IFM PGP SBS Full Term Revd Latest Exellent

Capital Flows - Some stats - Emerging markets $ Billion
Sl no Emerging markets - global Pvt Cap flows - Nett Private Direct Inv - Nett Private Portfolio flows Other Pvt. Capital flows Official flows - Nett Change in Reserves Emerging Asia Pvt Cap flows Nett Private Direct Inv Nett Private Portfolio flows Other Pvt Capital flows 0.2 70.9 54.1 (124.9) 20.6 50.5 (60.1) 30.2 64.0 99.6 (12.7) (22.9) 97.9 94.0 (13.1) 17.0 69.0 96.0 (8.4) (18.5) 75.4 177.3 60.7 (162.6) 13.0 (98.4) 77.3 150.6 (91.7) 18.4 (4.3) (200.6) 238.5 255.9 3.2 (20.6) (151.8) (592.5) 211.4 263.3 (31.1) (20.8) (238.7) (666.3) 182.2 246.1 (4.6) (59.2) (174.1) e 1999 2002 2005 2006 2007
Official flows Nett

Change in Reserves
1.6
(84.8)
3.0
(154.4)
(11.7)
(286.6)
(8.4)
(344.8)
(12.0)
(331.4)
International Fin Mgt
A Brief Introduction
Sep 2010
STRICTLY PRIVATE AND CONFIDENTIAL
Objectives of the Course

1. To provide
A conceptual framework of How financial decisions are undertaken In a multinational company.
2. To familiarize students with

Unique economic factors that challenge A Fin Mgr in the international context.
Principles of Collective learning

1. Learning Not by rote but by Logic, based on First principles 5 W 1 H framework Why , What, Where, When, Who and How till we reach first principles 2. Participation by all. Learning by all (Prof. included)
3. Preference to Depth over Width.
4. Preference to substance over form.
5. Mgt Paradigm : Timely Approximation is better than belated precision
Topics Pre Mid term UNIT I

Introduction to IFM
The environment The nature of international Fin Mgt International Monetary system Determination of exchange rates Balance of Payments Interest parity international fisher effect
UNIT II
Foreign exchange market
Functions Participants Currency derivatives
Forwards, Swaps, futures and Options
Interest rate futures speculation
Why IFM
1.
Do you need to answer these questions

a. b. c. d. e. Where should you source from ? - Op Decision Which markets to penetrate (Op decisions) - Op Decision Where should you Invest (eg. Where to locate your plant) - Invt Decision Where in the world shall we raise our finance from ? - Fin Decision What should be our response to our MNC competitor - Op decision
2.
Why IFM
a. a. b. c. d. e. Inter-dependent World (Resources are scattered Goods/Lab/Capital) Inter-connected world : Tech improvements (Trpt, Com, Web) Boundary-less Fin- Flows @ the speed of nanoseconds now. For each co some interest abroad : supplier, cust or competitor Implications dramatic : Even US Cos had to earn new lessons JP Morgan : We are a Global co with an important American Biz
3.
Empirically Global barriers are shrinking & global trade is growing

In 2002 - $ 6.4 Trillion : In 2008 - $ 15 Trillion
4.
Emerging Eco (GDP/Trade) Gr. - faster than Developed one
Why IFM for Indian students

1.
2007- Emerging Developed
- GDP gr - GDP Gr
- 7.5% - 2.5%
: Trade Gr : 10.5% : Trade Gr : 5.3%
2.
1991 : Watershed yr For India. Liberalization and Globalization a. Easing of Quantitative Restrictions (Trade, Labor & Capital) b. Lowering of Import Duties c. Foreign Investments on the rise controls lowered d. Current A/c convertibility e. Trend towards softening of Cap a/c convertibility provisos IFM course will deal with the Treasurers more than the controllers fn Treasury Function Acquisition and allocation of Fin resources To maximize rewards and Minimize costs Consistent with the level of fin risk acceptable to the firm Basically the Investment and Financing roles vs Operational role
3.
4.
What is special about international finance?
Foreign exchange risk
Eg. An unexpected devaluation adversely affects our export Mkt.
Political risk
Eg. A Coup that jeopardizes existing negotiated contracts.
Market imperfections
Eg. Trade barriers & Tax incentives affect location of production.
Expanded opportunity sets (Global diversification)
Eg. Raise funds in global markets, gains from economies of scale
Intnl Fin mgt The expanded opportunities

1. Arbitrage Opportunities: Defined as simultaneous purchase & sale in2 diff mkts To profit from price discrepancy Tax Arbitrage : shift from high to low tax regimes Risk arbitrage : diversification. Pl refer point 3 (Intnl CAPM) 2. Mkt efficiency related opportunites: Tendency of efficient mkts to price in all info to avert profits other than those thru pure risk taking. Inefficient Markets likley to allow more returns 3. Intnl CAPM reated Opportunities: Variability in asset returns a fn of Systematic & unsys risks IFM helps diversify away some unsystematic risk. (Cost push infl due to oil) 4. The value of good fin mgt is enhanced in a global context due to Market imperfections, multiple tax rates and complexities This presents as oppy as much as a threat. Sophisticated IFM exploits the opportunity. Precisely, the objective of the IFM course
International expanded Opportunity MNCs Cost-Benefit Evaluation - Domestic Firms versus set
Marginal Return on Projects
Purely Domestic Firm
MNC MNC Purely Domestic Firm
Marginal Cost of Capital
Appropriate Size for Purely Domestic Firm
Appropriate Size for MNC
Asset Level of Firm
The Setting
Empirical data on Global Money / Trade flows
Forex Mkt T/O in Billions of US$ /Day.
Global trade Stats (figs in Bil $ / Yr : Right Asia/Other)
12000 10000 8000 6000 4000 2000 0 1961 1971 Globe 1981 Advanced 1991 Asia 2001 Others 2005
2500 2000 1500 1000 500 0
Global Flows Indian policy environment

Labour Goods Capital / Tech
Emigrat ion Immigration Exports

Exec Body
Imports I/flows
O/flows
HRD Min
Commerce Ministry
Fin Min (FIPB/ SEBI/ RBI)
Policy
Supporti ve
Restrictive Immigration Laws, Resident status IT
Supportive
Selective ly FDI : Supportive Restricti FII : Selective ve restrictions FDI : Sectoral caps FII : Selective Restrictions like PN
Restrictive
Restri ctions
Emigrati on laws
Export Ban Export Duties
Quotas Tariffs
Selective permission
Global Capital Inflows

A. 2 categories
1. FDI : Invt in real assets or Cos in a host country 2. Portfolio : Invt in financial assets of a host country
B. Economic benefits of FDI

1. Prod of goods/serv in locations of comp advantage 2. Enhancement of labor productivity in the host country 3. Adoption of new tech /Mgt techniques to optimally utilize resources 4. Raises the level of competition, provides new/improved prod.
Global Trade flows C. International biz methods

Licensing Franchisee JV Subsidiaries Mgt contract : : : : : Typically to use IPR-related To Permit the use of brands /Logo etc. P/sip jointly owned/operated by 2/more firms New ops in the host country by parent corp. one firm owning and another Managing (eg. Magunta Oberoi)
D. Tactical Issues
1. Licensing involves lower risks but inflexible & host dependent 2. Subsidiary is preferred to JV. JVs over Licensing
Setbacks
East Asian crisis 97-98
Doubts about capital a/c convertibility started surfacing Benefits of unfettered capital flows were overestimated and The damage an enormous outflow of S/T money can cause has been underestimated Consensus on addl. safeguards and checks but not much on the form it needs to take By 99 some semblance of recovery started & all forgotten soon Financial meltdown 2008 Sub prime the ostensible cause. Toxic assets (CDS s etc.) were the other manifestation Real causes were consumption and savings imbalances between the advanced economies and the Asian tigers
Structure of the course
International Financial Environment

International Financial System
Basic Concepts in International Finance
International Money
International International International Theories of Financial Markets Financial Institutions Parity Conditions Financial Markets Behaviour
Money
Markets
Institutions / Players
Instruments
International Money

International Money International Financial Markets International Financial Institutions
International Monetary System
Exchange rates
Exchange Rate Arrangement
Evolution of International Monetary System
Exchange Rate Equilibrium
Exchange Rates Determinants
International Financial Markets

International financial System
IM
International Financial Markets
IFI
Foreign Exchange Markets (Forex)
International Money and Capital markets
International Derivatives Markets
Immediate Delivery Market (spot market)
Forward Market
International Money Market
International Capital Market
International financial System
IM
International Financial Markets International Debt and Equity Markets
IFI
Foreign Exchange Markets (Forex)
International Derivatives Markets Options
Immediate Delivery Market (spot market) Forward Market
International Debt Market

Bonds (corporate, government eurobonds) Loans/ Deposits Notes
International Equity Market

Stocks (shares)
Futures
ADRs
Swaps
Bankers Acceptances Commercial Papers
IFB - framework
A. Fin environment Overview International Monetary system International FIs and Dev Banks BOPs B. Forex Markets Derivatives Forex Currency futures and options Forex markets Forex Rate theories C. Forex exposure mgt Mgt of Forex risk Translation exposure and Transaction exposure D. Fin mgt of MNC firm FDI WACC and Cap structure of an MNC MNC Capital budgeting / Cash Mgt / Taxation Country Risk Mgt E. Financing foreign operations Eurocurrency markets Interest rate and currency swaps Depository receipts

A. Gold standard (1875 1914) Each country to peg currency to an ounce of gold. Free import and export of Gold Two way convertibility between currencies and gold B. Example for US $ and $ 20.67 / ounce of gold and 4.247 / ounce of Gold (20.67 / 4.247) = $ 4.866 / unit of
C. Gold Import / export Points (a Hypothetical example) Assumptions 1 ounce of gold = 20 $ / 4 (ie 5$ / ) Shipping Cost = 0.20 $/ounce US importer imports worth 4 / US exporter exports worth 4 US importer cam pay 1 ounce Gold or 4 : US exporter ok to accept 4 / 1 ounce gold
Gold Standard - Workings

If Exchange Rate has moved to (say) 5.1 $ / unit of then
Either the US importer can pay 4 paying $ 20.40 to get the same (rate 5.1/ ) or Ship 1 ounce gold : Cost of Gold + shipping cost = $ (20 +0.20) = $ 20.20 This is Called the Gold Export Point Thus, If the Rate exceeds $ 5.05 / , the US importer would rather export Gold than pay
Workings : If Exchange Rate is (say) 4.90 $ / unit of Either the US exporter can get 4 or $ 19.60 (since Rate is 4.9) now or Accept 1 ounce gold : Cost of Gold - shipping cost = $ (20 - 0.20) = $ 19.80 This is called the Gold Import Point Thus, if the Exch rate moves < 4.95$ , US Exporter would rather accept Gold into US than 4

A. Gold Std Equilibrium maintained thru Price-Specie Flow mechanism as below B. Assume a country experiences Trade deficit (Imports more thane exports) Currency loses competitiveness Exchange rate reaches Gold Export Point. Thus, Gold gets exported Results in loss of Gold reserves. Thus money supply to be downsized Accompanied by high intt rates, lower Prod /empl /low demand for Cons/ Import With reduced imports, Trade Bal improves/ with high intt rates, Fund I/Fl improve Hence, Exchange rate appreciates Assume a country experiences Trade Surplus (Exports more than Imports) Currency gains competitiveness Exchange rate reaches Gold import Point. Thus, Gold flows into the country Results in increase in Gold reserves and money supply increases Accompanied by Low intt rates, higher prod /Empl/Hi demand for Cons/ Import With higher imports, trade Bal suffers / with lower intt rates, Fund O/Fl increase Hence, Exchange rate depreciates
Gold standard : Why abandoned

1. The 3 Golden rules of Gold Standard were highly restrictive (A) Rate peg (B) Free Exp/ Imp of Gold (C) Currency stock = F (Gold reserves)
2. Gold being scarce, Gold volume could not grow fast enough to cope with Eco Gr
3. Gold reserves were with countries politically sensitive (eg. Russia, South Africa)
4. Nations had to subordinate their National Eco goals to the dictates of Global trade.
5. This proved to be unrealistic, given the political costs of such a presumption Many developing countries faced External trade imbalances during this time Instead of having the courage to face unemployment at home, countries resorted to Tariffs This affected the international trade
6. Hence, the system was eventually abandoned
Inter war years

1. WW1 interrupted the flow of trade and destabilized Exchange rates
2. Role of Britain as a creditor nation came to an end 3. Feeble attempts to get back to gold Std post war . Eg UK 1925. Failed 4. Since UK had run out of reserves and inflation was rampant. 5. Pound was overvalued.
6. US $ devalued to 35/ounce
7. US introduced modified Gold std. US to trade gold with only central banks not with Pvt citizens
8. Inter war Yrs saw Half-hearted attempts @ Gold std that failed
9. Great depression and stock market crash of 1929 also were contributory
Bretton woods.
1. Creation of 2 new institutions IMF and world bank 2. IMF for addressing balance of payments problems. 3. World bank to address for post war reconstruction and General Eco Development 4. US $ and became the reserve currencies 5. Each member would establish a par value with the reserve currency 6. And maintain it within 1% of the par value. intervene else. Ie Fixed peg with 7. US $ was pegged to 35 $/ oz Gold. US agreed to exchange $ for gold/ vice versa 8. Member could change par value with Fund approval /fundamental disequilibrium
9. Currencies became freely convertible.

10. To defend, countries had to keep a lot of dollar reserves and US, Gold reserves 11. Member countries to make subscription to the fund
Break down of Bretton woods

1. 1947 71 ; Stable. World Trade expanded faster than world output 2. There was imbalance. Countries with deficits underwent conditionalities 3. Countries with surplus treated favorably, thou persistent surplus was inflationary (Contrast with approach to Chinese surplus now) 4. Esp rigid was the approach to BOP disequilibria. Conditionalities were stringent
6. Low levels of conditionalities, if member needs funds for short period

7. Higher levels, where member wants access to LT fund resources 8. Involved stabilization programs to achieve IMF objectives. 9. Led to interference in their independent Monetary/ fiscal policy pursuits
Fixed Vs flexible : An evaluation

Fixed Rates :
Certainty & rigidity promote Eco efficiency, public confidence and Inflation control Downsides : Work well in periods of stability. Massive O/F during crises. FM closes
Floating rates
System causes uncertainty. Promotes speculation instead of trade Flexi rate system also encourages speculation, once upper band was reached. However in fixed, bets were one-way with no loss since parity to be restored Conclusion : Fixed rate system suffered from all that flexible systems had &more
Systems in vogue now :

Flexible ones Pegged Systems : like US $, Japanese Yen. But Interventions are a reality : To a base like US $. : Countries need to defend with Res
Parity Conditions and
Currency Forecasting
CHAPTER OVERVIEW
I. II. III. IV. V. VI.
PURCHASING POWER PARITY THE FISHER EFFECT THE INTERNATIONAL FISHER EFFECT INTEREST RATE PARITY THEORY THE R/SHIP BETWEEN FORWARD AND FUTURE SPOT RATE
CURRENCY FORECASTING
ER determination: Caselet : Utopia Vs Antarctica
Infla Items Burger Lee Jeans Total Vol 100 10 2008 100 1,000
20.0% 2009 2008 2009 2008 2 20
10.0% 2009 2008 2009
Ex Rate Determination
20.0% Items Burger Vol 100 2008 100 2009 2008 10,000 2009 2008 2
10.0% 2009 2008 200 2009
Ex Rate Determination
20.0% Items Burger Vol 100 2008 100 2009 120 2008 10,000 2009 12,000 2008 2
10.0% 2009 2.2 2008 200 2009 220
Exch Rate determination
20.0% Items Burger Lee Jeans Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 2009 12,000 12,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 2009 220 220
Exch Rate determination
20.0% Items Burger Lee Jeans Total Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 2009 220 220 440
Exch rate Determination
20.0% Items Burger Lee Jeans Total Exch rate by Price comparison Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 50.00 2009 220 220 440 54.55
Exch rate Determination
20.0%
Items Burger Lee Jeans Total Exch rate by Price comparison Exch rate by Formula ( Infl Diff Abs) Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0%
2009 2.2 22.0 2008 200 200 400 2009 220 220 440
50.00
54.55
1.20/1.10
1.091
50.00
54.55
Exch Rate Determination
20.0% Items Burger Lee Jeans Total Exch rate by Price comparison Exch rate by Formula ( Infl Diff Abs) Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 50.00 2009 220 220 440 54.55
1.20/1.10
1.091
50.00
54.55
Exch rate by Formula (Infl Diff Rel)
1.20/1.10
1.091
45.00
49.09
PART II. PURCHASING POWER PARITY

I.
THE THEORY OF PURCHASING POWER PARITY:
States that spot Exch rates between currencies will change
based on differential in inflation rates between countries.
ARBITRAGE AND THE LAW OF ONE PRICE
Inflation & home currency depreciation :
1.
jointly determined by Gr of domestic money Supply;
2.
Relative to the growth of domestic money demand.
PART I.
I.
THE LAW OF ONE PRICE A. Law states:
- Identical goods sell for the same price worldwide.
B. Theoretical basis:
- If the price after exchange-rate adjustment were not equal,

- Arbitrage in the goods worldwide ensures it will, eventually
Limitations
1. Tariffs, Quotas, Transportation costs, Other trade barriers 2. Non-traded goods & Services (like Beauticians) excluded
PURCHASING POWER PARITY

III. Relative
PPP
States that the exchange rate of one currency agt. another
will adjust to reflect Ch in Price levels of the two countries.

If purchasing power parity is Expd to hold, then
The best prediction for the one-period Spot rate should be
e1 e0
1 i
f
1 ih
1 1

A more simplified but less precise relationship is The % change should be approximately equal to - The Inflation rate differential (in decimals not %).
et 1 ih i f e0

A. Real exchange rates
If exchange rates adjust to Inflation differential, then ; PPP states that real exchange rates stay the same.
B. If Real exchange rates unchanged, - Competitive positions of Domestic & foreign firms are unaffected.
III. The Fisher Effect (FE)

I.
THE FISHER EFFECT states that

- Nominal interest rates (r) are a function of
- Real Interest rate (a) and

- A Premium (i) for inflation expectations.
r = a + i
THE FISHER EFFECT

B. Real Rates of Interest
1. Should tend toward equality everywhere thru arbitrage. 2. With no Govt interference, nominal rates vary by Infl. Diff
rh
rf = ih - if
3. According to the FE, - Countries with higher inflation rates have higher interest rates.
D.
Due to capital market Integration globally,

- Interest rate differentials are eroding.
THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE
e1
(1 rh ) e0 1 (1 r f )
1
IFE States that the spot rate adjusts to the Intt. rate Diff. between two countries
Interest differential in favour of foreign country in per cent per annum
Covered Interest Arbitrage and Interest Parity theory

Interest Rate Differentials, Forward Exchange Rates and Covered Interest Arbitrage
3 2 B 1 0 1 2 3 3 Arbitrage inflow A
Arbitrage outflow
Interest parity
Arbitrage outflow 1.+ve int rate diff > FD (point A) 2..FP > -ve interest rate diff (point .A) Arbitrage inflow 1.FD > + ve intrest rate diff (point B) 2.-ve intrest rate diff > FP (point B)
Forward exchange rate - discount or premium in per cent per annum
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM
22.50 23.25 3.33%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR
22.50 23.25 3.33% 10.20% 11.00% 0.80%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible
22.50 23.25 3.33% 10.20% 11.00% 0.80%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @
22.50 23.25 3.33% 10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest
22.50 23.25 3.33% 10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3
Cumulative
4,897.8
01-Jan-09 Spot DM Fwd 1 year
22.50 23.25
Forward Premium - DM
Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest Cumulative Sell DM fwd and Trfr to INR Yield %
3.33%
10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3 4,897.8
23.3
113,873.3 13.87%
22.50 23.25
Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest Cumulative Sell DM fwd and Trfr to INR Yield % Return if Invested in INR 11.00%
3.33%
10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3 4,897.8
23.3
113,873.3 13.87% 1,11,000.0
Present Rate
Equivalent rate
Description
Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible Buy DM Investment @ Interest Cumulative Sell DM fwd and Trfr to INR Yield % Return if Invested in INR 12.00%
62
Conversion
22.50 23.25 3.33% 10.20% 12.00% 1.80% Yes 100,000.00 10.20% 453.33 4,897.78 23.25 113,873.33 13.87% 112,000.00 12.00% 112,000.00 22.87 4,444.44 No 100,000.00 10.20% 453.33 4,897.78 112,000.00 4,444.44 10.20% 12.00% 22.50
Present Rate
Equivalent rate
Description
63
Conversion
22.50 23.25 3.33% 10.20% 12.00% 1.80% Yes 100,000.00 10.20% 453.33 4,897.78 23.25 113,873.33 13.87% 112,000.00 12.00% 112,000.00 22.87 4,444.44 No 100,000.00 10.20% 453.33 4,897.78 112,000.00 4,444.44 10.20% 12.00% 1.63% 22.50
Present Rate
Equivalent rate
Description
64
Conversion
22.50 23.25 3.33% 10.20% 12.00% 1.80% Yes 100,000.00 10.20% 453.33 4,897.78 23.25 113,873.33 13.87% 112,000.00 12.00% 112,000.00 22.87 4,444.44 No 100,000.00 10.20% 453.33 4,897.78 112,000.00 4,444.44 22.50 22.87 1.63% 10.20% 12.00% 1.63%
Present Rate
Equivalent rate
Description
65
Conversion
22.50 23.25 3.33% 10.20% 12.00% 1.80% Yes 100,000.00 10.20% 453.33 4,897.78 23.25 113,873.33 13.87% 112,000.00 12.00% 112,000.00 22.87 4,444.44 No 100,000.00 10.20% 453.33 4,897.78 112,000.00 4,444.44 22.50 22.87 1.63% 10.20% 12.00% 1.63%
INTEREST RATE PARITY THEORY

Covered Interest Arbitrage
Conditions required:
i. Interest rate differential does not equal the forward premium or discount.
ii. Funds will move to a country with a more attractive overall yield.

Market pressures develop:
a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates. c. Parity eventually reached.
Summary: Interest Rate Parity states : 1. Higher intt rates on a currency offset by Forward Discount 2. Lower interest rates are offset by forward premiums
IFE
Implications of IFE - Currency with lower Intt rate is Expd to appreciate ; - Proportionately - Relative to one with a higher rate. - Due to Arbitrage

IFE = PPP + FE
e1
(1 rh ) e0 1 (1 r f )
1
International Fisher Effect

Simplified IFE equation: (if rf is relatively small)
rh rf
e1 e0 e0

IFE = PPP + FE
et
(1 rh ) eo t (1 r f )
t
Equilibrium Exchange Rate Relationships
E(e)
IFE PPP
(i$ -i Rs)
FE RPPP
(E1 - E0 ) E0
$ - Rs
International flows Status now

Still, With growth in trade, labour movements, capital also has started flowing freely
Hence, the emergence of Multinational corporations Some studies predict the possibility of 500 of them owning 2/3 rd of world FA in 10 yrs FDI flows, for eg. have grown in India
Following factors have made IFM an indispensable tool esp for Global corps
A. Growth in internationals savings and reserves B. An ever expanding and an elaborate network of global banks and FIs C. Various forms of Fin instruments, guarantees and insurance products D. Innovative Risk mgt products and processes E. Emergence of sophisticated payments systems F. Efficient mechanisms for dealing with S/Term imbalances
For an IF Manager the following are the variety of choices before them
Funding techniques Investment Vehicles Risk Mgt products Speculative opportunities based on risk-reward profiles
Hence, for those willing to learn the complexities, there are opportunities for others, there is a minefield
Role of MNC firm

A. To maximize shareholder wealth / satisfice stakeholder interests B. Whichever of the above 2 win eventually, the MNC still has to grapple with the environment it operates in. Environment consists of 1. International Fin system. Official and others MNC banks and OTC deals/ cap markets 2. Forex market : MNC banks, Forex dealers. 24 hr operation 3. Host country environment : Political, social, cultural and other systems
C. MNC faces myriad of Complexities and challenges wrt ; Multiple Taxation laws Multiple currencies Multiple and differential policy frameworks Multiple political Systems Agency problem. :
Stands for conflict of goals between MNC shareholders and managers of the subsidiaries.
D. But an MNC can make the same diversity & complexity work in its favor eg. Geo Diversification
Objectives Sales as Expansion Supply source acquisition Diversification Investment Optimization
as
Influences : Geograhic Historical Political Legal Economic Cultural
Ext enviornment
Means
Operational Import & Export Licensing Franchising Mgt Contact Turnkey FDI Portfolio Invt
Functional Production Marketing Accounting Finance Personnel
Environment challenges
Speed of Product Changes Optimum Production site No of customers Amount bought by each customer Homogeneity of customers Local Vs International competitors Cost of moving products Unique capabilities of competitors
MNC Vs Local Firm Cost Benefit matrix
35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1 2 3 4 5 6 7 8 MNC Ret Local Ret MNC WACC Local WACC
IFM as a Discipline
A.
1. 2. 3. 4.
Till early 90s, IFM discipline was not much in demand as a specialization Things have changed since then. Indias share of Total Global trade may not be significant and is in fact declining While tariff barriers and quotas are being dismantled. Still they are high Yet, it is nave to conclude from above that the Developments in Intt. Fin are of little interest to us. Why 1. To maintain tempo of eco growth, India needs substantial FDI to augment domestic savings 2. Tech up gradation needs continuing import of technology 3. Indian export initiatives need L/T financing to buyers abroad 4. Indian IT sector is beginning to venture abroad. For both organic/ Inorganic gr. Needs Finance 5. Policy stance is in favor of more openness and greater competition
B.
Treasury functions Two major approaches

1. Treasury Function
Some Cos run an active treasury fn that leverages imperfections in the Fin Mkts to generate purely Fin gains from Mgt of Fin Assets/Liabilities
Others have a reactive finance function, focussing only on core Ops Former is a risky strategy. Eg. Forex losses by many Corps in 2008 The latter is a conservative approach. The complexity of IFB is s/that a wide variety of Instruments Financing options Investment Vehicles and Risk Mgt options Do exist for both styles of Mgt Treasurer in an MNC is concerned with purely Ops decisions like Sales/ Purchase, due to Exch/ Intt rate risks involved. Not in Non-MNC
Emerging Challenges For IF Managers

1. The 80/s 90s - marked by unprecedented pace of foll environ changes Political uncertainties at Home and abroad Economic Liberalization at home Greater Exposure to international markets Incr in volatility of key eco & fin variables like Exchange /Interest rates Increased competition with increased threats of take over Globalisation challenges increased the frustrations for Emerging Ecos Also offered many opportunities to benefit from. Look at china for eg.
2. 21st century is marked by even greater changes in the environment WTO deadlines wrt removal of trade barriers likely to lead to greater competition Cap A/C convertibility likely in phases may lead Cap flow challenges Ceilings on FII and FDI Investments being revised upwards Eg INR Appreciated from 2004 - 07, squeezing the margins of exporters To sum up, integration of India with Global Eco is likely to accelerate Hence, exposure for Indian Cos to global Fin Mkts is likely to increase
Fin Mgrs to do
1. To Be updated with environmental changes Exch / Intt rates, fiscal, monetary developments, Industrial, tax, Exim policies, Fin mkt trends New fin instruments, their Risk-reward implications 2. Understand /analyze complex r/ships between environ Var & Corp Fin Eg Stock market crash on credit conditions in intl markets Implications on our global funding prospects of default by a Dr country 3. Adoption of Fin fn to Changes in firms own strategic postures - Internal Changes in product market mix New M&A opportunity 4. To address the consequences of past decisions A major take over decision that has gone awry 5. To leverage opportunities offered by the environment
Evaluate
A. Distinct features of International Finance
Forex Risk : Esp due to managed float policy by all nations. Volatility can be mercurial Exch rates among even major currencies like $, Yen etc. fluctuate wildly Political risk : ranges from unforeseen policy actions to terrorist threats (Enron- India) Expanded opportunity sets Market imperfections Laws, tax systems, biz , cultural practice diff etc. B. Evaluation 1. Which of the above provide the maximum net benefit over cost 2. PV of expected future payoffs net of costs discounted at an apt rate
IFB - framework
A. Fin environment Overview International Monetary system International FIs and Dev Banks BOPs B. Forex Markets Derivatives Forex Currency futures and options Forex markets Forex Rate theories C. Forex exposure mgt Mgt of Forex risk Translation exposure and Transaction exposure D. Fin mgt of MNC firm FDI WACC and Cap structure of an MNC MNC Capital budgeting / Cash Mgt / Taxation Country Risk Mgt E. Financing foreign operations Eurocurrency markets Interest rate and currency swaps Depository receipts

A. Gold standard (1875 1914) Each country to peg currency to an ounce of gold. Free import and export of Gold Two way convertibility between currencies and gold B. Example for US $ and $ 20.67 / ounce of gold and 4.247 / ounce of Gold (20.67 / 4.247) = $ 4.866 / unit of
C. Gold Import / export Points (a Hypothetical example) Assumptions 1 ounce of gold = 20 $ / 4 (ie 5$ / ) Shipping Cost = 0.20 $/ounce US importer imports worth 4 / US exporter exports worth 4 US importer cam pay 1 ounce Gold or 4 : US exporter ok to accept 4 / 1 ounce gold
Gold Standard - Workings

If Exchange Rate has moved to (say) 5.1 $ / unit of then
Either the US importer can pay 4 paying $ 20.40 to get the same (rate 5.1/ ) or Ship 1 ounce gold : Cost of Gold + shipping cost = $ (20 +0.20) = $ 20.20 This is Called the Gold Export Point Thus, If the Rate exceeds $ 5.05 / , the US importer would rather export Gold than pay
Workings : If Exchange Rate is (say) 4.90 $ / unit of Either the US exporter can get 4 or $ 19.60 (since Rate is 4.9) now or Accept 1 ounce gold : Cost of Gold - shipping cost = $ (20 - 0.20) = $ 19.80 This is called the Gold Import Point Thus, if the Exch rate moves < 4.95$ , US Exporter would rather accept Gold into US than 4

A. Gold Std Equilibrium maintained thru Price-Specie Flow mechanism as below B. Assume a country experiences Trade deficit (Imports more thane exports) Currency loses competitiveness Exchange rate reaches Gold Export Point. Thus, Gold gets exported Results in loss of Gold reserves. Thus money supply to be downsized Accompanied by high intt rates, lower Prod /empl /low demand for Cons/ Import With reduced imports, Trade Bal improves/ with high intt rates, Fund I/Fl improve Hence, Exchange rate appreciates Assume a country experiences Trade Surplus (Exports more than Imports) Currency gains competitiveness Exchange rate reaches Gold import Point. Thus, Gold flows into the country Results in increase in Gold reserves and money supply increases Accompanied by Low intt rates, higher prod /Empl/Hi demand for Cons/ Import With higher imports, trade Bal suffers / with lower intt rates, Fund O/Fl increase Hence, Exchange rate depreciates
Gold standard : Why abandoned

1. The 3 Golden rules of Gold Standard were highly restrictive (A) Rate peg (B) Free Exp/ Imp of Gold (C) Currency stock = F (Gold reserves)
2. Gold being scarce, Gold volume could not grow fast enough to cope with Eco Gr
3. Gold reserves were with countries politically sensitive (eg. Russia, South Africa)
4. Nations had to subordinate their National Eco goals to the dictates of Global trade.
5. This proved to be unrealistic, given the political costs of such a presumption Many developing countries faced External trade imbalances during this time Instead of having the courage to face unemployment at home, countries resorted to Tariffs This affected the international trade
6. Hence, the system was eventually abandoned
Inter war years

1. WW1 interrupted the flow of trade and destabilized Exchange rates
2. Role of Britain as a creditor nation came to an end 3. Feeble attempts to get back to gold Std post war . Eg UK 1925. Failed 4. Since UK had run out of reserves and inflation was rampant. 5. Pound was overvalued. FF was undervalued.
6. US $ devalued to 35/ounce
7. US introduced modified Gold std. US to trade gold with only central banks not with Pvt citizens
8. Inter war Yrs saw Half-hearted attempts @ Gold std that failed
9. Great depression and stock market crash of 1929 also were contributory
Bretton woods.
1. Creation of 2 new institutions IMF and world bank 2. IMF for addressing balance of payments problems. 3. World bank to address for post war reconstruction and General Eco Development 4. US $ and became the reserve currencies 5. Each member would establish a par value with the reserve currency 6. And maintain it within 1% of the par value. intervene else. Ie Fixed peg with 7. US $ was pegged to 35 $/ oz Gold. US agreed to exchange $ for gold/ vice versa 8. Member could change par value with Fund approval /fundamental disequilibrium
9. Currencies became freely convertible.

10. To defend, countries had to keep a lot of dollar reserves and US, Gold reserves 11. Member countries to make subscription to the fund
Break down of Bretton woods

1. 1947 71 ; Stable. World Trade expanded faster than world output 2. There was imbalance. Countries with deficits underwent conditionalities 3. Countries with surplus treated favorably, thou persistent surplus was inflationary (Contrast with approach to Chinese surplus now) 4. Esp rigid was the approach to BOP disequilibria. Conditionalities were stringent
6. Low levels of conditionalities, if member needs funds for short period

7. Higher levels, where member wants access to LT fund resources 8. Involved stabilization programs to achieve IMF objectives. 9. Led to interference in their independent Monetary/ fiscal policy pursuits
Smithsonian Agreement
1. 1971 : Post Vietnam war, Dollar started weakening and
2. Various countries started becoming more protectionist

3. Hence, Worlds leading 10 countries, produced smithsonian agreement 4. US $ was still defined in terms of Gold and all other currencies in terms of $/gold 5. Band around $/gold was 2.25% on either direction (4.5% total) 6. Band across currencies could be as high as 9%
7. This band was more than permitted under earlier dispensation (1%)
8. Had the flexibility of a floating system while retaining the discipline of fixed rates
Flexible rates 1973 to now

1. Since 1973, it is the flexible Each rate system that is being practized 2. Variations thereof are being practiced as below 3. Crawling Peg
Infrequent adjustment of IMF par value needed larger devaluation of larger rate Crawling peg tried to change incrementally by small amounts, continuously As little as 0.5% pm. To reduce speculative profits vide massive delay Countries had to maintain ample reserves for prolonged incremental adjustments
4. Wider Band : over and above the 1% band permitted by IMF

Snake in the Tunnel by European countries Their currencies values were fixed to one another with a band of 2.25% With $, an important currency not in the loop, the system faultered Under inflationary conditions, the rate slipped faster, hit the floor Thereafter, had to suffer the consequences of a fixed rate system.
Fixed Vs flexible : An evaluation

Fixed Rates :
Certainty & rigidity promote Eco efficiency, public confidence and Inflation control Downsides : Work well in periods of stability. Massive O/F during crises. FM closes
Floating rates
System causes uncertainty. Promotes speculation instead of trade Flexi rate system also encourages speculation, once upper band was reached. However in fixed, bets were one-way with no loss since parity to be restored Conclusion : Fixed rate system suffered from all that flexible systems had &more
Systems in vogue now :

Flexible ones Pegged Systems : like US $, Japanese Yen. But Interventions are a reality : To a base like US $. : Countries need to defend with Res
EMU and Euro

A. There are two categories of limited Flexibility Gulf countries whose currencies are pegged to the $ Europe countries whose values were arranged around Euro currencies Mechanism : Snake in the tunnel Snake : 1.125% band for EEC countries Exch. rates Tunnel : 2.25% for other countries rates B. EMU To form a zone of monetary stability in Europe To coordinate Exch rate policies vis--vis non-EMS currencies To develop a European Common currency unit (ECU Euro) European Monetary cooperation fund (EMCF)
EMU and Euro

C. Exchange rate Mechanism
Managed thru a Parity grid method Bilateral rates amongst members Float allowed around 2.25% of Par Each ER has Par, max & min rates Divergence invites action Bilateral Resp for ER maint. Reserves needed to maintain ER For irretrievable divergence, re alignment The responsibility with both nations - not one as under IMF EMCF (Com fund) : ST and M/T cr to member countries & SGL banker for bilateral assistance FF BF SF SK DM DG
FF
X
1.0
1.0
2.0
3.0
4.0
5.0
BF
X
0.7
1.5
2.5
3.5
4.5
SF
0.5
X
0.8
1.3
2.3
3.3
SK
0.3
0.4
X
0.6
1.8
2.8
DM
0.3
0.3
0.4
X
0.6
1.8
DG
0.2
0.2
0.3
0.4
What is special about international finance?
Foreign exchange risk
Eg. An unexpected devaluation adversely affects our export Mkt.
Political risk
Eg. A Coup that jeopardizes existing negotiated contracts.
Market imperfections
Eg. Trade barriers & Tax incentives affect location of production.
Expanded opportunity sets (Global diversification)
Eg. Raise funds in global markets, gains from economies of scale
Global Flows Indian policy environment

Labour Goods Capital / Tech
Emigrat ion Immigration Exports

Exec Body
Imports I/flows
O/flows
HRD Min
Commerce Ministry
Fin Min (FIPB/ SEBI/ RBI)
Policy
Supporti ve
Restrictive Immigration Laws, Resident status IT
Supportive
Selective ly FDI : Supportive Restricti FII : Selective ve restrictions FDI : Sectoral caps FII : Selective Restrictions like PN
Restrictive
Restri ctions
Emigrati on laws
Export Ban Export Duties
Quotas Tariffs
Selective permission
World Bank
1. Objectives

Assist the rehabilitation of economies disrupted by war Promote flow of Foreign pvt capital thru guarantees, provide Own funds Promote L/T Balanced growth of Global trade and BOP equilibrium thru LT Invt (FDI) flows To make the transition to peacetime from war time smoother
3.
Composition

Membership is a function of countrys eco might G7 have nearly 45% share and voting rights (USA 17%) Change in Capital base/AOA need 85% votes (USA veto) All other matters incl loan approvals need simple majority Exec Board is in Washington DC By and large Coop in spirit. Voting has been rare.
2.
Affiliates
IBRD, IDA
World Bank
4. How Does it assist
Bank uses its Fin resources, Knowledge Base and Network Emphasizes on Social (People) development (Health, Education etc.) and inclusion Environment protection Encouraging Private sector Invts/ initiatives Goading Govts towards reform and efficient delivery of public services Institution building and Governance
5. 6.
Affiliates
IBRD, IDA
Borrowings thru AAA-rated bonds issued in global cap mkts
To Banks, Pension funds, Insurance cos, other Corporations Very conservatively managed. No defaults of either IBRD / IDA loans so far
7. Reforms Program
The tougher part of IBRD assistance. Calls for politically harsh decisions Poor donot suffer. Eg. Conditions include safety nets. L/T-Reforms Help poor Covenants for Adv countries too : Eg. Efforts to reduce US deficits
IBRD
1. Loans are to Govt for Infra projects generally (multiplier effect) 2. Members : 151 3. Sources : Subscription, Cap mkt borrowings, Retained earnings 4. Focus 5. Tenors : Emerging economies : Longer (15 = 5 +10)
6. Nature of Assistance : Loans / Guarantees for Pvt sector loans 7. Obligations of assisted Governments
Development of Industrial zones that facilitate free trade Polices that Promote of exports and Forex earnings Provision of Backward Linkages Improving institutions that promote trade facilitative zones Emphasis on Environmental / Womens empowerment / child labor issues
IDA
1. Aids to Developing countries (LDCs) for Infra, typically 2. Members : 137
3. Sources : Subscription by Rich members, Retained earnings

4. Focus 5. Tenors : Poorer nations amongst LDCs (Per apita < $ 480) : Extremely Long ( 50 = 10 + 40)
6. Nature of Assistance : Cheaper Loans 7. Admin : Same staff as IBRD. Focus Countries - different
7. Obligations of assisted Governments

Inclusive growth Emphasis on Environmental / Womens empowerment / child labor issues Conditionalities (Structural )
IFC
1. Target :Private sector in developing countries
2. Members : 133
3. Sources : Member subscription, Retained earnings

4. Tenors : Long ( 15 = 5 + 10)
5. Nature of Assistance Providing Risk capital to Tgts : Equity and LT loans Encouraging local Cap mkts : Eg U/writing Providing Tech and Fin assistance
6. Assistance covers a spectrum of industries
IMF
1. Commences operations in 1947 2. Membership is 182 countries (Initial m/ship 39) 3. Total Member quotas - $ 300 Billion (Member shares are a constant)
4. Participation voluntary
5. Currency unit - SDR ( = $ 1.3703)
6. Members came together to enjoy adv of a stable system of exch rates 7. Lends to Support Exch rate stabilization, s/to members u/taking Structural adj 8. Has withstood the test of time & facilitated increased Vol of Global Trade/Invt
IMF 1. Roles
Exchange rate stability, Global trade promotion, Payment facilitation
2. Activity
ER Surveillance (Bilateral and multilateral), Tech assistance, Fin assistance
3. Nature of Fin assistance 3 major ones

A. Standby Arrangements

For S/T BOP deficits of a cyclical nature Tenor upto 18 mths. Drawings periodic and conditional cascade of tranche release Purchase of member country currency/sale of another to support its parity Repurchase after 4-5 yrs
B. Extended Arrangements

For Medium Term Structural BOP problems Purchase based support. Repurchase max 10 yrs
C. Structural Adjustment facility

Loans not purchases for typically LDCs. Drawals semi annual Designed to address L/T structural imbalances in BOP situation Easier terms. 0.5% Intt. 10 yr Tenor. 1st Semi-annual repayment 5.5 yrs
Global financial Institutions

Sl no Particulars IBRD
To Help war ravaged economies thru Tech and Fin help Govt / Govt agencies / Pvt sector that can get a Govt guarantee Loan
IDA
Same as for IBRD (Aid instead of loan)
IFC
To promote eco dev in Developing nations by assisting pvt sector Pvt sector / Govt organizations that help Pvt enterprises Loan All developing countries from the poorest to the more advanced 7 - 12 yrs 3 yrs Mkt linked No
Purpose
2 3
Target Customers Nature of Assistance
Governments Concessional Aid
4 5 6 7 8
Type of countries Tenor Grace period Pricing Govt Guarantee
All Developing other than the Poorest 15 - 20 yrs 3 - 5 yrs @ 10% Yes
Poor countires 50 yrs 10 yrs 0% Yes
Method of raising Finance
Borrowings, Capital Markets
Grants from world Govt's
Borrowings and Capital, subscribed by members
Asian Development Bank

1. Strategic Objectives

Assist Small and less developed countries of the region Economic Growth across sectors Poverty reduction Human development Gender Development Environmental Development
2.
Composition
Membership open to Countries in the Asia Pacific Region Two largest share holders US and Japan with 16% each
3.
Evaluations

Country and project evaluation Project effectiveness (Viability, Impact, implementability, sustainability) operational evaluation (project completion evaluation etc)
Asian Development Bank

4. How Does it assist
Financing Multi /Single currency loans and Market based loans to pvt sector Co financing and Guarantees to Govts or Private sector borrowers Also uses its technical Knowledge Base and Network
5.
Finance sources
Ordinary Capital resource from members, Reserves and Mkt borrowings
6. Reforms Program

The tougher part of ADB assistance. Calls for politically harsh decisions Poor donot suffer. Eg. Conditions include safety nets. L/T-Reforms Help poor Covenants for Adv countries too :
Balance of Payment Accounting
Parity Conditions and
CHAPTER OVERVIEW
I. II. III. IV. V. VI. VI.
ARBITRAGE AND THE LAW OF ONE PRICE PURCHASING POWER PARITY THE FISHER EFFECT THE INTERNATIONAL FISHER EFFECT INTEREST RATE PARITY THEORY THE R/SHIP BETWEEN FORWARD AND FUTURE SPOT RATE CURRENCY FORECASTING
VII.
PART I.
I.
THE LAW OF ONE PRICE A. Law states:
- Identical goods sell for the same price worldwide.
B. Theoretical basis:
- If the price after exchange-rate adjustment were not equal,

- Arbitrage in the goods worldwide ensures it will, eventually

C.
5 Parity Conditions Result From these Arbitrage Activities 1. 2. 3. 4. Purchasing Power Parity (PPP) Relative Purchasing Power Parity International Fisher Effect (IFE) Interest Rate Parity (IRP)

Five Parity Conditions Linked by ;
1.The adjustment of various rates and prices to inflation.
2. Notion that money should have no effect on real variables

(since they are adjusted for price changes).
3. The Law of one price enforced by international arbitrage.
Inflation & home currency depreciation :
1.
jointly determined by Gr of domestic money Supply;
2.
Relative to the growth of domestic money demand.
PART II. PURCHASING POWER PARITY

I.
THE THEORY OF PURCHASING POWER PARITY:
States that spot Exch rates between currencies will change
based on differential in inflation rates between countries.

II. Absolute
PPP
A.
Price levels adjusted for Exch rates should be equal between countries
B. One unit of currency has same Purchasing Power globally.
Purchasing Power Parity absolute & Relative
20.0% Items Burger Vol 100 2008 100 2009 2008 10,000 2009 2008 2
10.0% 2009 2008 200 2009
20.0% Items Burger Vol 100 2008 100 2009 120 2008 10,000 2009 12,000 2008 2
10.0% 2009 2.2 2008 200 2009 220
20.0% Items Burger Lee Jeans Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 2009 12,000 12,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 2009 220 220
20.0% Items Burger Lee Jeans Total Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 2009 220 220 440
20.0% Items Burger Lee Jeans Total Exch rate by Price comparison Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 50.00 2009 220 220 440 54.55
20.0%
Items Burger Lee Jeans Total Exch rate by Price comparison Exch rate by Formula ( Infl Diff Abs) Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0%
2009 2.2 22.0 2008 200 200 400 2009 220 220 440
50.00
54.55
1.20/1.10
1.091
50.00
54.55
20.0% Items Burger Lee Jeans Total Exch rate by Price comparison Exch rate by Formula ( Infl Diff Abs) Vol 100 10 2008 100 1,000 2009 120 1,200 2008 10,000 10,000 20,000 2009 12,000 12,000 24,000 2008 2 20
10.0% 2009 2.2 22.0 2008 200 200 400 50.00 2009 220 220 440 54.55
1.20/1.10
1.091
50.00
54.55
Exch rate by Formula (Infl Diff Rel)
1.20/1.10
1.091
45.00
49.09
Limitations
1. Tariffs, Quotas, Transportation costs, Other trade barriers 2. Non-traded goods & Services (like Beauticians) excluded

III. Relative
PPP
States that the exchange rate of one currency agt. another
will adjust to reflect Ch in Price levels of the two countries.
If purchasing power parity is Expd to hold, then
The best prediction for the one-period Spot rate should be
et e0
i 1
f
ih 1
t t

A more simplified but less precise relationship is The % change should be approximately equal to - The Inflation rate differential (in decimals not %).
et 1 ih i f e0

A. Real exchange rates
If exchange rates adjust to Inflation differential, then ; PPP states that real exchange rates stay the same.
B. If Real exchange rates unchanged, - Competitive positions of Domestic & foreign firms are unaffected.
III. The Fisher Effect (FE)

I.
THE FISHER EFFECT states that

- Nominal interest rates (r) are a function of
- Real Interest rate (a) and

- A Premium (i) for inflation expectations.
r = a + i
THE FISHER EFFECT

B. Real Rates of Interest
1. Should tend toward equality everywhere thru arbitrage. 2. With no Govt interference, nominal rates vary by Infl. Diff
rh
rf = ih - if
3. According to the FE, - Countries with higher inflation rates have higher interest rates.
D.
Due to capital market Integration globally,

- Interest rate differentials are eroding.

IFE = PPP + FE
et e0 (1 rh ) 1 t e0 (1 r f )
t

Interest differential in favour of Foreign Currency in % pa
Arbitrage outflow
Interest parity
Forward exchange rate - Discount or Premium in % pa
22.50 23.25 3.33%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR
22.50 23.25 3.33% 10.20% 11.00% 0.80%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible
22.50 23.25 3.33% 10.20% 11.00% 0.80%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @
22.50 23.25 3.33% 10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest
22.50 23.25 3.33% 10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3
Cumulative
4,897.8
22.50 23.25
Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest Cumulative Sell DM fwd and Trfr to INR Yield %
3.33%
10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3 4,897.8
23.3
113,873.3 13.87%
22.50 23.25
Intt Rate DM Intt Rate INR Intt Rate diff for INR Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest Cumulative Sell DM fwd and Trfr to INR Yield % Return if Invested in INR 11.00%
3.33%
10.20% 11.00% 0.80%
100,000.0 10.2%
4,444.4 453.3 4,897.8
23.3
113,873.3 13.87% 1,11,000.0

IFE = PPP + FE
(1 rh ) e1 1 e0 (1 rf )
1
Exchange Rate : Determination

(100,000/22.5)*(1+0.102)* 23.25 (A/E0) * (1+Rf) * E1 A * (1 + Rf) * (E1/E0) = 100,000 *(1+0.11) = A * (1+Rh) = A * (1+Rh)
(1 + Rf) * (E1/E0)
(E1/E0)
= (1+Rh)
= (1+ Rh) / (1+Rf)
140

IFE = PPP + FE
et (1 rh ) t e0 (1 rf )
t

Covered Interest Arbitrage
Conditions required:
i. Interest rate differential does not equal the forward premium or discount.
ii. Funds will move to a country with a more attractive overall yield.

Market pressures develop:
a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates. c. Parity eventually reached.
Summary: Interest Rate Parity states : 1. Higher intt rates on a currency offset by Forward Discount 2. Lower interest rates are offset by forward premiums
IFE
Implications of IFE - Currency with lower Intt rate is Expd to appreciate ; - Proportionately - Relative to one with a higher rate. - Due to Arbitrage
International Fisher Effect

Simplified IFE equation: (if rf is relatively small)
rh rf
e1 e0 e0
Equilibrium Exchange Rate Relationships
E(e)
IFE PPP
(i$ -i Rs)
FE FRPPP
(E1 - E0 ) E0
$ - Rs
Determination of Exchange Rates & BOP
Lecture Objectives
Determination of Exchange Rates

Introduction to Balance of Payments

Balance of Payments Accounting
BOP & Exchange Rates
Determination of Exchange Rates
Parity Conditions Approach
PPP is the oldest and most widely followed of ER theories.
Most ER theories have PPP elements embedded in them

PPP forecasts are plagued with structural differences across countries and significant data challenges in estimation.
Balance of Payments Approach
BOP approach is the 2nd most utilized theoretical approach in ER The basic approach : Equilibrium ER is found when currency flows match up current and financial account activities. This framework has wide appeal as BOP transaction data is readily available and widely reported. Critics may argue that this theory does not take into account stocks of money or financial assets.
Asset Market Approach
Argues that ER determined by Supply of and demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter ER

Changes in monetary and fiscal policy alter Expd returns & perceived relative risks of Fin assets, which alter ER.
Asset Market Approach

approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others):
Relative real interest rates
Prospects for economic growth

Capital market liquidity A countrys economic and social infrastructure Political safety Corporate governance practices Contagion (spread of a crisis within a region) Speculation
Equilibrium Exchange Rate
INR/$
Equilibrium
D S
45
Qty
Reality check : What Changes the Equilibrium Rate (Empirically) ?
Inflation rates: Higher domestic inflation means less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).
Interest rates: Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. Economic growth: Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.
Reality Check :What Changes the Equilibrium Rate?
Political & economic risk: Higher political or economic risk in the domestic country results in increased demand and reduced supply of foreign currency.
Changes in future expectations: Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency. Government intervention: Maintain weak currency to improve export competitiveness.
Forecasting in Practice
Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.
Some multinational firms have their own in-house forecasting capabilities. Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.
Technical Approach
Tech. analysis looks for patterns in the past behavior of ER.
It is based upon the premise that history repeats itself.
Thus it is at odds with the Efficient Mkt Hypothesis
Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate.
Exchange rate movements can be subdivided into three periods:

Day-to-day Short-term (several days to several months)
Long-term
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be.
Forecasting for L/T must depend on the Eco fundamentals of ER determination, Many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.
Currency Forecasting Project
For each currency you can do the following:

RPPP and IFE (long-term influences) Technical analysis (past trends) Asset market approach (ongoing relationships and changes?) Balance of payments approach
Then you conclude with your overall prediction based on all of these methods and allocate funds to your trading strategy.
Performance of the Forecasters

Forecasting is difficult, especially with regard to the future.
As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.
The founder of Forbes Magazine once said: You can make more money selling advice than following it.
Balance of Payments
BOP
is a comprehensive record of all eco transactions between residents of a country With the Rest of the World (ROW) Of a given period of time
BOP is a Statistical record of the flow of all Eco transactions In goods , services, Incomes & C/flows (and ch in SDR,Forex Reserves & monetary Gold as well) Between the residents of a country and the rest of the world in a given year. Resident : eco entities that have a closer association with a given territory than another wrt their given eco activity
Balance of Payments
Sl/ No Particulars 1 Export of Goods 2 Import of civilian goods 3 Export of Services 4 Import of Services 5 Income Paymens 6 Income Receipts 7 Net Unilateral transfer O/flow 8 Net Current Account 9 Indian Pvt invt overseas 10 Foreign Pvt Invts in India 11 Foreign Official lending to India
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow
O/flow
Net
821.8 1077.9 355.3
12 Indian Official lending abroad 13 Statstical discrepency (+) 14 Net Capital A/c
15 Deficit Till now 16 Actual (deficit) /Surplus 17 Official Reserve Incr / (decr)
166
(1.5) 51.9
Sl/ No Particulars 1 Export of Goods 2 Import of civilian goods 3 Export of Services 4 Import of Services 5 Income Paymens 6 Income Receipts 7 Net Unilateral transfer O/flow 8 Net Current Account 9 Indian Pvt invt overseas 10 Foreign Pvt Invts in India 11 Foreign Official lending to India 12 Indian Official lending abroad 13 Statstical discrepency (+) 14 Net Capital A/c 15 Deficit Till now 16 Actual (deficit) /Surplus 17 Official Reserve Incr / (decr)
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1
821.8 1077.9 355.3 (1.5) 51.9
167
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2
821.8 1077.9 355.3 (1.5) 51.9
168
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0
821.8 1077.9 355.3 (1.5) 51.9
169
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 (665.9)
821.8 1077.9 355.3 (1.5) 51.9
170
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 (665.9)
821.8 1077.9 355.3 (1.5) 51.9
171
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 355.3 (1.5) (665.9)
821.8 1077.9 355.3 (1.5) 51.9
172
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 355.3 (1.5) 51.9 1485.1 820.5 664.6 (665.9)
821.8 1077.9 355.3 (1.5) 51.9
173
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 355.3 (1.5) 51.9 1485.1 820.5 664.6 (1.3) (665.9)
821.8 1077.9 355.3 (1.5) 51.9
174
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 355.3 (1.5) 51.9 1485.1 820.5 664.6 (665.9)
821.8 1077.9 355.3 (1.5) 51.9
(1.3)
175
1.5
Details 807.6 1473.1 339.6 291.2 344.9 369.0 72.9
Inflow 807.6
O/flow
Net
1473.1 339.6 291.2 344.9 369.0 72.9 1516.2 2182.1 821.8 1077.9 355.3 (1.5) 51.9 1485.1 820.5 664.6 (1.3) (665.9)
821.8 1077.9 355.3 (1.5) 51.9
176
1.5 (2.8)
BOP in Total
A surplus in the BOP implies that The demand for the countrys currency exceeded the supply and the Govt should allow the currency value to increase or Intervene & accumulate additional Forex reserves in the Official Reserves Account. A deficit in the BOP implies An excess supply of the countrys currency on world markets & The Govt should then either devalue the currency or Expend its official reserves to support its value.
Accounting Principles
1.
Any transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and given a positive sign. Current Account records transactions involving exports and imports of goods and services Capital Account records transactions involving the purchase and sale of assets. Double-Entry book keeping: Every international transaction automatically enters twice, once as a credit and once as a debit.
2.
3.
4.
5.
Examples of Transactions
Credit Transactions (+ve): Provision of goods and services to non-residents Income receivable from non-residents A decrease in foreign financial assets An increase in foreign financial liabilities
Debit Transactions (-ve): Purchase of goods & services from non-residents Income payable to non-residents An increase in foreign financial assets A decrease in foreign financial liabilities
Examples of Transactions
An Australian Co exports goods worth US$1 million to the US : Export of goods is credit for the current account. Increase in foreign asset (US$1 million) is debit for capital account. Australian company then coverts US$ into A$ and buys government bonds back in Australia: Decrease in foreign asset is credit for the capital account. Increase in government liability is debit for Official Res a/c Australian individual imports a sports car from Europe: Increase in foreign liabilities is credit for the Capital a/c Import of goods is debit for current account.
BOP & Macroeconomic Variables
A nations balance of payments interacts with nearly all of its key macroeconomic variables.
Interacts means that the BOP affects and is affected by such key macroeconomic factors as: Gross Domestic Product (GDP) Exchange rate Interest rates Inflation rates
A countrys BOP can have a significant impact on the level of its exchange rate and vice versa.
The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes the BOP (see next slide).
(X M) + (CI CO) + (FI FO) + FXB = BOP Where: X = exports of goods /services M = imports of goods /services CI = capital inflows CO = capital outflows
Current Account Balance
Capital Account Balance
FI = financial inflows FO = financial outflows FXB = official monetary reserves
Financial Account Balance
Fixed Exchange Rate Countries Under a fixed exchange rate system, The government bears the responsibility To ensure that the BOP is near zero. Floating Exchange Rate Countries Under a floating exchange rate system, Surpluses/deficits influence exchange rate.
Trade Balances & Exchange Rates
A countrys import and export of goods and services is affected by changes in exchange rates. The transmission mechanism is in principle quite simple: Changes in exchange rates change relative prices of imports and exports, And changing prices in turn result in changes in quantities demanded Through the price elasticity of demand.
Theoretically, this is straightforward, in reality global business is more complex.
Trade Balances & Exchange Rates
Balance of Payments
Resident : Eco entities that have a closer association with a given territory than another wrt their given eco activity With a degree of Permanance to their stay IT act 180 days Individuals Pvt corp Pvt Non profit Govt : : : : Residential status as per IT/similar acts Residence per IT/similar act (>180 days /yr) The territory where they are functioning All govt establishments on the native land & All Embassies, Counsulates, military or other Establishment of native govt. on foreign soil Foreign embassies on Indian soil Non-Res.
Balance of Payments
Transactions are recorded on the basis of Double Entry Bookkeeping by definition it has to balance. Every source must have a use and every debit a Credit
The two main components are: Current Account Capital/Financial Account
Economic Transactions
Two Parties needed Exchange of Goods and services for Value (moneys worth) Exceptions Transactions between Br and Ho Transfers of assets by migrants to new country Such one sided, non quid pro quo transactions are called unrequited Transfers
Transactions need be between Residents and Non residents

Exception Purchase/Sale of Gold by Central Bank from/to Residents (both are resident) Claims on / Liabilities to ROW even if between 2 residents Sale of forex by Com. bank to central bank/ Vice versa
Valuation uniformity Cr & Dr items to balance Comparison across the world not possible w/out Comparison across items not possible otherwise IMF recommends Market Prices for uniformity
Exceptions to market price as the basis Issue of Sweat equity Branch and HO transactions Exports undervalued & Imports overvalued (money laundering) Exports are valued @ FOB and Imports @ CIF Forex conversion rates (Average, Spot Yr end?)
Timing issue To avoid discrepencies in BOP a/cs The time is when the legal ownership in goods/ services passes Exports : When the goods are cleared by customs for shipment Imports : On making the payment Advance: counted as imports Transport and other services : when paid for/ recd Unrequited: When the offset transaction happened Capex : When the flows happen
Special Transactions
SDR allocation Debit & Item allocation Cr or NW incr. SDR Reduction Cr & Item allocation Debit or NW Decr.
Gold is both a commodity and a Financial Asset Central banks Purchase of Gold converts a commodity into Cash (Monetization of Gold) Central banks sale of Gold reduces money Supply and increases (Gold) Commodity holding - Demonetization Unrequited Transfers Covers Grants, Gifts, transfers, taxes, Migrant trfr One side provides Eco Value w/out any quid pro quo One side of the entry is the utem recd the other side is transfers in India. Unrequited trfr in ROW
Undistributed Income attributable to Direct Investors Retained earnings Both a current a/c outflow and A Capital a/c inflow simulatneously
Balance of Payments
Current Account (CA)
This is record of a countrys trade in goods and services in the current period. CA = Exports (X) Imports (M)
It is
divided into 4 sub-categories: Goods trade Services trade Income Current transfers
The sum of the four sub-categories = CA balance
Capital Account (KA)
This includes all short- and long-term transactions pertaining to financial assets. KA = Capital Inflow (cr) Capital outflow (dr)
The two main components: Capital account. Financial account (direct, portfolio, other).
KA balance = Sum of capital account and financial account.
Official Reserves
Records the purchase or sale of official reserve assets by the central bank. These assets include Commercial paper, Treasury bills and bonds Foreign currency Money deposited with the IMF This account shows the change in foreign exchange reserves held by the central bank. Since the BOP must balance CA + KA + RFX = 0 The Balance of Payments Identity
CA + KA = RFX
For floating rate regime countries, such as the U.S., official reserves are relatively unimportant.
Statistical Discrepancy (E&O)
The identity CA + KA = RFX assumes that all transactions are measured accurately. Inaccurate recording of transactions (errors & omissions), results in the above equality not holding. For BOP to balance, CA + KA + E&O = RFX Assuming changes in official reserves, errors are approximately zero: Current Account = () Capital Account This will hold approximately for floating rate countries
CA -KA ( US $)
No
Transaction
Normal A/ctng
BOP A/ctng
Books of country 'A' Debit Credit
Res Exports worth $ 1,000 agt Bills
Exporter discounts bill with Res Bank On due Date, Bank gets funds From Citi NY and keeps funds therein. Int $ 50 A Imports of $ 800 from B. Paid thru loan from As Bank
No
Transaction
Normal A/ctng
BOP A/ctng
B/ Recbl Dr
1,000
Sales - exports Cr 1,000
Exporter discounts bill with Res Bank On due Date, Bank gets funds From Citi NY and keeps funds therein. Int $ 50 A Imports of $ 800 from B. Paid thru loan from As Bank
No
Transaction
Normal A/ctng
BOP A/ctng
B/ Recbl Dr
1,000
S/T foreign 1,000 Assets- BR Export 1,000
Exporter discounts bill with Res Bank
On due Date, Bank gets funds From Citi NY and keeps funds therein. Int $ 50
A Imports of $ 800 from B. Paid thru loan from As Bank
No
Transaction
Normal A/ctng
BOP A/ctng
B/ Recbl Dr
1,000
S/T foreign 1,000 Assets- BR
Export
1,000

On due Date, Bank gets funds From Citi NY and keeps funds therein. Int $ 50 A Imports of $ 800 from B. Paid thru loan from As Bank
Cash Dr B/ Recbl Cr
1,000 1,000
No
Transaction
Normal A/ctng
BOP A/ctng
Books of country 'A'

Debit Credit
B/ Recbl Dr
1,000
Cash Dr B/ Recbl Cr
1,000 1,000
On due Date, Bank gets funds From Citi NY and keeps funds therein. Intt Income Cr Int $ 50 A Imports of $ 800 from B. Paid thru loan from
Cash Dr
50
S/T Forn Asst (Cash)

ST Foreign Asset (BR)
1,050 1,000 50
50
Interest Income
No
Transaction
Normal A/ctng
BOP A/ctng

Debit Credit
B/ Recbl Dr
1,000
Cash Dr B/ Recbl Cr
1,000 1,000
On due Date, Bank gets funds From Citi NY and keeps funds therein. Intt Income Cr Int $ 50 A Imports of $ 800 from B. Paid thru loan from Imports Dr A Bank loan Cr
Cash Dr
50

1,050 1,000 50
50
Interest Income
800 800
Imports ST Foreign Asset
800 800
No
Transaction
Normal A/ctng
BOP A/ctng
B/ Recbl Dr Sales - exports Cr Cash Dr B/ Recbl Cr
1,000 1,000 1,000 1,000
On due Date, Bank gets funds From B bank & keeps funds therein. Intt $ Intt Income Cr 50 A Imports of $ 800 from B. Paid thru loan from As Bank Imports Dr A Bank loan Cr
Cash Dr
50

1,050 1,000 50
50
Interest Income
800 800
Imports ST Foreign Asset
800 800
No Transaction
Normal A/ctng
BOP A/ctng
Res (x) spends $ 5000 during foreign travel, by buying equivalent Bs currency in B
X finds $ 100 by chance on the Road
7 Expat sends $ 100 to his family in B The Family buys a $ bond from A
No
Transaction
Normal A/ctng
BOP A/ctng
Travel Dr Cash Cr
5,000 5,000
Travel ST Foreign Liab
5,000 5,000
7 Expat sends $ 100 to his family in B The Family buys a $ bond from A
No Transaction
Normal A/ctng
BOP A/ctng
Travel Dr Cash Cr
5,000 5,000
5,000 5,000
Cash Dr Misc Income
100 100
ST foreign assets Transfers
100 100
Expat sends $ 100 to his family in B The Family buys a $ bond from A
No Transaction
Normal A/ctng
BOP A/ctng
Travel Dr Cash Cr
5,000 5,000
5,000 5,000
Cash Dr Misc Income
100 100
ST foreign assets Transfers
100 100
Expat sends $ 100 to his family in B The Family buys a $ bond from A
Trfr Dr Bond Cr
100 100
Transfers LT Forn Liab
100 100
Sl No
Transaction
Normal A/ctng
BOP A/ctng
Biz man ships Eqpt abroad to build factory $ 50,000 Addl Invt of $ 20,000 paid thru bonds Y makes a profit of $ 10,000 and uses it to Buy Back Bs bonds
10
11 A buys B's bonds back (50%)
Sl No
Transaction
Normal A/ctng
BOP A/ctng
F Assets Dr 8 Biz man ships Eqpt abroad to build factory $ 50,000 Sales exports
50,000 50,000
LT Investments Exports
50,000 50,000
Addl Invt of $ 20,000 paid thru bonds

Y makes a profit of $ 10,000 and uses it to Buy Back Bs bonds
10
11
A buys B's bonds back (50%)
Sl No
Transaction
Normal A/ctng
BOP A/ctng
F Assets Dr
50,000
LT Investments
50,000
Biz man ships Eqpt abroad to build factory $ 50,000
Sales exports
50,000
Exports
50,000
F Assets Dr Addl Invt of $ 20,000 paid thru Bonds bonds payable Y makes a profit of $ 10,000 and uses it to Buy Back Bs bonds
20,000 20,000
LT Investments LT foreign Liabilities
20,000 20,000
10
Sl No
Transaction
Normal A/ctng
BOP A/ctng
F Assets Dr
50,000
LT Investments
50,000
Biz man ships Eqpt abroad to build factory $ 50,000
Sales exports
50,000
Exports
50,000
F Assets Dr Addl Invt of $ 20,000 paid thru Bonds bonds payable Y makes a profit of $ 10,000 and uses it to Buy Back Bs bonds
20,000 20,000
LT Investments LT foreign Liabilities
20,000 20,000
10 Bonds Dr Cash 10,000 10,000 LT Foreign liab ST Liabilities 10,000 10,000
Sl No
Transaction
Normal A/ctng
BOP A/ctng
12 Z from B migrates to country A with Property worth $ 9000
13
Of the above, house worth $ 8,000 sold for 8000 (4000 now : 4000 Defd)
14 Gives $ 1000 back to the church
Sl No
Transaction
Normal A/ctng
BOP A/ctng
12 Z from B migrates to country A with Property worth $ 9000 Assets Misc receipts (trfr) 9,000 9,000
ST For Assets LT Investments Transfers
1,000 8,000 9,000
13
Sl No
Transaction
Normal A/ctng
BOP A/ctng
1,000 8,000 9,000
13
Cash A/Recbls F Assets
4,000 4,000 8,000
ST Foreign Assets LT foreign Assets LT Investments
4,000 4,000 8,000
Sl No
Transaction
Normal A/ctng
BOP A/ctng
1,000 8,000 9,000
13
Cash A/Recbls F Assets
4,000 4,000 8,000
ST Foreign Assets LT foreign Assets LT Investments
4,000 4,000 8,000
Gift Expense Cash
1,000 1,000
Trfr Exps ST Foreign assets
1,000 1,000
,.
Sl No Transaction Normal A/ctng BOP A/ctng Books of country 'A'
15
Gold imports into 'A' - $ 300000
16 Migrant inherits wealth of $ 3,000
17
Gift of dress worth $ 200 sent to A
,.
15 Gold imports into 'A' - $ 300000 16 Migrant inherits wealth of $ 3,000 Imports Bank (Deposit) 300,000 300,000
Gold Imports ST Liab to forn
200,000 100,000 300,000
17
,.
15 Gold imports into 'A' - $ 300000 16 F Assets Migrant inherits wealth of $ Bank 3,000 Misc Income 17 2,000 1,000 Imports 300,000 300,000
200,000 100,000 300,000
Bank (Deposit)
LT Investments ST Foreign Fin assets Transfers
2,000 1,000 3,000
,.
15 Gold imports into 'A' - $ 300000 16 F Assets Migrant inherits wealth of $ Bank 3,000 Misc Income 17 Gift Exps Exports 2,000 1,000 Imports 300,000 300,000
200,000 100,000 300,000
Bank (Deposit)
LT Investments ST Foreign Fin assets Transfers
2,000 1,000 3,000 200 200
200 200
Transfer gift Export
,.
18
Farm sold for $ 2000. This + 1000 invested in Bonds in 'B'
19
Gift to 'B' $ 600 in A's currency
,.
Sl No Transaction Normal A/ctng Bonds Dr Assets Cr 18 3,000 2,000 1,000 LT FA STFA 3,000 3,000 BOP A/ctng ST FA LT Invst Books of country 'A' 2,000 2,000
Bank Cr
19 Gift to 'B' $ 600 in A's currency
,.
Sl No Transaction Normal A/ctng Bonds Dr Assets Cr 18 3,000 2,000 1,000 BOP A/ctng LT FA LT Invst STFA Books of country 'A' 3,000 2,000 1,000
Bank Cr
19
Gift ($600) to 'B' - $ 100 note + $ 500 of watch
Gift Exp Dr Cash Sales Cr Cr
600 100 500
Transfers ST Fin Liab. Exports
600 100 500
ST Foreign Assets
Exports (1) 1,000
Exports
ST Fin Asst (1)
1,000
Imports
ST Foreign Assets
Exports (1) Interest Income (3) Trfrs (6) 1,000 50 100
Exports
ST Fin Asst (1)
1,000 50,000 200 500 51,700
Trfr (14)
1,000
LT Invt (8) Trfrs (17) ST For Ass (19)
LT FA (18 a) LT Invt (13) Transfers (12) Transfer (19) LT Invst (18) Trfr (16) 1,000 9,150 4,000 1,000 0 2,000 Imports (4)
3,000
Bal
51,700
800
Imports
ST For Assets (4) 4,800 ST For Liab (15)
800
100,000 100,800 Bal 100,800
LT Foreign Assets LT Invt (13) ST FA (18 a) 4,000 3,000 7,000 Gold ST For Liab (15) 0 ST For Ass (14) Exports (17)
Trfrs 1,000 200 100 ST + LT Invts (12) LT Inv / ST As (16) 0 1,900 Services ST For Ass (19) 9,000 STF Asset (6) 100
LT Forn Liab (7)

ST FA + Exp (19)
600
200,000 200,000 LT Direct Investment
3,000 0 12,100
Exports (8) LT For Liab (9) Transfers (12) Transfers (16)
50,000 20,000 ST/LTF Asset (13) ST FA (18) ST Forn Liab (5)
8,000 2,000
5,000 5,000
ST Foreign (3)
50 50
8,000
2,000 80,000 10,000
LT Liabilities ST forn Liab (11) 10,000 LT Dir Invt (9) Transfers (7) 20,000 100 Notes Recbl (2) 10,000 ST Liabilities Travel (5) Imports (15) Gold (15) LT Forn Liab (11) Exp + Trfr (19) 0 5,000 100,000 200,000 Notes Receivable Cash (2) 1,000 20,100 Cash 1,000
10,000
100
315,100 1,000 1,000
BOP A/cs
Debit Exports Imports Net Trfs Services Cur Ac Balance 4,950 105,750 61,900 43,850 100,800 10,200 Credit 51,700
LT FA LT Dir Invs LT For Liab LT Cap ac ST For Liab Gold ST Fin Assets ST Cap Ac Net Fin flows
7,000 70,000 10,100 77,000 200,000 4,350 204,350 315,100 (110,750) 0 10,100 315,100 66,900
Current AC
Exports Merchandize Services
Inflow
Inflow Inflow
Outflow
Factor Income Import Merchandize Services
Inflow Outflow Outflow
Factor Income
Outflow
Nett Unilateral Trfr

Pvt Trfr Official Trfr Balance on Cur Ac Recevie Recevie Give Give
Capital Ac Net Direct Investment Portfolio Investment Other Capital Receive Payment from Foreigner, Sell Foreign Assets / Domestic Assets to foreigners Make Payment to foreigners, Buy Foreign Assets/ Dom Assets from foreigners
Balance on Cap Ac Statistical Discrepency Overall balance Official reserve Ac Indian official Reserve Foreign Official Reserve Balance of Reserve - Balance - Balance - Balance + Balance + Balance + Balance
India vs ROW ($ = 50 Rs) 1. X an Indian exports Rs 50,000 of merchandise to US against BOE.
2. Y an Indian imports Rs 75,000 of merchandise from US against payment

3.An NRI sends $ 3,000 to his parents in India. Parents invest it in 2 yr FD 4. An Indian Sends Rs 5,000 worth of jewellery as gifts to his daughter in US 5. A US Auto co sends Cap eqpt worth $ 30,000 to India
Exchange Arithmetic
234
Forex
1. Retail Vs Wholesale Mkt

Individual and Bank

Small volumes and High margins
Banks, Invt Inst, NB Corp and Central banks Large Volumes (Avg size $ 4 mn) & small margins
2. Primary Vs Secondary Price makers

Primary : 2-way quote Secondary : 1 way quote : restaurants, hotels, export shops
3. Spot Vs Forward markets
4. Direct Vs Indirect Quotes

One unit of Forex = How many units of Rs One unit of Rs = How many units of Forex
235
Forex
236
You have called your Bank's forex trader and asked for quotations on US $ vis--vis INR
and received the same as below for Spot, 1-mth fwd, 3-mth fwd, 6-Mth forward
$ 2.479/81
"
3/5
"
8/7
"
13/10
a. What does it mean in terms of Dollar per INR b. If you wished to buy spot dollars, how much would you pay in INR c. What is the percent discount /Premium on Dollars
237
You have called your Bank's forex trader and asked for quotations on US $ vis--vis INR and received the same as below for Spot, 1-mth fwd, 3-mth fwd, 6-Mth forward
$ 2.479/81
"
3/5
"
8/7
"
13/10
a. What does it mean in terms of Dollar per INR b. If you wished to buy spot dollars, how much would you pay in INR c. What is the percent discount /Premium on Dollars Forex dealer ready to Exchange Rs 100 Buy Rs @ Sell Rs @ Spot $ 2.479 $ 2.481 Sell $ @ Buy $ @
238
$ 2.479/81
"
3/5
"
8/7
"
13/10
a. What does it mean in terms of Dollar per INR b. If you wished to buy spot dollars, how much would you pay in INR c. What is the percent discount /Premium on Dollars
Forex dealer ready to

Buy Rs @ Sell Rs @ Spot $ 2.479 $ 2.481 Sell $ @ Buy $ @ 40.339 40.306
239
$ 2.479/81
"
3/5
"
8/7
"
13/10
a. What does it mean in terms of Dollar per INR b. If you wished to buy spot dollars, how much would you pay in INR c. What is the percent discount /Premium on Belgian francs Vs Dollars

Buy Rs @ Sell Rs @ Spot One month 1 $ 2.479 $ 2.482 $ 2.481 Sell $ @ 40.339 Buy $ @ 40.306
240
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month 1 $ 2.479 $ 2.482 $ 2.481 $ 2.486 Sell $ @ 40.339 Buy $ @ 40.306
241
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month 1 $ 2.479 2.482 $ 2.481 2.486 Sell $ @ 40.339 40.290 Buy $ @ 40.306 40.225
242
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month 1 $ 2.479 2.482 $ 2.481 2.486 1.45% 2.42% Sell $ @ 40.339 40.290 Buy $ @ 40.306 40.225
243
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month Three Month 1 3 $ 2.479 2.482 2.471 $ 2.481 2.486 2.474 1.45% 2.42% Sell $ @ 40.339 40.290 Buy $ @ 40.306 40.225
244
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month Three Month 1 3 $ 2.479 2.482 2.471 $ 2.481 2.486 2.474 1.45% 2.42% Sell $ @ 40.339 40.290 40.469 Buy $ @ 40.306 40.225 40.420
245
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month Three Month 1 3 $ 2.479 2.482 2.471 $ 2.481 2.486 2.474 1.45% -1.29% 2.42% -1.13% Sell $ @ 40.339 40.290 40.469 Buy $ @ 40.306 40.225 40.420
246
$ 2.479/81
"
3/5
"
8/7
"
13/10

Buy Rs @ Sell Rs @ Spot One month Three Month Six month 1 3 6 $ 2.479 2.482 2.471 2.466 $ 2.481 2.486 2.474 2.471
247
Sell $ @ 40.339 1.45% -1.29% 2.42% -1.13% 40.290 40.469 40.552
Buy $ @ 40.306 40.225 40.420 40.469
$ 2.479/81
"
3/5
"
8/7
"
13/10

248
Sell $ @ 40.339 1.45% -1.29% -1.05% 2.42% -1.13% -0.81% 40.290 40.469 40.552
Buy $ @ 40.306 40.225 40.420 40.469
$ 2.479/81
"
3/5
"
8/7
"
13/10

249
Sell $ @ 40.339 1.45% -1.29% -1.05% 2.42% -1.13% -0.81% 40.290 40.469 40.552
Buy $ @ 40.306 40.225 40.420 40.469
250
Customer asks you to book a forward contract in DM 400,000 6 mts hence TT Margin 0.1500% Bill Margin 0.200%
D M quotes in Singapore as below Spot US 1 $ = DMs 1.5840 0.0300 0.0585 1.5850 0.0290 0.0575
3 mth forward ($ at Disc) 6 mth ($ @ disc)
Us $ quoted in interbank market as below

Spot US 1 $ = Rs 31.8500 32.4500 31.9000 32.5000
3 mth forward premium
6 mth premium
33.2000
33.2500
6 Mth. forward Re / $ rate
33.2500
6 Mth. forward Re / $ rate 6 Mth. Forward DM /$ Rate
33.2500
Spot
1.5840
33.2500
Spot
6 mth forward Prem. 6 mth forward Rate
1.5840
0.0585 1.5255
33.2500
Spot
6 mth forward Prem. 6 mth forward Rate Cross Rate DM / Rs
1.5840
0.0585 1.5255 21.7961
33.2500
Spot
6 mth forward Prem. 6 mth forward Rate Cross Rate Add Exch margin for TT Selling TT Selling Rate DM / Rs 0.15%
1.5840
0.0585 1.5255 21.7961 0.0327 21.8288
33.2500
Spot
6 mth forward Prem. 6 mth forward Rate Cross Rate Add Exch margin for TT Selling TT Selling Rate ADD Exch Margin for Bill selling Bill selling Rate 0.20% DM / Rs 0.15%
1.5840
0.0585 1.5255 21.7961 0.0327 21.8288 0.0437 21.8725
Customer does a swap of Selling Spot and Buying 2 mth forward $ US $ quoted @ 2 Mths Froward $ quoted @ Forward Rate Inerest Mumbai / US Brokerage (flat) / No of Mths 31.19 0.27 31.46 12.00% 0.0075%
100,000 31.22 0.27 31.49 6.00% 2
Selling $ spot @ 31.19 Less Brokerage Selling $ spot

3119*7.5%*2/12
3,119,000 234 3,118,766
Selling $ spot Less Brokerage Selling $ spot Interest earned in Rs Cumulative INR recd
3,119,000 234 3,118,766 62,375 3,181,141
3,119,000 234 3,118,766 62,375 3,181,141
3,119,000 234 3,118,766 62,375 3,181,141
Reversion to $
Less Brokerage Nett Recd on reversion
101,021
8 101,013
3,119,000 234 3,118,766 62,375 3,181,141
Reversion to $
Less Brokerage Nett Recd on reversion Intt Cost on $ Cos Paid
101,021
8 101,013 1,000 101,000
Profit (Loss) on Swap
13
3,119,000 234 3,118,766 62,375 3,181,141
Reversion to $
Less Brokerage Nett Recd on reversion Intt Cost on $ Cos Paid
101,021
8 101,013 1,000 101,000
Profit (Loss) on Swap
13
Bank Agrees to sell on 20 th Feb for 20th Apr delivery Sing $ Agreed rate Cover Deal 20th Mar, Customer wants sale to be advanced Rates on 20th Mar for 20th April Spot Forward 1 mth 19.71
10,000 19.52 19.47
19.76 19.70
19.65
Sell amount
195,200.00
Buy amount
Nett Margin
194,700.00
500.00
Sell amount
195,200.00
Buy amount
Nett Margin Pre Closure Deal Buy 20th Mar spot and Sell forward 20th Apr 20th Mar deals net cost Buy spot 10,000 Sing $ Sell forward Sing $ Apr 20 Nett Loss debited to customer
194,700.00
500.00
197,600.00 196,500.00 (1,100.00)
Sell amount
195,200.00
Buy amount
Nett Margin Pre Closure Deal Buy 20th Mar spot and Sell forward 20th Apr 20th Mar deals net cost Buy spot 10,000 Sing $ Sell forward Sing $ Apr 20 Nett Loss debited to customer Transaction cost debited Total Debit to Customer Ledger Original contract
194,700.00
500.00
197,600.00 196,500.00 (1,100.00)
195,200.0
Swap loss
Transaction Fee Total Debit
1,100.0
100.0 196,400.0
Sell amount
195,200.00
Buy amount
Nett Margin Pre Closure Deal Buy 20th Mar spot and Sell forward 20th Apr 20th Mar deals net cost Buy spot 10,000 Sing $ Sell forward Sing $ Apr 20 Nett Loss debited to customer Transaction cost debited Total Debit to Customer Ledger Original contract
194,700.00
500.00
197,600.00 196,500.00 (1,100.00)
195,200.0
Swap loss
Transaction Fee Total Debit
1,100.0
100.0 196,400.0
Derivatives
1. Value is derived from another underlying contract, reference or index 2. Recent developments have transformed them into a cheap & efficient means of Hedging : Neutralizes risk by fixing the price in Adv. For eg. Price of $ = 47 Rs on 1.Dec 09 Arbitraging : Take adv of discrepancy in prices across markets. Speculating : Take a directional bet. Thus contribute liquidity 3. Arrival of Floating Intt rate regime post 73, heralded the need for Risk mitigation mechanisms 4. Led to the development of Exchange traded Forex futures in Chicago 5. Computers expedited growth, since fast computing of complex derivative pricing became feasible
6. Three risks Market Basis Counter Party risk

7. 4 products Forwards Futures Options Swaps
: The Value of derivative changing, esp as expiry approaches : Hedge may not be a perfect match to the Risk one is exposed to : CP not paying up. Less than for Loans, for only diff is at stake
: : : :
Two-way negotiated agreement. OTC. Gen, when Exact date unknown Exchange traded. Standard Contracts wrt Price, settlement date, contracts no. Right but not obligation to buy/sale. Option to Buy - call. Option to sell - Put 2-way Contr. to exchange 2 streams of payment for a period. Fix to float
Derivatives 1. Value is derived from another underlying contract, ref or index Correlation may be positive or negative Derivatives are possible only if two contrary views are likely
2. Recent developments have transformed them into a cheap & efficient means of Hedging : Neutralizes risk by fixing the price in Adv. For eg. Price of $ = 47.10 Rs on 1.Jan 2010 Arbitraging : Take adv of discrepancy in prices across Mkts. Speculating : Take a directional bet. Thus contribute liquidity
3. Arrival of Floating Intt rate regime post 73 heralded the need for Risk mitigation mechanisms 4. Led to the development of Exch.-Traded Forex futures in Chicago
Derivatives 5. Computers expedited growth, since fast computing of complex derivative pricing became feasible 6. Three risks Mkt : The Value of derivative changing, esp as expiry approaches Basis : Hedge may not be a perfect match to the Risk exposure Counter Party risk : CP not paying up. Less than for Loans, for only diff is at stake Exists only for OTC. In Exch. traded, CP is the Exch-CH itself. Hence OTC has lesser liquidity than Exchange-traded 7. Four products Forwards : 2-way. OTC. Negotiated. Used when Exact date unknown Futures : Exch-traded. Std Cont wrt Price, Size, Setl. date, Cont. no. Options : Exch. Right /no obligation to buy/sale. Call Buy. Put Sell Swaps : OTC. 2-way Cont. Exc of Payt strm for a period. Eg. Fix-float
A. Forwards
1. A Forward contract is a negotiated agreement between two parties.
2. Tailor-made OTC contracts not traded on organized exchanges 3. Used to cover forward recbls/ payables where the date of trn. Is not fixed 4. Generally dont involve an upfront margin except an admin fee in some. 5. Example a. Infy IT export $ 10,020 on 21st Feb. Gets a B/E for it, due 31st Mar 10 b. Re/$ rate on 21st Feb (say) 45.5 Rs/ $ c. Infy is unsure of the Exchange rate on 31st Mar 10 and wants a hedge
d. SBI gives a quote for 31st Mar @ 46/$
Currency Futures 1. It is the price of a particular currency for settlement at a future date. 2. Futures are traded on future exchanges 3. Exchanges with contract fungibility (freely transferred) are popular. 4. Standardized wrt Quantity of u/lying, Expiration date and delivery
a. Infosys eg. above. 1 unit @ 46/$. Min $100/ Contr. 100 Contr. for a hedge b. Still hedge is not perfect ($ 20 not covered). c. Pl remember. The price of 46/$ will keep varying by the minute on the screen d. The above Exchange rate of Rs. 46/$ is a price @ a particular point in time
5. Futures are rarely settled by delivery. Closed out by a reverse transaction

a. Buy order 100 Contr. ($ 10,000) can be reversed with a Sell order for same b. A future contract for selling $ 10,000 reversed with a buy for a similar Amt
7. Profit or loss from the net position is absorbed by the concerned.
Traders in the Derivative Market Hedgers

Typically, corporates with Exim transactions hedge Eg. Co a has ECB repayment $ 100,000/ Qtr. Over 4 quarters Co can either keep it naked. Or hedge. Suppose it hedges SBI offers @ 46, 46.5, 47.0, 47.5 for 1 year (4 Qtrs) Typically quote is Fn of (Interest rate Diff and Trns costs) Speculators Take a directional bet. Thus contribute to Liquidity
Interested, generally, only in the net result (P&L)

Arbitrageurs Take adv of discrepancy in prices across markets. s/to Transaction costs Eg. Price of a scrip Rs 220 in DSE and Rs 200 in BSE. If Trn cost =10
Forwards Vs Futures
Features
Forwards
Futures
Trading Settlement Contract specs Counterparty Risk Liquidity Price discovery
Not traded on exchange Direct between clients May differ from trade to trade. Hi flexibility Exists Poor, for contracts are tailor made Poor as markets are fragmented
Traded on Exchange Thru the clearing house of the Exchange Standardized contracts only Nil, Since CP is Clearing house of exch for all contracts High. For contracts are std and exchange-traded Better, as traded on a transparent Exchange
Pricing of Forwards /Futures : Calculations Sl no Parameters $ 100 INR 5000 Spot / Fwd rate 50.0
1 Spot Exch rate (Rs/$)
Sl no
Parameters
INR
Spot / Fwd rate
2 Period (Yrs)
3 ROI
1
6.00%
1
12.00%
Sl no
Parameters
INR
Spot / Fwd rate
2 Period (Yrs)
3 ROI 4 Return
1
6.00% 6
1
12.00% 600
Sl no
Parameters
INR
Spot / Fwd rate
2 Period (Yrs)
3 ROI 4 Return 5 Cumulative
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
INR
Spot / Fwd rate
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
3 ROI ( % /100)
1
Rf
1
Rd
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
3 ROI ( % /100) 4 Return
1
Rf 1* Rf *1
1
Rd S* Rd*1
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
3 ROI ( % /100) 4 Return 5 Cumulative
1
Rf 1* Rf *1 (1+Rf)
1
Rd S* Rd*1 S+(S*Rd*1)
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
3 ROI ( % /100) 4 Return 5 Cumulative 6 Cumulative
1
Rf 1* Rf *1 (1+Rf) 1+Rf
1
Rd S* Rd*1 S+(S*Rd*1) S*(1+Rd) S*(1+Rd)^n/(1+Rf)^n
2 Period (Yrs)
1
6.00% 6 106
1
12.00% 600 5600 52.8
Sl no
Parameters
$ 1
INR S
Spot / Fwd rate S/1
2 Period (Yrs)
3 ROI ( % /100) 4 Return 5 Cumulative 6 Cumulative 7 Forward Rate
1
Rf 1* Rf *1 (1+Rf) 1+Rf 1.06
1
Rd S* Rd*1 S+(S*Rd*1) S*(1+Rd) S*(1+Rd)^n/(1+Rf)^n 56.00 52.8
Options 1. The right to Buy or sell w/out an obligation to do so
2. Two types of options

3. Call gives the buyer
: Call options and put options.
a. The right but not the duty
b. To purchase an underlying asset, reference rate or index

c. At a particular price before a specified date. d. Infy eg. A call option to buy $ @ Rs. 46. Option Premium : Rs 0.80/unit e. 1 contract Option premium : Rs. 80. 100 contr. Rs 8,000 paid
4. A put gives the buyer

a. The right, but not an obligation b. To sell an underlying asset, reference rate or Index c. At a particular price on a specified date.
Options : Based on exercise : Two Types 1. American Option : Can be exercised by buyer any time upto the expiration 2. European Option : Can be exercised only on the expiration date
Based on Contracting Party : Two types
1. Buying of options : Gives a right but not an obligation to buyer

2. Selling of options : Confers an obligation but not a right to sell/buy 3. Hence, Buyer pays a premium to buy the option. Risk Ltd. Rev Un-ltd 4. Sellers prem. is to compensate for his risk. Risk Un-ltd. Rev Capped Based on Profitability 1. In the Money : If the Nett cash flow is positive for the investor
2. At the Money : If the Nett C/flow is zero for the investor

3. Out of Money : If the Nett C/Flow is negative for the Investor
Spot Strike Call option price
45.000
Assumptions 48.000 1.700
45.000 Put Strike 2.500 Put option price
45.000
Pay-offs
Re/$ ER 43.0 Long Call
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
45.000
Pay-offs
Re/$ ER 43.0 Long Call (2.50)
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
45.000
Pay-offs
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50)
45.000
Pay-offs
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50)
45.000
Pay-offs
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.000
Pay-offs
Long Call option pay-off

Re/$ ER Long Call (2.50)
4.000 3.000 2.000 1.000 Call option pay-off 0.000 42.000 (1.000) (2.000) (3.000) 44.000 46.000 48.000 50.000 52.000
43.0
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.000
Pay-offs

Re/$ ER Long Call (2.50) Re/$ ER 43.0 44.0 Short Call
43.0
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.0
46.0 47.0 48.0 49.0 50.0 51.0
45.000
Pay-offs

Re/$ ER Long Call (2.50) Re/$ ER 43.0 44.0 Short Call 2.50 2.50
43.0
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.0
46.0 47.0 48.0 49.0 50.0 51.0
2.50
45.000
Pay-offs

43.0
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.0
46.0 47.0 48.0 49.0 50.0 51.0
2.50
1.50 0.50 (0.50) (1.50) (2.50) (3.50)
Spot Strike
45.000
Assumptions Long PUT Options 48.000
45.000 Put Strike
Call option price
2.500 Put option price
1.700
Spot Strike
45.000
45.000 Put Strike
Call option price
1.700
4.000 3.000 2.000 1.000 0.000 42.000 (1.000) (2.000)
Re / $ Exch Rate 43.000 44.000 45.000
Put option Pay off
Put option
Pay off
46.000 47.000
44.000
46.000
48.000
50.000
52.000
48.000 49.000 50.000 51.000
Spot Strike
45.000
45.000 Put Strike
Call option price
1.700
4.000 3.000 2.000 1.000 0.000 42.000 (1.000) (2.000)
Re / $ Exch Rate 43.000 44.000 45.000
Put option Pay off 3.300
Put option
Pay off
46.000 47.000
44.000
46.000
48.000
50.000
52.000
48.000 49.000 50.000 51.000
Spot Strike
45.000
45.000 Put Strike
Call option price
1.700
4.000 3.000 2.000 1.000 0.000 42.000 (1.000) (2.000)
Re / $ Exch Rate 43.000 44.000 45.000
Put option Pay off 3.300 2.300 1.300 0.300 (0.700)
Put option
Pay off
46.000 47.000
44.000
46.000
48.000
50.000
52.000
48.000 49.000 50.000 51.000
Spot Strike
45.000
45.000 Put Strike
Call option price
1.700
4.000 3.000 2.000 1.000 0.000 42.000 (1.000) (2.000)
Re / $ Exch Rate 43.000 44.000 45.000
Put option Pay off 3.300 2.300 1.300 0.300 (0.700) (1.700) (1.700) (1.700) (1.700)
Put option
Pay off
46.000 47.000
44.000
46.000
48.000
50.000
52.000
48.000 49.000 50.000 51.000
2-Way Hedge Both Long
45.000
Assumptions Long Call & Put options 48.000 1.700
Re / $
combined
4.000 3.000
43.000 44.000 45.000 46.000 47.000 48.000 49.000
0.800 (0.200) (1.200) (1.200) (1.200) (1.200) (0.200)
2.000 1.000 0.000 42.000 43.000 44.000 45.000 46.000 47.000 48.000 49.000 50.000 51.000 52.000 (1.000) (2.000) (3.000) Call option pay-off Put option Pay off
50.000
51.000
0.800
1.800
45.000
Pay-offs
Re/$ ER 43.0 44.0 Short Call 2.50 2.50
45.0
46.0 47.0 48.0 49.0 50.0 51.0
2.50
1.50 0.50 (0.50) (1.50) (2.50) (3.50)
45.000
Pay-offs

43.0
44.0
45.0 46.0 47.0 48.0 49.0 50.0 51.0
(2.50)
(2.50) (1.50) (0.50) 0.50 1.50 2.50 3.50
45.0
46.0 47.0 48.0 49.0 50.0 51.0
2.50
1.50 0.50 (0.50) (1.50) (2.50) (3.50)
Pay-off Equations
1. Long Call Option Pay-off = Max (S-Xt-OP, -OP)
5. S = Spot price : Xt = Exercise Price : OP = Option Prem.
Pay-off Equations
1. Long Call Option Pay-off = Max (S-Xt-OP, -OP) 2. Long Put Option Pay-off = Max (Xt-S-OP, -OP)
Pay-off Equations
3. Short Call Option Pay-off = Min (Xt-S+OP, OP)
Pay-off Equations
3. Short Call Option Pay-off = Min (Xt-S+OP, OP) 4. Short Put Option Pay-off = Min (S-Xt +OP, OP) 5. S = Spot price : Xt = Exercise Price : OP = Option Prem.
Effect on option Prices
Effect of Increase in factor on Factor Current Stock Price Call options Put option
Effect of Increase in factor on Factor Current Stock Price Striking Price Call options + Put option -
Effect of Increase in factor on Factor Current Stock Price Striking Price Time to expiration Call options + Put option +
Effect of Increase in factor on Factor Current Stock Price Striking Price Time to expiration Call options + + Put option + +
Stock Volatility
Stock Volatility
Interest Rate
Effects on Option Prices
Stock Volatility
Interest Rate Cash Dividends
+
+
+
-
Effects on option Prices
Stock Volatility
Interest Rate Cash Dividends
+
+ -
+
+
319
Chapter
10
Management of Foreign Exchange Risk
What is Exchange Risk?

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs
due to unanticipated changes in exchange rate. For example, if an Indian firm imports goods and pays in foreign currency (say dollars), its outflow is in dollars, thus it is exposed to foreign exchange risk. If the value of the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domestic currency to get the required amount of foreign currency.
Types of Exposure
Translation Exposure
Assets and liabilities translated at the current rate ie rate prevailing at the time of preparation of consolidated statements.
Rev/Exps translated at the actual Exch rates prevailing on the date of transactions. Or weighted averages for exchange rates can be used.
Translation gains / losses not to be charged to income of the reporting co

Cont.
Transaction Exposure
Refers to the extent of impact on firms domestic C/F of exchange rate flux
Arises from Possible forex gains/losses on transaction entered into in forex
Economic Exposure
Refers to the extent of impact on firms domestic C/F of exchange rate flux Arises from Possible gains/losses W/o direct exposure to forex transactions Economic exposure is a more managerial concept than an accounting concept.
Comparison of Four Translation Methods

All financial statement items restated in terms of the parent currency are the functional currency amount multiplied by the appropriate exchange rate.
Exchange Rates Used to Translate Balance Sheet Items

Balance Sheet Current/ Non-current Monetary Non-monetaryRate Temporal Current
Cash Receivables Payables Inventory Fixed Assets
C C C C H
C C C C H
C C C C or H H
C C C C C
L/Term Debt
Net Worth
H
H
C
H
C
H
C
Bal
Tools and Techniques of Foreign Exchange Risk Management

1. 2. 3. 4. Forward Contracts Futures contracts Option Contract Currency Swap
The most popular instrument used to hedge are forward exchange contracts in India. 1. Forward exchange markets are well established and transparent.
2.
3.
Forward contracts are accessible even by the smaller corporates.

Many corporate policies do not allow them to trade in options and derivatives.
Is Hedging Necessary for the Firm?

The various reasons in favour of exposure management at the corporate level are:
i. ii. Information asymmetry Transaction costs
iii. Default cost
What Risk Management Products do Firms Use?

Type of Product Forward contracts Foreign currency swaps Foreign currency futures Exchange traded currency options Exchange traded futures options Over-the-counter currency options Cylinder options Synthetic forwards Synthetic options Participating forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Lookback options, etc.
Heard of (Awareness)
100.% 98.8 98.8 96.4 95.8 93.5 91.2 88.0 88.0 83.6 81.7 77.7 65.3 55.8 52.1
Used (Adoption) 93.1% 52.6 20.1 17.3 8.9 48.8 28.7 22.0 18.6 15.8 14.8 4.2 4.9 3.8 5.1
Currency Correlation and Variability as Hedging Tools
The degree of simultaneous movements of two or more currencies with respect to some base currency is explained by currency correlations ( R )
Indicates the degree to which two currencies move in relation to each other.
This information can be used by MNC esp wrt Currency movement
MNC's are aware that R is not constant over time
Typically R can be used to help decide on hedging transaction exposure
Cont.
13
Chapte r
Management of Economic Exposure
Transaction Exposure Versus Eco Exposure

Conceptual Comparison of Difference Between Translation, Transaction & Economic Foreign Exchange Exposure
Moment in Time When Exchange Rate Changes
Translation Exposure
Accounting based changes in consolidated financial statements caused by a change in exchange rates
Economic Exposure
Change in expected cash flows arising because of an unexpected change in exchange rates
Impact of setting outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates
Cont.
Major differences between Transaction Exposure and Eco Exposure

1. Contact specific. 2. Cash flow losses Easy to compute change are easy to compute. accounting techniques can be used to compute losses due to transaction exposure.
Economic Exposure
General; relates to the entire investment. Opportunity losses caused by an exchange rate change are difficult to compute. A good variance accounting is needed to isolate the effect of exchange rate change on sales volume, costs and profit margins.
3. Firms generally have some policies to cope with Firms generally do not have policies to cope with transaction exposure. economic exposure. 4. Avoidance sometimes requires third-party cooperation (e.g., changing invoice currency). Avoidance requires good strategic planning (e.g., choice of markets, products, etc.).
5. The duration of exposure is the same as the time The duration of exposure is the time required for the period of the contract. restructuring of operations through such means as changing products, markets, sources and technology. 6. Relates to nominal contracts whose value is fixed in foreign currency terms. 7. The only source of uncertainty is the future exchange rate. 8. Transaction exposure is an uncertain domestic currency value of a cash flow which is known and fixed in foreign currency terms; e.g., a foreign currency receivable. Relates to cash flow effects through changes in cost, price and volume relationships. The many sources of uncertainties include the future exchange rate and its effect on sales, price and costs. Economic exposure is an uncertain domestic currency value of a cash flow whose value is uncertain even in foreign currency terms; e.g., cash flows from a foreign subsidiary.
Measuring Economic Exposure

1. Eco exposure to forex fluctuations is higher for a firm involved in international business than for a purely domestic firm.
2. 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.
3. Yet, economic exposure is crucial to operations of the firm in the long-run.
4. If an MNC has subsidiaries around the world, each subsidiary will be affected differently by fluctuations in currencies.
5. MNC attempts to measure its Eco exposure would be extremely complex.
Managing Economic Exposure

Following are some proactive Marketing/ production strategies which a firm can pursue in response to anticipated or actual real exchange rate changes. I. Marketing initiatives
a. Market selection b. Product strategy c. Pricing strategy d. Promotional strategy II. Production initiatives
a. Product sourcing b. Input mix c. Plant location d. Raising productivity
Marketing Management of Exchange Risk

Market Selection : Major strategy considerations for an exporter are the markets in which to sell,
Pricing Strategy : Market Share Versus Profit Margin
A firm selling overseas should follow the standard economic proposition of setting the price that maximises dollar profits (Marginal Rev = Marginal costs).
In making this decision, however, profits should be translated using the Fwd rate that reflects the true expected dollar value of the receipts upon collection. Promotional Strategy : This to take into account anticipated exchange rate changes. A key issue is the size of the promotional budget. Product Strategy product line decisions product innovations
Production Management of Exchange Risk

So far we attempted altering home currency value of foreign currency values.
At times, the exchange rate moves thwart Pricing/ marketing strategies
Prod sourcing and plant location are variables (eg. below) that Cos leverage to manage competitive risks that cannot be managed through Mktg strategies
a.
Input Mix
b.
c. d.
Shifting Production Among Plants

Plant Location Raising Productivity
Corporate Philosophy for Exposure Management

Hi Risk
All Exposures Left
Selective Hedging
Unhedged
Low Reward Active Trading
High Reward All Exposures Hedged
Cont.
Low Risk
Chapter
18
Country Risk Analysis
Nature of Country Risk Assessment

1. Country risk is an indispensable tool for asset management 2. It requires the assessment of economic opportunity against political odds. 3.The relevant factors into two important categories: Political factors & Economic factors.
Political Risk Indicators

i. ii. Stability of the local political environment Consensus regarding priorities
iii. Attitude of host government

iv. War v. Mechanisms for expression of discontent
Economic Risk Indicators

1. Inflation rate
2.
3. 4.
Current and potential state of the countrys economy

Resource base Adjustment to external shocks
Techniques to Assess Country Risk

Techniques identify key Eco, Political & Financial variables for country risk The broad parameters help expose basic strengths/weaknesses of a country. Listed below are some of the more popular indicators to assess country risk. I. Debt Related Factors The debt service indicators include: Debt /GDP Debt/ Foreign Exchange receipts Interest payments/Foreign exchange receipts (liquidity). Debt-service ratio Short-term debt/ Total exports. Imports/GDP Foreign public debt/ GNP Current account balance on Gross Net Product
Cont.
II. Balance of Payments % increase in imports / GDP Foreign income elasticity of demand for the exports Under/overvaluation of the Exch rate, on a PPP basis Current Account/GNP Effective Exchange Rate Index Imports of goods and services/GDP Non-essential consumer goods and services/Total imports Exports to 1015 main customers/Total exports Exports of 1015 main items/Total exports External reserves/Imports Reserves as % of imports (goods and services) Exports as % of imports (goods and services)
Cont.
III. Economic Performance The significant ratios that can be used to measure Eco Perf are: GNP Per capita (this measures the level of Dev of a country).
Gross Investment /Gross Domestic Product.

-This ratio captures prospects for Growth. Higher the ratio higher the Gr
Inflation : Measures % Change in Consumer Prices.

-Measures the quality of economic policy.
Money supply (serves as an early indicator for future inflation)
GDP / GNP : External sector impact

Cont.
IV. Political Instability 1. Effect of political instability on servicing problems : Emerge in the form of an unwillingness rather than an inability to service 2. The political instability indicators to be considered are: a. The political protests /demonstrations /Strikes/riots, Assassinations b. Successful/ unsuccessful power transfers, e.g., coup attempt, etc.
V. Weighted Checklist Approach 1. This approach employs a combo of statistical / Judgmental factors. 2. Statistical factors assess the performance of an economy in the recent past
3. In the expectation that this will provide an insight into the future.
4. These factors can be compiled relatively easily. 5. Range of statistical factors typically used a. b. c. d. e. f. g. h. Rapid rise in production costs, interest-service ratio, real GDP growth, Debt/GDP, imports/reserves, Foreign exchange receipt, Export/GDP ratio, Import/GDP, etc.
Raters of Country Risk

Rating of a countrys creditworthiness is mainly compiled by two magazines, Institutional Investor and Euromoney.
Rating agency
Institutional Investor
Criteria for ratings

Information provided by 75100 leading banks that grade each country on a scale of 0100, with
100 representing least chance of default.

Individual responses are weighted using a formula that gives more importance to responses from banks with greater worldwide exposure. Euromoney Assessment based on the following indicators.
Political risk (25 per cent)

Economic performance (25 per cent) Debt Indicators (10 per cent) Credit Ratings (10 per cent) Rescheduling (10 per cent)
Access to bank finance (5 per cent)

Access to capital markets (5 per cent) Access to short-term finance (5 per cent) Discount available on forfeiting (5 per cent)
What the Rankings Reveal Eco & Political factors have an impact on a countrys ranking over time. For a significant number of countries the increase or decrease in ranking over time could be explained by the economic factors alone. Political factors also play a key role in determining a countrys credit rating. Model for Country Risk Analysis for India The Country rankings published by various agencies is useful In as much as it ensures comparability and promotes consistency. This brings us to the concept of country risk rating.
Country risk rating refers to the degree or level of risk denoted by a figure.
Risk rating is a good tool for ensuring the comparability of risk across countries
Aggregated Micro Prudential Indicators

Capital adequacy Aggregate capital ratios Frequency distribution of Capital ratios Asset quality Lending Istitutions Sectoral credit concetration Foreign currecny denominated lending NPA Loans and provisions Loans to Public sector Entities Risk profile of assets Connected lending Leverage Ratios Liquidity Cantral Bank credit to Fin Institutions Depoists in relation to Monetary Aggregates Segmenation of Inter Bank rates Loan to deposit Rate Maturity structure of Assets and Liabilities Measures of Secondary Mkt liquidity Sensitivity to Market Risk Foreign Exchange Risk Interest Rate Risk Equity Price Risk Commodity Price Risk
Macro Eco Indicators

Economic Growth Aggregate Growth Rates Sectoral slumps Balance of payments Current A/c deficit foreign exch reserve Adequacy External Debt (Incl maturity sructure) Terms of Trade Composition & Maturity of Capital Flows Inflation Volatility in Inflation
Aggregated Micro Prudential Indicators
Macro Eco Indicators

Interest & Exchange rates
Borrowing entity Debt Equity Ratio Corporate Profitability Other Indicators of Corp conditions Household indebtedness Management Soundness Exoense Ratio Earnings Per employee Growth in no of Finance Institutions Earnings & Profitability Return on Assets Return on Equity Income and Expense Ratio Structure Profitability indicators
Market Based indicators Mkt Prices of Fin Instruments Indicators of Excess Yields Credit Ratings Sovereign Yield spreads
Volatility in Interest & exch rates Level of domestic Real Interest rates Exchange rate sustainability Exchange rate guarantee Lending and Asset price Booms Lending Booms Asset Price Booms Contagion Effects
Financial Market Correlation

Trade Spillovers Other Factors Directed Lending & Investments Govt resource to Banking system Arrears in the economy
Macro Prudential Indicators (MPIs)

In the aftermath of the international financial turmoil of the second half of the 1990s, the World Bank and the IMF have tried to work on ways to strengthen the global financial system. The MPIs defined broadly as indicators of the health and stability of the financial system can help countries access their banking systems vulnerability to crisis. This process, as part of the joint World Bank-IMF Financial Sector Assessment Programe (FSAP), May 1999. was introduced in MPIs compare both aggregated micropudential indicators of the health of individual financial institution and macro economic variables associated with financial system soundness.
Managing Risk in Foreign Exchange Trading

1. Market Risk: This risk refers to the risk of adverse changes in
1.
2.
Exchange rate risk and

Interest rate risk.
2.
Credit Risk: Credit risk, inherent in all banking activities, arises from the
possibility that the counterparty may not make the payment on maturity
3.
Sovereign Risk: A variation of credit risk. It refers to, the political, legal and other risks associated with a cross-border payment.
22
Chapte r
Interest Rate and Currency Swaps
The Conceptual View of Swaps

The concept of the swap (both interest rate and currency swaps) has broad implications and applications in finance. Condensed to its essence, however, its most important implication lies in the idea that swap allows the separation of the funding aspect of financing from the structure of the liability This ability of the swap to separate financing from its repayments structure produces a greatly increased universe of options available to the borrower or the investor. There are five basic components of financing: Credit The willingness of an investor to take the default risk of a company Funding The provision of loan funds and the return on those funds Tenor The repayment schedule Currency The currency denomination(s) of the repayment Interest Rate The basis on which loan interest is calculated
The Evolution of Swaps

The swap market as we have today has existed only since 1981. The earliest swaps were currency swaps and were mainly developed to resolve some of the problems associated with parallel and back-to-back loans.
Currency swaps largely resolve the problem of matching needs associated
with parallel and back-to-back loans. The first true currency swap was arranged in August 1981 by Salomon Brothers with the World Bank and IBM as counterparties.
The first interest rate swap appeared in London in 1982. The motivating factor behind the interest rate swaps was their ability to convert fixed rate interest payments into floating rate interest payments and vice versa
Terminology Related to Swap
Swap Facilitators
Swap Broker Notional Principal
I.
II.
Basis Points (BP)

Swap Coupon
Cont.
Rationale for Interest Rate Swaps

The key advantages of an interest swap are as follows:
1.
The interest rate swap does not involve any exchange of principal amounts. It consists only of an agreement to exchange interest flows.
2.
Because of the smaller amount at risk, the number of potential participants in the deals is larger.
3.
Also, because the deal is not a lending, it is possible to keep the documentation within reasonable bounds.
4.
Swapping allows the issuers to revise their debt profile to take advantage of current or expected future market conditions.
Cont.
Limitations of Swap Market 1. An inherent default risk exists in a Swap deal.
2. Swaps are not easily tradable.
3. Termination of the Swap deal is not possible without the agreement of the parties involved in the transaction.
4. In some cases it may be difficult to identify a counterparty to take the opposite side of the transaction.
5. The swap market is not exchange controlled It is OTC.
6. This calls for extra caution on the part of parties involved to look into the creditworthiness of the counterparties before entering into an agreement.
Reasons for Growth of Swap Market 1. IRS creates a link between distinct markets or firms with Diff mkt access
2. IRS provides a way to reduce the total
funding cost for debt.
3. Arises from the diff in the risk premium available to the various borrowers.
4. IRS is a flexible way for cos to manage B/S and
5. Reduce the mismatch between the maturities of assets and liabilities.
6. Swaps are desirable for they can minimise the costs of regulations / Tax
Cont.
Limitations of Swap Market

1. 2. 3. The Swap deal cannot be terminated without the agreement of the parties involved in the transactions. Swap are not easily tradable as a result of very slow development of standardised documentation. It is difficult to identify a counter-party to take the opposite side of the transaction.
Swap Market Terminology

Trade Date: It is the date on which swap is entered into. This is the date when both the parties have agreed for a swap.
Effective Date Reset Date Maturity Date Assignment Broker LIBOR
Interest Rate Swaps

The main aspects of an interest rate swap are:
effectively converts a floating rate borrowing to fixed rate or vice-versa. structured as a contract separate from the underlying funding.
principal repayment obligations are not exchanged.

can be applied to either new or existing borrowings. off-balance sheet treatment. only the net interest differential is paid.
Cont.
How Swaps Work
The risks associated with interest rate swaps are:
The counterparty to the contract may default.

Another risk with swaps is basis point risk, exposing the swapper to unexpected, additional costs. Finally, an issuer must factor in the cost of swapper fees.
Plain Vanilla Interest Rate Swaps The key features of this swap are:
The Notional Principal

The Fixed Rate Floating Rate Trade Date, Effective Date, Reset Dates and Payment Dates
Cont.
Type of Interest Rate Swaps
1.
2. 3.
Basis Swap
Forward Swaps Putable Swaps
4.
5. 6. 7.
Rate Capped Swaps

Deferred Rate Swaps Callable Swaps Extendible Swaps
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Swap Deal
ING borrows Fixed @ 6 % and ICICI float @ Libor +.5% ING lends Fixed @ 7.3% & ICICI lends Float @ Libor +.5%
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Fixed Paid
6.00%
7.3%
1.3%
Swap Deal
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Fixed Paid
Float Paid
6.00%
Libor +.5%
7.3% Libor + .5%
1.3%
Swap Deal
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Fixed Paid
Float Paid Fixed Recd
6.00%
Libor +.5% 7.30%
7.3% Libor + .5%
1.3%
Float Recd
Libor +.5%
Swap Deal
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Fixed Paid
6.00%
Libor +.5% 7.30%
7.3% Libor + .5%
1.3%
Float Recd
Nett Rate Libor - 0.8%
Libor +.5%
7.3%
Swap Deal
Details
Fixed
Floating Nett
ING
ICICI
6.00% 8.00
Libor Libor +0.5%
Difference
2.0%
0.5% 1.5%
Fixed Paid
6.00%
Libor +.5% 7.30%
7.3% Libor + .5%
1.3%
Float Recd
Nett Rate Alt Rate Gain Swap Deal Libor - 0.8% Libor 0.80%
Libor +.5%
7.3% 8.0%
0.7%
1.50%
Liability Based Interest Rate Swap

Creating Synthetic Fixed or Floating Rate Liabilities
Synthetic fixed or floating rate liability
8% p.a. ICICI ING
Six months MIBOR
Six months MIBOR Floating rate lenders
Asset Based IRS : Synthetic Fixed or Floating Rate Assets

The classic use of IRS in asset / Invt based transactions is to create synthetic fixed or floating rate securities which best satisfy return & portfolio needs.
Synthetic fixed or floating rate assets

12.50% p.a. Investor Counterparty
Six months LIBOR Six months LIBOR + 0.25

Floating Rate Investment Six months LIBOR Investor 12.75% p.a. Counterparty
14.00% p.a.
Fixed Rate Investment
Cont.
Improving Investment Performance
Managing floating rate investments

Original Swap Reverse Swap
11.5% p.a.
Counterparty Six months LIBOR Investor
10.5% p.a.
Counterparty Six months LIBOR
Six months LIBOR

Floating rate Investment
Cont.
Asset/liability management
Floating Rate (T-Bill based) Assets
Floating Rate Payment
Issuer
Fixed Rate Receipt
Swap Counterparty
Fixed Rate Bonds
Currency Swap
Basic Currency Swap
A Currency Swap
Japanese yen received from subsidiary
Yen payments Dollar payments US Multinational Yen payments Japanese multinational Yen payments
Dollars received from ongoing operations

Dollar payments
Dollar payments
US multinational issues dollar denominated bonds to investors
Japanese multinational issues yen denominated bonds to investors.

Cont.
The World Bank-IBM Currency Swap The Bank had 3 objectives in mind before thinking of entering into a Swap
The cost of borrowing via a swap to be < primary guidelines.

The counterparty must be of top creditworthiness. No currency exposure must be created. Rationale for Existence of Currency Swaps 1. Currency swap may be used to hedge against foreign exchange risk. Hedging can lower a firms costs because it reduces uncertainty of CF 2. It increases Amt a firm can borrow, incr Eco of scale which reduce op costs. 3. A firm may be able to use their surplus funds more effectively in blocked currencies. 4. Swaps may be used as a way of circumventing exchange control regulations.
Cont.
Various Forms of Currency Swaps
i. ii.
Cross-currency Fixed-to-fixed swap Cross-currency Floating-to-fixed swap
iii. Cross-currency Floating-floating (basis) swaps iv. Basis swaps
v.
Amortizing swaps
vi. Roller-coaster swaps
vii. LIBOR adjustments and Off-market coupons viii. LIBOR-in-arrears swaps
Pricing Currency Swaps

1. Banks act as dealers in currency swaps
2. Banks furnish potential customers with bid and ask prices stated in terms of interest rates and exchange rates that reflect bid-ask spreads.
3. Prices quoted depend on various factors, including life of a swap.
4. Risks involved in dealing in currency swaps are > those in IRS.
5. Spreads for currency swaps are > spreads for interest rate swaps.
6. Currency swaps involve both exchange rate risk and interest rate risk.
Chapter
Eurocurrency Market
Sl no
Borrower
Lender
Market
Currency of Loan Name
1 Indian Entity
Indian/ MNC Entity
India
Re
Domestic loan
2 Indian Entity
UK / Non-UK Entity
London
Sterling
Foreign loan
Sl no
Borrower
Lender
Market
Currency of Loan Name
1 Indian Entity
Indian/ MNC Entity
India
Re
Domestic loan
2 Indian Entity
UK / Non-UK Entity
London
Sterling
Foreign loan
3 Indian Entity
UK /Non-UK Entity
London
Dollar / Yen Euro loan
Eurocurrency : Freely convertible currency deposited in a bank outside country of origin. Deposits can be placed in a foreign bank/ foreign Br of a domestic bank.
Any convertible currency can exist in Euro e.g.

Characteristics of the Eurocurrency Market: 1. 2. 3. 4. 5. 6. 7. 8. Large international money market Relatively free from government regulation and interference Deposits in Eurocurrency market are primarily for S/T Sometimes leads to ALM risk, since most Euro Currency loans are L/T Transaction, in this market are generally very large Govt., Public sector organisations tending to borrow most of the funds. Makes the market a wholesale rather than a retail market. Eurocurrency market exists for savings/Time deposits rather than Demand
History of growth of the Eurodollar Mkt

1. 2. 3. 4. Large deficits in the US BOP, particularly in the 1960s
Massive BOP surpluses of OPEC due to Incr in oil prices in 73-74 & 78. Resulting in accumulation of $ by Foreign Fin institutions & individuals. Restrictive environment prevailing in US (19631974) to stem Cap OF
5.
6. 5. 6.
These controls encouraged US /MNCs to borrow dollars abroad.

Most of the petrodollars were deposited in FIs outside U S. Efficiency & lower cost base of the Eurodollar market was a plus Being a wholesale funds market, free of restrictions, in comp with US mkt
EuroCurrency Interest Rates :a. Base Intt rate paid on deposits among banks in Eurocurrency market is LIBOR b. LIBOR - Determined by supply /demand for funds in Euromkt for each currency c. Participating banks could default (and, infrequently, do default) d. So, Rate paid for Eurodollar deposits has a Cr-spread over LIBOR in Euromkt e. Cost of borrowing in Euromkt historically is marginally below the Domestic rate f. Interest rates on other Eurocurrencies generally follow the same pattern g. If Capital controls exist in a country (e.g., Japan), borrowing rates may be higher in the Euromkt (for Yen) than in domestic market.
Instruments
1. Euro CDs 2. Euro CPs 3. Euro Debt 4. External Commercial Borrowing (ECBs) 5. FCCBs 6. Euro Notes Issuance : FRNs, Floaters etc 7. GDR / ADRs
Instruments and Rates of Eurocurrency Markets

1. A feature of Eurocurrency Mkt is that loans are made on a floater
2. Loans are given to Govt / its agencies, Corporations & non-prime banks 3. Intt rates are set @ LIBOR + fixed margin for a given period & currency.
4. Interest for the next period is calculated at a fixed margin over new LIBOR.
Eurocurrency CDs are issued in two forms: Tap CDs Issued in large denominations ($ 2.5 to $5 million) For maturities of < 1 year, whenever banks need to tap the mkt
Tranche CDs Big Tkt issues (typically $10 mn to $50 mn), one or more drawal
International Bonds Market

The Euro Bond Market Unsecured debt securities
Issued and sold in mkts outside the Country of the borrower Denominated in a currency other than that of the borrowers Currency And in a currency diff from that of the market where it is mobilised Placed by the borrower directly on the Market & not lent to by banks
Features Euro bonds are underwritten and sold in more than one market Simultaneously usually through international syndicates And are purchased by an international investing public Extending far beyond the confines of the countries of issue.
Special Features /Innovations in the global Bond Mkt

The Euro bond market has flourished due to following unique features 1. Eurobond mkt - offshore operation not subject to national controls (Most countries have controls over domestic issues in local currency) Not subject to the costly and time-consuming registration procedure. Disclosure requirements are less stringent than for domestic issues Euro bonds are issued in bearer form. Facilitates negotiation is sec mkt (Country of ultimate owner of the bond is not a matter of public record). Offer exemption from tax-withholding provisions, not found in others)
2. 3. 4.
5.
Euro-Cur Mkt Instrument

1. Straight fixed-rate issue: bearer bonds, fixed coupon, set maturity date, full principal repayment upon final maturity. Coupons are normally paid annually. 2. Equity-linked bonds: convertible bonds or bonds with equity warrants (amounted to $64 billion in 1997, and $32 billion in 1998). Right to acquire equity stock in the issuing company (sometimes with detachable warrants containing the acquisition rights). The market value of an ELB is composed of the naked value and the conversion value. The conversion to stock prior to maturity is at a specified price per share, or a specified number of shares per bond. The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.
MH BOUCHET (c) CERAM
388
Eurobond Market
3- FRNs: since the early 1980s. medium-term notes where the interest is fixed as a percentage above sixmonth LIBOR. Pays a semi-annual coupon determined on variable-rate base. Negotiable and transferable securities with flexible interest rate, fixed interest periods, and issued in pre-determined and uniform amounts. FRNs are
directed at institutional investors
MH BOUCHET (c) CERAM 389
Euro - financial Instruments

No
1 2
Particulars
Fund Suppliers Exposure on Rate
Euro Loan
Bank Floating
Euro Bond
Customer Fixed or Floating
3
4 5
Maturity
Issue Size Floatation cost
Short to Long
Structurally high, since an inter bank mkt Low (0.5%) Draw down / repayment Per Fixed schedule A regular feature Faster (1- 2 weeks)
Long
Past - low. Now increasing High (upto 2.5%) Flexible s/to commitment fee on undrawn bal Possible only thru a costlier swap Slower
6 7 9
Flexibility Multi Currency option Speed of raising
Note Issuance Facility & Euro notes

A bank or a Syndicate of banks underwrites an amount for a client For a specified period (say 5 years) At an agreed rate Over Libor (say 1% over 6 mth LIBOR) Now let us assume the client needs $ 20 mn for 3 months Client seeks bids from intending sources The bids < above rate (LOBOR + 1%) are accepted (say 15mn) Balance ( 5 mn ) is funded by the underwriting banks So borrower is freed from worries of borrowing Basically, this is a Euro-CP with an u/writing option Concepts : Disc Rate : Disc Rate (DR) = Market Price = Annual yield = Annual yield = Mkt price and Annual (eff) Yield (Disc Amt/ FV) * 360/n) FV * [1 (Disc rate * n/360)] DR / [1- (DR*n/360)] DR * FV / MV
NIF Features, Pluses and minuses

Pluses in comparison with Euro bonds 1. 2. 3. 4. Lower Direct Costs Drawdown and rollover flexibility Flexibility in timing of issue : if rates can be foreseen Choice of maturities
Asia- currency market and Asia Bonds Singapore the trading hub for Asia currency markets Asia Bonds : issued directly to investors, avoiding banks
(97- Peregrine- Indonesia Suharto Rupiah dep (2400 8000/$) $260 M
Euro - MTN
1. Similar to NIF. But for M/T. ~ 5 yrs. Neednt be U/written 2. Adv : Speed, cost & flexibility in timing & volume of issuance
( eg $ 12 M for 1 mth, $ 15 M for 75 days & $23 mn for 90 days)
3. Offered continually to leverage on yield curve movements 4. Retired either thru a new issue or by redemption 5. GM, Coke, Pepsi, ford are regulars 6. Till mid 80s secondary trading languished. 7. Now issued thru dealers than direct . Facilitates mkt making 8. Risk for issuer - Mkt tanking before issue goal is fully met 9. U/writing with Banks / Fin players (like NIF) mitigates this.
Euro CP vs Normal CP
No
1 2 3 4 5 6 7
Particulars
Average maturity Underwriting Secondary market Typical investors Popularity Rating Currency
Euro CP
6 mths no Exists Central banks, com banks, Corporates Improving 4% - 5% - unrated
Normal CP
3 months Carved out of Bank WC india. US No U/W No. Held to maturity MMMFs, Local Banks India OK. US - Best Rarely unrated
Multi currency
Cross currency swap
Single Currency
Not needed
Addl feature
External Commercial Borrowings

1. 2. 3. 4. 5. 6. Scarcity of domestic capital hinders a high rate of capital formation.
The rate of savings is low because the income levels are at a low level Where small savings are possible, they are very difficult to mobilise. Scarcity of forex : Developing economies have adverse BOP LDC exports < large Capital imports needed during Growth Funding of infra by Govt alone cannot go on forever on borrowed money
Risks Involved in ECBs

a. Raising ECB offers a firm a cost advantage in comparison with others
b. Most prime blue-chip clients desert Indian Banks / FIs in favor of ECB
c. ECB exposes the firm to a currency risk. d. Borrower may spend more Rs to buy $ to meet Intt / Principal liability.
e. Borrower exposed to an interest rate risk too. f. Most ECBs are pegged to the 6-month LIBOR-Plus-spread
g. Variation in LIBOR at reset dates (dates on which the prevailing LIBOR is
used to compute the liability) may enhance the firms cost.
Managing Exposure Arising From ECBs

ECB exposes client to 2 risks: exchange rate risk and interest rate risk.
a. To mitigate, Co has to incur a cost for hedge agt Intt/currency risk
b. Leads to 2 Diff. contracts, more documentation and a greater default risk
c. Default by either can lead to overall default. Damages Co interests.
d. A single comprehensive cover may provide perfect hedge
e. But such a contract proves costlier than entering into two single contracts.
Foreign Currency Convertible Bonds (FCCBs)

Convertibles are more beneficial than a GDR Due to the following :i. ii. They have a lower coupon than straight debt. They provide a broader investor base, i.e., both, those who invest in debt as well as in equity. They allow a higher premium to the issuer than a GDR. Dilution of equity is not immediate, but deferred.
iii. iv.
Cont.
Depositary Receipts
Agenda
Basic Concepts History Basic Issuance Process Types of DR Programs Advantages & Disadvantages Current Trends
Basic Concepts
Depositary Receipt (DR) Certificates that represents shares of foreign companies Global Depositary Receipt (GDR) Negotiable Instrument denominated in US $ or One GDR may represent one or more shares Eg. 1 GDR = 100 Shares American Depositary Receipt (ADR) Payments and Receipts in US dollars Trade in US exchange markets only
Depository Receipts
DRs structured to resemble typical stocks on the exchanges
So that foreigners can buy an Interest in the company

Without worrying about differences in currency, accounting practices, or language barriers Or other risks in investing in foreign stock directly. Most GDRs are denominated in U.S. dollars regardless of the market they are traded in.
History : GDRs were created in 1927 in London

Selfridges, a London department store, wanted to expand the number of investors in the United States. Very difficult to trade across different countries at this time. Took at least 4 days to travel across the Atlantic. Orders could potentially take weeks to fully complete.
Issuance Process
Level II
Sponsored ADR
Toyota (Foreign Co) Yen Dividend
US Investor Easy process because ADRs are sold on
US Exchange markets &

Bank of New York Mellon (Depositary Bank) Dividend Listing US Stock Exchange Sold like another stock. Payment and receipt of dividends in US dollars
US dollars
US Investor (foreign investor)
Stock Search
Issuance Process
Toyota (Foreign Company) Yen Dividend
Depositary Bank Investors Purchases are made from depositary bank.
Bank of New York Mellon (Depositary Bank) Dividend
Listing US Stock Exchange
Authorized by the issuer Co to issue DRs.

The depositary bank is the Act Regd owner of the shares
US Dollars
Its most important role is that of stock transfer agent.
Issuance Process
Toyota (Foreign Company) Yen Dividend
Foreign Co Seeks to enhance liquidity. Seeks to expand & diversify investors Responsible for Preparing the issue proposal, Determining fin objective, Deciding the type of program
Bank of New York Mellon (Depositary Bank) Dividend
Listing US Stock Exchange
US dollars
Providing financial information.
What is the main role of the depositary bank in the issuance process?
Types of DR Programs
Unsponsored ADR Description: The foreign company has no formal participation with issuance Purpose: Broaden the shareholder base with the existing shares Trading: Over-the-counter market SEC: Minimal requirements from the SEC
Level I Sponsored American Depositary Receipt Formal participation by issuer company Purpose: Broaden the shareholder base with the existing shares Trading: OTC market SEC: Minimal SEC filings
Level II Sponsored American Depositary Receipt Description: Listed on US exchanges Purpose: Broaden the shareholder base with the existing shares
Trading: US stock exchanges

SEC: More requirements and regulations with SEC
Private Placement of ADRs Purpose: Faster and cheaper way for companies to raise capital than level III ADRs GDR Used most frequently in Europe where there are less regulations Variants Euro Depositary Receipts, Retail Depositary Receipts, and Singapore Depositary Receipts
What is the difference between a sponsored and unsponsored ADR?
ADVANTAGES OF GDRs
Allow investors to invest in foreign companies without worrying about Foreign trading practices Different laws Cross boarder taxes/fees
GDRs offer the same corporate rights, esp voting rights To the holders of GDRs as the investors of the u/lying stock
GDRs are liquid for the supply / demand can be regulated

By creating or canceling GDR shares (Co / Dep Bank)
DISADVANTAGES OF GDRs
GDRs do have foreign exchange risk if the currency of the issuer is different from the currency of the GDR, Which is usually the U.S. dollar.
What are some other advantages of GDRs or ADRs?
GDR Advantages
Allow investors to invest in foreign companies without worrying about foreign trading practices, different laws, or cross-border transactions. GDRs offer the same corporate rights, esp voting rights, to the holders Easier trading, payment of dividends in GDR Cur and corporate notifications Inst investors can buy them, even when they are restricted by law from buying shares of foreign Co GDRs overcome restrictions on foreign O/ship, Cap movement imposed by the country of the corporate issuer, avoids risky settlement procedures, eliminates local/Transfer taxes There are also no foreign custody fees, ranging from 10 to 35 BPS/yr. GDRs are liquid because supply and demand can be regulated by creating or cancelling GDR shares.
GDR Disadvantages
GDRs do, however, have foreign exchange risk If the currency of the issuer is different From the currency of the GDR
Trends
Although ADRs were the most prevalent form of DRs, The number of GDRs has recently surpassed ADRs Due to lower expense and time savings in issuing GDRs
GDR vs. ADR
Trends
In the 1990s, the development of DRs drastically increased because of changes in regulations by the SEC and the privatization of foreign companies. The number of sponsored DR programs grew from 352 representing 24 countries in 1990 To over 1,800 from 78 countries in 2001.
Conclusion
DRs make foreign investing easy for investors Foreign Cos are able to increase liquidity and raise capital An increase in DRs since 1990s
Doing Business in India Simplified
Indias Industrial Policy

Indian govt has removed controls on industry, post liberalization However, licensing/ restrictions still exist in the following sectors: 2 sectors reserved for PSU viz., Atomic Energy and Railways Five Industries in which licensing is compulsory Distillation and brewing of alcoholic drinks Cigars and cigarettes of tobacco Electronic Aerospace and Defence equipment Industrial explosives and Hazardous chemicals Manufacture of items reserved for Small Scale Sector. Note Exemption from licensing also applies to expansion
Foreign Investment in India

Foreign Direct Investment (FDI) India welcomes FDI in almost all sectors. Foreigners can directly invest in India Either by themselves or as a joint venture. The invt ceilings in sectors are gradually being removed. Opportunities exist for investing in India across sectors As diverse as Tourism and Infra, Petrochemicals and mining technology Engineering, real estate, Biotechnology, Bio-informatics and nanotechnology. India is also seen as global destination for R&D, Engg design and prototype development and a Mfr hub for Hi-Tech Prod.
FDI Policy
Per Current policy, FDI is not permitted in following sectors Atomic energy; Lottery business/gambling and betting; Agriculture (excluding floriculture, horticulture, seed development, animal husbandry, pisciculture and cultivation of vegetables, mushrooms, etc.)
Plantations (excluding tea plantation)

Retail Trading (other than single brand retail)
FDI Policy contd.
There are two routes for FDI in India Automatic Route (AR) FDI permitted under AR for all, except the 2 following 1. Where foreign collaborator has an existing venture/tieup in India in the same field. Exceptions are Investment by a VCF registered with SEBI; Existing JV has < 3% investment by either party; Existing joint venture is defunct or sick
2. Proposals ultra vires sectoral policy caps / sectors in which FDI is not permitted
FDI Policy contd.
FIPB Route (Approval Route) In all other cases, approval is required from FIPB. FIPB decision - normally conveyed within 30 days of applicn Proposals decided case-to-case basis based on merits And In accordance with the prescribed sectoral policy.
Acquisition of Shares
Acquisitions may be made of an existing Indian company which may be either a private or a public company. Acquisition of shares of a Listed Co is S/to the guidelines of the Securities Exchange Board of India (SEBI)
Foreign investors looking at acquiring equity in an existing Indian Co thru stock acquisitions can do so under auto route.
Foreign Institutional Investors (FII)

An FII must be registered with SEBI must comply with certain investment limits. They may purchase shares and/or Conv Debs of Indian Cos Under Portfolio Investment Scheme.
Shares/CDs of Indian Cos to be purchased through registered brokers on recognized stock exchanges in India.
FIIs are also permitted to purchase shares/CDs of Indian Cos thru Pvt Placement /arrangement.
Foreign Pension funds, MFs, Invt trusts, AMCs, Incorporated Inst portfolio Mgrs / their POAs may invest In India as FIIs.
Foreign Technology Transfer

Foreign technology induction is encouraged - By Govt both through FDI and - thru Foreign Technology collaboration agreements. No approvals are required in respect of all those foreign technology agreements which involve: (i) A lump sum payment of up to USD 2 million (ii) Royalty payable

up to 5% on net domestic sales & 8% on exports S/to to a total payment of 8% on sales, W/o restriction on the duration of royalty payments.
Note - It is permissible for an Indian Co to issue equity shares against lumpsum fee and royalty in convertible forex
GDRs / ADRs / FCCBs
Indian companies listed on the stock exchange are allowed to raise capital through GDRs/ADRs/FCCBs. Foreign Invt thru GDRs/ADRs/FCCBs is also treated as FDI. Issue of GDRs/ADRs does not require any prior approvals
Save when FDI after issue would exceed the sectoral caps in which case prior approval of FIPB would be required.
FCCBs issue <= $ 500 mn does not require prior approvals
Preference shares
Indian cos can mobilize foreign investment through issue of preference shares for financing their projects/industries. Pref share issue permissible only as Re denominated instruments. Pref shares to redeemed out of accumulated profits/ fresh capital within a period of 20 years as per Indian Co Law. Preference shares, carrying a conversion option, must comply with sectoral caps on foreign equity. If the preference shares do not have conversion option, they fall outside the FDI cap.
Exchange Control Regulations of India

Exchange control is regulated under the Foreign Exchange Management Act, 1999 (FEMA)
Forex transactions divided into two broad categories current account transactions and capital account transactions. The Indian Re is fully convertible for current account transactions S/to a Neg list of trans that are prohibited/require prior approval. The Exch control laws & regulations for residents apply to foreign Cos Investing in India as well. Foreign Capital invested in India is generally repatriable Along with Capital appreciation, if any, After payment of taxes due on them Provided the investment was on repatriation basis.
Laws Governing Business in India

The Companies Act, 1956 Arbitration and Reconciliation Act, 1996 The Competition Act, 2002 The Foreign Exchange Management Act, 1999 Income Tax Act, 1961 Central Sales Tax, 1956 Central Excise Act, 1944 Information Technology Act, 2000 Copyright Act, 1957 Trademarks Act, 1999 Geographical Indications of Goods Act, 1999 Indian Patents Act, 1970 Designs Act, 2000 Industrial Disputes Act, 1947 Workmen Compensation Act, 1956 Employees PF & Misc Provisions Act, 1952 Consumer Protection Act, 1956
Important Regulatory Authorities for Foreign Investment

Secretariat for Industrial Assistance (SIA) Foreign Investment Promotion Board (FIPB) The Foreign Investment Implementation Authority (FIIA) Reserve Bank of India (RBI) Registrar of Companies (RoC) Securities and Exchange Board of India (SEBI) Central Board of Excise and Customs (CBEC) Central Board of Direct Taxes (CBDT) Authority for Advance Rulings (AAR) Investment Commission (IC)
India vs ROW ($ = 50 Rs) 1. X an Indian exports Rs 50,000 of merchandise to US against BOE.
2. Y an Indian imports Rs 75,000 of merchandise from US against payment

3.An NRI sends $ 3,000 to his parents in India. Parents invest it in 2 yr FD 4. An Indian Sends Rs 5,000 worth of jewellery as gifts to his daughter in US . A US Auto co sends Cap eqpt worth $ 30,000n
Derivatives
1. Value is derived from another underlying contract, reference or index 2. Recent developments have transformed them into a cheap & efficient means of Hedging : Neutralizes risk by fixing the price in Adv. For eg. Price of $ = 47 Rs on 1.Dec 09 Arbitraging : Take adv of discrepancy in prices across markets. Speculating : Take a directional bet. Thus contribute liquidity 3. Arrival of Floating Intt rate regime post 73, heralded the need for Risk mitigation mechanisms 4. Led to the development of Exchange traded Forex futures in Chicago 5. Computers expedited growth, since fast computing of complex derivative pricing became feasible
6. Three risks Market Basis Counter Party risk

7. 4 products Forwards Futures Options Swaps
: The Value of derivative changing, esp as expiry approaches : Hedge may not be a perfect match to the Risk one is exposed to : CP not paying up. Less than for Loans, for only diff is at stake
: : : :
Two-way negotiated agreement. OTC. Gen, when Exact date unknown Exchange traded. Standard Contracts wrt Price, settlement date, contracts no. Right but not obligation to buy/sale. Option to Buy - call. Option to sell - Put 2-way Contr. to exchange 2 streams of payment for a period. Fix to float
INTERNATIONAL FINANCE
The Euromarkets: evolution, structure, instruments

Origins and developments Eurocredits and Eurobonds Legal Clauses in Syndication Capital adequacy guidelines Tax, accounting and regulatory framework
439
The EUROBOND MARKET
Origins Development Structure Instruments Volume
440
The Euromarkets: evolution, structure, instruments

Preparation: Clark, Chap. 5, pp. 113-130 Madura: Chap. 3 Eiteman, Stonehil & Moffett, MBF, chapter 13 BIS Annual Report, Chap. VIII BIS Quarterly Review, Statistical Annex Bouchet: Credit Creation, Multiplication and Maturity transformation in the Euromarkets, USC, United States. Milton Friedman, The Euro-dollar Market, Federal Reserve Bank of Saint Louis, July 1971. ISMA Annual Report BIS Annual Report
What is a Eurocurrency?
Any freely convertible currency, such as a $ or a DM or , deposited in a bank outside its country of origin. It is the residency of the bank and not its nationality that determines the euro nature of the deposit. Eurocurrency deposits are typically short-term deposits <1 year, whereas eurocredits are longer term, hence a maturity transformation in the Eurobanks balance sheets.
The Balance of Advantage for The Borrowers

Availability of international capital in larger amounts and to a wider range of borrowers than in the fixed-interest bond markets Capital is available more quickly, with fewer formalities and with fewer conditions (balance of payments financing) Flexibility against interest and exchange rate risk with currency options and variable roll-over period length (despite drawbacks of floating and unpredictable LIBOR cost of Eurocredits)
443
The EUROBOND MARKET

Whilst the international financing of public and private projects has existed since the 19th century, the market in its current form began life in the early 1960s. The driving factor behind its growth and development was the tax regime introduced by the US government in 1963, aimed at discouraging foreign issuers from borrowing from US investors. US tax law also made difficult for US multinationals to fund their overseas subsidiaries from within the USA. Until that time, the vast majority of international borrowing had been channeled through NY. After 1963, borrowers wishing to raise US$ denominated debt came to Europe, where a growing pool of investors was ready to provide MH BOUCHET (c) CERAM those funds without the burden of expensive 444 taxes.
The EUROBOND MARKET

Since the 1960s the market experienced rapid growth. Dealers and brokers worldwide trade issues denominated in a host of currencies, structured in a number of innovative ways, and issued to investors from every corner of the globe. In 1999, market size - a measurement of the total volume of outstanding international bond issues, reached some US$3 trillon equivalent. The range of instruments traded has grown substantially, and includes warrants, global depository receipts, international FRNs, and mediumterm notes, Euro commercial paper and debt denominated in Euro. As a result the term MH BOUCHET (c) Eurobond has given way CERAMa wider, and 445 to more
The EUROBOND MARKET

The international nature of the market means that it is not subject to the same controls which govern the primary and secondary markets in purely domestic securities. Since 1969, ISMA (International securities market association) has performed a central role by providing a global framework of industry-driven rules and recommandations which regulate and guide trading and settlement in this market. Membership has MH BOUCHET (c) CERAM now exceeded 700 446
EUROBONDS
Eurobonds: long-term financial instruments issued by MNCs, IFIs or country governments, and denominated in a currency other than that of the country of placement. Eurobonds are underwritten by a multinational syndicate of investment banks and simultaneously placed in many countries. They are issued in bearer form, and coupon payments are made yearly. The US$ accounts for about 50% of eurobonds. Liquidity in the secondary market is monitored by CERAM Euro-clear. Highly 447 MH BOUCHET (c)
Bonds
Contractual obligation on the part of the seller/issuer of the bond (the borrower) to pay a fixed amount per year for a set number of years to the buyer of the bond (the lender). At maturity, the borrower repays the original face value of the sum borrowed. Coupon= number of $ paid the lender per year Maturity= number of years over which the bond runs Par value= original sum borrowed
Bonds
Coupon, par value and coupon rate are invariant over the life of the bond. The coupon rate is established by competitive pricing in the market. The coupon rate is set so that the bond will be able to compete with comparable instruments in terms of maturity, yield, credit risk The bond can be traded on the secondary market at a market price which depends on the current market rate of interest for that type of bond. When the market rate of interest fluctuates, the price of the bond will
Bonds
P= M (1 + i) n M is bond value at maturity, P is present value, i is interest rate, n is number of years. There is an inverse relationship between bond prices and interest rates. For a given P, the higher i, the smaller M.
450
Price and YTM of a Bond

reflections of each other. The two are inversely related and one is neded to arrive at the other. This if price is given, an investor can calculate the yield on the bond, and compare it with his own required rate of return to see if the bond is a worthy investment or not. Alternatively, an investor can work out the price he would be willing to pay for a bond given his yield M C C C requirement. _____ 2 + ..+ ______ + ______ _____ + 1 n (1+y) (1+y) n (1+y) (1+y) the Bond price and YTM are held together by Thefollowing equation: YTM is essentially the bonds internal rate of return, i.e., that discount rate which makes the present value of all the bonds future cash infloxs equal to the current price of P=
the bond (initial investment oputlay)
Price and yield to maturity are mirror
Yield curve
Yield spreads refer to the difference between the yield on a given bond at the time of issuance and the yield on US Treasury securities of comparable maturity or other comparable government securities if the bond is issued in other currencies than the US$. The US Treasury securities are used as proxy for risk-free return. As of end2001, the US10-year rate is the base rate as opposed to the 30-year rate till 2000.
Eurobond Yield Curve in Per cent

7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 1 3 5 7 10 15 20
453
as of May 15, and October 24, 2000 and November 30, 2001
YIELD 05/99 YIELD 10/99 YIELD 11/01
30
Clearing procedures in the international bond markets

International Securities Market Association (ISMA) Euroclear (created by Morgan in 1968) CEDEL (Centrale de livraison des valeurs mobilires) created in Luxembourg in 1970 Eurobonds are engraved certificates. Euroclear and Cedel have a network of custodian banks where the certificates are deposited in bearer form for safekeeping. They manage the clearing of transactions on settlement date.MH BOUCHET (c) CERAM 454
Emerging Markets Eurobonds with low default track High risk/high yield
record (premium of 20 basis points compared with US corporate borrowers for identical ratings) historically, defaults only in the 1930s and late 1980s but recovery rate is better for sovereign debtors than corporate debtors (75% vs 40%) problem of comparability of treatment with Paris Club and London Club debt (Pakistan, Ukraine, Ecuador, Argentina) Market risk remains high due to concentration on 5 major countries 455 MH BOUCHET (c) CERAM (Argentina, Mexico, Korea, Brazil and
Eurobond Market
By spreading the risk among thousands of investors, both private and institutional, as opposed to a handful of banks in the loan market, the bond markets lower the cost of risk and thus reduce the cost of funding for companies and other borrowers. This in turn enables companies to raise larger amounts of debt. Many companies took benefit of the depreciating euro in the fist half of 1999 to borrow in Euros and swap the proceeds into US$, which had an immediate downward effect on the value of the , hence the link between the the euros weakness and the popularity of the euro456 MH BOUCHET (c) CERAM denominated bond market (US$300 b worth of
The Eurobond Market Size
Gross= completed new bond and note issues in US$ billion Net= Gross - redemptions and repurchases
10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 1994 1995 1996 1997 1998 1999 2000 2001 2002
457
Q2
Gross Net Stock
2003
Secondary market trading share/volume in 2003

12%
46% 37% US$1500 billion
Brady Eurobonds Local Other
458
Currency Breakdown of the international securities market

Net bond and note issues in US$ billion
800 700 600 500 400 300 200 100 0
$ Y Other
45% 34%
1997
1998
1999
2000
2001
2002
459
Largest issuers of Euro-denominated convertible debt in 2001-03

France Telecom 6.2 billion Vivendi Univ. 2.8 billion Olivetti 2.5 billion PPR 1.4 billion Lafarge 1.3 billion Artemis 1.2 billion Danone 1 billion
460
China and the global bond market
US$1.5 billion dollar and eurodenominated issue, as benchmark government bond: October 2003 Chinas rating = A2 (Moodys) * 10-year US$1 billion dollar tranche arranged by Goldman Sachs, Merrill and Morgan, at 53 bp over USTB * 5-year 400 million euro tranche arranged by Deutche Bank, BNP and UBS, at 7 bp over Euribor
Currency diversification and Eurobond issues
Between September and November of 2000, the US Agency Freddie Mac launched five-year two -denominated bond issues of 5 billion respectively as part of Euro-reference note programme, with ANB Amro and Morgan Stanley as lead managers. Multicurrency and global bond issues reach US$815 billion in 2000, a 14% rise. 11/2003: the EBRD is about to issue a US$150 million rouble bond in Russias market for on-lending purposes
Eurobond Market
Deutsche Bank Morgan Stanley Warburg Dillon Reed ABN Amro Merill Lynch Lazard Frres JP Morgan Salomon/Citibank BNP-Paribas Barclays Commerzbank Credit Suisse First Boston
Bond markets
Yankee market: issues have to satisfy SEC listing requirements. These require higher standards of accounting and disclosure than typical for Eurobond issuers. In 11/1993, the SEC adopted measures to simplify the listing of foreign companies in US markets. They include recognition of international accounting standards, easier registration procedures, and reduction in the required reporting history from 3 years to 12 months. Samura market
International Debt Markets and Instruments
International Securities Market

Fixed and floating rate/medium to long-term bond issues
Eurobond straight fixed-rate issue
Floating-rate note
Equity-related issue
465
Eurocurrency market Instruments 1: EURONOTE MARKET

Market of short- to medium-term debt instruments sourced in the Eurocurrency markets I. Euronote facilities: short-term, negotiable promissory notes, provided by international investment and commercial banks (fees for underwriting and placement services). The euronote is substantially cheaper source of ST funds than syndicated loans, because the notes are placed directly with the investor public, and the securitized
Eurocurrency market Instruments

II- Note-issuance facility (NIF): A medium-term legally-binding commitment under which a borrower can issue a shortterm paper in its own name, underwritten by banks which are committed either to purchase any note the borrower is unable to sell, or to provide credit. Issuing procedures with arranger or placing agent and tender panel.
III- Euro medium-term notes (EMTNs) It bridges the gap between the ST euro commercial paper issued in domestic markets < 6 months, and the longer-term international bond. Market expansion when the SEC instituted Rule # 415, allowing companies to obtain shelf registrations for debt issues: once the registration was obtained, the corporation could issue notes on a continuous basis without having to obtain new registrations for each additional issue. This allows a firm to sell S/MT notes through a cheaper and more flexible issuance facility than ordinary bonds.
Eurocurrency market Instruments
Eurocurrency market Instruments 2: The Eurobond Market A Eurobond is underwriten by an international
syndicate of investment banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated: $denominated bond issued by a US company, but sold to investors in Europe and Japan. Eurobonds offer tax anonimity and flexibility. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at a banking institution listed on the issue as paying agent. Eurobonds are offered simultaneoulsy in a 469 number of different MH BOUCHET (c)markets. capital CERAM
1. Straight fixed-rate issue: bearer bonds, fixed coupon, set maturity date, full principal repayment upon final maturity. Coupons are normally paid annually. 2. Equity-linked bonds: convertible bonds or bonds with equity warrants (amounted to $64 billion in 1997, and $32 billion in 1998). Right to acquire equity stock in the issuing company (sometimes with detachable warrants containing the acquisition rights). The market value of an ELB is composed of the naked value and the conversion value. The conversion to stock prior to maturity is at a specified price per share, or a specified number of shares per bond. The borrower is able toCERAM issue debt with470 lower MH BOUCHET (c) coupon payments due to the added value of the
Eurocurrency market Instruments The Eurobond Market
Eurocurrency market Instruments The Eurobond Market

3- FRNs: since the early 1980s. medium-term notes where the interest is fixed as a percentage above sixmonth LIBOR. Pays a semi-annual coupon determined on variable-rate base. Negotiable and transferable securities with flexible interest rate, fixed interest periods, and issued in pre-determined and uniform amounts. FRNs are
directed at institutional investors
Global bonds
Global bonds are issued simultaneously in several major international markets and allow issuers to tap into broader demand and obtain lower rates than those availabe in a single market. Some market participants estimate that EMCs such as Brazil and Argentina have been able to reduce the interest rate on funds raised through global issues by as much as 30 basis points. Argentina was the first borrower ever to issue a global bond on 12/1993 with a US$1 billion placement.
472
Peru and the Global Bond market
12/98: Telefonica del Peru (TDP) launched a $150 million 10-year bond backed by telephone receivables via JP Morgan, with a 7.48% coupon. The deal was priced at 315 bp over 5-year UST bills. The bonds were rated A- by DCR and A3 by Moodys. 11/2000: Banco de Credito raised a $100 million 7-year bond backed by its inflow of hard currency electronic transfers. The $ flow was transferred to the offshore trustee for the benefit of the certificate holder. (the structure was substantially over
Peru and the Global Bond market

01/2002: Peru raised $500 million of 12-year bonds, priced to yield 10.1% at a spread of 610 bp over US Treasuries (Deutsche Bank/Merrill Lynch) 03/2002: Peru reopened the issue, pricing $250 million-worth of 12-year bonds at 575 bp. The bond carries a 9.875% coupon.
474
Financial Clauses in Eurocurrency financing

Bullet Maturity: One-time payment of principal at maturity. Currency Redenomination: Switching of loans denominated in one currency or currencies into the currency of the creditor country or into ECUs. (The mechanism is intended to bring about a better match between the currency mix of debt service payments and the currency composition of external receipts.) Interest Rate Switching: Selection of a new basis for interest calculations on an existing loan. The options may include LIBOR, a domestic rate, the prime rate or a fixed rate, to which a margin is added.
Legal clauses in Eurocredits

Problem of comparability of treatment between various categories of creditors:
Axiom: an emerging market is a market from which you cannot emerge in an emergency! Ex.: Paris Club insists on involving Eurobond investors in refinancing and restructuring workouts. Test cases: Pakistan, Russia, Ukraine, Romania, Ecuador and Venezuela (US$60 billion question!); Rumania alone owes US$863 million eurobonds (i.e., tradeable instruments)
476

Prepayment clause: The prepayment clause is a standard clause in loan agreements between a debtor and a creditor bank. In its various forms, it can provide the debtor with the opportunity to accelerate repayment of the loan on a voluntary basis and/or provide for acceleration of repayment due to changes in laws affecting the creditor. In rescheduling agreements, the clause is intended to prevent the obligor to grant a preferential repayment schedule to other banks which have not signed the convention and which would be paid ahead of normal maturity terms.
pro rata sharing : A legal covenant in commercial bank agreements which specifies that debt service payments are to be made through the agent bank for allocation on a pro rata basis to all creditor banks. Further, payments received or recovered by any one lender must be shared on a pro rata basis with all co-creditors under the loan agreement. Thus, no one lender may be placed in a more favorable position than its co-lenders with respect to payments received and/or recovered. cross-default: A legal wrinkle which allows one creditor to declare default and exercise 478 MH BOUCHET (c) CERAM its remedies against the borrower in cases
. Mandatory repayment clause: standard
clause in loan agreements that stipulates certain circumstances under which repayment is accelerated. The debtor, by being obligated to prepay any one creditor, must repay all lenders on a pro rata basis. In the context of rescheduling agreements, the provision is intended to neutralize "free rider" banks which do not participate in debt restructuring and new money agreements. The provision applies across the universe of public sector borrowers so that a voluntary prepayment of one or more credits by one borrower would trigger mandatory prepayment not only by that borrower but 479 MH BOUCHET (c) CERAM

Optional prepayment provision: The optional prepayment provision permits the borrower to prepay all or part of the loan provided it prepays all lenders under the agreement on a pro rata basis.
Pari-passu clause: Clause inserted in lending and restructuring agreements that provides for a strict equality of treatment among various categories of debts and various families of creditors.
September-October 1999: The debt default of Ecuador in the limelight

Ecuador:
Brady bonds account for US$6.1 billion in Ecuadors overall external indebtedness of US$13 billion. The Brady bonds have been subject to a lot of financial engineering, including the stripping of the collateral out of the bonds. IMFs position: Ecuador needs to find out some US$500 million to cover its balance of payments shortfall until the end of next year, and about US$1 billion to cover its budget shortfall, and probably more since Ecuador has foreign currency denominated domestic debt.... For the first time in 55 years, the IMF is acquiescing in a countrys decision to default on its debts to the international bond markets.
. Negative Pledge provisions : they deal with
the granting of security interests by a borrower over its assets to its creditors. In the case of a debt refinancing agreement, the debtor agrees with the banks not to provide any other group of creditors with security interest on the country's reserves, exports of goods, and public sector companies' assets. The objective of such a clause is to prevent a situation where a debtor would allocate significant assets to other creditors, thereby effectively subordinating the unsecured bank credits, hence an unequal and unfair treatment of creditors!
How do Negative Pledge clauses work in practice?

Mexcobre/Paribas Citibank/Bancomext Pemex/JP Morgan Brady bonds and zero-coupon collaterals All required special waivers from IFIs!
483
Collateralization schemes
To facilitate the placement of debt instruments in the international bond market issuers use various structures of enhancements. Asset-backed securities allow borrowers to tap the bond markets at considerably lower rates. Pemex issue in Japan secured by four offshore drilling platforms in the Gulf of Mexico. Mexican insurance group launched an issue of mortage-backed securities with the bonds secured against US$-denominated mortgages granted to Mexican residents. Mexican company raised $200 million to finance a highway construction project through a bond issue backed by prospective toll revenues. 484 MH BOUCHET (c) CERAM
Asset-backed securities
October 1999: Argentina issued a $1.5 billion bond with a WB US$250 million collateral to guarantee sequential payments on the bond, borrowing for each payment the supranationals triple A credit rating. January 2001: Colombia issued a US$1.3 billion WB backed bond (Goldman Sachs and JP Morgan as advisers) November 2001: IFC, WBs private investment bank, responded positively to a request to provide guarantees to Philippines private sector companies
PERU: Jan. 2002 Debt Exchange offer
In a historic transaction, Peru returned to the global bond market for the first time in 74 years to exchange $1.21 billion of Bradys (mainly PDIs and Flirbs) for a new $930 million, 10year global bond. The exchange reduced Perus debt load by $280 million, generated NPV savings of $30 million.
EMBI+ index of most liquid and traded investments.
The new bond was priced 50 bp below the outstanding Bradys and qualified for JP Morgans
PERU s London Club Debt Secondary Market Price

(% of face value)
90 85 80 75 70 65 60 55 50 45
fe v00 A pr -0 0 Ju n00 A ug -0 0 O ct -0 0 M ar -0 1 Se p01 M ar -0 2 ju ly -0 2 de c02 ju ne -0 3
487
YTM 7% PDI 07/17 Asian crisis
FLIRB
-9 8
-9 8
98
-9 8
99
Se p-
Se p-
M ar
M ay
Ja
Ja
Ju
de c99
97
98
Ju
ov
n9
n-
l-9
n-
EMBI Spread Peru vs. Global, 1998 2003
488
Brady Bonds?
Default on interest payments triggers exercice of interest gurantee and of principal collateral guarantee Bullet Payment at maturity
LIBOR= 9 1/2
LIBOR = 5 1/4
t0
t10
t20
489
t30
How to assess and calculate the market value of a collateralized Brady Bond?
Brady bonds comprise defaulted London Club debt, repackaged and backed by 30-year US Treasury bonds as collateral, often including a rolling 18-month interest guarantee.
1. Strip the bond by separating the risk from the no-risk elements (interest and principal) 2. Calculate the risk-adjusted NPV of the guaranteed and non-guaranteed streams of interest payments and the principal payment at maturity, by using a risk-adjusted discount rate.
490
New Ball Game 1997/2003: Brady Debt Exchange Offers
Enhanced liability management gives rise to debt exchanges: 1997: Brazil: US$4 billion Bradys for new 30-year global bond 1997: Argentina: US$2.3 billion Bradys for new 30-year global 1997: Venezuela: US$4 billion Brady exchange 1997: Panama: US$0.7 billion Brady exchange 1999: Philippines: US$1 billion Bradys for new 10year bond 1999: Brazil: US$2 billion Pars, Flirbs, NMBs for new 10- year bond 2000: Argentina: US$2.4 billion Pars, Discounts, FRBs for new 15-year global bond 2000: Brazil: US$5.2 billion Bradys for new global 491 MH BOUCHET (c) CERAM bond
Larger and more complex ever bond issues

03/2001: France Telecom launched US$16 bn multi-currency bond issue (>Deutsche Telekoms $14.6 bn deal in June 2000), with eight tranches in $, , and , with maturities ranging from 2 to 30 years, with high bond yield and coupon increases by 25 bp for every notch Moodys or S&P rating cuts < A category. 11/2001: France Telecom (Baa1/BBB) completes 5 bn fundraising in the European bond market with twotranches short-dated deal: 18-month floating rate tranche of 2.25 bn and
International Fin Mgt
A Brief Introduction
Sep 2009
STRICTLY PRIVATE AND CONFIDENTIAL
Forex Markets
1. In Forex Mkt, currencies are bought and sold against each other.
2. Worlds largest market with a daily turnover of around $3.5 trillion a day.
3. The Indian Forex Mkt is very small compared to global 24 Hrs Forex market.
4. The Indian turnover is only around $ 5-10 billion/day.
5. The foreign exchange market is worldwide in scope
6. Major Centres : Tokyo, Singapore, New York, Frankfurt, Zurich, San Francisco.
Information and Communication Systems

1. Communications Handled by SWIFT 2. Society for Worldwide Interbank Financial Telecommunications (SWIFT).
3. SWIFT : is a non-profit Belgian cooperative from Geneva 4. All SWIFT centers around the world connected by data transmission lines.
5. A member bank can access a regional processor or main centre 6. This communications system links banks/ brokers in every financial centre.
7. The banks and brokers are in almost instant contact, 24 hours a day. 8. Significant events have Instantaneous impact due to Communication speed
Functions of the Foreign Exchange Market
1. Forex Mkt : One where individuals/firms banks buy and sell forex
2. Principle function of Forex Mkt is the transfer of funds across currencies
3.The above needed to facilitate International trade and capital transactions
The Foreign Exchange Rates

1. Two nations, the US and India. INR being the domestic currency 2. Exchange rate Expressed Directly 3. ER = INR/$ = 50. Two dollars are required to purchase one pound.
The exchange rate under a flexible exchange rate system

R = INR/$ S 4 3 E 2 1 H 0 1 2 3 4 5 Quantity of Pounds 6 7 D Million $/day A B G F
Foreign Exchange Markets
1. Forex market includes both the spot and forward exchange rates.
2. Spot : Delivery within two business days after the day of transaction
3. In forwards : Payment and delivery are not required until maturity.
4. Forward rates - For periods of 30, 60, 90 or 180 days from contract Date
The Spot Market
1. Indirect Quote : The number of units of $ for one unit of home currency.
2. Direct : Amount of rupees to exchange for one unit of foreign currency.
Cross Rates of Exchange

1. An Exch rate for a currency derived from the Exchange rates of those
currencies with a third currency is known as a cross rate of exchange.
2. A cross rate can be obtained by multiplying two exchange rates by each other so as to eliminate a third currency that is common to both rates.
3. Common use of cross rate is to determine the Exchange rate between 2 currencies that are quoted against the US dollar but not against each other.
Bid-Ask Spreads
1. Interbank quotations are given a bid and ask (also referred to as offer) price.
2. A bid is the price in one currency at which a dealer will buy another currency.
3. An offer or ask is the price at which a dealer will sell the other currency.
4. Dealers generally bid (buy) at one price and offer (sell) at a higher price.
5. Making profit from spread, The Difference between buying and selling prices.
The Forward Market

1. The spot market is for Forex traded within two business days. 2. However, some transactions may be entered into on one day but not completed until sometime in the future.
3. The forward rate is the rate quoted by foreign exchange traders for the
purchase or sale of foreign exchange in the future.
The Need for a Forward Market

1. The actual need for the existence of a forward market is not speculation. 2. Today, there is no clear-cut line of distinction between hedging and
speculating.
3. However, there are a couple of characteristic categories of people who use
Cont.
the forward market in order to cover for time lags.
Swaps
A swap Trn is a double-leg deal, in which one buys spot currency X selling
currency Y and simultaneously sells forward currency X buying currency Y.
Exc Rate
Spot
1 Mth Fwd
2 Mth Fwd
3 Mth Fwd
INR / DM
22.9410 / 40
20 / 24
20 / 25
15 / 19
INR / $
43.3125 / 10
15 / 10
20 / 15
20 / 20
Swaps
A swap Trn is a double-leg deal, in which one buys spot currency X selling
currency Y and simultaneously sells forward currency X buying currency Y.
Exc Rate
Spot
1 Mth Fwd
2 Mth Fwd
3 Mth Fwd
INR / DM
22.9410 / 40
20 / 24
20 / 25
15 / 19
INR / $
43.3125 / 10
15 / 10
20 / 15
20 / 20
Interest Arbitrage
Interest arbitrage refers to the international flow of short-term liquid capital to

earn a higher return abroad. Interest arbitrage can be covered or uncovered.
Interest differential in favour of foreign country in per cent per annum

Arbitrage outflow
Interest parity
Forward exchange rate - discount or premium in per cent per annum
22.5 23.25 3.33%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for DM
22.5 23.25 3.33% 10.20% 9.50% 0.70%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for DM Arbitrage possible
22.5 23.25 3.33% 10.20% 9.50% 0.70%
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for DM Arbitrage possible 01-Jan-09 Buy DM Investment @
22.5 23.25 3.33% 10.20% 9.50% 0.70%
100,000.0 10.2%
4,444.4
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for DM Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest
22.5 23.25 3.33% 10.20% 9.50% 0.70%
100,000.0 10.2%
4,444.4 453.3
Cumulative
4,897.8
01-Jan-09 Spot DM Fwd 1 year Forward Premium - DM Intt Rate DM Intt Rate INR Intt Rate diff for DM Arbitrage possible 01-Jan-09 Buy DM Investment @ 31-Dec-09 Interest
22.5 23.25 3.33% 10.20% 9.50% 0.70%
100,000.0 10.2%
4,444.4 453.3
Cumulative
Trfr to INR Return % 23.3
4,897.8
113,873.3 13.87%
Chapter
8
The Foreign Exchange Market
Using Currency Option

An option Profitable to exercise at the prevailing Forex rate is in-the money.
An out-of-the money option is not profitable to exercise at the current rate.
The price at which the option is exercised is called the exercise/ strike price.
Option whose spot rate is = Exch price is said to be at-the money.
Speculating with Currency Options

Break-even Point from Speculation if the revenue from selling the currency equals The payments for (i) Buying the currency + the option premium.
The computation of the break-even point is useful for a speculator deciding whether to purchase a currency call option or not.
Numerical Example Put option premium on $ = Rs. 0.4 per unit Strike price = Rs. 45.00 1 option contract represents 100 $
Relationship between Options and Futures
There is a symmetrical pay-off with the futures contract
whereas there is a asymmetrical pay-off with an option.
Nature of the symmetry refers to patterns of pay-offs around the exercise price
it is possible to combine options to replicate pay-offs from futures contract
Options vs Futures : Futures should be distinguished from options.

i. P&L on open futures positions. Ltd only by the Price of underlying ii. On options a. P&L is virtually unlimited for the purchaser but limited to writer b. Losses unlimited for the writer but Ltd to the premium for the writer
B. Hedging is possible with either options or futures.
But a single futures position can neutralise exposure in underlying asset. Same hedge with options requires simultaneous put and call in many Mkts.
Chapter 9
Forex. Rate Movement and International Parity Conditions
1. Exchange rates movement is an important issue in international finance
2. Managers of MNCs, FIIs, importers/ exporters attach importance to it.
The three theories of exchange rate determination are
1.
Purchasing Power Parity (PPP) : Links spot Fex rates to Price levels.
2.
3.
The Interest Rate Parity (IRP) : Links Fwd Exch rates and Nominal Intt.
The Intnl Fisher Effect (IFE) : Links Spot rate to nominal intt. rate levels.
Purchasing Power Parity (PPP)

a. The PPP theory focuses on the inflation-exchange rate relationships. b. Based on single price for similar commodities c. There are two forms of the PPP theory.
Absolute Purchasing Power Parity between Currencies
a. Postulate : Equilibrium exch. rate of 2 nations = Ratio of their price levels b. Thus, prices of similar products of 2 countries should be equal c. When measured in a common currency as per the absolute version of PPP
Rs / $
= PRs / P$
Relative Purchasing Power Parity

1. Postulate : Change in the Exchange rate is proportional to Delta price levels in the two nations over the same time period.
2. This theory a/cs for market imperfections like transport costs,Tariffs/ quotas.
3.Relative PPP theory accepts that prices of similar products can Differ across countries when measured in a common currency.
R 1 / $1
[ (P
R1/
PR0) / (P$1/P$0) ] * [R0 / $0]
Graphic Analysis of PPP : Exhibit 1

a. Helps us assess the potential impact of inflation on exchange rates.
b. Y axis measures % Appr/ Depr of Forex relative to home currency

c. X axis measures % Inflation diff. between home and abroad
I -I (%)
PPP line A
-4 B
-2 -2
4 % Incr in the foreign currency spot rate
-4
Empirical Testing of PPP Theory

Substantial empirical research has been done to test the validity of PPP theory.
The general conclusions of most of these tests have been that PPP does not accurately predict future exchange rates
That there are significant deviations from PPP persisting for lengthy periods.
International Fisher Effect (IFE)

The IFE uses interest rates rather than inflation rate differential to explain the
changes in exchange rates over time.
IFE is closely related to the 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 Fisher Effect.
The IFE suggests that given two countries, the currency in the country with the higher interest rate will depreciate by the amount of the interest rate differential.
Graphic Analysis of PPP : Exhibit 2

a. Helps us assess the potential impact of Intt on exchange rates.
b. Y axis measures % Appr/ Depr of Forex relative to home currency

c. X axis measures % Intt diff. between home and abroad
I -I (%)
PPP line A
-4 B
-2 -2
4 % Incr in the foreign currency spot rate
-4
Graphic Analysis of the International Fisher
Exhibit 2 illustrates the IFE. The X axis shows the percentage change in the foreign currencys spot rate The Y axis shows the difference between the home and foreign interest rats The diagonal line indicates the IFE line It depicts the exchange rate adjustment to offset the differential in interest rates. For all points on the IFE line, an investor will end up achieving the same yield, Whether investing at home or in a foreign country. The IFE suggests that if a company regularly makes foreign investments, The yield is sometimes below and sometimes above domestic yield.
Comparison of PPP, IFE and IRP Theories

Theory Interest rate party (IRP) Key Variables of Theory Forward rate premium (or Discount) Interest differential
a. b. c. b. c.
Summary of Theory The premium/ Discount in Forex rates Is a function of Difference in interest rates Between 2 countries. So, covered interest arbitrage return Will be no higher than domestic returns. The spot rate of one currency wrt another will change wrt differential in inflation rates between the two countries. So, purchasing power for consumers across countries will be similar
Purchasing Power Parity (PPP)
% change in spot Exch rate
Inflation differential
a. b. c. d.
International Fisher Effect (IFE)
% change in spot Exch rate
Intt. rate differential
The spot rate of one currency wrt another b. will change wrt differential in inflation rates c. between the two countries. d. So, purchasing power for consumers across countries will be similar e.So, the return on uncovered foreign money market securities will, on an average, be no higher than the return on domestic money
a.
Chapter
11
Management of Translation Exposure
Translation Methods
Four methods of foreign currency translation have been developed in various
countries. 1. The current rate method
2.
3. 4.
The monetary/non-monetary method

The temporal method The current/non-current method
Functional Versus Reporting Currency

Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December 1981, and all US MNCs were required to adopt the statement for
fiscal years beginning on or after December 15, 1982. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items were recognised or at an appropriate weighted average exchange rate for the period. FASB 52 differentiates between a foreign affiliates functional and reporting currency.
Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. The reporting currency is the currency in which the parent firm prepares
its own financial statements. This currency is normally the home country currency, i.e.,
Comparison of Four Translation Methods
All financial statement items restated in terms of the parent cur functional currency amount multiplied by the appropriate exchang
Exchange Rates Used to Translate Balance Sheet Items

Balance Sheet Current/ Non-current Monetary Non-monetaryRate Temporal Current
Cash Receivables Payables Inventory Fixed Assets
C C C C H
C C C C H
C C C C or H H
C C C C C
L/Term Debt
Net Worth
H
H
C
H
C
H
C
H
1.00
1.05
0.10
0.11
1.05
1.40
0.11
0.14
Current Method UK subsidiary Mil Sl no 1 2 3 4 Particulars Cash & Bank Balance A/cs receivable Inventories Fixed Assets Total Assets 31-1298 120 315 612 1,350 2,397 31Dec-99 143 407 750 1,300 2,600 French Subsidiary (Mil FF) 31-Dec98 2,143 4,020 3,950 7,010 17,123 31-Dec99 1,915 3,775 3,850 6,850 16,390 UK subsidiary Mil 31Dec-98 126 331 643 1,418 2,517 0 1 2 3 4 5 Bank Loans A/Cs Payable L/T Debt Net Worth 500 490 650 757 450 553 700 897 3,000 4,873 4,250 5,000 2,800 4,658 4,000 4,932 525 515 683 757 38 2,397 2,600 17,123 16,390 2,517 31-Dec99 200 570 1,050 1,820 3,640 0 630 774 980 942 314 3,640 French Subsidiary (Mil FF) 31-Dec98 238 447 439 779 1,903 0 333 541 472 500 56 1,903 31-Dec99 264 521 531 945 2,261 0 386 642 552 548 132 2,261
Transln Gain/ Loss

Total Liabilities
1.00 1.05
1.05 1.40
0.10 0.11
0.11 0.14
Monetary / Non-Monetary UK subsidiary Mil Sl no 1 2 3 4 Particulars Cash & Bank Balance A/cs receivable Inventories Fixed Assets 31Dec-98 120 315 612 1,350 31Dec-99 143 407 750 1,300 French Subsidiary (Mil FF) 31-Dec98 2,143 4,020 3,950 7,010 31-Dec99 1,915 3,775 3,850 6,850 UK subsidiary Mil 31Dec-98 126 331 612 1,350 31Dec-99 200 570 788 1,365 French Subsidiary (Mil FF) 31-Dec98 238 447 395 701 31-Dec99 264 521 428 761
Total Assets
2,397
2,600
17,123
16,390
2,419
2,923
1,781
1,974
1 2 3 4 5
Bank Loans A/Cs Payable L/T Debt Net Worth Transln Gain/ Loss Total Liabilities
500 490 650 757
450 553 700 897
3,000 4,873 4,250 5,000
2,800 4,658 4,000 4,932
525 515 683 757 (60)
630 774 980 942 (404) 2,923
333 541 472 500 (66) 1,781
386 642 552 548 (155) 1,974
2,397
2,600
17,123
16,390
2,419
Cur Rate Historical (Inv) Historical (Dep)
6.4 4.5 4
Normal 6.4
Revaluation 25.00 % 4.80
Devaluation 50.00% 9.60
Current / Non current Rate Amount Rate Amoun t Rate Amount
Sales
Cost of sales : Inv COS - Depr COS - Others SD O/Hs Intt Exps PBT I Tax PAT
8,000
600 1,000 900 900 600 4,000 1,600 2,400
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
1,468
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
1,468
4.7
1,720
7.1
1,135
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
1,468
4.7
4.7
1,720
129
7.1
7.1
1,135
85
5.5
110
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5
1,468
110
4.7
4.7 4.0
1,720
129 250
7.1
7.1 4.0
1,135
85 250
4.0
250
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0
1,468
110 250
4.7
4.7 4.0 4.7
1,720
129 250 194
7.1
7.1 4.0 7.1
1,135
85 250 128
5.5
165
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0 5.5
1,468
110 250 165
4.7
4.7 4.0 4.7 4.7
1,720
129 250 194 194
7.1
7.1 4.0 7.1 7.1
1,135
85 250 128 128
5.5
165
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0 5.5 5.5
1,468
110 250 165 165
4.7
4.7 4.0 4.7 4.7 4.7
1,720
129 250 194 194 129
7.1
7.1 4.0 7.1 7.1 7.1
1,135
85 250 128 128 85
5.5
110
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0 5.5 5.5 5.5
1,468
110 250 165 165 110
4.7
4.7 4.0 4.7 4.7 4.7 4.7
1,720
129 250 194 194 129 860
7.1
7.1 4.0 7.1 7.1 7.1 7.1
1,135
85 250 128 128 85 567
5.5
734
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0 5.5 5.5 5.5 5.5
1,468
110 250 165 165 110 734
4.7
4.7 4.0 4.7 4.7 4.7 4.7 4.7
1,720
129 250 194 194 129 860 344
7.1
7.1 4.0 7.1 7.1 7.1 7.1 7.1
1,135
85 250 128 128 85 567 227
5.5
294
6.4 4.5 4
Normal 6.4
Sales
8,000
600 1,000 900 900 600 4,000 1,600 2,400
5.5
5.5 4.0 5.5 5.5 5.5 5.5 5.5
1,468
110 250 165 165 110 734 294
4.7
4.7 4.0 4.7 4.7 4.7 4.7 4.7 4.7
1,720
129 250 194 194 129 860 344 516
7.1
7.1 4.0 7.1 7.1 7.1 7.1 7.1 7.1
1,135
85 250 128 128 85 567 227 340
5.5
440
Cur Rate
Historical (Inv) Historical (Dep) No 1 2 3 4 5 Particulars Cash & Bank Balance Mkt Securities Inventory Plant &Eqpt Goodwill Total Assets 1 2 3 4 5 6 Cur Liabilities LT Loan LT Debt Capital stock Ret. Earnings Tran Gain/ Loss Total Liabilities
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount Rate Amount Rate Amount
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount Rate Amount Rate Amount
6.4
250,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount Rate 4.8 Amount 333,333 Rate 9.6 Amount 166,667
6.4
250,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 Rate 4.8 4.8 Amount 333,333 666,667 Rate 9.6 9.6 Amount 166,667 333,333
6.4
500,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 Rate 4.8 4.8 4.8 Amount 333,333 666,667 500,000 Rate 9.6 9.6 9.6 Amount 166,667 333,333 250,000
6.4
375,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 Rate 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 Rate 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000
6.4
750,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333
6.4
312,500
2,187,500
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 4.8 166,667 9.6 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333
6.4
125,000
14,000,000
Cur Rate
Historical (Inv) Historical (Dep) No 1 2 3 4 5 Particulars Cash & Bank Balance Mkt Securities Inventory Plant &Eqpt Goodwill Total Assets 1 2 3 4 5 Cur Liabilities LT Loan LT Debt Capital stock Ret. Earnings
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 6.4 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 125,000 4.8 4.8 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 166,667 333,333 9.6 9.6 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333 166,667
6.4
250,000
Tran Gain/ Loss

Total Liabilities 14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 6.4 6.4 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 125,000 250,000 4.8 4.8 4.8 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 166,667 333,333 416,667 9.6 9.6 9.6 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333 166,667 208,333
6.4
312,500
14,000,000
2,187,500
2,916,667
1,458,333
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 6.4 6.4 6.4 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 125,000 250,000 312,500 4.8 4.8 4.8 4.0 4.0 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 166,667 333,333 416,667 2,000,000 400,000 9.6 9.6 9.6 4.0 4.0 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333 166,667 208,333 2,000,000 400,000
4.0
2,000,000
4.0
400,000
14,000,000
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 6.4 6.4 6.4 4.0 4.0 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 125,000 250,000 312,500 2,000,000 400,000 4.8 4.8 4.8 4.0 4.0 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 166,667 333,333 416,667 2,000,000 400,000 9.6 9.6 9.6 4.0 4.0 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333 166,667 208,333 2,000,000 400,000
14,000,000
2,187,500
2,916,667
1,458,333
Cur Rate
6.4
4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 6.4 6.4 6.4 4.0 4.0 Rate 6.4 6.4 6.4 6.4 6.4
Normal
6.4
Revaluation
25.00% 4.80
Devaluation
50.00% 9.60
Current Rate Amount 250,000 500,000 375,000 750,000 312,500 2,187,500 125,000 250,000 312,500 2,000,000 400,000 (900,000) 4.8 4.8 4.8 4.0 4.0 Rate 4.8 4.8 4.8 4.8 4.8 Amount 333,333 666,667 500,000 1,000,000 416,667 2,916,667 166,667 333,333 416,667 2,000,000 400,000 (400,000) 2,916,667 9.6 9.6 9.6 4.0 4.0 Rate 9.6 9.6 9.6 9.6 9.6 Amount 166,667 333,333 250,000 500,000 208,333 1,458,333 83,333 166,667 208,333 2,000,000 400,000 (1,400,000) 1,458,333
14,000,000
2,187,500
Cur Rate Historical (Inv) Historical (Dep) Sl no

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate
Normal 6.4
Devaluation 50.00 % 9.60
Current / Non current Amount Rate Amount Rate Amount
Particulars Cash & Bank Bal
Mkt Securities
Inventory Plant &Eqpt Goodwill Total Assets
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
1 2 3 4
Cur Liabilities LT Loan LT Debt Capital stock Retained Earnings Transln Gain/ Loss Total Liabilities
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate
Normal 6.4
Current / Non current Amount Rate Amount Rate Amount
6.4
250,000
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Current / Non current Amount 250,000 Rate Amount Rate Amount
4.8
333,333
9.6
166,667
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Current / Non current Amount 250,000 Rate 4.8 Amount 333,333 Rate 9.6 Amount 166,667
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4
500,000
375,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4
500,000
375,000
4.8
4.8
666,667
500,000
9.6
9.6
333,333
250,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4
500,000
375,000
4.8
4.8 4.0
666,667
500,000 1,200,000
9.6
9.6 4.0
333,333
250,000 1,200,000
4.0 1,200,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4 4.0
500,000
375,000 1,200,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
4.0
500,000
2,825,000
1 2 3 4
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate 6.4 6.4 6.4 4.0 4.0
Normal 6.4
Current / Non current Amount 250,000 500,000 375,000 1,200,000 500,000 2,825,000 Rate 4.8 4.8 4.8 4.0 4.0 Amount 333,333 666,667 500,000 1,200,000 500,000 3,200,000 4.8 166,667 9.6 Rate 9.6 9.6 9.6 4.0 4.0 Amount 166,667 333,333 250,000 1,200,000 500,000 2,450,000 83,333
Particulars Cash & Bank Bal Mkt Securities Inventory Plant &Eqpt Goodwill Total Assets
1 2 3 4 5 6
6.4
125,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4 4.0 4.0
500,000
375,000 1,200,000 500,000 2,825,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
1 2 3 4
6.4
125,000
4.8 4.8
166,667 333,333
9.6 9.6
83,333 166,667
6.4
250,000
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4 4.0 4.0
500,000
375,000 1,200,000 500,000 2,825,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
1 2 3 4
6.4 6.4
125,000 250,000
4.8 4.8 4.0
166,667 333,333 500,000
9.6 9.6 4.0
83,333 166,667 500,000
4.0
500,000
5
6
1,600,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000
6.4
6.4 4.0 4.0
500,000
375,000 1,200,000 500,000 2,825,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
Cur Liabilities
6.4
125,000
4.8
166,667
9.6
83,333
2
3 4 5
LT Loan
LT Debt Capital stock Retained Earnings Transln Gain/ Loss Total Liabilities
1,600,000
2,000,000 8,000,000 1,600,000
6.4
4.0
250,000
500,000
4.8
4.0 4.0 4.0
333,333
500,000 2,000,000 400,000
9.6
4.0 4.0 4.0
166,667
500,000 2,000,000 400,000
4.0 2,000,000 4.0 400,000
14,000,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4 4.0 4.0
500,000
375,000 1,200,000 500,000 2,825,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
1 2 3 4
6.4 6.4 4.0 4.0
125,000 250,000 500,000 2,000,000
4.8 4.8 4.0 4.0
166,667 333,333 500,000 2,000,000
9.6 9.6 4.0 4.0
83,333 166,667 500,000 2,000,000
5
6
1,600,000
4.0
400,000
4.0
400,000
4.0
400,000
14,000,000
0.0
2,825,000
3,200,000
2,450,000

1 2 3 4 5
6.4 4.5 4 31-Mar-01 1,600,000 Rate 6.4
Normal 6.4
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000
6.4
6.4 4.0 4.0
500,000
375,000 1,200,000 500,000 2,825,000
4.8
4.8 4.0 4.0
666,667
500,000 1,200,000 500,000 3,200,000
9.6
9.6 4.0 4.0
333,333
250,000 1,200,000 500,000 2,450,000
1 2 3 4
6.4 6.4 4.0 4.0
125,000 250,000 500,000 2,000,000
4.8 4.8 4.0 4.0
166,667 333,333 500,000 2,000,000
9.6 9.6 4.0 4.0
83,333 166,667 500,000 2,000,000
5
6
1,600,000
4.0
400,000
(450,000)
4.0
400,000
(200,000) 3,200,000
4.0
400,000
(700,000) 2,450,000
14,000,000
0.0
2,825,000
Cur Rate Historical (Inv) Historical (Dep) No 1 2 3 4 5 Particulars Cash & Bank Balance Mkt Securities Inventory Plant &Eqpt Goodwill Total Assets 1 2 3 4 5 6 Cur Liabilities LT Loan LT Debt Capital stock Retained Earnings Transln Gain/ Loss Total Liabilities
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Revaluation 25.00% 4.80
Monetary / Non-Monetary Amount Rate Amount Rate Amount
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount Rate Amount Rate Amount
6.4
250,000
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 Rate 4.8 Amount 333,333 Rate 9.6 Amount 166,667
6.4
14,000,000
Cur Rate Historical (Inv) Historical (Dep) No 1 Particulars Cash & Bank Balance
6.4 4.5 4 31-Mar-01 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 Rate 4.8 Amount 333,333 Rate 9.6 Amount 166,667
6.4
2
3 4 5
Mkt Securities
3,200,000
2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000
6.4
500,000
4.8
666,667
9.6
333,333
1 2 3 4 5 6
14,000,000
Cur Rate Historical (Inv) Historical (Dep) No 1 2 3 4 5 Particulars Cash & Bank Balance Mkt Securities Inventory Plant &Eqpt Goodwill Total Assets 1 2 3 4 5 6 Cur Liabilities LT Loan LT Debt Capital stock Retained Earnings Transln Gain/ Loss
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 Rate 4.8 4.8 4.5 Amount 333,333 666,667 533,333 Rate 9.6 9.6 4.5 Amount 166,667 333,333 533,333
6.4 6.4
4.5
533,333
Total Liabilities
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 Rate 4.8 4.8 4.5 Amount 333,333 666,667 533,333 Rate 9.6 9.6 4.5 Amount 166,667 333,333 533,333
6.4 6.4 4.5 4.0
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333
6.4 6.4 4.5 4.0
4.0
500,000
2,983,333
Total Liabilities
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 4.8 166,667 9.6 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333
6.4 6.4 4.5 4.0 4.0
6.4
125,000
Total Liabilities
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 6.4 125,000 4.8 4.8 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 166,667 333,333 9.6 9.6 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333 166,667
6.4 6.4 4.5 4.0 4.0
6.4
250,000
Total Liabilities
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 6.4 6.4 125,000 250,000 4.8 4.8 4.8 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 166,667 333,333 416,667 9.6 9.6 9.6 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333 166,667 208,333
6.4 6.4 4.5 4.0 4.0
6.4
312,500
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 6.4 6.4 6.4 125,000 250,000 312,500 4.8 4.8 4.8 4.0 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 166,667 333,333 416,667 2,000,000 9.6 9.6 9.6 4.0 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333 166,667 208,333 2,000,000
6.4 6.4 4.5 4.0 4.0
4.0
2,000,000
Total Liabilities
14,000,000
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 6.4 6.4 6.4 4.0 125,000 250,000 312,500 2,000,000 4.8 4.8 4.8 4.0 4.0 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 166,667 333,333 416,667 2,000,000 400,000 9.6 9.6 9.6 4.0 4.0 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333 166,667 208,333 2,000,000 400,000
6.4 6.4 4.5 4.0 4.0
4.0
400,000
2,983,333
Total Liabilities
14,000,000
3,233,333
2,733,333
6.4 4.5 4 31-Mar-01 1,600,000 3,200,000 2,400,000 4,800,000 2,000,000 14,000,000 800,000 1,600,000 2,000,000 8,000,000 1,600,000 Rate
Normal 6.4
Monetary / Non-Monetary Amount 250,000 500,000 533,333 1,200,000 500,000 2,983,333 6.4 6.4 6.4 4.0 4.0 125,000 250,000 312,500 2,000,000 400,000 (104,167) 4.8 4.8 4.8 4.0 4.0 Rate 4.8 4.8 4.5 4.0 4.0 Amount 333,333 666,667 533,333 1,200,000 500,000 3,233,333 166,667 333,333 416,667 2,000,000 400,000 (83,333) 3,233,333 9.6 9.6 9.6 4.0 4.0 Rate 9.6 9.6 4.5 4.0 4.0 Amount 166,667 333,333 533,333 1,200,000 500,000 2,733,333 83,333 166,667 208,333 2,000,000 400,000 (125,000) 2,733,333
6.4 6.4 4.5 4.0 4.0
14,000,000
2,983,333
Group presentations
1. 2. 3. 4. 5.
FDI MNC Capital Budgeting MNC Cash Management International Taxation Depository receipts GDR/ADRS
Ch Ch Ch Ch Ch
14 16 17 19 23
Group Group Group Group Group
1 5 2 4 2
Others (Self will handle) 1. Cost of Capital and Cap Structure 2. Country Risk analysis 3. International Banking 4. Euro currency markets 5. Swaps and Exch. Arithmetic 6. Euro and Implication for India
Measurement of Currency Variability Covariance among the Asian Currencies (1993-2000)

Taiwane se Dollar TWD/USD CNY/USD JPY/USD KRW/USD HKD/USD THB/USD 1.000 0.700 22.817 652.45 0.046 21.756 1.000 -0.356 46.193 0.003 1.621 1.000 1853.06 0.053 53.210 0.761 1.000 3.264 1751.03 23.822 1.000 0.142 0.002 0.115 1.000 0.868 39.737 1.000 0.557 1.000 Chinese Remni mbi Japanese Yen South Korean Won Hong Kong Dollar Thai Baht Singap ore Dollar Indian Rupee
SGD/USD
INR/USD
0.301
14.944
-0.014
1.532
30.446
1076.20
Correlations Shown by the Top Nine Currencies of the World Against Each other (1993-2000)
CAD
DEM
FRE
JPY
GBP
SHF
AUD
KHD
CAD DEM FRF JPY GBP SHF AUD HKD NZD
1.00 -0.46 0.53 -0.77 0.73 -0.66 0.72 0.31 0.41
1.00 0.28 0.85 -0.21 0.93 0.85 -0.27 0.83
1.00 -0.15 0.78 -0.04 0.85 0.12 0.83
1.00 -0.52 0.88 0.06 -0.53 0.22
1.00 -0.48 0.52 0.44 0.36
1.00 0.75 -0.32 0.83
1.00 0.67 0.90
1.00
Assigning risk grades to currencies

Risk grades to currencies have been arrived at after determining their standard deviations. The following formula has been used for arriving at the classification.
Standard Deviation 2000
Standard Deviation 1991
100
Risk Rating 1-20% 21-40% 41-60% 61-80% 81-100% 101-1000% >1000%
Risk Grade A+ (Very Low) A (Low) B + (Average) B (Medium) C (High) D (Very High) E (Extremely High)
Name of Co Its HO Currecny Tran Currency Problem DC needs (Sterling) When (no of days) Current Spot rate (no of $ / ) Forward rate 180 days quote (no of $ / ) Interest Rates
DC Corp $
100,000 180 1.5 1.48 UK US
Deposit rate
Borrowing rate (180 days)
4.5%
5.1%
4.5%
5.1%
Call option prem on 180 days strike 1.49 Future Spot rate Probabilities
$ 0.03 Expd rate $ 1.44 $ 1.46 $ 1.53 Prob 0.2 0.6 0.2
Forward Hedge
1 Forward Rate 180 days hence

2 Swap Needed after 180 days () Cumulative principal + intt in 180 days (Sterling)
148,000
100,000 1.045
Needed now ()
95,694
Price of needed presently in $ terms (1.5$/) Borrowing cost of $ for 180 days (5.1%) Cumulative Cost impact
143,541 7,321
150,861
Expd Spot
Exercise Call ?
Applicable rate Prem
Total cost
Actual O/F
Prob
Expd Value
1.44 1.46 1.53
No No Yes
1.44 1.46 1.49
0.03 0.03 0.03
1.47 1.49 1.52
147,000 149,000 152,000
0.2 0.6 0.2
29,400.0 89,400.0 30,400.0 149,200.0
Expd Spot
Applicable rate
Total cost
Actual O/F
Prob
Expd Value
1.44 1.46 1.53
1.44 1.46 1.53
1.44 1.46 1.53
144,000 146,000 153,000
0.2 0.6 0.2
28,800.0 87,600.0 30,600.0
147,000.0

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Capital Flows - Some stats - Emerging markets $ Billion

Official flows Nett

International Fin Mgt

STRICTLY PRIVATE AND CONFIDENTIAL

Objectives of the Course

2. To familiarize students with

Principles of Collective learning

3. Preference to Depth over Width.

4. Preference to substance over form.

5. Mgt Paradigm : Timely Approximation is better than belated precision

Topics Pre Mid term UNIT I

Foreign exchange market

Functions Participants Currency derivatives

Forwards, Swaps, futures and Options

Interest rate futures speculation

Do you need to answer these questions

Empirically Global barriers are shrinking & global trade is growing

Emerging Eco (GDP/Trade) Gr. - faster than Developed one

Why IFM for Indian students

2007- Emerging Developed

: Trade Gr : 10.5% : Trade Gr : 5.3%

What is special about international finance?

Foreign exchange risk

Eg. An unexpected devaluation adversely affects our export Mkt.

Eg. A Coup that jeopardizes existing negotiated contracts.

Eg. Trade barriers & Tax incentives affect location of production.

Expanded opportunity sets (Global diversification)

Eg. Raise funds in global markets, gains from economies of scale

Intnl Fin mgt The expanded opportunities

Marginal Return on Projects

Purely Domestic Firm

MNC MNC Purely Domestic Firm

Marginal Cost of Capital

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

Asset Level of Firm

Forex Mkt T/O in Billions of US$ /Day.

Global trade Stats (figs in Bil $ / Yr : Right Asia/Other)

2500 2000 1500 1000 500 0

Global Flows Indian policy environment

Emigrat ion Immigration Exports

Fin Min (FIPB/ SEBI/ RBI)

Restrictive Immigration Laws, Resident status IT

Export Ban Export Duties

Global Capital Inflows

B. Economic benefits of FDI

Global Trade flows C. International biz methods

Structure of the course

International Financial Environment

International Financial System

International Financial System

International Monetary System

Exchange Rate Arrangement

Evolution of International Monetary System

Exchange Rate Equilibrium

Exchange Rates Determinants

International Financial Markets

International Financial Markets

Foreign Exchange Markets (Forex)

International Money and Capital markets

International Derivatives Markets

Immediate Delivery Market (spot market)

International Money Market