72653145 international-financial-management-1


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  • 72653145 international-financial-management-1

    1. 1. 1International Financial ManagementIntroduction• World as a Global village• Free flow of goods and services –seamless• Quantum jump in International trade andcommerce• New forms of trade-Internet,e-commerce• Dynamic and Complex International markets
    2. 2. 2International Financial ManagementInternational Financial Environment• Natural sequel to International trade• Financial Management- Integral part of Tradeand commerce• Technology and its Impact• New funding techniques,InvestmentVehicles,Risk Management products etc.• Creative Financial Management• Financial Engineering!
    3. 3. 3International Financial ManagementInternational Financial Environment-contdChallenges before a Finance Manager• Keep up to date with the the changes in theEconomic Environment-eg exchangerates,Banking and Tax regulations,Foreigntrade policies,credit conditions at home andabroad,stock market trends etc.• Complex relationships between variousvariables eg, impact of changes in the worldfinancial markets and its effects on the firmand its bottom line and cash flows
    4. 4. 4International Financial ManagementChallenges before a Finance Manager-contd• To be prepared to face adverse businessconditions affecting the Financial Position ofthe Firm and minimize its adverse impact-Business decisions going wrong due tochanges in assumptions,changes in marketconditions beyond control etc• Design and Implement effective solutions totake advantages of the markets and advancesin Financial theories –Upgrading skills andusing new tools of Financial Management,useof latest technology etc.
    5. 5. 5International Financial Management1. Roles and Goals of MNCs-• Raw materials seekers-Vertical Integration• eg French,Dutch and British East Indiancompanies• Today they are large Oil and Gas companieseg BP,Shell,Indian cos Mittal steel etc• Mineral companies like Anaconda copperInternational Nickel etcGoals-exploit availabilty-cost advantages
    6. 6. 6International Financial ManagementRoles and Goals of MNCs- contd• Market seekers-Typical MNCs of Today-they go overseas to manufacture and sell inoverseas markets eg IBM,unilever,cocacola,Pepsi, Procter and Gamble,Nestle etc• Goals-Maximize businsessopportunities,Maximize profits,to beatperceived or real trade restrictions,eg Japaninvesting in US to avoid export restrictions inUS
    7. 7. 7International Financial ManagementRoles and Goals of MNCs-contdCost Minimisers-• Again very common today –companies seekand invest in low cost countries,e.g.BPO/KPO in India,TexasInstruments.Japanese Consumer Electroniccompanies in Malaysia,China etc.• Goals-To remain competitive in the Domesticand world market,utilize Economies of scale.
    8. 8. 8International Financial ManagementExposure to International Risks-Exposure and Risk-• Exposure is the measure of the sensitivity ofthe value of a Financial Item,vizAsset,Liability,Cash Flow,to changes in therisk factor• Risk is the quantifiable likelihood of loss orless-than-expected returns. It is a measure ofthe variability of the value of the itemattributable to the the risk factor.
    9. 9. 9International Financial ManagementExposure to International Risks-1. Macroeconomic Environmental Risks-Valueof a Firms Assets,Liabilities and OperatingIncome varies continually in response tochanges in the economic variables such asExchange rates,Interest rates,Inflationrates,prices and so forth.2. Core Business risks-Interruptions to Rawmaterial supplies, labor troubles,success orfailure of a new product,operational risks
    10. 10. 10International Financial ManagementExposure to International Risks• 3)Systemic Risks-Collapse of a Financial system-egStock market crash,Run on Banks etc• 4)Currency Risks-also known as FE risk- A risk that aBusiness operation or an Investment value will beaffected by exchange rates fluctuations.• 5)Liquidity Risk-The risk that arises from the difficultyof selling an asset. An investment may sometimesneed to be sold quickly. Unfortunately, an insufficientsecondary market may prevent the liquidation or limitthe funds that can be generated from the asset. Someassets are highly liquid and have low liquidity risk egShares.Some assets have low Liquidity and highliquidity risk eg Real estate property
    11. 11. 11International Financial ManagementExposure to International Risks-contd• 6)Market Risk-Risk which is common to anentire class of assets or liabilities. The valueof investments may decline over a given timeperiod simply because of economic changesor other events that impact large portions ofthe market.• 7)Interest rate risk-Interest rate risk is due tothe rise or fall in the Interest rate of aSecurity or Bond held as well the marketvalue of the fixed rate bonds• 8)Political Risk-change ingovernment,unstable government eg Projectsin Iraq,Ethiopia etc.
    12. 12. 12International Financial ManagementExposures;Transaction Exposure-arises due to exchangedifferences in transactions-Unanticipatedchanges in the exchange rate has an impact-favourable or adverse on its cash flows.It isusually within the year.• Eg-An Indian company imports Raw materials from aUS company valued at usd100000,payable after 3months.If it pays at today’s rate it would have paid@Rs 45 to a dollar.As the rupee is weakened the rategoes upto Rs 46 to a dollar within 3 months.It has topay Rs 100,000 more.
    13. 13. 13International Financial ManagementTranslation exposure-is the change in accountingIncome and Balance Sheet statementscausedby by the changes in exchange rates.It resultsfrom the need to translate foreign currencyassets /Liabilities into local currency whilepreparing final accounts.• Eg-an Indian company borrows usd 1 million from aus bank for importing a machine. When the importmaterialized,the exchange rate was Rs 45 to a usd.Thevalue of the machine in the books as on that datewould be Rs 45 million(Rs 4.5 crores) and acorresponding loan of Rs 4.5 crores. (contd)
    14. 14. 14International Financial ManagementAssuming no change in the exchange rate,the companywhile preparing the final accounts will provide fordepreciation on 4.5 cores ,say @25%=Rs1.125crores.If the rate of exchange as on the Balance sheet date becomesRs 46 to a dollar,then correspondingly the figures ofMachinery value ,the loan taken and the depreciationto be charged also get changed.It impacts both Pand LAccount and the Balance sheet.However there is nodirect impact on the Cash flows immediately.
    15. 15. 15Economic exposure-refers to the change in thevalue of a company that accompanies anunanticipated change in exchangerates.Anticipated changes are alreadyreflected in the market value of the company.Eg-when an Indian company transacts business with anAmerican company,it has expectation that the IndianRupee is likely to weaken and factors this in itstransactions.If there is a weakening of the rupee it willnot affect the market value of the company.In case it isdifferent from the expected ,then it will have a bearingon the Market Value of the company.International Financial Management
    16. 16. 16Economic Exposure-has two components1. Operating exposure-which captures the impact of theunanticipated changes on the company’srevenues,operating costs and operating net cash flowsover a medium term horizon-say 3 years-somethingsimilar to Transaction exposure(TE) but longer thanTE. In general an exchange rate will affect both futurerevenues as well as operating costs and also theoperating Income-2. Strategic exposure-In the long term,exchange rateseffects can undermine the company’s competitiveadvantage by raising its costs over itscompetitors.Such competitive exposure is also referredto as Strategic exposure eg Japanese goods becomingexpensive due to yen becoming stronger and hencestrategically shifting production bases out of Japan.International Financial Management
    17. 17. 17Important Terms used in International Finance• Exchange control-mechanism by which the countryregulates its foreign exchange transactions.RBI inIndia regulates the entire FE movement into and out ofIndia.• Authorized Dealers-are those authorized to deal in FEby RBI eg,Banks.they can buy and sell foreigncurrencies,open LCs ,remit FE, open accounts abroad.• Letter of credit-is a document issued by the openingbank (importer’s bank)to honor an exporter’s draft orclaim for payment provided the exporter has fulfilledall the conditions stipulated in the LC.• Terms used in the operation of LCOpening bank-The bank which opens the LC at therequest of the buyer. (contd)International Financial Management
    18. 18. 18Beneficiary-The seller/exporter who sells goods to the buyerand who will receive the proceeds of the LC.Advising Bank-The correspondent Bank to whom theopening bank sends the LC in the exporter’s countrywho in turn send it to the exporter’s bank for furtherprocess.It could be the branch of the opening bankalso.Confirming Bank-one who adds his confirmation to the LCDP/DA-Drafts against payment and Drafts againstAcceptance-presents the draft on the Importer throughhis bankers who in turn forward this draft along withthe documents to the importers’ bankers for paymentand releasing the documents.International Financial Management
    19. 19. 19Balance of Payments-BOP of a country is a systematicaccounting record of all economic transactionsbetween the residents of A country with the Rest ofthe WORLD.• BOP considers both Import and Exports of Goods andServices• Basic types of Economic Transactions• 1)Purchase or sale of Goods or Services with a financialquid pro quo-or a promise to pay.One financial and onephysical(one Real)• 2)Purchase or sale of Goods or services in return for goodsor services-Barter system(Two Real)• 3)Any exchange of Financial items,say purchase ofFinancial securities and payment there for by cheque(twoFinancial transactions)• 4)A unilateral Gift in kind(one real transfer)• 5)A unilateral financial gift.(One financial transfer)International Financial Management
    20. 20. 20Accounting Principles in BOP-Is a standard double entry accounting record-Thumb rules toremember;1. All transactions which lead to an immediate orprospective payment from the Rest of theworld(ROW) to the country should be recorded ascredit entries.The payments,actual orprospective,should be recorded as the offsetting debitentries.• Conversely,all transactions which result in an actual orprospective payment from the country to the ROWshould be recorded as debits and the correspondingpayments as creditsInternational Financial Management
    21. 21. 21Accounting Principles in BOP-contd;• Payment received from ROW increases thecountry’s foreign assets –either the payment will becredited to a bank account held abroad by aresident entity or a claim is acquired on a foreignentity.Thus an increase in Foreign Assets mustappear as debit entry.• Conversely, a payment to the ROW reduces thecountry’s foreign assets or increases its liabilitiesowed to foreigners;a reduction in foreign assets oran increase in foreign liabilities must thereforeappear as credit entriesInternational Financial Management
    22. 22. 22Accounting Principles in BOP-contd2 A Transaction which results in an increase in demandfor foreign exchange is to be recorded as a debit entrywhile a transaction which results in an increase in thesupply of Foreign exchange is to be recorded as acredit entry.Thus an increase in Foreign assets or reduction inForeign Liabilities ,because it uses up foreignExchange is a debit entry while a reduction in foreignassets or an increase in foreign liabilities because it isa source of foreign exchange now, is a creditentry.Capital outflow-such as when a residentpurchases foreign securities or pays off a bank loan isa debit entry while capital inflow such as adisbursement of world bank loan is a credit entryInternational Financial Management
    23. 23. 23COMPONENTS OF BOP-1. Current Account-Imports and Exports of goods andservices and unilateral transfers of goods andservices2. Capital Account-Under this are includedtransactions leading to changes in foreign Financialassets and Liabilities of the country3. Reserve Account-In principle this is no differentfrom the capital account in as much as it alsorelates to Financial Assets and Liabilities.Howeverin this category only “Reserve Assets” areincluded.These are assets which the the monetaryauthority of the country uses to settle deficits andsurplusesInternational Financial Management
    24. 24. 24Examples; India exports garments to USA worthusd10000.The goods have been invoiced and will bepaid in USD.Payment will be effected by crediting theaccount of India in USA.The balance in a foreign bankis a foreign asset for India and liability for USA.Indiawill record the entry as;Transaction Debit credit-Good exported(current) 10000-Increase in claims fromForeign bank (foreign asset-capital) 10000In the BOP of USA it will be the opposite.International Financial Management
    25. 25. 25Example 2;India agrees to supply leather goods worth usd 5000 toSaudi Arabia in return for CRUDE OIL equivalent to thesame amount .Both are current account transactions;Willbe recorded in India’s BOP as follows;Transactions Debit creditGoods Imports 5000Goods Export 50000In the BOP of Saudi Arabia it will be the opposite.Example 3;SBI purchases securities issued by USA valued at usd2000 and pays through its branch in the USA.Here it haschanged one foreign asset to another.The transaction iscapital in nature;Transaction Debit CreditIncrease in foreign Securities 2000Decrease in Foreign bank account 2000International Financial Management
    26. 26. 26Structure of current Account in India’s BOP-Current Account Debits credits Net• Merchandise(goods)• Invisibles(a+b+c)a)services1.Travel2.Transportation3.Insurance4.Miscb)Transfers1)official2)Privatec)Income1)Investment Income2)employees compensationTOTAL CURRENT ACCOUNTInternational Financial Management
    27. 27. 27MERCHANDISE-In principle,merchandise covers alltransactions relating to movable goods where theownership is transferred from R to NR in the case ofexports and NR to R in the case of imports with someexceptions.Exports valued on FOB basis are credit entries.Datafor these items are obtained form the various formsexporters fill up and submit to designated authoritieslike STPI,Expocil,RBI etc.Imports valued at CIF are the debit entries.The difference between the total of debits and total ofcredits appears in the “NET ‘column.This is theBalance on Merchandise Trade Account,deficit orsurplus depending upon whether negative or positive.International Financial Management
    28. 28. 28Invisibles-Includes services such as transportation,InsuranceIncome,Payments and receipts for factor services,viz labourand capital and unilateral transfers.Credits under Invisibles consist of services renderedby R to NR, Interest and Dividend Income earned byR from their ownership of Foreign FinancialAssets,cash and gifts received in kind by R from NR.The NET balance between the credit and debit entriesunder the heads Merchandise ,Non-monetary goldmovements and Invisibles taken together as theCurrent Account Balance.The Net balance is taken asdeficit if negative and surplus if positive.International Financial Management
    29. 29. 29Structure of Capital Account IN India’s BOP-1.Foreign Investments(a+b) Debit credit Neta.)Indiab)Portfolio2.Loansa)External AssistanceBy IndiaTo Indiab) Commercial Borrowings(MT and LT)By IndiaTo IndiaC)Short termTo India3.Banking Capitala)Commercial BanksAssetsLiabilitiesNon-Residentsb)others4. Rupee Debt Service5.Other capitalTOTAL CAPITAL ACCOUNT(1 TO 5)International Financial Management
    30. 30. 30Structure of ‘other Accounts” Debit CreditNet1.Errors and Omissions2.Overall Balance (Total of current,capital andErrors and omissions)3.Monetary movementsIMFForeign Exchange Reserves(increase /decrease)International Financial Management
    31. 31. 31Meaning of “Deficit” and “Surplus”• Deficit refers to the negative balance in the BOP aftergiving effect to the various transactions and Surplusrefers to the positive balance in the BOP• It refers to the imbalance in subset of accountsincluded in the BOP and also referred to as Economicequilibrium or disequilibrium.Disequilibrium calls fora policy Intervention,it is important to group thevarious accounts in the BOP into set of Accounts‘above the Line’ and “below the Line”.If the NETbalance is positive we say it is BOP surplus and if it isnegative then it is BOP Deficit.• BOP statistics are important for the Finance Manager.If negative it will mean more demand for the Foreigncurrency and will increase its cost and vice versa.International Financial Management
    32. 32. 32• Negative BOP can be corrected by increasingtaxes,reducing government expenditure,by increasingsavings and by reducing consumption.• BOP disequilibrium can be remedied by borrowingfrom International Institutions like IMF which arecalled Multilateral Borrowings or by Inter-governmental Borrowings called as Bilateralborrowings.• FDI ,exchange control mechanism can also beconsidered as a direct option for remedying the BOPposition.• BOP can be classified as –Autonomous andAccommodating.Autonomous Transaction takes placedue to Import and export of goods andservices.Accommodating transaction (compensatorytransactions) means borrowing to rectify Currentaccount deficit.International Financial Management
    33. 33. 33Importance of BOP statistics• BOP statistics reflect the Economic Performance of thecountry and contains useful information for financialdecision matters. Eg USA BOP statistics announcementimmediately reflects on the USD rate.• When exchange rates are market determined BOP statisticsindicate excess demand or supply for the currency and thepossible impact on exchange rate.• It may signal a policy shift on the part of the monetaryauthorities of the countries unilaterally or in concert with itstrading partners.It may force exporters to realise their exportearnings quickly and bring the foreign currency home.• BOP accounts are intimately connected with the overallsaving-investment balance in a country’s nationalaccounts.Continuing deficits or surpluses may lead to fiscaland monetary actions designed to correct the imbalanceswhich in turn will affect the Interest rates and FE rates in thecountry.International Financial Management
    34. 34. 34International Monetary Systems-Introduction• Gold standard- Initially there was a Gold standard system whichstarted in 1814 in UK and 1870 in the USA.Under this each currencyderived its value from its GOLD content.Was used till the First worldwar and a few years after that. Two versions-Gold Specie standard andGold Bullion standard.• Gold specie standard –The actual currency in circulation consisted ofGold coins with a FIXED GOLD CONTENT.• Gold Bullion standard-The basis of money remains a fixed weight ofGold but the currency in circulation consisted of Paper Notes with theauthorities standing ready to convert on demand,unlimited amounts ofpaper currency into gold and vice versa at a fixed conversion ratio.• Under the Gold Exchange Standard the authorities stand ready toconvert,at a fixed rate, ,the paper currency issued by them into the papercurrency of another country which is operating a Gold species or GoldBullion standard.• The exchange rates between any pair of currencies will be determined bytheir respective exchange rates against Gold.International Financial Management
    35. 35. 35BRETTON WOODS SYSTEM-Following the 2ndworld war,the main allied powers USA and UK took up the task ofthoroughly revamping the International Monetary system.In 1944 in a place calledBretton woods in New Hampshire,USA ,2 new supra National Institutions wereformed which are very much active today in the International Financial Arena, viz• World Bank• International Monetary Fund.• The exchange rate that was put in place can be characterized as the Gold Exchangestandard.• It had the following features;• The US govt undertook to convert the USD freely into Gold at a fixed PARITY ofusd 35 per ounce of gold.Other IMF member countries agreed to fix theircurrencies vis a vis the dollar within a variation of 1% on either side of the centralparity being permissible.• Under this system the USD in effect became International money.Other countriesaccumulated and held USD balances with which thy could settle their internationalpayments.• This system was abandoned in 1973 .International Financial Management
    36. 36. 36WORLD BANK(WB)-is a vital source of Financial & Technical assistance todeveloping countries around the world.WB representing a membership of 185countries has 2 unique development Institutions-• IBRDA- International Bank for Reconstruction and Development.• IDA- International Development Association• Aim of WB- Global Poverty Reduction• IBRDA- focuses on middle Income and creditworthy poor countries• IDA- focuses on the poorest countries upliftment and growth in projects likedrinking water,road construction, etc.• Together WB provides-Interest free loans,Interest free credits,Grants to developingcountries for education,health,infrastructure,and many other alleviation causes.• ADB- Asian development bank-was set up as an Asian version of the world bank toprovide development finance to countries in Asian Region .It’s HQ isManila,Phillipines.• IFC-Is a member of the WB GROUP. It helps private sector projects in developingcountries in the form of giving direct assistance,underwriting issues,undertakingfeasibility studies for projects,.It also acts as a guarantor for any lending to PVTsector and develops capital markets in the countries.International Financial Management
    37. 37. 37IMF-International Monetary Fund.- mandated to exercise firm surveillance overthe exchange rate policies of its memeber.and to help assure orderly exchangearrangements and to promote a stable exchange rate .The responsibility forcollection and allocation of reserves was given to IMF under the Bretton woodsarrangement.It was also given the responsibility of ;• supervising the adjustable Peg system• Rendering advise to member countries on their international monetary affairs• Promoting research in various areas of international economics and monetaryeconomics• Providing a forum for discussion and consultations among member nations.-The initial quantum of reserves was contributed by the members according to quotasfixed for each.Each member country was required to contribute 25% of its quotain Gold and the rest in its own currency.Thus the fund began with a pool ofcurrencies of its members.The quotas decide the the voting powers and maximumamount of financing its member countries can get within the policy making bodiesof IMF.Since 1980,IMF has been authorized to borrow from capital markets.-IMF established contingency reserve to tide over temporary BOP problems,whilestructural Reserve was established to tide over structural BOP problems.Countrieswith chronic BOP problems were allowed to depreciate their currencies. It hasplayed an important role in tackling the debt crisis of developing countries.International Financial Management
    38. 38. 38Exchange rate regimes;current scenario-1)Exchange arrangements with No separate legal tender-This group includesa) Countries which are members of a currency union and share a common currencyeg European union., who have adopted Euro as their currency since1-1-1999 andhave fixed their currency on parity with the Euro on that date.(11 members haveadopted this)b) Countries which have adopted the currency of another country as theirs.eg,Eastcarribean common market viz, Grenada,Antigua,,St Kitts,Nevis. And countriesbelonging to the central African Economic and Monetary union egCameroon,central African Republic.These countries have adopted the FrenchFranc as their currency.2)Currency Board Arrangement-A regime under which there is a legislativecommitment to exchange the domestic currency against a specified foreigncurrency at a fixed exchange rate.,coupled with restrictions on monetaryauthority to ensure that commitments will be honoured. Eg Argentina, HongKong have tied their currency with USD.( 8 members have adopted this )3)Conventional Fixed Peg Arrangements-This is similar to Bretton woods systemwhere the currency is pegged to another currency or a basket of currencies with aband of +/- 1% around the central parity.( 44 members have adopted this )International Financial Management
    39. 39. 39Exchange rate regimes;current scenario-4)Pegged Exchange rates with Horizontal bands-Here there is a peg but variationhas with wider bands.It is a compromise between a fixed peg and a floating peg.(8 countries have adopted this)5)Crawling peg-This is another variant of a limited flexibility Regime.The currency ispegged to another country or a basket of currencies but the peg is periodicallyattached.(6 countries have adopted this)6) Crawling Bands-The currency is maintained within certain margins around a centralparity which crawls as in the crawling peg regime(9 countries have adopted this)7)Managed Floating-with no pre announced path for the Exchange rate-The centralbank influences or attempts to influence the exchange rate by means of activeintervention in the FE market.-buying or selling foreign currency against thehome currency without any commitment to maintain the rate at any particularlevel or keep it on any pre announced trajectory(25 countries have adopted this)8)Independently Floating-The exchange rate is market determined with central bankintervening only to moderate the speed of change and to prevent excessivefluctuations but not attempting to maintain it t at or drive it towards any particularlevel(48 countries including India have adopted this)It is therefore clear that post 1973 a wide variety of arrangements existInternational Financial Management
    40. 40. 40International Trade organizations=1)GATT-General Agreement on Trade and Tariff was constitutedin 1947 to facilitate free trade.The main objectives of GATTare;• Progressively reduce Tariff rates• Extend Most favoured Nation status treatment to allmembers• Remove quantitative restrictions and• Free exchange control on current account transactionsSeveral rounds of discussions were held -Geneva,Kennedy,Tokyoand Uruguay RoundsIt did not take into consideration trade in services and Intellectualproperties.International Financial Management
    41. 41. 412)WTO-World Trade Organisation-was constituted in 1995.UnlikeGATT is permanent in nature.Apart from trade and services ,it alsodeals with Trade related aspects of Intellectual Propertyrights(TRIPS) wherein issues regardingcopyright,Patents,Industrial design Trademark are dealt with.Intrade related aspects of investment management(TRIMS),discrimination against Foreign Investments in the form ofrestrictions,discriminatory taxation are dealt with.Various objectives of WTO include implementationadministration,and operation of all multilateral trade disputesadministration and operation of trade agreements,administration ofrules governing settlement of trade disputes,trade policy reviewmechanism and providing a forum for discussion betweenmembers.3)UNCTAD-United Nations council for Trade and Development(UNCTAD) has been constituted to facilitate Internationaltrade.The first meeting was held in Geneva in 1964 and attendedby 120 countries.Its main aim was to reduce trade barriers indeveloped countries and through increased access to theirmarkets,improve standard of living in developing countriesInternational Financial Management
    42. 42. 42Global Financial Markets• Provide a forum where the currency of one country is traded for the currency ofanother• Deal with large volume of funds as well as a large number of currencies(ofdifferent countries)• London,New york, and Tokyo are the nerve centres of FEactivity.Frankfurt,Bahrain,Singapore are also very active in the 24 hour activity ofthe FE markets.• The large Central/ Commercial/Investment banks are the principal participants inthe FE markets.In general,business firms do not operate on their own but buy andsell through a commercial Banks who are also called “authorised dealers”.• Commercial banks deal in FE markets for commercial reasons where as Centralbanks in all countries are regulatory in nature .Central banks (RBI inIndia)maintain the exchange rate of the domestic currency in tune with therequirements of the national economy and government policy.They regulate the FEtransactions in order to avoid volatility(sudden upward or downward movement) ofthe domestic currency.• Most of the trading in the FE markets take place in the major currencies likeUSD,GBP,DM,YEN,EURO,FF,etc .There is an active market for these currencies asthere are a large number of buyers and sellers willing to execute FE dealings inthese currencies.Now a days,FE dealings primarily take place through usingtechnology,telephone,fax etc.and therefore does not have a geographical relevance.International Financial Management
    43. 43. 43Global Financial MarketsDomestic and Offshore Markets-• Financial Assets and Liabilities denominated in a particular currency,say USD,aretraded in the National Financial Markets of that country.In addition,in the case ofmany convertible currencies,they are traded outside the country of thatcurrency.Thus bank deposits loans,Promissory Notes,Bonds denominated in USDare bought and sold in the US money and capital markets such as New York as wellas the Financial Markets in London,Paris,Singapore and Tokyo.The former is theDomestic market while the latter is the Off shore market.• Domestic markets are usually subject to strict supervision and regulation by relevantNational Authorities.,like SEBI,Federal Reserve Board in the US,MOF inJapan,SEC in the US . Domestic banks are also regulated by the concernedmonetary authorities and may be subject to Reserve Requirements,capital adequacynorms etc.• Off shore markets ,on the other hand,have minimal regulation,often no registrationformalities and importance of rating varies• However in the recent years with the removal of barriers and increasingintegration,authorities have realized that regulation of financial markets andInstitutions cannot have a narrow national focus-To minimize the problem ofsystemic risks banks and Firms must be subject to norms and regulations that arecommon across countries. eg Basel Accord.International Financial Management
    44. 44. 44Euro markets• Prior to 1980Eurocurrncies Markets was the only International Financial Market ofany significance.It originated in the 1950s with the Russian authorities seeking dollar-denominated deposits with banks in Britain and France as the erstwhile USSR thoughtthat the US might freeze its dollar accounts if kept in the US.• “Eurocurrency”Deposit is a deposit in the relevant currency with a bank outside thehome country of that currency.Thus a US Dollar deposit in a London Bank is aEurodollar Deposit and Deutschemark Deposit in a bank in Luxembourg is a Euromark Deposit.• Thus a dollar deposit belonging to an American company held with a Paris subsidiaryof an American Bank is still a Eurodollar deposit.Main features of such deposits;• As these deposits are kept outside the country of the currency,monetary authoritiescould not place any restrictions on the issue of such currencies like Reserverequirements,withholding tax for foreign borrowers,deposit insurance requirements,other restrictions placed by the monetary authorities etc were .not applicable to suchdeposits as they were not under the purview of the MA.• Absence of restrictions made the deposits attractive not only to the depositors but alsoto the banks.Such deposits were parked in developing countries debt at attractivereturns without paying much heed for credit risk ratings, (which ,in fact ,led to theLatin American debt crisis).International Financial Management
    45. 45. 45• Euro deposits -contd• The prefix Euro is outdated now as such deposits and loans traded outside Europe .Forinstance,in Singapore and Hong Kong.They are called Asian Dollar Markets.• Over the years markets have evolved a variety of Instruments other than Time depositsand short term loans.Among them are(a) certificates of Deposits(COD) (b)Eurocommercial paper©Eurobonds(d)Floating Rate Notes etc.• In 1999,single currency Monetary union was formed.It is a unique integration ofcurrencies without political integration .It challenged the USD in as much as trading isdone in Euro as much as in USD and the EU has adopted this currency for trading andholding deposits.ECONOMIC IMPACT OF EURO MARKETS -Perceived Advantages of Euro Markets;1)More efficient allocation of capital world wide(2)Smoothing out the effects of suddenshifts in Balance of Payments,eg oil crisis in 1973and recycling of petrodollars withoutwhich a large number of oil importing companies would have to face severe crisis.(3)The spate of financial innovations that have been created by the market which havevastly enhanced the ability of companies and governments.to manage their financialrisks.Perceived Disadvantages of Euro markets;(1)Market stabilization is difficult for Centralbanks as the so called ‘hot Money’-Speculative capital flows is facilitated(2)NationalMonetary authorities lose effective control over monetary policies as Domesticresidents can frustrate their efforts by borrowing or lending abroad.(3) Euro marketscreate ‘private International Equity”and in the absence of a central coordinatingauthorities they could create”too much”contributing to inflationary tendencies in theworld economy.International Financial Management
    46. 46. 46FOREIGN EXCHANGE MARKETS-• Market in which currencies are bought and sold against each other.It is the largestMarket in the world.• Largest volume of Trade-estimated over USD per day1 trillion and during peakvolume it touched USD 1.6 trillion.• FE market is an over-the –counter market.This means that there is no singlephysical or electronic market or an organized exchange like a stock exchange witha central trade clearing mechanism where traders meet and exchange currencies.• THE MARKET ITSELF IS ACTUALLY A WORLD WIDE NETWORK OFINTER-BANK TRADERS,CONSISTING PRIMARILY OF BANKSCONNECTED BY TELEPHONE LINES AND COMPUTERS.• It is virtually a 24 hour market because it cuts across TIME ZONES.From Tokyoto New York ,it works through out the day and night and hence the huge volumes.• STRUCTURE;• 1)Retail market- This is the market where tourists and travellers exchange onecurrency for another in the form of currency notes or travellers cheques.The totalturnover and average transaction size are very small.The spread between buyingand selling is large.They are secondary Price Makers because they do not have a 2way transaction .eg Restaurants,Hotels ETC.International Financial Management
    47. 47. 47FOREIGN EXCHANGE MARKETS-2)Wholesale Market-often called the Inter Bank Market.Major categories of participants are(a) Commercialbanks(b)Investment Institutions©Central Banks.• The average size of the transaction will be very large,e.g. the average size oftransaction in the US market is around USD 4 million and many transactions evenlarger .• Among the Participants in this are-Professional dealers or Primary price makers whomake a 2 way quote to each other and to their clients- a price to buy currency X againstcurrency Y and a price to sell X against Y.This Group consists of mainly commercialbanks ,large Investment Institutions,and a few large corporations and MNCs. A dealerwill sell USD against Euro to one corporate customer,carry the position for a while andoffset it by buying USD against Euro from another customer or dealer.Meanwhile,if theprice has moved against the dealer he bears the loss.• Eg,The dealer might agree to buy Euro by selling USD,at a rate of USD 0.9 perEuro,and by the time he covers his position,the market may have moved ,so that hemust acquire the Euro at a price of USD 0..87 per Euro.if the transaction is for USD 1Million ,the loss he will undergo will be USD 30000.• Foreign Currency Brokers act as middlemen between the two Price makers.They do notbuy or sell on their Account but act as brokers to get information about customerswilling to buy or sell and from whom they will get their commission.They tend topossess a lot information because their of proximity to the customers regularly.International Financial Management
    48. 48. 48FOREIGN EXCHANGE MARKETS-• 3)Finally there are Price Takers, who take the prices quoted by Primary price makers,andbuy or sell currencies for their own purposes.eg,Large corporations buy or sell FE for theirown operations viz,Imports,Exports,payment of interest,hedging etc.Most of the companiesdeal in FE only limited to their transactions.But some MNCs and trans national companiesuse their knowledge and expertise to trade in FE and make profit out of the FE markets.• Central Banks intervene in the market from time to time ,to attempt to move exchange in aparticular direction or to moderate excessive fluctuations in the exchange rates.• Types of Transactions and Settlement Dates;Value Date-A settlement of transaction takes place between two parties by transfer ofDeposits between two parties..The date on which the transfer takes place is called thesettlement date or Value date .The locations of the 2 banks involved in the Trade are calledDealing locations which may not be the same as the settlement locations..The relevantcountries are called Settlement Locations.Obviously,to effect the transfers,banks in thecountries of the transfer ,banks in both the countries must be open for business.For example-A London Bank can sell Swiss Francs against USD to a Paris Bank .Thesettlement locations may be New York and Geneva while Dealing Locations are London andParis.The transaction can be settled only on a day on which both the US and Swiss banks areopen.International Financial Management
    49. 49. 49FOREIGN EXCHANGE MARKETS-• Value Dates for Spot Transactions- In a spot transaction,the Settlement or ValueDate is usually 2 business days ahead for the European currencies or the Yentraded against Dollar.Thus if a London Bank sells yen against Dollar to Paris Bankon MONDAY,the London Bank will turn over a Yen deposit to the Paris Bank onWEDNESDAY and the Paris bank will transfer a dollar deposit to the London Bankon the same day.If the value date is a bank Holiday it is considered as he nextworking day.The settlement date is reduced to one day if the pairs of currencies areUSD and Canadian Dollar or Mexican Peso.• Value Dates for Forward Transactions-In a one month Forward Purchase of say,Pounds against Dollar,the rate of Exchange is fixed on the transaction date;the valuedate is arrived at as a follows-For a one -month forward value date is on say June20,the corresponding spot Value date is June 22 and one-month forward value dateis July 22 and 2 months forward value is August 22.• A swap transaction in the Foreign Exchange market is a combination of SPOTAND A FORWARD in the opposite direction.Thus a bank will buy Euros spotagainst USD and simultaneously enter into a forward transaction with the samecounterparty to sell Euros against USD.As the term Swap implies .It is a temporaryexchange of one currency for another with an obligation to reverse it at a specificfuture date.International Financial Management
    50. 50. 50FOREIGN EXCHANGE MARKETS-• TOM RATES-In the case of TOM rates,the value date is one day after thetransaction instead of 2 days as in spot rates.• READY RATES-In Ready rates transactions,the value date is the same as that ofthe Transaction date.• CARD RATES- are rates quoted for a Retail customer,while for corporatecustomers or wholesale customers, Bulk special rates are quoted.Card Rate is notan Exchange rate but an approximate rate.• Buying Rate is called as a BID rate, and the selling rate is called as ASK rate.EXCHANGE RATE QUOTATIONS AND ARBITRAGE—An exchange rate betweencurrencies A and B is simply the price of one in terms of the other.The ISO has given a 3 letter codes for all the currencies.They are as follows;USD –US Dollar, GBP-British Pound , JPY-Japanese Yen , CAD-CanadianDollar,DEM-Deutschmark,NLG-Dutch Guilder,FRF-French Franc,ESP-Spanish Peseta,INR-Indian Rupee,EUR-Euro,IEP-Irish Pound,CHF-Swiss Franc,ITL-Italian Lira,AUD-Australian Dollar,SEK-Swedish Kroner,BEF-Belgian Franc,DRK-DanishKroner,SAR-Saudi Riyal etc.Other Important currencies are-South Korea-Won,Indonesia-Rupaiah, Malaysia-Ringet,Singapore-Dollars,South Africa-Rand,Russia-Rouble etcInternational Financial Management
    51. 51. 51FOREIGN EXCHANGE MARKETS-Exchange Rate quotations-Direct and Indirect quotations-A FE quotation can be Direct orIndirect—Direct when it is quoted/expressed in a manner that reflects the exchange of aspecified number of domestic currency vis- a-vis one unit of a foreign currency.Eg,Rs 46=1 USD is a direct quotation in India .(European quotation)Indirect quotation is when it is quoted to reflect the exchange of a specified numberof foreign currency vis a vis unit of a local currencyEg usd.0.2083=Re1.IS Indirect quotation India(American quotation)SPREAD- is the difference between the Ask Price and the Bid PriceIllustration for Spot and Forward rate contract-An exporter exports Goods valued at USD 100 Million. On 6 months credit on 1stFebruary 2007. And also enters into a Forward rate contract for Rs 49 to 1 USD.Byentering into such a contract the exporter is assured of receipt of INR 4900 millionon 1stAugust on which date the amount actually becomes payable,irrespective of thespot rate on that date.If he had not taken this forward cover,and if on that date ,theINR had become Rs 48 to 1 USD,he would have got only INR 4800 million onlywhere by he would have lost INR 100 million.By taking forward cover he has savedINR 100 million .In other words he has gained INR 100 Million.If the spot rate hasbecome INR 46 ,still the Exporter can get the agreed rate of Rs 49 to 1 usd.International Financial Management
    52. 52. 52FOREIGN EXCHANGE MARKETS AND DEALINGS;Cross Rates-When a direct/quote rate of the home currency or any other currency is notavailable in the forex market, it is computes with the help of of exchange rates ofother countries,it is termed as Cross Rates.eg An Indian Importer imports Farm eggs from New Zealand and is not able toget a quote for purchasing NZ dollars.The transaction has to be routed throughUSD.It will become INR—USD---NZD.The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate)INR/USD ;48.0465(buying rate)-48.211(selling rate)Determine the exchange rates between INR and NZD ;Steps; 1)The Indian importer has to buy USD at the rate of INR 48.2111(whenUSD is bought by the Importer,the dealer(bank)is selling USD and hence 48.2111isthe relevant rate,as the dealer (bank)sells the USD to the Importer.2)The Indian Importer then SELLS the USD to the dealer(bank).Thedealer BUYS the USD at the buying rate of USD1 =NZD 1.7908.3)Which means,the Indian Importer get NZD1.7908 in exchange forINR48.2111. And the Exchange rate is determined as- INR 48.2111/1.7908 which isequal to INR 26.9215 per NZD.Thus INR26.9215 per NZD is the “Cross “Ratederived from two sets f rates,which is the selling rate for the currency.International Financial Management
    53. 53. 53FOREIGN EXCHANGE MARKETS AND DEALINGSTo complete the quote the buying rate also needs to be established and given by the dealerusing the rate chart;.The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate)INR/USD ;48.0465(buying rate)-48.211(selling rate)The buying rate for INR /NZD would be worked out as follows;a)The dealer purchases 1 USD for INR 48.0465b)The dealer sells 1USD in exchange for 1.8510 NZD.c)NZD 1.8510 IS equivalent to INR 48.0465.Therefore the buying exchange rate would be INR 48.0465/1.8510 which would be Rs25.9571.The dealer will quote INR/NZD :25.9571(buying rate)-26.9215(selling rate).This means that the dealer would buy NZD at Rs 25.9571 and sell at Rs26.9215Arbitrage Process as a means of Attaining Equilibrium on Spot markets;The term Arbitrage in the context of Forex Markets refers to an act of buying currency inone market (at lower price ) and selling it in another market(at higher price).Thus thedifference in Exchange rates (in a specified pair of currencies)in two markets provide anopportunity to the dealers /Arbitrageurs to earn profits without risk.As a result,Equilibrium is restored in the exchange rates of currencies in different Forex markets.International Financial Management
    54. 54. 54Gains from International capital flows;• Transfer the savings to investors worldwide so as to maximize productivity ofInvestment.Savers in capital- rich counties,if confined to investment to their owncountries will not be able to get optimum returns.conversely if investment projects incapital-poor countries must be financed only out of domestic savings,many highyielding projects would have to be shelved due to shortage of funds.• A particular country may face temporary shortage in National income due to somespecial adverse circumstances.It cannot borrow internationally and is unwilling tocurtail investment it must sharply cut down consumption expenditures.During years ofextraordinary prosperity if it cannot invest abroad,it will be under utilizing itscapital.International lending and borrowing permit people to achieve a smootherconsumption profile.Overall welfare would be greater with cross border capitalflows.To day in the era of Globalization cross border investments are so common.Infact India n companies are investing very big in Foreign companies that the movementhas become two- way rather than one way.• FOREIGN DIRECT INVESTMENT;(FDI)One of the most important vehicle ofcross border investment has been FDI.Production and distribution of goods andservices has been globalised on an unprecedented scale during the preceding 4decades..Along with the emergence of of MNCs, JVs,technology licensingfranchising,management contracts,production sharing ,Rand D alliances have all madethis possible.The theory of ABC viz A for Aid ,B for Borrowing and C for Capital hascome to stay.International Financial Management
    55. 55. 55FOREIGN EXCHANGE MARKETS AND DEALINGS-The Essence of the Arbitrage process is to buy currencies from Markets whereprices are lower and sell in markets where prices are higher..In operational terms theArbitrage process is essentially a balancing operation that does not allow the samecurrency to have varying rate in different Forex markets on a sustainable basis.• TYPES OF ARBITRAGE IN SPOT MARKETS1)Geographical Arbitrage;As the name suggests the ,Geographical Arbitrage consists ofbuying currency for one Forex Market (say London) and where it is cheaper and sellin another Forex Market( say Tokyo) where it is costly.Because of Technology,geographical divide is not an issue today.2) Triangular Arbitrage ;As the name suggests ,Triangular Arbitrage takes place whenthere are currencies involving 3 markets.• ARBITRAGE IN FORWARD MARKETSThe concept of the arbitrage process is equally applicable in forward markets.In thecase of Spot markets,mismatch between cross rates and quoted rates provides anopportunity for arbitrage gains.Similar arbitrage gain possibilities exist in Forwardmarkets also.In case the difference between the forward rate and the spot rate (in termsof premium or discount)is not matched by the interest rate differentials of the 2currencies.Conceptually,interest rate differentials of the 2 currencies should be equalto to the forward premium or discount on their exchange rates.Since the comparison isto be made with Interest rate differentials,this is also referred to as “covered InterestArbitrage”.International Financial Management
    56. 56. 56Terms used in Foreign Exchange Market Dealings• SWIFT-Communications Pertaining to International Financial Transactions arehandled mainly by a large Network called “Society for worldwide Inter bankFinancial Telecommunication “-SWIFT. This is a non profit Belgian cooperativeorganization with main and regional centers around the world connected by DataTransmission lines.Depending on the location, a bank can access a regionalprocessor or a main center which then transmits to the appropriate information tothe appropriate location.• REUTERS- is a London based organization established in the year 1851.Itestablished the first Electronic Trading Screen which gives real time quotes basedon which trading in currencies take place.• TELRATE- is an American organization established in 1969 to deal in screenbased trading for Foreign Exchange.• CHAPS-Clearing House for Automated Payment system (chaps)is a UK basedElectronic payment System• CHIPS-Clearing House for Inter bank payment system (chips) is a US basedelectronics payment system.International Financial Management
    57. 57. 57Terminology used in International Trade and Finance-• Types of Lcsa)Irrevocable LC-- Irrevocable LC is one which cannot be revoked or cancelledwithout the consent of the beneficiary.This form LC is generally used byImporters and Exporters as this gives more security to both the parties.b)Confirmed LC-- is a LC which is confirmed by a third bank other than anopening bank and the negotiating bank.Sometimes the beneficiary wants the LCof buyers bank to be confirmed by a bank in his country.This process is called asconfirmation.It means that the confirming bank undertakes that in the event ofproper presentation of documents as required under the LC, it will make paymentirrespective of the fact whether the buyer’s bank reimburses the same or not.Itcharges its commission for confirmation.c)Transferable LC—In Transferable LC,the buyer can transfer a part of the valueof LC or the full value of LC in favour of one or morebeneficiaries.Transferability should be expressed specifically in the LC.Since thebuyer relies on the integrity of beneficiary,transferability in favour of someoneunknown has some risks .Normally Transferable LCs are taken by middlemenwho do not want to the buyer and seller to know each other and also want tomake a margin without both the parties being aware of the same.Usuallytransferability in several lots is possible but the transferee again transferring thecredit is not possible.International Financial Management
    58. 58. 58• Types of Lcs;d)Back to Back LCs—In back to back Lcs,Beneficiarys banks open several LCswithin the value of the mother LC.This is also known as countervailing LCs..Theterms and conditions of the second LC are exactly the same as that of the first LC.Thesecond LC may be a Domestic LC.Any change is the second LC is possible onlywhen the opener of the original LC agrees to such a change in the mother LC.e)Red clause LC—In Red clause LC,advance payment is provided against the supplyof certain documents like drawings and manufacturing schedule as mobilizationadvance for manufacture of capital goods whose manufacturing cycle time ishigh.The Advance payment details are printed in RED thereby being called Redclause LC.f)Green clause LC—In this type of LC,advance is provided against goods,which aremanufactured and kept in a warehouse for a buyer against warehouse receipt,beforethe same is shipped.g)Sight LC or DP LC—Sight LC or Document against LC means that as soon as theBE of seller is presented to the buyer ,he should make payment for the same. Andonly then the documents would be handed over to the buyer.Thus no credit is givento the buyer.h)Usance LC OR DA LC –Usance LC or Documents against Acceptance means thatpayment can be made after a particular period from presentation of Bill of Exchangepresented to him .By DA or Usance ,credit is given to the buyer.International Financial Management
    59. 59. 59• Advising Bank– Many times,LC received from buyer may be a forged one.If thesame is routed through a bank,it performs the function of advising whether the LCis genuine or not.For doing this ,the bank charges a commission.• Negotiating Bank-- Since the Buyer’s bank opens the LC,payment will be made tothe seller only when the buyer’s bank receives proper documents as per the LC.Thiswill involve delay like the transit time involved in transferring the necessarydocuments by the seller to buyer’s bank.Negotiating bank is a bank which is inseller’s country and negotiates the document presented by the seller against theLC.In the event of documents being proper,the negotiating bank credits theproceeds to seller’s Accounts immediately,thereby avoiding the delay.For doing thisthe negotiating bank charges a commission known as Negotiating commission.• Correspondent Bank—While a bank has to deal with many centers around theworld,it cannot afford to have branches in all those countries.It enters intocorrespondent agreement with a bank operating in the centers, detailing the scopeof responsibilities and sharing of commission.Such banks are referred to asCorrespondent Banks.• UCPDC-Uniform Customs and procedure for documentary credit or UCDPC isprepared by the International Chamber of commerce.,defining the responsibility ofbuyer’s bank,Negotiating bank,confirming bank, Advising bank.All InternationalLC must bear an endorsement that they adhere to UCPDC 500International Financial Management
    60. 60. 60• NOSTRO ACCOUNT-The Account of a local bank maintained with aforeign branch or correspondent bank is called as Nostro Account.It is opened tofacilitate remittances or credits into the banks account.• VOSTRO ACCOUNT—The Account of a foreign bank maintained with alocal bank or branch is called as Vostro Account.In this case all remittancesrelating to the foreign bank by local banks are credited to the Vostro account.• INCO TERMS—are terms issued by the International Chamber ofcommerce.,defining the meaning of various terms given above.If theinternational Purchase orders are subjected to INCO terms there will beuniformity in interpretation of various commercial terms.• PACKING CREDIT ---Packing credit is given for financing exports.It canbe classified as pre shipment -credit and Post –shipment credit.Packing credit isgiven against an Export order or LC.Pre-shipment credit is given for procuringmaterials,manufacture of goods,while post –shipment credit is given forfinancing receivables out of exports.Packing credit is extended at any time andexport receivables are NOT subject to Maximum Permissible BankFinance(MPBF)requirements.Post shipment is generally given in the form ofdiscounting of export bills..International Financial Management
    61. 61. 61Terms used in IFM-• Libor-Libor means London Inter Bank offered Rate.London is the premiere Financialcenter in the world.LIBOR is a benchmark floating rate at which one bank is willing tolend to another bank in inter –bank market.It is available for various tenors.Libor beingthe premier financial rate ,this rate is used as a landmark rate in many lendingtransactions.The quotes are generally Libor +or Libor – a certain percentage.• Forfaiting –is Export factoring.In Forfaiting,export bills are accepted by Importer aswell as by his bankers..Acceptance of such bills is by Importers banks is known asAvalising and bank accepted BE is called AVAL.Such avalised Bills are discounted byForfaiting agency on non-recourse basis and proceeds are credited to exportersaccount.Non recourse basis means that in the event of importers failure to makepayment ,the loss will be borne by the forfaiting agency and will not be recoveredfrom the exporter.In India EXIM bank offers such facilities.• Transfer Pricing(TP)—Due to increasing Globalization and Integration of worldeconomy and transactions between different branches of subsidiaries,Transfer Pricingis being increasingly resorted to avoid payment of taxes.To counter these all thegovernments have resorted to taxing the transactions where they find that the TP is notbeing done on an Arms Length principle.Prices are determined based on variousmethods as follows;(1)Comparable uncontrolled Price method(CUP method).(2)Resalemethod(3)Transaction Net Margin Method(4)Profit split method.The governments haverealised that MNCs and other companies with HOs outside their country resort to thismethod.(contd)International Financial Management
    62. 62. 62Transfer Pricing-contdThe general Feeling is that these companies fix the prices with their Head Offices insuch a manner that the Transfer Prices are not Loaded enough with adequate ProfitMargin so much so that the end prices are much higher compared to the TP,whichmeans that for products /services originating in India, the actual profit accruesoutside the country.This is the Crux of TP legislation. Therefore the Governments allover the world have sought to devise mechanisms to ensure that no undue advantageis taken by companies while fixing prices between HO and subsidiaries.eg IBMdoing a lot of work in India and invoicing at a price which will not get the actualprofit to the Indian Subsidiary but to the HO.In India,TP legislation came into effectthe years 2003 when the Government introduced new provisions in the Income TaxAct .It has already triggered a lot of litigation in the assessments .• BARRIERS TO INTERNATIONAL TRADE;1)TARIFF BARRIER;Countries levy customs duty to create barriers for import ofGoods into the country for various reasons.Thus by having high customs duty rates,imports are discouraged.This could be a deliberate attempt on the part of certainGovts to reduce consumption of certain types of goods.It could be to encourageindigenous manufacture also.2)NON-TARIFF BARRIER;Non Tariff Barriers could be in the form of restrictionsimposed by certain Govts,eg ,by way of quotas in Licensing.Restrictive agreementslike Multi-Fiber agreements for textiles also constitute one form of Non TariffBarrier.Sometime countries impose severe quality and environmental restrictionswhich would amount to non trade barriers.International Financial Management
    63. 63. 633)Trade Barriers-Trade Barriers are formed by entering into bilateral agreements andgiving Most Favored Nation(MFN) statues to import from certain countries.Apartfrom this ,Free Trade zones, Customs Union,Common Market,EconomicUnion,Monetary Union,Cartels which restrict free flow of International trade aslocome under Barrier.Extreme form of Trade Barrier is Embargo.4)Free Trade Zone;In Free Trade Zone goods move in the member countries withoutpayment of customs duty..Generally Free trade zones provide a lot of incentives forinvestment by outsiders so that they attract investments.Eg Jebel Ali Free Trade Zonenear Dubai where investment is encouraged and has become one of the well knownFTZs.The climate for investments,the sops provided,the concessions provided,etcmake these zones a very good destination for investments by outsiders.NEED FOR ERECTING BARRIERS• Protecting Infant and Domestic Industries.Eg,India imposed very high tariff barriersfor protecting its infant industry.This is cited as the main reason for poor quality ofIndian goods and lack of competitiveness in Indian Industry.• Revenue collection through customs Duty.Customs duty is very good source ofRevenue for any Govt.• To counter adverse BOP.Till early 90 Indian strategy was to stress for importSubstitution to set right the BOP deficit.thru deficit high tariff and non tariffbarriers.This led to illegal activities like smuggling .• To protect Local employment• For political reasons-Embargo in IraqInternational Financial Management
    64. 64. 64Theories explaining the need for International Trade;1)Theory of Absolute Advantage; Adam smith propounded the Theory of “AbsoluteAdvantage”.In this ,labor was considered the only factor of production..For example,one country has absolute advantage in producing software and another in producingHardware.Both can increase their wealth by producing goods/services in which theyhave absolute advantage.2)Theory of Comparative Advantage ;David Ricardo expounded the Theory of “ComparativeAdvantage”.As per this theory if a nation has absolute advantage over another nation inproducing both Software and Hardware,still they should produce that which gives themComparative Advantage and trade in them thereby increasing wealth.This increasesspecialization .A good example is Software development in India.Because of highlyeducated and Technically skilled labor force India has made a niche place for itself andhas been generating wealth which is ever growing .China/Taiwan is good in computerHardware and they have captured the world market in Hardware.3)Heckshire Ohlin Model;This model says that countries rich in capital will engage in capitalintensive industry.Thus USA which is capital-rich can produce and trade in capital –rich goods while India which is labor rich can make use of its strengths in this area.Thistheory focuses on factor endowments and the fact that production of different goodsrequires the various inputs in different proportions.Thus countries like India areendowed with human capital including knowledge workers but are poorly endowedwith Physical capital whereas countries like the US have plenty of physical capital butscarcity of skilled labor.Each has to exploit its potential.International Financial Management
    65. 65. 65• Capital Account convertibility;Refers to the free movement of currency in theCAPITAL ACCOUNT Transactions in BOP.In India ,The FEMA(Foreign ExchangeManagement Act) does not permit full capital Account convertibility but only limitedcapital account convertibility.As per one school of thought,India is not yet ready for afull convertibility.In fact the GOI set up the Tarapore committee which gave its reportcautioning the govt to go slow on the full convertibility,though it has stronglyrecommended partial convertibility.Dr Paul Krugman,the Nobel Laureate from USopined that developing countries should have exchange restriction in the capitalAccount..This school of thought argues that once the country achieves(1) mandatedinflation rate (around 3.5%)(2)mandated fiscal deficit(3)NPA of Banking assets fallingunder a threshold level (4)adequate financial system supervision,then Capital AccountConvertibility can be undertaken.Of late the Govt has been liberalizing the CapitalAccount transactions viz,increase in limits for advance remittances without BankGuarantee,Issuing GDRs and ADRs under automatic routes etc.• SPECIAL DRAWING RIGHTS-At the 1967 meeting of the IMF IN Rio de Janeiro,itwas decided to create such an asset,to be called Special Drawing Rights or SDRs..TheIMF would create SDRs by simply opening an account in the name of each member.andcrediting it with a certain amount of SDRs.the total volume created had to be ratified bythe governing board and its allocation among the members is proportional to thequotas.The value of SDR was initially fixed in terms of gold with same gold content asthe 1970 USD.In 1974 the SR became equivalent to a basket of 16 currencies and thenin 1981 to a basket of 5 currencies.After the birth of Euro,the SDR basket included4major “freely usable”currencies,viz,USD,EURO,GBP and JPY.(ALSO REFER TOTHE ATTACHED NOTE IN WORD DOC ON SDRs FOR MORE DETAILS)International Financial Management
    66. 66. 66Some more terms used in International Finance-• GR FORMS-Guaranteed Receipt Form OR GR form is used by RBI for physical exportto ascertain the value of export goods as well as to monitor their realization.It isprepared in duplicate and submitted to customs at the time of exports.Customs verify thevalue with contract and certify the same and one copy is given back to the exporter andthe other copy is sent by customs directly to RBI.Exporter has to forward this copy tothe AD with Invoice etc ,who then verifies with invoice value.The D also monitorswhether the money is realised within 180 DAYS from the date of Shipment.• ETX FORM-ETX is filed by the exporter with the RBI for any delays in getting thepayment from the overseas buyer.Normally this is done to get approval for the delayedremittance .The exporter has to give a certificate issued by a CA giving reasons for thedelay in getting the money.• SOFTEX FORM-Softex form performs the function as that of GR for Softwareexports.It is filed with STPI by the exporting company who approves and certifies theInvoice and the softex form which is then sent to the AD,as in the case of a GR .• EEFC Account –Exchange Earners Foreign currency Account is a facility given toexporters to keep a part of their Foreign currency earning in the form of FC. Normallyupto 50 % is allowed and in special cases even a higher percentage is allowed.withoutany Interest payment. EOUs,SEZs can keep upto 100 % of the FE earned in the EECaccount which can be used for any purpose more liberally for foreign projects,travel etcwithout quantitative restrictions.International Financial Management
    67. 67. 67EXPORT ORIENTED UNITS(EOUs)-EOUs can be set up in any place which isnotified as a warehousing station by the chief commissioner of Customs..There arearound 300 warehousing stations at present notified throughout India. EOUs atpresent operate under customs bonding and supervision.They cannot be involvedin Trading.They are allowed to sell in local market by entering into DTA(DomesticTariff Agreement).They can sell up to 50%FOB value of exports in domesticmarket by paying CD applicable for import or excise Duty whichever ismore.Even 100% Foreign Equity can be held for items reserved for SSI. EOUs areexpected to earn only positive Net Foreign Exchange(NFE).They can import allcapital goods including second hand capital goods as well as rawmaterials,components,consumables and packing materials without payment ofCD.Similarly they can make indigenous purchases without paying ExciseDuty.Many state governments have also exempted EOUs from paying sales Tax.Acts Development commissioner is the registering authority and acts as a singlewindow clearance.They enjoy Income Tax benefits as well.SPECIAL ECONOMIC ZONES-(SEZ) is a concept borrowed from China.These zonesare treated as foreign country within the country and are subjected to minimumrestrictions They are located in notified areas, eg Hassan in Karnataka,Kakinada inAP.They are subjected to minimum NFE conditions.Foreign equity is allowed upto 100%.,other than for trading.Domestic sales can be made by paying CDequivalent for similar goods.International Financial Management
    68. 68. 68Money Market Instruments• Commercial Paper(CP)- is a corporate short –term,unsecured Promissory Note, on adiscount to yield basis.It can be regarded as a corporate equivalent of Certificate ofDeposit which is an Inter bank Instrument..CP maturities generally do not exceed 270days.CP represents a cheap and flexible source of Funds especially for highly ratedborrowers.,cheaper than bank loans.Us has the largest and long established dollar CPmarket .It is used extensively by US corporations as well as some non UScorporations.Euro Commercial papers emerged in the 1980s.Investors in CP consist ofmoney-market funds,insurance companies,pension funds and other financial institutionsand other corporations with short-term cash surpluses• Certificates of Deposit(CD)- is a negotiable Instrument evidencing a deposit with abank.Unlike a traditional Bank deposit which is not transferable a CD is a marketableinstrument so that the investor can dispose it off in the secondary market, if required..The final holder is paid face value on maturity along with interest .CDs are issued inlarge denominations –usd 100000 or more are used by commercial banks as short termfunding instruments.Euro CDs are issued mainly in London by Banks.• Bankers Acceptances- This is an Instrument widely used in the US money market tofinance domestic as well as international trade.In a typical International tradetransaction,the seller (exporter)draws time or usance draft on the buyers bank.Oncompleting the shipment the exporter hands over the shipping docs and the LC issued bythe importers bank to his bank.The exporter gets paid the discounted value of draft..Theexporters bank presents the draft to the importers bank which stamps it as ‘accepted”.Abankers acceptance is created.International Financial Management
    69. 69. 69q.+0Money Market Instruments-In addition to these Securitised Instruments,short –termbank loans are also available.The Euro currencies market is essentially an Inter bankdeposit and loans market.• REPOS-meaning repurchase obligations are used by securities dealers to financetheir holdings of securities.This is a form of collateralized short term borrowing inwhich the borrower “ sells”securities to the lender with an agreement to “buy”themback at a later date.Hence the name “Repurchase obligations”.The Repo price is thesame as original buying price ,but the seller (borrower)pays interest in addition tobuying back the securities.The duration for the borrowing may be as short asovernight or as long as up to a year.The interest rate is determined by demand –supply conditions.International Financial Management
    70. 70. 70Foreign Exchange Market in INDIA-• Foreign exchange Management Act (FEMA) replaced Foreign ExchangeRegulations Act(FERA) in 1999 .• FEMA gives full freedom to a person resident in India who was earlier residentoutside India to hold property outside India when he /she was resident outside India.• Similar freedom is also given to a resident who inherits such security or immovableproperty from a person resident outside India.• Liberalization in Foreign exchange entitlements to people traveling abroad• Liberalization in Investments by Indian companies outside India.• LERMS- was introduced in the year 1992keeping in line with the spirit ofliberalization..in LERMS dual exchange rate mechanism was adopted .60%exchange rate was market determined while the balance 40% was determinedofficially to take care of bulk imports by the govt.In 1993 the dual rate system wasabolished and the entire rate was market determined.USD replaced GBP as theintervention currency.International Financial Management
    71. 71. 71Foreign Exchange Dealings-• Direct and Indirect quotations(also known as European and American quotationsrespectively)-(please see slide number 51.)The latter are also referred to as Inverse orReciprocal quotes.• Two way quotation /rates-In practice dealers quote two way rates,one for buying theforeign currency(known as bid price/rate)and another for selling of foreigncurrency(referred to as Ask price/rate).Since dealers expect profit in FEoperations,the 2 prices cannot be the same.The dealer will buy the FE at a lower rateand sell it at a higher rate and sell the foreign currency at a higher rate.For thisreason,the Bid quote is a lower rate and the Ask rate is a higher rate.The quotationsare always with respect to the dealer(say banker).• By convention,the buying rate follows the selling rates Eg a dealer in Mumbai quotesPound Sterling 1=Rs 83/83.5 implies that the dealer is prepared to buy 1 British Poundat Rs 83 and sell it at Rs83.5.Normally the rates are at 4 decimal points .• SPREAD-IS THE DIFFERENCE BETWEEN ASK PRICE AND THE BIDPRICE.The spread is affected by a number of factors .The currency involved,the volume ofbusiness,and the market sentiments./rumors about the currency are the major variablesreckoned by dealers/operators in the FE market.Spread is akin to the Gross Profit in anormal business,out of which the dealer has to meet his expenses.In percentage termsit can be expressed as follows;Spread(percent) =(Ask price-Bid price)/Ask pricex100.In the above instance,it worksout to;(Rs83.5-83)83.5x100=.05988%.Prima facie the spread appears to be very low.Itdepends on the volume of business the dealer generates.International Financial Management
    72. 72. 72• Therefore it follows that normally the dealers buy FE from Exporters and sell Fe toImporters.Thus if the Rupee becomes stronger,the dealers will buy FE from exportersand pay less in Rs.• Eg An exporter has earned USD 10000and if he has to convert it into Rs he will get Rs440000(usd 10000xRs44) and if the Re is weak he may get Rs 460000(usd10000x46).• Conversely if an importer has to buy dollars for payment,the dealer will sell dollarsand if the Re is strong he will pay less and pay more if the Re is weak.• Therefore it follows that if the Re is weak the Exporter gains and the Importer losesand conversely if the Re is strong the exporter loses and the importer gains.• The quotations are usually shortened as follows ;USD /INR 46.4870/90 which means46.4870/46.4890.Remember that the offer rate must always exceed the bid rate –thebank giving the quote will always want to make a profit in its currency dealing .Henceif a quote is USD/INR 46.9595/.10 means 46.9595/46.9610 and a quote USD/INR46.9595/8.10 means 46.9595/48.9610.• ARBITRAGE between Banks-Though we hear about “Market rates”it is oftenfound that different banks will give different quotes for a given pair ofcurrencies.Suppose SBI and Canara Bank are quoting as follows;GBP/USD (SBI)1.4550/1.4560 (CAN BANK)1.4538/1.4548. This gives rise to anarbitrage opportunity.”Arbitrage in finance refers to a set of transactions ,selling andbuying or borrowing and lending the same asset or equivalent group of assets,to profitfrom price discrepancies within a market or across markets.Most often no risk isinvolved and no capital has to be committed.International Financial Management
    73. 73. 73Arbitrage (contd)-In the given example,GBP can be bought from Canara Bank atUSD1.4548 and sold to SBI at USD1.4550 for a net profit of usd 0.0002 per poundwithout any risk or commitment of capital..One of the main characteristics of modernfinance is that they are very efficient these days and such arbitrage opportunities willbe spotted by the markets and exploited.Therefore the arbitrage opportunities willdisappear very fast.Suppose,the quotes are as follows;SBI Canara BankGBP/USD (bid) 1.4550/1.4560(ask) 1.4545/1.4555Here there is no arbitrage opportunity seen as earlier.The reason is that the 2 quotesoverlap..However now SBI will find that it is being “hit”on its bid side much moreoften,while Canara Bank will find that it is confronted largely with buyers of GBP andfew sellers.This could lead to a position where the banks building up a positionIf SBI has sold more GBP than it has bought it is said to have a NET SHORTPOSITION and if it has bought more GBP than it has sold ,it is said to have NETLONG POSITION.Given the volatility of the exchange rates,maintaining a large NETSHORT/LONG Positions for a long time can be a risky proposition.From time totime,a bank may deliberately move its quote in a manner designed to discourage onetype of deal and encourage the opposite deal.Thus SBI may have built up a large NETshort Position in GBP and may now want to encourage sellers of pounds anddiscourage buyers.of GBP.Canara Bank may be in a reverse position;it wants toencourage buyers and discourage sellers of GBP.Thus regular clients of SBI wanting toto buy GBP can save money by going to Canara bank and Vice versa.International Financial Management
    74. 74. 74Cross-rates and three-point Arbitrage- A New York bank(N) is currently offering thefollowing quotes;USD /JPY; 110.25/111.10USD/AUD; 1.6520/1.6530At the same time ,a bank in Sydney(S) is quoting;AUD/JPY ; 68.3/69.00Is there an Arbitrage opportunity?Let us see the sequence of transactions1)Sell JPY,buy USD.Then sell USD and then buy AUD in New Yorkand2) sell the AUD for JPY in SydneyThe calculations are as follows;1 JPY sold in NY gets USD {1/(USD/JPY)ask(N)}=USD(1/111.10)=USD 0.00900USD 0.00900 to be sold to buy AUD.=.00900X1.6520= AUD 0.014868Sell this AUD for JPY=0.014862X68.3=JPY1.0154844=Margin of .00154844.So by doing this ,for every JPY there is a profit of JPY 0.0154844(say 0.0155) and for100 Million JPY ,the profit would be JPY 1.55 Million.International Financial Management
    75. 75. 75Forward Quotations-• Outright Forwards –are quotations for outright forward transactions given in thesame manner as spot quotations.Thus a quote like;• USD/SEK – 3 Month forward;9.1570/9.1595 means ,as in the case of a similar spotquote,that the bank will give SEK9.1570 to buy a USD and require SEK to sell adollar,delivery 3 months from the corresponding SPOT VALUE DATE.• DISCOUNTS and PREMIUM in the FORWARD MARKET; Let us look at thefollowing pair of Spot and Forward quotes;GBP/USD SPOT; 1.5677/1.5685GBP/USD 1- month forward ;1.5575/1.5585.—The GBP is cheaper for deliveryone month hence compared to spot GBP..The GBP is said to be at ForwardDiscount in relation to the USD or equivalently,the USD is at Forward Premiumcompared to the GBP.Options forward-A Standard forward contract calls for delivery on a specific day,thesettlement date of the contract..In the inter-bank market, banks offer what are knownas Optional Forward contracts or Options Forwards.Here the contract is entered intoat some time(T0) with the rate and quantities being fixed at this time,but the buyer hasthe option to take/ make delivery on any day between T1 and T2 with T2>T1>T0.Swaps in Foreign Exchange Markets-Swap Transactions between currencies A and Bconsists of a spot purchase (sale) of A coupled with a forward sale (purchase) of bothA against B.International Financial Management
    76. 76. 76Forward Forward swaps-Forward forward swaps is to do a swap for two Forward dates..ForInstance, purchase (sale) of currency A 3-Months forward and simultaneous sale(purchase)of currency A 6-Months Forward,both against currency B.Such a transaction is called aForward Forward Swap. It is a combination of of two SPOT -forward swaps;1)Sell A spot and buy 3- months forward against B. 2)Buy A spot and sell 6- monthsforward against BIn such a deal,both the spot-forward swaps will be ‘done off”an identical spot so that thespot transactions cancel out..The customer and the Bank have created what is known as aSwap Position –matched inflow and outflow in a currency but with mismatched timing.,withan inflow of A,three months hence and a matching outflow six months hence.The gain/lossfrom such a transaction depends only on the relative sizes of the 3 month and 6 monthsswap margins.APPLICATIONS OF SWAP –(1)Banks use swaps amongst themselves to offset positionscreated in outright forwards done with some customers(2)Swaps can be used to roll overlong-term exposures .For many currency pairs,forward contracts are not readily availablebeyond a certain maturity.For example ,in the Indian market till a few years ago ,the tenorof forward contracts could not exceed 6 months.Firms could handle their long termexposure using the so called “roll –over Forward contracts”A firm could use swaps asfollows;• Buy USD 1,000,000, 6- months forward at a rate known today.• 6 months later,take delivery,use USD 100,000to repay the first Installment .For theremaining USD 900,000,do a six –month swap-sell in the spot market,buy 6 monthsforward,Rupee outflow 6 months later is again known with certainty.• Repeat this operation every 6 months till the loan is repaid.International Financial Management
    77. 77. 77The Spot bill buying rate is calculated as• Spot bill buying rate =Inter bank forward rate for a forward tenor equal to transit plususance period of the bill ,if any minus the Exchange Margin..In addition the bank isentitled to recover from the customer,interest for the transit period plus usance period.• SPOT TT SELLING RATE- is computed as follows;TT selling rate =Base rate+exchange marginThus if a customer wishes to purchase a draft drawn on London for GBP 10000.Th interbank GBP/INR selling rate is Rs 85/GBP.The bank wants an exchange margin of0.15%.The TT selling rate would be Rs 85(1+0.0015)=85.1275,rounded off to Rs85.13.The customer will have to pay 85.13x10000=Rs 851300• BILL SELLING RATE-When an importer requests the bank to make a payment to aforeign supplier against a Bill drawn on the importer,the bank has to handle documentsrelated to the transaction.For this the bank loads another margin over the TT SELLINGrate to arrive at the Bill Selling rate.ThusSPOT BILL SELLING RATE =TT selling rate + exchange marginExamples-A Bank customer wants to buy USD 1 Million for value date spot.The client contactsthe bank(corporate desk )and asks for a rate.The AD for corporate clients, asks his interbank for USD 1 million for value spot.The inter bank spot dealer quotes 44.92/93.Thecorporate dealer in turn quotes this to the customer..If the customer wants to buyUSD,then he would buy at 44.93 plus the agreed spread for the corporate client,say0.0050=Rs 44.9350 per one unit of USD.The customer has to pay Rs 43,95,000 to getUSD 1 million.International Financial Management
    78. 78. 78Exchange Rate calculations-• Till August 2,1993,exchange rate quotations in the wholesale markets used to be givenas Indirect quotes,ie units of Foreign Currency per Rs 100..Since then the quotes areDirect given as Rs per unit of foreign currency.The rates quoted by banks to their Non-Bank customers are called ‘Merchant Rates’..Banks quote a variety of exchangerates.The so called “TT” rates(the abbreviation denotes Telegraphic Rates ) areapplicable for clean forward or outward remittances,that is ,the bank undertakes onlycurrency transfers and does not have to perform any other function such as handlingdocuments.For eg,,suppose an individual purchases from Citibank in New York,a demand draft forUSD 2000 drawn on Citibank,Mumbai.The New York Bank will credit the MumbaiBanks Account with itself immediately.When the individual sells the draft to CitibankMumbai,the bank will buy the USD at its TT Buying Rate .Similarly TT selling rate isapplicable when the bank sells a foreign currency draft or MT.TT buying rate alsoapplies when an exporter asks the bank to collect an export bill and the bank pays theexporter only when it receives payment from the foreign buyer as well as in cancellationof forward sale contracts.• When there is some delay between the bank paying the customer and itself gettingpaid.,eg,the bank discounts export bills ,various margins are subtracted from the TTbuying rates .Similarly on the selling side when the bank has to handle documents suchas LC,shipping docs and so forth apart from effecting the payment,margins are added tothe TT selling rate.as per FEDAI(in India)International Financial Management
    79. 79. 79• SPOT TT BUYING RATE-is calculated as –Spot TT Buying Rate=Base rate-Exchange Margin, where Base rate is the Inter-bank rate Thus suppose the inter bankUSD quote rate is Rs 46.75/46.76 and the bank wants exchange margin of 0.125%,theTT buying rate would be;(46.75)(1-0.00125)=46.6916 rounded off to Rs.46.69.Thus if adraft is encashed by the bank where its overseas account has already been credited,itwill give Rs Usd 10000x46.69= Rs 466900.when cashing a personal cheque or abankers;cheque payable overseas the Bank will not give this rate,because it has to sendthe cheque overseas for collection.This means a delay which is called Transitperiod..The bank will further subtract an exchange margin from the TT buying rate andalso recover Interest from the customer for the transit period.The transit periods forvarious countries are specified by the FEDAI(Foreign Exchange Dealers Association ofIndia).The Interest rates are given By RBI..The purpose of the exchange margin is torecover the costs involved and provide a profit margin to the bank.• SPOT BILL BUYING RATE –Exporters draw BE on their foreign customers.They cansell these bills to an AD for immediate payment.The AD buys the bill and collectspayment from the importer .Since there is delay between the AD paying the exporter anditself getting paid,various margins have to be subtracted from the TT buying rate tocompute the bill buying rate.Bills are of two kinds;Sight or Demand bills requirepayment by the drawee on presentation .The delay involved in such a bill is the transitperiod;Time or Usance bills give time to the importer to settle the payment ,i.e. ,theexporter has agreed to give credit to the importer.In such a case the delay involved is theUsance period plus the transit period.In addition to the exchange margin to cover costsand provide profit ,the AD will now load the forward margin for an appropriateperiod..If the bill is bought on a spot basis ,the forward period included the transitperiod plus usance period if any,International Financial Management
    80. 80. 80International Financial ManagementExample 2- A sight Export Bill for USD 100000-A bank purchases a demand export billdrawn by an Indian exporter on an American company.The transit period is 15days.The inter bank market spot buying rate is Rs 45.25.One month forwardbuying rate is at a premium of 15 paise,that is the buying rate is Rs45.40,EXCHANGE MARGIN IS 0.125%.The market for 15 day forward buyingrate would be;Rs 45.25 plus a premium of 7.5paise(for 15 days )that is Rs 45.3250. With thecommission the rate given to the customer would be 45.3250((1-0.00125)=45.2683rounded off to the 45.27.The customer will be debited separately to the customersaccount.Example 3-A Usance Bill for GBP 50000.An exporter wants the bank to buy a 30-daybill drawn on a British co for GBP 50000.Exchange margin is to be retained at .0.15%.the transit period is 10days.The market spot buying rate is Rs 69.5.Onemonth discount on sterling is 20paise. And two month discount is 50paise.Transit plus usance period adds up to 40days.Interpolating between 30and 60days,thediscount for 40 days would be {20+10/30x30}=30paise.The rate paid to thecustomer w ill be 69.2(1-0.0015)=69.0962 rounded off to 69.1.The customer wouldbe paid Rs 34,55,000.Interest for 40days would be recovered separately.
    81. 81. 81International Financial Management• INTEREST ARBITRAGE-Interest rate Arbitrage refers to the International flow ofshort-term liquid capital to earn higher return abroad.• UNCOVERED INTEREST ARBITRAGE-The transfer of funds abroad to takeadvantage of higher interest rates in foreign monetary centers usually involves conversionof the domestic currency to the foreign currency ,to make the investment.At the time ofmaturity,the funds (plus the interest)are reconverted from the foreign currency to thedomestic currency.During the period of investment, a foreign exchange risk is involveddue to the possible depreciation of the foreign currency.If such a foreign exchange iscovered we have covered interest arbitrage,otherwise we have uncovered arbitrage.
    82. 82. 82COVERED INTEREST ARBITRAGE -Interest Arbitrage is usually covered as investors ofshort- term funds abroad generally want to avoid the foreign exchange risk.To do thisthe investor exchanges the domestic currency for the foreign currency at the currentspot rate so as to purchase the foreign treasury bills or investment and at the same timehe sells forward the amount of the foreign currency he is investing plus the interest hewill earn ,so as to coincide with maturity of the foreign investment.Thus coveredarbitrage refers to the spot purchase of the foreign currency to make the investmentand off setting the simultaneous forward sale (swap of the currency) to cover theforeign exchange risk..When the investment matures ,the investor can then get the domestic currencyequivalent of the foreign investment plus the interest earned without a FE risk.Sincethe currency with the higher interest rate is usually at a forward discount ,the netreturn on the investment is roughly equal to the positive interest differential earnedabroad minus the forward discount on the foreign currency.This reduction in earningsis the cost of insurance against the FE risk..In Covered Interest arbitrage,the rule is that if the interest rate differential is greaterthan the premium or discount ,place the money in the currency that has a higher rate ofinterest or vice versa.International Financial Management
    83. 83. 83EXCHANGE RATE THEORIES AND EXCHANGE RATE FORECASTING-Are changes in exchange rates predictable?How does inflation affect exchange ratesHow are Interest rates related to exchange rates?what is the proper exchange rate?.Foran answer to these questions it is essential to understand the different theories ofExchange rate determination.A Swedish economist Gustav Cassel popularized. the PPPin the 1920s.When many countries like Germany,Hungary and the Soviet Union experiencedhyperinflation,in those years the Purchasing Power of the currencies in these countriessharply declined.The same currencies also depreciated sharply against the stablecurrencies like the USD.The PPP theory became popular against this Historicalbackdrop.PURCHASING POWER PARITY THEORY-PPP Theory-The PPP theory focuses onthe inflation exchange rate relationships.If the law of one price were true for all goodsand services, we could obtain the theory of theory of PPP.There are two forms of thePPP theory;International Financial Management
    84. 84. 84Absolute Purchasing Power Parity; Underlying the absolute version of the PPP is the “Law ofone Price”,Viz that commodity arbitrage will equate prices of a good in all countrieswhen prices are expressed in a single common currency. PPP postulates that theequilibrium exchange rate between currencies of 2 countries is equal to the ratio of theprice levels in the two nations.Thus prices of similar products of two different countriesshould be equal when measured in a common currency as per the absolute version ofPPP theory..Let Pa refer to the general price level in country A and Pb refer to thegeneral price level of country B,and Rab to the exchange rate between the currency ofcountry A and country B.The Absolute PPP theory postulates that ---Rab=Pa/PbFor example if country A is USA and country B is UK the exchange rate between the USDand the GBP is EQUAL to the ratio of US to UK prices. viz,if the general price level inthe US is twice the general price level in the UK ,the absolute PPP theory postulatesthe equilibrium exchange rate to be 2USD=1GBP..In reality the exchange rate betweenUSD and GBP could vary considerably from USD 1 to GBP 2 due to various factorslike transportation costs, tariffs,or other trade barriers between the 2 countries..Thisversion of the absolute form of PPP has a number of defects..First, the existence oftransportation costs,tariffs,, quotas or other obstructions to the free flow ofInternational trade may prevent the absolute form of PPP.Secondly,The absolute formof PPP appears to calculate the exchange rate that equilibrates trade in goods andservices so that a country experiencing capital outflows would have a deficit in its BOPwhile a country receiving capital inflows would have a surplus. Finally, the theorydoes not even equilibrate trade in goods and services because of the existence of non-traded good and services.International Financial Management
    85. 85. 85Absolute PPP Theory (contd)-Non –traded goods such as cement and bricks, for which thecost of transportation cost is too high,cannot enter international trade except perhaps inthe border areas.Also specialized services like those of doctors hairstyles etc,do notenter international trade .International trade tend to equate the prices of traded goodsand services among nations but not the prices of non traded goods and services.Thegeneral price level in each nation included traded and non traded goods and since theprices of non traded goods are not equalized by international trade,the absolute PPPtheory will not lead to the exchange rate that equilibrates trade and therefore has to berejected.Relative Purchasing Power Parity-The relative form of PPP is an alternative version whichpostulates that the change in the price levels in the two nations should beproportional to the relative change in the inflation levels in the two nations over thesame time period.This form of PPP theory accounts for market imperfections such astransport costs,tariffs and quotas.Relative PPP theory accepts that because of marketimperfections prices of similar products in different countries will not be the samewhen measured in a common currency.What it specifically states is that the rate ofchange in the price of products will be somewhat similar when measured in a commoncurrency as long as the trade barriers and transportation costs remain unchanged.Inother words,it states that a proportionate (or %)change in exchange rate between twocurrencies A and B between 2 points of time(approx)equals the difference in theinflation rates in the two countries over the same time interval.International Financial Management
    86. 86. 86The fact that some goods do not (and cannot )enter international trade means that even therelative version of PPP can be expected to hold only for traded goods.Therefore,theprice indices used to measure inflation differentials must cover only traded goods.REAL EFFECTIVE EXCHANGE RATE(REER)-Related to the notion of PPP is theconcept of RER.It is the exchange rate after adjusting for inflation .It is a measure ofexchange rate between 2 countries adjusted for relative purchasing power of thecurrencies.Since purchasing power of money is measured with reference to a giventime period.,it is only the changes in real exchange rate that have significanteconomic implications.Eg-suppose at the end of August 2000 ,the USD /INR exchange rate was Rs45,while at the end of August 1985 it was only Rs 18.This implies that in nominalterms,that is,without adjusting for Inflation,the rupee depreciated by 150%.in 15years.But if we were to answer the following question-In August 2000 how manyrupees worth of Purchasing power had to be given up to acquire one dollar worth ofPurchasing Power when both PPs are measured with reference to August 1985?The following data are also available;The consumer price index (CPI) in India at theend of August 2000,with March 1985 as the base stood at 375 while the CPI in theUS with reference to the same base was 180.This means that Rs 45 in August 2000was worth Rs(45/3.75)=Rs 12 of 1985 purchasing power.We had to give up Rs 12worth of 1985 purchasing power in India to acquire USD 0.5556(1/180) worth of1985 purchasing power in the US.International Financial Management
    87. 87. 87The real effective exchange rate in August 2000,with reference to March 1985 wastherefore (12/0.5556)=21.6 though by definition, the real exchange rate in march 1985was Rs 18.Thus in inflation adjusted terms the rupee depreciated by about 20%.(3.6/18)The importance of the concept of Real Exchange Rate is in the fact that changes in ithave implications for the relative competitiveness of a 1)country’s exports and 2)import substitutes.If an exporter can raise the FE currency price in line with the foreign inflation,if hiscosts increase in line with domestic inflation and if the exchange rate depreciates byan amount equal to the excess of home inflation over foreign inflation,the exporterscompetitiveness in the export market remains unchanged..we now see that the realexchange rate must remain unchanged.The case of a company which makes import substitutes can be analyzed along similarlines..A real appreciation of the home currency hurts real profitability of producingimport substitutes and will channel resources into production of home goods –goodswhich face no international competition because they are not traded.Thus realexchange rate determines not only relative competitiveness of exports but also relativeattractiveness of producing for international markets versus producing for homemarkets.NOMINAL EFFECTIVE EXCHANGE RATE(NEER)-is the exchange rate beforeadjusting inflation difference .In the example given above Rs 18 is the NEER while 21.6 is the REERInternational Financial Management