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International Financial Management 14MBAFM410

Department of MBA, SJBIT

Syllabus

Sub Code: 14MBAFM410

Sem: IV sem MBA

Subject:INTERNATIONAL FINANCIAL MANAGEMENT

IA Marks : 50

No.of Lecture Hrs/week : 04

Exam Hrs. : 03 Hours

Total No. of Lecture Hrs. : 56

Exam Marks : 100

Practical Component : 01 Hr/ Week

Module I (6Hours)

International financial Environment- The Importance, rewards & risk of international finance-

Goals of MNC- International Business methods –Exposure to international risk- International

Monetary system- Multilateral financial institution

Module II (8Hours)

International flow of funds and International Monetary system:-

International Flow of Funds: Balance of Payments (BoP), Fundamentals of BoP, Accounting

components of BOP, Factors affecting International Trade and capital flows, Agencies that

facilitate International flows. BOP, Equilibrium & Disequilibrium. Trade deficits. Capital

account convertability.( problems on BOP)

International Monetary System: Evolution, Gold Standard, Bretton Woods system, the flexible

exchange rate regime, the current exchange rate arrangements, the Economic and Monetary

Union (EMU).

Module III ( 6Hours)

Foreign Exchange Market: Function and Structure of the Forex markets, Foreign exchange

market participants, Types of transactions and Settlements Dates, Exchange rate quotations,

Nominal , Real and Effective exchange rates, Determination of Exchange rates in Spot markets.

Exchange rates determinations in Forward markets. Exchange rate behavior-Cross Rates-

Arbitrage profit in foreign exchange markets, Swift Mechanism. Triangular and locational

arbitrage.

Module IV (8 Hours)

International Financial Markets and Instruments :- Foreign Portfolio Investment.

International Bond & Equity market. GDR, ADR, Cross listing of shares Global registered

shares. International Financial Instruments: Foreign Bonds & Eurobonds , Global Bonds.

Floating rate Notes, Zero coupon Bonds International Money Markets International Banking



services –Correspondent Bank, Representative offices, Foreign Branches. Forward Rate

Agreements

Module V (8 Hours)

International Parity Relationships & Forecasting Foreign Exchange rate:- Measuring

exchange rate movements-Exchange rate equilibrium – Factors effecting foreign exchange rate-

Forecasting foreign exchange rates .Interest Rate Parity, Purchasing Power Parity & International

Fisher effects. Covered Interest Arbitrage

Module VI ( 8Hours)

Foreign Exchange exposure:- Management of Transaction exposure- Management of

Translation exposure- Management of Economic exposure- Management of political Exposure-

Management of Interest rate exposure.

Module VII (10Hours)

Foreign exchange risk Management: Hedging against foreign exchange exposure – Forward

Market- Futures Market- Options Market- Currency Swaps-Interest Rate Swap-. Cross currency

Swaps-Hedging through currency of invoicing- Hedging through mixed currency invoicing –

Country risk analysis.

International Capital Budgeting: Concept, Evaluation of a project, Factors affecting, Risk

Evaluation, Impact on Value, Adjusted Present Value Method

Practical Component:

Students can study the Balance of Payment statistics of India for the last five year and

present the same in the class.

Students can carry out a survey of Exporters and report the foreign exchange risk

management practices adopted by them.

Students can study the impact of exchange rate movement on the stock Index.

Students can predicting exchange rates using technical analysis and find arbitrage

opportunities using newspaper quotes present the same in the class.

Students can visit a bank and study the foreign exchange derivatives offered by them.

RECOMMENDED BOOKS:

1. International Finance Management - Eun & Resnick, 4/e, Tata McGraw Hill.

2. Multinational Business Finance – Eiteman, Moffett and Stonehill, 12/e, Pearson, 2011.

3. International Corporate Finance - Jeff madura, Cengage Learning, 10/e2012.

4. International Financial Management – Vyupthakesh Sharan, 5/e, PHI, 2011.

5. Multinational Financial Management – Alan C. Shapiro, 8/e, Wiley India Pvt. Ltd., 2011.

6. International Financial Management – Madhu Vij, Excel Books, 2010.

REFERENCE BOOKS:

1. International Financial Management – Siddaiah T, 1/e, Pearson,2011.

2. International Finance – Imad Moosa, 3/e, Tata McGraw Hill, 2011.



3. International Finance – Shailaja G, 2/e, University Press, 2011.

4. International Financial Management – Apte P. G, 6/e, TMH, 2011.

5. International Finance – Maurice Levi, 5/e, Routledge, 2009.

6. International Financial Management – Jain, Peyrard & Yadav,Macmillan 2010

7. International Finance – Thomas O’Brien, Oxford University Press,2010.



INDEX

Module No. Module Name Page No.

1 International financial Environment 5

2 International flow of funds and International

Monetary system

26

3 Foreign Exchange Market 58

4 International Financial Markets and

Instruments

78

5 International Parity Relationships &

Forecasting Foreign Exchange rate

92

6 Foreign Exchange exposure 116

7 Foreign exchange risk Management 130



MODULE-1

International financial Environment

The Importance, rewards & risk of international finance- Goals of MNC- International

Business methods – Exposure to international risk- International Monetary system-

Multilateral financial institution

---------------------------------------------------------------------------------------------------------------------

International finance (also referred to as international monetary economics or international

macroeconomics) is the branch of financial economics broadly concerned with monetary and

macroeconomic interrelations between two or more countries. International finance examines the

dynamics of the global financial system, international monetary systems, balance of payments,

exchange rates, foreign direct investment, and how these topics relate to international trade.

Sometimes referred to as multinational finance, international finance is additionally concerned

with matters of international financial management. Investors and multinational corporations

must assess and manage international risks such as political risk and foreign exchange risk,

including transaction exposure, economic exposure, and translation exposure.

Some examples of key concepts within international finance are the Mundell–Fleming model,

the optimum currency area theory, purchasing power parity, interest rate parity, and the

international Fisher effect. Whereas the study of international trade makes use of mostly

microeconomic concepts, international finance research investigates predominantly

macroeconomic concepts.

International financial management also known as international finance is a popular concept

which means management of finance in an international business environment, it implies, doing

of trade and making money through the exchange of foreign currency.[1] The international

financial activities help the organizations to connect with international dealings with overseas

business partners- customers, suppliers, lenders etc. It is also used by government organization

and non-profit institutions.

International financial Environment- The Importance

Compared to national financial markets international markets have a different shape and

analytics. Proper management of international finances can help the organization in

achieving same efficiency and effectiveness in all markets, hence without IFM sustaining

in the market can be difficult.

Companies are motivated to invest capital in abroad for the following reasons



Efficiently produce products in foreign markets than that domestically.

Obtain the essential raw materials needed for production.

Broaden markets and diversify

Earn higher returns

What’s Special about International Finance?

1. Foreign exchange risk

a. E.g., an unexpected devaluation adversely affects your export market…

2. Political risk

a. E.g., an unexpected overturn of the government that jeopardizes existing

negotiated contracts…

3. Market imperfections

a. E.g., trade barriers and tax incentives may affect location of production…

4. Expanded opportunity sets

a. E.g., raise funds in global markets, gains from economies of scale…

Rewards & risk of international finance

International financial markets face a variety of risks and they are collectively known

as international finance risks. The premier financial institutions of the world apply various

principles and practical applications to deal with the risks of international finance. Financial risks

usually are those kind of risks which are related to finance or money. The financial risks related

to investments include capital risk, currency risk, as well as liquidity risk. The debt related risks

include interest rate risk and credit risk.

The international insurance industry also faces a number of risks.

The various risks that influence international financial markets usually include the following:

Political risk



Financial risk

Economic risk

Country risk

Market risk

Exchange rate risk

Operational risk

Legal risk

Hedging risk

Systemic risk

The international financial market has experienced a significant shift in the 1980s and 1990s.

The international financial transactions have become more complicated and rapid and as a result

of this, the international financial markets are facing greater uncertainties. Currently, the

financial services industry has become much more aggressive and the international market

participants are getting the exposure to increased financial risks than earlier. The reasons behind

this are:

The globalization of financial markets

The unpredictability or volatility of the international financial markets

The complex structure of the new types of investments

The increase in the global supply of loanable funds

The intense international market competition, which is increasing day by day

Hence, it is absolutely necessary that the financial risks are properly measured and preventive

actions for efficient management of international financial risks are applied. For maintaining the

stability of both international financial market and domestic financial market, the performance of

efficient risk management by banks and financial institutions is crucial. Supply of accurate and

reliable information on international financial markets is important for the market participants

because with help of dependable information, they are able to make knowledgeable investment

decisions.

Benefits of International Finance

Knowledge of international finance can help a financial manager consider how international

events may affect a firm and what steps can be taken to exploit positive developments and

insulate the firm from harmful ones. Among the events that affect the firm and that must be

managed are changes in exchange rates as well as interest rates, inflation rates and asset values.

These different changes are themselves related. For example, declining exchange rates tend to

be associated with relatively high interest rates and inflation. Furthermore, some asset prices are

positively affected by a declining currency, such as stock prices of export-oriented companies



that are more profitable after devaluation. Other asset prices are negatively affected, such as

stock prices of companies with foreign-currency denominated debt that lose when the company’s

home currency declines: the company’s debt is increased in terms of domestic currency. These

connections between exchange rates, asset and liability values and so on mean that foreign

exchange does not simply add an extra exposure and risk to other business exposures and risks.

Instead, the amount of exposure and risk depends crucially on the way exchange rates and other

financial prices are connected. For example, effects on investors in foreign countries when

exchange rates change depend on whether asset values measured in foreign currency move in the

same direction as the exchange rate, thereby reinforcing each other, or in opposite directions,

thereby offsetting each other. International finance is not just finance with an extra cause of

uncertainty. It is a legitimate subject of its own, with its own risks and ways of managing them.

It is difficult to think of any firm or country that is not affected in some way or other by the

international financial environment. Inflation, jobs, economic growth rates bond and stock

prices, oil and food prices, government revenues and other important financial variables are all

ties to exchange rates and other developments in the increasingly integrated,

global financial environment.

Multinational corporations

(MNCs) are defined as firms that engage in some form of international business. Their managers

conduct international financial management, which involves international investing and

financing decisions that are intended to maximize the value of the MNC. The goal of their

managers is to maximize the value of the firm, which is similar to the goal of managers

employed by domestic companies. Initially, firms may merely attempt to export products to a

particular country or import supplies from a foreign manufacturer. Over time, however, many of

them recognize additional foreign opportunities and eventually establish subsidiaries in foreign

countries. Dow Chemical, IBM,Nike, and many other firms have more than half of their assets in

foreign countries. Some businesses, such as ExxonMobil, Fortune Brands, and Colgate-

Palmolive, commonly generate more than half of their sales in foreign countries. Even smaller

U.S. firms commonly generate more than 20 percent of their sales in foreign markets, including

Ferro (Ohio), and Medtronic (Minnesota). Seventy-five percent of U.S. firms that export have

fewer than 100 employees.

International financial management is important even to companies that have no

international business because these companies must recognize how their foreign competitors

will be affected by movements in exchange rates, foreign interest rates, labor costs, and inflation.

Such economic characteristics can affect the foreign competitors ’ costs of production and

pricing policies.

Goals of MNC

The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers

employed by the MNC are expected to make decisions that will maximize the stock price and

therefore serve the shareholders. Some publicly traded MNCs based outside the United States



may have additional goals, such as satisfying their respective governments, creditors, or

employees. However, these MNCs now place more emphasis on satisfying shareholders so that

they can more easily obtain funds from shareholders to support their operations. Even in

developing countries such as Bulgaria and Vietnam that have only recently encouraged the

development of business enterprise, managers of firms must serve shareholder interests so that

they can obtain funds from them. If firms announced that they were going to issue stock so that

they could use the proceeds to pay excessive salaries to managers or invest in unprofitable

business projects, they would not attract demand for their stock. The focus in this text is on the

U.S.-based MNC and its shareholders, but the concepts commonly apply to MNCs based in other

countries.

The focus of this text is on MNCs whose parents wholly own any foreign subsidiaries, which

means that the U.S. parent is the sole owner of the subsidiaries. This is the most common form of

ownership of U.S.-based MNCs, and it enables financial managers throughout the MNC to have

a single goal of maximizing the value of the entire MNC instead of maximizing the value of any

particular foreign subsidiary.

International Finance: Benefits

Some of the benefits of international finance are:

Access to capital markets across the world enables a country to borrow during tough

times and lend during good times.

It promotes domestic investment and growth through capital import.

Worldwide cash flows can exert a corrective force against bad government policies.

It prevents excessive domestic regulation through global financial institutions.

International finance leads to healthy competition and, hence, a more effective banking

system.

It provides information on the vital areas of investments and leads to effective capital

allocation.

International finance promotes the integration of economies, facilitating the easy flow of capital.

The free transfer of fundswould eventually result in more equality among countries that are a

part of the global financial system.

International Business methods



1. Exporting

Is the selling of products to a foreign country or countries.

Advantages:

Involves less financial risk

Little cost or investment associated with the exception of establishing distribution

networks or local advertising

Allows business to enter the global market gradually

Agents are used as they have better understanding of local markets n assist in the

marketing strategies

Disadvantages:

Loss of control over the product once it has been sold to the distributor or agent

Lack of understanding of the firm’s history and product range

Types are:

Direct – this involves a business selling directly to an overseas buyer (not really the end

user). They use their own sales representatives based in foreign markets or agents

Indirect – is where business's use intermediaries to get their products into overseas

markets. Adv is that its easy and inexpensive and using the agents experience. Disad is

that the agents may be handling more than one customer so negligence can occur and

ending contracts can be a very expensive and time consuming process.

2. Foreign Direct Investment (FDI)

It’s investment that gains control of foreign assets or businesses. Method of international

expansion that gets controlling interest in property, assets or companies in other countries.

Involves higher commitment as it usually involves a transfer of money, personnel and

technology.



Methods of FDI:

3. Relocation of Production

Important factors to consider are:

Cost and availability – labour and raw materials

Political stability

Economic development

Reasons for relocating production overseas are:

Reduce labour costs – take adv of lower wages and raw materials

Get around trade barriers – doing this business can be consequently protected from

foreign competition

To be closer to customers – reduces transportation costs/ respond quickly to changes in

demand



4. Management Contracts

These are agreements where one business provides managerial assistance, technical

expertise to another organisation for a certain period of time

Advantages for business receiving assistance are:

Good for developing nations

Obtain skilled labour – without increased foreign investment

Advantages for business providing services:

Get a flat fee or % of sales

Extra income with little cash outlay

Exposure to a foreign market

5. Licensing

Licensing is an agreement where a licensor, grants the licensee the right to use its patent,

copyright or brand name.

Advantages for licensee are:

Has right to use a proven design – costs less than developing own

Advantages for licensor:

Take advantage of foreign production without any ownership or investment obligations

Learn about a new market without investing a lot time and effort

Can overcome problem of limited resources for establishing production internationally

Disadvatanges are:

Loss of control over asset including quality standards and distribution

Licensing of technology can create a future competitor

Licensee can learn the secrets and use the knowledge for own operations



6. Franchising

Franchising is the same as licensing in that the franchiser allows the franchisee to use the

trademark or brand or reputation.

It different from licensing because:

Franchisers provide ongoing support to the franchisees including management training,

business advice and advertising

Franchisers have more control over the sales of its products

Used in service industry such as hotels, restaurants and real estate

Advantages are:

Low cost, low risk way of entering new markets (franchiser)

Ability to maintain product consistency by duplicating processes around the world (sers)

Have access to cultural knowledge of local managers (sers)

Get well known and proven products, operating systems and brand names (sees)

Can often have deals arranged with suppliers, reducing costs for production (sees)

Disadvantages are:

Difficulty in managing a large no of stores around the world

Actions of either party affect the other

Franchisees don’t have much flexibility

7. Acquisitions of existing operations

Firms frequently acquire other firms in foreign countries as a means of penetrating foreign

markets. Acquisitions allow firms to have full control over their foreign businesses and to

quickly obtain a large portion of foreign market share.

EXAMPLE Cadbury Schweppes has grown mainly through acquisitions in recent years including

Wedel chocolate (Poland, 1999), Hollywood chewing gum (France, 2000), a buyout of

minority shareholders of Cadbury India (2002), Dandy chewing gum from Denmark

(2002) and the Adams chewing gum business ($4.2 bn, 2003). Clearly they were seeking

synergies by being dominant in the chewing gum business. Then in early 2010 Cadbury

Schweppes were taken over by Kraft Foods to create a 'global confectionery leader'.



An acquisition of an existing corporation is a quick way to grow. An MNC that grows in this

way also partly protects itself from adverse actions from the host government of the acquired

company. The MNC has control of a usually well-established firm with good connections to its

government. The risk is that too much has been paid for the acquisition, also that there are

unforeseen problems with the acquired company. It has to be remembered that the sellers of the

company have a thorough knowledge of the business and the price at which they are selling is

presumably higher than their estimate. The acquiring company is therefore to a certain extent

outguessing the local owners - a risky proposition.

Some firms engage in partial international acquisitions in order to obtain a stake in foreign

operations. This requires a smaller investment than full international acquisitions and therefore

exposes the firm to less risk. On the other hand, the firm will not have complete control over

foreign operations that are only partially acquired.

8. Establishing new foreign subsidiaries

Firms can also penetrate foreign markets by establishing new operations in foreign countries to

produce and sell their products. Like a foreign acquisition, this method requires a large

investment. Establishing new subsidiaries may be preferred to foreign acquisitions because the

operations can be tailored exactly to the firm's needs. Development will be slower, however, in

that the firm will not reap any rewards from the investment until the subsidiary is built and a

customer base established.

Exposure to international risk

1. Exposure to International Economic Conditions.

The amount of consumption in any country is influenced by the income earned by consumers in

that country. If economic conditions weaken, the income of consumers becomes relatively low,

consumer purchases of products decline, and an MNC ’s sales in that country may be lower than

ex-pected. This results in a reduction in the MNC’s cash flows, and therefore in its value.

Example:

In October 2008, the credit crisis intensified. Investors were concerned that the economic

conditions in the United States and in many other countries would deteriorate. This resulted in

expectations of a reduced demand for exports produced by U.S. firms. In addition, it resulted in

expectations of reduced earnings of foreign subsidiaries (because of a reduced local demand for

the subsidiary s products), and therefore a reduction in remitted earnings to the MNC s parent.

These revised expectations reflected a reduction in cash flows to be received by the parent, and

therefore caused reduced valuations of MNCs. Stock prices of many U.S.-based MNCs declined

by more than 20 percent during the October 6 –10 period in 2008



2.Exposure to International Political Risk.

Political risk in any country can affect the level of an MNCs sales. A foreign government may

increase taxes or impose barriers on the MNC s subsidiary. Alternatively, consumers in a foreign

country may boycott the MNC if there is friction between the government of their country and

the MNC s home country. Political actions like these can reduce the cash flows of the MNC.

3.Exposure to Exchange Rate Risk.

If the foreign currencies to be received by aU.S.-based MNC suddenly weaken against the dollar,

the MNC will receive a lower amount of dollar cash flows than was expected. This may reduce

the cash flows of the MNC.

Example:

Missouri Co. has a foreign subsidiary in Canada that generates earnings (in Canadian dollars)

each year. Before the subsidiary remits earnings to the parent, it converts Canadian dollars to

U.S. dollars. The managers of Missouri expect that because of a recent government policy in

Canada, the Canadian dollar will weaken substantially against the U.S. dollar over time. Conse-

quently, the expected U.S. dollar cash flows to be received by the parent are reduced, so the

valuation of Missouri Co. is reduced

Many MNCs have cash outflows in one or more foreign currencies because they import supplies

or materials from companies in other countries. When an MNC has future cash outflows in

foreign currencies, it is exposed to exchange rate movements, but in the opposite direction. If

these foreign currencies strengthen, the MNC will need a larger amount of dollars to obtain the

foreign currencies that it needs to make its payments. This reduces the MNC ’s dollar cash flows

(on a net basis) overall, and therefore reduces its value.

4. Uncertainty of an MNC’s Cost of Capital

An MNC ’s cost of capital is influenced by the return required by its investors. If there is

suddenly more uncertainty surrounding its future cash flows, investors may only be willing to

invest in the MNC if they can expect to receive a higher rate of return. Consequently, the higher

level of uncertainty increases the return on investment required by investors (which reflects an

increase in the MNC ’s cost of obtaining capital), and the MNC ’s valuation decreases.



International Monetary system

GOLD STANDARD

A monetary system in which a country's government allows its currency unit to be freely

converted into fixed amounts of gold and vice versa. The exchange rate under the gold

standard monetary system is determined by the economic difference for an ounce of gold

between two currencies. The gold standard was mainly used from 1875 to 1914 and also

during the interwar years

The use of the gold standard would mark the first use of formalized exchange rates in

history. However, the system was flawed because countries needed to hold large gold

reserves in order to keep up with the volatile nature of supply and demand for currency.

After World War II, a modified version of the gold standard monetary system, the

Bretton Woods monetary system created as its successor. This successor system was

initially successful, but because it also depended heavily on gold reserves, it was

abandoned in 1971 when U.S President Nixon "closed the gold window."

A gold standard is a monetary system in which the standard economic unit of account is based

on a fixed quantity of gold.

Three types may be distinguished: specie, exchange, and bullion. In the gold specie standard the

monetary unit is associated with the value of circulating gold coins or the monetary unit has the

http://en.wikipedia.org/wiki/Monetary_system#Commodity_money_system

http://en.wikipedia.org/wiki/Economics

http://en.wikipedia.org/wiki/Unit_of_account

http://en.wikipedia.org/wiki/Gold



value of a certain circulating gold coin, but other coins may be made of less valuable metal. The

gold exchange standard usually does not involve the circulation of gold coins. The main feature

of the gold exchange standard is that the government guarantees a fixed exchange rate to the

currency of another country that uses a gold standard (specie or bullion), regardless of what type

of notes or coins are used as a means of exchange. This creates a de facto gold standard, where

the value of the means of exchange has a fixed external value in terms of gold that is

independent of the inherent value of the means of exchange itself. Finally, the gold bullion

standard is a system in which gold coins do not circulate, but the authorities agree to sell gold

bullion on demand at a fixed price in exchange for currency.

As of 2013 no country used a gold standard as the basis of its monetary system, although some

hold substantial gold reserves.

The International Monetary System

The rules and procedures for exchanging national currencies are collectively known as the

international monetary system. This system doesn't have a physical presence, like the Federal

Reserve System, nor is it as codified as the Social Security system. Instead, it consists of

interlocking rules and procedures and is subject to the foreign exchange market, and therefore to

the judgments of currency traders about a currency.

Yet there are rules and procedures—exchange rate policies—which public finance officials of

various nations have developed and from time to time modify. There are also physical

institutions that oversee the international monetary system, the most important of these being the

International Monetary Fund.

Exchange Rate Policies

In July 1944, representatives from 45 nations met in Bretton Woods, New Hampshire to discuss

the recovery of Europe from World War II and to resolve international trade and monetary

issues. The resulting Bretton Woods Agreement established the International Bank for

Reconstruction and Development (the World Bank) to provide long-term loans to assist Europe's

recovery. It also established the International Monetary Fund (IMF) to manage the international

monetary system of fixed exchange rates, which was also developed at the conference.

The new monetary system established more stable exchange rates than those of the 1930s, a

decade characterized by restrictive trade policies. Under the Bretton Woods Agreement, IMF

member nations agreed to a system of exchange rates that pegged the value of the dollar to the

price of gold and pegged other currencies to the dollar. This system remained in place until 1972.

http://en.wikipedia.org/wiki/Fixed_exchange_rate

http://en.wikipedia.org/wiki/De_facto

http://en.wikipedia.org/wiki/Gold_bullion


http://en.wikipedia.org/wiki/Gold_reserve



In 1972, the Bretton Woods system of pegged exchange rates broke down forever and was

replaced by the system of managed floating exchange rates that we have today.

The Bretton Woods system broke down because the dynamics of supply, demand, and prices in a

nation affect the true value of its currency, regardless of fixed rate schemes or pegging policies.

When those dynamics are not reflected in the foreign exchange value of the currency, the

currency becomes overvalued or undervalued in terms of other currencies. Its price—fixed or

otherwise—becomes too high or too low, given the economic fundamentals of the nation and the

dynamics of supply, demand, and prices. When this occurs, the flows of international trade and

payments are distorted.

In the 1960s, rising costs in the United States made U.S. exports uncompetitive. At the same

time, western Europe and Japan emerged from the wreckage of World War II to become

productive economies that could compete with the United States. As a result, the U.S. dollar

became overvalued under the fixed exchange rate system. This caused a drain on the U.S. gold

supply, because foreigners preferred to hold gold rather than overvalued dollars. By 1970, U.S.

gold reserves decreased to about $10 billion, a drop of more than 50 percent from the peak of

$24 billion in 1949.

In 1971, the U.S. decided to let the dollar float against other currencies so it could find its proper

value and imbalances in trade and international funds flows could be corrected. This indeed

occurred and evolved into the managed float system of today.

A nation manages the value of its currency by buying or selling it on the foreign exchange

market. If a nation's central bank buys its currency, the supply of that currency decreases and the

supply of other currencies increases relative to it. This increases the value of its currency.

On the other hand, if a nation's central bank sells its currency, the supply of that currency on the

market increases, and the supply of other currencies decreases relative to it. This decreases the

value of its currency.

The International Monetary Fund plays a key role in operations that help a nation manage the

value of its currency.

The International Monetary Fund

The International Monetary Fund (www.imf.org) is like a central bank for the world's central

banks. It is headquartered in Washington, D.C., has 184 member nations, and cooperates closely

with the World Bank, which we discuss in The Global Market and Developing Nations. The IMF

has a board of governors consisting of one representative from each member nation. The board

of governors elects a 20-member executive board to conduct regular operations.

http://www.imf.org/

http://www.infoplease.com/cig/economics/global-market-developing-nations.html



The goals of the IMF are to promote world trade, stable exchange rates, and orderly correction of

balance of payments problems. One important part of this is preventing situations in which a

nation devalues its currency purely to promote its exports. That kind of devaluation is often

considered unfairly competitive if underlying issues, such as poor fiscal and monetary policies,

are not addressed by the nation.

Member nations maintain funds in the form of currency reserve units called Special Drawing

Rights (SDRs) on deposit with the IMF. (This is a bit like the federal funds that U.S. commercial

banks keep on deposit with the Federal Reserve.) From 1974 to 1980, the value of SDRs was

based on the currencies of 16 leading trading nations. Since 1980, it has been based on the

currencies of the five largest exporting nations. From 1990 to 2000, these were the United States,

Japan, Great Britain, Germany, and France. The value of SDRs is reassigned every five years.

SDRs are held in the accounts of IMF nations in proportion to their contribution to the fund. (The

United States is the largest contributor, accounting for about 25 percent of the fund.)

Participating nations agree to accept SDRs in exchange for reserve currencies—that is, foreign

exchange currencies—in settling international accounts. All IMF accounting is done in SDRs,

and commercial banks accept SDR-denominated deposits. By using SDRs as the unit of value,

the IMF simplifies its own and its member nations' payment and accounting procedures.

In addition to maintaining the system of SDRs and promoting international liquidity, the IMF

monitors worldwide economic developments, and provides policy advice, loans, and technical

assistance in situations like the following:

After the collapse of the Soviet Union, the IMF helped Russia, the Baltic states, and other

former Soviet countries set up treasury systems to assist them in moving from planned to

market-based economies.

During the Asian financial crisis of 1997 and 1998, the IMF helped Korea to bolster its

reserves. The IMF pledged $21 billion to help Korea reform its economy, restructure its

financial and corporate sectors, and recover from recession.

In 2000, the IMF Executive Board urged the Japanese government to stimulate growth by

keeping interest rates low, encouraging bank restructuring, and promoting deregulation.

In October 2000, the IMF approved a $52 million loan for Kenya to help it deal with

severe drought. This was part of a three-year $193 million loan under an IMF lending

program for low-income nations.

Most economists judge the current international monetary system a success. It permits market

forces and national economic performance to determine the value of foreign currencies, yet

enables nations to maintain orderly foreign exchange markets by cooperating through the IMF.



OBJECTIVES OF IMF:

1.To promote exchange rate stability among the different countries.

2. To make an arrangement of goods exchange between the countries.

3. To promote short term credit facilities to the member countries.

4. To assist in the establishment of International Payment System.

5. To make the member countries balance of payment favourable.

6.To facilitate the foreign trade.

7. To promote the international monetary corporation.

FUNCTIONS OF IMF:

1.Merchant Of Currencies :- IMF main function is to purchase and sell the member countries currencies.

2. Helpful For The Debtor Countries :- If any country is facing adverse balance of payment and facing the difficulty to get the currency

of creditor country, it can get short term credit from the fund to clear the debt. The IMF allows

the debtor country to purchase foreign currency in exchange for its own currency upto 75% of its

quota plus an addition 25% each year. The maximum limit of the quota is 200% in special

circumstances.

3. Declared Of Scarce Currency :- If the demand of any particular country currency increases and its stock with the fund falls below

75% of its quota, the IMF can declare it scare. But IMF also tries to increase its supply by these

methods.

1. Purchasing :- IMF purchases the scare currency by gold.

2. Borrowing :- IMF borrows from those countries scare currency who has surplus amount.

3. Permission :- IMF allows the debtor countries to impose restrictions on the imports of

creditor country.

4. To promote exchange stability :- The main aim of IMF is to promote exchange stability

among the member countries. So it advises the member countries to conduct exchange

transactions at agreed rates. On the other hand one country can change the parity of the currency



without the consent of the IMF but it should not be more than 10%. If the changes are on large

scale and IMF feels that according the circumstances of the country these are essential then it

allows. The country can not change the exchange rate if IMF does not allow.

5. Temporary aid for the devalued currency :- When the devaluation policy is indispensable

or any country then IMF provides loan to correct the balance of payment of that country.

6. To avoid exchange depreciation :- IMF is very useful to avoid the competitive exchange

depreciation which took place before world war.

7. Providing short terms credit to member countries for meeting temporary difficulties due to

adverse balance of payments.

8. Reconciling conflicting claims of member countries.

9. Providing a reservoir of currencies of member-countries and enabling members to borrow on

another's currency.

10. Promoting orderly adjustment of exchange rates.

11. Advising member countries on economic, monetary and technical matters.



MULTILATERAL FINANCIAL INSTITUTIONS or INTERNATIONAL FINANCIAL

INSTITUTIONS

International financial institutions (IFIs) are financial institutions that have been established

(or chartered) by more than one country, and hence are subjects of international law. Their

owners or shareholders are generally national governments, although other international

institutions and other organizations occasionally figure as shareholders. The most prominent IFIs

are creations of multiple nations, although some bilateral financial institutions (created by two

countries) exist and are technically IFIs. Many of these are multilateral development banks

(MDB).

http://en.wikipedia.org/wiki/Financial_institution

http://en.wikipedia.org/wiki/International_law

http://en.wikipedia.org/wiki/International_institution

http://en.wikipedia.org/wiki/International_institution



A multilateral development bank (MDB) is an institution, created by a group of countries, that

provides financing and professional advising for the purpose of development. MDBs have large

memberships including both developed donor countries and developing borrower countries.

MDBs finance projects in the form of long-term loans at market rates, very-long-term loans (also

known as credits) below market rates, and through grants.

The following are usually classified as the main MDBs:

1. World Bank

The World Bank Group's (WBG) mission is to reduce global poverty, increase economic growth,

and improve the quality of people's lives. The WBG is made up of five institutions:

International Bank for Reconstruction and Development (IBRD), established in 1945

International Development Association (IDA), established in 1960

International Finance Corporation (IFC), established in 1956

Multilateral Investment Guarantee Agency (MIGA), established in 1988

http://en.wikipedia.org/wiki/Financing

http://en.wikipedia.org/wiki/International_development

http://en.wikipedia.org/wiki/Developed_country

http://en.wikipedia.org/wiki/Developing_country

http://en.wikipedia.org/wiki/World_Bank



International Centre for Settlement of Investment Disputes (ICSID), established in 1966

Together, these organizations provide low-interest loans, interest-free credits and grants to

developing countries for investments in education, health, public administration, infrastructure,

financial and private sector development, agriculture, and environmental and natural resource

management.

2. IMF (REFER 2 PAGES ABOVE)

3. Asian Development Bank (ADB)

The Asian Development Bank's (ADB) mission is to help its developing member

countries reduce poverty and improve the quality of life of their people. Established in

1966, the ADB provides loans, technical assistance and grants to its developing member

countries in Asia and the Pacific. It is the third largest provider of development finance in

the region.

4. European Bank for Reconstruction and Development (EBRD)

The European Bank for Reconstruction and Development (EBRD) is a multilateral

development bank, using investment as a tool to help build market economies. Initially

focused on the countries of the former Eastern Bloc it expanded to support development

in the democracies of 30 countries from central Europe to central Asia. Besides Europe,

member countries of the EBRD are from all 5 continents (North America, Africa, Asia

and Australia see below), with the biggest shareholder being the United States, so the

name is somewhat a misnomer. Headquartered in London, the EBRD is owned by 64

countries and two EU institutions. Despite its public sector shareholders, it invests mainly

in private enterprises, together with commercial partners.

5. Inter-American Development Bank Group (IDB, IADB)

Created in 1959, the Inter-American Development Bank (IDB) is the main source of

multilateral funding for economic, social and institutional development in Latin America

and the Caribbean. It works with partners to reduce poverty and inequality and to achieve

sustainable economic growth.

6. African Development Bank (AfDB)

Created in 1964, the African Development Bank's (AfDB) mission is to help reduce

poverty, improve living conditions for Africans and mobilize resources for Africa's

economic and social development.

http://en.wikipedia.org/wiki/Asian_Development_Bank

http://en.wikipedia.org/wiki/European_Bank_for_Reconstruction_and_Development

http://en.wikipedia.org/wiki/Multilateral_development_bank

http://en.wikipedia.org/wiki/Multilateral_development_bank

http://en.wikipedia.org/wiki/Investment

http://en.wikipedia.org/wiki/Market_economies

http://en.wikipedia.org/wiki/Eastern_Bloc

http://en.wikipedia.org/wiki/United_States

http://en.wikipedia.org/wiki/London

http://en.wikipedia.org/wiki/EU

http://en.wikipedia.org/wiki/Inter-American_Development_Bank

http://en.wikipedia.org/wiki/African_Development_Bank



7. Islamic Development Bank (IsDB)

The Islamic Development Bank (IDB) is a multilateral development financing

institution located in Jeddah, Saudi Arabia. It was founded in 1973 by the Finance

Ministers at the first Organisation of the Islamic Conference (now called the Organisation

of Islamic Cooperation).

The bank officially began its activities on 20 October 1975, inspired by King Faisal.

There are 56 shareholding member states. Mohammed bin Faisal is the former president

of the IsDB.

On the 22 May 2013, IDB tripled its authorized capital to $150 billion to better serve

Muslims in member and non-member countries. The Bank continues to receive the

highest credit ratings of AAA by major rating agencies.

8. The European Investment Bank (EIB) is the European Union's nonprofit long-term

lending institution established in 1958 under the Treaty of Rome. As a "policy-driven

bank" whose shareholders are the member states of the EU, the EIB uses its financing

operations to bring about "European integration and social cohesion". It should not be

confused with the European Central Bank.

The EIB is a publicly owned international financial institution and its shareholders are the

member states of the European Union. Thus the member states set the bank's broad policy

goals and oversee the independent decision-making bodies: the board of governors and

the board of directors

http://en.wikipedia.org/wiki/Islamic_Development_Bank

http://en.wikipedia.org/wiki/Jeddah

http://en.wikipedia.org/wiki/Saudi_Arabia

http://en.wikipedia.org/wiki/Organisation_of_Islamic_Cooperation

http://en.wikipedia.org/wiki/Organisation_of_Islamic_Cooperation

http://en.wikipedia.org/wiki/Faisal_of_Saudi_Arabia

http://en.wikipedia.org/wiki/Shareholder

http://en.wikipedia.org/wiki/Mohammed_bin_Faisal_Al_Saud

http://en.wikipedia.org/wiki/European_Union

http://en.wikipedia.org/wiki/Long-term_liabilities

http://en.wikipedia.org/wiki/Treaty_of_Rome

http://en.wikipedia.org/wiki/Shareholder

http://en.wikipedia.org/wiki/Member_state_of_the_European_Union

http://en.wikipedia.org/wiki/European_integration

http://en.wikipedia.org/wiki/European_Central_Bank

http://en.wikipedia.org/wiki/International_financial_institution

http://en.wikipedia.org/wiki/Member_states_of_the_European_Union



Module II

International flow of funds and International Monetary system:-

International Flow of Funds: Balance of Payments (BoP), Fundamentals of BoP, Accounting

components of BOP, Factors affecting International Trade and capital flows, Agencies that

facilitate International flows. BOP, Equilibrium & Disequilibrium. Trade deficits. Capital

account convertability.( problems on BOP)

International Monetary System: Evolution, Gold Standard, Bretton Woods system, the flexible

exchange rate regime, the current exchange rate arrangements, the Economic and Monetary

Union (EMU).

---------------------------------------------------------------------------------------------------------------------

International Flow of Funds

International business is facilitated by markets that allow for the flow of funds between

countries. The transactions arising from international business cause money flows from one

country to another. The balance of payments is a measure of international money flows and is

discussed in this chapter.

Financial managers of MNCs monitor the balance of payments so that they can determine

how the flow of international transactions is changing over time. The balance of payments can

indicate the volume of transactions between specific countries and may even signal potential

shifts in specific exchange rates.

BALANCE OF PAYMENTS

The balance of payments is a summary of transactions between domestic and foreign residents

for a specific country over a specified period of time. It represents an accounting of a country’s

international transactions for a period, usually a quarter or a year. It accounts for transactions by

businesses, individuals, and the government.

Fundamentals of BOP

The balance of payments must balance Subaccounts may be imbalanced

Three main elements to the process of measuring international economic activity

include:

Identifying what is and is not an international economic transaction

Understanding how the flow of goods, services, assets, and money creates debits and

credits to the overall BOP

Understanding the bookkeeping procedures for BOP accounting

Defining International Transactions

Identifying many international transactions is ordinarily not difficult

However, some international transactions are not obvious



The BOP as a Flow Statement

The BOP is often believed to be a balance sheet rather than a cash flow

statement

There are two types of business transactions that dominate the BOP:

Real assets

Financial assets

BOP Accounting: Double-Entry Bookkeeping

BOP employs an accounting technique called double-entry bookkeeping

In this age-old method every transaction produces a debit and a credit of the

same amount

A debit is created whenever: An asset is increased

A liability is decreased

An expense is increased

A credit is created whenever: An asset is decreased

A liability is increased

An expense is decreased

BOP Accounting: Double-Entry Bookkeeping

The measurement of all international transactions in and out of a country over a

year is a difficult task

Mistakes, errors, and statistical discrepancies will and do occur

Current and capital account entries are recorded independent of one another,

not together as this accounting method would prescribe

The following table shows the elements of BOP.

BALANCE OF PAYMENTS ACCOUNT

Receipts (Credits) Payments (Debits)

1. Export of goods. Imports of goods.

Trade Account Balance

2. Export of services.

3. Interest, profit and dividends

received.

4. Unilateral receipts.

Import of services.

Interest, profit and dividends paid.

Unilateral payments.

Current Account Balance (1 to 4)



5. Foreign investments.

6. Short term borrowings.

7. Medium and long term borrowing.

Investments abroad.

Short term lending.

Medium and long term lending. Capital Account Balance (5 to 7)

8. Errors and omissions.

9. Change in reserves. (+)

Errors and omissions.

Change in reserve (-)

Total Reciepts = Total Payments

Total payments.

Accounting components of BOP A balance-of-payments statement can be broken down into various components. Those that

receive the most attention are the current account and the capital account.

The current account represents a summary of the flow of funds between one specified

country and all other countries due to purchases of goods or services, or the provision of

income on financial assets.

The capital account represents a summary of the flow of funds resulting from the sale of

assets between one specified country and all other countries over a specified period of

time. Thus, it compares the new foreign investments made by a country with the foreign

investments within a country over a particular time period. Transactions that reflect

inflows of funds generate positive numbers (credits) for the country’s balance, while

transactions that reflect outflows of funds generate negative numbers (debits) for the

country’s balance.

I. Current Account

The main components of the current account are payments for (1) merchandise (goods)

and services, (2) factor income, and (3) transfers.

(1)Payments for Merchandise and Services. Merchandise exports and imports

represent tangible products, such as computers and clothing, that are transported between

countries. Service exports and imports represent tourism and other services, such as legal,

insurance, and consulting services, provided for customers based in other countries. Service

exports by the United States result in an inflow of funds to the United States, while service

imports by the United States result in an outflow of funds.

The difference between total exports and imports is referred to as the balance of trade. A

deficit in the balance of trade means that the value of merchandise and services exported by the

United States is less than the value of merchandise and services imported by the United States.



Before 1993, the balance of trade focused on only merchandise exports and imports. In 1993, it

was redefined to include service exports and imports as well. The value of U.S. service exports

usually exceeds the value of U.S. service imports. However, the value of U.S. merchandise

exports is typically much smaller than the value of U.S. merchandise imports. Overall, the

United States normally has a negative balance of trade.

(2)Factor Income Payments. A second component of the current account is factor income,

which represents income (interest and dividend payments) received by investors on foreign

investments in financial assets (securities). Thus, factor income received by U.S. investors

reflects an inflow of funds into the United States. Factor income paid by the United States

reflects an outflow of funds from the United States.

(3)Transfer Payments. A third component of the current account is transfer payments, which

represent aid, grants, and gifts from one country to another.

Examples of Payment Entries. Exhibit 2.1 shows several examples of transactions that would

be reflected in the current account. Notice in the exhibit that every transaction that generates a

U.S. cash inflow (exports and income receipts by the United States) represents a credit to the

current account, while every transaction that generates a U.S. cash outflow (imports and income

payments by the United States) represents a debit to the current account. Therefore, a large

current account deficit indicates that the United States is sending more cash abroad to buy goods

and services or to pay income than it is receiving for those same reasons.

Actual Current Account Balance. The U.S. current account balance in the year 2007 is

summarized in Exhibit 2.2. Notice that the exports of merchandise were valued at $1,148 billion,

while imports of merchandise by the United States were valued at $1,967 billion. Total U.S.

exports of merchandise and services and income receipts amounted to $2,463 billion, while total

U.S. imports and income payments amounted to $3,082 billion. The bottom of the exhibit shows

that net transfers (which include grants and gifts provided to other countries) were –$112 billion.

The negative number for net transfers represents a cash outflow from the United States. Overall,

the current account balance was –$731 billion, which is primarily attributed to the excess in U.S.

payments sent for imports beyond the payments received from exports.

Exhibit 2.2 shows that the current account balance (line 10) can be derived as the difference

between total U.S. exports and income receipts (line 4) and the total U.S. imports and income

payments (line 8), with an adjustment for net transfer payments (line 9). This is logical, since the

total U.S. exports and income receipts represent U.S. cash inflows while the total U.S. imports

and income payments and the net transfers represent U.S. cash outflows. The negative current

account balance means that the United States spent more on trade, income, and transfer payments

than it received.

Exhibit 2.1 Examples of Current Account TransactionNATIONAL TRADEMENTS

ACCOUNTRANSACTION



U.S. CA

ATINIONAL TRADE

TRANSAC

INTERNATIONAL TRADE

TRANSACTIONSTIONS

U

S US CASH FLOW

POSITION

EN

ENTRY ON US BOP

ACCOUNT

J.C. Penney purchases stereos

produced in Indonesia that it

will sell in its U.S. retail

stores.

U.S. cash outflow

Debit

Individuals in the United

States purchase CDs over the

Internet from a firm based in

China.

U.S. cash outflow Debit

The Mexican government

pays a U.S. consulting

firm for consulting services

provided by the firm.

U.S. cash inflow Credit

PAYMENTS ACCOUNT

IBM headquarters in the

United States purchases

computer chips from

Singapore that it uses in

assembling computers

.

U.S. cash outflow

Debit

A university bookstore in

Ireland purchases textbooks

produced by a U.S. publishing

company.

U.S. cash inflow

INTERNATIONAL INCOME

Credit

INTERNATIONAL

INCOME

TRANSACTIONSTIONS

U

S US CASH FLOW

POSITION

EN

ENTRY ON US BOP

ACCOUNT

A U.S. investor receives a

dividend payment from a

French firm in which she

purchased stock.




The U.S. Treasury sends an

interest payment to a German

insurance company that

purchased U.S. Treasury

bonds 1 year ago.


PAYMENTS ACCOUNT

A Mexican company that

borrowed dollars from a bank

based in the United States

sends an interest payment to

that bank.

ENTRY ON U.S.

BALANCEOF-

U.S. cash inflow

INTERNATIONAL

TRANSFER

TRANSACTION

Credit

INTERNATIONAL

TRANSFER

TRANSACTIONSTIO

U

S US CASH FLOW

POSITION

EN

ENTRY ON US BOP

ACCOUNT

The United States provides aid

to Costa Rica in response to a

flood in Costa Rica.


Switzerland provides a grant

to U.S. scientists to work on

cancer research.


SH FLOW

POSITION

Exhibit 2.2 Summary of Current Account in the Year 2008 (in billions of $)

(1)U.S. exports of merchandise

+ (2) U.S. exports of services

+ (3) U.S. income receipts

= (4) Total U.S. exports and income receipts

(5) U.S. imports of merchandise

+ (6) U.S. imports of services

+ (7) U.S. income payments

= (8) Total U.S. imports and income payments

(9) Net transfers by the United States

(10) Current account balance = (4) – (8) – (9)

+ $1,148

+ 497

+ 818

= $2,463

– $1,967

– 378

– 737

= $3,082

– $112

– $731



II. Capital and Financial Accounts

The capital account category has been changed to separate it from the financial account, which is

described next. The capital account includes the value of financial assets transferred across

country borders by people who move to a different country. It also includes the value of non

produced nonfinancial assets that are transferred across country borders, such as patents and

trademarks. The sale of patent rights by a U.S. firm to a Canadian firm reflects a credit to the

U.S. balance-of-payments account, while a U.S. purchase of patent rights from a Canadian firm

reflects a debit to the U.S. balance-of-payments account. The capital account items are relatively

minor compared to the financial account items.

The key components of the financial account are payments for

(1) direct foreign investment,

(2) portfolio investment, and

(3) other capital investment.

1.Direct Foreign Investment. Direct foreign investment represents the investment in fixed

assets in foreign countries that can be used to conduct business operations. Examples of direct

foreign investment include a firm’s acquisition of a foreign company, its construction of a new

manufacturing plant, or its expansion of an existing plant in a foreign country.

2.Portfolio Investment. Portfolio investment represents transactions involving long-term

financial assets (such as stocks and bonds) between countries that do not affect the transfer of

control. Thus, a purchase of Heineken (Netherlands) stock by a U.S. investor is classified as

portfolio investment because it represents a purchase of foreign financial assets without changing

control of the company. If a U.S. firm purchased all of Heineken’s stock in an acquisition, this

transaction would result in a transfer of control and therefore would be classified as direct

foreign investment instead of portfolio investment.

3.Other Capital Investment. A third component of the financial account consists of other

capital investment, which represents transactions involving short-term financial assets (such as

money market securities) between countries. In general, direct foreign investment measures the

expansion of firms’ foreign operations, whereas portfolio investment and other capital

investment measure the net flow of funds due to financial asset transactions between individual

or institutional investors.

Errors and Omissions and Reserves. If a country has a negative current account balance, it

should have a positive capital and financial account balance. This implies that while it sends

more money out of the country than it receives from other countries for trade and factor income,

it receives more money from other countries than it spends for capital and financial account

components, such as investments. In fact, the negative balance on the current account should be

offset by a positive balance on the capital and financial account. However, there is not normally

a perfect offsetting effect because measurement errors can occur when attempting to measure the



value of funds transferred into or out of a country. For this reason, the balance-of-payments

account includes a category of errors and omissions.

INTERNATIONAL TRADE FLOWS

Canada, France, Germany, and other European countries rely more heavily on trade than

the United States does. Canada’s trade volume of exports and imports per year is valued

at more than 50 percent of its annual gross domestic product (GDP). The trade volume

of European countries is typically between 30 and 40 percent of their respective GDPs.

The trade volume of the United States and Japan is typically between 10 and 20 percent

of their respective GDPs. Nevertheless, for all countries, the volume of trade has grown

over time. As of 2008, exports represented about 15 percent of U.S. GDP.

FACTORS AFFECTING INTERNATIONAL TRADE FLOWS

Because international trade can significantly affect a country’s economy, it is important

to identify and monitor the factors that influence it. The most influential factors are:

• Inflation

• National income

• Government policies

• Exchange rates

1) Impact of Inflation

If a country’s inflation rate increases relative to the countries with which it trades, its current

account will be expected to decrease, other things being equal. Consumers and corporations in

that country will most likely purchase more goods overseas (due to high local inflation), while

the country’s exports to other countries will decline.

2) Impact of National Income

If a country’s income level (national income) increases by a higher percentage than those of

other countries, its current account is expected to decrease, other things being equal. As the real

income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that

increase in consumption will most likely reflect an increased demand for foreign goods.

Impact of the Credit Crisis on Trade. The credit crisis weakened the economies (and national

incomes) of many different countries. Consequently, the amount of spending, including spending

for imported products, declined. MNCs cut back on their plans to boost exports as they lowered

their estimates for economic growth in their foreign markets. As they reduced their expansion

plans, they also reduced their demand for imported supplies. Thus, international trade flows were

reduced in response to the credit crisis.

A related reason for the decline in international trade is that some MNCs could not obtain

financing. International trade is commonly facilitated by letters of credit, which are issued by

commercial banks on behalf of importers promising to make payment upon delivery. Exporters

tend to trust that commercial banks would follow through on their obligation even if they did not



trust the importers. However, because many banks experienced financial problems during the

credit crisis, exporters were less willing to accept letters of credit.

3) Impact of Government Policies

A country’s government can have a major effect on its balance of trade by its policies on

subsidizing exporters, restrictions on imports, or lack of enforcement on piracy.

Subsidies for Exporters. Some governments offer subsidies to their domestic firms so that those

firms can produce products at a lower cost than their global competitors. Thus, the demand for

the exports produced by those firms is higher as a result of subsidies.

EXAMPLE

Many firms in China commonly receive free loans or free land from the government. They thus

incur a lower cost of operations and are able to price their products lower as a result. Lower

prices enable them to capture a larger share of the global market. _

Some subsidies are more obvious than others. It could be argued that every government

provides subsidies in some form.

Restrictions on Imports. A country’s government can also prevent or discourage imports from

other countries. By imposing such restrictions, the government disrupts trade flows. Among the

most commonly used trade restrictions are tariffs and quotas.

If a country’s government imposes a tax on imported goods (often referred to as a tariff),

the prices of foreign goods to consumers are effectively increased. Tariffs imposed by the U.S.

government are on average lower than those imposed by other governments.

Some industries, however, are more highly protected by tariffs than others. American

apparel products and farm products have historically received more protection against foreign

competition through high tariffs on related imports.

In addition to tariffs, a government can reduce its country’s imports by enforcing a quota,

or a maximum limit that can be imported. Quotas have been commonly applied to a variety of

goods imported by the United States and other countries.

Lack of Restrictions on Piracy. In some cases, a government can affect international trade

flows by its lack of restrictions on piracy.

EXAMPLE

In China, piracy is very common. Individuals (called pirates) manufacture CDs and DVDs that

look almost exactly like the original product produced in the United States and other countries.

They sell the CDs and DVDs on the street at a price that is lower than the original product. They

even sell the CDs and DVDs to retail stores. Consequently, local consumers obtain copies of

imports rather than actual imports. According to the U.S. film industry 90 percent of the DVDs

that were the intellectual property of U.S. firms and purchased in China may be pirated. It has

been estimated that U.S. producers of film, music, and software lose $2 billion in sales per year

due to piracy in China. The Chinese government has periodically stated that it would attempt to

crack down, but piracy is still prevalent.



As a result of piracy, China’s demand for imports is lower. Piracy is one reason why the United

States has a large balance-of-trade deficit with China. However, even if piracy were eliminated,

the U.S. trade deficit with China would still be large.

4) Impact of Exchange Rates

Each country’s currency is valued in terms of other currencies through the use of exchange rates.

Currencies can then be exchanged to facilitate international transactions. The values of most

currencies fluctuate over time because of market and government forces . If a country’s currency

begins to rise in value against other currencies, its current account balance should decrease, other

things being equal. As the currency strengthens, goods exported by that country will become

more expensive to the importing countries. As a consequence, the demand for such goods will

decrease.

EXAMPLE

A tennis racket that sells in the United States for $100 will require a payment of C$125 by the

Canadian importer if the Canadian dollar is valued at C$1 = $.80. If C$1 = $.70, it would require

a payment of C$143, which might discourage the Canadian demand for U.S. tennis rackets. A

strong local currency is expected to reduce the current account balance if the traded goods are

price-elastic (sensitive to price changes).

Using the tennis racket example above, consider the possible effects if currencies of several

countries depreciate simultaneously against the dollar (the dollar strengthens). The U.S. balance

of trade can decline substantially.

EXAMPLE

In the fall of 2008, exchange rates of the European currencies such as the euro, British pound,

Hungarian forint, and Swiss franc declined substantially against the dollar, which caused the

prices of European products to decline from the perspective of consumers in the United States.

In addition, the prices of American products increased from the perspective of consumers in

Europe. This trend was a reversal of the exchange rate movements in 2006–2007.

Interaction of Factors

While exchange rate movements can have a significant impact on prices paid for U.S. exports or

imports, the effects can be offset by other factors. For example, as a high U.S. inflation rate

reduces the current account, it places downward pressure on the value of the dollar (as discussed

in detail in Chapter 4). Because a weaker dollar can improve the current account, it may partially

offset the impact of inflation on the current account.

INTERNATIONAL CAPITAL FLOWS

One of the most important types of capital flows is direct foreign investment(DFI). Firms

commonly attempt to engage in direct foreign investment so that they can reach additional

consumers or can rely on low-cost labor. Exhibit 2.7 identifies the countries that heavily engage

in direct foreign investment. MNCs based in the United States engage in DFI more than any

other country. MNCs in the United Kingdom, France, and Germany also frequently engage in

DFI. Notice that European countries in aggregate account for more than half of the total DFI in



other countries. This is not surprising since the MNCs there commonly pursue DFI among other

European countries.

Factors Affecting DFI

Capital flows resulting from DFI change whenever conditions in a country change the desire of

firms to conduct business operations there. Some of the more common factors that could affect a

country’s appeal for DFI are identified here.

Changes in Restrictions. During the 1990s, many countries lowered their restrictions on DFI,

thereby opening the way to more DFI in those countries. Many U.S.-based MNCs, including

Bausch & Lomb, Colgate-Palmolive, and General Electric, have been penetrating less developed

countries such as Argentina, Chile, Mexico, India, China, and Hungary. New opportunities in

these countries have arisen from the removal of government barriers.

Privatization. Several national governments have recently engaged in privatization, or the

selling of some of their operations to corporations and other investors. Privatization is popular in

Brazil and Mexico, in Eastern European countries such as Poland and Hungary, and in such

Caribbean territories as the Virgin Islands. It allows for greater international business as foreign

firms can acquire operations sold by national governments.

Privatization was used in Chile to prevent a few investors from controlling all the shares and in

France to prevent a possible reversion to a more nationalized economy. In the United Kingdom,

privatization was promoted to spread stock ownership across investors, which allowed more

people to have a direct stake in the success of British industry.

The primary reason that the market value of a firm may increase in response to privatization is

the anticipated improvement in managerial efficiency. Managers in a privately owned firm can

focus on the goal of maximizing shareholder wealth, whereas in a state-owned business, the state

must consider the economic and social ramifications of any business decision. Also, managers of

a privately owned enterprise are more motivated to ensure profitability because their careers

may depend on it. For these reasons, privatized firms will search for local and global

opportunities that could enhance their value. The trend toward privatization will undoubtedly

create a more competitive global marketplace.

Potential Economic Growth. Countries that have greater potential for economic growth are

more likely to attract DFI because firms recognize that they may be able to capitalize on that

growth by establishing more business there.

Tax Rates. Countries that impose relatively low tax rates on corporate earnings are more likely

to attract DFI. When assessing the feasibility of DFI, firms estimate the after-tax cash flows that

they expect to earn.

Exchange Rates. Firms typically prefer to pursue DFI in countries where the local currency is

expected to strengthen against their own. Under these conditions, they can invest funds to

establish their operations in a country while that country’s currency is relatively cheap (weak).



Then, earnings from the new operations can periodically be converted back to the firm’s

currency at a more favorable exchange rate.

Factors Affecting International Portfolio Investment

The desire by individual or institutional investors to direct international portfolio

investment to a specific country is influenced by the following factors.

Tax Rates on Interest or Dividends. Investors normally prefer to invest in a country where the

taxes on interest or dividend income from investments are relatively low. Investors assess their

potential after-tax earnings from investments in foreign securities.

Interest Rates. Portfolio investment can also be affected by interest rates. Money tends to flow

to countries with high interest rates, as long as the local currencies are not expected to weaken.

Exchange Rates. When investors invest in a security in a foreign country, their return is affected

by (1) the change in the value of the security and (2) the change in the value of the currency in

which the security is denominated. If a country’s home currency is expected to strengthen,

foreign investors may be willing to invest in the country’s securities to benefit from the currency

movement. Conversely, if a country’s home currency is expected to weaken, foreign investors

may decide to purchase securities in other countries.

AGENCIES THAT FACILITATE INTERNATIONAL FLOWS

A variety of agencies have been established to facilitate international trade and financial

transactions. These agencies often represent a group of nations. A description of some of the

more important agencies follows.

1.International Monetary Fund

The United Nations Monetary and Financial Conference held in Bretton Woods, New

Hampshire, in July 1944 was called to develop a structured international monetary system. As a

result of this conference, the International Monetary Fund (IMF) was formed. The major

objectives of the IMF, as set by its charter, are to (1) promote cooperation among countries on

international monetary issues, (2) promote stability in exchange rates, (3) provide temporary

funds to member countries attempting to correct imbalances of international payments, (4)

promote free mobility of capital funds across countries, and (5) promote free trade. It is clear

from these objectives that the IMF’s goals encourage increased internationalization of business.

The IMF is overseen by a Board of Governors, composed of finance officers (such as the head of

the central bank) from each of the 185 member countries. It also has an executive board

composed of 24 executive directors representing the member countries. This board is based in

Washington, D.C., and meets at least three times a week to discuss ongoing issues.

One of the key duties of the IMF is its compensatory financing facility (CFF), which attempts to

reduce the impact of export instability on country economies. Although it is available to all IMF

members, this facility is used mainly by developing countries. A country experiencing financial



problems due to reduced export earnings must demonstrate that the reduction is temporary and

beyond its control. In addition, it must be willing to work with the IMF in resolving the problem.

Each member country of the IMF is assigned a quota based on a variety of factors reflecting that

country’s economic status. Members are required to pay this assigned quota. The amount of

funds that each member can borrow from the IMF depends on its particular quota.

The financing by the IMF is measured in special drawing rights (SDRs). The SDR is not a

currency but simply a unit of account. It is an international reserve asset created by the IMF and

allocated to member countries to supplement currency reserves. The SDR’s value fluctuates in

accordance with the value of major currencies.

The IMF played an active role in attempting to reduce the adverse effects of the Asian crisis. In

1997 and 1998, it provided funding to various Asian countries in exchange for promises from the

respective governments to take specific actions intended to improve economic conditions.

Funding Dilemma of the IMF. The IMF typically specifies economic reforms that a country

must satisfy to receive IMF funding. In this way, the IMF attempts to ensure that the country

uses the funds properly. However, some countries want funding without adhering to the

economic reforms required by the IMF.

For example, the IMF may require that a government reduce its budget deficit as a condition for

receiving funding. Some governments have failed to implement the reforms required by the IMF.

2.World Bank

The International Bank for Reconstruction and Development (IBRD), also referred to as the

World Bank, was established in 1944. Its primary objective is to make loans to countries to

enhance economic development. For example, the World Bank recently extended a loan to

Mexico for about $4 billion over a 10-year period for environmental projects to facilitate

industrial development near the U.S. border. Its main source of funds is the sale of bonds and

other debt instruments to private investors and governments. The World Bank has a profit-

oriented philosophy. Therefore, its loans are not subsidized but are extended at market rates to

governments (and their agencies) that are likely to repay them.

A key aspect of the World Bank’s mission is the Structural Adjustment Loan (SAL), established

in 1980. The SALs are intended to enhance a country’s long-term economic growth. For

example, SALs have been provided to Turkey and to some less developed countries that are

attempting to improve their balance of trade.

Because the World Bank provides only a small portion of the financing needed by developing

countries, it attempts to spread its funds by entering into cofinancing agreements. Cofinancing is

performed in the following ways:

• Official aid agencies. Development agencies may join the World Bank in financing

development projects in low-income countries.

• Export credit agencies. The World Bank cofinances some capital-intensive projects that are

also financed through export credit agencies.

• Commercial banks. The World Bank has joined with commercial banks to provide financing

for private-sector development. In recent years, more than 350 banks



from all over the world have participated in cofinancing, including Bank of America, J.P.

Morgan Chase, and Citigroup.

The World Bank recently established the Multilateral Investment Guarantee Agency (MIGA),

which offers various forms of political risk insurance. This is an additional means (along with its

SALs) by which the World Bank can encourage the development of international trade and

investment.

The World Bank is one of the largest borrowers in the world; its borrowings have amounted to

the equivalent of $70 billion. Its loans are well diversified among numerous currencies and

countries, and it has received the highest credit rating (AAA) possible.

World Trade Organization

The World Trade Organization (WTO) was created as a result of the Uruguay Round of trade

negotiations that led to the GATT accord in 1993. This organization was established to provide a

forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.

It began its operations in 1995 with 81 member countries, and more countries have joined since

then. Member countries are given voting rights that are used to make judgments about trade

disputes and other issues.

3.International Financial Corporation

In 1956 the International Financial Corporation (IFC) was established to promote private

enterprise within countries. Composed of a number of member nations, the IFC works to

promote economic development through the private rather than the government sector. It not

only provides loans to corporations but also purchases stock, thereby becoming part owner in

some cases rather than just a creditor. The IFC typically provides 10 to 15 percent of the

necessary funds in the private enterprise projects in which it invests, and the remainder of the

project must be financed through other sources. Thus, the IFC acts as a catalyst, as opposed to a

sole supporter, for private enterprise development projects. It traditionally has obtained financing

from the World Bank but can borrow in the international financial markets.

4.International Development Association

The International Development Association (IDA) was created in 1960 with country

development objectives somewhat similar to those of the World Bank. Its loan policy is more

appropriate for less prosperous nations, however. The IDA extends loans at low interest rates to

poor nations that cannot qualify for loans from the World Bank.

5. Bank for International Settlements

The Bank for International Settlements (BIS) attempts to facilitate cooperation among countries

with regard to international transactions. It also provides assistance to countries experiencing a

financial crisis. The BIS is sometimes referred to as the “central banks’ central bank” or the

“lender of last resort.” It played an important role in supporting some of the less developed

countries during the international debt crisis in the early and mid-1980s. It commonly provides

financing for central banks in Latin American and Eastern European countries.

6.OECD



The Organization for Economic Cooperation and Development (OECD) facilitates governance in

governments and corporations of countries with market economics. It has 30 member countries

and has relationships with numerous countries. The OECD promotes international country

relationships that lead to globalization.

7.Regional Development Agencies

Several other agencies have more regional (as opposed to global) objectives relating to economic

development. These include, for example, the Inter-American Development Bank (focusing on

the needs of Latin America), the Asian Development Bank (established to enhance social and

economic development in Asia), and the African Development Bank (focusing on development

in African countries).

In 1990, the European Bank for Reconstruction and Development was created to help the

Eastern European countries adjust from communism to capitalism. Twelve Western European

countries hold a 51 percent interest, while Eastern European countries hold a 13.5 percent

interest. The United States is the biggest shareholder, with a 10 percent interest. There are 40

member countries in aggregate.

EQUILIBRIUM AND DISEQUILIBRIUM IN BOP :-

Balance of payments is the difference between the receipts from and payments to

foreigners by residents of a country. In accounting sense balance of payments, must always

balance. Debits must be equal to credits. So, there will be equilibrium in balance of payments.

Symbolically, B = R - P

Where : - B = Balance of Payments

R = Receipts from Foreigners

P = Payments made to Foreigners

When B = Zero, there is said to be equilibrium in balance of payments.

When B is positive there is favourable balance of payments; When &. B is negative

there is unfavourable or adverse balance of payments.' When there is a surplus or a deficit in

balance of payments there is said : to be disequilibrium in balance of payments. Thus

disequilibrium refers to imbalance in balance of payments.

B. TYPES OF DISEQUILIBRIUM IN BOP

The following are the main types of disequilibrium in the balance of payments:-

1. Structural Diseguilibrium :-

Structural disequilibrium is caused by structural changes in the economy affecting

demand and supply relations in commodity and factor markets. Some of the structural

disequilibrium are as follows :-



a. A shift in demand due to changes in tastes, fashions, income etc. would

decrease or increase the demand for imported goods thereby causing a

disequilibrium in BOP.

b. If foreign demand for a country's products declines due to new and cheaper substitutes

abroad, then the country's exports will decline causing a deficit.

c. Changes in the rate of international capital movements may also cause structural

disequilibrium.

d. If supply is affected due to crop failure, shortage of raw-materials, strikes, political

instability etc., then there would be deficit in BOP.

e. A war or natural calamities also result in structural changes which may affect not only goods

but also factors of production causing disequilibrium in BOP.

f. Institutional changes that take place within and outside the country may result in BOP

disequilibrium. For Eg. if a trading block imposes additional import duties on products imported

in member countries of the block, then the exports of exporting country would be restricted or

reduced. This may worsen the BOP position of exporting country.

2. Cyclical Disequilibrium :-

Economic activities are subject to business cycles, which normally have four phases

Boom or Prosperity, Recession, Depression and Recovery. During boom period, imports may

increase considerably due to increase in demand for imported goods. During recession and

depression, imports may be reduced due to fall in demand on account of reduced income. During

recession exports may increase due to fall in prices. During boom period, a country may face

deficit in BOP on account of increased imports.

Cyclical disequilibrium in BOP may occur because

a. Trade cycles follow different paths and patterns in different countries.

b. Income elasticities of demand for imports in different countries are not identical.

c. Price elasticities of demand for imports differ in different countries.

3. Short - Run Disequilibrium :-

This disequilibrium occurs for a short period of one or two years. Such BOP

disequilibrium is temporary in nature. Short - run disequilibrium arises due to unexpected

contingencies like failure of rains or favourable monsoons, strikes, industrial peace or unrest etc.

Imports may increase exports or exports may increase imports in a year due to these reasons and

causes a temporary disequilibrium exists.

International borrowing or lending for a short - period would cause short - run

disequilibrium in balance of payments of a country. Short term disequilibrium can be corrected



through short - term borrowings. If short - run disequilibrium occurs repeatedly it may pave way

for long - run disequilibrium.

4. Long - Run I Secular Disequilibrium :-

Long run or fundamental disequilibrium refers to a persistent deficit or a surplus in the

balance of payments of a country. It is also known as secular disequilibrium. The causes of long

- term disequilibrium are

a. Continuous increase in demand for imports due to increasing population.

b. Constant price changes - mostly inflation which affects exports on continuous basis.

c. Decline in demand for exports due to technological improvements in importing countries, and

as such the importing countries depend less on imports.

The long run disequilibrium can be corrected by making constant efforts to increase

exports and to reduce imports.

5. Monetary Diseguilibrium

Monetary disequilibrium takes place on account of inflation or deflation. Due to

inflation, prices of products in domestic market rises, which makes exports expensive. Such a

situation may affect BOP equilibrium. Inflation also results in increase in money income with

people, which in turn may increase demand for imported goods. As a result imports may turn

BOP position in disequilibrium.

6. Exchange Rate Fluctuations :-

A high degree of fluctuation in exchange rate may affect the BOP position. For Eg. if

Indian Rupee gets appreciated against dollar, then Indian exporters will receive lower amounts of

foreign exchange, whereas, there will be more outflow of foreign exchange on account of higher

imports. Such a situation will adversely affect BOP position. But, if domestic currency

depreciates against foreign currency, then the BOP position may have positive impact.

CAUSES OF DISEQUILIBRIUM IN BOP

Any disequilibrium in the balance of payment is the result of imbalance between

receipts and payments for imports and exports. Normally, the term disequilibrium is interpreted

from a negative angle and therefore, it implies deficit in BOP.

The disequilibrium in BOP is caused due to various factors. Some of them are

I. Import - Related Causes

The rise in imports has been the most important factor responsible for large BOP

deficits. The causes of rapid expansion of imports are :-

1. Population Growth



Population Growth may increase the demand for imported goods such as food

items and non food items, to meet their growing needs. Thus, increase in imports may lead to

BOP disequilibrium.

2. Development Programme

Increase in development programmes by developing countries may require import

of capital goods, raw materials and technology. As development is a continuous process, imports

of these items continue for a long time landing the developing countries in BOP deficit.

3. Imports Of Essential Items

Countries which do not have enough supply of essential items like Crude oil or

Capital equipments are required to import them. Again due to natural calamities government may

resort to heavy imports, which adversely affect the BOP position.

4. Reduction Of Import Duties

When import duties are reduced, imports becomes cheaper as such imports

increases. This increases the deficit in BOP position.

5. Inflation

Inflation in domestic markets may increase the demand for imported goods,

provided the imported goods are available at lower prices than in domestic markets.

6. Demonstration Effect

An increase in income coupled with awareness of higher living standard of

foreigners, induce people at home to imitate the foreigners. Thus, when people become victims

of demonstration effect, their propensity to import increases.

II. Export Related Causes :-

Even though export earnings have increased but they have not been sufficient enough to

meet the rising imports. Exports may reduce without a corresponding decline in imports.

Following are the causes for decrease in exports

1. Increase In Population :-

Goods which were earlier exported may be consumed by rising population. This

reduces the export earnings of the country leading to BOP disequilibrium.

2. Inflation :-

When there is inflation in domestic market, prices of export goods increases. This

reduces the demand of export goods which in turn results in trade deficit.

3. Appreciation Of Currency :-

Appreciation of domestic currency against foreign currencies results in lower foreign

exchange to exporters. This demotivates the exporters.

4. Discovery Of Substitutes :-

With technological development new substitutes have come up. Like plastic for rubber,

synthetic fibre for cotton etc. This may reduce the demand for raw material requirement.



5. Technological Development :-

Technological Development in importing countries may reduce their imports. This can be

possible when they start manufacturing goods which they were exporting earlier. This will have

an adverse effect on exporting countries.

6. Protectionist Trade Policy :-

Protectionist trade policy of importing country would encourage domestic producers by

giving them incentives, whereas, the imports would be discouraged by imposing high duties.

This will affect exports.

III. Other Causes :-

1. Flight of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks. Investors

may also withdraw their investments, which in turn puts pressure on foreign exchange reserves.

2. Globalisation

Globalisation and the rules of WTO have brought a liberal and open environment in

global trade. It has positive as well as negative effects on imports, exports and investments. Poor

countries are unable to cope up with this new environment. Ultimately they become loser and

their BOP is adversely affected.

3. Cyclical Transmission

International trade is also affected by Business cycles. Recession or depression in one or

more developed countries may affect the rest of the world. The negative effects of trade cycle

(low income, low demand, etc.) are transmitted from one country to another. For eg. The current

financial crisis in U.S.A. is affecting the rest of the world.

4. Structural Adjustments

Many countries in recent years are undergoing structural changes. Their economies are

being liberalised. As a result, investment, income and other variables are changing resulting in

changes in exports and imports.

5. Political factors

The existence of political instability may result in disrupting the productive apparatus of

the country causing a decline in exports and increase in imports. Likewise, payment of war

expenses may also serious affect disequilibrium in the country’s BOP. Thus political factors may

also produce serious disequilibrium in the country’s BOPs.

MEASURES TO CORRECT DISEQUILIBRIUM IN BOP :-

Any disequilibrium (deficit or surplus) in balance of payments is bad for normal internal

economic operations and international economic relations. A deficit is more harmful for a



country’s economic growth, thus it must be corrected sooner than later. The measures to correct

disequilibrium can be broadly divided into four groups

MEASURES

1.Monetary Policy

2. Fiscal Policy

3.Exchange Rate Policy

4.Non-monetary Policy

I. Monetary Measures :-

1) Monetary Policy :-

The monetary policy is concerned with money supply and credit in the economy. The

Central Bank may expand or contract the money supply in the economy through appropriate

measures which will affect the prices.

A. Inflation :-

If in the country there is inflation, the Central Bank through its monetary policy will make

an attempt to reduce inflation. The Central Bank will adopt tight monetary policy. Money supply

will be controlled by increase in Bank Rate, Cash Reserve Ratio, Statutory Ratio etc.

The monetary policy measures may reduce money supply, and encourage people to save

more, which would reduce inflation. If inflation is reduced, the prices of domestic market will

decrease and also that of export goods. In foreign markets there will be more demand for export

goods, which would correct BOP disequilibrium.

B. Deflation :- During deflation the Central Bank of the country may adopt easy monetary

policy. It will try to increase money supply and credit in the economy, which would increase

investment. More investment leads to more production. Surplus can be exported, which in turn

may improve BOP position.

2) Fiscal Policy

Fiscal policy is government's policy on income and expenditure. Government

incurs development and non - development expenditure,. It gets income through taxation and non

- tax sources. Depending upon the situation governments expenditure may be increased or

decreased.

a) Inflation

During inflation the government may adopt easy fiscal policy. The tax rates for

corporate sector may be reduced, which would encourage more production and distribution

http://www.blogger.com/post-create.g?blogID=2459821890457927651



including exports. Increased exports will bring more foreign exchange there by making the BOP

position favourable.

b) Deflation

During deflation the government would adopt restrictive fiscal policy.It may

impose additional taxes on consumers or may introduce tax saving schemes. This may reduce the

consumption of citizens, which in turn may enable more export surplus.

To restrict imports the government may also impose additional tariffs or customs duties

which may improve the BOP position.

3) Exchange Rate Policy

Foreign exchange rate in the market may directly or indirectly be influenced by the

Government.

a) Devaluation

When foreign exchange problem is faced by the country, the government tries to reduce

imports and .increase exports. This is done through devaluation of domestic currency. Under

devaluation, the- government makes a deliberate effort to reduce the value of home country. If

devaluation is carried out, then the exports will become cheaper and imports costlier. This is turn

will help to reduce imports and increase exports.

b) Depreciation

Depreciation like devaluation lowers the value of domestic currency or increases the

value of foreign currency. Depreciation of a country's currency takes place in free or competitive

foreign exchange market due to market forces. Depreciation and devaluation have the same

effect on exchange rate. If there is high demand for foreign currency than its supply, it will

appreciate and vice versa. However, in several countries the system of managed flexibility is

followed. If there is more demand for foreign exchange, the central bank will release the foreign

currency in the market from its reserves so as to reduce the appreciation of foreign currency. If

there is less demand for foreign exchange, it will purchase the foreign currency from market so

as to reduce the depreciation of foreign country and appreciation of domestic currency.

Due to devaluation and depreciation of domestic currency, the exports become cheaper

and imports become expensive. This helps to increase exports.

I) Non-Monetary / General Measures :

A deficit country along with monetary measures may adopt the following non-monetary

measures too, which will either restrict imports or promote exports.

1) Tariffs :-

Tariffs refer to duties on imports to restrict imports. Tariff is a fiscal device which may

be used to correct an adverse balance of payments. The imposition of import duties will raise the



prices of imports. This will lead to a reduction in demand for imports thereby improving the

balance of payments position.

2) Quotas :-

Under Quota System, the government may fix and permit the maximum quantity or value

of a commodity to be imported during a given period. By restricting imports through quota

system, the deficit is reduced and the balance of payments position is improved.

3) Export Promotion :-

The government may introduce a number of export promotion measures to encourage

exporters to export more so as to earn valuable foreign exchange, which in turn would improve

BOP Situation. Some of the incentives are Subsidies, Tax Concessions, Grants, Octroi refund,

Excise exemption, Duty Drawback, Marketing facilities etc.

4) Import Substitution

Governments, especially, that of the developing countries may encourage import

substitution so as to restrict imports and save valuable foreign exchange. The government may

encourage domestic producers to produce goods which were earlier imported. The domestic

producers may be given several incentives such as Tax holiday, Cash Subsidy, Assistance in

Research & Development, Providing technical assistance, Providing Scarce inputs etc.

A. CONCLUSION :-

From the above measures it is clear that more exports with import substitution based on

economic strength of the country are the real effective solutions to correct the disequilibrium in

the balance of payments.

Trade deficit

An economic measure of a negative balance of trade in which a country's imports exceeds its

exports. A trade deficit represents an outflow of domestic currency to foreign markets.

The commercial balance or net exports (sometimes symbolized as NX), is the difference

between the monetary value of exports and imports of output in an economy over a certain

period, measured in the currency of that economy. It is the relationship between a nation's

imports and exports. A positive balance is known as a trade surplus if it consists of exporting

more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade

gap. The balance of trade is sometimes divided into a goods and a services balance.

CORRECTING A BALANCE-OF-TRADE DEFICIT

A balance-of-trade deficit is not necessarily a problem. It may enable a country’s consumers to

benefit from imported products that are less expensive than locally produced products. However,

the purchase of imported products implies less reliance on domestic production in favor of

foreign production. Thus, it may be argued that a large balance-of-trade deficit causes a transfer

of jobs to some foreign countries. Consequently, a country’s government may attempt to correct

a balance-of-trade deficit.

http://en.wikipedia.org/wiki/International_trade



By reconsidering some of the factors that affect the balance of trade, it is possible to develop

some common methods for correcting a deficit. Any policy that will increase foreign demand for

the country’s goods and services will improve its balance-of-trade position. Foreign demand may

increase if export prices become more attractive. This can occur when the country’s inflation is

low or when its currency’s value is reduced, thereby making the prices cheaper from a foreign

perspective.

A floating exchange rate could possibly correct any international trade imbalances in the

following way. A deficit in a country’s balance of trade suggests that the country is spending

more funds on foreign products than it is receiving from exports to foreign countries. Because it

is selling its currency (to buy foreign goods) in greater volume than the foreign demand for its

currency, the value of its currency should decrease. This decrease in value should encourage

more foreign demand for its goods in the future.

While this theory seems rational, it does not always work as just described. It is possible that,

instead, a country’s currency will remain stable or appreciate even when the country has a

balance-of-trade deficit.

EXAMPLE

The United States normally experiences a large balance-of-trade deficit, which should place

downward pressure on the value of the dollar when holding other factors constant. Yet in many

periods there are more financial flows into the United States to purchase securities than there are

financial outflows. These forces can offset the downward pressure on the dollar’s value caused

by the trade imbalance. Thus, the value of the dollar will not necessarily decline when there is a

large balance-of-trade deficit in the United States.

Capital account convertibility

There is no formal definition of capital account convertibility (CAC). The Tarapore committee

set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC defined it as the

freedom to convert local financial assets into foreign financial assets and vice versa at market

determined rates of exchange.

In simple language what this means is that CAC allows anyone to freely move from local

currency into foreign currency and back.

CAC different from current account convertibility-

Current account convertibility allows free inflows and outflows for all purposes other than for

capital purposes such as investments and loans. In other words, it allows residents to make and

receive trade-related payments — receive dollars (or any other foreign currency) for export of

goods and services and pay dollars for import of goods and services, make sundry remittances,

access foreign currency for travel, studies abroad, medical treatment and gifts etc. In India,

current account convertibility was established with the acceptance of the obligations under

Article VIII of the IMF’s Articles of Agreement in August 1994.



CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen

as a major comfort factor for overseas investors since they know that at anytime they will be able

to re-convert local currency back into foreign.

International Monetary System

Evolution of IMS

GOLD STANDARD

A monetary system in which a country's government allows its currency unit to be freely

converted into fixed amounts of gold and vice versa. The exchange rate under the gold

standard monetary system is determined by the economic difference for an ounce of gold

between two currencies. The gold standard was mainly used from 1875 to 1914 and also

during the interwar years

The use of the gold standard would mark the first use of formalized exchange rates in

history. However, the system was flawed because countries needed to hold large gold

reserves in order to keep up with the volatile nature of supply and demand for currency.

After World War II, a modified version of the gold standard monetary system, the

Bretton Woods monetary system created as its successor. This successor system was

initially successful, but because it also depended heavily on gold reserves, it was

abandoned in 1971 when U.S President Nixon "closed the gold window."



A gold standard is a monetary system in which the standard economic unit of account is based

on a fixed quantity of gold.

Three types may be distinguished: specie, exchange, and bullion. In the gold specie standard the

monetary unit is associated with the value of circulating gold coins or the monetary unit has the

value of a certain circulating gold coin, but other coins may be made of less valuable metal. The

gold exchange standard usually does not involve the circulation of gold coins. The main feature

of the gold exchange standard is that the government guarantees a fixed exchange rate to the

currency of another country that uses a gold standard (specie or bullion), regardless of what type

of notes or coins are used as a means of exchange. This creates a de facto gold standard, where

the value of the means of exchange has a fixed external value in terms of gold that is

independent of the inherent value of the means of exchange itself. Finally, the gold bullion

standard is a system in which gold coins do not circulate, but the authorities agree to sell gold

bullion on demand at a fixed price in exchange for currency.

As of 2013 no country used a gold standard as the basis of its monetary system, although some

hold substantial gold reserves.

Bretton Wood System

The Bretton Woods system of monetary management established the rules for commercial and

financial relations among the world's major industrial states in the mid-20th century. The Bretton

Woods system was the first example of a fully negotiated monetary order intended to govern

monetary relations among independent nation-states.

Preparing to rebuild the international economic system while World War II was still raging, 730

delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods,

New Hampshire, United States, for the United Nations Monetary and Financial Conference, also

known as the Bretton Woods Conference. The delegates deliberated during 1–22 July 1944, and

signed the Agreement on its final day.

Setting up a system of rules, institutions, and procedures to regulate the international monetary

system, the planners at Bretton Woods established the International Monetary Fund (IMF) and

the International Bank for Reconstruction and Development (IBRD), which today is part of the

World Bank Group. These organizations became operational in 1945 after a sufficient number of

countries had ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a

monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the

ability of the IMF to bridge temporary imbalances of payments.

http://en.wikipedia.org/wiki/Monetary_system#Commodity_money_system


http://en.wikipedia.org/wiki/Unit_of_account


http://en.wikipedia.org/wiki/Fixed_exchange_rate

http://en.wikipedia.org/wiki/De_facto



http://en.wikipedia.org/wiki/Gold_reserve

http://en.wikipedia.org/wiki/Money

http://en.wikipedia.org/wiki/Developed_country

http://en.wikipedia.org/wiki/World_War_II

http://en.wikipedia.org/wiki/Allies_of_World_War_II

http://en.wikipedia.org/wiki/Mount_Washington_Hotel

http://en.wikipedia.org/wiki/Bretton_Woods,_New_Hampshire

http://en.wikipedia.org/wiki/Bretton_Woods,_New_Hampshire

http://en.wikipedia.org/wiki/United_Nations_Monetary_and_Financial_Conference

http://en.wikipedia.org/wiki/Bretton_Woods_Conference

http://en.wikipedia.org/wiki/International_Monetary_Fund

http://en.wikipedia.org/wiki/International_Bank_for_Reconstruction_and_Development

http://en.wikipedia.org/wiki/World_Bank_Group

http://en.wikipedia.org/wiki/Monetary_policy

http://en.wikipedia.org/wiki/Exchange_rate

http://en.wikipedia.org/wiki/Balance_of_payments



On 15 August 1971, the United States unilaterally terminated convertibility of the US$ to gold.

This brought the Bretton Woods system to an end and saw the dollar become fiat currency.[1]

This action, referred to as the Nixon shock, created the situation in which the United States dollar

became a reserve currency used by many states. At the same time, many fixed currencies (such

as GBP, for example), also became free-floating.

The flexible exchange rate regime

An exchange-rate regime is the way an authority manages its currency in relation to

other currencies and the foreign exchange market. It is closely related to monetary policy and the

two are generally dependent on many of the same factors.

The basic types are a floating exchange rate, where the market dictates movements in the

exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a

target band or value; and a fixed exchange rate, which ties the currency to another currency,

mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies.

A flexible exchange-rate system is a monetary system that allows the exchange rate to be

determined by supply and demand.

Every currency area must decide what type of exchange rate arrangement to maintain. Between

permanently fixed and completely flexible however, are heterogeneous approaches. They have

different implications for the extent to which national authorities participate in foreign exchange

markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are

arranged into three categories: currency unions, dollarized regimes, currency boards and

conventional currency pegs are described as “fixed-rate regimes”; Horizontal bands, crawling

pegs and crawling bands are grouped into “intermediate regimes”; Managed and independent

floats are described as flexible regimes. All monetary regimes except for the permanently fixed

regime experience the time inconsistency problem and exchange rate volatility, albeit to different

degrees.

The exchange rate in which the value of the currency is determined by the free market.

That is, a currency has a floating exchange rate when its value changes constantly depending on

the supply and demand for that currency, as well as the amount of the currency held in foreign

reserves. An advantage to a floating exchange rate is that it tends to be more economically

efficient. However, floating exchange rates tend to be more volatile depending on the particular

currency. A currency with a floating exchange rate may undergo currency appreciation or

http://en.wikipedia.org/wiki/Convertibility


http://en.wikipedia.org/wiki/Fiat_currency

http://en.wikipedia.org/wiki/Bretton_Woods_system#cite_note-1

http://en.wikipedia.org/wiki/Nixon_shock

http://en.wikipedia.org/wiki/Reserve_currency

http://en.wikipedia.org/wiki/Fixed_exchange-rate_system

http://en.wikipedia.org/wiki/GBP

http://en.wikipedia.org/wiki/Currency

http://en.wikipedia.org/wiki/Foreign_exchange_market



http://en.wikipedia.org/wiki/Fixed_exchange_rate_system

http://en.wikipedia.org/wiki/U.S._dollar

http://en.wikipedia.org/wiki/Euro

http://en.wikipedia.org/wiki/Monetary


http://en.wikipedia.org/wiki/Supply_and_demand

http://en.wikipedia.org/wiki/Bretton_Woods_system

http://en.wikipedia.org/wiki/Currency_union

http://en.wikipedia.org/wiki/Currency_board

http://en.wikipedia.org/wiki/Time_inconsistency

http://financial-dictionary.thefreedictionary.com/Exchange+Rate

http://financial-dictionary.thefreedictionary.com/Value

http://financial-dictionary.thefreedictionary.com/Currency

http://financial-dictionary.thefreedictionary.com/Free+Market

http://financial-dictionary.thefreedictionary.com/Supply

http://financial-dictionary.thefreedictionary.com/Demand

http://financial-dictionary.thefreedictionary.com/Reserves

http://financial-dictionary.thefreedictionary.com/Economically+Efficient

http://financial-dictionary.thefreedictionary.com/Economically+Efficient

http://financial-dictionary.thefreedictionary.com/Currency+Appreciation



currency depreciation, depending on market fluctuations. A floating exchange rate is also called

a flexible exchange rate

Difference between a fixed and a floating exchange rate

A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary

authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a

floating exchange rate is determined in foreign exchange markets depending on demand and

supply, and it generally fluctuates constantly.

A fixed exchange rate regime reduces the transaction costs implied by exchange rate uncertainty,

which might discourage international trade and investment, and provides a credible anchor for

low-inflationary monetary policy. On the other hand, autonomous monetary policy is lost in this

regime, since the central bank must keep intervening in the foreign exchange market to maintain

the exchange rate at the officially set level. Autonomous monetary policy is thus a big advantage

of a floating exchange rate. If the domestic economy slips into recession, it is autonomous

monetary policy that enables the central bank to boost demand, thus 'smoothing" the business

cycle, i.e. reducing the impact of economic shocks on domestic output and employment. Both

types of exchange rate regime have their pros and cons, and the choice of the right regime may

differ for different countries depending on their particular conditions. In practice there is a range

of exchange rate regimes lying between these two extreme variants, thus providing a certain

compromise between stability and flexibility.

The exchange rate in the Czech Republic was pegged to a basket of currencies until early 1996,

then the peg was effectively eliminated through a substantial widening of the fluctuation band,

and now the Czech economy operates in the so-called managed floating regime, i.e. the exchange

rate is floating, but the central bank may turn to interventions should there be any extreme

fluctuations.

The current exchange rate arrangements

An exchange-rate regime is the way an authority manages its currency in relation to other

currencies and the foreign exchange market. It is closely related to monetary policy and the two

are generally dependent on many of the same factors.

The basic types are a floating exchange rate, where the market dictates movements in the

exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a

target band or value; and a fixed exchange rate, which ties the currency to another currency,

mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies.

Types

http://financial-dictionary.thefreedictionary.com/Currency+Depreciation

http://financial-dictionary.thefreedictionary.com/Market

http://financial-dictionary.thefreedictionary.com/Fluctuations





http://en.wikipedia.org/wiki/Fixed_exchange_rate_system

http://en.wikipedia.org/wiki/U.S._dollar




Float

Floating rates are the most common exchange rate regime today. For example, the dollar, euro,

yen, and British pound all are floating currencies. However, since central banks frequently

intervene to avoid excessive appreciation or depreciation, these regimes are often called

managed float or a dirty float.

Pegged float

Pegged floating currencies are pegged to some band or value, either fixed or periodically

adjusted. Pegged floats are:

Crawling bands

the rate is allowed to fluctuate in a band around a central value, which is adjusted

periodically. This is done at a preannounced rate or in a controlled way following

economic indicators.

Crawling pegs

the rate itself is fixed, and adjusted as above.

Pegged with horizontal bands

the rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.

Fixed exchange-rate system

Fixed rates are those that have direct convertibility towards another currency. In case of a

separate currency, also known as a currency board arrangement, the domestic currency is backed

one to one by foreign reserves. A pegged currency with very small bands (< 1%) and countries

that have adopted another country's currency and abandoned its own also fall under this category.

Dollarization

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or

instead of the domestic currency. The term is not only applied to usage of the United States

dollar, but generally to the use of any foreign currency as the national currency. Zimbabwe is an

example of dollarization since the collapse of the Zimbabwean dollar.

Classification of Exchange Rate Regimes by IMF

http://en.wikipedia.org/wiki/Yen

http://en.wikipedia.org/wiki/British_pound

http://en.wikipedia.org/wiki/Managed_float_regime

http://en.wikipedia.org/wiki/Managed_float_regime

http://en.wikipedia.org/wiki/Band_of_fluctuation

http://en.wikipedia.org/wiki/Economic_indicator

http://en.wikipedia.org/wiki/Crawling_peg

http://en.wikipedia.org/wiki/Fixed_exchange-rate_system

http://en.wikipedia.org/wiki/Currency_board

http://en.wikipedia.org/wiki/Foreign_reserves

http://en.wikipedia.org/wiki/Zimbabwean_dollar



Exchange Arrangements with No Separate Legal Tender

The currency of another country circulates as the sole legal tender (formal dollarization), or the

member belongs to a monetary or currency union in which the same legal tender is shared by the

members of the union. Adopting such regimes implies the complete surrender of the monetary

authorities' independent control over domestic monetary policy.

Currency Board Arrangements

A monetary regime based on an explicit legislative commitment to exchange domestic currency

for a specified foreign currency at a fixed exchange rate, combined with restrictions on the

issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic

currency will be issued only against foreign exchange and that it remains fully backed by foreign

assets, eliminating traditional central bank functions, such as monetary control and lender-of-

last-resort, and leaving little scope for discretionary monetary policy. Some flexibility may still

be afforded, depending on how strict the banking rules of the currency board arrangement are.

Other Conventional Fixed Peg Arrangements

The country (formally or de facto) pegs its currency at a fixed rate to another currency or a

basket of currencies, where the basket is formed from the currencies of major trading or financial

partners and weights reflect the geographical distribution of trade, services, or capital flows. The

currency composites can also be standardized, as in the case of the SDR. There is no

commitment to keep the parity irrevocably. The exchange rate may fluctuate within narrow

margins of less than ±1 percent around a central rate-or the maximum and minimum value of the

exchange rate may remain within a narrow margin of 2 percent-for at least three months. The

monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via

sale/purchase of foreign exchange in the market) or indirect intervention (e.g., via aggressive use

of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that

constrains foreign exchange activity, or through intervention by other public institutions).

Flexibility of monetary policy, though limited, is greater than in the case of exchange

arrangements with no separate legal tender and currency boards because traditional central

banking functions are still possible, and the monetary authority can adjust the level of the

exchange rate, although relatively infrequently.

Pegged Exchange Rates within Horizontal Bands

The value of the currency is maintained within certain margins of fluctuation of at least ±1

percent around a fixed central rate or the margin between the maximum and minimum value of

the exchange rate exceeds 2 percent. It also includes arrangements of countries in the exchange

rate mechanism (ERM) of the European Monetary System (EMS) that was replaced with the

ERM II on January 1, 1999. There is a limited degree of monetary policy discretion, depending

on the band width.



Crawling Pegs

The currency is adjusted periodically in small amounts at a fixed rate or in response to changes

in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading

partners, differentials between the inflation target and expected inflation in major trading

partners, and so forth. The rate of crawl can be set to generate inflation-adjusted changes in the

exchange rate (backward looking), or set at a preannounced fixed rate and/or below the projected

inflation differentials (forward looking). Maintaining a crawling peg imposes constraints on

monetary policy in a manner similar to a fixed peg system.

Exchange Rates within Crawling Bands

The currency is maintained within certain fluctuation margins of at least ±1 percent around a

central rate-or the margin between the maximum and minimum value of the exchange rate

exceeds 2 percent-and the central rate or margins are adjusted periodically at a fixed rate or in

response to changes in selective quantitative indicators. The degree of exchange rate flexibility is

a function of the band width. Bands are either symmetric around a crawling central parity or

widen gradually with an asymmetric choice of the crawl of upper and lower bands (in the latter

case, there may be no preannounced central rate). The commitment to maintain the exchange rate

within the band imposes constraints on monetary policy, with the degree of policy independence

being a function of the band width.

Managed Floating with No Predetermined Path for the Exchange Rate

The monetary authority attempts to influence the exchange rate without having a specific

exchange rate path or target. Indicators for managing the rate are broadly judgmental (e.g.,

balance of payments position, international reserves, parallel market developments), and

adjustments may not be automatic. Intervention may be direct or indirect.

Independently Floating

The exchange rate is market-determined, with any official foreign exchange market intervention

aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate,

rather than at establishing a level for it.

Economic and Monetary Union

Economic and Monetary Union (EMU) represents a major step in the integration of EU

economies. It involves the coordination of economic and fiscal policies, a common monetary

policy, and a common currency, the euro. Whilst all 27 EU Member States take part in the

economic union, some countries have taken integration further and adopted the euro. Together,

these countries make up the euro area.



The decision to form an Economic and Monetary Union was taken by the European Council in

the Dutch city of Maastricht in December 1991, and was later enshrined in the Treaty on

European Union (the Maastricht Treaty). Economic and Monetary Union takes the EU one step

further in its process of economic integration, which started in 1957 when it was founded.

Economic integration brings the benefits of greater size, internal efficiency and robustness to the

EU economy as a whole and to the economies of the individual Member States. This, in turn,

offers opportunities for economic stability, higher growth and more employment – outcomes of

direct benefit to EU citizens. In practical terms, EMU means:

Coordination of economic policy-making between Member States

Coordination of fiscal policies, notably through limits on government debt and deficit

An independent monetary policy run by the European Central Bank (ECB)

The single currency and the euro area

Stages of Economic and Monetary Union (EMU)

STAGE ONE starting

1 Jul 1990

Complete freedom for capital transactions;

Increased co-operation between central banks;

Free use of the ECU (European Currency Unit, forerunner of the €);

Improvement of economic convergence;

STAGE TWO starting

1 Jan 1994

Establishment of the European Monetary Institute (EMI);

Ban on the granting of central bank credit;

Increased co-ordination of monetary policies;

Strengthening of economic convergence;

Process leading to the independence of the national central banks, to

be completed at the latest by the date of establishment of the European

System of Central Banks;

Preparatory work for Stage Three;

STAGE THREE Irrevocable fixing of conversion rates;

http://www.ecb.europa.eu/ecb/history/emu/html/index.en.html#stage1







starting 1 Jan 1999 Introduction of the euro;

Conduct of the single monetary policy by the European System of

Central Banks;

Entry into effect of the intra-EU exchange rate mechanism (ERM II);

Entry into force of the Stability and Growth Pact;




Module III ( 6Hours)

Foreign Exchange Market

Function and Structure of the Forex markets, Foreign exchange market participants, Types

of transactions and Settlements Dates, Exchange rate quotations, Nominal , Real and

Effective exchange rates, Determination of Exchange rates in Spot markets. Exchange rates

determinations in Forward markets. Exchange rate behavior-Cross Rates- Arbitrage profit in

foreign exchange markets, Swift Mechanism. Triangular and locational arbitrage.

FOREIGN EXCHANGE

Foreign Exchange refers to foreign currencies possessed by a country for making

payments to other countries. It may be defined as exchange of money or credit in one country for money

or credit in another. It covers methods of payment, rules and regulations of payment and the institutions

facilitating such payments.

A. FOREIGN EXCHANGE MARKET

A foreign exchange market refers to buying foreign currencies with domestic currencies

and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign

moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic

currencies and importers buy foreign currencies with domestic currencies.

According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions

and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid

claim on foreign money". Foreign Exchange transactions result in inflow & outflow of foreign exchange.

The FX market is almost a 24 hour market.

The major foreign exchange trading centers are in

London, New York, and Tokyo ---60%

Zurich, Singapore, and Hong Kong --- 20%

B. FUNCTIONS OF FOREIGN EXCHANGE MARKET

Foreign exchange is also referred to as forex market. Participants are importers,

exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks. Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the

important foreign exchange instruments used in foreign exchange market to carry out its functions.

The Foreign Exchange Market performs the following functions.

1. Transfer Of Purchasing Power I Clearing Function



The basic function of the foreign exchange market is to facilitate the conversion of one

currency into another i.e. payment between exporters and importers. For eg. Indian rupee is converted

into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used

such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of

transferring the purchasing power.

2. Credit Function

The foreign exchange market also provides credit to both national and international, to

promote foreign trade. It is necessary as sometimes, the international payments get delayed for 60 days or

90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about

3 months, till their maturity, is required.

For eg. Mr. A can get his bill discounted with a foreign exchange bank in New York and

this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the

stipulated time.

3. Hedging Function

A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we

mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this

function the foreign exchange market tries to protect the interest of the persons dealing in the market from

any unforseen changes in exchange rate. The exchange rates under free market can go up and down, this

can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well

as importers, against any changes in exchange rate.

Hedging can be done either by means of a spot exchange market or a forward exchange market

involving a forward contract.

Structure of Forex Market



PARTICIPANTS IN FOREIGN EXCHANGE MARKET

Foreign exchange market needs dealers to facilitate foreign exchange transactions. Bulk

of foreign exchange transaction are dealt by Commercial banks & financial institutions. RBI has also

allowed private authorised dealers to deal with foreign exchange transactions i.e buying & selling foreign

currency. The main participants in foreign exchange markets are



1. Retail Clients

Retail Clients deal through commercial banks and authorised agents. They comprise

people, international investors, multinational corporations and others who need foreign exchange. 2. Commercial Banks

Commercial banks carry out buy and sell orders from their retail clients and of their own

account. They deal with other commercial banks and also through foreign exchange brokers.

3. Foreign Exchange Brokers

Each foreign exchange market centre has some authorised brokers. Brokers act as

intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers. 4. Central Banks

Under floating exchange rate central bank does not interfere in exchange market. Since

1973, most of the central banks intervened to buy and sell their currencies to influence the rate at which

currencies are traded.

From the above sources demand and supply generate which in turn helps to determine the

foreign exchange rate.

B. TYPES OF FOREIGN EXCHANGE MARKET

Foreign Exchange Market is of two types retail and wholesale market.

1. Retail Market

The retail market is a secondary price maker. Here travellers, tourists and people who are

in need of foreign exchange for permitted small transactions, exchange one currency for another.

2. Wholesale Market

The wholesale market is also called interbank market. The size of transactions in this market is

very large. Dealers are highly professionals and are primary price makers. The main participants are

Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible

for determining exchange rate.

3. Other Participants a) Brokers

Brokers have more information and better knowledge of market. They provide

information to banks about the prices at which there are buyers and sellers of a pair of currencies. They

act as middlemen between the price makers.

b) Price Takers

Price takers are those who buy foreign exchange which they require and sell what they

earn at the price determined by primary price makers.

c) Indian Foreign Exchange Market

It is made up of three tiers

i. Here dealings take place between RBI and Authorised dealers (ADs) (mainly



commercial banks).

ii. Here dealings take place between ADs

iii. Here ADs deal with their corporate customers.

Types of Transactions in Forex Market

The following types of transactions in the foreign exchange market are available :

TOD - currency exchange transaction involving the supply of currency on the day of

transaction conclusion

TOM - currency exchange transaction involving the supply of currency on the next

working day

SPOT - currency exchange transaction involving the supply of currency in 2 working

days

FORWARD - OTC currency exchange transaction involving the future supply of

currency on the fixed date with the transaction rate agreed on the day of transaction

FUTURES - standardized exchange contract, involving the future supply of currency on

the fixed date with the transaction rate agreed on the day of transaction

SWAP - a combination of two opposite currency exchange transactions for the same

amount with different valuation dates

OPTION - a contract that provides the buyer with the right to buy or sell a certain

amount of currency at a certain date and price fixed by the contract

Three major types of transactions

1. Spot

2. Forward

3. Swap

Spot transaction

An agreement on price today, with settlement usually two business days later.

Settlement = actual delivery of currency for currency

In the case of the US dollar for the Canadian dollar (or the Mexican peso), settlement is

on the next day of the transaction.

Forward transaction

An agreement on price today for settlement at some date (called the “value date”) in the

future (one or two weeks, or 1 ~ 12 months).



Example

Exxon has a scheduled payment of £25 million in 8 months and buys that amount

of British pounds forward today. No money will change hands now.

Swap

A sale (purchase) of a foreign currency with a simultaneous agreement to repurchase

(resell) it at some date in the future.

Usually in the inter-bank market

Example

Citibank buys DM 2.5 million from Deutsch Bank for $1 million, with a

simultaneous agreement to sell the DM back in 6 months for $1.05 million.

$50,000 = swap rate.

FX transaction

65% of transactions: spot

33% of transactions : swap

2% : (outright) forward

Types of Settlement Dates

The date by which an executed security trade must be settled. That is, the date by which a buyer

must pay for the securities delivered by the seller.

The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two

business days from the trade date. A notable exception is the USD/CAD currency pair, which

settles at T + 1.

Execution methods

Common methods of executing a spot foreign exchange transaction include the following:

Direct – Executed between two parties directly and not intermediated by a third party.

For example, a transaction executed via direct telephone communication or direct

electronic dealing systems such as Reuters Conversational Dealing

http://en.wikipedia.org/wiki/United_States_dollar

http://en.wikipedia.org/wiki/Canadian_dollar

http://en.wikipedia.org/wiki/Thomson_Reuters



Electronic broking systems – Executed via automated order matching system for foreign

exchange dealers. Examples of such systems are EBS and Reuters Matching 2000/2

Electronic trading systems – Executed via a single-bank proprietary platform or a

multibank dealing system. These systems are generally geared towards customers.

Examples of multibank systems include Integral, FXall, Currenex, FX Connect,

Globalink, and eSpeed

Voice broker – Executed via telephone with a foreign exchange voice broker

Exchange rate quotations

1. For interbank Quotation

a. American terms

example: $.5838/dm

b. European terms

example: dm1.713/$

2. Direct and Indirect Quotation

Direct quote gives the home currency price of one unit of foreign currency. A foreign

exchange rate quoted as the domestic currency per unit of the foreign currency. In other words,

it involves quoting in fixed units of foreign currency against variable amounts of the domestic

currency.

EXAMPLE: dm0.25/FF

An indirect quote is a foreign currency price of a unit of home currency.

In the US, a direct quote for the CAD is USD 0.6341 / CAD

This quote would be an indirect quote in Canada.

Direct quotation: This is also known as price quotation. The exchange rate of the domestic

currency is expressed as equivalent to a certain number of units of a foreign currency. It is

usually expressed as the amount of domestic currency that can be exchanged for 1 unit or 100

units of a foreign currency. The more valuable the domestic currency, the smaller the amount of

domestic currency needed to exchange for a foreign currency unit and this gives a lower

http://en.wikipedia.org/wiki/Order_%28business%29

http://en.wikipedia.org/wiki/Electronic_Broking_Services

http://en.wikipedia.org/wiki/D2000-2

http://en.wikipedia.org/wiki/Proprietary_software

http://en.wikipedia.org/wiki/FXall

http://en.wikipedia.org/wiki/Currenex

http://en.wikipedia.org/wiki/ESpeed

http://en.wikipedia.org/wiki/Broker



exchange rate. When the domestic currency becomes less valuable, a greater amount is needed to

exchange for a foreign currency unit and the exchange rate becomes higher.

Under the direct quotation, the variation of the exchange rates are inversely related to the

changes in the value of the domestic currency. When the value of the domestic currency rises,

the exchange rates fall; and when the value of the domestic currency falls, the exchange rates

rise. Most countries uses direct quotation. Most of the exchange rates in the market such as

USD/JPY, USD/HKD and USD/RMD are also quoted using direct quotation.

Indirect quotation: This is also known as the quantity quotation. The exchange rate of a foreign

currency is expressed as equivalent to a certain number of units of the domestic currency. This is

usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100 units

of domestic currency. The more valuable the domestic currency, the greater the amount of

foreign currency it can exchange for and the lower the exchange rate. When the domestic

currency becomes less valuable, it can exchange for a smaller amount of foreign currency and

the exchange rate drops.

Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in

value of the domestic currency. When the value of the domestic currency rises, the exchange

rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well.

Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use

indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly.

Direct Quotation Indirect Quotation

USD/JPY = 134.56/61 EUR/USD = 0.8750/55

USD/HKD = 7.7940/50 GBP/USD = 1.4143/50

USD/CHF = 1.1580/90 AUD/USD = 0.5102/09

There are two implications for the above quotations:

(1) Currency A/Currency B means the units of Currency B needed to exchange for 1 unit of

Currency A.

(2) Value A/Value B refers to the quoted buy price and sell price. Since the difference between

the buy price and sell price is not large, only the last 2 digits of the sell price are shown. The two

digits in front are the same as the buy price.

Defintion of “pip” in foreign exchange rates quotation



Based on the market practice, foreign exchange rates quotation normally consists of 5 significant

figures. Starting from right to left, the first digit, is known as the “pip”. This is the smallest unit

of movement in the exchange rate. The second digit is known as “10 pips”, so on and so forth.

For example: 1 EUR = 1.1011 USD; 1 USD = JPY 120.55

If EUR/USD changes from 1.1010 to 1.1015, we say that the EUR/USD has risen by 5 pips.

If USD/JPY changes from 120.50 to 120.00, we say that USD/JPY has dropped by 50 pips.

3.Bid-Ask Quotation

Spread is used to calculate the fee charged by the bank. It is the difference between bid and

Ask

Bid = the price at which the bank is willing to buy

Ask = the price it will sell the currency

Factors That Affect the Spread. The spread on currency quotations is influenced

by the following factors:

• Order costs. Order costs are the costs of processing orders, including clearing costs

and the costs of recording transactions.

• Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular

currency. Holding an inventory involves an opportunity cost because the funds

could have been used for some other purpose. If interest rates are relatively high, the

opportunity cost of holding an inventory should be relatively high. The higher the inventory

costs, the larger the spread that will be established to cover these costs.

• Competition. The more intense the competition, the smaller the spread quoted by

intermediaries. Competition is more intense for the more widely traded currencies

because there is more business in those currencies.

• Volume. More liquid currencies are less likely to experience a sudden change in price.

Currencies that have a large trading volume aremore liquid because there are numerous

buyers and sellers at any given time. This means that the market has sufficient depth that

a few large transactions are unlikely to cause the currency’s price to change abruptly.

• Currency risk. Some currencies exhibit more volatility than others because of economic

or political conditions that cause the demand for and supply of the currency

to change abruptly. For example, currencies in countries that have frequent political

crises are subject to abrupt price movements. Intermediaries that are willing to buy

or sell these currencies could incur large losses due to an abrupt change in the values

of these currencies.



NOMINAL, REAL AND EFFECTIVE EXCHANGE RATES

The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate

between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always

represented in terms of the amount of foreign currency that can be purchased for one unit of domestic

currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency

that can be purchased for one unit of domestic currency.

THE nominal exchange rate is simply the price of one currency in terms of the number of units of some

other currency. This is determined by fiat in a fixed rate regime and by demand and supply for the two

currencies in the foreign exchange rate market in a floating rate regime.

The real exchange rate is a bit more complicated than the nominal exchange rate. While the

nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic

currency, the real exchange rate tells how much the goods and services in the domestic country

can be exchanged for the goods and services in a foreign country. The real exchange rate is

represented by the following equation: real exchange rate = (nominal exchange rate X domestic

price) / (foreign price).

Let's say that we want to determine the real exchange rate for wine between the US and Italy. We

know that the nominal exchange rate between these countries is 1600 lira per dollar. We also

know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember

that we are attempting to compare equivalent types of wine in this example. In this case, we

begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate

X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange

rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine.

By using both the nominal exchange rate and the real exchange rate, we can deduce important

information about the relative cost of living in two countries. While a high nominal exchange

rate may create the false impression that a unit of domestic currency will be able to purchase

many foreign goods, in reality, only a high real exchange rate justifies this assumption.

Net Exports and the Real Exchange Rate

An important relationship exists between net exports and the real exchange rate within a country.

When the real exchange rate is high, the relative price of goods at home is higher than the

relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in

real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease

as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports

rise. This relationship helps to show the effects of changes in the real exchange rate.

Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket

of other currencies.[citation needed] Although typically that basket is trade-weighted, the trade-weighted

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effective exchange rate index is not the only way to derive a meaningful effective exchange rate index.

Ho(2012)proposed a new approach to compiling effective exchange rate indices. It defines the effective

exchange rate as a ratio if the "normalized Exchange Value of Currency i against the US dollar" to the

normalized exchange value of the "benchmark currency basket" against the US dollar. The US dollar is

here used as numeraire for convenience, and since it cancels out, in principle any other currency can be

used instead without affecting the results. The benchmark currency basket is a GDP-weighted basket of

the major fully convertible currencies of the world.

1)Spot Exchange Rate :-

When foreign exchange is bought and sold for immediate delivery, it is called spot

exchange. It refers to a day or two in which two currencies are involved. The basic principle of spot

exchange rate is that it can be analysed like any other price with the help of demand and supply forces.

The exchange rate of dollar is determined by intersection of demand for and supply of

dollars in foreign exchange. The Remand for dollar is derived from country’s demand for imports which

are paid in dollars and supply is derived from country’s exports which are sold in dollars.

The exchange rate determined by market forces would change as these forces change in

market. The primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates

continuously change in a free market depending on demand and supply. The primary dealer (bank) quotes

two-way rates i.e., buy and sell rate.

(Bid) Buy Rate 1 US $ = ` 45.50

(Ask) Sell Rate 1 US $ = ` 45.75

The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of

Rs.0.25 is the profit margin of dealer.

2) Forward Exchange Rate

Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or

90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in contract for

future delivery. The price for such transactions is fixed at the time of contract, it is called a forward rate.

Forward exchange rate differs from spot exchange rate as the former may either be at a

premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate is said to

be at a premium. If the forward rate is below the present spot rate, the foreign exchange rate is said to be

at a discount. Thus foreign exchange rate may be at forward premium or at forward discount.

For Eg. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty

days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement, except for usual security

margin money of about 10% of the total amount. 60 days form today, the importer will get 10,000 US $ in

exchange for Rs. 4,80,000 irrespective of the Spot exchange rate prevailing on that date.

Factors Influencing Forward Exchange Rate

i) Interest rates.

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ii) Degree of speculation in foreign exchange market.

iii) Inflation rate.

iv) Foreign investor’s confidence in domestic country.

v) Economic situation in the country.

vi) Political situation in the country.

vii) Balance of payments position etc.

Determination of Exchange rates in Spot markets

Numerous factors determine exchange rates, and all are related to the trading relationship

between two countries. Remember, exchange rates are relative, and are expressed as a

comparison of the currencies of two countries. The following are some of the principal

determinants of the exchange rate between two countries. Note that these factors are in no

particular order; like many aspects of economics, the relative importance of these factors is

subject to much debate.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency

value, as its purchasing power increases relative to other currencies. During the last half of the

twentieth century, the countries with low inflation included Japan, Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

inflation typically see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-

Push Inflation Versus Demand-Pull Inflation.)

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest

rates, central banks exert influence over both inflation and exchange rates, and changing interest

rates impact inflation and currency values. Higher interest rates offer lenders in an economy a

higher return relative to other countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing interest rates - that is, lower

interest rates tend to decrease exchange rates.

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3. Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting

all payments between countries for goods, services, interest and dividends. A deficit in the

current account shows the country is spending more on foreign trade than it is earning, and that it

is borrowing capital from foreign sources to make up the deficit. In other words, the country

requires more foreign currency than it receives through sales of exports, and it supplies more of

its own currency than foreigners demand for its products. The excess demand for foreign

currency lowers the country's exchange rate until domestic goods and services are cheap enough

for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For

more, see Understanding The Current Account In The Balance Of Payments.)

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and

governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. The reason? A large debt

encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off

with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but

increasing the money supply inevitably causes inflation. Moreover, if a government is not able to

service its deficit through domestic means (selling domestic bonds, increasing the money

supply), then it must increase the supply of securities for sale to foreigners, thereby lowering

their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country

risks defaulting on its obligations. Foreigners will be less willing to own securities denominated

in that currency if the risk of default is great. For this reason, the country's debt rating (as

determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its

exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts

and the balance of payments. If the price of a country's exports rises by a greater rate than that of

its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater

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demand for the country's exports. This, in turn, results in rising revenues from exports, which

provides increased demand for the country's currency (and an increase in the currency's value). If

the price of exports rises by a smaller rate than that of its imports, the currency's value will

decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in

which to invest their capital. A country with such positive attributes will draw investment funds

away from other countries perceived to have more political and economic risk. Political turmoil,

for example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.

Conclusion

The exchange rate of the currency in which a portfolio holds the bulk of its investments

determines that portfolio's real return. A declining exchange rate obviously decreases the

purchasing power of income and capital gains derived from any returns. Moreover, the exchange

rate influences other income factors such as interest rates, inflation and even capital gains from

domestic securities. While exchange rates are determined by numerous complex factors that

often leave even the most experienced economists flummoxed, investors should still have some

understanding of how currency values and exchange rates play an important role in the rate of

return on their investments.

Determination of Exchange rates in Forward markets

i)Interest rates.

ii) Degree of speculation in foreign exchange market.

iii) Inflation rate.

iv) Foreign investor’s confidence in domestic country.

v) Economic situation in the country.

vi) Political situation in the country.

Difference between forwards and futures markets

Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead

they deal in contracts that represent claims to a certain currency type, a specific price per unit

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and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine

the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and

settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the

U.S., the National Futures Association regulates the futures market. Futures contracts have

specific details, including the number of units being traded, delivery and settlement dates, and

minimum price increments that cannot be customized. The exchange acts as a counterpart to the

trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question

upon expiry, although contracts can also be bought and sold before they expire. The forwards

and futures markets can offer protection against risk when trading currencies. Usually, big

international corporations use these markets in order to hedge against future exchange rate

fluctuations, but speculators take part in these markets as well.

Exchange rate behavior

The Impact of Productivity Changes

Overvaluation

Real Exchange Rate Behavior and Market Characteristics

Interest rates, exchange rates and expectations

Cross Exchange Rates.

Most tables of exchange rate quotations express currencies relative to the dollar, but in some

instances, a firm will be concerned about the exchange rate between two nondollar currencies.

For example, if a Canadian firm needs Mexican pesos to buy Mexican goods, it wants to know

the Mexican peso value relative to the Canadian dollar. The type of rate desired here is known as

a cross exchange rate, because it reflects the amount of one foreign currency per unit of another

foreign currency.

Cross exchange rates can be easily determined with the use of foreign exchange quotations. The

value of any nondollar currency in terms of another is its value in dollars divided by the other

currency’s value in dollars.

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Arbitrage profit in foreign exchange markets,

Arbitrage is the act of simultaneously buying a currency in one market and

selling it in another to make a profit by taking advantage of exchange rate differences in two markets. If

the arbitrages are confined to two markets only it is said “two-point” arbitrage. If they extend to three or

more markets they are known as “three-point” or “multi-point” arbitrage. Those who deal with arbitrage

are called arbitrageurs.

A Spot sale of a currency when combined with a forward repurchase in a single

transaction is called “Currency Swap". The Swap rate is the difference between spot and forward

exchange rates in currency swap.

Arbitrage opportunities may exist in a foreign exchange market.. Suppose the rate of

exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then an arbitrageur can

buy dollars in US market and sell it in Indian market and get a profit of `. 5 per dollar..

In today’s modern well connected and advanced markets, arbitrageurs (which are mainly

banks) can spot it quickly and exploit the opportunity. Such opportunities vanish over a period of time

and equilibrium is again maintained.

For Eg.

Bank A ` / $ = 50.50 / 50.55

Bank B ` / $ = 50.40 / 50.45

The above rates are very close. The arbitrageur may take advantage and he can purchase $

1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus making a profit of

0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is earned without any risk and

blocking of capital.

B. ARBITRAGE.AND INTEREST RATE

Interest arbitrage refers to differences in interest rates in domestic market and in overseas

markets. If interest rates are higher in overseas market than in domestic market, an investor may invest in

overseas market to take the advantage of interest differential.

Interest arbitrage may be covered and uncovered.

1) Uncovered Arbitrage

In this system, arbitrageurs would take a risk to earn profit by investing in a high interest

bearing risk free securities in a foreign market. His earnings would be according to his calculations if the

currency of foreign market where he invested does not depreciate. If depreciation is equal to the

difference in interest rate, the investor would not incur loss. However, if depreciation is more than interest

rate, then the arbitrageur will incur loss.



For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain it is 8%.

An US investor may convert US dollars in EURO and invest in Spain, thereby taking an advantage of

+2% interest rate. Now when bill matures, US investor will convert EURO into dollars. However, by that

time EURO may have depreciated the US investor will get less dollars per EURO. If EURO depreciates

by 1%, US investor will gain only +1% (+2 – 1%). If EURO depreciates by 2% or more, US investor will

not gain anything or incur loss. If EURO appreciates, US investor will gain, +2% and interest rate

differential

2) Covered Arbitrage

International investors would like to avoid the foreign exchange risk, thus interest arbitrage is

usually covered. The investor converts the domestic currency for foreign currency at the current spot rate

for the purpose of investment. At the same time, investor sells forward the amount of foreign currency

which he is investing plus the interest that he will earn so as to coincide with maturity of foreign

investment.

The covered interest arbitrage refers to spot purchase of foreign currency to make investment and

offsetting simultaneous forward sale of foreign currency to cover foreign exchange risk. When treasury

bills mature, the investor will get the domestic currency equivalent of foreign investment plus interest

without a foreign exchange risk.

SWIFT MECHANISM

A member-owned cooperative that provides safe and secure financial transactions for its

members. Established in 1973, the Society for Worldwide Interbank Financial

Telecommunication (SWIFT) uses a standardized proprietary communications platform to

facilitate the transmission of information about financial transactions. This information,

including payment instructions, is securely exchanged between financial institutions.

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides a

network that enables financial institutions worldwide to send and receive information about

financial transactions in a secure, standardized and reliable environment. Swift also sells

software and services to financial institutions, much of it for use on the SWIFTNet Network, and

ISO 9362. Business Identifier Codes (BICs) are popularly known as "SWIFT codes".

The chairman of SWIFT is Yawar Shah, who is from Pakistan.[1] The CEO is Gottfried

Leibbrandt, who is from the Netherlands.

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The majority of international interbank messages use the SWIFT network. As of September

2010, SWIFT linked more than 9,000 financial institutions in 209 countries and territories, who

were exchanging an average of over 15 million messages per day (compared to an average of 2.4

million daily messages in 1995). SWIFT transports financial messages in a highly secure

way[how?] but does not hold accounts for its members and does not perform any form of clearing

or settlement.

SWIFT does not facilitate funds transfer; rather, it sends payment orders, which must be settled

by correspondent accounts that the institutions have with each other. Each financial institution, to

exchange banking transactions, must have a banking relationship by either being a bank or

affiliating itself with one (or more) so as to enjoy those particular business features.

SWIFT hosts an annual conference every year called SIBOS which is specifically aimed at the

financial services industry.

SWIFT is a cooperative society under Belgian law and it is owned by its member financial

institutions. It has offices around the world. SWIFT headquarters, designed by Ricardo Bofill

Taller de Arquitectura are in La Hulpe, Belgium, near Brussels.

SWIFT means several things in the financial world:

1. a secure network for transmitting messages between financial institutions;

2. a set of syntax standards for financial messages (for transmission over SWIFTNet or any

other network)

3. a set of connection software and services, allowing financial institutions to transmit

messages over SWIFT network.

Triangular arbitrage

Triangular arbitrage (also referred to as cross currency arbitrage or three-point

arbitrage) is the act of exploiting an arbitrage opportunity resulting from a pricing

discrepancy among three different currencies in the foreign exchange market.[1][2][3] A

triangular arbitrage strategy involves three trades, exchanging the initial currency for a

second, the second currency for a third, and the third currency for the initial. During the

second trade, the arbitrageur locks in a zero-risk profit from the discrepancy that exists when

the market cross exchange rate is not aligned with the implicit cross exchange rate.

Mechanics of triangular arbitrage

Some international banks serve as market makers between currencies by narrowing their bid-ask

spread more than the bid-ask spread of the implicit cross exchange rate. However, the bid and

ask prices of the implicit cross exchange rate naturally discipline market makers. When banks'

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quoted exchange rates move out of alignment with cross exchange rates, any banks or traders

who detect the discrepancy have an opportunity to earn arbitrage profits via a triangular arbitrage

strategy. To execute a triangular arbitrage trading strategy, a bank would calculate cross

exchange rates and compare them with exchange rates quoted by other banks to identify a

pricing discrepancy.

For example, Citibank detects that Deutsche Bank is quoting dollars at a bid price of 0.8171 €/$,

and that Barclays is quoting pounds at a bid price of 1.4650 $/£ (Deutsche Bank and Barclays are

in other words willing to buy those currencies at those prices). Citibank itself is quoting the same

prices for these two exchange rates. A trader at Citibank then sees that Crédit Agricole is quoting

pounds at an ask price of 1.1910 €/£ (in other words it is willing to sell pounds at that price).

While the quoted market cross exchange rate is 1.1910 €/£, Citibank's trader realizes that the

implicit cross exchange rate is 1.1971 €/£ (by calculating 1.4650 × 0.8171 = 1.1971), meaning

that Crédit Agricole has narrowed its bid-ask spread to serve as a market maker between the euro

and the pound. Although the market suggests the implicit cross exchange rate should be 1.1971

euros per pound, Crédit Agricole is selling pounds at a lower price of 1.1910 euros. Citibank's

trader can hastily exercise triangular arbitrage by exchanging dollars for euros with Deutsche

Bank, then exchanging euros for pounds with Crédit Agricole, and finally exchanging pounds for

dollars with Barclays. The following steps illustrate the triangular arbitrage transaction.[5]

1. Citibank sells $5,000,000 to Deutsche Bank for euros, receiving €4,085,500. ($5,000,000

× 0.8171 €/$ = €4,085,500)

2. Citibank sells €4,085,500 to Crédit Agricole for pounds, receiving £3,430,311.

(€4,085,500 ÷ 1.1910 €/£ = £3,430,311)

3. Citibank sells £3,430,311 to Barclays for dollars, receiving $5,025,406. (£3,430,311 ×

1.4650 $/£ = $5,025,406)

4. Citibank ultimately earns an arbitrage profit of $25,406 on the $5,000,000 of capital it

used to execute the strategy.

The reason for dividing the euro amount by the euro/pound exchange rate in this example is that

the exchange rate is quoted in euro terms, as is the amount being traded. One could multiply the

euro amount by the reciprocal pound/euro exchange rate and still calculate the ending amount of

pounds.

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Locational Arbitrage

A strategy in which a trader seeks to profit from differences in the exchange rate offered by

different banks on the same currency. These differences are small and short-lived.

Locational arbitrage can occur when the spot rate of a given currency varies among locations.

Specifically, the ask rate at one location must be lower than the bid rate at another location. The

disparity in rates can occur since information is not always immediately available to all banks. If

a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations

should become realigned.

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Module IV (6Hours)

International Financial Markets and Instruments

Foreign Portfolio Investment. International Bond & Equity market. GDR, ADR, Cross listing

of shares Global registered shares. International Financial Instruments: Foreign Bonds &

Eurobonds , Global Bonds. Floating rate Notes, Zero coupon Bonds International Money

Markets International Banking services –Correspondent Bank, Representative offices,

Foreign Branches. Forward Rate Agreements

Foreign portfolio investment

FPI (Foreign Portfolio Investment) represents passive holdings of securities such as foreign

stocks, bonds, or other financial assets, none of which entails active management or control of

the securities' issuer by the investor.

Foreign portfolio investment is the entry of funds into a country where foreigners make

purchases in the country’s stock and bond markets, sometimes for speculation.

It is a usually short term investment (sometimes less than a year, or with involvement in the

management of the company), as opposed to the longer term Foreign Direct Investment

partnership (possibly through joint venture), involving transfer of technology and "know-how".

For example, Ford Motor Company may invest in a manufacturing plant in Mexico, yet not be in

direct control of its affairs. Foreign Portfolio Investment (FPI): passive holdings of securities and

other financial assets, which do NOT entail active management or control of the securities's

issuer. FPI is positively influenced by high rates of return and reduction of risk through

geographic diversification. The return on FPI is normally in the form of interest payments or

non-voting dividends.

FDI

FDI- Foreign Direct Investment refers to international investment in which the investor obtains

a lasting interest in an enterprise in another country.

Most concretely, it may take the form of buying or constructing a factory in a foreign country or

adding improvements to such a facility, in the form of property, plants, or equipment.

FDI is calculated to include all kinds of capital contributions, such as the purchases of stocks, as

well as the reinvestment of earnings by a wholly owned company incorporated abroad

(subsidiary), and the lending of funds to a foreign subsidiary or branch. The reinvestment of

earnings and transfer of assets between a parent company and its subsidiary often constitutes a

significant part of FDI calculations.

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FDI is more difficult to pull out or sell off. Consequently, direct investors may be more

committed to managing their international investments, and less likely to pull out at the first sign

of trouble.

FDI v/s FPI

FDI FPI

Involvement - direct or indirect

Involved in management and

ownership control; long-term

interest

No active involvement in

management. Investment

instruments that are more easily

traded, less permanent and do

not represent a controlling stake

in an enterprise.

Sell off It is more difficult to sell off or

pull out.

It is fairly easy to sell securities

and pull out because they are

liquid.

Comes from Tends to be undertaken by

Multinational organizations

Comes from more diverse

sources e.g.a small company's

pension fund or through mutual

funds held by individuals;

investment via equity

instruments (stocks) or debt

(bonds) of a foreign enterprise.

What is invested

Involves the transfer of non-

financial assets e.g. technology

and intellectual capital, in

addition to financial assets.

Only investment of financial

assets.

Stands for Foreign Direct Investment Foreign Portfolio Investment

Volatility Having smaller in net inflows Having larger net inflows

Management Projects are efficiently managed Projects are less efficiently

managed



International Bond & Equity market.

GDR

1.A bank certificate issued in more than one country for shares in a foreign company. The shares

are held by a foreign branch of an international bank. The shares trade as domestic shares, but

are offered for sale globally through the various bank branches.

2. A financial instrument used by private markets to raise capital denominated in either U.S.

dollars or euros.

3.A GDR is very similar to an American Depositary Receipt.

4. These instruments are called EDRs when private markets are attempting to obtain euros.

A global depository receipt or global depositary receipt (GDR) is a certificate issued

by a depository bank, which purchases shares of foreign companies and deposits it on the

account. GDRs represent ownership of an underlying number of shares.

Global depository receipts facilitate trade of shares, and are commonly used to invest in

companies from developing or emerging markets.

Prices of global depositary receipt are often close to values of related shares, but they are traded

and settled independently of the underlying share.

Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, Deutsche Bank,

The Bank of New York Mellon. GDRs are often listed in the Frankfurt Stock Exchange,

Luxembourg Stock Exchange and in the London Stock Exchange, where they are traded on the

International Order Book (IOB). Normally 1 GDR = 10 Shares,but not always. It is a negotiable

instrument which is denominated in some freely convertible currency. It is a negotiable

certificate denominated in US dollars which represents a non-US Company's publicly traded

local equity.

characteristics of GDRs: 1.it is an unsecured security 2.a fixed rate of interest is paid on it 3.it

may be converted into number of shares 4.interest and redemption price is public in foreign

agency 5.it is listed and traded in the share market

Global Depository Receipt is not a very different financial instrument, from that of ADR. In fact

if the Indian Company which has issued GDRs in the American market wishes to further extend

http://en.wikipedia.org/wiki/Depository_bank

http://en.wikipedia.org/wiki/Share_%28finance%29

http://en.wikipedia.org/wiki/Account_%28accountancy%29

http://en.wikipedia.org/wiki/Emerging_markets

http://en.wikipedia.org/wiki/JPMorgan_Chase

http://en.wikipedia.org/wiki/Citigroup

http://en.wikipedia.org/wiki/Deutsche_Bank

http://en.wikipedia.org/wiki/The_Bank_of_New_York_Mellon

http://en.wikipedia.org/wiki/Frankfurt_Stock_Exchange

http://en.wikipedia.org/wiki/Luxembourg_Stock_Exchange

http://en.wikipedia.org/wiki/London_Stock_Exchange



it to other developed and advanced countries such as Europe, then they can sell these ADRs to

the public of Europe and the same would be named as GDR.

ADR

A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one

share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S.

dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to

reduce administration and duty costs that would otherwise be levied on each transaction.

An American depositary receipt (ADR) is a negotiable security that represents securities of a

non-US company that trades in the US financial markets.[1] Securities of a foreign company that

are represented by an ADR are called American depositary shares (ADSs).

Shares of many non-US companies trade on US stock exchanges through ADRs. ADRs are

denominated and pay dividends in US dollars and may be traded like regular shares of stock.[2]

Over-the-counter ADRs may only trade in extended hours.

The first ADR was introduced by J.P. Morgan in 1927 for the British retailer Selfridges.

Cross listing of Shares

The listing of a company's common shares on a different exchange than its primary and original

stock exchange. In order to be approved for cross-listing, the company in question must meet the

same requirements as any other listed member of the exchange, such as basic requirements for

the share count, accounting policies, filing requirements for financial reports and company

revenues.

The principle considerations that drive a company’s decision to seek a cross-listing of its shares

on one or more foreign stock exchanges are:

Financial gains: Cross-listing is a principle source of corporate financing, and one of the

main reasons for a company to cross-list its shares on a foreign stock exchange is raise

capital funds at a lower cost compared to debt financing. This arises because their stocks

become more available to foreign investors. Their access to these stocks may otherwise

be restricted due to international investment barriers, which hinder them from accessing

particular markets.

Increased Liquidity: Cross-listing enables companies to trade their shares in numerous

time zones and multiple currencies. This increases the issuing company’s liquidity and

gives it more ability to raise capital. It has been proven that there is a correlation between

share valuation and market liquidity2.

Shares Marketability: Cross-listing assists companies to expand their shareholders base

“as it brings foreign securities closer to potential investors”. This makes the company’s

http://en.wikipedia.org/wiki/American_Depositary_Receipt#cite_note-1

http://en.wikipedia.org/wiki/American_depositary_share

http://en.wikipedia.org/wiki/American_Depositary_Receipt#cite_note-2

http://en.wikipedia.org/wiki/JPMorgan

http://en.wikipedia.org/wiki/Selfridges



securities visible or recognised in the foreign market, enabling the company to access

additional cash, if required, by selling debt in the foreign market3.

Marketing and Growth Motivations: Cross-listing in a foreign country will assist the

issuing company in its marketing and cross border expansion plan, as the company’s

brand and its products will be identifiable to investors and consumers of the foreign

countries, creating new distributing channels and export opportunities.

Global Registered Share

A share issued and registered in multiple markets around the world. Global registered shares

represent the same class of shares. Also known as a "global share".

Global Registered Share-Shares that trade on multiple exchanges with different currencies. For

example, if a publicly-traded company issues shares in dollars on the New York Stock Exchange

and in pounds on the London Stock Exchange, it is issuing global registered shares. These are

fairly uncommon, and are certainly less common than International Depository Receipts,

whereby a company issues its shares in one currency but allows banks effectively to trade them

in another. Global registered shares are also called simply global shares.

International Financial Instruments

Foreign Bond

A bond traded in a given country that was issued by a foreign government or company. The

foreign bond market trades in the domestic currency and is regulated by domestic regulators.

A bond that is issued in a domestic market by a foreign entity, in the domestic market's currency.

A foreign bond is most often issued by a foreign firm to raise capital in a domestic market that

would be most interested in purchasing the firm's debt. For foreign firms doing a large amount of

business in the domestic market, issuing foreign bonds is a common practice. Types of foreign

bonds include bulldog bonds, matilda bonds and samurai bonds.

Foreign bonds are regulated by the domestic market authorities and are usually given nicknames

that refer to the domestic market in which they are being offered. Since investors in foreign

bonds are usually the residents of the domestic country, investors find them attractive because

they can add foreign content to their portfolios, without the added exchange rate exposure.

Euro Bond

European bonds are suggested government bonds issued in Euros jointly by the 18 eurozone

nations. Eurobonds are debt investments whereby an investor loans a certain amount of money,

for a certain amount of time, with a certain interest rate, to the eurozone bloc altogether, which

then forwards the money to individual governments.

http://financial-dictionary.thefreedictionary.com/Shares

http://financial-dictionary.thefreedictionary.com/Trade

http://financial-dictionary.thefreedictionary.com/Exchanges

http://financial-dictionary.thefreedictionary.com/Currencies

http://financial-dictionary.thefreedictionary.com/Publicly-Traded+Company

http://financial-dictionary.thefreedictionary.com/Issues

http://financial-dictionary.thefreedictionary.com/New+York+Stock+Exchange

http://financial-dictionary.thefreedictionary.com/London+Stock+Exchange

http://financial-dictionary.thefreedictionary.com/International+Depository+Receipts

http://financial-dictionary.thefreedictionary.com/Trade

http://financial-dictionary.thefreedictionary.com/Bond


http://en.wikipedia.org/wiki/Government_bonds


http://en.wikipedia.org/wiki/Eurozone



Eurobonds have been suggested as a way to tackle the European sovereign debt crisis as the

indebted states could borrow new funds at better conditions as they are supported by the rating of

the non-crisis states.

Because Eurobonds would allow already highly-indebted states access to cheaper credit thanks to

the strength of other Eurozone economies, they are controversial, and may suffer from the free

rider problem.

Global Bond

A global bond is a bond which is issued in several countries at the same time. It is typically

issued by a large multinational corporation or sovereign entity with a high credit rating. By

offering the bond to a large number of investors, a global issuance can reduce borrowing cost.

These bonds are usually issued by large multinational organizations and sovereign entities, both

of which regularly carry out large fund-raising exercises. By issuing global bonds, an issuing

entity is able to attract funds from a vast set of investors and reduce its cost of borrowing.

Global bonds are issued in different currencies and distributed in the currency of the country

where it is issued. For example, a global bond issued in the United States will be in US Dollars

(USD), while a global bond issued in the Netherlands will be in euros. Bonds are loaned in terms

of years; for example, a three-year $2 billion USD global loan will be paid back by the country it

is loaned to within three years at face value plus the interest rate.

http://en.wikipedia.org/wiki/European_sovereign_debt_crisis

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http://en.wikipedia.org/wiki/Multinational_corporation



Floating rate notes

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market

reference rate, like LIBOR or federal funds rate, plus a quoted spread (a.k.a. quoted margin).

The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay

out interest every three months. At the beginning of each coupon period, the coupon is calculated

by taking the fixing of the reference rate for that day and adding the spread. A typical coupon

would look like 3 months USD LIBOR +0.20%.

A debt instrument with a variable interest rate. Also known as a “floater” or “FRN," a floating

rate note’s interest rate is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the fed

funds or the prime rate. Floaters are mainly issued by financial institutions and governments, and

they typically have a two- to five-year term to maturity.

Floating rate notes (FRNs) make up a significant component of the U.S. investment-grade bond

market, and they tend to become more popular when interest rates are expected to increase.

http://en.wikipedia.org/wiki/Bond_%28finance%29

http://en.wikipedia.org/wiki/Coupon_%28bond%29

http://en.wikipedia.org/wiki/Money_market

http://en.wikipedia.org/wiki/Reference_rate

http://en.wikipedia.org/wiki/LIBOR

http://en.wikipedia.org/wiki/Federal_funds_rate

http://en.wikipedia.org/wiki/Reference_rate



Compared to fixed-rate debt instruments, floaters protect investors against a rise in interest rates.

Because interest rates have an inverse relationship with bond prices, a fixed-rate note’s market

price will drop if interest rates increase. FRNs, however, carry lower yields than fixed notes of

the same maturity. They also have unpredictable coupon payments, though if the note has a cap

and/or a floor, the investor will know the maximum and/or minimum interest rate the note might

pay.

Zero-coupon bond

A zero-coupon bond (also discount bond or deep discount bond) is a bond bought at a price

lower than its face value, with the face value repaid at the time ofmaturity. It does not make

periodic interest payments, or have so-called "coupons", hence the term zero-coupon bond.

When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-

coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon

bonds,[1] and any type of coupon bond that has been stripped of its coupons.

In contrast, an investor who has a regular bond receives income from coupon payments, which

are usually made semi-annually. The investor also receives the principal or face value of the

investment when the bond matures.

Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the

bond holder is calculated to have a set amount of purchasing powerrather than a set amount of

money, but the majority of zero coupon bonds pay a set amount of money known as the face

value of the bond.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity

dates typically start at ten to fifteen years. The bonds can be held until maturity or sold

on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than

one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt

market in the world.

INTERNATIONAL MONEY MARKET

In most countries, local corporations commonly need to borrow short-term funds to support their

operations. Country governments may also need to borrow short-term funds to finance their

budget deficits. Individuals or local institutional investors in those countries provide funds

through short-term deposits at commercial banks. In addition, corporations and governments

may issue short-term securities that are purchased by local investors. Thus, a domestic money

market in each country serves to transfer short-term funds denominated in the local currency

from local surplus units (savers) to local deficit units (borrowers).

The growth in international business has caused corporations or governments in a particular

country to need short-term funds denominated in a currency that is different from their home

currency. First, they may need to borrow funds to pay for imports denominated in a foreign

currency. Second, even if they need funds to support local operations, they may consider

borrowing in a currency in which the interest rate is lower. This strategy is especially desirable if

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http://en.wikipedia.org/wiki/Face_value

http://en.wikipedia.org/wiki/Maturity_(finance)

http://en.wikipedia.org/wiki/Interest

http://en.wikipedia.org/wiki/Par_value

http://en.wikipedia.org/wiki/Treasury_security#Treasury_bill

http://en.wikipedia.org/wiki/Treasury_security#Savings_bond

http://en.wikipedia.org/wiki/Zero-coupon_bond#cite_note-mishkin-1

http://en.wikipedia.org/wiki/Inflation-indexed_bond

http://en.wikipedia.org/wiki/Purchasing_power



http://en.wikipedia.org/wiki/Maturity_date

http://en.wikipedia.org/wiki/Maturity_date

http://en.wikipedia.org/wiki/Secondary_market

http://en.wikipedia.org/wiki/Treasury_bill



the firms will have receivables denominated in that currency in the future. Third, they may

consider borrowing in a currency that will depreciate against their home currency, as they would

be able to repay the loan at a more favorable exchange rate over time. Thus, the actual cost of

borrowing would be less than the interest rate of that currency.

Meanwhile, there are some corporations and institutional investors that have motives to invest in

a foreign currency rather than their home currency. First, the interest rate that they would receive

from investing in their home currency may be lower than what they could earn on short-term

investments denominated in some other currencies. Second, they may consider investing in a

currency that will appreciate against their home currency because they would be able to convert

that currency into their home currency at a more favorable exchange rate at the end of the

investment period. Thus, the actual return on their investment would be higher than the quoted

interest rate on that foreign currency.

The preferences of corporations and governments to borrow in foreign currencies and of

investors to make short-term investments in foreign currencies resulted in the creation of the

international money market.

Origins and Development The international money market includes large banks in countries around the world. Two other

important components of the international money market are the European money market and

the Asian money market.

European Money Market. The origins of the European money market can be traced to the

Eurocurrency market that developed during the 1960s and 1970s. As MNCs expanded their

operations during that period, international financial intermediation emerged to accommodate

their needs. Because the U.S. dollar was widely used even by foreign countries as a medium for

international trade, there was a consistent need for dollars in Europe and elsewhere. To conduct

international trade with European countries, corporations in the United States deposited U.S.

dollars in European banks.

The banks were willing to accept the deposits because they could lend the dollars to corporate

customers based in Europe. These dollar deposits in banks in Europe (and on other continents as

well) came to be known as Eurodollars, and the market for Eurodollars came to be known as the

Eurocurrency market. (“Eurodollars” and “Eurocurrency” should not be confused with the

“euro,” which is the currency of many European countries today.)

The growth of the Eurocurrency market was stimulated by regulatory changes in the United

States. For example, when the United States limited foreign lending by U.S. banks in 1968,

foreign subsidiaries of U.S.-based MNCs could obtain U.S. dollars from banks in Europe via the

Eurocurrency market. Similarly, when ceilings were placed on the interest rates paid on dollar

deposits in the United States, MNCs transferred their funds to European banks, which were not

subject to the ceilings.

The growing importance of the Organization of Petroleum Exporting Countries (OPEC) also

contributed to the growth of the Eurocurrency market. Because OPEC generally requires

payment for oil in dollars, the OPEC countries began to use the Eurocurrency market to deposit a

portion of their oil revenues. These dollar-denominated deposits are sometimes known as

petrodollars. Oil revenues deposited in banks have sometimes been lent to oil-importing



countries that are short of cash. As these countries purchase more oil, funds are again transferred

to the oil-exporting countries, which in turn create new deposits.

This recycling process has been an important source of funds for some countries. Today, the

term “Eurocurrency market” is not used as often as in the past because several other international

financial markets have been developed. The European money market is still an important part of

the network of international money markets, however.

Asian Money Market. Like the European money market, the Asian money market originated as

a market involving mostly dollar-denominated deposits. Hence, it was originally known as the

Asian dollar market. The market emerged to accommodate the needs of businesses that were

using the U.S. dollar (and some other foreign currencies) as a medium of exchange for

international trade. These businesses could not rely on banks in Europe because of the distance

and different time zones. Today, the Asian money market, as it is now called, is centered in

Hong Kong and Singapore, where large banks accept deposits and make loans in various foreign

currencies.

The major sources of deposits in the Asian money market are MNCs with excess cash and

government agencies. Manufacturers are major borrowers in this market. Another function is

interbank lending and borrowing. Banks that have more qualified loan applicants than they can

accommodate use the interbank market to obtain additional funds.

Banks in the Asian money market commonly borrow from or lend to banks in the European

market.

International banking services

It is possible to obtain the full spectrum of financial services from offshore banks, including:

Corporate administration

Credit

Deposit taking

Foreign exchange

Fund management

Investment management and investment custody

Letters of credit and trade finance

Trustee services

Wire- and electronic funds transfers

Not every bank provides each service. Banks tend to polarise between retail services and private

banking services. Retail services tend to be low cost and undifferentiated, whereas private

banking services tend to bring a personalised suite of services to the client.

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http://en.wikipedia.org/wiki/Letter_of_credit

http://en.wikipedia.org/wiki/Trustee

http://en.wikipedia.org/wiki/Wire_transfer

http://en.wikipedia.org/wiki/Electronic_money

http://en.wikipedia.org/wiki/Retail

http://en.wikipedia.org/wiki/Private_banking

http://en.wikipedia.org/wiki/Private_banking



Correspondent Bank

A financial institution that provides services on behalf of another, equal or unequal,

financial institution. A correspondent bank can conduct business transactions, accept deposits

and gather documents on behalf of the other financial institution. Correspondent banks are more

likely to be used to conduct business in foreign countries, and act as a domestic bank's agent

abroad.

Correspondent banks are used by domestic banks in order to service transactions

originating in foreign countries, and act as a domestic bank's agent abroad. This is done because

the domestic bank may have limited access to foreign financial markets, and cannot service its

client accounts without opening up a branch in another country.

A correspondent account is an account (often called a nostro or vostro account) established by

a banking institution to receive deposits from, make payments on behalf of, or handle

otherfinancial transactions for other financial institutions.

Commonly, correspondent accounts are the accounts of foreign banks who require the ability to

pay and receive the domestic currency. The accounts allow them to pay others from the account

or receive money from others into the account. This allows the bank to offer various services to

their customers such as foreign exchange and foreign currency denominated loans and deposits,

despite them not having a bank licence for the foreign country in that country's currency.

Such accounts are necessary for international trade which demands people and business pay for

things in a currency other than their own. It is impractical to transport large amounts of currency

around the world and physically exchange your own currency for the currency that your

customer/supplier demands. Instead money is taken out of your account at your local bank

(which is in your local currency) and an equivalent amount of money is put in your

customer/suppliers account at their local bank (in a foreign currency). The money from your

account goes to an internal account of your bank. The money to your customer/supplier comes

from an account your local bank holds with a bank in your supplier's country - your

bank's correspondent account, at their correspondent bank.

For example, a customer of Wells Fargo Bank may wish to pay a German firm EUR1,000,000

for machinery. Wells Fargo determines that this is equivalent to USD1,200,000. Wells Fargo

takes the $1,200,000 out of the customers bank account, and instruct their German correspondent

bank -- perhaps Deutsche Bank -- to take EUR1,000,000 out of Wells Fargo's correspondent

account with Deutsche Bank, and pay the money into the German company's EUR.

So, the customer has their machinery. The supplier have their money (in EUR) . Wells Fargo is

square by having fewer EUR, correspondingly greater amount of USD.

It is established through bilateral agreements between two counterparts (in this case two financial

organizations) to support the multi lateral economic balances established throughout the globe.

http://en.wikipedia.org/wiki/Nostro_and_vostro_accounts

http://en.wikipedia.org/wiki/Banking_institution

http://en.wikipedia.org/wiki/Financial_transaction



Representative offices

A representative office is an office established by a company to conduct marketing and other

non-transactional operations, generally in a foreign country where a branch

office or subsidiary is not warranted. Representative offices are generally easier to establish than

a branch or subsidiary, as they are not used for actual "business" (e.g. sales) and therefore there

is less incentive for them to be regulated.

They have been used extensively by foreign investors in emerging markets such as

China, India and Vietnam although they do have restrictions through not being able to invoice

locally for goods or services. Consequently Representative Offices tend to be utilized by foreign

investors in fields such as sourcing of products, quality control, and general liaison activities

between the Head Office and the Representative Offices overseas.

Foreign Branches

A type of foreign bank that is obligated to follow the regulations of both the home and host

countries. Because the foreign branch banks' loan limits are based on the parent bank's capital,

foreign banks can provide more loans than subsidiary banks.

Banks often open a foreign branch in order to provide more services to their multinational

corporation customers. However, operating a foreign branch bank may be considerably

complicated because of the dual banking regulations that the foreign branch needs to follow.

For example, suppose the Bank of America opens a foreign branch bank in Canada. The branch

would be legally obligated to follow both Canadian and American banking regulations.

Forward Rate Agreements

An over-the-counter contract between parties that determines the rate of interest, or the currency

exchange rate, to be paid or received on an obligation beginning at a future start date. The

contract will determine the rates to be used along with the termination date and notional value.

On this type of agreement, it is only the differential that is paid on the notional amount of the

contract.

Also known as a "future rate agreement".

http://en.wikipedia.org/wiki/Company

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http://en.wikipedia.org/wiki/Subsidiary



Typically, for agreements dealing with interest rates, the parties to the contract will exchange a

fixed rate for a variable one. The party paying the fixed rate is usually referred to as the

borrower, while the party receiving the fixed rate is referred to as the lender.

For a basic example, assume Company A enters into an FRA with Company B in which

Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three

years. In return, Company B will receive the one-year LIBOR rate, determined in three years'

time, on the principal amount. The agreement will be settled in cash in three years.

If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that

Company A pay Company B. This is because the LIBOR is higher than the fixed rate.

Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million

at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net difference

between the two amounts is $5,000, which is paid to Company B.

A Forward Rate Agreement, or FRA, is an agreement between two parties who want to protect

themselves against future movements in interest rates. By entering into an FRA, the parties lock

in an interest rate for a stated period of time starting on a future settlement date, based on a

specified notional principal amount. The buyer of the FRA enters into the contract to protect

itself from a future increase in interest rates. This occurs when a company believes that interest

rates may rise and wants to fix its borrowing cost today. The seller of the FRA wants to protect

itself from a future decline in interest rates. This strategy is used by investors who want to hedge

the return obtained on a future deposit.

FRAs are settled using cash on the settlement date. This is the start date of the notional loan or

deposit. The exposure to each counterparty is determined by the interest rate differential between

the market rate on settlement date and the rate specified in the FRA contract. There are no

principal flows.

The FRA is a very flexible instrument and can be tailored to meet the needs of both the buyer

and seller to protect themselves against the volatility of interest rates which affect their future

borrowings or investments. The principle advantages of FRAs are:

contracts can be structured to meet the specific needs of the user;

counterparty exposure is limited to the interest rate differential between the market rate

and the contract rate;

administration costs are minimized as there is only one cash flow on the settlement date

as opposed to daily futures settlement;

they are off-balance sheet items; and

they can easily be reversed or closed out using an offsetting FRA at a new price.



Module V

International Parity Relationships & Forecasting Foreign Exchange rate

Measuring exchange rate movements-Exchange rate equilibrium – Factors effecting foreign

exchange rate- Forecasting foreign exchange rates .Interest Rate Parity, Purchasing Power

Parity & International Fisher effects. Covered Interest Arbitrage

----------------------------------------------------------------------------------------- MEASURING EXCHANGE RATE MOVEMENTS

Exchange rate movements affect an MNC’s value because they can affect the amount of cash

inflows received from exporting or from a subsidiary and the amount of cash outflows needed to

pay for imports. An exchange rate measures the value of one currency in units of another

currency. As economic conditions change, exchange rates can change substantially. A decline in

a currency’s value is often referred to as depreciation. When the British pound depreciates

against the U.S. dollar, this means that the U.S. dollar is strengthening relative to the pound. The

increase in a currency value is often referred to as appreciation. When a foreign currency’s spot

rates at two specific points in time are compared, the spot rate at the more recent date is denoted

as S and the spot rate at the earlier date is denoted as St–l. The percentage change in the value of

the foreign currency is computed as follows:

Percent Δ in foreign currency value S − St−1

St−1

A positive percentage change indicates that the foreign currency has appreciated, while a

negative percentage change indicates that it has depreciated. The values of some currencies have

changed as much as 5 percent over a 24-hour period.

On some days, most foreign currencies appreciate against the dollar, although by different

degrees. On other days, most currencies depreciate against the dollar, but by different degrees.

There are also days when some currencies appreciate while others depreciate against the dollar;

the media describe this scenario by stating that “the dollar was mixed in trading.”

Foreign exchange rate movements tend to be larger for longer time horizons. Thus, if yearly

exchange rate data were assessed, the movements would be more volatile for each currency than

what is shown here, but the euro’s movements would still be more volatile.

If daily exchange rate movements were assessed, the movements would be less volatile for each

currency than what is shown here, but the euro’s movements would still be more volatile. A

review of daily exchange rate movements is important to an MNC that will need to obtain a

foreign currency in a few days and wants to assess the possible degree of movement over that

period. A review of annual exchange movements would be more appropriate for an MNC that

conducts foreign trade every year and wants to assess the possible degree of movements on a

yearly basis. Many MNCs review exchange rates based on short-term and long-term horizons

because they expect to engage in international transactions in the near future and in the distant

future.



EXCHANGE RATE DETERMINATION

“Having endeavored to forecast exchange rates for more than half a century, I have understandably

developed significant humility about my ability in this area…”1

- Alan Greenspan

Figure 1: Exchange Rate Determination

Source: Exchange Rate Determination

I. Short-Run Forecasting Tools



Short-term changes in exchange rates are the most difficult to predict and are often determined based

on bandwagon effects, overreaction to news, speculation, and technical analysis.2

Trend-Following Behavior is the tendency for the market to follow a trend. In other words an increase

in the exchange rate is more likely to be followed by another increase.

Investor Sentiment is based on the consensus of the market. For example if the market is bullish on the

dollar, then the dollar is likely to strengthen versus other currencies.

The FX market is quite different from the world equity markets in one important aspect: transparency.

In equity markets, rules ensure that volume and price data are readily available to all parties… this is

NOT the case in FX markets. In fact large FX dealers are able to observe factors such as: shifts in risk

appetite, liquidity needs, hedging demands, and institutional rebalancing.3

Order Flow - there is evidence of a positive correlation between spot exchange rate movements and

order flows in the inter-dealer market4 and with movements in customer order flows.5

Three explanations for the cause of these correlations have been put forth: 1) Private information -

related to the payoff from holding the currency may be contained in the order flow data. For example,

future interest rates or the discount rate may be known to traders. 2) Liquidity effects – dealers charge

a temporary risk premium to absorb unwanted inventory. 3) Feedback trading – the positive correlation

could be related to customers buying a currency that has just appreciated (or vice versa).

II. Long-Run Forecasting Tools



Purchasing Power Parity (PPP) states that since the prices should be the same across countries, the

exchange rate between two countries should be the ratio of the prices in each country.6

: ( )

, ( )A

B

Price of a product in Country APPP Spot rate S

Price of a product in Country B

Pwhere the spot rate S is

P

Relative PPP states that the exchange rate will change to offset differences in national interest rates. In

other words, if Country A has higher inflation than Country B, you can expect Country A’s currency to

depreciate versus Country B’s currency.

Structural Changes – three structural changes can affect long-term trends in exchange rates: 1) an

increase in investment spending, 2) fiscal stimulus, 3) a decline in private savings. It is the net impact of

structural changes that determines if the country’s currency will rise or fall.

1) Investment spending – domestic investment in a country will help to strengthen a country’s currency. For example, the United States experienced an investment boom in the 1990s.

2) Fiscal stimulus – government investment in a country can also help strengthen a country’s currency. For example, Turkey has enjoyed fiscal stimulus and government spending in recent years.

3) Private savings – the citizens of a country’s tendency to save will help strengthen a country’s currency. For example, Japan has had a large and persistent current-account surplus that has led to a stronger currency.

Terms of Trade – is the idea that the price of a good that trades in international markets will have an

impact of the associated country’s currency. This can work in terms of both imports and exports. For

example, in countries where commodities make up a large portion of GDP, like Australia, Canada, and

New Zealand, there is a strong positive relationship between the price of commodities and the strength

of the associated country’s currency. On the other hand, in Europe, the higher prices for oil, have led to

a weaker currency.



II. Medium-Run Forecasting Tools

International Parity Conditions – the key international parity conditions are 1) purchasing power parity,

2) covered interest-rate parity, 3) uncovered interest-rate parity, 4) the Fisher effect, and 5) forward

exchange rates.

Figure 2: International Parity Conditions

Source: Exchange Rate Determination



1) Purchasing power parity – states that since the prices should be the same across countries, the exchange rate between two countries should be the ratio of the prices in each country.

: ( )

, ( )A

B

Price of a product in Country APPP Spot rate S

Price of a product in Country B

Pwhere the spot rate S is

P

Example: If a hamburger is $2.54 in the United States and 3.60 real (R$) in Brazil, then the PPP

spot rate should be:

3.60 $ 1.42 $,

$2.54 1$

R RS which reduces to

If the actual exchange rate is2.19 $

1$

RS , then according to the PPP theory the Brazilian real is

undervalued by 35%.

1.42 $ 2.19 $1 % ( )

1$ 1$

R RPPP implied rate Actual exchange rate over or under valued

FYI McDonalds' Big Mac is produced locally in almost 120 countries!7

2) Covered interest-rate parity –the idea that an imbalance in parity conditions can create a “risk less” opportunity for an arbitrager.



Exhibit 6.7 Covered Interest Arbitrage (CIA)8

Eurodollar rate = 8.00 % per annum

180 days

Dollar money market

Yen money market

$1,000,000 $1,040,000

$1,044,638

S =¥ 106.00/$

¥ 106,000,000 ¥ 108,120,000

F180 = ¥ 103.50/$

x 1.02

x 1.04

Start End

Euroyen rate = 4.00 % per annum

Arbitrage

Potential

Eurodollar rate = 8.00 % per annum

180 days

Dollar money market

Yen money market

$1,000,000 $1,040,000

$1,044,638

S =¥ 106.00/$

¥ 106,000,000 ¥ 108,120,000

F180 = ¥ 103.50/$

x 1.02

x 1.04

Start End

Euroyen rate = 4.00 % per annum

Arbitrage

Potential

Example:

Step 1: Convert $1,000,000 at the spot rate of ¥106.00/$ to ¥106,000,000

Step 2: Invest the proceeds, (¥106,000,000), in a euroyen account for six months, earning 4%

per annum, or 2% for 180 days.

Step 3: Simultaneously sell the future yen proceeds (¥108,120,000) forward for dollars at the

180-day forward rate of ¥103.50/$. Note: at this point you have “locked in” the amount of

$1,044,638 in 180 days (or 6 months).

Step 4: Out of the $1,044,638 you have to repay the loan (plus interest), this is called your

opportunity cost of capital. To do this, calculate the interest rate for the period (8% per year is

4% for 180 days)9. So to borrow $1,000,000 you have to pay $40,000 in interest at the end of 6

months. Subtract the $1,040,000 from the $1,044,638 that you will receive from your forward

contract for a “risk less” profit of $4,638.

8 Multinational Finance, 10th edition

9 180

8% 4%360

x



Notice that these activities should help the currencies return to equilibrium.

3) Uncovered interest-rate parity - Uncovered interest arbitrage is great when you are dealing with fixed exchange currencies, because the profit at the end of the period is dependant of the exchange rate (and since this is “uncovered” it is a very risky investment).

1 0 f dE S S i i

Exhibit 6.7 Uncovered Interest Arbitrage10

Investors borrow yen at 0.40% per annum

360 days

Japanese yen money market

US dollar money market

¥ 10,000,000 ¥ 10,040,000 Repay

¥ 10,500,000 Earn

¥ 460,000 Profit

S =¥ 120.00/$

$ 83,333,333 $ 87,500,000

S360 = ¥ 120.00/$

x 1.05

x 1.004

Start End

Investors borrow yen at 0.40% per annum

360 days

Japanese yen money market

US dollar money market

¥ 10,000,000 ¥ 10,040,000 Repay

¥ 10,500,000 Earn

¥ 460,000 Profit

S =¥ 120.00/$

$ 83,333,333 $ 87,500,000

S360 = ¥ 120.00/$

x 1.05

x 1.004

Start End

Since there are men and women making a killing in this business, the opportunities for smaller

investors are almost impossible… It is these two types of arbitrage that keep exchange rates

more or less in equilibrium.

4) Fisher effect - the nominal interest rate (i) in a country should be equal to the real rate of interest (r) plus expected inflation (π).11

11 Remember, the nominal exchange rate is the actual spot rate while the real exchange rate is adjusted

for inflation.

Note: there

is a typo in

the book.

The correct

figures are:

$83,333.33

and

$87,500.00



i = r + π

5) Forward exchange rates – an exchange rate quoted today for settlement at a future date.

1360

1360

, ( ) ( )

f

f

days

days dddays

f

d

daysi x

FF S x

F daysi x

Pwhere the spot rate S is and i is the annual interest rate

P

Forward rates are unbiased predictors of future exchange rates. An unbiased predictor means

that “on average” the estimation will be wrong on the up side or the downside with equal

frequency and degree. In other words, the errors are normally distributed.

0%-∞% +∞%0%-∞% +∞%

Exchange Rate Equilibrium

The exchange rate at which the supply for a currency meets the demand of the same currency.

As foreign exchange rates are affected by a number of factors, the equilibrium exchange rate

in turn, are also influenced by its supply and demand. Hence equilibrium is achieved when

a currency's demand is equal to its supply.

The exchange rate at which the demand for a currency and supply of the same currency are

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equal. The equilibrium exchange rate indicates that the price of exchanging two currencies will

remain stable.

EXCHANGE RATE EQUILIBRIUM

Although it is easy to measure the percentage change in the value of a currency, it is more

difficult to explain why the value changed or to forecast how it may change in the future. To

achieve either of these objectives, the concept of an equilibrium exchange rate must be

understood, as well as the factors that affect the equilibrium rate.

Before considering why an exchange rate changes, realize that an exchange rate at a given point

in time represents the price of a currency, or the rate at which one currency can be exchanged for

another. While the exchange rate always involves two currencies, our focus is from the U.S.

perspective. Thus, the exchange rate of any currency refers to the rate at which it can be

exchanged for U.S. dollars, unless specified otherwise. Like any other product sold in markets,

the price of a currency is determined by the demand for that currency relative to supply. Thus,

for each possible price of a British pound, there is a corresponding demand for pounds and a

corresponding supply of pounds for sale. At any point in time, a currency should exhibit the price

at which the demand for that currency is equal to supply, and this represents the equilibrium

exchange rate. Of course, conditions can change over time, causing the supply or demand for a

given currency to adjust, and thereby causing movement in the currency’s price.

This topic is more thoroughly discussed in this section.

Demand for a Currency

The British pound is used here to explain exchange rate equilibrium. The United Kingdom has

not adopted the euro as its currency and continues to use the pound. Exhibit 4.2 shows a

hypothetical number of pounds that would be demanded under various possibilities for the

exchange rate. At any one point in time, there is only one exchange rate. The exhibit shows the

quantity of pounds that would be demanded at various exchange rates at a specific point in time.

The demand schedule is downward sloping because corporations and individuals in the United

States will be encouraged to purchase more British goods when the pound is worth less, as it will

take fewer dollars to obtain the desired amount of pounds. Conversely, if the pound’s exchange

rate is high, corporations and individuals in the United States are less willing to purchase British

goods, as they may obtain goods at a lower price in the United States or other countries.

Supply of a Currency for Sale

Up to this point, only the U.S. demand for pounds has been considered, but the British demand

for U.S. dollars must also be considered. This can be referred to as a British supply of pounds for

sale, since pounds are supplied in the foreign exchange market in exchange for U.S. dollars.

A supply schedule of pounds for sale in the foreign exchange market can be developed in a

manner similar to the demand schedule for pounds. Exhibit 4.3 shows the quantity of pounds for

sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each

possible exchange rate at a given point in time. Notice from the supply schedule in Exhibit 4.3

that there is a positive relationship between the value of the British pound and the quantity of

British pounds for sale (supplied), which can be explained as follows. When the pound is valued

high, British consumers and firms are more likely to purchase U.S. goods. Thus, they supply a

greater number of pounds to the market, to be exchanged for dollars. Conversely, when the

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pound is valued low, the supply of pounds for sale is smaller, reflecting less British desire to

obtain U.S. goods.

Equilibrium

The demand and supply schedules for British pounds are combined in Exhibit 4.4. At an

exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for

sale. Consequently, the banks that provide foreign exchange services would experience a

shortage of pounds at that exchange rate. At an exchange rate of $1.60, the quantity of pounds

demanded would be less than the supply of pounds for sale.

Therefore, banks providing foreign exchange services would experience a surplus of pounds at

that exchange rate. According to Exhibit 4.4, the equilibrium exchange rate is $1.55 because this

rate equates the quantity of pounds demanded with the supply of pounds for sale.

Factors affecting Foreign Exchange Rate

Aside from factors such as interest rates and inflation, the exchange rate is one of the most

important determinants of a country's relative level of economic health. Exchange rates play a

vital role in a country's level of trade, which is critical to most every free market economy in the

world. For this reason, exchange rates are among the most watched, analyzed and

governmentally manipulated economic measures. But exchange rates matter on a smaller scale as

well: they impact the real return of an investor's portfolio. Here we look at some of the major

forces behind exchange rate movements.

Overview

Before we look at these forces, we should sketch out how exchange rate movements affect a

nation's trading relationships with other nations. A higher currency makes a

country's exports more expensive and imports cheaper in foreign markets; a lower currency

makes a country's exports cheaper and its imports more expensive in foreign markets. A higher

exchange rate can be expected to lower the country's balance of trade, while a lower exchange

rate would increase it.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship

between two countries. Remember, exchange rates are relative, and are expressed as a

comparison of the currencies of two countries. The following are some of the principal

determinants of the exchange rate between two countries. Note that these factors are in no

particular order; like many aspects of economics, the relative importance of these factors is

subject to much debate.

1. Differentials in Inflation

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As a general rule, a country with a consistently lower inflation rate exhibits a rising currency

value, as its purchasing power increases relative to other currencies. During the last half of the

twentieth century, the countries with low inflation included Japan, Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

inflation typically see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-

Push Inflation Versus Demand-Pull Inflation.)

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest

rates, central banks exert influence over both inflation and exchange rates, and changing interest

rates impact inflation and currency values. Higher interest rates offer lenders in an economy a

higher return relative to other countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing interest rates - that is, lower

interest rates tend to decrease exchange rates.

3. Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting

all payments between countries for goods, services, interest and dividends. Adeficit in the current

account shows the country is spending more on foreign trade than it is earning, and that it is

borrowing capital from foreign sources to make up the deficit. In other words, the country

requires more foreign currency than it receives through sales of exports, and it supplies more of

its own currency than foreigners demand for its products. The excess demand for foreign

currency lowers the country's exchange rate until domestic goods and services are cheap enough

for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and

governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. The reason? A large debt



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encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off

with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but

increasing the money supply inevitably causes inflation. Moreover, if a government is not able to

service its deficit through domestic means (selling domestic bonds, increasing the money

supply), then it must increase the supply of securities for sale to foreigners, thereby lowering

their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country

risks defaulting on its obligations. Foreigners will be less willing to own securities denominated

in that currency if the risk of default is great. For this reason, the country's debt rating (as

determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its

exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts

and the balance of payments. If the price of a country's exports rises by a greater rate than that of

its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater

demand for the country's exports. This, in turn, results in rising revenues from exports, which

provides increased demand for the country's currency (and an increase in the currency's value). If

the price of exports rises by a smaller rate than that of its imports, the currency's value will

decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in

which to invest their capital. A country with such positive attributes will draw investment funds

away from other countries perceived to have more political and economic risk. Political turmoil,

for example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.

Conclusion

The exchange rate of the currency in which a portfolio holds the bulk of its investments

determines that portfolio's real return. A declining exchange rate obviously decreases the

purchasing power of income and capital gains derived from any returns. Moreover, the exchange

rate influences other income factors such as interest rates, inflation and even capital gains from

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domestic securities. While exchange rates are determined by numerous complex factors that

often leave even the most experienced economists flummoxed, investors should still have some

understanding of how currency values and exchange rates play an important role in the rate of

return on their investments.

Forecasting foreign exchange rates

I. Forecasting Exchange Rates

International transactions are usually settled in the near future. Exchange rate forecasts are

necessary to evaluate the foreign denominated cash flows involved in international transactions.

Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to

the international business environment.

A forecast represents an expectation about a future value or values of a variable. The

expectation is constructed using an information set selected by the forecaster. Based on the

information set used by the forecaster, there are two pure approaches to forecasting foreign

exchange rates:

(1) The fundamental approach.

(2) The technical approach.

1.A Fundamental Approach

The fundamental approach is based on a wide range of data regarded as fundamental economic

variables that determine exchange rates. These fundamental economic variables are taken from

economic models. Usually included variables are GNP, consumption, trade balance, inflation

rates, interest rates, unemployment, productivity indexes, etc. In general, the fundamental

forecast is based on structural (equilibrium) models. These structural models are then modified to

take into account statistical characteristics of the data and the experience of the forecasters. It is a

mixture of art and science

Practitioners use structural model to generate equilibrium exchange rates. The equilibrium

exchange rates can be used for projections or to generate trading signals. A trading signal can be



generated every time there is a significant difference between the model-based expected or

forecasted exchange rate and the exchange rate observed in the market. If there is a significant

difference between the expected foreign exchange rate and the actual rate, the practitioner should

decide if the difference is due to a mispricing or a heightened risk premium. If the practitioner

decides the difference is due to mispricing, then a buy or sell signal is generated.

1.B Technical Approach

The technical approach (TA) focuses on a smaller subset of the available data. In general, it is

based on price information. The analysis is "technical" in the sense that it does not rely on a

fundamental analysis of the underlying economic determinants of exchange rates or asset prices,

but only on extrapolations of past price trends. Technical analysis looks for the repetition of

specific price patterns. Technical analysis is an art, not a science.

Computer models attempt to detect both major trends and critical, or turning, points. These

turning points are used to generate trading signals: buy or sell signals. The most popular TA

models are simple and rely on moving averages (MA), filters, or momentum indicators.

There are numerous methods of forecasting exchange rates, likely because none of them

have been shown to be superior to any other. This speaks to the difficulty of generating a quality

forecast. However, this article will introduce you to four of the most popular methods for

forecasting exchange rates.

Purchasing Power Parity (PPP) The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination

in most economic textbooks. The PPP forecasting approach is based off of the theoretical Law of

One Price, which states that identical goods in different countries should have identical prices.

For example, this law argues that a pencil in Canada should be the same price as a pencil in the

U.S. after taking into account the exchange rate and excluding transaction and shipping costs. In

other words, there should be no arbitrage opportunity for someone to buy pencils cheap in one

country and sell them in another for a profit.

Based on this underlying principle, the PPP approach forecasts that the exchange rate will

change to offset price changes due to inflation. For example, suppose that prices in theU.S. are

expected to increase by 4% over the next year while prices in Canada are expected to rise by

only 2%. The inflation differential between the two countries is:

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4% - 2% = 2%

This means that prices in the U.S. are expected to rise faster relative to prices in Canada. In this

situation, the purchasing power parity approach would forecast that the U.S. dollar would have to

depreciate by approximately 2% to keep prices between both countries relatively equal. So, if the

current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an

exchange rate of:

(1 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$1

Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar.

One of the most well-known applications of the PPP method is illustrated by the Big Mac Index,

compiled and published by The Economist. This light-hearted index attempts to measure whether

a currency is undervalued or overvalued based on the price of Big Macs in various countries.

Since Big Macs are nearly universal in all the countries they are sold, a comparison of their

prices serves as the basis for the index.

Relative Economic Strength Approach

As the name may suggest, the relative economic strength approach looks at the strength of

economic growth in different countries in order to forecast the direction of exchange rates. The

rationale behind this approach is based on the idea that a strong economic environment and

potentially high growth is more likely to attract investments from foreign investors. And, in order

to purchase investments in the desired country, an investor would have to purchase the country's

currency - creating increased demand that should cause the currency to appreciate.

This approach doesn't just look at the relative economic strength between countries. It takes a

more general view and looks at all investment flows. For instance, another factor that can draw

investors to a certain country is interest rates. High interest rates will attract investors looking for

the highest yield on their investments, causing demand for the currency to increase, which again

would result in an appreciation of the currency.

Conversely, low interest rates can also sometimes induce investors to avoid investing in a

particular country or even borrow that country's currency at low interest rates to fund other

investments. Many investors did this with the Japanese yen when the interest rates in Japan were

at extreme lows. This strategy is commonly known as the carry-trade.

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Unlike the PPP approach, the relative economic strength approach doesn't forecast what the

exchange rate should be. Rather, this approach gives the investor a general sense of whether a

currency is going to appreciate or depreciate and an overall feel for the strength of the

movement. This approach is typically used in combination with other forecasting methods to

develop a more complete forecast.

Econometric Models

Another common method used to forecast exchange rates involves gathering factors that you

believe affect the movement of a certain currency and creating a model that relates these factors

to the exchange rate. The factors used in econometric models are normally based on economic

theory, but any variable can be added if it is believed to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with

forecasting the USD/CAD exchange rate over the next year. He believes an econometric model

would be a good method to use and has researched factors he thinks affect the exchange rate.

From his research and analysis, he concludes the factors that are most influential are: the interest

rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP),

and income growth rate (IGR) differences between the two countries. The econometric model he

comes up with is shown as:

USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)

We won't go into the details of how the model is constructed, but after the model is made, the

variables INT, GDP and IGR can be plugged into the model to generate a forecast. The

coefficients a, b and c will determine how much a certain factor affects the exchange rate and

direction of the effect (whether it is positive or negative). You can see that this method is

probably the most complex and time-consuming approach of all the ones discussed so far.

However, once the model is built, new data can be easily acquired and plugged into the model to

generate quick forecasts.

Time Series Model

The last approach we'll introduce you to is the time series model. This method is purely technical

in nature and is not based on any economic theory. One of the more popular time series

approaches is called the autoregressive moving average (ARMA) process. The rationale for

using this method is based on the idea that past behavior and price patterns can be used to predict

future price behavior and patterns. The data you need to use this approach is simply a time series

of data that can then be entered into a computer program to estimate the parameters and

essentially create a model for you.

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Bottom Line

Forecasting exchange rates is a very difficult task, and it is for this reason that many companies

and investors simply hedge their currency risk. However, there are others who see value in

forecasting exchange rates and want to understand the factors that affect their movements. For

people who want to learn to forecast exchange rates, these four approaches are a good place to

start.

Interest Rate parity

A theory in which the interest rate differential between two countries is equal to the differential

between the forward exchange rate and the spot exchange rate. Interest rate parity plays an

essential role in foreign exchange markets, connecting interest rates, spot exchange rates and

foreign exchange rates.

The relationship can be seen when you follow the two methods an investor may take to convert

foreign currency into U.S. dollars.

Option A would be to invest the foreign currency locally at the foreign risk-free rate for a

specific time period. The investor would then simultaneously enter into a forward rate agreement

to convert the proceeds from the investment into U.S. dollars, using a forward exchange rate, at

the end of the investing period.

Option B would be to convert the foreign currency to U.S. dollars at the spot exchange rate, then

invest the dollars for the same amount of time as in option A, at the local (U.S.) risk-free rate.

When no arbitrage opportunities exist, the cash flows from both options are equal.

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which

investors will be indifferent to interest rates available on bank deposits in two countries.[1] The

fact that this condition does not always hold allows for potential opportunities to earn riskless

profits from covered interest arbitrage. Two assumptions central to interest rate parity are capital

mobilityand perfect substitutability of domestic and foreign assets. Given foreign exchange

market equilibrium, the interest rate parity condition implies that the expected return on domestic

assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors

cannot then earn arbitrage profits by borrowing in a country with a lower interest rate,

exchanging for foreign currency, and investing in a foreign country with a higher interest rate,

due to gains or losses from exchanging back to their domestic currency at maturity.[2] Interest

rate parity takes on two distinctive forms: uncovered interest rate parity refers to the parity

condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates)

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is uninhibited, whereascovered interest rate parity refers to the condition in which a forward

contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the

parity condition demonstrates a unique relationship with implications for the forecasting of

future exchange rates: the forward exchange rate and the future spot exchange rate.[1]

Economists have found empirical evidence that covered interest rate parity generally holds,

though not with precision due to the effects of various risks, costs, taxation, and ultimate

differences in liquidity. When both covered and uncovered interest rate parity hold, they expose

a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate.

This relationship can be employed to test whether uncovered interest rate parity holds, for which

economists have found mixed results. When uncovered interest rate parity and purchasing power

parity hold together, they illuminate a relationship named real interest rate parity, which

suggests that expected real interest rates represent expected adjustments in the real exchange

rate. This relationship generally holds strongly over longer terms and among emerging

market countries.

Purchasing Power Parity

Purchasing power parity expresses the idea that a bundle of goods in one country should cost the

same in another country after exchange rates are taken into account. Suppose that with existing

relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars

in Canada than in the United States. We would then expect U.S.consumers to buy those goods

in Canada. Even if this is not possible from a transportation or cost viewpoint, some businesses

will have an incentive to buy the goods cheaply inCanada and remarket them in the United

States. Such actions would cause U.S. dollars to be sold in exchange for Canadian dollars. As a

result, the U.S. dollar would depreciate in relation to the Canadian dollar. We would expect the

currency depreciation to continue until the bundle of goods costs the same in both countries.

In economics, purchasing power parity (PPP) is a component of some economic theories and

is a technique used to determine the relative value of different currencies.

Theories that invoke purchasing power parity assume that in some circumstances (for example,

as a long-run tendency) it would cost exactly the same number of, say, US dollars to

buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use

those dollars directly in purchasing the market basket of goods.

The concept of purchasing power parity allows one to estimate what the exchange rate between

two currencies would have to be in order for the exchange to be on par with the purchasing

power of the two countries' currencies. Using that PPP rate for hypothetical currency

conversions, a given amount of one currency thus has the same purchasing power whether used

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directly to purchase a market basket of goods or used to convert at the PPP rate to the other

currency and then purchase the market basket using that currency. Observed deviations of the

exchange rate from purchasing power parity are measured by deviations of the real exchange

rate from its PPP value of 1.

PPP exchange rates help to avoid misleading international comparisons that can arise with the

use of market exchange rates. For example, suppose that two countries produce the same

physical amounts of goods as each other in each of two different years. Since market exchange

rates fluctuate substantially, when the GDP of one country measured in its own currency is

converted to the other country's currency using market exchange rates, one country might be

inferred to have higher real GDP than the other country in one year but lower in the other; both

of these inferences would fail to reflect the reality of their relative levels of production. But if

one country's GDP is converted into the other country's currency using PPP exchange rates

instead of observed market exchange rates, the false inference will not occur.

International Fisher effects(IFE)

International Fisher Effect Meaning: In foreign exchange terminology, the International Fisher Effect is based on the idea that a

country with a higher interest rate will have a higher rate of inflation which, in turn, could cause

its currency to depreciate. In theoretical terms, this relationship is expressed as an equality

between the expected percentage exchange rate change and the difference between the two

countries’ interest rates, divided by one plus the second country’s interest rate. Because the

divisor approximates 1, the expected percent exchange rate change roughly equals the interest

rate differential.

International Fisher Effect Example: Putting the International Fisher Effect or IFE into practice would mean that exchange rates

change based on nominal interest rate differentials and independent of inflation rates. An

example of using the IFE to forecast exchange rate shifts would be if the U.S. nominal interest

rate was at 1%, but the Australian rate was at 3%, then the Aussie would be expected to rise by

2% against the U.S. Dollar.

An economic theory that states that an expected change in the current exchange rate between any

two currencies is approximately equivalent to the difference between the two countries' nominal

interest rates for that time.

Calculated as:

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Where:

"E" represents the % change in the exchange rate

"i1" represents country A's interest rate

"i2" represents country B's interest rate

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's

currency should appreciate roughly 5% compared to country A's currency.

The rational for the IFE is that a country with a higher interest rate will also tend to have a higher

inflation rate. This increased amount of inflation should cause the currency in the country with

the high interest rate to depreciate against a country with lower interest rates.

The Fisher Effect Vs. The IFE

The Fisher Effect model says nominal interest rates reflect the real rate of return and expected

rate of inflation. So the difference between real and nominal interest rates is determined by

expected inflation rates. The approximate nominal rate of return = real rate of return plus the

expected rate of inflation. For example, if the real rate of return is 3.5% and expected inflation is

5.4%, then the approximate nominal rate of return is 0.035 + 0.054 = 0.089 or 8.9%. The precise

formula is (1 + nominal rate) = (1 + real rate) x (1 + inflation rate), which would equal 9.1% in

this example. The IFE takes this example one step further to assume appreciation or depreciation

of currency prices is proportionally related to differences in nominal interest rates. Nominal

interest rates would automatically reflect differences in inflation by a purchasing power parity or

no-arbitrage system.

Covered Interst Arbitrage

A strategy in which an investor uses a forward contract to hedge against exchange rate risk.

Covered interest rate arbitrageis the practice of using favorable interest rate differentials to invest

in a higher-yielding currency, and hedging the exchange risk through a forward currency

contract. Covered interest arbitrage is only possible if the cost of hedging the exchange risk is

less than the additional return generated by investing in a higher-yielding currency. Such

arbitrage opportunities are uncommon, since market participants will rush in to exploit an

arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance.

An investor undertaking this strategy is making simultaneous spot and forward market

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transactions, with an overall goal of obtaining riskless profit through the combination of currency

pairs. Covered interest arbitrage is not without its risks, which include differing tax treatment in

various jurisdictions, foreign exchange or capital controls, transaction costs and bid-ask spreads.

Returns on covered interest rate arbitrage tend to be small, especially in markets that are

competitive or with relatively low levels of information asymmetry. While the percentage gains

are small they are large when volume is taken into consideration. A four cent gain for $100 isn't

much but looks much better when millions of dollars are involved. The drawback to this type of

strategy is the complexity associated with making simultaneous transactions across different

currencies.

Note that forward exchange rates are based on interest rate differentials between two currencies.

As a simple example, assume currency X and currency Y are trading at parity in the spot market

(i.e. X = Y), while the one-year interest rate for X is 2% and that for Y is 4%. The one-year

forward rate for this currency pair is therefore X = 1.0196 Y (without getting into the exact math,

the forward rate is calculated as [spot rate] times [1.04 / 1.02]).

The difference between the forward rate and spot rate is known as “swap points”, which in this

case amounts to 196 (1.0196 – 1.0000). In general, a currency with a lower interest rate will

trade at a forward premium to a currency with a higher interest rate. As can be seen in the above

example, X and Y are trading at parity in the spot market, but in the one-year forward market,

each unit of X fetches 1.0196 Y (ignoring bid/ask spreads for simplicity).

Covered interest arbitrage in this case would only be possible if the cost of hedging is less than

the interest rate differential. Let’s assume the swap points required to buy X in the forward

market one year from now are only 125 (rather than the 196 points determined by interest rate

differentials). This means that the one-year forward rate for X and Y is X = 1.0125 Y.

A savvy investor could therefore exploit this arbitrage opportunity as follows -

Borrow 500,000 of currency X @ 2% per annum, which means that the total loan

repayment obligation after a year would be 510,000 X.

Convert the 500,000 X into Y (because it offers a higher one-year interest rate) at the spot

rate of 1.00.



Lock in the 4% rate on the deposit amount of 500,000 Y, and simultaneously enter into a

forward contract that converts the full maturity amount of the deposit (which works out to

520,000 Y) into currency X at the one-year forward rate of X = 1.0125 Y.

After one year, settle the forward contract at the contracted rate of 1.0125, which would

give the investor 513,580 X.

Repay the loan amount of 510,000 X and pocket the difference of 3,580 X.

Covered Interest Rate Parity

This term refers to a condition where the relationship between interest rates and the spot and

forward currency values of two countries are in equilibrium. As a result, there are no interest rate

arbitrage opportunities between those two currencies.

As an example, assume Country X's currency is trading at par with Country Z's currency, but the

interest rate in Country X is 6% and the interest rate in country Z is 3%. All other things being

equal, it would make good sense to borrow in the currency of Z, convert it in the spot market to

currency X and invest the proceeds in Country X. However, in order to repay the loan in

currency Z, one must enter into a forward contract to exchange the currency back from X to Z.

Covered interest rate parity exists when the forward rate of converting X to Z eradicates all the

profit from the transaction.

'Uncovered Interest Rate Parity - UIP'

A parity condition stating that the difference in interest rates between two countries is equal to

the expected change in exchange rates between the countries' currencies. If this parity does not

exist, there is an opportunity to make a profit.

"i1" represents the interest rate of country 1

"i2" represents the interest rate of country 2

"E(e)" represents the expected rate of change in the exchange rate

For example, assume that the interest rate in America is 10% and the interest rate in Canada is

15%. According to the uncovered interest rate parity, the Canadian dollar is expected to

depreciate against the American dollar by approximately 5%. Put another way, to convince an



investor to invest in Canada when its currency depreciates, the Canadian dollar interest rate

would have to be about 5% higher than the American dollar interest rate.



Module VI

Foreign Exchange exposure

Management of Transaction exposure- Management of Translation exposure- Management

of Economic exposure- Management of political Exposure- Management of Interest rate

exposure.

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A firm's economic exposure to the exchange rate is the impact on net cash flow effects of a

change in the exchange rate. It consists of the combination of transaction exposure and operating

exposure. Having determined whether the firm should hedge its exposure, this note will discuss

the various things that a firm can do to reduce its economic exposure. Our discussion will

consider two different approaches to handling these exposures: real operating hedges and

financial hedges.

Transaction Exposure

The risk, faced by companies involved in international trade, that currency exchange rates will

change after the companies have already entered into financial obligations. Such exposure to

fluctuating exchange rates can lead to major losses for firms. Often, when a company identifies

such exposure to changing exchange rates, it will choose to implement a hedging strategy, using

forward rates to lock in an exchange rate and thus eliminate the exposure to the risk.

Transaction exposure is a form of financial risk associated with transactions conducted in a

foreign currency, where the exchange rate may change before settlement, forcing a company to

pay more to finish the deal. This is also known as transaction risk and can be a concern for any

company doing business internationally, as it may be engaged in deals in a number of currencies

at any given point in time. There are steps companies can take to limit their transaction exposure,

with the goal of protecting the company and the shareholders.

In a simple example, a company in Germany could enter a contract with a company in the United

States to buy products for a set amount in US dollars. If the dollar appreciates, the German

company would need to spend more Euros to meet the difference in the exchange rate, driving up

the cost of the business transaction. This could result in passing a loss on to shareholders, or

force the company to ask for more for the product from consumers in order to make up the

difference. It might not be as competitive as a result, since consumers could seek out the same

product at lower prices from other companies.

Financial Techniques of Managing Transaction Exposure

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Transaction exposure hedging will briefly go over the standard financial methods available for

hedging this exposure. The main distinction between transaction exposure and operating

exposure is the ease with which one can identify the size of a transaction exposure. This,

combined with the fact that it has a well-defined time interval associated with it makes it

extremely suitable for hedging with financial instruments. Among the more standard methods for

hedging transaction exposure are:

i) Forward Contracts - When a firm has an agreement to pay (receive) a fixed amount of

foreign currency at some date in the future, in most currencies it can obtain a contract today that

specifies a price at which it can buy (sell) the foreign currency at the specified date in the future.

This essentially converts the uncertain future home currency value of this liability (asset) into a

certain home currency value to be received on the specified date, independent of the change in

the exchange rate over the remaining life of the contract.

ii) Futures Contracts - These are equivalent to forward contracts in function, although they

differ in several important features. Futures contracts are exchange traded and therefore have

standardized and limited contract sizes, maturity dates, initial collateral, and several other

features. Given that futures contracts are available in only certain sizes, maturities and

currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the

exposure. The futures contracts, unlike forward contracts, are traded on an exchange and have a

liquid secondary market that make them easier to unwind or close out in case the contract timing

does not match the exposure timing. In addition, the exchange requires position taker to post s

bond (margins) based upon the value of their positions. This virtually eliminates the credit risk

involved in trading in futures.

iii) Money Market Hedge - Also known as a synthetic forward contract, this method utilizes

the fact from covered interest parity, that the forward price must be exactly equal to the current

spot exchange rate times the ratio of the two currencies' riskless returns. It can also be thought of

as a form of financing for the foreign currency transaction. A firm that has an agreement to pay

foreign currency at a specified date in the future can determine the present value of the foreign

currency obligation at the foreign currency lending rate and convert the appropriate amount of

home currency given the current spot exchange rate. This converts the obligation into a home

currency payable and eliminates all exchange risk. Similarly a firm that has an agreement to

receive foreign currency at a specified date in the future can determine the present value of the

foreign currency receipt at the foreign currency borrowing rate and borrow this amount of

foreign currency and convert it into home currency at the current spot exchange rate. Since as a

pure hedging need, this transaction replicates a forward, except with an additional transaction, it



will usually be dominated by a forward (or futures) for such purposes; however, if the firm needs

to hedge and also needs some short term debt financing, wants to pay off some previously higher

rate borrowing early, or has the home currency cash sitting around, this route may be more

attractive that a forward contract.

iv) Options - Foreign currency options are contracts that have an up front fee, and give the

owner the right, but not the obligation to trade domestic currency for foreign currency (or vice

versa) in a specified quantity at a specified price over a specified time period. There are many

different variations on options: puts and calls, European style, American style, and future-style

etc. The key difference between an option and the three hedging techniques above is that an

option has a nonlinear payoff profile. They allow the removal of downside risk without cutting

off the benefit form upside risk.

There are different kinds of options depending on the exercise time the determination of the

payoff price or the possibility of a payoff. While many different varieties exist, there are a few

that corporations have found useful for the purposes of hedging transaction exposures.

One of these is the average rate (or Asian or Look back) option. This option has as its payoff

price, not the spot price but the average spot price over the life of the contract. Thus these

options can be useful to a firm that has a steady stream on inflows or outflows in a particular

currency over time. One large average rate option will basically act as a hedge for the entire

stream of transaction. Moreover, the firms will lock in an average exchange rate over the period

no worse than that of the strike price of this option. Finally, because the average rate is less

volatile than the end of period rate (remember the average smoothes volatility this option will be

cheaper than equivalent standard options. Thus the firms obtains in a single instrument hedging

for a stream of transaction so reduces transaction costs plus benefits from the “hedging” over

time of the averaging effect.

Another popular exotic option for corporations is the basket rate option. Rather than buy options

on a bunch of currencies individually, the firms can buy an option based upon some weighted

average of currencies that match its transaction pattern. Here again since currencies are not

perfectly correlated the average exchange rate will be less volatile and this option will therefore

be less expensive. There firm can take advantage of its own natural diversification of currency

risk and hedge only the remaining risk.

Operational Techniques for Managing Transaction Exposure



Transaction exposures can also be managed by adopting operational strategies that have the

virtue of offsetting existing foreign currency exposure. These techniques are especially important

when well functioning forward and derivative market do not exist for the contracted foreign

currencies.

These strategies include:

i) Risk Shifting- The most obvious way to reduce the exposure is to not have an exposure. By

invoicing all transactions in the home currency a firm can avoid transaction exposure all

together. However, this technique can not work for every one since someone must bear

transaction exposure for a foreign currency transaction. Generally the firm that will bear the risk

is the one that can do so at the lowest cost. Of course, the decision on who bears the currency

risk may also impact the final price at which the contract is set.

ii ) Currency risk sharing - An alternative to trying to avoid the currency risk is to have the

two parties to the transaction share the risk. Since short terms transaction exposure is roughly a

zero sum game, one party's loss is the other party's gain. Thus, the contract may be written in

such a way that any change in the exchange rate from an agreed upon rate for the date for the

transaction will be split between the two parties.

For example a U.S. firm A contracts to pay a foreign firm B FC100 in 6 months based upon an

agreed on spot rate for six months from now of $1 = FC10, thus costing the U.S. firm $10.

However, under risk sharing the U.S. firm and the foreign firm agree to share the exchange rate

gain or loss faced by the U.S. firm by adjusting the FC price of the good accordingly. Thus, if the

rate in 6 months turns out to be $1 = FC12, then rather than only costing the U.S. firm $100/12 =

$8.50, the $1.50 gain over the agreed upon rate is split between the firms resulting in the U.S.

firm paying $9.25 and the foreign firm receiving FC 111. Alternatively if the exchange rate had

fallen to $1 = FC8, then instead of paying $12.50 for the good, the exchange rate loss to the U.S.

firm is shared and it only pays $11.25 and the foreign firm accepts FC90. Note that this does not

eliminate the transaction exposure, it simply splits it.

iii) Leading and Lagging - Another operating strategy to reduce transaction gains and losses

involves playing with the timing of foreign currency cash flows. When the foreign currency in

which an existing nominal contract is denominated is appreciating, you would like to pay off the

liabilities early and take the receivables later. The former is known as leading and the latter is

known as lagging. Of course when an the foreign currency in which a nominal contract is

denominated is depreciating, you would like to take the receivables early and pay off the

liabilities later.



iv) Reinvoicing Centers - A reinvoicing center is a separate corporate subsidiary that manages

in one location all transaction exposure from intracompany trade. The manufacturing affiliate

sells the goods to the foreign distribution affiliates only by selling to the reinvoicing center. The

reinvoicing center then sells the good to the foreign distribution affiliate. The importance of the

reinvoicing center is that the transactions with each affiliate are carried out in the affiliates local

currency, and the reinvoicing center absorbs all the transaction exposure. Three main advantages

exist to reinvoicing centers: the gains associated with centralized management of transaction

exposures from within company sales, the ability to set foreign currency prices in advance to

assist foreign affiliates budgeting processes, and an improved ability to manage intra affiliate

cash flows as all affiliates settle their intracompany accounts in their local currency. Reinvoicing

centers are usually an offshore (third country) affiliate in order to qualify for local non resident

status and gain from the potential tax and currency market access benefits that arise with that

distinction.

Translation Exposure

A firm's translation exposure is the extent to which its financial reporting is affected by

exchange rate movements. As all firms generally must prepare consolidated financial statements

for reporting purposes, the consolidation process for multinationals entails translating foreign

assets and liabilities or the financial statements of foreign subsidiary/subsidiaries from foreign to

domestic currency. While translation exposure may not affect a firm's cash flows, it could have a

significant impact on a firm's reported earnings and therefore its stock price. Translation

exposure is distinguished from transaction risk as a result of income and losses from various

types of risk having different accounting treatments.

The risk that a company's equities, assets, liabilities or income will change in value as a

result of exchange rate changes. This occurs when a firm denominates a portion of its equities,

assets, liabilities or income in a foreign currency.

Accountants use various methods to insulate firms from these types of risks, such as

consolidation techniques for the firm's financial statements and the use of the most effective cost

accounting evaluation procedures. In many cases, this exposure will be recorded in the financial

statements as an exchange rate gain (or loss).

The risk of loss that might arise due to changes in value of

the stock, revenue, assets or liabilities of a business due to foreign exchange rate movements.

A business has translation exposure when some of its stock, revenue, assets or liabilities

are denominated in a foreign currency and need to be translated back to

its base currency for accounting purposes.

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Economic Exposure

A firm has economic exposure (also known as operating exposure) to the degree that its market

value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments

can severely affect the firm's market share position with regards to its competitors, the firm's

future cash flows, and ultimately the firm's value. Economic exposure can affect the present

value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also

exposes the firm economically, but economic exposure can be caused by other business activities

and investments which may not be mere international transactions, such as future cash flows

from fixed assets. A shift in exchange rates that influences the demand for a good in some

country would also be an economic exposure for a firm that sells that good.

The risks faced by a company that does business or holds investments abroad.

Economic exposure can include changes in foreign exchange rates or the chance

of foreign countries defaulting on their debt. Companies often hedge against this type of risk

through the foreign exchange market.

Marketing Strategies for Managing Operating Exposure

1.Market Selection:

A major strategic consideration for a firm is what market to sell in and the relative marketing

support to devote to each market. For example, firms may decide to pull out of markets that have

become unprofitable due to real exchange rate changes, and more aggressively pursue market

share or expand into new markets when the real exchange rate depreciates. These decisions

depend, among other things, on the fixed costs associated with establishing or increasing market

share. Market selection and market segmentation provide the basic parameters within which a

company can adjust its marketing mix over time. They are primarily medium and longer term

decisions and may not be feasible strategies to react to exchange rate exposure in the short run.

For shorter run marketing reactions to exchange rate exposure, the firm may have to turn to

pricing or promotional policies.

2.Pricing Policies:

As we saw previously, in response to changes in real exchange rates, a firm has to make a

decision regarding market share versus profit margin. This involves the passthrough decision

with respect to the foreign currency price of foreign sales. Of course, such a decision should be

made by setting the price that maximizes dollar profits to the firm; however, since the world is

stochastic, this is not always a clear choice. The decision on how to adjust the foreign currency

price in response to exchange rate changes will depend upon how long the real exchange rate

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change is expected to persist, the extent of economies of scale that occur from maintaining large

quantity of production, the cost structure of expanding output, the price elasticity of demand, and

the likelihood of attracting competition if high unit profitability is apparent. The longer the

exchange rate change is expected to persist, the greater the price elasticity of demand, the greater

are the economies of scale and the greater is the possibility of attracting competition, the greater

will be the incentive to lower home currency price and expand demand in light of a home

currency depreciation, and to keep home currency price fixed and maintain demand in light of a

home currency appreciation. However, in deciding to change prices, the firm should take into

account the impact on cash flows not just today but in the future as well, as once a customer is

lost, he may be lost for a long period of time making it difficult for a firm to regain market share

3.Promotional Strategies:

An essential issue in any marketing program is the size of the promotional budget for

advertising, selling and merchandising. These budgets should explicitly build in exchange rate

impacts. An example is European ski areas in the mid 1980s. When the dollar was strong, they

found that they obtained larger returns on advertising in the U.S. for ski vacations in the Alps as

the costs compared to the Rocky Mountains has fallen due to the currency movements.

Production Strategies for Managing Operating Exposure

All of these responses have involved attempts to alter the dollar value of foreign currency

revenues. However, sometime real exchange rates change but such a large margin that marketing

strategies and pricing decisions cannot make the product profitable. Firms facing such

circumstances must either drop the products or cut costs. Product mix, product sourcing and

plant location are the principle production strategies that companies can use to manage

competitive risks that cannot be handled by marketing strategies alone. The basic idea is to

diversify the production mix such that the effect of exchange rate changes washes out or tie your

costs more closely to your foreign competitors.

1.Diversifying Operations:

One possibility to dealing with the impact of exchange rate exposure on the firm's cash flows is

to have the firm diversify into activities with offsetting exposures to the exchange rate. For

example, combine the production and exporting of a manufactured good with an importing

operation that imports competitive consumer goods from foreign producers. This creates a

natural operating hedge that keep total dollar cash flows steady in light of real exchange rate

movements. While the benefits of this strategy are obvious, it has some potential drawbacks: it



may lead the firm to enter into activities in which it has no apparent comparative advantage

resulting in an inefficient source of resources, or alternatively, the firm may view the two

activities as complementary and allow cross subsidization to occur for long periods of time and

not consider the economic viability of each operation on its own. Put another way, unless done

carefully, this can be an expensive way to hedge an operating exposure.

2.Diversifying Sources of Inputs:

For firms wishing to stick to their knitting, the goal of a production strategy should be to reduce

operating costs. The most flexible way to do this in light of a real home currency appreciation is

to purchase more components from overseas. As long a the inputs are not priced in a globally

integrated market (i.e., gold or oil), then the appreciation should lower the dollar cost of the

inputs and thus total production costs. For the longer term, the firm may wish to consider the

option of designing new local facilities that provide added flexibility in making substitutions

among various sources of inputs, either form domestic sources or foreign sources. However, this

strategy does not bode well for the concept of good supplier relations, and potential costs

associated with constantly switching suppliers’ needs to be taken into consideration when

evaluating this strategy.

3.Plant Location:

The most obvious way to be able to take advantage of relative costs changes due to real currency

movements is to have production costs based in different currency by actually having production

capacity in different countries. The simplest response is to move production to your competitors

market. Then any relative cost advantage he may gain from exchange rate changes also accrues

to you as well. Alternatively, placing a plant in a third country based upon the intensity of certain

inputs to production (i.e., labor, raw materials) may make more sense; however one needs to

think about the correlations between the third country exchange rate and the foreign competitor's

exchange rate to evaluate the hedge value of such an decision.

Financial Strategies for Managing Operating Exposure

The financial strategies for hedging operating exposure can roughly be broken down into two

groups, the goals of these two groups are the same, it is just the relation to firm operations that

differs. These are evaluating and managing the currency structure of a firm's debt, and the

addition to the firm of external contracts whose market values or net payoffs are negatively

related to the impact of real exchange rate change on firm value.

1.Denomination of Firm Debt:



The basic goal of hedging is to try to eliminate exposure. For real operating exposure to

exchange rates, this can be done by trying to match (as best as possible) foreign currency inflows

with foreign currency outflows. Since operating exposure is based upon long terms currency

flows, and we have seen previously that future foreign currency revenues are affected by

exchange rate changes, the firm may attempt to hedge some of this exposure by denominating

some of their long term debt in foreign currency so as to generate offsetting impacts on expected

cash flows.

2.Swaps:

Swaps are a financial instrument that allows the buyer to exchange one set of cash flows for

another. Thus the buyer of a swap agrees to make periodic payments based upon some financial

price and in return receives periodic payments based upon some other financial price. The most

common swaps are interest rate swaps. In these, a firm agrees to pay the market (floating) rate

over time (say every six month) on a given principal while at the same time receiving fixed

interest rate payments on the same principal amount. Generally, the rates are set so that the PV of

the expected payments equal the PV of the fixed receipts. Thus the swap is a zero NPV contract.

Since the principal amount is purely notional (only for determining the size of the payments) no

money is exchange up front or at the end.

Currency swaps are slightly different. Because two currencies are involved we can use either

fixed or floating interest rates. The most popular currency swaps are fixed currency swaps in

which a fixed rate n one currency is exchange for a fixed rate in another. Also because different

currencies are involved, there is an exchange of initial principal amounts. Usually these principal

amounts are equal value given the two currencies’ spot rate. At the end of the swap these initial

principals are swapped back. Below is a diagrammatic representation of the cash flows to a firm

entering a FC swap. Notice the firms exchange initial principals, cash flows (interest payments)

occur periodically and at the end the firms make the final interest payments and exchange back

the initial principals.

Contingent exposure

A firm has contingent exposure when bidding for foreign projects or negotiating other contracts

or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly

face a transactional or economic foreign exchange risk, contingent on the outcome of some

contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a

foreign business or government that if accepted would result in an immediate receivable. While

waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that

receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a

transaction exposure, so a firm may prefer to manage contingent exposures.



Managing Political Exposure

For multinational companies, political risk refers to the risk that a host country will make

political decisions that will prove to have adverse effects on the multinational's profits and/or

goals. Adverse political actions can range from very detrimental, such as widespread destruction

due to revolution, to those of a more financial nature, such as the creation of laws that prevent

the movement of capital.

In general, there are two types of political risk, macro risk and micro risk. Macro risk refers to

adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas

micro risk refers to adverse actions that will only affect a certain industrial sector or business,

such as corruption and prejudicial actions against companies from foreign countries. All in all,

regardless of the type of political risk that a multinational corporation faces, companies usually

will end up losing a lot of money if they are unprepared for these adverse situations. For

example, after Fidel Castro's government took control of Cuba in 1959, hundreds of millions of

dollars worth of American-owned assets and companies were expropriated. Unfortunately, most,

if not all, of these American companies had no recourse for getting any of that money back.

So how can multinational companies minimize political risk? There are a couple of measures that

can be taken even before an investment is made. The simplest solution is to conduct a little

research on the riskiness of a country, either by paying for reports from consultants that

specialize in making these assessments or doing a little bit of research yourself, using the many

free sources available on the internet (such as the U.S. Department of State's background notes).

Then you will have the informed option to not set up operations in countries that are considered

to be political risk hot spots.

While that strategy can be effective for some companies, sometimes the prospect of entering a

riskier country is so lucrative that it is worth taking a calculated risk. In those cases, companies

can sometimes negotiate terms of compensation with the host country, so that there would be a

legal basis for recourse in the event that something happens to disrupt the company's operations.

However, the problem with this solution is that the legal system in the host country may not be

as developed and foreigners rarely win cases against a host country. Even worse, a revolution

could spawn a new government that does not honor the actions of the previous government.

If you do go ahead and enter a country that is considered at risk, one of the better solutions is to

purchase political risk insurance. Multinational companies can go to one of the many

organizations that specialize in selling political risk insurance and purchase a policy that would

http://www.investopedia.com/terms/p/politicalrisk.asp

http://www.investopedia.com/terms/m/macrorisk.asp

http://www.investopedia.com/terms/m/microrisk.asp

http://www.investopedia.com/terms/m/multinationalcorporation.asp

http://www.state.gov/r/pa/ei/bgn/



compensate them if an adverse event occurred. Because premium rates depend on the country,

the industry, the number of risks insured and other factors, the cost of doing business in one

country may vary considerably compared to another.

However, be warned: buying political risk insurance does not guarantee that a company will

receive compensation immediately after an adverse event. Certain conditions, such as trying

other channels for recourse and the degree to which the business was affected, must be met.

Ultimately, a company may have to wait months before any compensation is received.



Management of Interest rate exposure

The successful management of a portfolio includes maximizing returns from shifts in exchange

and interest rates, which in turn requires an appreciation of the associated exposures. Not

knowing the exposure can leave the portfolio open to significant risk.

The interest rate risk relates to changes in the floating rate. Failure to understand exposure to

interest rates can lead to substantial risk. The two main areas of concern here should be

borrowings and cash investments. The best way of appreciating exposure to changing interest

rates is to stress-test various scenarios. How, for example, would a change in rate from 4% to 6%

affect your ability to borrow?

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility

of a change in the asset's value resulting from the variability of interest rates. Interest rate risk

management has become very important, and assorted instruments have been developed to deal

with interest rate risk.

Interest Rate Exposure-Once identified, the risks can be minimized using the following

methods:

Interest rate swap: A method for changing the interest rate you earn/pay on an agreed

amount for a specified time period.

Cross-currency swap: An exchange of principal and interest payments in separate

currencies.

Forward rate agreement: Two parties fix the interest rate that will apply to a loan or

deposit.

Interest rate caps: The seller and borrower agree to limit the borrower’s floating interest

rate to a specified level for a period of time.

Structured swap: An interest rate/cross-currency swap embedded with one or more

derivatives. This allows the client to minimize exposure on their perception of the

market.

Advantages


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http://www.investopedia.com/terms/r/riskmanagement.asp



The one key advantage to identifying exposure to interest and exchange rate fluctuations is the

ability to minimize possible losses in the event that your view of the market is wrong. This

approach will also minimize the chance of unexpected events disrupting the investment strategy.

Disadvantages

As with any hedge strategy, minimizing possible losses also reduces potential gains. Only those

who are supremely confident in their forecasts and with a cushion to absorb losses should

consider taking any extra risk to maximize returns.



Module VII

Foreign exchange risk Management

Hedging against foreign exchange exposure – Forward Market- Futures Market- Options

Market- Currency Swaps-Interest Rate Swap- problems on both two way and three way swaps.

Cross currency Swaps-Hedging through currency of invoicing- Hedging through mixed

currency invoicing –Country risk analysis.

International Capital Budgeting:Concept, Evaluation of a project, Factors affecting, Risk

Evaluation, Impact on Value, Adjusted Present Value Method

---------------------------------------------------------------------------------------------------------------------

Foreign exchange risk

Foreign exchange risk is your exposure to fluctuating exchange rates. Foreign Exchange Markets

are volatile and are constantly moving. These movements can have implications for any business

that has receipts and/or payments in a foreign currency. On conversion, these receipts/payments

can change in value from one day to the next, depending on the rate at which they are exchanged.

1.The risk of an investment's value changing due to changes in currency exchange rates.

2. The risk that an investor will have to close out a long or short position in a foreign currency at

a loss due to an adverse movement in exchange rates. Also known as "currency risk" or

"exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect investors

making international investments. For example, if money must be converted to another currency

to make a certain investment, then any changes in the currency exchange rate will cause that

investment's value to either decrease or increase when the investment is sold and converted back

into the original currency.

Hedging against foreign exchange exposure

(a) Forward contracts

The client can use forward contracts to sell or purchase foreign currency amounts at a future time

and a given exchange rate. The settlement takes place at the time and the exchange rate

mentioned in the contract, regardless of any fluctuations of the exchange rate on the foreign

exchange market.

Benefits

The risk of exchange rate fluctuations is mitigated

It increases the management’s control over the company’s cash-flows and profitability

The exchange rate used in budgeting is fixed ex ante

This product is suitable for your business if:

Your incomings are denominated in one currency and your payments are denominated in

another currency

You have a time gap between incomings and the corresponding payments



You use a certain level of the exchange rate when pricing your products

(b) Flexible forward transactions

A flexible forward transaction has the same characteristics as a forward transaction with only one

specific difference, which is that the settlement of the transaction can take place at any time until

the maturity of the contract. The client may choose to make partial settlements for his transaction

at any time until the maturity of the contract, having the only obligation to exchange the entire

notional amount until maturity.

Benefits

Flexible tenor for the foreign exchange transactions as the settlement may take place at

any time until the maturity date, at the same pre-established exchange rate

Better liquidity management

Better coordination between incomings and payments



another currency


You can anticipate the total volume of you payments but you cannot be certain in what

regards the exact moment of your incomings


(c) FX Options

FX Options give their buyer the right but not the obligation to sell/buy a specific amount at a pre-

agreed exchange rate. In order to have this right, the client pays a premium.

An option contract has the same functionality as an insurance contract. The client pays a

premium in order to be able to take advantage of its right in case a certain event occurs.

Benefits

Complete foreign exchange risk hedging

Better cash-flow and profit management

Establishing a level for the exchange rate that will be used for constituting the budget of

the company

The possibility to benefit of a favorable exchange rate movement



another currency



You want to be able to drop the contract and take advantage of a favorable exchange rate

movement if this happens



The CALL option gives its buyer the right and not the obligation to buy a specific amount of

currency at a pre-established rate in exchange of a premium paid (the cost of the option).

The PUT option gives its buyer the right and not the obligation to sell a specific amount of

currency at a pre-established rate in exchange of a premium paid (the cost of the option).

A large series of complex products can be obtained on the basis of these two types of vanilla

options in order to build-up a product that is most suitable for your company’s foreign exchange

risk hedging needs.

(d) Currency Swaps

A currency swap transaction represent an agreement to exchange one currency for another at an

agreed upon exchange rate. There are two simultaneous transactions, one of buying and one of

selling the same amount at two different value dates (usually SPOT and FORWARD) and at

exchange rates (SPOT and FORWARD) that are pre-agreed at the moment when the transaction

is closed.

In a currency swap, the holder of an unwanted currency exchanges that currency for an

equivalent amount of another currency. Thus, the client exchanges his interest and currency rate

exposures from one currency to another or benefits of bank financing at a lower rate.

(e)Hedging with Futures

Noting the shortcomings of the forward market, particularly the need and the difficulty in finding

a counter party, the futures market came into existence. The futures market basically solves some

of the shortcomings of the forward market. A currency futures contract is an agreement between

two parties – a buyer and a seller – to buy or sell a particular currency at a future date, at a

particular exchange rate that is fixed or agreed upon today. This sounds a lot like the forward

contract. In fact the futures contract is similar to the forward contract but is much more liquid. It

is liquid because it is traded in an organized exchange– the futures market (just like the stock

market). Futures contracts are standardized contracts and thus are bought and sold 4 just like

shares in the stock market. The futures contract is also a legal contract just like the forward, but

the obligation can be ‘removed’ before the expiry of the contract by making an opposite

transaction. As for hedging with futures, if the risk is an appreciation of value one needs to buy

futures and if the risk is depreciation then one needs to sell futures.

Advantages

• Liquid and central market. Since futures contracts are traded on a central market, this

increases the liquidity. There are many market participants and one may easily buy or sell

futures. The problem of double coincidence of wants that could exist in the forward market is

easily solved. A trader who has taken a position in the futures market can easily make an

opposite transaction and close his or her position. Such easy exit is not a feature of the forward

market though.



• Leverage. This feature is brought about by the margin system, where a trader takes on a large

position with only a small initial deposit. If the futures contract with a value of RM1,000,000 has

an initial margin of RM100,000 then a one percent change in the futures price (i.e. RM10,000)

would bring about a 10 percent change relative to the trader’s initial outlay. This amplification of

profit (or losses) is called leverage. Leverage allows the trader to hedge big amounts

with much smaller outlays.

• Position can be easily closed out. As mentioned earlier, any position taken in the futures

market can be easily closed-out by making an opposite transaction. If a trader had sold 5 Rupee

futures contracts expiring in December, then the trader could close that position by buying 5

December Rupee futures. In hedging, such closing-out of position is done close to the expected

physical spot transaction. Profits or losses from futures would offset losses or profits from the

spot transaction. Such offsetting may not be perfect though due to the imperfections brought

about by the standardized features of the futures contract.

• Convergence. As the futures contract approach expiration, the futures price and spot price

would tend to converge. On the day of expiration both prices must be equal. Convergence is

brought about by the activities of arbitrageurs who would move in to profit if they observe price

disparity between the futures and the spot; buying in the cheaper market and selling the higher

priced one.

Disadvantages

• Legal obligation. The futures contract, just like the forward contract, is a legal obligation.

Being a legal obligation it can sometimes be a problem to the business community. For example,

if hedging is done through futures for a project that is still in the bidding process, the futures

position can turn into a speculative position in the event the bidding turns out not successful.

• Standardized features. As mentioned earlier, since futures contracts have standardized

features with respect to some characteristics like contract size, expiry date etc., perfect hedging

may be impossible. Since overhedging is also generally not advisable, some part of the spot

transactions will have to go unhedged.

• Initial and daily variation margins. This is a unique feature of the futures contract. A trader

who wishes to take a position in the futures market must first pay an initial margin or deposit.

This deposit will be returned when the trader closes his or her position. As mentioned earlier,

futures contracts are marked to market – meaning to say that the futures position is tracked on a

daily basis - and the trader would be required to pay up daily variation margins in the event of

daily losses. The initial and daily variation margins can cause significant cash flow burden on

traders or hedgers.

• Forego favourable movements. In hedging using futures, any losses or profits in the spot

transaction would be offset by profits or losses from the futures transaction.

(f)Interest rate Swap



A common interest rate risk management product is an interest rate swap. Interest rate swaps are

used to manage potential exposure to risk in interest rates. The variable rate of interest that a

customer has on a loan is swapped to a fixed rate. Interest rate swaps account for the majority of

transactions with small and medium-sized enterprises (SMEs) Swaps are negotiated individually

between the customer and the bank and may include further options and clauses.

An interest rate cap offers unlimited protection for a borrower if rates rise above an agreed level,

whilst allowing a borrower to participate fully in any falls in base rate. The customer pays a

premium for such a contract.

Interest rate swaps are used to manage potential exposure to changes in interest rates. The swap

allows the business to control the underlying variable rate of interest paid by crediting or

debiting the business with the interest difference between the variable rate and the fixed interest

rate. This means that if the variable rate is higher than the fixed rate the customer will be

credited, but if the variable rate is lower than the fixed rate the customer will be debited.

Interest rate swaps are used widely by many types of businesses to plan and budget with a

greater degree of certainty over their borrowing costs.

(g)Cross currency Swaps

A cross currency swap, also referred to as cross currency interest rate swap,[1] is an

agreement between two parties to exchange interest payments and principals denominated in two

different currencies.

It is best to explain the structure of a cross currency swap with an example.

The chart above (to be created) illustrates the flow of funds involved in a typical EUR/USD cross

currency swap. At the start of the contract, A borrows X·S USD from, and lends X EUR to B.

During the contract term, A receives EUR 3M Libor + α from, and pays USD 3M Libor to, B

every three months, where α is called the cross currency basis or cross currency spread, and is

agreed upon by the counterparties at the start of the contract. At the maturity of the contract, A

returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the

start of the contract.

Cross hedging is a form of a hedge developed in a currency whose value is highly correlated

with the value of the currency in which the receivable or payable is denominated. In some cases,

it is relatively easy to find highly correlated currencies, because many smaller countries try to

peg the exchange rate between their currency and some major currency such as the dollar, the

franc or euro. However, these currencies may not be perfectly correlated because efforts to peg

values frequently fail.

(h)Hedging through Invoice Currency

The firm can shift, share, or diversify:

shift exchange rate risk by invoicing foreign sales in home currency

share exchange rate risk by pro-rating the currency of the invoice between foreign and

home currencies

http://en.wikipedia.org/wiki/Cross_currency_swap#cite_note-ISDAGlossary-1

http://en.wikipedia.org/wiki/Interest




diversify exchange rate risk by using a market basket index

(i)Hedging through Mixed Currency Invoicing

It is not unusual for both parties in an import/export contract to prefer invoicing the transaction

using their own home currencies. As a compromise, both parties agree to denominate the

contract partly in an importer’s currency and partly in exporter’s currency.

Additionally, internationally trading companies often use composite currency units such as the

Special Drawing Rights and European Currency Unit to denominate the export contract. Because

these composite units are constructed by taking a weighted average of a number of major world

currencies, their values are considerably more stable than that of any single currency. Because

they offer some diversification benefits , the composite currency units will reduce transaction

risk and exposure, though not completely.

Hedging Strategies

The objective underlying hedging should be made explicit.

Trying to manage accounting exposure is inconsistent with empirical evidence; since it

doesn’t affect cashflows, it amounts to assuming that investors cannot see beyond financial

statements.

If this assumption is false, hedging for this purpose would have positive costs and no

benefits.

Selective hedging may end up increasing cashflow variances, rather than reduce them, if the

firm has no predictive abilities.

All costs of hedging should be taken into account. For example, the cost of increasing LC

borrowings is the cost of the LC loan less the profit generated from those funds, such as prepaying a

hard currency loan. Interest rates on loans in local currencies may be higher because of anticipated

devaluations

Forward Market Hedge

A company that is long (short) a foreign currency will sell (buy) the foreign currency forward.

Suppose GE expects to received €10m. from the sale of turbines in 1 year.



Suppose the current spot price is $1.00/€ and the forward price is $0.957/€.

A forward sale of €10m. For delivery in one year will yield GE $9.57m on Dec. 31.

Without hedging, GE will have a €10m asset, whose value will fluctuate with the euro. With the

hedge, the value is fixed at $9.57m

Hedging with forward contracts eliminates the forward risk at the expense of forgoing the upside

potential.

Money Market Hedge

A money market hedge involves simultaneous borrowing and lending in two different currencies

to lock in the dollar value of a future foreign currency flow.

Suppose Euro and US dollar interest rates are 15% and 10% resply.

GE can borrow €(10/1.15)m = €8.7m in the spot market and invest it for one year.

On 12/31, GE will get (1.1)(8.7) = $9.57m

GE will use the €10m from its euro receivable to repay the euro loan.

The payoff in one year should be the same with the forward hedge or the money market hedge

provided interest rate parity holds.

Exposure Netting

This refers to offsetting exposures in one currency with exposures in the same or other currency,

where exchange rates are expected to move in such a way that loss on the first exposed position

are offset by gains on the second exposure. This assumes that the net gain or loss on the entire

currency exposure portfolio is what matters.

This can be achieved in one of three ways:

A firm can offset a long position in a currency with a short position in that same

currency.

If the exchange rate movements of two currencies are positively correlated, then the firm

can offset a long position in one currency with a short position in the other.

If the currency movements are negatively correlated, then short (or long) positions can be

used to offset each other.



Such offset of exposures does not require actual netting (bilateral or multilateral). Rather, if there

is the potential for actual netting, then there is no real exchange exposure, whether or not the

netting is actually done.

However, it may be useful to do the actual netting – one to reduce costs, and two, to have better

control of how much hedging is actually necessary.

Reinvoicing centers and in-house factoring can also procure the same result.

Cross Hedging

Hedging with futures is similar to hedging with forwards.

However, it is very difficult to find a futures contract that matches the needs of the hedger in

currency, maturity and amount simultaneously.

As long as the futures price on the futures contract that is available is positively correlated with

the exposure being hedged, the company can obtain some protection. Such use of futures

contracts is called cross-hedging.

Suppose a US firm has a Danish Krone receivable, but it wants to use euro futures to hedge.

Then, the slope coefficient from the regression of changes in the DK/$ rate against changes in the

€/$ rate is the number of euros it should sell forward per DK.

Foreign Currency Options

Using forwards/futures or currency collars makes sense if the extent of the exposure is known.

However, at times, a firm might want to hedge against a future exposure that might or might not

materialize.

In this case, using forwards might not be a good idea. If the exposure does materialize, well and

good. However, if the exposure does not materialize, then the firm would end up with an

unwanted exposure, once again.

One way around this would be to buy an option. This is more like insurance.

Internal hedging techniques

Internal hedging means using techniques available within the company or group to manage

exchange-rate risks. These techniques do not operate through the foreign exchange markets and

therefore they avoid the associated costs. However, this does not mean they are costless.



Invoicing in the home currency

Here, the company simply invoices in its own currency. The exchange rate risk is not avoided, it

is merely transferred to the customer. This technique may not always be possible, given that the

company may well be competing with local industries invoicing in the local currency, and, as

such, the overseas quote may become uncompetitive.

Bilateral and multilateral netting

This is a form of matching appropriate for multinational groups or companies with subsidiaries

or branches in a number of overseas countries. Bilateral netting applies where pairs of companies

in the same group net off their own positions regarding payables and receivables, often without

the involvement of a central treasury department. Multilateral netting is performed by a central

treasury department where several subsidiaries are involved and interact with head office. The

process is based on determining a base currency, for example, sterling or US dollars, so that the

intra-group transactions are recorded only in that currency; each group company reports its

obligations to other group companies to a central, say UK, treasury department, which then

informs each subsidiary of the net receipt or payment needed to settle their foreign exchange

intra-group positions. While this procedure undoubtedly reduces transaction costs by reducing

the number of transactions and also reduces exchange-rate risk by reducing currency flows, the

difficulties are that there are regulations in certain countries which severely limit or even prohibit

netting, and there may also be cross-border legal and taxation problems to overcome as well as

the extra administrative costs of the centralised treasury operation.

Hedging with Forwards

Hedging refers to managing risk to an extent that makes it bearable. In international trade and

dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can

have significant impact on business decisions and outcomes. Many international trade and

business dealings are shelved or become unworthy due to significant exchange rate risk

embedded in them. Historically, the foremost instrument used for exchange rate risk

management is the forward contract. Forward contracts are customized agreements between

two parties to fix the exchange rate for a future transaction. This simple arrangement would

easily eliminate exchange rate risk, but it has some shortcomings, particularly getting a counter

party who would agree to fix the future rate for the amount and time period in question may not

be easy. In Malaysia many businesses are not even aware that some banks do provide forward

rate arrangements as a service to their customers. By entering into a forward rate agreement

with a bank, the businessman simply transfers the risk to the bank, which will now have to bear

this risk. Of course the bank in turn may have to do some kind of arrangement to manage this



risk. Forward contracts are somewhat less familiar, probably because there exists no formal

trading facilities, building or even regulating body.

Hedging with Futures

Noting the shortcomings of the forward market, particularly the need and the difficulty in finding

a counter party, the futures market came into existence. The futures market basically solves

some of the shortcomings of the forward market. A currency futures contract is an agreement

between two parties – a buyer and a seller – to buy or sell a particular currency at a future date, at

a particular exchange rate that is fixed or agreed upon today. This sounds a lot like the forward

contract. In fact the futures contract is similar to the forward contract but is much more liquid.

It is liquid because it is traded in an organized exchange– the futures market (just like the stock

market). Futures contracts are standardized contracts and thus are bought and sold just like

shares in the stock market. The futures contract is also a legal contract just like the forward, but

the obligation can be ‘removed’ before the expiry of the contract by making an opposite

transaction. As for hedging with futures, if the risk is an appreciation of value one needs to buy

futures and if the risk is depreciation then one needs to sell futures. Consider our earlier

example, instead of forwards, Company A could have thus sold Rupee futures to hedge against

Rupee depreciation. Let’s assume accordingly that Company A sold Rupee futures at the rate

RM0.10 per Rupee. Hence the size of the contract is RM1,000,000. Now say that Rupee

depreciates to RM0.07 per Rupee – the very thing Company A was afraid of. Company A would

then close the futures contract by buying back the contract at this new rate. Note that in essence

Company A basically bought the contract for RM0.07 and sold it for RM0.10. This would give a

futures profit of RM300,000 [(RM0.10-RM0.07) x 10,000,000]. However in the spot market

Company A gets only RM700,000 when it exchanges the 10,000,000 Rupees contract value at

RM0.07. The total cash flow however, is RM1,000,000 (RM700,000 from spot and RM300,000

profit from futures). With perfect hedging the cash flow would be RM1 million no matter what

happens to the exchange rate in the spot market. One advantage of using futures for hedging is

that Company A can release itself from the futures obligation by buying back the contract

anytime before the expiry of the contract. To enter into a futures contract a trader needs to pay a

deposit (called an initial margin) first. Then his position will be tracked on a daily basis so much

so that whenever his account makes a loss for the day, the trader would receive a margin call

(also known as variation margin), i.e. requiring him to pay up the losses.

Hedging using Options

A currency option may be defined as a contract between two parties – a buyer and a seller -

whereby the buyer of the option has the right but not the obligation, to buy or sell a specified

currency at a specified exchange rate, at or before a specified date, from the seller of the option.



While the buyer of option enjoys a right but not obligation, the seller of the option nevertheless

has an obligation in the event the buyer exercises the given right. There are two types of options:

• Call options – gives the buyer the right to buy a specified currency at a specified exchange rate,

at or before a specified date.

• Put options – gives the buyer the right to sell a specified currency at a specified exchange rate,

at or before a specified date. Of course the seller of the option needs to be compensated for

giving such a right.

The compensation is called the price or the premium of the option. Since the seller of the option

is being compensated with the premium for giving the right, the seller thus has an obligation in

the event the right is exercised by the buyer. For example assume a trader buys a September

RM0.10 Rupee call option for RM0.01. This means that the trader has the right to buy Rupees

for RM0.10 per Rupee anytime till the contract expires in September. The trader pays a

premium of RM0.01 for this right. The RM0.10 is called the strike price or the exercise price. If

the Rupee appreciates over RM0.10 anytime before expiry, then the trader may exercise his right

and buy it for RM0.10 per Rupee. If however Rupee were to depreciate below RM0.10 then the

trader may just let the contract expire without taking any action since he is not obligated to buy it

at RM0.10. If he needs physical Rupee, then he may just buy it in the spot market at the new

lower rate. In hedging using options, calls are used if the risk is an upward trend in price and puts

are used if the risk in a downward trend in price. In our Company A example, since the risk is a

depreciation of Rupees, Company A would need to buy put options on Rupees. If Rupees were

to actually depreciate by the time Company A receives its Rupee revenue then Company A

would exercise its right and exchange its Rupees at the higher exercise rate. If however Rupees

were to appreciate instead, Company A would just let the contract expire and exchange its

Rupees in the spot market for the higher exchange rate. Therefore the options market allows

traders to enjoy unlimited favourable movements while limiting losses. This feature is unique to

options, unlike the forward or futures contracts where the trader has to forego favourable

movements and there is also no limit to losses.

Options are particularly suited as a hedging tool for contingent cash flows, for example like in

bidding processes. When a firm bids for a project overseas, which involves foreign exchange

risk, it may quote its bidding price and at the same time protect itself from foreign exchange risk

by buying put options. If the bidding was successful, the firm will be protected from a

depreciation of the foreign currency. However, if the bidding was unsuccessful and the currency

appreciated, then the firm may just let the contract expire. In this case the firm loses the

premium paid, which is the maximum loss possible with options. If the bidding was

unsuccessful and the currency depreciated, the firm may exercise its right and make some profits



from this favourable movement. In the case of hedging with forward or futures, the firm would

be automatically placed in a speculative position in the event of an unsuccessful bid, without a

limit to its downside losses.

SWAPS

Swaps literally mean exchange.

An agreement between the two parties to exchange a series of payments the terms of which are

predetermined can be considered as financial swap.

Financial swap are broadly classified into

Interest Rate Swaps

Currency rate Swaps

Interest Rate Swaps

In the interest rate swaps or the plain vanilla swap the fixed rate obligations are exchanged for

floating rate obligations over a specified period of time for a notional principal.

Let us assume that X & Y enter the interest rate swap agreement wherein X lends to Y at LIBOR

and Y lends to X at fixed rate 10% .

The net cost of funds to X and Y using the swap agreement can be seen by examining their cash

flows.

Currency Swaps

Currency swaps involve three steps, although the first step may be notional.

Intial exchange of principal

Exchange of interest rates

Re-exchange of principal at the end of the contract.

Generally this is known as cross- currency swaps

A cross-currency swap is an interest rate swap in which the cash flows are in different

currencies. Upon initiation of cross currency swap, the counterparties make the initial exchange

of the notional principals in the two currencies. During the life of the swap, each party pays

interest( in the currency of the principal received) to the other. And at the maturity of the swap,



the parties make a final exchange of the initial principal amounts, reversing the initial exchange

at the same spot rate.

Generic cross currency swap: A 5 year EUR/USD example (Spot =1.30)

The figure above illustrates a structure in which the company receives USD interest and pays

EUR interest. The front and back exchanges of principal amounts are based on the current spot

rate. The grey Euro cash flows are economically equivalent to issuing a Euro bond; the USD

cashflows are equivalent to investing in a USD bond. If paired with a USD borrowing, the CCS

converts the USD borrowings into a synthetic EUR one; if paired with a EUR investment, the

CCS converts the EUR asset into a synthetic USD one.

Country Risk Analysis

A collection of risks associated with investing in a foreign country. These risks include political

risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of

capital being locked up or frozen by government action. Country risk varies from one country to

the next. Some countries have high enough risk to discourage much foreign investment.

Country risk can reduce the expected return on an investment and must be taken into

consideration whenever investing abroad. Some country risk does not have an effective hedge.

Other risk, such as exchange rate risk, can be protected against with a marginal loss of profit

potential.



The United States is generally considered the benchmark for low country risk and most nations

can have their risk measured as compared to the U.S. Country risk is higher with longer term

investments and direct investments, which are investments not made through a regulated market

or exchange.

Country risk refers to the risk of investing in a country, dependent on changes in the business

environment that may adversely affect operating profits or the value of assets in a specific

country. For example, financial factors such as currency controls, devaluation or regulatory

changes, or stability factors such as mass riots, civil war and other potential events contribute to

companies' operational risks. This term is also sometimes referred to as political risk; however,

country risk is a more general term that generally refers only to risks affecting all companies

operating within a particular country.

Political risk analysis providers and credit rating agencies use different methodologies to assess

and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative

econometric models and focus on financial analysis, whereas political risk providers tend to use

qualitative methods, focusing on political analysis. However, there is no consensus on

methodology in assessing credit and political risks.

MNCs constantly assess business environments of countries they operate in, as well as the ones

they are considering investing in. Similarly, private and public investors are interested in

determining which countries offer the best opportunities for sound investments.

This is the area of country risk analysis --- assessing the potential risks and rewards associated

with making investments and doing business in a country.

MNCs are interested in the economic policies of these countries, because economic policies

determine the business environment. However, country risk assessment cannot be only economic

in nature. It is also important to consider the political factors that lead to economic policies. This

interaction of politics and economics is the subject area of political economy.

Key Indicators

Expropriation (nationalization) is the most extreme form of political risk. However, there are

other levels and forms of political risk, including currency and trade controls, changes in tax or

labor laws, regulatory restrictions, and requirements for additional local production.

Political risk can be assessed from a country-specific (macro or country risk analysis) and a firm-

specific (micro or firm risk analysis) perspective. A useful indicator of the degree of political risk

is the seriousness of capital flight. Capital flight refers to the export of savings by a nation’s

citizens because of fears about the safety of their capital.

We now turn to some key indicators of the general level of risk in the country as a whole –

termed country risk. Some of the common characteristics of country risk are:

i) A large government deficit relative to GDP



ii) A high rate of money expansion, especially if it is combined with a relatively fixed

exchange rate

iii) Substantial government expenditures yielding low rates of return

iv) Price controls, interest rate ceilings, trade restrictions, rigid labor laws, and other

government-imposed barriers to the smooth adjustment of the economy to changing relative

prices

v) High tax rates that destroy incentives to work, save, and invest

vi) Vast state-owned firms run for the benefit of their managers and workers

vii) a citizenry that demands, and a political system that accepts, government responsibility

for maintaining and expanding the nation’s standard of living through public-sector spending and

regulations (the less stable the political system, the more important this factor will likely be.)

viii) Pervasive corruption that acts as a large tax on legitimate business activity, holds back

development, discourages foreign investment, breeds distrust of capitalism, and weakens the

basic fabric of society

ix) the absence of basic institutions of government – a well-functioning legal system, reliable

regulation of financial markets and institutions, and an honest civil service

Alternatively, indicators of a nation’s long-run economic health include the following:

a) A structure of incentives that rewards risk taking in productive ventures

b) A legal structure that stimulates the development of free markets

c) Minimal regulations and economic distortions

d) Clear incentives to save and invest

e) An open economy

f) Stable macroeconomic policies

In summary, from the standpoint of an MNC, country risk analysis is the assessment of factors

that influence the likelihood that a country will have a healthy investment climate. Several costly

lessons have led to a new emphasis on country risk analysis in international banking as well.

From the bank’s standpoint, country risk – the credit risk on loans to a nation – is largely

determined by the real cost of repaying the loan versus the real wealth that the country has to

draw on. These parameters, in turn, depend on the variability of the nation’s terms of trade and

the government’s willingness to allow the nation’s standard of living to adjust rapidly to

changing economic fortunes.



International Capital Budgeting

Concept

Capital budgeting (or investment appraisal) is the planning process used to determine whether an

organization's long term investments such as new machinery, replacement machinery, new

plants, new products, and research development projects are worth the funding of cash through

the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating

resources for major capital, or investment, expenditures. One of the primary goals of capital

budgeting investments is to increase the value of the firm to the shareholders.

Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return

Payback period

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annuity

Real options valuation

These methods use the incremental cash flows from each potential investment, or project.

Techniques based on accounting earnings and accounting rules are sometimes used - though

economists consider this to be improper - such as the accounting rate of return, and "return on

investment." Simplified and hybrid methods are used as well, such as payback period and

discounted payback period.

In International capital budgeting multinational firms engaged in evaluating foreign projects face

a number of complexities, many of which are not there in the domestic capital budgeting process.

International capital budgeting is more complicated than domestic capital budgeting.

International capital budgeting involves substantial spending(capital investment) in projects that

are located in foreign(host) countries, rather than in the home country of the MNC.

Foreign-exchange rates, interest rates, and inflation are three external factors that affect

multinational companies (MNCs) and their markets. Changes in these three factors stem from

several sources, such as economic conditions, government policies, monetary systems, and

political risks. Each factor is a significant external variable that affects areas such as policy

decisions, strategic planning, profit planning, and budget control. To minimize the possible

negative impact of these factors, MNCs must establish and implement policies and practices that

recognize and respond to their influences.



These three factors – exchange rates, interest rates, and inflation – affect sales budgets, expense

budgets, capital budgeting, and cash budgets. However, they are particularly useful when

evaluating international capital budgeting alternatives.

Foreign-exchange rates have the most significant effect on the capital budgeting process. A

foreign investment project will be affected by exchange rate fluctuations during the life of the

project, but these fluctuations are difficult to forecast. There are methods of hedging against

exchange rate risks, but most hedging techniques are used to cover short-term positions.The cost

of capital is used as a cutoff point to accept or reject a proposed project. Because the cost of

capital is the weighted average cost of debt and equity, interest rates play a key role in a capital

expenditure analysis. Most components of project cash flows – revenues, variable costs, and

fixed costs – are likely to rise in line with inflation, but local price controls may not permit

internal price adjustments. A capital expenditure analysis requires price projections for the entire

life of the project. In some The basic principles of analysis are the same for foreign and domestic

investment projects. However , a foreign investment decision results from a complex process,

which differs, in many aspects, from the domestic investment decision.

Relevant cash flows are the dividends and royalties that would be repatriated by each subsidiary

to a parent firm. Because these net cash flows must be converted into the currency of a parent

company, they are subject to future exchange rate changes. Moreover, foreign investment

projects are subject to political risks such as exchange controls and discrimination. Normally, the

cost of capital for a foreign project is higher than that for a similar domestic project. Certainly,

this higher risk comes from two major sources, political risk and exchange risk.

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the

cash inflows and outflows associated with prospective long-term (foreign) investment projects.

The basic steps are:

� Identify the initial capital invested

� Estimate cash flows to be derived from the project over time, including an estimate of the

terminal value of the investment

� Identify the appropriate discount rate to use in valuation

� Apply traditional capital budgeting decision criteria such as Net Present Value (NPV) and

Internal Rate of Returns (IRR)

� Alternative, Adjusted Present Value (APV).

Evaluation of a project

In sum, the capital budgeting process is the tool by which a company administers its investment

opportunities in additional fixed assets by evaluating the cash inflows and outflows of such

opportunities. Once such opportunities have been identified or selected, management is then

tasked with evaluating whether or not the project is desirable.

Depending on the business, the competitive environment and industry forces, companies will

certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember



that the capital budgeting process involves two sets of decisions, investment decisions and

financial decisions; given the unique business and market environments that exist at the time,

each decision may not initially be seen as worthwhile individually, but could be worthwhile if

both were to be undertaken.

Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks

announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million.

The offer price for Teavana represented a 50% premium over the then market value of Teavana.

Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana.

Looking at this capital investment today, one can suggest that the financial decision – paying

$620 million for a company that generated $167 and $18 million in sales and profits in 2011 –

was not a desirable one for Starbucks.

On the other hand, from an investment perspective, Starbucks is paying $620 million for

ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the

fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks

approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality

tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a

purely financial perspective, the decision would have ignored that highly-valuable benefit of

combining the most well-known coffee brand with the highest-quality tea brand.

Generally speaking however, businesses will consider the following questions when evaluating

whether or not a project is desirable and should be pursued.

What Will the Project Cost?

This is the first and most basic question a company must answer before pursuing a project.

Identifying the cost, which includes the actual purchase price of the assets along with any future

investment costs, determines whether or not the business can afford to take on such a project.

How Long Will It Take to Re-coup the Investment?

Once the costs have been identified, management must determine the cash return on that

investment. An affordable project that has little chance of recouping the initial investment, in a

reasonable period of time, would likely be rejected unless there were some unique strategic

decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is

matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related

projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that

management's forecast will prove accurate or correct; nevertheless, forecasting future cash

inflows and outflows are a vital exercise in the capital budgeting process.

Mutually Exclusive or Independent?

All investment projects are considered to be mutually exclusive or independent. An independent

project is one where the decision to accept or reject the project has no effect on any other

projects being considered by the company. The cash flows of an independent project have no



effect on the cash flows of other projects or divisions of the business. For example the decision

to replace a company's computer system would be considered independent of a decision to build

a new factory.

A mutually-exclusive project is one where acceptance of such a project will have an effect on the

acceptance of another project. In mutually exclusive projects, the cash flows of one project can

have an impact on the cash flows of another. Most business investment decisions fall into this

category. Starbucks decision to buy Teavana will most certainly have a profound effect on the

future cash flows of the coffee business as well as influence the decision making process of other

future projects undertaken by Starbucks.

Factors affecting International Capital Budgeting

Exchange Rate fluctuations

Inflation

Financing Arrangements

Subsidiary financing

Parent financing

Financing with other subsidiary’s Retained Earnings

Blocked funds

In some cases, the host country may block funds that the subsidiary attempts to send to

the parent. Some countries require that earnings generated by the subsidiary be

reinvested locally for at least 3 years before they can be remitted. Political coditions in

the host country and restrictions that may be imposed by a country’s host govt. needs to

be considered.

Uncertain salvage value

Impact of project on prevailing cash flows

Host govt. incentives

Real options

A real option is an option on specified real assets such as machinery or a facility.

Some capital budgeting projects contain rel option in that they may allow

oppurtunities to obtain or eliminate real assets. Since these opportunities can

generate cash flows, they can enhance value of the project.

Risk Evaluation

Project Risk

Some of the risk you face from a long-term investment is from the project itself. Project risk

approximates the chance that the project will not be as profitable as expected due to errors from

the company or from the project's initial evaluation. Project risk is increased when a company

invests in a business that is not in its area of expertise. This increases the chance that

management will not be able to properly value the project's cash flows and that the company will

make errors while running the business.



Market Risk

Market risk measures the part of a project's risk from macroeconomic factors such as inflation

and interest rates. Market risk is increased during a weak economy. A poor economy can

decrease demand for a product, potentially turning a project unprofitable. Banks may be more

reluctant to lend in a weak economy, raising the cost of capital for the project. High inflation can

also be a problem at it weakens the long-term real return of the project. These factors increase

the market risk of a project and contribute higher total risk.

International Risk

If a company's capital budget project will involve another country, it will be exposed to

international risk. This entails political and exchange-rate risk of the project. If a project is based

in a country with an unstable political structure, civil or political unrest could cause the entire

investment to be lost. If currency rates move in an unfavorable direction, the company could face

higher relative costs and lower relative gains. Domestic projects are completely devoid of this

type of risk.

Methods commonly used to adjust the evaluation of risk:

Risk-adjusted discount Rate

Sensitivity analysis

Simulation

Adjusted Present Value Method

The APV model is a value-additivity approach to capital budgeting. That is, each cash flow that

is a source of value is considered individually. Note that in the APV model, each cash flow is

discounted at a rate of discount consistent with the risk inherent in that cash flow. The OCFt and

TVT are discounted at Ku. The firm would receive these cash flows from a capital project

regardless of whether the firm was levered or unlevered. The tax savings due to interest, τIt, are

discounted at the before-tax borrowing rate, i, as in equation 8b. It is suggested that the tax

savings due to risky than operating cash flows if tax laws are not likely to change radically over

the economic life of the project.

The APV model is useful for a domestic firm analyzing a domestic capital expenditure. If APV ≥

0, the project should be accepted. If APV < 0, the project should be rejected. Thus, the model is

useful for a MNC for analyzing one of its domestic capital expenditures or for a foreign

subsidiary of the MNC analyzing a proposed capital expenditure from the subsidiary’s

viewpoint.

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