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    INTERNATIONAL

    FINANCIALMANAGEMENT

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    International Financial ManagementSyllabus

    Unit 1 Foreign Exchange Market

    Unit 2 Foreign Risk

    Unit 3 International Investment Decisions

    Unit 4 Evaluation and Explanations of

    Foreign Direct Investment

    Unit 5 International Investing.

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    Reference Books

    International Finance: The Markets and Financial Management ofMultinational Business Mauric D.Levi, McGraw Hill Inc, Newyork (1990)

    International Financial Management Dr.P.K.Jain & others, McMillan

    Financial Management and Policy, James C Van Horne, Prentice Hall of IndiaPvt.Ltd.,New Delhi (1994)

    Principles of Corporate Finance, Richard A Brealely, Stewart C.Myers,

    McGraw Hill Book Company, Newyork (1988)

    Management of Investments, Jack Clark Francies, McGraw Hill Inc (1993).

    Modern Investments & Security Analysis, Russel J Fuller & fuller & James, L

    Farrell Jr. McGraw Hill Inc.(1981).

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    Foreign Exchange Markets

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    Foreign ExchangeIt is the system or process of

    converting one national currencyinto another, and of transferring

    money from one country to another.

    Dr. Paul Einzig

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    Foreign ExchangeThe section of economic science

    which deals with the means andmethods by which rights to wealth in

    one countrys currency are converted

    into rights to wealth in terms ofanother countryscurrency.

    H.E. Evitt

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    INTRODUCTION

    Foreign exchange market: a market for converting the currency ofone country into the currency of another.

    Exchange rate:

    the rate at which one currency isconverted into another Foreign exchange risk: the risk that arises from changes in

    exchange rates.

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    THE FUNCTIONS OF THEFOREIGN EXCHANGE MARKET

    The foreign exchange market serves twomain functions:

    Convert the currency of one country intothe currency of another

    Provide some insurance against foreignexchange risk

    Foreign exchange risk: the adverseconsequences of unpredictable changes in theexchange rates.

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    CURRENCY CONVERSION

    Consumers can compare therelative prices of goods andservices in different countriesusing exchange rates.

    International business have fourmain uses of foreign exchange

    markets To exchange currency received in

    the course of doing businessabroad back into the currency of itshome country.

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    CURRENCY CONVERSION

    To pay a foreign company for itsproducts or services in its countryscurrency

    To invest excess cash for short terms

    in foreign markets To profit from the short-term

    movement of funds from onecurrency to another in the hopes of

    profiting from shifts in exchangerates, also called currencyspeculation.

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    THE NATURE OF THE FOREIGN

    EXCHANGE MARKET

    The foreign exchange market is a global network ofbanks, brokers and foreign exchange dealersconnected by electronic communications systems

    The most important trading centers include: London,New York, Tokyo, and Singapore

    Londons dominance is explained by:

    History (capital of the first major industrializednation)

    Geography (between Tokyo/Singapore andNew York)

    Two major features of the foreign exchange market:

    The market never sleeps Market is highly integrated

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    FOREIGN EXCHANGE MARKETThe organizational setting within whichindividuals, businesses, government, and

    banks buy and sell foreign currencies

    and other debt instruments. It is an over-

    the-counter market consisting of a global

    network of inter-bank traders, primarily

    the banks connected by

    telecommunication facilities.

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    TYPES OF FOREIGNEXCHANGE MARKETSInter-bank or wholesale market: Trading

    between the banks where banks can obtainquotes, or they can contact brokers whosometimes act as intermediaries.

    Retail market: It consists of travellers andtourists who exchange one currency to anotherin the form of travellers cheques or currencynotes. In retail markets, transaction size of retail

    foreign exchange market is very small whereasthe spread between buying and selling prices islarge.

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    Participants in the ForeignExchange

    Market

    Traders use forward contract to eliminate or cover the risk ofloss on export or import orders that are denominated inforeign currencies.

    Hedgers are mostly multinational firms, engage in forwardcontracts to protect the home currency value of variousforeign currency-denominated assets and liabilities on theirbalance sheets that are not to be realized over the life of the

    contracts.

    Arbitrageurs seek to earn risk-free profits by takingadvantage of differences in interest rates among countries.They use forward contracts to eliminate the exchange risk

    involved in transferring their funds from one nation to

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    Exchange rate: The value of one currency in units of

    another.

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    EXCHANGE RATE QUOTATIONSSpot vs. Forward Quote

    Spot rate: The price agreed for purchase or sale of foreign

    currency with delivery and payment to take place not more

    than two business days after the day the transaction has

    been concluded.Forward rate: The price at which the foreign exchange

    rate is quoted for delivery at a specified later date. The

    date of maturity of a forward contract is more than two

    business days in a future whereas the exchange rate is

    fixed at the time of entering the contract.

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    DIRECT VS. INDIRECT QUOTESDirect quotes: Units of the home currency per unit of a foreigncurrency.

    For instance, Indian Rs. 39.5075 per US $ is a direct quote in Indiawhereas Yen 106.5050 per US $ is a direct quote in Japan.

    Indirect quote: Units of foreign currency per unit of home currency.It may be arrived at by inversing the direct quote as follows:

    Indirect quote = 1/direct quote

    For instance, US$ 0.0253 per Indian Rupee is an indirect quote inIndia.

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    Cross Rates

    Sometime the value of a currency in terms ofanother currency may not be known directly.In such an event, one currency is sold for acommon currency and again the commoncurrency is exchanged for the desiredcurrency.

    This is known as cross currency trading andthe rate established between the twocurrencies is known as the cross rate.

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    An Indian corporate needs Canadian dollarsto buy Canadian goods, it is concerned about

    the Canadian dollar relative to the Indianrupee. It receives a quote of USD/INR atRs.47.5010/47.6015 and a quote of USD/CADat 1.0367/1.0371.

    Thus the rate of exchange between the rupeeand the Canadian dollar can be foundthrough the common currency the US dollar.

    The technique is similar for both the spot andthe forward cross rates.

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    BID VS. ASK QUOTATIONSBid rate: The price that a bank is willing to pay for a

    foreign currency.

    Ask or offer rate: The price at which a bank is willing to

    sell the currency.

    The bid-ask spread is the difference between the bid

    and ask prices.

    Bid/ask spread = (ask rate- bid rate)/ask rate

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    Computation of Bid/Ask spread

    The following are the q1uotes of the major currencies as on 23rd

    June2010 at 12.30.

    Calculate the spread percentage.

    Bid/Ask spread = (Ask rate bid rate)/Ask rate X 100

    Currency sell buy spread %

    AUD/USD 0.8724 0.8726CAD/CHF 1.07 1.07

    CAD/JPY 86.94 86.94EUR/CHF 1.3608 1.3611

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    Dealings on the Foreign Exchange Market

    Important types of transactions conducted in theforeign exchange market:

    Spot and forward exchanges

    Futures

    Options

    Swap operation

    Arbitrage.

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    In the spot market, foreign

    exchange transactions arecompleted on the spot or

    immediately.

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    INSURING AGAINST FOREIGNEXCHANGE RISKA spot exchange occurs when two

    parties agree to exchange currencyand execute the deal immediately

    The spot exchange rate is the rate atwhich a foreign exchange dealerconverts one currency into anothercurrency on a particular day

    Reported dailyChange continually

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    Forward Market

    In a forward market, contractsare delivered at a specifiedfuture date.

    The rate of exchange applicable to theforward contract is called the forwardexchange rate and the market for

    forward transaction is known as theforward market.

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    INSURING AGAINST FOREIGNEXCHANGE RISK

    Forward exchanges occur when two partiesagree to exchange currency and execute thedeal at some specific date in the future

    Exchange rates governing such futuretransactions are referred to as forwardexchange rates

    For most major currencies, forwardexchange rates are quoted for 30 days, 90days, and 180 days into the future.

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    INSURING AGAINST FOREIGN

    EXCHANGE RISK

    When a firm enters into a forwardexchange contract, it is taking out

    insurance against the possibility thatfuture exchange rate movements willmake a transaction unprofitable by the

    time that transaction has beenexecuted.

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    Forward exchange rate

    With reference to its relationship with the spot

    rate, the forward rate may be at par, discount

    or premium.

    At Par:

    If the forward exchange rate quoted is exactly

    equivalent to the spot rate at the time ofmaking the contract, the forward exchange

    rate is said to be at par.

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    At Premium:

    The forward rate for a currency, say thedollar, is said to be at premium with respect

    to the rate when one dollar buys more units

    of other currency, say rupee, in the forwardthan in the spot market.

    The premium is usually expressed as a

    percentage deviation from the spot rate on a

    per annum basis.

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    At Discount:

    The forward rate for a currency, say the

    dollar, is said to be at discount with respect

    to the spot rate when one dollar buys fewer

    rupees in the forward than in the spotmarket.

    The discount is usually expressed as apercentage deviation from the spot rate on

    a per annum basis.

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    The forward exchange rate is determined mostly by

    the demand for and supply of forward exchange.

    When the demand for forward exchange exceeds

    its supply, the forward rate will be quoted at a

    premium .

    When the supply of forward exchange exceeds the

    demand for it, the rate will be quoted at discount.

    When the supply is equivalent to the demand for

    forward exchange, the forward rate will be tend to

    be at par.

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    Forward cross rates

    Here the selling rate of one currency is divided by

    the buying rate of another currency and vice versa.

    One month forward of two currencies are USD/INR

    at 47.6010/47.9015 and that of USD/CAD at

    1.1367/1.1371.

    Determine the forward rate of Canadian dollar in

    terms of the Indian rupee.

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    Futures

    Futures contracts have standardfeatures while a forward contract may

    be customised.

    Futures contract

    It is the contract for buying and selling a

    currency in the market for currency

    futures.

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    In terms of standardisation they havethe following characteristics:

    1.The quantity, quality and the unit

    price of the asset is clearlymentioned in the contract.

    2.The date, month and place of

    delivery3. The minimum amount and the time

    duration by which the price wouldchange etc.

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    Options

    An option is a contract that gives theholder a right, without any obligation,

    to buy or sell an asset, at an agreed

    price, on or before a specified periodof time.

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    Types of options

    Call options

    Put options

    Call options:

    An option to buy the underlying asset is known as acall option.

    An option to sell the underlying asset is known as a

    put option.

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    The key provisions of the contract includes:

    1.The number and type of common shares thatcan be purchased

    2.The price at which the shares can be

    purchased3.The last date at which they can be purchased4.Whether or not the shares can be purchased

    only on the last date or on any date up to and

    including the last date5.Who is obligated to sell the shares?

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    Strike price

    The price at which option can be exercised is called an exercise price or a strike

    price.

    Underlying asset

    The asset on which the put or call option is created is referred to as the

    underlying asset.

    European option

    When an option is allowed to be exercised only on the maturity date, is called a

    European option.

    American option

    When the option can be exercised any time before its maturity, is called an

    American option.

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    INSURING AGAINST FOREIGN

    EXCHANGE RISK

    Currency swap: the simultaneous purchaseand sale of a given amount of foreign

    exchange for two different value dates Swaps are transacted between international

    businesses and their banks, between banks,and between governments when it is

    desirable to move out of one currency intoanother for a limited period without incurring

    foreign exchange risk .

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    A common kind of swap is spot against forward. Consider a

    company such as Apple Computer. Apple assembles laptop

    computers in the United States, but the screens are made in

    Japan.

    Apple also sells some of the finished laptops in Japan. So, like

    many companies, Apple both buys from and sells to Japan.

    Imagine Apple needs to change $1 million into yen to pay its

    supplier of laptop screens today. Apple knows that in 90 daysit will be paid 120 million by the Japanese importer that

    buys its finished laptops.

    It will want to convert these yen into dollars for use in the

    United States. Let us say todays spot exchange rate is $1120 and the 90-day forward exchange rate is $1 110. Apple

    sells $1 million to its bank in return for 120 million.

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    Now Apple can pay its Japanese supplier. At the same time,

    Apple enters into a 90-day forward exchange deal with its

    bank for converting 120 million into dollars.

    Thus, in 90 days Apple will receive $1.09 million (120

    million/ 110 $1.09 million).

    Since the yen is trading at a premium on the 90-day forward

    market, Apple ends up with more dollars than it started with

    (although the opposite could also occur).The swap deal is just like a conventional forward deal in one

    important respect: It enables Apple to insure itself against

    foreign exchange risk.

    By engaging in a swap, Apple knows today that the 120million payment it will receive in 90 days will yield $1.09

    million.

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    Arbitrage:

    Arbitrage is the simultaneous buying and

    selling of foreign currencies with theintention of making profits from the

    differences between the exchange rate

    prevailing at the same time in different

    markets.

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    Assume the rate of exchange in London is 1= $ 2, while in New York 1 = $ 2.10.

    This presents a situation wherein one can

    purchase one sterling pound in London fortwo dollars and a yearn a profit of $ 0.10 by

    selling the pound sterling in New York for $

    2.10.

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    International

    Monetary System

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    SIGNIFICANCE OF INTERNATIONAL FINANCEGlobalization has made understanding

    international finance pertinent even to

    business enterprises solely operating

    domestically in order to assess the impact

    of movements in exchange rates, foreign

    interest rates, labour costs, and inflation onthe costs and prices of their foreign

    competitors.

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    The International MonetarySystem plays a crucial role inthe financial management of a

    multinational business andeconomic and social policiesof each country.

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    INTERNATIONAL MONETARY SYSTEMS

    A set of rules, regulations, policies,

    practices, instruments, institutions, and

    mechanisms that determine exchange rates

    between currencies.

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    EVOLUTION OF THEIMS

    Evolution of the InternationalMonetary System can be analysed infour stages:

    The Gold Standard: 1875-1914

    Inter-war Period: 1915-1944

    Bretton Woods System: 1945-1972The Flexible Exchange Rate Regime:

    1973-Present.

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    THE GOLD STANDARD:1875-1914

    The three important features of the goldstandard were: The government of each country defines its

    national monetary unit in terms of gold.

    There was two-way convertibility betweengold and national currencies at a stableratio.

    Gold could be freely exported or imported. The exchange rate between twocountrys currencies would bedetermined by their relative gold

    contents.

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    GOLD STANDARD:1875-1914

    For example, The United States declaredthe dollar to be convertible to at a rate of$ 20.67/ounce of gold. The British poundwas pegged at 4.2474/ounce of gold.

    The dollar-pound exchange rate would bedetermined as:

    $20.67/ounce of gold

    4.2474/ounce of gold

    = $4.86656/

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    GOLD STANDARD:1875-1914

    Highly stable exchange rates under thegold standard provided an environmentthat was conducive to international tradeand investment.

    Misalignment of exchange rates andinternational imbalances of payment

    were automatically corrected by theprice-specie-flow mechanism.

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    PRICE-SPECIE-FLOW MECHANISM

    Suppose Great Britain exported more to Francethan France imported from Great Britain.

    This cannot persist under a gold standard.

    Net export of goods from Great Britain to France willbe accompanied by a net flow of gold from France toGreat Britain.

    This flow of gold will lead to a lower price level in

    France and, at the same time, a higher price level inBritain.

    The resultant change in relative price levels willslow exports from Great Britain and encourage

    exports from France.

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    The Inter-war period 1915-1944

    The gold standard as an InternationalMonetary System worked well until WorldWar 1 interrupted trade flows and disturbed

    the stability of exchange rates for currenciesof major countries.

    There was widespread fluctuation incurrencies in terms of gold during World War1 and in the early 1920s.

    I 1934 th U it d St t t d t difi d ld

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    In 1934, the United States returned to a modified goldstandard and the US dollar was devalued from theprevious $20.67/ounce of gold to $35.00/ounce of gold.

    The modified gold standard was known as the GoldExchange Standard.

    Under this standard, the US traded gold only withforeign central banks, not with private citizens.

    From 1934 till the end of World War II, exchange rateswere theoretically determined by each currencys valuein terms of gold.

    World War II also resulted in many of the worlds majorcurrencys losing their convertibility. The only majorcurrency that continued to remain convertible was the

    dollar.

    Th h i i d

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    Thus, the inter-war period wascharacterised by half-hearted

    attempts and failure to restore thegold standard, economic andpolitical stabilities, widely

    fluctuating exchange rates, bankfailures and financial crisis.The Great Depression in 1929 and

    the stock market crash alsoresulted in the collapse of manybanks.

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    BRETTON WOODS SYSTEM:1945-1972

    Named for a 1944 meeting of 44 nationsat Bretton Woods, New Hampshire.

    The purpose was to design a postwarinternational monetary system.

    The goal was exchange rate stabilitywithout the gold standard.

    The result was the creation of the IMFand the World Bank.

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    BRETTON WOODS SYSTEM:1945-1972

    Under the Bretton Woods system, theU.S. dollar was pegged to gold at $35 perounce and other currencies were pegged

    to the U.S. dollar. Each country was responsible for

    maintaining its exchange rate within 1%

    of the adopted par value by buying orselling foreign reserves as necessary.

    The Bretton Woods system was a dollar-based gold exchange standard.

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    BRETTON WOODS SYSTEM:

    1945-1972

    German

    markBritish

    pound

    French

    franc

    U.S. dollar

    Gold

    Pegged at

    $35/oz.

    Par

    Value

    INTERNATIONAL MONETARY FUND

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    INTERNATIONAL MONETARY FUND

    (IMF)

    The IMF also known as the Fund, wasconceived at a UN Conference convened in

    Bretton Woods, New Hampshire, US in July 1944

    aimed to build a framework for economic

    cooperation that would avoid a repetition of the

    disastrous economic policies that had contributed

    to the Great Depression of the 1930s.

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    Objective

    To promote exchange stability and orderlyexchange arrangements and to avoid

    competitive devaluation.

    Also it ensures devaluation is not used as aweapon of competitive trade policy.

    However if a currency become too weak to

    defend, a devaluation of up to 10% would beallowed without any formal approval of IMF.

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    THE FLEXIBLE EXCHANGE RATE REGIME:1973-PRESENT.

    Flexible exchange rates were declaredacceptable to the IMF members.

    Central banks were allowed to intervene inthe exchange rate markets.

    Gold was abandoned as an internationalreserve asset.

    Non-oil-exporting countries and less-developed countries were given greateraccess to IMF funds.

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    FLOATING EXCHANGE RATE SYSTEM

    Currency prices are determined by market

    demand and supply conditions without the

    intervention of the governments.

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    INDEPENDENT OR FREE FLOAT

    The exchange rates are market-determined

    and central banks intervene only to

    moderate the speed of change or to prevent

    excessive fluctuations without any attempt

    to maintain it or drive it to a particular level.

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    MANAGED FLOAT

    Although currencies are allowed to

    fluctuate on a daily basis with no official

    boundaries, national governments

    intervene to prevent their currencies

    from moving too far in a certain direction.

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    Pegged Exchange Rate System

    In this system, currency values are fixed in relation to

    another currency such as the U.S. dollar or euro.

    Pegging value of home currency to a foreign currencyor a

    basket of currencies and it is allowed to move in line with

    that currency against other currencies.

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    SOFT PEGSConventional fixed peg: The currency fluctuates for

    at least three months within a band of less than 2

    per cent or +/-1 per cent against another currency or

    a basket of currencies.

    Intermediate pegs

    Pegs within horizontal bands: Currencies are

    generally not allowed to fluctuate beyond +_1 per

    cent of central parity.

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    Crawling Peg: A currency is pegged to

    a single currency or a basket of

    currencies, but the peg is periodicallyadjusted with a range of less than 2

    per cent in response to changes in

    selective macro-economic indicators.

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    EUROPEAN MONETARY SYSTEMEleven European countries maintain

    exchange rates among their currencieswithin narrow bands, and jointly floatagainst outside currencies.

    Objectives:To establish a zone of monetary stability

    in Europe.

    To coordinate exchange rate policies vis--vis non-European currencies.To pave the way for the European

    Monetary Union.

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    WHAT IS THE EURO?

    The euro is the single currency ofthe European Monetary Union which

    was adopted by 11 Member Stateson 1 January 1999.

    These original member states were:

    Belgium, Germany, Spain, France,Ireland, Italy, Luxemburg, Finland,Austria, Portugal and the

    Netherlands.

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    EURO CONVERSION RATES1 Euro is Equal to:

    40.3399 BEF Belgian franc

    1.95583 DEM German mark

    166.386 ESP Spanish peseta

    6.55957 FRF French franc

    .787564 IEP Irish punt

    1936.27 ITL Italian lira

    40.3399 LUF Luxembourg franc

    2.20371 NLG Dutch gilder

    13.7603 ATS Austrian schilling

    200.482 PTE Portuguese escudo

    5.94573 FIM Finnish markka

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    WHAT IS THE OFFICIAL SIGN OF THEEURO? The sign for the new single currency

    looks like an E with two clearlymarked, horizontal parallel lines across

    it.

    It was inspired by the Greek letter

    epsilon, in reference to the cradle ofEuropean civilization and to the first

    letter of the word 'Europe'.

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    WHAT ARE THE DIFFERENT DENOMINATIONS OFTHE EURO NOTES AND COINS ? There are be 7 euro notes and 8 euro

    coins.

    The notes are: 500, 200, 100, 50,20, 10, and 5.

    The coins will be: 2 euro, 1 euro, 50 eurocent, 20 euro cent, 10, euro cent, 5 eurocent, 2 euro cent, and 1 euro cent.

    The euro itself is divided into 100 cents,just like the U.S. dollar.

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    THE MEXICAN PESO CRISIS On 20 December, 1994, the Mexican

    government announced a plan to devaluethe peso against the dollar by 14 percent.

    This decision changed currency tradersexpectations about the future value of thepeso.

    They stampeded for the exits.

    In their rush to get out the peso fell by asmuch as 40 percent.

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    THE ASIAN CURRENCY CRISIS The Asian currency crisis turned out to

    be far more serious than the Mexicanpeso crisis in terms of the extent of the

    contagion and the severity of theresultant economic and social costs.

    Many firms with foreign currency bonds

    were forced into bankruptcy. The region experienced a deep,

    widespread recession.

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    Exchange rate determination

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    ECONOMIC THEORIES OFEXCHANGE RATE DETERMINATION Exchange rates are determined by the

    demand and supply of one currency relativeto the demand and supply of another.

    Price and exchange rates:Law of One Price

    Purchasing Power Parity (PPP)

    Money supply and price inflation Interest rates and exchange rates.

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    LAW OF ONE PRICE In competitive markets free of

    transportation costs and trade barriers,identical products sold in different

    countries must sell for the same pricewhen their price is expressed in termsof the same currency

    Example: US/French exchange rate: $1= .78Eur

    A jacket selling for $50 in New Yorkshould retail for 39.24Eur in Paris

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    PURCHASING POWER PARITYBy comparing the prices of

    identical products in differentcurrencies, it should be possible todetermine the PPP exchange rate -

    if markets were efficient.

    In relatively efficient markets (few

    impediment to trade andinvestment) then a basket ofgoods should be roughly

    equivalent in each country.

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    PPP

    In the absence of government control, exchange ratebetween two currencies is determined by the pricelevels in the respective countries.

    While the value of the unit of one currency in terms

    of another currency is determined at any particulartime by the market conditions of demand and supply,in the long run, that value is determined by therelative values of the two currencies as indicated by

    their relative purchasing power over goods andservices(in their respective countries).

    According to purchasing power parity theory, the

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    exchange rate between one currency and another isin equilibrium when their domestic purchasingpowers at the rate of exchange are equivalent.

    Example: a particular bundle of goods in India costsRs.48 and the same in USA costs $ 1. Then theexchange rate will be in equilibrium if the exchange

    rate is $ 1 = Rs.48.00. If the exchange ranges to $ 1 =50 when the purchasing powers of these currenciesremain stable, dollar holder will convert dollars intorupees because, by doing so, they can save Rs.2

    when they purchase a commodity worth $ 1. This willincrease the demand for the Indian currency and thesupply of dollars will increase in the foreignexchange market and ultimately, the equilibrium rateof exchange will be re-established.

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    MONEY SUPPLY AND INFLATION PPP theory predicts that changes in relative

    prices will result in a change in exchangerates.

    A country with high inflation should expectits currency to depreciate against thecurrency of a country with a lower inflationrate.

    Inflation occurs when the money supplyincreases faster than output increases.

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    INTEREST RATES ANDEXCHANGE RATESTheory says that interest rates

    reflect expectations about

    future exchange rates.

    Fisher Effect.

    International Fisher Effect.

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    Fisher Effect (FE) Theory

    An American economist, Irving Fisherintroduced this theory. He bifurcatedthe nominal interest into two parts the real interest rate and the expectedrate of inflation and the relationshipbetween these two fundamentals is

    known as the Fisher effect.The nominal interest rate is theamalgam of real interest rate and the

    inflation rate.

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    Fisher effect can be expressed as follows:

    1 + r = (1 + ) (1 + I)

    Where r = nominal interest rate

    = real interest rate

    I = expected rate of inflation.

    Example : Suppose, the required real interest rate is 5% and

    the expected rate of inflation is 8%, calculate the required

    nominal interest rate.

    1 + r = (1 + 0.05) (1 + 0.08)

    r = 13.40%

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    Fisher Effect (FE) Theory

    The nominal interest rate r in a country is

    determined by the real interest rate R and the

    expected inflation rate i as follows:r = R + i

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    Fisher Effect:

    The proportion that the nominalinterest rate varies directly with theexpected inflation rate, known as theFisher effect.

    International Fisher Effect:

    The relationship between thepercentage change in the spot

    exchange rate over time and thedifferential between comparableinterest rates in different national

    capital markets is known as the INTERNATIONAL FISHER EFFECT (IFE)

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    THEORYThe exchange rate movements are caused

    by interest rate differentials. If real interest

    rates are the same across the country, any

    difference in nominal interest rates could

    be attributed to differences in expected

    inflation.

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    The IFE theory suggests that the

    spot rate will change inaccordance with the interest ratedifferentials.

    The PPP theory suggests that thespot rate will change in

    accordance with inflation ratedifferentials.

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    Interest Rate Parity Theory (IRP)

    The interest rate parity theory states thatequilibrium is achieved when the forward ratedifferential is approximately equal to the

    interest rate differential.

    The IFE states that the interest rate differentialshall equal the inflation rate differential .

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    OTHER DETERMINANTS OF EXCHANGE RATESIn addition to inflation, real income and interest

    rates, market fundamentals that influence the

    exchange rates include bilateral trade

    relationships, customer tastes, investment

    profitability, product availability, productivity

    changes and trade policies.