may not be necessary for the counter parties involved in a swap deal to be aware of the each other because of the role assumed by a swap dealer .Collectively swap dealers are called Swap banks .(2)Swap Broker is an economic agent who helps in identifying the potential counter to a swap transaction.He is also called as the market maker. (3)Basis points- A basis point is one hundredth of a percentage point (0.01%) For example, a bond 139 yield rise from 5.20% to 5.35% represents an increase of 15 basis points (4) Swap coupon refers to the fixed rate of interest on the swap.

HEDGING THROUGH MIXED CURRENCY INVOICING/CURRENCY OF INVOICING/SELECTION OF SUPPLYING COUNTRY Ina addition to the various market-based hedging devices a firm may be able to reduce or eliminate currency exposure by means of INTERNAL STRATEGIES or INVOICING ARRANGEMENTS like risk sharing between the firms and its foreign customers. INVOICING-A firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency.Of course the choice of Currency of Invoicing is often dictated by marketing considerations and exchange control factors.An exporter may wish to invoice in the buyers currency to gain competitive edge.Invoicing in a weak currency --which may be neither the buyers nor sellers currencymay be an indirect way of offering discounts which otherwise may be difficult to offer.In some countries,due to exchange control the only way a company can take a position in a currency,is by invoicing a trade transaction in that currency. If Forward markets in a particular currency are thin or non existent it is better to avoid invoicing in that country s currency since the exposure cannot be effectively hedged.Also in the presence of well functioning forward markets this method will not yield any added benefit compared to a forward hedge.140

Empirically, in a study of the financial structure the following irregularities were Discovered1)Trade between developed countries in manufactured products is generally invoiced in the exporters currency. 2)Trade in primary products and capital assets is generally invoiced in the exporters currency. 3)Trade between a developed and less developed currency tends to be invoiced in the developed countrys currency. 4)If a country has a higher and more volatile inflation rate than its trading partners there is a tendency NOT to use that countrys currency in trade invoicing. Another hedging tool in this context is the use of currency cocktailsor Mixed currency invoicing for invoicing .Thus for instance,a British importer of chemicals from Switzerland can negotiate with the supplier that the invoice be partly in CHF and partly in GBP. Basket invoicing offers the advantage of diversification and can reduce the variance of home currency value of the payable or receivable as long as there is no perfect correlation between the constituent currencies.The risk is reduced but not eliminated. SELECTING a country whose currency is less volatile is another form of 141 Preventive Hedging.Supplies from these countries will have a steady FE transactions.
International Financial Management Important Terminology in FE 1)Forward Rate Agreements-A Forward Rate Agreement (FRA) is notionally an agreement between two parties in which one of them (the seller of the FRA),contracts to lend to the other (the buyer), a specified amount of funds ,in a specific currency , for a specified period starting at a specified future date ,at an interest rate fixed at the time of agreement.we say notionally,because in practice,actual lending or borrowing of the underlying principal does not take place but only the interest rate is locked in.The buyer of the FRA in turn agrees to borrow (again notionally),funds for a specified duration,starting at a specified duration,starting at a specified future date,at a rate fixed at the time the FRA is bought. A typical FRA quote from a bank might look like this; USD 6/9 MONTHS;7.2-7.3%PA-Which means that the bank is willing to accept a 3 month USD deposit,that is ,borrow funds,starting 6 months from now,maturing nine months from now,at an interest rate of 7.20%pa (the bid rate).The bank is willing to lend dollars for a period of 3 months,starting 6 months from now at an interest rate of 142 7.3%pa(the ask rate).There is no exchange of Principal amount.

FRAs like Forward exchange contracts are a conservative way of hedging exposure.It removes all uncertainty from cost of borrowing or rate of return on investment.The relationship between FRA and an Interest Rate Futures contract ic exactly analogous to that between a Forward currency contract and Currency Futures contract.
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INTERNATIONAL CAPITAL BUDGETING-Capital Budgeting for multinational firms uses the same framework as domestic capital budgeting .However they face a number of complexities as follows; 1)Parents cash flows are different from project(subsidiaries)cash flows 2)All cash flows from the foreign projects must be converted into the currency of the parent company. 3)Profits remitted to the parent company are subject to two taxing jurisdictions. 4)Anticipate the differences in the rates of national inflation as they can result in changes in competitive position and thus in cash flow positions over a period of time. 5)The possibility of Foreign exchange risk and its effect on the parents cash flows. 6)If the host country provides some concessionary financing arrangements and /or other benefits,the profitability of the foreign project may go up 7) Host countries may impose various restrictions on the distribution of cash.generated form foreign projects. 8)Political risks must be evaluated thoroughly as changes in political events can drastically affect the cash flows. 9) Economic situations can affect the projects and may affect the cash flows
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Another problem in multinational capital budgeting is the problem of Blocked funds.Accounting for blocked funds in the capital budgeting process depends on the opportunity cost of blocked funds.I they can be used for foreign investments ,the project costs to the investor may be below the local cost of the project.Also if the opportunity cost of the blocked funds is zero the entire amount released for the project should be considered as a reduction in the initial investment. 3) TAXATION ISSUES-Both in domestic and International capital budgeting ,only after tax cash flows are relevant for project evaluation.However ,in International( or multinational) capital budgeting ,the tax issue is complicated by the existence of two taxing jurisdictions,plus a number of other factors,like remittances to the parent,dividends, management fees royalty ,withholding tax provisions ,tax treaties etc.The ability of the MNC to reduce its overall tax burden through the Transfer pricing Mechanism should also be considered.If treaties exist ,the highest tax rates of either of the countries should be reckoned for budgeting purposes,to be on a conservative basis.
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PROBLEMS AND ISSUES IN FOREIGN INVESTMENT ANAYSIS1)FE RISK-Multinational companies investing abroad are exposed to FE risks the risk that the currency will appreciate or depreciate over a period of time.understanding this is an important evaluation of cash flows generated by the project over its life cycle.To incorporate the FE risk element in the cash flows estimates,first an estimate is made of the inflation rate in the host country during the life span of the project.The cash flows ,in terms of the local currency,are then adjusted upwards for the inflation factor.Then the cash flows are converted into the parents currency at the spot exchange rate multiplied by an expected depreciation rate calculated by the PPP theory. 2)REMITTANCE RESTRICTIONS-Where there are restrictions on the repatriation of income,substantial differences exist between project cash flows and cash flows received by the parents firm.Only those flows that are remittable to the parent are relevant from the MNCs perspective.Many countries impose a variety of restrictions on transfer of profits,depreciation and other fees accruing to the parent company.Project cash flows consist of profits and depreciation charges whereas parents cash flows consist of the amounts that can be legally transferred by the project/subsidiary. 4)PROJECT VS PARENTS CASH FLOWS substantial differences can exist between the Project and the parent cash flows because of tax regulations and 146 exchange controls.

In the light of substantial differences that can exist between a parent company and project cash flows,the important question is how to evaluate cash flows? 1)Its own cash flows 2)cash flows accruing to the parent company 3)both Some experts have suggested a 3 stage financial analysis of foreign projects. In the first stage,project cash flows are computed and analyzed from the point of view of the subsidiary or the affiliate as if it were a separate entity. The second stage involves evaluation of the profit on the basis of forecasts of cash flows which will be transferable to the parent company. In the third s and last stage ,the analysis from the viewpoint of the parent company is widened to include indirect benefits or costs from the company as a whole,which are attributable to the foreign project in question. METHOD OF CAPITAL BUDGETING 1)DCF technique involves the use of the time-value of money principle to project evaluation.The two most widely used criteria of the DCF technique are the NVP and the IRR methods.Both the techniques discounts the project cash flow at an appropriate discount rate.The results are then used to evaluate the projects based on the acceptance/rejection criteria developed by the 147 management.

The NPV of a project is the present value of all cash inflows ,including those at the end of the Project's life,minus the present value of all cash outflows. The IRR method finds the discount rate which equated the present value of the cash flows the present value of all cash flows to zero.generated by the project with the initial investment or the rate at which would equate the present value of all cash flows to zero. THE ADJUSTED PRESENT VALUE APPROACH A DCF technique aspect that can be adapted o the unique aspect of evaluating foreign projects is the adjusted present value approach (APV).The APV format allows different components of the projects cash flow to be discounted separately.This allows the required flexibility ,to be accommodated in the analysis of the foreign project..The APV approach uses different discount rates for different segments of the total cash flows depending upon the degree of certainty attached with each cash flow..In addition ,the APV format helps the analyst to test the basic viability of the foreign project before accounting for all the complexities.If the project is acceptable in this scenario,no further evaluation based on accounting for other cash flows is done.The APV model is a value added approach to capital budgeting,I,e, each cash flow as a source of value is considered individually.Also in the APV approach each cash flow is discounted at a rate of discount consistent with the risk inherent in that cash 148 flow.

ADJUSTMENT FOR RISK;CASH FLOW VERSUS DISCOUNT RATE ADJUSTMENT-Another important dimension in Multinational capital
budgeting is whether to adjust cash flows or the discount rate for the additional risk that arises from the foreign location of the project.Traditionally MNCs adjust the discount rate by moving it upwards for riskier projects to reflect the political and FE uncertainties.A significant number of firms that use the DCF technique in domestic projects also assign different hurdle rates for different projects depending on their risk categories. The other alternative is to adjust cash flows rather than the discount rate in treating risk.The annual cash flows are discounted using the applicable rate for that type of project. Either at the host country or at the parent country,Probability and certainty equivalent techniques like Decision tree analysis are used in economic and financial forecasting.Cash flows generated by the project and remitted to the parent company during each time period are adjusted for political risk ,exchange rate and other uncertainties by converting the into certainty equivalent.The method of adjusting the cash flows rather than the discount rate is generally the more popular method and is usually recommended by Finance managers.There is generally more information on the specific impact of a given risk on a projects cash flows than on its discount rate.
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FOREIGN DIRECT INVETSMENT Foreign Direct Investment is an investment made by a Transnational Corporation to increase its international business.It generally involves the establishment of new production facilities in foreign countries to earn extra returns..Foreign Direct Investment is motivated by a complex set of strategic ,behavioral economic and financial considerations. FDI has been a major factor in stimulating economic growth and development in recent times.The contribution that MNCs can make as agents of growth,structural change and International integration has been made FDI a coveted tool of economic development and a source of capital.FDI links the host economy and fosters economic growth. WHY DO FIRMS INVEST ABROAD New sources of demand.-penetrate new markets-Domestic market saturation Existence of various market imperfections-in product,factor,capital markets,currencies,costs. Economies of scale-volume sales,larger facilities cater to larger markets Use of foreign raw material and technology. Use existing obsolete secondary technology in domestic market outside the country 150 Exploit monopolistic advantage-- Firms becoming internationalized due to competitive advantage.

Diversify Internationally-hold assets internationally in many countries-capital market imperfections may thus motivate firms to undertake FDI. Political safety seekers Knowledge seeking HOW TO INVEST ABROAD-ALTERNATIVES TO DFI(Direct Foreign Investment) 1)Joint Venture-A Joint Venture is a coming together of two companies and establishing an entity to do business together in the host country/location.It is a viable form of increasing international business. 2)Mergers and Acquisitions/cross border acquisitions-Mergers and Acquisitions take place internationally to increase market share and competitive position 3)Licensing-is a popular method used by MNCs to profit from foreign markets without the need to commit sizable funds.Since the foreign producer is 100% locally owned,the political risk tends to get minimized.In licensing, local firm in the host country produces the goods to the licensing corporations specs. When the goods are sold , a portion of the revenues, as specified by the agreement, are sent o the licensor. 4)Franchising-Franchising is another form of expansion internationally.Here,the Franchiser gives right to sell his product in a specified territory.There is an 151 upfront fee payment and Royalty payment based on sales done by the franchisee.

SIX MANTRAS FOR FDI in INDIA 1)Legislative and Policy Reforms;(a)Remove unnecessary restrictions on equity participation(b)standardize guidelines for environmental issues. (c )Strengthened IP laws (d)Reduce the variance of FDI laws based on sectors.(e)Increase trade openness 2)Government processes and machinery-(a)Increase areas for automatic approval (b)Reduce the role of the FIPB(C )Streamline the number of agencies-single window clearance 3)Center-State Dynamics-Devolve more authority in selected areas to the states to negotiate projects. 4)Infrastructure-(a)Increase Political commitment,regulatory transparency and dispute resolution mechanisms to attract foreign participation in infrastructure (b) focus immediately on the infrastructure of airports,telecom ports ,roads 5)Concentrated Zones for FDI activity-(a)Expand export processing zones to provide modern infrastructure for export oriented projects(b)Expand the issues of technology parks and other zones to increase the opportunities of agglomeration of industries for which India is particularly attractive(c )Allow the private sector to set up and operate some of these sites.
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6)Engagement of Foreign Investors-(a) create a council of senior union and state government officials and representatives of large foreign-invested companies.(b)Use the council to deepen the insights into issues that impede FDI.(c )Use the council to develop high impact decisions and learn from the these actions quickly (d)use the council to build mutual respect and trust Some of the important factors taken into consideration by foreign investors when entering into a country are1)Reliable access to economic information 2)Level of corruption 3)Stability of political and business environment. 4)Character of local market or the distance and the access to neighboring markets.Many MNCs invest in one country and use it as a stepping stone to enter another country. 5)The existence of good and quality infrastructure consisting of ,among others,advanced telecommunications and energetic network is an advantage that may decide in the selection of a country. 6)Ability to meet and comply with internationally acceptable standards and norms.
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FDI permitted under the following forms of Investments Through financial collaborations Through JVs and technical collaborations Through capital markets and euro issues Through private placements FDI not permitted in the following industrial sectors Ammunition Atomic energy Railway Transport Coal and Lignite Mining of Iron ,manganese,chrome,gypsum,sulphur ,gold ,diamonds,copper and zinc. FOREIGN PORTFOLIO INVESTMENT-The twentieth century has seen massive cross-border flows of capital.However,till the 80s,it was predominantly debt capital in the form of bank loans and bond issues.The International new issues equity market with globally syndicated offerings emerged during the eighties grew rapidly till the stock market crash of 1987 .The initial thrust to cross- border flows of equity investment came from the desire on the part of institutional investors to diversify their Portfolios 154

Globally in search of both higher return and risk reduction Foreign Portfolio Investment is through GDRs/ADRs .Indian companies are allowed to raise equity capital in the International market through the issue of these instruments.These are not subject to any ceiling on investment. Foreign Portfolio Investment is subject to greater volatility due to shorter-term commitments.An important point here is that private portfolio investment inflows in emerging markets dropped sharply after the East Asian crisis.
INTERNATIONAL EQUITY MARKETThe International equity market can be divided into two categories1)Foreign Equity;If the equity issue is made in a particular domestic market (and in the domestic currency of that market)it is known as a Foreign Equity Issue. For example ,an Indian company accessing exclusively the US market through an equity issue would be called aforeign equity issue..The instrument available for the above case is called American Depository Receipt( ADR) .if a non European country raises funds exclusively from European countries through International /European Depository Receipts(IDRs/EDRs),it is also referred to as Foreign Equity Issue. 155 2

2) )EURO EQUITY;If a company raises funds using equity route through
Instruments like Global Depository Receipts(GDR).or super stock Equity in more than one foreign market except the domestic market of the issuing company and denominated in a currency other than that of the issuer's home country is known as Euro Equity Issue. DEPOSITORY CERTIFICATE-A Depository certificate(DR) is a negotiable certificate that usually represents a companys publicly traded equity or debt.DRs are created when a broker purchases the companys shares on the home market and delivers those to the Depositorys local custodian bank,which then instructs the Depository bank to issue Depository receipts.Depository receipts are traded in the currency of the country in which they trade and are governed by the trading and settlement procedures of the market. DRs are issued for a number of reasons; To raise capital in foreign markets To potentially increase the liquidity of their shares by broadening shareholders base. To gain visibility through financial market presence which can generate support for and interest in potential mergers and acquisitions. 156 To allow employees outside the home market to participate in equity..

AMERICAN DEPOSITORY RECEIPTS-is a Dollar denominated negotiable certificate that represents a non-Us companys publicly traded equity.It falls within the regulatory framework of the USA and requires registration of the ADRs and the underlying shares with the SEC.In 1990,changes in rule 144A allowed companies to raise capital without having to register with SEC..Non US companies have a choice of 5 types of ADR facilities1)Unsponsored ADR programme-initiated by a third party,not the issuing firm 2)Sponsored ADR programmes Level-1-is exempt from full compliance with the SECs reporting requirements and cannot be listed on the national exchanges Level 2- should be in full compliance with the SECs registration disclosure and reporting requirements which allow ADRs to be listed on NYSE,AMEX,or NASDAQ.However this type of ADR cannot be used to raise capital through a public offering. Level-3 has the same requirements and privileges as level 2 plus it is allowed to raise capital through a public offering provided that the issuer submits appropriate information to the SEC. Rule 144(a)ADRs-restricted ADRs are not required to comply with with the full SECs registration and reporting requirements and are used for private 157 placement to qualified institutional buyers.

Benefits of ADRs-For issuers,there are several reasons for launching and managing an ADR programme1)An ADR programme can stimulate investor interest ,enhance a companys visibility,broaden its shareholder base and increase liquidity. 2)By enabling a company to access US capital markets ADR offers a new avenue for raising capital at highly competitive costs. 3)ADRs provide an easy way for US employees of non US companies to invest in their companies employee stock purchase plans.Features such as dividend reinvestments programme can help ensure that an issuers ADRs trade is in comparable range with those of its peers in the US market. Benefits to INVESTORS American Depository receipts are US securities ADRs are easy to buy and sell ADRs are liquid ADRs are global ADRs are cost effective ADRs are convenient to own ADRS have improved quality of disclosure 158 Better valuations

GLOBAL DEPOSITORY RECIPT-It is a global finance vehicle that allows to raise
capital simultaneously in two or more markets through a global offering. GDRs may be used in either public or private markets inside or outside the US. They are marketed internationally ,mainly to financial institutions .A GDR is an instrument to raise capital in multiple markets outside the issuer;s domestic market through one security which is traded in a foreign stock market. Characteristics of GDRs Holders of GDRs participate in the economic benefits of being ordinary shareholders though they do not have voting rights. GDRs are listed on the Luxemburg stock exchange Trading takes place between professional market makers on an OTC basis Liquidation of GDR---after 45 days GDRs have become synonymous with selling equity in the Euro markets.This is so because fresh shares are issued by the company which is raising money from the markets,and transferred, to a depository which ,in turn,issues, a receipt which is quoted at any stock exchange where it is listed.Considering that a company does not need to be evaluated by the international rating agency before marketing GDRs-which suits Indian companies just fine-,they 159 are easy to issue.

Not only is the cost of selling a GDR issue comparatively low,this instrument provides access to a broad investor base spread across various continents.And best of all ,the time lag between concept and execution can be as short as 7 weeks. There are several variations to plain Vanilla GDRs.E.g.,there could be call options which allow the issuer to limit the benefits to equity holders by insisting on conversions of the GDR into more equity beyond certain limits. Thus a GDR is a negotiable instrument denominated in dollars or some other freely convertible currency.It is used as a funding vehicle for raising capital simultaneously in 2 or more markets.The GDR structure allows for simultaneous issuance of securities in multiple markets.This facilitates greater liquidity through cross border trading.GDRs can be issued in either public or private markets in the US or other countries. A GDR gives its holder the right to get equity shares of the issuer company as per the terms of Offer.Till such conversion takes place ,the GDR holder has no voting rights.The shares represented by the a GDR are identical to other equity shares in all respects. Once a GDR is issued it can be traded freely among International investors.GDRs are freely tradable in the overseas market like any other dollar denominated security either on as foreign stock exchange or in the 160 OTC market.

COMPARISON OF ADR VS GDR ADR GDR Center-NYSE is the largest stock The LSE is not as large as the exchange in the world for ADRs NYSE overall but is the global for both value and turnover center for international business
Instrument-No legal or technical difference between an ADR and GDR.Level3 suited for fund raising Disclosure-Comprehensive disclosure required GAAP-Must reconcile their accounts to US GAAP Unlike the NYSE,the LSE makes no demands requiring companies to give holders the right to vote Less onerous than ADR LSE satisfied with a statement of the difference between the UK and Indian Accounting standards Comparatively inexpensive.around 200 to 400k usd Legal liability of a company and its directors is less than in the case of an ADR
Cost-US listing could be expensive.Initial cost 1 to 2 million usd Liability-Legal liability of both a company and its individual directors increased by a full US listing
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International Financial InstrumentsThe Funding avenues potentially open to a borrower in the global capital marketare; 1)BONDS a)Straight Bonds b)Floating Rate Notes(FRNs) c)Zero-coupon Bonds d)Bonds with a variety of option features embedded in them 2)Syndicated credits --These are bank loans,usually at floating rate of Interests,arranged by one or more lead managers(banks) with a number of other banks participating in the loan.A number of variations on the basic theme are possible. 3)Medium Term NotesInitially conceived as instruments to fill the maturity gap between short-term money market instruments like commercial paper and long term instruments like bonds,these subsequently evolved into very flexible borrowing instruments for well-rated issuers,particularly in their Euro Version,viz Euro-medium term Notes(EMTNS) 4)Committed underwritten FacilitiesThe basic structure under this is the Note Issuance Facility.Introduced in the 1980s these instruments were popular for a while before introduction of risk based capital adequacy norms rendered 162 them unattractive for banks.

5)Money Market InstrumentsThese are short-term borrowing instruments and
include Commercial Paper,Certificates of Deposits,Bankers Acceptance among others.(also refer to slides 68 and 69) In addition to these ,export related credit mechanism such as buyers and suppliers credits credit,general purpose lines of credit,forfaiting are other forms of medium/long term financing.(already discussed earlier) BOND MARKETS-A bond is a debt security issued by the borrower,purchased by the investor,usually through the intermediation of a Group of Intermediation of a group of underwriters. A straight Bond is the Traditional Bond .It is a debt instrument with a fixed maturity period, a fixed coupon which is a fixed periodic payment usually expressed as a percentage o the face or par value, and repayment of the face value at maturity.-also known as Bullet payment of the principal amount.The market price at which it bought by an investor either in the primary market (new issue) or in the secondary market is its Purchase Price, which could be different from its face value.When they are identical the bond is said to be selling at Par,when the face value is less than (more than),the MARKET PRICE,the Bond is said to be trading at a Premium(Discount).The difference could arise because the Coupon is different from the ruling rates on bonds with equal perceived risk and maturity or creditworthiness of the163 issuer is different.

YIELD is a measure of return to the holder of the bond and is a combination of the purchase price and coupon.There are many concepts of yields and the coupon payments could be annual.semi- annual or even longer. Variants OF Straight Bonds(A) A callable bond can be redeemed by the issuer at his choice.,prior to its maturity..The first call date is normally some years from the date of issue e.g. a 15 year bond may have call provision which allows the issuer to redeem the bond at any time after 10 years.The CALL PRICE,that is the price at which the bond will be redeemed is normally above face value with the difference shrinking as the maturity date approaches. (B) A Puttable Bond IS THE OPPOSITE OF callable Bond.It allows the investor to sell it back to the issuer prior to maturity.The investor pays for this privilege in the form of lower yield. (C) Sinking Fund Bonds --were a device,often used by small risky companies to assure the investors that they will get their money back (D) Floating Rate Notes(FRNs)-are instruments in which interest rate is floating based on bench mark like LIBOR.There are various variants of floating rate notes like(a) FRNs with multi currency option,(b)minimax FRN where cap and floor are fixed for interest rates,(c )Perpetual FRN which does 164 not have any redemption period, (d)Flip-Flop FRN wherein the holder ha an option to treat the FRN as perpetual after holding it for a time period.

Medium Term Notes are facilities issued for more than one year up to desired level of maturity.Insurance companies are the major investors in these funds.Interest rates depend on credit rating, off take by pension funds,banks,MFs etc (E)-ZERO COUPON BONDS (called simply zeros) are similar to the cumulative deposits schemes offered by companies in India.The Bond is purchased at a substantial discount from the face value and redeemed at face value on maturity.There are no interim interest payments. (F) Deep discount bonds-do pay a coupon(annual interest rate ) but at a rate below the market rate for a corresponding straight bond .Bulk of the return to the investor is in the form of capital gains. (G) Convertible Bonds are bonds that can be exchanged for equity shares either of the issuing company or some other company.The conversion price determines the number of shares for which the bond will be exchanged.The conversion value is the market value of the share s which is less than the face value of the bond at the time of issue.As the share price rises,the conversion value rises.It is a form of deferred equity. (H) WARRANTS- are an option sold with a bond which gives the holder the right to purchase a financial asset at a stated price.The warrants may be permanently attached to the bond or detachable and separately 165 tradable.Initially warrants were used by speculative issues as an added incentive to the investor to keep the interest costs within limits

(I)Bonds with embedded options will be priced to include the value of the
option.If the issuer gets the option (for e.g. ,a callable bond),the yield would have to be higher than a comparable straight bond;If the option is granted to the Investors , for instance, a puttable bond or a convertible bond,its value will be reflected in the lower yield. The largest International Bond market is the Euro bond market which is s aid to have originated in 1963 with an issue of eurodollar bonds by Autostrade ,an Italian Borrower.Eurobond markets in all currencies ,except Yen are quite free from any regulation by the respective governments except Euro yen which is controlled by the Ministry of Finance ,Japan.They are listed on stock exchanges in Europe.Secondary markets trading in eurobonds is almost entirely OTC by telephone between dealers. Among the national capital markets US market is largest in the world.It is complemented by worlds largest and most active derivative markets,both OTC and exchange traded. (J)YANKEE BONDSFrom a non -resident borrowers point of view,the most prestigious funding avenue is public issue of Yankee Bonds.These are Dollar denominated Bonds issued by foreign borrowers.It is the largest and most active in the world but potential borrowers must meet very stringent disclosure ,dual rating and other listing requirements. 166

Yankee Bonds are also offered under rule 144 A OF THE sec.These issues are exempt from elaborate registration and disclosure requirements,but rating ,while not mandatory is helpful.Finally low rated or unrated borrowers can make private placements. (K)SAMURAI BONDS are publicly issued Yen denominated binds and like Yankee bonds are the most prestigious funding vehicle.The Japanese Ministry of Finance lays down the eligibility guidelines for potential foreign borrowers.They specify the minimum rating ,size of the issue ,maturity and so forth.Syndication and underwriting procedures are quite elaborate and so is the documentation.Hence floatation costs tend to be high.Pricing is done with reference to the Long term prime rate (LTPR). (L)SHIBOSAI BONDS are private placement bonds with distribution limited to institutions and banks,while eligibility criteria are less stringent,the MOF still controls the market in terms of rating,size and maturity of the issue. (M)SHOGUN BONDS-are publicly floated bonds denominated in a foreign currency. (N)GEISHA BONDS- are their private placement counterparts. (o)BUNNY BONDS-These bonds permit investors to reinvest their interest incomes into more such bonds with the same terms and conditions. (p)Bulldog bonds-are denominated in GBP for UK investors floated by non-UK 167 entity.

EXTERNAL COMMERCIAL BORROWINGS(ECB)-are defined to include (1)commercial Bank loans(2)Buyers credit(3)Suppliers credit(4)securitised Instruments such as Floating Rate Notes and Fixed Rate Bonds(5)Various forms of Euro and syndicated loans Purposes1) Meet forex cost of capital goods and services 2) For project related rupee expenditure in infrastructure projects in Power,telecom and railways 3) Corporate borrowers able to raise long- term resources with an average maturity of 10 years and 20 years will be allowed to use the ECB proceeds up to usd 100 million and 200 million respectively without any end use restrictions. APPROVALS REQUIRED-1)For ECB of minimum maturity of less than 3 years approval from RBI alone is required.(2)For minimum average maturity of 3 years and above ,sanction is required from MOF and then from RBI
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COUNTRY RISK ANALYSIS-Country Risk is an indispensable tool

for asset management as it requires the assessment of economic opportunity against political odds.The list of factors to be analyzed in a country risk varies from forecaster to forecaster .Two important indicators emerge in this process; A)POLITICAL RISK(PR) INDICATORS-It is very difficult to assess political risk associated with a particular country or a borrower..Assessing a political risk is a continuous process and it is very difficult to identify a few political risk factors.Some of the common political risks are; 1)Stability of the local political environment--The level of PR for each nation is analyzed here.Measures here take cognizance of changes in the government,levels of violence in the country ,internal and external conflict and so on. Existing political status and continuity of the government will be assessed. 2)Consensus regarding Priorities-This is a measure of the degree of agreement and unity on the fundamental objectives of Govt policy and the extent to which this consensus cuts across party lines. 3)Attitude of Host Government-If the host government starts imposing restrictions and becomes unfriendly then it becomes greater risk..e,g anti MNC stand of 169 the left Govt always stopping FDI in certain sectors,levy of higher taxes etc.

4)war-If war is possible for the country under ,the safety of employees and Assets will be affected and needs to be reviewed. 5)Mechanism for expression of discontent- This is related to the ability to effect peaceful change,provide internal continuity and to alter direction of policy without major changes of the political system . B)ECONOMIC RISK (ER)INDICATORS1)Inflation rate-The inflation rate is used as a measure of economic instability,disruption and government mismanagement .Inflation also affects the purchasing power of consumers and also the consumers demand for MNCs goods. 2)Current and Potential state of the countrys economy-Several economic factors have to be weighed before any conclusion about the soundness of the economy can be arrived at-External Debt,Forex position,BOP position,GDP growth,Current account position,Interest rates etc . 3)Resource baseThe resource base of a country consists of a country consists of its national ,human and financial resources.But it could be paradoxical in some cases-eg Mexico with resources being worse off that Korea and Japan in terms of risk. 4)Adjustment to external shock-The ability of the country to adapt o external 170 shocks.

TECHNIQUES TO ASSESS COUNTRY RISKS1)Debt related Factors 2)Balance of Payments 3)Economic performance 4)Political instability
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WORKING CAPITAL MANAGEMENT IN MNCsOBJECTIVE1)Minimize the currency exposure risk 2)Minimize country and political risk 3)Minimize the overall cash requirements of the company as a whole without disturbing the smooth operations of the subsidiary or its affiliate. 4)Minimize the transaction costs. 5) Full benefits of economies of scale as well as benefit of superior knowledge. CENTRALISED PERSPECTIVE OF CASH FLOW ANALYSIS 1)Maintaining minimum cash balance during the year. 2)Helping the center to generate maximum possible returns by investing all cash resources optimally. 3)Judiciously manage the liquidity requirements of the center. 4)Helping the center to take complete advantage of multinational netting so as to minimize transaction costs and currency exposure. 5)Optimally utilize the various hedging strategies so as to minimize the MNCs foreign exchange exposure. 6)Achieve maximum utilization of the transfer pricing mechanism so as to enhance 172 profitability.and growth of the firm.

Techniques to Optimize cash flow1)Accelerating cash inflows 2)Managing blocked funds 3)Leading and Lagging funds 4)Using netting to reduce overall transactions costs by eliminating a number of unnecessary conversions and transfer of currencies 5)Minimizing the tax on cash flow through International TP. 6) Cash pooling SHORT-TERM FINANCIAL MANAGEMENT IN MNCs Management of short term Assets and Liabilities Cash,Investments,Receivables,Payables,-is an important part of the Finance Mangers job.The essence of short-term financial management can be summarized as follows1)Minimize the working capital needs consistent with other policies (eg granting credit to boost sales,maintain inventories,to provide a desired level of customer services etc) 2)Raise short term funds at the minimum possible cost and deploy short-term cash surpluses at the maximum possible rate of return consistent with the firms 173 preferences and liquidity needs.

Cash Management in a MNC poses more challenges than inventory or receivable management which are more or less similar to the domestic environment. Ways and means 1)EEFC ACCOUNT EXCHANGE EARNERS FOREIGN CURRENCY ACCOUNT(Indian companies only) 2)SHORT TERM BORROWING-VARIOUS INSTRUMNETS LIKE CP,BA ETC. 3)INVESTING SURPLUS FUNDS-Short term liquid money market instruments are available in various markets.Once the treasures has identified the cash flows and determined how much surplus funds are available in which currencies and for what durations,he or she must chose appropriate investment vehicles so as to maximize the interest income while at the same time minimizing currency and credit risks-instruments like short term bank deposits,fixed term money market deposits etc.consideration for choosing an instrument would be(a)Yield (b) Marketability (c )Exchange rate risk (d) Price risk (e)Transaction costs
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International Financial Management