International Financial Management(IFM) REVISION QUESTIONS
Section – A (Two Marks Questions)
1. What are „invisibles‟ in the balance of payments
A. The current account records all exports and imports of merchandise and invisibles. Invisibles
include (a) Services b) income flows iii) unilateral transfers Services earnings/payments include
earnings on royalties, transportation and communication. Income flows includes payments made
or payments received on foreign borrowings, earnings in the form of interest, dividends and rent.
Unilateral transfers like contributions to international institutions, gifts or aid to the foreigners.
2. What is the law of one price
A. The law of one price states that “ if a commodity or product can be sold in two different
markets, its price should be the same in both the markets”.
3. What is foreign exchange risk?
A. The risk that the one currency will appreciate or depreciate against another currency over a
period of time.
4. What is forward rate?
A. Forward rate is the rate negotiated agreement between two parties for selling/buying specified
amount of a specified currency at a fixed rate and date. If the exchange of currencies takes place
after a certain period from the date of the deal (more than two working days) it is called forward
5. What is a currency futures contract?
A. A currency futures contract is a standardized agreement to deliver or receive a specified
amount of a specified currency at a fixed rate and date
6. What is „functional currency‟ and reporting currency?
A. Functional currency is defined as the currency in which the affiliate operates and in which it
generates cash flows. Generally it is the local currency of the country in which the affiliate
conducts most of its business. Under certain circumstances the functional currency may be the
parent‟s firm‟s home currency or some third country currency. The reporting currency is the
currency in which the parent firm prepares its own financial statements. This currency is
normally the home currency, i.e the currency of the country currency i.e the currency of the
country in which the parent is located and conducts most of its business
8. What is covered interest rate arbitrage?
A . The covered Interest arbitrage is the act of making profits by exploiting the lack of equality
between forward premium /discount on a foreign currency and the interest in the two currencies.
Th movement of money to take advantage of a covered interest differential is known as covered
interest rate arbitrage.
9. What is marking to market?
A. Settling changes in the value of futures contracts on a daily basis. When the futures are
marked to market at the end of each trading day, the previous trading day‟s futures contract is
settled. The counterparties realize their profits or losses on a day-to-day basis rather than all at
once upon the maturity of the contract. The daily settlement as per the marked-to-market
procedure reduces the default risk of the futures contract.
10. What is PPP?
A. PPP states that the home currency price of a commodity in different countries when converted
into a common currency at the spot exchange rate, is the same in all the countries across the
11. Distinguish between Direct and Indirect quotation.
A. Direct Quote: A direct quote is the number of units of home currency that can be exchanged
for one unit of a foreign currency. 1 FX (foreign currency) = no of units of DX (domestic
currency) Indirect Quote: is the number of units of the foreign currency exchanged for one unit
of home currency. 1 DX (Domestic currency) = no of units of FX(foreign currency)
12. What is clean and direct float?
A. Dirty Float: It is an exchange rate system in which exchange rates are allowed to fluctuate
without set boundaries and government intervene as they wish Clean Float: It is an exchange rate
system in which exchange rates are allowed to fluctuate as per the demand and supply and
government/monetary authority do not intervene.
13. Who are the participants in the foreign exchange market?
A. The participants of the foreign exchange market are
i. Retail Customers: Tourists, Students seeking education, restaurants, shops hotels, importers
ii. Foreign Exchange dealers (Wholesalers) which include large commercial banks investments
banks, corporations, HNI(High Net-worth Individuals)
iii. Foreign exchange brokers who buy/sell currencies for commission
iv. Nation‟s Central Banks like RBI
14. Define translation exposure?
A. Translation exposure is also called as Accounting exposure. It is exposure which measures the
effect or impact of the exchange rate changes/fluctuations on the financial statements. It effects
both the income statement and balance sheet items
15. What is syndicated loan?
A. Syndicated loans are different from general loans in that one of the lending banks is the lead
manager who originates the transaction, structures it, selects the lending members, supervises the
documentation and in many cases services the loan after agreement is complete. It serves as a
link between the borrower and the other banks of the syndicate. It collects interest and principal
from the borrower and disburses the collected amount among the co-lenders at an additional fee.
16. Distinguish between absolute and relative PPP theory?
A. Absolute PPP: The absolute version of the PPP theory is also called the law of one price,
suggests that prices of identical products in two different countries should be equal when
measured in common currency. The assumption of the absolute PPP is that there are no
transaction costs or trade barriers. The relative form of PPP is an alternative version that
accounts for the possibility of market imperfection such as transportation costs, tariffs and quota.
According to this version prices of similar products of different countries will not necessarily be
the same when measured in a common currency because of these market imperfections. The
percentage change in the foreign currency (ef) ef = (1 + Ih ) / (1+ If) – 1 Ih – Inflation rate of the
home currency If – Inflation rate of the foreign currency
17. Write the structure of current Account in BOP?
A. The current account consists of all exports and imports of merchandise and invisibles.
Merchandise includes agricultural commodities and industrial components and products.
Invisibles include services, income flows in and out of the country and unilateral gifts. Export of
services include various banking, insurance, consulting and accounting undertaken by
individuals and firms. Import of services include residents tourists spending abroad, payments
made to the firms for their services and royalties on foreign books etc.
18. Who are authorised dealers?
A. Authorised dealers are wholesale dealers of the currencies of different countries. These are
authorised by the central banks of that particular country to deal with currencies. They normally
deal with large amounts of currencies.
19. State three benefits of centralised cash management system?
A. i. Maintaining minimum cash balance during the year.
ii. Judiciously manage the liquidity requirements of the centre
iii. Optimally utilize the various hedging strategies so as to minimize the MNC‟s foreign
iv. Helping the centre to take complete advantage of multinational netting so as to minimize the
MNC‟s foreign transaction costs and currency exposure.
v. Achieve maximum utilization of the transfer pricing mechanism so as to enhance the
profitability and growth by the firm
20. Explain the terms bid rate and offer rate
A. Bid rate: Is the rate at which the bank (dealer) buys one unit of the foreign currency
Ask rate: Is the rate at which the bank (dealer) sells one unit of the foreign currency
21. What do you mean by short position?
A. A market commitment is the number of contracts bought or sold for which no offsetting
transaction has been entered into. The buyer of an asset (currency) is said to have a long position,
and the seller of an asset (currency) is said to have a short position. One has a long position when
one owns something, while one has a short position when something is sold, especially sold short
22. What is country risk?
A. Is the risk which emanates from political, social, and economic (financial) instability of a
country and manifests in the form of more or less strong hostility towards foreign investments
23. What is economic exposure?
A. Economic exposure measures the impact of unanticipated currency changes on monetary
transactions as well as the uncertain future cash-flows generated by the firm‟s income-generating
24. Contrast the speculative and hedging motives for usage of derivatives
A. Speculators are the class of investors who willingly take price risks to profit from price
changes in the underlying. They want to make quick fortune by anticipating/forecasting future
market movements. Hedgers wish to eliminate or reduce the price risk to which they are already
exposed. Hedging is a mechanism to reduce price risk inherent in open positions. A hedging can
help lock in existing profits.
27. What do you mean by balance of payments?
A. The BOP(Balance of Payments) of a country can be defined as a systematic record of all
economic transactions between the residents of a country and the residents of the other countries
of the world over a specified period of time(usually one year). It accounts for transactions by
individuals, businesses and government.
29. Differentiate between risk and exposure?
A. Foreign Exchange Risk is the uncertainty or variance of the domestic currency value of assets,
liabilities, unanticipated changes in the foreign exchange rates while Foreign exchange exposure
is the measure of the sensitivity of the changes in the real domestic currency value of assets,
liabilities or operating incomes. Exposure is a measure of sensitivity of value of the financial
items to change in variables like exchange rates, Inflation rates, relative prices etc.
30. What do you mean by soft or weak and hard or strong currency?
A. Soft or weak Currency: It is the currency which is expected to depreciate rapidly or that it is
difficult to convert into other currencies. Hard or Strong Currency: It is currency which is
expected to appreciate and can serve as a reliable and stable value.
31. What is interest rate parity? Explain the terms with examples bid and ask quote.
A. The interest rate parity theory states that the difference in the interest rates( risk-free) on two
currencies should be equal to the difference between the forward exchange rate and the spot
exchange rate if there are to be no arbitrage opportunities.
32. What is the difference between a put on British pounds sterling and call on sterling
A. A put on British Pounds provides the holder with the right to sell the underlying currency. A
call on sterling provides the holder with the right to buy the underlying currency
33. Define the terms hedging and currency risk
A. Hedging is an instrument made in order to reduce the risk of adverse price movements in a
security, by taking an offsetting position in a related security such as an option or a short sale.
34. What do you mean by political risk?
A. Political risk is the exposure to a change in the value of an investment or cash-flows of a
foreign firm arising out of unexpected change in the political environment of the host country.
Political risks are caused by the unanticipated changes in the tax laws, labour laws and other
laws that hurt the profitability and viability of the foreign projects.
35. What is dollarization
A. Dollarization is system of adopting the currency (dollar or not) of another nation in place of a
domestic currency. For example panama has been using the U.S
39. What is triangular Arbitrage?
A. If three currencies are involved in an arbitrage operation, it is called a three point arbitrage. In
a triangular arbitrage one currency is traded for another currency, which is traded for the third
currency, which is then traded for the first currency. Triangular arbitrage exists when the
currency direct quotes are not in alignment with the cross exchange rates.
40. What is foreign exchange market?
A. The foreign exchange market is a market where one currency is traded for another. It allows
currencies to be exchanged in order to facilitate international trade or financial transactions.
41. What is International Capital Budgeting?
A. It refers to the analysis of cash inflows and outflows associated with prospective long- -term
foreign investment projects. It helps in identifying the cash flows put to risk and estimate cash
flows to be derived over time
42. What is foreign Direct Investment?
A. Foreign Direct Investment is any form of investment and the parent company builds
productive capacity in a foreign country and processes foreign ownership of an enterprise. The
IMF defines Foreign Investment as FDI when the investor holds 10% or more of the equity of an
enterprise. FDI is an important source of capital.
43. What is multilateral Netting? What is Bilateral Netting
A. It refers to offsetting exposure in one currency with exposure in the same or another currency
whose exchange rates are expected to move in such a way that loss or gain on first exposed
position will be offset by gain or loss in the second exposed position. Bilateral netting is done
between two parties and two currencies.
44. What is CTA?
A. The gains or losses caused by translation adjustment are not included in the net income but
reported separately and accumulated in a separate equity account known as Cumulative
Translation Adjustment (CTA). The CTA account helps in balancing the balance sheet.
45. What are Depository Receipts (DRs)
A. It is a type of negotiable (transferable) financial security that is traded on a local stock
exchange but represents a security, usually in the form of equity that is issued by a foreign
publicly listed company.
46. What is Euro-currency?
A. It refers to the currency held by non-residents and placed on deposit with the banks outside
the country of the currency. Eg US dollars owned by a ABN AMRO Bank and deposited in
47. What is Back-to-Back Loan?
A. It is a type of loan where by two companies in different companies borrow offsetting amounts
from one another in each others currency. The purpose of this transaction is to hedge against
currency risk. Nowadays these are replaced by Currency swaps.
48. What is SWIFT?
A. It refers to Society For World Wide Inter Bank Financial Telecommunication. The SWIFT
operates a worldwide financial messaging network which exchanges messages between banks
and financial institutions.
49. What is the difference between Reciprocal rate and cross rate?
A. Reciprocal Rate: It is also known as Indirect quote. It is the number of units of the foreign
currency exchanged for one unit of home currency. 1 DX (Domestic currency) = no of units of
Cross rate: When quotations are not available for a pair of currency, third currency is used to find
out the exchange rate between the pair of the currency. Determining the exchange rate for two
unpopular traded currencies by using a third popular currency is called Cross rate.
50. Distinguish between Spot, Forward and Future market.
A. The spot market is where securities or currencies are characterised by simultaneous delivery
and payment. The payment for the transaction takes place immediately or in T+2 days. Forward
Transactions: are transactions in which the price, number and delivery date of the securities to be
traded are agreed upon between the buyer and the seller. It is done over the counter (OTC)
consisting of tailor made contracts. Future Market: is a market where the price, number and
delivery date of the securities to be traded are standardized and are traded over the exchange and
the contract agreed upon will be executed at a future date.
51. What is currency call and put option?
A. The right bit not the obligation to buy one currency against another currency is known as Call
Option. The right but not the obligation to sell one currency against another currency is known as
52. Distinguish between Leading and Lagging?
A. Leading and lagging involves an adjustment in the timing of the payment or disbursement to
reflect expectations about the future currency movements. Leading means fastening (paying or
receiving early) and lagging means delaying (paying or receiving late)
53. What do you mean by SDR?
A. The SDR (Special Drawing Rights) is an international reserve asset, created by the IMF in
1969 to supplement the existing official reserves of member countries. SDRs are allocated to
member countries in proportion to their IMF quota. The SDR also serves as the unit of account
of the IMF and some other international organizations. Its value is based on a basket of key
international currencies. SDR is a composite reserve asset to supplement existing reserve
asset.SDR is valued with a basket of 5 country‟s currencies with the largest share of world
exports of goods and services. SDRs can used by countries to reduce the deficits in the balance
54. Define exposure netting.
A. Exposure netting involves offsetting exposures in one currency with exposures in the same or
another currency, where exchange rates are expected to move in such a way that losses /gains on
the first exposed position should be offset by gains/ losses on the second currency exposure.
55. What is money market hedge?
A. A money market hedge involves simultaneous borrowing and lending activities in two
different currencies to lock the home currency value of a foreign currency cash flow.
56. What do you mean by double Taxation?
A. Double taxation means taxation of same income of an individual in more than one country.
This results due to countries following different rules for taxation.
57. Explain the meaning of cross-rate consistency?
A. The exchange rate for a non-US currency expressed in terms of another US currency is
referred to as cross rate. Cross-rate consistency refers to the stability of exchange rate over a
period of time.
Section-B --1. Explain the three types of transactions takes place in forex market?
A. i. Spot Market: These are the quickest transactions involving currency in foreign markets.
These transactions involve immediate payment at the current exchange rate, which is also called
the spot rate. The trades usually take place within two days of the agreement. This does leave the
traders open to the volatility of the currency market, which can raise or lower the price between
the agreement and the trade.
ii. Forward Transactions: In this type of transaction, money does not actually change hands until
some agreed upon future date. A buyer and seller agree exchange rate for any date in the future
date. The date can be days, months or years. Examples include: i) Futures ii) Swap Futures
Market: These transactions involve future payment and future delivery at an agreed exchange
rate, also called the future rate. These contracts are standardized, which means the elements of
the agreement are set and non-negotiable. It also takes the volatility of the currency market,
specifically the spot market, out of the equation. These are popular among traders who make
large currency transactions and are seeking a steady return on their investments. Forward
Market: These transactions are identical to the Futures Market except for one important
difference---the terms are negotiable between the two parties. This way, the terms can be
negotiated and tailored to the needs of the participants. It allows for more flexibility. In many
instances, this type of market involves a currency swap, where two entities swap currency for an
agreed-upon amount of time, and then return the currency at the end of the contract.
iii. Options: This transaction overcomes the problems of forward transactions, an option
provides its owner the right to sell/buy a specified amount of foreign currency at a specified
2. State the main features of currency futures?
A. The main features of currency futures are
• Is a standardized agreement to sell or buy a specified amount of currency at a fixed rate and
• Currency futures trade on a quarterly cycle, being in the month of March, June, September and
December. The future maturing on the Monday before the third wednesday of the month
• Every trader who desires to buy or sell futures contracts must open an account with his or her
broker and deposit some amount before the transaction is executed. The amount thus deposited is
known as Initial Margin. The initial margin is a certain percentage of futures contract.
• Unlike a forward contract future contract are settled every trading day at the settlement price.
This process is called marking to market. At the end of the day a party‟s gain (loss) is added to
(subtracted) from the margin account.The balance in the margin account of the investor should
never be negative. In order to ensure that another kind of margin, known as the maintenance
margin or maintenance performance bond. If the balance goes down below the maintenance
margin a margin call is given to the trader to replenish or rather square-off.
• Currency futures transactions can be closed out either through delivery of the underlying
foreign currency on full settlement or by an offsetting trade.
3. State the methods of managing transaction exposure OR Bring out the various internal
strategies a firm can take if it anticipates depreciation /appreciation of home currency against the
A. Transaction exposure can be hedged by financial contracts like i) Forward Market Hedge ii)
Future Hedge iii) Money Market Hedge iv) Options Market Hedge
i) Forward contracts can be used to lock in the futures exchange rate at which an MNC can buy
or sell a currency. A forward rate at which a MNC can buy or sell a currency.A forward market
are used for large transactions whereas the futures market hedge are used for small contracts.
ii) Currency Futures can be used by firms that desire to hedge transaction exposure either by
purchasing currency futures or by selling a currency future for a stated price on a specified date.
iii) Money market hedge involves simultaneous borrowing & lending activities in two different
currencies to lock in the home currency value of a future foreign currency cash flow. The
simultaneous borrowing & lending activities enable a company to create a home-made forward
contracts. The firm seeking money market hedge borrows in one currency & exchanges the
proceeds for another currencies
iv) Options market hedge: Forward hedge and Money market hedge can backfire when a
payable currency depreciates (or) a receivables currency appreciates over the hedge period. In
such situations an un-hedged strategy would likely outperform the forward hedge or money
market hedge. The ideal type of hedge would insulate the firm from adverse exchange rate
movements but also allow the firm to benefit from favourable exchange rate movements.
The other alternative Hedging Techniques for transaction exposure are: a) Leading or lagging b)
Currency swaps c) Cross Hedging d) Pricing of transactions e) Currency Diversification f)
Matching of cash flows g) Risk Sharing h) Parallel Loans or Back-to-Back loans
4. Why do discrepancies arises in the balance of payment?
A. Discrepancies may arise in the balance of payments because there is no single source for
balance of payments data and no way to ensure that data from different sources are fully
consistent. Sources include customs data, monetary accounts of the banking systems, external
debt records, information provided by enterprises, surveys to estimate service transactions and
foreign exchange records. Differences in recording methods for example in the timing of
transactions in definitions of residence and ownership and in the exchange rate used to value
transactions contribute to net errorsand omissions. In addition smuggling and other illegal or
quasi-legal transactions may be unrecorded or misrecorded.
5. What factors influencing pricing of a currency option?
A. The factors affecting the Currency Options are
i. Exercise price and the share/underlying asset price: If the underlying asset is a currency the
value of the call option would increase as the value of the currency increase
ii. Volatility of an underlying asset: The greater the risk of the underlying asset, the greater the
value of an option.
iii. Interest rate: The present value of the exercise price will depend on the interest rate (and the
time until expiration of the option) . The value of a call option will increased with the rising
interest rate since the present value of the exercise price will fall. The buyer of the put option
receives the exercise price and hence, with increasing interest rate the value of put option
iv. Time and date to option expiration: The present value of the exercise price will be less if the
time to expiration is longer and consequently the value of the option will be higher.
v. Strike Price
vi. Whether it is a call or put
6. Distinguish between currency futures and options?
A. Currency Options Currency Futures
1.obligations An currency option gives the buyer A futures contract gives the the right, but not
the obligation to buyer the obligation to buy (or sell) a certain currency at a purchase a specific
Currency, specific price at any time during the and the seller to sell and deliver life of the
contract that asset at a specific future date
2.commission/ Besides commission an investor can an options position does premium enter into
a futures contract with no require the payment of a upfront cost premium
3. underlying Comparatively lesser for options is much larger for futures position contracts
4. Gain The gain on a option can be realized gains on futures positions are in the following three
automatically marked to ways: exercising the option when it market daily, meaning the is deep in
the money, going to the change in the value of the market and taking the opposite positions is
attributed to the position, or waiting until expiry and futures accounts of the parties collecting the
difference between at the end of every trading day the asset price and the strike price - but a
futures contract holder can realize gains also by going to the market and taking the opposite
7. Explain the different types of transactions takes place in forex market or Briefly describe the
foreign exchange derivatives market?
A. The common derivatives products are forwards, futures, options and swaps. Currency Market
Hedges To hedge currency exposure is through devices of several currency markets-forward
contracts, futures contracts, currency options, and currency swaps. Currency FuturesClosely
related to the use of a forward contract is a futures contract. A currency futuresmarket exists for
the major currencies of the world. For example, the Australian dollar, theCanadian dollar, the
British pound, and the Swiss franc, and the yen. A futures contract is astandardized agreement
that calls for delivery of a currency at some specified future date,either the third Wednesday of
March, June, September, or December. Contracts are traded onan exchange, and the
clearinghouse of the exchange interposes itself between the buyer andtheseller. This means that
all transactions are with the clearinghouse, not made directlybetween two parties. Very few
contracts involve actual delivery at expiration. Rather, a buyerand a seller of a contract
independently take offsetting positions to close out a contract. Theseller cancels a contract by
buying another contract, while the buyer cancels a contract byselling another
contract.CurrencyOptionsForward and futures contracts provide a "two-sided" hedge against
currency movements.That is, if the currency involved moves in one direction, the forward or
futures positionoffsets it. Currency options, in contrast, enable the hedging of "one-sided" risk.
Only adversecurrency movements are hedged, either with a call option to buy the foreign
currency or witha put option to sell it. The holder has the right, but not the obligation, to buy or
sell thecurrency over the life of the contract. If not exercised, of course" the option expires. For
thisprotection, one pays a premium.There are both options on spot market currencies and options
on currency futurescontracts. Because currency options are traded on a number of exchanges
throughout theworld, one is able to trade with relative ease. The use of currency options and their
valuationare largely the same as for stock options. The value of the option, and hence the
premiumpaid, depends importantly on exchange-rate volatility.CurrencySwapsYet another
device for shifting risk is the currency swap. In a currency swap two partiesexchange debt
obligations denominated in different currencies. Each party agrees to pay theothers interest
obligation. At maturity, principal amounts are exchanged, usually at a rate ofexchange agreed to
in advance. The exchange is notional in that only the cash-flow differenceis paid. If one party
should default, there is no loss of principal per se. There is, however, theopportunity cost
associated with currency movements after the swaps initiation.Currency swaps typically are
arranged through an intermediary, such as a commercialbank. Many different arrangements are
possible: a swap involving more than two currencies;a swap with option features; and a currency
swap combined with an interest-rate swap, wherethe obligation to pay interest on long-term debt
is swapped for that to pay interest on short-term, floating-rate, or some other type of debt. As can
be imagined, things get complicatedrather quickly. The point to keep in mind, however, is that
currency swaps are widely usedand serve as longer-term risk-shifting devices.
8. Distinguish between futures and forwards
A. Feature Forward Contracts Future ContractsType of contract Customized Standardized
Maturity As desired by contracting There are only few parties usually in maturity dates such as
multiples of 30 days quarterly in an year Contract Size Generally large averaging Small enough
that it is more than 1 million accessible to small-scale dollars per contract forex participants
Security Arrangements Bank forward customers All traders must maintain must maintain
minimum margin deposits that are deposit balances small % of the contract values Cash flows
No cash flow until Daily settlement results in delivery cash payments to some parties Final
settlement 90% of the forward are Less then 2% is physical settled physically by delivery
remaining 98% is delivery cash settlement Default risk There is substantial loss Default risks are
taken can occur if one party care by the margins paid defaults to the exchange Variety of
currencies Forward are available in Are limited to a small all currencies of number of currencies
9. Why did the fixed exchange regime of 1945-1973 eventually fail?
A. The Bretton woods systems worked without major changes from 1947 to 1971. During this
period the fixed exchange rates were maintained by official intervention of the foreign exchange
market. The system however suffered from a number of inherent structural problems. Firstly
there was much imbalance in the roles and responsibilities of the surplus and deficit nations.
Countries with persistent deficits in their balance of payments had to undergo tight and stringent
economic policy measures if they wanted to take help from the IMF and stop the drain on their
reserves. The basic problem here was the rigid approach adopted by the IMF to the balance of
payments. From August-December 1971 most of the major currencies were permitted to
fluctuate. Although the US dollar was not convertible into gold, it was still defined in terms of
gold. The united States agreed to devalue the dollar from $35 per ounce of gold to $ 38 in return
for promises from other members to up-value their relative to the dollar by specified.
10. How can a MNE minimize its translation and transaction exposure simultaneously?
A. The methods for managing Translation exposure are
i. Adjusted Fund flows: It involves altering either the amount of currencies or both cash flows of
parent or subsidiary to reduce the firm‟s local currency exposure If local currency devaluation is
expected then exports are priced in hard currency (foreign currency) and imports are priced in
soft currency(local currency)
ii. Entering into forward contracts: It demands a formal market in the respective local currency.
Forward contract creates an offsetting asset or liability in the foreigncurrency the gain or loss on
the transaction exposure is offset or liability in the foreign currency the gain or loss on the
transaction exposure is offset by a corresponding loss or gain in forward market
iii. Exposure rating: It refers to offsetting exposure in one currency with exposure in the same or
another currency whose exchange rates rae expected to move in a way such that loss or gain on
first exposed position will be offset by gain or loss to the second exposed position
The methods of managing transaction exposure are
Price adjustment Forward Market
Borrowing or lending in foreign
SECTION – C
1. Briefly explain the important factors that should be assessed from the pointsofview of Income
tax, while entering into foreign collaboration agreement.
A. i. Choose the right country: It is very essential to choose the right country fromwhere
investment should be made. Such a choice would be depend upon the effective rate oftaxation in
the hands of the foreign company on dividend income and capital gains taxincome.
ii. Tax Credit: Double taxation avoidance agreements provide for tax credit in respect oftaxed
paid in other country. Tax credit is normally a benefit which accrues to the foreigncollaborator
and should be taken into account in fixing the consideration payable to theforeign collaborator.
iii. Dependent service: Generally salaries, wages and other remuneration received by theforeign
personnel deputed to India, are not taxable if the period of stay does not exceed 181days in the
iv. Split up of total consideration payable to foreign party: In case of many treaties,different
rates are provided for royalty and technical service fees.
v. Take advantage
vi. Tax Sparing: Tax sparing provisions in the treaties should be carefully considered.
vii. Royalty via business profits:
viii. Accommodation/living expenses provided to technicians
2. What do you mean by Depository Receipt and also explain the mechanism of depository
receipt, what are its advantages.
A. Depository Receipts is a negotiable certificate that usually represents a company‟s publicly
traded debt or equity. Depository receipts are created when a broker purchases the company‟s
shares on the home stock market and delivers those to the Depository‟s local custodian bank,
which then instructs the depository bank, to issue Depository Receipts. Depository receipts are
quoted and traded in the currency of the country in which they are trade and are governed by the
trading and settlement procedures. The ease of trading and settling DRs makes them an attractive
investment opinion for the investor wishing to purchase shares in the foreign
companies.Depository receipts may trade freely, just like any other security, either on an
exchange or in the over-the-counter market and can be used to raise capital. The most common
DRs are the American Depository Receipts (ADRs) and the Global Depository Receipts (GDRs).
A GDR is issued in America is called as American Depository Receipts (ADR). The mechanism
for Depository Receipts
5. What do you understand by the term “International Cash Management”? Briefly elucidate its
A. Cash management is an important aspect of working capital management and effectivecash
management is one of the chief concerns of the MNCs. International cash managementis more
complicated because it needs to recognise the principles and practices of othercountries. For
example many countries require that their exporters repatriate the proceeds offoreign sales within
a specific period or there could be a problem of blocked funds. Thisrestrictions hinder the free
flow of capital and effective cash management.
The Objectives of an effective International Cash Management Systems
Minimise the country exposure risk
Minimise the country political risk
Minimise the overall cash requirements of the company as a whole without disturbing the
smooth operations of the subsidiary or its affiliate
Minimise the transactions costs
Avoidance of foreign exchange losses
Minimization of the tax burden of the firm as a whole
Full benefits of economies of scale as well as the benefits of superior knowledge
The complexity and problems in international cash management decisions arise due to
theconflicting nature of the above mentioned objectives. For example minimizing
transactioncosts of currency covers would require that cash balances be kept in the currency in
whichthey are received, which conflicts with both the currency and political exposure criteria
6. Identify factors to be considered when assessing country risk. Briefly elaborate how each
factor can affect the risk to the MNC.
A. The factors that affect country risk can be of two types
i. Political Risk Factors • Political Stability • Philosophy and Ideology of political parties •
Integration into the world system • Ethnic and Religious Stability • Attitude of the Host Country
Consumers • Disruptions in operations • Blockage of funds transfer by subsidiary to the parent
firm • Loss of Intellectual Property rights • Economic source of political Corruption
ii. Financial Risk Factors: • Current and potential economic health of the host country • Financial
state of the host country • Monetary and Fiscal policies of the Host Country • Unproductive
spending by the host country government
Country Risk Analysing Technique
Combination of Techniques
7. Describe briefly the distinguishing features of international finance.
A. The distinguishing features of international finance are:
i. Foreign Exchange risk
ii. Political risks
iii. Expanded opportunities
iv. Market imperfections
i. Foreign exchange risk: when different national currencies are exchanged for each other there
is a definite risk of volatility in foreign exchange rates
ii. Political risks: ranges from the risk of loss or gain from unforeseen government action. Since
MNCs are exposed to more countries they are exposed to various types of political risks.
iii. Expanded opportunities: when firms go global, they also tend to benefit from expanded
opportunities which are available. They can raise money from markets where cost of capital is
iv. Market Imperfections: the world markets are highly imperfect due to differences in the
nations laws, tax system, business practices etc
8. Explain briefly the role of international finance manager.
A. i. Making investment decisions: the finance manager has to identify profitable opportunities
for a long term investment by using capital budgeting techniques.
ii. Managing working capital: one very important role of international finance manager is
management of current assets and liabilities and maintain an optimum working capital.
iii. Making finance decisions
iv. management of assets from cash management
v. Exchange risk measurement
vi. Performance evaluation and control
9. Explain the objectives and Functions of IMF.
A. The objectives of IMF are
a) To promote international monetary co-operation, exchange stability and orderly exchange
b) To foster economic growth and a multilateral system of payments and transfers while
eliminating exchange restrictions
c) To provide temporary financial assistance to countries to help ease balance of payments
d) To facilitate the balanced growth of international trade and to contribute to high levels of
employment, real income and productive capacity.
e) To make financial resources available to members.
The functions of IMF are: a) Surveillance: is the regular advice IMF provides for its member
b) Technical assistance: and training are offered mostly free of charge to help member countries
strengthen their capacity to design and implement effective policies.
c) Financial Assistance: is available to give member countries the chance to correct balance of
payments problems. A policy program supported by IMF financing is designed by the national
authorities in close co-operation with the IMF.
10. Briefly describe the evolution of the International Monetary System. OR What are the five
basic mechanisms for establishing exchange rates? How does each work?
A. The Gold Standard :This is the older state system, which was in operation till the beginning
of the First World War and for a few years after that. In the version called Gold Specie Standard
the actual currency in circulation consisted of gold coins with a fixed gold content. In a version
called Gold Bullion Standard, the basis of money remains a fixed weight of gold but the currency
circulation consists 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. Thus a
pound sterling note can be exchanged for say x ounces of gold, while a dollar note can be
converted into say y ounces of gold on demand. Finally, 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-specie or gold-bullion standard thus
if rupees are freely convertible into dollars and dollars in turn into gold, rupee can be said to be
on a gold-exchange standard. The exchange rate between any pair of currencies will be
determined by their respective exchange rates against gold. This is the so-called "mint parity"
rate of exchange. In practice because of costs of storing and transporting gold, the actual
exchange rate can depart from this mint parity by a small margin on either side.
Under the true gold standard, the monetary authorities must obey the following three rules of the
game: - They must fix once-for-all the rate of conversion of the paper money issued by them into
- There must be free flows of gold between countries on gold standard. The money supply in the
country must be tied to the amount of gold the monetary authorities have reserve. If this amount
decreases, money supply must contract and vice-versa. The gold standard regime imposes very
rigid discipline on the policy makers. Often, domestic considerations such as full employment
have to be sacrificed in order to continue operating the standard, and the political cost of doing
so can be quite high. For this reason, the system was rarely allowed to work in its pristine
During the Great Depression, the gold standard was finally abandoned in form and substance. In
modern times, some economists and politicians have advocated return to gold standard precisely
because of the discipline it imposes on policy makers regarding reckless expansion of money
supply. As we will see later, such discipline can be achieved by adopting other types of exchange
B. The Bretton Woods System Following the Second World War, policy makers from the
victorious allied powers, principally the US and the UK, took up the task of thoroughly
revamping the world monetary system for the non-communist world. The outcome was the so-
called "Bretton Woods System” and the birth of two new supra- national institutions, the
International Monetary Fund (the IMF or simply "the Fund") and the Word Bank- the former
being the linchpin of the proposed monetary system. The exchange rate regime that was put in
place can be characterized as the Gold Exchange Standard. It had the following features: - The
US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per
ounce. - Other member countries of the IMF agreed to fix the parities of their currencies vis –`a -
vis the dollar with variation within 1 % on either side of the central parity being permissible. If
the exchange rate hit either of the limits, the monetary authorities of the country were obliged to
"defend" it by standing ready to buy or sell dollars against their domestic currency to any extent
required to keep the exchange rate withinthe limits. In return for undertaking this obligation, the
member countries were entitled to borrow from the IMF to carry out their intervention in the
currency markets. The novel feature of the regime, which makes it an adjustable peg system
rather than a fixed rate system like the gold standard was that the parity of a currency against the
dollar could be changed in the face of fundamental disequilibria. Changes of up to 10% in either
direction could be made without the consent of the Fund while larger changes could be effected
after consulting the Fund and obtaining their approval. However, this degree of freedom was not
available to the US, which had to maintain gold value of the dollar.
C. Exchange Rate Regimes: The Current Scenario The IMF classifies member countries into
eight categories according to the exchange rate regime they have adopted.
(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, like the eleven members
of the Economic and Monetary Union (EMU) who have adopted Euro as their common currency
or (b) Countries which have adopted the currency of another country as their currency. This latter
group includes among others, countries of the East Caribbean Common Market (e.g. Grenada,
Antigua, St. Kitts & Nevis), countries belonging to the West African Economic and Monetary
Union (e.g. Benin, Burkina Faso, Guinea- Bisseau, Mali etc.) and countries belonging to the
Central African Economic and Monetary Union (e.g. Cameroon, Central African Republic, Chad
etc.). These two latter groups have adopted the French Franc as their currency. As of 1999, 37
IMF member countries had this sort of exchange rate regime.
(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 the monetary authority to ensure that this commitment will be
honored. This implies constraints on the ability of the monetary authority to manipulate domestic
money supply. As of 1999, eight IMF members had adopted a currency board regime including
Argentina and Hong Kong Tying their currency to the US dollar.
(3) Conventional fixed Peg Arrangements: This is identical to the Bretton Woods system where a
country pegs its currency to another or to a basket of currencies with a band of variation not
exceeding 1% around the central parity. The peg is adjustable at the discretion of the domestic
authorities. Forty-four IMF members had this regime as of 1999. Of these thirty had pegged their
currencies in to a single currency and the rest to a basket.
(4) Pegged Exchange Rates within Horizontal Bands: Here there is a peg but variation is
permitted within wider bands. It can be interpreted as a sort of compromise between a fixed peg
and a floating exchange rate. Eight countries had such wider band regimes in 1999.
(5) Crawling Peg: This is another variant of a limited flexibility regime. The currency is pegged
to another other currency or a basket but the peg is periodically adjusted. The adjustments may
be pre-an- enounced and according to a well specified criterion, or discretionary in response to
changes in selected quantitative indicators such as inflation rate differentials. Six countries were
under such a regime in 1999.
(6) Crawling Bands: The currency is maintained within certain margins around a central parity.
Which "crawls" as in the crawling peg regime either in a preannounced fashion or in response to
certain indicators. Nine countries could be characterized as having such an arrangement in 1999.
(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
foreign exchange 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. Twenty-five countries could be classified as belonging to this group.
(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 at or drive it towards any particular level. In 1999, forty-eight countries
including India characterized themselves as independent floaters. It is evident from this that
unlike in the pre-I973 years, one cannot characterize the international monetary regime with a
single label. A wide variety of arrangements exist and countries move from one category to
another at their discretion. This has prompted some analysts to call it the international monetary
11. Mention the different types of exchange rate system and explain them.
A. The different types of A managed floating rate system is a hybrid of a fixed exchange rate and
a flexible exchange rate system. In a country with a managed floating exchange rate system, the
central bank becomes a key participant in the foreign exchange market. Under the managed
floating regime the central bank holds stocks of foreign currency known as the foreign exchange
reserves Fixed (pegged) Exchange rate systems: The basic motivation for keeping exchange rates
fixed is the belief that a stable exchange rate will help facilitate trade and investment flows
between countries by reducing fluctuations in relative prices. Here the central bank stands ready
to exchange local currency and at a pre-defined rate. Under the fixed exchange rate system the
central bank remains prepared to absorb the excess of demand or supply.
13. Explain the foreign exchange market.
A. The foreign exchange market is an over-the-counter market; this means that there is nosingle
physical or electronic market place or an organized exchange (like a stockexchange) with a
central trade clearing mechanism where traders meet and exchangecurrencies, The market itself
is actually a worldwide network of inter-bank traders,consisting primarily of banks, connected by
telephone lines and computers. The marketfunctions virtually 24 hours enabling a trader to offset
a position created in one market usinganother market. The five major centers of inter-bank
currency trading, which handle morethan two thirds of all forex transactions, are London, New
York, Tokyo, Zurich, andFrankfurt. Transactions in Hong Kong, Singapore, Paris and Sydney
account for bulk of therest of the market.
Foreign Exchange Market Participants: The participants may include hedgers,arbitrageurs,
speculators, institutional investors, individual investors and financial institutionssuch as
commercial banks, investment banks , retail agents such as tourists, hotels etc.
The market participants that comprise the FX market can be categorised into five
groups:International banks , bank customers, non-bank dealers, FX brokers, and central banks.
Mostinterbank trades are speculative or arbitrage transactions where market participants attempt
tocorrectly judge the future direction of price movements in one currency versus anotherBid ask
price: Bid price is the price to buy currency and ask price is the price to sellcurrency. The
interbank market is a network of correspondent banking relationships withlarge commercial
banks maintaining demand deposit account with another, calledcorrespondent bank accounts.
The foreign exchange market is unique because:
• Its trading volume
• Its extremely liquidity in the market
• The large number of and variety of traders in the market
• The geographical dispersion
• Its long trading hours: 24 hrs a day
• The variety of factors that affect the exchange rate
• The low margins of profit compared with other markets of fixed income.Central banks
sometimes intervene in the foreign exchange market in an attempt to influencethe price of the
currency against that of a major trading partner or country that it fixes or pegsits currency
against.Bid-ask spread: The difference b/w the bid rate and ask rate is referred as the bid-ask
rate. Ask rate - Bid rate Spread = x 100 Ask rateForeign Exchange rate: The rate at which the
home currency is exchanged for a foreigncurrencyDirect quote: is the number of units of home
currency that can be exchanged for one unit ofa foreign currencyFor ex 1$ = Rs 45.54Indirect
Currency: is the number of units of a foreign currency that can be exchanged forone unit of the
home currency. For example 0.0022 Rs/S is an indirect quote.Forward rates of currency are
either quoted as out- right rates or a discount/premium
20. Explain the various theories of exchange rate determination
A. The various theories of exchange rate determination are
Purchasing power parity (PPP)
Fisher Effect (FE)
International Fisher Effect (IFE)
Interest rate parity (IRP)
Purchasing Power ParityPurchasing power parity (PPP) was first stated in a rigorous manner by
the Swedisheconomist Gustav Cassel in 1918.PPP has been widely used by central banks as a
guide to establishing new par values for theircurrencies when the old ones were clearly in
disequilibria. From a management standpoint,purchasing power parity is often used to forecast
future exchange rates, for purposes rangingfrom deciding on the currency denomination of long-
term debt issues to determining in whichcountries to build plants.In its absolute version,
purchasing power parity states that exchange-adjusted price levelsshould be identical worldwide.
In other words, a unit of home currency (HC) should have thesame purchasing power around the
world. This theory is just an application of the law of oneprice to national price levels rather than
to individual prices. (That is, it rests on theassumption that free trade will equalize the price of
any good in all countries; otherwise,arbitrage opportunities would exist) However, absolute PPP
ignores the effects on free tradeof transportation costs, tariffs, quotas and other restrictions, and
product differentiation.The relative version of purchasing power parity, which is used more
commonly now,states that the exchange rate between the home currency and any foreign
currency will adjust to reflect changes in the price levels of the two countries. For example, if
inflation is 5% inthe United States and 1 % in Japan, then in order to equalize the dollar price of
goods in thetwo countries, the dollar value of the Japanese yen must rise by about 4%.
The Fisher effect states that the nominal interest rate r is made up of two components: (I) areal
required rate of returns a and (2) an inflation premium equal to the expected amount ofinflation i.
Formally, the Fisher effect is1 + Nominal rate = (l + Real rate)(l + Expected inflation rate)1 + r =
(1 +a) (l +i)orr = a + i + aiIn equilibrium, then, with no government interference, it should follow
that the nominalinterest rate differential will approximately equal the anticipated inflation rate
differential, or (1+rh ) / (1+rf ) = (1+ih ) / (1+if )where rh and rf are the nominal home- and
foreign-currency interest rates, respectively.If rf and if are relatively small.In effect, the
generalized version of the Fisher effect says that currencies with high rates ofinflation should
bear higher interest rates than currencies with lower rates of inflationThe International Fisher
EffectThe key to understanding the impact of relative changes in nominal interest rates
amongcountries on the foreign exchange value of a nations currency is to recall the implications
ofPPP and the generalized Fisher effect. PPP implies that exchange rates will move to
offsetchanges in inflation rate differentials. Thus, a rise in the U.S. inflation rate relative to those
ofother countries will be associated with a fall in the dollars value. It will also be associatedwith
a rise in the U.S. interest rate relative to foreign interest rates.Combine these two conditions and
the result is the international Fisher effect:(1 + rh) t / (1 + rf ) t = et / e0where et is the expected
exchange rate in period t. The single period analogue to aboveEquationis(1 + rh) / (1 + rf ) = e1 /
e0Note the relation here to interest rate parity. If the forward rate is an unbiased predictor ofthe
future spot rate-that is,f l = e1 -then Equation becomes the interest rate parity condition:(1 + rh) /
(1 + rf ) = f1 / e0
Interest rate parity (IRP): The interest rate parity is the basic identity that relates interestrates and
exchange rates. It states that the returns from the borrowing in one currencyexchanging that
currency for another currency.Interest rate parity is a relationship that must hold between the
spot interest rate of twocurrencies if there are to be no arbitrage opportunities. The relationship
depends upon spotand forward exchange rates between the two currencies m f 1 + r a =
S 1 + rb where S– spot rate f- forward rate , ra and rb are the interest rates for
therespectivecurrenciesTheory Key variables of theory Summary of TheoryInterest Rate parity
(IRP) Forward rate Interest The forward rate of one premium or differential currency with
respect to discount another will contain a premium (or discount) that is determined by the
differential in interest rates between the two countries. As a result, covered interest rate arbitrage
will provide a return that is no higher than a domestic returnPurchasing Power Percentage
Inflation The spot rate of one currencyParity(PPP) change in the rate with respect to another will
spot exchange differential change in reaction to the rate differential in reaction to the differential
in inflation rates between the two countries. Consequently the purchasing power for consumers
when purchasing goods in their own country will be similar to their purchasing power when
importing goods from the foreign countryInternational Fisher Effect Percentage Interest rate The
spot rate of one currency(IFE) change in the differential with respect to another will spot rate
change in accordance with the differential in interest rates between the two countries.
Consequently the return on uncovered foreign money market securities will on an average be no
higher than the return on the domestic money market securities from the perspective of investors
in the home country
14. Explain briefly the four methods of Translation exposure.
A. The four methods of foreign currency translation are
i. The current rate method
ii. The monetary/non-monetary method
iii. The temporal method
iv. The current /non-current method
i. The current rate method: All items of the balance sheet and income statement are translated at
the current spot rate exchange
ii. Monetary and Non-monetary method: Under this method monetary items are translated at the
current spot exchange rate and the no-monetary items are translated at the historical rates.
iii. The temporal method: Under this method if an item is originally stated at historical cost its
translation is carried out at the historical spot rate of exchange. If the item is originally stated at
its market value the translation is carried out at the current spot exchange rate.
iv. The current/Non-current method: According to this method all the current assets and current
liabilities of a foreign subsidiary are translated into the home currency of the parent company at
the current spot exchange rate. In non-current asset or liabilities are translated at historical rate of
15. Describe the various methods of capital budgeting that are normally adopted byMNCs
A. Once a firm has compiled a list of prospective investments, it must then select from
amongthem that combination of projects that maximizes the companys value to its
shareholders.This selection requires a set of rules and decision criteria that enables manager‟s e
todetermine, given an investment opportunity, whether to accept or reject it. It is generallyagreed
that the criterion of net present value is the most appropriate one to use since itsconsistent
application will lead the company to select the same investments the shareholderswould make
themselves, if they had the opportunity.
Net Present ValueThe net present value (NPV) is defined as the present value of future cash
flows discounted atan appropriate rate minus the initial net cash outlay for the project. Projects
with a positiveNPV should be accepted; negative NPV projects should be rejected. If two
projects aremutually exclusive, the one with the higher NPV should be accepted. The discount
rate,known as the cost of capital, is the expected rate of return on projects of similar risk.
Fornow, we take its value as given.In mathematical terms, the formula for net present value is
nNPV = - I0 + Σ CFt / (1 + K)t t=1Where I0 = the initial cash investmentCFt = the net cash flow
in period tk = the projects cost of capitaln = the investment horizonThe most desirable property
of the NPV criterion is that it evaluates investments in the sameway the companys shareholders
do; the NPV method properly focuses on cash rather than onaccounting profits and emphasizes
the opportunity cost of the money invested. Thus, it isconsistent with shareholder wealth
maximization.Another desirable property of the NPV criterion is that it obeys the value
additively principal.That is, the NPV of a set of independent projects is just the sum of the NPVs
of the individual projects. This property means that managers can consider each project on its
own. It alsomeans that when a firm undertakes several investments, its value increases by an
amountequal to the sum of the NPV s of the accepted projectsThe NPV of a project is the present
value of all cash inflows, including those at the end of theproject‟s life, minus the present value
of all cash outflows.The decision criteria is to accept a project if NPV≥ 0 and reject if NPV<
0The Adjusted Present Value (APV) FrameworkThe APV framework" allows us to disentangle
the financing effects and other special featuresof the project from the operating cash flows of the
project. It is based on the well-knownvalue additively principal. It is a two-step approach:1. In
the first step, evaluate the project as if it is financed entirely by equity. The rate ofdiscount is the
required rate of return on equity corresponding to the risk class of the project.2. In the second
step, add the present values of any cash flows arising out of special financingfeatures of the
project such as external financing, special subsidies if any, and so forth. Therate of discount f
used to find these present values should reflect the risk associated with eachof the cash flows.In
APV approach each cash flow is discounted at a rate of discount consistent with the riskinherent
in that cash flow n CFt n Tt APV = I0 + ∑ t ∑ + t+ 1 (1 + k ) t+ 1 (1 + id )tWhere T – tax savings
id = cost of debt
16. Discuss the difference between cost of capital for MNCs and domestic firms.
A. The difference between cost of capital for MNCs and domestic firms include
:i. Size of the firms: Firms that operate internationally are usually much bigger in size thanfirms
which operate only in domestic market.
ii. Foreign exchange risk: A firm more exposed to exchange rate fluctuations would have awider
spread of possible cash flows in future periods. Thus exposure to exchange ratefluctuations could
lead to higher cost of capital.
iii. Access to international capital markets: The fact that MNCs can normally access
theinternational capital market helps them to attract funds at a lower cost than the domesticfirms.
This form of financing helps to lower the cost of capital and will generally not increasethe MNCs
exposure to exchange rate risk.
iv. International diversification effect: If a firm‟s cash inflows come from sources all over
theworld , there might be more stability in them. MNCs by their virtue of their
diversificationoperations, can reduce their cost of capital compared to domestic firms
v. Political risk: can be accounted for in the cost of capital calculations by adding an arbitrary
risk premium to the domestic cost of capital for a project of comparable risk.
vi. Country risk: Country risk represents the potentially adverse impact of a country‟s
environment on the MNCs cash flows. If the country‟s risk level of a particular country increase,
the MNC may consider divesting its subsidiaries located there.
vii. Tax Concessions: MNCs generally choose countries where the tax laws are favourable for
them as their net income is substantially influenced by the tax laws in the locations where they
17. Explain the distinguishing features of multinational cash management and discussthe
techniques used to optimise cash flows.
A. Though the principles of domestic and international cash management are the
sameinternational cash management is wider in scope and is more complicated because it needs
torecognise the principles and practices of other countries. Other important complicatingfactors
in international cash management include multiple tax jurisdictions and currenciesand the
relative absence of internationally integrated interchange facilities as are availabledomestically in
the United States
The basic objectives of an effective international cash management system are: 1. Minimise the
currency exposure risk.
2. Minimise the country and political risk
3. Minimise the overall cash requirements of the company as whole without disturbing the
smooth operations of the subsidiary or its affiliate
4. Minimise the transactions costs
5. Full benefits of economies of scale as well as the benefit of superior knowledge
A centralised cash management group may be needed to monitor and manage the
parentsubsidiary and inter-subsidiary cash flows.
International cash management requires achieving two basic objectives: 1. Optimising cash flow
2. Investing excess cashTechniques to optimise cash flow
The various ways by which cash inflows can be optimised are:
1. Accelerating cash inflows
2. Managing blocked funds
3. Leading and lagging strategy
4. Using netting to reduce overall transaction costs by eliminating a number of unnecessary
conversions and transfer of currencies
5.Minimising the tax on cash flow through international transfer pricing
Accelerating cash inflows: is the first objective in cash management, quicker recovery ofinflows
assures that they are available with the firm for use or for investment
Managing blocked funds: the host country may block funds that the subsidiary attempts tosend to
the parent. The parent may also instruct the subsidiary to obtain financing from alocal bank
rather than from the parent. This also helps the subsidiaries as they may be able tobetter utilise
blocked funds by repaying the local loan.
Leading and Lagging: The leading and lagging technique can be used by subsidiaries
foroptimising cash flow movements by adjusting the timing of payment to reflect
expectationsabout the future currency movements. MNCs can accelerate (lead) or delay(lag) the
timing offoreign currency payments by modifying the credit terms extended by one unit to
another.Leading and lagging is adopted by MNCs in order to reduce foreign exchange exposure
or toincrease available working capital.
Netting: Netting is a technique of optimising cash flow movements with the joint efforts
ofsubsidiaries. The process involves the reduction of administration and transaction costs
thatresult from currency conversion.
Advantages of Netting:
• It reduces the number of cross-border transactions between subsidiaries thereby reducing the
overall administrative costs of such cash transfers.
• The technique reduces the need for foreign exchange conversion and hence reduces transaction
costs associated with foreign exchange conversion
• It helps in improved cash flow forecasting since only net cash transfers are made at the end of
Netting is of two types: 1. Bilateral Netting setting: A bilateral netting system involves
transactions between the parent and a subsidiary or between the two subsidiaries.
2. Multilateral Netting: Under a multilateral netting system, each affiliate nets all its inter-
affiliate receipts against all its disbursements. It then transfers or receives the balance, depending
on whether it is a net receiver or a payer. A multinational netting system involves a more
complex interchange among the parent and its several affiliates but it results in a considerable
saving in exchange and transfer costs. However for multinational netting to be effective there is a
need for centralised cash management from the side of MNCs. An effective cash management
system should be based on a cash budget that projectsexpected cash inflows and outflows over
some planning horizon.
18. What are the fundamental considerations which are taken into consideration whileevaluating
A. The basic steps involved in evaluation of a project:
• Determine net investment outlay
• Estimate net cash flows to be derived from the project over time, including an estimate of
• Identify the appropriate discount rate for determining the present value of the expected cash
• Apply NPV or IRR techniques to determine the acceptability or priority ranking of potential