TYBMS SEM VI_ INTERNATIONAL FINANCE PAPER SOLUTION

INTERNATIONAL FINANCE QUEST TUTORIALS______________________________________________________________________________________

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TYBMS_INTERNATIONAL FINANCE

SOLUTION FOR 2012-2013

1. Explain in brief:

2. Junk Bonds: Companies with very poor credit rating or entering into high risk business

ventures issue such bonds. These bonds carry coupon rates at-least 3 - 4% above the normal

rates. A characteristic feature of these bonds is the high turnover of investors. Such bonds are

used by corporate entities and individuals to make short term gains on temporary surplus

liquidity.

3. Participatory Notes : Participatory notes (PNs / P-Notes) are instruments used by investors or

hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to

invest in Indian securities. Participatory notes are instruments that derive their value from an

underlying financial instrument such as an equity share and, hence, also known as, 'derivative

instruments'.

Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors.

Any dividends or capital gains collected from the underlying securities go back to the investors.

Participatory notes are instruments used for making investments in the stock markets.

However, they are not used within the country. They are used outside India for making

investments in shares listed in that country. That is why they are also called offshore derivative

instruments.

In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use

these instruments for facilitating the participation of their overseas clients, who are not

interested in participating directly in the Indian stock market. For example, Indian-based

brokerages buy India-based securities and then issue participatory notes to foreign investors.

Any dividends or capital gains collected from the underlying securities go back to the investors.

Any entity investing in participatory notes is not required to register with SEBI (Securities and

Exchange Board of India), whereas all FIIs have to compulsorily get registered. Trading through

participatory notes is easy because participatory notes are like contract notes transferable by

endorsement and delivery. Secondly, some of the entities route their investment through

participatory notes to take advantage of the tax laws of certain preferred countries. Thirdly,

participatory notes are popular because they provide a high degree of anonymity, which

enables large hedge funds to carry out their operations without disclosing their identity.




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4. Arbitrage: Arbitrage can be defined as an operation which involves simultaneous purchase and

sale of equal quantity of asset or currency with the intention of deriving risk-free profit out of

imperfect quotations in one or more markets. An arbitrageur is an entity who identifies an

opportunity for arbitrage and derives profit from it. Arbitrageurs are not market makers and

therefore do not provide any quotations. They only utilize quotations made by others and profit

from them, Arbitrage operations help to equalize prices and remove imperfections. There are no

arbitrage possibilities in a perfect market. The volume and profit of arbitrage transactions is

market dependent. The arbitrageur does not use his/her assessment in this operation.

5. Holgate’s Principle:

This principle states that –

(1) Premium on base currency is always added whereas discount on base currency is always

subtracted from the spot rate to arrive at the corresponding forward rate.

(2) Premium on base currency implies discount on variable currency and discount on base

currency implies premium on variable currency.

6. Autonomous Transactions:

An autonomous transaction is a transaction undertaken in the normal course of business in

response to the given environment of price levels, exchange rates, interest rates etc. It does not

take into account the equilibrium aspect of the BOP. These transactions effectively represent

Current and Capital account transactions. These are classified as ‘Above the Line’ transactions.

These transactions are normally undertaken by market participants other than the Central Bank.

BOP is surplus if net balance of autonomous transactions is positive. BOP is deficit if net balance

of autonomous transactions is negative.

1.

Given:

CHF 1.3615 per USD spot (USD/CHF)

CHF 1.3595 per USD 6 month forward (USD/CHF)

CHF interest rate 2% p.a

USD interest rate 4% p.a

Identify and calculate interest rate arbitrage (Assume 1 million USD)

Ans:

Identification:

Factor I : (F-S)/S = (1.3595 – 1.3615) / 1.3615




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= (0.0015)

Factor II : (Rv-Rb)/100 * n/12

= (2 – 4) /100 * 6/12

= (0.0100)

Factor 1 > Factor 2; we borrow Vc CHF to gain Arbitrage

But as it is mentioned in the question to solve assuming borrowing Bc USD

Assume borrowing Bc USD as 1 million.

Amount Payable:

P* (1 + R/100 * n/12)

1000000* (1 + 4/100 * 6/12)

= 1020000 USD

Amount Receivable:

Step A: Convert to CHF

= 1000000 * 1.3615

Step B: Invest in CHF

= 1000000 * 1.3615 * (1 + 2/100 * 6/12)

Step C: Reconvert to USD

= (1000000 * 1.3615 * (202/200)) / 1.3595

= 1011485 USD

Arbitrage = Amount Receivable – Amount Payable

= 1011485 – 1020000

= (8515)

If we borrow Bc USD, then there is no opportunity for Arbitrage.

Case Study:

1. Different exchange rate systems followed by different countries in the world:

FIXED SYSTEM: Provides for stable exchange rates. Exchange rates are officially controlled.

The system promoted trade and investments, Rates are artificially controlled and hence may

not reflect the correct state of the underlying economy. Subject to devaluation / revaluation by

the monetary authority. Devaluation / Revaluation are one time effects which cannot be




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factored into trade negotiations since they are unpredictable. It provided for greater control

over inflation by the monetary authority,

FLEXIBLE SYSTEM: Provides for variable exchange rates. Exchange rates are market

determined. The system promoted transparency in price discovery. Market established rates

reflect the true state of the economic changes. Subject to depreciation / appreciation through

market demand / supply forces. Depreciation / Appreciation are gradual effects which can be

reasonably predicted and hence can be factored into trade negotiations. The monetary

authority has lesser control over inflation.

2. Explain the impact of appreciation of Yuan on Chinese economy

1. Appreciation would significantly cut China's trade surplus or the difference between

what it sells to, and what it buys from, its trading partners.

2. One positive effect that the appreciation of the yuan will have on the Chinese economy is

the reinforcement of domestic market targeted industries as appreciation will increase the

purchasing power of Chinese people.

3. The actual appreciation may lead to much more increase in stock prices later in the

future.

4. The yuan appreciation leads to an increase in Chinese export prices in dollars, which

leads to a decrease in U.S. imports from China. Evaluate the reactions of emerging

economies towards appreciation of Yuan

5. Appreciation represents increase in the value of the currency through market action. It is

a continuous process which can be anticipated and is associated with flexible exchange

rate system.

3. Evaluate the reactions of emerging economies towards appreciation of yuan

Ans. Many of the economies feel they have no choice but to intervene daily in forex markets to

prevent their respective currencies from appreciating faster than the yuan. The appreciation in the

Asian and Latin American currencies will keep pace with the yuan. This is a long term secular

trend for emerging market currencies especially in Asia.

2. Given:

USD/SGD 1.5423 – 1.5433

SGD/GBP 0.3323 – 0.3333

Calculate GBP/USD quotation




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(GBP/USD)BID = (GBP/SGD)BID * (SGD/USD)BID

= (1/ 0.3333) * (1/ 1.5433)

= 1.9441

(GBP/USD)ASK = (GBP/SGD)ASK * (SGD/USD)ASK

= (1/0.3323) * (1/1.5423)

= 1.9512

The following quote is given in Mumbai

1 USD = Rs. 44.7250 – 44.7300

Is it a direct or indirect quote?

Find the mid rate, spread, and the spread percentage

SOLUTION

1. It’s a direct quote in India

2. Mid Rate = (Bid Rate + Ask Rate)/2

= (44.7250 + 44.7300) / 2

= 44.7275

Spread = (Ask rate – Bid rate)

= (44.7300 – 44.7250)

= 0.0050

%Spread = (Spread / Mean Rate) * 100

= (0.0050/ 44.7275) * 100

= 0.0112 %

1USD = Rs. 44.7250 – 44.7300

Inverse Quote;

100 INR/USD = (100 / 44.7300) - (100/44.7250)

100 INR/USD = 2.2356 - 2.2359

3.

Given:-

USD/CAD 1.1685 – 1.1695

USD/CHF 1.3785 – 1.3795

CAD/CHF 1.1885 – 1.1895




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Identify and calculate Triangular

Derived USD/CAD

USD/CAD = (USD/CHF)BID * (CHF/CAD)BID

= 1.3785 * (1/1.1895)

= 1.1589

USD/CAD = (USD/CHF)ASK * (CHF/CAD)ASK

= 1.3795 * (1/1.1885)

= 1.1607

USD/CAD 1.1589 – 1.1607

Derived; USD/CAD 1.1685 – 1.1695

Bid 1.1685 > Ask 1.1607

Arbitrage exists

Assume borrowing USD as 1 million

Gain = (P*B/A) – P

= (1000000 * 1.1685/1.1607) - 1000000

= ((1000000 * 1.1685 * 1.1885) / 1.3795)) – 1000000

= USD 6714 per USD 1 million




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Forward Rate Calculation

Spot GBP/USD 1.9845 – 1.9855

USD interest rate: 4.1250 – 4.3750 % p.a

GBP interest rate : 5.8750 – 6.1250 % p.a

Calculate Swap points (forward margins) for three months

SOLUTION

Swap Points

Fbid Fask

Spot bid Spot ask

Bc – Lending Bc – Deposit

Vc – Deposit Vc – Lending

F(Bid) = SR * (1 + Rv/100 * n/12)

(1 + Rb/100 * n /12)

= 1.9845 * (404.1250 / 406.1250)

= 1.9747

F(Ask)) = SR * (1 + Rv/100 * n/12)

(1 + Rb/100 * n /12)

= 1.9855 * (404.3750 / 405.8750)

= 1.9782

3 months forward GBP/USD 1.9747 – 1.9782

Bid Points = Fbid – Sbid

= 1.9747 – 1.9845

= (0.0098)

Ask Points = Fask – Sask

= 1.9782 – 1.9855

= (0.0073)

3 Months Swap Points = 98 – 73




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4. (a) Distinguish between Gold Standard and Bretton Woods System

No Gold Standard Bretton Woods System

1. The Gold Standard promoted by the Bank of

England and introduced in 1870, was the first

universally Rate implemented Exchange

Determination system

The Bretton Woods system was introduced

by the IMF in 1946 and represented the first

semi-fixed exchange rate determination

system. (Adjustable Peg System)

2. Only gold was used as reserve asset In addition to gold, US Dollars were also

accepted as reserve asset.

3. The Central bank of each country was

required to announce an official price for

gold in terms of the domestic currency

Only Federal Reserve Bank of the US was

required to fix the price of gold in terms of

US Dollars

4. Each Central Bank gave an unconditional

guarantee to buy or sell unlimited quantity of

gold at the official price

The Federal Reserve Bank gave an

unconditional guarantee to buy or sell

unlimited quantity of gold at 1 ounce gold =

US Dollars 35

5. Every currency note carried an irrevocable

promise of redemption against specific

quantity of gold.

Every currency note carried an irrevocable

promise of redemption against specific

amount of US Dollars.

6. The system failed because it lacked flexibility

for changing the money supply

Oversupply of US Dollars reduced the

acceptability of the currency. Failure to fulfill

the gold convertibility clause resulted in the

failure of the system

7. Exchange rates varied between upper and

lower gold points

Exchange rates varied between support

points at (+/-) 1% on either side of parity

rates.

8. Each currency pair had unique gold points All currency pairs had a standardized

variation range

9. Central exchange rates were based on the

ratio of the official gold rates in the two

currencies

Parity rates were fixed against US Dollars by

the respective Central Bank

10. The system had an in-built mechanism for

achieving exchange rate stability

Protection of parity was to be achieved

through intervention

11. International settlements were done in terms International settlements were done in terms




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of gold of US Dollars

12. Mechanism for calculating exchange rates

was ‘The Mint Par of Exchange’ system

Mechanism for calculating exchange rates

was ‘The Par Value’ mechanism

13. Rigid system in which liquidity adjustment

was difficult. It promoted Bilateral approach

More flexible with greater liquidity. It

promoted a Multilateral approach

14. In the gold standard the reserves did not earn

any interest

Under the Bretton Woods System, USD

reserves could be invested to get return on

reserves

15. There was no commitment mechanism in the

gold standard since there was no institutional

support to monitor the Mint Parities

In the Bretton Woods System the IMF

functioned as a supervisor of the Par Value

Mechanism

16. The Price Specie Adjustment Mechanism

helped in achieving trade equilibrium

Trade policy controls were necessarily to

achieve trade equilibrium

4. (b) What are FRNs? State its features?

A Floating Rate Note (FRN) is as its name implies, a bond with varying coupon. Periodically

(typically every six months), the interest rate payable for the next six months is set with reference

to a market index such as LIBOR. In some cases, a ceiling may be put on the interest rate

(capped FRNs), while in some cases there may be a ceiling and a floor (collared FRNs).

5. (a) Explain the term FDI. State its advantages and disadvantages

FOREIGN DIRECT INVESTMENT (FDI):

Foreign Direct Investment can be described as investment made by a foreign entity in the equity of a

domestic company (Target Company) with the intention of participating in the management of the

enterprise. Alternatively it can be described as an investment transaction in which an investor from

one country (home country) seeks to obtain managerial interest in an entity in another country (host

country) for controlling and operating physical assets created through such investments.

ADVANTAGES OF FDI:

1. FDI inflows are long-term in nature and therefore do not lead to volatility either in foreign

exchange or capital markets

2. Since the investments are in physical assets it is not easy to instantly withdraw such investments

therefore there is no panic withdrawal during periods of economic crises




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3. Very often foreign inflows by way of debt or loans get used to finance consumption leading to

debt repayment problems and increase in money supply. Such features are not seen in the case of

FDI because the funds translate into productive capacity.

4. FDI not only helps to achieve economic growth but also improves the technological knowhow

available to the country. This leads to sustainable development.

5. Access to international markets becomes easier and cost effective because the target company can

leverage the existing brand of the contributing foreign investor.

6. The single most important advantage of FDI is employment generation which develops

marketable skills in the local population and becomes the basis of sustainable economic growth. It

effectively helps to build human capital.

Disadvantages of FDI:

1. Repatriation, reinvestment and distribution of profits cannot be controlled by the host country.

2. Cultural differences between the foreign investor and the local management can lead to friction as

also have adverse social side effects therefore social regulations need to be in place before permitting

FDI.

3. Excessive dependence on the foreign entity may result in gradual loss of control over the business

entity.

5. (b) State about the role of ECB and its objectives

EUROPEAN CENTRAL BANK: (ECB)

BACKGROUND:

The Bretton Woods Agreement provided the US Dollar with the status of Universal Reserve Asset

and simultaneously reduced the importance of European currencies. The idea of a Monetary Union

arose out of the need to establish a currency to effectively compete with the US Dollar. The European

nations formed a club called the ‘European Union’ (EU) and achieved integration of trade and

convergence of economies. The intention was to create a single frontierless market with a common

currency and a common central bank. 16 of the 27 participating members have adopted a common

currency called ‘EURO’ (EUR).

During the course of these developments it was essential to create a common institution which would

monitor and implement a common monetary policy. The European Monetary Institute (EMI) was

established to handle transitional issues of countries adopting the EURO and to prepare for creation

of the European Central Bank and the European System of Central Banks (ESCB). In keeping with the




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terms of the Amsterdam Treaty (2 October 1997) the ECB replaced the EMI effective 1 June 1998. The

bank assumed full powers effective 1 Jan 1999 when the EURO was introduced.

ROLE OF ECB:

The ECB has the mandate to administer the monetary policy of the 16 EU member countries who

have adopted the common currency EURO. These nations are collectively called ‘EUROZONE’.

OBJECTIVES OF ECB:

1. To ensure price stability within the Euro-zone through low inflation rates. (Ideally less than 2 %)

2. To define and implement a common monetary policy.

3. To take care of the foreign currency reserves of the ESCB.

4. To promote smooth operation of the financial markets.

5. To maintain an exclusive right over issuance of Euro-banknotes and coins. National Central Banks

of participating nations are permitted to mint coins under quantitative control of the ECB.

6. To maintain a stable financial system and monitor the banking sector.

Documents

TYBMS SEM VI_ INTERNATIONAL FINANCE PAPER SOLUTION