Master of Business Administration - MBA Semester 4
MF0015 - International Financial Management
Assignment Set- 1
Q1. What is meant by BOP? How are capital account convertibility and current
account convertibility different? What is the current scenario in India?
Ans:- The balance of payments (or BOP) of a country is a record of international
transactions between residents of one country and the rest of the world over a specified
period, usually a year. Thus, India’s balance of payments accounts record transactions
between Indian residents and the rest of the world. International transactions include
exchanges of goods, services or assets. The term “residents” means businesses,
individuals and government agencies and includes citizens temporarily living abroad but
excludes local subsidiaries of foreign corporations.
The balance of payments is a sources-and-uses-of-funds statement. Transactions such
as exports of goods and services that earn foreign exchange are recorded as credit,
plus, or cash inflows (sources). Transactions such as imports of goods and services that
expend foreign exchange are recorded as debit, minus, or cash outflows (uses).
The Balance of Payments for a country is the sum of the Current Account, the
Capital Account and the change in Official Reserves.
The current account is that balance of payments account in which all short-term flows
of payments are listed. It is the sum of net sales from trade in goods and services, net
investment income (interest and dividend), and net unilateral transfers (private transfer
payments and government transfers) from abroad. Investment income for a country is
the payment made to its residents who are holders of foreign financial assets (includes
interest on bonds and loans, dividends and other claims on profits) and payments made
to its citizens who are temporary workers abroad. Unilateral transfers are official
government grants-in-aid to foreign governments, charitable giving (e.g., famine relief)
and migrant workers’ transfers to families in their home countries. Net investment
income and net transfers are small relative to imports and exports. Therefore a current
account surplus indicates positive net exports or a trade surplus and a current
account deficit indicates negative net exports or a trade deficit.
The capital (or financial) account is that balance of payments account in which all
cross-border transactions involving financial assets are listed. All purchases or sales of
assets, including direct investment (FDI) securities (portfolio investment) and bank
claims and liabilities are listed in the capital account. When Indian citizens buy foreign
securities or when foreigners buy Indian securities, they are listed here as outflows and
inflows, respectively. When domestic residents purchase more financial assets in
foreign economies than what foreigners purchase of domestic assets, there is a net
capital outflow. If foreigners purchase more Indian financial assets than domestic
residents spend on foreign financial assets, then there will be a net capital inflow. A
capital account surplus indicates net capital inflows or negative net foreign
investment. A capital account deficit indicates net capital outflows or positive net
Current scenario in India
The official reserves account (ORA) records the total reserves held by the official
monetary authorities (central banks) within the country. These reserves are normally
composed of the major currencies used in international trade and financial transactions.
The reserves consist of “hard” currencies (such as US dollar, British Pound, Euro, Yen),
official gold reserve and IMF Special Drawing Rights (SDR). The reserves are held by
central banks to cushion against instability in international markets. The level of
reserves changes because of the central bank’s intervention in the foreign exchange
markets. Countries that try to control the price of their currency (set the exchange rate)
have large net changes in their Official Reserve Accounts. In general, a net decrease in
the Official Reserve Account indicates that a country is buying its currency in exchange
for foreign exchange reserves, to try to keep the value of the domestic currency high
with respect to foreign currencies. Countries with net increases in the Official Reserve
Account are usually attempting to keep the price of the domestic currency cheap
relative to foreign currencies, by selling their currencies and buying the foreign
exchange reserves. When a central bank sells its reserves (foreign currencies) for the
domestic currency in the foreign exchange market, it is a credit item in the balance of
payment accounts as it makes available foreign currencies. Similarly, when a central
bank buys reserves (foreign currency), it is a debit item in the balance of payment
The Balance of Payments identity states that: Current Account + Capital Account =
Change in Official Reserve Account. If a country runs a current account deficit and it
does not run down its official reserve to cover this deficit (there is no change in official
reserve), then the current account deficit must be balanced by a capital account surplus.
Typically, in countries with floating exchange rate system, the change in official reserves
in a given year is small relative to the Current Account and the Capital Account.
Therefore, it can be approximated by zero. Thus, such a country can only consume
more than it produces (or imports are greater than exports; a current account deficit)
only if it has a capital account surplus (foreign residents are willing to invest in the
country). Even in a fixed exchange rate system, the size of the official reserve account
is small compared to the transactions in the current and capital account. Thus the
residents of a country cannot have a current account deficit (imports exceeding exports)
unless the foreigners are willing to invest in that country (capital account surplus).
Q2. What is arbitrage? Explain with the help of suitable example a tow-way and a
Ans:- Arbitrage is the activity of exploiting imbalances between two or more markets.
Foreign money exchangers operate their entire businesses on this principle. They find
tourists who need the convenience of a quick cash exchange. Tourists exchange cash
for less than the market rate and then the money exchanger converts those foreign
funds into the local currency at a higher rate. The difference between the two rates is
the spread or profit.
There are plenty of other instances where one can engage in the practice arbitrage. In
some cases, one market does not know about or have access to the other market.
Alternatively, arbitrageurs can take advantage of varying liquidities between markets.
The term 'arbitrage' is usually reserved for money and other investments as opposed to
imbalances in the price of goods. The presence of arbitrageurs typically causes the
prices in different markets to converge: the prices in the more expensive market will
tend to decline and the opposite will ensue for the cheaper market. The the efficiency of
the market refers to the speed at which the disparate prices converge.
Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the
biggest risk is the potential for rapid fluctuations in market prices. For example, the
spread between two markets can fluctuate during the time required for the transactions
themselves. In cases where prices fluctuate rapidly, would-be arbitrageurs can actually
There are basically two types of arbitrage. One is two-way arbitrage and the other is
three-way arbitrage. The more popular of the two is the two-way forex arbitrage.
In the international market the currency is expressed in the form AAA/BBB. AAA
denotes the price of one unit of the currency which the trader wishes to trade and it
refers the base currency. While BBB is international three-letter code 0f the counter
currency. For instance, when the value of EUR/USD is 1.4015, it means 1 euro =
If the speculator is shrewd and has a deeper understanding of the forex market, then he
can make use of this opportunity to make big profits. Forex arbitrage transactions are
quite easy once you understand the method by which the business is conducted.
For instance, the exchange rates of EUR/USD = 0.652, EUR/GBP = 1.312 and
USD/GBP = 2.012. You can buy around 326100 Euros with $500,000. Using the Euros
you buy approximately 248420 Pounds which is sold for approximately $500,043 and
thereby earning a small profit of $43.
To make a large profit on triangular arbitrage you should be ready to invest a large
amount and deal with trustworthy brokers.
Arbitrage is one of the strategies of forex trading. To make a substantial income out of
this strategy you need to make an enormous amount of investment. Though
theoretically it is considered to be risk free, in reality it is not the case. You should enter
into this transaction only if you have deeper understanding of forex market. Hence, it
would be wise not to devote much time in looking out for arbitrage opportunities.
However, forex arbitrage is a rare opportunity and if it comes your way, then grab it
without any hesitation.
Three Way (Triangular) Arbitrage
The three way arbitrate inefficiency now arises when we consider a case in which the
EUR/JPY exchange rate is NOT equivalent to the EUR/USD/USD/JPY case so there
must be something going on in the market that is causing a temporary inconsistency. If
this inconsistency becomes large enough one can enter trades on the cross and the
other pairs in opposite directions so that the discrepancy is corrected. Let us consider
the following example :
USD/JPY = 84.75
The exchange rate inferred from the above would be 1.2713*84.75 which would be
107.74 and the actual rate is 107.86. What we can do now is short the EUR/JPY and go
long EUR/USD and USD/JPY until the correlation is reestablished. Sounds easy, right ?
The fact is that there are many important problems that make the exploitation of this
three way arbitrage almost impossible.
Q3. You are given the following information:
Spot EUR/US: 0.7940/0.8007
Three months swap: 25/35
Calculate three month EUR/USD rate.
Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) - Spot
OCR = Other Currency Rate
BCR = Base Currency Rate
Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360))) –
SWAP = -0.00120
Forward rate = 0.07940 - 0.00120 = 0.0782
Q.4 Explain various methods of Capital budgeting of MNCs.
Ans:- Methods of Capital Budgeting
Discounted Cash Flow Analysis (DCF)
DCF technique involves the use of the time-value of money principle to project
evaluation. The two most widely used criteria of the DCF technique are the Net Present
Value (NPV) and the Internal Rate of Return (IRR). Both the techniques discount the
projects’ cash flow at an appropriate discount rate. The results are then used to
evaluate the projects based on the acceptance/rejection criteria developed by
NPV is the most popular method and is defined as the present value of future cash
flows discounted at an appropriate rate minus the initial net cash outlay for the projects.
The discount rate used here is known as the cost of capital. The decision criteria is to
accept projects with a positive NPV and reject projects which have a negative NPV.
The NPV can be defined as follows:
I0 = initial cash investment
CFt = expected after-tax cash flows in year t.
k = the weighted average cost of capital
n = the life span of the project.
The NPV of a project is the present value of all cash inflows, including those at the end
of the project’s life, minus the present value of all cash outflows.
The decision criteria is to accept a project if NPV ≥ o and to reject if
NPV < o.
IRR is calculated by solving for r in the following equation.
where r is the internal rate of return of the project.
The IRR method finds the discount rate which equates the present value of the cash
flows generated by the project with the initial investment or the rate which would equate
the present value of all cash flows to zero.
Adjusted Present Value Approach (APV)
A DCF technique that can be adapted to the unique aspect of evaluating foreign
projects is the Adjusted Present Value approach. The APV format allows different
components of the project’s cash flow to be discounted separately. This allows the
required flexibility, to be accommodated in the analysis of the foreign project. The APV
approach uses different discount rates for different segments of the total cash flows
depending upon the degree of certainty attached with each cash flow. In addition, the
APV format helps the analyst to test the basic viability of the foreign project before
accounting for all the complexities. If the project is acceptable in this scenario, no further
evaluation based on accounting for other cash flows is done. If not, then an additional
evaluation is done taking into account the other complexities.
As mentioned earlier, foreign projects face a number of complexities not encountered in
domestic capital budgeting, for example, the issue of remittance, foreign exchange
regulation, lost exports, restriction on transfer of cash flows, blocked funds, etc.
The APV model is a value additivity approach to capital budgeting, i.e., each cash flow
as a source of value is considered individually. Also, in the APV approach each cash
flow is discounted at a rate of discount consistent with the risk inherent in that cash flow.
In equation form the APV approach can be written as:
Where the term Io = Present value of investment outlay
= Present value of operating cash flows
= Present value of interest tax shields
= Present value of interest subsidies
The various symbols denote
Tt = Tax savings in year t due to the financial mix adopted
St = Before-tax value of interest subsidies (on the home currency) in year t due to
project specific financing
id = Before-tax cost of dollar debt (home currency)
The last two terms in the APV equation are discounted at the before-tax cost of dollar
debt to reflect the relative certain value of the cash flows due to tax savings and interest
Q.5 a. What are depository receipts?
Ans:- Depository Receipt (DR) is a negotiable certificate that usually represents a
company’s publicly traded equity or debt. When companies make a public offering in a
market other than their home market, they must launch a depository receipt program.
Depository receipts represent shares of company held in a depository in the issuing
company’s country. They are quoted in the host country currency and treated in the
same way as host country shares for clearance, settlement, transfer and ownership
purposes. These features make it easier for international investors to evaluate the
shares than if they were traded in the issuer’s home market.
There are two types of depository receipts – GDRs and ADRs. Both ADRs and GDRs
have to meet the listing requirements of the exchange on which they are traded.
Q.5 b. Boeing commercial Airplane Co. manufactures all its planes in United
States and prices them in dollars, even the 50% of its sales destined for overseas
markets. Assess Boeing’s currency risk. How can it cope with this risk?
Ans:- Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes
overseas and the demand for these planes depends on the foreign exchange value of
the dollar, and (2) Boeing faces stiff competition from
Airbus Industry is a European consortium of companies that builds the Airbus. As the
dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus
unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to
finance a portion of its assets in foreign currencies in proportion to its sales in those
countries. However, this tactic ignores the fact that Boeing is competing with Airbus.
Absent a more detailed analysis, another suggestion is for Boeing to finance at least
half of its assets with ECU bonds as a hedge against depreciation of the currencies of
its European competitors. ECU bonds would also provide a hedge against appreciation
of the dollar against the yen and other Asian currencies since European and Asian
currencies tend to move up and down together against the dollar (albeit imperfectly).
Q6. Distinguish between Eurobond and foreign bonds? What are the unique
characteristics of Eurobond markets?
Ans:- A Eurobond is underwritten by an international syndicate of banks and other
securities firms, and is sold exclusively in countries other than the country in whose
currency the issue is denominated. For example, a bond issued by a U.S. corporation,
denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors
in the United States), would be a Eurobond. Eurobonds are issued by multinational
corporations, large domestic corporations, sovereign governments, governmental
enterprises, and international institutions. They are offered simultaneously in a number
of different national capital markets, but not in the capital market of the country, nor to
residents of the country, in whose currency the bond is denominated. Almost all
Eurobonds are in bearer form with call provisions and sinking funds.
A foreign bond is underwritten by a syndicate composed of members from a single
country, sold principally within that country, and denominated in the currency of that
country. The issuer, however, is from another country. A bond issued by a Swedish
corporation, denominated in dollars, and sold in the U.S. to U.S. investors by U.S.
investment bankers, would be a foreign bond. Foreign bonds have nicknames: foreign
bonds sold in the U.S. are "Yankee bonds"; those sold in Japan are "Samurai bonds";
and foreign bonds sold in the United Kingdom are "Bulldogs."
Figure 4 specifically reclassifies foreign bonds from a U.S. investor`s perspective.
FOREIGN BONDS TO U.S. INVESTORS
Foreign currency bonds are issued by foreign governments and foreign corporations,
denominated in their own currency. As with domestic bonds, such bonds are priced
inversely to movements in the interest rate of the country in whose currency the issue is
denominated. For example, the values of German bonds fall if German interest rates
rise. In addition, values of bonds denominated in foreign currencies will fall (or rise) if
the dollar appreciates (or depreciates) relative to the denominated currency. Indeed,
investing in foreign currency bonds is really a play on the dollar. If the dollar and foreign
interest rates fall, investors in foreign currency bonds could make a nice return. It should
be pointed out, however, that if both the dollar and foreign interest rates rise, the
investors will be hit with a double whammy.
Characteristics of Eurobond markets
1. Currency denomination: The generic, plain vanilla Eurobond pays an annual
fixed interest and has a long-term maturity. There are a number of different
currencies in which Eurobonds are sold. The major currency denominations are
the U.S. dollar, yen, and euro. (70 to 75 percent of Eurobonds are denominated
in the U.S. dollar.) The central bank of a country can protect its currency from
being used. Japan, for example, prohibited the yen from being used for Eurobond
issues of its corporations until 1984.
2. Non-registered: Eurobonds are usually issued in countries in which there is little
regulation. As a result, many Eurobonds are unregistered, issued as bearer
bonds. (Bearer form means that the bond is unregistered, there is no record to
identify the owners, and these bonds are usually kept on deposit at depository
institution). While this feature provides confidentiality, it has created some
problems in countries such as the U.S., where regulations require that security
owners be registered on the books of issuer.
3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer
protective covenants, making them an attractive financing instrument to
corporations, but riskier to bond investors. Eurobonds differ in term of their
default risk and are rated in terms of quality ratings.
4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2
to 10 years), referred to as Euronotes, and long terms (10-30 years), and called
Eurobonds. There are also short-term Europaper and Euro Medium-term notes.
5. Other features:
• Like many securities issued today, Eurobonds often are sold with many
innovative features. For example:
a) Dual-currency Eurobonds pay coupon interest in one currency and
principal in another.
b) Option currency Eurobond offers investors a choice of currency. For
instance, a sterling/Canadian dollar bond gives the holder the right to
receive interest and principal in either currency.
1. A number of Eurobonds have special conversion features. One
type of convertible Eurobond is a dual-currency bond that allows
the holder to convert the bond into stock or another bond that is
denominated in another currency.
2. A number of Eurobonds have special warrants attached to them.
Some of the warrants sold with Eurobonds include those giving the
holder the right to buy stock, additional bonds, currency, or gold.
Master of Business Administration - MBA Semester 4
MF0015 – International Financial Management
Assignment Set- 2
Q.1 What do you mean by optimum capital structure? What factors affect cost of
Ans:- The objective of capital structure management is to mix the permanent sources of
funds in a manner that will maximize the company’s common stock price. This will also
minimize the firm’s composite cost of capital. This proper mix of fund sources is referred
to as the optimal capital structure. Thus, for each firm, there is a combination of debt,
equity and other forms (preferred stock) which maximizes the value of the firm while
simultaneously minimizing the cost of capital. The financial manager is continuously
trying to achieve an optimal proportion of debt and equity that will achieve this objective.
Cost of Capital across Countries
Just like technological or resource differences, there exist differences in the cost of
capital across countries. Such differences can be advantageous to MNCs in the
1. Increased competitive advantage results to the MNC as a result of using low cost
capital obtained from international financial markets compared to domestic firms
in the foreign country. This, in turn, results in lower costs that can then be
translated into higher market shares.
2. MNCs have the ability to adjust international operations to capitalize on cost of
capital differences among countries, something not possible for domestic firms.
3. Country differences in the use of debt or equity can be understood and
capitalised on by MNCs.
We now examine how the costs of each individual source of finance can differ across
Country differences in Cost of Debt
Before tax cost of debt (Kd) = Rf + Risk Premium
This is the prevailing risk free interest rate in the currency borrowed and the risk
premium required by creditors. Thus the cost of debt in two countries may differ due to
difference in the risk free rate or the risk premium.
(a) Differences in risk free rate: Since the risk free rate is a function of supply and
demand, any factors affecting the supply and demand will affect the risk free rate.
These factors include:
• Tax laws: Incentives to save may influence the supply of savings and thus
the interest rates. The corporate tax laws may also affect interest rates
through effects on corporate demand for funds.
• Demographics: They affect the supply of savings available and the
amount of loanable funds demanded depending on the culture and values
of a given country. This may affect the interest rates in a country.
• Monetary policy: It affects interest rates through the supply of loanable
funds. Thus a loose monetary policy results in lower interest rates if a low
rate of inflation is maintained in the country.
• Economic conditions: A high expected rate of inflation results in the
creditors expecting a high rate of interest which increases the risk free
(b) Differences in risk premium: The risk premium on the debt must be large enough
to compensate the creditors for the risk of default by the borrowers. The risk varies with
• Economic conditions: Stable economic conditions result in a low risk of
recession. Thus there is a lower probability of default.
• Relationships between creditors and corporations: If the relationships
are close and the creditors would support the firm in case of financial
distress, the risk of illiquidity of the firm is very low. Thus a lower risk
• Government intervention: If the government is willing to intervene and
rescue a firm, the risk of bankruptcy and thus, default is very low, resulting
in a low risk premium.
• Degree of financial leverage: All other factors being the same, highly
leveraged firms would have to pay a higher risk premium.
Q.2 What is sub-prime lending? Explain the drivers of sub-prime lending? Explain
briefly the different exchange rate regime that is prevalent today.
Ans:- Subprime lending is the practice of extending credit to borrowers with certain
credit characteristics – e.g. a FICO score of less than 620 – that disqualify them from
loans at the prime rate (hence the term ’sub-prime’). Sub-prime lending covers different
types of credit, including mortgages, auto loans, and credit cards. Since sub-prime
borrowers often have poor or limited credit histories, they are typically perceived as
riskier than prime borrowers. To compensate for this increased risk, lenders charge sub-
prime borrowers a premium. For mortgages and other fixed-term loans, this is usually a
higher interest rate; for credit cards, higher over-the-limit or late fees are also common.
Despite the higher costs associated with sub-prime lending, it does give access to credit
to people who might otherwise be denied. For this reason, sub-prime lending is a
common first step toward “credit repair”; by maintaining a good payment record on their
sub-prime loans, borrowers can establish their creditworthiness and eventually
refinance their loans at lower, prime rates.
Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt
increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there
was an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages
originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years
ago. This substantial increase is attributable to industry enthusiasm: banks and other
lenders discovered that they could make hefty profits from origination fees, bundling
mortgages into securities, and selling these securities to investors.
These banks and lenders believed that the risks of sub-prime loans could be managed,
a belief that was fed by constantly rising home prices and the perceived stability of
mortgage-backed securities. However, while this logic may have held for a brief period,
the gradual decline of home prices in 2006 led to the possibility of real losses. As home
values declined, many borrowers realized that the value of their home was exceeded by
the amount they owed on their mortgage. These borrowers began to default on their
loans, which drove home prices down further and ruined the value of mortgage-backed
securities (forcing companies to take write downs and write-offs because the underlying
assets behind the securities were now worth less). This downward cycle created a
mortgage market meltdown.
The practice of sub-prime lending has widespread ramifications for many companies,
with direct impact being on lenders, financial institutions and home-building concerns. In
the U.S. Housing Market, property values have plummeted as the market is flooded with
homes but bereft of buyers. The crisis has also had a major impact on the economy at
large, as lenders are hoarding cash or investing in stable assets like Treasury securities
rather than lending money for business growth and consumer spending; this has led to
an overall credit crunch in 2007. The sub-prime crisis has also affected the commercial
real estate market, but not as significantly as the residential market as properties used
for business purposes have retained their long-term value.
The International Monetary Fund estimated that large U.S. and European banks lost
more than $1 trillion on toxic assets and from bad loans from January 2007 to
September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S.
banks losses were forecast to hit
$1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S.
banks were about 60 percent through their losses, but British and euro zone banks only
Drivers of sub-prime lending
Home price appreciation
Home price appreciation seemed an unstoppable trend from the mid-1990’s through to
today. This "assumption" that real estate would maintain its value in almost all
circumstances provided a comfort level to lenders that offset the risk associated with
lending in the sub-prime market. Home prices appeared to be growing at annualized
rates of 5-10% from the mid-90s forward. In the event of default, a very large
percentage of losses could be recouped through foreclosure as the actual value of the
underlying asset (the home) would have since appreciated.
Lax lending standards
Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor
in lending standards can be seen as the product of many of the preceding themes. The
increased acceptance of securitized products meant that lending institutions were less
likely to actually hold on to the risk, thus reducing their incentive to maintain lending
standards. Moreover, increasing appetite from investors not only fueled a boom in the
lending industry, which had historically been capital constrained and thus unable to
meet demand, but also led to increased investor demand for higher-yielding securities,
which could only be created through the additional issuance of sub-prime loans. All of
this was further enabled by the long-term home price appreciation trends and altered
rating agency treatment, which seemed to indicate risk profiles were much lower than
they actually were.
As standards fell, lenders began to relax their requirements on key loan metrics. Loan-
to-value ratios, an indicator of the amount of collateral backing loans, increased
markedly, with many lenders even offering loans for 100% of the collateral value. More
dangerously, some banks began lending to customers with little effort made to
investigate their credit history or even income. Additionally, many of the largest sub-
prime lenders in the recent boom were chartered by state, rather than federal,
governments. States often have weaker regulations regarding lending practices and
fewer resources with which to police lenders. This allowed banks relatively free rein to
issue sub-prime mortgages to questionable borrowers.
Adjustable-rate mortgages and interest rates
Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage
market, particularly the sub-prime sector, toward the end of the 1990s and through the
mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rate that is
linked to current prevailing interest rates. In the recent sub-prime boom, lenders began
heavily promoting ARMs as alternatives to traditional fixed-rate mortgages. Additionally,
many lenders offered low introductory, or “teaser”, rates aimed at attracting new
borrowers. These teaser rates attracted droves of sub-prime borrowers, who took out
mortgages in record numbers.
While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan
origination, rising interest rates can substantially increase both loan rates and monthly
payments. In the sub-prime bust, this is precisely what happened. The target federal
funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadily upward in
2004. As of
mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This
4.25% increase in interest rates over a three-year period left borrowers with steadily
rising payments, which many found to be unaffordable. The expiration of teaser rates
didn’t help either; as these artificially low rates are replaced by rates linked to prevailing
interest rates, sub-prime borrowers are seeing their monthly payments jump by as much
as 50%, further driving the increasing number of delinquencies and defaults. Between
September of 2007 and January 2009, however, the U.S. Federal Reserve slashed
rates from 5.25% to 0-.25% in hopes of curbing losses. Though many sub-prime
mortgages continue to reset from fixed to floating, rates have fallen so much that in
many circumstances the fully indexed reset rate is below the pre-existing fixed rate;
thus, a boon for some sub-prime borrowers.
The exchange rate is an important price in the economy and some governments like to
control it, manage it or influence it. Others prefer to leave the exchange rate to be
determined only by market forces. This decision is the choice of exchange rate regime.
Many alternative regimes exist:
Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one
where the value of the currency is not officially fixed but varies according to the supply
and demand for the currency in the foreign exchange market. In this system, currencies
are allowed to:
• Appreciate – when the currency becomes more valuable relative to others.
• Depreciate– when the currency becomes less valuable relative to others.
Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value
of the currency is set by official government policy. The exchange rate is determined by
government actions designed to keep rates the same over time. The currencies are
altered by the government:
• Revaluation – Government action to increase the value of domestic currency
relative to others.
• Devaluation – Government action to decrease the value of domestic currency.
After the transition period of 1971-73, the major currencies started to float. Flexible
exchange rates were declared acceptable to the IMF members. Gold was abandoned
as an international reserve asset. Since 1973, most major exchange rates have been
“floating” against each other. However, there are countries which have fixed exchange
Q.4 Explain double taxation avoidance agreement in detail .
Ans:- Double Taxation Avoidance Agreements
Double taxation relief
Double taxation means taxation of same income of a person in more than one country.
This results due to countries following different rules for income taxation. There are two
main rules of income taxation (a) source of income rule and (b) residence rule.
As per source of income rule, the income may be subject to tax in the country where the
source of such income exists (i.e. where the business establishment is situated or
where the asset/property is located) whether the income earner is a resident in that
country or not.
On the other hand, the income earner may be taxed on the basis of his residential
status in that country. For example if a person is resident of a country, he may have to
pay tax on any income earned outside that country as well.
Further some countries may follow a mixture of the above two rules.
Thus problem of double taxation arises if a person is taxed in respect of any income on
the basis of source of income rule in one country and on the basis of residence in
another country or on the basis of mixture of above two rules.
Relief against such hardship can be provided mainly in two ways
• Bilateral relief
• Unilateral relief.
The governments of two countries can enter into agreement to provide relief against
double taxation, worked out on the basis of mutual agreement between the two
concerned sovereign states. This may be called a scheme of ‘bilateral relief’ as both
concerned powers agree as to the basis of the relief to be granted by either of them.
The above procedure for granting relief will not be sufficient to meet all cases. No
country will be in a position to arrive at such agreement as envisaged above with all the
countries of the world for all time. The hardship of the taxpayer, however, is a crippling
one in all such cases. Some relief can be provided even in such cases by home country
irrespective of whether the other country concerned has any agreement with India or
has otherwise provided for any relief at all in respect of such double taxation. This relief
is known as unilateral relief.
Types of Agreements
Agreements can be divided into two main categories:
1. Limited agreements
2. Comprehensive agreements
Limited agreements are generally entered into to avoid double taxation relating to
income derived from operation of aircraft, ships, carriage of cargo and freight.
Comprehensive agreements, on the other hand, are very elaborate documents which
lay down in detail how incomes under various heads may be dealt with.
Countries with which no agreement exists [section 91] [unilateral relief]
If any person who is resident in India in any previous year proves that, in respect of his
income which accrued or arose during that previous year outside India (and which is not
deemed to accrue or arise in India), he has paid in any country with which there is no
agreement under section 90 for the relief or avoidance of double taxation, income-tax,
by deduction or otherwise, under the law in force in that country, he shall be entitled to
the deduction from the Indian income-tax payable by him of a sum calculated on such
doubly taxed income ‘at the Indian rate of tax or the rate of tax of the said country,
whichever is the lower, or at the Indian rate of tax if both the rates are equal’.
In other words, unilateral relief will be available, if the following conditions are satisfied:
1. The assessee in question must have been resident in the taxable territories.
2. That some income must have accrued or arisen to him outside the taxable
territory during the previous year and it should also be received outside India.
3. In respect of that income, the assessee must have paid by deduction or
otherwise tax under the law in force in the foreign country in question in which
the income outside India has arisen.
4. There should be no reciprocal arrangement for relief or avoidance from double
taxation with the country where income has accrued or arisen.
India has agreements for avoidance of double taxation with over 60 countries.
If all the above conditions are satisfied, such person shall be entitled to deduction from
the Indian income-tax payable by him of a sum calculated on such doubly taxed income
• At the average Indian rate of tax or the average rate of tax of the said country,
whichever is the lower, or
• At the Indian rate of tax if both the rates are equal.
Average rate of tax means the tax payable on total income divided by the total income.
Steps for calculating relief under this section:
Step I: Calculate tax on total income inclusive of the foreign income on which relief is
available. Claim relief if available under sections 88, 88B and 88C.
Step II: Calculate average rate of tax by dividing the tax computed under Step I with the
total income (inclusive of such foreign income).
Step III: Calculate average rate of tax of the foreign country by dividing income-tax
actually paid in the said country after deduction of all relief due but before deduction of
any relief due in the said country in respect of double taxation by the whole amount of
the income as assessed in the said country.
Step IV: Claim the relief from the tax payable in India at the rate calculated at Step II or
Step III whichever is less
Q.5 Explain American depository receipt sponsored programme and
Ans:- When a company establishes an American Depositary Receipt program, it must
decide what exactly it wants out of the program, and how much time, effort and
resources they are willing to commit. For this reason, there are different types of
programs that a company can choose.
ADRs may be sponsored or unsponsored; however, unsponsored ADRs are
increasingly rare and cannot be listed on the major American stock exchanges because
they are not registered with the SEC, and lack other necessary qualifications. An
unsponsored ADR is created by a U.S. investment bank or brokerage that buys the
shares in the country where the shares trade, deposits them in a local bank—the
custodian bank, which is often a branch of a U.S. bank, called the depositary bank
(aka depository bank). The depositary bank then issues shares that represent an
interest in the stocks and handles most of the transactions with the American investors,
serving both as transfer agent and registrar for the ADR. The shares of the foreign stock
that are held in the custodian bank are called American Depositary Shares (ADS),
although this term is sometimes used as a synonym for ADRs.
Most often, the company will sponsor the creation of its own ADR, in which case it is a
sponsored ADR. There are 3 levels of sponsorship.
A Level 1 sponsored ADR is created by the company to extend the market for its
securities to this country, but without needing to register with the SEC, or conforming to
generally accepted accounting principles (GAAP). Consequently, this ADR can only
be traded in the OTC Bulletin Board or Pink Sheets trading systems, usually by
institutional investors. These ADRs have more risk, and it is more difficult to compare a
Level I ADR with other investments, because of the differences in accounting.
Level 2 and Level 3 sponsored ADRs must register with the SEC, and financial
statements must be reconciled to generally accepted accounting principles. A Level 2
ADR requires partial compliance with GAAP, while a Level 3 ADR requires complete
compliance. A Level 3 sponsorship is required, if the ADR is a primary offering and is
used to raise capital for the company. Only Level 2 and Level 3 sponsored ADRs can
be listed on the New York Stock Exchange, the American Stock Exchange, or
Q.6 Explain (a) Parallel Loans (b) Back – to- Back loans
Ans: - Parallel loan
The forerunner of a swap is a method of raising capital in a foreign country to finance
assets there without a cross-border movement of capital. For example, a $US loan
would be made to an Australian company to finance its factory in the US; at the same
time the US party which made the loan would borrow $A in Australia from the Australian
company's parent to finance a project in Australia. Parallel loans enjoyed considerable
popularity in the 1970s in the UK when they were frequently used to circumvent strict
A Back-to-back loan is a loan agreement between entities in two countries in which the
currencies remain separate but the maturity dates remain fixed. The gross interest rates
of the loan are separate as well and are set on the basis of the commercial rates in
place when the agreement is signed.
Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated
as a way of avoiding currency regulations, the practice had, by the mid-1990s, largely
been replaced by currency swaps.