IFM PGP SBS Full Term Revd Latest Exellent

Sl no 1999 2002 2005 2006 2007

Emerging markets - global

Pvt Cap flows - Nett 75.4 77.3 238.5 211.4 182.2

Private Direct Inv - Nett 177.3 150.6 255.9 263.3 246.1

Private Portfolio flows 60.7 (91.7) 3.2 (31.1) (4.6)

Other Pvt. Capital flows (162.6) 18.4 (20.6) (20.8) (59.2)

Official flows - Nett 13.0 (4.3) (151.8) (238.7) (174.1)

Change in Reserves (98.4) (200.6) (592.5) (666.3) e

Emerging Asia

Pvt Cap flows – Nett 0.2 20.6 64.0 97.9 69.0

Private Direct Inv – Nett 70.9 50.5 99.6 94.0 96.0

Private Portfolio flows 54.1 (60.1) (12.7) (13.1) (8.4)

Other Pvt Capital flows (124.9) 30.2 (22.9) 17.0 (18.5)

Official flows – Nett 1.6 3.0 (11.7) (8.4) (12.0)

Change in Reserves (84.8) (154.4) (286.6) (344.8) (331.4)

Capital Flows - Some stats - Emerging markets $ Billion

S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L

International Fin Mgt

A Brief Introduction

Sep 2010

Objectives of the Course

1. To provide – A conceptual framework of – How financial decisions are undertaken – In a multinational company.

2. To familiarize students with – Unique economic factors that challenge – A Fin Mgr in the international context.

Principles of Collective learning

1. Learning “ Not by rote “ but by Logic, based on First principles – 5 W 1 H framework– Why , What, Where, When, Who and How– till we reach first principles

2. Participation by all. Learning by all (Prof. included)

3. Preference to Depth over Width.

4. Preference to substance over form.

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

Topics – Pre Mid term

UNIT I Introduction to IFM – The environment – The nature of international Fin Mgt – International Monetary system – Determination of exchange rates – Balance of Payments – Interest parity – international fisher effect

UNIT II Foreign exchange market – Functions – Participants – Currency derivatives

• Forwards, Swaps, futures and Options

– Interest rate futures – speculation

Why IFM

1. Do you need to answer these questionsa. Where should you source from ? - Op Decisionb. Which markets to penetrate (Op decisions) - Op Decisionc. Where should you Invest (eg. Where to locate your plant) - Invt Decision d. Where in the world shall we raise our finance from ? - Fin Decisione. What should be our response to our MNC competitor - Op decision

2. Why IFM a. Inter-dependent World (Resources are scattered – Goods/Lab/Capital)a. Inter-connected world : Tech improvements (Trpt, Com, Web)b. Boundary-less Fin- Flows @ the speed of nanoseconds now. c. For each co some interest abroad : supplier, cust or competitord. Implications dramatic : Even US Co’s had to earn new lessons e. JP Morgan : “We are a Global co with an important American Biz”

3. Empirically Global barriers are shrinking & global trade is growing In 2002 - $ 6.4 Trillion : In 2008 - $ 15 Trillion

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

Why IFM for Indian students

1. 2007- Emerging - GDP gr - 7.5% : Trade Gr : 10.5% Developed - GDP Gr - 2.5% : Trade Gr : 5.3%

2. 1991 : Watershed yr For India. Liberalization and Globalization a. Easing of Quantitative Restrictions (Trade, Labor & Capital)b. Lowering of Import Dutiesc. Foreign Investments on the rise – controls loweredd. Current A/c convertibilitye. Trend towards softening of Cap a/c convertibility provisos

3. IFM course will deal with the Treasurer’s more than the controller’s fn

4. Treasury Function – Acquisition and allocation of Fin resources– To maximize rewards and Minimize costs– Consistent with the level of fin risk acceptable to the firm – Basically the Investment and Financing roles vs Operational role

What is special about international finance?

Foreign exchange risk– Eg. An unexpected devaluation adversely affects our export Mkt.

Political risk– Eg. A Coup that jeopardizes existing negotiated contracts.

Market imperfections– Eg. Trade barriers & Tax incentives affect location of production.

Expanded opportunity sets (Global diversification)– Eg. Raise funds in global markets, gains from economies of scale

Intnl Fin mgt – The expanded opportunities

1. Arbitrage Opportunities: – Defined as simultaneous purchase & sale in2 diff mkts– To profit from price discrepancy– Tax Arbitrage : shift from high to low tax regimes– Risk arbitrage : diversification. Pl refer point 3 (Intnl CAPM)

2. Mkt efficiency related opportunites: – Tendency of efficient mkts to price in all info to avert profits – other than those thru pure risk taking. – Inefficient Markets – likley to allow more returns

3. Intnl CAPM reated Opportunities: – Variability in asset returns a fn of Systematic & unsys risks– IFM helps diversify away some unsystematic risk. (Cost push infl due to oil)

4. The value of good fin mgt is enhanced in a global context due to– Market imperfections, multiple tax rates and complexities– This presents as oppy as much as a threat. – Sophisticated IFM exploits the opportunity.– Precisely, the objective of the IFM course

International expanded Opportunity setCost-Benefit Evaluation - Domestic Firms versus MNCs

Marginal Return on

Projects

Marginal Cost of Capital

Purely Domestic Firm

Purely Domestic Firm

MNC

MNC

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

X YAsset Level of Firm

The Setting

Empirical data

on Global Money / Trade flows

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

0

2000

4000

6000

8000

10000

12000

1961 1971 1981 1991 2001 2005

0

500

1000

1500

2000

2500

Globe Advanced Asia Others

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

Global Flows – Indian policy environment

Labour Goods Capital / Tech

Emigration Immigration Exports Imports I/flows O/flows

Exec Body HRD Min Commerce Ministry Fin Min (FIPB/ SEBI/ RBI)

PolicySupportive Restrictive Supportive

Selectively Restrictive

FDI : Supportive FII : Selective restrictions Restrictive

Restrictions

Emigration laws

Immigration Laws, Resident status IT

Export Ban Export Duties

Quotas Tariffs

FDI : Sectoral caps

FII : Selective Restrictions like PN

Selective permission

Global Capital Inflows

A. 2 categories

– 1. FDI : Invt in real assets or Cos in a host country– 2. Portfolio : Invt in financial assets of a host country

B. Economic benefits of FDI

– 1. Prod of goods/serv in locations of comp advantage– 2. Enhancement of labor productivity in the host country– 3. Adoption of new tech /Mgt techniques to optimally utilize

resources– 4. Raises the level of competition, provides new/improved prod.

Global Trade flows

C. International biz methods

– Licensing : Typically to use IPR-related – Franchisee : To Permit the use of brands /Logo etc.– JV : P/sip jointly owned/operated by 2/more firms– Subsidiaries : New ops in the host country by parent corp.– Mgt contract : one firm owning and another Managing (eg. Magunta Oberoi)

D. Tactical Issues

– 1. Licensing involves lower risks but inflexible & host dependent– 2. Subsidiary is preferred to JV. JV’s over Licensing

Setbacks

East Asian crisis – 97-98

– Doubts about capital a/c convertibility started surfacing– Benefits of unfettered capital flows were overestimated and – The damage an enormous outflow of S/T money can cause has

been underestimated– Consensus on addl. safeguards and checks but not much on the

form it needs to take– By ‘99 some semblance of recovery started & all forgotten soon

Financial meltdown 2008

– Sub prime the ostensible cause.– Toxic assets (CDS’ s etc.) were the other manifestation – Real causes were consumption and savings imbalances between

the advanced economies and the Asian tigers

Structure of the course

In terna tional M oney In te rna tionalF inancia l M arke ts

In te rna tionalF inancia l Institu tions

Interna tiona lF inancial System

In te rna tionalPa rity C onditions

T heo ries ofF inancia l M arke ts

Behaviour

Basic C oncepts inInternational F inance

International F inancia l Environm ent

International Financial System

Money

Markets

Institutions / Players

Instruments

E xch a ng e R a teA rran g e m e nt

E vo lu tion o f In te rna tion a lM o n e ta ry S ys tem

In te rn a tio n a lM o n e ta ry S ys tem

E xch a ng e R a teE q u ilib rium

E xcha n ge R a tesD e te rm in a n ts

E xch a ng e ra tes

In te rn a tio n a lM o n ey

In te rn a tio n a l F in a n c ia l M a rke ts

In te rn a tio n a lF in a nc ia l In s titu t io ns

International F inanc ial System

International Money

International Financial Markets

IM

Im m e d ia teD e live ry M a rke t

(sp o t m a rke t)

F o rw a rdM a rke t

F o re ig n E xcha n g e M arke ts(F o re x )

In te rn a tio n a lM o n eyM a rke t

In te rn a tio n a lC a p ita lM a rke t

In te rn a tio n a l M on eya n d C a p ita l m arke ts

In te rn a tio n a lD e riva tives

M a rke ts

In te rn a tio n a lF in a n c ia l M a rke ts

IF I

In te rna tion a l f in a n cia l S ys tem

IM

Im m ediateDelivery M arke t

(spot m arket)

ForwardM arke t

Foreign E xchange M arkets(Forex)

Bonds(corporate, governm ent

eurobonds)

Loans/D eposits

N otes

BankersAcceptances

C om m ercia lPapers

Interna tiona lDebt

M arke t

Stocks (shares)

AD R s

Interna tiona lEquityM arke t

Internationa l Debtand Equity M arkets

Options

Futures

Swaps

Interna tiona lDerivatives

M arkets

Interna tiona lF inancia l M arkets

IF I

International financ ial System

IFB - framework

A. Fin environment– Overview – International Monetary system – International FI’s and Dev Banks– BOP’s

B. Forex Markets– Derivatives– Forex Currency futures and options– Forex markets – Forex Rate theories

C. Forex exposure mgt – Mgt of Forex risk– Translation exposure and – Transaction exposure

D. Fin mgt of MNC firm– FDI– WACC and Cap structure of an MNC– MNC Capital budgeting / Cash Mgt / Taxation– Country Risk Mgt

E. Financing foreign operations– Eurocurrency markets– Interest rate and currency swaps– Depository receipts

International Monetary System

A. Gold standard (1875 – 1914)– Each country to peg currency to an ounce of gold.– Free import and export of Gold– Two way convertibility between currencies and gold

B. Example for US $ and £– $ 20.67 / ounce of gold and £ 4.247 / ounce of Gold – (20.67 / 4.247) = $ 4.866 / unit of £

C. Gold Import / export Points (a Hypothetical example)– Assumptions

• 1 ounce of gold = 20 $ / £ 4 (ie 5$ / £ )• Shipping Cost = 0.20 $/ounce• US importer imports worth 4 £ / US exporter exports worth £ 4 • US importer cam pay 1 ounce Gold or 4 £ : US exporter ok to accept

£ 4 / 1 ounce gold

Gold Standard - Workings

If Exchange Rate has moved to (say) 5.1 $ / unit of £ then

• Either the US importer can pay £ 4 paying $ 20.40 to get the same (rate 5.1/ £) or

• Ship 1 ounce gold : Cost of Gold + shipping cost = $ (20 +0.20) = $ 20.20

• This is Called the “ Gold Export Point”– Thus, If the Rate exceeds $ 5.05 / £, the US importer would rather

export Gold than pay £

– Workings : If Exchange Rate is (say) 4.90 $ / unit of £

• Either the US exporter can get £ 4 or $ 19.60 (since Rate is 4.9) now or

• Accept 1 ounce gold : Cost of Gold - shipping cost = $ (20 - 0.20) = $ 19.80

• This is called the “ Gold Import Point” – Thus, if the Exch rate moves < 4.95$ , US Exporter would rather accept

Gold into US than 4 £

A. Gold Std Equilibrium maintained thru “ Price-Specie Flow” mechanism as below

– Assume a country experiences Trade deficit (Imports more thane exports)– Currency loses competitiveness– Exchange rate reaches Gold Export Point. Thus, Gold gets exported – Results in loss of Gold reserves. Thus money supply to be downsized– Accompanied by high intt rates, lower Prod /empl /low demand for Cons/ Import– With reduced imports, Trade Bal improves/ with high intt rates, Fund I/Fl improve – Hence, Exchange rate appreciates

B. – Assume a country experiences Trade Surplus (Exports more than Imports)– Currency gains competitiveness– Exchange rate reaches Gold import Point. Thus, Gold flows into the country – Results in increase in Gold reserves and money supply increases– Accompanied by Low intt rates, higher prod /Empl/Hi demand for Cons/ Import– With higher imports, trade Bal suffers / with lower intt rates, Fund O/Fl increase – Hence, Exchange rate depreciates


Gold standard : Why abandoned

1. The 3 Golden rules of “ Gold Standard “ were highly restrictive– (A) Rate peg (B) Free Exp/ Imp of Gold (C) Currency stock = F (Gold reserves)

2. Gold being scarce, Gold volume could not grow fast enough to cope with Eco Gr

3. Gold reserves were with countries politically sensitive (eg. Russia, South Africa)

4. Nations had to subordinate their National Eco goals to the dictates of Global trade.

5. This proved to be unrealistic, given the political costs of such a presumption

– Many developing countries faced External trade imbalances during this time – Instead of having the courage to face unemployment at home, countries resorted

to Tariffs– This affected the international trade

6. Hence, the system was eventually abandoned

Inter war years

1. WW1 interrupted the flow of trade and destabilized Exchange rates

2. Role of Britain as a creditor nation came to an end

3. Feeble attempts to get back to gold Std post war . Eg UK 1925. Failed

4. Since UK had run out of reserves and inflation was rampant.

5. Pound was overvalued.

6. US $ devalued to 35/ounce

7. US introduced modified Gold std. – US to trade gold with only central banks not with Pvt citizens

8. Inter war Yrs saw Half-hearted attempts @ Gold std that failed

9. Great depression and stock market crash of 1929 also were contributory

Bretton woods.

1. Creation of 2 new institutions IMF and world bank

2. IMF for addressing balance of payments problems.

3. World bank to address for post war reconstruction and General Eco Development

4. US $ and £ became the reserve currencies

5. Each member would establish a par value with the reserve currency

6. And maintain it within 1% of the par value. intervene else. Ie Fixed peg with ±

7. US $ was pegged to 35 $/ oz Gold. US agreed to exchange $ for gold/ vice versa

8. Member could change par value with Fund approval /“fundamental disequilibrium”

9. Currencies became freely convertible.

10. To defend, countries had to keep a lot of dollar reserves and US, Gold reserves

11. Member countries to make subscription to the fund

Break down of Bretton woods

1. 1947 – 71 ; Stable. World Trade expanded faster than world output

2. There was imbalance. Countries with deficits underwent conditionalities

3. Countries with surplus treated favorably, thou persistent surplus was inflationary (Contrast with approach to Chinese surplus now)

4. Esp rigid was the approach to BOP disequilibria. Conditionalities were stringent

6. Low levels of conditionalities, if member needs funds for short period

7. Higher levels, where member wants access to LT fund resources

8. Involved stabilization programs to achieve IMF objectives.

9. Led to interference in their independent Monetary/ fiscal policy pursuits

Fixed Vs flexible : An evaluation

Fixed Rates :

– Certainty & rigidity promote Eco efficiency, public confidence and Inflation control– Downsides : Work well in periods of stability. Massive O/F during crises. FM closes

Floating rates

– System causes uncertainty. Promotes speculation instead of trade– Flexi rate system also encourages speculation, once upper band was reached.– However in fixed, bets were one-way with no loss since parity to be restored– Conclusion : Fixed rate system suffered from all that flexible systems had &more

Systems in vogue now :

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

Parity Conditions

and

Currency Forecasting

CHAPTER OVERVIEW

I. PURCHASING POWER PARITY

II. THE FISHER EFFECT

III. THE INTERNATIONAL FISHER EFFECT

IV. INTEREST RATE PARITY THEORY

V. THE R/SHIP BETWEEN FORWARD AND FUTURE SPOT RATE

VI. CURRENCY FORECASTING

ER determination: Caselet : Utopia Vs Antarctica

Items Vol

Infla 20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 2

Lee Jeans 10 1,000 20

Total

Ex Rate Determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 10,000 2 200

Ex Rate Determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Exch Rate determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Exch Rate determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440

Exch rate Determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440

Exch rate by Price comparison 50.00 54.55

Exch rate Determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440


Exch rate by Formula ( Infl Diff Abs) 1.20/1.10 1.091 50.00 54.55

Exch Rate Determination

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440



Exch rate by Formula (Infl Diff – Rel) 1.20/1.10 1.091 45.00 49.09

PART II. PURCHASING POWER PARITY

I. THE THEORY OF PURCHASING POWER PARITY:

States that spot Exch rates between currencies will change

based on differential in inflation rates between countries.

ARBITRAGE AND THE LAW OF ONE PRICE

Inflation & home currency depreciation :

1. jointly determined by Gr of domestic money Supply;

2. Relative to the growth of domestic money demand.

PART I. ARBITRAGE AND THE LAW OF ONE PRICE

I. THE LAW OF ONE PRICE

A. Law states:

- Identical goods sell for the same price worldwide.

B. Theoretical basis:

- If the price after exchange-rate adjustment were not equal,

- Arbitrage in the goods worldwide ensures it will, eventually

Limitations

1. Tariffs, Quotas, Transportation costs, Other trade barriers

2. Non-traded goods & Services (like Beautician’s) excluded

PURCHASING POWER PARITY

III. Relative PPP

States that the exchange rate of one currency agt. another

will adjust to reflect Ch in Price levels of the two countries.


If purchasing power parity is Expd to hold, then

The best prediction for the one-period Spot rate should be

1

1

01

1

1

f

h

i

iee


A more simplified but less precise relationship is

The % change should be approximately equal to

- The Inflation rate differential (in decimals not %).

fht ii

e

e 1

0


A. Real exchange rates

If exchange rates adjust to Inflation differential, then ;

PPP states that real exchange rates stay the same.

B. If Real exchange rates unchanged,

- Competitive positions of Domestic & foreign firms are unaffected.

III. The Fisher Effect (FE)

I. THE FISHER EFFECT states that

- Nominal interest rates (r) are a function of

- Real Interest rate (a) and

- A Premium (i) for inflation expectations.

r = a + i

THE FISHER EFFECT

B. Real Rates of Interest

1. Should tend toward equality everywhere thru arbitrage.

2. With no Govt interference, nominal rates vary by Infl. Diff

rh - rf = ih - if

3. According to the FE, - Countries with higher inflation rates have higher interest rates.

D. Due to capital market Integration globally,

- Interest rate differentials are eroding.

THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE

IFE States that the spot rate adjusts to the Intt. rate Diff. between two countries

1

1

01

)1(

)1(

f

h

r

re

e

Covered Interest Arbitrage and Interest Parity theory

–3– 2 –1 0 1 2 3

Inte

rest

diff

eren

tial i

n fa

vour

of f

orei

gn c

ount

ry in

per

cen

t per

ann

um

3

2

1

0

–1

–2

–3

Arbitrageinflow

Interestparity

Arbitrageoutflow

•B

A•

•A’

B’•

Forward exchange rate - discount or premium in per cent per annum

Arbitrage outflow

1.+ve int rate diff > FD (point A)

2..FP > -ve interest rate diff(point .A’)

Arbitrage inflow

1.FD > + ve intrest rate diff(point B)

2.-ve intrest rate diff > FP(point B’)

Interest Rate Differentials, Forward Exchange Rates and Covered Interest Arbitrage

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25

Forward Premium - DM 3.33%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 11.00%

Intt Rate diff for INR 0.80%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%

31-Dec-09 Interest 453.3

Cumulative 4,897.8

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8

Sell DM fwd and Trfr to INR 23.3 113,873.3

Yield % 13.87%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8


Yield % 13.87%

Return if Invested in INR 11.00% 1,11,000.0

Present Rate Equivalent rate

Description Conversion

Spot DM 22.50 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20% 10.20%

Intt Rate INR 12.00% 12.00%


Arbitrage possible Yes

No

Buy DM 100,000.00 4,444.44 100,000.00 4,444.44

Investment @ 10.20% 10.20%

Interest 453.33 453.33

Cumulative 4,897.78 4,897.78

Sell DM fwd and Trfr to INR 23.25 113,873.33 22.87 112,000.00

Yield % 13.87%

Return if Invested in INR 12.00% 112,000.00 12.00% 112,000.0062



Spot DM 22.50 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20% 10.20%

Intt Rate INR 12.00% 12.00% 1.63%



No

Buy DM 100,000.00 4,444.44 100,000.00 4,444.44

Investment @ 10.20% 10.20%

Interest 453.33 453.33

Cumulative 4,897.78 4,897.78


Yield % 13.87%




Spot DM 22.50 22.50

Fwd 1 year 23.25 22.87

Forward Premium - DM 3.33% 1.63%

Intt Rate DM 10.20% 10.20%

Intt Rate INR 12.00% 12.00% 1.63%



No

Buy DM 100,000.00 4,444.44 100,000.00 4,444.44

Investment @ 10.20% 10.20%

Interest 453.33 453.33

Cumulative 4,897.78 4,897.78


Yield % 13.87%




Spot DM 22.50 22.50

Fwd 1 year 23.25 22.87

Forward Premium - DM 3.33% 1.63%

Intt Rate DM 10.20% 10.20%

Intt Rate INR 12.00% 12.00% 1.63%



No

Buy DM 100,000.00 4,444.44 100,000.00 4,444.44

Investment @ 10.20% 10.20%

Interest 453.33 453.33

Cumulative 4,897.78 4,897.78


Yield % 13.87%


INTEREST RATE PARITY THEORY

Covered Interest Arbitrage

Conditions required:

i. Interest rate differential does not equal the forward premium or discount.

ii. Funds will move to a country with a more attractive overall yield.


Market pressures develop:

a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates.

c. Parity eventually reached.

Summary: Interest Rate Parity states :

1. Higher intt rates on a currency offset by Forward Discount

2. Lower interest rates are offset by forward premiums

IFE

Implications of IFE

- Currency with lower Intt rate is Expd to appreciate ;

- Proportionately

- Relative to one with a higher rate.

- Due to Arbitrage


IFE = PPP + FE


1

1

01

)1(

)1(

f

h

r

re

e

International Fisher Effect

Simplified IFE equation: (if rf is relatively small)

1 0

0h f

e er r

e


IFE = PPP + FE


tf

th

ot

r

re

e

)1(

)1(

Equilibrium Exchange Rate Relationships

0

01

E

) - E(E

E(e)

)-i(i Rs$

$ - Rs

PPP

FE RPPP

IFE

International flows – Status now

Still, With growth in trade, labour movements, capital also has started flowing freely

– Hence, the emergence of Multinational corporations– Some studies predict the possibility of 500 of them owning 2/3rd of world FA in 10 yrs– FDI flows, for eg. have grown in India

Following factors have made IFM an indispensable tool esp for Global corps– A. Growth in internationals savings and reserves– B. An ever expanding and an elaborate network of global banks and FI’s– C. Various forms of Fin instruments, guarantees and insurance products– D. Innovative Risk mgt products and processes– E. Emergence of sophisticated payments systems– F. Efficient mechanisms for dealing with S/Term imbalances

For an IF Manager the following are the variety of choices before them– Funding techniques– Investment Vehicles– Risk Mgt products– Speculative opportunities based on risk-reward profiles

Hence, for those willing to learn the complexities, there are opportunities

for others, there is a minefield

Role of MNC firm

A. To maximize shareholder wealth / satisfice stakeholder interests

B. Whichever of the above 2 win eventually, the MNC still has to grapple with the environment it operates in. Environment consists of

– 1. International Fin system. Official • and others – MNC banks and OTC deals/ cap markets

– 2. Forex market : MNC banks, Forex dealers. 24 hr operation– 3. Host country environment : Political, social, cultural and other systems

C. MNC faces myriad of Complexities and challenges wrt ;– Multiple Taxation laws– Multiple currencies– Multiple and differential policy frameworks– Multiple political Systems – Agency problem. :

• Stands for conflict of goals between MNC shareholders and managers of the subsidiaries.

D. But an MNC can make the same diversity & complexity work in its favor– eg. Geo Diversification

as

as

Objectives

Sales ExpansionSupply source acquisitionDiversificationInvestment Optimization

Influences : Ext enviornment

GeograhicHistoricalPoliticalLegalEconomicCultural

Operational Import & ExportLicensingFranchisingMgt ContactTurnkeyFDIPortfolio Invt

Means

Functional ProductionMarketingAccountingFinancePersonnel

Environment challenges

Speed of Product ChangesOptimum Production siteNo of customersAmount bought by each customerHomogeneity of customersLocal Vs International competitorsCost of moving productsUnique capabilities of competitors

MNC Vs Local Firm Cost Benefit matrix

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

1 2 3 4 5 6 7 8

MNC Ret

Local Ret

MNC WACC

Local WACC

IFM – as a Discipline

A. 1. Till early 90’s, IFM discipline was not much in demand as a specialization2. Things have changed since then.3. India’s share of Total Global trade may not be significant and is in fact

declining4. While tariff barriers and quotas are being dismantled. Still they are high

B. Yet, it is naïve to conclude from above that the Developments in Intt. Fin are of little interest to us. Why

1. To maintain tempo of eco growth, India needs substantial FDI to augment domestic savings2. Tech up gradation needs continuing import of technology3. Indian export initiatives need L/T financing to buyers abroad4. Indian IT sector is beginning to venture abroad. For both organic/ Inorganic gr. Needs Finance5. Policy stance is in favor of more openness and greater competition

Treasury functions – Two major approaches

1. Treasury Function

– Some Cos run an active treasury fn that leverages imperfections in the Fin Mkts to generate purely Fin gains from Mgt of Fin Assets/Liabilities

– Others have a reactive finance function, focussing only on core Ops

– Former is a risky strategy. Eg. Forex losses by many Corps in 2008

– The latter is a conservative approach.

– The complexity of IFB is s/that a wide variety of • Instruments• Financing options• Investment Vehicles and• Risk Mgt options

Do exist for both styles of Mgt

– Treasurer in an MNC is concerned with purely Ops decisions like Sales/ Purchase, due to Exch/ Intt rate risks involved. Not in Non-MNC

Emerging Challenges – For IF Managers

1. The 80’/s 90’s - marked by unprecedented pace of foll environ changes

– Political uncertainties at Home and abroad– Economic Liberalization at home– Greater Exposure to international markets– Incr in volatility of key eco & fin variables like Exchange /Interest rates– Increased competition with increased threats of take over– Globalisation challenges increased the frustrations for Emerging Ecos– Also offered many opportunities to benefit from. Look at china for eg.

2. 21st century is marked by even greater changes in the environment– WTO deadlines wrt removal of trade barriers likely to lead to greater

competition– Cap A/C convertibility – likely in phases – may lead Cap flow challenges– Ceilings on FII and FDI Investments being revised upwards – Eg INR Appreciated from 2004 - 07, squeezing the margins of exporters– To sum up, integration of India with Global Eco is likely to accelerate – Hence, exposure for Indian Cos to global Fin Mkts is likely to increase

Fin Mgrs to do

1. To Be updated with environmental changes– Exch / Intt rates, – fiscal, monetary developments, – Industrial, tax, Exim policies,– Fin mkt trends– New fin instruments, their Risk-reward implications

2. Understand /analyze complex r/ships between environ Var & Corp Fin– Eg Stock market crash on credit conditions in intl markets– Implications on our global funding prospects of default by a Dr country

3. Adoption of Fin fn to Changes in firm’s own strategic postures - Internal– Changes in product market mix– New M&A opportunity

4. To address the consequences of past decisions– A major take over decision that has gone awry

5. To leverage opportunities offered by the environment

Evaluate

A. Distinct features of International Finance

– Forex Risk : Esp due to managed float policy by all nations. Volatility can be mercurial

– Exch rates among even major currencies like $, Yen etc. fluctuate wildly– Political risk : ranges from unforeseen policy actions to terrorist threats

(Enron- India)– Expanded opportunity sets– Market imperfections – Laws, tax systems, biz , cultural practice diff etc.

B. Evaluation

– 1. Which of the above provide the maximum net benefit over cost– 2. PV of expected future payoffs net of costs discounted at an apt rate

IFB - framework

A. Fin environment– Overview – International Monetary system – International FI’s and Dev Banks– BOP’s

B. Forex Markets– Derivatives– Forex Currency futures and options– Forex markets – Forex Rate theories

C. Forex exposure mgt – Mgt of Forex risk– Translation exposure and – Transaction exposure

D. Fin mgt of MNC firm– FDI– WACC and Cap structure of an MNC– MNC Capital budgeting / Cash Mgt / Taxation– Country Risk Mgt

E. Financing foreign operations– Eurocurrency markets– Interest rate and currency swaps– Depository receipts


A. Gold standard (1875 – 1914)– Each country to peg currency to an ounce of gold.– Free import and export of Gold– Two way convertibility between currencies and gold

B. Example for US $ and £– $ 20.67 / ounce of gold and £ 4.247 / ounce of Gold – (20.67 / 4.247) = $ 4.866 / unit of £

C. Gold Import / export Points (a Hypothetical example)– Assumptions

• 1 ounce of gold = 20 $ / £ 4 (ie 5$ / £ )• Shipping Cost = 0.20 $/ounce• US importer imports worth 4 £ / US exporter exports worth £ 4 • US importer cam pay 1 ounce Gold or 4 £ : US exporter ok to accept

£ 4 / 1 ounce gold

Gold Standard - Workings

If Exchange Rate has moved to (say) 5.1 $ / unit of £ then

• Either the US importer can pay £ 4 paying $ 20.40 to get the same (rate 5.1/ £) or

• Ship 1 ounce gold : Cost of Gold + shipping cost = $ (20 +0.20) = $ 20.20

• This is Called the “ Gold Export Point”– Thus, If the Rate exceeds $ 5.05 / £, the US importer would rather

export Gold than pay £

– Workings : If Exchange Rate is (say) 4.90 $ / unit of £

• Either the US exporter can get £ 4 or $ 19.60 (since Rate is 4.9) now or

• Accept 1 ounce gold : Cost of Gold - shipping cost = $ (20 - 0.20) = $ 19.80

• This is called the “ Gold Import Point” – Thus, if the Exch rate moves < 4.95$ , US Exporter would rather accept

Gold into US than 4 £

A. Gold Std Equilibrium maintained thru “ Price-Specie Flow” mechanism as below

– Assume a country experiences Trade deficit (Imports more thane exports)– Currency loses competitiveness– Exchange rate reaches Gold Export Point. Thus, Gold gets exported – Results in loss of Gold reserves. Thus money supply to be downsized– Accompanied by high intt rates, lower Prod /empl /low demand for Cons/ Import– With reduced imports, Trade Bal improves/ with high intt rates, Fund I/Fl improve – Hence, Exchange rate appreciates

B. – Assume a country experiences Trade Surplus (Exports more than Imports)– Currency gains competitiveness– Exchange rate reaches Gold import Point. Thus, Gold flows into the country – Results in increase in Gold reserves and money supply increases– Accompanied by Low intt rates, higher prod /Empl/Hi demand for Cons/ Import– With higher imports, trade Bal suffers / with lower intt rates, Fund O/Fl increase – Hence, Exchange rate depreciates


Gold standard : Why abandoned

1. The 3 Golden rules of “ Gold Standard “ were highly restrictive– (A) Rate peg (B) Free Exp/ Imp of Gold (C) Currency stock = F (Gold reserves)

2. Gold being scarce, Gold volume could not grow fast enough to cope with Eco Gr

3. Gold reserves were with countries politically sensitive (eg. Russia, South Africa)

4. Nations had to subordinate their National Eco goals to the dictates of Global trade.

5. This proved to be unrealistic, given the political costs of such a presumption

– Many developing countries faced External trade imbalances during this time – Instead of having the courage to face unemployment at home, countries resorted

to Tariffs– This affected the international trade

6. Hence, the system was eventually abandoned

Inter war years

1. WW1 interrupted the flow of trade and destabilized Exchange rates

2. Role of Britain as a creditor nation came to an end

3. Feeble attempts to get back to gold Std post war . Eg UK 1925. Failed

4. Since UK had run out of reserves and inflation was rampant.

5. Pound was overvalued. FF was undervalued.

6. US $ devalued to 35/ounce

7. US introduced modified Gold std. – US to trade gold with only central banks not with Pvt citizens

8. Inter war Yrs saw Half-hearted attempts @ Gold std that failed

9. Great depression and stock market crash of 1929 also were contributory

Bretton woods.

1. Creation of 2 new institutions IMF and world bank

2. IMF for addressing balance of payments problems.

3. World bank to address for post war reconstruction and General Eco Development

4. US $ and £ became the reserve currencies

5. Each member would establish a par value with the reserve currency

6. And maintain it within 1% of the par value. intervene else. Ie Fixed peg with ±

7. US $ was pegged to 35 $/ oz Gold. US agreed to exchange $ for gold/ vice versa

8. Member could change par value with Fund approval /“fundamental disequilibrium”

9. Currencies became freely convertible.

10. To defend, countries had to keep a lot of dollar reserves and US, Gold reserves

11. Member countries to make subscription to the fund

Break down of Bretton woods

1. 1947 – 71 ; Stable. World Trade expanded faster than world output

2. There was imbalance. Countries with deficits underwent conditionalities

3. Countries with surplus treated favorably, thou persistent surplus was inflationary (Contrast with approach to Chinese surplus now)

4. Esp rigid was the approach to BOP disequilibria. Conditionalities were stringent

6. Low levels of conditionalities, if member needs funds for short period

7. Higher levels, where member wants access to LT fund resources

8. Involved stabilization programs to achieve IMF objectives.

9. Led to interference in their independent Monetary/ fiscal policy pursuits

Smithsonian Agreement

1. 1971 : Post Vietnam war, Dollar started weakening and

2. Various countries started becoming more protectionist

3. Hence, World’s leading 10 countries, produced smithsonian agreement

4. US $ was still defined in terms of Gold and all other currencies in terms of $/gold

5. Band around $/gold was 2.25% on either direction (4.5% total)

6. Band across currencies could be as high as 9%

7. This band was more than permitted under earlier dispensation (1%)

8. Had the flexibility of a floating system while retaining the discipline of fixed rates

Flexible rates – 1973 to now

1. Since 1973, it is the flexible Each rate system that is being practized

2. Variations thereof are being practiced as below

3. Crawling Peg– Infrequent adjustment of IMF par value needed larger devaluation of larger rate– Crawling peg tried to change incrementally by small amounts, continuously– As little as 0.5% pm. To reduce speculative profits vide massive delay– Countries had to maintain ample reserves for prolonged incremental adjustments

4. Wider Band : over and above the 1% band permitted by IMF – Snake in the Tunnel by European countries– Their currencies’ values were fixed to one another with a band of 2.25%– With $, an important currency not in the loop, the system faultered– Under inflationary conditions, the rate slipped faster, hit the floor– Thereafter, had to suffer the consequences of a fixed rate system.

Fixed Vs flexible : An evaluation

Fixed Rates :

– Certainty & rigidity promote Eco efficiency, public confidence and Inflation control– Downsides : Work well in periods of stability. Massive O/F during crises. FM closes

Floating rates

– System causes uncertainty. Promotes speculation instead of trade– Flexi rate system also encourages speculation, once upper band was reached.– However in fixed, bets were one-way with no loss since parity to be restored– Conclusion : Fixed rate system suffered from all that flexible systems had &more

Systems in vogue now :

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

EMU and Euro

A. There are two categories of limited Flexibility

– Gulf countries whose currencies are pegged to the $– Europe countries whose values were arranged around Euro currencies

• Mechanism : Snake in the tunnel• Snake : 1.125% band for EEC countries’ Exch. rates • Tunnel : 2.25% for other countries’ rates

B. EMU

– To form a zone of monetary stability in Europe– To coordinate Exch rate policies vis-à-vis non-EMS currencies– To develop a European Common currency unit (ECU – Euro)– European Monetary cooperation fund (EMCF)

EMU and Euro

C. Exchange rate Mechanism

– Managed thru a Parity grid method– Bilateral rates amongst members– Float allowed around 2.25% of Par– Each ER has Par, max & min rates– Divergence invites action

• Bilateral Resp for ER maint.• Reserves needed to maintain ER• For irretrievable divergence, re

alignment• The responsibility with both

nations - not one as under IMF• EMCF (Com fund) : ST and M/T

cr to member countries &• SGL banker for bilateral

assistance

FF BF SF SK DM DG

FF X 1.0 2.0 3.0 4.0 5.0

BF 1.0 X 1.5 2.5 3.5 4.5

SF 0.5 0.7 X 1.3 2.3 3.3

SK 0.3 0.4 0.8 X 1.8 2.8

DM 0.3 0.3 0.4 0.6 X 1.8

DG 0.2 0.2 0.3 0.4 0.6 X

What is special about international finance?

Foreign exchange risk– Eg. An unexpected devaluation adversely affects our export Mkt.

Political risk– Eg. A Coup that jeopardizes existing negotiated contracts.

Market imperfections– Eg. Trade barriers & Tax incentives affect location of production.

Expanded opportunity sets (Global diversification)– Eg. Raise funds in global markets, gains from economies of scale

Global Flows – Indian policy environment

Labour Goods Capital / Tech

Emigration Immigration Exports Imports I/flows O/flows

Exec Body HRD Min Commerce Ministry Fin Min (FIPB/ SEBI/ RBI)

PolicySupportive Restrictive Supportive

Selectively Restrictive

FDI : Supportive FII : Selective restrictions Restrictive

Restrictions

Emigration laws

Immigration Laws, Resident status IT

Export Ban Export Duties

Quotas Tariffs

FDI : Sectoral caps

FII : Selective Restrictions like PN

Selective permission

World Bank

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

3. Composition• Membership is a function of country’s eco might • G7 have nearly 45% share and voting rights (USA 17%)• Change in Capital base/AOA need 85% votes (USA veto)• All other matters incl loan approvals need simple majority• Exec Board is in Washington DC • By and large Coop in spirit. Voting has been rare.

2. Affiliates • IBRD, IDA

World Bank

4. How Does it assist – Bank uses its Fin resources, Knowledge Base and Network– Emphasizes on

• Social (People) development (Health, Education etc.) and inclusion • Environment protection• Encouraging Private sector Invts/ initiatives• Goading Govt’s towards reform and efficient delivery of public services• Institution building and Governance

5. Affiliates IBRD, IDA

6. Borrowings thru AAA-rated bonds issued in global cap mkts

• To Banks, Pension funds, Insurance cos, other Corporations• Very conservatively managed. No defaults of either IBRD / IDA loans so far

7. Reforms Program• The tougher part of IBRD assistance. Calls for politically harsh decisions• Poor donot suffer. Eg. Conditions include safety nets. L/T-Reforms Help poor• Covenants for Adv countries too : Eg. Efforts to reduce US deficits

IBRD

1. Loans are to Govt for Infra projects generally (multiplier effect)

2. Members : 151

3. Sources : Subscription, Cap mkt borrowings, Retained earnings

4. Focus : Emerging economies

5. Tenors : Longer (15 = 5 +10)

6. Nature of Assistance : Loans / Guarantees for Pvt sector loans

7. Obligations of assisted Governments – Development of Industrial zones that facilitate free trade – Polices that Promote of exports and Forex earnings– Provision of Backward Linkages – Improving institutions that promote trade facilitative zones – Emphasis on Environmental / Women’s empowerment / child labor issues

IDA

1. Aids to Developing countries (LDC’s) for Infra, typically

2. Members : 137

3. Sources : Subscription by Rich members, Retained earnings

4. Focus : Poorer nations amongst LDC’s (Per apita < $ 480)

5. Tenors : Extremely Long ( 50 = 10 + 40)

6. Nature of Assistance : Cheaper Loans

7. Admin : Same staff as IBRD. Focus Countries - different

7. Obligations of assisted Governments – Inclusive growth– Emphasis on Environmental / Women’s empowerment / child labor issues – Conditionalities (Structural )

IFC

1. Target :Private sector in developing countries

2. Members : 133

3. Sources : Member subscription, Retained earnings

4. Tenors : Long ( 15 = 5 + 10)

5. Nature of Assistance• Providing Risk capital to Tgts : Equity and LT loans• Encouraging local Cap mkts : Eg U/writing• Providing Tech and Fin assistance

6. Assistance covers a spectrum of industries

IMF

1. Commences operations in 1947

2. Membership is 182 countries (Initial m/ship 39)

3. Total Member quotas - $ 300 Billion (Member shares are a constant)

4. Participation voluntary

5. Currency unit - SDR ( = $ 1.3703)

6. Members came together to enjoy adv of a stable system of exch rates

7. Lends to Support Exch rate stabilization, s/to members u/taking Structural adj

8. Has withstood the test of time & facilitated increased Vol of Global Trade/Invt

IMF

1. Roles – Exchange rate stability, Global trade promotion, Payment facilitation

2. Activity– ER Surveillance (Bilateral and multilateral), Tech assistance, Fin assistance

3. Nature of Fin assistance 3 major ones – A. Standby Arrangements

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

– B. Extended Arrangements• For Medium Term Structural BOP problems• Purchase based support. Repurchase max 10 yrs

– C. Structural Adjustment facility • Loans not purchases for typically LDC’s. Drawals semi annual• Designed to address L/T structural imbalances in BOP situation• Easier terms. 0.5% Intt. 10 yr Tenor. 1st Semi-annual repayment – 5.5 yrs

Global financial Institutions

Sl no Particulars IBRD IDA IFC

1 Purpose

To Help war ravaged economies thru Tech

and Fin help

Same as for IBRD (Aid instead

of loan)

To promote eco dev in Developing nations by

assisting pvt sector

2 Target Customers

Govt / Govt agencies / Pvt sector that can get a

Govt guarantee Governments

Pvt sector / Govt organizations that

help Pvt enterprises

3 Nature of Assistance Loan Concessional Aid Loan

4 Type of countriesAll Developing other than

the Poorest Poor countires

All developing countries from the poorest to the more advanced

5 Tenor 15 - 20 yrs 50 yrs 7 - 12 yrs

6 Grace period 3 - 5 yrs 10 yrs 3 yrs

7 Pricing @ 10% 0% Mkt linked

8 Govt Guarantee Yes Yes No

9Method of raising

FinanceBorrowings, Capital

MarketsGrants from world

Govt's

Borrowings and Capital, subscribed by

members

Asian Development Bank

1. Strategic Objectives • Assist Small and less developed countries of the region• Economic Growth across sectors• Poverty reduction• Human development• Gender Development • Environmental Development

2. Composition• Membership open to Countries in the Asia Pacific Region• Two largest share holders – US and Japan with 16% each

3. Evaluations• Country and project evaluation• Project effectiveness (Viability, Impact, implementability, sustainability)• operational evaluation (project completion evaluation etc)

Asian Development Bank

4. How Does it assist – Financing

• Multi /Single currency loans and Market based loans to pvt sector– Co financing and – Guarantees to Govt’s or Private sector borrowers– Also uses its technical Knowledge Base and Network

5. Finance sources• Ordinary Capital resource from members, Reserves and Mkt borrowings

6. Reforms Program• The tougher part of ADB assistance. Calls for politically harsh decisions• Poor donot suffer. Eg. Conditions include safety nets. L/T-Reforms Help poor• Covenants for Adv countries too :

Balance of Payment Accounting

Parity Conditions

and


CHAPTER OVERVIEW

I. ARBITRAGE AND THE LAW OF ONE PRICE

II. PURCHASING POWER PARITY

III. THE FISHER EFFECT

IV. THE INTERNATIONAL FISHER EFFECT

V. INTEREST RATE PARITY THEORY VI.

VI. THE R/SHIP BETWEEN FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

PART I. ARBITRAGE AND THE LAW OF ONE PRICE

I. THE LAW OF ONE PRICE

A. Law states:

- Identical goods sell for the same price worldwide.

B. Theoretical basis:

- If the price after exchange-rate adjustment were not equal,

- Arbitrage in the goods worldwide ensures it will, eventually


C. 5 Parity Conditions Result From these Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. Relative Purchasing Power Parity

3. International Fisher Effect (IFE)

4. Interest Rate Parity (IRP)


Five Parity Conditions Linked by ;

1.The adjustment of various rates and prices to inflation.

2. Notion that money should have no effect on real variables

(since they are adjusted for price changes).

3. The Law of one price enforced by international arbitrage.


Inflation & home currency depreciation :

1. jointly determined by Gr of domestic money Supply;

2. Relative to the growth of domestic money demand.

PART II. PURCHASING POWER PARITY

I. THE THEORY OF PURCHASING POWER PARITY:

States that spot Exch rates between currencies will change

based on differential in inflation rates between countries.


II. Absolute PPP

A. Price levels adjusted for Exch rates should be

equal between countries

B. One unit of currency has same Purchasing Power globally.

Purchasing Power Parity – absolute & Relative

Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 10,000 2 200


Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220


Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220


Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440


Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440



Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440




Items Vol

20.0% 10.0%

2008 2009 2008 2009 2008 2009 2008 2009

Burger 100 100 120 10,000 12,000 2 2.2 200 220

Lee Jeans 10 1,000 1,200 10,000 12,000 20 22.0 200 220

Total 20,000 24,000 400 440



Exch rate by Formula (Infl Diff – Rel) 1.20/1.10 1.091 45.00 49.09

Limitations

1. Tariffs, Quotas, Transportation costs, Other trade barriers

2. Non-traded goods & Services (like Beautician’s) excluded


III. Relative PPP

States that the exchange rate of one currency agt. another

will adjust to reflect Ch in Price levels of the two countries.


If purchasing power parity is Expd to hold, then

The best prediction for the one-period Spot rate should be

tf

th

ti

iee

1

10


A more simplified but less precise relationship is

The % change should be approximately equal to

- The Inflation rate differential (in decimals not %).

fht ii

e

e 1

0


A. Real exchange rates

If exchange rates adjust to Inflation differential, then ;

PPP states that real exchange rates stay the same.

B. If Real exchange rates unchanged,

- Competitive positions of Domestic & foreign firms are unaffected.

III. The Fisher Effect (FE)

I. THE FISHER EFFECT states that

- Nominal interest rates (r) are a function of

- Real Interest rate (a) and

- A Premium (i) for inflation expectations.

r = a + i

THE FISHER EFFECT

B. Real Rates of Interest

1. Should tend toward equality everywhere thru arbitrage.

2. With no Govt interference, nominal rates vary by Infl. Diff

rh - rf = ih - if

3. According to the FE, - Countries with higher inflation rates have higher interest rates.

D. Due to capital market Integration globally,

- Interest rate differentials are eroding.


IFE = PPP + FE


1)1(

)1(

0

0

tf

tht

r

r

e

ee


–3– 2 –1 0 1 2 3

Inte

rest

diff

eren

tial i

n fa

vour

of F

orei

gn C

urre

ncy

in %

pa

3

2

1

0

–1

–2

–3

Arbitrageinflow

Interestparity

Arbitrageoutflow

•B

A•

•A’

B’•

Forward exchange rate - Discount or Premium in % pa

Arbitrage outflow



Arbitrage inflow




01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8


Yield % 13.87%

01-Jan-09 Spot DM 22.50

Fwd 1 year 23.25


Intt Rate DM 10.20%



Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8


Yield % 13.87%

Return if Invested in INR 11.00% 1,11,000.0


IFE = PPP + FE


1

1

0

1

)1(

)1(

f

h

r

r

e

e

Exchange Rate : Determination

(100,000/22.5)*(1+0.102)* 23.25 = 100,000 *(1+0.11)

(A/E0) * (1+Rf) * E1 = A * (1+Rh)

A * (1 + Rf) * (E1/E0) = A * (1+Rh)

(1 + Rf) * (E1/E0) = (1+Rh)

(E1/E0) = (1+ Rh) / (1+Rf)

140


IFE = PPP + FE


tf

tht

r

r

e

e

)1(

)1(

0


Covered Interest Arbitrage

Conditions required:

i. Interest rate differential does not equal the forward premium or discount.

ii. Funds will move to a country with a more attractive overall yield.


Market pressures develop:

a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates.

c. Parity eventually reached.

Summary: Interest Rate Parity states :

1. Higher intt rates on a currency offset by Forward Discount

2. Lower interest rates are offset by forward premiums

IFE

Implications of IFE

- Currency with lower Intt rate is Expd to appreciate ;

- Proportionately

- Relative to one with a higher rate.

- Due to Arbitrage

International Fisher Effect

Simplified IFE equation: (if rf is relatively small)

1 0

0h f

e er r

e

Equilibrium Exchange Rate Relationships

0

01

E

) - E(E

E(e)

)-i(i Rs$

$ - Rs

PPP

FE FRPPP

IFE

Determination of Exchange Rates & BOP

Lecture Objectives

Determination of Exchange Rates


Introduction to Balance of Payments

Balance of Payments Accounting

BOP & Exchange Rates

Determination of Exchange Rates

– PPP is the oldest and most widely followed of ER theories.

– Most ER theories have PPP elements embedded in them

– PPP forecasts are plagued with • structural differences across countries and • significant data challenges in estimation.

Parity Conditions Approach

BOP approach is the 2nd most utilized theoretical approach in ER

– The basic approach : Equilibrium ER is found when currency flows match up current and financial account activities.

– This framework has wide appeal as BOP transaction data is readily available and widely reported.

– Critics may argue that this theory does not take into account stocks of money or financial assets.

Balance of Payments Approach

Argues that ER determined by Supply of and demand for a wide variety of financial assets:

– Shifts in the supply and demand for financial assets alter ER

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

Asset Market Approach

approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others):

– Relative real interest rates

– Prospects for economic growth

– Capital market liquidity

– A country’s economic and social infrastructure

– Political safety

– Corporate governance practices

– Contagion (spread of a crisis within a region)

– Speculation

Asset Market Approach

Equilibrium Exchange Rate

Qty

45

S

INR/$D

Equilibrium

Reality check : What Changes the Equilibrium Rate (Empirically) ?

Inflation rates: Higher domestic inflation means less demand for local goods

(decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Interest rates: Higher domestic (real) interest rates attract investment funds

causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

Economic growth: Stronger economic growth attracts investment funds causing a

decrease in demand for foreign currency and an increase in supply of foreign currency.

Reality Check :What Changes the Equilibrium Rate?

Political & economic risk: Higher political or economic risk in the domestic country results

in increased demand and reduced supply of foreign currency.

Changes in future expectations: Any improvement in future expectations regarding the domestic

currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention: Maintain weak currency to improve export competitiveness.

Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.

Some multinational firms have their own in-house forecasting capabilities.

Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

Forecasting in Practice

Technical Approach

Tech. analysis looks for patterns in the past behavior of ER.

It is based upon the premise that history repeats itself.

Thus it is at odds with the Efficient Mkt Hypothesis

Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future.

The single most important element of technical analysis is that future exchange rates are based on the current exchange rate.

Exchange rate movements can be subdivided into three periods:

– Day-to-day

– Short-term (several days to several months)

– Long-term


The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be.

Forecasting for L/T must depend on the Eco fundamentals of ER determination,

Many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.



Currency Forecasting Project

For each currency you can do the following:

RPPP and IFE (long-term influences)

Technical analysis (past trends)

Asset market approach (ongoing relationships and changes?)

Balance of payments approach

Then you conclude with your overall prediction based on all of these methods and allocate funds to your trading strategy.

Performance of the Forecasters

Forecasting is difficult, especially with regard to the future.

As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.

The founder of Forbes Magazine once said: “You can make more money selling advice than following it.”

Balance of Payments

BOP is a comprehensive record of all eco transactions between residents of a country With the Rest of the World (ROW) Of a given period of time

BOP is a Statistical record of the flow of all Eco transactions

In goods , services, Incomes & C/flows (and ∆ ch in SDR,Forex Reserves & monetary Gold as well)

Between the residents of a country and the rest of the world in a given year.

Resident : eco entities that have a closer association with a given territory than another wrt their given eco activity

Balance of Payments

Sl/ No Particulars Details Inflow O/flow Net

1Export of Goods 807.6

2Import of civilian goods 1473.1

3Export of Services 339.6

4Import of Services 291.2

5Income Paymens 344.9

6Income Receipts 369.0

7Net Unilateral transfer O/flow 72.9

8Net Current Account

9Indian Pvt invt overseas 821.8

10Foreign Pvt Invts in India 1077.9

11Foreign Official lending to India 355.3

12Indian Official lending abroad (1.5)

13Statstical discrepency (+) 51.9

14Net Capital A/c

15Deficit Till now

16Actual (deficit) /Surplus

17Official Reserve Incr / (decr) 166


1Export of Goods 807.6 807.6

2Import of civilian goods 1473.1 1473.1

3Export of Services 339.6

4Import of Services 291.2










14Net Capital A/c

15Deficit Till now






3Export of Services 339.6 339.6

4Import of Services 291.2 291.2










14Net Capital A/c

15Deficit Till now








5Income Paymens 344.9 344.9

6Income Receipts 369.0 369.0








14Net Capital A/c

15Deficit Till now










7Net Unilateral transfer O/flow 72.9 72.9

8Net Current Account 1516.2 2182.1 (665.9)






14Net Capital A/c

15Deficit Till now












9Indian Pvt invt overseas 821.8 821.8

10Foreign Pvt Invts in India 1077.9 1077.9




14Net Capital A/c

15Deficit Till now














11Foreign Official lending to India 355.3 355.3

12Indian Official lending abroad (1.5) (1.5)


14Net Capital A/c

15Deficit Till now
















13Statstical discrepency (+) 51.9 51.9

14Net Capital A/c 1485.1 820.5 664.6

15Deficit Till now

















14Net Capital A/c 1485.1 820.5 664.6

15Deficit Till now (1.3)

















14Net Capital A/c 1485.1 820.5 664.6


16Actual (deficit) /Surplus 1.5
















14Net Capital A/c 1485.1 820.5 664.6


16Actual (deficit) /Surplus 1.5

17Official Reserve Incr / (decr) (2.8)176

A surplus in the BOP implies that The demand for the country’s currency exceeded the supply and the Govt should allow the currency value to increase or Intervene & accumulate additional Forex reserves in the Official

Reserves Account.

A deficit in the BOP implies An excess supply of the country’s currency on world markets & The Govt should then either devalue the currency or Expend its official reserves to support its value.

BOP in Total

Accounting Principles

1. Any transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit and is given a negative sign.

2. Any transaction resulting in a receipt from foreigners is entered as a credit and given a positive sign.

3. Current Account records transactions involving exports and imports of goods and services

4. Capital Account records transactions involving the purchase and sale of assets.

5. Double-Entry book keeping: Every international transaction automatically enters twice, once as a credit and once as a debit.

Examples of Transactions

Credit Transactions (+ve): Provision of goods and services to non-residents Income receivable from non-residents A decrease in foreign financial assets An increase in foreign financial liabilities

Debit Transactions (-ve): Purchase of goods & services from non-residents Income payable to non-residents An increase in foreign financial assets A decrease in foreign financial liabilities

Examples of Transactions

An Australian Co exports goods worth US$1 million to the US : Export of goods is credit for the current account. Increase in foreign asset (US$1 million) is debit for capital

account.

Australian company then coverts US$ into A$ and buys government bonds back in Australia: Decrease in foreign asset is credit for the capital account. Increase in government liability is debit for Official Res a/c

Australian individual imports a sports car from Europe: Increase in foreign liabilities is credit for the Capital a/c Import of goods is debit for current account.

A nation’s balance of payments interacts with nearly all of its key macroeconomic variables.

Interacts means that the BOP affects and is affected by such key macroeconomic factors as:– Gross Domestic Product (GDP)– Exchange rate– Interest rates– Inflation rates

BOP & Macroeconomic Variables

A country’s BOP can have a significant impact on the level of its exchange rate and vice versa.

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes the BOP (see next slide).


(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:

X = exports of goods /servicesM = imports of goods /services

CI = capital inflowsCO = capital outflows

FI = financial inflowsFO = financial outflowsFXB = official monetary reserves

Current Account Balance

Capital Account Balance

Financial Account Balance


Fixed Exchange Rate Countries– Under a fixed exchange rate system, – The government bears the responsibility – To ensure that the BOP is near zero.

Floating Exchange Rate Countries– Under a floating exchange rate system,– Surpluses/deficits influence exchange rate.


A country’s import and export of goods and services is affected by changes in exchange rates.

The transmission mechanism is in principle quite simple: Changes in exchange rates change relative prices of

imports and exports, And changing prices in turn result in changes in

quantities demanded Through the price elasticity of demand.

Theoretically, this is straightforward, in reality global business is more complex.

Trade Balances & Exchange Rates

Trade Balances & Exchange Rates

Balance of Payments

Resident : Eco entities that have a closer association with a given

territory than another wrt their given eco activity With a degree of Permanance to their stay IT act – 180 days

Individuals : Residential status as per IT/similar acts Pvt corp : Residence per IT/similar act (>180 days /yr) Pvt Non profit : The territory where they are functioning Govt : All govt establishments on the native

land & All Embassies, Counsulates, military or other

Establishment of native govt. on foreign soil

Foreign embassies on Indian soil – Non-Res.

Balance of Payments

Transactions are recorded on the basis of Double Entry Bookkeeping –

by definition it has to balance. Every “source” must have a “use” and every debit a Credit

The two main components are: Current Account Capital/Financial Account

Economic Transactions– Two Parties needed– Exchange of Goods and services for Value (moneys worth)– Exceptions

• Transactions between Br and Ho• Transfers of assets by migrants to new country• Such one sided, non quid pro quo transactions are called “

unrequited Transfers “

Transactions need be between Residents and Non residents– Exception Purchase/Sale of Gold by Central Bank from/to

Residents (both are resident)– Claims on / Liabilities to ROW even if between 2 residents – Sale of forex by Com. bank to central bank/ Vice versa

Valuation uniformity

– Cr & Dr items to balance– Comparison across the world not possible w/out– Comparison across items not possible otherwise– IMF recommends “ Market Prices” for uniformity– Exceptions to market price as the basis

• Issue of Sweat equity• Branch and HO transactions• Exports undervalued & Imports overvalued (money laundering)• Exports are valued @ FOB and Imports @ CIF• Forex conversion rates (Average, Spot Yr end?)

– Timing issue• To avoid discrepencies in BOP a/cs• The time is when the legal ownership in goods/ services passes• Exports : When the goods are cleared by customs for shipment• Imports : On making the payment• Advance: counted as imports • Transport and other services : when paid for/ recd• Unrequited: When the offset transaction happened• Capex : When the flows happen

Special Transactions – SDR allocation Debit & Item allocation Cr or NW incr.– SDR Reduction Cr & Item allocation Debit or NW Decr.

– Gold is both a commodity and a Financial Asset– Central bank’s Purchase of Gold converts a commodity into

Cash (Monetization of Gold)– Central banks sale of Gold reduces money Supply and

increases (Gold) Commodity holding - Demonetization

– Unrequited Transfers• Covers Grants, Gifts, transfers, taxes, Migrant trfr• One side provides Eco Value w/out any quid pro quo• One side of the entry is the utem recd the other side is

‘transfers’ in India. “ Unrequited trfr” in ROW

Undistributed Income attributable to Direct Investors– Retained earnings– Both a current a/c outflow and– A Capital a/c inflow simulatneously

Balance of Payments

Current Account (CA)

This is record of a country’s trade in goods and services in the current period.

CA = Exports (X) – Imports (M)

It is divided into 4 sub-categories: Goods trade Services trade Income Current transfers

The sum of the four sub-categories = CA balance

Capital Account (KA)

This includes all short- and long-term transactions pertaining to financial assets.

KA = Capital Inflow (cr) – Capital outflow (dr)

The two main components: Capital account. Financial account (direct, portfolio, other).

KA balance = Sum of capital account and financial account.

Official Reserves

Records the purchase or sale of official reserve assets by the central bank. These assets include

Commercial paper, Treasury bills and bonds Foreign currency Money deposited with the IMF

This account shows the change in foreign exchange reserves held by the central bank.

Since the BOP must balance

CA + KA + RFX = 0

CA + KA = – RFX

The Balance of Payments Identity

For floating rate regime countries, such as the U.S., official reserves are relatively unimportant.

Statistical Discrepancy (E&O)

The identity CA + KA = – RFX assumes that all transactions are measured accurately.

Inaccurate recording of transactions (errors & omissions), results in the above equality not holding. For BOP to balance,

CA + KA + E&O = – RFX

Assuming changes in official reserves, errors are approximately zero:

Current Account = (–) Capital Account

This will hold approximately for floating rate countries

CA ≈ -KA ( US $)

NoTransaction Normal A/ctng BOP A/ctng

Books of country 'A'

Debit Credit

1Res Exports worth

$ 1,000 agt Bills

2Exporter

discounts bill with Res Bank

3

On due Date, Bank gets funds From Citi NY and keeps funds therein. Int $ 50

4

A Imports of $ 800 from B. Paid thru loan from A’s Bank



Debit Credit

1Res Exports worth

$ 1,000 agt Bills

B/ Recbl Dr 1,000

Sales - exports Cr 1,000

2Exporter


3


4




Debit Credit

1Res Exports worth

$ 1,000 agt Bills

B/ Recbl Dr 1,000 S/T foreign

Assets- BR1,000

Sales - exports Cr 1,000 Export 1,000

2Exporter


3


4




Debit Credit

1Res Exports worth

$ 1,000 agt Bills


Assets- BR1,000


2Exporter


Cash Dr 1,000

B/ Recbl Cr 1,000

3


4




Debit Credit

1Res Exports worth

$ 1,000 agt Bills


Assets- BR1,000


2Exporter


Cash Dr 1,000

B/ Recbl Cr 1,000

3


Cash Dr 50 S/T Forn Asst

(Cash)1,050

ST Foreign Asset (BR)

1,000

Intt Income Cr 50 Interest

Income 50

4




Debit Credit

1Res Exports worth

$ 1,000 agt Bills


Assets- BR1,000


2Exporter


Cash Dr 1,000

B/ Recbl Cr 1,000

3



(Cash)1,050


1,000


Income 50

4


Imports Dr 800 Imports 800

A Bank loan Cr 800 ST Foreign

Asset 800



Debit Credit

1Res Exports worth

$ 1,000 agt Bills


Assets- BR1,000

Sales - exports Cr

1,000 Export 1,000

2Exporter discounts

bill with Res Bank

Cash Dr 1,000

B/ Recbl Cr 1,000

3

On due Date, Bank gets funds From ‘B’ bank & keeps funds therein. Intt $ 50


(Cash)1,050


1,000


Income 50

4


Imports Dr 800 Imports 800

A Bank loan Cr 800 ST Foreign

Asset 800

No

TransactionNormal

A/ctng BOP A/ctngBooks of country

'A'

Debit Credit

5

Res (x) spends $ 5000 during foreign

travel, by buying equivalent B’s currency in ‘B’

6X finds $ 100 by

chance on the Road

7Expat sends $ 100 to

his family in ‘B’ The Family buys a $ bond from ‘A’

No

TransactionNormal


'A'

Debit Credit

5



Travel Dr 5,000 Travel 5,000

Cash Cr 5,000 ST Foreign

Liab 5,000

6X finds $ 100 by

chance on the Road



No

TransactionNormal


'A'

Debit Credit

5





Liab 5,000

6X finds $ 100 by

chance on the Road

Cash Dr 100 ST foreign

assets100

Misc Income

100 Transfers 100



No

TransactionNormal


'A'

Debit Credit

5





Liab 5,000

6X finds $ 100 by

chance on the Road

Cash Dr 100 ST foreign

assets100

Misc Income

100 Transfers 100



Trfr Dr 100 Transfers 100

Bond Cr 100 LT Forn Liab 100

Sl No Transaction Normal A/ctng BOP A/ctng Books of country 'A'

8Biz man ships Eqpt

abroad to build factory $ 50,000

9 Addl Invt of $ 20,000 paid thru bonds

10Y makes a profit of

$ 10,000 and uses it to Buy Back B’s bonds

11

A buys B's bonds back (50%)


8Biz man ships Eqpt


F Assets Dr 50,000 LT Investments 50,000

Sales - exports

50,000 Exports 50,000




11



8Biz man ships Eqpt



Sales - exports

50,000 Exports 50,000



Bonds payable

20,000 LT foreign Liabilities

20,000



11



8Biz man ships Eqpt



Sales - exports

50,000 Exports 50,000



Bonds payable

20,000 LT foreign Liabilities

20,000



Bonds Dr 10,000 LT Foreign liab 10,000

Cash 10,000 ST Liabilities 10,000

11


Sl No Transaction Normal A/ctng BOP A/ctngBooks of country 'A'

12

Z from B migrates to country A with Property worth $ 9000

13

Of the above, house worth $ 8,000 sold for 8000

(4000 now : 4000 Defd)

14

Gives $ 1000 back to the church


12


ST For Assets 1,000

Assets 9,000 LT Investments 8,000

Misc receipts (trfr)

9,000 Transfers 9,000

13


(4000 now : 4000 Defd)

14



12


ST For Assets 1,000




13


(4000 now : 4000 Defd)

Cash 4,000 ST Foreign

Assets4,000

A/Recbls 4,000 LT foreign

Assets4,000

F Assets 8,000 LT Investments 8,000

14



12


ST For Assets 1,000




13


(4000 now : 4000 Defd)


Assets4,000

A/Recbls 4,000 LT foreign

Assets4,000


14


Gift Expense 1,000 Trfr Exps 1,000


assets 1,000

,.


15Gold imports

into 'A' - $ 300000

16

Migrant inherits wealth of $

3,000

17 Gift of dress worth $ 200

sent to A

,.


15Gold imports

into 'A' - $ 300000

Gold 200,000

Imports 300,000 Imports 100,000

Bank (Deposit)

300,000 ST Liab to forn 300,000

16


3,000


sent to A

,.


15Gold imports

into 'A' - $ 300000

Gold 200,000


Bank (Deposit)

300,000 ST Liab to forn 300,000

16


3,000


Bank 1,000 ST Foreign Fin

assets1,000

Misc Income Transfers 3,000


sent to A

,.


15Gold imports

into 'A' - $ 300000

Gold 200,000


Bank (Deposit)

300,000 ST Liab to forn 300,000

16


3,000


Bank 1,000 ST Foreign Fin

assets1,000

Misc Income Transfers 3,000


sent to A

Gift Exps 200 Transfer gift 200

Exports 200 Export 200

,.

Sl No Transaction Normal A/ctng BOP A/ctng


18

Farm sold for $ 2000. This +

1000 invested in Bonds in 'B'

19Gift to 'B' $ 600 in

A's currency

,.



18



Bonds Dr 3,000 ST FA 2,000

Assets Cr 2,000 LT Invst 2,000

Bank Cr 1,000

LT FA 3,000

STFA 3,000

19Gift to 'B' $ 600 in

A's currency

,.



18



Bonds Dr 3,000 LT FA 3,000

Assets Cr 2,000 LT Invst 2,000

Bank Cr 1,000 STFA 1,000

19 Gift ($600) to 'B' - $ 100 note + $ 500

of watch

Gift Exp Dr 600 Transfers 600

Cash Cr 100 ST Fin Liab. 100

Sales Cr 500 Exports 500

ST Foreign Assets Exports

Exports (1) 1,000 ST Fin Asst

(1)1,000

Imports

ST Foreign Assets Exports

Exports (1) 1,000 ST Fin Asst

(1)1,000

Interest Income (3)

50 Trfr (14) 1,000

LT Invt (8) 50,000

Trfrs (6) 100 Trfrs (17) 200

ST For Ass (19)

500

LT FA (18 a) 3,000 Bal 51,700 51,700

LT Invt (13) 4,000

Transfers (12) 1,000 Imports (4) 800 Imports

Transfer (19) 0

LT Invst (18) 2,000

Trfr (16)1,000

ST For Assets

(4)800

9,150 4,800 ST For Liab

(15) 100,000

100,800 Bal 100,800

LT Foreign Assets Trfrs

LT Invt (13) 4,000

ST For Ass (14) 1,000

ST FA (18 a) 3,000 Exports (17) 200 STF Asset

(6) 100

7,000 0

LT Forn Liab (7) 100

Gold ST FA + Exp (19) 600

ST + LT Invts

(12)9,000

ST For Liab (15) 200,000

LT Inv / ST As (16)

3,000

200,000 0 ST For Ass

(19)0

LT Direct Investment 1,900 12,100

Exports (8) 50,000 Services

LT For Liab (9)

20,000 ST/LTF

Asset (13) 8,000

ST Forn Liab (5) 5,000

ST Foreign (3)

50

Transfers (12)

8,000 ST FA (18) 2,000 5,000 50

Transfers (16) 2,000

80,000 10,000

LT Liabilities

ST forn Liab (11)

10,000 LT Dir Invt (9) 20,000

Transfers (7) 100 Cash

Notes Recbl

(2)1,000

10,000 20,100

ST Liabilities

Travel (5) 5,000 Notes Receivable

Imports (15)

100,000 Cash (2) 1,000

Gold (15)

200,000

LT Forn Liab (11) 10,000

Exp + Trfr

(19) 100

0 315,100 1,000 1,000

BOP A/cs

Debit Credit

Exports 51,700

Imports 100,800

Net Trfs 10,200

Services 4,950

Cur Ac Balance 105,750 61,900 43,850

LT FA 7,000

LT Dir Invs 70,000

LT For Liab 10,100

LT Cap ac 77,000 10,100 66,900

ST For Liab 315,100

Gold 200,000

ST Fin Assets 4,350

ST Cap Ac 204,350 315,100 (110,750)

Net Fin flows 0

Current AC Inflow Outflow

Exports Merchandize Inflow

Services Inflow

Factor Income Inflow

Import Merchandize Outflow

Services Outflow

Factor Income Outflow

Nett Unilateral

Trfr

Pvt Trfr Recevie Give

Official Trfr Recevie Give

Balance on Cur

Ac

Capital Ac

Receive Payment from Foreigner, Sell Foreign Assets / Domestic Assets to foreigners

Net Direct Investment Make Payment to foreigners, Buy Foreign Assets/

Dom Assets from foreigners

Portfolio Investment

Other Capital

Balance on Cap Ac

Statistical Discrepency

Overall balance

Official reserve Ac

Indian official Reserve - Balance + Balance

Foreign Official Reserve - Balance + Balance

Balance of Reserve - Balance + Balance

India vs ROW ($ = 50 Rs)

1. X an Indian exports Rs 50,000 of merchandise to US against BOE.

2. Y an Indian imports Rs 75,000 of merchandise from US against payment

3.An NRI sends $ 3,000 to his parents in India. Parents invest it in 2 yr FD

4. An Indian Sends Rs 5,000 worth of jewellery as gifts to his daughter in US

5. A US Auto co sends Cap eqpt worth $ 30,000 to India

Exchange Arithmetic

234

Forex

1. Retail Vs Wholesale Mkt• Individual and Bank

– Small volumes and High margins

• Banks, Invt Inst, NB Corp and Central banks– Large Volumes (Avg size $ 4 mn) & small margins

2. Primary Vs Secondary Price makers– Primary : 2-way quote– Secondary : 1 way quote : restaurants, hotels, export shops

3. Spot Vs Forward markets

4. Direct Vs Indirect Quotes• One unit of Forex = How many units of Rs• One unit of Rs = How many units of Forex

235

Forex

236

You have called your Bank's forex trader and asked for quotations on US $ vis-à-vis INR

and received the same as below for Spot, 1-mth fwd, 3-mth fwd, 6-Mth forward

$ 2.479/81 " 3/5 " 8/7 " 13/10

a. What does it mean in terms of Dollar per INR

b. If you wished to buy spot dollars, how much would you pay in INR

c. What is the percent discount /Premium on Dollars

237



$ 2.479/81 " 3/5 " 8/7 " 13/10




Forex dealer ready to Exchange Rs 100

Buy Rs @ Sell Rs @ Sell $ @ Buy $ @

Spot $ 2.479 $ 2.481

238



$ 2.479/81 " 3/5 " 8/7 " 13/10




Forex dealer ready to


Spot $ 2.479 $ 2.481 40.339 40.306

239



$ 2.479/81 " 3/5 " 8/7 " 13/10



c. What is the percent discount /Premium on Belgian francs Vs Dollars



Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 $ 2.482

240



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 $ 2.482 $ 2.486

241



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 40.290 40.225

242



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

243



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474

244



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474 40.469 40.420

245



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474 -1.29% -1.13% 40.469 40.420

246



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474 -1.29% -1.13% 40.469 40.420

Six month 6 2.466 2.471 40.552 40.469

247



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474 -1.29% -1.13% 40.469 40.420

Six month 6 2.466 2.471 -1.05% -0.81% 40.552 40.469

248



$ 2.479/81 " 3/5 " 8/7 " 13/10






Spot $ 2.479 $ 2.481 40.339 40.306

One month 1 2.482 2.486 1.45% 2.42% 40.290 40.225

Three Month 3 2.471 2.474 -1.29% -1.13% 40.469 40.420

Six month 6 2.466 2.471 -1.05% -0.81% 40.552 40.469

249

250

Customer asks you to book a forward contract in DM 400,000 6 mts hence

TT Margin 0.1500% Bill Margin 0.200%

D M quotes in Singapore as below

Spot US 1 $ = DMs 1.5840 1.5850

3 mth forward ($ at Disc) 0.0300 0.0290

6 mth ($ @ disc) 0.0585 0.0575

Us $ quoted in interbank market as below

Spot US 1 $ = Rs 31.8500 31.9000

3 mth forward premium 32.4500 32.5000

6 mth premium 33.2000 33.2500

6 Mth. forward Re / $ rate 33.2500


6 Mth. Forward DM /$ Rate

Spot 1.5840



Spot 1.5840

6 mth forward Prem. 0.0585

6 mth forward Rate 1.5255



Spot 1.5840



Cross Rate DM / Rs 21.7961



Spot 1.5840




Add Exch margin for TT Selling 0.15% 0.0327

TT Selling Rate 21.8288



Spot 1.5840




Add Exch margin for TT Selling 0.15% 0.0327

TT Selling Rate 21.8288

ADD Exch Margin for Bill selling 0.20% 0.0437

Bill selling Rate 21.8725

Customer does a swap of Selling Spot and Buying 2 mth forward $ 100,000

US $ quoted @ 31.19 31.22

2 Mths Froward $ quoted @ 0.27 0.27

Forward Rate 31.46 31.49

Inerest Mumbai / US 12.00% 6.00%

Brokerage (flat) / No of Mths 0.0075% 2

Selling $ spot @ 31.19 3,119,000

Less Brokerage 3119*7.5%*2/12 234

Selling $ spot 3,118,766


Less Brokerage 234


Interest earned in Rs 62,375

Cumulative INR recd 3,181,141


Less Brokerage 234





Less Brokerage 234




Reversion to $ 101,021

Less Brokerage 8

Nett Recd on reversion 101,013


Less Brokerage 234





Less Brokerage 8


Intt Cost on $ 1,000

Cos Paid 101,000

Profit (Loss) on Swap 13


Less Brokerage 234





Less Brokerage 8


Intt Cost on $ 1,000

Cos Paid 101,000

Profit (Loss) on Swap 13

Bank Agrees to sell on 20 th Feb for 20th Apr delivery Sing $ 10,000

Agreed rate 19.52

Cover Deal 19.47

20th Mar, Customer wants sale to be advanced

Rates on 20th Mar for 20th April

Spot 19.71 19.76

Forward 1 mth 19.65 19.70

Sell amount 195,200.00

Buy amount 194,700.00

Nett Margin 500.00



Nett Margin 500.00

Pre Closure Deal

Buy 20th Mar spot and Sell forward 20th Apr

20th Mar deals net cost

Buy spot 10,000 Sing $ 197,600.00

Sell forward Sing $ Apr 20 196,500.00

Nett Loss debited to customer (1,100.00)



Nett Margin 500.00

Pre Closure Deal



Buy spot 10,000 Sing $ 197,600.00



Transaction cost debited

Total Debit to Customer Ledger

Original contract 195,200.0

Swap loss 1,100.0

Transaction Fee 100.0

Total Debit 196,400.0



Nett Margin 500.00

Pre Closure Deal



Buy spot 10,000 Sing $ 197,600.00



Transaction cost debited

Total Debit to Customer Ledger

Original contract 195,200.0

Swap loss 1,100.0

Transaction Fee 100.0

Total Debit 196,400.0

Derivatives

1. Value is derived from another underlying contract, reference or index

2. Recent developments have transformed them into a cheap & efficient means of– Hedging : Neutralizes risk by fixing the price in Adv. For eg. Price of $ = 47 Rs on 1.Dec 09– Arbitraging : Take adv of discrepancy in prices across markets. – Speculating : Take a directional bet. Thus contribute liquidity

3. Arrival of Floating Intt rate regime post ‘73, heralded the need for Risk mitigation mechanisms

4. Led to the development of Exchange traded Forex futures in Chicago

5. Computers expedited growth, since fast computing of complex derivative pricing became feasible

6. Three risks • Market : The Value of derivative changing, esp as expiry

approaches• Basis : Hedge may not be a perfect match to the Risk one is

exposed to• Counter Party risk : CP not paying up. Less than for Loans, for only diff is at stake

7. 4 products– Forwards : Two-way negotiated agreement. OTC. Gen, when Exact date unknown– Futures : Exchange traded. Standard Contracts wrt Price, settlement date, contracts no. – Options : Right but not obligation to buy/sale. Option to Buy - call. Option to sell - Put– Swaps : 2-way Contr. to exchange 2 streams of payment for a period. Fix to float

Derivatives

1. Value is derived from another underlying contract, ref or index– Correlation may be positive or negative– Derivatives are possible only if two contrary views are likely

2. Recent developments have transformed them into a cheap & efficient means of – Hedging : Neutralizes risk by fixing the price in Adv.

• For eg. Price of $ = 47.10 Rs on 1.Jan 2010– Arbitraging : Take adv of discrepancy in prices across Mkts. – Speculating : Take a directional bet. Thus contribute liquidity

3. Arrival of Floating Intt rate regime post ’73– heralded the need for Risk mitigation mechanisms

4. Led to the development of Exch.-Traded Forex futures in Chicago

Derivatives

5. Computers expedited growth,– since fast computing of complex derivative pricing became feasible

6. Three risks • Mkt : The Value of derivative changing, esp as expiry approaches• Basis : Hedge may not be a perfect match to the Risk exposure• Counter Party risk :

– CP not paying up. Less than for Loans, for only diff is at stake– Exists only for OTC. In Exch. traded, CP is the Exch-CH itself.– Hence OTC has lesser liquidity than Exchange-traded

7. Four products– Forwards : 2-way. OTC. Negotiated. Used when Exact date unknown– Futures : Exch-traded. Std Cont wrt Price, Size, Setl. date, Cont. no. – Options : Exch. Right /no obligation to buy/sale. Call – Buy. Put – Sell– Swaps : OTC. 2-way Cont. Exc of Payt strm for a period. Eg. Fix-float

A. Forwards

1. A Forward contract is a negotiated agreement between two parties.

2. Tailor-made OTC contracts not traded on organized exchanges

3. Used to cover forward recbls/ payables where the date of trn. Is not fixed

4. Generally don’t involve an upfront margin except an admin fee in some.

5. Example

a. Infy IT export $ 10,020 on 21st Feb. Gets a B/E for it, due 31st Mar ‘10

b. Re/$ rate on 21st Feb (say) 45.5 Rs/ $

c. Infy is unsure of the Exchange rate on 31st Mar 10 and wants a hedge

d. SBI gives a quote for 31st Mar @ 46/$

Currency Futures

1. It is the price of a particular currency for settlement at a future date.

2. Futures are traded on future exchanges

3. Exchanges with contract fungibility (freely transferred) are popular.

4. Standardized wrt Quantity of u/lying, Expiration date and delivery

a. Infosys eg. above. 1 unit @ 46/$. Min $100/ Contr. 100 Contr. for a hedge

b. Still hedge is not perfect ($ 20 not covered).

c. Pl remember. The price of 46/$ will keep varying by the minute on the screen

d. The above Exchange rate of Rs. 46/$ is a price @ a particular point in time

5. Futures are rarely settled by delivery. Closed out by a reverse transaction

a. Buy order 100 Contr. ($ 10,000) can be reversed with a Sell order for same

b. A future contract for selling $ 10,000 reversed with a buy for a similar Amt

7. Profit or loss from the net position is absorbed by the concerned.

Traders in the Derivative Market

Hedgers

Typically, corporates with Exim transactions hedge

Eg. Co a has ECB repayment $ 100,000/ Qtr. Over 4 quarters

Co can either keep it naked. Or hedge. Suppose it hedges

SBI offers @ 46, 46.5, 47.0, 47.5 for 1 year (4 Qtrs)

Typically quote is Fn of (Interest rate Diff and Trns costs)

Speculators

Take a directional bet. Thus contribute to Liquidity

Interested, generally, only in the net result (P&L)

Arbitrageurs

Take adv of discrepancy in prices across markets. s/to Transaction costs

Eg. Price of a scrip Rs 220 in DSE and Rs 200 in BSE. If Trn cost =10

Forwards Vs Futures

Features Forwards Futures

Trading Not traded on exchange Traded on Exchange

Settlement Direct between clients Thru the clearing house of the Exchange

Contract specs May differ from trade to trade. Hi flexibility

Standardized contracts only

Counterparty Risk

Exists Nil, Since CP is Clearing house of exch for all contracts

Liquidity Poor, for contracts are tailor made

High. For contracts are std and exchange-traded

Price discovery Poor as markets are fragmented

Better, as traded on a transparent Exchange

Pricing of Forwards /Futures : Calculations

Sl no Parameters $ INR Spot / Fwd rate

1 Spot Exch rate (Rs/$) 100 5000 50.0




1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%




1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600




1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8




1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8


1 Spot Exch rate (Rs/$) 1 S S/1

2 Period (Yrs) 1 1



1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8



2 Period (Yrs) 1 1

3 ROI ( % /100) Rf Rd



1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8



2 Period (Yrs) 1 1

3 ROI ( % /100) Rf Rd

4 Return 1* Rf *1 S* Rd*1



1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8



2 Period (Yrs) 1 1

3 ROI ( % /100) Rf Rd


5 Cumulative (1+Rf) S+(S*Rd*1)



1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8



2 Period (Yrs) 1 1

3 ROI ( % /100) Rf Rd



6 Cumulative 1+Rf S*(1+Rd) S*(1+Rd)^n/(1+Rf)^n



1 Spot Exch rate (Rs/$) 100 5000 50.0

2 Period (Yrs) 1 1

3 ROI 6.00% 12.00%

4 Return 6 600

5 Cumulative 106 5600 52.8



2 Period (Yrs) 1 1

3 ROI ( % /100) Rf Rd



6 Cumulative 1+Rf S*(1+Rd) S*(1+Rd)^n/(1+Rf)^n

7 Forward Rate 1.06 56.00 52.8

Options

1. The right to Buy or sell w/out an obligation to do so

2. Two types of options : Call options and put options.

3. Call gives the buyer

a. The right but not the duty

b. To purchase an underlying asset, reference rate or index

c. At a particular price before a specified date.

d. Infy eg. A call option to buy $ @ Rs. 46. Option Premium : Rs 0.80/unit

e. 1 contract Option premium : Rs. 80. 100 contr. Rs 8,000 paid

4. A put gives the buyer

a. The right, but not an obligation

b. To sell an underlying asset, reference rate or Index

c. At a particular price on a specified date.

Options : Based on exercise : Two Types

1. American Option : Can be exercised by buyer any time upto the expiration

2. European Option : Can be exercised only on the expiration date

Based on Contracting Party : Two types

1. Buying of options : Gives a right but not an obligation to buyer

2. Selling of options : Confers an obligation but not a right to sell/buy

3. Hence, Buyer pays a premium to buy the option. Risk Ltd. Rev Un-ltd

4. Seller’s prem. is to compensate for his risk. Risk Un-ltd. Rev Capped

Based on Profitability

1. In the Money : If the Nett cash flow is positive for the investor

2. At the Money : If the Nett C/flow is zero for the investor

3. Out of Money : If the Nett C/Flow is negative for the Investor

Spot 45.000 Assumptions

Strike 45.000 Put Strike 48.000

Call option price 2.500 Put option price 1.700

Re/$ ER

Long Call

43.0

44.0

45.0

46.0

47.0

48.0

49.0

50.0

51.0




Pay-offs

Re/$ ER

Long Call

43.0 (2.50)

44.0

45.0

46.0

47.0

48.0

49.0

50.0

51.0




Pay-offs

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0

47.0

48.0

49.0

50.0

51.0




Pay-offs

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0

48.0

49.0

50.0

51.0




Pay-offs

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Pay-offs

Long Call option pay-off

(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Call option pay-off

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Pay-offs


(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Call option pay-off

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Re/$ ER

Short Call

43.0

44.0

45.0

46.0

47.0

48.0

49.0

50.0

51.0

Pay-offs


(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Call option pay-off

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Re/$ ER

Short Call

43.0 2.50

44.0 2.50

45.0 2.50

46.0

47.0

48.0

49.0

50.0

51.0

Pay-offs


(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Call option pay-off

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Re/$ ER

Short Call

43.0 2.50

44.0 2.50

45.0 2.50

46.0 1.50

47.0 0.50

48.0 (0.50)

49.0 (1.50)

50.0 (2.50)

51.0 (3.50)

Pay-offs

Spot 45.000 Assumptions Long PUT ‘Options”



(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Put option Pay off

Re / $ Exch Rate

Put option Pay off

43.000

44.000

45.000

46.000

47.000

48.000

49.000

50.000

51.000




(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Put option Pay off

Re / $ Exch Rate

Put option Pay off

43.000 3.300

44.000

45.000

46.000

47.000

48.000

49.000

50.000

51.000




(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Put option Pay off

Re / $ Exch Rate

Put option Pay off

43.000 3.300

44.000 2.300

45.000 1.300

46.000 0.300

47.000 (0.700)

48.000

49.000

50.000

51.000




(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Put option Pay off

Re / $ Exch Rate

Put option Pay off

43.000 3.300

44.000 2.300

45.000 1.300

46.000 0.300

47.000 (0.700)

48.000 (1.700)

49.000 (1.700)

50.000 (1.700)

51.000 (1.700)




2-Way Hedge – Both Long

(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 43.000 44.000 45.000 46.000 47.000 48.000 49.000 50.000 51.000 52.000

Call option pay-off Put option Pay off

Re / $ combined

43.000 0.800

44.000 (0.200)

45.000 (1.200)

46.000 (1.200)

47.000 (1.200)

48.000 (1.200)

49.000 (0.200)

50.000 0.800

51.000 1.800

Spot 45.000 Assumptions Long ‘Call & Put’ options






Re/$ ER

Short Call

43.0 2.50

44.0 2.50

45.0 2.50

46.0 1.50

47.0 0.50

48.0 (0.50)

49.0 (1.50)

50.0 (2.50)

51.0 (3.50)

Pay-offs


(3.000)

(2.000)

(1.000)

0.000

1.000

2.000

3.000

4.000

42.000 44.000 46.000 48.000 50.000 52.000

Call option pay-off

Re/$ ER

Long Call

43.0 (2.50)

44.0 (2.50)

45.0 (2.50)

46.0 (1.50)

47.0 (0.50)

48.0 0.50

49.0 1.50

50.0 2.50

51.0 3.50




Re/$ ER

Short Call

43.0 2.50

44.0 2.50

45.0 2.50

46.0 1.50

47.0 0.50

48.0 (0.50)

49.0 (1.50)

50.0 (2.50)

51.0 (3.50)

Pay-offs

Pay-off Equations

1. Long Call Option Pay-off = Max (S-Xt-OP, -OP)

5. S = Spot price : Xt = Exercise Price : OP = Option Prem.

Pay-off Equations


2. Long Put Option Pay-off = Max (Xt-S-OP, -OP)


Pay-off Equations



3. Short Call Option Pay-off = Min (Xt-S+OP, OP)


Pay-off Equations



3. Short Call Option Pay-off = Min (Xt-S+OP, OP)

4. Short Put Option Pay-off = Min (S-Xt +OP, OP)


Effect on option Prices

Effect of Increase in factor on

Factor Call options Put option

Current Stock Price




Current Stock Price + -

Striking Price





Striking Price - +

Time to expiration





Striking Price - +

Time to expiration + +

Stock Volatility





Striking Price - +


Stock Volatility + +

Interest Rate

Effects on Option Prices




Striking Price - +



Interest Rate + -

Cash Dividends

Effects on option Prices




Striking Price - +



Interest Rate + -

Cash Dividends - +

319

Chapter1

0 Management of ForeignExchange Risk

What is Exchange Risk?

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs

due to unanticipated changes in exchange rate. For example, if an Indian firm

imports goods and pays in foreign currency (say dollars), its outflow is in

dollars, thus it is exposed to foreign exchange risk. If the value of the foreign

currency rises (i.e., the dollar appreciates), the Indian firm has to pay more

domestic currency to get the required amount of foreign currency.

Types of Exposure

Translation Exposure

Assets and liabilities translated at the current rate

ie rate prevailing at the time of preparation of consolidated statements.

Rev/Exps translated at the actual Exch rates prevailing on the date of

transactions. Or weighted averages for exchange rates can be used.

Translation gains / losses not to be charged to income of the reporting co

Cont….

Transaction Exposure

Refers to the extent of impact on firms domestic C/F of exchange rate flux

Arises from Possible forex gains/losses on transaction entered into in forex

Economic Exposure

Refers to the extent of impact on firms domestic C/F of exchange rate flux

Arises from Possible gains/losses W/o direct exposure to forex transactions

Economic exposure is a more managerial concept than an accounting concept.

Comparison of Four Translation MethodsAll financial statement items restated in terms of the parent currency are the functional currency amount multiplied by the appropriate exchange rate.

Balance Sheet Current/Non-current

Temporal CurrentMonetaryNon-monetaryRate

Cash C C C C

Receivables C C C C

Payables C C C C

Inventory C C C or H C

Fixed Assets H H H C

L/Term Debt H C C C

Net Worth H H H Bal

Exchange Rates Used to Translate Balance Sheet Items

Tools and Techniques of Foreign Exchange Risk

Management

1. Forward Contracts

2. Futures contracts

3. Option Contract

4. Currency Swap

The most popular instrument used to hedge are forward exchange contracts in

India.

1. Forward exchange markets are well established and transparent.

2. Forward contracts are accessible even by the smaller corporates.

3. Many corporate policies do not allow them to trade in options and

derivatives.

Is Hedging Necessary for the Firm?

The various reasons in favour of exposure management at the corporate

level are:

i. Information asymmetry

ii. Transaction costs

iii. Default cost

What Risk Management Products do Firms Use?

Type of ProductHeard of

(Awareness)Used

(Adoption)

Forward contracts 100.% 93.1%Foreign currency swaps 98.8 52.6Foreign currency futures 98.8 20.1Exchange traded currency options 96.4 17.3Exchange traded futures options 95.8 8.9Over-the-counter currency options 93.5 48.8Cylinder options 91.2 28.7Synthetic forwards 88.0 22.0Synthetic options 88.0 18.6Participating forwards, etc. 83.6 15.8Forward exchange agreements, etc. 81.7 14.8Foreign currency warrants 77.7 4.2Break forwards, etc. 65.3 4.9Compound options 55.8 3.8Lookback options, etc. 52.1 5.1

Currency Correlation and Variability as Hedging Tools

The degree of simultaneous movements of two or more currencies with

respect to some base currency is explained by currency correlations (‘ R ‘‘ )

Indicates the degree to which two currencies move in relation to each other.

This information can be used by MNC esp wrt Currency movement

MNC's are aware that ‘ R’ is not constant over time

Typically ’ R’ can be used to help decide on hedging transaction exposureCont….

Chapter1

3Management of Economic Exposure

Transaction Exposure Versus Eco Exposure

Conceptual Comparison of Difference Between Translation, Transaction & Economic Foreign Exchange Exposure

Moment in Time WhenExchange Rate Changes

Translation Exposure Economic Exposure

Accounting based changes inconsolidated financial statementscaused by a change in exchange rates

Change in expected cash flows arisingbecause of an unexpected change inexchange rates

Transaction ExposureImpact of setting outstanding obligations

entered into before change in exchange rates

but to be settled after change in exchange rates

Cont….

Major differences between Transaction Exposure and Eco Exposure

1. Contact specific. General; relates to the entire investment.

2. Cash flow losses Easy to compute Opportunity losses caused by an exchange rate change are easy to compute. change are difficult to compute. A good variance accounting techniques can be used to compute accounting is needed to isolate the effect of

exchange losses due to transaction exposure. rate change on sales volume, costs and profit

margins.

3. Firms generally have some policies to cope with Firms generally do not have policies to cope with transaction exposure. economic exposure.

4. Avoidance sometimes requires third-party Avoidance requires good strategic planning (e.g., cooperation (e.g., changing invoice currency). choice of markets, products, etc.).

5. The duration of exposure is the same as the time The duration of exposure is the time required for the

period of the contract. restructuring of operations through such means as changing products, markets, sources and technology.

6. Relates to nominal contracts whose value is Relates to cash flow effects through changes in cost,

fixed in foreign currency terms. price and volume relationships.

7. The only source of uncertainty is the future The many sources of uncertainties include the future

exchange rate. exchange rate and its effect on sales, price and costs.

8. Transaction exposure is an uncertain domestic Economic exposure is an uncertain domestic currency

currency value of a cash flow which is known value of a cash flow whose value is uncertain even in

and fixed in foreign currency terms; e.g., a foreign currency terms; e.g., cash flows from a foreign

foreign currency receivable. subsidiary.

Transaction Exposure Economic Exposure

Measuring Economic Exposure

1. Eco exposure to forex fluctuations is higher for a firm involved in

international business than for a purely domestic firm.

2. Assessing the economic exposure of an MNC is difficult due to the complex

interaction of funds that flow into, out of and within the MNC.

3. Yet, economic exposure is crucial to operations of the firm in the long-run.

4. If an MNC has subsidiaries around the world, each subsidiary will be

affected differently by fluctuations in currencies.

5. MNC attempts to measure its Eco exposure would be extremely complex.

Managing Economic Exposure

Following are some proactive Marketing/ production strategies which a firm can pursue in response to anticipated or actual real exchange rate changes.

I. Marketing initiatives

a. Market selection

b. Product strategy

c. Pricing strategy

d. Promotional strategy

II. Production initiatives

a. Product sourcing

b. Input mix

c. Plant location

d. Raising productivity

Marketing Management of Exchange Risk

Market Selection : Major strategy considerations for an exporter are the markets in which to sell,

Pricing Strategy : Market Share Versus Profit Margin

A firm selling overseas should follow the standard economic proposition of setting the price that maximises dollar profits (Marginal Rev = Marginal costs).

In making this decision, however, profits should be translated using the Fwd rate that reflects the true expected dollar value of the receipts upon collection.

Promotional Strategy : This to take into account anticipated exchange rate changes. A key issue is the size of the promotional budget.

Product Strategy

product line decisions product innovations

Production Management of Exchange Risk

So far we attempted altering home currency value of foreign currency values.

At times, the exchange rate moves thwart Pricing/ marketing strategies

Prod sourcing and plant location are variables (eg. below) that Cos leverage to

manage competitive risks that cannot be managed through Mktg strategies

a. Input Mix

b. Shifting Production Among Plants

c. Plant Location

d. Raising Productivity

Corporate Philosophy for Exposure Management

All Exposures Left

Unhedged

Selective

Hedging

All Exposures

Hedged

Active Trading

Hi Risk

Low Reward

High Reward

Low Risk

Cont….

Chapter1

8Country Risk Analysis

Nature of Country Risk Assessment

1. Country risk is an indispensable tool for asset management

2. It requires the assessment of economic opportunity against political odds.

3.The relevant factors into two important categories:

Political factors & Economic factors.

Political Risk Indicators

i. Stability of the local political environment

ii. Consensus regarding priorities

iii. Attitude of host government

iv. War

v. Mechanisms for expression of discontent

Economic Risk Indicators

1. Inflation rate

2. Current and potential state of the country’s economy

3. Resource base

4. Adjustment to external shocks

Techniques to Assess Country Risk

Techniques identify key Eco, Political & Financial variables for country risk

The broad parameters help expose basic strengths/weaknesses of a country.

Listed below are some of the more popular indicators to assess country risk.

I. Debt Related FactorsThe debt service indicators include:- Debt /GDP - Debt/ Foreign Exchange receipts- Interest payments/Foreign exchange receipts (liquidity).- Debt-service ratio- Short-term debt/ Total exports.- Imports/GDP- Foreign public debt/ GNP - Current account balance on Gross Net Product Cont….

II. Balance of Payments

- % increase in imports / GDP

- Foreign income elasticity of demand for the exports

- Under/overvaluation of the Exch rate, on a PPP basis

- Current Account/GNP

- Effective Exchange Rate Index

- Imports of goods and services/GDP

- Non-essential consumer goods and services/Total imports

- Exports to 10–15 main customers/Total exports

- Exports of 10–15 main items/Total exports

- External reserves/Imports

- Reserves as % of imports (goods and services)

- Exports as % of imports (goods and services)

Cont….

III. Economic Performance

The significant ratios that can be used to measure Eco Perf are:

- GNP Per capita (this measures the level of Dev of a country).

- Gross Investment /Gross Domestic Product.

-This ratio captures prospects for Growth. Higher the ratio higher the Gr

- Inflation : Measures % Change in Consumer Prices.

-Measures the quality of economic policy.

- Money supply (serves as an early indicator for future inflation)

- GDP / GNP : External sector impact

Cont….

IV. Political Instability

1. Effect of political instability on servicing problems :

Emerge in the form of an unwillingness rather than an inability to service

2. The political instability indicators to be considered are:

a. The political protests /demonstrations /Strikes/riots, Assassinations

b. Successful/ unsuccessful power transfers, e.g., coup attempt, etc.

V. Weighted Checklist Approach

1. This approach employs a combo of statistical / Judgmental factors.

2. Statistical factors assess the performance of an economy in the recent past

3. In the expectation that this will provide an insight into the future.

4. These factors can be compiled relatively easily.

5. Range of statistical factors typically used

a. Rapid rise in production costs, b. interest-service ratio, c. real GDP growth, d. Debt/GDP, e. imports/reserves, f. Foreign exchange receipt, g. Export/GDP ratio, h. Import/GDP, etc.

Raters of Country RiskRating of a country’s creditworthiness is mainly compiled by two magazines, Institutional Investor and Euromoney.

Rating agency Criteria for ratings

Institutional Investor Information provided by 75–100 leading banks

that grade each country on a scale of 0–100, with

100 representing least chance of default.

Individual responses are weighted using a

formula that gives more importance to responses

from banks with greater worldwide exposure.

Euromoney Assessment based on the following indicators.

Political risk (25 per cent)

Economic performance (25 per cent)

Debt Indicators (10 per cent)

Credit Ratings (10 per cent)

Rescheduling (10 per cent)

Access to bank finance (5 per cent)

Access to capital markets (5 per cent)

Access to short-term finance (5 per cent)

Discount available on forfeiting (5 per cent)

What the Rankings Reveal

Eco & Political factors have an impact on a country’s ranking over time.

For a significant number of countries the increase or decrease in ranking over time could be explained by the economic factors alone.

Political factors also play a key role in determining a country’s credit rating.

Model for Country Risk Analysis for India

The Country rankings published by various agencies is useful

In as much as it ensures comparability and promotes consistency.

This brings us to the concept of country risk rating.

Country risk rating refers to the degree or level of risk denoted by a figure.

Risk rating is a good tool for ensuring the comparability of risk across countries

Aggregated Micro Prudential Indicators Macro Eco Indicators

Capital adequacy Liquidity Economic Growth

Aggregate capital ratiosCantral Bank credit to Fin

Institutions Aggregate Growth Rates

Frequency distribution of Capital ratios

Depoists in relation to Monetary Aggregates Sectoral slumps

Asset quality Segmenation of Inter Bank rates Balance of payments

Lending Istitutions Loan to deposit Rate Current A/c deficit

Sectoral credit concetrationMaturity structure of Assets and

Liabilities foreign exch reserve Adequacy

Foreign currecny denominated lending

Measures of Secondary Mkt liquidity

External Debt (Incl maturity sructure)

NPA Loans and provisions Sensitivity to Market Risk Terms of Trade

Loans to Public sector Entities Foreign Exchange RiskComposition & Maturity of Capital

Flows

Risk profile of assets Interest Rate Risk Inflation

Connected lending Equity Price Risk Volatility in Inflation

Leverage Ratios Commodity Price Risk

Aggregated Micro Prudential Indicators Macro Eco Indicators

Interest & Exchange rates

Borrowing entity Market Based indicators Volatility in Interest & exch rates

Debt Equity Ratio Mkt Prices of Fin Instruments Level of domestic Real Interest rates

Corporate Profitability Indicators of Excess Yields Exchange rate sustainability

Other Indicators of Corp conditions Credit Ratings Exchange rate guarantee

Household indebtedness Sovereign Yield spreads Lending and Asset price Booms

Management Soundness Lending Booms

Exoense Ratio Asset Price Booms

Earnings Per employee Contagion Effects

Growth in no of Finance Institutions Financial Market Correlation

Earnings & Profitability Trade Spillovers

Return on Assets Other Factors

Return on Equity Directed Lending & Investments

Income and Expense Ratio Govt resource to Banking system

Structure Profitability indicators Arrears in the economy

Macro Prudential Indicators (MPIs)

In the aftermath of the international financial turmoil of the second half of the

1990’s, the World Bank and the IMF have tried to work on ways to strengthen

the global financial system. The MPIs —defined broadly as indicators of the

health and stability of the financial system can help countries access their

banking system’s vulnerability to crisis. This process, as part of the joint World

Bank-IMF Financial Sector Assessment Programe (FSAP), May 1999. was

introduced in MPI’s compare both aggregated micropudential indicators of the

health of individual financial institution and macro economic variables

associated with financial system soundness.

Managing Risk in Foreign Exchange Trading

1. Market Risk: This risk refers to the risk of adverse changes in

1. Exchange rate risk and

2. Interest rate risk.

2. Credit Risk: Credit risk, inherent in all banking activities, arises from the

possibility that the counterparty may not make the payment on maturity

3. Sovereign Risk: A variation of credit risk. It refers to, the political, legal

and other risks associated with a cross-border payment.

Chapter2

2Interest Rate and Currency Swaps

The Conceptual View of SwapsThe concept of the swap (both interest rate and currency swaps) has broad implications and applications in finance. Condensed to its essence, however, its most important implication lies in the idea that swap allows the separation of the funding aspect of financing from the structure of the liability

This ability of the swap to separate financing from its repayments structure produces a greatly increased universe of options available to the borrower or the investor.

There are five basic components of financing: Credit The willingness of an investor to take the default risk of a

company Funding The provision of loan funds and the return on those funds Tenor The repayment schedule Currency The currency denomination(s) of the repayment Interest Rate The basis on which loan interest is calculated

The Evolution of Swaps

The swap market as we have today has existed only since 1981. The earliest

swaps were currency swaps and were mainly developed to resolve some of

the problems associated with parallel and back-to-back loans.

Currency swaps largely resolve the problem of matching needs associated

with parallel and back-to-back loans. The first true currency swap was

arranged in August 1981 by Salomon Brothers with the World Bank and IBM

as counterparties.

The first interest rate swap appeared in London in 1982. The motivating factor

behind the interest rate swaps was their ability to convert fixed rate interest

payments into floating rate interest payments and vice versa

Terminology Related to Swap

Swap Facilitators

Swap Broker

Notional Principal

I. Basis Points (BP)

II. Swap Coupon

Cont….

Rationale for Interest Rate Swaps

The key advantages of an interest swap are as follows:

1. The interest rate swap does not involve any exchange of principal

amounts. It consists only of an agreement to exchange interest flows.

2. Because of the smaller amount at risk, the number of potential

participants in the deals is larger.

3. Also, because the deal is not a lending, it is possible to keep the

documentation within reasonable bounds.

4. Swapping allows the issuers to revise their debt profile to take advantage

of current or expected future market conditions.Cont….

Limitations of Swap Market

1. An inherent default risk exists in a Swap deal.

2. Swaps are not easily tradable.

3. Termination of the Swap deal is not possible without the agreement of the

parties involved in the transaction.

4. In some cases it may be difficult to identify a counterparty to take the

opposite side of the transaction.

5. The swap market is not exchange controlled It is OTC.

6. This calls for extra caution on the part of parties involved to look into the

creditworthiness of the counterparties before entering into an agreement.

Reasons for Growth of Swap Market

1. IRS creates a link between distinct markets or firms with Diff mkt access

2. IRS provides a way to reduce the total funding cost for debt.

3. Arises from the diff in the risk premium available to the various borrowers.

4. IRS is a flexible way for cos to manage B/S and

5. Reduce the mismatch between the maturities of assets and liabilities.

6. Swaps are desirable for they can minimise the costs of regulations / Tax Cont….

Limitations of Swap Market

1. The Swap deal cannot be terminated without the agreement of the parties involved in the transactions.

2. Swap are not easily tradable as a result of very slow development of standardised documentation.

3. It is difficult to identify a counter-party to take the opposite side of the transaction.

Swap Market Terminology

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

Interest Rate Swaps

The main aspects of an interest rate swap are:

- effectively converts a floating rate borrowing to fixed rate or vice-versa.

- structured as a contract separate from the underlying funding.

- principal repayment obligations are not exchanged.

- can be applied to either new or existing borrowings.

- off-balance sheet treatment.

- only the net interest differential is paid.

Cont….

How Swaps Work

The risks associated with interest rate swaps are:

The counterparty to the contract may default.

Another risk with swaps is basis point risk, exposing the swapper to

unexpected, additional costs.

Finally, an issuer must factor in the cost of swapper fees.

Plain Vanilla Interest Rate Swaps

The key features of this swap are:

The Notional Principal

The Fixed Rate

Floating Rate

Trade Date, Effective Date, Reset Dates and Payment DatesCont….

Type of Interest Rate Swaps

1. Basis Swap

2. Forward Swaps

3. Putable Swaps

4. Rate Capped Swaps

5. Deferred Rate Swaps

6. Callable Swaps

7. Extendible Swaps

Details ING ICICI Difference

Fixed 6.00% 8.00 2.0%

Floating Libor Libor +0.5% 0.5%

Nett 1.5%


Fixed 6.00% 8.00 2.0%


Nett 1.5%

Swap ING borrows Fixed @ 6 % and ICICI float @ Libor +.5%

Deal ING lends Fixed @ 7.3% & ICICI lends Float @ Libor +.5%


Fixed 6.00% 8.00 2.0%


Nett 1.5%

Fixed Paid 6.00% 7.3% 1.3%




Fixed 6.00% 8.00 2.0%


Nett 1.5%

Fixed Paid 6.00% 7.3% 1.3%

Float Paid Libor +.5% Libor + .5%




Fixed 6.00% 8.00 2.0%


Nett 1.5%

Fixed Paid 6.00% 7.3% 1.3%


Fixed Recd 7.30%

Float Recd Libor +.5%




Fixed 6.00% 8.00 2.0%


Nett 1.5%

Fixed Paid 6.00% 7.3% 1.3%


Fixed Recd 7.30%


Nett Rate Libor - 0.8% 7.3%




Fixed 6.00% 8.00 2.0%


Nett 1.5%

Fixed Paid 6.00% 7.3% 1.3%


Fixed Recd 7.30%


Nett Rate Libor - 0.8% 7.3%

Alt Rate Libor 8.0%

Gain 0.80% 0.7% 1.50%



Liability Based Interest Rate SwapCreating Synthetic Fixed or Floating Rate Liabilities

ICICI8% p.a.

INGSix months MIBOR

Six months MIBOR

Floating rate lenders

Synthetic fixed or floating rate liability

Asset Based IRS : Synthetic Fixed or Floating Rate Assets

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

Synthetic fixed or floating rate assets

Investor Counterparty

Six months LIBOR

Six months LIBOR + 0.25

Floating Rate Investment

InvestorSix months LIBOR

Counterparty12.75% p.a.

14.00% p.a.

Fixed Rate Investment

12.50% p.a.

Cont….

Improving Investment Performance

Original Swap Reverse Swap

Counterparty11.5% p.a.

Investor10.5% p.a.

Counterparty

Six months Six monthsLIBOR LIBOR

Six months LIBOR

Floating rateInvestment

Managing floating rate investments

Cont….

Asset/liability management

Issuer SwapCounterparty

Floating Rate Payment

Fixed Rate Receipt

Fixed RateBonds

Floating Rate(T-Bill based)

Assets

Currency SwapBasic Currency Swap

A Currency Swap

Japanese yenreceived from

subsidiary

USMultinational

US multinationalissues dollar

denominated bondsto investors

Dollars receivedfrom ongoingoperations

Japanesemultinational

Japanesemultinational issuesyen denominated

bonds to investors.

Yen payments Dollar payments

Dollar payments Yen payments

Dollar payments

Yen payments

Cont….

The World Bank-IBM Currency Swap

The Bank had 3 objectives in mind before thinking of entering into a Swap

The cost of borrowing via a swap to be < primary guidelines.

The counterparty must be of top creditworthiness.

No currency exposure must be created.

Rationale for Existence of Currency Swaps

1. Currency swap may be used to hedge against foreign exchange risk. Hedging can lower a firm’s costs because it reduces uncertainty of CF

2. It increases Amt a firm can borrow, incr Eco of scale which reduce op costs.

3. A firm may be able to use their surplus funds more effectively in blocked currencies.

4. Swaps may be used as a way of circumventing exchange control regulations. Cont….

Various Forms of Currency Swaps

i. Cross-currency Fixed-to-fixed swap

ii. Cross-currency Floating-to-fixed swap

iii. Cross-currency Floating-floating (basis) swaps

iv. Basis swaps

v. Amortizing swaps

vi. Roller-coaster swaps

vii. LIBOR adjustments and Off-market coupons

viii. LIBOR-in-arrears swaps

Pricing Currency Swaps

1. Banks act as dealers in currency swaps

2. Banks furnish potential customers with bid and ask prices stated in terms of

interest rates and exchange rates that reflect bid-ask spreads.

3. Prices quoted depend on various factors, including life of a swap.

4. Risks involved in dealing in currency swaps are > those in IRS.

5. Spreads for currency swaps are > spreads for interest rate swaps.

6. Currency swaps involve both exchange rate risk and interest rate risk.

Chapter

Eurocurrency Market

Sl no Borrower Lender MarketCurrency of

Loan Name

1 Indian EntityIndian/ MNC

Entity India ReDomestic

loan

2 Indian EntityUK / Non-UK

Entity London SterlingForeign

loan

Sl no Borrower Lender MarketCurrency of

Loan Name

1 Indian EntityIndian/ MNC

Entity India ReDomestic

loan

2 Indian EntityUK / Non-UK

Entity London SterlingForeign

loan

3 Indian EntityUK /Non-UK

Entity London Dollar / Yen Euro loan

Eurocurrency :

Freely convertible currency deposited in a bank outside country of origin.

Deposits can be placed in a foreign bank/ foreign Br of a domestic bank.

Any convertible currency can exist in “Euro” e.g.

Characteristics of the Eurocurrency Market:

1. Large international money market 2. Relatively free from government regulation and interference3. Deposits in Eurocurrency market are primarily for S/T4. Sometimes leads to ALM risk, since most Euro Currency loans are L/T5. Transaction, in this market are generally very large 6. Govt., Public sector organisations tending to borrow most of the funds.7. Makes the market a wholesale rather than a retail market. 8. Eurocurrency market exists for savings/Time deposits rather than Demand

History of growth of the Eurodollar Mkt 1. Large deficits in the US BOP, particularly in the 1960s

2. Massive BOP surpluses of OPEC due to Incr in oil prices in 73-74 & ‘78.

3. Resulting in accumulation of $ by Foreign Fin institutions & individuals.

4. Restrictive environment prevailing in US (1963–1974) to stem Cap OF

5. These controls encouraged US /MNC’s to borrow dollars abroad.

6. Most of the “petrodollars” were deposited in FI’s outside U S.

5. Efficiency & lower cost base of the Eurodollar market was a plus

6. Being a wholesale funds market, free of restrictions, in comp with US mkt

EuroCurrency Interest Rates :-

a. Base Intt rate paid on deposits among banks in Eurocurrency market is LIBOR

b. LIBOR - Determined by supply /demand for funds in Euromkt for each currency

c. Participating banks could default (and, infrequently, do default)

d. So, Rate paid for Eurodollar deposits has a Cr-spread over LIBOR in Euromkt

e. Cost of borrowing in Euromkt historically is marginally below the Domestic rate

f. Interest rates on other Eurocurrencies generally follow the same pattern

g. If Capital controls exist in a country (e.g., Japan), borrowing rates may be

higher in the Euromkt (for Yen) than in domestic market.

Instruments

1. Euro CD’s

2. Euro CP’s

3. Euro Debt

4. External Commercial Borrowing (ECB’s)

5. FCCB’s

6. Euro Notes Issuance : FRN’s, Floaters etc

7. GDR / ADR’s

Instruments and Rates of Eurocurrency Markets

1. A feature of Eurocurrency Mkt is that loans are made on a floater

2. Loans are given to Govt / its agencies, Corporations & non-prime banks

3. Intt rates are set @ LIBOR + fixed margin for a given period & currency.

4. Interest for the next period is calculated at a fixed margin over new LIBOR.

Eurocurrency CDs are issued in two forms:

Tap CDs

Issued in large denominations ($ 2.5 to $5 million)

For maturities of < 1 year, whenever banks need to “tap” the mkt

Tranche CDs – Big Tkt issues (typically $10 mn to $50 mn), one or more drawal

International Bonds Market

The Euro Bond Market

Unsecured debt securities

Issued and sold in mkts outside the Country of the borrower

Denominated in a currency other than that of the borrower’s Currency

And in a currency diff from that of the market where it is mobilised

Placed by the borrower directly on the Market & not lent to by banks

Features

Euro bonds are underwritten and sold in more than one market

Simultaneously usually through international syndicates

And are purchased by an international investing public

Extending far beyond the confines of the countries of issue.

Special Features /Innovations in the global Bond Mkt

The Euro bond market has flourished due to following unique features

1. Eurobond mkt - offshore operation not subject to national controls

(Most countries have controls over domestic issues in local currency)

2. Not subject to the costly and time-consuming registration procedure.

3. Disclosure requirements are less stringent than for domestic issues

4. Euro bonds are issued in bearer form. Facilitates negotiation is sec mkt

(Country of ultimate owner of the bond is not a matter of public record).

5. Offer exemption from tax-withholding provisions, not found in others)

MH BOUCHET (c) CERAM 388

Euro-Cur Mkt Instrument

1. Straight fixed-rate issue: bearer bonds, fixed coupon, set maturity date, full principal repayment upon final maturity. Coupons are normally paid annually.

2. Equity-linked bonds: convertible bonds or bonds with equity warrants (amounted to $64 billion in 1997, and $32 billion in 1998). Right to acquire equity stock in the issuing company (sometimes with detachable warrants containing the acquisition rights). The market value of an ELB is composed of the naked value and the conversion value. The conversion to stock prior to maturity is at a specified price per share, or a specified number of shares per bond. The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.


Eurobond Market

3- FRNs: since the early 1980s. medium-term notes where the interest is fixed as a percentage above six-month LIBOR. Pays a semi-annual coupon determined on variable-rate base. Negotiable and transferable securities with flexible interest rate, fixed interest periods, and issued in pre-determined and uniform amounts. FRNs are directed at institutional investors

Euro - financial Instruments

No Particulars Euro Loan Euro Bond

1Fund Suppliers

Exposure on Bank Customer

2 Rate Floating Fixed or Floating

3 Maturity Short to Long Long

4 Issue SizeStructurally high, since an

inter bank mktPast - low. Now

increasing

5 Floatation cost Low (0.5%) High (upto 2.5%)

6 FlexibilityDraw down / repayment –

Per Fixed schedule

Flexible s/to commitment fee on undrawn bal

7 Multi Currency option A regular featurePossible only thru a

costlier swap

9 Speed of raising Faster (1- 2 weeks) Slower

Note Issuance Facility & Euro notes

A bank or a Syndicate of banks underwrites an amount for a clientFor a specified period (say 5 years)At an agreed rate Over Libor (say 1% over 6 mth LIBOR)

Now let us assume the client needs $ 20 mn for 3 monthsClient seeks bids from intending sources The bids < above rate (LOBOR + 1%) are accepted (say 15mn)Balance ( 5 mn ) is funded by the underwriting banksSo borrower is freed from worries of borrowingBasically, this is a Euro-CP with an u/writing option

Concepts : Disc Rate : Mkt price and Annual (eff) Yield– Disc Rate (DR) = (Disc Amt/ FV) * 360/n)– Market Price = FV * [1 – (Disc rate * n/360)] – Annual yield = DR / [1- (DR*n/360)]– Annual yield = DR * FV / MV

NIF – Features, Pluses and minuses

Pluses in comparison with Euro bonds

1. Lower Direct Costs 2. Drawdown and rollover flexibility3. Flexibility in timing of issue : if rates can be foreseen4. Choice of maturities

Asia- currency market and Asia Bonds– Singapore the trading hub for Asia currency markets– Asia Bonds : issued directly to investors, avoiding banks(97- Peregrine- Indonesia– Suharto– Rupiah dep (2400– 8000/$)– $260 M

-

Euro - MTN

1. Similar to NIF. But for M/T. ~ 5 yrs. Needn’t be U/written2. Adv : Speed, cost & flexibility in timing & volume of issuance ( eg $ 12 M for 1 mth, $ 15 M for 75 days & $23 mn for 90 days)

3. Offered continually to leverage on yield curve movements4. Retired either thru a new issue or by redemption

5. GM, Coke, Pepsi, ford are regulars6. Till mid 80’s secondary trading languished.

7. Now issued thru dealers than direct . Facilitates mkt making8. Risk for issuer - Mkt tanking before issue goal is fully met

9. U/writing with Banks / Fin players (like NIF) mitigates this.

Euro CP vs Normal CP

No Particulars Euro CP Normal CP

1 Average maturity 6 mths 3 months

2 Underwriting noCarved out of Bank WC

india. US – No U/W

3 Secondary market Exists No. Held to maturity

4 Typical investorsCentral banks, com

banks, Corporates MMMF’s, Local Banks

5 Popularity Improving India – OK. US - Best

6 Rating 4% - 5% - unrated Rarely unrated

7 Currency Multi currency Single Currency

9 Addl feature Cross currency swap Not needed

External Commercial Borrowings

1. Scarcity of domestic capital hinders a high rate of capital formation.

2. The rate of savings is low because the income levels are at a low level

3. Where small savings are possible, they are very difficult to mobilise.

4. Scarcity of forex : Developing economies have adverse BOP

5. LDC exports < large Capital imports needed during Growth

6. Funding of infra by Govt alone cannot go on forever on borrowed money

Risks Involved in ECBs

a. Raising ECB offers a firm a cost advantage in comparison with others

b. Most prime blue-chip clients desert Indian Banks / FI’s in favor of ECB

c. ECB exposes the firm to a currency risk.

d. Borrower may spend more Rs to buy $ to meet Intt / Principal liability.

e. Borrower exposed to an interest rate risk too.

f. Most ECBs are pegged to the 6-month LIBOR-Plus-spread

g. Variation in LIBOR at reset dates (dates on which the prevailing LIBOR is

used to compute the liability) may enhance the firm’s cost.

Managing Exposure Arising From ECBs

ECB exposes client to 2 risks: exchange rate risk and interest rate risk.

a. To mitigate, Co has to incur a cost for hedge agt Intt/currency risk

b. Leads to 2 Diff. contracts, more documentation and a greater default risk

c. Default by either can lead to overall default. Damages Co interests.

d. A single comprehensive cover may provide perfect hedge

e. But such a contract proves costlier than entering into two single contracts.

Foreign Currency Convertible Bonds (FCCBs)

Convertibles are more beneficial than a GDR Due to the following :-

i. They have a lower coupon than straight debt.

ii. They provide a broader investor base, i.e., both, those who invest in debt as well as in equity.

iii. They allow a higher premium to the issuer than a GDR.

iv. Dilution of equity is not immediate, but deferred.

Cont….

Depositary Receipts

Agenda

Basic Concepts

History

Basic Issuance Process

Types of DR Programs

Advantages & Disadvantages

Current Trends

Basic Concepts

Depositary Receipt (DR)– Certificates that represents shares of foreign companies

Global Depositary Receipt (GDR)– Negotiable Instrument denominated in US $ or €– One GDR may represent one or more shares – Eg. 1 GDR = 100 Shares

American Depositary Receipt (ADR)– Payments and Receipts in US dollars– Trade in US exchange markets only

Depository Receipts

DR’s structured to resemble typical stocks on the exchanges

– So that foreigners can buy an Interest in the company

– Without worrying about differences in currency, accounting practices, or language barriers

– Or other risks in investing in foreign stock directly.

– Most GDRs are denominated in U.S. dollars – regardless of the market they are traded in.

History : -

GDRs were created in 1927 in London

– Selfridges, a London department store, wanted to expand the number of investors in the United States.

– Very difficult to trade across different countries at this time.

– Took at least 4 days to travel across the Atlantic.

– Orders could potentially take weeks to fully complete.

Issuance ProcessLevel II Sponsored ADR

US Investor (foreign investor)

US dollarsDividend

Bank of New York Mellon (Depositary Bank)

US Stock Exchange

Listing

Yen Dividend

Toyota (Foreign Co) •US Investor

•Easy process because ADRs are sold on

•US Exchange markets &

•Sold like another stock.

•Payment and receipt of dividends in US dollars

Stock Search

Issuance Process


US Dollars


US Stock Exchange

Listing

Yen Dividend

•Depositary Bank

Investors’ Purchases are made from depositary bank.

Authorized by the issuer Co to issue DRs.

The depositary bank is the Act Regd owner of the shares

Its most important role is that of stock transfer agent.

Dividend

Toyota (Foreign Company)

Issuance Process


US dollars


US Stock Exchange

Listing

Yen Dividend

Dividend

•Foreign Co

•Seeks to enhance liquidity.

•Seeks to expand & diversify investors

•Responsible for

Preparing the issue proposal,

Determining fin objective,

Deciding the type of program

Providing financial information.

Toyota (Foreign Company)

What is the main role of the depositary bank in the issuance process?


Unsponsored ADR

– Description: The foreign company has no formal participation with issuance

– Purpose: Broaden the shareholder base with the existing shares

– Trading: Over-the-counter market

– SEC: Minimal requirements from the SEC


Level I Sponsored American Depositary Receipt

– Formal participation by issuer company


– Trading: OTC market

– SEC: Minimal SEC filings


Level II Sponsored American Depositary Receipt

– Description: Listed on US exchanges


– Trading: US stock exchanges

– SEC: More requirements and regulations with SEC


Private Placement of ADRs– Purpose: Faster and cheaper way for companies to raise

capital than level III ADRs

GDR– Used most frequently in Europe where there are less

regulations

Variants– Euro Depositary Receipts, Retail Depositary Receipts, and

Singapore Depositary Receipts

What is the difference between a sponsored and unsponsored ADR?

ADVANTAGES OF GDRs

Allow investors to invest in foreign companies without worrying about…– Foreign trading practices – Different laws– Cross boarder taxes/fees

GDRs offer the same corporate rights, esp voting rights

To the holders of GDRs as the investors of the u/lying stock

GDRs are liquid for the supply / demand can be regulated

By creating or canceling GDR shares (Co / Dep Bank)

DISADVANTAGES OF GDRs

GDRs do have foreign exchange risk if the currency of the issuer is different from the currency of the GDR,

Which is usually the U.S. dollar.

What are some other advantages of GDRs or ADRs?

GDR Advantages

Allow investors to invest in foreign companies without worrying about – foreign trading practices, different laws, or cross-border transactions.

GDRs offer the same corporate rights, esp voting rights, to the holders

Easier trading, payment of dividends in GDR Cur and corporate notifications

Inst investors can buy them, even when they are restricted by law from buying shares of foreign Co

GDRs overcome restrictions on foreign O/ship, Cap movement imposed by the country of the corporate issuer, – avoids risky settlement procedures, eliminates local/Transfer taxes – There are also no foreign custody fees, ranging from 10 to 35 BPS/yr.

GDRs are liquid because supply and demand can be regulated by creating or cancelling GDR shares.

GDR Disadvantages

GDRs do, however, have foreign exchange risk

– If the currency of the issuer is different

– From the currency of the GDR

Trends

Although ADRs were the most prevalent form of DRs,

The number of GDRs has recently surpassed ADRs

Due to lower expense and time savings in issuing GDRs

GDR vs. ADR

Trends

In the 1990’s, the development of DRs drastically increased

because of changes in regulations by the SEC and the privatization of foreign companies.

– The number of sponsored DR programs grew from 352

– representing 24 countries in 1990

– To over 1,800 from 78 countries in 2001.

Conclusion

DRs make foreign investing easy for investors

Foreign Cos are able to increase liquidity and raise capital

An increase in DRs since 1990’s

Doing Business in India Simplified

India’s Industrial Policy

Indian govt has removed controls on industry, post liberalization

However, licensing/ restrictions still exist in the following sectors:

2 sectors reserved for PSU viz., Atomic Energy and Railways

Five Industries in which licensing is compulsory – Distillation and brewing of alcoholic drinks Cigars and cigarettes of tobacco Electronic Aerospace and Defence equipment Industrial explosives and Hazardous chemicals Manufacture of items reserved for Small Scale Sector.

Note – Exemption from licensing also applies to expansion

Foreign Investment in India

Foreign Direct Investment (“FDI”)

India welcomes FDI in almost all sectors. Foreigners can directly invest in India Either by themselves or as a joint venture. The invt ceilings in sectors are gradually being removed.

Opportunities exist for investing in India across sectorsAs diverse as Tourism and Infra, Petrochemicals and mining technologyEngineering, real estate, Biotechnology, Bio-informatics and nanotechnology.

India is also seen as global destination for R&D, Engg design and prototype development and a Mfr hub for Hi-Tech Prod.

FDI Policy

Per Current policy, FDI is not permitted in following sectors

Atomic energy;

Lottery business/gambling and betting;

Agriculture – (excluding floriculture, horticulture, seed development,

animal husbandry, pisciculture and cultivation of vegetables, mushrooms, etc.)

Plantations (excluding tea plantation)

Retail Trading (other than single brand retail)

FDI Policy contd….

There are two routes for FDI in India –

Automatic Route (AR)FDI permitted under AR for all, except the 2 following

• 1. Where foreign collaborator has an existing venture/tie-up in India in the same field. Exceptions are

• Investment by a VCF registered with SEBI;• Existing JV has < 3% investment by either party;• Existing joint venture is defunct or sick

• 2. Proposals ‘ultra vires’ sectoral policy caps / sectors in

which FDI is not permitted

FDI Policy contd….

FIPB Route (Approval Route)

In all other cases, approval is required from FIPB.

FIPB decision - normally conveyed within 30 days of applicn

Proposals decided case-to-case basis based on merits

And In accordance with the prescribed sectoral policy.

Acquisition of Shares

Acquisitions may be made of an existing Indian company which may be either a private or a public company.

Acquisition of shares of a Listed Co is S/to the guidelines of the Securities Exchange Board of India (SEBI)

Foreign investors looking at acquiring equity in an existing Indian Co thru stock acquisitions can do so under auto route.

Foreign Institutional Investors (“FII”)

An FII must be registered with SEBI must comply with certain investment limits. They may purchase shares and/or Conv Debs of Indian CosUnder Portfolio Investment Scheme.

Shares/CD’s of Indian Cos to be purchased through registered brokers on recognized stock exchanges in India.

FII’s are also permitted to purchase shares/CD’s of Indian Co’s thru Pvt Placement /arrangement.

Foreign Pension funds, MF’s, Invt trusts, AMC’s, Incorporated Inst portfolio Mgrs / their POA’s may invest In India as FIIs.

Foreign Technology Transfer

Foreign technology induction is encouraged - By Govt both through FDI and - thru Foreign Technology collaboration agreements.

No approvals are required in respect of all those foreign technology agreements which involve: (i) A lump sum payment of up to USD 2 million(ii) Royalty payable

• up to 5% on net domestic sales & 8% on exports• S/to to a total payment of 8% on sales, • W/o restriction on the duration of royalty payments.

Note - It is permissible for an Indian Co to issue equity shares against lumpsum fee and royalty in convertible forex

GDRs / ADRs / FCCBs

Indian companies listed on the stock exchange are allowed to raise capital through GDRs/ADRs/FCCBs.

Foreign Invt thru GDRs/ADRs/FCCBs is also treated as FDI.

Issue of GDRs/ADRs does not require any prior approvals– Save when FDI after issue would exceed the sectoral caps– in which case prior approval of FIPB would be required.

FCCBs issue <= $ 500 mn does not require prior approvals

Preference shares

Indian cos can mobilize foreign investment through issue of preference shares for financing their projects/industries.

Pref share issue permissible only as Re denominated instruments.

Pref shares to redeemed out of accumulated profits/ fresh capital within a period of 20 years as per Indian Co Law.

Preference shares, carrying a conversion option, must comply with sectoral caps on foreign equity.

If the preference shares do not have conversion option, they fall outside the FDI cap.

Exchange Control Regulations of India

Exchange control is regulated under the Foreign Exchange Management Act, 1999 (“FEMA”)

Forex transactions divided into two broad categories– current account transactions and capital account transactions.

The Indian Re is fully convertible for current account transactions– S/to a Neg list of trans that are prohibited/require prior approval.–

The Exch control laws & regulations for residents apply to foreign Cos Investing in India as well.

Foreign Capital invested in India is generally repatriable– Along with Capital appreciation, if any, – After payment of taxes due on them– Provided the investment was on repatriation basis.

Laws Governing Business in India

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

Important Regulatory Authorities for Foreign Investment

Secretariat for Industrial Assistance (SIA)Foreign Investment Promotion Board (FIPB)The Foreign Investment Implementation Authority (FIIA) Reserve Bank of India (RBI)Registrar of Companies (RoC)Securities and Exchange Board of India (SEBI)Central Board of Excise and Customs (CBEC)Central Board of Direct Taxes (CBDT)Authority for Advance Rulings (AAR)Investment Commission (IC)

India vs ROW ($ = 50 Rs)

1. X an Indian exports Rs 50,000 of merchandise to US against BOE.

2. Y an Indian imports Rs 75,000 of merchandise from US against payment

3.An NRI sends $ 3,000 to his parents in India. Parents invest it in 2 yr FD

4. An Indian Sends Rs 5,000 worth of jewellery as gifts to his daughter in US

. A US Auto co sends Cap eqpt worth $ 30,000n

Derivatives

1. Value is derived from another underlying contract, reference or index

2. Recent developments have transformed them into a cheap & efficient means of– Hedging : Neutralizes risk by fixing the price in Adv. For eg. Price of $ = 47 Rs on 1.Dec 09– Arbitraging : Take adv of discrepancy in prices across markets. – Speculating : Take a directional bet. Thus contribute liquidity

3. Arrival of Floating Intt rate regime post ‘73, heralded the need for Risk mitigation mechanisms

4. Led to the development of Exchange traded Forex futures in Chicago

5. Computers expedited growth, since fast computing of complex derivative pricing became feasible

6. Three risks • Market : The Value of derivative changing, esp as expiry

approaches• Basis : Hedge may not be a perfect match to the Risk one is

exposed to• Counter Party risk : CP not paying up. Less than for Loans, for only diff is at stake

7. 4 products– Forwards : Two-way negotiated agreement. OTC. Gen, when Exact date unknown– Futures : Exchange traded. Standard Contracts wrt Price, settlement date, contracts no. – Options : Right but not obligation to buy/sale. Option to Buy - call. Option to sell - Put– Swaps : 2-way Contr. to exchange 2 streams of payment for a period. Fix to float


INTERNATIONAL FINANCE

The Euromarkets: evolution, structure, instruments

Origins and developments Eurocredits and EurobondsLegal Clauses in SyndicationCapital adequacy guidelinesTax, accounting and regulatory framework


The EUROBOND MARKET

OriginsDevelopment

StructureInstruments

Volume


The Euromarkets: evolution, structure, instruments

Preparation: Clark, Chap. 5, pp. 113-130Madura: Chap. 3Eiteman, Stonehil & Moffett, MBF, chapter 13BIS Annual Report, Chap. VIIIBIS Quarterly Review, Statistical AnnexBouchet: Credit Creation, Multiplication and Maturity transformation in the Euromarkets, USC, United States.Milton Friedman, The Euro-dollar Market, Federal Reserve Bank of Saint Louis, July 1971. ISMA Annual ReportBIS Annual Report


What is a Eurocurrency?

Any freely convertible currency, such as a $ or a DM or £, deposited in a bank outside its country of origin. It is the residency of the bank and not its nationality that determines the “euro” nature of the deposit. Eurocurrency deposits are typically short-term deposits <1 year, whereas eurocredits are longer term, hence a maturity transformation in the Eurobanks’ balance sheets.


The Balance of Advantage forThe Borrowers

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


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


The EUROBOND MARKET

Since the 1960s the market experienced rapid growth. Dealers and brokers worldwide trade issues denominated in a host of currencies, structured in a number of innovative ways, and issued to investors from every corner of the globe. In 1999, market size - a measurement of the total volume of outstanding international bond issues, reached some US$3 trillon equivalent. The range of instruments traded has grown substantially, and includes warrants, global depository receipts, international FRNs, and medium-term notes, Euro commercial paper and debt denominated in Euro. As a result the term Eurobond has given way to a wider, and more appropriate, label for all these forms of borrowing as “international securities”.


The EUROBOND MARKET

The international nature of the market means that it is not subject to the same controls which govern the primary and secondary markets in purely domestic securities. Since 1969, ISMA (International securities market association) has performed a central role by providing a global framework of industry-driven rules and recommandations which regulate and guide trading and settlement in this market. Membership has now exceeded 700 institutions based in some 50 countries.


EUROBONDS

Eurobonds: long-term financial instruments issued by MNCs, IFIs or country governments, and denominated in a currency other than that of the country of placement. Eurobonds are underwritten by a multinational syndicate of investment banks and simultaneously placed in many countries. They are issued in bearer form, and coupon payments are made yearly. The US$ accounts for about 50% of eurobonds. Liquidity in the secondary market is monitored by Euro-clear. Highly tradeable securities.


Bonds

Contractual obligation on the part of the seller/issuer of the bond (the borrower) to pay a fixed amount per year for a set number of years to the buyer of the bond (the lender). At maturity, the borrower repays the original face value of the sum borrowed. Coupon= number of $ paid the lender per yearMaturity= number of years over which the bond runsPar value= original sum borrowedCoupon rate= coupon expressed as a % of the par value


Bonds

Coupon, par value and coupon rate are invariant over the life of the bond. The coupon rate is established by competitive pricing in the market. The coupon rate is set so that the bond will be able to compete with comparable instruments in terms of maturity, yield, credit risk…The bond can be traded on the secondary market at a market price which depends on the current market rate of interest for that type of bond. When the market rate of interest fluctuates, the price of the bond will adjust in such a way that the ratio coupon/price will equal the current interest rate.


Bonds

P = M (1 + i) nM is bond value at maturity, P is present value, i is interest rate, n is number of years.There is an inverse relationship between bond prices and interest rates. For a given P, the higher i, the smaller M.


Price and YTM of a Bond

Price and yieldPrice and yield to maturity are mirror reflections of each other. The two are inversely related and one is neded to arrive at the other. This if priceprice is given, an investor can calculate the yieldyield on the bond, and compare it with his own required rate of return to see if the bond is a worthy investment or not. Alternatively, an investor can work out the priceprice he would be willing to pay for a bond given his yieldyield requirement.Bond price and YTM are held together by the following equation:P =

C_____

(1+y)1

+ C_____

(1+y)2+ …..+ C______

(1+y) n+ M

______

(1+y) n

The YTM is essentially the bond’s internal rate of return, i.e., that discount rate which

makes the present value of all the bond’s future cash infloxs equal to the current price of

the bond (initial investment oputlay)


Yield curve

Yield spreads refer to the difference between the yield on a given bond at the time of issuance and the yield on US Treasury securities of comparable maturity or other comparable government securities if the bond is issued in other currencies than the US$. The US Treasury securities are used as proxy for risk-free return. As of end-2001, the US10-year rate is the base rate as opposed to the 30-year rate till 2000.

MH BOUCHET (c) CERAM453

Eurobond Yield Curve in Per centas of May 15, and October 24, 2000 and November 30, 2001

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

1 3 5 7 10 15 20 30

YIELD 05/99YIELD 10/99YIELD 11/01


Clearing procedures in the international bond markets

International Securities Market Association (ISMA)Euroclear (created by Morgan in 1968)CEDEL (Centrale de livraison des valeurs mobilières) created in Luxembourg in 1970

Eurobonds are engraved certificates. Euroclear and Cedel have a network of custodian banks where the certificates are deposited in bearer form for safekeeping. They manage the clearing of transactions on settlement date.


Emerging Markets Eurobonds

High risk/high yield with low default track record (premium of 20 basis points compared with US corporate borrowers for identical ratings)historically, defaults only in the 1930s and late 1980s but recovery rate is better for sovereign debtors than corporate debtors (75% vs 40%)problem of comparability of treatment with Paris Club and London Club debt (Pakistan, Ukraine, Ecuador, Argentina)Market risk remains high due to concentration on 5 major countries (Argentina, Mexico, Korea, Brazil and Russia)


Eurobond Market

By spreading the risk among thousands of investors, both private and institutional, as opposed to a handful of banks in the loan market, the bond markets lower the cost of risk and thus reduce the cost of funding for companies and other borrowers. This in turn enables companies to raise larger amounts of debt.Many companies took benefit of the depreciating euro in the fist half of 1999 to borrow in Euros and swap the proceeds into US$, which had an immediate downward effect on the value of the €, hence the link between the the euro’s weakness and the popularity of the euro-denominated bond market (US$300 b worth of securities issued in euros during the first half of 1999)


The Eurobond Market SizeGross= completed new bond and note issues in US$ billionNet= Gross - redemptions and repurchases

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Gross

Net

Stock

Q2


Secondary market trading share/volume in 2003

BradyEurobondsLocalOther

37%37%

46%46%

12%12%

US$1500 billion


Currency Breakdown of the international securities marketNet bond and note issues in US$ billion

0

100

200

300

400

500

600

700

800

1997 1998 1999 2000 2001 2002

$

€

Y

Other34%

45%


Largest issuers of Euro-denominated convertible debt in 2001-03

France Telecom € 6.2 billionVivendi Univ. € 2.8 billionOlivetti € 2.5 billionPPR € 1.4 billionLafarge € 1.3 billionArtemis € 1.2 billionDanone € 1 billion


China and the global bond market

US$1.5 billion dollar and euro-denominated issue, as benchmark government bond: October 2003China’s rating = A2 (Moody’s)* 10-year US$1 billion dollar tranche arranged by Goldman Sachs, Merrill and Morgan, at 53 bp over USTB* 5-year €400 million euro tranche arranged by Deutche Bank, BNP and UBS, at 7 bp over Euribor


Currency diversification and Eurobond issues

Between September and November of 2000, the US Agency Freddie Mac launched five-year two €-denominated bond issues of €5 billion respectively as part of Euro-reference note programme, with ANB Amro and Morgan Stanley as lead managers.Multicurrency and global bond issues reach US$815 billion in 2000, a 14% rise.11/2003: the EBRD is about to issue a US$150 million rouble bond in Russia’s market for on-lending purposes


Eurobond Market

Deutsche BankMorgan StanleyWarburg Dillon ReedABN AmroMerill LynchLazard FrèresJP MorganSalomon/CitibankBNP-ParibasBarclaysCommerzbankCredit Suisse First Boston


Bond markets

Yankee market: issues have to satisfy SEC listing requirements. These require higher standards of accounting and disclosure than typical for Eurobond issuers. In 11/1993, the SEC adopted measures to simplify the listing of foreign companies in US markets. They include recognition of international accounting standards, easier registration procedures, and reduction in the required reporting history from 3 years to 12 months.Samuraï market


International Debt Markets and Instruments

In ternational Securities M arket

E u ro bo n d s tra igh t f ixe d -ra te issue F loa tin g -ra te no te E qu ity- re la te d issue

F ixed an d f loa ting ra te /m e d iu m to lo ng - te rm b on d issu es


Eurocurrency market Instruments1: EURONOTE MARKET

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


Eurocurrency market Instruments

II- Note-issuance facility (NIF): A medium-term legally-binding commitment under which a borrower can issue a short-term paper in its own name, underwritten by banks which are committed either to purchase any note the borrower is unable to sell, or to provide credit.

Issuing procedures with arranger or placing agent and tender panel.


Eurocurrency market InstrumentsIII- Euro medium-term notes (EMTNs)

It bridges the gap between the ST euro commercial paper issued in domestic markets < 6 months, and the longer-term international bond.

Market expansion when the SEC instituted Rule # 415, allowing companies to obtain shelf registrations for debt issues: once the registration was obtained, the corporation could issue notes on a continuous basis without having to obtain new registrations for each additional issue. This allows a firm to sell S/MT notes through a cheaper and more flexible issuance facility than ordinary bonds.

Maturity: from 1 year to < 10 yearsSmall denominations (from $2 to $5 million)


Eurocurrency market Instruments2: The Eurobond MarketA Eurobond is underwriten by an international syndicate of investment banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated: $-denominated bond issued by a US company, but sold to investors in Europe and Japan. Eurobonds offer tax anonimity and flexibility. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at a banking institution listed on the issue as paying agent. Eurobonds are offered simultaneoulsy in a number of different capital markets.


Eurocurrency market InstrumentsThe Eurobond Market

1. Straight fixed-rate issue: bearer bonds, fixed coupon, set maturity date, full principal repayment upon final maturity. Coupons are normally paid annually.

2. Equity-linked bonds: convertible bonds or bonds with equity warrants (amounted to $64 billion in 1997, and $32 billion in 1998). Right to acquire equity stock in the issuing company (sometimes with detachable warrants containing the acquisition rights). The market value of an ELB is composed of the naked value and the conversion value. The conversion to stock prior to maturity is at a specified price per share, or a specified number of shares per bond. The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.


Eurocurrency market InstrumentsThe Eurobond Market

3- FRNs: since the early 1980s. medium-term notes where the interest is fixed as a percentage above six-month LIBOR. Pays a semi-annual coupon determined on variable-rate base. Negotiable and transferable securities with flexible interest rate, fixed interest periods, and issued in pre-determined and uniform amounts. FRNs are directed at institutional investors


Global bonds

Global bonds are issued simultaneously in several major international markets and allow issuers to tap into broader demand and obtain lower rates than those availabe in a single market. Some market participants estimate that EMCs such as Brazil and Argentina have been able to reduce the interest rate on funds raised through global issues by as much as 30 basis points. Argentina was the first borrower ever to issue a global bond on 12/1993 with a US$1 billion placement.


Peru and the Global Bond market

12/98: Telefonica del Peru (TDP) launched a $150 million 10-year bond backed by telephone receivables via JP Morgan, with a 7.48% coupon. The deal was priced at 315 bp over 5-year UST bills. The bonds were rated A- by DCR and A3 by Moody’s. 11/2000: Banco de Credito raised a $100 million 7-year bond backed by its inflow of hard currency electronic transfers. The $ flow was transferred to the offshore trustee for the benefit of the certificate holder. (the structure was substantially over collateralized): arranger: ING Barings.


Peru and the Global Bond market

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


Financial Clauses in Eurocurrency financing

Bullet Maturity: One-time payment of principal at maturity.

Currency Redenomination: Switching of loans denominated in one currency or currencies into the currency of the creditor country or into ECUs. (The mechanism is intended to bring about a better match between the currency mix of debt service payments and the currency composition of external receipts.)

Interest Rate Switching: Selection of a new basis for interest calculations on an existing loan. The options may include LIBOR, a domestic rate, the prime rate or a fixed rate, to which a margin is added.


Legal clauses in Eurocredits

Problem of “comparability of treatment” between various categories of creditors:

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



Prepayment clause: The prepayment clause is a standard clause in loan agreements between a debtor and a creditor bank. In its various forms, it can provide the debtor with the opportunity to accelerate repayment of the loan on a voluntary basis and/or provide for acceleration of repayment due to changes in laws affecting the creditor. In rescheduling agreements, the clause is intended to prevent the obligor to grant a preferential repayment schedule to other banks which have not signed the convention and which would be paid ahead of normal maturity terms.



pro rata sharing : A legal covenant in commercial bank agreements which specifies that debt service payments are to be made through the agent bank for allocation on a pro rata basis to all creditor banks. Further, payments received or recovered by any one lender must be shared on a pro rata basis with all co-creditors under the loan agreement. Thus, no one lender may be placed in a more favorable position than its co-lenders with respect to payments received and/or recovered. cross-default: A legal wrinkle which allows one creditor to declare default and exercise its remedies against the borrower in cases where other loans of the borrower have been suspended, terminated, accelerated or declared in default by other creditors.



. Mandatory repayment clause: standard clause in loan agreements that stipulates certain circumstances under which repayment is accelerated. The debtor, by being obligated to prepay any one creditor, must repay all lenders on a pro rata basis. In the context of rescheduling agreements, the provision is intended to neutralize "free rider" banks which do not participate in debt restructuring and new money agreements. The provision applies across the universe of public sector borrowers so that a voluntary prepayment of one or more credits by one borrower would trigger mandatory prepayment not only by that borrower but also by the other public sector borrowers.

Ex. Ecuador’s default on Brady bonds in October of 1999!



Optional prepayment provision: The optional prepayment provision permits the borrower to prepay all or part of the loan provided it prepays all lenders under the agreement on a pro rata basis.

Pari-passu clause: Clause inserted in lending and restructuring agreements that provides for a strict equality of treatment among various categories of debts and various families of creditors.


September-October 1999: The debt default of Ecuador in the limelight

Ecuador: Brady bonds account for US$6.1 billion in Ecuador’s overall external indebtedness of US$13 billion. The Brady bonds have been subject to a lot of financial engineering, including the stripping of the collateral out of the bonds. IMF’s position: Ecuador needs to find out some US$500 million to cover its balance of payments shortfall until the end of next year, and about US$1 billion to cover its budget shortfall, and probably more since Ecuador has foreign currency denominated domestic debt.... For the first time in 55 years, the IMF is acquiescing in a country’s decision to default on its debts to the international bond markets.


Legal clauses in Eurocredits. Negative Pledge provisions : they deal with the

granting of security interests by a borrower over its assets to its creditors. In the case of a debt refinancing agreement, the debtor agrees with the banks not to provide any other group of creditors with security interest on the country's reserves, exports of goods, and public sector companies' assets. The objective of such a clause is to prevent a situation where a debtor would allocate significant assets to other creditors, thereby effectively subordinating the unsecured bank credits, hence an unequal and unfair treatment of creditors!

Subordination: ranking of current debt compared to future debt obligations in case of default


How do Negative Pledge clauses work in practice?

Mexcobre/ParibasCitibank/BancomextPemex/JP MorganBrady bonds and zero-coupon collaterals

All required special waivers from IFIs!


Collateralization schemes

To facilitate the placement of debt instruments in the international bond market issuers use various structures of enhancements. Asset-backed securities allow borrowers to tap the bond markets at considerably lower rates.Pemex issue in Japan secured by four offshore drilling platforms in the Gulf of Mexico. Mexican insurance group launched an issue of mortage-backed securities with the bonds secured against US$-denominated mortgages granted to Mexican residents.Mexican company raised $200 million to finance a highway construction project through a bond issue backed by prospective toll revenues.


Asset-backed securities

October 1999: Argentina issued a $1.5 billion bond with a WB US$250 million collateral to guarantee sequential payments on the bond, borrowing for each payment the supranational’s triple A credit rating.January 2001: Colombia issued a US$1.3 billion WB backed bond (Goldman Sachs and JP Morgan as advisers)November 2001: IFC, WB’s private investment bank, responded positively to a request to provide guarantees to Philippines’ private sector companies tapping offshore debt markets, to help bring down borrowing costs in the capital markets;


PERU: Jan. 2002 Debt Exchange offer

In a historic transaction, Peru returned to the global bond market for the first time in 74 years to exchange $1.21 billion of Bradys (mainly PDIs and Flirbs) for a new $930 million, 10-year global bond. The exchange reduced Peru’s debt load by $280 million, generated NPV savings of $30 million. The new bond was priced 50 bp below the outstanding Bradys and qualified for JP Morgan’s

EMBI+ index of most liquid and traded investments.


PERU ’s London Club Debt Secondary Market Price (% of face value)

45

50

55

60

65

70

75

80

85

90

PDI 07/17

FLIRB

YTM 7%

Asian crisis

MH BOUCHET (c) CERAM

488

EMBI Spread Peru vs. Global, 1998 - 2003

MH BOUCHET (c) CERAM

489

Brady Bonds?

t0 t10 t20 t30

Bullet Payment at maturity

Default on interest payments triggers exercice of interest gurantee

and of principal collateral guarantee

LIBOR = 5 1/4

LIBOR= 9 1/2


How to assess and calculate the market value of a collateralized Brady Bond?

Brady bonds comprise defaulted London Club debt, repackaged and backed by 30-year US Treasury bonds as collateral, often including a rolling 18-month interest guarantee.

1. Strip the bond by separating the risk from the no-risk elements (interest and principal)2. Calculate the risk-adjusted NPV of the guaranteed and non-guaranteed streams of interest payments and the principal payment at maturity, by using a risk-adjusted discount rate.


New Ball Game 1997/2003: Brady Debt Exchange Offers

Enhanced liability management gives rise to debt exchanges:1997: Brazil: US$4 billion Bradys for new 30-year global bond1997: Argentina: US$2.3 billion Bradys for new 30-year global1997: Venezuela: US$4 billion Brady exchange1997: Panama: US$0.7 billion Brady exchange1999: Philippines: US$1 billion Bradys for new 10-year bond1999: Brazil: US$2 billion Pars, Flirbs, NMBs for new 10- year bond2000: Argentina: US$2.4 billion Pars, Discounts, FRBs for new 15-year global bond2000: Brazil: US$5.2 billion Bradys for new global bond2000: Ecuador: Eurobonds and Bradys for new 12-year and 30-year global bonds08/2003: Venezuela’s $3.8 billion buyback of 2007 bonds financed by new 2010 notes paying a below-market coupon


Larger and more complex ever bond issues

03/2001: France Telecom launched US$16 bn multi-currency bond issue (>Deutsche Telekom’s $14.6 bn deal in June 2000), with eight tranches in $, £, and €, with maturities ranging from 2 to 30 years, with high bond yield and coupon increases by 25 bp for every notch Moody’s or S&P rating cuts < A category. 11/2001: France Telecom (Baa1/BBB) completes €5 bn fundraising in the European bond market with two-tranches short-dated deal: 18-month floating rate tranche of €2.25 bn and €2.75bn 3-year fixed rate bond, sold to >600 different investors!

S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L

International Fin Mgt

A Brief Introduction

Sep 2009

Forex Markets

1. In Forex Mkt, currencies are bought and sold against each other.

2. World’s largest market with a daily turnover of around $3.5 trillion a day.

3. The Indian Forex Mkt is very small compared to global 24 Hrs Forex market.

4. The Indian turnover is only around $ 5-10 billion/day.

5. The foreign exchange market is worldwide in scope

6. Major Centres : Tokyo, Singapore, New York, Frankfurt, Zurich, San Francisco.

Information and Communication Systems

1. Communications Handled by SWIFT

2. Society for Worldwide Interbank Financial Telecommunications (SWIFT).

3. SWIFT : is a non-profit Belgian cooperative from Geneva

4. All SWIFT centers around the world connected by data transmission lines.

5. A member bank can access a regional processor or main centre

6. This communications system links banks/ brokers in every financial centre.

7. The banks and brokers are in almost instant contact, 24 hours a day.

8. Significant events have Instantaneous impact due to Communication speed

Functions of the Foreign Exchange Market

1. Forex Mkt : One where individuals/firms banks buy and sell forex

2. Principle function of Forex Mkt is the transfer of funds across currencies

3.The above needed to facilitate International trade and capital transactions

The Foreign Exchange Rates1. Two nations, the US and India. INR being the domestic currency

2. Exchange rate Expressed Directly

3. ER = INR/$ = 50. Two dollars are required to purchase one pound.

The exchange rate under a flexible exchange rate system

4

3

2

1

0 1 2 3 4 5 6 7

E

BA

G

F

S

H D £

Million$/day

R = INR/$

Quantity of Pounds

Foreign Exchange Markets

1. Forex market includes both the spot and forward exchange rates.

2. Spot : Delivery within two business days after the day of transaction

3. In forwards : Payment and delivery are not required until maturity.

4. Forward rates - For periods of 30, 60, 90 or 180 days from contract Date

The Spot Market

1. Indirect Quote : The number of units of $ for one unit of home currency.

2. Direct : Amount of rupees to exchange for one unit of foreign currency.

Cross Rates of Exchange

1. An Exch rate for a currency derived from the Exchange rates of those

currencies with a third currency is known as a cross rate of exchange.

2. A cross rate can be obtained by multiplying two exchange rates by each

other so as to eliminate a third currency that is common to both rates.

3. Common use of cross rate is to determine the Exchange rate between 2

currencies that are quoted against the US dollar but not against each other.

Bid-Ask Spreads

1. Interbank quotations are given a bid and ask (also referred to as offer) price.

2. A bid is the price in one currency at which a dealer will buy another currency.

3. An offer or ask is the price at which a dealer will sell the other currency.

4. Dealers generally bid (buy) at one price and offer (sell) at a higher price.

5. Making profit from spread, The Difference between buying and selling prices.

The Forward Market

1. The spot market is for Forex traded within two business days.

2. However, some transactions may be entered into on one day but not

completed until sometime in the future.

3. The forward rate is the rate quoted by foreign exchange traders for the

purchase or sale of foreign exchange in the future.

The Need for a Forward Market

1. The actual need for the existence of a forward market is not speculation.

2. Today, there is no clear-cut line of distinction between hedging and

speculating.

3. However, there are a couple of characteristic categories of people who use

the forward market in order to cover for time lags.

Cont….

Swaps

A swap Trn is a double-leg deal, in which one buys spot currency X selling

currency Y and simultaneously sells forward currency X buying currency Y.

Exc Rate Spot 1 Mth Fwd 2 Mth Fwd 3 Mth Fwd

INR / DM 22.9410 / 40 20 / 24 20 / 25 15 / 19

INR / $ 43.3125 / 10 15 / 10 20 / 15 20 / 20

Swaps

A swap Trn is a double-leg deal, in which one buys spot currency X selling

currency Y and simultaneously sells forward currency X buying currency Y.

Interest Arbitrage

Interest arbitrage refers to the international flow of short-term liquid capital to

earn a higher return abroad. Interest arbitrage can be covered or uncovered.

Exc Rate Spot 1 Mth Fwd 2 Mth Fwd 3 Mth Fwd

INR / DM 22.9410 / 40 20 / 24 20 / 25 15 / 19

INR / $ 43.3125 / 10 15 / 10 20 / 15 20 / 20


–3– 2 –1 0 1 2 3

Inte

rest

diff

eren

tial i

n fa

vour

of f

orei

gn c

ount

ry in

per

cen

t per

ann

um

3

2

1

0

–1

–2

–3

Arbitrageinflow

Interestparity

Arbitrageoutflow

•B

A•

•A’

B’•

Forward exchange rate - discount or premium in per cent per annum

Arbitrage outflow



Arbitrage inflow




01-Jan-09 Spot DM 22.5

Fwd 1 year 23.25



Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 9.50%

Intt Rate diff for DM 0.70%


Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 9.50%


Arbitrage possible


Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 9.50%


Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 9.50%


Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8


Fwd 1 year 23.25


Intt Rate DM 10.20%

Intt Rate INR 9.50%


Arbitrage possible

01-Jan-09 Buy DM 100,000.0 4,444.4

Investment @ 10.2%


Cumulative 4,897.8

Trfr to INR 23.3 113,873.3

Return % 13.87%

Chapter8

The Foreign Exchange Market

Using Currency Option

An option Profitable to exercise at the prevailing Forex rate is ‘in-the money’.

An ‘out-of-the money’ option is not profitable to exercise at the current rate.

The price at which the option is exercised is called the exercise/ strike price.

Option whose spot rate is = Exch price is said to be ‘at-the money’.

Speculating with Currency Options

Break-even Point from Speculation

if the revenue from selling the currency equals

The payments for (i) Buying the currency + the option premium.

The computation of the break-even point is useful for a speculator deciding

whether to purchase a currency call option or not.

Numerical Example

Put option premium on $ = Rs. 0.4 per unit

Strike price = Rs. 45.00

1 option contract represents 100 $

Relationship between Options and Futures

There is a symmetrical pay-off with the futures contract

whereas there is a asymmetrical pay-off with an option.

Nature of the symmetry refers to patterns of pay-offs around the exercise price

it is possible to combine options to replicate pay-offs from futures contract

Options vs Futures : Futures should be distinguished from options.

i. P&L on open futures positions. Ltd only by the Price of underlying

ii. On options

a. P&L is virtually unlimited for the purchaser but limited to writer

b. Losses unlimited for the writer but Ltd to the premium for the writer

B. Hedging is possible with either options or futures.

But a single futures position can neutralise exposure in underlying asset.

Same hedge with options requires simultaneous put and call in many Mkts.

Chapter9

Forex. Rate Movement and International Parity Conditions

1. Exchange rates movement is an important issue in international finance

2. Managers of MNC’s, FII’s, importers/ exporters attach importance to it.

The three theories of exchange rate determination are

1. Purchasing Power Parity (PPP) : Links spot Fex rates to Price levels.

2. The Interest Rate Parity (IRP) : Links Fwd Exch rates and Nominal Intt.

3. The Intnl Fisher Effect (IFE) : Links Spot rate to nominal intt. rate

levels.

Purchasing Power Parity (PPP)

a. The PPP theory focuses on the inflation-exchange rate relationships.

b. Based on single price for similar commodities

c. There are two forms of the PPP theory.

Absolute Purchasing Power Parity between Currencies

a. Postulate : Equilibrium exch. rate of 2 nations = Ratio of their price levels

b. Thus, prices of similar products of 2 countries should be equal

c. When measured in a common currency as per the absolute version of PPP

Rs / $ = PRs / P$

Relative Purchasing Power Parity

1. Postulate : Change in the Exchange rate is proportional to Delta price levels

in the two nations over the same time period.

2. This theory a/cs for market imperfections like transport costs,Tariffs/ quotas.

3.Relative PPP theory accepts that prices of similar products can Differ across

countries when measured in a common currency.

R1 / $1 = [ (PR1/PR0) / (P$1/P$0) ] * [R0 / $0]

Graphic Analysis of PPP : Exhibit 1

a. Helps us assess the potential impact of inflation on exchange rates.

b. ‘ Y ‘ axis measures % Appr/ Depr of Forex relative to home currency

c. ‘X’ axis measures % Inflation diff. between home and abroad

I -I (%)

4

2

-2

-4

-4 -2 2 4

% Incr in the foreigncurrency spot rate

PPP line

A

B

Empirical Testing of PPP Theory

Substantial empirical research has been done to test the validity of PPP

theory.

The general conclusions of most of these tests have been that PPP does not

accurately predict future exchange rates

That there are significant deviations from PPP persisting for lengthy periods.

International Fisher Effect (IFE)

The IFE uses interest rates rather than inflation rate differential to explain the

changes in exchange rates over time.

IFE is closely related to the PPP because interest rates are significantly

correlated with inflation rates.

The relationship between the percentage change in the spot exchange rate

over time and the differential between comparable interest rates in different

national capital markets is known as the ‘International Fisher Effect.’

The IFE suggests that given two countries, the currency in the country with the

higher interest rate will depreciate by the amount of the interest rate

differential.

Graphic Analysis of PPP : Exhibit 2

a. Helps us assess the potential impact of Intt on exchange rates.

b. ‘ Y ‘ axis measures % Appr/ Depr of Forex relative to home currency

c. ‘X’ axis measures % Intt diff. between home and abroad

I -I (%)

4

2

-2

-4

-4 -2 2 4

% Incr in the foreigncurrency spot rate

PPP line

A

B

Graphic Analysis of the International Fisher

Exhibit 2 illustrates the IFE.

The X axis shows the percentage change in the foreign currency’s spot rate

The Y axis shows the difference between the home and foreign interest rats

The diagonal line indicates the IFE line

It depicts the exchange rate adjustment to offset the differential in interest rates.

For all points on the IFE line, an investor will end up achieving the same yield,

Whether investing at home or in a foreign country.

The IFE suggests that if a company regularly makes foreign investments,

The yield is sometimes below and sometimes above domestic yield.

Comparison of PPP, IFE and IRP Theories

Theory Key Variables of Theory Summary of Theory

Interest rate party (IRP)

Forward rate premium (or Discount)

Interest differential

a. The premium/ Discount in Forex ratesb. Is a function of Difference in interest ratesc. Between 2 countries. b. So, covered interest arbitrage return c. Will be no higher than domestic returns.

Purchasing Power Parity (PPP)

% change in spot Exch rate

Inflation differential

a. The spot rate of one currency wrt anotherb. will change wrt differential in inflation rates c. between the two countries. d. So, purchasing power for consumers across

countries will be similar

International Fisher Effect (IFE)

% change in spot Exch rate

Intt. rate differential

a. The spot rate of one currency wrt anotherb. will change wrt differential in inflation rates c. between the two countries. d. So, purchasing power for consumers across

countries will be similar e.So, the return on uncovered foreign money

market securities will, on an average, be no higher than the return on domestic money

Chapter11

Management of Translation Exposure

Translation Methods

Four methods of foreign currency translation have been developed in various

countries.

1. The current rate method

2. The monetary/non-monetary method

3. The temporal method

4. The current/non-current method

Functional Versus Reporting Currency

Financial Accounting Standards Board Statement 52 (FASB 52) was issued in

December 1981, and all US MNCs were required to adopt the statement for

fiscal years beginning on or after December 15, 1982. All foreign currency

revenue and expense items on the income statement must be translated at

either the exchange rate in effect on the date these items were recognised or

at an appropriate weighted average exchange rate for the period. FASB 52

differentiates between a foreign affiliate’s “functional” and “reporting” currency.

Functional currency is defined as the currency of the primary economic

environment in which the affiliate operates and in which it generates cash

flows. The reporting currency is the currency in which the parent firm prepares

its own financial statements. This currency is normally the home country

currency, i.e.,

Comparison of Four Translation MethodsAll financial statement items restated in terms of the parent currency are the functional currency amount multiplied by the appropriate exchange rate.

Balance Sheet Current/Non-current

Temporal CurrentMonetaryNon-monetaryRate

Cash C C C C

Receivables C C C C

Payables C C C C

Inventory C C C or H C

Fixed Assets H H H C

L/Term Debt H C C C

Net Worth H H H H

Exchange Rates Used to Translate Balance Sheet Items

1.00 1.05 0.10 0.11

1.05 1.40 0.11 0.14

Current Method

UK subsidiary Mil £

French Subsidiary (Mil FF)



Sl no Particulars

31-12-98

31-Dec-99

31-Dec-98

31-Dec-99

31-Dec-98

31-Dec-99

31-Dec-98

31-Dec-99

1Cash & Bank Balance 120 143 2,143 1,915 126 200 238 264

2 A/cs receivable 315 407 4,020 3,775 331 570 447 521

3 Inventories 612 750 3,950 3,850 643 1,050 439 531

4 Fixed Assets 1,350 1,300 7,010 6,850 1,418 1,820 779 945

Total Assets 2,397 2,600 17,123 16,390 2,517 3,640 1,903 2,261

0 0 0 0

1 Bank Loans 500 450 3,000 2,800 525 630 333 386

2 A/Cs Payable 490 553 4,873 4,658 515 774 541 642

3 L/T Debt 650 700 4,250 4,000 683 980 472 552

4 Net Worth 757 897 5,000 4,932 757 942 500 548

5Transln Gain/ Loss 38 314 56 132

Total Liabilities 2,397 2,600 17,123 16,390 2,517 3,640 1,903 2,261

1.00 1.05 0.10 0.11

1.05 1.40 0.11 0.14

Monetary / Non-Monetary





Sl no Particulars

31-Dec-98

31-Dec-99

31-Dec-98

31-Dec-99

31-Dec-98

31-Dec-99

31-Dec-98

31-Dec-99

1Cash & Bank Balance 120 143 2,143 1,915 126 200 238 264

2 A/cs receivable 315 407 4,020 3,775 331 570 447 521

3 Inventories 612 750 3,950 3,850 612 788 395 428

4 Fixed Assets 1,350 1,300 7,010 6,850 1,350 1,365 701 761

Total Assets 2,397 2,600 17,123 16,390 2,419 2,923 1,781 1,974

1 Bank Loans 500 450 3,000 2,800 525 630 333 386

2 A/Cs Payable 490 553 4,873 4,658 515 774 541 642

3 L/T Debt 650 700 4,250 4,000 683 980 472 552

4 Net Worth 757 897 5,000 4,932 757 942 500 548

5Transln Gain/ Loss (60) (404) (66) (155)

Total Liabilities 2,397 2,600 17,123 16,390 2,419 2,923 1,781 1,974

Cur Rate 6.4 Normal Revaluation Devaluation

Historical (Inv) 4.5 6.425.00

% 4.80 50.00% 9.60

Historical (Dep) 4 Current / Non current

Rate Amount RateAmoun

t Rate Amount

Sales 8,000

Cost of sales : Inv 600

COS - Depr 1,000

COS - Others 900

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468


COS - Depr 1,000

COS - Others 900

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135


COS - Depr 1,000

COS - Others 900

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000

COS - Others 900

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900 5.5 165 4.7 194 7.1 128

Intt Exps 600

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900 5.5 165 4.7 194 7.1 128

Intt Exps 600 5.5 110 4.7 129 7.1 85

PBT 4,000

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900 5.5 165 4.7 194 7.1 128

Intt Exps 600 5.5 110 4.7 129 7.1 85

PBT 4,000 5.5 734 4.7 860 7.1 567

I Tax 1,600

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900 5.5 165 4.7 194 7.1 128

Intt Exps 600 5.5 110 4.7 129 7.1 85

PBT 4,000 5.5 734 4.7 860 7.1 567

I Tax 1,600 5.5 294 4.7 344 7.1 227

PAT 2,400



% 4.80 50.00% 9.60



t Rate Amount

Sales 8,000 5.5 1,468 4.7 1,720 7.1 1,135

Cost of sales : Inv 600 5.5 110 4.7 129 7.1 85

COS - Depr 1,000 4.0 250 4.0 250 4.0 250

COS - Others 900 5.5 165 4.7 194 7.1 128

SD O/Hs 900 5.5 165 4.7 194 7.1 128

Intt Exps 600 5.5 110 4.7 129 7.1 85

PBT 4,000 5.5 734 4.7 860 7.1 567

I Tax 1,600 5.5 294 4.7 344 7.1 227

PAT 2,400 5.5 440 4.7 516 7.1 340


Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60

Historical (Dep) 4 Current Rate

No Particulars 31-Mar-01 Rate Amount Rate Amount Rate Amount

1Cash & Bank

Balance 1,600,000

2 Mkt Securities 3,200,000

3 Inventory 2,400,000

4 Plant &Eqpt 4,800,000

5 Goodwill 2,000,000

Total Assets 14,000,000

1 Cur Liabilities 800,000

2 LT Loan 1,600,000

3 LT Debt 2,000,000

4 Capital stock 8,000,000

5 Ret. Earnings 1,600,000

6 Tran Gain/ Loss

Total Liabilities 14,000,000


Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333


4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333


2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000



6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333



6 Tran Gain/ Loss

Total Liabilities 14,000,000 2,187,500 2,916,667 1,458,333


Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5 Ret. Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000

6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5 Ret. Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000

6 Tran Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 6.4 750,000 4.8 1,000,000 9.6 500,000

5 Goodwill 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

Total Assets 14,000,000 2,187,500 2,916,667 1,458,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5 Ret. Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000

6 Tran Gain/ Loss (900,000) (400,000) (1,400,000)




% 4.80 50.00

% 9.60


Sl no Particulars 31-Mar-01 Rate Amount Rate Amount Rate Amount

1 Cash & Bank Bal 1,600,000



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5

Retained Earnings 1,600,000

6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000

3 Inventory 2,400,000 6.4 375,000

4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000


2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000


5


6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5

Retained Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000

6

Transln Gain/ Loss




% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5


6

Transln Gain/ Loss

Total Liabilities 14,000,000 0.0 2,825,000 3,200,000 2,450,000



% 4.80 50.00

% 9.60



1 Cash & Bank Bal 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 6.4 375,000 4.8 500,000 9.6 250,000

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,825,000 3,200,000 2,450,000

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5


6

Transln Gain/ Loss (450,000) (200,000) (700,000)

Total Liabilities 14,000,000 0.0 2,825,000 3,200,000 2,450,000


Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60

Historical (Dep) 4 Monetary / Non-Monetary


1Cash & Bank

Balance 1,600,000



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000


5 Retained Earnings 1,600,000

6 Transln Gain/ Loss



Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667



4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333


4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000




2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333


2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333






Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000





Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5 Retained Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000




Historical (Inv) 4.5 6.4 25.00% 4.80 50.00% 9.60



1Cash & Bank

Balance 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

2 Mkt Securities 3,200,000 6.4 500,000 4.8 666,667 9.6 333,333

3 Inventory 2,400,000 4.5 533,333 4.5 533,333 4.5 533,333

4 Plant &Eqpt 4,800,000 4.0 1,200,000 4.0 1,200,000 4.0 1,200,000

5 Goodwill 2,000,000 4.0 500,000 4.0 500,000 4.0 500,000

Total Assets 14,000,000 2,983,333 3,233,333 2,733,333

1 Cur Liabilities 800,000 6.4 125,000 4.8 166,667 9.6 83,333

2 LT Loan 1,600,000 6.4 250,000 4.8 333,333 9.6 166,667

3 LT Debt 2,000,000 6.4 312,500 4.8 416,667 9.6 208,333

4 Capital stock 8,000,000 4.0 2,000,000 4.0 2,000,000 4.0 2,000,000

5 Retained Earnings 1,600,000 4.0 400,000 4.0 400,000 4.0 400,000

6 Transln Gain/ Loss (104,167) (83,333) (125,000)


Group presentations

1. FDI Ch 14 - Group 12. MNC Capital Budgeting Ch 16 - Group 53. MNC Cash Management Ch 17 - Group 24. International Taxation Ch 19 - Group 45. Depository receipts GDR/ADRS Ch 23 - Group 2

Others (Self will handle)1. Cost of Capital and Cap Structure2. Country Risk analysis3. International Banking4. Euro currency markets5. Swaps and Exch. Arithmetic6. Euro and Implication for India

Measurement of Currency Variability

Taiwanese Dollar

Chinese Remnimbi

Japanese Yen

South Korean Won

Hong Kong Dollar

Thai Baht

Singapore Dollar

Indian Rupee

TWD/USD

CNY/USD

JPY/USD

KRW/USD

HKD/USD

THB/USD

SGD/USD

INR/USD

1.000

0.700

22.817

652.45

0.046

21.756

0.301

14.944

1.000

-0.356

46.193

0.003

1.621

-0.014

1.532

1.000

1853.06

0.053

53.210

0.761

30.446

1.000

3.264

1751.03

23.822

1076.20

1.000

0.142

0.002

0.115

1.000

0.868

39.737

1.000

0.557 1.000

Covariance among the Asian Currencies (1993-2000)

CAD DEM FRE JPY GBP SHF AUD KHD

CADDEMFRFJPYGBPSHFAUDHKDNZD

1.00-0.460.53-0.770.73-0.660.720.310.41

1.000.280.85-0.210.930.85-0.270.83

1.00-0.150.78-0.040.850.120.83

1.00-0.520.880.06-0.530.22

1.00-0.480.520.440.36

1.000.75-0.320.83

1.000.670.90 1.00

Correlations Shown by the Top Nine Currencies of the World Against Each other (1993-2000)

Assigning risk grades to currenciesRisk grades to currencies have been arrived at after determining their standard deviations. The following formula has been used for arriving at the classification.

Standard Deviation 2000

Standard Deviation 1991 × 100

Risk Rating Risk Grade

1-20% A+ (Very Low)21-40% A (Low)41-60% B + (Average)61-80% B (Medium)81-100% C (High)101-1000% D (Very High)>1000% E (Extremely High)

Name of Co DC Corp

Its HO Currecny $

Tran Currency £

Problem

DC needs (Sterling) 100,000

When (no of days) 180

Current Spot rate (no of $ / £) 1.5

Forward rate 180 days quote (no of $ / £) 1.48

Interest Rates UK US

Deposit rate 4.5% 4.5%

Borrowing rate (180 days) 5.1% 5.1%

Call option prem on £ 180 days strike 1.49 $ 0.03

Future Spot rate Probabilities Expd rate Prob

$ 1.44 0.2

$ 1.46 0.6

$ 1.53 0.2

Forward Hedge

1 Forward Rate 180 days hence 148,000

2 Swap

Needed after 180 days (£) 100,000

Cumulative principal + intt in 180 days (Sterling) 1.045

Needed now (£) 95,694

Price of £ needed presently in $ terms (1.5$/£) 143,541

Borrowing cost of $ for 180 days (5.1%) 7,321

Cumulative Cost impact 150,861

Expd Spot

Exercise Call ?

Applicable rate Prem

Total cost Actual O/F Prob Expd Value

1.44 No 1.44 0.03 1.47 147,000 0.2 29,400.0

1.46 No 1.46 0.03 1.49 149,000 0.6 89,400.0

1.53 Yes 1.49 0.03 1.52 152,000 0.2 30,400.0

149,200.0

Expd Spot

Applicable rate

Total cost Actual O/F Prob Expd Value

1.44 1.44 1.44 144,000 0.2 28,800.0

1.46 1.46 1.46 146,000 0.6 87,600.0

1.53 1.53 1.53 153,000 0.2 30,600.0

147,000.0

Documents

IFM PGP SBS Full Term Revd Latest Exellent