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LECTURE NOTES
INTERNATIONAL FINANCIAL
MANAGEMENT
MBA IV SEMESTER

Prepared by
Mr
...

IFM, International Business Methods, recent changes and challenges in international financial
management
...
1 An Overview of International Finance Management (IFM)
International financial management is also known as ‗international finance‘
...
Assets in the financial aspect are
considered not just as money, but money as the capital, i
...
the value that brings added value (profit)
...
So, finance is the monetary capital, money flow, serving
the circulation of capital
...

The definition of international finance is the combination of monetary relations that develop in process
of economic agreements - trade, foreign exchange, investment - between residents of the country and
residents of foreign countries
...

When a firm operates in the domestic market, both for procuring inputs as well as selling its output, it
needs to deal only in the domestic currency
...
On
this regards, as different nations have different currencies, dealing with the currencies becomes a
problem-variability in exchange rates have a profound effect on the cost, sales and profits of the firm
...


1
...
1 TRANSFER PRICING
It is determination of exchange price when different business units within a firm exchange the products
and services
Definition: As per section 92 (1) of the Income Tax Act, 1961 – Income from an international transaction
shall be computed having regard to the Arm‘s length Price (correct market price)
...
One party transfers to another, goods or
services, for a price
...

Uses of Transfer Pricing
When product is transferred between profit centers or investment centers within a decentralized firm,
transfer prices are necessary to calculate divisional profits, which then affect divisional performance

2

evaluation
...
When
multinational firms transfer product across international borders, transfer prices are relevant in the
calculation of income taxes, and are sometimes relevant in connection with other international trade and
regulatory issues
...

 the price at which an enterprise transfers goods and services, intangible and intangible assets,
services or lending/ borrowing money to associated enterprises
...

Transfer Pricing in Multinational Companies
Internal auditors play key roles in multinational corporations, including providing valuable input
regarding effectiveness of business operations
...
International transfer pricing is
a major issue for multinational corporations, as transfer pricing is a key element in corporate taxation
strategies
...
Transfer pricing, if done correctly, can improve the overall success and value of an
international company
...
The transfer pricing problem for multinationals is of great significance
...
So, it becomes desirable from the view point of overall
corporate strategy to show higher profits in low-tax countries and lower profits in high-tax countries
...

The resale price method begins with the price at which a product is resold to an independent enterprise
(IE) by an associate enterprise
...
1000 (profit: 300)
...
2000 (profit of Rs
...
Arms length price = 2000 - 500 = 1500
...
1
...
1 Reason for growth in international business
International business has growth dramatically in recent years because of strategic imperatives and
environmental changes
...
Although strategic imperatives indicate why firms wish to
internationalize their operations, significant changes in the political and technical environment have
facilitated the explosive growth in international business activity that has since World War 2
...

There are many reasons why international business is growing at such a rapid pace
...
For example in Japan, 95% of people have all types of electronic
appliances and there is no growth of organization there, as a result they have to look out for new markets
overseas
...
Organizations have great opportunities to boost their sales and profits by selling
their products in these markets
...

Availability of Low Cost Labor
When we compare labor cost in developed countries with respect to developing countries they are very
high
...
This leads to lower
production cost for the organization and increased profits
...
International companies are using overseas market entry as a counter measure to increase
competition
...
This is one of the reasons why
international business is developing at a rapid pace
...
This has stimulated
cross border trade between countries and opened markets that were previously unavailable for
international companies
...

Adding to this is the reducing cost of transport and improved efficiency has also led to expansion of
business
...
This has
led to consumers demanding new and better goods and services
...

Global Competition
More companies operate internationally because
–
New products quickly become known globally
–
Companies can produce in different countries
–
Domestic companies, competitors, suppliers have becomes international
As international companies venture into foreign markets, these companies will need managers and other
personals who understand and are exposed to the concepts and practices that govern international
companies
...


1
...
1
...

For the long-term survival of a multinational firm, it is important that interdivisional profitability is
measured accurately
...

For correct profitability, the firm should be sure that interdivisional transfer prices are the prices that
would have been paid had the transactions been with independent companies, so-called ‗arm‘s length
process‘
...

Profit allocations will usually be according to the distribution of corporate sales, with the sales valued at
the ―correct‖ exchange rate
...
2 Importance of IFM
All the major economic functions-consumption, production and investment-are highly globalized
...
Proper management of international finances can help the organization in achieving same
efficiency and effectiveness in all markets
...


5

Six aspects provide importance to IFM
i)
ii)
iii)
iv)
v)
vi)

Specialization of some goods and services
Opening of new economies
Globalization of firms
Emergence of new form of business
Growth of world trade
Development process of Nations

1
...

The treasurer is responsible for financial planning analysis, fund acquisition, investment financing, cash
management, investment decision and risk management
...

Multinational finance is multidisciplinary in nature
...

Because of changing nature of environment at international level, the knowledge of latest changes in
forex rates, volatility in capital market, interest rate fluctuations, macro level changes, micro level
economic indicators, savings, consumption pattern, interest preference, investment behavior of investors,
export and import trends, competition, banking sector performance, inflationary trends, demand and
supply conditions etc
...

Nature of the financial Management





IFM is concerned with financial decisions taken in international business
...

IFM set the standard for international tax planning and international accounting
IFM includes management of exchange rate risk
...


Scope of IFM includes







Foreign exchange markets, international accounting, exchange rate risk management etc
...

IFM sorts out the issues relating to FDI and foreign portfolio investment
...

It manages the changes in the foreign exchange market
...


6





Investment and financing across the nations widen the scope of IFM to international accounting
standards
...

It helps in taking decisions related to international business
...
4 International Financial Management Different From Financial Management At Domestic Level
The important distinguishing features of international finance from domestic financial management are
discussed below:

1
...
1 Foreign exchange risk
An understanding of foreign exchange risk is essential for managers and investors in the modern day
environment of unforeseen changes in foreign exchange rates
...
When different national currencies are exchanged for each other, there is a definite risk of
volatility in foreign exchange rates
...

In fact, this variability of exchange rates is widely regarded as the most serious international financial
problem facing corporate managers and policy makers
...
Exchange rates have fluctuated
since the 1970s after the fixed exchange rates were abandoned
...

Thus, changes in the exchange rates of foreign currencies results in foreign exchange risks
...
4
...
Political risk ranges from
the risk of loss (or gain) from unforeseen government actions or other events of a political character such
as acts of terrorism to outright expropriation of assets held by foreigners
...
MNCs must assess the political risk not only in
countries where it is currently doing business but also where it expects to establish subsidiaries
...

Example: In 1992, Enron Development Corporation, a subsidiary of a Houston based Energy Company,
signed a contract to build India‘s longest power plant
...
The company had
spent nearly $ 300 million on the project
...

Thus, political risk associated with international operations is generally greater than that associated with
domestic operations and is generally more complicated
...
4
...

They can raise funds in capital markets where cost of capital is the lowest
...


1
...
4 Market imperfections
The final feature of international finance that distinguishes it from domestic finance is that world markets
today are highly imperfect
...
Imperfections in the world financial markets tend to restrict
the extent to which investors can diversify their portfolio
...


1
...
5 Tax and Legal system
Tax and legal system varies from one country to another country and this leads to complexity in their
financial implications and hence give rise to tax and legal risks
...
4
...
Higher inflation rates in few countries denote inflation
risks
...
5 Major turmoil influencing International financial Market
Frictions on International financial market can be in the form of

1
...
1 Government controls
With the help of different controlling procedures, government tries to control international financial flows
like maintaining the multiple exchange rates, taxes on international flows and constructs on outflow of
funds
...
5
...


1
...
3 Implicit and explicit transaction costs
Trading fees/commission, bid ark speared is a form of Implicit and explicit transaction which affects the
International financial market
...
Transactions costs per unit decreases when the size of transaction is large
...


1
...
Exporting
2
...
Franchising
4
...
6
...
Exporting means selling
abroad, either directly to target customers or indirectly by retaining foreign sales agents or/and
distributors
...

Exporting is the practice of shipping goods from the domestic country to a foreign country
...
In national accounts ―exports‖ consist of transactions in goods and services (sales, barter, gifts or
grants) from residents to non-residents
...
An export‘s counterpart is an import
...
Export of commercial quantities of goods normally requires the involvement of customs
authorities in both the country of export and the country of import
...
If a country applies the general trade system,
all goods entering or leaving the country are recorded
...
6
...
In case of international licensing,
there is an agreement whereby a firm, called licensor, grants a foreign firm the right to use intangible
(intellectual) property for a specific period of time, usually in return for a royalty
...
The Indian basmati (rice) is one such example
...

Compared to the other potential entry models for foreign market entry, licensing is relatively low risk in
terms of time, resources, and capital requirements
...

Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign
market, and lower returns due to lower risk
...

A ‗licensor‘ in a licensing relationship is the owner of the produce, service, brand or technology being
licensed
...

A licensor (i
...
the firm with the technology or brand) can provide their products, services, brand and/or
technology to a licensee via an agreement
...
This is potentially a strong win-win
arrangement for both parties, and is a relatively common practice in international business
...
In order to circumvent this strategic barrier,
the licensor finds a local sports drink manufacturer to license their recipe to
...

Licenses are signed for a variety of time periods
...
The
license will make all necessary capital investment such as machinery inventory and so on and market the
products in the assigned sales territories, which may consist of one or more countries
...

The Pros and Cons
Before deciding to use licensing as an entry strategy, it‘s important to understand in which situations
licensing is best suited
...

Licensing is low risk in terms of assets and capital investment
...

Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry
...
Licensing provides
critical resources in this regard, as the licensee has local contacts, mastery of local language, and a deep
understanding of the local market
...
Particularly
relevant is the licensing of a brand name, as any quality control issue on behalf of the licensee will impact
the licensor‘s parent brand
...
Just
like investing in an organization in the stock market, licensing requires due diligence regarding which
organization to partner with
...
(Lower risk,
lower returns
...
6
...
Franchising is an option in which a
parent company grants another company/firm the right to do business in a prescribed manner
...
And a ‗franchiser‘ is a person
who grants franchises
...
Further, licensing tends to be confined to
manufacturers, whereas franchising is more popular with service firms such as restaurants, hotels and
rental services
...
g
...
In exchange, the

10

franchisee will pay a certain percentage of the profits of the venture back to the franchiser
...

Franchising business is very important to companies here and abroad
...
, Coca-Cola, Wimpey‘s Domino, McDonald, and
Nirula
...

Franchising enables organizations a low cost and localized strategy to expanding to international markets,
while offering local entrepreneurs the opportunity to run an established business
...

Franchising is designed to enable large organizations rapid access to new markets with relatively low
barriers to entry
...

Disadvantages of franchising (for the franchiser) include loss of some organizational and brand control,
as well as relatively lower returns than other strategic entry models (with lower risk)
...
For the franchiser,
international expansion can be both complex and expensive, particularly when the purchase of land and
building of facilities is necessary
...

Localization
Franchising also allows for localization of the brand, products, and distribution systems
...
This high level of integration into the new location can create significant advantages compared
to other entry models, with much lower risk
...
Franchising requires very little capital investment on behalf of the parent company, and the time
and effort of building the stores are similar outsources to the franchisee
...

Downsides to Franchising
Franchising has some weaknesses as well, from a strategic point of view
...
Quality assurance and protection of the brand is much more
difficult when ownership of the franchise is external to the organization itself
...
g
...

It is also of importance to keep the risk/return ratio in mind
...
While it is a faster and cheaper mode of entry, it ultimately results in a profit share
between the franchiser and the franchisee
...
6
...

Companies aspiring to take full advantage of opportunities offered by foreign markets decide to make a
substantial direct investment of their own funds in another country
...

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other
privileges in that foreign country
...
FDI can help the
economic situations of developing countries, as well as facilitate progressive internal policy reforms
...

Foreign direct investment (FDI) is investment into production in a country by a company located in
another country, either by buying a company in the target country or by expanding operations of an
existing business in that country
...
FDI is in contrast to portfolio investment which is a
passive investment in the securities of another country, such as stocks and bonds
...
However, identifying the
conditions that best attract such investment flow is difficult, since foreign investment varies greatly across
countries and over time
...

Foreign direct investment refers to operations in one country that are controlled by entities in a foreign
country
...
In India, a foreign direct
investment means acquiring control by more than 74% of the operation
...

There are two forms of direct foreign investment: joint ventures and wholly-owned subsidiaries
...
In contrast, a wholly-owned
subsidiary is owned 100% by the foreign firm
...
6
...
They exercise control over the enterprise and consequently share revenues, expenses
and assets
...
In this scenario, both parties are equally invested in the project in terms of
money, time and effort to build on the original concept
...
A joint venture can ensure the success of smaller projects
for those that are just starting in the business world or for established corporations
...


12

Since money is involved in a joint venture, it is necessary to have a strategic plan in place
...
Ultimately, short term and long term successes are both important
...

A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological
expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time
contracts
...
Some major joint ventures include Dow
Corning, Miller Coors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning
...
7 Recent Changes and Challenges in IFM
1
...
1 Challenges in IFM
Financial management of a company is a complex process, involving its own methods and procedures
...
The integration is both across countries as
well as markets
...

Managers of international firms have to understand the environment in which they function if they are to
achieve their objective in maximizing the value of their firms, or the rate of return from foreign
operations
...

The foreign exchange market, which consists of multinational banks, foreign exchange dealers, and
organized exchanges where currency futures are regularly traded
...
Understanding of the host country‘s environment is crucial
for successful operation and essential for the assessment of the political risk
...
The challenges are the
unique risks and variables the manager has to contend with which his or her domestic counterpart does
not have to worry about
...
But this same challenge presents
the manager with opportunities to reduce the firm‘s overall tax burden, through transfer of funds from
high- to low-tax affiliates and by using tax havens
...
The manager has to worry about the foreign exchange and
political risks in positioning funds and in mobilizing cash resources
...


1
...
2 Recent changes in IFM
Emergence of Euro market in 1960‘s the major cause for development and growth of IFM
...

International financial markets have undergone rapid and extensive changes in the recent past
...

o Remarkable developments in stock prices around the world, and in particular in stocks in the
telecommunications and internet sectors
...
stocks", which
experienced sharp price increases in late 1999 and early 2000
...
This period saw emergence of new financial
instruments, securities, methods of settlement and persons involved in the market
...
7
...
1 Emergence of Euro market
In 1960‘s this is the major cause for development and growth of IFM
This market resulted in
 A series of parallel money markets free from regulations
...
7
...
2 Introduction of Floating Exchange Rate
Introduced in 1973, another important change, which resulted in volatility
...
To manage risk new institutions and products emerged like
futures, swaps, options etc
...
compelled them to introduce new products and services, which often the banks themselves
cannot understood

1
...
2
...
Integration resulted in
 Reducing the gap between local, regional, national and offshore financial markets led to the
creation of a unified, globalised financial markets
 Increasing the rate of growth of financial systems than that of production
 Establishment of branches of banks and financial institutions of developed and industrial
countries in other countries
 Establishment of branch banks in different countries and permission to tap the national financial
markets
 Integration among the financial markets of industrialized countries like US, Japan and Europe
 Resulted in reducing the gap between the financial markets of different advanced countries

14

1
...
2
...
Financial institutions
were divided as commercial banks, investment banks, EXIM banks etc
...

Thus recently, there is a spatial and functional integration
Major reasons for these changes are
 Liberalization in cross boarder financial transaction
 Deregulation within the financial system of the major industrialized nations
Major liberalization steps include:
 Lifting exchange controls in UK, France and Japan (other nations like US, Germany, Switzerland
etc, which were already liberalized)
 Removal of tax on interest paid for non-resident
 Opening up of domestic financial markets to foreign borrowers
 Allowing domestic borrowers to borrow from foreign markets

1
...
2
...

This helped the borrower in borrowing funds economically from different parts of the world at
competitive level, minimizing all costs
...

Emergence of international financial markets stock markets etc
...
Another remarkable change was in the field of securitization and disintermediation
...

Borrowers began to borrow directly by issuing new variety of securities like depository receipt etc
...

Underwriting commission, brokerage etc reduced and the hegemony of US financial institutions also
reduced
...


1
...
2
...
Rapid advances in technology, financial engineering, and risk
management are major reasons
...

Increased use of derivatives to adjust exposure to risk in financial markets has also contributed to the rise
in speculation in securities
...

Derivatives also provide scope for a more efficient allocation of risks in the economy, which is beneficial
for the functioning of financial markets, and hence enhances the conditions for economic growth
...
7
...
7 Launch of Euro
Euro launched in 1st January 1999 was a historic event
...
This marked the start of a period of profound change in Europe's financial
settings
...
This process of integration in
European financial markets coincided with the trend towards globalization
Matters of Concern
Liberalization and globalization still continue imposing more and more changes and creating more and
more challenges
Still some countries and governments indirectly control the flow capital through taxes and other kinds of
regulations
Excessive speculation, hoarding and profiteering in the international financial market is rampant
Greedy nature of operations have resulted in the collapse several well-known financial institutions and
several such institutions have to be rescued by the government
Conclusion
Unprecedented development in international financial markets
Due to the liberalization of markets, rapid technological progress and major advances in
telecommunications
This has opened new vistas for investment and financing opportunities for businesses and people around
the world, and easier access to global financial markets for individuals and corporations
This has led to a more efficient allocation of capital, paving way to economic growth and prosperity
...
8 Theories of International Business
International trade is the exchange of capital, goods, and services across international borders or
territories
...

To understand the pattern in international trade, different trade theories are postulated
...
Mercantilism
2
...
Comparative Advantage Theory
4
...
Product Life Cycle Theory
6
...
7
...


1
...
1 Theory of Mercantilism:
Mercantilism is an economic theory that advocates government regulation of international trade to
generate wealth and strengthen national power
...
It funds corporate, military, and national growth
...
It advocates trade policies that protect domestic industries
...
The four
factors are entrepreneurship, capital goods, natural resources, and labor
...
It imposes tariffs on imports
...
It doesn't allow anything that could help foreign
companies
...
Its taxes pay for
increase national growth and political power
...
Countries wanted to export
more than they imported
...
It powered the evolution of nation-states out of the
ashes of feudalism
...

These countries created skilled labor forces and armed forces
...
They strengthened the need
for a self-governing nation to protect business rights
...

Mercantilism depended upon colonialism
...
Businesses would exploit the natural and human resources
...

Mercantilism also worked hand-in-hand with the gold standard
...
The nations with the most gold were the richest
...
They also funded wars against other nations who wanted to exploit them
...

Mercantilism relied upon shipping
...

Countries developed strong merchant marines
...
England
required all trade to be carried out in its vessels
...

Mercantilism which stresses government regulation
...

The End of Mercantilism
Democracy and free trade destroyed mercantilism in the late 1700s
...
They endorsed capitalism
...
" He argued that
foreign trade strengthens the economies of both countries
...
He also explained that a government which put business ahead of
its people would not last
...

In 1791, mercantilism was breaking down, but free trade hadn't yet developed
...
U
...
Treasury Secretary Alexander Hamilton was a
proponent of mercantilism
...
The industries needed government support until they were strong enough to defend
themselves
...

The Rise of Neomercantilism
World War II's devastation scared Allied nations into desiring global cooperation
...
They saw mercantilism as dangerous and
globalization as its salvation
...
The Soviet Union and China continued to promote a form of mercantilism
...
Over time, they sold many stateowned companies to private owners
...

Neomercantilism fit in well with their communist governments
...
It allowed them to regulate foreign trade
...
Their leaders selected which industries to promote
...
For example, China bought U
...
Treasurys to
fuel its trade with the United States
...
S
...

China and Russia planned for rapid economic growth
...

Drawbacks of Mercantilism theory or Neo-Mercantilism theory
1
...
Restrictions on free trade decreases country‘s wealth
3
...

4
...
Colonial Exploitation

1
...
2 Global Strategic Rivalry Theory
Global strategic rivalry theory developed by Paul Krugman & Kelvin Lancaster in 1980 to examine the
impact on trade flows arising from global strategic rivalry between MNCs
...

According to the theory, a new firm needs to optimize a few factors that will guide the brand in
overcoming all the barriers to achievement and gaining a significant appreciation in that international
market
...
Whereas,
having the total ownership rights of rational properties is also essential
...

1
...
2
...
It is done by brand name, trademark, patent/copy right, unique formula etc
...
8
...
2 Investing in R&D
It is the process of gaining competitive advantage by R&D techniques
...
8
...
3 Achieving economic of scale or scope
At the time of international trade, the production increased
...

1
...
2
...
Very often firms recruit
experienced people for their need
...
These
decisions influence both international trade and international investment
...
Some of the ways are by ownership or patenting of rational property rights, channeling
money into research and development, the exceptional procedure of the experience curve and
development of their business to international business or economics
...

1
...
3 Theory Of Absolute Cost Advantage
Adam Smith propounded the theory of absolute cost advantage as the basis of foreign trade; under such
circumstances an exchange of goods will take place only if each of the two countries can produce one
commodity at an absolutely lower production cost than the other country
...
Smith also stated that the wealth of nations depends upon the goods and services available to
their citizens, rather than their gold reserves
...
Comparative advantage focuses on the range of
possible mutually beneficial exchanges
...
Trade is between two countries
2
...
Free Trade exists between the countries
4
...
Theory is based upon principle of division of labour
...
Free Trade among countries can increase a country‘s wealth
3
...

4
...

5
...

Suppose, there are two countries I & II and two commodities A and B
...
Now country I has absolute cost
advantage in tin- production of (A) and it will confine itself to the production of (A) and country II in the
production of (B)
...
We speak
of an absolute- differences in costs because each country can produce one commodity at an absolutely
lower cost them the other
...

Absolute Cost Advantage
1
...

2
...
Economies of Scale: It helps to reduce the labour cost per unit of output
Natural Advantage
1
...
Climatic Conditions
Example: A
...

B
...
USA - Production of wheat
Aquired Advantage
1
...
Skills
Example: Japan - Advantages in steel production through imports of steel & coal England - Production of
Textiles France - Production of Wine
Absolute Advantage Theory: Significance
1
...
Increased standard of living for both countries
3
...
Increase in global efficiency and effectiveness
5
...

 It also assumes that labor can switch between products easily and they will work with same
efficiency which in reality cannot happen
...
Indian BOP trends
...


2
...
These transactions include payments for the country's exports and
imports of goods, services, financial capital, and financial transfers
...
The three main categories are: (a) The Current Account: Under this are included imports and
exports of goods and services and uni-lateral transfers of goods and services
...
(c) The Reserve Account: In principle this is no different from the capital account in as much as
it also relates to financial assets and liabilities
...

The IMF definition: The International Monetary Fund (IMF) use a particular set of definitions for the
BOP accounts, which is also used by the Organization for Economic Cooperation and Development
(OECD), and the United Nations System of National Accounts (SNA)
...
The IMF uses the term capital account to
designate a subset of transactions that, according to other usage, form a small part of the overall capital
account
...
Expressed with the IMF definition, the BOP identity can be written:
Current account financial account capital account balancing item=0
...
1
...
1
...
1 Current Account transactions
The Current accounts records the transaction in merchandise and invisibles with the rest of the world
...
The current account mainly consists of 4 types of transactions
...
Imports of
goods are debits (-) to the current account
...

Imports of services are debits (-) to the current account
...
S
...
Interest,
dividends and payments made on foreign assets held in the U
...
are debits (-)
...
S
...
S
...

Current transfers
Remittances by Americans working abroad, pensions paid by foreign countries to their citizens living in
the U
...
, aid offered by foreigners to the U
...
count as credits (+)
...
S
...
S
...
S
...

The sum of these components is known as the current account balance
...
As expected, given that it
runs a surplus only in the services component of the current account, the U
...
runs a substantial current
account deficit
...
1
...
The
transaction under the Capital account is classified as:
 Foreign Investment
 Loans
 Banking Capital
 Rupee debt services
 Other debt capital
Loans include the concessional loans received by the government‘ or public sector bodies , long term loan
and medium term borrowings from the commercial capital market in the form of loans Bond issue and
short term credits
...
An decrease in assets and increase in liability is a credit item
...


2
...
3 Factors affecting the components of BOP account
Exports of goods and services affected by following factors
 The prevailing rate of domestic currency
 Inflation rate
 Income of foreigners
 World price of the commodity

22



Trade barriers
...
1 Factors affecting the international financial Market
i)

Cost of Labor: Firms in countries where labor costs are low commonly have an advantage when
competing globally, especially in labor intensive industries
ii) Inflation: Current account decreases if inflation increases relative to trade partners
...

iv) Government Policies: can increase imports through:
v) Restrictions on imports
vi) Subsidies for exporters
 Lack of Restriction on piracy
 Environmental restrictions
 Labor laws
 Tax breaks
 Country security laws
vii) Exchange Rates: current account decreases if currency appreciates relative to other currencies
...
1
...
Quotas limit the volume of imports
...

iii) Restrictions on Piracy: A government can affect international trade flows by its lack of
restrictions on piracy
...

v) Labor Laws: countries with more restrictive laws will incur higher expenses for labor, other
factors being equal
...

vii) Tax Breaks: Though not necessarily a subsidy, but still a form of government financial support
that might benefit many firms that exports products
...

2
...
2 Impact of Exchange Rates
Effect of exchange rate on balance of trade deficit:

23

When a home currency is exchanged for a foreign currency to buy foreign goods, then the home currency
faces downward pressure, leading to increased foreign demand for the country‘s products
...


2
...
2
...
Established in 1946, it aims
 to promote international monetary cooperation and exchange stability;
 to foster economic growth and high levels of employment; and
 to provide temporary financial assistance to help ease imbalances of payments
...

Its operations involve surveillance, and financial and technical assistance
...
The IM F uses
a quota system, and its unit of account is the SDR (special drawing right)
...
2
...

It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and
ICSID
...
2
...

In particular, its structural adjustment loans are intended to enhance a country‘s long-term
economic growth
...
Nevertheless, it has earned a net income every
year since 1948
...


2
...
4 IDA: International Development Association




IDA was set up in 1960 as an agency that lends to the very poor developing nations on highly
concessional terms
...

IBRD and IDA are run on the same lines, sharing the same staff, headquarters and project
evaluation standards
...
2
...


2
...
6 MIGA: Multilateral Investment Guarantee Agency
The MIGA was created in 1988 to promote FDI in emerging economies, by
 offering political risk insurance to investors and lenders; and
 Helping developing countries attract and retain private investment
...
2
...


2
...
8 World Trade Organization (WTO)




Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT)
...

At the heart of the WTO's multilateral trading system are its trade agreements
...


2
...
9 Bank for International Settlements (BIS)


Set up in 1930, the BIS is an international organization that fosters cooperation among central
banks and other agencies in pursuit of monetary and financial stability
...
‖
The BIS functions as:
 a forum for international monetary and financial cooperation;
 a bank for central banks;
 a center for monetary and economic research; and
 an agent or trustee in connection with international financial operations
...
2
...


25

2
...
Two decades of economic reforms and free trade opened
several opportunities that, of course, reflected in the balance of payments performance of the country
...
3
...
To understand the
complex procedure of international trading practices, it is pertinent to have a look at the historical
perspective of the financial and monetary system
...
e
...
To have an understanding of historical perspectives of international monetary system, firstly
one must have a knowledge of exchange rate regimes
...
The other version called "Gold Bullion Standard", where the basis of
money remained fixed gold but the authorities were ready to convert, at a fixed rate, the paper currency
issued by them into paper currency of another country which is operating in Gold
...
Three rules were followed with respect to this conversion:
• The authorities must fix some once-for-all conversion rate of paper money issued by them into gold
...

• The money supply should be tied with the amount of Gold reserves kept by authorities
...
In modern times
some economists and policy makers advocate this standard to continue because of its ability to control
excessive money supply
...
3
...
In 1931, England took its foot back which resulted in abolition of this
regime
...
This was termed as "beggar-thy-neighbour " policy
...

Allied nations held a conference in New Hampshire, the outcome of which gave birth to two new
institutions namely the International Monetary Fund (IMF) and the World Bank, (WB) and the system
was known as Bretton Woods System which prevailed during (1946-1971) (Bretton Woods, the place in
New Hampshire, where more than 40 nations met to hold a conference)
...
3
...
In Bretton
Woods modified form of Gold Exchange Standard was set up with the following characteristics :
• One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce of Gold
• Other members agreed to fix the parities of their currencies vis-àvis dollar with respect to permissible
central parity with one per cent (± 1%) fluctuation on either side
...

The mechanism of Bretton Woods can be understood with the help of the following illustration:
Suppose there is a supply curve SS and demand curve DD for Dollars
...
)

Suppose Indian residents start demanding American goods & services
...
And suppose US residents develop an interest in buying goods and services from India, it will
increase supply of dollars from America
...
10
...
The ± 1% limits are therefore Rs
...
10 (Upper
support and Rs
...
90 lower support)
...

Suppose demand curve shifts towards right due to a shift in preference of Indians towards buying
American goods and the market determined exchange rate would fall outside the band, in this situation,
Indian authorities will intervene and buy rupees and supply dollars to bring back the demand curve within
permissible band
...

There can be two consequences of this intervention
...
N
...

etc
...
Secondly, excessive supply of dollars from reserves may lead to exhaustion or
depletion of forex reserves, there by preventing all possibilities to borrow dollars from other countries or
IMF
...
US could buy goods and services from her own money
...
Though "Smithsonian
Agreement" also failed to resolve the crisis yet by 1973, the world moved to a system of floating rates
...

Post Bretton Woods Period (1971-1991)
Two major events took place in 1973-74 when oil prices were quadrupled by the Organisational of
Petroleum Exporting Countries (OPEC)
...
From 1977
to 1985, US dollar observed fluctuations in the oil prices which imposed on the countries to adopt a much
flexible regime i
...
a hybrid between fixed and floating regimes
...


2
...
4 Flexible exchange rate regime
The flexible exchange rate regime that replaced the Bretton Woods system was ratified by the Jamaica
Agreement
...
The Louvre Accord of 1987 marked the
inception of the managed-float system under which the G-7 countries would jointly intervene in the
foreign exchange market to correct over- or undervaluation of currencies
...
The
advent of a single European currency, which may eventually rival the US dollar as a global vehicle
currency, will have major implications for the European as well as world economy
...
Prior to World War II,
governments used to purchase and sell foreign and domestic currency in order to maintain a desirable
exchange rate, especially in accordance with each country‘s trade policy
...
In 1930, before a
new wave of flexible rate regimes started, prior to the war, over 50 countries were on the gold standard
...

In 1944, with the war almost over, international policy coordination was starting to make sense in
everybody‘s mind
...
It was not until 1973, when Bretton Woods completely
collapsed, that countries started to implement flexible exchange rate regimes
...
In other words, they are prices of foreign exchange determined by the market, that can rapidly
change due to supply and demand, and are not pegged nor controlled by central banks
...

Within this pure definition of flexible exchange rate, we can find two types of flexible exchange
rates: pure floating regimes and managed floating regimes
...

On the other hand, managed (also called dirty) floating regimes, are those flexible exchange rate regimes
where at least some official intervention happens
...
3
...
Floating rates offset the
differences in inflation rates so that other elements such as : wages, employment, output etc
...
Earlier experience revealed that the fixed rates did not efficiently work for longer periods
Criticism: Critics state that the system leads to uncertainty which discourages free trade
...

As Per Imf Survey On Floating Regime: Exchange rate volatility since early 1970s does not impede
world trade
...
The statement of critics that uncertainty in the
exchange rates, drives the investors in to speculation, is also not valid
...
Both fixed and floating regime has the same fault of
speculation
...
Keeping in view inflationary
trends, a no
...
Although history never offers a
convincing model for a system that will lead to long term exchange rate stability, it points outs 2 (two)
basic requirement: Credible system-System must have price stability build into its very core
...
3
...
3
...
1 Exchange arrangement with no separate legal tender
The members of a currency union share a common currency
...
As of 1999,
37 IMF member countries had this sort of exchange rate regime
...
3
...
2 Currency Board Agreement
In this regime, there is a legislative commitment to exchange domestic currency against a specified
currency at a fixed rate
...

2
...
6
...
Upto 1999, thirty
countries had pegged their currencies to a single currency while fourteen countries to a basket of
currencies
...
3
...
4 Pegged Exchange Rates Within Horizontal Bands
In this regime, the variation around a central parity is permitted within a wider band
...
Upto 1999, eight countries had this regime
...
3
...
5 Crawling Peg
Here also a currency is pegged to another currency or a basket of currencies but the peg is adjusted
periodically which may be pre-announced or discretion based or well specified criterion
...

2
...
6
...
Upto 1999, nine countries enjoyed this regime
...
3
...
7 Managed float
In this regime, central bank interferes in the foreign exchange market by buying and selling foreign
currencies against home currencies without any commitment or pronouncement
...

2
...
6
...
Including India, in 1999,
forty eight countries had this regime
...
That's why some analysts are calling is a monetary "non-system"
...
3
...
It
involves the coordination of economic and fiscal policies, a common monetary policy, and a common
currency, the euro
...
It was a way of creating an area of currency
stability throughout the European Community by encouraging countries to co-ordinate their monetary
policies
...
The Treaty of Maastricht laid down a set of criteria to be
met by member states if they were to qualify for the EMU
...
The Maastricht Treaty laid down the three-stage
process(First stage (1st Jul 1990) Second stage(1st Jan 1994) Third stage(1st Jan 1999)) in which EMU
was established
...

As well as the governments and central banks of the Member States, the Council, the European
Commission, the European Parliament and the European Central Bank all have roles to fulfill
...


31

UNIT –III
FOREIGN EXCHANGE MARKET
Function and Structure of the Forex markets, major participants, types of transactions and settlements
dates, foreign exchange quotations
...

Currency futures and options markets, overview of the other markets, Euro currency market, Euro credit
market,Euro bond market, international stock market
...
1 Foreign Exchange Market
Foreign exchange market is the market in which foreign currencies are bought and sold
...
Like
any other market, foreign exchange market is a system in which the transactions are not confined to only
one or few foreign currencies
...

The foreign exchange market assists international trade and investment by enabling currency conversion
...

The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global
decentralized trading of international currencies
...

3
...
2
...
e
...
This transfer of
purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank
draft and foreign bills
...

3
...
2Credit Function
It provides credit for foreign trade
...
Credit is required for this period in order to enable the importer to take
possession of goods, sell them and obtain money to pay off the bill
...
2
...
Hedging means the
avoidance of a foreign exchange risk
...
e
...
Under
this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims
or net liabilities which are to be met in foreign money
...
For this the exchange market provides facilities for hedging anticipated or actual claims or
liabilities through forward contracts in exchange
...
No money passes at the time of the contract
...
The existence of a forward market thus makes it possible to
hedge an exchange position
...
, are the important foreign exchange instruments used in the foreign exchange market to carry out its
functions
...

Thus, the foreign exchange market is merely a part of the money market in the financial centers
...
The buyers and sellers of claim on foreign money and
the intermediaries together constitute a foreign exchange market
...
Thus, the foreign exchange market is the market for a national currency (foreign
money) anywhere in the world, as the financial centers of the world are united in a single market
...
The most important among them are the banks
...

Through their branches and correspondents, the services of such banks, usually called ―Exchange Banks,‖
are available all over the world
...
3 Structure of the Foreign Exchange Market

33

3
...
1Retail Market
Transactions are exchange of currenct, bank draft, bank notes ordinary and traveller‘ s cheques etc
...
Retail banking is largely intra-bank: the bank itself
...
3
...
This is broadly classified as
inter-bank market and central bank market
...

3
...
2
...
The largest participants in this network are
private banks
...
The interbank market is not regulated
...
In
practice, it may take one or two days to settle transactions
...
The exchange rate
that prevails in the spot market for foreign exchange is called Spot Rate
...

It deals with transactions (sale and purchase of foreign exchange) which are contracted today but
implemented sometimes in future
...
Thus, forward rate is the rate at which a future contract for
foreign currency is made
...
Its value is "derived" from (or based upon) that of another asset, typically referred to as the
underlying asset or simply "the underlying
...
Common types of derivative contracts include options, forwards, futures and swaps
...
A futures contract (more colloquially, futures) is a standardized contract between two
parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon
today (the futures price or strike price) with delivery and payment occurring at a specified future date
...
The right
to sell a currency is known as a "call option" and the right to buy is known as a "put option
...


34



Swap Market: The idea of a swap by definition normally refers to a simple exchange of property or
assets between parties
...
That includes the exchange rate value of each currency and the interest rate
environment of the countries that have issued them
...


3
...
2
...
They try to control the
money supply, inflation, and/or interest rates and often have official or unofficial target rates for their
currencies
...
They
work as the lender of the last resort and the custodian of foreign exchange of the country
...
One of the major functions of the central bank is to prevent the aggressive fluctuations in
the foreign exchange market, if necessary, by direct intervention
...

The commercial banks are the second most important organ of the foreign exchange market
...
Also, they function as clearing
houses, thereby helping in wiping out the difference between the demand for and the supply of currencies
...

The foreign exchange brokers function as a link between the central bank and the commercial banks and
also between the actual buyers and commercial banks
...

These are the persons who do not themselves buy the foreign currency, but rather strike a deal between
the buyer and the seller on a commission basis
...
4 Market participates of foreign exchange Market
The foreign exchange market assists international trade and investment by enabling currency conversion
...

The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global
decentralized trading of international currencies
...
4
...
It is a bank that
lends money and provides transactional, savings, and money market accounts and that accepts time
deposit n order to facilitate international trade and development, commercial banks convert and trade
foreign currencies
...
While some of these revenues will be used to pay workers in that country and for
administrative expense such as office rent, utilities and supplies, the company may need to purchase
goods from a neighboring country in that country's currency, or convert cash to its native currency for
return to the home office
...
4
...
They try to control the
money supply, inflation, and/or interest rates and often have official or unofficial target rates for their
currencies
...

3
...
3 Foreign exchange fixing
Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country
...

Fixing exchange rates reflects the real value of equilibrium in the market
...


3
...
4 Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions are speculative
...
Hedge funds have
gained a reputation for aggressive currency speculation since 1996
...

3
...
5 Investment management firms
Investment management is the professional management of various securities (shares, bonds and other
securities) and assets (e
...
, real estate) in order to meet specified investment goals for the benefit of the
investors
...
4
...
Retail foreign exchange trading is a
small segment of the large foreign exchange market
...
5 Market rate Quotations-currency rate fluctuation
A currency pair is the quotation of the relative value of a currency unit against the unit of another
currency in the foreign exchange market
...
2500 means that 1 Euro is
exchanged for 1
...

Quotes using a country's home currency as the price currency (e
...
, EUR 0
...
00 in the
euro zone) are known as direct quotation or price quotation (from that country's perspective)[4] and are
used by most countries
...
g
...
00 =
USD 1
...

Fluctuation in the exchange rate
A market based exchange rate will change whenever the values of either of the two component currencies
change
...
It will become less valuable whenever demand is less than available supply (this does
not mean people no longer want money, it just means they prefer holding their wealth in some other form,
possibly another currency)
...
6 Types of transactions & settlements in FOREX Market
The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies
...

3
...
1 Spot Transaction
The spot transaction is when the buyer and seller of different currencies settle their payments within the
two days of the deal
...
Here, the currencies are exchanged
over a two-day period, which means no contract is signed between the countries
...
This rate is often the prevailing
exchange rate
...

3
...
2 Forward Transaction
A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale
and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future
...
The market in which
the deals for the sale and purchase of currency at some future date are made is called a ‗Forward Market‘
...
But however, the transactions made
in a future contract differ from the transaction made in the forward contract on the following grounds:
 The forward contracts can be customized on the client‘s request, while the future contracts
are standardized such as the features, date, and the size of the contracts is standardized
...

 No margin is required in case of the forward contracts, while the margins are required of all the
participants and an initial margin is kept as collateral so as to establish the future position
...
6
...
Here one investor borrows the currency and lends another currency to the second
investor
...
The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off
the obligations denominated in a different currency without suffering a foreign exchange risk
...

An option to buy the currency is called as a ‗Call Option‘ while the option to sell the currency is called as
a ‗Put Option‘
...

3
...
4 Settlement dates
Settlement date, as the name implies refers to the date on which the transaction is settled by the transferor
of deposits, with reference to foreign exchange transactions
...

Though the spot rate is the rate of the day on which the transaction has taken place, the execution of the
transaction occurs within a maximum of two working days
...
There are two aspects involved in settlement dates: the settlement
location and dealing location
...

Forward exchange rates are applicable for the delivery of foreign exchange at some future date, which
may be specified
...
Let us assume that Emirates in
UAE is purchasing aircrafts from the United States
...
Suppose if the agreement between the two countries is to settle the payment after 2 months time,
there are now two options available for Emirates, UAE: one, to remain silent now and after 2 months
period, buy the US Dollars at the spot market at the then prevailing spot rate and settle the payment to the
United States
...
Secondly, the
country can buy US dollars at the forward exchange market at the agreed prevailing forward exchange
rate, which would be valid for settlement after two months period, irrespective of the spot rate prevailing
at the time of settlement after two months
...

3
...
Direct quotation is when the
one unit of foreign currency is expressed in terms of domestic currency
...

Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are expressed
against the US dollar
...

Now, a lower exchange rate in a direct quote implies that the domestic currency is appreciating in value
...
8 Currency futures and options markets
3
...
1 Exchange-traded derivative
option, the arithmetic average of the Exchange-traded derivative contract are standardized derivative
contracts such as futures and options contracts that are transacted on an organized futures exchange
...
Since the
contracts are standardized, accurate pricing models are often available
...

3
...
2 Over the Counter derivatives
Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation) without going
through an exchange or any other intermediaries
...
These are also known as unlisted stocks where the securities
are traded by broker-dealers through direct negotiations
...
8
...
For
this right, a premium is paid to the seller
...

 Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a
specified price (the strike price), for a certain period of time
...
Investors buy calls when they
think the share price of the underlying security will rise or sell a call if they think it will fall
...

 Put options give the holder the right to sell an underlying asset at a specified price (the strike price)
...
Put options can
be exercised at any time before the option expires
...
Put buyers - those who hold a "long"
- put are either speculative buyers looking for leverage or "insurance" buyers who want to protect
their long positions in a stock for the period of time covered by the option
...
An American style option allows investors to
capture profit as soon as the stock price moves favorably
...
In
other words, if the underlying security such as a stock has moved in price an investor would not be
able to exercise the option early and take delivery of or sell the shares
...

 Asian option (also known as average price option) is an option whose payoff is determined with
respect to the (arithmetic or geometric) average price of the underlying asset over the term of the
option
...
e
...
e
...

 There are two types of Asian options with respect to the method of averaging: in arithmetic Asian
price of the underlying is used in payoff calculations; while in geometric Asian options, geometric
average is used
...
They are used by traders
who are exposed to the underlying asset over a period of time such as consumers and suppliers of
commodities, etc
...
8
...
For example,
imagine ABC Co
...
3% (or 130 basis points)
...
5% and ABC management is anxious about an interest rate rise
...
As this example suggests, commodity swaps most
commonly involve crude oil
...
Unlike an interest rate swap, the principal is not a notional amount, but it is exchanged along
with interest obligations
...
For example, China has used
swaps with Argentina, helping the latter stabilize its foreign reserves
...
S
...

Debt-Equity Swaps
A debt-equity swap involves the exchange of debt for equity – in the case of a publicly-traded company,
this would mean bonds for stocks
...

Total Return Swaps
In a total return swap, the total return from an asset is exchanged for a fixed interest rate
...
For example, an investor
could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool
of stocks
...
Excessive leverage and poor risk management in
the CDS market were primary causes of the 2008 financial crisis
...
9 Features of Futures Contracts-Foreign Exchange
This article throws light upon the six major features of futures contracts
...
Organized
Exchanges 2
...
Clearing House 4
...
Marking to Market 6
...

3
...
1 Organized Exchanges
Unlike forward contracts which are traded in an over-the-counter market, futures are traded on organized
exchanges with a designated physical location where trading takes place
...

3
...
2 Standardization
In the case of forward currency contracts, the amount of commodity to be delivered and the maturity date
are negotiated between the buyer and seller and can be tailor-made to buyer‘s requirements
...
thus, for instance,
one futures contract in pound sterling on the International Monetary Market (IMM), a financial futures
exchange in the US, (part of the Chicago Board of Trade or CBT), calls for delivery of 62,500 British
Pounds and contracts are always traded in whole numbers, i
...
, you cannot buy or sell fractional contracts
...

The exchange also specifies the minimum size of price movement (called the ―tick‖) and, in some cases,
may also impose a ceiling on the maximum price change within a day
...


40

3
...
3 Clearing House
The exchange acts as a clearing house to all contracts struck on the trading floor
...
Upon entering into the records of the exchange, this is immediately replaced
by two contracts, one between A and the clearing house and another between B and the clearing house
...
The advantage of this is that A and B do not have to undertake any exercise to
investigate each other‘s creditworthiness
...
The
exchange enforces delivery for contracts held until maturity and protects itself from default risk by
imposing margin requirements on traders and enforcing this through a system called ―marking to market‖
...
9
...
Others can
use the services of the members as brokers to use this instrument
...
A subset of the members is the ―clearing members‖ or
members of the clearing house and non- clearing members must clear all their transactions through a
clearing member
...
The amount of the margin is generally between 2
...
A member acting on behalf of a client, in turn, requires a margin from the client
...

3
...
5 Marking to Market
The exchange uses a system called marking to market where, at the end of each trading session, all
outstanding contracts are reprised at the settlement price of that trading session
...
The exchange adjusts this by
debiting the margin accounts of those members who made a loss and crediting the accounts of those
members who have gained
...
In a forward contract, gains or losses arise only on maturity
...

Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the
accruals is different
...

3
...
6 Actual Delivery is Rare
In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer
...

In contrast to this, in most futures markets, actual delivery takes place in less than one per cent of the
contracts traded
...
To achieve this,
most of the contracts entered into are nullified by a matching contract in the opposite direction before
maturity of the first
...
10
Forward Contract Vs Future Contract
BASIS
FOR FORWARD CONTRACT
COMPARISON
Meaning
Forward Contract is an agreement
between parties to buy and sell the
underlying asset at a specified date and
agreed rate in future
...

Traded on
Over the counter, i
...
there is no
secondary market
...

Risk
High
Default
As they are private agreement, the
chances of default are relatively high
...

Collateral
Not required
Maturity
As per the terms of contract
...
11

FUTURES CONTRACT
A contract in which the parties agree to
exchange the asset for cash at a fixed
price and at a future specified date, is
known as future contract
...

Organized stock exchange
...

Low
No such probability
...

Predetermined date
By stock exchange
High

Over view of the other markets
3
...
1 The International Money Market
The international money market is a market where international currency transactions between numerous
central banks of countries are carried on
...
The basic operations of the international money market include the money borrowed or
lent by the governments or the large financial institutions
...
The international money market‘s major responsibility is to handle the currency
trading between the countries
...

Unlike share markets, the international money market sees very large funds transfer
...
The international money market
investments are less risky and consequently, the returns obtained from the investments are less too
...

Features of International Money Market
 It is a wholesale market, as the transaction volume is large
...

 Participants include banks, mutual funds, investment institutions and Central Banks
...

 Money market operations focus on a particular area, which serves a region or an area
...


42



There are five major segments of money market which are Certificate of Deposits (CD), Commercial
Paper, Swaps, Repo and Government treasury securities
...

 It provides a centre for the intervention of central bank, for controlling liquidity and general interest
rate level
...

Money market plays a vital role in equating the short term liquidity imbalances within the country
...


3
...
2 Euro currency market
Europeans wished to hold their assets outside their own country or in currencies which is not locally
denominated
...
Dollar denominated, Euro bonds
were designed to address these issues
...
Hence, there was no ownership and no tax withheld
...
But later on expanded fast to the
countries like Honk Kong and Singapore in the far East-at present more than half of the transactions in the
Euro markets take place outside the Europe
...
‗Foreign Currency Market‘ would be the
appropriate term to describe this expanding market
...

Despite the emergence of other currencies and the expansion of the market to other areas, Europe and the
dollar still hold the key to the market
...

Now, the ‗Eurodollar Market‘ consists of Asian dollar market, Rio dollar market, Euro- yen market, etc
...
In
short, in these markets, the commercial banks accept interest bearing deposits denominated in a currency
other than the currency of the country in which they operate and they re-lend these funds either in the
same currency or in the currency of the country in which they operate or in the currency of a third
country
...
‖
The Important Characteristics of the Eurocurrency market are the following:
i) It is an International Market and it is under no National Control:
The Eurocurrency market has emerged as the most important channel for mobilizing and deploying funds
on an international scale
...
―It is aptly said that the dollar deposits in London are outside United States
control because they are in London and outside British control because they are in dollars
...


43

ii) It is a Short-Term Money Market:
The deposits in this market range in maturity from one day to several months and interest are paid on all
of them
...
The Eurodollar market is viewed in most discussions more as a
credit market- a market in dollar bank loans-and as an important accessory to the Eurobond market
...
The Eurobonds developed out of
the Eurodollar market to provide longer-term loans than was usual with Eurodollars
...


3
...
3 Euro credit market
Euro credit helps the flow of capital between countries and the financing of investments at home and
abroad
...
Being able to do this internationally, both across borders and across
currencies improves both liquidity and efficiency in the markets for financing
...
Syndicated loans reduce the risk of borrower default for each individual bank
loaning funds and are often found where the size of the loan is too big for one bank to do by itself
...


3
...
4 Euro bond market
A Eurobond is debt instrument that's denominated in a currency other than the home currency of the
country or market in which it is issued
...
Since Eurobonds are issued in an
external currency, they're often called external bonds
...

Issue of Eurobonds is usually handled by an international syndicate of financial institutions on behalf of
the borrower, one of which may underwrite the bond, thus guaranteeing the purchase of the entire issue
...
It underwrites and sells by a national underwriting syndicate
in the lending country
...

The bond issue would sell to investors in the UK capital market, where it would quote and traded
...
Canadian entities are the major floaters of foreign bonds in the USA
...
A domestic bond is a bond
issue in a country by a resident of that country
...

i
...
Straight
bonds may issue with a floating rate of interest
...
So, in the
case of a Eurodollar bond, the interest rate may base upon LIBOR for Eurodollar deposits
...


Convertible Eurobond: The Eurobond is a bond having a specified interest coupon and maturity
date
...

iii
...
Their issuing procedure is less formal than for large bonds
...
Medium-term Euro-notes are similar to medium-term roll-over
Eurodollar credits
...

Characteristics of Euro bonds or Features of Eurobonds
The following characteristics of euro bonds below are
i
...

ii
...

iii
...

iv
...

v
...

vi
...

vii
...

 Eurobonds place simultaneously in many countries through syndicates of underwriting banks
...
S
...

 The interest on Eurobonds is not subject to withholding tax
...
11
...
Such financial activities are
conducted through institutionalized formal exchanges or over-the-counter (OTC) marketplaces which
operate under a defined set of regulations
...

While both terms - stock market and stock exchange - are used interchangeably, the latter term is
generally a subset of the former
...
The leading stock
exchanges in the U
...
include the New York Stock Exchange (NYSE), Nasdaq, the Better Alternative
Trading System (BATS) and the Chicago Board Options Exchange (CBOE)
...
S
...

Functions of a Stock Market
A stock market primarily serves the following functions:

45

i
...


iii
...


v
...


Fair Dealing in Securities Transactions: Depending on the standard rules of demand and
supply, the stock exchange needs to ensure that all interested market participants have instant
access to data for all buy and sell orders thereby helping in the fair and transparent pricing of
securities
...

For example, there may be three buyers who have placed orders for buying Microsoft shares at
$100, $105 and $110, and there may be four sellers who are willing to sell Microsoft shares at
$110, $112, $115 and $120
...

Efficient Price Discovery: Stock markets need to support an efficient mechanism for price
discovery, which refers to the act of deciding the proper price of a security and is usually
performed by assessing market supply and demand and other factors associated with the
transactions
...
S
...
A news item comes in that the EU regulator has imposed a fine of $2 billion on the
company which essentially means that 40 percent of the company‘s value may be wiped out
...

Liquidity Maintenance: While getting the number of buyers and sellers for a particular financial
security are out of control for the stock market, it needs to ensure that whosoever is qualified and
willing to trade gets instant access to place orders which should get executed at the fair price
...
Additionally, it should ensure that all associated entities operating in the market must also
adhere to the rules, and work within the legal framework given by the regulator
...
All these participants
operate in the stock market with different roles and functions
...
A market maker provides necessary liquidity in the market, while a
hedger may like to trade in derivatives for mitigating the risk involved in investments
...

Investor Protection: Along with wealthy and institutional investors, a very large number of
small investors are also served by the stock market for their small amount of investments
...
The stock exchange must implement necessary
measures to offer the necessary protection to such investors to shield them from financial loss and
ensure customer trust
...
Derivatives,
which have been described by Warren Buffett as financial weapons of mass destruction, are not
for everyone as one may lose much more than they bet for
...

vii
...
S
...
Failure to adhere to the regulations can lead
to suspension of trading by the exchanges and other disciplinary measures
...

Regulating the Stock Market
A local financial regulator or competent monetary authority or institute is assigned the task of
regulating the stock market of a country
...
S
...
The SEC is a federal agency that
works independently of the government and political pressure
...
"
Stock Market Participants
Along with long-term investors and short term traders, there are many different types of players
associated with the stock market
...

Stockbrokers, also known as registered representatives in the U
...
, are the licensed professionals who
buy and sell securities on behalf of investors
...
An account with a retail
broker is needed to gain access to the markets
...
These
managers get recommendations from analysts and make the buy or sell decisions for the portfolio
...

Investment bankers represent companies in various capacities, such as private companies that want to go
public via an IPO or companies that are involved in pending mergers and acquisitions
...

Custodian and depot service providers, which are institution holding customers' securities for
safekeeping so as to minimize the risk of their theft or loss, also operate in sync with the exchange to
transfer shares to/from the respective accounts of transacting parties based on trading on the stock market
...

Dark Pools: Dark pools, which are private exchanges or forums for securities trading and operate within
private groups, are posing a challenge to public stock markets
...


47

Block chain Ventures: Amid rising popularity of block chains, many crypto exchanges have emerged
...

Though their popularity remains limited, they pose a threat to the traditional stock market model by
automating a bulk of the work done by various stock market participants and by offering zero- to low-cost
services
...

It allows companies to raise money by offering stock shares and corporate bonds
...
While institutional investors and
professional money managers do enjoy some privileges owing to their deep pockets, better knowledge
and higher risk taking abilities, the stock market attempts to offer a level playing field to common
individuals
...
In the long term, it helps in capital formation &
economic growth for the country
...
Government influence on
exchange rates, exchange rate systems
...
International arbitrage and
interest rate parity
...

4
...
1
...
In 1931, England took its foot back which resulted in abolition of this
regime
...
This practice led to great depression which was a threat to war
ravaged world after the Second World War
...

4
...
2 The Bretton Woods Era (1946 to 1971)
To streamline and revamp the war ravaged world economy & monetary system, allied powers held a
conference in 'Bretton Woods', which gave birth to two super institutions - IMF and the WB
...
In case of crossing the limits, the
authorities were free hand to intervene to bring back the exchange rate within limits
...
1
...
Since A has had a relatively greater rise in prices, A‘s currency depreciates, will
fall, and a new exchange rate will get established
...

4
...
4 Floating rate system
A floating exchange rate occurs when governments allow the exchange rate to be determined by market
forces and there is no attempt to influence the exchange rate
...
A situation where the government try to keep the exchange rate within a certain
target against other currencies
...
2 Factors influencing Exchange rates
Foreign Exchange rate (ForEx rate) is one of the most important means through which a country‘s relative
level of economic health is determined
...
While sending or receiving
money from overseas, there‘s a need to keep a keen eye on the currency exchange rates
...
"
It may fluctuate daily with the changing market forces of supply and demand of currencies from one
country to another
...

i) Inflation Rates
Changes in market inflation cause changes in currency exchange rates
...
The prices of goods and services
increase at a slower rate where the inflation is low
...
Forex rates, interest rates, and
inflation are all correlated
...
It consists of
total number of transactions including its exports, imports, debt, etc
...
Balance of payments fluctuates exchange rate of its domestic currency
...
A country with
government debt is less likely to acquire foreign capital, leading to inflation
...
As a
result, a decrease in the value of its exchange rate will follow
...
A country's terms of trade improves if its exports prices raise at a greater rate than its
imports prices
...
This results in an appreciation of exchange rate
...
A country with less
risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from
other countries with more political and economic stability
...
A country with sound financial and trade policy does

50

not give any room for uncertainty in value of its currency
...

vii) Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to
acquire foreign capital
...

viii) Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to
make a profit in the near future
...
With this increase in currency value comes a rise in the exchange rate as well
...
If you send or receive money frequently, being
up-to-date on these factors will help you better evaluate the optimal time for international money transfer
...

4
...
The Reserve Bank delegated powers to authorized dealers
(ADs) to release foreign exchange for a variety of purposes
...
To further the
participatory process in a more holistic manner by taking into account all segments of the financial
markets, the ambit of the Technical Advisory Committee (TAC) on Money and Securities Markets set up
by the Reserve Bank in 1999 was expanded in 2004 to include foreign exchange markets and the
Committee was rechristened as TAC on Money, Government Securities and Foreign Exchange Markets
...
The rupee-foreign currency swap market was
allowed
...

Liberalization Measures
Authorized dealers were permitted to initiate trading positions, borrow and invest in overseas market,
subject to certain specifications and ratification by respective banks‘ Boards
...

Participants in the foreign exchange market, including exporters, Indians investing abroad, and FIIs were
permitted to avail forward cover and enter into swap transactions without any limit, subject to genuine
underlying exposure
...

The Reserve Bank has been taking initiatives in putting in public domain all data relating to foreign
exchange market transactions and operations
...
The
Reserve Bank has already achieved full disclosure of information pertaining to international reserves and
foreign currency liquidity position under the Special Data Dissemination Standards (SDDS) of the IMF
...
4 Types of Exchange Rate Systems
There are three broad exchange rate systems
 currency board,
 fixed exchange rate and
 floating rate exchange rate
...

The fixed exchange rate has three variants and the floating exchange rate has two variants
...

4
...
1 Variants of a Fixed Exchange Rate System
4
...
1
...
The specified band may be onesided (+7% in Vietnam), a narrow range (+ 2
...
5% in Libya)
...
4
...
2 Crawling Peg
The par value of the domestic currency is set with reference to a selected foreign currency (or precious
metal or currency basket) and is reset at intervals, according to pre-set criteria such as change in inflation
rate
...
The biggest advantage of the crawling peg is its
responsiveness to the market value of the domestic currency
...
4
...
3 Crawling Band
The domestic currency is on a crawling peg which is maintained within a range (band)
...
4
...

When a country has its own currency as legal tender, it can choose between the three broad types of
exchange rate systems
...
Again within each peg, it can choose to have a horizontal band within which its exchange rate would
be permitted to fluctuate
...
The main source of the exchange rate system followed by any country is the IMF‘s
Annual Report on exchange rate arrangements
...
Exchange Arrangements with No Separate Legal Tender
A few countries (such as Micronesia and San Marino) select another country‘s currency as legal tender
...


52

ii
...
In order to fulfill this promise,
the central bank has to hold foreign exchange reserves in the selected foreign currency
...

The first currency board was set up in Mauritius in 1849
...
Argentina chose the currency board in 1991 and Bosnia in
1997
...
The Central Bank
held only 66% of the peso as dollar reserves, when it should have held 100% (given the 1:1 peso/dollar
currency board arrangement)
...
There was a run on the banking system, and the government
abandoned the currency board
...
Market forces
determine the value of the domestic currency against a selected foreign currency
...
India is on a managed
float
...

Flexible Exchange Rate System-Advantages
1
...

2
...
So the country‘s growth prospects are brighter
...
Exchange rate risk is high due to greater volatility in the short- and long-term
...

2
...

3
...

Determination of Floating Exchange Rates
There are four theories that explain how floating exchange rates are set
...
The other three theories
(the monetary theory, the asset price theory, and the portfolio balance theory) are called stock theories,
since they study the amount of currency available at a certain time-the stock of currency-and peoples‘
willingness to hold the currency
...

4
...
3 Fixed Exchange Rate
It is also called the pegged exchange rate
...
The exchange rate fluctuates with a
range (usually +1% of the par value)
...
A precious metal (gold in the gold standard)
b
...
When a single currency is chosen, in some cases colonial legacy
determines the choice-most former French colonies chose the French franc, while former British colonies
tended to choose the pound sterling
...
In September 1998, the Malaysian monetary authorities announced a rigid
peg of 3
...

c
...
The central bank may keep the currencies in the basket a
secret, or make the currency In 2005, China pegged its yuan to a currency basket whose composition and
weights are undisclosed
...
There is stability in exchange rate and exchange rate risk is nil
...
Capital inflows through foreign direct investment are higher because there is no exchange rate
volatility
...

3
...

Disadvantages:
1
...
The entire foreign exchange entering and
leaving the country has to be converted at the fixed exchange rate
...
Punitive action for contravening rules
...
A fixed exchange rate creates a
flourishing parallel market for foreign exchange in which the ‗true‘ value of the domestic currency is
determined by market forces
...

Very often countries fix a separate par value for exports and a separate one for imports
...
This merely increase the draconian system needed to monitor foreign
currency inflows and outflows
...
The possibility of overvaluation of the domestic currency is quite high
...
40/$ instead of Rs
...
So, instead of 1$ being able to
buy Rs
...
40 worth of goods)
...

2
...
Consider the hypothetical example below
...
60/$ but is instead kept at yuan 7
...

4
...
4 De Facto and De Jure Exchange Rate Systems
A de facto exchange rate is the one that a country actually follows
...
Both systems need not always be the same
...
The IMF conducts surveys of

54

exchange rate systems around the world
...

4
...

There are three possible objectives:
i
...
Allow mobility of capital
iii
...

With a floating exchange rate, the last two objectives can be attained but there will be exchange rate
volatility
...
In other words, irrespective of whether the fixed rate or the floating exchange
rate is selected, only two of the three objectives can be attained
...
In practice, countries can and do fine-tune their exchange rate systems, and need not
choose either extreme
...
5
...
Canada has followed a flexible exchange rate since 1971,
Hong Kong has had a currency board since 1983 and Argentina moved from a flexible exchange rate to a
currency board in 1991
...

There has been a gradual shift from fixed exchange rate (and its variants) to flexible exchange rate
...
Economists advocate a fixed exchange rate when an economy is affected by shifts in
the demand for money that can affect price levels
...

A country that makes a successful transition from a fixed to a floating rate has a deep foreign exchange
market, a well thought out policy of intervention by the central bank, and effective mechanisms to
manage exchange rate risks
...
Countries moved away from the hard peg towards the crawling peg
...
No single exchange rate system has been an unqualified success across
countries in terms of improvement in growth rates or financial stability
...
The same is true of the floating exchange rate
...

4
...


55

The Hong Kong dollar-It is on a currency board
...

The Malaysian ringitt-The currency peg to a currency basket was replaced by a fixed exchange rate in
1998
...

The Singapore dollar-The currency peg to a currency basket was replaced by a fixed exchange rate in
1985
...

Theory Supply and Demand:
This theory states that the exchange rate is the intersection of the supply of domestic currency (shown as
the supply curve) and its demand (shown as the demand curve)
...

Monetary Theory:
This theory links money supply and prices to the exchange rate
...
According to the monetary theory, the exchange rate is the ratio of prices in
two countries, so an increase in price causes the exchange rate to be reset
...
When the money supply in each country rises, the prices in each country rise
...

According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of prices
between two countries
...

The monetary theory states that there is a direct connection between relative changes in money supply in
two countries and the exchange rate between both countries, provided there are no transportation costs in
moving goods between both countries
...
The desire to hold a
particular type of asset is driven by the perception of the asset‘s future value
...
Conversely, if
they think the asset‘s value will drop, all those holding the asset now will start selling the asset fearing a
greater decline in price in the near future
...
In other words, future expectations decide
current buy/sell decisions
...
If the market believes that the domestic currency is going to rise in value,
everyone will start buying it
...
43/$, and the expectation is that the rupee
will appreciate over the next six months
...
Because demand rises, the rupee will appreciate against the dollar, and the exchange rate will
settle at Rs
...

If on the other hand, the market expects the rupee to depreciate, there will be selling pressure and the
rupee will depreciate, probably settling at Rs
...
At any point in time, the current exchange rate
contains market expectations of the future value of the domestic currency
...


56

Its assumptions are:
i
...

ii
...

iii
...

Investors in two countries prefer to hold more of bonds in the country where wealth (value of the
portfolio) is higher when translated into domestic currency
...
Changes in money supply affect wealth which in turn, has an impact on the
exchange rate
...

When a central bank conducts open market operations by buying domestic currency-denominated
government bonds, money supply increases and the domestic currency declines in value (depreciates)
against the selected foreign currency and the exchange rate changes
...
But since the domestic currency has depreciated, the domestic
currency value of foreign currency-denominated bonds rises
...

4
...
Also known as currency risk, FX risk and exchange-rate risk, it describes the
possibility that an investment‘s value may decrease due to changes in the relative value of the involved
currencies
...

Understanding Foreign Exchange Risk
Foreign exchange risk arises when a company engages in financial transactions denominated in a
currency other than the currency where that company is based
...
Foreign exchange risk can also affect investors, who trade in
international markets, and businesses engaged in the import / export of products or services to multiple
countries
...
Fluctuations in the exchange rate could
adversely affect this conversion resulting in a lower than expected amount
...
This risk originates when a contract
between two parties specifies exact prices for goods or services, as well as delivery dates
...

4
...
1 Types Of Foreign Exchange Risk
There are three types of foreign exchange risk:
Transaction risk: This is the risk that a company faces when it's buying a product from a company
located in another country
...
If the selling company's currency were to appreciate versus the buying company's currency then
the company doing the buying will have to make a larger payment in its base currency to meet the
contracted price
...

Economic risk: Also called forecast risk, refers to when a company‘s market value is continuously
impacted by an unavoidable exposure to currency fluctuations
...
This usually
involves forward contracts, options, and other exotic financial products and, if done properly, can protect
the company from unwanted foreign exchange moves
...
7
...
Capital markets such as the stock, bond, foreign currency and derivatives
markets are considered risky because of the constantly changing prices of the securities that are traded
...
Securities prices are not influenced just by their fundamentals,
but also by broader market influences such as economic news, political developments, currency
movements, or even ―black-swan‖ unexpected events such as a massive earthquake, tsunami or general
market panic
...
The risk of financial
loss associated with either choosing to or being forced to sell a security when prices have declined is what
is meant by capital market risk
...

Market risk
Market risk is the possibility of an investor experiencing losses due to factors that affect the overall
performance of the financial markets in which he or she is involved
...

ii
...

iii
...
Companies must abide by regulations set by governing bodies that oversee their industry
...

Regulations can increase costs of operations, introduce legal and administrative hurdles, and sometimes
even restrict a company from doing business
...

Business Risk
Business risk can be defined as uncertainties or unexpected events, which are beyond control
...
These
factors cannot be controlled by the businessmen and these can result in a decline in profit or can also lead
to a loss
...
Business risk is influenced by numerous factors, including sales volume, perunit price, input costs, competition, and the overall economic climate and government regulations
...

Interest rate risk

58

Interest rate risk is the danger that the value of a bond or other fixed-income investment will suffer as the
result of a change in interest rates
...
They also may allay the risk by hedging fixed-income investments with interest rate swaps
and other instruments
...

vi
...

This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital
and/or income in the process
vii
...
And if you do deliver the product, the risk is
also in that the product may not work exactly as well as hoped or promised or envisioned
...
Credit/Default risk
2
...
Settlement risk
4
...
Foreign exchange risk
6
...

Credit/Default risk
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required
payments
...
The loss may be complete or partial
...
Credit ratings for debt issues are provided
by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P),
Moody's, and Fitch Ratings
...
Economic recession can impact the revenues and earnings of many companies, influencing their
ability to make interest payments on debt and, ultimately, repay the debt itself
...

Entities need to generate sufficient net income and cash flow to mitigate default risk
...

Basis risk
Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price
changes in entirely opposite directions from each other
...

Settlement risk
Settlement risk-also often called delivery risk - is the risk that one party will fail to deliver the terms of a
contract with another party at the time of settlement
...
Default risk can
also be associated with principal risk
...

Currency risk

59

Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation
will negatively affect the value of one's assets, investments, and their related interest and dividend
payment streams, especially those securities denominated in foreign currency
...

Foreign exchange risk
Foreign exchange risk refers to the losses that an international financial transaction may incur due
to currency fluctuations
...
They
are classified into three types:
 Transaction risks
 Translation risks
 Economic risks
vi
...
These commodities may be grains, metals, gas,
electricity etc
...
For example, automobile manufacturers face
commodity price risk because they use commodities like steel and rubber to produce cars
...
This led many Wall Street financial analysts to conclude that auto
manufacturers and auto parts makers could see a negative impact on their profit margins
...
8 International arbitrage and interest rate parity
Arbitrage can be defined as capitalizing on a discrepancy in quoted prices
...
In response to the imbalance in demand and supply resulting from arbitrage
activity, prices will realign very quickly, such that no further risk-free profits can be made
...
Locational arbitrage is possible when a
bank‘s buying price (bid) is higher than another bank‘s selling price (ask) for the same currency
...
This is possible, if quoted cross exchange
rate differs from the appropriate cross exchange rate
...

Covered Interest Arbitrage is the process of capitalizing on the interest rate differential between two
countries, while covering for exchange rate risk
...

As many investors capitalize on covered interest arbitrage, there is Upward pressure on the spot rate and
Downward pressure on the 90-day forward rate
...

Interest Rate Parity (IRP)
Sometimes market forces cause the forward rate to differ from the spot rate by an amount that is sufficient
to offset the interest rate differential between the two currencies
...


60

When IRP exists, it does not mean that both local and foreign investors will earn the same returns
...

4
...

Inflation is commonly thought of as the pace at which prices increase in a given economy and determines
the "worth" of money in relation to goods and services offered
...
Conversely, if the offer of money
by consumers appears to be scarce, suppliers often react by lowering prices to attract buyers, meaning
inflation will decelerate and money in that economy will gain relative value
...
These include measures such as a producer price index (PPI), which measures
wholesale inflation, and a consumer price index (CPI), which measures inflation for consumers
...

Inflation in the economies of currencies being traded is an important factor to consider because it affects
the relative value of those currencies internationally and because it can determine future policy
adjustments by governments and central banks
...
The
theory is that when there is more, or cheaper, money perceived to be available in the economy through
bank loans and other types of credit, consumers and businesses will spend more, sellers of goods and
services will adjust prices upward, and inflation can accelerate
...
Thus, if central banks want to curb
inflation, they will raise interest rates; and if they want to induce spending and economic activity, they
will lower interest rates
...
This
theory posits that the real interest rates (interest rates less inflation) across borders tend to move toward
equilibrium, and that currencies in economies with higher interest rates tend to weaken over time
...
Thus, if one country has a higher interest rate than
another, money will tend to flow to the country with the higher interest rate, causing that country's weaker
currency to once again appreciate over time
...

Currency traders, then, hope to predict future exchange rate movements by paying attention to the relative
levels of inflation in the countries of their target currency pairs in addition to where each country is in its
monetary policy cycle, and the size and pace of currency flows moving into and out of each country
...
10 Purchasing Power Parity Theory
Under the theory of Purchasing Power Parity, the change in the exchange rate between two countries'
currencies is determined by the change in their relative price levels locally that are affected by inflation
...

As a result of this relationship, one can expect the currencies of countries with higher inflation rates to
weaken over time versus their peers, whereas currencies of countries with lower inflation rates tend to
strengthen
...

When a country‘s inflation rate rises relative to that of another country, decreased exports and increased
imports depress the high-inflation country‘s currency because of worsening trade and current account
balances
...

Interpretations of PPP
 The absolute form of PPP is an extension of the law of one price
...

 The relative form of PPP accounts for market distortions like transportation costs, labor costs,
tariffs, taxes, and quotas
...

Rationale behind PPP Theory
Suppose U
...
inflation > U
...
inflation
...
S
...
K
...
S
...
K
...
S
...
This shift in consumption and the $‘s depreciation
will continue until
in the U
...
: price U
...
goods ≥price U
...
goods and
in the U
...
: price U
...
goods ≤ price U
...
goods
Derivation of PPP
Assume that PPP holds
...
e
...
e
...
S
...
K
...

Then e £ ={ (1 + 0
...
05)}– 1 = 3
...

If the points deviate significantly from the PPP line over time, then PPP does not hold
...
If any coefficient differs
significantly from what was expected, PPP does not hold
...
However, the use of inflation differentials to forecast long-run movements in
exchange rates is supported
...

PPP does not occur consistently due toconfounding effects, a lack of substitutes for some traded goods
...

PPP can be tested by assessing a ―real‖ exchange rate over time (e
...
, crawling pegs)
...
If the real
exchange rate follows a random walk, it cannot be viewed as being a constant in the long run
...


63

4
...

The International Fisher Effect (IFE) theory suggests that currencies with higher interest rates will
depreciate because the higher nominal rates reflect higher expected inflation
...

rf = (1 + if )(1 + ef ) – 1
if = interest rate in the foreign country ef = % change in the foreign currency‘s value
rh = ih = interest rate in the home country
Setting rf = rh : (1 + if )(1 + ef ) – 1 = ih
Solving for ef : e f =] (1 + i h ) / 1 (1 + i f )]-1
ih > if  ef > 0 i
...
foreign currency appreciate
ih < if  ef < 0 i
...
foreign currency depreciates
Example: Suppose iU
...
= 11% and iU
...
= 12%
...
K
...
11)/ (1 +
...
89)%
...
S
...
Then U
...
investors would earn about the same return on British
deposits as they would on U
...
deposits
...
Empirical studies indicate that the IFE theory
holds during some time frames
...


64

Then apply t-tests to the regression coefficients
...
IFE does not hold if any
coefficient differs significantly from what was expected
...
• In particular, if there are factors
other than inflation that affect exchange rates, exchange rates may not adjust in accordance with the
inflation differential
...
12 Expectations theory
Expectations theory attempts to predict what short-term interest rates will be in the future based on
current long-term interest rates
...

The theory is also known as the "unbiased expectations theory
...
The theory uses long-term rates, typically from government bonds, to forecast the rate for shortterm bonds
...

Example of Calculating Expectations Theory

65

In this example, the investor is earning an equivalent return to the Let's say that the present bond
market provides investors with a two-year bond that pays an interest rate of 20% while a one-year bond
pays an interest rate of 18%
...

The first step of the calculation is to add one to the two-year bond‘s interest rate
...
2
...
2 * 1
...
44)
...
44 / 1
...
22)
...
22 -1 = 0
...

present interest rate of a two-year bond
...


66

UNIT-V
ASSET-LIABILITY MANAGEMENT

Foreign direct investment, international capital budgeting, international capital structure and cost of
capital
...
International financing: Equity, Bond financing, parallel
loans, international cash management, accounts receivable management, inventory management
...

5
...
Generally, FDI takes place when an investor establishes
foreign business operations or acquires foreign business assets in a foreign company
...

Foreign direct investments are commonly made in open economies that offer a skilled workforce and
above-average growth prospects for the investor, as opposed to tightly regulated economies
...
It may include provisions of
management or technology as well
...

5
...
1 Types of Foreign Direct Investment
1
...
Therefore, basically
such investors are from the same industry where investments are done but operating in two different
countries
...
g
...

2
...
This type of FDI is further classified as:
a) Forward Vertical FDI: In such investments, foreign investments are done in organizations
which can take the products forward towards the customers
...
g
...

b) Backward Vertical FDI: In such investments, foreign investments are done in an organization
which is involved in sourcing of products for the particular industry
...
g
...

c) Conglomerate FDI: Such investments are done to gain control in unrelated business segments
and industries in a foreign land
...
g
...
Here the investing company ideally manages two challenges,
first being gaining operational control in a foreign land, and the second being starting operations
in a new industry segment
...
2 Theories Of FDI
5
...
1 Mac Dougall -Kemp Hypothesis
FDI moves from capital abundant economy to capital scarce economy till the marginal production is
equal in both countries
...
According to this theory, foreign direct investment is a result of
differences in capital abundance between economies
...
2
...
Krugman (1989) points out that it was technological advantage
possessed by European countries which led to massive investment in USA
...

5
...
3 Currency Based Approaches
A firm moves from strong currency country to weak currency country
...
Froot and Stain (1989) holds that,
depreciation in real value of currency of a country lowers the wealth of a domestic residents visa avis the
wealth of the foreign residents, thus being cheaper for foreign firms to acquire assets in such countries
...

5
...
4 Location-Specific Theory
Hood and Young (1979) stress on the location factor
...
Since real wage cost varies among countries, firms with
low-cost technology move to low wage countries
...
Countries with cheap labor and abundant raw material will tend to attract FDI
...
2
...
At maturity stage, the demand for new product in developed countries
grow substantially and rival firms begin to emerge producing similar products at lower price
...

5
...
6 Political-Economic Theories
They concentrate on the political risks
...
Similarly, political instability in the home country encourages FDI in other
countries(Tallman 1988)
...
3 Strategy for FDI
5
...
1 Firm-Specific Strategy
It means offering new kind of product or differentiated product
...
This is done through putting trade mark on the product or
branding
...
Bata for example, operates in 92 countries under the same trade mark, while Uniliver‘s low
- leather fabric washing product is marketed is market under five different brands in Western Europe
...
3
...
labour and raw materials)
...
3
...

5
...
4 Investment Mode Strategy
This strategy depends on the move of investment favored by the host country
...
If the host government does not favor a particular
mode, an investing company cannot adopt it even if it is the most suitable
...
4 Costs And Benefits Of FDI
A cost-benefit analysis is a process by which business decisions are analyzed
...
•
Prior to erecting a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis
as a means of evaluating all the potential costs and revenues that may be generated if the project is
completed
...

Cost and benefits of FDI can be classified as two
 Cost and Benefits of the Host Country
 Cost and Benefits of the investing MNC
a) Benefits of Host Country
 Improving the balance of payments
Inward investment will usually help a country's balance of payments situation
...
Export promotion comes due to the multinational using their
production facility as a basis for exporting, while import substitution means that products previously
imported may now be bought domestically
...
These benefits may be relatively greater given that governments will usually try to attract
firms to areas where there is relatively high unemployment or a good labour supply
 Source of tax revenue
Profits of multinationals will be subject to local taxes in most cases, which will provide a valuable
source of revenue for the domestic government
...
Workers will be trained to use the new
technology and production techniques and domestic firms will see the benefits of the new technology
...


69

•
•

Strengthening of the government budget
...

• Unhealthy competition to Domestic players
• Over utilization of local resources (both natural and human resources)
• Violation of human rights (child labor eg
...

• Threat to local products
...
Some countries may extremely limit
foreign company access to their domestic markets
...
Oil companies, for example, often make tremendous FDIs to develop oil fields
...
For example, it's a well-known fact that the shoe and
clothing industries have been able to drastically reduce their costs of production by moving operations to
developing countries
...

Costs to Investing MNCs
• Risk from Political Changes
...
Plus, most of the risk factors that you are going to experience are extremely
high
...
As it focuses its resources elsewhere other than the investor‘s
home
Country, foreign direct investment can sometimes hinder domestic investment
• Economic Non-Viability
...

•
measured in terms of cash flows
...
The risk associated with each project must be carefully analyzed and sufficient
provision must be made for covering the different types of risks
...
Remember that political
changes can also lead to expropriation, which is a scenario where the
government will have control over your property and assets
...


70

5
...
Capital
budgeting is defined ―as the firm‘s formal process for the acquisition and investment of capital
...

―Capital budgeting is long term planning for making and financing proposed capital outlays‖
―Capital budgeting consists in planning development of available capital for the purpose of maximizing
the long term profitability of the concern‖- Lynch

...
potentially large anticipated benefits
b
...
relatively long time period between the initial outlay and the anticipated return
...

 It‘s a main tool of financial management
...

 They are irreversible in nature
 Capital rationing gives sufficient scope for the financial manager to evaluate different proposals
and only viable
 project must be taken up for investments
...
It helps the
management to avoid
 over investment and under investments
...

• The investment proposal may fall into one of the following categories:
• Proposals to add new product to the product line,
• proposals to expand production capacity in existing lines
• proposals to reduce the costs of the output of the existing products without altering the
scale of operation
...
The
screening and selection procedures are different from firm to firm
ii) Project Evaluation: It involves two steps
Estimation of benefits and costs: the benefits and costs are
Once the proposal for capital expenditure is finalized, it is the duty of the finance manager to explore the
different alternatives available for acquiring the funds
...
Sufficient care
must be taken to reduce the average cost of funds
...
Systematic procedure should be developed to review the
performance of projects during their lifetime and after completion
...


71

Selection of appropriate criteria to judge the desirability of the project: It must be consistent with the
firm‘s objective of maximizing its market value
...

5
...
1 Factors influencing capital budgeting
• Availability of funds
• Structure of capital
• Taxation policy
• Government policy
• Lending policies of financial institutions
• Immediate need of the project
• Earnings
• Capital return
• Economical value of the project
• Working capital
• Accounting practice
• Trend of earnings
5
...
2 Methods of capital budgeting
Traditional methods
• Payback period
• Accounting rate of return method
Discounted cash flow methods
• Net present value method
• Profitability index method
• Internal rate of return method (IRR)
Merits of IRR
‘It considers the time value of money
...

IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid
out of the cash inflows arising from the project
...

It considers cash inflows throughout the life of the project
...
However, reinvestment of funds at the cut off rate is more appropriate than at the IRR
...

• This is especially true in case of mutually exclusive project
Step 1: Calculation of cash outflow
Cost of project/asset
xxxx
Transportation/installation charges
xxxx
Working capital xxxx Cash outflow
xxxx
Step 2: Calculation of cash inflow
Sales
xxxx
Less: Cash expenses
xxxx

72

PBDT
xxxx
Less: Depreciation
xxxx
PBT
xxxx
Less: Tax
xxxx
PAT
xxxx
Add: Depreciation
xxxx
Cash inflow p
...
6 International capital structure and cost of capital
The capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth
...
Short-term debt such as working capital
requirements is also considered to be part of the capital structure
...
As a result, these corporations are becoming
multinational not only in the scope of their business activities but also in their capital structure
...
This trend reflects the ongoing liberalization and deregulation of international
financial markets that make them accessible for many firms
...
When analysts and investors discuss the cost of capital, they typically mean the
weighted average of a firm's cost of debt and cost of equity blended together
...
The cost of capital depends on the mode of financing used
...

Many companies use a combination of debt and equity to finance their businesses and, for such
companies, the overall cost of capital is derived from the weighted average cost of all capital sources,
widely known as the weighted average cost of capital (WACC)
...
7 International Portfolio Management
An international portfolio is a grouping of investment assets that focuses on securities from foreign
markets rather than domestic ones
...

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio
...
The rationale behind this technique is that a portfolio
constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk
of any individual holding or security
...

Portfolio management refers to managing an individual‘s investments in the form of bonds, shares, cash,
mutual funds etc so that he earns the maximum profits within the stipulated time frame
...

In a layman‘s language, the art of managing an individual‘s investment is called as portfolio management
...

• Portfolio management minimizes the risks involved in investing and also increases the chance of
making profits
...

• Portfolio management enables the portfolio managers to provide customized investment solutions to
clients as per their needs and requirements
...

• Passive Portfolio Management: In a passive portfolio management, the portfolio manager deals with a
fixed portfolio designed to match the current market scenario
...
The
individual issues money to the portfolio manager who in turn takes care of all his investment needs,
paper work, documentation, filing and so on
...

• Non-Discretionary Portfolio management services: In non discretionary portfolio management
services, the portfolio manager can merely advise the client what is good and bad for him but the
client reserves full right to take his own decisions
...
Two concepts are important here which can be categorized as Portfolio Equity and Portfolio
Bonds
...
A brief explanation is provided hereunder
...

Portfolio Bonds
Bonds are normally medium to long-term investments
...

One seek income, growth potential, or a combination of the two
...
In fact, it is helpful if there are open-ended mutual funds available for
investment
...
This is helpful because the
interest rates may be higher, making it more profitable to earn money in that particular country
...
However, in such investments, the investor does not have
ample scope for reaping the benefits of diversification, because the systematic risks are not reducible to
that extent
...
The most important ones are listed below
...
This is beyond the control of the investors
...
The weakening of
currency reduces the value of securities as well
...
These frictions may result from Governmental control, changing tax laws, and
explicit or implicit transaction costs
...
To do this, they use different forms of control mechanisms such as taxes on
international flows of FDI and applied restrictions on the outflow of funds
...

Governments can heavily influence the prices by modifying their monetary and fiscal policies
...

 Unequal Access to Information -Wide cross-cultural differences may be a barrier to GPM
...

5
...
8
...
Companies raise money
because they might have a short-term need to pay bills or they might have a long-term goal and require
funds to invest in their growth
...

Equity financing comes from many sources; for example, an entrepreneur's friends and family, investors,
or an initial public offering (IPO)
...

Equity risk is "the financial risk involved in holding equity in a particular investment"
...

The measure of risk used in the equity markets is typically the standard deviation of a security's price over
a number of periods
...
However, since most investors would not
consider fluctuations above the average return as "risk", some economists prefer other means of
measuring it
...
8
...
They obtain this money by selling bonds to
investors
...

International bonds
International bonds are debt instruments that are issued by a non-domestic company in order to raise
money from international investors and are usually denominated in the currency of the issuing country
with the primary objective to attract more investors on a large scale
...
For example, an US company issues bond and raises capital in Japan denominated
in Japanese Yen
...
At this junction it is important to understand that a Japanese company may
also issue bond and raise capital in Japan denominated in Japanese Yen
...
In case of a foreign bond, the bond issuer is from a foreign
country
...

In Euro bond, a foreign company issues a bond denominated in a currency which is not the home
currency of the investors
...
This will be an example Euro Bond
...
In the earlier case, it would be considered as a
Euro Dollar Bond while in the later case, it would be known as Euro Sterling Bond
...
This
forced companies to issue USD denominated bond outside USA
...

ii) Global bonds
Though very few companies have issued these bonds
...
Normally these bonds are denominated in multiple currencies
...
Global bonds can have following differences among issuer, denomination and the country in
which it is being issued:
• Issuer (Issuing company‘s nationality)
• What is the denomination of bonds (currency) and for which country this currency is local?
• The country in which it is being issued
An example would be an Australian Bank (A) issuing a GBP Bond (B‘s currency) in London (B‘s
country) and in Japan (C)
...
A Eurobond is an
international bond that is issued and traded in countries other than the country in which the bond‘s

76

currency or value is denominated
...

iii) Straight Bonds
A straight bond is a bond that pays interest at regular intervals, and at maturity pays back the principal
that was originally invested
...
U
...
Treasury bonds issued by the government are examples of straight bonds
...

The features of a straight bond include constant coupon payments, face value or par value, purchase
value, and a fixed maturity date
...
At maturity date, the principal investment is
repaid to the investor
...
If the
bond was purchased at par, the bondholder receives the par value at maturity
...
Finally, a bond acquired at a discount to par means that the investor‘s repayment at maturity
will be higher than his or her initial investment
...
Bullet bonds cannot be redeemed early by an issuer,
which means they are non-callable
...
More specifically, the bond
pays a given coupon for a specific period of time, and then its coupon is stepped up in regular periods
until maturity
...
Typically, issuers
embed rising-coupon bonds with call options which give them the right to redeem the bonds at par on the
date the coupon is set to step up
...

c) Zero-coupon bond
A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep discount,
rendering a profit at maturity, when the bond is redeemed for its full face value
...
Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in
price, much moreso than coupon bonds
...

d) Bonds with currency option
The investor possesses the right for receiving the payments in a currency except the currency of issue
e) Bull and bear bonds
A bull bond is a term used to refer to a bond that is likely to increase in value in a bull market
...
A bull bond is a specific type of bond that performs well in a bull
market
...


77

A bull market is a financial market marked by optimism and investor confidence
...

4) Floating-rate Bonds
• Floating rate bonds pay coupon based on some reference interest rate, such as LIBOR
...

•

The coupon payments are linked to the movement in a reference interest rate (frequently money
market rates, such as the LIBOR) to which they are adjusted at specific intervals, typically on each
coupon date for the next coupon period
...

• Floating rate bonds may be viewed as zero coupon bonds with a face value equaling the sum of the
forthcoming coupon payment and the principal because their regular interest rate adjustments
guarantee interest payments in line with market conditions
A floating rate note (FRN) is a debt instrument whose coupon rate is tied to a benchmark rate such
as LIBOR or the US Treasury Bill rate
...
It is
typically composed of a variable benchmark rate + a fixed spread
...
The maturity period of FRN‘s vary
but are typically in the range of two to five years
...
The notes are
typically traded over-the-counter
...
25
Reset Period: Three months
Maturity: Five years
This note would have a face value of $1,000
...
During that five years the note will have an interest rate set at the Federal Reserve‘s interest rate
plus 0
...
For example, if the Federal Reserve rate was 2
...
75%
...

If the Federal Reserve rate has changed, this note will update its interest rate to match
...
This floating rate note, at its next reset
date, would take on an interest rate of 2
...

FRNs are present in various forms:
a) Perpetual FRNs
A floating-rate note (FRN) whose principal never matures, i
...
, it doesn't have a redemption payment and
only makes perpetual coupon payments, which are reset periodically on a fixing date by reference to a
benchmark rate such as 3- or 6-month LIBOR
...
The coupon is reset and paid on a periodic basis by
adding a specific spread to the reference rate
...
In other words, although perpetual FRNs are essentially debt instruments, the perpetual

78

feature bestows on them the nature of equity
...

A perpetual FRN is also referred to as a perpetual floater
...
e
...

This collar has the effect of limiting the reference rate to minimum and maximum values so that the
holder can confine fluctuations in the reference rate to a specific range (a lower and an upper boundary)
...

c) Drop Lock FRNs\Flip-flop FRN
A floating-rate note (FRN) which has a rate trigger allowing the interest to convert to a specified fixed
rate for the remaining life of the underlying debt instrument should the floating rate reaches or drops
below a pre-determined level on an interest fixing (resetting) date or on a number of consecutive fixing
dates
...
A drop-lock FRN is also referred to as
a drop-lock floater
...
Furthermore, the bondholder
has the right to convert back into the original note before the short-dated note reaches maturity
...

A flip-flop FRN is also known as a flip-flop floater
...
That is the
interest rate is refixed on a more times than the interest is paid
...

For example, a coupon payment may be made after three consecutive monthly refixes
...
A
mismatch FRN is also known as a mismatch floater
...
For example, this floating-rate note can be structured as follows:
Over the first two years: it pays 10%
...

Investors who expect short-term rates to fall in a future period can earn very large coupons
...

iv)
Convertible Bonds
Convertible bonds are corporate bonds that can be converted by the holder into the common stock of the
issuing company
...
When issued, they act just like regular corporate
bonds, albeit with a slightly lower interest rate
...
If the stock performs poorly, there is no

79

conversion and an investor is stuck with the bond's sub-par return-below what a non-convertible corporate
bond would get
...

v)
Cocktail bonds
Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs, instead of a
single currency
...
They are typically straight fixed-rate
bonds
...

5
...

The purpose of a parallel loan is to avoid borrowing money across country lines with possible restrictions
and fees
...

The first parallel loans were implemented in the 1970s in the United Kingdom in order to bypass taxes
that were imposed to make foreign investments more expensive
...

For example, say an Indian company has a subsidiary in the United Kingdom and a U
...
firm has a
subsidiary in India
...
Rather than each company borrowing in its home currency and then
converting the funds into the other currency, the two parent firms enter into a parallel loan agreement
...
At the same time, the British company borrows 10 million pounds from its local bank
...
At the end of the term of the loans, the money is
repaid with interest, and the parent companies repay that money to their home banks
...

Companies might also directly make loans to each other, skipping the use of banks altogether
...

5
...
2 - cash on hand refers to
notes, coins, and deposits held on demand by government institutional units with a bank or another
financial institution
...

Cash management is necessary because there are mismatches between the timing of payments and the
availability of cash
...
For
example, if taxes are paid quarterly, there can be large temporary cash surpluses around the time taxes are
due, and temporary deficits in other time periods

80

Storkey (2003) provides the following definition: ―cash management is having the right amount of money
in the right place and time to meet the government‘s obligations in the most cost-effective way
...

Moderrn cash management has four major objectives:
• To ensure that adequate cash is available to pay for expenditures when they are due
...

• To borrow only when needed and to minimize government borrowing costs
...
e
...

• To manage risks, by investing temporary surpluses productively, against adequate collateral
...

5
...
1 Approaches of Centralized Cash Management
a) Netting
In a typical multinational family of companies, there are a large number of intra-corporate transactions
between subsidiaries and between subsidiaries and the parent
...
With a centralized system, netting is possible whereby the cash management
center (CMC) nets out receivables against payables, and only the net cash flows are settled among
different units of the corporate family
...
For
example, the German subsidiary of an MNC sells goods worth $1 million to its Italian affiliate that in turn
sells goods worth $2 million to the German unit
...
On the net basis,
however, the German unit need remit only $1 million to the Italian unit
...
It
is valuable, though only if subsidiaries sell back and forth to each other
...

The netting center will use a matrix of payables and receivables to determine the net payer or creditor
position of each affiliate at the date of clearing
...
Under this system,
all units are asked to transfer their surplus cash to the CMC, which transfers them among the units as
needed and undertakes investment of surplus funds and short-term borrowing on behalf of the entire
corporate family
...
By denominating the intra-corporate loans in the units‘ currencies, the responsibility for
exposure management is entirely transferred to the finance company and the operating subsidiaries can
concentrate on their main business, viz
...
Cash pooling will
also reduce overall cash needs since cash requirements of individual units will not be synchronous
...
Considering either national or international collections, accelerating the receipt of
funds usually involves the following:
 defining and analyzing the different available payment channels,

81

 selecting the most efficient method (which can vary by country and customer),
 giving specific instructions regarding procedures to the firm‘s customers and banks
...
It requires a detailed knowledge of individual country and supplier policies, as well
as the different payment instruments and banking services available around the world
...

5
...
The acute competition requires the firm to sustain
among the other competitors through more volume of credit sales and in the intention of retaining the
existing customers
...

Objectives of Accounts Receivables
Achieving the growth in the volume of sales
Increasing the volume of profits
Meeting the acute competition
Cost of Maintaining the Accounts Receivables
Capital cost: Due to in sufficient amount of working capital with reference to more volume of credit
sales which drastically affects the existence of the working capital of the firm
...
The interest which is paid
by the firm due to the borrowings in order to meet the shortage of working capital is known as capital cost
of receivables
...

Collection cost: Whatever the cost incurred for the collection of the receivables are known as collection
cost
...

Factors Affecting the Accounts Receivables
• Level of sales: The volume of sales is the best indicator of accounts receivables
...

• Credit policies: The credit policies are another major force of determinant in deciding the size of the
accounts receivable
...

• Lenient credit policy: Enhances the volume of the accounts receivable due to liberal terms of the
trade which normally encourage the buyers to buy more and more
...

• Terms of trade: The terms of the trade are normally bifurcated into two categories viz credit period
and cash discount
• Credit period: Higher the credit period will lead to more volume of receivables, on the other side
that will lead to greater volume of debts from the side of buyers
...


82

Management of Accounts Payable/Financing the Resources is more important at par with the
management of receivable, in order to avail the short term resources for the smooth conduct of the firm
...
12 Inventory management
Inventory management refers to the process of ordering, storing, and using a company's inventory
...

For companies with complex supply chains and manufacturing processes, balancing the risks of inventory
gluts and shortages is especially difficult
...

An inventory account typically consists of four separate categories:
• Raw materials
• Work in process
• Finished goods
• Merchandise
• Raw materials
Raw materials represent various materials a company purchases for its production process
...

Work in process
Works-in-process represent raw materials in the process of being transformed into a finished product
...

Merchandise
Merchandise represents finished goods a company buys from a supplier for future resale
...

Customer Service
Customer service is a company's ability to satisfy the needs of its customers
...
In this sense, customer service measures the effectiveness of the
company's inventory management
...

A customer service measure appropriate when customer orders vary in number of line items ordered
...
13 Methods of Payment in International Trade
To succeed in today‘s global marketplace and win sales against foreign competitors, exporters must offer
their customers attractive sales terms supported by the appropriate payment methods
...
As
shown in figure 1, there are five primary methods of payment for international transactions
...

For exporters, any sale is a gift until payment is received
...

For importers, any payment is a donation until the goods are received
...

Cash-in-Advance
With cash-in-advance payment terms, an exporter can avoid credit risk because payment is received
before the ownership of the goods is transferred
...
With the advancement of the
Internet, escrow services are becoming another cash-in-advance option for small export transactions
...
Foreign buyers are also concerned that the goods may not be sent if payment is
made in advance
...

Letters of Credit
Letters of credit (LCs) are one of the most secure instruments available to international traders
...
The buyer establishes credit and pays his or her bank to render this service
...
An LC also protects the buyer since no
payment obligation arises until the goods have been shipped as promised
...

Funds are received from the importer and remitted to the exporter through the banks involved in the
collection in exchange for those documents
...
The collection letter gives instructions that specify the documents required for the transfer of
title to the goods
...
D/Cs are generally less expensive than LCs
...
Obviously, this is one of the most

84

advantageous options to the importer in terms of cash flow and cost, but it is consequently one of the
highest risk options for an exporter
...
Therefore, exporters who are reluctant to extend credit may lose a sale to their
competitors
...

When offering open account terms, the exporter can seek extra protection using export credit insurance
...
An international
consignment transaction is based on a contractual arrangement in which the foreign distributor receives,
manages, and sells the goods for the exporter who retains title to the goods until they are sold
...
Consignment helps exporters
become more competitive on the basis of better availability and faster delivery of goods
...
The key
to success in exporting on consignment is to partner with a reputable and trustworthy foreign distributor
or a third-party logistics provider
...

Letter Of Credit
When a buyer or importer wants to purchase goods from an unknown seller or exporter
...

Bank issues a LETTER OF CREDIT in addressed to the supplier or exporter after it, supplier or exporter
will supply the goods to such unknown buyer or importer
...
In this post, we are
classifying them by their purpose
...

A letter of credit is an important financial tool in trade transactions
...
A bank or a
financial institution acts as a third-party between the buyer and the seller and assures the payment of
funds on the completion of certain obligations
...
A draft is a written order by which the party creating it, orders another party to pay money to a
third party
...

• Bill Of Lading
A bill of lading is a document listing and detailing all of the goods in a shipment of any kind, whether by
land, sea or air
...
The seller then signs the bill of

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lading and attaches it to the shipment as it is passed off to the distributor, assuming the seller uses a thirdparty distributor
...

Although shippers generally cannot check the contents of containers, like boxes or pallets, they can check
the number and type of containers present in the shipment
...
It is the accounting document for seller‘s
claim on the buyer for goods sold to the buyer
...
14 Trade Finance Methods
The most popular trade financing methods are the following
Accounts Receivable Financing
It is a special type of asset-financing arrangement
...

Factoring
In this type of financing, the company gets an amount that is a reduced value of the total receivables owed
by customers
...
For
older receivables, the company will get less financing
...

Letters of Credit
As mentioned earlier, Letters of Credit are one of the oldest methods of trade financing
...
BAs are used by firms as a part of the commercial transaction
...

BAs are also traded at a discount from the actual face value on the secondary market
...
BAs are regular instruments that are used in
international trade
...
It is calculated as the current assets minus the current liabilities
...

Forfaiting
Forfaiting is the purchase of the amount importers owe the exporter at a discounted value by paying cash
...

Countertrade

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It is a form of international trade where goods are exchanged for other goods, in place of hard currency
...

Barter
is the oldest countertrade process
...

In a counter-purchase, the foreign seller contractually accepts to buy the goods or services obtained from
the buyer's nation for a defined amount
...

It may also allow a portion of the assembly of the exported products for the manufacturers to carry out in
the buying country
...

5
...
Even today India is one of the largest exporters of agricultural goods
...
Let us take a
look
...
It is the
principal financial institution in India for foreign and international trade
...

The main function of the Export and Import Bank of India is to provide financial and other assistance to
importers and exporters of the country
...
The ultimate aim is to promote foreign trade activities in the country
...
There are 17 other
Directors on the board
...

Functions of the EXIM Bank
Some of the main functions of Export and Import Bank of India bank:
1
...
It also finances the import and export of goods and services from countries other than India
...
It finances the import or export of machines and machinery on lease or hires purchase basis as well
...
Provides refinancing services to banks and other financial institutes for their financing of foreign trade
5
...


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6
...
Depending n the
country of origin there are a lot of processes and procedures involved in the import-export of goods
...

7
...

8
...

9
...

EXIM bank can also provide business advisory services and expert knowledge to Indian exporters in
respect of multi-funded projects in foreign countries
Importance of the EXIM Bank
Other than providing financial assistance, the Export and Import Bank of India bank is always looking for
ways to promote the foreign trade sector in India
...

The aim was to improve the quality standards of our imports and exports
...
It has agreed to co-finance programs with them in
eastern Europe
...

5
...
The Government of India notifies the Exim Policy for a period of five years
(1997 2002) under Section 5 of the Foreign Trade (Development and Regulation Act), 1992
...
The Export Import Policy is updated every year on the 31st of
March and the modifications, improvements and new schemes becames effective from 1st April of every
year
...

5
...
1 Highlight of Exim Policy 2002 - 07
i) Service Exports
Duty free import facility for service sector having a minimum foreign exchange earning of Rs
...

The duty free entitlement shall be 10% of the average foreign exchange earned in the preceding three
licensing years
...
Imports of agriculture and dairy products shall not be allowed for imports
against the entitlement
...

ii) Status Holders
Duty free import entitlement for status holder having incremental growth of more than 25% in FOB value
of exports (in free foreign exchange)
...
25 core (in free foreign exchange)
...

Status holder in STPI shall be permitted free movement of professional equipments like laptop/computer
...

To promote growth of exports in embedded software, hardware shall be admissible for duty free import
for testing and development purpose
...

100% depreciation to be available over a period of 3 years to computer and computer peripherals for units
in EOU/EHTP/STP/SEZ
...

Nominated agencies to accept payment in dollar for cost of import of precious metals from EEFC account
of exporter
...
This means that they can bring export proceeds
in kind against the present provision of bringing in cash only
...

vi) Special Economic Zones Scheme
a
...
This would now entitle
domestic suppliers to Duty Drawback / DEPB benefits, CST exemption and Service Tax exemption
...
Agriculture/Horticulture processing SEZ units will now be allowed to provide inputs and equipments
to contract farmers in DTA to promote production of goods as per the requirement of importing
countries
...
Foreign bound passengers will now be allowed to take goods from SEZs to promote trade, tourism
and exports
...
Domestics sales by SEZ units will now be exempt from SAD
...
Restriction of one year period for remittance of export proceeds removed for SEZ units
...
Netting of export permitted for SEZ units provided it is between same exporter and importer over a
period of 12 months
...
SEZ units permitted to take job work abroad and exports goods from there only
...
SEZ units can capitalize import payables
...
Wastage for sub contracting/exchange by gem and jewellery units in transactions between SEZ and
DTA will now be allowed
...
Export/Import of all products through post parcel /courier by SEZ units will now be allowed
...
The value of capital goods imported by SEZ units will now be amortized uniformly over 10 years
...
SEZ units will now be allowed to sell all products including gems and jewellery through exhibition
and duty free shops or shops set up abroad
...
Goods required for operation and maintenance of SEZ units will now be allowed duty free
...
Besides these, the other important provisions are:

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EOUs are now required to be only net positive foreign exchange earner and there will now be no export
performance requirement
...

Gems and jewellery EOUs are now being permitted sub contracting in DTA
...

viii) EPCG Scheme
The Export Promotion Capital Goods (EPCG) Scheme shall allow import of capital goods for
preproduction and post production facilities also
...

To facilities upgradation of existing plant and machinery, import of spares shall be allowed under the
scheme
...

Greater flexibility for fulfillment of export obligation under the scheme by allowing export of any other
product manufactured by the exporter
...

Capital goods up to 10 years old shall also be allowed under the Scheme
...

Royalty payments received from abroad and testing charges received in free foreign exchange to be
counted for discharge of export obligation under EPCG Scheme
...

DEPB rates rationalize in line with general reduction in Customs duty
...

Value addition under DFRC scheme reduced from 33% to 25%
...

 Reduction in penal interest rate from 24% to 15% for all old cases of default under Exim policy
 Restriction on export of warranty spares removed
...

Export of free of cost goods for export promotion @ 2% of average annual exports in preceding three
years subject to ceiling of Rs
...


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