72653145 international-financial-management-1

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International Financial Management
Introduction
• World as a Global village
• Free flow of goods and services –seamless
• Quantum jump in International trade and
commerce
• New forms of trade-Internet,e-commerce
• Dynamic and Complex International markets

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International Financial Environment
• Natural sequel to International trade
• Financial Management- Integral part of Trade
and commerce
• Technology and its Impact
• New funding techniques,Investment
Vehicles,Risk Management products etc.
• Creative Financial Management
• Financial Engineering!

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International Financial Environment-contd
Challenges before a Finance Manager
• Keep up to date with the the changes in the
Economic Environment-eg exchange
rates,Banking and Tax regulations,Foreign
trade policies,credit conditions at home and
abroad,stock market trends etc.
• Complex relationships between various
variables eg, impact of changes in the world
financial markets and its effects on the firm
and its bottom line and cash flows

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Challenges before a Finance Manager-contd
• To be prepared to face adverse business
conditions affecting the Financial Position of
the Firm and minimize its adverse impact-
Business decisions going wrong due to
changes in assumptions,changes in market
conditions beyond control etc
• Design and Implement effective solutions to
take advantages of the markets and advances
in Financial theories –Upgrading skills and
using new tools of Financial Management,use
of latest technology etc.

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1. Roles and Goals of MNCs-
• Raw materials seekers-Vertical Integration
• eg French,Dutch and British East Indian
companies
• Today they are large Oil and Gas companies
eg BP,Shell,Indian cos Mittal steel etc
• Mineral companies like Anaconda copper
International Nickel etc
Goals-exploit availabilty-cost advantages

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Roles and Goals of MNCs- contd
• Market seekers-Typical MNCs of Today-
they go overseas to manufacture and sell in
overseas markets eg IBM,unilever,coca
cola,Pepsi, Procter and Gamble,Nestle etc
• Goals-Maximize businsess
opportunities,Maximize profits,to beat
perceived or real trade restrictions,eg Japan
investing in US to avoid export restrictions in
US

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Roles and Goals of MNCs-contd
Cost Minimisers-
• Again very common today –companies seek
and invest in low cost countries,e.g.
BPO/KPO in India,Texas
Instruments.Japanese Consumer Electronic
companies in Malaysia,China etc.
• Goals-To remain competitive in the Domestic
and world market,utilize Economies of scale.

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Exposure to International Risks-
Exposure and Risk-
• Exposure is the measure of the sensitivity of
the value of a Financial Item,viz
Asset,Liability,Cash Flow,to changes in the
risk factor
• Risk is the quantifiable likelihood of loss or
less-than-expected returns. It is a measure of
the variability of the value of the item
attributable to the the risk factor.

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Exposure to International Risks-
1. Macroeconomic Environmental Risks-Value
of a Firms Assets,Liabilities and Operating
Income varies continually in response to
changes in the economic variables such as
Exchange rates,Interest rates,Inflation
rates,prices and so forth.
2. Core Business risks-Interruptions to Raw
material supplies, labor troubles,success or
failure of a new product,operational risks

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Exposure to International Risks
• 3)Systemic Risks-Collapse of a Financial system-eg
Stock market crash,Run on Banks etc
• 4)Currency Risks-also known as FE risk- A risk that a
Business operation or an Investment value will be
affected by exchange rates fluctuations.
• 5)Liquidity Risk-The risk that arises from the difficulty
of selling an asset. An investment may sometimes
need to be sold quickly. Unfortunately, an insufficient
secondary market may prevent the liquidation or limit
the funds that can be generated from the asset. Some
assets are highly liquid and have low liquidity risk eg
Shares.Some assets have low Liquidity and high
liquidity risk eg Real estate property

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Exposure to International Risks-contd
• 6)Market Risk-Risk which is common to an
entire class of assets or liabilities. The value
of investments may decline over a given time
period simply because of economic changes
or other events that impact large portions of
the market.
• 7)Interest rate risk-Interest rate risk is due to
the rise or fall in the Interest rate of a
Security or Bond held as well the market
value of the fixed rate bonds
• 8)Political Risk-change in
government,unstable government eg Projects
in Iraq,Ethiopia etc.

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Exposures;
Transaction Exposure-arises due to exchange
differences in transactions-Unanticipated
changes in the exchange rate has an impact-
favourable or adverse on its cash flows.It is
usually within the year.
• Eg-An Indian company imports Raw materials from a
US company valued at usd100000,payable after 3
months.If it pays at today’s rate it would have paid
@Rs 45 to a dollar.As the rupee is weakened the rate
goes upto Rs 46 to a dollar within 3 months.It has to
pay Rs 100,000 more.

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Translation exposure-is the change in accounting
Income and Balance Sheet statementscaused
by by the changes in exchange rates.It results
from the need to translate foreign currency
assets /Liabilities into local currency while
preparing final accounts.
• Eg-an Indian company borrows usd 1 million from a
us bank for importing a machine. When the import
materialized,the exchange rate was Rs 45 to a usd.The
value of the machine in the books as on that date
would be Rs 45 million(Rs 4.5 crores) and a
corresponding loan of Rs 4.5 crores. (contd)

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Assuming no change in the exchange rate,the company
while preparing the final accounts will provide for
depreciation on 4.5 cores ,say @25%=Rs1.125crores.
If the rate of exchange as on the Balance sheet date becomes
Rs 46 to a dollar,then correspondingly the figures of
Machinery value ,the loan taken and the depreciation
to be charged also get changed.It impacts both Pand L
Account and the Balance sheet.However there is no
direct impact on the Cash flows immediately.

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Economic exposure-refers to the change in the
value of a company that accompanies an
unanticipated change in exchange
rates.Anticipated changes are already
reflected in the market value of the company.
Eg-when an Indian company transacts business with an
American company,it has expectation that the Indian
Rupee is likely to weaken and factors this in its
transactions.If there is a weakening of the rupee it will
not affect the market value of the company.In case it is
different from the expected ,then it will have a bearing
on the Market Value of the company.

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Economic Exposure-has two components
1. Operating exposure-which captures the impact of the
unanticipated changes on the company’s
revenues,operating costs and operating net cash flows
over a medium term horizon-say 3 years-something
similar to Transaction exposure(TE) but longer than
TE. In general an exchange rate will affect both future
revenues as well as operating costs and also the
operating Income-
2. Strategic exposure-In the long term,exchange rates
effects can undermine the company’s competitive
advantage by raising its costs over its
competitors.Such competitive exposure is also referred
to as Strategic exposure eg Japanese goods becoming
expensive due to yen becoming stronger and hence
strategically shifting production bases out of Japan.

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Important Terms used in International Finance
• Exchange control-mechanism by which the country
regulates its foreign exchange transactions.RBI in
India regulates the entire FE movement into and out of
India.
• Authorized Dealers-are those authorized to deal in FE
by RBI eg,Banks.they can buy and sell foreign
currencies,open LCs ,remit FE, open accounts abroad.
• Letter of credit-is a document issued by the opening
bank (importer’s bank)to honor an exporter’s draft or
claim for payment provided the exporter has fulfilled
all the conditions stipulated in the LC.
• Terms used in the operation of LC
Opening bank-The bank which opens the LC at the
request of the buyer. (contd)

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Beneficiary-The seller/exporter who sells goods to the buyer
and who will receive the proceeds of the LC.
Advising Bank-The correspondent Bank to whom the
opening bank sends the LC in the exporter’s country
who in turn send it to the exporter’s bank for further
process.It could be the branch of the opening bank
also.
Confirming Bank-one who adds his confirmation to the LC
DP/DA-Drafts against payment and Drafts against
Acceptance-presents the draft on the Importer through
his bankers who in turn forward this draft along with
the documents to the importers’ bankers for payment
and releasing the documents.

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Balance of Payments-BOP of a country is a systematic
accounting record of all economic transactions
between the residents of A country with the Rest of
the WORLD.
• BOP considers both Import and Exports of Goods and
Services
• Basic types of Economic Transactions
• 1)Purchase or sale of Goods or Services with a financial
quid pro quo-or a promise to pay.One financial and one
physical(one Real)
• 2)Purchase or sale of Goods or services in return for goods
or services-Barter system(Two Real)
• 3)Any exchange of Financial items,say purchase of
Financial securities and payment there for by cheque(two
Financial transactions)
• 4)A unilateral Gift in kind(one real transfer)
• 5)A unilateral financial gift.(One financial transfer)

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Accounting Principles in BOP-
Is a standard double entry accounting record-Thumb rules to
remember;
1. All transactions which lead to an immediate or
prospective payment from the Rest of the
world(ROW) to the country should be recorded as
credit entries.The payments,actual or
prospective,should be recorded as the offsetting debit
entries.
• Conversely,all transactions which result in an actual or
prospective payment from the country to the ROW
should be recorded as debits and the corresponding
payments as credits

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Accounting Principles in BOP-contd;
• Payment received from ROW increases the
country’s foreign assets –either the payment will be
credited to a bank account held abroad by a
resident entity or a claim is acquired on a foreign
entity.Thus an increase in Foreign Assets must
appear as debit entry.
• Conversely, a payment to the ROW reduces the
country’s foreign assets or increases its liabilities
owed to foreigners;a reduction in foreign assets or
an increase in foreign liabilities must therefore
appear as credit entries

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Accounting Principles in BOP-contd
2 A Transaction which results in an increase in demand
for foreign exchange is to be recorded as a debit entry
while a transaction which results in an increase in the
supply of Foreign exchange is to be recorded as a
credit entry.
Thus an increase in Foreign assets or reduction in
Foreign Liabilities ,because it uses up foreign
Exchange is a debit entry while a reduction in foreign
assets or an increase in foreign liabilities because it is
a source of foreign exchange now, is a credit
entry.Capital outflow-such as when a resident
purchases foreign securities or pays off a bank loan is
a debit entry while capital inflow such as a
disbursement of world bank loan is a credit entry

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COMPONENTS OF BOP-
1. Current Account-Imports and Exports of goods and
services and unilateral transfers of goods and
services
2. Capital Account-Under this are included
transactions leading to changes in foreign Financial
assets and Liabilities of the country
3. Reserve Account-In principle this is no different
from the capital account in as much as it also
relates to Financial Assets and Liabilities.However
in this category only “Reserve Assets” are
included.These are assets which the the monetary
authority of the country uses to settle deficits and
surpluses

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Examples; India exports garments to USA worth
usd10000.The goods have been invoiced and will be
paid in USD.Payment will be effected by crediting the
account of India in USA.The balance in a foreign bank
is a foreign asset for India and liability for USA.India
will record the entry as;
Transaction Debit credit
-Good exported(current) 10000
-Increase in claims from
Foreign bank (foreign asset-
capital) 10000
In the BOP of USA it will be the opposite.

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Example 2;India agrees to supply leather goods worth usd 5000 to
Saudi Arabia in return for CRUDE OIL equivalent to the
same amount .Both are current account transactions;Will
be recorded in India’s BOP as follows;
Transactions Debit credit
Goods Imports 5000
Goods Export 50000
In the BOP of Saudi Arabia it will be the opposite.
Example 3;SBI purchases securities issued by USA valued at usd
2000 and pays through its branch in the USA.Here it has
changed one foreign asset to another.The transaction is
capital in nature;
Transaction Debit Credit
Increase in foreign Securities 2000
Decrease in Foreign bank account 2000

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Structure of current Account in India’s BOP-
Current Account Debits credits Net
• Merchandise(goods)
• Invisibles(a+b+c)
a)services
1.Travel
2.Transportation
3.Insurance
4.Misc
b)Transfers
1)official
2)Private
c)Income
1)Investment Income
2)employees compensation
TOTAL CURRENT ACCOUNT

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MERCHANDISE-In principle,merchandise covers all
transactions relating to movable goods where the
ownership is transferred from R to NR in the case of
exports and NR to R in the case of imports with some
exceptions.
Exports valued on FOB basis are credit entries.Data
for these items are obtained form the various forms
exporters fill up and submit to designated authorities
like STPI,Expocil,RBI etc.
Imports valued at CIF are the debit entries.
The difference between the total of debits and total of
credits appears in the “NET ‘column.This is the
Balance on Merchandise Trade Account,deficit or
surplus depending upon whether negative or positive.

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Invisibles-
Includes services such as transportation,Insurance
Income,
Payments and receipts for factor services,viz labour
and capital and unilateral transfers.
Credits under Invisibles consist of services rendered
by R to NR, Interest and Dividend Income earned by
R from their ownership of Foreign Financial
Assets,cash and gifts received in kind by R from NR.
The NET balance between the credit and debit entries
under the heads Merchandise ,Non-monetary gold
movements and Invisibles taken together as the
Current Account Balance.The Net balance is taken as
deficit if negative and surplus if positive.

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Structure of Capital Account IN India’s BOP-
1.Foreign Investments(a+b) Debit credit Net
a.)India
b)Portfolio
2.Loans
a)External Assistance
By India
To India
b) Commercial Borrowings(MT and LT)
By India
To India
C)Short term
To India
3.Banking Capital
a)Commercial Banks
Assets
Liabilities
Non-Residents
b)others
4. Rupee Debt Service
5.Other capital
TOTAL CAPITAL ACCOUNT(1 TO 5)

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Structure of ‘other Accounts” Debit Credit
Net
1.Errors and Omissions
2.Overall Balance (Total of current,capital and
Errors and omissions)
3.Monetary movements
IMF
Foreign Exchange Reserves(increase /decrease)

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Meaning of “Deficit” and “Surplus”
• Deficit refers to the negative balance in the BOP after
giving effect to the various transactions and Surplus
refers to the positive balance in the BOP
• It refers to the imbalance in subset of accounts
included in the BOP and also referred to as Economic
equilibrium or disequilibrium.Disequilibrium calls for
a policy Intervention,it is important to group the
various accounts in the BOP into set of Accounts
‘above the Line’ and “below the Line”.If the NET
balance is positive we say it is BOP surplus and if it is
negative then it is BOP Deficit.
• BOP statistics are important for the Finance Manager.
If negative it will mean more demand for the Foreign
currency and will increase its cost and vice versa.

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• Negative BOP can be corrected by increasing
taxes,reducing government expenditure,by increasing
savings and by reducing consumption.
• BOP disequilibrium can be remedied by borrowing
from International Institutions like IMF which are
called Multilateral Borrowings or by Inter-
governmental Borrowings called as Bilateral
borrowings.
• FDI ,exchange control mechanism can also be
considered as a direct option for remedying the BOP
position.
• BOP can be classified as –Autonomous and
Accommodating.Autonomous Transaction takes place
due to Import and export of goods and
services.Accommodating transaction (compensatory
transactions) means borrowing to rectify Current
account deficit.

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

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International Monetary Systems-Introduction
• Gold standard- Initially there was a Gold standard system which
started in 1814 in UK and 1870 in the USA.Under this each currency
derived its value from its GOLD content.Was used till the First world
war and a few years after that. Two versions-Gold Specie standard and
Gold Bullion standard.
• Gold specie standard –The actual currency in circulation consisted of
Gold coins with a FIXED GOLD CONTENT.
• Gold Bullion standard-The basis of money remains a fixed weight of
Gold but the currency in circulation consisted of Paper Notes with the
authorities standing ready to convert on demand,unlimited amounts of
paper currency into gold and vice versa at a fixed conversion ratio.
• Under the Gold Exchange Standard the authorities stand ready to
convert,at a fixed rate, ,the paper currency issued by them into the paper
currency of another country which is operating a Gold species or Gold
Bullion standard.
• The exchange rates between any pair of currencies will be determined by
their respective exchange rates against Gold.

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BRETTON WOODS SYSTEM-
Following the 2nd
world war,the main allied powers USA and UK took up the task of
thoroughly revamping the International Monetary system.In 1944 in a place called
Bretton woods in New Hampshire,USA ,2 new supra National Institutions were
formed which are very much active today in the International Financial Arena, viz
• World Bank
• International Monetary Fund.
• The exchange rate that was put in place can be characterized as the Gold Exchange
standard.
• It had the following features;
• The US govt undertook to convert the USD freely into Gold at a fixed PARITY of
usd 35 per ounce of gold.Other IMF member countries agreed to fix their
currencies vis a vis the dollar within a variation of 1% on either side of the central
parity being permissible.
• Under this system the USD in effect became International money.Other countries
accumulated and held USD balances with which thy could settle their international
payments.
• This system was abandoned in 1973 .

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WORLD BANK(WB)-is a vital source of Financial & Technical assistance to
developing countries around the world.WB representing a membership of 185
countries has 2 unique development 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 like
drinking water,road construction, etc.
• Together WB provides-Interest free loans,Interest free credits,Grants to developing
countries for education,health,infrastructure,and many other alleviation causes.
• ADB- Asian development bank-was set up as an Asian version of the world bank to
provide development finance to countries in Asian Region .It’s HQ is
Manila,Phillipines.
• IFC-Is a member of the WB GROUP. It helps private sector projects in developing
countries in the form of giving direct assistance,underwriting issues,undertaking
feasibility studies for projects,.It also acts as a guarantor for any lending to PVT
sector and develops capital markets in the countries.

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IMF-International Monetary Fund.- mandated to exercise firm surveillance over
the exchange rate policies of its memeber.and to help assure orderly exchange
arrangements and to promote a stable exchange rate .The responsibility for
collection and allocation of reserves was given to IMF under the Bretton woods
arrangement.It was also given the responsibility of ;
• supervising the adjustable Peg system
• Rendering advise to member countries on their international monetary affairs
• Promoting research in various areas of international economics and monetary
economics
• Providing a forum for discussion and consultations among member nations.
-The initial quantum of reserves was contributed by the members according to quotas
fixed for each.Each member country was required to contribute 25% of its quota
in Gold and the rest in its own currency.Thus the fund began with a pool of
currencies of its members.The quotas decide the the voting powers and maximum
amount of financing its member countries can get within the policy making bodies
of IMF.
Since 1980,IMF has been authorized to borrow from capital markets.
-IMF established contingency reserve to tide over temporary BOP problems,while
structural Reserve was established to tide over structural BOP problems.Countries
with chronic BOP problems were allowed to depreciate their currencies. It has
played an important role in tackling the debt crisis of developing countries.

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Exchange rate regimes;current scenario-
1)Exchange arrangements with No separate legal tender-This group includes
a) Countries which are members of a currency union and share a common currency
eg European union., who have adopted Euro as their currency since1-1-1999 and
have fixed their currency on parity with the Euro on that date.(11 members have
adopted this)
b) Countries which have adopted the currency of another country as theirs.eg,East
carribean common market viz, Grenada,Antigua,,St Kitts,Nevis. And countries
belonging to the central African Economic and Monetary union eg
Cameroon,central African Republic.These countries have adopted the French
Franc as their currency.
2)Currency Board Arrangement-A regime under which there is a legislative
commitment to exchange the domestic currency against a specified foreign
currency at a fixed exchange rate.,coupled with restrictions on monetary
authority to ensure that commitments will be honoured. Eg Argentina, Hong
Kong have tied their currency with USD.( 8 members have adopted this )
3)Conventional Fixed Peg Arrangements-This is similar to Bretton woods system
where the currency is pegged to another currency or a basket of currencies with a
band of +/- 1% around the central parity.( 44 members have adopted this )

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Exchange rate regimes;current scenario-
4)Pegged Exchange rates with Horizontal bands-Here there is a peg but variation
has with wider bands.It is a compromise between a fixed peg and a floating peg.
(8 countries have adopted this)
5)Crawling peg-This is another variant of a limited flexibility Regime.The currency is
pegged to another country or a basket of currencies but the peg is periodically
attached.(6 countries have adopted this)
6) Crawling Bands-The currency is maintained within certain margins around a central
parity which crawls as in the crawling peg regime(9 countries have adopted this)
7)Managed Floating-with no pre announced path for the Exchange rate-The central
bank influences or attempts to influence the exchange rate by means of active
intervention in the FE market.-buying or selling foreign currency against the
home currency without any commitment to maintain the rate at any particular
level or keep it on any pre announced trajectory(25 countries have adopted this)
8)Independently Floating-The exchange rate is market determined with central bank
intervening only to moderate the speed of change and to prevent excessive
fluctuations but not attempting to maintain it t at or drive it towards any particular
level(48 countries including India have adopted this)
It is therefore clear that post 1973 a wide variety of arrangements exist

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International Trade organizations=
1)GATT-General Agreement on Trade and Tariff was constituted
in 1947 to facilitate free trade.The main objectives of GATT
are;
• Progressively reduce Tariff rates
• Extend Most favoured Nation status treatment to all
members
• Remove quantitative restrictions and
• Free exchange control on current account transactions
Several rounds of discussions were held -Geneva,Kennedy,Tokyo
and Uruguay Rounds
It did not take into consideration trade in services and Intellectual
properties.

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2)WTO-World Trade Organisation-was constituted in 1995.Unlike
GATT is permanent in nature.Apart from trade and services ,it also
deals with Trade related aspects of Intellectual Property
rights(TRIPS) wherein issues regarding
copyright,Patents,Industrial design Trademark are dealt with.In
trade related aspects of investment management
(TRIMS),discrimination against Foreign Investments in the form of
restrictions,discriminatory taxation are dealt with.
Various objectives of WTO include implementation
administration,and operation of all multilateral trade disputes
administration and operation of trade agreements,administration of
rules governing settlement of trade disputes,trade policy review
mechanism and providing a forum for discussion between
members.
3)UNCTAD-United Nations council for Trade and Development
(UNCTAD) has been constituted to facilitate International
trade.The first meeting was held in Geneva in 1964 and attended
by 120 countries.Its main aim was to reduce trade barriers in
developed countries and through increased access to their
markets,improve standard of living in developing countries

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

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Global Financial Markets
Domestic and Offshore Markets-
• Financial Assets and Liabilities denominated in a particular currency,say USD,are
traded in the National Financial Markets of that country.In addition,in the case of
many convertible currencies,they are traded outside the country of that
currency.Thus bank deposits loans,Promissory Notes,Bonds denominated in USD
are bought and sold in the US money and capital markets such as New York as well
as the Financial Markets in London,Paris,Singapore and Tokyo.The former is the
Domestic market while the latter is the Off shore market.
• Domestic markets are usually subject to strict supervision and regulation by relevant
National Authorities.,like SEBI,Federal Reserve Board in the US,MOF in
Japan,SEC in the US . Domestic banks are also regulated by the concerned
monetary authorities and may be subject to Reserve Requirements,capital adequacy
norms etc.
• Off shore markets ,on the other hand,have minimal regulation,often no registration
formalities and importance of rating varies
• However in the recent years with the removal of barriers and increasing
integration,authorities have realized that regulation of financial markets and
Institutions cannot have a narrow national focus-To minimize the problem of
systemic risks banks and Firms must be subject to norms and regulations that are
common across countries. eg Basel Accord.

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Euro markets
• Prior to 1980Eurocurrncies Markets was the only International Financial Market of
any significance.It originated in the 1950s with the Russian authorities seeking dollar-
denominated deposits with banks in Britain and France as the erstwhile USSR thought
that the US might freeze its dollar accounts if kept in the US.
• “Eurocurrency”Deposit is a deposit in the relevant currency with a bank outside the
home country of that currency.Thus a US Dollar deposit in a London Bank is a
Eurodollar Deposit and Deutschemark Deposit in a bank in Luxembourg is a Euro
mark Deposit.
• Thus a dollar deposit belonging to an American company held with a Paris subsidiary
of an American Bank is still a Eurodollar deposit.
Main features of such deposits;
• As these deposits are kept outside the country of the currency,monetary authorities
could not place any restrictions on the issue of such currencies like Reserve
requirements,withholding tax for foreign borrowers,deposit insurance requirements,
other restrictions placed by the monetary authorities etc were .not applicable to such
deposits as they were not under the purview of the MA.
• Absence of restrictions made the deposits attractive not only to the depositors but also
to the banks.Such deposits were parked in developing countries debt at attractive
returns without paying much heed for credit risk ratings, (which ,in fact ,led to the
Latin American debt crisis).

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• Euro deposits -contd
• The prefix Euro is outdated now as such deposits and loans traded outside Europe .For
instance,in Singapore and Hong Kong.They are called Asian Dollar Markets.
• Over the years markets have evolved a variety of Instruments other than Time deposits
and short term loans.Among them are(a) certificates of Deposits(COD) (b)Euro
commercial paper©Eurobonds(d)Floating Rate Notes etc.
• In 1999,single currency Monetary union was formed.It is a unique integration of
currencies without political integration .It challenged the USD in as much as trading is
done in Euro as much as in USD and the EU has adopted this currency for trading and
holding deposits.
ECONOMIC IMPACT OF EURO MARKETS -Perceived Advantages of Euro Markets;
1)More efficient allocation of capital world wide(2)Smoothing out the effects of sudden
shifts in Balance of Payments,eg oil crisis in 1973and recycling of petrodollars without
which a large number of oil importing companies would have to face severe crisis.
(3)The spate of financial innovations that have been created by the market which have
vastly enhanced the ability of companies and governments.to manage their financial
risks.
Perceived Disadvantages of Euro markets;(1)Market stabilization is difficult for Central
banks as the so called ‘hot Money’-Speculative capital flows is facilitated(2)National
Monetary authorities lose effective control over monetary policies as Domestic
residents can frustrate their efforts by borrowing or lending abroad.(3) Euro markets
create ‘private International Equity”and in the absence of a central coordinating
authorities they could create”too much”contributing to inflationary tendencies in the
world economy.

46
FOREIGN EXCHANGE MARKETS-
• Market in which currencies are bought and sold against each other.It is the largest
Market in the world.
• Largest volume of Trade-estimated over USD per day1 trillion and during peak
volume it touched USD 1.6 trillion.
• FE market is an over-the –counter market.This means that there is no single
physical or electronic market or an organized exchange like a stock exchange with
a central trade clearing mechanism where traders meet and exchange currencies.
• THE MARKET ITSELF IS ACTUALLY A WORLD WIDE NETWORK OF
INTER-BANK TRADERS,CONSISTING PRIMARILY OF BANKS
CONNECTED BY TELEPHONE LINES AND COMPUTERS.
• It is virtually a 24 hour market because it cuts across TIME ZONES.From Tokyo
to New York ,it works through out the day and night and hence the huge volumes.
• STRUCTURE;
• 1)Retail market- This is the market where tourists and travellers exchange one
currency for another in the form of currency notes or travellers cheques.The total
turnover and average transaction size are very small.The spread between buying
and selling is large.They are secondary Price Makers because they do not have a 2
way transaction .eg Restaurants,Hotels ETC.

47
2)Wholesale Market-
often called the Inter Bank Market.Major categories of participants are(a) Commercial
banks(b)Investment Institutions©Central Banks.
• The average size of the transaction will be very large,e.g. the average size of
transaction in the US market is around USD 4 million and many transactions even
larger .
• Among the Participants in this are-Professional dealers or Primary price makers who
make a 2 way quote to each other and to their clients- a price to buy currency X against
currency Y and a price to sell X against Y.This Group consists of mainly commercial
banks ,large Investment Institutions,and a few large corporations and MNCs. A dealer
will sell USD against Euro to one corporate customer,carry the position for a while and
offset it by buying USD against Euro from another customer or dealer.Meanwhile,if the
price has moved against the dealer he bears the loss.
• Eg,The dealer might agree to buy Euro by selling USD,at a rate of USD 0.9 per
Euro,and by the time he covers his position,the market may have moved ,so that he
must acquire the Euro at a price of USD 0..87 per Euro.if the transaction is for USD 1
Million ,the loss he will undergo will be USD 30000.
• Foreign Currency Brokers act as middlemen between the two Price makers.They do not
buy or sell on their Account but act as brokers to get information about customers
willing to buy or sell and from whom they will get their commission.They tend to
possess a lot information because their of proximity to the customers regularly.

48
• 3)Finally there are Price Takers, who take the prices quoted by Primary price makers,and
buy or sell currencies for their own purposes.eg,Large corporations buy or sell FE for their
own operations viz,Imports,Exports,payment of interest,hedging etc.Most of the companies
deal in FE only limited to their transactions.But some MNCs and trans national companies
use their knowledge and expertise to trade in FE and make profit out of the FE markets.
• Central Banks intervene in the market from time to time ,to attempt to move exchange in a
particular direction or to moderate excessive fluctuations in the exchange rates.
• Types of Transactions and Settlement Dates;
Value Date-A settlement of transaction takes place between two parties by transfer of
Deposits between two parties..The date on which the transfer takes place is called the
settlement date or Value date .The locations of the 2 banks involved in the Trade are called
Dealing locations which may not be the same as the settlement locations..The relevant
countries are called Settlement Locations.Obviously,to effect the transfers,banks in the
countries of the transfer ,banks in both the countries must be open for business.
For example-A London Bank can sell Swiss Francs against USD to a Paris Bank .The
settlement locations may be New York and Geneva while Dealing Locations are London and
Paris.The transaction can be settled only on a day on which both the US and Swiss banks are
open.

49
• Value Dates for Spot Transactions- In a spot transaction,the Settlement or Value
Date is usually 2 business days ahead for the European currencies or the Yen
traded against Dollar.Thus if a London Bank sells yen against Dollar to Paris Bank
on MONDAY,the London Bank will turn over a Yen deposit to the Paris Bank on
WEDNESDAY and the Paris bank will transfer a dollar deposit to the London Bank
on the same day.If the value date is a bank Holiday it is considered as he next
working day.The settlement date is reduced to one day if the pairs of currencies are
USD and Canadian Dollar or Mexican Peso.
• Value Dates for Forward Transactions-In a one month Forward Purchase of say
,Pounds against Dollar,the rate of Exchange is fixed on the transaction date;the value
date is arrived at as a follows-For a one -month forward value date is on say June
20,the corresponding spot Value date is June 22 and one-month forward value date
is July 22 and 2 months forward value is August 22.
• A swap transaction in the Foreign Exchange market is a combination of SPOT
AND A FORWARD in the opposite direction.Thus a bank will buy Euros spot
against USD and simultaneously enter into a forward transaction with the same
counterparty to sell Euros against USD.As the term Swap implies .It is a temporary
exchange of one currency for another with an obligation to reverse it at a specific
future date.

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• TOM RATES-In the case of TOM rates,the value date is one day after the
transaction instead of 2 days as in spot rates.
• READY RATES-In Ready rates transactions,the value date is the same as that of
the Transaction date.
• CARD RATES- are rates quoted for a Retail customer,while for corporate
customers or wholesale customers, Bulk special rates are quoted.Card Rate is not
an Exchange rate but an approximate rate.
• Buying Rate is called as a BID rate, and the selling rate is called as ASK rate.
EXCHANGE RATE QUOTATIONS AND ARBITRAGE—An exchange rate between
currencies A and B is simply the price of one in terms of the other.
The ISO has given a 3 letter codes for all the currencies.They are as follows;
USD –US Dollar, GBP-British Pound , JPY-Japanese Yen , CAD-Canadian
Dollar,
DEM-Deutschmark,NLG-Dutch Guilder,FRF-French Franc,ESP-Spanish Peseta,
INR-Indian Rupee,EUR-Euro,IEP-Irish Pound,CHF-Swiss Franc,ITL-Italian Lira,
AUD-Australian Dollar,SEK-Swedish Kroner,BEF-Belgian Franc,DRK-Danish
Kroner,SAR-Saudi Riyal etc.Other Important currencies are-South Korea-Won,
Indonesia-Rupaiah, Malaysia-Ringet,Singapore-Dollars,South Africa-
Rand,Russia-Rouble etc

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Exchange Rate quotations-Direct and Indirect quotations-A FE quotation can be Direct or
Indirect—
Direct when it is quoted/expressed in a manner that reflects the exchange of a
specified number of domestic currency vis- a-vis one unit of a foreign currency.
Eg,Rs 46=1 USD is a direct quotation in India .(European quotation)
Indirect quotation is when it is quoted to reflect the exchange of a specified number
of foreign currency vis a vis unit of a local currency
Eg usd.0.2083=Re1.IS Indirect quotation India(American quotation)
SPREAD- is the difference between the Ask Price and the Bid Price
Illustration for Spot and Forward rate contract-
An exporter exports Goods valued at USD 100 Million. On 6 months credit on 1st
February 2007. And also enters into a Forward rate contract for Rs 49 to 1 USD.By
entering into such a contract the exporter is assured of receipt of INR 4900 million
on 1st
August on which date the amount actually becomes payable,irrespective of the
spot rate on that date.If he had not taken this forward cover,and if on that date ,the
INR had become Rs 48 to 1 USD,he would have got only INR 4800 million only
where by he would have lost INR 100 million.By taking forward cover he has saved
INR 100 million .In other words he has gained INR 100 Million.If the spot rate has
become INR 46 ,still the Exporter can get the agreed rate of Rs 49 to 1 usd.

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

53
FOREIGN EXCHANGE MARKETS AND DEALINGS
To complete the quote the buying rate also needs to be established and given by the dealer
using the rate chart;.
The rates are as follows; NZD/USD ;1.7908(buying rate)-1.8510(selling rate)
INR/USD ;48.0465(buying rate)-48.211(selling rate)
The buying rate for INR /NZD would be worked out as follows;
a)The dealer purchases 1 USD for INR 48.0465
b)The dealer sells 1USD in exchange for 1.8510 NZD.
c)NZD 1.8510 IS equivalent to INR 48.0465.
Therefore the buying exchange rate would be INR 48.0465/1.8510 which would be Rs
25.9571.
The dealer will quote INR/NZD :25.9571(buying rate)-26.9215(selling rate).
This means that the dealer would buy NZD at Rs 25.9571 and sell at Rs26.9215
Arbitrage Process as a means of Attaining Equilibrium on Spot markets;
The term Arbitrage in the context of Forex Markets refers to an act of buying currency in
one market (at lower price ) and selling it in another market(at higher price).Thus the
difference in Exchange rates (in a specified pair of currencies)in two markets provide an
opportunity to the dealers /Arbitrageurs to earn profits without risk.As a result
,Equilibrium is restored in the exchange rates of currencies in different Forex markets.

54
Gains from International capital flows;
• Transfer the savings to investors worldwide so as to maximize productivity of
Investment.Savers in capital- rich counties,if confined to investment to their own
countries will not be able to get optimum returns.conversely if investment projects in
capital-poor countries must be financed only out of domestic savings,many high
yielding projects would have to be shelved due to shortage of funds.
• A particular country may face temporary shortage in National income due to some
special adverse circumstances.It cannot borrow internationally and is unwilling to
curtail investment it must sharply cut down consumption expenditures.During years of
extraordinary prosperity if it cannot invest abroad,it will be under utilizing its
capital.International lending and borrowing permit people to achieve a smoother
consumption profile.Overall welfare would be greater with cross border capital
flows.To day in the era of Globalization cross border investments are so common.In
fact India n companies are investing very big in Foreign companies that the movement
has become two- way rather than one way.
• FOREIGN DIRECT INVESTMENT;(FDI)One of the most important vehicle of
cross border investment has been FDI.Production and distribution of goods and
services has been globalised on an unprecedented scale during the preceding 4
decades..Along with the emergence of of MNCs, JVs,technology licensing
franchising,management contracts,production sharing ,Rand D alliances have all made
this possible.The theory of ABC viz A for Aid ,B for Borrowing and C for Capital has
come to stay.

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FOREIGN EXCHANGE MARKETS AND DEALINGS-
The Essence of the Arbitrage process is to buy currencies from Markets where
prices are lower and sell in markets where prices are higher..In operational terms the
Arbitrage process is essentially a balancing operation that does not allow the same
currency to have varying rate in different Forex markets on a sustainable basis.
• TYPES OF ARBITRAGE IN SPOT MARKETS
1)Geographical Arbitrage;As the name suggests the ,Geographical Arbitrage consists of
buying currency for one Forex Market (say London) and where it is cheaper and sell
in another Forex Market( say Tokyo) where it is costly.Because of Technology,
geographical divide is not an issue today.
2) Triangular Arbitrage ;As the name suggests ,Triangular Arbitrage takes place when
there are currencies involving 3 markets.
• ARBITRAGE IN FORWARD MARKETS
The concept of the arbitrage process is equally applicable in forward markets.In the
case of Spot markets,mismatch between cross rates and quoted rates provides an
opportunity for arbitrage gains.Similar arbitrage gain possibilities exist in Forward
markets also.In case the difference between the forward rate and the spot rate (in terms
of premium or discount)is not matched by the interest rate differentials of the 2
currencies.Conceptually,interest rate differentials of the 2 currencies should be equal
to to the forward premium or discount on their exchange rates.Since the comparison is
to be made with Interest rate differentials,this is also referred to as “covered Interest
Arbitrage”.

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Terms used in Foreign Exchange Market Dealings
• SWIFT-Communications Pertaining to International Financial Transactions are
handled mainly by a large Network called “Society for worldwide Inter bank
Financial Telecommunication “-SWIFT. This is a non profit Belgian cooperative
organization with main and regional centers around the world connected by Data
Transmission lines.Depending on the location, a bank can access a regional
processor or a main center which then transmits to the appropriate information to
the appropriate location.
• REUTERS- is a London based organization established in the year 1851.It
established the first Electronic Trading Screen which gives real time quotes based
on which trading in currencies take place.
• TELRATE- is an American organization established in 1969 to deal in screen
based trading for Foreign Exchange.
• CHAPS-Clearing House for Automated Payment system (chaps)is a UK based
Electronic payment System
• CHIPS-Clearing House for Inter bank payment system (chips) is a US based
electronics payment system.

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Terminology used in International Trade and Finance-
• Types of Lcs
a)Irrevocable LC-- Irrevocable LC is one which cannot be revoked or cancelled
without the consent of the beneficiary.This form LC is generally used by
Importers and Exporters as this gives more security to both the parties.
b)Confirmed LC-- is a LC which is confirmed by a third bank other than an
opening bank and the negotiating bank.Sometimes the beneficiary wants the LC
of buyers bank to be confirmed by a bank in his country.This process is called as
confirmation.It means that the confirming bank undertakes that in the event of
proper presentation of documents as required under the LC, it will make payment
irrespective of the fact whether the buyer’s bank reimburses the same or not.It
charges its commission for confirmation.
c)Transferable LC—In Transferable LC,the buyer can transfer a part of the value
of LC or the full value of LC in favour of one or more
beneficiaries.Transferability should be expressed specifically in the LC.Since the
buyer relies on the integrity of beneficiary,transferability in favour of someone
unknown has some risks .Normally Transferable LCs are taken by middlemen
who do not want to the buyer and seller to know each other and also want to
make a margin without both the parties being aware of the same.Usually
transferability in several lots is possible but the transferee again transferring the
credit is not possible.

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• Types of Lcs;
d)Back to Back LCs—In back to back Lcs,Beneficiary's banks open several LCs
within the value of the mother LC.This is also known as countervailing LCs..The
terms and conditions of the second LC are exactly the same as that of the first LC.The
second LC may be a Domestic LC.Any change is the second LC is possible only
when the opener of the original LC agrees to such a change in the mother LC.
e)Red clause LC—In Red clause LC,advance payment is provided against the supply
of certain documents like drawings and manufacturing schedule as mobilization
advance for manufacture of capital goods whose manufacturing cycle time is
high.The Advance payment details are printed in RED thereby being called Red
clause LC.
f)Green clause LC—In this type of LC,advance is provided against goods,which are
manufactured and kept in a warehouse for a buyer against warehouse receipt,before
the same is shipped.
g)Sight LC or DP LC—Sight LC or Document against LC means that as soon as the
BE of seller is presented to the buyer ,he should make payment for the same. And
only then the documents would be handed over to the buyer.Thus no credit is given
to the buyer.
h)Usance LC OR DA LC –Usance LC or Documents against Acceptance means that
payment can be made after a particular period from presentation of Bill of Exchange
presented to him .By DA or Usance ,credit is given to the buyer.

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• Advising Bank– Many times,LC received from buyer may be a forged one.If the
same is routed through a bank,it performs the function of advising whether the LC
is genuine or not.For doing this ,the bank charges a commission.
• Negotiating Bank-- Since the Buyer’s bank opens the LC,payment will be made to
the seller only when the buyer’s bank receives proper documents as per the LC.This
will involve delay like the transit time involved in transferring the necessary
documents by the seller to buyer’s bank.Negotiating bank is a bank which is in
seller’s country and negotiates the document presented by the seller against the
LC.In the event of documents being proper,the negotiating bank credits the
proceeds to seller’s Accounts immediately,thereby avoiding the delay.For doing this
the negotiating bank charges a commission known as Negotiating commission.
• Correspondent Bank—While a bank has to deal with many centers around the
world,it cannot afford to have branches in all those countries.It enters into
correspondent agreement with a bank operating in the centers, detailing the scope
of responsibilities and sharing of commission.Such banks are referred to as
Correspondent Banks.
• UCPDC-Uniform Customs and procedure for documentary credit or UCDPC is
prepared by the International Chamber of commerce.,defining the responsibility of
buyer’s bank,Negotiating bank,confirming bank, Advising bank.All International
LC must bear an endorsement that they adhere to UCPDC 500

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• NOSTRO ACCOUNT-The Account of a local bank maintained with a
foreign branch or correspondent bank is called as Nostro Account.It is opened to
facilitate remittances or credits into the banks account.
• VOSTRO ACCOUNT—The Account of a foreign bank maintained with a
local bank or branch is called as Vostro Account.In this case all remittances
relating to the foreign bank by local banks are credited to the Vostro account.
• INCO TERMS—are terms issued by the International Chamber of
commerce.,defining the meaning of various terms given above.If the
international Purchase orders are subjected to INCO terms there will be
uniformity in interpretation of various commercial terms.
• PACKING CREDIT ---Packing credit is given for financing exports.It can
be classified as pre shipment -credit and Post –shipment credit.Packing credit is
given against an Export order or LC.Pre-shipment credit is given for procuring
materials,manufacture of goods,while post –shipment credit is given for
financing receivables out of exports.Packing credit is extended at any time and
export receivables are NOT subject to Maximum Permissible Bank
Finance(MPBF)requirements.Post shipment is generally given in the form of
discounting of export bills..

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Terms used in IFM-
• Libor-Libor means London Inter Bank offered Rate.London is the premiere Financial
center in the world.LIBOR is a benchmark floating rate at which one bank is willing to
lend to another bank in inter –bank market.It is available for various tenors.Libor being
the premier financial rate ,this rate is used as a landmark rate in many lending
transactions.The quotes are generally Libor +or Libor – a certain percentage.
• Forfaiting –is Export factoring.In Forfaiting,export bills are accepted by Importer as
well as by his bankers..Acceptance of such bills is by Importers banks is known as
Avalising and bank accepted BE is called AVAL.Such avalised Bills are discounted by
Forfaiting agency on non-recourse basis and proceeds are credited to exporters
account.Non recourse basis means that in the event of importers failure to make
payment ,the loss will be borne by the forfaiting agency and will not be recovered
from the exporter.In India EXIM bank offers such facilities.
• Transfer Pricing(TP)—Due to increasing Globalization and Integration of world
economy and transactions between different branches of subsidiaries,Transfer Pricing
is being increasingly resorted to avoid payment of taxes.To counter these all the
governments have resorted to taxing the transactions where they find that the TP is not
being done on an Arms Length principle.Prices are determined based on various
methods as follows;(1)Comparable uncontrolled Price method(CUP method).(2)Resale
method(3)Transaction Net Margin Method(4)Profit split method.The governments have
realised that MNCs and other companies with HOs outside their country resort to this
method.(contd)

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

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3)Trade Barriers-Trade Barriers are formed by entering into bilateral agreements and
giving Most Favored Nation(MFN) statues to import from certain countries.Apart
from this ,Free Trade zones, Customs Union,Common Market,Economic
Union,Monetary Union,Cartels which restrict free flow of International trade aslo
come under Barrier.Extreme form of Trade Barrier is Embargo.
4)Free Trade Zone;In Free Trade Zone goods move in the member countries without
payment of customs duty..Generally Free trade zones provide a lot of incentives for
investment by outsiders so that they attract investments.Eg Jebel Ali Free Trade Zone
near Dubai where investment is encouraged and has become one of the well known
FTZs.The climate for investments,the sops provided,the concessions provided,etc
make these zones a very good destination for investments by outsiders.
NEED FOR ERECTING BARRIERS
• Protecting Infant and Domestic Industries.Eg,India imposed very high tariff barriers
for protecting its infant industry.This is cited as the main reason for poor quality of
Indian goods and lack of competitiveness in Indian Industry.
• Revenue collection through customs Duty.Customs duty is very good source of
Revenue for any Govt.
• To counter adverse BOP.Till early 90 Indian strategy was to stress for import
Substitution to set right the BOP deficit.thru deficit high tariff and non tariff
barriers.This led to illegal activities like smuggling .
• To protect Local employment
• For political reasons-Embargo in Iraq

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Theories explaining the need for International Trade;
1)Theory of Absolute Advantage; Adam smith propounded the Theory of “Absolute
Advantage”.In this ,labor was considered the only factor of production..For example
,one country has absolute advantage in producing software and another in producing
Hardware.Both can increase their wealth by producing goods/services in which they
have absolute advantage.
2)Theory of Comparative Advantage ;David Ricardo expounded the Theory of “Comparative
Advantage”.As per this theory if a nation has absolute advantage over another nation in
producing both Software and Hardware,still they should produce that which gives them
Comparative Advantage and trade in them thereby increasing wealth.This increases
specialization .A good example is Software development in India.Because of highly
educated and Technically skilled labor force India has made a niche place for itself and
has been generating wealth which is ever growing .China/Taiwan is good in computer
Hardware and they have captured the world market in Hardware.
3)Heckshire Ohlin Model;This model says that countries rich in capital will engage in capital
intensive industry.Thus USA which is capital-rich can produce and trade in capital –
rich goods while India which is labor rich can make use of its strengths in this area.This
theory focuses on factor endowments and the fact that production of different goods
requires the various inputs in different proportions.Thus countries like India are
endowed with human capital including knowledge workers but are poorly endowed
with Physical capital whereas countries like the US have plenty of physical capital but
scarcity of skilled labor.Each has to exploit its potential.

65
• Capital Account convertibility;Refers to the free movement of currency in the
CAPITAL ACCOUNT Transactions in BOP.In India ,The FEMA(Foreign Exchange
Management Act) does not permit full capital Account convertibility but only limited
capital account convertibility.As per one school of thought,India is not yet ready for a
full convertibility.In fact the GOI set up the Tarapore committee which gave its report
cautioning the govt to go slow on the full convertibility,though it has strongly
recommended partial convertibility.Dr Paul Krugman,the Nobel Laureate from US
opined that developing countries should have exchange restriction in the capital
Account..This school of thought argues that once the country achieves(1) mandated
inflation rate (around 3.5%)(2)mandated fiscal deficit(3)NPA of Banking assets falling
under a threshold level (4)adequate financial system supervision,then Capital Account
Convertibility can be undertaken.Of late the Govt has been liberalizing the Capital
Account transactions viz,increase in limits for advance remittances without Bank
Guarantee,Issuing GDRs and ADRs under automatic routes etc.
• SPECIAL DRAWING RIGHTS-At the 1967 meeting of the IMF IN Rio de Janeiro,it
was decided to create such an asset,to be called Special Drawing Rights or SDRs..The
IMF would create SDRs by simply opening an account in the name of each member.and
crediting it with a certain amount of SDRs.the total volume created had to be ratified by
the governing board and its allocation among the members is proportional to the
quotas.The value of SDR was initially fixed in terms of gold with same gold content as
the 1970 USD.In 1974 the SR became equivalent to a basket of 16 currencies and then
in 1981 to a basket of 5 currencies.After the birth of Euro,the SDR basket included4
major “freely usable”currencies,viz,USD,EURO,GBP and JPY.(ALSO REFER TO
THE ATTACHED NOTE IN WORD DOC ON SDRs FOR MORE DETAILS)

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Some more terms used in International Finance-
• GR FORMS-Guaranteed Receipt Form OR GR form is used by RBI for physical export
to ascertain the value of export goods as well as to monitor their realization.It is
prepared in duplicate and submitted to customs at the time of exports.Customs verify the
value with contract and certify the same and one copy is given back to the exporter and
the other copy is sent by customs directly to RBI.Exporter has to forward this copy to
the AD with Invoice etc ,who then verifies with invoice value.The D also monitors
whether the money is realised within 180 DAYS from the date of Shipment.
• ETX FORM-ETX is filed by the exporter with the RBI for any delays in getting the
payment from the overseas buyer.Normally this is done to get approval for the delayed
remittance .The exporter has to give a certificate issued by a CA giving reasons for the
delay in getting the money.
• SOFTEX FORM-Softex form performs the function as that of GR for Software
exports.It is filed with STPI by the exporting company who approves and certifies the
Invoice and the softex form which is then sent to the AD,as in the case of a GR .
• EEFC Account –Exchange Earners Foreign currency Account is a facility given to
exporters to keep a part of their Foreign currency earning in the form of FC. Normally
upto 50 % is allowed and in special cases even a higher percentage is allowed.without
any Interest payment. EOUs,SEZs can keep upto 100 % of the FE earned in the EEC
account which can be used for any purpose more liberally for foreign projects,travel etc
without quantitative restrictions.

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EXPORT ORIENTED UNITS(EOUs)-EOUs can be set up in any place which is
notified as a warehousing station by the chief commissioner of Customs..There are
around 300 warehousing stations at present notified throughout India. EOUs at
present operate under customs bonding and supervision.They cannot be involved
in Trading.They are allowed to sell in local market by entering into DTA(Domestic
Tariff Agreement).They can sell up to 50%FOB value of exports in domestic
market by paying CD applicable for import or excise Duty whichever is
more.Even 100% Foreign Equity can be held for items reserved for SSI. EOUs are
expected to earn only positive Net Foreign Exchange(NFE).They can import all
capital goods including second hand capital goods as well as raw
materials,components,consumables and packing materials without payment of
CD.Similarly they can make indigenous purchases without paying Excise
Duty.Many state governments have also exempted EOUs from paying sales Tax.
Acts Development commissioner is the registering authority and acts as a single
window clearance.They enjoy Income Tax benefits as well.
SPECIAL ECONOMIC ZONES-(SEZ) is a concept borrowed from China.These zones
are treated as foreign country within the country and are subjected to minimum
restrictions They are located in notified areas, eg Hassan in Karnataka,Kakinada in
AP.They are subjected to minimum NFE conditions.Foreign equity is allowed up
to 100%.,other than for trading.Domestic sales can be made by paying CD
equivalent for similar goods.

68
Money Market Instruments
• Commercial Paper(CP)- is a corporate short –term,unsecured Promissory Note, on a
discount to yield basis.It can be regarded as a corporate equivalent of Certificate of
Deposit which is an Inter bank Instrument..CP maturities generally do not exceed 270
days.CP represents a cheap and flexible source of Funds especially for highly rated
borrowers.,cheaper than bank loans.Us has the largest and long established dollar CP
market .It is used extensively by US corporations as well as some non US
corporations.Euro Commercial papers emerged in the 1980s.Investors in CP consist of
money-market funds,insurance companies,pension funds and other financial institutions
and other corporations with short-term cash surpluses
• Certificates of Deposit(CD)- is a negotiable Instrument evidencing a deposit with a
bank.Unlike a traditional Bank deposit which is not transferable a CD is a marketable
instrument so that the investor can dispose it off in the secondary market, if required.
.The final holder is paid face value on maturity along with interest .CDs are issued in
large denominations –usd 100000 or more are used by commercial banks as short term
funding instruments.Euro CDs are issued mainly in London by Banks.
• Bankers Acceptances- This is an Instrument widely used in the US money market to
finance domestic as well as international trade.In a typical International trade
transaction,the seller (exporter)draws time or usance draft on the buyers bank.On
completing the shipment the exporter hands over the shipping docs and the LC issued by
the importers bank to his bank.The exporter gets paid the discounted value of draft..The
exporters bank presents the draft to the importers bank which stamps it as ‘accepted”.A
bankers acceptance is created.

69
q.
+0Money Market Instruments-In addition to these Securitised Instruments,short –term
bank loans are also available.The Euro currencies market is essentially an Inter bank
deposit and loans market.
• REPOS-meaning repurchase obligations are used by securities dealers to finance
their holdings of securities.This is a form of collateralized short term borrowing in
which the borrower “ sells”securities to the lender with an agreement to “buy”them
back at a later date.Hence the name “Repurchase obligations”.The Repo price is the
same as original buying price ,but the seller (borrower)pays interest in addition to
buying back the securities.The duration for the borrowing may be as short as
overnight or as long as up to a year.The interest rate is determined by demand –
supply conditions.

70
Foreign Exchange Market in INDIA-
• Foreign exchange Management Act (FEMA) replaced Foreign Exchange
Regulations Act(FERA) in 1999 .
• FEMA gives full freedom to a person resident in India who was earlier resident
outside India to hold property outside India when he /she was resident outside India.
• Similar freedom is also given to a resident who inherits such security or immovable
property from a person resident outside India.
• Liberalization in Foreign exchange entitlements to people traveling abroad
• Liberalization in Investments by Indian companies outside India.
• LERMS- was introduced in the year 1992keeping in line with the spirit of
liberalization..in LERMS dual exchange rate mechanism was adopted .60%
exchange rate was market determined while the balance 40% was determined
officially to take care of bulk imports by the govt.In 1993 the dual rate system was
abolished and the entire rate was market determined.USD replaced GBP as the
intervention currency.

71
Foreign Exchange Dealings-
• Direct and Indirect quotations(also known as European and American quotations
respectively)-(please see slide number 51.)The latter are also referred to as Inverse or
Reciprocal quotes.
• Two way quotation /rates-In practice dealers quote two way rates,one for buying the
foreign currency(known as bid price/rate)and another for selling of foreign
currency(referred to as Ask price/rate).Since dealers expect profit in FE
operations,the 2 prices cannot be the same.The dealer will buy the FE at a lower rate
and sell it at a higher rate and sell the foreign currency at a higher rate.For this
reason,the Bid quote is a lower rate and the Ask rate is a higher rate.The quotations
are always with respect to the dealer(say banker).
• By convention,the buying rate follows the selling rates Eg a dealer in Mumbai quotes
Pound Sterling 1=Rs 83/83.5 implies that the dealer is prepared to buy 1 British Pound
at Rs 83 and sell it at Rs83.5.Normally the rates are at 4 decimal points .
• SPREAD-IS THE DIFFERENCE BETWEEN ASK PRICE AND THE BID
PRICE.
The spread is affected by a number of factors .The currency involved,the volume of
business,and the market sentiments./rumors about the currency are the major variables
reckoned by dealers/operators in the FE market.Spread is akin to the Gross Profit in a
normal business,out of which the dealer has to meet his expenses.In percentage terms
it can be expressed as follows;
Spread(percent) =(Ask price-Bid price)/Ask pricex100.In the above instance,it works
out to;(Rs83.5-83)83.5x100=.05988%.Prima facie the spread appears to be very low.It
depends on the volume of business the dealer generates.

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

73
Arbitrage (contd)-In the given example,GBP can be bought from Canara Bank at
USD1.4548 and sold to SBI at USD1.4550 for a net profit of usd 0.0002 per pound
without any risk or commitment of capital..One of the main characteristics of modern
finance is that they are very efficient these days and such arbitrage opportunities will
be spotted by the markets and exploited.Therefore the arbitrage opportunities will
disappear very fast.
Suppose,the quotes are as follows;
SBI Canara Bank
GBP/USD (bid) 1.4550/1.4560(ask) 1.4545/1.4555
Here there is no arbitrage opportunity seen as earlier.The reason is that the 2 quotes
overlap..However now SBI will find that it is being “hit”on its bid side much more
often,while Canara Bank will find that it is confronted largely with buyers of GBP and
few sellers.This could lead to a position where the banks building up a position
If SBI has sold more GBP than it has bought it is said to have a NET SHORT
POSITION and if it has bought more GBP than it has sold ,it is said to have NET
LONG POSITION.Given the volatility of the exchange rates,maintaining a large NET
SHORT/LONG Positions for a long time can be a risky proposition.From time to
time,a bank may deliberately move its quote in a manner designed to discourage one
type of deal and encourage the opposite deal.Thus SBI may have built up a large NET
short Position in GBP and may now want to encourage sellers of pounds and
discourage buyers.of GBP.Canara Bank may be in a reverse position;it wants to
encourage buyers and discourage sellers of GBP.Thus regular clients of SBI wanting to
to buy GBP can save money by going to Canara bank and Vice versa.

74
Cross-rates and three-point Arbitrage- A New York bank(N) is currently offering the
following quotes;
USD /JPY; 110.25/111.10
USD/AUD; 1.6520/1.6530
At the same time ,a bank in Sydney(S) is quoting;
AUD/JPY ; 68.3/69.00
Is there an Arbitrage opportunity?
Let us see the sequence of transactions
1)Sell JPY,buy USD.Then sell USD and then buy AUD in New York
and
2) sell the AUD for JPY in Sydney
The calculations are as follows;
1 JPY sold in NY gets USD {1/(USD/JPY)ask(N)}=USD(1/111.10)=USD 0.00900
USD 0.00900 to be sold to buy AUD.=.00900X1.6520= AUD 0.014868
Sell this AUD for JPY=0.014862X68.3=JPY1.0154844=Margin of .00154844.
So by doing this ,for every JPY there is a profit of JPY 0.0154844(say 0.0155) and for
100 Million JPY ,the profit would be JPY 1.55 Million.

75
Forward Quotations-
• Outright Forwards –are quotations for outright forward transactions given in the
same manner as spot quotations.Thus a quote like;
• USD/SEK – 3 Month forward;9.1570/9.1595 means ,as in the case of a similar spot
quote,that the bank will give SEK9.1570 to buy a USD and require SEK to sell a
dollar,delivery 3 months from the corresponding SPOT VALUE DATE.
• DISCOUNTS and PREMIUM in the FORWARD MARKET; Let us look at the
following pair of Spot and Forward quotes;
GBP/USD SPOT; 1.5677/1.5685
GBP/USD 1- month forward ;1.5575/1.5585.—The GBP is cheaper for delivery
one month hence compared to spot GBP..The GBP is said to be at Forward
Discount in relation to the USD or equivalently,the USD is at Forward Premium
compared to the GBP.
Options forward-A Standard forward contract calls for delivery on a specific day,the
settlement date of the contract..In the inter-bank market, banks offer what are known
as Optional Forward contracts or Options Forwards.Here the contract is entered into
at some time(T0) with the rate and quantities being fixed at this time,but the buyer has
the option to take/ make delivery on any day between T1 and T2 with T2>T1>T0.
Swaps in Foreign Exchange Markets-Swap Transactions between currencies A and B
consists of a spot purchase (sale) of A coupled with a forward sale (purchase) of both
A against B.

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

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

78
Exchange Rate calculations-
• Till August 2,1993,exchange rate quotations in the wholesale markets used to be given
as Indirect quotes,ie units of Foreign Currency per Rs 100..Since then the quotes are
Direct given as Rs per unit of foreign currency.The rates quoted by banks to their Non-
Bank customers are called ‘Merchant Rates’..Banks quote a variety of exchange
rates.The so called “TT” rates(the abbreviation denotes Telegraphic Rates ) are
applicable for clean forward or outward remittances,that is ,the bank undertakes only
currency transfers and does not have to perform any other function such as handling
documents.
For eg,,suppose an individual purchases from Citibank in New York,a demand draft for
USD 2000 drawn on Citibank,Mumbai.The New York Bank will credit the Mumbai
Banks Account with itself immediately.When the individual sells the draft to Citibank
Mumbai,the bank will buy the USD at its TT Buying Rate .Similarly TT selling rate is
applicable when the bank sells a foreign currency draft or MT.TT buying rate also
applies when an exporter asks the bank to collect an export bill and the bank pays the
exporter only when it receives payment from the foreign buyer as well as in cancellation
of forward sale contracts.
• When there is some delay between the bank paying the customer and itself getting
paid.,eg,the bank discounts export bills ,various margins are subtracted from the TT
buying rates .Similarly on the selling side when the bank has to handle documents such
as LC,shipping docs and so forth apart from effecting the payment,margins are added to
the TT selling rate.as per FEDAI(in India)

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 bank
USD quote rate is Rs 46.75/46.76 and the bank wants exchange margin of 0.125%,the
TT buying rate would be;(46.75)(1-0.00125)=46.6916 rounded off to Rs.46.69.Thus if a
draft is encashed by the bank where its overseas account has already been credited,it
will give Rs Usd 10000x46.69= Rs 466900.when cashing a personal cheque or a
bankers;cheque payable overseas the Bank will not give this rate,because it has to send
the cheque overseas for collection.This means a delay which is called Transit
period..The bank will further subtract an exchange margin from the TT buying rate and
also recover Interest from the customer for the transit period.The transit periods for
various countries are specified by the FEDAI(Foreign Exchange Dealers Association of
India).The Interest rates are given By RBI..The purpose of the exchange margin is to
recover the costs involved and provide a profit margin to the bank.
• SPOT BILL BUYING RATE –Exporters draw BE on their foreign customers.They can
sell these bills to an AD for immediate payment.The AD buys the bill and collects
payment from the importer .Since there is delay between the AD paying the exporter and
itself getting paid,various margins have to be subtracted from the TT buying rate to
compute the bill buying rate.Bills are of two kinds;Sight or Demand bills require
payment by the drawee on presentation .The delay involved in such a bill is the transit
period;Time or Usance bills give time to the importer to settle the payment ,i.e. ,the
exporter has agreed to give credit to the importer.In such a case the delay involved is the
Usance period plus the transit period.In addition to the exchange margin to cover costs
and provide profit ,the AD will now load the forward margin for an appropriate
period..If the bill is bought on a spot basis ,the forward period included the transit
period plus usance period if any,

80
Example 2- A sight Export Bill for USD 100000-A bank purchases a demand export bill
drawn by an Indian exporter on an American company.The transit period is 15
days.The inter bank market spot buying rate is Rs 45.25.One month forward
buying rate is at a premium of 15 paise,that is the buying rate is Rs
45.40,EXCHANGE MARGIN IS 0.125%.The market for 15 day forward buying
rate would be;
Rs 45.25 plus a premium of 7.5paise(for 15 days )that is Rs 45.3250. With the
commission the rate given to the customer would be 45.3250((1-0.00125)=45.2683
rounded off to the 45.27.The customer will be debited separately to the customers
account.
Example 3-A Usance Bill for GBP 50000.An exporter wants the bank to buy a 30-day
bill drawn on a British co for GBP 50000.Exchange margin is to be retained at .
0.15%.the transit period is 10days.The market spot buying rate is Rs 69.5.One
month discount on sterling is 20paise. And two month discount is 50paise.
Transit plus usance period adds up to 40days.Interpolating between 30and 60days,the
discount for 40 days would be {20+10/30x30}=30paise.The rate paid to the
customer w ill be 69.2(1-0.0015)=69.0962 rounded off to 69.1.The customer would
be paid Rs 34,55,000.Interest for 40days would be recovered separately.

81
• INTEREST ARBITRAGE-Interest rate Arbitrage refers to the International flow of
short-term liquid capital to earn higher return abroad.
• UNCOVERED INTEREST ARBITRAGE-The transfer of funds abroad to take
advantage of higher interest rates in foreign monetary centers usually involves conversion
of the domestic currency to the foreign currency ,to make the investment.At the time of
maturity,the funds (plus the interest)are reconverted from the foreign currency to the
domestic currency.During the period of investment, a foreign exchange risk is involved
due to the possible depreciation of the foreign currency.If such a foreign exchange is
covered we have covered interest arbitrage,otherwise we have uncovered arbitrage.

82
COVERED INTEREST ARBITRAGE -Interest Arbitrage is usually covered as investors of
short- term funds abroad generally want to avoid the foreign exchange risk.To do this
the investor exchanges the domestic currency for the foreign currency at the current
spot rate so as to purchase the foreign treasury bills or investment and at the same time
he sells forward the amount of the foreign currency he is investing plus the interest he
will earn ,so as to coincide with maturity of the foreign investment.Thus covered
arbitrage refers to the spot purchase of the foreign currency to make the investment
and off setting the simultaneous forward sale (swap of the currency) to cover the
foreign exchange risk.
.When the investment matures ,the investor can then get the domestic currency
equivalent of the foreign investment plus the interest earned without a FE risk.Since
the currency with the higher interest rate is usually at a forward discount ,the net
return on the investment is roughly equal to the positive interest differential earned
abroad minus the forward discount on the foreign currency.This reduction in earnings
is the cost of insurance against the FE risk..
In Covered Interest arbitrage,the rule is that if the interest rate differential is greater
than the premium or discount ,place the money in the currency that has a higher rate of
interest or vice versa.

83
EXCHANGE RATE THEORIES AND EXCHANGE RATE FORECASTING-
Are changes in exchange rates predictable?How does inflation affect exchange rates
How are Interest rates related to exchange rates?what is the proper exchange rate?.For
an answer to these questions it is essential to understand the different theories of
Exchange rate determination.A Swedish economist Gustav Cassel popularized. the PPP
in the 1920s.
When many countries like Germany,Hungary and the Soviet Union experienced
hyperinflation,in those years the Purchasing Power of the currencies in these countries
sharply declined.The same currencies also depreciated sharply against the stable
currencies like the USD.The PPP theory became popular against this Historical
backdrop.
PURCHASING POWER PARITY THEORY-PPP Theory-The PPP theory focuses on
the inflation exchange rate relationships.If the law of one price were true for all goods
and services, we could obtain the theory of theory of PPP.There are two forms of the
PPP theory;

84
Absolute Purchasing Power Parity; Underlying the absolute version of the PPP is the “Law of
one Price”,Viz that commodity arbitrage will equate prices of a good in all countries
when prices are expressed in a single common currency. PPP postulates that the
equilibrium exchange rate between currencies of 2 countries is equal to the ratio of the
price levels in the two nations.Thus prices of similar products of two different countries
should be equal when measured in a common currency as per the absolute version of
PPP theory..Let Pa refer to the general price level in country A and Pb refer to the
general price level of country B,and Rab to the exchange rate between the currency of
country A and country B.The Absolute PPP theory postulates that ---Rab=Pa/Pb
For example if country A is USA and country B is UK the exchange rate between the USD
and the GBP is EQUAL to the ratio of US to UK prices. viz,if the general price level in
the US is twice the general price level in the UK ,the absolute PPP theory postulates
the equilibrium exchange rate to be 2USD=1GBP..In reality the exchange rate between
USD and GBP could vary considerably from USD 1 to GBP 2 due to various factors
like transportation costs, tariffs,or other trade barriers between the 2 countries..This
version of the absolute form of PPP has a number of defects..First, the existence of
transportation costs,tariffs,, quotas or other obstructions to the free flow of
International trade may prevent the absolute form of PPP.Secondly,The absolute form
of PPP appears to calculate the exchange rate that equilibrates trade in goods and
services so that a country experiencing capital outflows would have a deficit in its BOP
while a country receiving capital inflows would have a surplus. Finally, the theory
does not even equilibrate trade in goods and services because of the existence of non-
traded good and services.

85
Absolute PPP Theory (contd)-Non –traded goods such as cement and bricks, for which the
cost of transportation cost is too high,cannot enter international trade except perhaps in
the border areas.Also specialized services like those of doctors hairstyles etc,do not
enter international trade .International trade tend to equate the prices of traded goods
and services among nations but not the prices of non traded goods and services.The
general price level in each nation included traded and non traded goods and since the
prices of non traded goods are not equalized by international trade,the absolute PPP
theory will not lead to the exchange rate that equilibrates trade and therefore has to be
rejected.
Relative Purchasing Power Parity-The relative form of PPP is an alternative version which
postulates that the change in the price levels in the two nations should be
proportional to the relative change in the inflation levels in the two nations over the
same time period.This form of PPP theory accounts for market imperfections such as
transport costs,tariffs and quotas.Relative PPP theory accepts that because of market
imperfections prices of similar products in different countries will not be the same
when measured in a common currency.What it specifically states is that the rate of
change in the price of products will be somewhat similar when measured in a common
currency as long as the trade barriers and transportation costs remain unchanged.In
other words,it states that a proportionate (or %)change in exchange rate between two
currencies A and B between 2 points of time(approx)equals the difference in the
inflation rates in the two countries over the same time interval.

86
The fact that some goods do not (and cannot )enter international trade means that even the
relative version of PPP can be expected to hold only for traded goods.Therefore,the
price indices used to measure inflation differentials must cover only traded goods.
REAL EFFECTIVE EXCHANGE RATE(REER)-Related to the notion of PPP is the
concept of RER.It is the exchange rate after adjusting for inflation .It is a measure of
exchange rate between 2 countries adjusted for relative purchasing power of the
currencies.Since purchasing power of money is measured with reference to a given
time period.,it is only the changes in real exchange rate that have significant
economic implications.
Eg-suppose at the end of August 2000 ,the USD /INR exchange rate was Rs
45,while at the end of August 1985 it was only Rs 18.This implies that in nominal
terms,that is,without adjusting for Inflation,the rupee depreciated by 150%.in 15
years.But if we were to answer the following question-In August 2000 how many
rupees worth of Purchasing power had to be given up to acquire one dollar worth of
Purchasing Power when both PPs are measured with reference to August 1985?
The following data are also available;The consumer price index (CPI) in India at the
end of August 2000,with March 1985 as the base stood at 375 while the CPI in the
US with reference to the same base was 180.This means that Rs 45 in August 2000
was worth Rs(45/3.75)=Rs 12 of 1985 purchasing power.We had to give up Rs 12
worth of 1985 purchasing power in India to acquire USD 0.5556(1/180) worth of
1985 purchasing power in the US.

87
The real effective exchange rate in August 2000,with reference to March 1985 was
therefore (12/0.5556)=21.6 though by definition, the real exchange rate in march 1985
was Rs 18.Thus in inflation adjusted terms the rupee depreciated by about 20%.
(3.6/18)
The importance of the concept of Real Exchange Rate is in the fact that changes in it
have implications for the relative competitiveness of a 1)country’s exports and 2)
import substitutes.
If an exporter can raise the FE currency price in line with the foreign inflation,if his
costs increase in line with domestic inflation and if the exchange rate depreciates by
an amount equal to the excess of home inflation over foreign inflation,the exporters
competitiveness in the export market remains unchanged..we now see that the real
exchange rate must remain unchanged.
The case of a company which makes import substitutes can be analyzed along similar
lines..A real appreciation of the home currency hurts real profitability of producing
import substitutes and will channel resources into production of home goods –goods
which face no international competition because they are not traded.Thus real
exchange rate determines not only relative competitiveness of exports but also relative
attractiveness of producing for international markets versus producing for home
markets.
NOMINAL EFFECTIVE EXCHANGE RATE(NEER)-is the exchange rate before
adjusting inflation difference .
In the example given above Rs 18 is the NEER while 21.6 is the REER

88
INTEREST RATE PARITY THEORY-According to Interest Rate Parity theory ,the difference
in exchange rate is explained by difference in the interest rate.Thus if one year interest
rate on dollar is 6% and one year interest rate on rupee rate is 12% and the spot rate
between rupee and usd is USD 1=INR 50.A person will borrow in dollar and invest in
Rupee..After one year he has to pay back usd1.06 and he will get Rs 56.Interest rate
parity theory suggests that the exchange rate between dollar and rupee should be usd
1.06=Rs 56 or usd 1=56/1.06=52.83.
Interest rate parity theory assumes no exchange control,absence of transaction cost and taxes
and a perfect market.Interest rate before adjusting for inflation is called as Nominal
Interest rate and interest rate after adjusting for inflation is called as Real Interest rate.
INTERNATIONAL FISCHER EFFECT(IFE)- The IFE uses interest rates rather than
inflation rate to explain the changes in exchange rates over time.IFE is closely related
to PPP because interest rates are significantly correlated with inflation rates.
The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is
known as the International Fischer effect . Under IFE ,real interest rate across the
world determines the difference in exchange rate.otherwise there will be scope for
arbitrage.Fischer effect states that real interest rates should converge ,or else there will
be scope for arbitrage.

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