0015 For Manahgemenrt For MBA and MBA Assinemnt

International Financial Management
Sikkim Manipal University

Manipal INSPIRED BY LIFE
Directorate of Distance Education
Subject Code: MF0015 / MBF404 / IB0010 Revised Edition: Spring 2010
Book ID: B1759

Department of Management Studies
Board of Studies Chairman HOD, Department of Management Studies SMU DDE Dean SMU DDE Additional Registrar SMU DDE Deputy Registrar Student Evaluation Examinations Branch SMU DDE Dr T.V. Narasimha Rao Adjunct Faculty and Advisor SMU DDE Prof. K.V. Varambally Director Manipal Institute of Management, Manipal Pankaj Khanna Director HR, Fidelity Mutual Fund Shankar Jagannathan Former Group Treasurer W ipro Technologies Limited Abraham Mathew Chief Financial Officer Infosys BPO Sadhana Dash Senior HR Consultant Bangalore
Revised Edition: Spring 2010 Print: Printed at Manipal Technologies Ltd Published on behalf of Sikkim Manipal University, Gangtok, Sikkim by Vikas Publishing House Pvt Ltd Authors: Dr Harmeet Kaur: Units (1.31.4, 1.8, 1.6, 3.3, 6.46.4.1, 6.5.16.5.2, 6.66.6.2, 6.7, 7.3 7.6, 8.38.4, 9.3, 9.5, 10.310.4, 12.312.6, 13.313.9, 14.314.6) Reserved, 2012 Neelesh Kumar: Units (2.32.5, 3.43.8, 5.3, 5.65.7, 6.3, 8.5, 9.4, 9.7, 11.4, 11.7, 12.7) Neelesh Kumar, 2012 Subhash Chander Gulati & Sumit Gulati: Units (4.6, 6.4.26.4.3, 6.5, 6.7.16.7.2, 7.7, 8.6, 10.5 10.6, 11.3, 11.511.6, 11.8, 14.7) Reserved, 2012 Dr Sudershan Kuntluru: Units (4.34.5, 5.45.5, 5.85.11, 9.6) Reserved, 2012
All rights reserved. No part of this publication which is material protected by this copyright notice may be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior written permission from the Publisher. Information contained in this book has been pre-approved by SMU and published by VIKAS Publishing House Pvt. Ltd. and has been obtained by its Authors (pre-approved by SMU) from sources believed to be reliable and correct to the best of their knowledge. However, the Publisher and its Authors shall in no event be liable for any errors, omissions or damages arising out of use of this information and specifically disclaim any implied warranties or merchantability or fitness for any particular use.
Vikas is the registered trademark of Vikas Publishing House Pvt. Ltd. VIKAS PUBLISHING HOUSE PVT LTD E-28, Sector-8, Noida - 201301 (UP) Phone: 0120-4078900 Fax: 0120-4078999 Regd. Office: 576, Masjid Road, Jangpura, New Delhi 110 014 Website: www.vikaspublishing.com Email: helpline@vikaspublishing.com
Authors Profile Dr Harmeet Kaur is an Assistant Professor in Business Management Guru Nanak Institute of Management and Technology. She is a Ph.D and an MBA and also holds a Postgraduate Diploma in Investment Banking. She has over 12 years of teaching experience. She works with PAMETI Punjab Agricultural University as Deputy Director. Neelesh Kumar is an Assistant Professor at the MBA Department - Hindustan College of Science & Technology Sharda Group of Institutions, Agra. He teaches Supply Chain Management, Strategic Management and International Business. He has published a number of research papers. Subhash Chander Gulati, an ex - Executive Director Hindustan Aeronautics Limited, is a B.Tech. (Honours) in Mechanical Engineering from Indian Institute of Technology (IIT), Kharagpur , an M.Sc. (Technology) from Cranfield Institute of Technology (CIT), Bedford, U.K. and an MBA from Osmania University, Hyderabad. Earlier he has worked with Sigma Microsystems Private Ltd at Hyderabad as Vice President, Marketing. He has also been working as a Consultant and Management Trainer in the areas of soft skills, finance and management related topics. Sumit Gulati holds an MBA (Finance) from the ICFAI Business School, Hyderabad. He is a B.E. (Mechanical) from Bharati Vidyapeeth College of Engineering, Pune. He possesses sound knowledge of the prevalent Financial / Industry information and is well versed with the fundamental analysis tools and systems. He has worked at I.T.S Ghaziabad as Assistant Professor (Finance) and has taught PGDM/MBA students. Earlier, he has worked as an Investment Research Analyst at Evalueserve and a Senior Sales Manager at Aviva Life Insurance Co. (I) Ltd. Dr Sudershan Kuntluru , Ph.D., Osmania University, Hyderabad, India, is a Post Doctoral Fellow from the Indian School of Business, Hyderabad. Earlier he has been an Associate Professor, Finance and Accounting Area, School of Business Management, NMIMS University and an Academic Associate, India Institute of Management (IIM-A), Ahmedabad. He has taught MBA students on subjects ranging from Financial Management, Mergers and Acquisitions to Corporate Valuation and Corporate Restructuring. He has various articles published in journals to his name on Accounting and Finance. Peer Reviewer: Dr P.C. Biswal is an Associate Professor, Finance at Management Development Institute, Gurgaon. He has a Ph.D. degree from University of Hyderabad. Prior to MDI, Dr Biswal was working as ICICI Bank BFSI Chair Professor in T. A. Pai Management Institute (TAPMI), Manipal. Dr Biswal has about 8 years of experience in teaching and research. He has taught various courses in India and abroad in the areas of Risk Management and Derivatives, International Financial Management, Investment Analysis and Portfolio Management, Financial Markets and Institutions, and Open Economy Macroeconomics. His research interest is in Risk Management and Derivatives, Commodity Derivatives and Applied Econometrics. In House Content Review Team Dr G.P. Sudhakar HOD, Department of Management Studies SMU DDE Arpita Agrawal Assistant Professor Department of Management Studies SMU DDE Shubha Pissay Assistant Professor Department of Management Studies SMU DDE
Contents
Unit 1 International Financial Environment Unit 2 Balance of Payments Unit 3 Foreign Exchange Market Unit 4 Currency Derivatives Unit 5 Exchange Rate Determination Unit 6 International Financial Markets Unit 7 Foreign Trade Finance Unit 8 Nature and Measurement of Foreign Exchange Exposure Unit 9 Management of Foreign Exchange Exposure 175-197 157-174 135-156 109-133 85-108 59-83 39-58 21-38 1-20
Contents
Unit 10 International Capital Structure Unit 11 International Capital Budgeting Unit 12 Country Risk Analysis Unit 13 International Taxation Unit 14 Foreign Direct Investment, International Portfolio and Cross-Border Acquisitions 281-300 261-280 239-259 217-238 199-216
Page No. (vi)
MF0015 / MBF404 / IB0010 International Financial Management Course Description

International financial management deals with the financial decisions taken in the area of international business. The growth in international business is quite evident in the form of highly inflated quantum of international trade. In the immediate post-war years, the general agreement on the Trade and Tariffs (GATT) was set up in order to boost trade. It reduced the trade barriers significantly over the years, as a result of which international trade grew manifold. Also, as a logical fallout, basic financial decisions now involve cross-border complexities. Choices about raising capital, investment, risk management, acquisition activity, restructuring, and other aspects of financial policy typically involve international considerations. When making these choices, managers must analyze exchange rates, differences in tax rules, country risk factors, and variation in legal regimes. The 1980s brought a rapid integration of international capital and financial markets. Impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. The economic integration and globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization is the process by which a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Lastly, trade liberalization and economic integration continued to proceed at both the regional and global levels. Ultimately, because of international borrowing and lending, economic opportunities are expanded and households have better options to smooth their incomes. The fundamental job of the financial manager is to maximize shareholders wealth. These are good things. But just as the existence of banks makes bank crises a possibility, the existence of an international financial system makes international financial crises possible. Though this is the flip side, this is exactly where all the interesting action of the course emanates. In order to understand such crises we need to understand the nature of the international financial system. This course provides the foundations for learning how finance works in the backdrop of cross-border setting.
Course Objectives
In a world where all the major economic functions, i.e., consumption, production, and investment, are highly globalized, it is essential for financial managers to fully understand vital international dimensions of financial management. You are aware that as with international trade, international macro is the result of the fact that economic activity is affected by the existence of nations. If there was no international trade, we would not need international macro. But countries do trade with each other, and because countries (not all, but many) use their own currencies we have to wonder about how these goods are paid for and what determines the prices that currencies trade at. The two way flow of funds, outward in the form of investment and inward in the form of repatriation divided, royalty, technical service fees, among others, requires proper management and so the study of International Finance Management has become a real necessity. In fact, International Finance Management suggests the most suitable technique to be applied at a particular moment and in a particular case in order to hedge the risks that are involved in every international transaction. Though this course does not require a high level of mathematical ability, a basic understanding will help the learners. After studying this subject, the student should be able to: discuss multinational and transnational companies explain the goals of international financial management discuss the international monetary system explain the concept and principles of BOP accounting explain the concept of capital account convertibility differentiate between fixed and floating rates describe forward, futures, swaps, and option markets discuss international bond markets and international equity markets discuss the tools and techniques of foreign exchange risk management examine how to expect the future expected exchange rate define the bases of international tax system and the principles of taxation define the concept of FDI
Page No. (ix)
Course Objectives
The Self Learning Material (SLM) for this subject is divided into 14 units. A brief description of all the 14 units is given below: Unit 1 - International Financial Environment: This unit explains the term globalization and presents the goals of International Financial Management in order to discuss the concept better. Unit 2 - Balance of Payments: This unit examines the concepts and principles of balance of payments and its various components. The Current Account Deficit and Surplus and Capital Account Convertibility have also been discussed. Unit 3 - Foreign Exchange Market: The unit elucidates the origin of the concept of foreign exchange and the difference between fixed and floating rates. It also explains the foreign exchange transactions and the derivatives instruments traded in foreign exchange market such as forwards, futures, swaps, and options. Unit 4 - Currency Derivatives: The unit elucidates the importance of forward markets and the different concepts associated with it. You will also know what currency futures markets and currency options markets are and how they function. Unit 5 - Exchange Rate Determination: This unit outlines the exchange rate movements and you will also learn about the factors that influence exchange rates and the movements in cross exchange rates. You will also study about various concepts such as international arbitrage, interest rate parity, and purchasing power parity and the International Fisher effect. Unit 6 - International Financial Markets: This unit highlights the basic concepts of the international money market. You will also study the International credit markets which are defined as the forum where companies and governments can obtain credit (loans in various forms) from the creditors/investors. Unit 7 - Foreign Trade Finance: This unit explains the concept of foreign trade finance. You will be introduced to the concepts of financing exports and financing imports and you will also learn about documentary collections, factoring, forfeiting and countertrade. Unit 8 - Nature and Measurement of Foreign Exchange Exposure: This unit outlines the nature and measurement of foreign exchange exposure. You will also learn about the different types of exposures and the various types of translation methods used. Unit 9 - Management of Foreign Exchange Exposure: This unit will take the concept of exposure forward and understand how foreign exchange exposure is managed. You will learn about the various tools and techniques of foreign risk management and the risk management products.
Sikkim Manipal University Page No. (x)
Course Objectives
Unit 10 - International Capital Structure: This unit will provide information about the international capital structure. You will learn about the cost of capital and the capital structure of MNCs. In addition to this, you will also learn about cost of capital in segmented versus integrated markets. Unit 11 - International Capital Budgeting: In this unit, you will understand the different topics related to international capital budgeting. You will learn about the adjusted present value model, capital budgeting from parent firms perspective and expecting the future expected exchange rate analysis. Unit 12 - Country Risk Analysis: In this unit, you will study the country risk factors and the assessment of risk factors. The unit also presents a detailed description of the techniques through which the country risks can be assessed as well as measured. Unit 13 - International Taxation: This unit examines the bases of international tax system and the principles of taxation. You will study about double taxation, tax havens and transfer pricing. You will also learn about international tax management strategy and Indian tax environment. Unit 14 - Foreign Direct Investment, International Portfolio and CrossBorder Acquisitions: In this unit, you will learn about the flow, cost and benefits of Foreign Direct Investment. You will also study about ADR and GDR as well as the concept of portfolio. In addition to these, you will also study about cases on cross border acquisitions.
Page No. (xi)

Manipal INSPIRED BY LIFE
Subject Code: MF0015 / MBF404 / IB0010 Revised Edition: Spring 2010
Book ID: B1759

Department of Management Studies
Board of Studies Chairman HOD, Department of Management Studies SMU DDE Dean SMU DDE Additional Registrar SMU DDE Deputy Registrar Student Evaluation Examinations Branch SMU DDE Dr T.V. Narasimha Rao Adjunct Faculty and Advisor SMU DDE Prof. K.V. Varambally Director Manipal Institute of Management, Manipal Pankaj Khanna Director HR, Fidelity Mutual Fund Shankar Jagannathan Former Group Treasurer W ipro Technologies Limited Abraham Mathew Chief Financial Officer Infosys BPO Sadhana Dash Senior HR Consultant Bangalore
Revised Edition: Spring 2010 Print: Printed at Manipal Technologies Ltd Published on behalf of Sikkim Manipal University, Gangtok, Sikkim by Vikas Publishing House Pvt Ltd Authors: Dr Harmeet Kaur: Units (1.31.4, 1.8, 1.6, 3.3, 6.46.4.1, 6.5.16.5.2, 6.66.6.2, 6.7, 7.3 7.6, 8.38.4, 9.3, 9.5, 10.310.4, 12.312.6, 13.313.9, 14.314.6) Reserved, 2012 Neelesh Kumar: Units (2.32.5, 3.43.8, 5.3, 5.65.7, 6.3, 8.5, 9.4, 9.7, 11.4, 11.7, 12.7) Neelesh Kumar, 2012 Subhash Chander Gulati & Sumit Gulati: Units (4.6, 6.4.26.4.3, 6.5, 6.7.16.7.2, 7.7, 8.6, 10.5 10.6, 11.3, 11.511.6, 11.8, 14.7) Reserved, 2012 Dr Sudershan Kuntluru: Units (4.34.5, 5.45.5, 5.85.11, 9.6) Reserved, 2012
All rights reserved. No part of this publication which is material protected by this copyright notice may be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior written permission from the Publisher. Information contained in this book has been pre-approved by SMU and published by VIKAS Publishing House Pvt. Ltd. and has been obtained by its Authors (pre-approved by SMU) from sources believed to be reliable and correct to the best of their knowledge. However, the Publisher and its Authors shall in no event be liable for any errors, omissions or damages arising out of use of this information and specifically disclaim any implied warranties or merchantability or fitness for any particular use.
Vikas is the registered trademark of Vikas Publishing House Pvt. Ltd. VIKAS PUBLISHING HOUSE PVT LTD E-28, Sector-8, Noida - 201301 (UP) Phone: 0120-4078900 Fax: 0120-4078999 Regd. Office: 576, Masjid Road, Jangpura, New Delhi 110 014 Website: www.vikaspublishing.com Email: helpline@vikaspublishing.com
Authors Profile Dr Harmeet Kaur is an Assistant Professor in Business Management Guru Nanak Institute of Management and Technology. She is a Ph.D and an MBA and also holds a Postgraduate Diploma in Investment Banking. She has over 12 years of teaching experience. She works with PAMETI Punjab Agricultural University as Deputy Director. Neelesh Kumar is an Assistant Professor at the MBA Department - Hindustan College of Science & Technology Sharda Group of Institutions, Agra. He teaches Supply Chain Management, Strategic Management and International Business. He has published a number of research papers. Subhash Chander Gulati, an ex - Executive Director Hindustan Aeronautics Limited, is a B.Tech. (Honours) in Mechanical Engineering from Indian Institute of Technology (IIT), Kharagpur , an M.Sc. (Technology) from Cranfield Institute of Technology (CIT), Bedford, U.K. and an MBA from Osmania University, Hyderabad. Earlier he has worked with Sigma Microsystems Private Ltd at Hyderabad as Vice President, Marketing. He has also been working as a Consultant and Management Trainer in the areas of soft skills, finance and management related topics. Sumit Gulati holds an MBA (Finance) from the ICFAI Business School, Hyderabad. He is a B.E. (Mechanical) from Bharati Vidyapeeth College of Engineering, Pune. He possesses sound knowledge of the prevalent Financial / Industry information and is well versed with the fundamental analysis tools and systems. He has worked at I.T.S Ghaziabad as Assistant Professor (Finance) and has taught PGDM/MBA students. Earlier, he has worked as an Investment Research Analyst at Evalueserve and a Senior Sales Manager at Aviva Life Insurance Co. (I) Ltd. Dr Sudershan Kuntluru , Ph.D., Osmania University, Hyderabad, India, is a Post Doctoral Fellow from the Indian School of Business, Hyderabad. Earlier he has been an Associate Professor, Finance and Accounting Area, School of Business Management, NMIMS University and an Academic Associate, India Institute of Management (IIM-A), Ahmedabad. He has taught MBA students on subjects ranging from Financial Management, Mergers and Acquisitions to Corporate Valuation and Corporate Restructuring. He has various articles published in journals to his name on Accounting and Finance. Peer Reviewer: Dr P.C. Biswal is an Associate Professor, Finance at Management Development Institute, Gurgaon. He has a Ph.D. degree from University of Hyderabad. Prior to MDI, Dr Biswal was working as ICICI Bank BFSI Chair Professor in T. A. Pai Management Institute (TAPMI), Manipal. Dr Biswal has about 8 years of experience in teaching and research. He has taught various courses in India and abroad in the areas of Risk Management and Derivatives, International Financial Management, Investment Analysis and Portfolio Management, Financial Markets and Institutions, and Open Economy Macroeconomics. His research interest is in Risk Management and Derivatives, Commodity Derivatives and Applied Econometrics. In House Content Review Team Dr G.P. Sudhakar HOD, Department of Management Studies SMU DDE Arpita Agrawal Assistant Professor Department of Management Studies SMU DDE Shubha Pissay Assistant Professor Department of Management Studies SMU DDE
Contents
Unit 1 International Financial Environment Unit 2 Balance of Payments Unit 3 Foreign Exchange Market Unit 4 Currency Derivatives Unit 5 Exchange Rate Determination Unit 6 International Financial Markets Unit 7 Foreign Trade Finance Unit 8 Nature and Measurement of Foreign Exchange Exposure Unit 9 Management of Foreign Exchange Exposure 175-197 157-174 135-156 109-133 85-108 59-83 39-58 21-38 1-20
Contents
Unit 10 International Capital Structure Unit 11 International Capital Budgeting Unit 12 Country Risk Analysis Unit 13 International Taxation Unit 14 Foreign Direct Investment, International Portfolio and Cross-Border Acquisitions 281-300 261-280 239-259 217-238 199-216
Page No. (vi)
MF0015 / MBF404 / IB0010 International Financial Management Course Description

International financial management deals with the financial decisions taken in the area of international business. The growth in international business is quite evident in the form of highly inflated quantum of international trade. In the immediate post-war years, the general agreement on the Trade and Tariffs (GATT) was set up in order to boost trade. It reduced the trade barriers significantly over the years, as a result of which international trade grew manifold. Also, as a logical fallout, basic financial decisions now involve cross-border complexities. Choices about raising capital, investment, risk management, acquisition activity, restructuring, and other aspects of financial policy typically involve international considerations. When making these choices, managers must analyze exchange rates, differences in tax rules, country risk factors, and variation in legal regimes. The 1980s brought a rapid integration of international capital and financial markets. Impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. The economic integration and globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization is the process by which a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Lastly, trade liberalization and economic integration continued to proceed at both the regional and global levels. Ultimately, because of international borrowing and lending, economic opportunities are expanded and households have better options to smooth their incomes. The fundamental job of the financial manager is to maximize shareholders wealth. These are good things. But just as the existence of banks makes bank crises a possibility, the existence of an international financial system makes international financial crises possible. Though this is the flip side, this is exactly where all the interesting action of the course emanates. In order to understand such crises we need to understand the nature of the international financial system. This course provides the foundations for learning how finance works in the backdrop of cross-border setting.
Course Objectives
In a world where all the major economic functions, i.e., consumption, production, and investment, are highly globalized, it is essential for financial managers to fully understand vital international dimensions of financial management. You are aware that as with international trade, international macro is the result of the fact that economic activity is affected by the existence of nations. If there was no international trade, we would not need international macro. But countries do trade with each other, and because countries (not all, but many) use their own currencies we have to wonder about how these goods are paid for and what determines the prices that currencies trade at. The two way flow of funds, outward in the form of investment and inward in the form of repatriation divided, royalty, technical service fees, among others, requires proper management and so the study of International Finance Management has become a real necessity. In fact, International Finance Management suggests the most suitable technique to be applied at a particular moment and in a particular case in order to hedge the risks that are involved in every international transaction. Though this course does not require a high level of mathematical ability, a basic understanding will help the learners. After studying this subject, the student should be able to: discuss multinational and transnational companies explain the goals of international financial management discuss the international monetary system explain the concept and principles of BOP accounting explain the concept of capital account convertibility differentiate between fixed and floating rates describe forward, futures, swaps, and option markets discuss international bond markets and international equity markets discuss the tools and techniques of foreign exchange risk management examine how to expect the future expected exchange rate define the bases of international tax system and the principles of taxation define the concept of FDI
Page No. (ix)
Course Objectives
The Self Learning Material (SLM) for this subject is divided into 14 units. A brief description of all the 14 units is given below: Unit 1 - International Financial Environment: This unit explains the term globalization and presents the goals of International Financial Management in order to discuss the concept better. Unit 2 - Balance of Payments: This unit examines the concepts and principles of balance of payments and its various components. The Current Account Deficit and Surplus and Capital Account Convertibility have also been discussed. Unit 3 - Foreign Exchange Market: The unit elucidates the origin of the concept of foreign exchange and the difference between fixed and floating rates. It also explains the foreign exchange transactions and the derivatives instruments traded in foreign exchange market such as forwards, futures, swaps, and options. Unit 4 - Currency Derivatives: The unit elucidates the importance of forward markets and the different concepts associated with it. You will also know what currency futures markets and currency options markets are and how they function. Unit 5 - Exchange Rate Determination: This unit outlines the exchange rate movements and you will also learn about the factors that influence exchange rates and the movements in cross exchange rates. You will also study about various concepts such as international arbitrage, interest rate parity, and purchasing power parity and the International Fisher effect. Unit 6 - International Financial Markets: This unit highlights the basic concepts of the international money market. You will also study the International credit markets which are defined as the forum where companies and governments can obtain credit (loans in various forms) from the creditors/investors. Unit 7 - Foreign Trade Finance: This unit explains the concept of foreign trade finance. You will be introduced to the concepts of financing exports and financing imports and you will also learn about documentary collections, factoring, forfeiting and countertrade. Unit 8 - Nature and Measurement of Foreign Exchange Exposure: This unit outlines the nature and measurement of foreign exchange exposure. You will also learn about the different types of exposures and the various types of translation methods used. Unit 9 - Management of Foreign Exchange Exposure: This unit will take the concept of exposure forward and understand how foreign exchange exposure is managed. You will learn about the various tools and techniques of foreign risk management and the risk management products.
Sikkim Manipal University Page No. (x)
Course Objectives
Unit 10 - International Capital Structure: This unit will provide information about the international capital structure. You will learn about the cost of capital and the capital structure of MNCs. In addition to this, you will also learn about cost of capital in segmented versus integrated markets. Unit 11 - International Capital Budgeting: In this unit, you will understand the different topics related to international capital budgeting. You will learn about the adjusted present value model, capital budgeting from parent firms perspective and expecting the future expected exchange rate analysis. Unit 12 - Country Risk Analysis: In this unit, you will study the country risk factors and the assessment of risk factors. The unit also presents a detailed description of the techniques through which the country risks can be assessed as well as measured. Unit 13 - International Taxation: This unit examines the bases of international tax system and the principles of taxation. You will study about double taxation, tax havens and transfer pricing. You will also learn about international tax management strategy and Indian tax environment. Unit 14 - Foreign Direct Investment, International Portfolio and CrossBorder Acquisitions: In this unit, you will learn about the flow, cost and benefits of Foreign Direct Investment. You will also study about ADR and GDR as well as the concept of portfolio. In addition to these, you will also study about cases on cross border acquisitions.
Page No. (xi)
Unit 1
Structure
International Financial Environment
1.1 Caselet 1.2 Introduction Objectives 1.3 Globalization 1.4 Multinational Corporations and Transnational Corporations 1.5 Objectives of MNCs 1.6 International Financial Management and Domestic Financial Management 1.7 Goals of International Financial Management 1.8 International Monetary System 1.9 Case Study 1.10 Summary 1.11 Glossary 1.12 Terminal Questions 1.13 Answers References/e-References
1.1 Caselet
IMF cuts India's 2013 growth forecast to 6.5% The International Monetary Fund on July 16, 2012 projected Indias economic growth forecast as 6.5 per cent, down from its April projection of 7.2 per cent. It also stated that the global forecast has been lowered to 3.9 per cent in the financial year 2013 from 4.1 per cent indicating that there are harder times ahead for economies around the globe. "Growth momentum has also slowed in various emerging market economies, notably Brazil, China, and India. This partly reflects a weaker external environment, but domestic demand has also decelerated sharply in response to capacity constraints and policy tightening over the past year," IMF said in an update to its World Economic Outlook, first released in April. The growth of Indias economy is already slowing down and it fell to 6.5 per cent for the financial year ended March 2012, after hitting a nine-year low of 5.3 per cent in the March quarter. However, last month, the World Bank made a forecast that the gross domestic product of India would grow at a rate of 6.9 per cent. "Many emerging market economies have also been hit by increase in investor risk aversion and perceived growth uncertainty, which have led not
Unit 1
only to equity price declines, but also to capital outflows and currency depreciation," the IMF added in its statement. In sectors such as insurance, aviation and retail, foreign direct investment has been stalled, largely due to political opposition. Most Indian political parties have the fear that if FDI is allowed in retail in India, the small businessmen and traders who run the retail market of india and constitute a sizeable vote bank will go against them in the national elections. Prime Minister of India, who is in charge of the Finance Ministry, pointed out that India's slower growth is a reflection of the larger slowdown in the global economy, but conceded the economy "continues to grow at an impressive rate". Source: Adapted from http://profit.ndtv.com/News/Article/imf-cuts-india-s2013-growth-forecast-to-6-5307925. Accessed on 18 July 2012
1.2 Introduction
International Financial Management is the branch of financial economics that is broadly concerned with the macroeconomic and monetary interrelations between two or more countries. The main objective of international financial management is to make optimal decisions for a corporate, in terms of dividend policy, working capital management, investment decisions, and the capital structure in international business context. Finally, what matters is whether the goal of wealth maximization has been achieved or not. In this unit, you will learn about the concept of International Financial Management in contrast with Domestic Financial Management. Along with it, you will also learn about multinational national corporations (MNCs) and transnational corporations. The term globalization has also been discussed in details along with its advantages and disadvantages. The unit also presents the goals of International Financial Management in order to discuss the concept better. You will also study about the International Monetary System and the advantages and disadvantages of the Gold Standard.
Objectives
After studying this unit, you should be able to: define what is meant by globalization identify the objectives of MNCs
Sikkim Manipal University Page No. 2
Unit 1
discuss multinational and transnational companies explain the goals of international financial management discuss the international monetary system
1.3 Globalization
Globalization can be defined as the process of international integration that arises due to increasing human connectivity as well as the interchange of products, ideas and other aspects of culture. It includes the spread and connectedness of communication, technologies and production across the world and involves the interlacing of cultural and economic activity. The term 'globalization' was used by the late professor Theodore Levitt of Harvard Business School in an article titled 'Globalization of Markets' which appeared in Harvard Business Review in 1983. The world turning into a global market has its own advantages and disadvantages for various countries. During the last couple of years, there has been a rapid internationalization of the world financial markets. The US financial investors have invested heavy funds into overseas markets to reap the benefits of rate differentials and high growth rates in new and budding economies. No country can now boast of selfsufficiency since the growth of population all over has a tremendous impact on the growth in consumption, production, and investment around the globe. With such a rise in global demands, a country has to engage itself in trade with international markets. These opportunities have given rise to big fund houses, financial institutions and multinational banks. The tradeoff between risk of investing in global markets and return from these investments is focused to achieve wealth maximization of the stakeholders. It is important to note that in international financial management, stakeholders are spread all over the world. Globalization affects the foreign exchange market to a great extent. According to the theory of comparative advantage by David Ricardo, countries can benefit by exploiting the comparative advantage that arises from specialized production and economies of scale. Not just in goods, globalization of investments allows a country to invest its surplus funds in other countries where the rate of return is comparatively higher and there are better investment opportunities. This also helps in diversification of risk. Therefore cross border investments is a good strategy for growth. However, the downside is that if the exchange rate is volatile, it can affect the trade and investment adversely. In this light, let us now look at the distinct advantages and disadvantages of globalization.
Page No. 3
Unit 1
Advantages of Globalization 1. Economic growth: An open economy can have a higher GDP growth than a closed one because of increased access to various markets and exposure to better technology. An economy can be called a closed economy if it has no economic transactions with any other economy. An open economy is one that has economic interactions with other economies. 2. Lower costs: Open economies can import inputs, raw materials, and technology at cheaper rates and, thus benefit in terms lower cost structure. 3. Improved availability of goods and services: Open economies have access to many countries. They can use the best among all that are available. India which is a labour-intensive country has been able to use cheap Chinese goods due to open trade. 4. Global prosperity and flow of productive resources: Open economies can exchange raw materials and other goods with other. This will benefit both the producers and the customers. 5. Incentives for research and adoption of innovations: The countries that have human resources can develop new products and technology and use the market of less-developed countries to increase trade. 6. Raise cheaper loans: Open economies not only gain on the customerend, but also have access to financial markets of the countries in which they do business with. They can raise cheaper loans than their home country. Disadvantages of Globalization 1. Open economies are interdependent that makes them prone to unavoidable risks like trade cycles. The most recent example is that of the American recession that had affected the whole world. 2. Import dependence can expose a country to undue political, economic and cultural risks. 3. Large-scale increase in international capital flows has increased the problem of heavy indebtedness of some countries and their inability to repay their debts. 4. Problems of foreign exchange due to different currencies of different countries.
Page No. 4
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Self-Assessment Questions
1. ____________can be defined as the process of international integration that arises due to increasing human connectivity as well as the interchange of products, ideas and other aspects of culture. 2. The term 'globalization' was used by the late professor _____________of Harvard Business School in an article titled 'Globalization of Markets'. 3. An economy can be called a__________ if it has no economic transactions with any other economy. Activity 1 Make a SWOT Analysis of impact of globalization on India since 1991. Hint: Analyze the liberalization regime in India and then find out the impact of globalization on the Indian economy.
1.4 Multinational Corporations and Transnational Corporations

Shapiro has defined 'Multinational Corporation' as a company engaged in producing and selling goods or services in more than one country. It ordinarily consists of a parent company located in the home country and at least five or six foreign subsidiaries. The business strategy of MNCs is based classical theory of international trade developed by Adam Smith and David Ricardo. Ricardo emphasized that each nation should specialize in the production and export of those goods that it can produce with maximum efficiency than any other nation (Theory of Comparative Advantage). A multinational corporation is one whose offices or plants or operations are located mostly outside its own home country and the majority of whose revenue is generated outside its home country, i.e. from across the globe. An MNC is an enterprise that owns and controls production or service facilities outside of the country in which it is based (United Nations, 1973). To qualify as an MNC, the number of countries in which the firm operates, must be at least six (Vernon, 1971; United Nations, 1978) and at the same time, the firm must generate a sizeable proportion of its revenue from the foreign operations, although no exact percentage has been specified or agreed upon.
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Overview of the Multinational Financial Environment Multinational companies across the globe form a major part of the multinational financial environment. They function in international financial operations and try to gain advantage from the local or customized environmental conditions of that market. But the global multinational financial environment also consists of the very small, small, medium and large enterprises or companies which provide support to the overall environment, directly and indirectly. No firm or business enterprise is free from the effects of the elements of the global financial environment like price movements, international buffer stock, fluctuation in interest rate or the economic or political environment. Macro and micro level environmental issues can adversely or positively affect the international financial environment. The multinational financial environment of a parent company and its subsidiary depends on the multilateral agreements, the banking system and the multilateral agencies available in the given country. Both the parent as well as the subsidiary companies have to consider several environmental factors such as economic, social, legal, financial and cultural aspects related to business. The environment of domestically oriented organizations is quite different from that of multinational organizations/firms. Both types of companies face political, legal, socio-cultural, financial and physical environments but the difference is that multinational firms/companies have to face the set of environment in more than one country. This implies that the more the number of countries a firm /organization operates in or conducts business in , the higherthe risks it faces as it has to cope with the environments of different countries. The set of environmental factors become more complex with the increase of international business operations in more number of countries. We will now analyse some of these factors/parameters which form a part of the global financial environment: 1. Multiplicity and complexities of the taxation system: Every country has its own taxation system and the corporate tax imposed on foreign companies varies from country to country. Many countries have a very complex tax system while some other countries deliberately keep the tax rates high. This has a major effect on the profitability of any business belonging to a foreign company. The multiplicity parameter means that the number and level of taxes being charged are many. Besides, the filing procedure, documentation and payment mechanism of corporate taxes too can be very cumbersome.
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2. Diversity of medium of financing: Any company which wishes to go international has different sources/means from which it can generate funds for its new venture. At the same time, if the funding is done in a country where the sources of funds are diverse and the company has a lot of options to choose from, then the rate of return on investments may be higher, as funds are easily available. 3. Political risk: For MNCs, this risk is very significant because the political risk in every country varies depending upon several factors such as stability of the government, support of the opposition parties, etc. Political risk may take the form of expropriation or confiscation if the modus operandi of the MNC is not found to be in line with the government policies. In fact, the governments of many countries these days have to be environmentally conscious, and do not compromise on the social well-being of the customers and stakeholders whom they serve. Also, they have to be and are conscious of the impact of their business on the citizens - directly or indirectly. On the other hand, there are MNCs, which, because of their environment friendly products and company image have been able to establish themselves very well in foreign countries. 4. Foreign exchange risk: This is one of the most volatile factors of the international financial environment. Foreign currency fluctuations happen across the world because the demand for and supply of different currencies are different in different countries at the same point of time. Some currencies like pound (), dollar ($), euro () and Japanese yen () are more in demand vis--vis other currencies and the supply of these four currencies is also low in relation to their demand. 5. Diversity of physical environment: The diversity of the physical environment can adversely affect the overall environment facing the MNCs. These parameters can be infrastructural facilities like roads, railways, post and telegraph, transport, communication, etc., which vary from one country to another. For example, the road conditions in Vietnam are so bad that it takes 12 hours to travel a distance of 350-400 hours by road. Also, the climate and weather conditions vary from country to country. 6. Conflicts with the host country environment or government: Here, we are talking about the host country's socio-cultural environment related to tastes and preferences, consumer behaviour, fashion and fad and other aspects such as traditions, etc., which continuously vary from time to time and also within countries. The host country government may have different economic and developmental policies, fiscal and monetary
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policies, balance of payments policies and labour and employment policies which may clash with the overall objective of a multinational firm and make the international financial environment more complex.
4. The diversity of financial sources enables the MNC to reduce its cost of capital but at the same time maximizes the return on its excess cash resources by investing funds in capital markets. (True/False) 5. Investment decisions are concerned with generating funds from internal sources or from external sources that costs less. (True/False) 6. The diversity of the physical environment does not have any impact on the overall environment facing the MNCs. (True/False)
1.5 Objectives of MNCs

Multinational Corporations have many objectives to fulfill and they need to ensure that they frame their policies keeping in mind the investment policies and culture of different companies. There are certain risks like political risk, foreign exchange risks that can affect the performance of a global financial manager. It remains a constant endeavour to manage these risks, use various tools and techniques that are available to counter the risks while keeping a goal in mind goal of wealth maximization of the shareholder. Maximization of stockholder wealth globally is the most commonly accepted objective of an MNC. Shareholder wealth maximization means that the firm makes all business decisions and investments with an eye toward making the owners of the firm the shareholders better off financially, or more wealthy, than they were before. Thus, the objective of the management of a firm is maximization of the current value of the wealth of the shareholder, i.e. the current value of the equity shares.
7. Maximization of ____________globally is the most commonly accepted objective of an MNC. 8. There are certain risks like political risk, __________ that can affect the performance of a global financial manager.
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1.6 International Financial Management and Domestic Financial Management

International financial management is concerned with the financial decisions that are taken in the field of international business. The general agreement on Trade and Tariffs were set up in the immediate post-war years in order to increase trade. It led to the reduction of trade barriers over the years and as a result, international trade grew manifold. It also resulted in the increase of the involvement of the traders exporters and importers as well as the quantum of the cross-country transactions. And these required that the international flow of funds is properly managed for which the study of international finance management became important. International financial management encompasses the following areas: 1. Foreign exchange market 2. Exchange rate determination 3. Determination and management of exchange rate risk 4. MNCs' investment decisions 5. International working capital management 6. Financing decisions in international market However, with the growth of multinational companies, a number of complexities also arose in the area of financial decisions. Apart from taking decisions about where and how much to invest, decisions related to the management of working capital among the parent units and their different subsidiaries also became more complex. Domestic Financial management deals with the payoffs from investments and costs of financing sources. Movements in exchange rates are significantly ignored in the domestic arena. The management of finance in domestic and international enterprises is considerably different. The four major aspects which distinguish international financial management from domestic financial management explained as follows: Foreign exchange risks: The foreign exchange risks states the fluctuation or variation in the prices of currency which will have a tendency to convert a profitable deal to a loss making one. This creates a situation of additional risk to the finance manager.
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Country risks: The political risks may include any changes that will result in the economic environment of the country. For example, Taxation rules, Contract Act and so on. It is pertaining to the management of the country which can alter the rules of the game in an unanticipated manner. Market imperfection: By the integration in the world economy, the differences across the countries have resulted with respect to the transportation costs and different tax rates. Inadequate markets can force a finance manager to struggle for best opportunities across the countries border. Enhanced opportunities: When business is undertaken in a country other than native country, it will help them to expand the chances in business. In addition, it will enhance the opportunity for the business and it diversifies the overall risk.
9. International financial management is concerned with the financial decisions that are taken in the field of international business. (True/False) 10. Movements in exchange rates are given utmost importance in the domestic arena. (True/False)
1.7 Goals of International Financial management

Effective financial management is not limited to the application of the latest business techniques or functioning more efficiently but includes maximization of wealth meaning that it aims to offer profit to the shareholder, the owners of the businesses and to ensure that they gain benefits from the business decisions that have been made. So, the goal of international financial management is to increase the wealth of shareholders just like in domestic financial management. The goals are not only limited to just the shareholders, but also to the suppliers, customers and employees. It is also understood that any goal cannot be achieved without achieving the welfare of the shareholders. Increasing the price of the share would mean maximizing shareholders wealth. Though in many countries such as Canada, the United Kingdom, Australia and the United States, it has been accepted that the primary goal of financial management is to maximize the wealth of the shareholders; in other countries it is not as widely embraced. In countries such as Germany and France, the
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shareholders are generally viewed as a part of the stakeholders along with the customers, banks, suppliers and so on. In European countries, the managers consider the most important goal to be the overall welfare of the stakeholders of the firm. On the other hand, in Japan, many companies come together to form a small number of business groups known as Keiretsu, including companies such as Mitsui, Sumitomo and Mitsubishi which were formed due to consolidation of family-owned business empires. The growth and the prosperity of their Keiretsu is the most critical goal for the Japanese managers. However, it doesnt mean that the maximization of shareholders wealth is just an alternative but it is a goal that a company seeks to fulfill along with other goals. The maximization of shareholders wealth is a long term goal. If a firm does not treat the employees properly or produces merchandises of poor quality, it cannot be expected that such firms will be able to maximize the shareholders wealth. Only those firms can stay in business for a long term and provide opportunities for employment that efficiently produces what is demanded from them. However, in recent times, as capital markets are becoming more integrated and liberalized, managers in countries such as France, Germany and Japan have started paying serious attention to the maximization of the shareholders wealth. For instance, in Germany, companies can now repurchase stocks, if necessary for the shareholders benefit.
Fill in the blanks with the appropriate words. 11. The goals of International Financial Management are not only limited to just the shareholders, but also to the suppliers, ____________. 12. The foremost goal of international financial management is maximization of the________________________.
1.8 International Monetary System

A successful exchange rate system is needed to stabilize the international payment system. An exchange rate system needs to fulfill three conditions: (i) Balance of payments (BOP) deficits or surpluses by individual countries should not be large.
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(ii) These deficits should be corrected in such a way that it does not cause inflation on trade and payments for either the individual country or whole of the world. (iii) The maximum sustainable expansion of trade and other international economic activities should be facilitated. BOP is an accounting system that measures all economic transactions between residents (including government) of one country and residents of all other countries. Economic transactions include exports and imports of goods and services, capital inflows and outflows, gifts and other transfer payments, and changes in a country's international reserves. The International Monetary Fund (IMF) Since its establishment in 1944, the International Monetary Fund has been the centerpiece of the world monetary order though its supervisory role in exchange rate arrangements has been considerably weakened after the advent of floating rates in 1973. The IMF was given the responsibility for collecting and allocating reserves. The role of supervising the adjustable peg system, offering advice to the member countries on their international monetary affairs, promoting research in different areas of monetary and international economics were also given to the IMF. It also offers the member countries a forum for consultation and discussion. Funding Facilities As we have seen above, operation of the peg requires a country to intervene in the foreign exchange markets to support its exchange rate when it threatens to move out of the permissible band. If a country faces a BOP deficit, reserves are needed for carrying out the intervention and for this; it must take the step of selling foreign currencies and buying its own currency. In case its own reserves are inadequate, it must borrow from other countries or from the IMF. (Note that the country which has a surplus does not face this problem.) International Liquidity and International Reserves The stock of means of international payments are referred to as international liquidity refers to the. On the other hand, the assets that the country can make use of when settlement of payment imbalances arises in its transactions with other countries are known as international reserves. The monetary authority of the company takes care of the reserves and uses them while carrying out interventions on the foreign exchange markets. In addition, liquidity can be
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provided by the private markets by lending to deficit countries out of funds that are deposited with them by the surplus countries. This sort of private financing of BOP deficits took place on a large scale during the post oil-crisis years and has come to be known as recycling of petrodollars. Gold Standard 1876-1913 From the ancient times, gold has been used as a medium of exchange as it is durable, portable and easily tradable. Increase in the trade activity during the free-trade period in the 19th century led to the need for a more formalized system for settling business transactions. This made gold desirable to be used as a standard to determine the value of currency. The rules of the game under the gold standard were that each country would establish the rate at which its currency could be converted to the weight of gold. Each country's government agreed to buy or sell gold at its own fixed rate of demand. This served as a mechanism to preserve the value of each individual currency in terms of gold. Each country had to maintain adequate reserves of gold in order to back its currency's value. There was a limit to the rate at which any individual country could expand its supply of money. The growth in the money was limited to the rate at which additional gold could be acquired by official authorities. Advantages of Gold Standard 1. Gold standard provided stable exchange rates, which were conducive for trade policy because this eliminates another source of price instability. 2. An efficient operating gold standard exchange rate system ensures automatic adjustment of balance payment problem through price changes. 3. This system imposes orthodoxy on fiscal policies and restricts governments from resorting to indiscriminate spending. Disadvantages of Gold Standard 1. The burden of BOP adjustment shifts to domestic variables which subordinate the domestic economy to external economic factors. 2. There is always a problem of selecting an appropriate par value which reflects the external and internal equilibria. 3. Emergence of misaligned values might have encouraged speculations of sufficient magnitude to effect exchange rate realignment. 4. The gold standard was dependent on an adequate supply and not excess supply of new gold.
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5. The mining process of gold involves huge cost and is used as a reserve only. The same purpose can be served by some other asset that has no cost. 6. There is unequal geographic distribution of gold throughout the world. The countries which had greater gold reserves enjoyed greater strength. Interwar Years 1914-1944 The gold standard worked adequately till World War I. Subsequently, it broke down during World War I but was again put to practice from 1925-1931. Under this standard, the US and England could hold only gold reserves but other nations could hold both gold and dollars/pounds as reserves. The Bretton Wood System 1945-1971 In 1944, a conference was held at Bretton Woods, New Hampshire, in which each participating government agreed to maintain a fixed exchange rate for its currency in comparison to dollar/gold. One ounce of gold was set equal to $35. Thus, fixing a currency's gold price was equivalent to setting its exchange rate relative to the dollar. For example, Germany's currency was set equal to 1/140 of an ounce of gold. So, if we convert to dollar, then $ 35/140 = $0.20.1 German Mark= $ 0.20 The Smithsonian Agreement 1971-1973 From August to December 1971, most of the major currencies were allowed to fluctuate. The US dollar fell in value against a number of major currencies. Several countries imposed trade and exchange controls causing a major concern. It was feared that such protective measures may become widespread and limit the international trade. In order to solve these problems, the world's leading trading countries called the 'Group of ten' signed an agreement on 18 December 1971. The agreement established a new set of exchange rates. The dollar was devalued to 1/38 of an ounce of gold and other currencies were re-valued by agreed on amounts of dollars. Officially, in 1971 it turned to floating exchange rates. It was proposed that the new system would reduce economic volatility and facilitate free trade but it failed miserably. The government control on foreign exchange did not decrease, so this agreement came to an end in March 1973. Post-1973 The fixed rate system was replaced by the floating exchange rate system. However, there are five different market mechanisms for establishing exchange rates. The choice of the method of fixing the exchange rate depends on the government of the country.
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1. Free float: In a free market, exchange rates are determined by the interaction of currency supplies and demands. For example, in India there are more imports from America. So there will be more demand of American dollars. If the exports are less as compared to imports, there will be a gap in demand and supply of dollars, leading to a fluctuation in the exchange rate. This system is also called a clean float. 2. Managed float: When the central bank of a country intervenes in the determination of exchange rates so as to smoothen the exchange rates fluctuations, it is called as managed or dirty float system. The bank may smoothen out the daily fluctuations by entering the market as a buyer or seller to control the exchange rate variations. 3. Target-zone arrangement: Countries adjust their economic policies to control the variations in the exchange rates within a margin agreed upon. This system exists in Europe, the US, Japan and Germany. 4. Fixed-rate system: The governments of the countries where such a system exists maintain the exchange rate by actively buying and selling their currencies in the foreign exchange market whenever their exchange rates fluctuate from the stated par value. 5. Current hybrid system: The current international monetary system is a hybrid, with major currencies floating on a managed basis, some freely floating and moving from a target-zone to a fixed-rate system. Activity 2 In the present economic scenario, assess the contribution of IMF towards India. Find news item regarding the same and paste them in a chart. Hints: 1. Browse the internet and study the functions of IMF. 2. Collect newspapers and search for news item.
13. __________is an accounting system that measures all economic transactions between residents (including government) of one country and residents of all other countries. 14. The Fixed rate system was replaced by the ______________________. 15. The International Monetary Fund was established in _______________.
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16. In 1944, a conference was held at ______________________in which each participating government agreed to maintain a fixed exchange rate for its currency in comparison to dollar/gold.
1.9 Case Study

UnileverA Case Study Unilever being one of the oldest and largest foreign multinationals conducting businesses in the U.S. presents an opportunity for understanding the various problems that are encountered by multinationals in the foreign land. Different issues related to the multinationals can be studied through the help of the case of Unilever. A complex organization Since 1929, the company has been headed by two different Dutch and British companies having different sets of shareholders but the same boards of directors. Two head offices were located in Rotterdam and London and had two chairmen. The role of the "chief executive" was performed by a three person special committee comprising two chairmen and one other director. The complexity of the organization was further compounded by the wide range of products offered by UniIever and the changes that took place in these products over time. Unilever also manufactured convenience foods such as ice cream, meat products, tea as well as frozen foods and soups. Other than these, they also manufactured personal care products such as shampoo, hairspray, toothpaste and deodorants. In Europe, its food business spanned all stages of the industry, from fishing fleets to retail shops. It also owned a trading company, the United Africa Company employing around 70,000 people in the 1970s and became the largest modern business enterprise in West Africa. In 1981, a ranking by sales revenues in Forbes put it in twelfth place. As an early multinational investor, Unilever had the advantage of extensive manufacturing and trading businesses throughout Europe, North and South America by the postwar decades, Unilever was one of the largest and oldest foreign multinationals in the United States and its longevity in the United States offers an opportunity to study the issue of inward FDI in the United States. The case of Unilever provides new empirical evidences of important issues related to the functioning and impact of the multinationals. It also brings into focus the issue of what is meant by "control" within multinationals.
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Questions 1. What do you think are the issues faced by Multinationals in foreign lands? 2. What do you think were the advantages that Unilever had being an early multinational investor? Hint: As an early multinational investor, Unilever had the advantage of extensive manufacturing and trading businesses throughout Europe. Source: Adapted from http://hbswk.hbs.edu/item/3212.html Accessed on 16 July 2012
1.10 Summary
Let us recapitulate the important concepts discussed in this unit: The term 'globalization' was used by the late professor Theodore Levitt of Harvard Business School in an article titled 'Globalization of Markets' which appeared in Harvard Business Review in 1983. An open economy can have a higher GDP than a closed one because of increased access to improved economies and exposure to better technology that can provide an upwards thrust to economic development. Shapiro has defined 'Multinational Corporation' as a company engaged in producing and selling goods or services in more than one country. The classical theory of international trade developed by Adam Smith and David Ricardo emphasized that each nation should specialize in the production and export of those goods that it can produce with maximum efficiency than any other nation (Theory of Comparative Advantage). No firm or business enterprise is free from the effects of the elements of the global financial environment like price movements, international buffer stock, fluctuation in interest rate or the economic or political environment. The foremost goal of international financial management is maximization of the wealth of the shareholder. A successful exchange system is needed to stabilize the international payment system.
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1.11 Glossary
Globalization: Processes of international integration as a result of increase in human connectivity and the interchange of ideas, products, worldviews as well as other aspects of culture Open economy: Economy which is free from trade barriers and where a large percentage of the GDP includes exports and imports Liquidity: Flow of assets Subsidiary: An organization that is controlled by another due to the ownership of more than 50 percent of the voting stock Mobilization: Make mobile or capable of moving Buffer Stock: Supply of inputs that is kept as a reserve for facing any kind of demands or unforeseen shortages. Expropriation: Deprive of possession Stockholder: One who owns a share or shares of stock in a company
1.12 Terminal Questions

1. Explain the term Globalization. 2. Discuss the advantages of Globalization. 3. Discuss what you mean by multinational corporations. 4. What do you think is the most commonly accepted objective of an MNC? Discuss. 5. How does International Financial Management helps in maximizing the wealth of the shareholders? 6. Discuss the disadvantages of Gold Standard.
1.13 Answers Answers to Self-Assessment Questions

1. Globalization 2. Theodore Levitt 3. Closed economy
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4. True 5. False 6. False 7. Stockholder wealth 8. Exchange rate risks 9. True 10. False 11. Customers and employees 12. Wealth of the shareholder 13. BOP 14. Floating exchange rate system 15. 1944 16. Bretton Woods, New Hampshire
Answers to Terminal Questions

1. Globalization can be defined as the process of international integration that arises due to increasing human connectivity as well as the interchange of products, ideas and other aspects of culture. For further details, refer to Section 1.3. 2. The advantages of Globalization are: Economic growth Lower costs Improved availability of goods and services For further details, refer to Section 1.3. 3. 'Multinational Corporation' is a company engaged in producing and selling goods or services in more than one country. For further details, refer to Section 1.4. 4. Maximization of stockholder wealth globally is the most commonly accepted objective of an MNC. For further details, refer to Section 1.5.
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5. Effective financial management is not limited to the application of the latest business techniques or functioning more efficiently but includes maximization of wealth meaning that it aims to offer profit to the shareholder, the owners of the businesses and to ensure that they gain benefits from the business decisions that have been made. For further details, refer to Section 1.7. 6. The disadvantages of Gold Standard are: The burden of BOP adjustment shifts to domestic variables which subordinate the domestic economy to external economic factors. There is always a problem of selecting an appropriate par value which reflects the external and internal equilibrium. For further details, refer to Section 1.8.
References/e-References
Kaur, Dr. Harmeet. International Finance, Delhi: Vikas Publishing House. Apte, P.G. International Financial Management. 2006. New Delhi: Tata McGraw Hill.
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Structure 2.1 Caselet 2.2 Introduction Objectives 2.3 Principles of BOP Accounting 2.4 Balance of Payments Statement 2.5 Current Account Deficit and Surplus 2.6 Capital Account Convertibility 2.7 Case Study 2.8 Summary 2.9 Glossary 2.10 Terminal Questions 2.11 Answers References/e-References
Balance of Payments
2.1 Caselet
Tarapore Committee Recommendations on the Capital Account Convertibility in India Since 1991, the Indian Government thought of liberalizing both the current and the capital accounts. After the Government attained full convertibility on current account transactions by August 1994, a long debate on whether to go for capital account convertibility (CAC) and also how to go about it ensued. In February 1997, the Reserve Bank of India appointed a committee for exploring the possibility for CAC and for suggesting important measures. Taking into consideration issues such as the pre-conditions that are necessary for the smooth functioning of the committee and to find out how to phase on to the CAC, the Tarapore Committee report was tabled in June 1997. Some of the suggestions were implemented while some others could not be implemented due to some unwarranted changes in macro-economic variables in general and in external sector variables in particular, since late 1997. The committee suggested that the resident individuals should be allowed to make foreign-currency denominated deposits with a bank in India, in order to borrow from the non-residents at an interest rate not exceeding the London Interbank Offered Rate (LIBOR). Through this, they could also transfer financial capital abroad.
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The committee also recommended that the limit of the Indian banks borrowings can also be enhanced from the then existing level of US $ 10 million to 50% of their unimpaired Tier 1 capital in the first year to 100% of such capital in the final year. It also suggested that liberal provisions should be made for the forward cover in the foreign exchange market and also allow the NBFCs to function as authorized dealers. Source: Adapted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/ 72250.pdf Accessed on 18 July 2012
2.2 Introduction
In the previous unit, you learnt broadly about the international financial environment in which the world economy operates. You also understood the concept of International Financial Management as well as Domestic Financial Management. Along with it, you learnt about the multinational and transnational corporations and the concept of the term globalization. The economies of the world are interdependent one with other and in this light international trade and flow of capital gain importance. Therefore, in order to analyse and understand the monetary aspects of a countrys international interactions, a statement of balance of international payments is prepared by every country. In this unit, you will learn about the concepts and principles of balance of payments and its various components. The Current Account Deficit and Surplus and Capital Account Convertibility have also been discussed.
Objectives
After studying this unit, you should be able to: explain the concept and principles of BOP accounting define the Balance of Payment Statement identify capital account, current account and the official reserve account describe current account deficit and surplus explain the concept of capital account convertibility
2.3 Principles of BOP Accounting

Balance of payments (BOPs) measures the payments that flow between a country and other countries. It determines economic transactions of a country
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during a specific time period. The BOP is determined by a countrys export and imports of goods services, and financial capital, as well as financial transfers. The balance of payments is based on the principles of double-entry bookkeeping, according to which two entries - credit and debit - are made for every transaction, so that the total credits match the total debits. BOP accounting principles regarding debits and credits are as follows: 1. Credit Transactions (+) are those that involve the receipt of payment from foreigners. The following are some of the important credit transactions: (i) Exports of goods or services (ii) Unilateral transfers (gift) received from foreigners (iii) Capital inflows 2. Debit Transactions (-) are those that involve the payment of foreign exchange i.e., transactions that expend foreign exchange. The following are some of the important debit transactions: (i) Import of goods and services (ii) Unilateral transfers (gift) given to foreigners (iii) Capital outflows
2.3.1 Debits and Credits

Debits and credits can be defined as the two fundamental aspects of every financial transaction in the system of double-entry bookkeeping. They are a system of notation through which it can be determined how any financial transaction is recorded. In order to determine whether a person should credit or debit a specific account, the modern accounting equation approach is used that comprises five rules or accounting elements. These elements are expenses, liabilities, income, equity and assets. The rules of double-entry bookkeeping show the credit and debit items vertically in the BOP of a country. Debit can be defined as any economic transaction that leads to a payment to foreigners and is characterized by a negative arithmetic sign (-). Any economic transaction giving rise to a receipt from the rest of the world is known as credit with a positive arithmetic sign (+). Thus, it is known that every credit in the account is balanced by a corresponding debit and vice versa. While numbers are being recorded in accounting, a credit value is placed on the right side of a ledger (Accounting Book) and a debit value is placed on
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the left side of a ledger. Depending on the kind of accounts, there is an increase or a decrease in the total balance in each account. In the accounting sense, the balance of payment always balances, since every economic transaction recorded in BOP is represented by two entries with equal values.
2.3.2 Debit and Credit Entries

All the transactions that lead to a prospective payment or an immediate payment from the rest of the world (ROW) to the country in question should be recorded as credit entries in the BOP of that country. And the payments themselves should be recorded as the offsetting debit entries. Thus, while the sale of the product is recorded as a credit entry, the payment made by a foreign firm is recorded as a debit entry. For instance, if an Indian firm is purchasing machinery from a foreign firm, the machinery that is imported is recorded as a debit entry and the payment which is made is recorded as a credit entry. A credit entry can be defined as an international transaction that results in a demand for domestic currency in the foreign exchange market or a transaction which is a source of foreign currency. On the other hand, debit entry is the transaction that leads to a supply of the home currency in the foreign exchange market. The individual items that make up the BOP are categorized under five groups of transactions:
Credit entries Trade items Visible exports Invisible exports (payments to the domestic countries for services rendered abroad) Gold exports (physical export of the metal) Unrequited receipts (gifts received from foreigners) Capital receipts (loans from, capital repaid by, or assets sold to foreign nationals) Total receipts Debit entries Visible imports Invisible imports (payments by the domestic countries for services rendered abroad) Gold imports (physical import of the metal) Unrequited receipts (gifts paid to foreigners) Capital payments (loans to, capital repaid to, or assets purchased from foreign nationals) Total payments
Non-trade items
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We will learn about how these transactions appear in the Balance of Payment statements in the next section. Activity 1 Suppose Country A supplies machinery products worth 300 million to Country B and exports crude oil worth 300 million, what will be the credit and debit entries? Write them down on a chart. Hint: While the sale of the product is recorded as a credit entry, the payment made by a foreign firm is recorded as a debit entry.
1. The balance of payments is based on the principles of ___________, according to which two entries-credits and debits are made for every transaction, so that the total credits match the total debits. 2. ____________can be defined as any economic transaction that leads to a payment to foreigners and is characterized by a negative arithmetic sign (-). 3. While the sale of the product is recorded as a ____________, the payment made by a foreign firm is recorded as a debit entry.
2.4 Balance of Payments Statement

The economic transactions of a countrys residents in relation to the rest of the world are summarized by the balance of payments statement. It also presents the transactions of movements in official reserves, the net income that has been generated abroad and the transactions that take place in the physical and financial assets. The BOP consists of current account, capital account and reserve account. The current account records flow of goods, services and unilateral transfers. The capital account shows the transactions that involve changes in the foreign financial assets and liabilities of a country. The reserve account records transactions pertaining to reserve assets like monetary gold, special drawings right (SDRs) and assets denominated in foreign currencies. BOP is neither an income statement nor a balance sheet. It is a statement of sources and uses of funds that reflects changes in assets, liabilities and net
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worth during a specified period of time. Decreases in assets and increases in liabilities or net worth represent credits or sources of funds. Increases in assets and decreases in liabilities or net worth represent debits or uses of funds. Sources of funds include exports of goods and services, investment and interest earnings, unilateral transfers received from abroad and loans from foreigners. Uses of funds include imports of goods and services, dividends paid to foreign investors, transfer payments abroad, loans to foreigners and increase in reserve assets.
2.4.1 The Current Account

The current account of the balance of payments refers to the monetary value of all exports and imports of merchandise and invisibles. All international flows associated with transactions in goods and services, investment income, and unilateral transfers are included in this account. It is divided into merchandise trade balance, the service balance and the balance on unilateral transfers. All the entries that are made in these accounts are of current value and they do not give rise to any future claim. A surplus in the current account represents an inflow of funds while a deficit represents an outflow of funds. The detail of these three sub-categories is presented as follows: Merchandise trade: It includes the balance between exports or imports of goods such as machinery, electronic goods, cars etc. A surplus balance of merchandise trade happens when exports are greater in value than imports. A deficit in balance of merchandise occurs when imports exceed exports. Invisibles: These include services like payments for legal assistance, tourists expenditures, and shipping fees, royalty payments and interest payments. International interest and dividend payments and the earnings of domestically owned firms operating abroad. Unilateral transfers: These include remittances, gifts and grants by both government and private sector. Government transfers include money, goods and services sent as an aid to other countries in the hour of need. Private gifts and grants include personal gifts of all kinds. Merchandise trade includes all of the goods a country exports or imports, such as agricultural products, machinery, automobiles, petroleum, electronics, textiles, and the like. The dollar value of merchandise exports is recorded as a plus (credit), and the dollar value of merchandise imports is recorded as a minus (debit). Combining the exports and imports of goods gives the merchandise
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trade balance. When this balance is negative, the result is a merchandise trade deficit; a positive balance implies a merchandise trade surplus. Exports and imports of services include a variety of items. When Indian ships carry foreign products or foreign tourists spend money at Indian restaurants and hotels, valuable services are being provided by Indian residents, who must be compensated. Such services are considered as exports and are recorded as credit items on the goods and services account. Conversely, when foreign ships carry Indian products or when Indian tourists spend money at hotels and restaurants abroad, foreign residents are providing services that require compensation. Because Indian residents are, in effect, importing these services, the services are recorded as debit items. Insurance and banking services are explained in the same way. Services also include items such as transfers of goods under military programmes, construction services, legal services, technical services, and the like. When the sum of all debits and credits is calculated, a country may have a deficit or surplus on the merchandise trade account. This measures whether the country is a net exporter or importer of goods. A trade surplus indicates that the countrys exports are greater than imports and a trade deficit indicates that a countrys imports are greater than exports. Just what does a surplus or deficit balance on the goods and services account mean? A surplus shows how much the country will have to lend or invest abroad. A deficit shows how much a country will have to borrow from aboard by issuing certain financial securities like bonds or stocks to finance its deficit.
2.4.2 Capital Account

It is an accounting measure of the total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. This account consists of loans, investments and other transfers of financial assets and the creation of liabilities. It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. It includes three categories: direct investment, Portfolio investment and other capital flow. The detail of these three sub-categories is presented as follows: Direct investment: It occurs when the investor acquires shares of a company acquires the entire firm or the establishment of new subsidiaries. FDI takes place when the firms tend to take advantage of various market imperfections. Firms also undertake FDI when the expected returns from
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foreign investment exceed the cost of capital, allowing for foreign exchange and political risks. The expected returns from the foreign profits can be higher than those from domestic projects due to lower material and labour costs, subsidized financing, investment tax allowances, exclusive access to local markets etc. An example of direct investment is an Indian firm doing business in a foreign country. Portfolio investment: This represents the sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors. International portfolio investments have seen a boom in the recent years as the investors have become aware about the risk diversification that can be reduced if they invest in various financial assets globally. The increased returns from the foreign markets have also given a boost to such category of investors. An example is a foreign institutional investor buys the equity stock of an Indian company. Capital flows: It represents the claim with a maturity of less than one year. Such claims include bank deposits, short-term loans, short-term securities, money market investment etc. these investments are sensitive to both changes in relative interest rates between countries and the anticipated change in the exchange rate. Let us understand with the help of an example. If the interest rate increases in India then it will experience a capital inflow as investors would like to take advantage of the situation by buying bonds when prices are low, since interest rates on bonds and inversely proportional to the bond prices.
2.4.3 The Official Reserve Account

The Official reserve account of BOP measures a countrys official reserves which are in the form of liquid assets like the central banks holding of gold. They are government owned assets. This account represents only purchases and sales by the central bank (RBI). These reserves also include foreign exchange in the form of balances with the foreign banks and the IMF and the governments holding of Special drawing rights (SDRs).The changes in official reserves are necessary to account for the deficit or surplus in the BOPs. While an increase in the holdings of foreign currency reserves by the countrys central bank is debited to the official reserve account, a decrease in the holdings of foreign currency reserves by the countrys central bank is credited to the reserve account.
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4. The goods account of a country includes all transactions of the visible items. (True/False) 5. Short-term capital account follows internationally acceptable means of settling international obligations. (True/False) 6. Unilateral transfers account is also known as a gift account, which includes all gifts, grants, reparation receipts and payments given to foreign countries. (True/False) 7. The official reserve account of the balance of payments refers to the monetary value of international flows associated with transactions in goods and services, investment income, and unilateral transfers. (True/False)
2.5 Current Account Deficit and Surplus

If the BOP is considered as a double-entry accounting record, then apart from errors and omissions, it must always balance. Obviously, the terms deficit or surplus cannot then refer to the entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The imbalance must be interpreted in some sense as an economic disequilibrium. Concerning the balance of payments, the current account and the capital and financial account are not unrelated. They are essentially reflections of one another. Because the balance of payments is a double-entry accounting system, the total debits will always equal total credits. It follows that if the current account registers a deficit (debits outweigh credits), the capital and financial account must register a surplus, or net capital/financial inflow (credits outweigh debits). Conversely, if the current account registers a surplus, the capital and financial account must register a deficit, or net capital/financial outflow. To better understand this notion, assume that in a particular year your spending is greater than your income. How will you finance your deficit? The answer is by borrowing or by selling some of your assets. You might liquidate some real assets (for example, sell your personal computer) or perhaps some financial assets. In like manner when a nation experiences a current account deficit, its expenditures for foreign goods and services are greater than the income received from the international sales of its own goods and services, after making allowances for investment income flows and gifts to and from
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foreigners. The nation must somehow finance its current account deficit. But how? The answer lies in selling assets and borrowing. In other words, a nations current account deficit (debits outweigh credits) is financed essentially by a net financial inflow (credits outweigh debits) in its capital and financial account. The transactions that constitute the BOP are also categorized as autonomous transactions and accommodating transactions. An autonomous transaction is undertaken for its own purpose, i.e. to realize profits. An accommodating transaction is undertaken to correct the imbalance in an autonomous transaction. Is a current account deficit a problem? Contrary to commonly held views, a current account deficit has little to do with foreign trade practices or any inherent inability of a country to sell its goods on the world market. Instead, it is because of underlying macroeconomic conditions at home requiring more imports to meet current domestic demand for goods and services than can be paid for by export sales. In effect, the domestic economy spends more than it produces, and this excess of demand is met by a net inflow of foreign goods and services leading to the current account deficit. This tendency is minimized during periods of recession but expands significantly with the rising income associated with economic recovery and expansion. When a nation realizes a current account deficit, it becomes a net borrower of funds from the rest of the world. Is this a problem? Not necessarily. The benefit of a current account deficit is the ability to push current spending beyond current production. However, the cost is the debt service that must be paid on the associated borrowing from the rest of the world. Is it good or bad for a country to get into debt? The answer obviously depends on what the country does with the money. What matters for future incomes and living standards is whether the deficit is being used to finance more consumption or more investment. If used exclusively to finance an increase in domestic investment, the burden could be slight. We know that investment spending increases the nations stock of capital and expands the economys capacity to produce goods and services. The value of this extra output may be sufficient to both pay foreign creditors and also augment domestic spending. In this case, because future consumption need not fall below what it otherwise would have been, there would be no true economic burden. If, on the other hand, foreign borrowing is used to finance or increase domestic consumption (private or public), there is no boost given to future productive capacity.
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Therefore, to meet debt service expense, future consumption must be reduced below what it otherwise would have been. Such a reduction represents the burden of borrowing. This is not necessarily bad; it all depends on how one values current versus future consumption. During the 1980s, when the United States realized current account deficits, the rate of domestic saving decreased relative to the rate of investment. In fact, the decline of the overall saving rate was mainly the result of a decrease of its public saving component, caused by large and persistent federal budget deficits in this periodbudget deficits are in effect negative savings that subtract from the pool of savings. This indicated that the United States used foreign borrowing to increase current consumption, not productivity-enhancing public investment. The US current account deficits of the 1980s were thus greeted by concern by many economists. In the 1990s, however, US current account deficits were driven by increases in domestic investment. This investment boom contributed to expanding employment and output. It could not, however, have been financed by national saving alone. Foreign lending provided the additional capital needed to finance the boom. In the absence of foreign lending, US interest rates would have been higher, and investment would inevitably have been constrained by the supply of domestic saving. Therefore, the accumulation of capital and the growth of output and employment would all have been smaller had the United States not been able to run a current account deficit in the 1990s. Rather than choking growth and employment, the large current account deficit allowed faster long-run growth in the US economy, which improved economic welfare. Balance of Payments deficit or surplus has an immediate impact on the exchange rate. It was mentioned earlier that BOP records all transactions that create demand for and supply of currency. Hence a current account deficit will raise interest rates to attract short term capital inflow to prevent depreciation of the currency. Or the monetary authorities may tighten credit and money supply to make it difficult for domestic banks to borrow the home currency to make investments abroad. It may force exporters to quickly realize their earnings and bring foreign currency home. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret it as evidence that the country may have difficulty in servicing its debts.
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8. A nations current account deficit (debits outweigh credits) is financed essentially by a net financial inflow (credits outweigh debits) in its capital and________________________. 9. The ___________ of an economy can be expressed as the sum of the net borrowing by each of its sectors: government and the private sector including business and households. 10. In the ___________, US current account deficits were driven by increases in domestic investment.
2.6 Capital Account Convertibility

When free inflows and outflows are allowed abroad except for capital purposes like loans and investments, it is referred to as Current Account Convertibility. This really means that residents of a country can make or receive trade related payments, for example dollars, for exporting goods and services. They can also pay dollars for import of goods and services to make sundry remittances, access foreign currency for studying abroad, or undergoing medical treatments, gifts or for travel purpose. Current Account Convertibility in India was established with the acceptance of the obligations under Article VIII of the IMFs Articles of Agreement in August 1994. The term capital account convertibility means relaxing control on capital account transactions. For instance, it could mean quantitative restriction on the movement of capital, a multiple exchange rate system suggesting different exchange rates for commercial/financial transactions or explicit/implicit tax on international financial transactions for discouraging the flow of capital. Thus, CAC gives way to an absence of quantitative taxes on capital account transactions or the presence of a market-based exchange rate system. Capital account convertibility (CAC) permits the local currency to be exchanged for foreign currency and no restrictions are put on the limit. Through this, the local merchants can easily conduct transnational business without the need for foreign currency exchanges in order to carry out small transactions. However, questions also arise whether the monetary authorities of a country should go for CAC or not. According to the advocates of capital control, there are three basic advantages of control. They are:
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1. It leads to a lessening of the effects of the balance of payment crisis and also leads to the reduction of instability in exchange rates. 2. It ensures that the requirements of investments are met by the domestic savings and also assist in avoiding the foreign ownership of the domestic factors of production. 3. It helps in maintaining the ability of the authorities in taxing domestic financial activities. For ensuring CAC, the advocates who are arguing for relaxing the control however opine that the arguments behind control are free from flaws. Though investments are financed by the domestic savings, they often fall short of the requirements. Foreign capital also possesses a number of advantages that the domestic capital does not have. It is also important to note that the experience of capital control measures in the developing and the developed countries states that such kinds of measures have not been very effective. In order to make it more effective, a technically sophisticated bureaucracy is required which is not present in the developing countries. Moreover, firms can also transfer funds across borders through the transfer pricing techniques. This also makes the controls ineffective. Again, there is greater freedom for individual decision making as to how to get necessary resources and how to use the excess reserves. The residents are also capable of holding internationally diversified portfolio of assets, which leads to reduction of the risks involved in investment and augments the riskadjusted returns on capital. Due to the increased competition abroad, domestic providers of financial services are required to be more efficient. In addition to fostering efficiency in the domestic financial market, CAC also allows an economy to access international financial market. It receives the desired amount of external funds with minimal borrowing cost. However, it cannot function successfully in the presence of domestic distortions, such as lopsided development of the domestic financial market. CAC finds support in both the international and the regional level. The CAC also gains support from the IMF if the country has witnessed current account surpluses and has also received a large inflow of capital. Many developing countries have also received technical assistance from the IMF in the field of the management of foreign exchange.
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Activity 2 Browse the Internet and find out how CAC is functioning in India. Make a report. Hint: The authorities officially involved with CAC (Capital Account Convertibility) for Indian Economy encourage all companies, commercial entities and individual countrymen for investments, divestments, and real estate transactions in India as well as abroad.
11. Capital account convertibility (CAC) permits the local currency to be exchanged for foreign currency and no restrictions are put on the limit. (True/False) 12. Control leads to an increase in the effects of the balance of payment crisis and also raises instability in exchange rates. (True/False)
2.7 Case Study

Worst may be over on Balance of Payments Indias Central bank released a data on 29 June, 2012 stating that the external position of India is the most fragile since the country witnessed a balance of payments crisis in the summer of 1991. However, many analysts are also of the opinion that there is going to be an improvement in the external position of India. The data released by the Central bank showed that Indias current account deficit ballooned to a record high of $21.7 billion, or 4.5% of gross domestic product (GDP), in the January-March quarter, from $6.3 billion a year earlier. The money that crosses the borders of a country for all purposes excepting investment and loans is counted by the current account. If the imports as well as other external payments exceed the exports in addition to the external receipts, it is considered to be in deficit. As the investments made by the foreigners into India during the JanuaryMarch quarter was not enough to fulfill the shortfall of current account, the Reserve Bank of India required to supply dollars from the foreign-exchangereserves of India for the second consecutive quarter. The data also revealed that Indias current account deficit jumped from 2.7% to 4.2% of GDP for the fiscal year ending on March 31 after staying below 3% since 1991.
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However, there are a number of barriers to the growth of the external position of India. Slow growth in the developed economic markets of Europe and the US could be a barrier to the growth of export. The price of oil may further rise due to the rise in the European Union oil sanctions on Iran from July 1. The Indian government also subsidizes some fuel products for the end-consumers thus resulting in high demand of fuel. If the Government doesnt cut down on fuel subsidies the way it has committed to do, the pressure on the current account deficit may continue. But still, there are many analysts who believe that the worst is over. Imports will be highly discouraged due to the sharp fall of the Indian rupee against the US dollar as it will result in the companies paying more rupees for the goods that are priced in dollars. However, it will also result in the Indian companies exporting more as their earnings will increase when converted into Indian rupees. These simultaneous developments could lead to the reduction of the current account gap. Its worth noting that in the past 12 months, the rupee has fallen more than 20% against the dollar. Why hasnt the current account improved over that period? What has suddenly changed now? Nomura, a leading financial services group, is of the opinion that the benefit of a weak local currency can be seen after a time period as it takes time for the importers and the exporters to adjust. Some of the imports are also inelastic in nature meaning that their demand does not decrease even if there is an increase in the price. Goldman Sachs estimates that every 1% fall in the value of the rupee, adjusted for inflation, leads to a 1.1% increase in exports with a lag of two months and a similar fall in imports after four months. Goldman Sachs further says that the recent fall in crude prices is also likely to lower the current account gap. India imports three-fourths of its crude oil requirement and, if oil costs less, India has to pay fewer dollars for it though of course, it now needs more rupees to buy those dollars. Nomura expects the current account deficit to fall to 3.0% to 3.5% of GDP in the year that started April 1, while Barclays Capital estimates it at 3.6%. Questions 1. Do you agree that India will benefit from the fall in the value of rupee? 2. What do you think are the barriers to the growth of the external position of India? Source: Adapted from http://blogs.wsj.com/indiarealtime/2012/07/02/worstmay-be-over-on-balance-of-payments/ Accessed on 28 July 2012
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2.8 Summary
Let us recapitulate the important concepts discussed in this unit: Balance of payments (BOPs) measures the payments that flow between a country and other countries. The balance of payments is based on the principles of double-entry bookkeeping, according to which two entries-credits and debits are made for every transaction, so that the total credits match the total debits. Debits and credits can be defined as the two fundamental aspects of every financial transaction in the system of double-entry bookkeeping. A current account surplus means an excess of exports over imports of goods, services, investment income, and unilateral transfers. During the 1980s, when the United States realized current account deficits, the rate of domestic saving decreased relative to the rate of investment. Capital account convertibility (CAC) permits the local currency to be exchanged for foreign currency and no restrictions are put on the limit.
2.9 Glossary
Double-entry bookkeeping: An accounting technique which records each transaction as both a credit and a debit Reparation: The act or process of making amends Tangible: Material or substantial Subsidized: Having partial financial support from public funds Assets: Something valuable that an entity owns, benefits from, or has use of, in generating income Liquidate: To convert to cash Maturity: Arrival of the time fixed for payment; termination of the period a note, etc Merchandise: The objects of commerce Special drawing rights (SDRs): They are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF)
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1. Define debits and credits in BOP. 2. Explain the major accounts of the balance of payments statement. 3. Discuss the three sub-categories of capital account. 4. What is official reserves account? Explain. 5. Discuss current account surplus. 6. What do you mean by capital account convertibility? Discuss.

1. Double-entry bookkeeping 2. Debit 3. Credit entry 4. True 5. False 6. True 7. False 8. Financial account 9. Net borrowing 10. 1990s 11. True 12. False

1. Debits and credits can be defined as the two fundamental aspects of every financial transaction in the system of double-entry bookkeeping. For further details, refer to Section 2.3.1. 2. The balance of payments statement includes six major accounts which are as follows:
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Goods account Services account Unilateral transfers account Long-term capital account Short-term capital account International liquidity account For further details, refer to Section 2.4. 3. The three sub-categories of capital account are: Direct investment Portfolio investment Capital flows For further details, refer to Section 2.4.1. 4. Official reserves are government owned assets. This account represents only purchases and sales by the RBI. The changes in official reserves are necessary to account for the deficit or surplus in the BOPs. For further details, refer to Section 2.4.3. 5. A current account surplus means an excess of exports over imports of goods, services, investment income, and unilateral transfers. For further details, refer to Section 2.5. 6. Capital account convertibility (CAC) permits the local currency to be exchanged for foreign currency and no restrictions are put on the limit. For further details, refer to Section 2.6.
Apte, P.G. 2012. International Financial Management. Sixth edition. New Delhi: Tata McGraw-Hill. Sharan, Vyuptakesh. 2012. International Financial Management. Sixth edition. New Delhi: PHI Learning Private Limited. Siddaiah, Thummuluri. 2010. International Financial Management. New Delhi: Pearson. Kaur, Dr. Harmeet. Basics of International Finance. Delhi: Vikas Publishing Private Limited.
Unit 3
Structure
Foreign Exchange Market
3.1 Caselet 3.2 Introduction Objectives 3.3 History of Foreign Exchange 3.4 Fixed and Floating Rates 3.5 Foreign Exchange Transactions 3.6 Foreign Exchange Quotations 3.7 Interpreting Foreign Exchange Quotation 3.8 Forward, Futures and Options Market 3.9 Case Study 3.10 Summary 3.11 Glossary 3.12 Terminal Questions 3.13 Answers References/e-References
3.1 Caselet
Currency options trading in India There are two types of options market that are found in India. One is the rupee foreign currency (INR-FC) options and the other is the cross-currency options. The call or put options can be purchased by the banks in order to hedge their cross-currency proprietary trading positions. However, the banks also need to take care that there is no initiation of the "no stand-alone" transactions. Due to the fact that the small exporters and importers could not use such transactions in view of large standard size, they were not used widely in the 1990s. Such options were initially found in US dollars. But now, they are found in other currencies as well such as Japanese yen, euro and British pound. It has become possible for the foreign exchange market participants to hedge dollar-rupee risk due to the introduction of the INR-FC options. In case an Indian economy is bidding for an international assignment where the costs are in rupees and the bid quote in dollar, there is a risk for the company until the contract is awarded. In cases like this, reverse positions are created by the currency options if the company is not allotted the contract.
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The underlying currency is US dollar and the size of the contract is US $ 1000. The option premium is expressed in rupee terms and is paid on cash on t1 day. The requirements of the margin money are dependent on the exchange norms. The options found in the Indian market are European options but they can be squared up early through taking offsetting positions in the market. The settlement of the transaction takes place in rupee terms and the maturity falls on two working days prior to the last working day of the expiry month. On 29 October 2010, the currency options were introduced at the National Stock Exchange besides the OTC market. It is easier for a small currency to hedge the currency risk on an exchange as the banks have become strict and letter of credit as well as some form of guarantee and supplier consignment has to be shown in the full amount. But in case of an exchange, companies can trade by paying only the margin. Source: Adapted from http://business-standard.com/india/prof_page.php? search=currency+options&select=1 Accessed on 18 July 2012
3.2 Introduction
In the previous unit, you learnt about the concepts and principles of balance of payments and its various components. The Current Account Deficit and Surplus and capital account convertibility were also discussed. In this unit, you will learn about the origin of the concept of foreign exchange and the difference between fixed and floating rates. You will also study foreign exchange transactions and the types of foreign exchange transactions. You will also learn about the derivatives instruments traded in foreign exchange market such as forwards, futures, swaps, and options.
Objectives
After studying this unit, you should be able to: discuss the history of foreign exchange differentiate between fixed and floating rates explain foreign exchange transactions and foreign exchange quotations interpret foreign exchange quotation describe forwards, futures, swaps, and options markets
Unit 3
3.3 History of Foreign Exchange

The 17th century saw the start of the depositing of coins and bullion with money changers, goldsmiths, etc. The first people to start the system of money by book entry were the goldsmiths in England. This development further led to the expansion of banking services and the people started gaining the confidence that they can receive certain commodities against the bank note they possessed. Thus, the history of foreign exchange can be traced back to the time when the moneychangers in the Middle East would exchange money from all over the world. In 1880, the practice of using gold as the standard of value started whose main aim was to guarantee any currency against a set amount of gold. Under the gold standard exchange rates, currency was backed by gold and was measured in ounces. For this, the countries needed huge reserves of gold in order to back the demand for currency. The foreign exchange rate was determined by the difference of the price of gold between these two countries. The foreign exchange history changed due to the birth of an international standard through which foreign exchange can take place conveniently between different countries. During the First World War, financial issues arose in Europe which gave way to a lack of gold and this led to a historical change in foreign exchange. There emerged a void due to the abolishment of the Gold standard and to discuss this concern, a convention was held in July 1944 at Bretton Woods, New Hampshire. The new Bretton Woods monetary system led to a changed forex market which put forward the following solutions: A new method was to be established in order to obtain a fixed foreign exchange rate The US Dollar is to replace the gold standard as the new final exchange currency The US dollar will be the only currency which will be backed by gold Three international authorities will be founded who would guard over all the foreign transactions. However, the Bretton Woods monetary system also failed after a period of 25 years and on 15 August 1971, the US announced the end of the exchange of gold for US dollar.
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1. The history of foreign exchange began in the year ____________ with the establishment of the gold standard monetary system. 2. In 1880, the practice of using gold as the ____________ started whose main aim was to guarantee any currency against a set amount of gold. 3. There emerged a void due to the abolishment of the Gold standard and to discuss this concern, a convention was held in_________ at Bretton Woods, New Hampshire.
3.4 Fixed and Floating Rates

The currency system in which the regulator tries to keep exchange rate constant between domestic currency and foreign currencies is known as the fixed exchange rate system. In this system, the government of a country determines the value of its currency against a fixed amount of another currency. The gold standard is the oldest fixed exchange rate regime. The gold standard functioned till the beginning of the World War I and even few years after that. According to the gold standard, the currency in circulation is convertible into gold at a fixed rate. Therefore, the exchange rate between any two currencies is determined by the value of the currencies in terms of gold. After the fall of the gold standard, the world monetary system was in chaos and the volume of international trade fell considerably. Thus, in place of the gold standard, the gold exchange standard, popularly known as the Bretton Woods System, was put up after the World War II by the victorious allies of the war. Advantages of fixed rates system 1. The system provides exchange rates stability by eliminating uncertainty. 2. Volatility of exchange rate is controlled as it insulates the economy from external disturbances. 3. Foreign investors are encouraged to invest in countries without the fear of exchange rate fluctuations. 4. Poorer nations could get foreign exchange for development purposes at low costs.
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Disadvantages of fixed rates system 1. The system required regular rigorous control and monitoring by the monetary authorities. 2. The system is not self equilibrating therefore over-valuation and undervaluation existed. 3. Since the realignment was to be done only when all other avenues to correct the balance of payment were exhausted, therefore the burden accumulated and the economies which resorted to devaluation faced a lot of economic problems. 4. The system required regular rigorous control and monitoring by the monetary authorities. Floating exchange rate system Floating exchange rates can be broadly classified into two types: clean float and dirty float. In the clean float exchange rate system, the exchange rate is determined by the forces of demand and supply without any intervention from the central authorities. But when the central banks intervene to either raise or lower the exchange rate in the floating exchange rate system, it is referred to as dirty float or managed float. In the dirty float, there are two main reasons why the central banks and other authorities intervene in the exchange rate system. The reasons are as follows: To stabilize fluctuations in the exchange rate To reverse the growth of trade deficit In the pure float, the system is close to a free float, whereas in the dirty float system, it is close to an adjustable peg. There are various other substitutes between the two extremes of fixed and floating exchange rate regimes and these substitutes try to incorporate the good features of both the regimes. The alternate exchange rate systems are as follows: The crawling peg system allows for modifications within the narrow band of +1 or -1 per cent, and thus, replaces the abrupt parity changes of the adjustable peg system. In simple words, the crawling peg is the system in which a currency exchange rate is changed frequently, may be many times a year, mainly to make adjustments for rapid inflation. The wider bands system is more flexible as it has wider bands of variation around the central parity. The parity can either be shifted as in the case of the crawling peg and then the wider bands are referred to as gliding bands or there may be discrete jumps as in the adjustable peg.
Unit 3
The multiple exchange rate system allows for applying different exchange rates to different transactions. For example, in 1992, India had two exchange ratesthe 'official' exchange rate applicable to certain imports and a 'market determined' exchange rate for other transactions. Activity 1 Browse the Internet and find out which exchange rate system is found in India. Also put forward your own views on whether the fixed or the floating exchange rate is better. Hint: There are two types of exchange rate: Fixed and Floating.
4. Exchange rates are of two types: fixed or rigid exchange rates and flexible or floating exchange rates. (True/False) 5. The gold standard is a new system of fixed exchange rate regime. (True/ False) 6. In the pure float, the system is close to a free float, whereas in the dirty float system, it is close to an adjustable peg. (True/False)
3.5 Foreign Exchange Transactions

The foreign exchange market can be defined as the market where foreign currencies are bought and sold. In case an Indian importer needs to import goods from the USA, he has to pay in US dollars, He will take the help of the foreign exchange market in order to buy dollars for rupees. The exporter, on the other hand, converts the export proceeds that have been obtained in a foreign currency to his own currency. Apart from these transactions, there are many types of transactions that are involved in the import and export of goods.
3.5.1 Spot and Forward Transactions

Foreign exchange transactions, depending on the time gap between the settlement and the transaction date, are classified into spot transactions and forward transactions.
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In case of spot transactions, even though the name suggests spot transactions, an immediate or on-the-spot transaction doesnt take place. The settlement of spot transactions takes place within two days of the transaction date. During the two-day period, the parties that are associated with the transaction arrange to effect the exchange of a deposit denominated in one currency for a deposit denominated in the other currency. In other words, during the two-day period, the necessary crediting and debiting of banks that are situated in different locations are carried out. In certain cases, the settlement is carried out after the deal. In case the foreign trading centres are situated in the same time zone, it will be possible to settle the deal on the very day the deal is carried out. These types of transactions are known as cash transactions or short date transactions as they can give way to immediate exchange of currencies that are involved in the transaction. The exchange rates in which the spot transactions are carried out are known as the spot rate. These transactions can also be rolled over at a cost is based on the interest rate differential between the two currencies. The trader will earn interest in case the trader is long in the currency with a higher rate of interest. On the contrary, the trader will pay interest in case the trader is short in the currency with a higher rate of interest. On the other hand, in case of forward transaction, the parties enter into a forward contract which permits the sale or purchase of a particular amount of a foreign currency at a future date at an exchange rate that has already been agreed upon while entering the contract. Thus, in case of forward transaction, there is no need for immediate settlement and the transactions are settled on any date that has been predetermined after the transaction date. After the deal date, the date of settlement of the forward transactions may be 30, 60, 90, 120 or 180 days. The transaction may be further referred to as a 30 day forward, 60 day forward and so on depending on the days in which a forward transaction may be settled. The forward transactions are very important in the sense that they increase currency risks across countries. These transactions are also very flexible and can be customized to meet the specific needs of a trader with regard to the amount, currency and the date of the settlement. Sometimes, a deal can be carried out by a trader to exchange one currency for another currency immediately, with an obligation of reversing the exchange at a specified future date.
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7. The settlement of ____________takes place within two days of the transaction date. 8. The exchange rates in which the spot transactions are carried out are known as the____________. 9. In case of_________, there is no need for immediate settlement and the transactions are settled on any date that has been predetermined after the transaction date.
3.6 Foreign Exchange Quotations

Two - Way Quotations Foreign exchange quotations between banks have 2 rates - one at which the quoting bank is willing to buy (bid price) and the other at which it is willing to sell the foreign currency (ask price). For example, on 21 June 2012, the inter-bank rates for one $1US were `55.87 /98 indicating that the buying rate was `55.87 and the selling rate was `55.98. The difference between the two rates is called exchange rate spread and that is the source of profit for the bank. The spread is lower in currencies where the volume traded is large and is higher where the volume traded is small. As the volume involved in the case of inter-bank dealings is very high, and bankers would like to make a profit while dealing in currencies, they have developed certain maxims to help themselves. A foreign exchange rate is quoted as the foreign currency per unit of the domestic currency. In an indirect quote, the foreign currency is a variable amount and the domestic currency is fixed at one unit. For example, in the US, an indirect quote for the Canadian dollar would be C$1.17 = US$1. Conversely, in Canada an indirect quote for US dollars would be US$0.85 = C$1. For direct quotations, they 'buy low and sell high', i.e., they pay fewer units of the home currency for buying a fixed unit of foreign currency but receive more units of home currency while selling the same. (a) For indirect quotations, they 'buy high and sell low', i.e., they acquire more units of a foreign currency for a fixed unit of home currency but part with fewer units of foreign currency while selling it.
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Banks are able to manage within this small margin. In the case of merchant rate, however, the percentage spread is much higher as the gap between the buying and selling rates is more. RBI's Reference Rate The Reserve Bank of India also publishes a rate called RBI reference rate. This rate is based on 12 noon rates of a few select banks in Mumbai. The SDRRupee rate is based on this rate. Based on the RBI reference rate for US dollar and middle rates of the cross currency quotes at 12 noon, the exchanges of US dollar, Pound Sterling, EURO and yen are published. For example, the reference rate from RBIs published data is presented below: The Reserve Bank of Indias Reference Rate for the US dollar is `55.1515 and the Reference Rate for Euro is `67.6030 on July 20, 2012. The corresponding rates for the previous day (July 19, 2012) were `55.3830 and `68.0639 respectively. Based on the Reference Rate for the US dollar and middle rates of the cross-currency quotes, the exchange rates of GBP and JPY against the Rupee are given below:
Date July 19, 2012 July 20, 2012 1 GBP 86.7464 86.5768
Currency 100 JPY 70.47 70.22
Note: The SDR-Rupee rate will be based on the reference rate. Types of Exchange Rate Quotes There is no single quote for exchange rate. A number of rates exist at the same time between two currencies. The rates differ between currency notes and foreign currency denominated travellers cheques. Inter-bank rates are the rates quoted for trading in currencies between banks, and merchant rates are the rates quoted by banks for merchants, e.g., exporters and importers. Merchant Rates The Reserve Bank of India has authorized some commercial banks to undertake foreign exchange transactions with merchants. The inward/outward foreign exchange remittances of banks include (a) Telegraphic Transfer, (b) Mail Transfer (MT) (c) Demand Draft (DD) and (d) Bills for clearing. In recent years, electronic transfer has become one of the most important and speedy ways of transferring
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funds from one centre to another. Telegraphic transfer of funds from one centre to another is done by way of instructions through telex, telegram or cable. Telex has been the most important mode of transferring funds for reasons of security and record-keeping. Wherever facilities were available are now being replaced by electronic transfer facilities. A mail transfer is an order in writing to pay to the beneficiary the sum mentioned therein. A demand draft is a written order issued by a bank on another bank (correspondent) or its own branch at a different financial centre equivalent to the amount already received by the banker. Similarly, there are selling and buying rates for import and export bills. TT selling rates are for outward remittances in foreign currency and TT buying rates are meant for clean inward remittance. In order to avoid cut-throat competition amongst its members, the Foreign Exchange Dealers Association of India has issued guidelines for quoting the various rates.
10. Inter-bank rates are quoted up to 4 decimal points while merchant rates are quoted up to 2 decimal places. (True/False) 11. A mail transfer is an order in writing to pay to the beneficiary the sum mentioned therein. (True/False)
3.7 Interpreting Foreign Exchange Quotation

Exchange Rate Quotations In the foreign exchange market, quotations adopted by the Association Cambiste Internationale (ACI) are used for determining the exchange rate for a currency. ACI is an international financial market association in which foreign exchange professionals work for market development. A quotation is represented by a pair of three-letter SWIFT codes for currencies separated by an oblique or a hyphen. The currency that appears before the hyphen is the base currency and the currency after the hyphen is the quoted currency. Some examples of quotation are: USD/JPY: In this quotation, US dollar is the base currency and Japanese yen is the quoted currency. EUR/GBP: In this quotation, euro is the base currency and the pound is the quoted currency. INR/AUD: In this quotation, Indian rupee is the base currency and Australian dollar is the quoted currency.
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Thus, an exchange rate quotation is the representation of the number of units of quoted currency per unit of the base currency. A quotation can also consist of prices of two currencies separated by a hyphen. The price before the hyphen is known as the bid price and the price after the hyphen is called the ask or offer price. The bid price is the price at which a trader wants to buy base currency against the quoted currency. The ask price is the price at which a trader wants to sell the base currency against the quoted currency. Quotations are used to indicate the exchange rate of currencies. These contain the names of the currencies and their exchange rates. Normally, each country has two types of quotations, direct and indirect. A direct quotation represents the number of units of home currency of the country per unit of foreign country. An indirect quotation or reciprocal quotation represents the number of units of foreign currency for per unit of home currency of a country. This type of quotation is the inverse representation of the direct quotation, so it is also called inverse quotation. An example of an indirect quotation is USD 2.1010 per INR 100 in India indicating that the number of units of the rupee is 100. An indirect quotation represents the exchange rate of currency in European terms, which represents the number of units of a currency per US dollar. A quotation that is used to represent the exchange rate for two non-dollar currencies is known as cross rate; for example, GBP/EUR represents non-dollar currencies pound and euro. Sometimes, traders use short forms for the quotations; for example, INR/ JPY: 1.2940/1.2960 can be represented in the following forms: 1.2940/60, when the price of currencies is changed to decimal points. 40/60, when two traders regularly interact for trading a particular currency pair because they know the big figure of the currency rate. Big figure means starting digits of the rate that is 1.29 in the 1.2940/60 quotation. All the quotations used in the foreign exchange market are divided into three main categories. These categories are: Spot quotation Outright forward quotation Swap quotation Spot quotation Spot quotations are used to represent the exchange rate of a currency according to the present rate in the market. It must be in such a form that no arbitrage situation is created in the market.
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Arbitrage situation Sometimes, there exist market situations which help participants of the market to make a profit without any risk. These market situations are known as arbitrage situations. Participants of the market can gain by making some currency transactions with such banks which have quoted different prices for the same currency pair. Inverse quote and two-point arbitrage Two-point arbitrage is the condition when there is a chance to buy a currency from one market and sell that currency in another market where the price of the currency is higher. For example, Bank A in France has quoted USD/EUR: 1.9345/ 1.9350 and Bank B in America has also quoted for the same currency pair as EUR/USD: 0.5345/0.5360 which is the inverse or reciprocal quote of Bank A. This means ask rate of Bank A, which is EUR/USD, is the reciprocal of the bid rate of Bank B, that is, USD/EUR. This means reciprocal of the ask rate of Bank A is 1/(EUR/USD) which is equal to the bid rate of Bank B. You can also say that the EUR/USD bid rate of Bank B implies 1/(USD/EUR) ask rate of Bank A andEUR/USD ask rate of Bank A implies 1/(USD/EUR) bid rate of Bank B. In this way an inverse quotation is used in a two-point arbitrage situation. The bid rate in the quotation of Bank B should be overlapped with the ask rate in the quotation of Bank A to avoid two-point arbitrage situation. Triangular arbitrage Triangular arbitrage is that market situation in which a bank provides some exchange rates that are not directly inverse of the exchange rate of another bank but provides an indirect way to make a profit without any risk to the trader.
12. An____________ or reciprocal quotation represents the number of units of foreign currency for per unit of home currency of a country. 13. ____________ ____________ are used to represent the exchange rate of a currency according to the present rate in the market. 14. ____________ ____________ is that market situation in which a bank provides some exchange rates that are not directly inverse of the exchange rate of another bank but provides an indirect way to make a profit without any risk to the trader.
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3.8 Forward, Futures and Options Market

3.8.1 Forward Market
In the forward market, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month, two months and so on. The rate of exchange for the transaction is agreed upon on the very day the deal is finalized. The rate of exchange for the transaction is agreed upon on the very day the deal is finalized. The forward rates with varying maturity are quoted in the newspapers and those rates form the basis of the contract. Both parties have to abide by the contract at the exchange rate mentioned therein irrespective of whether the spot rate on the maturity date resembles the forward rate or not. The value date in case of a forward contract lies definitely beyond the value date applicable to a spot contract. Sometimes the value date is structured to enable one of the parties to the transaction to have freedom to select a value date within the prescribed period. This happens when the party does not know in advance the precise date on which it would be able to deliver the currency, for instance, an exporter who sells a foreign currency forward without knowing in advance the precise date of shipment.
3.8.2 Futures Market

The foreign exchange market involving forward contracts has a long history but the market for currency futures has a comparatively recent origin. It came into being in 1972 when the Chicago Mercentile Exchange has set up its international monetary market division for trading of currency futures. Currency futures are traded only in a limited number of currencies. A forward contract is finalized on telephone, etc. meaning that it represents an over-the-counter market. But in case of currency futures, brokers strike the deals sitting face to face under a trading roof, known as pits. The brokers can trade for themselves as well as on behalf of the customers. When they trade for themselves, they are called locals or floor traders. On the other hand, when the brokers trade on behalf of their customers, they are known as commission brokers or floor brokers. When a trader has to enter a currency futures contract, he informs his agent who in turn informs the commission broker at the stock exchange. The commission broker executes the deal in the pit for a commission/fee. After the deal is executed, the commission broker confirms the trade with the agent of the trader. There are different costs associated with the transactions in the
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market for currency futures. The first is the brokerage commission that is charged by the commission brokers and covers both the opening and the reversing trade. The second is the floor trading and clearing fee charged by the stock exchange and its associated clearing house. Normally, this fee is included in the brokerage commission but when the locals trade for themselves, the fee is quite exclusively found. The third is the delivery cost that is related to the delivery of the currencies but since actual delivery of the currencies seldom takes place, such cost is not common.
3.8.3 Options Market

The market for currency options is the other form of the derivatives market representing large-scale sale and purchase of currencies. This form of market possesses some distinguishing features and also the methods of operation are different. There are three different types of option market. They are listed currency options market, currency futures options market and over-the-counter options market. Listed currency options market Listed currency options are standardized contracts. In such contracts, the clearinghouse is essentially a party to the contract. For the option- buyer, the clearinghouse is a seller of options and for the seller of the options, it is a buyer. It guarantees both sides of the contract and charges a small fee for facilitating such contracts. Currency futures options market In this market, which is basically a listed currency options market, the contracts present a mixture of currency futures and currency options. The buyer and the seller of options have, however, to deposit margin money with the exchange that is equal to a small function of the contract price. The options are marked to market meaning that they undergo daily settlement as in the case of a futures contract. Over-the-counter options market The second type of market for currency options is known as inet-bank currency options market or the over-the-counter options market. Such a market is centred in New York or London and the size of transactions is many times that of the market in the organized exchanges.
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Activity 2 Approach a broker and find out the differences between the forward markets, futures markets and option market. Write them down on a chart. Hint: Analyse what forward, future and option markets are.
15. In the options market, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month, two months and so on. (True/False) 16. In listed currency options, the clearinghouse is essentially a party to the contract. (True/False)
3.9 Case Study

Currency Futures Market in India Rupee currency futures were started in Dubai in 2007 at the Dubai Gold and Commodity Exchange. In India, after a green signal from the Raghuram Rajan Committee and the Expert Group at the RBI, three Indian exchanges, viz. BSE, NSE and MCX, applied for dealing in currency futures. RBI and SEBI released the guidelines in this respect on 6 August 2008. Finally, NSE started operating on the 29 August 2008. MCX and BSE followed the suit. The guidelines allowed only US dollar-rupee contracts with a size of $ 1,000 for a maturity not exceeding 12 months. The trading is done on Monday through Friday excluding public holidays between 9.00 AM and 5 PM and the settlement is done on the last working day of the month, and not earlier. Thus, the standardized size is smaller than those at the international exchanges. The contracts are quoted and settled in rupee. The membership of the currency futures market would be separate from the membership of derivatives/cash segment. Again, only a resident Indian can participate in the deal. A bank being a member must have reserves worth rupees 5 billion, 10 per cent CRAR, an NPA of 3 per cent at the maximum and a profit record for at least three years. The trading limit for
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an individual client is $ 5 million or 6.0 per cent of the total open interest, whichever is higher. For a trading member bank or broker, it is $ 25 million or 15.0 per cent of the total open interest, whichever is higher. The hedger or the client is first registered with the trading member who buys or sells the currency futures contract on behalf of the client. The marking to market is based on the daily settlement price and are carried forward to the next day. Finally, on the settlement day, the settlement is done in cash payable in rupee. Now the question is whether the currency futures are better than the forwards transacted in India. First of all, while in the case of OTC forward contracts, the banks quote different bid-ask rates for different customers, the futures rates are shown on the screen of the exchange. Thus, the price discovery is more transparent in the case of futures. Second, participants such as exporters and importers can go for a forward contract only for their underlying transactions. Their purpose cannot be speculation. But in the case of currency futures, no underlying securities are required. Questions 1. How is the membership of the currency futures market separate from the membership of derivatives/cash segment? 2. Dou you think currency futures are better than forwards transacted in India? If yes, why? Source: Adapted from http://www.marketswiki.com/mwiki/Dubai_Gold_ and_Commodities_Exchange Accessed on 30 September 2012
3.10 Summary
Let us recapitulate the important concepts discussed in this unit: The foreign exchange began in the year 1875 with the establishment of the gold standard monetary system. The term exchange rate regime refers to a set of mechanisms, procedures and framework to determine the exchange rates at a given point of time and changes in the exchange rates over a certain time period.
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Floating exchange rates can be broadly classified into two types: pure float and dirty float. Foreign exchange transactions depending on the time gap between the settlement and the transaction date have been classified into spot transactions and forward transactions. Sometimes, there exist market situations which help participants of the market to make a profit without any risk. These market situations are known as arbitrage situations. There are three different types of option market. They are listed currency options market, currency futures options market and over-the-counter options market.
3.11 Glossary
Monetary: Of or relating to money Convertible: That can be converted Intervention: Government action to influence market forces Crawling Peg system: A system of exchange rate adjustment in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates Obligation: Act of binding oneself by a social, legal or moral tie Maxims: An established principle or proposition Remittance: The act of transmitting money or bills especially to a distant place, in discharge of an obligation or as in satisfaction of a demand

1. Trace the history of Foreign Exchange. 2. Define the advantages of the Fixed Rates System. 3. State the differences between pure float and dirty float. 4. Define spot and forward transactions. 5. Discuss devaluation and revaluation. 6. Discuss the three different types of option markets.
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1. 1875 2. Standard of value 3. July 1944 4. True 5. False 6. True 7. Spot transactions 8. Spot rate 9. Forward transactions 10. True 11. False 12. Indirect quotation 13. Spot quotations 14. Triangular arbitrage 15. False 16. True

1. The foreign exchange began in the year 1875 with the establishment of the gold standard monetary system. In earlier times, people used the barter system to fulfill his needs of different products and commodities and the exchange was limited to food items only For further details, refer to Section 3.3.
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2. The advantages of the fixed rates system are: The system provides a measure of exchange rates stability and eliminates the source uncertainty and price instability. Volatility of exchange rate is controlled as it insulates the economy towards the economic disturbances For further details, refer to Section 3.4. 3. The differences between pure float and dirty float are: In the pure float exchange rate system, the exchange is determined by the forces of demand and supply without any intervention from the central authorities. But when the central banks intervene to either raise or lower the exchange rate in the floating exchange rate system, it is referred to as dirty float or managed float. In the pure float, the system is close to a free float, whereas in the dirty float system, it is close to an adjustable peg. For further details, refer to Section 3.4. 4. In case of spot transactions, the settlement of spot transactions takes place within two days of the transaction date. On the other hand, in case of Forward transaction, the parties enter into a forward contract which permits the sale or purchase of a particular amount of a foreign currency at an exchange rate that has already been agreed upon at a future date. For further details, refer to Section 3.5 5. Technically, the term 'devaluation' refers to the reduction in the value of the currency made by the authorities concerned. An increase in the value of the currency in a pegged exchange rate regime is referred to as revaluation. For further details, refer to Section 3.6. 6. There are three different types of option market. They are: listed currency options market currency futures options market over-the-counter options market. For further details, refer to Section 3.8.
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Apte, P.G. 2006. International Financial Management. New Delhi: Tata McGraw Hill. Sharan, Vyuptakesh. 2012. International Financial Management. Sixth edition. New Delhi: PHI Learning Private Limited. Kumar, Neelesh. International Finance Management. Delhi: Vikas Publishing.
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Structure
Currency Derivatives
4.1 Caselet 4.2 Introduction Objectives 4.3 Forward Markets 4.4 Currency Futures Market 4.5 Currency Options Market 4.6 Contingency Graphs for Currency Options 4.7 Swap 4.8 Case Study 4.9 Summary 4.10 Glossary 4.11 Terminal Questions 4.12 Answers References/e-References
4.1 Caselet
Forex hedging remains geared to benefit from rupee weakness The finance chief of Tata Consultancy Services Ltd. recently said that in case the rupee continues its downward trend, the company will benefit from it. He further told Dow Jones Newswires that TCS continues to use an options-based currency hedging strategy to guard against a rise in the rupee and gain from a fall, which indicates that the broader market is still betting against the rupee. Over the past 12 months, rupee plunged 20 per cent against the US dollar and this has increased the uncertainty for those companies which have overseas exposure. If the local currency is weak, it helps exporters such as TCS because their overseas earnings get converted into rupees. However, a volatile market also leads to a dilemma whether to lock in hedging contracts at the going rate, or hold out for the rupee to slide further. TCS also benefitted from the weak rupee which helped it to beat the expectations of the analysts to report a 38 per cent rise in its April-June net profit to 32.81 billion rupees ($593 million). The finance chief also said that TCS has bought put options at 52 rupees, making it possible for them to sell dollars and buy rupees in case the greenback falls below that level.
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However, the company hasnt sold call options that would oblige it to sell dollars to the holder at the contracted rate if the greenback were to rise. Though the selling of offsetting call options would have led to reduction in its hedging costs, it would also have limited the benefit in case the dollar rose above the strike price of the option. He said that the gain in revenue due to the rupee's weakness helped the company in allocating a higher budget for its hedging costs. Source: Adapted from http://online.wsj.com/article/BT-CO-20120713704794.html Accessed on 18 July 2012
4.2 Introduction
In the previous unit, you learnt about the history of foreign exchange, the concepts of foreign exchange rates, transactions and quotations and also the financial markets that function in this domain. In this unit, you will further learn about forward markets and the different concepts associated with it. You will also know what currency futures markets and currency options markets are. We will also discuss the concept of a swap, which is an agreement between two or more parties to exchange sets of cash flows over a period in future. Objectives After studying this unit, you should be able to: define the concept of forward markets explain the currency future and option markets discuss currency call options and put options interpret contingency graphs for currency options identify the different features and types of swaps
4.3 Forward Markets

Features In the forward market, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month two months, or three months. The rate of exchange for the transaction is agreed upon on the very day the deal is finalized. The forward rates with varying maturity are quoted in the newspapers
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and those rates form the basis of the contract. Both the parties have to abide by the exchange rate mentioned in the contract irrespective of whether the spot rate on the maturity date is more or less than that of the forward rate. In other words, no party can back out of the deal, even if changes in the future spot rate are not in his or her favour. The value date in case of a forward contract lies definitely beyond the value date applicable to a spot contract. If it is a one-month forward contract, the value date will be the date in the next month corresponding to the spot value date. Suppose a currency is purchased on 1 August, if it is a spot transaction, the currency will be delivered on 3 August. But if it is a one-month forward contract, the value date will fall on 3 September. If the value date falls on a holiday, the subsequent date will be the value date. If the value date does not exist in the calendar, such as 29 February (if it is not a leap year) the value date will fall on 28 February. Sometimes, the value date is structured to enable one of the parties to the transaction to have the freedom to select a value date within the prescribed period. This happens when the party does not know in advance the precise date on which it would be able to deliver the currency; for instance, an exporter who sells a foreign currency forward without knowing in advance the precise date of shipment. Again, the maturity period of forward contract is normally for one month, two months, three months, and so on but sometimes it may not be for the whole month and a fraction of a month may also be involved. A forward contract with a maturity period of thirty-five days is an opposite example. Naturally, in this case, the value date falls on a date between two complete months. Such a contract is known as broken-date contract. Arbitrage in forward markets It is said that the forward rate differential is approximately equal to the interest rate differential. Sometimes, there may be marked deviation between these two differentials. In such cases, covered interest arbitrage begins and continues till the two differentials become equal. This is an arbitrage in forward markets. Forward markets hedging Forward markets are used not only by the arbitrageurs or speculators but by the hedgers too. Changes in the exchange rates are a usual phenomenon. Such changes entail some foreign exchange risk in terms of loss or gain to the traders and other participants in the foreign exchange market. Risk is reduced
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or hedged through forward markets transactions. Under the process of hedging, currencies are bought and sold forward. Forward buying and selling depends upon whether the hedger finds himself in a long, or a short position. An export billed in foreign currency creates a long position for the exporter. On the contrary, an import billed in foreign currency leads to a short position for the importer. Speculation in forward markets In addition to the arbitrageur or the hedger, speculators are also very active in the forward markets operations. Their purpose is not to reduce the risk but to reap profits from the changes in the exchange rates. The source of profit to them being the difference between the forward rate and the future spot rate, they are not very concerned with the direction of the exchange rate change. Suppose a speculator sells US $1,000 three-month forward at the rate of `40.50/US $. If, on maturity, the US dollar depreciates to `40, the speculator will get `40,500 under the forward contract. At the same time, he will exchange `40,500 at the future spot rate of `40/US $ and will get US $1,012.50. Both these activities the selling and the purchasing of the US dollars will be simultaneous. Thus, without making any investment, the speculator will make a profit of US $12.50 through the forward markets deal. This is an example of speculation in the forward markets. Speculation in the forward markets cannot extend beyond the date of maturity of the forward contract. However, if the speculator wants to close the speculation operation prior to maturity, say by one month, he may buy an offsetting contract. In other words, if he has already entered into a three-month forward contract for selling the US dollars, he would have to opt for a two-month forward contract for selling the US dollars. The profit or loss would naturally depend upon the exchange rate involved in the two forward contracts. The above is a very simple example. Many other examples can be cited about speculation in the forward markets. In fact, the type of speculation depends upon the expected movement of the future spot rate.
1. The foreign exchange market is classified either as ____________or as____________. 2. The electronic clearance system in New York is called the____________.
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3. The ____________is used not only by the arbitrageurs but by the hedgers too. 4. Speculation in the forward markets cannot extend beyond the date of maturity of the____________.
4.4 Currency Futures Market

Futures and options are derivative assets; that is, their values are derived from underlying asset values. Futures derive their value from the underlying currency, and options on currency futures derive their values from the underlying futures contracts...
Chicago Fed Letter, November 1989 What are currency futures? Currency futures are standardized contracts that are traded like conventional commodity futures in the futures exchange market. Brokers or exchange members receive orders to buy or sell a fixed amount of foreign currency. These orders from companies, individuals, or even commercial banks are communicated to the floor of the futures exchange. Long positions (orders to buy a currency) are matched with the short positions (orders to sell) at the exchange. The exchange, or more precisely, its clearing corporation, guarantees both sides of each of the two-sided contracts, that is, the contract to buy and the contract to sell. The willingness to buy versus the willingness to sell moves futures prices up and down to maintain a balance between the number of buy and sell orders. The market-clearing price is reached in the vibrant, somewhat chaotic-appearing trading pit of the futures exchange. Currency futures began trading in the International Money Market (IMM) of the Chicago Mercantile Exchange in 1972. Since then many other markets have opened, including the Commodities Exchange Inc. (COMEX) in New York, the Chicago Board of Trade, and the London International Financial Futures Exchange (LIFFE). It is necessary to have only a few value dates for a market to be made in currency futures contracts. The Chicago IMM has four value dates of contracts: the third Wednesday in the months of March, June, September and December. In the rare event that contracts are held to maturity, delivery of the underlying foreign currency occurs two business days after the contract matures to allow for the normal two-day delivery of spot currency. Contracts are traded in specific sizes, 62,500, Canadian $100,000, and so on. This keeps the contracts sufficiently homogeneous and few in variety that there is enough depth for a
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market to be made. (The Case Study given at the end of this unit will help clarify the concept better.) Futures contracts versus forward contracts The daily settlement of bets on futures means that a futures contract is the same as entering a forward contract everyday and settling each forward contract before opening another one, where the forwards and futures are for the same future delivery date. The daily marking to market on futures means that any losses or gains are realized as they occur, on a daily cycle. With the loser supplementing the margins daily and in relatively modest amounts, the risk of default is minimal. Of course, with the clearing corporation of the exchange guaranteeing all contracts, the risk of default is faced by the clearing corporation. Were the clearing corporation not to guarantee all contracts, the party winning the daily bets would be at risk if the losing party did not pay. In the forward markets there is no formal and universal arrangement for settling up as the expected future spot rate and consequent forward contract value move up and down. Indeed, there is no formal and universal margin requirement. Generally, in the case of interbank transactions and transactions with large corporate clients, banks require no margin, make no adjustment for dayto-day movements in exchange rates, and simply wait to settle up at the originally contracted rate. A bank will, however, generally reduce a client's existing line of credit. However, despite the large difference in the sizes of the two markets, there is a mutual interdependence between them; each one is able to affect the other. This interdependence is the result of the action of arbitrageurs who can take offsetting positions in the two markets when prices differ. The most straightforward type of arbitrage involves offsetting outright forward and futures positions. If, for example, the three-month forward buying price of pounds is $1.5000/ , while the selling price on the same date on the Chicago IMM is $1.5020/, an arbitrager can buy forward from a bank and sell futures on the IMM. The arbitrager will make $0.0020/, so that on each contract for 62,500, he or she can make a profit of $125 ($0.0020/ x 62,500). However, we should remember that since the futures markets require daily maintenance or marking to market, the arbitrage involves risk which can allow the futures and forward rates to differ a little. It should also be clear that the degree to which middle exchange rates on the two markets can deviate will depend very much on the spreads between the
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buying and the selling prices. Arbitrage will ensure that the bid price of the forward currency does not exceed the ask price of the currency futures, and vice versa. However, the prices can differ a little beyond this due to marking-tomarket risk. We should also note that the direction of influence is not invariably from the rate set on the larger forward markets to the smaller futures markets. When there is a move on the Chicago IMM that results in a very large numberof margins being called to scramble to close positions with sudden buying or selling can spillover into the forward markets.
5. Currency futures are standardized contracts that are traded like conventional commodity futures in the futures exchange market. (True/False) 6. The Chicago IMM has four value dates of contracts: the third Friday in the months of March, June, September and December. (True/False) 7. The most straightforward type of arbitrage involves offsetting outright forward and futures positions. (True/False) Activity 1 Talk to a broker and find out how transactions for currency future markets are done. Write them down and analyse the transaction. Hint: Currency futures are standardized contracts that are traded like conventional commodity futures in the futures exchange market.
4.5 Currency Options Market

What is a currency option? Forward exchange and currency futures contracts must be exercised. It is true that currency futures can be sold and margin gains can be withdrawn, and that forward contracts can be offset by going into an offsetting forward agreement. However, all forward contracts and currency futures must be honoured by both the parties, that is, the banks and their counterparties, or those holding outstanding futures, must settle. There is no option allowing a party to settle only if it is to that party's advantage.
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Unlike forward and futures contracts, currency options give the buyer the opportunity, but not the obligation, to buy or sell at a pre-agreed price in the future. As the name suggests, an option contract allows the buyer who purchases it the option or right either to trade at the rate or price stated in the contract, if that is to the option buyer's advantage, or to let the option expire, if that is better. Currency options also trade on the Philadelphia Exchange. Unlike the IMM options, which are on currency futures, the Philadelphia options are on spot currency. These options give the buyers the right to buy or sell the currency itself at a pre-agreed price. Therefore, options on spot currency derive their value directly from the expected future spot value of the currency, not indirectly via the price of futures. However, ultimately, all currency options derive their value from movements in the underlying currency, and so we can focus on the more direct linkage involving spot option contracts. Quotation conventions and market organization Option dealers quote a bid and ask a premium on each contract, with the bid being what buyers are willing to pay and the ask being what sellers want to be paid. Of course, a dealer must state whether a bid or an ask premium is for a call or put, whether it is for an American or European option, the strike price, and the month the option expires. After the buyer has paid for an option contract, he or she has no financial obligation. Therefore, there is no need to talk about margins for option buyers. The person selling the option is called the writer. The writer of a call option must be ready, when required, to sell the currency to the option buyer at the strike price. Similarly, the writer of a put option must be ready to buy the currency from the put option buyer at the strike price. The commitment of the writer is open throughout the life of the option for American options, and on the maturity date of the option for European options. The option exchange guarantees that the option seller honours their obligations to option buyers and therefore requires option sellers to post a margin. On the Philadelphia Exchange, there is a 10 per cent option premium plus a lump sum to a maximum of $2500 per contract, depending on the extent the option is in or out of money. As in the case of futures contracts, an exchange can make a market in currency options only by standardizing the contracts. This is why option contracts are written for specific amounts of foreign currency, for a limited number or maturity dates, and for a limited number of strike exchange rates. The
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standardization allows buyers to resell contracts prior to maturity. It also allows writers to offset their risks more readily, because for example, the writer of a call option can enter the market as a buyer of a call option to limit losses or to lock in gains. Determinants of market values of currency options The factors that influence the price of an option are: 1. Spot rate 2. Exercise rate 3. Time to maturity 4. Interest rate 5. Volatility 6. Dividends
Table 4.1 Comparison of Forwards, Futures and Options
Forward Contracts Delivery discretion Nothing Currency Futures* Nothing Currency Options# Buyer's discretion. must honour if exercises. Seller buyer
Maturity date
Any date
Third Wednesday of March, June, September or December 12 months Can sell via exchange Formal fixed sum per contract, e.g., $2000. Daily marketing to market. Outright Futures clearing corporation Primarily speculators
Friday before the third Wednesday of March, June, September or December on regular options. Last Friday of the month on the end-ofmonth options. 9 months Can sell via exchange No margin for buyer who pays for contract. Seller posts 130% of premium plus lump sum varying with intrinsic value. Outright Options clearing corporation Hedgers and speculators
Maximum length Secondary market Margin requirement
Several years Must offset with bank Informal; often line of credit or 5-10% on account Swap or outright form None Primarily hedgers
Contract variety Guarantor Major users
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Forwards, Futures and Options: A Comparison While forwards, futures and options can all be used both to reduce foreign exchange risk (that is, to hedge) and to purposely take foreign exchange risk (that is, to speculate), the differences between forwards, futures, and options make them suitable for different purposes. An explanation of which type of contract would be most appropriate in different circumstances must wait until we have dealt with many other matters, including further ways of hedging and speculating. So at this point we can do little more than list the differences between forwards, futures, and options as shown in Table 4.1. The table notes the primary users of the markets, as well as the institutional differences between forwards, futures and options. The reasons different markets have different primary users can be explained with the pay-off profiles.
8. Unlike forward and futures contracts, ____________give the buyer the opportunity, but not the obligation, to buy or sell at a pre-agreed price in the future. 9. As in the case of____________, an exchange can make a market in currency options only by standardizing the contracts. Call Options Currency call options can be defined as the option which allows the buyer the right to purchase the underlying currency from the seller. The buyer expects that the underlying foreign currency will strengthen against the home currency during the life of the option. It can be simply put as a financial contract between two parties, i.e. the buyer and the seller of the option. The buyer of the call option is given the right to buy from the seller an agreed quantity of a financial instrument or a particular product, for a certain price at a certain time. The seller on the other hand is compelled to sell the product or the financial instrument if the buyer so decides. For the application of this right, the buyer pays a fee, called the premium. While buying call options, the buyer expects that the price of the underlying instrument will rise in the future though the seller might or might not expect it. It is the most profitable for the buyer of call options if the price of the underlying instrument moves up and comes closer to the strike price.
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The buyer of the call options believes that the price of the underlying asset will rise by the exercise date. The buyer can get a large profit and this profit is limited by the extent of the rise in the spot price of the underlying asset. When the price of the underlying instrument is higher than the strike price, it is said that the option is "in the money". On the other hand, the call seller or the call writer does not gain any benefit in case the stock rises above the strike price. The initial transaction that takes place in the buying and selling of the call option does not include the supplying of the underlying instrument but grants the right to buy the underlying instrument in return of a premium or the exchange fee. However, specifications regarding the options might differ in different countries depending on the opinion style. While in case of an American call option, the buyer can exercise the option anytime throughout the lifetime of the call option, in European call option, the holder can exercise the option only on the expiration date of the option.
10. Currency call options can be defined as the option which allows the buyer the right to purchase the underlying currency from the seller. (True/False) 11. When the price of the underlying instrument is higher than the strike price, it is said that the option is "in the money". (True/False) Put Options An option contract through which the holder gets the right to sell a certain amount of an underlying currency to the writer of the option at a particular price up to a particular expiration date is known as currency put option. Unlike the call options, in case of the put options, a buyer expects that the foreign currency will weaken against the home currency during the life of the option. It can be further defined as a contract between two parties through which the exchange of assets is done at a specified price by a predetermined date. While the buyer of the put option has the right but not an obligation to sell the underlying asset at the strike price, the seller of the option is obliged to purchase the asset at the strike price in case the buyer exercises the option. A put option is more like insurance in the sense that no matter what happens, losses are limited. The Put option establishes a floor for the exchange rate, and the option can be used to hedge foreign currency inflows.
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As far as the seller is concerned, the profit will be equal to the amount of premium when the buyer does not exercise the option. It occurs when the spot price is greater than the strike rate. On the other hand, the seller will face a loss if the option is exercised. The amount of loss will vary depending upon how much lower the spot price is. The most important use of a put option is as a type of insurance. Under the protective put strategy, the investor buys enough puts so that if the price of the underlying currency decreases suddenly, the option of selling the holdings at the strike price still remains with them. Another use of this kind of option is speculation in the sense that an investor can take a short position in the underlying currency without trading in it directly.
12. In case of the put options, a buyer expects that the foreign currency will ____________against the home currency during the life of the option. 13. The most important use of a put option is as a type of____________.
4.6 Contingency Graphs for Currency Options

A graph which illustrates the potential profit or loss, which a speculator dealing in currencies will realize on his positions for various exchange rate scenarios, is known as contingency graph. In other words, it shows how much profit/loss a currency speculator will make if the underlying currency moves anywhere within the graphs range. Graphs are a simple yet powerful way to communicate the risk and reward associated with any option call or put. The Profit/Loss vs Price graph has Profit or (loss) of the position plotted on the Y-axis and the underlying price plotted on the X-axis.
profit (loss)
underlying price
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The current price of the underlying is located in the center of the X-axis underlying price range.
profit (loss) underlying price current price
Buying a call option: (a call option is: a right to buy an underlying for a specific price and time period)
profit (loss) underlying price
BUY CALL
The above graph shows the profit or loss of buying a call option for a range of projected underlying prices at expiration day for the call option. Buying a put option: (a put option is: a right to sell an underlying for a specific price and time period)
profit (loss) underlying price
BUY PUT
The above graph shows the profit or loss of buying a put option for a range of projected underlying prices at expiration day for the call option.
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Selling call or put options

profit (loss) underlying price profit (loss) underlying price
SELL CALL
SELL PUT
The above graphs show the profit and loss at options expiration for selling a call or put. We have already discussed currency call and put options. Now, we will discuss various commonly used option combinations. These combinations simultaneously use call and put options and create a unique payoff suited or customized to the needs of the speculator or hedger. They are used for both hedging future cash flows in other countrys currency and speculating future exchange rate movement. For each of the combination there will be a unique contingency graph. Many combinations are popular and frequently used. Few of these combinations are, Straddle (Long and Short), Strangle (Long and Short), Straps and Strips, Bull spread, Bear Spread, Butterfly spread, and Box spread. Here, we will discuss the combination and contingency graph of the two most commonly used combinations, i.e. straddle and strangle in detail and few others in brief. Straddles This strategy is commonly used by the investors who are of the view that the exchange rate will move significantly, but are unable to guess whether currency will appreciate or depreciate. To construct a long straddle the buyer take long position (buy) both a call option and a put option for that currency i.e. holds a position in both a call and a put. The condition in this being that both the call and the put should have the same strike price and expiration date. We now take an example to construct the contingency graph and show how this strategy will work.
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Example: The put and call options with the following details are available in the market: Premium of call option: `1.5 Premium of put option: `3 Strike Price: `87/ Evaluate payoff and construct a contingency graph of a long straddle using the above details? Solution: To construct a long straddle, the investor would take a long position in both call and a put. He will have to pay a premium of `4.5 per unit. If the exchange rate at expiration is `87/, the put option is in the money and the call option is out of the money and vice versa for exchange rate at expiration being greater than `87/. The payoff at various exchange rates are a shown as follows:
Exchange Rate (`/) 78 79 81 82 84 85 87 89 90 92 93 Long Call Payoff -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 0.5 1.5 3.5 4.5 Long put Payoff 6 5 3 2 0 -1 -3 -3 -3 -3 -3 Net Payoff 4.5 3.5 1.5 0.5 -1.5 -2.5 -4.5 -2.5 -1.5 0.5 1.5
Contingency graph for a long currency straddle It can be seen from above contingency graph that long straddle will give positive results only if the exchange rate moves by a substantial amount. There are two break even points at exchange rate of `82.5 and 91.5, these values are what we get if we subtract and add total premium to the strike price respectively.
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87 91.5 82.5
Net Payoff
Short straddle strategy involves going short (selling) both the call and the put. Its payoff and the contingency graph will be exactly opposite to long straddle. A general contingency graph for short straddle is given below: Contingency graph for a short currency straddle
Short Straddle Net Profit Per Unit Future Spot Rate
Strangle A long (short) strangle position is developed by going short (selling) on both a put and a call with different strike prices with the same expiration. In this strategy the call strike is higher than the put strike price. Investors who go this strategy expect prices to be volatile. Compared to straddle the premium paid in this strategy is less. In this strategy, the upside potential is unlimited; whereas the downside risk is limited to the net amount of premium that is paid on the two options. Contingency graph for a long currency strangle The contingency graph of short strangle will be exactly the mirror image of the above graph.
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Net Profit per unit
Long Strangle
Future Spot Rate
Currency Spreads There are various currency spreads which exist that are used by hedgers to either hedge against unanticipated foreign cash flows or by speculators to profit an unanticipated foreign currency movement. The two most commonly used are bull spread and bear spread: Bull Spread Investors go for this strategy if they have an expectation of a price rise. This strategy involves: Buying a call option with a lower strike price Selling/writing a call option with a higher strike price Same expiration date This currency bull spreads can also be easily constructed using put options, Contingency graph for a bull spread strategy The contingency graph for Bear Spread will be the mirror image of the above graph.
Net Profit Per Unit
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14. Straddles are commonly used by the investors who are of the view that the exchange rate will move significantly, but are unable to guess whether currency will appreciate or depreciate. (True/False) 15. Long straddle strategy involves going short (selling) both the call and the put. (True/False)
4.7 Swap
Swap is an agreement between two or more parties to exchange sets of cash flows over a period in future. The parties that agree to swap are known as counter parties. It is a combination of a purchase with a simultaneous sale for equal amount but different dates. Swaps are used by corporate houses and banks as an innovating financing instrument that decreases borrowing costs and increases control over other financial instruments. It is an agreement to exchange payments of two different kinds in the future. Financial swap is a funding technique that permits a borrower to access one market and then exchange the liability for another type of liability. The first swap contract was negotiated in 1981 between Deutsche Bank and an undisclosed counter party. The International Swap Dealers association (ISDA) was formed in 1984 to speed up the growth in the swap market by standardizing swap documentation. In 1985, ISDA published the standardized swap code. Features of swap Swaps are contracts of exchanging the cash flows and are tailored to the needs of counter parties. Swaps can meet the specific needs of customers. Counter parties can select amount, currencies, maturity dates etc. Exchange trading involves loss of some privacy but in the swap market privacy exists and only the counter parties know the transactions. There is no regulation in swap market. There are some limitations like (a) Each party must find a counter party which wishes to take opposite position. (b) Determination requires to be accepted by both parties. (c) Since swaps are bilateral agreements the problem of potential default exists.
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There are two kinds of swap, they are as follows: 1. Currency swap: It is an agreement whereby currencies are exchanged at specified exchange rates and at specific intervals. The reason is to lock in the exchange rate. Large commercial banks that serve as an intermediary agree to swap currencies with a firm. Two currencies are exchanged in the beginning and again at the maturity, they are reexchanged because one counter party is able to borrow a particular currency at a lower interest rate than the other counter-party. 2. Interest rate swap: It is an arrangement whereby one party exchange one set of interest rate payments for another. Most common arrangement is an exchange of Fixed Interest rate payment for another rate of over a period of time. Features The following are the features: The principal value upon which the interest rate is to be applied should be known Fixed interest rate to be exchanged for another rate. Formula type of index is used to determine the flowing rate. Frequency of payment is agreed upon. Life time of swap. Various types of interest rate swap Following are the most important types of interest rate swap: Plain vanilla swap: This swap involves the periodic exchange of fixed rate payments for floating rate payments. It is sometimes referred as fixed for floating swaps. Forward swap: This involves an exchange of interest rate payments that does not begin until a specified future point in time. It is a swap involving fixed for floating interest rates. Callable swap: Another use of swap is through swap options (swaptions). A callable swap provides a party making the fixed payments it the right to terminate the swap prior to its maturity. It allows a fixed rate payer to avoid exchanging future interest rate payments if its so desired. Putable swap: It provides the party making the floating rate payments with a right to terminate swap.
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Extendable swap: It contains an extendable feature that allows fixed for floating party to extend the swap period. Zero coupon for floating swap: In this swap, the fixed rate pair makes a bullet payment at the end and floating rate pair makes the periodic payment throughout the swap period. Rate capped swaps: This involves the change of fixed rate payments for floating rate payments whereby the floating rate payments are capped. An upfront fee is paid by the floating rate party to fixed rate party for the cap. Equity swaps: An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. Cost of swap While there is no exchange risk involved in swap transactions, there is a cost involved. The swap cost depends on the currency being in premium or discount in the forward markets. A currency is said to be at premium against the other currency if it is costlier in the forward and it is said to be at discount against the other currency, if it is cheaper in the forward. When a currency is at a premium against the other currency, then the currency will be costlier in the forward so in the vent of swap, i.e. when the buying and selling transaction is undertaken then the swap cost will be favourable. Suppose, $/Rupee quote in value on 1/9/2011 = 51.87 and $/Rupee quote in value on 31/10/2011 = 52.93 The currency is bought at 51.87 and sold at 52.93, so the swap cost will be received. Alternatively, when swap is reversed, that is selling and buying transaction takes place, the swap cost is to be paid.
16. The ____________was formed in 1984 to speed up the growth in the swap market by standardizing swap documentation. 17. ____________involves the periodic exchange of fixed rate payments for floating rate payments. 18. An arrangement whereby one party exchanges one set of interest rate payments for another is known as________________________.
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4.8 Case Study

To check speculation, RBI seeks curbs on currency futures The Reserve Bank of India has asked for checks on currency trading based on the argument that it was resulting in speculation. The demand for checks was recently made during a meeting of the Financial Stability and Development Council (FSDC). However, it has not found favour with SEBI. It also came at a time when the rupee is touching new lows against the dollar and putting pressure on the overall Indian economy. However, it has been known that SEBI has managed to get a reprieve for the currency futures markets where trading started in 2008 after RBI agreed to the plan after years of debate. Futures aim to help traders hedge their currency bets. The joint regulation with SEBI was also one of the major reasons for RBIs opposition. The FSDC, which is headed by the finance minister, is a regulatory coordination body comprising the regulators. The RBI however, in the recent weeks has sought to clamp down on activities that could impact currency fluctuations. The proposal has also been made towards that direction. In the past twelve months, the rupee has depreciated over 20 per cent and closed at 56.80 against the dollar, compared to Wednesday's close of 57.16.SEBI has taken the appeal that in the absence of a regulated segment such as currency futures, traders would be forced to hedge their risks in unregulated markets such as the non-deliverable forwards market in Singapore, where volumes are of the order of $20 billion, compared to $4 billion for currency futures. The over-the-counter market regulated by the central bank where business worth around $15 billion is transacted. "It is already a matter of worry that the largest market is not regulated by Indian regulators. By putting in restrictions on currency futures, you will only drive out business from the country," said a source. Action taken by SEBI against United Stock Exchange to argue that the market was well regulated was also pointed out by sources. Market players said that instead of banning currency futures, the regulators could look to club position limits and use other tools to check speculative behaviour. For instance, like the Forward Markets Commission they can seek higher margins from buyer along with the stipulation that cash payments be made. SEBI has also stepped up the vigil, sources said and has sought detailed data from exchanges so that it can crack down on errant behaviour.
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Questions 1. Why do you think RBI asked for checks on currency trading? What was the argument against it? 2. Do you think the decision taken by RBI to curb on currency futures is justified? If yes, why? Source: Adapted from http://timesofindia.indiatimes.com/business/indiabusiness/To-check-speculation-RBI-seeks-curbs-on-currency-futures/ articleshow/14480326.cms Accessed on 23 July 2012
4.9 Summary
Let us recapitulate the important concepts discussed in this unit: In case of forward markets, contracts are made for buying and selling currencies for future delivery, for instance, a fortnight, one month and two months. The value date in case of a forward contract lies definitely beyond the value date applicable to a spot contract. The forward markets are used both by the arbitrageurs and the hedgers. Changes in the exchange rates are a usual phenomenon. In the forward markets operations, in addition to the arbitrageur or the hedger, speculators are also very active. Their purpose is not to reduce the risk but to reap profits from the changes in the exchange rates. Currency futures are standardized contracts that are traded like conventional commodity futures in the futures exchange market. Currency options give the buyer the opportunity, but not the obligation, to buy or sell at a pre-agreed price in the future. Option dealers quote a bid and ask a premium on each contract, with the bid being what buyers are willing to pay and the ask being what sellers want to be paid. Currency call options can be defined as the option which allows the buyer the right to purchase the underlying currency from the seller. The agreement between two or more parties for exchanging sets of cash flows over a period in future is known as swap. The parties that agree to swap are known as counter parties.
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4.10 Glossary
Arbitrageur: A person or company which practices arbitrage Depreciation: A non cash expense that reduces the value of an asset as a result of wear and tear, age, or obsolescence Diminution: The act of diminishing, or of making or becoming less Volatility: A measure of risk based on the standard deviation of the asset return. Hedge: It is used for reducing any substantial losses/gains suffered by an individual or an organization

1. Define what you mean by Forward Markets. 2. Discuss the differences between futures options and spot options. 3. State the factors that influence the price of an option. 4. Define contingency graph. 5. Define various kinds of swaps. 6. Discuss the cost of swap.

1. Spot market, forward markets 2. Clearing House Interbank Payment System (CHIPS) 3. Forward markets 4. Forward contract 5. True 6. False 7. True 8. Currency options
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9. Futures contracts 10. True 11. True 12. Weaken 13. Insurance 14. True 15. False 16. International Swap Dealers association (ISDA) 17. Plain vanilla swap 18. Interest rate swap

1. In the forward markets, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month and two months. The rate of exchange for the transaction is agreed upon on the very day the deal is finalized. For further details, refer to Section 4.3. 2. The differences between futures options and forward options are: Such options give the buyers the right to buy or sell currency futures contracts at a pre-agreed price. Options on futures derive their value from the prices of the underlying futures For further details, refer to Section 4.5. 3. The factors that influence the price of an option are: Intrinsic value Volatility of the spot or futures exchange rate Length of period to expiration For further details, refer to Section 4.5. 4. A graph which illustrates the potential profit or loss, which a speculator dealing in currencies will realize on his positions for various exchange rate scenarios, is known as contingency graph. For further details, refer to Section 4.6.
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5. There two kinds of swap. They are as follows: Currency swap Interest rate swap For further details, refer to Section 4.7. 6. Cost of Swap: While there is no exchange risk involved in swap transactions, there is a cost involved. The swap cost depends on the currency being in premium or discount in the forward markets. For further details, refer to Section 4.7
Apte, P.G. 2012. International Financial Management. Sixth edition. New Delhi : Tata Mc-graw Hill. Sharan, Vyuptakesh. 2012. International Financial Management. Sixth edition. New Delhi: PHI Learning Private Limited. Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing.
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Structure
Exchange Rate Determination
5.1 Caselet 5.2 Introduction Objectives 5.3 Measuring Exchange Rate Movements 5.4 Factors that Influence Exchange Rates 5.5 Movements in Cross Exchange Rates 5.6 Anticipation of Exchange Rate Movements 5.7 International Arbitrage 5.8 Interest Rate Parity Theory 5.9 Purchasing Power Parity 5.10 International Fisher Effect 5.11 Forecasting Foreign Exchange Rates 5.12 Case Study 5.13 Summary 5.14 Glossary 5.15 Terminal Questions 5.16 Answers References/e-References
5.1 Caselet
To loosen or not to loosen policy The Reserve Bank of India faced a similar situation that it faced at the time of the mid-quarter review. The formulation of monetary policy by the RBI was announced on 31 July 2012. The economic environment in India deteriorated further due to the delayed monsoon. Inflation, being aggravated by the steep depreciation of the rupee continues to be a major problem for the country. However, the inter-bank exchange rates do not reveal the plans about the future direction. The price level reflects the impact of imported inflation through the inter-industry transactions that are captured by the Leontief-type input-output matrix or is revealed directly. Keeping in mind the continuation of inflation, it is needed for the RBI to carry out research on the issue.
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Building up reserves The RBI is being faced with two challenges: one, to increase the flows of foreign capital and second, to build up the reserves which have decreased substantially in recent times because of market intervention. The Central bank states that its aim in market intervention is to remove volatility and not to establish any particular level or band for the exchange rate. If the purpose of the RBI is to remove volatility, it also means that it is trying to decrease the standard deviation to a level which is close to the mean. However, it would then imply that the RBI is targeting the mean unless it puts forward proper arguments that the mean is changing all the time. It is very proper for the market to expect action from the RBI when a particular level is reached. In the West though whenever market intervention was practiced, it stated that its main aim was to appreciation or depreciation but not volatility in rates. Unlike the West, the flow of foreign funds into and out of the stock markets affects the exchange rate movements in India. Source: Adapted from http://www.thehindubusinessline.com/opinion/ columns/a-seshan/article3682899.ece?homepage=true Accessed on 03 August 2012
5.2 Introduction
In the earlier unit, you learnt about the various concepts associated with the forward markets. You also studied the currency futures market and currency options markets and understood the differences between the futures options and the spot options. You now know that Swap is an agreement that is made between two or more parties in order to exchange sets of cash flows over a period in future. In this unit, you will learn how exchange rate movements are measured. You will also learn about the factors that influence exchange rates and study the movements in cross exchange rates. You will study about various concepts such as international arbitrage, interest rate parity, and purchasing power parity and the International Fisher effect.
Objectives
After studying this unit, you should be able to: explain how exchange rate movements are measured list the factors that influence exchange rates
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describe the movements in cross exchange rates interpret international arbitrage, interest rate parity, purchasing power parity and fisher effect
5.3 Measuring Exchange Rate Movements

Exchange rates respond quickly to all sorts of events - both economic and noneconomic. The movement of exchange rates is the result of the combined effect of a number of factors that are constantly at play. Economic factors, also called fundamentals, are better guides as to how a currency moves in the long run. Short-term changes are affected by a multitude of factors which may also have to be examined carefully. In recent years, global interdependence has increased to an unprecedented degree. Changes in one nation's economy are rapidly transmitted to that nation's trading partners. These fluctuations in economic activity are reflected almost immediately in fluctuations of currency values. These changes in exchange rates expose all those firms having export import operations as also multinationals with integrated cross border production and marketing operations. It is useful to be aware of the various factors that influence exchanges rates. By a study of these factors and the trend of movements in the value of particular currency, an experienced businessman may be able to forecast the possible future movement of that currency. This will enable him to: (i) estimate his risk and (ii) make an informed, prudent decision as to whether it would be worthwhile for him to carry the risk or to take some appropriate steps to reduce that risk. The demand for foreign exchange comes from importers of goods and services; outflow of capital through foreign direct investment and portfolio investment; profits, interest, dividend and other incomes earned by foreigners/ corporate bodies and repatriated to their country; Indian travelers going abroad for education, medical treatment; pleasure trips, etc.; expenditures incurred by our embassies abroad; bilateral loans/aids granted to other countries; subscription payment to international organizations; grants and gifts to other friendly countries; repayment of foreign loans and interest payments; etc.
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All these transactions can be classified in three classes: (1) Purchases and sales for trading purposes; (2) Speculative deals by professional dealers; (3) Protective movements by substantial holders. Interest rate differentials Foreign exchange markets and exchange rates are quite sensitive to movements in interest rates. This is because financial markets were becoming more closely linked due to (i) Growing interest in international investment; (ii) Elimination or constraints on mobility of capital to a large extent; (iii) More rapid means of communications. Most investors would like to move their funds from a country having lower interest rates to a country having higher interest rates. Such funds are usually termed as 'hot money'. If the interest rate in the UK is higher than the interest rate in the USA, investors would find it profitable to invest funds in the UK and would purchase pounds and sell dollars in the spot market, leading to an upward movement in pound sterling. In fact, the UK very often uses interest rate as a weapon to push up the 'pound'. However, if the rise in interest rates is due to people expecting a higher inflation rate or bigger budget deficits, there is reason to doubt the strength of the currency. Thus it would not lead to higher investment. The role of interest rate differences thus depends upon what is causing them. Activity 1 Browse the Internet and make a report on how the value of currency has fluctuated in India in recent times. Also write down how it affects the exchange rate movements. Hints: The fluctuations in economic activity are reflected almost immediately in fluctuations of currency values. Demand and supply of a particular currency are the most important factors affecting its exchange rate.
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1. Economic factors are also called ________ 2. Most investors would like to move their funds from a country having lower interest rates to a country having higher interest rates. Such funds are usually termed as____________.
5.4 Factors that Influence Exchange Rates

In foreign exchange trading, technical indicators such as charts and moving average lines are very significant in the determination of movement of the prices of various currencies. Fundamental analysis of economic data and current events is also helpful in the prediction of how the price of a currency will change. The basic economic principle of supply and demand underlies the fundamental and technical methods. Prices in the free marketplace can radically change from the changes in the supply of a currency and the differences in the demand for a currency. Focus on the Demand-Supply Model The demand factor At the most primary level, a change in the price of a currency will occur because of more or less demand for it. High demand signifies a higher price experience of the currency pair. Less demand signifies fall in the price of the currency pair. An increased demand for a currency suggests a strong economy, while a currency's demand can go down if the central bank lowers the rates of interest. The movement of price is based on the demand for the currency. Actually, currencies rally when the demand for it goes up. The supply side factor A basic economic principle of supply says that a currency's value will change with the rise and fall of the levels of supply. The value and price of a currency will diminish if there is a higher supply of a currency. Similarly, the value and price of a currency will increase when there is a lower supply of a currency. Even though the supply side is important, the demand factor is the primary moving force that determines the value and price of a currency.
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Long term vs. short term A time period of a year or more signifies a long-term supply and demand. Shortterm is generally thirty days or less than that. The currency prices in both the time periods can be affected by the same factors. A trader should be conscious of the time factor in which a trade is placed. Long and short-term price movements can happen in parallel. However, they can also deviate, which can lead to inconsistency in price movements. Hence, a trader should always keep in mind the trading environment and the time frame while doing foreign exchange trade. Factors affecting Currency Trading A number of factors affect the rates of exchange. At the end, costs of currency result from the supply of currency. The currency markets all over the world can be considered a huge melting pot. The supply and demand ingredients constantly change in relation to the changing mix of current events and the cost of one currency in relation to another change accordingly. Economic factors These include the economic policy of the government which is made known through various government agencies and the central bank of the country, and economic conditions, generally revealed through economic reports. Economic conditions include: Inflation levels and trends: If there is a high level of inflation in the country, or if the inflation level seems to be rising, typically a currency will lose value because inflation brings down the purchasing power and thus the demand for that particular currency. Economic growth and health: The economic growth and health of a country can be known through a country's gross domestic product (GDP), level of employment, capacity utilization, retail sales and other indicators. Generally, a currency will perform better and there will be more demand for it if the economy of the country is healthy and robust. The better the economic performance, the higher will be the currency's demand. Government budget deficits or surpluses: Widening government budget deficits lead to a negative reaction in the market, whereas the market reacts positively in case of narrowing budget deficits. The impact of budget deficit or budget surplus is reflected in the value of the currency of a country. Balance of trade levels and trends: The flow of trade from a country to other parts of the world shows the demand for goods and services of the
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country, which in turn indicates the demand for a country's currency for conducting trade. The competitiveness of a country's economy is reflected by the surpluses and deficits in trade of goods and services. Trade deficits, for example, may negatively impact the currency of a nation. Political conditions Internal, regional and international political conditions and issues can profoundly affect currency markets; for instance, political upheaval and instability can negatively impact the economy of a nation. Similarly, the growth of a political faction that is considered to be fiscally responsible can have a positive opposite effect on the economy. Again, cases in one country in a region may spur positive or negative interest in a neighbouring country, and in the process, affect its currency.
3. High demand signifies a higher price experience of the currency pair. (True/False) 4. A basic economic principle of supply says that a currency's value remains constant even with the rise and fall of the levels of supply. (True/False) 5. The economic growth and health of a country can be known through a country's gross domestic product (GDP), level of employment, capacity utilization, retail sales and other indicators. (True/False)
5.5 Movements in Cross Exchange Rates

A cross-rate may be defined as the rate of exchange calculated from two (or more) other rates. Thus, the rate for the euro to the Swedish krona will be derived as the cross-rate from the US dollar to the euro and the US dollar to the krona. Traditionally, a cross-rate denotes an exchange rate that does not involve the home currency. Thus, to the Indian, quotes such as $ per GBP () and Yen per are cross-rates. In contrast, a straight rate denotes a rate that involves the home currency. To the Indian, INR per USD and INR per GBP are straight rates. In global foreign exchange markets, currencies are quoted against the US dollar. Unless otherwise specified, if a bank asks another bank for its Deutsch mark rate, that rate will be quoted against the US dollar. Most dealings are done against the US dollar. Hence, the market rate of a currency at any time is most accurately reflected in its rate of exchange against the US dollar. A bank that
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has to quote sterling against the Swiss franc would normally do so by calculating this rate from the /$ rate and the $/Sfr rate. It would, therefore, be using crossrates to arrive at its quotation. The cross-rate between two currencies is obtained by getting quotes for each currency in terms of the exchange rate with a third nation's currency. For example the exchange rate of the U.S. dollar per euro is 1.2440 and the exchange rate for U.S. dollar per British pound is 1.8146. The euro-to-pound cross rate can be calculated as the euro-to-dollar rate multiplied by the dollar-to-pound rate, which is equal to (1/1.2440) 1.8146 = 1.4587, or dollar 1.4587 per British pound. This result is an indirect quote from the a British entity viewpoint, however it is a direct quote from the viewpoint of an entity whose domestic currency is the euro.
6. A ___________may be defined as the rate of exchange calculated from two (or more) other rates. 7. In global foreign exchange markets, currencies are quoted against the___________.
5.6 Anticipation of Exchange Rate Movements

Foreign-exchange markets are highly competitive in nature. Participants have excellent, up-to-the-minute information about the exchange rates between any two currencies. As a result, currency values are determined by the unregulated forces of supply and demand as long as central banks do not attempt to stabilize them. The supplies and demands for a currency are those of private individuals, corporations, banks, and government agencies other than central banks. If we are to understand why some currencies depreciate and others appreciate, we must investigate the factors that cause the supply and demand schedules of currencies to change. These factors include market fundamentals (economic variables) and market expectations Market fundamentals Bilateral trade balances Real income
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Real interest rates Inflation rates Consumer preferences for domestic or foreign products Productivity changes affecting production costs Profitability and riskiness of investments Product availability Monetary policy and fiscal policy Government trade policy Market expectations News about future market fundamentals Speculative opinion about future exchange rates Because economists believe that the determinants of exchange-rate fluctuations are rather different in the short run (a few weeks or even days), medium run (several months), and long run (one, two or even five years), we will consider these time frames when analysing exchange rates. In the short run, foreign-exchange transactions are dominated by transfers of financial assets that respond to differences in real interest rates and to shifting expectations of future exchange rates. Such transactions have a major influence on short-run exchange rates. Over the medium run, exchange rates are governed by cyclical factors such as cyclical fluctuations in economic activity. Over the long run, foreign-exchange transactions are dominated by flows of goods, services and investment capital, which respond to forces such as inflation rates, investment profitability, consumer tastes, real income, productivity, and government trade policy. Such transactions have the dominant impact on long-run exchange rates. Note that day-to-day influences on foreign exchange rates can cause the rate to move in the opposite direction from that indicated by longer-term fundamentals. Although, today's exchange rate may be out of line with longterm fundamentals, this should not be construed as implying that it is necessarily inconsistent with short-term determinants. Medium-run cyclical forces can induce fluctuations of a currency above and below its long-run equilibrium path. However, fundamental forces serve to push a currency toward its long-run equilibrium path. Note that medium-run cyclical fluctuations from a currency's long-run equilibrium path can be large at times, if economic disturbances induce significant changes in either trade flows or capital movements.
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Longer-run structural forces and medium-run cyclical forces interact to establish a currency's equilibrium path. Exchange rates may sometimes move away from this fundamental equilibrium path if short-run forces (for example, changing market expectations) induce fluctuations in exchange rates beyond those based on fundamental factors. Although such overshooting behaviour can persist for significant periods, fundamental forces generally push the currency back into its fundamental equilibrium path. Unfortunately, exchange-rate determination (forecasting) is a difficult job. That is because economic forces affect exchange rates through a variety of channelssome of which may induce negative impacts on a currency's value, others of which may exert positive impacts on a currency's value. Some of those channels may be more important in determining short- or medium-run tendencies, whereas other channels may be more important in explaining the long-run trend that a currency follows.
8. The factors that cause the supply and demand schedules of currencies to change include ___________and___________. 9. ___________can induce fluctuations of a currency above and below its long-run equilibrium path. 10. ______________________and medium-run cyclical forces interact to establish a currency's equilibrium path.
5.7 International Arbitrage

An exchange rate can be defined as the price of a currency in terms of another. It can be explained as the number of units of currency B in terms of a unit of currency A or vice versa. Thus, the exchange rate between US dollar and British pound can be stated as 1.7656 dollars per pound or 0.5664 pound per dollar. When we state the price of goods in terms of money, the most common way of doing so is by stating it in terms of units of money per unit of the good and not vice versa. For example, rupee 10 per litre of water. The choice of unit, though, is subject to the convenience of the user. Thus, the rupee-dollar rate is usually stated as number of rupees per dollar while the rupee-yen rate is stated as number of rupees per 100 yen.
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Arbitraging between Banks It is not possible for all banks to have the same and identical quotes although we always hear one market rate or exchange rate for any two given currencies at any particular point of time. The exchange rate quotations may be similar to each other for any two given banks but they cannot be exactly the same in almost most of the cases. Therefore, it may be possible for a company to benefit by trading or exchanging currencies through one particular bank and not through the other. We will now discuss and try to understand the possible relationships between the quotes offered by different banks. 1. Suppose banks A and B are quoting: A GBP/USD: bid bid 1.4550/1.4560 Bank A ask Bank B ask We will represent this as: B 1.4538/1.4548
A situation in which the ask and bid rates overlap, it will give rise to an arbitrage opportunity. Pounds can be bought from B at $1.4548 and sold to A at $1.4550 for a net profit of $0.0002 per pound without any risk or commitment of capital. One of the basic tenets of modern finance is that markets are efficient and such arbitrage opportunities are quickly spotted and exploited by alert traders. The result will be, bank B will have to raise its ask rate and/or A will have to lower its bid rate. The arbitrage opportunity will disappear very fast. An opportunity of making a huge amount of profit from arbitrage opportunities is not going to stay for a very long time because there will be arbitrageurs who are going to move from investing in one market to the another and such an opportunity is going to be wiped out very soon. 2. Now suppose the quotes are as follows: A GBP/USD: 1.4550/1.4560 B 1.4545/1.4555
As is evident from the quotations, there is no arbitrage opportunity because the ask and bid rates at two different banks are overlapping in nature. We can
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conclude that in order to prevent arbitrage that two quotes must overlap. In such a scenario, A would find itself competing with many other sellers of pound sterling and B would find itself amidst a large number of buyers of pound sterling and a lesser number of sellers. Banks are always on the move for influencing the quote. Most corporate or large scale customers run a check on the rates being offered by various banks, but this is only when the sum involved is large. It must also be observed that usually the customers who make frequent jumps while using such services of various banks are not treated on the same scale as the more 'regular' customers. 'Regular' customers usually get better rates in the routine foreign exchange transactions. Inverse Quotes and Two-point Arbitrage Consider the following spot quotation: USD/CHF: 1.4955/1.4962 Suppose this is a quote available from a bank in Zurich. At the same time, a bank in New York is offering the following spot quote: CHF/USD: 0.6695/0.6699 In this situation, let us explore if there is an arbitrage possibility. Suppose we buy one million Swiss francs against dollars from the Zurich bank and sell them to the New York bank. The Zurich Bank will give CHF 1.4955 for every dollar it buys. It will cost us $(1,000,000/1.4955) i.e. $6,68,700 to acquire the Swiss francs. In New York, the bank will give $0.6695 for every CHF it purchases. Thus, CHF 1 million can be sold to the New York bank for $(0.6695 x 1000000) i.e. $6,69,500. One can make a risk-less profit of $800 with the help of a few phone calls. Obviously, the CHF/USD rates implied by the Swiss Bank's USD/ CHF quotes and the New York bank's CHF/USD quotes are out-of-line. Recall that (CHF/USD) ask is the rate that applies when the bank sells Swiss francs in exchange for dollars. But this is precisely the deal we did with the Zurich Bank and for each Swiss franc we bought, we had to pay $(1/1.4955) which is nothing but l/ (USD/CHF) bid. In the same way, die (CHF/USD) bid implied by the Swiss bank's USD/CHF quotes would be the amount of US dollars it would give when it buys one CHF. It requires CHF 1.4962 for every USD it sells. This means that it will give USD (l/l.4962) when it buys one CHF. Thus, the (CHF/USD) bid implied by its USD/CHF quote is l/ (USD/CHF) ask. Thus, we have:
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Implied (CHF/USD) bid = I/ (USD/CHF) ask Implied (CHF/USD) ask = 1/ (USD/CHF) bid To prevent arbitrage, the New York bank's (CHF/USD) quotes must overlap the (CHF/USD) quotes implied by the Swiss bank's quotes. The latter work out to 0.6684/0.6687. A CHF/USD quote such as 0.6686/0.6690 will not lead to arbitrage though it may lead to a one-way market for the banks. The rates found in the markets will obey the above relations to a very close approximation. The arbitrage transaction described above, viz., buying a currency in one market and selling it at a higher price in another market is called Two-Point Arbitrage'. Foreign exchange markets eliminate two-point arbitrage opportunities very quickly if and when they arise.
11. The exchange rate quotations may be similar to each other for any two given banks but they cannot be exactly the same in almost most of the cases. (True/False) 12. An exchange rate can be defined as the price of a currency in terms of another. (True/False)
5.8 Interest Rate Parity Theory

This theory is a link between exchange rates and interest rates. Proposition 1: The interest rates prevailing in two countries affect the exchange rate between the currencies of those countries. Interest rates in India and in the US, for example, will drive the exchange rate between dollar and rupee. Proposition 2: In an efficient market, if the interest rates in two countries are different, the exchange rates between the two countries will move in such a way as to bring about parity in interest rates, offsetting the apparent interest rate differentials, thereby denying any arbitrage opportunity. This implies that high interest rate in one country will be offset by the depreciation of the currency of that country. If, for example, the interest rate in India is higher than that in the US, the rupees will depreciate against the US dollar.
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According to the Interest Rate Parity Theory, it is argued that forward rate would reflect the interest rate. In the absence of it, arbitrage opportunities would open up and a shrewd investor could make a lot of money. To understand further, one needs to understand the arbitrage and then about how it works in the field of international finance. Arbitrage means the existence of two different prices in two markets for the same commodity. If this happens investors would make money. Let us understand the same with an example: Suppose a fruit cake cost `10 in Bakery A and `12 in Bakery B. You know a cake is eatable wherever it is brought or sold (assuming other things remain constant). You would buy 100 pieces of cake in Bakery A and sell 100 pieces of cake in Bakery B making a profit of `200 per day for no effort. Your action of buying and selling pushes up the demand for cakes in Bakery A and the supply of cakes in Bakery B. In line with the law of demand and supply, the price of cake goes up in Bakery A and the price of cake comes down in Bakery B. Over time, the two prices would catch up and arbitrage would dissolve. This is an example of arbitrage over space. We could also have an arbitrage over time. If, for example, the time value of money is 6 per cent and a cake costs `10 today, it would have to cost `10.6 a year later. If you know that it would cost, say `11 a year later, you would borrow `10 today at 6 per cent, buy a cake, sell it a year later at `11, pay the interest and repay the principal amounting to `10.60 and pocket the difference of `0.40. And if you knew that it would cost less, say `10.40 a year later, you would sell cakes today at `10, invest the proceeds at 6 per cent, get `10.6 a year later and buy cakes at `10.40 thus pocketing `0.20 in the bargain. Arbitrage over space in forex refers to the price of the currency in two countries. Arbitrage over time refers to the prices in the two markets, spot and forward. One can identify arbitrage opportunities in one of the two ways. One, compute what should be the forward price (theoretical price) and compare it with what is the forward price (actual forward rate). If the two are not equal, there could be an arbitrage opportunity. Two, compute what should be the home country interest rate (theoretical interest rate) for the given forward rate and compare it with what is the actual home country rate (actual interest rate). If the two are not equal, there could be an arbitrage opportunity.
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13. According to the______________________, it is argued that forward rate would reflect the interest rate. 14. Arbitrage over time refers to the prices in the two markets____________ and____________.
5.9 Purchasing Power Parity

This theory presents a link between exchange rates and inflation. Proposition 1: The inflation rates prevailing in two countries affect the exchange rate between the currencies of those countries. For instance, the inflation rates ruling in India and the US will determine the exchange rate between rupee and US dollar. Proposition 2: In an efficient market, if the inflation rates in two countries are different, the exchange rates between the two countries will move in such a way as to bring about parity in inflation rates, offsetting the apparent inflation rate differentials, thereby denying any arbitrage opportunity. This implies that high inflation rate in one country will be offset by the depreciation of the currency of that country. If for instance, the inflation rate in India is higher than in the US, rupee will depreciate against dollar. A second implication is that similar to the linkage between forward exchange rates and interest rate differentials in the Interest Rate Parity Theory, there is a similar connection between inflation rates and the exchange rates of currencies of two countries. This link is also called the law of one price. The law of one price states that the price of a commodity should be the same in two markets or else arbitrage opportunity will open up. Relative purchasing power parity Rather than focusing on a particular good when applying the purchasing-powerparity concept, most analysts look at market baskets consisting of many goods. They consider a nation's, overall inflation (deflation) rate as measured by, say, the producer price index or consumer price index. According to the theory of relative purchasing power parity, changes in relative national price levels determine changes in exchange rates over the long run. The theory predicts that the foreign-exchange value of a currency
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tends to appreciate or depreciate at a rate equal to the difference between foreign and domestic inflation. As an example, if US inflation exceeds Switzerland's inflation by 4 percentage points per year, the purchasing power of the dollar falls 4 points relative to the franc. The foreign-exchange value of the dollar should therefore depreciate 4 percent per yet. Conversely, the US dollar should appreciate against the franc if US inflation is less than Switzerland's inflation. If the US price level rises relative to the UK price level, imports become relatively less expensive in the United States. US consumers tend to increase their spending on imports from the United Kingdom, which leads to an increase in the demand for pounds. At the same time, UK consumers see US goods becoming more expensive. As they reduce their demand for exports from the United States, the supply of pounds decreases. The result is depreciation in the dollar's exchange value against the pound. Although the purchasing-powerparity theory can be helpful in forecasting appropriate levels to which currency values should be adjusted, it is not an infallible guide to exchange-rate determination. For instance, the theory overlooks the fact that exchange-rate movements may be influenced by capital flows. The theory also faces the problems of choosing the appropriate price index to be used in price calculations (for example, consumer prices or producer prices) and of determining the equilibrium period to use as a base. Moreover, government policy may interfere with the operation of the theory (for example, trade restrictions that disrupt the flow of exports and imports among nations). Activity 2 Suppose the domestic price level increases rapidly in the United States and remains constant in the United Kingdom. Will the US consumers favour British goods? How will it affect the dollar and pound? Hint: The increase in the demand for pounds and the decrease in the supply of pounds result in a depreciation of the dollar.
15. The inflation rates prevailing in two countries affect the exchange rate between the currencies of those countries. (True/False)
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16. According to the theory of relative purchasing power parity, changes in relative national price levels determine changes in exchange rates over the long run. (True/False) 17. When applying the purchasing-power-parity concept, most analysts consider a particular product. (True/False)
5.10 International Fisher Effect

Irving Fisher argued that, over time, money interest rates change to reflect changes in the anticipated inflation rates. In other words, this theory states that changes in the anticipated inflation produce corresponding changes in the rate of interest. While some authors have provided statistical evidence to negate this theory, there is a consensus that Fishers theory provides a useful rule of thumb. If the inflation rate is likely to change, it is a fairly good bet that interest rates will also change. According to Fisher, the nominal rate of interest comprises two components, the real rate of return and the expected rate of inflation. The rationale is extended to substantiate a view that international differences in the money interest rates also reflect the differences in the anticipated inflation rates. Some countries experience a higher interest rate than their trading partners (interest rate in Germany is less than that in India, while in the US, interest rate is lower than even in Germany). The latter countries expect that they would experience depreciation in their currencies. Countries with high rates of inflation will generally have high nominal rates of interest too. This at least partially serves to allow investors to obtain a high enough real rate of return, where inflation is relatively high. The International Fisher Effect suggests the following: Changes in interest rates reflect the changes in anticipated inflation rates, and interest rate differentials provide an unbiased predictor of future changes in spot exchange rates. Currency of countries with relatively high interest rates is expected to depreciate because higher interest rates are considered necessary to compensate for anticipated currency depreciation. Given the free movement of capital internationally, the real rate of return in different countries will equalize as a result of adjustments to spot exchange rates.
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The International Fisher Effect reinforces the Interest Rate Parity and the Purchasing Power Parity theories by highlighting the inflation element in nominal interest rates. Fisher formula (1+Money rate) = (1+Real rate) (1+Inflation rate)
18. ____________argued that, over time, money interest rates change to reflect changes in the anticipated inflation rates. 19. The ________________________reinforces the Interest Rate Parity and the Purchasing Power Parity theories by highlighting the inflation element in nominal interest rates.
5.11 Forecasting Foreign Exchange Rates

Corporate financial decisions include exchange rate forecasts as one of the most important inputs. They have several usages such as making investment decisions, hedging decisions and financing decisions. The speculative businesses in the foreign exchange market are also benefitted by forecasts. There are a number of models which offer explanation about the different factors that are influencing exchange rates and they are also used for forecasting or predicting the exchange rates of currencies. Approaches to Forecasting Two basic approaches to forecasting foreign exchange rates are found. They are fundamental analysis and technical analysis. While fundamental analysis includes the study of certain macroeconomic variables that have the possibility of influencing exchange rates, technical analysis studies the technical characteristics expected in major market turning points. There are different models for analyzing the effect of macroeconomic variables on the demand and supply of a currency. Three most popular models are discussed below. Asset market model: This theory suggests that there will be more demand of a currency and so will likely appreciate in value if there is an increase in the flow of funds into other financial market of the country, such as equities and bonds and vice versa. It is also based on the assumption that asset
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markets are efficient and they reflect completely all the available information. Monetary model: This model aims towards predicting a proportional relationship between the relative supply of money and nominal exchange rates between nations. According to the monetary model, three independent variables determine the exchange rate. They are relative interest rates, relative money supply and relative national output. Portfolio balance model: This model suggests that depending on the expected return and risk, people divide their total wealth between foreign and domestic bonds and foreign and domestic money. There are three assets that are included in this model. They are domestic bonds denominated in the home currency (B), money (M) and foreign currency bonds (FB).
20. Corporate financial decisions include exchange rate forecasts as one of the most important inputs. (True/False) 21. The portfolio balance model aims towards predicting a proportional relationship between the relative supply of money and nominal exchange rates between nations. (True/False)
5.12 Case Study

Managed Floating Exchange Rate Regime in India Managed float includes the intervention of the Reserve Bank of India in the foreign exchange market either directly through the sale and purchase of US dollars or indirectly by making changes in the repo rate and the resultant size of liquidity in the monetary and the financial system. Though the new system of exchange rate helped in boosting trade and investments, the oscillations however cannot be ruled out. It has been seen that the value of rupee has been fluctuating. Though it depreciated in the year 2002-03, it again appreciated at a rapid pace in 2007-08. It again depreciated in 2009-10 and saw rise in the FY 20102011. The most important factors that determine the exchange rate is the demand and supply. For instance, in FY 2007-08, the inflow of a large
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amount of foreign direct investments and foreign portfolio investment led to the increase in the supply of dollar in the foreign exchange market. During the first half of FY 2008-09 the rupee depreciated fast as foreign international investors made disinvestment during the sub-prime crisis. The risk of exchange rate and the resultant forward trading to hedge the risk could not be avoided by Managed float. In the late 1990s, the issue of financial stability achieved importance in order to reduce the effects of the turbulence in the South-East Asian financial markets and the deepening of the financial crisis in Russia. In June 1998, the Reserve Bank of India announced a set of policy measures that emphasized the role of the RBI in meeting the mismatches between the demand and supply of foreign currency through market intervention. It further permitted the institutional investors to manage the exposure of exchange rate by undertaking foreign exchange cover on their incremental investment, advising the traders and the banks to monitor their foreign currency position and allowing domestic financial institutions to buy back their debt from the international financial market. From 1 June, 2000, the Foreign Exchange Management Act came into force by replacing the Foreign Exchange Regulation Act (FERA). The aim of FEMA was to promote an orderly development and maintenance of the foreign exchange market in India. It also offers transparent norms related to Reserve Bank of Indias approval for acquiring and holding of foreign exchange and the limits to which foreign exchange is admissible to current/ capital account transactions from the viewpoint of full current account convertibility and the growing convertibility on capital account. Questions 1. Do you think the managed floating exchange rate regime is beneficial for the Indian economy? 2. What was the aim of the FEMA? Source: Compiled by Author
5.13 Summary
Let us recapitulate the important concepts discussed in this unit: Exchange rates respond quickly to all sorts of events - both tangible and psychological.
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The fluctuations in economic activity are reflected almost immediately in fluctuations of currency values. Demand and supply of a particular currency are the most important factors affecting its exchange rate. In foreign exchange trading, technical indicators such as charts and moving average lines are very significant in the determination of movement of the prices of various currencies. Rather than focusing on a particular good when applying the purchasingpower-parity concept, most analysts look at market baskets consisting of many goods. The Fisher Effect theory states that changes in the anticipated inflation produce corresponding changes in the rate of interest. Corporate financial decisions include exchange rate forecasts as one of the most important inputs.
5.14 Glossary
Fluctuations: A price or interest rate change Determinants: Factor or element that limits or defines a decision or condition Repatriate: Capital flow from a foreign country to the country of origin Deficits: A situation in which outflow of money exceeds inflow Fiscal: Involving financial matters Upheaval: A state of violent disturbance and disorder Equilibrium: A state of stable prices brought about by the rough equality of supply and demand

1. Discuss the primary determinants of foreign exchange rates. 2. Define the factors that determine the exchange rates. 3. Discuss what you mean by cross-rate. 4. Define Exchange rate.
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5. Discuss the ways in which arbitrage opportunities can be identified. 6. Money interest rates change to reflect changes in the anticipated inflation rates. Discuss. 7. What are the various approaches to forecasting?

1. fundamentals 2. Hot money 3. True 4. False 5. True 6. Cross-rate 7. US dollar 8. Market fundamentals, market expectations 9. Medium-run cyclical forces 10. Longer-run structural forces 11. True 12. True 13. Interest Rate Parity Theory 14. Spot, forward 15. True 16. True 17. False 18. Irving Fisher 19. International Fisher Effect 20. True 21. False
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1. Demand and supply of a particular currency are the primary determinants of foreign exchange rate. For further details, refer to Section 5.3. 2. The factors that determine the foreign exchange rates are: The demand factor The supply side Long term vs. short term Factors affecting Currency Trading Economic factors For further details, refer to Section 5.4. 3. A cross-rate may be defined as the rate of exchange calculated from two (or more) other rates. For further details, refer to Section 5.5. 4. An exchange rate can be defined as the price of a currency in terms of another. For further details, refer to Section 5.7. 5. One can identify arbitrage opportunities in one of the two ways. One, compute what should be the forward price (theoretical price) and compare it with what is the forward price (actual forward rate). For further details, refer to Section 5.8. 6. Irving Fisher argued that, over time, money interest rates change to reflect changes in the anticipated inflation rates. For further details, refer to Section 5.9. 7. The various approaches to forecasting are: Asset Market Model Monetary Model Portfolio Balance Model For further details, refer to Section 5.11.
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References/ e-References
Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing. Kumar Neelesh. Foreign Exchange Management. Delhi: Vikas Publishing.
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Structure
International Financial Markets
6.1 Caselet 6.2 Introduction Objectives 6.3 Foreign Exchange Market 6.4 International Money Market 6.5 International Credit Markets 6.6 International Bond Markets 6.7 International Equity Markets 6.8 Case Study 6.9 Summary 6.10 Glossary 6.11 Terminal Questions 6.12 Answers References/e-References
6.1 Caselet
Foreign investors lap up SBI dollar bonds State Bank of India, the largest lender of the country has managed to raise $1.25 billion from investors abroad for five years at 4.125 per cent. Despite the recent concerns expressed about the countrys economy by international credit rating agencies, it was the largest single tranche bond sale that received overwhelming response. The dollar-denominated bonds of SBI were subscribed 5.4 times and they received $6.8 billion from around 350 accounts that are spread over European, Asian, and US investors. Citibank, Deutsche Bank, Barclays, Bank of America, JP Morgan Merrill Lynch and UBS were the lead managers of this issue. SBI managed to raise $1 billion for five years at 4.5 per cent in 2010. Rajiv Nayar, the head of the capital markets organization at Citi India stated that the issuance has offered a window of opportunity to the other high quality Indian issuers to tap the international bond markets. He further said that in the five-year duration, the SBI notes were priced at the lowest ever coupon achieved in the US dollar market for an Indian issuer. Since April, a number of large Indian banks, private and government owned are waiting on the sidelines because they had to restrain from carrying out their plans due to
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the risk-averse investor sentiments after developments in the Euro zone. A senior treasury official from a Mumbai-based public sector bank stated that SBIs dollar bond pricing indicates that the interest rates are coming back to normal. Source: Adapted from http://www.business-standard.com/india/news/ foreign-investors-lapsbi-dollar-bonds/481572/ Accessed on 3 August 2012
6.2 Introduction
In the earlier unit, you learnt about measuring exchange rate movements and the various factors that influence exchange rates. You also studied various concepts such as international arbitrage, interest rate parity, and purchasing power parity and the Fisher effect. Forecasting foreign exchange rates and the approaches to forecasting were also discussed. In this unit, you will learn about foreign exchange markets and the international money market. You will also study the International credit markets which are defined as the forum where companies and governments can obtain credit (loans in various forms) from the creditors/investors. You will also learn about the international equity markets.
Objectives
After studying this unit, you should be able to: explain foreign exchange market define international money market interpret international credit markets discuss international bond markets and international equity markets
6.3 Foreign Exchange Market

The foreign exchange market is like any other over-the-counter market. This means that the foreign exchange market is unlike an electronic or a physical market like a stock exchange wherein traders would assemble and trade their currencies. This market is an across-the-world network of inter-bank traders, consisting of different players such as banks, connected by different
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communication tools and techniques such as telephony services, fax machines, the internet, video conferencing, and computers. The market functions virtually 24 hours in respect of the time differences across the world. Inter-bank currency trading is handled largely by five major centres of the currency trade, who handle two-thirds of the foreign currency transactions. They are London, New York, Tokyo, Zurich, and Frankfurt. Transactions in Hong Kong, Singapore, Paris and Sydney account for the bulk of the transactions in rest of the market. Functions of Foreign Exchange Market Foreign exchange market plays a very important role in smoothing the progress of international trade, commerce and investment transactions. It provides the foundation and the structure through which one countrys currency is exchanged with that of another country. The major functions of the market are as follows: (a) The foreign exchange market provides a method by which participants transfer purchasing power denominated in one currency into another currency. Since each party is eager to deal its transaction in its own currency, there is a need for a market to deal in foreign currency. (b) The foreign exchange market provides a source of credit for facilitating international trade and capital transactions. (c) The foreign exchange markets help participants to reduce their foreign exchange risk exposure by offering multiple hedging facilities, viz., forward market hedge, money market hedge, option hedge, swaps etc. (d) The foreign exchange market complements the primary role of the commercial banks to help its stakeholders to carry out international trade and exchange transactions. Structure of Foreign Exchange Market The foreign exchange market is a two-tiered market: 1. Interbank Market (Wholesale) The foreign exchange market is globally dominated by about 700 banks. Currency trading is a major source of profits for commercial banks across the globe. Many of these banks in the United States and Europe dealing with largescale foreign currency trading. Large commercial banks retain demand deposit accounts with one another which make possible the efficient functioning of the FX market.
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International commercial banks communicate with one another with: (a) The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It allows international commercial banks to communicate information of the above type to one another. It is a non-profit private message transfer system with headquarters in Brussels and international switching centres at Netherlands and Virginia. (b) Clearing House Interbank Payments System (CHIPS): It functions in cooperation with Fedwire, a system of US Federal Reserve Bank. It provides clearing house for interbank settlement for over 95 percent of US dollar payments between international banks. (c) Exchange Clearing House Limited (ECHO): It was the first global clearing house for settling transactions on foreign exchange among the commercial banks. Set up in 1995, this multilateral netting system nets a clients payments and receipts in each currency on each settlement date. This reduces significantly the risk and inefficiency of individual settlement. Apart from the commercial banks, nonbank dealers large nonbank financial institutions such as investment banks, hedge funds, mutual funds, pension funds account for about 30 per cent of the interbank trading volume. There are foreign exchange (FX) brokers who match buy and sell orders but do not carry inventory. These have the expertise and knowledge of the quotes offered by many dealers in the foreign exchange market. 2. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FX brokers and central banks. Exporters and importers, international portfolio investors, tourists, multinational enterprises and even government participate in the foreign exchange market to facilitate international trade and capital transactions. Speculators and arbitragers are also essential participants in the foreign exchange market. They seek to make money from trading in the market, mostly by taking advantage of exchange rate differentials existing simultaneously in different markets. Their activities are guided by self-motives, with or without any need to serve the clients. The central bank of a country often intervenes in the foreign exchange market. Since 1993, Indias currency regime is said to be a managed float.
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1. Large commercial banks retain ____________with one another which make possible the efficient functioning of the FX market. 2. Since____________, Indias currency regime is said to be a managed float. 3. ____________provides clearing house for interbank settlement for over 95 percent of US dollar payments between international banks.
6.4 International Money Market

One of the key components of the financial system is the money market that acts as a fulcrum of monetary operations that are carried out by the Central bank while pursuing the objectives of monetary policy. The maturity of such markets range from overnight to a year and involves financial instruments that are considered as close substitute of money. There are three broad functions that are performed by the money market. 1. For the demand and supply of short term funds, the money market provides an equilibrating mechanism. 2. It helps the lenders and the borrowers of the short term funds in fulfilling the borrowing and investment requirements at a competent market clearing price. 3. It offers an avenue to the central bank to intervene in influencing the cost of liquidity and the quantum in the financial system which in turn transmits monetary policy impulses to the real economy.
6.4.1 Origins and Development

Over the centuries, money markets have evolved and have presented new instruments and participants to fit the changing procedures of the monetary policies. Various changes in the structures of the financial market, macroeconomic objectives and economic environment have led to the demand for shifts in the monetary regimes, necessitating refinements both in the procedures and the operating instruments and in institutional arrangements by the Central banks. After the breakdown of the Bretton Woods System, a shift was witnessed from the rule-based frameworks towards discretion in using the instruments of
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monetary policy that finally led to the abandonment of exchange rate targets. The various changes that took place in financial innovations and financial structures made the monetary targeting ineffective by making the money demand functions unstable. In the same way, there has also been a shift towards greater flexibility of exchange rate adoption of inflation targeting by some central banks partly due to repeated instances of currency crisis, increase in capital mobility and greater financial market integration. Keeping in mind these changes, central banks have also distanced themselves from the conventional instruments of monetary control and have moved towards the use of indirect instruments such as operating through the price channel. Also the use of direct credit controls and reserve requirements have also been de-emphasized and to signal the monetary policy stance, they are depending more on interest rates. The most common strategy that has been adopted by the Central banks is to direct influence only on short-term interest rates to allow market expectations to exert an impact on the long-term interest rates through financial market inter-linkages. Thus, the structure of the money market guides the choice of monetary policy instruments. Since the early 1990s, the different financial sector reforms have offered strong impetus to the financial market development, which also paved the way for the introduction of market-based monetary policy instruments. With innovations in the financial field, money demand was viewed as less stable and the money market disequilibrium got reflected in short-term interest rates. Interest rates have also emerged as the operational instrument of policy since the adoption of the multiple indicator approach in 1998. For the purpose of widening the money market, a range of new money market instruments emerged. They were certificates of deposit and repos and commercial papers. Moreover, the increase in the development of the financial markets also led to changes in the risk profiles of the participants of the financial market giving way to the introduction of derivative instruments as effective risk management tools.
6.4.2 International Interest Rates

Money market rates are interest rates used by banks for operations among themselves. Money market enables the banks to trade their surpluses and deficits. This rate is also commonly known as inter-bank rate. The rates for various countries vary substantially. The reason for this substantial difference in rates is due to the interaction of supply or availability of short term funds (bank deposits) in a particular country versus the demand by borrowers for short term
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funds in that country. If the supply is more than the demand the interest rate will be low. A typical case is of Japan where the short term rates are very low for the same reason. On the other hand, if the supply of short term funds is less, than the demand of rates will be high as in the case of Australia. In general, the interest rates in developing countries are higher than the other developed countries. Let us now examine the linkages between: 1. Interest rate in the domestic and foreign market 2. Interest rate for different countries in foreign market We examine the above two linkages considering mainly the US and European markets. Eurocurrency market is considered to be an interbank deposit market. LIBOR (London Inter Bank Offer Rate) is a rate which a first class bank in London will charge from another first class bank for a short term loan. It is the most commonly used benchmark. One more rate, (London interbank bid rate) is a rate which a bank is willing to pay for deposits accepted from another bank. Generally LIBOR quotations are provided for 3 to 6 months LIBORs. However, LIBOR varies according to the term of the underlying deposit. LIBOR also varies according to the currency in which the loan or deposit is denominated.
6.4.3 Standardized Global Market Regulations

Regulations contribute to the development of international money markets because these impose restrictions on local markets. Local investors and borrowers try to circumvent the restrictions in local markets. Difference in regulations among countries puts banks in some countries to advantageous position compared to banks in other countries. Over a period of time, international banking regulations have been standardized, which permit competitive global banking. Three most significant regulatory events for creating more competitive global level playing field are given below: 1. The Single European Act 2. The Basel I Accord 3. The Basel II Accord Single European Act This was one of the most significant events pertaining to international banking. It was introduced in 1992 throughout the European Union countries. The main features of this act are:
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(i) Capital can flow freely throughout Europe. (ii) Banks can offer a wide variety of lending, leasing and securities activities in European Union. (iii) Regulations regarding competition, mergers and taxes are similar throughout the European Union. (iv) A bank established in any one of the European Union countries has the right to expand into any or all of the other European Union countries. The Basel I Accord In July 1988, central bank governors of 12 countries agreed on standard guidelines for banking regulation under The Basel Accord. As per the guidelines of The Basel Accord, banks are required to maintain capital equal to minimum of 4 per cent of their assets. For the purpose of this assessment, the banks assets are weighted by the risk involved, i.e. more risky assets will have higher required capital ratio. Items which are not appearing on the balance sheet are also accounted so that banks cannot circumvent the provisions of the accord. This applies to services which are not explicitly shown on the balance sheet. The Basel II Accord The banking regulators those formed the Basel Accord introduced a new accord called The Basel II Accord. The objective of this accord is to rectify some inconsistencies that still exist in the earlier accord. For example, banks in some countries require better collateral to back the loans. The Basel II Accord is aiming to resolve such differences amongst banks. Additionally, this accord will also account for the operational risk. The operational risk is defined by the Basel Committee as the risk of losses resulting from failure of internal processes or systems which are inadequate. The Basel committee aims to help banks to improve their techniques for reducing operational risk. This will in turn result in reducing failures in the banking system. The Basel committee also wants banks to provide more information about their exposure to different type of risks to the existing and prospective shareholders. Thereafter, Basel III was developed in response to the deficiencies in financial regulation this was revealed by the occurrence of the financial meltdown of 2008. Basel III has strengthened bank capital requirements and imposes new regulatory requirements on bank liquidity and bank leverage.
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The regulatory barriers Due to increasing competition, deregulation of financial barriers has increased worldwide. Deregulation is speeded up by the process of regulatory arbitrage in which the users of capital markets issue and trade securities in financial centres with low regulatory standards and hence lowest costs. With a view to win back the business, financial centres across the world are eliminating obsolete and costly regulations. Many countries have felt that the bank centred financial system does not provide adequately for the credit requirements of small and medium sized firms which are engines of growth and innovation. The combination of free markets with widely available information has formed the basis of global growth. Fund raising has become global with growing amount of money being raised on the international capital markets. Treasurers are looking for international sources of funding and are quick to exploit any attractive opportunity that appears anywhere in the world. Activity 1 Put on chart the aims and objectives of The Basel Accord and Basel II Accord. Hints: As per the guidelines of The Basel Accord, banks are required to maintain capital equal to minimum of 4 per cent of their assets.
4. After the breakdown of the Bretton Woods System, a shift was witnessed from the rule-based frameworks towards discretion in using the instruments of monetary policy that finally led to the abandonment of exchange rate targets. (True/False) 5. Eurocurrency market is considered to be an interbank deposit market. (True/False) 6. In September 1998, central bank governors of 12 countries agreed on standard guidelines for banking regulation under The Basel Accord. (True/ False)
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6.5 International Credit Markets

International credit markets are the forum where companies and governments can obtain credit (loans in various forms) from the creditors/investors. These markets are an important part of international capital markets. International capital market is that financial market or world financial centre where shares, bonds, debentures, currencies, mutual funds and other long term securities are purchased and sold. These markets provide the opportunity for international companies and investors to deal in shares and bonds of different companies from various countries. Two very important aspects of international credit market are the syndicated loans and impact of credit crisis on the credit market, which are explained below.
6.5.1 Syndicated Loans

Syndicated loans are credits granted by a group of banks, called a syndicate to a borrower who may be a company or the government. Interest rates can be fixed for the term of the loan or floating based on a benchmark rate such as the London Interbank Offered Rate (LIBOR).These are hybrid instruments combining features of relationship lending and publicly traded debt. These allow sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face. Syndicated credits are a very significant source of international financing, these accounting for more than a third of all international financing, including bonds, commercial papers and equity issues. Two or more banks agree jointly to make a loan to a borrower. There is a single loan agreement. Every member of the syndicate has a claim on the debtor. The creditors can be many syndicate members led by one or several lenders, acting as lead managers or agents. Leading banks are selected by the borrower to form a syndicate who is willing to lend money at specified terms. Syndicate leaders are generally borrowers relationship banks, who provide major portion of loan and join in with other participants for relatively smaller portions of loan. The number and size of the syndicate member banks depends on the size of the loan, the terms involved and concurrence of the borrower.
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6.5.2 External Commercial Borrowings (ECB)

ECBs refer to loans from commercial banks, suppliers credit, buyers credit, fixed rate bonds, floating rate notes, credit from authorized export credit agencies, and loans from institutions such as IFC (International Finance Corporation), ADB (Asian Development Bank) and CDC (Commonwealth Development Corporation). Guidelines for ECBs were first liberalized in India in 1997. Ever since then, corporate firms have been allowed to raise capital for expanding existing capacity, making new investments and finance working capital. All infrastructure and Greenfield projects are allowed to make use of ECB up to 35 per cent of total project expenses. The average maturity time of ECBs ranges from three to five to seven years. ECBs are mostly used for: (a) Project related cost of infrastructure projects (b) License fee payments in the telecom sector (c) Foreign exchange cost of capital goods and services Those corporate firms which manage to acquire ECBs with maturity time of 10 to 20 years are able to use the capital for general corporate purposes. However, the funds acquired through ECBs cannot be invested in stock markets or for dabbling in real estate. How much an ECB can be mobilized depends on the relative value of current rates of interest in India and other countries. The cost of an ECB should ideally include the margin of depreciation/appreciation in the value of the rupee abroad. Also, if interest rates in India are low, the demand for the ECB would also be low. Commonly, it has been seen that when the value of the rupee falls, the value of the ECB increases. The interest rate restrictions on ECB acquired for project financing permit an interest spread of up to 350 basis points over the LIBOR/US treasury rate. A corporate can only opt for an ECB only after they have obtained government approval. The government has specifies limits on the overall ECB that can be financed in a particular year. As happens with other types of foreign capital, the ECB actually received may be less than the amount approved. In a nutshell we can say that, arranging a syndicated loan meets borrowers demand for loan requirements without the lender having to bear the market and credit risk. The prime goal of syndicate lending is to spread out the risk of default amongst a number of lending banks or institutional investors. These loans are generally large in size and a single default can seriously jeopardize the safety of a single bank. These loans are also used in the leveraged
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buyout of international companies where loan amounts are large and the risk level is high.
7. ____________are credits granted by a group of banks, called a syndicate to a borrower who may be a company or the government. 8. ____________is the rate at which large global banks lend to each other.
6.6 International Bond Markets

Although debt financing has always been international in nature, there is still no unified international bond market. The international bond market is divided into three bond market groups: 1. Domestic bonds: They are issued locally by a domestic borrower and are usually denominated in the local currency. 2. Foreign bonds: They are issued on a local market by a foreign borrower and are usually denominated in the local currency. Foreign bond issues and trading are under the supervision of local market authorities. 3. Eurobonds: They are underwritten by a multinational syndicate of banks and placed mainly in countries other than the one in whose currency the bond is denominated. These bonds are not traded on a specific national bond market.
6.6.1 Euro Bond Markets

This is an international market for borrowing capital by any countries government, corporate and institutions. The centre of activity of borrowing and lending in London and Europe is called as Euro bond market. The borrowers and lenders can come from all over the world. A Bond market is a long term market in which the International Banks transact. It was developed in the 1960s when there was huge surplus of US Dollars in countries other than US. Euro bond is defined as a debt instrument underwritten by an international syndicate and offered for sale simultaneously in a number of countries. Therefore, it is usually denominated in a currency that is foreign. There are different names for particular segments of the foreign bond markets, for example, Yankee bonds are the bonds issued by the US companies in US markets.
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It is a telephone and telex market depending upon the means of communication for trading. The main features are as follows: The bonds issued by the issuer range from medium to long term. Repayment of principal amount in these instruments takes place in two forms; one is by means of agreed amortization over a period of time and the other is one lump sum payment at the end of the given maturity of the bond called as bullet payment. Bonds are issued in the form of bearer instruments that are transferable by delivery. Bonds are characterized by annual servicing and settlements are done through international clearing house mechanism. Placement of bonds There are two ways in which issuer can issue their bonds to the investors. They are discussed as follows: 1. Public offering: In this mode, the issue is opened to general public to invest in the issue and the issue is placed in the market by a syndicate of international banks that make elaborate arrangements to market the issue to their clients. Once the public offering is over, they are listed on any of the international stock exchanges. 2. Private placement: In this mode, the issue is made on a retail basis with individual investors in certain markets and the investors who generally invest in these issues are of professional in nature. Listing arrangement is done away as the issue is to be placed privately. The instrument is traded by leading banks on OTC market or through bank dealing rooms.
6.6.2 Development of other Bond Markets

International bonds are debt instruments issued by international agencies, governments and companies to borrow foreign currencies for a particular period of time. Interest to the creditor and repayment of the capital is made by the issuer. There are various types of international bonds and the procedure of issue of such bonds is very specific. Types of International Bonds International bonds are categorized into two types: foreign bonds and euro bonds. They are discussed as follows:
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Eurobonds These are basically debt instruments denominated in a currency issued outside the country of that currency; for example, yen bond floated in France. The primary attraction of these bonds is the refuge from tax and regulations, and also the scope for arbitraging yields. These are usually bearer bonds and can take the form of: (i) Traditional fixed rate bonds (ii) Floating rate notes (FRNs) (iii) Convertible bonds Foreign/global bonds In 1989-90, the World Bank issued global bonds for the first time and from 1992, various companies also started issuing such bonds. Currently, global bonds are issued in seven currencies in which such bonds are denominated, namely euro, Japanese yen, Australian dollar, Canadian dollar and Swedish krona. Straight bonds The traditional types of bonds are the straight bonds. The interest rate for straight bonds is fixed and it is known as the coupon rate. The rate is fixed in terms of the rates on treasury bonds for comparable maturity. The borrowers credit standing is also taken into account for fixing the coupon rate. There are several varieties of straight bonds. They are as follows: Bullet redemption bond: In this type of bond, the principal amount is repaid at the end of the maturity period and not in installments every year. Rising-coupon bonds: In these bonds, the coupon rate rises over time. The borrower has to pay little amount of interest payment during the early years of debt. Zero-coupon bond: This type of bond does not carry any interest payment. As a result of no interest payment, this bond is issued at discount. This discount compensates for the loss of interest of the creditors. Zerocoupon bond was issued in 1981 for the first time. Bonds with currency options: For this type of bonds, the investor has the right of receiving payments in a currency other than the currency of the issue.
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Bull and bear bonds: These bonds are indexed to some particular benchmark and are issued in two tranches. The bonds for which the amount of redemption increases with a rise in the index are called the bull bonds and the bonds for which the amount of redemption falls with a fall in the index are called the bear bonds. Debt warrant bond: This bond has a call warrant attached with it. Zerocoupon bonds are known as warrants. The creditors have the right of purchasing another bond at a given price. Floating rate notes Floating rate notes (FRNs) are bonds which do not carry a fixed rate of interest. The rate of interest is quoted as a premium or a discount to a reference rate which is always the London Interbank Offered Rate (LIBOR). Depending upon the period for which the interest rate is referenced to, the rate of interest is periodically revised, say, at every three-month or every six-month period. There are various forms of FRNs. They are as follows: Perpetual FRNs: In this type of FRNs, the principal amount is never repaid, which means they are like equity shares. Minimax FRNs: These are FRNs where the minimum and maximum rates are mentioned. The minimum rate is advantageous for the investors, while the maximum rate is beneficial for the issuer. It is only the maximum rate that is payable even if LIBOR rises beyond the maximum rate. Drop-lock FRNs: Under this type of FRNs, the investor has the right of converting the FRN into a straight bond. Flip-flop FRNs: These FRNs were issued by the World Bank for the first time. In the case of flip-flop FRNs, the investor has the choice to convert a FRN into a three-month note with a flat three-month yield. Mismatch FRNs: In case of mismatch FRNs, the rate of interest rate is fixed on a monthly basis, but the interest is paid every six months. The investor, in such a situation can go for arbitrage on account of the difference in rates of interest. Such FRNs are also called rolling-rate FRNs. Hybrid fixed rate reverse FRNs: This type of floating rate notes is a recent innovation. They were developed in the Deutschmark segment of the market in 1990. These FRNs pay a fixed high rate of interest for a couple of years. The investors receive the difference between LIBOR and even a higher fixed rate of interest. They earn profits as the LIBOR becomes low.
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Convertible bonds Convertible bonds are bonds that can be converted into equity shares. International bonds are also convertible bonds. Some of the convertible bonds have detachable warrants that involve acquisition rights while other convertible bonds have automatic convertibility into a particular number of shares. Cocktail bonds Bonds that are denominated in a mixture of currencies are known as cocktail bonds. The SDIR bonds represent a weighted average of four currencies. The investors who purchase cocktail bonds automatically get the benefits of currency diversification. The depreciation of any one currency on account of a change in the foreign exchange rate is offset by appreciation of another currency. Activity 2 Analyse the present bond market in India and find out how it is affecting the Indian economy. Make a report. Hint: Browse the Internet and to gather notes on the bond market.
9. Foreign bonds are issued locally by a domestic borrower and are usually denominated in the local currency. (True/False) 10. Bullet redemption bond the coupon rate rises over time. (True/False) 11. Bonds that are denominated in a mixture of currencies are known as cocktail bonds. (True/False)
6.7 International Equity Markets

Equity markets are seen as an avenue by a large number of investors both individual and institutional as an investment source. Securities market includes the distribution of new issues of securities by new or existing companies as well as the purchase and sale of old securities in the stock exchange markets. A company always prefers equity to debt because debt servicing is a compulsory commitment. Equity markets encourage savings among the
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nationals and increases the efficiency of capital allocation by channeling the savings into productive investments. Participants of securities market Investors and the issuers: In every economy, the saving of individuals reaches the business sector by circulation of money in the other sectors. The individuals and institutional investors save their earnings and invest in the stock market. Issuers are the corporate world that raises money through the stock market. Intermediaries: The merchant bankers, underwriting agents and the other institutions like banks are an important link between the investors and the corporate world. They are involved since the beginning when the issue is planned and continue as the dividends are continuing affair in the securities market. Regulators: As more and more scams occurred in the different stock markets across the world, the need for a regulatory body was felt. The regulatory bodies regulate the functioning of the securities market by over viewing the process of issue till the securities are issued. They protect the interest of investors and ensure the companies that are operating in the secondary market, report all the facts and figures to the investors on timely basis.
6.7.1 Issuance of Stock in Foreign Markets

Up to the year 1980, there were hardly any equity issues of firms in international markets. However, in the 1980s, especially between 1983 and 1987, the number of equity issues in the international markets saw a large increase. During the 1990s, institutional investors from developed countries bought equities of developing markets in a big way. The advantage for the issuer was to obtain low cost funds, broaden their shareholders base, initiate steps for international activities like acquisitions, grant stock options to foreign employees and improve the access to large size term funding. The advantage for the investors was the motive for diversification. Technology boom in the 1990s also attracted the investors towards the technology stocks from emerging stocks. Most firms who have gone for global equity markets have done so for one or more of the following considerations: 1. The size of the stock is large and the domestic market is not large enough to support the stock. So, the issuing companies issue stocks in another country and often more than one country at the same time.
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2. For obtaining better price and terms for equity issue, if all the markets had been totally integrated, there would be no change in prices of the stock in any country except for the issue cost. However, most markets are fragmented and segmented from each other due to constraints placed by various countries, so that liquidity position of each market is different and share prices will also be different. 3. For establishing their image as global companies and, thus improving the demand for their products and services. 4. Liquidity of the stock in the secondary market: This also applies to instruments which are based on the stocks like depository receipts, which are listed and traded on foreign stock exchanges. 5. Regulatory issues pertaining to reporting and disclosures Sometimes, shares of a firm are traded by indirect route in the form of depository receipts. The shares issued by the firm are held by a depository who is a large international bank which receives dividends, reports etc. and issues claims against these. The claims are called depository receipts. Each receipt is a claim on specified number of shares. The depository receipts are denominated in a foreign currency usually US dollars. The depository receipts are listed and traded on major stock exchanges. The issuing firm pays dividends in the home currency of the firm and the depository converts the same to dollar and pays to investors. This mechanism originated in the US and is called American Depository Receipts (ADRs). Further, European Depository Receipts (EDRs) and Global Depository Receipts (GDRs) can be used to tap multiple markets in other countries with single instrument. Reliance Ltd. issued the first GDR in 1992 and many Indian software and other firms have issued ADRs. Domestic firms and MNCs generally obtain long term capital by issue of shares in domestic markets. However, the firms can attract funds from foreign investors by issuing stocks in foreign markets. If the size of issue is large, it can be issued in more than one country at the same time. Such issues are called Euro issues. For the MNCs, the country for the issue of stock can be based on the location of its operations. It may like to issue stocks in countries where it has operations and expects to generate future cash flows so that dividend can be paid out of the revenues in the local currency of that country. The stocks are designated in the currency of the country where these are issued and also these are listed in those countries so that the investors can sell the stocks in
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secondary market. For example, the Coca-Cola stock issued to investors in Germany is designated in Euros and not Dollars. For large companies, while issuing shares they tap investors in a number of countries because domestic market may be too small for the level of operation. For example, when KLM company which is an airline located in Holland issued 5 crore shares, it placed 70 lakh shares in Europe, 70 lakh shares in US and 10 lakh shares in Japan. Selling stocks in foreign markets increases its demand and hence, the stock price goes up. Since the investor base is widened, stock prices also become more stable as the offloading of stock by any single investor or financial institution cannot have a major impact on the prices. Another major advantage of issuing stocks in foreign markets is that the brand name and the product get support and the effect on sales is large. For example, Apple computers of US issued its shares in Japan and Germany and also listed on Tokyo and Frankfurt exchanges to raise the profile of its products in those countries.
6.7.2 Issuance of Foreign Stock in the United States

Sometimes firm in different countries wants to issue stocks in the US with the objective of obtaining large amount of funds due to high liquidity in US markets. These are called Yankee stock offerings. A foreign corporation may be able to sell an entire issue of stock in the US market. The companies are looking for those markets where they can reach shareholders at the lowest cost and investors are looking for good prices and low transaction costs. In the case of non-US firms issuing stocks in their own country, the spread of shareholders is limited and a few large institutional investors may buy a bulk of the shares. If any major institutional investor sells his shares, the share prices can drop substantially. When the firm sells shares in the US, the spread of shareholding increases and the effect of a single shareholder selling his stocks on the price will not be much. Thus, the volatility of the firms shares will reduce. In US, the investment bankers serve as underwriters for the shares being issued in the US financial market and charge high underwriting fee of around 5 to 8 per cent of the value of the total stock issue. Many financial institutions in the US buy foreign stocks purely as investments; non-US firms can sell large stocks fully in the US.
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In many countries, there are large businesses owned by respective governments. When the government wants to sell any business to private shareholders, local markets are not large enough to provide necessary liquidity. Thus, when the stocks are sold in the US, it amounts to US investors financing the private business in foreign countries. For the purpose of issue of stocks in US markets, the foreign firms have to comply with stringent disclosure rules on the financial condition of the firms. The foreign firm will be exempted from some of these rules when they qualify for Security and Exchange Commission (SEC) guidelines (adopted the Rule 144A in 1990) through a direct placement of stock to institutional investors. Rule 144 A permits the qualified institutional investors to trade in private placements of unregistered firms. This rule increased the liquidity of the private placement market and makes it attractive to foreign firms who are often unable to enter the US market by SECs stringent disclosure and reporting rules. The main advantage of private placement is that its total cost would be less than half of the public offering cost, and it takes less time to make private placement. However, the pricing for private placement is less competitive compared to a public offering and the firm has limited access to US markets. Many foreign companies decide to sell their initial public offerings (IPOs) in US because they get better price, a shareholder base which understands the business and they can in the process get publicity for their products. A classical example is that of the Daimler-Benz, the company that manufactures Mercedes; when it listed its shares on New York Stock exchange in 1993, it was the first German company to do so. The company had to comply with stringent disclosure rules and had to modify its accounting practices to confirm to US generally accepted accounting principles. Daimler-Benz undertook this difficult task because it wanted access to larger and liquid pool of capital in the US market. The firm also thought that the positive image of its Mercedes cars would help it to raise capital at lower prices. During the next six weeks, from the announcement of its plan to issue of stock in US markets and the date of actual listing, the share prices in US market had risen by about 30 per cent whereas in the German market, the share prices during the same period rose about 10 per cent. Non-US firms also obtain equity financing by using American Depository Receipts (ADRs). These are certificate representing bundles of stocks. The use of ADRs circumvents some of the disclosure requirements for stock offerings in US, but still enables the non-US firms to obtain funds from US markets. ADR shares can be traded just like shares of the stock, the price of ADR changes
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continuously as a consequence of demand and supply conditions. In the long run, the ADR is expected to move in tandem with the value of its shares listed in foreign stock exchange except for adjustment of exchange rate effect.
12. The ____________regulate the functioning of the securities market by over viewing the process of issue till the securities are issued. 13. ____________permits the qualified institutional investors to trade in private placements of unregistered firms. 14. Selling stocks in foreign markets increases its ____________and hence, the stock price goes up.
6.8 Case Study

Euro-issues of the Indian Firms The Indian companies receive funds from the International market through the euro-issues, viz., American Depository Receipt (ADRs), Global Depository Receipts (GDRs) and Foreign Currency Convertible Bond (FCCBs). In case the bank depository is situated in the USA, the receipt that is issued by it is known as ADR. In the international financial market, the ADRs and GDRs are issued and sold by the depositories depending on the shares that are deposited by Indian companies with a custodian bank located in India. The flow of fund takes place from the ultimate investors to the GDs, from the GDs to the custodian bank and from the custodian bank to the company. Before the depository receipts are issued, the value of the depository issues, ratio between the depository receipts and the Indian shares are agreed upon between the foreign depository and the custodian bank in India. An ADR/GDR issue can be sponsored by an Indian company. When a resident shareholder gives back his shares to the company, the latter can go for the issue of depository shares on the basis of those shares. Three different types of ADR issues exist although an alternative approach under Rule 144A is also found. These types depend on some factors such as the choice of the accounting standards, profile of the company that is sought by the investor and the amount that is to be raised. At level 1, the disclosure
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requirements to the US Securities and Exchange Commission (USSEC) are the minimum possible and the ADRs are traded in the US over-thecounter market under the provision. The issues are also not found listed on the National Stock Exchanges. The provisions of the Generally Accepted Accounting Principles (GAAP) are also not applicable. At level 2, the issue needs a greater amount of disclosures. The GAAP provisions are also applicable and the ADRs are registered at the New York Stock Exchange or the NASDAQ. At level 3, public offerings are raised by the ADRs in order to raise money. They need to comply with the listing requirement of the Stock Exchange and are needed to be registered with the USSEC. Here, the GAAP provisions are also applicable. The issue under the Rule 144 A, is restricted only to the qualified institutional buyers. In the first two years, the securities being unregistered or unsponsored are sold under very stringent processes. In the case of FCCBs, as they are debt instruments, they include the repayment of the principal and payment of interest in foreign currency. The high promoter shareholding companies generally issues the FCCBs as they do not perceive any risk that they will lose management control even after the exercise of the conversion option. In India, the FCCBs are often unsecured and the holder of this bond can sell a part or the entire holding or convert it into American depository share. Questions 1. What do you think are the differences between ADRs, GDRs and FCCBs? 2. How do the Indian companies receive funds from the international market?
6.9 Summary
Let us recapitulate the important concepts discussed in this unit: The foreign exchange market is an across-the-world network of interbank traders, consisting of different players such as banks, connected by different communication tools and techniques such as telephony services, fax machines, the Internet, video conferencing, and computers. Foreign exchange market plays a very important role in smoothing the progress of international trade, commerce and investment transactions.
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One of the key components of the financial system is the money market that acts as a fulcrum of monetary operations that are carried out by the Central bank while pursuing the objectives of monetary policy. Syndicated loans are credits granted by a group of banks, called a syndicate to a borrower who may be a company or the government. International bonds are debt instruments issued by international agencies, governments and companies to borrow foreign currencies for a particular period of time. Equity markets are seen as an avenue by a large number of investors both individual and institutional as an investment source.
6.10 Glossary
Transaction: An agreement between a buyer and a seller to exchange an asset for payment. Hedging: Reducing or controlling risk Multilateral: A trading system that facilitates the exchange of financial instruments between multiple parties Macroeconomic: The field of economics studying the behavior of the aggregate economy Impetus: Incentive, stimulus Repos: A form of short-term borrowing for dealers in government securities Deregulation: Reduction of governments role in controlling markets leading to freer markets, and presumably a more efficient marketplace

1. Discuss the functions of the foreign exchange market. 2. Discuss the single european act in brief. 3. What are international credit markets? Explain. 4. Define euro bond market. 5. Explain the different forms of FRNs. 6. Discuss the process of issue of stocks by MNCs.
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1. Demand deposit accounts 2. 1993 3. Clearing House Interbank Payments System (CHIPS) 4. True 5. True 6. False 7. Syndicated loans 8. LIBOR 9. False 10. False 11. True 12. Regulatory bodies 13. Rule 144 A 14. Demand

1. The major functions of the Foreign Exchange Market are as follows: (i) The foreign exchange market provides a method by which participants transfer purchasing power denominated in one currency into another currency. (ii) The foreign exchange market provides a source of credit for facilitating international trade and capital transactions. For further details, refer to Section 6.3. 2. This was one of the most significant events pertaining to international banking. It was introduced in 1992 throughout the European Union countries. For further details, refer to Section 6.4.3.
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3. International credit markets are the forum where companies and governments can obtain credit (loans in various forms) from the creditors/ investors. For further details, refer to Section 6.5. 4. This is an international market for borrowing capital by any countries government, corporate and institutions. The centre of activity of borrowing and lending in London and Europe is called as Euro bond market. For further details, refer to Section 6.6.1. 5. There are various forms of FRNs. They are as follows: Perpetual FRNs Minimax FRNs Drop lock FRNs Flip-flop FRNs Mismatch FRNs Hybrid Fixed Rate Reverse FRNs For further details, refer to Section 6.6.2. 6. For the MNCs, the country for the issue of stock can be based on the location of its operations. For further details, refer to Section 6.6.2.
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing. Kumar Neelesh. Foreign Exchange Management. Delhi: Vikas Publishing.
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Structure 7.1 Caselet 7.2 Introduction Objectives 7.3 Financing Exports 7.4 Financing Imports 7.5 Documentary Collections 7.6 Factoring and Forfeiting 7.7 Countertrade 7.8 Case Study 7.9 Summary 7.10 Glossary 7.11 Terminal Questions 7.12 Answers References/e-References
Foreign Trade Finance
7.1 Caselet
Factoring WindowNarrowed by RBI The central bank announced on 23 July 2012 that any company who is planning of undertaking the factoring business are needed to register itself as an NBFC-Factor with the Reserve Bank of India (RBI). It is also required for them to have a minimum net owned fund of `5 crore. Factoring which is a financial transaction allows the entity to sell its receivables at discounted prices to a third party called a factor. The direction of RBI follows notification of the Factoring Regulation Act, 2011, whose aim is regulating factors and assignment of receivables in favour of factors. It has also been stated that under this Act, companies undertaking factoring business, other than the government companies and banks would be registered with the RBI as non-banking financial companies (NBFCs). RBI has further said that in accordance with the Act, it had been decided that a new category of NBFCs would be introduced and separate directions would be provided to these. The RBI has also said that every company who is willing to undertake factoring business is required to put forward an application so that a certificate of registration as an NBFC-Factor to the RBI is registered.
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Moreover, it should also have a minimum NOF of `5 crore. However, companies who needs registration but do not fulfill the criteria of NOF can also approach the RBI requesting for time in order to fulfill the requirement. It has also been stated by the Apex bank that it should be ensured by the NBFC-Factor that the factoring business constitutes at least 75 per cent of its total assets. It should also be taken into consideration that the income that has been derived from the factoring business is not less than 75 per cent of its gross income. The NBFC-Factor (Reserve Bank) Directions, 2012 come into operations with immediate effect. Source: Adapted from http://www.business-standard.com/india/news/rbinarrows-factoring-window/481246/. Accessed on 3 August 2012
7.2 Introduction
In the previous unit, you learnt about the foreign exchange market as well as the international money market. Topics related to money market interest rates and standardizing global market regulations had also been discussed. You also studied about the international bond markets and the international stock markets. In this unit, you will learn about foreign trade finance. You will be introduced to the concepts of financing exports and financing imports and you will also learn about documentary collections, factoring, forfeiting and countertrade.
Objectives
After studying this unit, you should be able to: discuss financing exports and imports define documentary collections explain factoring and forfeiting evaluate the concept of countertrade
7.3 Financing Exports

It is very necessary to provide attractive payment terms that is customary in the trade in order to make a sale. Many export financing options are available in the market and the exporters should be aware of them so as to choose the most acceptable and profitable one. Many a times, the assistance of the government
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in financing exports to small and medium-sized businesses can also increase options for the firm. While extending credit to foreign buyers, it should be known that they often ask the buyers for longer payment periods. Thus, the exporters should weigh carefully the credit or financing that they are extending to the foreign customers. For determining the appropriate credit period, the exporters can consult the normal commercial terms available in the exporters industry. The normal commercial terms for products like agricultural commodities, consumer goods, chemicals and other raw materials range from 30 to 180 days. However, exceptions can be made for longer shipment times as foreign buyers are often unwilling to start the credit period even before the receipt of the goods. Government Assistance Programs Different programs are offered by the federal government agencies to help the exporters fulfill their financial needs. Some of these include loans or grants to an exporter or a foreign government while others include guarantee programs. The main aim of the government programs is to improve the access of the exporters to credit rather than subsidizing the cost at below-market levels. With few exceptions, banks are also allowed to charge fees and market interest rates to the government agencies in order to cover the default risks and the administrative costs of the agencies. Generally, the commercial banks use government guarantee and insurance programs to lessen the risk that is associated with loans to exporters. Lenders who are concerned with the ability of the exporters about performing under the terms of sale uses government programs in order to reduce the risks that would have otherwise prevented them from providing financing. There are different forms of credit that are provided to the exporters. They are as follows: 1. Pre-shipment credit 2. Post-shipment credit 3. Medium-term credit 4. Credit under duty draw-back scheme 1. Pre-shipment credit This credit is provided to the exporters meant for procuring raw material, packing and processing of goods as well as for other processes till the goods are really shipped. This type of credit is normally extended on the strength of letter of credit but sometimes also on the strength of purchase order. This credit is
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extended generally in stages and not as a lump sum, depending on the needs of the customer. It is a short-term credit normally not exceeding 180 days but in exceptional cases may exceed up to 270 days. 2. Post-shipment credit It is extended by the banks after the goods have been shipped and against the submission of export documents evidencing the shipment of the goods. It is also a short-term credit and the rate of interest is lower up to 90 days. But later, it increases and it is still higher beyond 180 days. Post-shipment credit is extended also in the case of deemed export or supplies that are made to international bodies. The banks in India have also started extending the postshipment credit in foreign currency since January 1992. The process is that Indian exporter is paid in Indian rupees and the liability of the exporter is denominated in US dollar. 3. Medium-term Credit The medium-term credit is used in case of certain categories of export such as capital goods, project export and engineering items. In case of such products, the short-term finance does not help. In case the maturity exceeds a period of three years or less, the credits will be either suppliers credit or buyers credit. 4. Credit under Duty Drawback Scheme Under the Duty Drawback Scheme, the duty that is paid on the imported inputs or the excise duty that is paid on the goods produced for export are repaid to the exporter when the export is completed. The banks provide a cash advance for this period as the exporters cash is locked up during the period between the payment of duty and the completion of export and this advance is given both at the pre-shipment and the post-shipment stage. The time period necessary for this advance is three months. In case of this scheme, the exporters bank gets the duty drawback from the government in behalf of the exporter. No interest is charged on this amount. Activity 1 Make a report about what form of credit is provided to the exporters in India. Hint: The different kinds of credit are pre-shipment credit, post-shipment credit, medium-term credit and credit under duty drawback scheme.
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1. ____________is provided to the exporters meant for procuring raw material, packing and processing of goods as well as for other processes till the goods are really shipped. 2. The banks in India have also started extending the post-shipment credit in foreign currency since____________. 3. Under the________________________, the duty that is paid on the imported inputs or the excise duty that is paid on the goods produced for export are repaid to the exporter when the export is completed.
7.4 Financing Imports

Financing imports relieves the importer of a huge burden and helps the importer in overcoming the challenges of cash flow and leaves working capital free for investments. Import finance can also be tailored to meet the funding needs of different businesses. The most important way through which imports are financed is through letters of credit (L/C). A Letter of Credit includes four parties which are the applicant, issuing bank, beneficiary and the advising bank. The importer who approaches the bank for the issuance of the letter is known as the applicant. The issuing bank is the one which issues the letter. Beneficiary is the exporter in favour of whom the letter of credit is opened. The advising bank, on the behalf of the issuing bank informs the exporter about the opening of the letter of credit. There are different types of Letters of Credit. They are discussed as follows: 1. Revocable Letter of Credit: This is a type of credit which the issuing bank can cancel or revoke at the request of the applicant, without the beneficiarys consent. 2. Irrevocable Letter of Credit: This type of credit cannot be cancelled by the issuing bank without the prior consent of the beneficiary. 3. Deferred Payment Letter of Credit: Through this credit, the beneficiary receives the payment in installments from the issuing bank. The amount of these installments and the time in which it has to be paid are predetermined.
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4. Confirmed Letter of Credit: The confirmed letter of credit is a type of credit that is guaranteed or confirmed by a bank in addition to the issuing bank. 5. Unconfirmed Letter of Credit: Unlike the confirmed letter of credit, this letter is not confirmed by any other bank other than the issuing bank. 6. Revolving Letter of Credit: This type of credit gets reinstated after having been utilized once. However, it is might be limited by the overall credit that is available or by the time period in which such credit may be utilized or both. 7. Transferable Letter of Credit: A transferable letter of credit is one where the beneficiary can transfer his rights to a third party. The third party is usually the manufacturer of the goods utilizing the services of the beneficiary as a marketer or a middleman. 8. Back-to-back Letter of Credit: This letter of credit is opened with the security of another letter of credit. The letter of credit that acts as the security is known as the principal credit or the overriding credit. A number of parties are associated with this credit. They are the buyer and his bank, the seller/manufacturer and his bank and the manufacturers subcontractor and his bank. 9. Anticipatory Letter of Credit: Under this credit, the payment is made to the beneficiary even at the pre-shipment stage. Two kinds of anticipatory letters of credit are found, the red clause credit and the green clause credit. Advance for the processing and or packing of goods and the purchase of raw materials are given under the red clause credit and under the green clause credit, advance is also given for warehousing and insurance charges.
4. The most important way through which imports are financed is letters of credit (L/C). (True/False) 5. Beneficiary is the one which issues the letter. (True/False) 6. Two kinds of anticipatory letters of credit are found, the red clause credit and the green clause credit. (True/False)
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7.5 Documentary Collections

Every business needs cash for its successful operations. However, at the same time cash and near cash assets are the least productive assets of a business. The global financial manager will have to frame and maintain policies and procedures that are necessary for an MNC to achieve an efficient flow of cash for its operations. The elements of a cash system include collection system for getting the cash into the MNC and the disbursement system for paying the suppliers and other people who have to be paid in cash. These elements are now discussed in detail. Collection system Collection system is designed to receive payments from buyers as soon as possible. A collection system has five elements: (i) The number of collection points (ii) Location of collection points (iii) Operations of collection points (iv) Assignment of individual payers to collection points (v) Information about payment to the user of the collection system The collection system works on the concept of collection float. Collection float is the total time lag between the mailing of the payment by the payer and the availability of the cash in the bank. An MNC has to measure float with respect to the time lag and the amount involved and thereby calculate the cost involved. Float is usually measured in amount days, which is calculated by multiplying the time lags in days by the amount being delayed. MNCs can measure float either on each item that is processed or on an average daily basis. Types of collection systems Over-the-counter collection: In this method, the payment is received in a face-to-face meeting with the customer. Mailed payment collection system: The payments are made through the mode of cheques or the instruments of the payment are mailed by the customer in response to an invoice. This type of system has all the three floats
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Lock box system: Lock box is a post office box number of a company, and the companys customers have to send their payments in the form of the instrument Netting: Netting is the elimination of counter payments as only the net amount is paid. For example, if the parent company is to receive US$ 3.0 million from its subsidiary and if the same subsidiary is to get US$ 1.0 million from the parent company, the two transactions can be netted and the subsidiary will pay US$ 2.0 million to the parent company. This will lower the cost of transfer. Netting can be bilateral or multilateral. Bilateral netting: If Company A exports goods to Company B for `1 million and imports goods worth `1.5 million from Company B and their dates of maturity are the same, both companies will have to bear the transaction cost in case of normal movements of funds. But in case netting is followed, it will save the transaction cost of both the companies as the cost will be only borne by one company and also the amount will be less as the amount of transaction has been reduced. Multi-lateral netting: It involves netting of risk exposure among more than two companies. The total risk exposure without netting is `7,890,000. As a result of bilateral netting, as shown in Figure 7.1, the total risk exposure gets reduced to `1,710,000.
Parent
`3,50,000 `3,50,000
Subsidiary A
`50,000
Subsidiary D
`1,00,000
Figure 7.1 Movements of Funds with Bilateral Netting
Source: Compled by Author
`1,00,000
Subsidiary B
Subsidiary C
`2,50,000
`1,60,000
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Multi-lateral netting simplifies funds flow as only net amounts are transferred. A further simplification is possible in such a manner that a company is either paying or receiving a net sum. As a result, the total risk exposure gets further reduced to `4,10,000 (see Figure 7.2).
Parent
`3,50,000
`3,50,000
Subsidiary A
Subsidiary D
`1,50,000
Subsidiary B
`4,10,000
Subsidiary C
Figure 7.2 Centralized International Cash Management
Source: Compiled by author Centralization is not the control by headquarter but the concentration of decision-making power at a sufficiently high level within the corporation. With this, all information will be available at a centralized position and can be utilizedto strengthen the position of a firm. Cash Concentration Strategies The parent MNC has cash distributed in all its subsidiaries spread across the globe. Once the payments are received from customers, the firm has to make a decision to ensure that cash is moved efficiently to a central place where it will benefit the parent company the most. The process of collecting funds at a central place is called concentration strategy. This will simplify the work for MNCs whichhave to calculate short-term borrowings for its various subsidiaries. It can also have the knowledge about the excess cash that can be invested in shortterm marketable securities. The parent MNC would have to accelerate the collections from within a home country and across borders, i.e. from the host country. Collecting cash from different subsidiaries without any delay is a key element of international cash management.
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Disbursement system A firm can optimize its working capital requirement by managing both its receiptsfrom customers and payments to be made to vendors. It can reduce its cash requirement by delaying the payments as much as possible or by matching the dates of cash receipts with cash payments. Disbursement system includes banks and the delivery procedures that an MNC uses to facilitate the movement of cash from the centralized cash pool to the disbursement banks and then to the suppliers. Cash planning A good reporting system between various subsidiaries and the parent company is a must for successful coordination of cash and marketable securities. Cash receipts at various locations must be summarized and reporting to the parent should be done in a comprehensive and accurate manner. A multinational cash mobilization system should be framed to optimize the use of funds by using current and near-term cash positions. Liquidity management When an MNC is able to achieve efficiency in cash-flow management, it should focus on the management of liquidity of its assets. An MNC aims to achieve the lowest possible funding cost on debits and the highest possible return on invested cash. A cash-flow forecast is prepared to help the MNC to have an idea about cash balances that would have to be managed. Cash management structures There are four stages in a companys evolution from a decentralized organization to a centralized cash management organization. Lesser centralized the cash management model is, greater the gains a company can achieve. 1. Decentralized liquidity and cash-flow management: If the MNC follows a fully decentralized cash management policy, each subsidiary would be allowed to maintain its cash position on its own. It will not be affected and also would not affect the cash positions of its sister concerns and even the parent company. The cash manager will have complete independence of managing the operations of the subsidiary. 2. Centralized liquidity and decentralized cash-flow management: If the parent MNC follows this model, liquidity of the group will be managed centrally by it. This model can operate with or without delegation of the cash function to a local financial representative of the subsidiary.
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3. Decentralized liquidity and centralized cash-flow management: In this policy, cash-flow management is managed by a transaction centre which has a single pipeline to the bank for settlement by way of the appropriate local clearing mechanism. Each subsidiary manages its liquidity at its own level without being affected by the liquidity of other subsidiaries in different countries. This policy is used in multi-currency environments, but it is unlikely to be used in the Euro zone. 4. Centralized liquidity and centralized cash-flow management: In this policy, all activities are centralized. The parent company acts on behalf of the local operating companies and provides full administration of both liquidity and cash flow to them. It agrees to specific service levels with the individual operating companies and maintains a single pipeline to a panEuropean bank.
Degree of centralized liquidity management Low Degree of centralized cash flow management 1 I Low 3 4 High III IV 2 II High
Figure 7.3 Centralized Liquidity and Centralized Cash Flow Management
Source: Compiled by Author
7. The collection system works on the concept of____________. 8. ________________________is a post office box number of a company, and the companys customers have to send their payments in the form of the instrument. 9. A________________________ is prepared to help the MNC to have an idea about cash balances that would have to be managed.
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7.6 Factoring and Forfeiting

Formulation of a credit policy of an MNC has to manage the receivables in international trade. The procedure of credit evaluation for overseas customers and credit granting decision is a specialized field. The credit policy of MNC lays down the parameters that will help the manager to decide whether to grant credit to a particular party or not. It also helps in determining the length of period for which credit can be extended to the customer and what will be the discount and to what extent efforts are to be made for the collection of receivables. Creditworthiness of an applicant is judged by the three Cs. For checking the creditworthiness, a company needs to check (1) character, (2) capacity and (3) collateral. Character represents the willingness to pay, capacity means the ability to pay and collateral means the security offered by the firm in the form of mortgages. Generally, the payment is received by an exporter after a couple of days of the shipment and during this period, the export is considered as account receivables. There is also the possibility that the exporter might face bad debt loss for which the exporter sells its receivables without recourse to a bank. This helps them in avoiding collection expenses and getting immediate payment for export. This procedure of selling receivables is known as factoring. After the selling is done, it is the responsibility of the bank to collect the amount from the importer. The bank usually purchases the receivables at discount and receives a flat processing fee as the bank faces the risk of non-payment and also has to make the payment of the collection charges. One of the most essential credit management strategies to be evolved is to carry out effective Forfeiting services. Forfeiting is a fund-based financial service that provides resources to finance receivables as well as facilitates the collection of receivables. Forfeiting is a type of finance of receivables that arise due to international trade. In this technique, a bank or a financial institution buys trade bills/promissory notes of a firm involved in business of export-import without recourse to the seller. The buyer of the bills is called the forfeiter. The forfeiter would purchase the assets by discounting the documents that cover all the risks of non-payment in collection. It is the responsibility of the forfeiter to cover all risks and collection problems. The forfeiter pays cash to the seller after discounting the bills. A cross-border factoring has common features of non-recourse and advance payment. The entire value of the note/bill is discounted by a forfeiter. So there is 100 per cent financing arrangement of
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receivables finance. The availing bank that provides an unconditional and irrevocable guarantee is a critical element in the Forfeiting arrangement. The forfeiters decision to provide financing depends upon the financial standing of the availing bank. Forfeiting is a pure financing arrangement. It includes ledger collection, administration, etc. Forfeiting finances notes/bills arising out of deferred credit transactions spread over three to five years. The increase in the threshold of credit increases the sales and profits, and the contraction of credit will lead to less sales. It will increase the administrative costs incurred in the collection of debts from customers globally. Now we will discuss the main highlights of Forfeiting as a form of export-linked financing. As per the agreement made in a commercial contract between an exporter and an importer, goods are sold and delivered by the exporter and the importer receives them on the deferred payment basis. Now in turn, the importer draws a series of promissory notes in favour of the exporter for payment including the interest charge. The other way is that the exporter draws a series of bills which are accepted by the importer. The bills/notes are sent to the exporter. These bills/notes are guaranteed by a bank. The bank may not necessarily be the importers bank. The guarantee by the bank is called an Aval. An Aval is defined as an endorsement by a bank guaranteeing payment by the buyer (importer). The exporter enters into a forfeiting arrangement with a Forfeiter which is usually a reputed bank including exporters bank. The exporter sells the availed notes/bills to the forfeiter at discount recourse. The agreement between the two parties provides for the basic terms of the arrangement such as cost of forfeiting margin to cover risk, days of grace, commitment charges, period of forfeiting contract, fee to compensate the forfeiter for loss of interest due to transfer and payment delays, installment of repayment, usually bi-annual installment, and rate of interest. The rate of interest/discount charged by the forfeiter depends upon the terms of the note/bill, the currency in which it is denominated, the country risk of the importer, the credit rating of the availing bank. In case of payment to forfeiter by the exporter of the face value of the bill/note has less discount, the forfeiter may hold these notes/bills till maturity for payment by the importers bank. Alternatively, he can also secure them and sell the short-term paper in the secondary market as a high-yielding unsecured paper. Based on the features built into the Forfeiting deal to cater to the varying needs of the trade/clients in international trade, it offers several advantages to a client. The advantages include (1) reduction in current liabilities, (2) off-balance
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sheet financing, (3) higher credit standing, (4) progress in current ratio, (5) improved efficiency, (6) reduction of costs, (7) additional sources of funds, and so on. Activity 2 Browse the Internet and find out the list of companies offering factoring in India. Also make a report of their operation and mechanism. Hint: A financial transaction through which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount is known as factoring.
10. The credit policy of MNC lays down the parameters that will help the manager to decide whether to grant credit to a particular party or not. (True/False) 11. Forfeiting finances notes/bills arising out of deferred credit transactions spread over three to five years. (True/False)
7.7 Countertrade
Thousands of years ago, the concept of bartering between parties was prevalent, when the concept of money had not evolved. A person could give say 100 bags of wheat and get wood or coal, a certain quantity for cooking. These bartering contracts were between individuals or small kingdoms. Bartering exists today also but at different level. For example, Iran may give 100 million barrels of oil to France and get 5000 guns of certain type in exchange. We can say that bartering is exchange of goods between parties as per agreed terms without the use of money. Today, most business is transacted with money as medium. Trading between countries is through respective currencies using international exchange rate. Countertrade means all types of foreign trade in which the sale of goods to another country is associated with parallel purchase of some other goods from that country.
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The level of international trade is going up every year. All countries are trying to export what they can in order to earn foreign exchange to be in a position to import what they need. The prosperity and living standard of general population of a country depends a great deal on the total exports made by the country. In this back drop, the industrially advanced countries are at advantage as high technology products like computers, machines, arms, helicopters, aeroplanes,etc,are required by all countries. The importing countries in many cases are not in a position to make huge payments for such items. So, it is in the interest of both parties to agree to accept an arrangement where either full or part of the payment is made through export of some other item which the country can supply. In countertrade, there is exchange of goods between two parties in different countries under two separate contracts in money terms. Delivery and payment of the two contracts are independent transactions. Countertrade deals are mostly negotiated and executed either at government to government level or between organisations with approval of respective governments. Countertrade takes many different forms as explained below: (i) Barter: It is exchange of goods without the use of money. Typical examples are: (a) Oman exchange oil for airconditions with Taiwan (b) Sri Lanka exchange fish for mobile hand sets with Germany (ii) Buy back: In this part, the payment of the price of contract is through supply of related products. Typical examples are: (a) A firm in China purchases plant & technology for manufacture of high precision bearings from Germany,and the firm in Germany agrees to buy a part of bearings produced by the plant in China. (b) An Indian aerospace firm sets up production facility for manufacture of executive jets under technical collaboration from an American firm who in turn agrees to provide a part of worldwide business of overhauling of executive jets to the Indian firm. (c) A firm establishes gas pipeline for another firm to transport gas and produce electricity and in turn agrees to buy a portion of electric power for prolonged period at predetermined terms.
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(iii) Counter purchase: In such cases, there is direct purchase of items as exchange deals. Typical examples are: (a) A firm in US sold soft drinks to Russian counterpart and imported vodka in exchange. (b) Canada sold wheat to Indonesia in exchange for import of rubber. (c) A German firm sold machine tools to a firm in Romania in exchange for import of hosiery items. Examples of countertrade are many and in a variety of forms. Though countertrade is existing to create win-win situation between parties involved, it has its own ills; typically following issues are existing: 1. The exporting country sells high technology items at inflated prices and the items which they import are disposed off to other countries at a discount, using a part of high premium charged on their exports. 2. The middlemen in the countertrade agreements are usually shrewd traders who exploit the political and social circumstances to obtain large gains for themselves. 3. The goods that are offered in countertrade are not the required items, because the desirable items have already been exported. For example, if Switzerland sells high precision machines to Brazil, it may like Brazilian coffee beans in exchange, but what it may get is only leather goods. What in principle is a good idea to export your items to another country and accept something else in countertrade which the other country can offer, has been often misused. Price manipulations, routing the product imported from one country to another country, mis-representation of facts by middlemen for their own gains, excessive discussions/negotiations between firms / governments with less resulting action makes the whole process inefficient. Technologically advanced developed countries are trying to exploit weaker and less developed countries through these trades. Time has come where weaker countries must develop their own strength and export their own goods in the international market based on quality and prices instead of taking the shelter of countertrade. Notwithstanding what is said above, countertrade is there to stay and it may take very long time before all international trades are independently handled on their own strength.
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12. In______________________, there is direct purchase of items as exchange deals. 13. In_____________, there is exchange of goods between two parties in different countries under two separate contracts in money terms.
7.8 Case Study

Goodbye to Govt-to-Govt trade A couple of years ago, it was not possible for India to sell rice due to pricing issues. As the grain inventories touched 80 million tonnes in May-June 2012, it was expressed by the Indian authorities that they intended to conclude Government to Government (G to G) deals in order to export wheat to some African and West Asian countries. Though the Indian government, through STC/PEC from FCI stocks agreed to supply three lakh tonnes of rice and two lakh tonnes of wheat to the Government of Bangladesh in 2010-11, no agreement on the pricing and other commercial terms were made. This was because FCI prices needed that acute subsidization should be carried out in order to structure the deal. GOI, considering the sensitivity on food matters refused to offer concessional rates to Bangladesh and bilateral negotiations were also terminated. Bangladesh, nevertheless, sourced grains from international traders. The Ministry of Food, GOI, initiated discussions on the criteria of government to government trade for importing 0.5 million tonnes of pulses from Myanmar in 2008-09. However, it was demanded by Myanmar that an advance amount in US dollars should be paid to them before affecting supplies. They in the meantime kept their pricing open as per their commercial convenience. The proposition fell through. Later, pulses were imported by Indian Public Sector Undertakings (PSUs) at market prices via Singapore traders at market prices on government account. Since some time, India has been approaching Iran for a wheat deal for offsetting the import of crude oil, under rupee payment. In a similar way, Pakistan is pursuing Iran for a wheat deal for the barter of urea. Phytosanitary concerns related to wheat have stalled commercial activity on a G to G basis, while from countries like US/Australia/Russia, it has contracted more than 3 million tonnes. However, other commodities such as sugar, soy meal, and tea are being profitably exported by India to Iran and this in turn is
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offsetting crude payments partially. Thus, the above examples suggest that G to G deals take place when a country is not capable of selling its product on internationally competitive terms. In todays world, when information regarding almost everything is available on the Internet, it is not possible to keep the pricing and contractual terms opaque. Overpriced commodities cannot be bought and the cargoes that are priced below the market datum cannot be sold even by state agencies. It is also known that behind the faade of Government deals, private trade is active most of the time. This leads to the buying nations becoming overcautious and it is not possible to formalize deals unless it is advantageous. Since the deals are offered by the traders on a marked to market values, they are neither cheap nor expensive and, thus, there can be no point of questions being asked. Many countries do not undertake any G to G business. For instance, countries like Indonesia or South Africa do not offer coal on G to G basis. Australia and the US do not make such unworkable propositions either. Though Russia was the hub of socialism not too long ago, it also sells grains at market-determined prices. There is a clear distinction between G to G understanding and barter/counter-trade, or offset mechanism. Such kinds of agreements were beneficial in periods such as from 1960 to 1990. India also imported defence equipment in rupees due to the non-availability of the NATO-compatible armaments to our armed forces. Deals were carried out in secret and commodities such as coffee, rice, etc., could be exported in rupees at a premium to the Soviet bloc. However, with time such deals have ceased to exist and now due to the transparency that exists due to the web, media and newswires, secrecy in carrying out such deals has been demolished. Audit and vigilance are overactive and thus any statesponsored deal is not possible. Thus, the existence of government to government mechanisms is coming to an end, whether on commercial terms or barter of some sort. Questions 1. Government to Government (G to G) deals take place when a country is not capable of selling its product on internationally competitive terms. Do you agree? 2. Why do you think countries like the US and Australia do not make deals for import and export? Source: Adapted from http://www.thehindubusinessline.com/opinion/ article3628083.ece?homepage=true Accessed on 3 August 2012
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7.9 Summary
Let us recapitulate the important concepts discussed in this unit: The main aim of the government programs is to improve the access of the exporters to credit rather than subsidizing the cost at below-market levels. Financing imports relieves the importer of a huge burden and helps the importer in overcoming the challenges of cash flow and leaves working capital free for investments. A Letter of Credit includes four parties which are the applicant, issuing bank, beneficiary and the advising bank. The credit policy of MNC lays down the parameters that will help the manager to decide whether to grant credit to a particular party or not. In countertrade, there is exchange of goods between two parties in different countries under two separate contracts in money terms.
7.10 Glossary
Subsidize: Having partial financial support from public funds Denominated: To be expressed in terms of a particular currency unit Disbursement: Payment of money Float: Shares that are publicly owned and are available for trading Invoice: A commercial document issued by a seller to the buyer Netting: Settlement of obligations between two parties processing the combined value of transactions Subsidiary: A wholly or partially owned company that is part of a large corporation Aval: It is defined as an endorsement by a bank guaranteeing payment by the buyer (importer) Receivables: Money that a customer owes a company for a good or service purchased on credit Forfeiting: It is a fund-based financial service that provides resources to finance receivables as well as facilitates the collection of receivables
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1. Explain the different forms of credit provided to the exporters. 2. What are the different types of letters of credit? Discuss. 3. Define a collection system. 4. Define factoring. 5. What is forfeiting? State the advantages of forfeiting. 6. Define countertrade. Discuss the different forms of countertrade.

1. Pre-shipment credit 2. January 1992 3. Duty Drawback Scheme 4. True 5. False 6. True 7. Collection float 8. Lock box 9. Cash-flow forecast 10. True 11. True 12. Counter purchase 13. Countertrade

1. There are different forms of credit that are provided to the exporters. They are as follows: Pre-shipment credit Post-shipment credit
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Medium-term credit Credit under duty draw-back scheme For further details, refer to Section 7.3. 2. The different types of Letters of Credit are: Revocable letter of credit Irrevocable letter of credit Deferred payment letter of credit Confirmed letter of credit Unconfirmed letter of credit Revolving letter of credit Transferable letter of credit Back-to-back letter of credit Anticipatory letter of credit For further details, refer to Section 7.4. 3. Collection system is designed to receive payments from buyers as soon as possible. For further details, refer to Section 7.5. 4. A financial transaction through which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount is known as factoring. For further details, refer to Section 7.6. 5. Forfeiting is a fund-based financial service that provides resources to finance receivables as well as facilitates the collection of receivables. For further details, refer to Section 7.6. 6. Countertrade means all types of foreign trade in which the sale of goods to another country is associated with parallel purchase of some other goods from that country. The different forms of countertrade are: Barter Buy-back Counter purchase For further details, refer to Section 7.7.
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Sharan, Vyuptakesh. 2012. International Financial Management.Sixth edition. New Delhi: PHI Learning Private Limited. Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing. Kumar Neelesh. Foreign Exchange Management. Delhi: Vikas Publishing. http://www.unzco.com/basicguide/c13.html Accessed on 18 July 2012
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Structure
Nature and Measurement of Foreign Exchange Exposure
8.1 Caselet 8.2 Introduction Objectives 8.3 Meaning of Exposure 8.4 Types of Exposure 8.5 Measuring Economic Exposure 8.6 Translation Methods 8.7 Case Study 8.8 Summary 8.9 Glossary 8.10 Terminal Questions 8.11 Answers References/e-References
8.1 Caselet
Maruti aims to cut forex exposure to $600 mn by Mar 2015 With adverse currency movements affecting margins, car market leader Maruti Suzuki India is targeting to reduce its forex exposure by nearly 65% to $600 million by March 2015, for which it is working with its vendors to reduce imports. Besides, the company is looking out for new markets to increase exports of its products to ease the impact of unfavourable foreign exchange fluctuations. The reason given by the sources is that the adverse currency movements are affecting their bottomline. Hence they are planning to reduce their net forex exposure to $0.6 billion by 2014-15 fiscal from about $1.7 billion at present. The companys current foreign currency exposure, along with its vendors, due to import is $2.5 billion. They have identified 14-15 vendors, whose import content is very high, and requested them to reduce it. They are also providing them all help for localization of their products. The aim is to bring down the import content to $1.8 billion in the next three years. On the export front, the companys exposure at present is around $800 million. Sources reveal that the company is on a lookout for newer markets for expanding their exports and are aiming to increase the exports to $1.2 billion by 2014-15.
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Hit by rupee depreciation and higher overall expenses, MSI had reported 22.84% decline in its net profit to `423.77 crore for the quarter ended June 30 this year. Rupee devalued this year drastically and crossed `56 against each dollar. However, on the back of robust capital inflows and persistent dollar selling by exporters and some banks, the rupee has risen by 35 paise to over four-month high of 53.10 against the American currency in the month of September, 2012. The management is focused on lowering forex exposure over the next three years and it expects at least 25-30% savings on localized components. The key components targeted for localization are diesel engine and transmission components. MSI has also set localization targets for the vendors, who have very high import content, unlike in the past where it used to compensate them for adverse forex movement. Led by higher exports and increased localization, margins are expected to rise by about 10% by FY16. Source: Adapted from http://www.business-standard.com/india/news/ maruti-aims-to-cut-forex-exposure-to-600-mn-by-mar-2015/188195/on Accessed on 6 October 2012
8.2 Introduction
In the earlier unit, you learnt about foreign trade finance and the ways of exporting and importing finance. You also learnt about documentary collections, factoring and forfeiting and countertrade. Michael Adler and Bernard Dumas have defined foreign exchange exposure as the sensitivity of changes in the real domestic currency value of assets, liabilities or operating incomes to unanticipated changes in exchange rates. In this unit, you will learn about the nature and measurement of foreign exchange exposure. You will also learn about the different types of exposures and the various types of translation methods used.
Objectives
After studying this unit, you should be able to: define foreign exchange exposure discuss the types of foreign exposure explain the measures for economic exposure discuss the translation methods
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8.3 Meaning of Exposure

The foreign exchange exposure of a firm can be defined as a measure of the sensitivity of its cash flows to changes in exchange rates. Due to the difficulty of measuring cash flows, exposure is examined by most of the researchers through the study of how a firms market value responds to the changes in the exchange rates. The value of a currency in a floating exchange-rate regime changes frequently and these changes influence the value of those firms involved in international transactions. A number of changes occur in regards to the value of their assets and their liabilities in addition to their cash flow. This, in other words, means that they face foreign exchange exposure. According to Michael Adler and Bernard Dumas, foreign exchange exposure is the measure of the sensitivity of changes in the real domestic currency value of assets, liabilities or operating income to unanticipated changes in exchange rates. In the case of domestic currency, a firms values of assets, liabilities and operating incomes are exposed to the effects of the changes in the values of other factors along with the effects of exchange rate fluctuations. Theoretically, foreign exchange exposure is the result of the difference between the actual change in the exchange rate and the anticipated change. For instance, if a firm has fixed that the price of the product will be exported on a 30-day credit keeping into account the changes that have been anticipated in the value of its home currency relative to a foreign currency, then the exporter is free from foreign exchange exposure. But in case there is a change in the foreign exchange rate from what had been expected, then the exporter will have to face foreign exchange exposure. From this, it can be concluded that the value of assets, liabilities or operating income needs to be denominated in the functional currency of a firm which is also the primary currency of the firm and in which the financial statements are published. While theoretically, the correct way of defining exposure is with respect to the real values, due to the difficulty of dealing with an uncertain inflation rate, this is often ignored and the exposure is estimated with reference to changes in nominal values. However, there are different views in regards to the exchange rate exposure. While one section opines that any talk of exchange rate exposure is irrelevant, other section talks in favor of the exchange rate exposure. This argument is based on the PPP theory which explains that the movement in
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exchange rate is matched by the movement in the price and thus there is no impact on the financial performance of a firm. The other argument states that the exchange rate exposure is very relevant as the PPP theory is not very relevant in the short term. They state that there are many other factors other than the inflation rate differential that affect the exchange rate. For instance, if the exchange rate changes due to some other factors then the resulting factor will not match the changes in the inflation rate differential which means that the exchange rate exposure does matter. Also the instability in exchange rate will lead to instability in the growth of a firm which might lead to bankruptcy. For this, reason, firms are very careful with regards to the exchange rate and they apply various hedging tools to protect themselves from the foreign rate exposure. Activity 1 Browse the Internet and find out the difference between foreign exchange exposure and foreign exchange risk. Hint: Foreign Exchange exposure is the measure of sensitivity whereas foreign exchange risk is a variance.
1. The value of assets, liabilities or operating income needs to be denominated in the____________ of a firm which is also the primary currency of the firm and in which the financial statements are published. 2. The PPP theory explains that the movement in ____________is matched by the movement in the price and thus there is no impact on the financial performance of a firm.
8.4 Types of Exposure

There are different types of exposure to which a particular company-domestic or internationalis exposed to. The types of exposure are related to two parameters: 1. One is related to the time of the transactions, the transactions and the flows of money (payment and receivables) related to them and the other one to the aspect of conducting international business in host countries.
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2. The second one is based on the analysis of how to reconcile the balance sheet of the subsidiary company with that of the parent companys balance sheet. The types of exposure are broadly divided into economic and translation exposure. Economic exposure is further divided into transaction exposure and operating exposure.
8.4.1 Economic Exposure

The potential changes in all future cash flows of a firm resulting from unanticipated changes in the exchange rates are referred to as economic exposure. The monetary assets and liabilities, in addition to the future cash flows, get influenced by the changes in foreign exchange rates. Of all the three exposures, economic exposure is the most important, as it has an impact on the valuation of a firm. Suppose a Japanese company imports children toys from India. The same product is also available from China but it is costly. If the rupee appreciates against the yen and the Chinese currency decreases against yen, Japan will prefer to import the toys from China as it will get at a cheaper rate. Since economic exposure comes from unanticipated changes, its measurement is not as precise as those of transaction and translation exposures. There are two components of economic exposure transaction. (a) Transaction Exposure (b) Operating Exposure (a) Transaction exposure Transaction exposure is concerned with the impact of change in exchange rate on present cash flows. Transaction exposure emerges mainly on account of export and import of commodities on open account, borrowing and lending in a foreign currency and intra-firm flows within an international company.
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Transaction exposure measures profits or losses that occur once the existing financial obligations as per the terms of reference are settled. Given that the transaction will result in a future foreign currency cash inflow or outflow, any unanticipated changes in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change value of the net cash flow in terms of the home currency. Examples of a transaction exposure of an Indian company would be the account receivable associated with a sale denominated in US dollars or the obligation of an account payable in Euro debt. (b) Operating exposure Operating exposure has an impact on the firms future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes. If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any operating risk exposure as its operating future cash flows are likely to remain unaffected. In addition to supply and demand elasticity, the firms ability to shift production and sourcing of inputs is another major factor affecting operating risk exposure. Sensitivity of future operating cash flows to unexpected changes in the foreign exchange rate is known as the operating exposure. In other words, it arises when the changes in the exchange rate in addition to the rates of inflation changes the risk element and the amount of the companys future revenue and cost stream. The word operating means the change in the operating cash flow which leads to change in the value of the firm. It is not very easy to measure real operating exposure as far as the measurement of the inflation rate differential is not easy, more so when countries are going through a phase when they experience a highly volatile rate of exposure. Operating exposure analysis assesses the impact of changing exchange rates on a firms own operations over coming months and years and on its competitive position vis--vis other firms. The goal is to identify strategic moves or operating techniques that the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes. Suppose an Indian MNC, such as Videocon, has sales in India, United States, China and Europe and therefore, posts a continuing series of foreign currency receivables (and payables). Sales and expenses that are already contracted for are traditional transaction exposures. Sales that are highly probable based on the Videocons historical business line and market share but have no legal basis yet are anticipated transaction exposures. Let us extend the analysis of the firms exposure to exchange rate changes even further into
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the future. The analysis of this longer term, where exchange rate changes are unpredictable and, therefore, unexpected, is the goal of operating exposure analysis. From a broader perspective, operating exposure is not just the sensitivity of a firms future cash flows to unexpected changes in foreign exchange rates, but also to its sensitivity to other key macroeconomic variables. This factor has been labelled as macroeconomic uncertainty. Some firms face operating exposure without even dealing in foreign exchange. Consider an Indian perfume manufacturer who sources and sells only in the domestic market. Since the firms product competes against imported perfumes (say from Paris) it is subject to foreign exchange exposure. It faces severe competition when rupee gains against other currencies (here, euro), lowering the prices of imported perfumes.
8.4.2 Translation Exposure

Translation exposure, which is also known as accounting exposure, emerges on account of consolidation of financial statements of different units of a multinational firm. The parent company is normally interested in maximizing its overall profitability and to make it possible, it consolidates the financial statements of its subsidiaries with its own. Whatever may be the objective of consolidation, it is done through translating the items of the financial statements of subsidiaries denominated in different currencies into the domestic currency of the parent company. When the currency of any of the host countries changes its value, it is translated into a value in the domestic currency of the parent company. The extent of this change represents the magnitude of translation exposure. If the subsidiary maintains its account in the reporting currency, i.e., the domestic currency of the parent company as is sometimes done by the extended departments of a firm abroad, the translation exposure does not emerge. Normally though, the subsidiaries maintain their accounts in a functional currency that is normally the currency of the host country, there is every possibility for the translation exposure to emerge in the wake of exchange rate changes. It is sometimes argued that the translation exposure is irrelevant, because it does not influence the cash flow, nor is the subsidiaries earning actually converted into the parents currency. However, since the change in the value of the currency of the host countries has an impact on the net worth of the firm as a whole, measurement of the accounting exposure is highly relevant. The size of accounting exposure depends no doubt on the extent of change in the value of related currencies, it also depends upon the extent of involvement
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of subsidiaries in the parents business on the location of the subsidiaries in countries with stable or unstable currency and on the methods that are used in the translation of currencies. The larger the involvement of subsidiaries in the parents business, the greater will be the exposure. Again, if the subsidiaries are located in countries where the currency is highly unstable, the accounting exposure will be large.
3. Operating exposure has an impact on the firms future operating costs and cash flows. (True/False) 4. Economic exposure is divided into translation exposure and operating exposure. (True/False) 5. When the currency of any of the host countries changes its value, it is translated into a value in the domestic currency of the parent company. (True/False)
8.5 Measuring Economic Exposure

A firm involved in international business faces a higher degree of exposure to exchange rate fluctuations than a purely domestic firm. It is also difficult to assess the economic exposure of an MNC as there is a complex interaction funds flowing into, out of and within an MNC. Economic exposure is very important for the functioning of the firms in the long run. In case an MNC has subsidiaries around the world then the fluctuations in currencies will affect the subsidiaries. One method of measuring the economic exposure of an MNC is through classification of cash flows into different items on the income statement and prediction of movement of each item in the income statement that is based on a forecast of exchange rates. This will facilitate the development of an alternative exchange rate scenario. It will also help in revising the forecasts of the income statement items. Depending on the change in the forecasts for the economic statement items, it will become possible for the firm to assess the influence of currency movements on cash flows and earnings. The economic exposure is further divided into transaction exposure and real operating exposure. Transaction exposure refers to the foreign exchange loss or gain on transactions already entered into and denominated in a foreign
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currency, as a result of changes in the exchange rate. In other words, transaction exposure is concerned with the changes in the present cash flows. Real operating exposure, on the other hand, is related to changes in future cash flows. It is concerned with the impact of exchange rate changes along with the changes in inflation rate on the cost and revenue structure of a firm. Transaction exposure on account of trade is divided into three parts. The first part, known as quotation exposure, is created when the exporter quotes a price in foreign currency and exists till the importer places on order with the exporter at that price. The second part is backlog exposure that exists between the placement of an order by the importer and the shipping and billing by the seller. The third part is the billing exposure and exists between the billing of the shipment and the settlement of the trade payments (Eiteman, et al., 1995). Borrowing and lending in a foreign currency Transaction exposure emerges also when borrowing or lending is done in a foreign currency. If the foreign currency appreciates, the burden of borrowing will be greater in terms of domestic currency, while if the foreign currency depreciates, the burden will be lower. Similarly, the receipt of the lender in case of the foreign currency will be larger in terms of the domestic currency. If foreign currency depreciates, there will be loss to the lenders in terms of domestic currency. It is not only the principal but also the amount of interest that changes owing to changes in the exchange rate. Intra-firm flow in an international company In case of international companies, when funds flow among the different units that are located in different countries, any change in the exchange rate alters the value of cash flow. Suppose, the Indian subsidiary of an American firm has declared a dividend and it has to repatriate it to the parent company. If in the meantime, the rupee depreciates, the amount of dividend to be received by the parent company in dollar terms will be lower and this will amount to a loss to the parent company. If the exchange rate moves the other way, there will be gain of the parent company.
6. ___________ ___________ refers to the foreign exchange loss or gain on transactions already entered into and denominated in a foreign currency, as a result of changes in the exchange rate.
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7. Real operating exposure is related to changes in___________________. 8. ___________ ___________ is created when the exporter quotes a price in foreign currency and exists till the importer places on order with the exporter at that price.
8.6 Translation Methods

The methods of translation vary as they are not unanimous on the items of the financial statement which are exposed to changes in the exchange rate. Every method has its merits and demerits. A particular method is used depending upon the circumstances and the legal and accounting procedures adopted in a particular country. The methods are: Current rate method Current/non-current method Monetary/non-monetary method Temporal method Current rate method The current rate method is also known as the closing rate method. In this method, all items of the income statement and the balance sheet are translated at current rate or the post-change rate. This method is preferred in case of those host countries where the local currency accounts are periodically adjusted for inflation. The translation exposure in this case is simply the net worth of the affiliate as stated in local currency. The merit of this method is that the relative proportion of individual balance sheet accounts remains the same and the process of translation does not distort the various balance sheet ratios. However, the demerit is that the fixed assets are also translated at current rate and that goes against the principles of accounting. Current/non-current method Under this method, current assets and current liabilities of the subsidiary are translated at current rate or the post-change rate. The fixed assets and longterm liabilities are translated at the historical or pre-change rate or at a rate at which they were acquired. In fact, this approach is based on traditional accounting that makes a clear-cut distinction between current and long-term items. The magnitude of the exposure is measured by the difference between current assets
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and current liabilities, that is, the subsidiarys working capital. The critics of this approach opine that the long-term debt which is also exposed to exchange rate change is ignored by this method. This is perhaps the reason that this method is not frequently used. As far as the income statement items are concerned, they are translated at the average rate of exchange - the average of the pre-change and the postchange rates. However, there are a few income statement items which by virtue of being closely related to non-current assets and long-term liabilities are translated at the pre-change rate. Monetary/non-monetary method Under the monetary/non-monetary method, the assets and liabilities are classified as monetary and non-monetary. Items that represent a claim to receive or an obligation to pay, a fixed amount of foreign currency, such as cash, accounts receivable, accounts payable, etc. come under the monetary group, while the physical assets and liabilities, such as fixed assets, inventory and long-term investment are treated as non-monetary items. The monetary assets and liabilities are translated at current rate, while the non-monetary items are translated at historical rate. The translation exposure under this method is measured by the net monetary assets or by the difference between the monetary assets and the monetary liabilities. As far as the income statement items are concerned, they are translated at an average rate and those closely related to non-monetary assets and liabilities are translated at historical rate. Temporal method The temporal method uses historical rate for the items that are stated at historical cost. Fixed assets, for example, are translated at historical rate but items that are stated at replacement cost, realizable value, and market value or expected future value, are translated at current rate. This is done in order to preserve the value of assets and liabilities as shown in the original financial statement. As regards income statement items, the same norm is applied as in the monetary/ non-monetary method. The temporal method to a great extent resembles the monetary/nonmonetary method. The main difference is that under the temporal method, inventory is translated at current rate if it is shown at market value. In the monetary/non-monetary method, it is translated at historical rate in all probabilities.
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Let us now understand the translation methods with examples by bringing in the income statement of a company and showing how translation would be different for different methods.
Balance Sheet Items Rupee: Local Currency Historical Rate = `30/US $ Current Rate = `50/US $
Current Rate current/non-current monetary/non- temporal monetary Current assetsinventory Inventory (market value) Fixed assets(net of depreciation) Goodwill Total assets Current liabilities Long term debit Share capital Retained earnings (asset s-liabilities) Total liabilites Translation gains (loss) 2000 4000 4000 1000 11000 4000 3000 2000 2000 11000 67 133 133 33 366 133 100 67 67 366 40 80 80 20 220 80 60 40 40 220 -27 40 80 133 33 286 80 100 67 39 286 -11 40 133 133 33 339 80 60 40 159 339 33 40 80 133 33 286 80 60 40 80 260 13
Literature on the subject often explains accounting exposure not only in terms of the impact of exchange rate changes on the book value of assets and liabilities, but also in terms of real balance sheet exposure that arises when a firms real net asset position is affected by the exchange rate changes (Click and Coval, 2002). What is real net asset position? It is the market value of total assets net of the market value of liabilities. It shows the real value of the balance sheet as it is based on the market value and not on the book value. For measuring the net worth exposure, one needs to distinguish between the monetary assets and non-monetary assets. Monetary assets earn national returns manifest in the interest rates. The Interest Rate Parity Theory suggests, among other things, that the depreciation in currency is matched by a rise in interest rate. So if the value of a monetary asset of the subsidiary falls in terms of the parent country currency in the wake of the currency depreciation in the host country, that monetary asset will be earning higher interest to compensate the loss in the value. If the loss in the value is exactly matched by the gain in terms of interest, there will be no net worth exposure insofar as it does not represent a deviation from the Interest Rate Parity Theory. Net worth exposure will arise only when
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there is unanticipated deviation from the interest rate parity meaning that the loss/gain on account of exchange rate changes is not exactly matched by changes in interest rates. Similarly, in case of non-monetary assets, net worth exposure will arise only when there is deviation from the PPP Theory. If inflation is higher in India than in the USA, rupee will depreciate vis--vis US dollar. If depreciation is matched by a rise in the market price of the asset, there is no net worth exposure. The net worth exposure will arise only when the rise in the asset price is not matched by the deprecation in rupee. Activity 2 Make a chart and write down the differences between the translation methods. Hint: The different types of translation methods are current rate method, current/non-current method, monetary/non-monetary method and temporal method.
9. A particular method is used depending upon the circumstances and the legal an d accounting procedures adopted in a particular country. (True/ False) 10. Under the monetary/non-monetary method, current assets and current liabilities of the subsidiary are translated at current rate or the post-change rate. (True/False) 11. The temporal method uses historical rate for the items that are stated at historical cost. (True/False)
8.7 Case Study

Watch Out for Currency Manipulators The reason behind the volatility of rupee is attributed to a number of reasons such as Indias current account deficits as well as the dwindling foreign portfolio flows. The role of currency manipulators is hardly mentioned. There
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are a wide number of participants who are involved with the foreign exchange market. Other than those who buy or sell currency in order to hedge foreign exchange exposure, there is another group who bet on the currency volatility in order to make money. This group is suspected of leading to exaggerated currency movements. While regulators can ignore the argument stating that the size of the foreign exchange market acts as a barrier to price manipulation, the question still remains whether it is possible for a single player to influence price movements in currencies. However, this argument has been further affirmed by Dr. Kaushik Basu who states in his paper The Art Of Currency Manipulation: How Some Profiteer By Deliberately Distorting Exchange Rates, that it is possible to do so. He writes in his paper that it is possible for a foreign exchange player to make a profit by deliberately making the exchange rates fluctuate. Basu presents in his paper that in most of the countries, the foreign exchange market consists of a few small, price-taking agents who transact in the market without creating any impact on the market. Other than them, there are large strategic agents having market-power and are also power driven. In India, banks and other institutions comprising the Foreign Exchange Dealers Association of India (FEDAI) are such agents. The model of Dr. Basu shows that the manipulator is capable of buying dollars and yet leaving the exchange rate unchanged The manipulator in the next period can create a confusion for the other dealers as they raise the price higher when they face the manipulators strategy, resulting in the manipulator selling at a price higher than he originally purchased. In other words, the manipulator works out how many dollars he will buy or sell at out of equilibrium price. When faced with such kind of strategies, the dealers functioning in isolation move the price in such a way that the manipulator profits from it. In most of the countries, the regulators deny the presence of the manipulators which in turn curbs the possibility of dealing with the ways of the manipulators. If the regulators are aware of the methods that are taken up by the manipulators then the currency fluctuations can be curbed without disturbing the free functioning of market forces. Recently, the RBI has also taken a step by imposing limits on overnight open positions and intra-day open positions held by dealers in inter-bank forex market. This is among the first acknowledgement by the central bank
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that speculation could be one of the reasons for currency volatility. While it is easy to regulate the domestic inter-bank and the exchange-traded forex market, it is not easy to find out what the regulator is possible of doing in case the manipulator operates from off-shore currency market. That said acknowledging the presence of currency manipulators is the first step. The Government and the RBI appear to be doing that now. The next step is to understand how it is done. The final step would be to impose checks, as completely stopping the manipulation is next to impossible. Questions 1. How do you think the manipulators profit from the currency volatility? 2. Do you think the steps taken by the RBI will help in reducing the activities of the manipulators? Source: Adapted from http://www.thehindubusinessline.com/opinion/ columns/lokeshwarri-sk/article3624422.ece?homepage=true Accessed on 5 August 2012
8.8 Summary
Let us recapitulate the important concepts discussed in this unit: According to Michael Adler and Bernard Dumas, Foreign Exchange exposure is the measure of the sensitivity of changes in the real domestic currency value of assets, liabilities or operating income to unanticipated changes in exchange rates. Foreign exchange exposure is the result of the difference between the actual change in the exchange rate and the anticipated change. The types of exposure are broadly divided into economic and translation exposure. Economic exposure is further divided into transaction exposure and operating exposure. Transaction exposure is concerned with the impact of change in exchange rate on present cash flows. Operating exposure has an impact on the firms future operating costs and cash flows. A firm involved in international business faces a higher degree of exposure to exchange rate fluctuations than a purely domestic firm.
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8.9 Glossary
Nominal Value: A value expressed in monetary terms for a specific year or years, without adjusting for inflation Macroeconomic: The field of economics that studies the behaviour of the aggregate economy Consolidation: The combining of separate companies, functional areas, or product lines, into a single one Repatriate: To send back a sum of money previously invested abroad to its country of origin

1. Discuss foreign exchange exposure. 2. What are the different types of exposure? Explain. 3. Define translation exposure. 4. State the translation methods. 5. Define the temporal method. 6. How does operating exposure have an impact on the firms future operating costs and cash flows?

1. Functional currency 2. Exchange rate 3. True 4. False 5. True 6. Transaction exposure 7. Future cash flows 8. Quotation exposure
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9. True 10. False 11. True

1. The foreign exchange exposure of a firm can be defined as a measure of the sensitivity of its cash flows to changes in exchange rates. For further details, refer to Section 8.3. 2. The types of exposure are broadly divided into economic and translation exposure. Economic exposure is further divided into transaction exposure and operating exposure. For further details, refer to Section 8.4 3. Translation exposure, which is also known as accounting exposure, emerges on account of consolidation of financial statements of different units of a multinational firm. For further details, refer to Section 8.4.2. 4. The translation methods are Current rate method Current/non-current method Monetary/non-monetary method Temporal method For further details, refer to Section 8.6. 5. The temporal method uses historical rate for the items that are stated at historical cost. Fixed assets, for example, are translated at historical rate but items that are stated at replacement cost, realizable value, and market value or expected future value, are translated at current rate. For further details, refer to Section 8.6. 6. Operating exposure has an impact on the firms future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes. For details, refer to Section 8.4.1
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Sharan, Vyuptakesh. International Financial Management. 2012. Sixth edition. New Delhi: PHI Learning Private Limited. Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kuntluru, Dr. Sudershan. International Finance. Delhi: Vikas Publishing. Kumar Neelesh. Foreign Exchange Management. Delhi: Vikas Publishing.
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Structure
Management of Foreign Exchange Exposure
9.1 Caselet 9.2 Introduction Objectives 9.3 Tools of Foreign Exchange Risk Management 9.4 Distinguishing between Functional and Reporting Currency 9.5 Currency Volatility Over Time 9.6 Risk Management Products 9.7 Techniques of Exposure Management 9.8 Case Study 9.9 Summary 9.10 Glossary 9.11 Terminal Questions 9.12 Answers References/e-References
9.1 Caselet
A primer on corporate hedging In the recent past, many instances relating to capital losses have surfaced due to wrong decisions taken by companies in regard to the market movements and erroneous hedging. Without hedging, a company is open to the elements of the markets on which they have no control and in adverse times the companies post losses due to poor market condition. A case in point is with Hexaware Systems. The company booked a loss of Rs 10.3 crore ($2.6 million). This was mainly because of dealing in foreign exchange options contracts. Another example is that of Larsen and Tuobro. It had booked a `200-crore ($51 million) loss on commodity futures on the London Metals Exchange. Many IT companies were also mercilessly hit by the sharp depreciation in the dollar in 2007. The reason attributed was inadequate hedging. These instances bring out the need and importance of having a clear-cut and guiding policy frame-work for hedging by corporate. However, one must not confuse these situations from losses that banks
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(such as ICICI Bank) have incurred due to taking speculative positions in financial markets. The basic rule behind the policy of hedging is that it is a preventive measure taken to reduce losses in a possible adverse market situation. The etymology of the word probably comes from the fact that hedges protect gardens from destructive visitors like stray dogs. It is a myth that all hedging is financial; for example, constituting a bench strength in an IT company to ensure availability of talent when required; diversification to reduce reliance on one market or one client and decentralization and creation of back-ups to reduce reliance on a few key employees are all examples of non-financial or strategic hedging. Typically, the level of financial hedging is more in companies whose main activity is trading (such as investment banks and hedge funds) vis-a-vis brick-and-mortar companies that produce something. Source: Adapted from http://www.thehindubusinessline.com/todays-paper/ article1620827.ece?ref=archive Accessed on 8 October 2012
9.2 Introduction
In the previous unit, you learnt about the concept of foreign exchange exposure. The different types of exposure had also been discussed. You also studied how to measure economic exposure and the various translation methods. In this unit, we will take the concept forward and understand how foreign exchange exposure is managed. You will learn about the various tools and techniques of foreign risk management and the risk management products. You will understand the differences between the functional and the reporting currency and various techniques used for exposure management.
Objectives
After studying this unit, you should be able to: discuss the tools and techniques of foreign exchange risk management define the differences between functional and reporting currency assess risk management products and currency volatility discuss the techniques of exposure management
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9.3 Tools of Foreign Exchange Risk Management

Various financial instruments are used by companies in India and abroad in order to hedge the exchange risk. Such kinds of instruments are available to the company at varying costs. The various tools that hedge the different kinds of risks are given below: Forward contracts: A forward contract is a non-standardized contract that takes place between two parties for the purpose of selling or buying an asset at a specified future time at a price that has already been agreed. The party who buys the underlying position assumes a long position and the party who sells the asset assumes a short position. Delivery price is the price that has been agreed upon. It is one of the most common means of hedging transactions in foreign currencies. It offers the ability to the users to lock in a sale price or a purchase without the involvement of any direct cost. It is also used by speculators who use forward contracts so as to place bets on the price movements of the underlying asset. Banks and many multinational corporations also use it to hedge the price risk by the elimination of uncertainty about prices. Futures contracts: It is a standardized contract that takes place between two parties for buying and selling a specified asset of standardized quality and quantity for a price that has been agreed at the present date. The payment and delivery takes place at a future specified date which is also known as the delivery date. Option contracts: In this type of contract, the buyer of the option has the right but not the obligation to fulfill the transaction while the seller has the responsibility of fulfilling the conditions stated in the contract through the delivery of the shares to the appropriate party. An option can be distinguished as a call option or a put option. The option conveying the right to buy the underlying asset at a specific price is called a call and the option conveying the right to sell the underlying asset at a specific price is known as the put option. Currency Swap: The agreement that takes place between two parties through which they exchange a series of cash flows in one currency for a series of cash flows in another currency is known as currency swap. It takes place at agreed intervals and over an agreed period of time. Law doesnt require it to be shown on a companys balance sheet as it is considered to be a foreign exchange transaction.
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Activity 1 Select an MNC of your choice and study the hedging techniques it had applied for foreign risk management. Make a report. Hint: Browse the Internet and find out the hedging techniques that are applied in the market.
1. A ____________ is a non-standardized contract that takes place between two parties for the purpose of selling or buying an asset at specified future time at price that has already been agreed. 2. The option conveying the right to buy the underlying asset at a specific price is called a ____________ . 3. ____________ is a standardized contract that takes place between two parties for buying and selling a specified asset of standardized quality and quantity for a price that has been agreed at the present date.
9.4 Distinguishing between Functional and Reporting Currency

In December 1981, the Financial Accounting Standards Board Statement 52 (FASB 52) was issued after which it was required of all the American MNCs to adopt the statement for fiscal years starting on or after 15 December 1982. The FASB 52 states that the firms must make use of the current rate method for translating foreign currency denominated assets and liabilities into dollars. The expense items on the income statement and all the foreign currency revenue must be translated at either the exchange rate in effect on the date when these items were recognized or at an appropriated weighted average exchange rate for the period. It is also required by the FASB 52 that the translation gains and the losses needs to be accumulated and presented in a different equity account on the parents balance sheet and this account is known as the cumulative translation adjustment account. A foreign affiliates functional and reporting currency have also been differentiated by ASB 52. The currency of the primary economic environment where the affiliate operates and in which it generates cash flows is known as functional currency. It is also the local currency in which most of the business of the entity is
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conducted. However, in some situations, it can also function as the home country currency of the parent firm or some third country currency. The reporting currency on the other hand is the one in which the financial statements are prepared by the parent firm. It is also generally the currency in which the parent is located and most of the business is conducted. The management also needs to determine the nature and purpose of the foreign operations in order to decide on the appropriate functional currency. Generally the functional currency will become the local currency of the country if the operations of the foreign affiliate are self-contained and integrated with a particular country.
4. In December 1981, the Financial Accounting Standards Board Statement 52 (FASB 52) was issued. (True/False) 5. The currency of the primary economic environment where the affiliate operates and in which it generates cash flows is known as reporting currency. (True/False)
9.5 Currency Volatility Over Time

Currency volatility can be defined as the measure of the change in price that takes place over a given time period. It doesnt remain constant from one time period to another. The currency volatility keeps on changing from time to time and thus the assessment conducted by the MNCs of the future volatility of the currency will not be accurate. However, it can still be beneficial for the MNCs as they can derive information even though the MNCs may not be able to predict accurately. Currencies such as the British pound whose value is most likely to remain constant unlike the highly volatile currencies like the South Korean Won or the Italian Lira can be identified. Change in the value of a company that accompanies an unanticipated change in exchange rates is called as economic exposure risk. This is also related to the currency volatility over time. Of all the three exposures, economic exposure is the most important as it has an impact on the valuation of a firm. Suppose a Japanese company imports children toys from India. The same product is also available from China but it is costly. If the rupee appreciates
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against the yen and the Chinese currency decreases against yen, Japan will prefer to import the toys from China as it will get at a cheaper rate. Since economic exposure comes from unanticipated changes, its measurement is not as precise as those of transaction and translation exposures. Shapiro has classified economic exposure into two components, transaction exposure and operating exposure. The changes in the value of financial obligations incurred before a change in exchange rates but to be settled after the change is defined as transaction exposure. Operating exposure has an impact on the firms future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes. If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any operating risk exposure as its operating future cash flows are likely to remain unaffected. In addition to supply and demand elasticity, the firms ability to shift production and sourcing of inputs is another major factor affecting operating risk exposure. High-low Position Index (HLPI) is an important tool that is used to measure the volatility of currencies and also to describe the position of the current exchange rate relative to its one year high and low.
6. Currency volatility can be defined as the measure of the change in price that takes place over a given time period. (True/False) 7. Transaction exposure has an impact on the firms future operating costs and cash flows. (True/False)
9.6 Risk Management Products

The most important products that the firms use to meet their exchange risk management risks are through the forward, swap and options contracts. A survey conducted by the Fortune 500 firms found that the most popular product is the traditional forward contract. A currency option is the next most commonly used instrument followed by options contract. In another survey conducted by Jesswein, Kwok and Folks, it has been stated that the finance/insurance/real estate industry is the one which uses the risk management products most frequently. It also further stated that the corporate use of foreign exchange risk management is also related to international involvement of a firm.
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Through a forward contract, a buyer or a seller can lock in a purchasing or selling price for an asset with the arrangement that the transaction would take place in the future. In this contract, the buyer or the seller arrives at a price and date when they are obligated to buy or sell a given asset. Until the expiry or the delivery date, there is no exchange of cash or assets and on the day of the delivery it can be be settled either by physical delivery of the asset or the cash settlement. It helps the buyer and the seller to reduce the fluctuation risks in the currency markets through which businesses are affected. Currency swap: A derivative in which cash flows of the financial instrument of one party is exchanged for the cash flow of another partys financial instrument is known as a swap. The type of the financial instrument involved determines the benefits in question. The dates when the cash flows are to be paid and the way in which they are to be calculated are defined by the swap agreement. Various kinds of swaps are available but the most commonly used swaps are the interest rate swaps and currency swaps. An interest rate swap can be defined as a financial contract that takes place between two parties through which interest payments are made on a notional amount of principal on a number of occasions throughout a specified period. One of the parties involved in the contract make a cash payment on each payment date during the specified period. This cash payment depends on the differential between the fixed and the floating rates. A currency swap on the other hand can be defined as a contract which takes place in order to exchange interest payments in one currency for those denominated in another currency. Back-to-back loans and parallel loans gives way to currency swap and at present the current swap market is smaller and less sophisticated. Option: A derivative financial instrument through which a contract takes place between two parties for a future transaction on a particular asset at a reference price is known as an option. In this type of contract, the buyer gains the right but not the obligation to engage in that transaction. There are different types of options market. They are exchange traded option and over-the-counter option. Exchange traded options are a class of exchange traded derivatives that are settled through a clearing house and the fulfillment is guaranteed by the Options Clearing Corporation (OCC). In this type of contracts, accurate pricing models are often available as the contracts are standardized. In case of over-the-counter options, the trade takes place between two private parties who are not listed on an exchange. The options can also be individually tailored to meet any business needs.
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8. Through a____________, a buyer or a seller can lock in a purchasing or selling price for an asset with the arrangement that the transaction would take place in the future. 9. A derivative financial instrument through which a contract takes place between two parties for a future transaction on a particular asset at a reference price is known as an____________. 10. ____________are a class of exchange traded derivatives that are settled through a clearing house and the fulfillment is guaranteed by the Options Clearing Corporation (OCC).
9.7 Techniques of Exposure Management

9.7.1 Managing Transaction Exposure
Transaction exposure calculates gains or losses which occur after the current financial compulsions according to terms of reference are resolved. Taken that the deal would lead to a future inflow or outflow of foreign currency cash, any unprecedented alterations in rate of exchange amid the period in which transaction is entered and the time taken for it to settle in cash would guide to a change in worth of net flow of cash in terms of the home currency. For example a transaction exposure of an Indian company will be the account receivable which is associated with a sale denominated in US dollars or the compulsion of an account payable in Euro debt. Presume an Indian firm sells goods with an open account to a German buyer for 1,800,000 payment of which is to be done in 2 months. The current exchange rate is ` 50/, and the Indian seller expects to exchange the euros received for ` 90,000,000 when payment is received. If euro weakens to `45/ when payment is received, the Indian seller will receive only `81,000,000, or some `9,000,000 less than anticipated. Opposite will be the case should euro strengthen. Thus exposure is a chance of either gain or loss. Alternative 1: Invoice the German buyer in rupees; but the Indian firm might not have obtained the sale in the first place. Alternative 2: Invoice the German buyer in dollars; both the parties are exposed should an unanticipated change in exchange rate between dollar and the respective home currency.
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In either case, the remedy might be worse than the disease! (i) Forward market hedge: If you might owe foreign currency in upcoming future, be in agreement to purchase foreign currency in present by entering into long position in a onward contract. If you might get foreign currency in future, consent to sell it now by entering into small time position in a forward contract. Let us take an example of an Indian importer of readymade garments from Britain who has just placed the order for next years stock. Payment of amount of 100 million is pending in coming year. Question: How can you fix outflow of cash in rupees? Another method involves putting oneself in a situation that lets one gain 100 million a year, resulting in a long forward contract on the pound. Suppose both the spot and one-year forward exchange rate is `80/. If he does not hedge the 100 million payable, in one year your gain (loss) on the unhedged position is calculated as follows. The importer will be better off if the pound depreciates: he still buys 100 million but at an exchange rate of only `79/, he saves `100 million relative to `80/. But he will be worse off if the pound appreciates. If the importer agrees to buy 100 million in one year at forward exchange rate of `80/, his gain (loss) on the forward is as follows. If he agrees to buy 100 million at a price of `80 per pound, he will make `50 million if the price of a pound reaches `80.50. If he agrees to buy 100 million at a price of `80 per pound, he will lose `50 million if the price of a pound is only `79.50. This analysis is based on actual results as the future spot rate cannot be predicted. However, the decision of going forward with the hedge must be based on the predications. So the firm has to form an expectation about future spot rate (a) If E(ST)=F, the expected gains or losses are zero. But forward hedging eliminates exchange exposure. (b) If E(ST)<F, the firm expects a loss from forward hedging. Thus the firm would be less inclined to hedge under this scenario. However, assuming that the firm is averse to risk and the firm does go ahead with the hedge, the reduction in the predicted proceeds (in dollars) can also be viewed as the insurance premium. In other words, it can be used to make necessary payments in order to avoid or minimize the risks involved with exchange rates.
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(c) If E(ST)>F, the firm expects a positive gain from forward hedging. Thus the firm would be more inclined to hedge under this scenario. (ii) Money market hedge: In order to hedge the payable foreign currency, a firm can purchase a lump sum of that foreign currency and then sit on it for a long period of time. This can be done in following ways: The current value of the payable foreign currency can be bought. The amount may be invested at the foreign rate. The amount can be converted back at maturity. This ensures that the investment grows enough to cover the payable foreign currency. The Indian importer of British readymade garments, owes in one year 100 million to the British supplier. The spot exchange rate is `80/. The one-year interest rate in UK is i = 5 per cent. Borrow ` x million in India. Translate ` x million into pounds at the spot rate S(`/) = `80/. Invest x/ 80 million in the UK at i = 5 per cent for one year. In one year investment x (1.05)/80 million will have grown to 100 million. Solving for x, we get x=7619 (approximately), so that we have redenominated a one-year 100 million payable into a `7619 million payable due today. If the interest rate in India is i` = 6 per cent, the Indian importer could borrow the `7619 million today and owe in one year. `8076 million = `7619 million (1.06) Let us suppose that a firm wishes to hedge received in the sum of y along with a maturity of T: (i) Borrow y/(1+ i)T at t = 0. (ii) Exchange y/(1+ i)T for $x at the prevailing spot rate.
At the time of maturity, the firm will owe a $y which can be paid with the receivable sum. This way, the firms exposure to the exchange rates involving dollar and pound will be reduced considerably.
(iii) Option hedge: One possible shortcoming of both forward and money market hedges is that the firm has to forgo the opportunity to benefit from favourable exchange rate changes. Keeping several options available creates a flexible hedge against the downside. At the same time, it helps in preserving the upside potential. The payable buys are called on the foreign currency in order to hedge the currency. If there is an appreciation in the value of the currency, then the call option allows the firm to purchase
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the currency at the exercise price of the call. In order to hedge a foreign currency, receivable buy is put on the currency. In case of depreciation in the value of the currency, the put option allows the firm to sell off the currency at the exercise rate. Suppose our importer buys a call option on 100 million with an exercise price of `80 per pound. He pays ` 8 per pound for the call, so that the total payment for the option is `800,000,000. This transaction provides Indian importer with the right, but not the obligation, to buy upto 100 million for `80/, regardless of the future spot rate. Assume that the spot exchange rate turns out to be `79.50 on the expiration date. Since the importer has the right to buy each pound at `80, he will not exercise the option. However if the rupee depreciates to `80.50 on the expiration date, he will surely exercise the call option by buying each pound at a much cheaper rate of `80. The foremost benefit of option hedging is that it allows the firm to decide if it wants to exercise this option on the basis of the realized spot exchange rate on expiry. Recall that Indian importer has paid `800,000,000 upfront for the option. Considering the time value of money, this upfront cost at i` = 6 per cent is equivalent to `848,000,000 (= `800,000,000 x 0.06) as of expiration date. Transaction Buy a call option on 100 million for an upfront cost of `800,000,000. In one year, decide whether to exercise the option upon observing the prevailing spot exchange rate. Outcome Assurance of not having to pay more than ` 848,000,000, in case the future spot exchange rate is found to be more than the exercise exchange rate. Cross-hedging minor currency exposure In todays market, the most prominent currencies are US dollar, euro, Canadian dollar, Swiss francs, Japanese yen and Mexican pesos. Currencies like Thai bath, Indian rupee and Korean won are minor currencies circulating in the market. Obtaining financial contracts for hedge exposure of these minor currencies is a difficult task and proves to be costly. For this purpose, cross-hedging is often used. It can be understood as the hedging of a particular position in one asset and replacing a position in some other asset. The success and effectiveness of cross-hedging depends on the degree of interrelatedness of the assets.
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9.7.2 Managing Operating Exposure

Operating exposure is alternatively known as economic exposure. It evaluates the changes that occur in the current value of the firm. The change in the current value may be a result of the change that takes place in predicted operating cash flows on account of fluctuations in exchange rates. They are similar in that they both deal with future cash flows. They differ in terms of which cash flows management considers. Transaction exposure deals with the predicted cash flows for future that have already been contracted and hence accounted for. At the same time, the operating exposure focuses on the predicted-but not yet contracted-cash flows in future. These future cash flows may undergo changes in case of a major fluctuation in the exchange rate, resulting in changes in the overall competitiveness at international level. Suppose an Indian MNC, such as Videocon, has sales in India, United States, China and Europe and therefore, posts a continuing series of foreign currency receivables (and payables). Sales and expenses that are already contracted for are traditional transaction exposures. Sales that are highly probable based on the Videocons historical business line and market share but have no legal basis yet are anticipated transaction exposures. Let us extend the analysis of the firms exposure to exchange rate changes even further into the future. The analysis of this longer term where exchange rate changes are unpredictable and, therefore, unexpected is the goal of operating exposure analysis. Broadly speaking, operating exposure and its implications are not limited to the sensitivity and dependability of the future cash flows of a firm upon the unpredictable fluctuations in foreign exchange rates. It is also directly affected by other chaif macroeconomic variables. This phenomenon is often known as macroeconomic uncertainty. Some firms face operating exposure without even dealing in foreign exchange. Consider an Indian perfume manufacturer who sources and sells only in the domestic market. Since the firms product competes against imported perfumes (say from Paris) it is subject to foreign exchange exposure. It faces severe competition when rupee gains against other currencies (here, euro), lowering the prices of imported perfumes. Suppose that an Indian manufacturer has contracted to sell 100 pairs of jeans per year to Britain at `1200 per pair and to buy 200 yards of denim from Britain in this same period for 2 per yard. Suppose that 2 yards of denim are required per pair and that the labour cost for each pair is `400. Suppose that at the time of contracting the exchange rate is S(`/) = 80 and the rupee is then
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devalued to S(`/) = 81. Suppose also that the elasticity of demand for Indian jeans in Britain is -2 and that after the contract expires the Indian manufacturer raises the price of jeans to `1205 per pair. What are the gains/losses from the devaluation on the jeans sold and on the denim bought at the pre-contracted prices? (i.e., what are the gains/losses from transaction exposure on payables and receivables?) What are the gains/losses from the extra competitiveness of Indian jeans, that is, from operating exposure? Solution: Effect of transaction exposure Before the devaluation Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected total cost /year =100 pairs x 2yd/pair 2/yd x `80/ + 100 pairs x `400/pair = `72,000. Expected profit = `120,000 `72,200 = `48,000. After the devaluation Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected total cost /year =100 pairs x 2yd/pair x 2/yd x `81/ + 100 pairs x `400/pair = `72,400. Expected profit = `120,000 `72,400 = `47,600. Exporters profit on contracted quantities and prices of jeans supplied and denim purchased is reduced by `400 per year because of the transaction exposure. Solution: Effect of operating exposure Before the devaluation Expected profit = ` 48,000 After the contract expires When the rupee price of jeans rises from `1200/pair to `1205/pair, the pound price falls from 15 to 14.88, i.e., a 0.8 per cent reduction. With a demand elasticity of -2, it will result in sales increasing by 1.6 per cent to 101 pairs per year. Expected total revenue/year =101 pairs x `1205/pair =`121,705. Expected total cost /year =101 pairs x 2yd/pair x 2/yd x `81/ + 101 pairs x `400/pair = `73,124. Expected profit = `121,705 `73,124 = `48,581. We find that the exporters profit is increased by `581 per year from the devaluation because of operating exposure. The operating exposure of a firm is dependent upon the following: 1. The overall market structure in terms of inputs and products 2. The level of competitiveness and monopoly existing in the market that the firm is looking to face
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3. The capability of the firm to align its marketing strategies, product mix, and sourcing in relation to the exchange rates and the accompanying changes In case, the cost or the price of a firm is directly affected by the changes in the exchange rates, then the firm is understood to be subjected to increased levels of operating exposure. As an extension of this, when the cost as well as the price of the firm is being affected by the changes in exchange rates, then firm can be said to have little or no operating exposure. Consider a hypothetical company, Ford Indiana, a subsidiary of Ford, which imports cars from US and distributes in India. If dollar is expected to appreciate against the rupee, Ford Indianas expected cost goes up in rupee terms. Whether this creates operating exposure for Ford critically depends on the structure of the car market in India. If Ford Indiana faces competition from India (or other foreign) car makers for whom rupee costs did not arise, raising the rupee price of imported car is not a feasible option. In contrast, if Ford Indiana faces competition only from other US car makers (like General Motors) for whom rupee costs would have similarly been affected by dollar appreciation, competitive position of Ford Indiana would not be adversely affected, leading to a higher rupee price of imported cars. Even if Ford Indiana faces competition from local car makers in India, it can reduce exposure by starting to source Indian parts and materials, which would be cheaper in dollar terms after the dollar appreciation. Ford can even start to produce cars in India by hiring local workers and sourcing local inputs, thereby making its costs less sensitive to changes in the dollar/rupee exchange rate. The firms flexibility regarding production locations, sourcing, and financial hedging strategy is an important determinant of its operating exposure to exchange risk. Suppose the annual inflation rate in US is 2 per cent and in India, it is 6 per cent. Recollect the relative PPP condition: the exchange rate change during a period should equal the inflation differential for that same time period, to avoid possibility of any arbitrage. Case 1: dollar appreciates about 4 per cent against the rupee. Since the rupee prices of both Ford and locally produced cars rise by the same 6 per cent (for Ford it includes a 2 per cent increase in the dollar price of cars + a 4 per cent appreciation of dollar against rupee), the 4 per cent appreciation of the dollar will not affect the competitive position of Ford vis--vis local car makers. Ford is thus not exposed to exchange risk
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Case 2: Suppose dollar appreciates by more than 4 per cent against rupee. Ford cars will become relatively more expensive than locally produced cars, adversely affecting Fords competitive position. Ford is thus exposed to exchange risk. Managing operating exposure (i) Selecting low cost production sites: A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements. The adverse repercussions of the fluctuations in exchange rates can be avoided, if the location of the production sites is shifted to other countries with currencies that have depreciated in real terms. One condition to this is that the production costs in these countries should involve plenty of local and topical content. The Japanese car maker Nissan has manufacturing facilities in US other than Japan. During the JanuaryMay, 1993 yen appreciated against the dollar by more than 13 per cent, thereby affecting the competitive position of Nissan in US car market. Nissan choose to shift production from Japan to US manufacturing facilities in order to mitigate the negative effect of the strong yen on US sales. Another example is of Honda Group, which constructed factories in North America in the view of the strong position of yen in the market. However, later when the yen began to weaken, the company decided to import more cars from Japan than to build them in North American factories. (ii) Flexible sourcing policy: It is found that if the inputs and raw materials are bought in foreign markets where the local content in the production costs is considerably high, then the fluctuations in excshange rates result in a corresponding change in the relative cost of sourcing from alternative sources. Example: Facing strong yen, Japanese manufacturers in the car and consumer electronics industries, depend heavily on parts and intermediate products from such low-cost countries as Thailand, Malaysia and China. Sourcing is not limited to components used in production but also extend to hiring guest workers. For instance, Japan Airlines recruited people from foreign countries for its crew in order to retain its competitive edge in the wake of strong yen. Later, however, it reversed its strategy when the yen began to weaken and there was a rise in the rate unemployment in the local market. (iii) Diversification of market: this can be understood in terms of sale of products in a number of markets in order to maximize advantage on account of diversification of the exchange rate risk. Suppose Infosys is
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outsourcing its services in US as well as in Germany. Reduced outsourcing/ sales in US, following rupee appreciation against dollar can be compensated by increased sales in Germany due to rupee depreciation against the euro. As a result Infosys overall cash flows will be much more stable, than would be the case if it were to outsource in only one country. (iv) R&D and product differentiation: This entails an effective R&D in order to facilitate the following: Cost reduction Increase in productivity Product differentiation An effective product differentiation results in a decrease in demand elasticity, which in turn, translates into reduced risks involving exchange rate fluctuations. (v) Financial hedging: Transaction exposure to currency risk is mostly shortterm in nature. In contrast operating exposure has a very long time horizon. The four most commonly employed financial hedging policies are: Matching currency cash flows Risk-sharing agreements Back-to-back or parallel loans Currency swaps (a) Matching currency cash flows: Let us suppose, that an Indian company is involved in continuous export sales in the US market. In order to gain a competitive advantage, the firm invoices all its sales in American dollars. This strategy leads to a continuous receipt of dollars every month. This continuous string of transactions results in a continuous hedging with forwards and contractual agreements. Alternatively, the firm can match its continual inflow of American dollars, with an equivalent outflow by acquiring debt denominated in dollars. Exposure:The sale of manufactured products in the US markets results in the creation of a foreign currency exposure out of inflow of American dollars. Hedge: The payment of debts in American dollars serves as a financial hedge. It requires debt service, which is an outflow of American dollars.
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Situation 1: A predicted and constant exposure to a company can be counterbalanced by acquiring debt dominated in the currency, by the method of matching. Situation 2: Alternatively, the method of currency switching can be adopted, according to which, the company can pay the foreign supplier/ dealers in American dollars. (b) Risk-sharing agreements: Long-term cash flow exposure between firms can also be managed by using the method of risk sharing. The risk-sharing method involves a contractual agreement between the buyer firm and the seller firm, to share or divide the impact, if any, of the currency movements on the transaction being done between them. This agreement serves as an ideal and co-operative way of functioning between firms that look forward to building a long-term relationship based on the product quality and mutual reliability. It facilitates building a relationship that does not depend on the whims of the unpredictable currency markets. It helps in smoothening the impact of the changes and movements of exchange rates by dividing the burden of the impact on the involved parties (firms). For example, Fords operations in America involve importing the automotive parts from Mazda in Japan every year. Major fluctuations in the exchange rates tend to profit one firm at the expense of the other. The Agreement All purchases by Ford will be made in Japanese yen at the current exchange rate, as long as the spot exchange rate on the date of invoice is between 115/$ and 125/$; so that whatever transaction exposure exists is borne by Ford. If however, the exchange rate falls outside this range on the payment date, Ford and Mazda will share the difference equally. Suppose Ford has an account payable of 25,000,000 for the month of March and the spot rate on the date of invoice is 110/$, i.e., the Japanese yen would have appreciated versus dollar increasing Fords costs from $217,391.30 to $227,272.73. However, since the rate falls outside the stipulated range, the difference of 5/$ would be shared between Ford and Mazda; so that Fords total payment in Japanese yen would be calculated using an effective exchange rate
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of 112.5/$, and saves Ford $5,050.51. This savings is a reduction in an increased cost, not a true cost reduction. (c) Back-to-Back loans: When two companies from two different countries borrow each others currencies for a particular time period, the arrangement is termed as back-to-back loan (parallel loan or credit swap). The borrowed currencies are returned on a terminal decided with retural consent. Suppose a British parent firm discuss of make funds investment to invest funds in its Dutch subsidiary locates a Dutch parent firm that wants to invest funds in the UK. The British parent lends pounds to the Dutch subsidiary in UK, while the Dutch parent lends euros to the British subsidiary in the Netherlands. The two loans would be for equal values at the current spot rate and for a specified maturity. At maturity the two separate loans would each be repaid to the original lender, without the need to use the FX markets. Two primary obstacles to the extensive usage of the back-to-back loan exist which are as follows: It is not easy for a firm to find a partner, termed a counterparty for the currency amount and timing desired. One risk is that one of the parties will fail to return the borrowed funds at the designated maturityalthough each party has 100 per cent collateral (denominated in a different currency). These disadvantages have resulted in the rapid development and wide use of the currency swap, where a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. (d) Currency Swaps: This is already discussed in earlier subsection. Activity 2 Find out the various alternatives that are available to the Indian corporate for hedging risk. Put it down on a chart. Hint: Some of the alternatives are forward market hedge, money market hedge, futures market hedge and options market hedge.
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11. In order to ____the payable foreign currency, a firm can purchase a lump sum of that foreign currency and then sit on it for a long period of time. 12. Cross-hedging is the hedging of a particular position in one asset and replacing a position in some other asset. (True/False)
9.8 Case Study

Reserve Bank of India eases hedging rules to aid volumes For the purpose of boosting trading volumes in the over-the-counter market, the Reserve Bank of India has liberalized the norms related to hedging. It has imposed these restrictions for restricting speculation in the foreign exchange market after the weakening of the rupee by over 18 per cent between August and December 2011. This has enabled the exporters to credit 100 percent of their foreign exchange earnings to the EEFC (exchange earners foreign currency account) without the need of converting 50 per cent of it in rupee terms. EEFC is an account that is maintained in foreign currency with a bank or an authorized dealer. The foreign exchange earners are provided this facility to credit 100 per cent of their foreign exchange earnings to the account. However, it is needed that the exporters convert the total accrual into rupee terms by the end of the month. Experts state that this measure will help the exporters in hedging their exposures with banks in turn giving a boost to the rupee which has become weak by 9 per cent against the dollar in the first quarter of the financial year 2013. Anil Bhansali, the vice-president of Mecklai Financial said that though exporters might sell, it will stand to have a limited impact as the demand for dollars is high and one-off inflows have not helped the rupee correct much in the recent past The exporters have also been permitted by the RBI to book and cancel forward contracts to about 25% of their total contracts that have been booked for hedging exposures. RBI has already stated in a circular that was issued in July that the forward contracts that have been booked once will not be cancelled. While getting into a forward contract, the exporters and the importers comes to an agreement to buy or sell a currency at a pre-
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determined exchange rate at a given time. Subir Gokarn, the deputy governor of SBI had said that the steps that have been taken by the RBI seem to be helping in the reduction of volatility. And having reached that situation, we felt that there was some room to give our participants a little more flexibility in their management of their exposures, their genuine hedging requirements and that has motivated the actions that we took today. RBI has also freed the net overnight open positions (NOOP) of overseas branches of banks from the limits imposed earlier. Net open positions are transactions which have not been squared off on an overnight basis. This liberalizes the NOOP a bit more, said the ED, trading, UBS. These moves are directed towards undoing the restrictions the RBI had put in place in December. Trading volumes in the OTC market will certainly increase, he added. Questions 1. Do you think that the steps taken by the RBI will help in easing hedging? 2. What are the opinions of the experts in this matter? Source: Adapted from http://articles.economictimes.indiatimes.com/201208-01/news/32981521_1_eefc-foreign-currency-exporters-and-importers Accessed on 5 August 2012
9.9 Summary
Let us recapitulate the important concepts discussed in this unit: The different tools that hedge the different kinds of risks are forward contracts, futures contracts, Option contracts and currency swap. An option can be distinguished as a call option or a put option. In December 1981, the Financial Accounting Standards Board Statement 52 (FASB 52) was issued after which it was required of all the American MNCs to adopt the statement for fiscal years starting on or after 15 December 1982. The FASB 52 states that the firms must make use of the current rate method for translating foreign currency denominated assets and liabilities into dollars.
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The hedge involves a money market position to cover a future payable or receivables position. A natural hedge is applied when the contractual hedge fails to give good results. It may be mentioned that the contractual hedge provides only temporary protection against exchange rate movement. Risk-sharing is a contractual arrangement through which the buyer and the seller agree to share the exposure.
9.10 Glossary
Hedge: To make an investment for the reduction of the risk of adverse price movements in an asset Underlying asset: The security or property or loan agreement through which the option holder receives the right to buy or to sell Cumulative: A preferred stock where the publicly-traded company must pay all dividends Affiliate: A corporation that is related to another corporation by one owning shares of the other Transaction exposure: Transaction exposure measures gains or loses that arises from the settlement of existing financial obligations the terms of which are stated in a foreign currency Translation exposure: Accounting exposure, also called translation exposure, arises because financial statements of foreign subsidiaries which are stated in foreign currencymust be restated in the parents reporting currency for the firm to prepare consolidated financial statements

1. Define the tools of foreign exchange risk management. 2. Discuss functional currency. 3. What is the function of a forward contract? Discuss. 4. Define reporting currency. 5. Explain the types of contractual hedges. 6. What is transaction exposure?
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1. Forward contract 2. Call option 3. Futures contracts 4. True 5. False 6. True 7. False 8. Forward contract 9. Option 10. Exchange traded options 11. hedge 12. True

1. The different tools of Foreign risk management are: Forward contracts Future contracts Options contract Currency swap For further details, refer to Section 9.3. 2. The currency of the primary economic environment where the affiliate operates and in which it generates cash flows is known as functional currency. For further details, refer to Section 9.4. 3. The reporting currency on the other hand is the one in which the financial statements are prepared by the parent firm. For further details, refer to Section 9.4.
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4. Currency volatility can be defined as the measure of the change in price that takes place over a given time period. It doesnt remain constant from one time period to another. For further details, refer to Section 9.5. 5. Through a forward contract, a buyer or a seller can lock in a purchasing or selling price for an asset with the arrangement that the transaction would take place in the future. In this contract, the buyer or the seller arrives at a price and date when they are obligated to buy or sell a given asset. For further details, refer to Section 9.6. 6. Transaction exposure calculates gains or losses which occur after the current financial compulsions according to terms of reference are resolved. For further details, refer to Section 9.7.1.
References/ e-References
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kuntluru, Dr. Sudarshan. International Financial Management. Delhi: Vikas Publishing.
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Structure
International Capital Structure
10.1 Caselet 10.2 Introduction Objectives 10.3 Cost of Capital 10.4 Capital Structure of MNCs 10.5 Cost of Capital in Segmented vs. Integrated Market 10.6 Describe Cost of Capital Across Countries 10.7 Case Study 10.8 Summary 10.9 Glossary 10.10 Terminal Questions 10.11 Answers References/e-References
10.1 Caselet
Equity capital market deal value falls to 8-yr low at $7.3 billion Dealogic, a global deal tracking firm has stated that the activity in the Indian equity capital market has seen a significant decrease due to the fall of the deal value by over 18 per cent to an eight year low of USD 7.3 billion this year so far. Last year in the comparable period, almost 76 equity capital market transactions took place that led to an increase in the capital worth USD 9 billion. Dealogic further said that the Indian ECM volume has reached USD 7.3 billion by way of 44 transactions till August 7 this year the lowest year-to-date volume since 2004, when it stood at USD 5.9 billion. Oil & Natural Gas Corps USD 2.6 billion follow-on via Citi, Bank of America Merrill Lynch, HSBC, JM Financial Group, Morgan Stanley and Nomura was the largest Indian ECM transaction this year so far. The Indian ECM bookrunner ranking till August 7,2012 was led by Citi with a 39.9 per cent share, followed by HSBC and Morgan Stanley with 8.6 per cent and 7.7 per cent share, respectively. Meanwhile, Indian ECM convertible volume totaled USD 130 million via just one deal Amtek Indias USD 130 million issues via Standard Chartered Bank. This is the lowest volume since 2003 and down 83 per cent compared with 2011 year-to-date period when USD 775 million was raised via three deals, Dealogic said. The peak year for Indian
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convertible issuance was in 2007 YTD when USD 5.6 billion was raised via 42 deals. Issuance has subsequently failed to reach the USD 2 billion mark in every YTD period since 2007, the report said. Source: Adapted from http://zeenews.india.com/business/news/finance/ equity-capital-market-deal-value-falls-to-8-yr-low-at-7-3-bn_57643.html Accessed on 11 August 2012
10.2 Introduction
In the earlier unit, you learnt about the management of foreign exchange exposure. Concepts such as tools and techniques of foreign exchange risk management were also discussed. You also learnt about the differences between the functional and reporting currency. It also provided detailed information about hedging and the different ways of hedging risks. This unit will provide information about the international capital structure. You will also learn about the cost of capital and the capital structure of MNCs. In addition to this, you will learn about cost of capital in segmented versus integrated markets. You will also study the cost of capital across countries.
Objectives
After studying this unit, you should be able to: define cost of capital discuss the capital structure of MNCs assess the cost of capital in segmented versus integrated markets examine cost of capital across countries
10.3 Cost of Capital

Let us begin with an example. There are two projects A and B which the firm is considering. It has to choose only one of them. It chooses project B. By taking up project B, the firm has to forego the opportunity to undertake project A. This means that the firm incurs an opportunity cost in terms of what it could have earned on an alternative investment. Suppose project A yields a return of 10 per cent. So, by undertaking project B, the firm forgoes the 10 per cent return on project A. Hence the firm should get a return of at least 10 per cent on project B. This is the required rate of return. The higher the risk of a project, the
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higher is the rate of return. However, if the project risk is zero, this does not imply that the rate of return is zero. This means that the project still requires compensation for the passage of time. This is called risk free rate of return. Thus, the required rate of return is a sum of risk free rate of return plus the risk premium. Cost of capital is another name for required rate of return. It is the minimum rate of return required by a firm on its investment in order to provide the rate of return required by its suppliers of capital. The suppliers of capital are equity shareholders and debt holders. A firm may have cost of equity, cost of retained earnings and cost of debt. The cost of capital is the combined cost of all sources of capital. As the components are combined according to the weight of each component of the firms capital structure, the overall cost of capital is also known as weighted average cost of capital (WACC). The cost of capital for foreign investment projects like domestic capital budgeting projects should be based on the weighted average cost of long-term sources of finance. While calculating the cost of capital, cash flows warrant adjustment not only for corporate taxes, but also for foreign exchange risk, withholding taxes on repatriations made, and so on. It must be added here that in case of international project evaluation, it is important to consider the country risk factor and therefore, the sovereign spread of the country gets added to the cost of debt and equity. The country risk arises due to macroeconomic variable, volatility and the inefficiencies of the capital market and the political situations. The determination of weighted average cost of capital (WACC) requires the calculation of specific costs of different sources of long-term funds. The procedure of computing various sources of finance is the measurement of:
10.3.1 Cost of Debt

The cost of debt is the rate of return required by the debt holders. This rate of return is generally designated as kd. For example, a company has issued debentures that have value of INR 5000 and coupon rate of 10 per cent. Here,
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kd is equal to 10 per cent. As the interest on debt is tax deductible for the company it is the interest rate on debt less than tax saving that is actually the cost of debt. Thus, the cost of debt is defined ads kd (1-T), where T is the companys marginal tax rate. Suppose the marginal tax rate is 30 per cent the cost of debt is 7 per cent. Thus, the cost of debt to the company is less the rate of return required by lenders (debt holders). When foreign debt is used to finance a foreign project, the costs of debt in the home currency of the parent firm should incorporate the interest on the debt, currency gains of losses and taxes.
10.3.2 Cost of Retained Earnings

There is implicit cost of retained earnings, that is, the firm is implicitly required to earn on the retained earnings, at least equal to the rate that would have been earned by the shareholders, if they were distributed to them. Thus, retained earnings involve opportunity cost; the opportunity cost of retention of earnings is the rate of return that could be earned by investing the funds retained in investment opportunities that have the same degree of risk as that of the finances itself. In other words, the rate of return the equity holders have been deprived of by allowing retentions with the corporate firm is the cost of retained earnings (k). Accordingly, the cost of retained earnings (kd) for all practical purposes is equal to the cost of equity. Gitman has appropriately referred retained earnings as unissued equity shares. However, since raising funds through equity involves flotation costs, the kr is marginally lower. Apart from the adjustment for flotation costs, the cost of retained earnings in the context of foreign firms may require additional adjustment with respect to withholding taxes, as repatriation of dividends in most countries is subject to such taxes. As a result ke gets reduced.
10.3.3 Cost of Equity Capital

Two possible approaches employed to calculate the cost of equity capital are:
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(i) Dividend approach: As per this approach, the cost of equity capital is worked out on the basis of a required rate of return, in terms of the future dividends to be paid on the shares. Accordingly, ke is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. (ii) CAPM approach: Another technique that can be used to estimate the cost of equity is the CAPM approach. According to the CAPM approach, k is a function of the riskless rate of return (normally represented by the rate of return/ yield available on long-term treasury bonds of the government of the country), market rate of return (average rate of return on market portfolio, represented in India by, say, the National Stock Exchange Index, NIFTY, and so on), and beta is the measure of systematic risk. It is significant to note that foreign companies/MNCs, in general, may have a lower ke than domestic companies due to the fact that they have access to several foreign capital markets to raise funds. Activity 1 Make a report differentiating the cost of capital, cost of debt, cost of equity capital and cost of retained earnings. Hint: The procedure of computing various sources of finance is the measurement of cost of debt, retained earnings and equity.
1. The ________________________is a sum of risk free rate of return plus the risk premium. 2. ________________________is the minimum rate of return required by a firm on its investment in order to provide the rate of return required by its suppliers of capital. 3. The cost of debt is the rate of return required by the________________.
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10.4 Capital Structure of MNCs

Capital structure refers to the financing mix (mix of debt and equity capital) used by a firm, domestic or and MNC. The capital structure of a firm has a rearing on the cost of capital. Firms using debt capital enjoy a substantial advantage as the interest on debt is tax deductible, however the financial risk of the firm goes up and the cost of capital goes up as well. The time has come for global managers to refresh their domestically oriented concepts that have guided the choice of financial structure of their organization. Under the present situation, MNCs would like to finance their foreign subsidiaries with as much foreign borrowing as possible. The benefits of being cheaper and the finances with lesser restrictions have made them a profitable option for MNCs. Though there are many benefits but the foreign borrowing makes it difficult for a global manager to choose the optimum financial structure. The main difficulty in this is that financial structure norms differ from one country to the other. The managers of these companies would have to be tactical to benefit from the borrowing and will have to be well versed with the different norms of different countries. This is the reason that consultancies hire MBA graduates from different countries who do the project feasibility studies. Most MNCs report the consolidated foreign and domestic balance sheet and income statement as the accounting standards are different for different countries. As the global culture is growing fast, the International Accounting Standards will have to be followed so that the reporting should be uniform all over the world. We will discuss this issue in later units. But foreign borrowings also make the reporting difficult. If a country increases or decreases its foreign borrowing, it will change the various debt ratios. There is always a struggle with the proportion of foreign and domestic borrowing, and the MNC tries to achieve optimal financial structure. Irrespective of the theoretical issues, there is a similarity in the financial structures of the firms in the same industry. This suggests that there is an optimal financial structure for a specific industry. There is an influence of industry norms on the financial structure, but there are some intra-industry differences due to variables such as size, managerial risk preference and credit rating that will make the optimal financial structure difficult to achieve. Now take the case of a small firm; it would not be able to float bond issues as that would be a costly proposition as the underwriters would charge them heavily. They could look for other avenues that would be less costly.
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We have understood that industry norms influence the financial structure, but this concept does not hold true if the firms are in the same industry but in different countries. Country norms overshadow the industry norms. A research study was conducted on 463 corporate financial structures in nine selected industries of eleven developed countries. The results of the study showed that the average proportion of debt to total assets of the sample corporations in each of the nine industries is consistently higher in Japan, Italy, Sweden and Germany than it is in the US or France. The paper did not explain how a countrys financial norms influenced but it definitely played a role. Differences in tax regulations between countries have an influence on the comparative financial structure. Tax treatment of interest on debt is not the same in all countries. Some countries take it as a tax deductible item whereas others treat it as an expense. It has been proved that the depreciation policy and use of tax-free reserves vary greatly that would affect the debt ratios because the book value of the total assets was used. Finance theory suggests that the lack of adequate corporate leverage can be offset by an individuals personal leverage. High debt ratios would be considered as a good hedge in those countries where inflation is a problem. Inflation would also increase debt ratios based on book value because the equity would typically be undervalued relative to the market value. Since different countries have different financial structure norms, one has to observe wherever the host countries permit. MNCs should guide their various subsidiaries to adopt such a financial structure that will profit them the most with respect to the norms of the host country. The main advantages of localized financial structure are the environmental factors that cause different companies to opt for such a financial structure. When a foreign subsidiary follows a localized financial structure, it will save the subsidiary from the accusation that it is draining the countrys fund to its parent. The MNCs subsidiaries that have too high a proportion of debt contribute a fair share of risk capital to the host country. It improves the image of foreign subsidiaries that use very little of the financial resources that are available from the host country. If these subsidiaries use the local finances they will have to be aware of the various rules and regulations of the host countries law. The monetary and the credit policy of the host country will have to be analysed thoroughly as they will have a deep impact on the operations of the subsidiary. Once a foreign subsidiary borrows from the local market, it has to abide by the rules and regulations of the host country. Also, the sense that the subsidiary will close its operations will be reduced as it has to stay in the market to repay the loan.
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4. The capital structure of a firm has a rearing on the cost of capital. (True/ False) 5. Differences in tax regulations between countries do not affect the comparative financial structure. (True/ False) 6. The MNCs subsidiaries that have too high a proportion of debt contribute a fair share of risk capital to the host country. (True/ False)
10.5 Cost of Capital in Segmented vs. Integrated Market

Multinational companies (MNCs) have the parent company in one country and the subsidiaries in many other countries. For these companies, it is possible to raise capital in any other country in which they operate. The option to raise capital in different markets improves their liquidity situation and they can create optimum capital structure to take better advantage of cheaper debt capital, easy availability of funds and possibility of diversifying cash flows. The value of a firm depends upon its profitability, which in turn is the combined effect of the income generated from operations and the sources of capital deployed to fund the operations. If cheaper funds have been used, value of firm goes up and returns on shareholders equity increases, which is the main goal of the organization. In order to decide the sources from where funds are to be procured, the firm has to examine many aspects. Some of the important aspects are given here: 1. Segmented markets: Segmentation in market is created by restriction to free flow of capital. In such markets, inflow of international capital is generally restricted and hence, cost of capital is higher. This is the situation in most developing countries. A market is segmented if the required rate of return on securities of comparable risk in that market is different from securities traded in other countries with similar risk. 2. Integrated markets: Integrated market securities of comparable expected returns and risks have identical values in each international market except for adjustments of foreign exchange risk and political risk. Since the capital can be arranged in any of the countries where the firm operates, it has possibility of choosing a financial market which is cheapest keeping similar risk level.
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4. Taxation rules: Tax rules in different countries are different and the firm has to see the combined effect of basic cost of capital and the applicable taxes. 5. Lending norms: Different countries have different rules regarding the liquidity, proportion of foreign capital, fulfilling taxation and legal requirements and compliance, to all the norms. All these raise the cost of capital. 6. Disclosure norms: Disclosure norms are different in each country for firms seeking capital. If norms are strict, fewer firms will be seeking capital and hence, cost of capital becomes cheaper in such a situation. 7. Information barrier: The main information barriers are language, accounting practices and quality of disclosures. In case, language is not understood, international accounting standards are not followed, the requisite disclosures are not made, and the required rate of return by investor will be increased due to increase perception of risk. 8. Small country bias: Small countries have small financial markets 9. Exchange rate fluctuation: If the exchange rates are volatile, the investor would raise the rate of return to cater for the higher risk involved. 10. Transaction cost: Imposition of higher taxes is one of the main ways to segment the market. 11. Political risk : The possibility of political instability or disturbances increases the risk level and the investor would raise the cost of capital as they would be less inclined to invest in such circumstances. The cost of capital is dependent on degree of segmentation. For fully segmented market, the cost of capital would be higher. Sometimes, it is possible to circumvent the situation and assess other capital markets in which case, the cost of capital would be lower. If a financial market is fully integrated with rest of the world, the most competitive cost of capital can be obtained.
D Cost of capital and rate of return in per cent
Kc Kb Ka
C B A
D1
Budget in local currency
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The integrated market provides least cost of capital. It is also to be noted that when the firm moves from domestic market to free market to fully integrated market, the cost of capital progressively goes down and the budget size progressively goes up. Floatation cost and WACC When a firm raises funds with debt or equity to finance a long term project, it incurs flotation costs. These costs are related to issue of securities and pertain to advertising, publicity, fees, brokerage and, underwriting charges for the merchant banker, legal and administrative expenses and other miscellaneous expenses. The result of these expenses is that the actual debt and equity becomes costlier than their real cost of issue. There are two ways to recover these costs from the project. One way is to include these in the costs of debt and equity and such modified costs of debt and equity be used to determine the cost of capital for the project. Another way is not to include these costs in the calculation of cost of capital and use the flotation expenses as a part of the initial expenses for the project. Since these are onetime expenses, it is considered better to use these as one time initial cost of the project and not include in the WACC calculation. Activity 2 Find out an example of segmented market and one example of integrated market. Put them down on a chart. Hints: A market is segmented if the required rate of return on securities of comparable risk in that market is different from securities traded in other countries with similar risk. Integrated market securities of comparable expected returns and risks have identical values in each international market except for adjustments of foreign exchange risk and political risk.
7. The value of a firm depends upon its____________, which in turn is the combined effect of the income generated from operations and the sources of capital deployed to fund the operations. 8. ____________in market is created by restriction to free flow of capital. 9. For fully segmented market, the cost of capital would be____________.
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10.6 Describe Cost of Capital Across Countries

Each country is unique in terms of technology and other resources as well as in the cost of capital for its components like debt, preference and equity. MNCs which have parent company in one country and subsidiaries in various other countries would like to take advantages of the unique situation in each country. The parent company is interested in maximizing the shareholders wealth in its parent country. For example, if the cost of capital is high in some country, the operations may be kept at a lower level compared to the countries where the cost of capital is low. In the countries with high cost of capital, many projects may not be viable as per capital budgeting analysis, whereas similar projects may be highly profitable in countries with lower cost of capital. The most advantageous method for the MNCs would be to receive capital in those countries where the cost of capital is low and to expand business in markets where the market potential is high. However, the exchange rate variations will have to be kept in mind while taking such decisions. Further, the difference in cost of capital of its various components may influence the MNCs to use different capital structure in each country based on the relative value of cost of capital for its components. If the debt is available cheaper, more debt may be used in the capital structure and vice versa. Effect of country difference in the cost of debt The cost of debt in a country is based primarily on risk free rate and the risk premium demanded by creditors. Differences in risk free rate depend upon the rate of interest which is available on government securities at any point in time and thus depends on the general economic conditions, financial policies, tax laws and political stability. It also depends on the demand and supply of funds for investment. These conditions are different in each country. Tax laws in some countries provide high incentives for savings and therefore, more funds will be available for investment. Further, tax laws relating to tax rate on profits, depreciation tax provisions, investment and investment tax incentives affect the demand of the firms for funds. Demographical differences between countries affect their supply of funds and hence, the interest rate; countries with higher proportion of younger population have higher rate of interest, as the tendency today is to spend more and save less compared to senior age group. The central bank in each country like RBI in India implement the monetary policies which influence the supply of funds and this in turn influences the interest
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rates. One exception to this is that European Central Bank controls the supply of Euros and hence all the member countries using Euros as currency have identical risk free rate. The economic conditions of each country affect the interest rates and as these are different in each country, the interest rates would be different. Generally, the interest rate is higher in less developed countries due to economic conditions. Differences in the risk premium: The risk premium must compensate the creditors for the risk that the firm would not be able to meet its obligations to creditors. The level of risk depends upon the general economic conditions, relationship between the firm and its creditors, degree of financial leverage and government intervention. If the economic condition of a country is stable and risk for the firm of not being able to meet its obligations is less, this in turn would lead to lower risk premium. The cultural differences between countries result in having different relationships between companies and creditors. This is especially true for Japan where the creditors would come to the rescue of the firm in the case of crisis by offering further loans to reduce the liquidity risk. Thus, there is a less chance of bankruptcy of a Japanese firm and it leads to low risk premium. In some other countries, the cultural position may be the other way round, i.e. the moment creditors sense trouble with the firm, they will act relentlessly to demand their outstanding interest dues and pull out the principal amounts as soon as possible and stay away from the firm. In such cultures, the risk of bankruptcy is higher and therefore, the risk premium would be more. In some countries, the government intervenes and tries to rescue the firms when these are in difficult times by providing subsidies and special loans etc. and in such countries, the failure risk will be less and accordingly, the risk premium will be lower. Such practice is common in UK, where as in US this type of government intervention is the least. In some countries, the firm can have borrowings because the lenders are willing to accept high degree of financial leverage and not demand higher interest rates. This depends upon the relationship between the firm with the lenders and the government. For example, the firms in Japan and Germany deploy higher financial leverage compared to the firms in US. Country differences in cost of equity A firms cost of equity depends upon the opportunity cost based upon alternate investment options which the investor would have used, if he had not invested in the firm. Return on equity consists of two parts, a risk free interest rate that
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they would have achieved by depositing their funds in government securities and the premium to cover the risk of the firm. Since risk free interest rate is different between the countries, accordingly the cost of equity. The cost of equity is also dependent on the investment options in the country. If there are many investment opportunities in a country, the cost of equity will be high and vice versa. Another parameter to watch is the price-earnings ratios as it reflects share price of the firm as a multiple of its earnings. A high priceearnings ratio indicates that for the given earnings, the firm is able to command higher prices and that indicates low cost of equity. While comparing the price earning multiple in different countries, it needs to be adjusted for inflation, earnings growth, exchange rate etc. The European countries which have common currency Euro are in an integrated market situation, because investors can freely trade in the equity in other European countries using the same Euro currency. This has led to increased demands for shares and has led to increased share prices. Due to increased liquidity in European market, MNCs can obtain equity financing at lower cost. Examining debt and equity cost together The cost of debt and equity can be combined in proportion to their market value to obtain overall cost of capital also called Weighted Average Cost of Capital (WACC). Due to differences in the cost of debt and equity in different countries, the cost of capital will be different. Some countries like Japan have relatively low cost of capital. They have low risk free rate which also has reducing effect on the cost of equity. The price earnings multiples are high and funding can be obtained at a lower cost. MNCs can obtain such low cost funding. However, if these funds are used to finance operations in another country, the cost of this capital is exposed to exchange rate risk. The firms using such capital must be careful that the ultimate cost of using such low cost capital may turn out to be more expensive due to the exchange rate involved. Estimating the cost of capital MNCs can estimate the cost of debt and equity when they want to finance new projects in order to decide about the capital structure to use for the project. Post-tax cost of debt can be estimated relatively easily by looking at the data of other firms with similar risk level as the project. The cost of equity is an opportunity cost which the investors could earn while deploying their funds in other investments with similar risk. The MNCs can try to determine the expected
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return on other stocks with similar risk level and this can be used as cost of equity. The cost of capital for the project which is also called discount rate or required rate of return is the weighted average cost of the estimated debt and equity cost.
10. The most advantageous method for the MNCs would be to receive capital in those countries where the cost of capital is low and to expand business in markets where the market potential is high. (True/False) 11. The cost of capital for the project is also called discount rate or required rate of return. (True/False)
10.7 Case Study

Central Bank of India to seek `700 crore from government The Central Bank of India has stated that it will request for `700 crore capital from the government. It needs almost `1,200 crore in order to increase its credit by 20 per cent in the current financial year. MV Tanksale, the chairman and the managing director of the bank has stated that the bank has enough headroom for raising subordinated debt or tier II capital but no bank is keen to use this option as the imminent Basel 3 regimes emphasizes on core capital. Indian banks will adopt Basel 3 from January 2013. If the plea is accepted by the government, the amount will be invested in pure equity through the subscription to preference shares issued by the bank. The internal accruals will also provide balance which gets added to tier I capital too. The government holds 79 per cent in the bank. Tanksale further said that the banks are now under the compulsion to create capital out of profit generation. He also announced that the bank aim to seek `700-800 crore from the government. The rest of the amount will come from the profits. Mr. Tanksale was in Kolkata to attend a FICCI seminar and he there announced that they are targeting an 18-20 per cent growth this fiscal year which is more than what the Reserve Bank of India had projected. RBI had
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projected a growth of 17 per cent. However, the slow deposit growth has also made him concerned. He said that the deposit growth is not in commensuration with the credit growth. This was mainly because of the fact that high inflation led the people towards physical savings instead of the financial savings. The Mumbai-based entity with a 31 per cent share of high cost bulk deposits said it would not able to reduce the share to 15 per cent by March 2013 as directed by the government. Questions 1. Do you think the Central Bank will benefit of if their plea is granted? 2. State the plans put forward by the chairman of the bank. Source: Adapted from an article at http://articles.economictimes. indiatimes.com/2012-08-10/news/33137623_1_deposit-growth-creditgrowth-mv-tanksale written by Atmadip Ray Accessed on 11 August 2012
10.8 Summary
Let us recapitulate the important concepts discussed in this unit: Cost of capital is another name for required rate of return. It is the minimum rate of return required by a firm on its investment in order to provide the rate of return required by its suppliers of capital. The cost of capital for foreign investment projects like domestic capital budgeting projects should be based on the weighted average cost of longterm sources of finance. The cost of debt is the rate of return required by the debt holders. The opportunity cost of retention of earnings is the rate of return that could be earned by investing the funds retained in investment opportunities that have the same degree of risk as that of the finances itself. Two possible approaches employed to calculate the cost of equity capital are: (i) the dividend approach and (ii) the capital asset pricing model (CAPM) approach. Capital structure refers to the financing mix (mix of debt and equity capital) used by a firm, domestic or and MNC.
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The difference in cost of capital of its various components may influence the MNCs to use different capital structure in each country based on the relative value of cost of capital for its components. MNCs can estimate the cost of debt and equity when they want to finance new projects in order to decide about the capital structure to use for the project.
10.9 Glossary
Repatriation: The act of an individual or company bringing foreign capital into a home country and converting it to the domestic currency Dividends: A distribution of a portion of a companys earnings, decided by the board of directors, to a class of its shareholders Deductible: An amount subtracted from an individuals adjusted gross income to reduce the amount of taxable income Optimal: An optimum return on capital Leverage: The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. Diversifying: Dividing investment funds among a variety of securities with different risk, reward, and correlation statistics so as to minimize unsystematic risk Disclosure: A companys release of all information pertaining to the companys business activity, regardless of how that information may influence investors Retained earnings: Profits generated by a company that are not distributed to stockholders (shareholders) as dividends but are either reinvested in the business or kept as a reserve for specific objectives

1. Define cost of capital. 2. Discuss the approaches that are employed to calculate the cost of equity capital. 3. What do you mean by capital structure? Discuss. 4. Explain the aspects that a firm needs to examine in order to decide the sources from where funds are to be procured.
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5. Define the effect of country difference in the cost of debt. 6. How do MNCs estimate the cost of debt and equity? Discuss.

1. Required rate of return 2. Cost of Capital 3. Debt holders 4. True 5. False 6. True 7. Profitability 8. Segmentation 9. Higher 10. True 11. True

1. Cost of capital is another name for required rate of return. It is the minimum rate of return required by a firm on its investment in order to provide the rate of return required by its suppliers of capital. For further details, refer to Section 10.3. 2. Two possible approaches employed to calculate the cost of equity capital are: (i) the dividend approach and (ii) the capital asset pricing model (CAPM) approach. For further details, refer to Section 10.3.3. 3. Capital structure refers to the financing mix (mix of debt and equity capital) used by a firm, domestic or and MNC. The capital structure of a firm has a rearing on the cost of capital. For further details, refer to Section 10.3.3.
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4. In order to decide the sources from where funds are to be procured, the firm has to examine many aspects. Some of the important aspects are given here: Segmented markets Integrated markets Taxation rules Lending norms Disclosure norms Information barrier Small country bias Exchange rate fluctuation Transaction cost Political risk For further details, refer to Section 10.5. 5. The cost of debt in a country is based primarily on risk free rate and the risk premium demanded by creditors. Differences in risk free rate depend upon the rate of interest which is available on government securities at any point in time and thus depends on the general economic conditions, financial policies, tax laws and political stability. For further details, refer Section 10.6. 6. MNCs can estimate the cost of debt and equity when they want to finance new projects in order to decide about the capital structure to use for the project. For further details, refer to Section 10.6.
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kuntluru, Dr. Sudarshan. International Financial Management. Delhi: Vikas Publishing.
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Structure
International Capital Budgeting
11.1 Caselet 11.2 Introduction Objectives 11.3 Review of Domestic Capital Budgeting 11.4 Adjusted Present Value Model 11.5 Capital Budgeting from Parent Firms Perspective 11.6 Expecting the Future Expected Exchange Rate 11.7 Risk Adjustment in Capital Budgeting: Sensitivity Analysis 11.8 Case Study 11.9 Summary 11.10 Glossary 11.11 Terminal Questions 11.12 Answers Reference/e-References
11.1 Caselet
A Vision for Tomorrow The head of a company which sells fairness crme was once asked What do you sell? We sell hope, she said. The same question was posed to the head of UTV. He said, We sell happiness through entertainment. And when a furniture business owner was asked the question, he said, We are into furniture and furnishings business. The first two replies were from two successful business people, whose vision of business was clear and futuristic right from the word go. Whereas, in the furniture sellers case, it is most unlikely that his company, however well it may be faring, would never attain the heights of the FMCG giant or UTV. Their vision is sure to help make them move ahead in their business as they have long term plans; they will think in terms of leveraging themselves on to a higher plane. For example, they may have envisioned that by year 2020 or so, they will be at least five times the size they are today. Now, we know that if we need to plan for anything for the future, it well means that it has to be planned and budgeted for now. Capital budgeting is based on identifying the opportunities, threats and internal weaknesses, setting long-term goals, formulating action plans and strategies, and monitoring them on a continuous basis.
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Whenever businesses take capital budgeting decisions, they add value to their company, which gets reflected in shareholder earnings, the priceearnings ratio, the share price, market capitalization and dividends. Source: Adapted from http://www.thehindubusinessline.in/mentor/2003/07/ 21/stories/2003072100321000.htm Accessed on 14 August 2012
11.2 Introduction
In the earlier unit, you learnt about the international capital structure. You also learnt about the cost of capital and the capital structure of MNCs. Various concepts related to the cost of capital such as cost of debt, cost of retained earnings and cost of equity capital were also discussed. You also learnt about the cost of capital in segmented versus integrated markets as well as the cost of capital across countries and states. Every firm is a going concern, whether domestic or an MNC. This means that the business of that firm will go on for years on end. Over the years, every business needs to grow profitably. To grow, the firms need capital. Capital projects are important for firms as these generate the products which can be sold to obtain revenue. These projects require large investments and the income accrues over a number of years in the future. In this unit, you will learn about different topics related to international capital budgeting. You will learn about the adjusted present value model, capital budgeting from parent firms perspective and expecting the future expected exchange rate. You will also learn about the political risk and will also know about transaction and exchange rates. In addition to these, you will also learn about risk adjustment in capital budgeting analysis and sensitivity analysis.
Objectives
After studying this unit, you should be able to: explain domestic capital budgeting discuss the adjusted present value model define capital budgeting from parent firms perspective examine how to expect the future expected exchange rate discuss risk adjustment in capital budgeting analysis and sensitivity analysis
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11.3 Review of Domestic Capital Budgeting

Every financial manager has to deal with two main issues; how to raise funds and how to use these funds. Funds are raised normally by equity shares, preference shares and debt. Capital projects are important for the firm as these generate the products which can be sold to obtain revenue. These projects require large investments and the income accrues over a number of years in the future. The whole process of planning and selecting a long term project on the basis of financial analysis is called capital budgeting. The steps involved in financial analysis or capital budgeting analysis are assessing the cash flows, determining the opportunity cost of capital and finally selecting and applying the techniques of capital budgeting to decide whether to accept the project or not. Also, if only one project can be accepted, then which project to accept in order to maximize shareholders wealth. Techniques of Capital Budgeting There are many techniques which can be used to analyze the projects. These techniques can be broadly classified into discounted cash flow techniques, which include net present value (NPV), internal rate of return (IRR), profitability index (PI) and discounted payback methods, and non-discounted cash flow techniques which include payback and accounting rate of return (ARR) methods. The most commonly and most widely accepted technique is NPV method. We now describe some of these techniques in brief and NPV method in greater detail. Net Present Value (NPV) In this method all future cash flows occurring in different time periods are discounted to present value using opportunity cost of capital as discount rate. Whenever there is a cash inflow, we take it with positive sign and cash outflow, we take it as negative sign. If present value (PV) of cash inflows is greater than present value (PV) of cash outflows the project can be accepted. However, if there are more than one project and only one can be accepted then the project with highest difference of PV of all cash inflow and PV of cash outflows is accepted. The difference of PV of all future cash flows and initial investment is known as NPV. So, we can say that project with positive NPV can be accepted and in case of more than one project, the project with highest NPV will be accepted.
NPV = C3 C1 C2 Cn + + + ................. + C0 1 2 3 (1 + k) (1 + k) (1 + k) (1 + k)n
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C1, C2, ...................., Cn are the cash flows in respective years k = opportunity cost of capital C0 is the initial investment (-ve sign taken since it is an outflow) n is life of the project Example: The expected cash flow in respective years of a project which is under consideration by a firm is given below. The firms opportunity cost of capital is 9 per cent. Calculate the NPV and make your recommendation of whether to accept or reject the project.
Year Cash flow (`)

Solution:
NPV =
0 1,200
1 500
2 400
3 400
4 400
5 300
500 400 400 400 300 + + + + 1,200 1 2 3 4 (1 + .09) (1 + .09) (1 + .09) (1 + .09) (1 + .09)5
Solving we get NPV = 382.61 Since NPV is positive so project can be accepted. Internal Rate of Return (IRR) Internal rate of return is defined as that discount rate at which NPV is equal zero. This internal rate of return is compared with opportunity cost of capital. If IRR is greater than opportunity cost of capital the project can be accepted; if IRR is less than opportunity cost of capital the project cannot be accepted as in such a case, the project will not be able to generate even the opportunity cost of capital. If IRR is equal to opportunity cost of capital the project will not generate any extra returns so it can either be accepted or rejected. The greater the magnitude by which IRR exceeds the opportunity cost of capital the greater will be the profitability, so ranking of projects can be done based on the magnitude of difference. Profitability Index (PI) It is defined as the ratio of present value of all cash inflows divided by the initial cash outflow. It is similar to NPV in the sense that it also uses discounted cash
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flows and initial outflow but instead of subtracting initial cash outflow from discounted cash flows, here we divide the discounted cash flows by initial cash outflow. We accept the project if PI is greater than one, reject it if PI is less than one and may or may not accept it if PI is equal to one. Payback Period This is a non-discounted cash flow technique. It finds out the time in years in which the initial investment would be recovered. It is the easiest method as far as computation is concerned but drawback being that it does not consider time value of money. Mathematically, it is calculated by dividing initial cash outflow by annual constant cash inflows. Discounted payback period is a better method than payback period in the sense that it considers the time value of money and discounts all future cash flows. Determining cash flows We need to determine the incremental cash flows over the existing cash flows which will take place by acceptance of the project under evaluation. Any expenses which are already incurred will not be included in cash flows. Such expenses are called sunk costs. The step of determining cash flows with accuracy is the most important step in capital budgeting analysis as further process is dependent on it, but it is a difficult task due to the following reasons: 1. Future is uncertain, and uncertainty gives rise to risks 2. Accounting information which is based on various assumptions is used as basis to determine cash flows 3. Economic conditions may change suddenly due to some event In any capital investment project there will be three main cash flows: Initial cash outflow Cash flows during the project. It may be inflow or a mix of inflow and outflow Final period cash flow; generally referred to as terminal cash flow Though cash flows (not profits) are used as basis for evaluation of capital projects, both are important. These are connected by the following equation: Cash Flow = Profit (P) + Depreciation (D) Capital Expenditure (CAPEX)
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The drawback with the use of profit as basis of the evaluation is that it is based on past data and does not fully reflect the likelihood of future cash flows. Projects are of two types. Independent projects are those projects which can be accepted or rejected without the effect on any other project. Mutually exclusive projects are those projects where out of a number of options, only one can be accepted. When we accept one option, the other options do not exist. For example, a firm has a plot of land and the options are to build a hotel or to build a hospital. The moment one project is accepted, the land is utilized and therefore, the other project cannot be accepted. Sometimes, independent projects become mutually exclusive due to constraint on the availability of funds. Such projects are called capital rationing projects. The important points to be noted are: 1. Cash flows are considered only on after tax basis. 2. Financing costs are not included as these are covered under the projects required rate of return. 3. Cash flows are assessed on an incremental basis and represent difference in cash flows after and before the investment. Activity 1 Browse the Internet and find out the capital budgeting practices used by MNCs. Also make a chart and write down how they are different from a domestic firm. Hint: The techniques used are NPV, IRR or APV.
1. _____________are raised normally by equity shares, preference shares and debt. 2. The whole process of planning and selecting a long term project on the basis of financial analysis is called_____________. 3. ____________are those projects which can be accepted or rejected without the effect on any other project.
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11.4 Adjusted Present Value Model

Debt has an advantage over equity since the interest paid on debt is almost always deductible from income while calculating corporate taxes, which is not the case for dividends on equity. So, the post cost of debt is less than the pretax cost of debt. Debt creates additional value for a project. How is this so? By reducing the taxes paid, so adjustments to the calculation of the projects present value must be made if it supports additional debt. Therefore, the contribution to present value of issuing debt is calculated as the present value of tax savings. This present value (PV) can then be added to the PV of a project calculated using the all-equity cost of capital. The method of adding the tax benefits of debt to the separately calculated present value of the project using the allequity cost of capital is known as the adjusted present value (APV) approach. Let us understand this from another angle. The NPV model that you studied earlier involves discounting all cash flows at the cost of capital. You already know that the cost of capital measures the risk and also the opportunity cost of the money invested. The conventional NPV model assumes that the project has the same business risk (financial and operating risk). It is also assumed that the debt-equity ratio is unchanged over the life of a project. However, in reality all the assumptions may prove to be untrue. Therefore a conventional model needs to be adjusted to take care of the risks. Such an adjusted model is known as Adjusted Present Value Model. This model considers that the project will have differing discount rates in its evaluation process based on the risks that it bears. The APV method also identifies the cash flows of a project by different components and discounts each one at the appropriate risk-adjusted discount rate. The APV model is a three step approach
Step 1: Evaluate the project as if it is financed entirely by equity, to obtain the cash flows. The rate of discount is the required rate of return on equity corresponding to the risk class of the project. Step 2: Add the present value of any cash flows arising out of special financing features of the project such as external financing. The rate of discount used should reflect the associated risk with each of the cash flows.
Step 3: Add cash flows of Step 1 and Step 2 to obtain APV
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Accordingly, we can say that: Value of the levered firm = Value of the unlevered firm + Value of financing effects. In other words, NPV of a project has two components: all equity NPV and the value of financing effects which includes interest tax shields that arise from use of debt financing and subsidies. For example, the government of a country may provide loans at subsidized rates or offer a tax holiday to promote Foreign Direct Investment. The value of such concessions will be added to the project evaluation. Issue costs that arise due to issue of equity shares and debentures will also add to the cost. This will reduce the project APV. If you compare the NPV and the APV model, the latter is definitely a better method as it deals with the financing effects and the operating cash flows of the project. However, it is difficult to obtain the precise tax shield as the shareholders and creditors are subject to diverse tax rates and regulations. Whether it is conventional NPV or APV, the decision is to accept the project if the NPV or APV is greater than zero. If it is less than zero, the project should be rejected. In case the NPV and APV are zero, then at times, the project may be accepted on the basis of consideration of certain other factors of business.
4. The contribution to present value of issuing debt is calculated as the present value of tax savings. (True/False) 5. Debt creates additional value for a project by reducing taxes paid, so adjustments to the calculation of the projects present value must be made if it supports additional debt. (True/False)
11.5 Capital Budgeting from Parent Firms Perspective

In the case of MNCs, the parent firm is in one country and subsidiaries are in various other countries. A very pertinent question arises that for capital budgeting project analysis, it should be seen from the perspective of parent company or from the perspective of subsidiary. Analysis of a foreign project involves two issues in addition to the investment and financing, and these are:
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1. Are the cash flows to be measured from the perspective of the foreign subsidiary or from the perspective of the parent company? 2. Should the additional economic and political risks which are unique to the foreign country where subsidiary is located, be used in adjustments of cash flows to arrive at net present value? The basic point is that the main firm is in the parent country and shareholders in that country have invested their funds; so their interest must be the foremost objective of the organization. This still does not fully answer the question about the capital budgeting project. If a project in a foreign country is going to be beneficial to the parent firm in the long run, it can be accepted. As per economic theory, the value of a project is measured by net present value of future cash flows to the investor. Major differences can exist in the cash flows of the project and the cash flow remittances to the parent firm due to tax laws and exchange control regulations. Basically, the net present value of the future cash inflows in relation to the initial outlay will determine the acceptability and profitability of the project. However, the total effect has to be seen from the perspective of investors in the parent country. A three stage approach is suggested in such cases:
Carry out the project evaluation from the perspective of the subsidiary as if it was a separate company
In this stage, the perspective shifts to the parent firm. It requires specific forecasts regarding amount, timing and the form of transfer of funds to the parent company and information regarding taxes and other expenses required to be incurred in the process of transfer of funds.
In this state, the firm has to consider other indirect costs and benefits that this project provides on the total system such as increase or decrease of export business by another affiliated firm.
Estimating incremental cash flows The company must estimate the projects true profitability and it involves marginal revenues and marginal costs associated with the project from all subsidiary operations of the world. The incremental cash flows to the parent can be found out from the worldwide cash flow with and without this project. While doing so, one has to take care of the following aspects:
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1. Include fees and royalties to the parent firm in the cash inflows 2. Remove overhead costs which are anyway to be incurred by the parent firm 3. Use market value of capital resources and other services transferred internally 4. Cannibalisation of sales of other units 5. Creation of incremental sales by other units 6. Foreign tax credits which can be separately utilised 7. Provision of a key link in the firms global services network, and providing seamless service to customers 8. Competitors, technology, products 9. Diversification of production facilities 10. Market diversification 11. Firms reputation of being a market leader and always taking the lead in introducing new technology / products 12. Effect on brand building 13. Considering the projects strategic purpose and its effect on future opening up of opportunities So, you can see that the calculation of future cash flows in the foreign country and the remittances to the parent country with reference to the initial outlays may be simple to calculate, the strategic considerations of investing in a new project in a foreign country far outweigh those cash flow benefits. Besides the above, the following aspects require special considerations: Economic and political risk Generally, firms want to invest in countries which have sound economy, stable currency and healthy social and political condition involving minimal political risk. It is essential to make an assessment of economic and political risk before deciding about the investment projects. Three methods to include these risks in the analysis are: Reducing the payback period requirement Increasing the required rate of return for the project Adjusting cash flows to incorporate impact of specific risk
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One or more of the above methods can be used. Broadly, it implies that when risk levels are higher, you invest in shorter duration projects and require larger cash flows to make the project viable. Adjusting discount rate and payback period are general approaches to protect the firm from risky investments. Most often, the economic and political risks are not clearly well defined but rather vaguely hidden in the circumstances as these keep unfolding. It requires great insight to be able to assess the magnitude of such risks one year or five years down the line. For example, if you raise the required rate of return from 16 per cent to 18 per cent, it simply means that you are adding some safety cushion to cover the risk. Similarly, if you reduce the requirement of payback period from 4 years to 3.5 years, it implies that you are keen to go for short duration projects because investments in distant future are more risky. Adjusting cash flows for specific periods based on expected risks on those periods is a better approach so that you can address the specific risks in our assessment. However, by taking such actions, you are restricting the new projects to those really profitable ones. In case, there is a heavy competition for our products, you have to be careful in raising the acceptance level of the project, because you may lose good opportunities to competition. Exchange rate changes and inflation Exchange rates between currencies keep fluctuating all the time and inflation in different countries is at different rates. Present value of future cash flows from a foreign project can be calculated in two steps. First convert nominal foreign currency cash flows to nominal parent country cash flows and then discount these cash flows with nominal parent country required rate of return. It is required to analyze the effect of inflation and effect of exchange rate separately for each component of cash flow. For example, depreciation tax shield will not change with inflation whereas revenues and costs will be affected. So generally what is done is to first convert the foreign currency cash flows for inflation in the foreign country and then projecting these cash flows into parent country currency using prevailing exchange rate. International taxation In addition to the taxes the subsidiary pays to the host government, there is withholding of taxes on dividends and other income remitted to the parent. Also, the home government may tax this income in the hands of the parent. If double
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taxation avoidance treaty is in place, the parent may get some credit for the taxes paid abroad. However this will depend on the financial arrangements between the countries. There is also the issue of transfer pricing which may enable the parent to further reduce the overall tax burden. Blocked funds It may happen that a foreign project becomes an attractive proposal because the parent has some funds accumulated in a foreign country which cannot be taken out or may only be withdrawn after giving heavy penalties in the form of taxes. Investing these funds locally in a subsidiary or a joint venture may be a better way to use such blocked funds.
6. In the case of MNCs, the ________________________is in one country and subsidiaries are in various other countries. 7. Major differences can exist in the cash flows of the project and the cash flow remittances to the parent firm due to __________and_____________. 8. Adjusting__________ and payback period are general approaches to protect the firm from risky investments.
11.6 Expecting the Future Expected Exchange Rate

For the MNCs the exchange rate between currencies is of paramount importance due to the following reasons: 1. Most important are the capital budgeting decisions in which case the future cash inflows would be in the currency of the foreign country and cash flows for the parent company in home country will depend upon the exchange rates applicable to remit the funds. Thus future cash flows are dependent on future exchange rates. 2. In the case of financing decisions the firms generally borrow in the country where the cost of capital is low and those currencies that are expected to depreciate. 3. Expected future exchange rates are important in order to decide whether to hedge the exchange rate risk or not.
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There are three forecasting methods for future exchange rates: (1) Fundamental (2) Technical (3) Market Based Fundamental forecasts These are based on changes in the underlying economic factors that affect exchange rates. For example, purchasing power parity (PPP) gives a forecast of future exchange rates based on estimates of inflation in two countries: This is dependent on estimates of inflation rates over the next period. PPP generally gives an unbiased estimate of long run changes in exchange rates. Technical forecasts This is based on assumption of repeated patterns in exchange rate changes over a period. An investor might find that if the exchange rate goes up three months in a row it usually goes down the next month. Technical forecasting may be useful on a very short term basis. However, from the viewpoint of an MNC, longer term changes in exchange rates are important. Market based forecasts These forecasts use current information from the foreign exchange market to forecast future exchange rates. There are two market based estimates that can be used for a forecast of future rates: (1) The current spot rate (2) The forward rate Current spot rate The exchange rate in next period generally has no correlation with exchange rate in last period. This means that changes from period to period are random and therefore unpredictable. One way to forecast what next periods exchange rate will be is to simply use todays exchange rate. That is, if you want an estimate of what next years Dollar Yen rate will be and todays rate is 80, then using 80 as your forecast will be the best guess.
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It has been found that the current spot rate is good estimate of the future spot rate. However, the errors in any particular period can be very large. Forward rate Important place to look for a forecast of future rates is the forward rate. Forward rate is arrived at based on the combined wisdom of competing parties and is most likely to be right. Forward rate = Expected spot rate at maturity of forward Thus, looking at forward quotations may be a very good way to get an unbiased estimate of the future spot rate. Since the forward rate is set in the forward market, it is really a combined effect of all investors expectations (the final rate is actually an average of each investors forecasts). Hence, it is expected to be better forecast than any one individual could make. According to the above discussion, the forward rate should be the best possible forecast of future spot exchange rates. However, this is not true. First, interest rate parity states that the forward rate is simply a reflection of interest rate differentials between countries. This means that the forward rate is not determined by peoples expectations of the future spot rate. Second, there are two groups of people in the forward market: hedgers and speculators. Hedgers are trying to get rid of exchange rate risk and the speculators are agreeing to take on this risk in the hope that they make a profit. In order for a speculator (i.e., a bank) to be convinced to enter a forward contract, it must expect to make a profit. From the opposite viewpoint, this means that the hedger must expect to lose money on the forward contract. In effect, this expected loss by the hedger is the price that must be paid for getting rid of the exchange rate risk. The difference between the expected future spot rate and the forward rate is referred to as the risk premium. Many studies have been made to determine if a risk premium exists in forward rates, and the result has been that it exists. Therefore, the forward rate is not an unbiased estimate of the future spot rate; it ends up being wrong on average. So the question is, even if forward rates are not an unbiased forecast of future spot rates, do they provide a reasonable forecast and/or the best forecast available?
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This is an important question because there are a number of exchange rate forecasting services which can be engaged. It has been found that: (1) Forward rates are closer to the actual spot rate. (2) Professional forecasting services can accurately predict the direction of change, in terms of movement of the rate up or down To engage or not to engage a professional forecasting service for estimating future exchange rates depends upon the purpose for which the forecasts are required (i.e., the accuracy required) and also the cost involved. Activity 2 Make a report stating the differences between current spot rate and forward rate. Also state their usefulness in forecasting future exchange rate. Hint: Current spot rate and forwards rate are two market based estimates that can be used for a forecast of future rates.
9. In the case of financing decisions the firms generally borrow in the country where the cost of capital is low and those currencies that are expected to depreciate. (True/False) 10. Technical forecasts are based on changes in underlying economic factors that affect exchange rates. (True/False) 11. In order to justify the extra cost involved in using a professional forecasting service it is important to know if professional forecasts outperform forward rates in the accuracy of their predictions. (True/False)
11.7 Risk Adjustment in Capital Budgeting: Sensitivity Analysis

The problem of project risk For now, we will define the risk of an investment project as the variability of its cash flows from those that are expected. The greater the variability, the riskier the project is said to be. For each project under consideration, we can make
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estimates of the future cash flows. Rather than estimate only the most likely cash-flow outcome for each year in the future, we estimate a number of possible outcomes. In this way we can consider the range of possible cash flows for a particular future period rather than just the most likely cash flow. As far as the foreign projects are concerned, their expected nominal cash flows can be converted into nominal home currency terms and discounted at the expected nominal domestic discount rate. If the ash flow is in foreign currency then the foreign currency discount rate has to be used. Risk is usually measured as by a standard deviation or variance of the expected cash flows. In estimation, the concept of probability should be understood. Probability is a measure of the likelihood that a particular event will occur; in this case, it is the cash flow. So, in the process of appraisal of a project, the probability of the cash flow should also be considered. Risk-handling techniques There are different techniques to handle risk in investment decisions. The important techniques include the risk adjusted discount rate approach, the certainty equivalent approach, sensitivity analysis, scenario analysis and the decision tree approach. We will discuss the sensitivity analysis here. Sensitivity analysis It is important for international firms to forecast exchange rate variations in order to protect themselves from the fluctuations. The firms use sensitivity analysis for this purpose. Sensitivity analysis is a technique to find out the effect in variation or fluctuation in one parameter on the movement of another parameter. In fact in terms of international trade the most important aspect is the fluctuation of foreign currency exchange rate. So, if we can identify the factors which cause these, then through the use of sensitivity analysis we can attempt to forecast the exchange rate changes when any one of these factors undergo a given change. When a regression model is used for forecasting, some factors have lagged impact on exchange rate while some other factors have instantaneous impact on exchange rate. Assume an MNC desires to determine the effect of change in the forecast demand for the product or the effect of change in tax rates by the foreign government; we attempt to answer the question like what would happen to APV or NPV if this input variable changes. The objective is to determine how sensitive NPV is to the alternative values of the input variable. In this technique alternative
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values of APV/NPV are calculated and examined. The advantage of sensitivity analysis in comparison to use of simple point estimates is that it reassesses the project on the basis of various circumstances that are likely to occur. To conduct sensitivity analysis large number of computer software are available. In the above discussions the focus is on how to make adjustment in each cash flow and discount rate in case of international capital budgeting. Estimated cash flow is used in the calculation of NPV and IRR but the point is how the estimation of cash flow varies under different assumptions. For example if the foreign country is having pessimistic, expected and optimistic outlook the cash flows would be different. It is difficult to foresee the future possibilities and accordingly equally difficult to estimate future cash flow with full certainty. Similarly the cost of capital will have wide variations under different levels of political, financial and business risk. The varying cash flows and varying discount rates under different assumptions will have effect on acceptability of the project. The sensitivity analysis determines how sensitive the NPV is to varying values of input variables. Actually when cash flows are not known with full certainty, probabilistic techniques are used. Magnitude of uncertainty is measured in terms of dispersion from expected value, which can be quantified by the variance or standard deviation of the project. It is also important to understand the reliability of NPV or IRR or APV depends on how accurate are we able to forecast the variables underlying the estimates of net cash flows. To determine the reliability of NPV and IRR of any project, we need to work out how much would be the difference in the outcome if any of these estimates goes wrong. We can change each of the forecasts, taking one at a time, to minimum three values pessimistic, expected, and optimistic.
12. In the process of _____________of a project, the probability of the cash flow should also be considered. 13. _____________is a technique to find out the effect in variation or fluctuation in one parameter on the movement of another parameter. 14. __________________________is measured in terms of dispersion from expected value, which can be quantified by the variance or standard deviation of the project.
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11.8 Case Study

Interest Rate, Exchange Rate and Inflation in India The higher interest rate regime in India is seen as one of the important reasons for the recent economic slowdown, industrial growth and low appetite for investment. In the present weak global market environment where the risk appetite is low, the interest rates tend to remain high in order to attract more risk premium. Even with high nominal rates, if proper allowance is provided for inflation and taxes, the real estate rates become much lower in comparison to the return on other classes of assets such as real estate and gold. In markets where investments move from lower currencies to higher ones, large carry trades take place. The US Fed signals that till the middle of 2014, there will be no increase in the low interest rates. This provides opportunities to the operators to bring inflows from those countries only when there is high interest arbitrage. This further leads to exertion of pressure on interest rates. The Indian economy is not fully market-driven and a number of elements are present that are administered by the government and other authorities. Such elements are minimum support prices, interest subventions and subsidies. This also means that the interest rates are not freely determined by demand and supply. Factors such as a countrys balance of payments and exchange rates also determine the exchange rates. One of the reasons leading to such high interest rates is also the burgeoning current account deficit. The Central banks signal in its monetary policy will also play an important role in determining the interest rates in the market. Any stringent measure to squeeze liquidity through monetary action and stiff policy rates will drive interest rates northwards, as demand for liquidity outstrips supply. It is not possible to bring down nominal rates until inflation is tamed. This is because real interest rates will tend to move to unsustainable levels. It is necessary to make the supply-side bottlenecks smoother in order to keep the inflation rate in control. Sovereign rating can be improved through a strong currency, better fiscal discipline and sustained growth. They also help in raising the earning potential of large sections of society, increasing savings and bringing down interest rates. Banks on their part would also do
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their best in considering rate cuts for ensuring adequate flow credit to ensure adequate flow credit to productive and select sectors of the economy. Questions 1. State the factors that determine the exchange rate. 2. How do you think inflation can be tamed? Source: Adapted from http://economictimes.indiatimes.com/opinion/etdebate/interest-rate-will-stay-high-till-inflation-is-tamed/articleshow/ 15398539.cms Accessed on 9 August 2012
11.9 Summary
Let us recapitulate the important concepts discussed in this unit: Two main issues needed to be dealt by every financial manager are how to raise funds and how to use these funds. Capital projects are important for the firm as these generate the products which can be sold to obtain revenue. In the NPV method, all future cash flows occurring in different time periods are discounted to present value using opportunity cost of capital as discount rate. Internal rate of return is defined as that rate at which NPV is zero. This internal rate of return is compared with opportunity cost of capital. Though cash flows (not profits) are used as basis for evaluation of capital projects, both are important. Expected future exchange rates are important in order to decide whether to hedge the exchange rate risk or not. The technique through which the variation or the fluctuation in one parameter on the movement of another parameter is found out is known as the sensitivity analysis.
11.10 Glossary
Capital budgeting analysis: The process in which it is determined by the business whether projects such as building a new plant or investing in a long-term venture are worth pursuing
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Discounted payback: The method through which the time value of money is considered and all future cash flows are discounted Incremental cash flow: The difference between the cash flows of a firm with and without a project Tax shield: The reduction in taxable income for a corporation or an individual that is achieved through the claiming of allowable deductions such as medical expenses, mortgage interest and depreciation Remittance: Transfer of funds, usually from a buyer to a distant seller, instrument of transfer (such as a check or draft), or funds so transferred Speculator: One whose work is to predict changes in price and who aims to make profits through buying and selling contracts

1. Discuss the techniques that are used to analyse the projects. 2. What do you mean by net present value? Discuss. 3. Define the adjusted present value approach. 4. Discuss the methods of assessing the economic and political risk. 5. Explain the forecasting methods for future exchange rates. 6. Define sensitivity analysis.

1. Funds 2. Capital budgeting 3. Independent projects 4. True 5. True 6. Parent firm 7. Tax laws, Exchange control regulations
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8. Discount rate 9. True 10. False 11. True 12. Appraisal 13. Sensitivity analysis 14. Magnitude of uncertainty

1. There are many techniques which can be used to analyze the projects. These techniques can be broadly classified into discounted cash flow techniques, which include net present value (NPV), internal rate of return (IRR), profitability index (PI) and discounted payback methods, and nondiscounted cash flow techniques which include payback and accounting rate of return (ARR) methods. For further details, refer to Section 11.3. 2. In the net present value (NPV), all future cash flows occurring in different time periods are discounted to present value using opportunity cost of capital as discount rate. Whenever there is a cash inflow, we take it with positive sign and cash outflow, we take it as negative sign. For further details, refer to Section 11.3. 3. The method of adding the tax benefits of debt to the separately calculated present value of the project using the all-equity cost of capital is known as the adjusted present value (APV) approach. For further details, refer to Section 11.4. 4. The three methods of assessing the economic and political risk before deciding about investment projects are: Reducing the payback period requirement Increasing the required rate of return for the project Adjusting cash flows to incorporate impact of specific risk For further details, refer to Section 11.5.
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5. There are three forecasting methods for future exchange rates: Fundamental Forecasts Technical Forecasts Market Based Forecasts For further details, refer to Section 11.6. 6. Sensitivity analysis is a technique to find out the effect in variation or fluctuation in one parameter on the movement of another parameter. In fact in terms of international trade the most important aspect is the fluctuation of foreign currency exchange rate. For further details, refer to Section 11.7
Reference/e-Reference
Kumar, Neelesh. International Financial Management. Delhi: Vikas Publishing.
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Structure
Country Risk Analysis
12.1 Caselet 12.2 Introduction Objectives 12.3 Country Risk Factors 12.4 Assessment of Risk Factors 12.5 Techniques to Assess Country Risk 12.6 Measuring Country Risk 12.7 Governance of Country Risk Assessment 12.8 Case Study 12.9 Summary 12.10 Glossary 12.11 Terminal Questions 12.12 Answers References/e-References
12.1 Caselet
Q3 economic situation is found unfavourable by finance executives A study has put forward that most of the senior finance executives are of the opinion that the macro-economic conditions of a country are likely to remain unchanged or unfavourable in the July-September quarter. The Dun and Bradstreet India CFO survey states that in comparison to the previous quarter, the optimism level for the overall macroeconomic conditions has gone down in the third quarter of 2012. This is mainly because of difficult domestic as well as international economic conditions. It is considered by around 73 per cent of the surveyed CFOs that the overall macro-economic conditions during Q3 2012 will be unfavourable or will remain unchanged. There is an increase of around 24 per cent from Q2 2012, thus expressing a weak business sentiment. The chief operating officer of Dun & Bradstreet India said that the overall CFO optimism level has further declined during Q3 2012 due to tough domestic conditions in addition to the prolonged worries about the European debt crisis weigh on overall confidence.
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The increasing concerns related to both global and domestic economy have led to an increasing focus on risk management tools for the coming six months. Around 82 per cent are of the opinion that the level of financial risk on the companys balance sheet will either increase or will remain constant in Q3 2012. A large number of CFOs continue to remain focused on Risk Management as a key priority area and implementing risk mitigation measures that will help them minimize the impact of the volatile economic and political environment on the companys balance sheet, he said. Source: Adapted from http://zeenews.india.com/business/news/economy/ finance-executives-find-q3-economic-situation-unfavourable_57536.html Accessed on 12 August 2012
12.2 Introduction
In the previous unit, you learnt about the international capital structure, where concepts such as cost of capital and capital structure of MNCs were discussed. You also understood how to describe the cost of capital in international business context. Now that you understand the concept of the capital structure of an MNC, you might want to acquire the assets of a company, for monetary gains, which lies outside your domestic market. For this you will have to use foreign currency. When you use foreign currency, you are subjecting yourself to two types of risks country risk and foreign exchange risk. Country risk is the risk of investing in a country, where a change in the business environment may adversely affect the profits or the value of the assets in a specific country. For example, financial factors such as devaluation or stability factors such as a civil war may jeopardize your investment. So we need to understand the theory behind country risk before we can think about making an investment abroad. In this unit, you will learn about country risk analysis. You will also study the country risk factors and the assessment of risk factors. The unit also presents a detailed description of the techniques through which the country risks can be assessed as well as measured. You will also learn about incorporating risk in capital budgeting, governance of country risk assessment and preventing host government takeovers.
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Objectives
After studying this unit, you should be able to: define country risk and assess the risk factors explain the techniques of assessing country risk and measuring country risk discuss incorporating country risk in capital budgeting and governance of country risk assessment assess how to prevent host government takeovers
12.3 Country Risk Factors

We can define country risk as the risk of losing money due to changes that can occur in a countrys government or regulatory environment. The most common examples are acts of war, civil wars, terrorism and military coups, etc. It comes in various forms: for example, change in the government of a country, a new president or prime minister, some new laws, a ruling party becoming minority, and so on. Such changes do impact a countrys economic environment. They have a great impact on the investors perception about a countrys prospects. Political stability means the frequency of changes in the government of a country, the level of violence in the country, etc. A country is called politically stable if there are no frequent changes in the government and the level of violence is low or nil. For example, Australia was considered a dream destination by Indians earlier. Now the country is being avoided due to the instances of violence against Indians. In some countries, government can expropriate either a legal title to property or the stream of income it generates. Such countries are said to be high political risk countries. Political risk is also said to exist if property owners may be constrained in the way they use their property. Host government may enact laws to prevent foreign companies from taking money out of the country or from exchanging the host countrys currency for any other currency. This can be called financial form of country risk. It is difficult to calculate the exact value of country risk like any economic or financial variables. The calculation of country risk scores is difficult, but there are many important financial decisions that are based on the assessment of the country risk of a country. A company will have to do its own calculations for taking financial decisions.
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Stephen Kobrin (1982) has classified country risk as: Macro or country-specific risk Micro or firm-specific risk Factors determining the extent of political risk for a country The factors determining the extent of political risk for a country are broadly classified into: Country-related factors Company-related factors Country-related factors: These have three broad categories that have been discussed in detail. (a) Economic factors Fiscal discipline: This is indicated by the ratio of the fiscal deficit of a country to its GNP. Higher the ratio, the more government is promising to its population relative to resources it is obtaining from them. Controlled exchange rate system: This system increases the problem of BOP and makes fiscal discipline difficult. Government uses currency controls to fix exchange rates. This provides little flexibility to respond to changing prices. Wasteful government expenditure: This is an indicator of financial problems. Resource base: If a country has natural resources, it is considered economically stable. Countrys capacity to adjust to external shocks: If a country has a vast resource base, it possesses greater capacity to respond to external shocks. (b) Geographical factors: The best example in this case would be Sri Lanka, where due to the presence of the LTTE, there was a border issue. (c) Sociological factors: These include religious diversity, language diversity, ethnic diversity, etc. (i) Company-related factors Nature of industry: Government of a country controls certain critical industries that affect the economy of the country, e.g. oil and petroleum
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Level of operations: An MNC with a global presence is safe from government interventions. Level of technology and research and development: Companies using sophisticated technology and having high degree of R&D content are difficult to be regulated. Level of competition: Companies that have little or no competition are not regulated by government. Form of ownership: Local ownership is favoured by government. Nationality of management: Foreign management is more vulnerable to hostile treatment from the government. Activity 1 Find out the latest country risk ratings. Also analyse how country risks are evaluated. Hint: Country risk is measured through economic, political factors and social factors.
1. _________means the frequency of changes in the government of a country, the level of violence in the country, etc. 2. ___________increases the problem of BOP and makes fiscal discipline difficult. 3. Country risk is the risk of losing money due to changes that can occur in a ___________or regulatory environment.
12.4 Assessment of Risk Factors

There are risk assessment agencies that provide country risk indices which try to assess the political stability of a country. The factors from which the political instability occurs can be classified into three categories: 1. Economic factors: These factors include inflation, unemployment, fiscal deficit, trade policies, large external debt, etc.
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2. Geographic factors: These include border disputes, natural calamities, etc. 3. Sociological factors: These include religious diversity, diversity in language, etc. When a firm has to do business in a foreign country, it has to be doubly sure about the uncertainties that it can face. It has to analyse all the risks that are theoretically said to exist. MNCs have to assess the country risk both qualitatively and quantitatively. Qualitative approach: This approach involves interpersonal contact. MNCs may know influential people in a foreign country. They may know politicians, bureaucrats, officials, etc. who might make MNCs aware about the political environment present in their country. They might update the MNC about the future prospects of business in their country. The entire process is based on judgement and there is no data to support such decisions. The MNC may send a team of experts for the on-the-spot study of the political situation in a particular country. This is a preparatory step taken to start talks with companys management. The qualitative approach involves examination and interpretation of diverse secondary facts and figures. On the past trends of events, future trends are assessed (Kramer, 1981). Quantitative models: There are specific quantitative tools for estimating country risk. One such tool is a computer program named Primary Risk Investment Screening Matrix (PRISM) that has 200 variables and reduces them to general ratings. It represents an index of economic viability as also an index of country stability. The variables include the level of violence in a country, frequency of changes in government, number of armed insurrections, conflict with other nations and economic factors such as inflation rate, external balance deficit and growth rate of the economy. The other commonly used tool is the decision tree approach used by Stobaugh (1969) which finds out the probability of nationalization. He has done his analysis by taking two cases, i.e. whether the government will change or not. If there is a change, a new government may or may not go in for nationalization. If it goes in for nationalization, then again there are two possibilities: whether it will pay adequate compensation or not. Thus, each possibility has many possible sub-events. The probabilities are indicated along tree branches. Probabilities are multiplied along the tree branches. Then they are summed up.
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Example 12.1: There is 50 per cent probability of change in government and 50 per cent probability for no change in government. If a government changes, there is 40 per cent probability for nationalization and 60 per cent probability for no nationalization. Again, if there is nationalization, then there is 60 per cent probability for adequate compensation. With these figures, the probability for inadequate compensation can be calculated as: 0.5 x 0.4 x 0.4 = 0.08 Probability = 8% Knudsen (1974) used comparatively measurable variables and not very subjective ones. Notable among his variables are: the degree of urbanization, literacy rate, degree of labour unionism, national resource endowment, infant survival rate, calorie intake, access to civic amenities, per capita GNP, etc. Haner (1979) used a scale from 0-7 to rate country risks. He grouped the factors leading to country risks into two parts: internal and external. The internal factors are fractionalization of political spectrum, fractionalization of social spectrum, restrictive measures required to retain power, xenophobia, socio-economic conditions and the strength of radical left government. The external factors were dependence on a hostile major power and negative influence of regional political forces. After adding up the rating points, if the total is 19 or below, he is of the view that the country risk is minimal. If the total is between 20 and 34, the risk may be acceptable, but if the total lies between 35 and 44, the risk is supposed to be very high. Lastly, if the total exceeds 44 rating points, it is not advisable to make any investment in that country. The country risk index tries to incorporate all these economic, geographical and social aspects and measures overall business climate of a country. Business Environment Risk Information (BERI) classifies countries into different categories on the basis of risk perception: Low-risk countries Medium-risk countries High-risk countries Prohibitive-risk countries Another method is of capital flight. Capital flight is an indicator of the degree of country risk. It means the export of savings by a nations citizens because of the fears about the safety of their capital. The reasons for occurrence of capital flight can be as follows: Government regulations and controls Taxes
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Low returns High inflation Political instability
4. Qualitative approach involves interpersonal contact. MNCs may know influential people in a foreign country. (True/False) 5. Capital flight is an indicator of the degree of country risk. (True/False) 6. Economic factors include religious diversity, diversity in language, etc. (True/False)
12.5 Techniques to Assess Country Risk

Approaches to country risk management There are two approaches to country risk management. 1. Defensive approach: In this approach, the company tries to protect its interest by finding those aspects of the company that are beyond the reach of the host government. This reduces the firms dependence on the host country and the government of the host country. The important strategies in the functional areas of the company are discussed as follows: Financial strategies: To protect against the hostility of the host government, a company can take the following steps: Maximum utilization of debt instruments. Company does not raise all the capital through a single source but a variety of sources are used like host government, local banks and third parties. Companies prefer to enter into joint venture with the host government. The most successful example is that of Suzuki. It entered into a joint venture with the Government of India to form Maruti Suzuki. Company can obtain host countrys guarantees for investment. They can minimize local retained earnings. If possible, the company should use transfer pricing.
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Management policies: To protect the information about the companys functioning, the following steps have to be taken: Minimize the role of host nationals at strategic points and limit locals to low and junior levels. Train and educate host country nationals to inculcate loyalty. If the host countrys nationals are at key positions, try to replace them. Logistics: Once the country risk has been assessed, it is necessary to: Locate the crucial segment of the companys process outside the country but near the country. Concentrate on R&D in the home country, making the subsidiary dependent on the parent company. Balance the production of goods among several locations, thus reducing dependence on a single location. Marketing management: Companys marketing policies should follow the following steps: Control markets wherever and whenever possible. Maintain control over distribution network including transportation of goods. Maintain a strong single global trademark. Government relations: The company should assess its own strengths and weaknesses and try to negotiate with the government to defend its interests. 2. Integrative approach: This approach aims at integrating the company with the host economy to make it appear local. The important strategies adopted are as follows: Financial strategies: The following strategies should be adopted for financing the projects in a host country: Raise equity from the host country and take credit from the local parties. Establish joint ventures with locals and the government. Ensure that internal pricing among subsidiaries and between headquarters and subsidiaries is fair.
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Management strategies: The following strategies are required to be adopted for integrating the company with the host country: Employ high percentage of locals in the organization Ensure that the expatriate understood the host environment Establish commitment among local employees Operations management: The following steps are required to be undertaken: Maximize localization in terms of sourcing, employment and research and development. Use local sub-contractors, distributors, professionals and transport system. Marketing management: Marketing policies should: Share markets with domestic players as collaborators. Appoint local distributors and use local network Maintain a strong single global trademark Government relations: A company should develop good and cordial relationships by: Developing and maintaining channels of communication with members of country elite Being willing to negotiate agreements that are fair to host government Providing expert opinion whenever asked for Providing public services
7. In ___________approach, the company tries to protect its interest by finding those aspects of the company that are beyond the reach of the host government. 8. The two approaches to country risk management are _________ and __________.
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12.6 Measurement of Country Risk

Risks that are faced by MNCs on an overseas direct investment are those related to the local economy. Among these, some may be due to the possibility of confiscation (government takeover without any compensation) and the rest may be because of the possibility of expropriation (government takeover with compensation). The other risks may be the political risks, risk of currency inconvertibility and restrictions on the repatriation of income beyond those reflected in the cash flows of an MNC. Before a company can consider how much of its country risk is systematic, it must be able to determine the risk in each country. One of the best-known country-risk evaluations is prepared by Euro money, a monthly magazine that periodically produces a ranking of country risks. It consults a cross-section of specialists. These specialists give their opinion on each country with regard to one or more factors used in their calculation. Three broad categories of factors are considered. These are analytical indicators, credit indicators and market indicators. The analytical indicators consist of economic and political-risk evaluations. The economic evaluation is based on the actual and projected growth in GNP. The political risk evaluation is provided by a panel of experts comprising risk analysts, insurance brokers and bank credit officers. The credit indicator includes measures of the ability of the country to service debts based on debt service versus exports, the size of the current account deficit or surplus versus GNP, and external debt versus GNP. Market indicators are based on assessments of a countrys access to bank loans, short-term credits, syndicated loans and the bond market as well as on the premiums occurring on recourse loans made to the exporters. Methods of reducing country risk Measures of country risk do not distinguish different risks facing different industries. They measure only the risk of countries. An MNC will have to reduce the country risk to gain. The various techniques that can be adopted by them are summarized as follows: Keeping control of crucial elements of corporate operations: Some companies making direct foreign investments try to prevent operations from running without their cooperation. This can be achieved if the investor maintains control of a crucial element of operations. For example, food and soft-drink manufacturers keep their special ingredients a secret. Auto companies can
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produce vital parts such as engines in some other countries and can refuse to supply these parts if their operations are seized. Programmed stages of planned divestment: An alternative technique for reducing the probability of expropriation is for the owner of an FDI to promise to turnover ownership and control to local people in the future. Joint ventures: Instead of promising shared ownership in the future, an alternative technique for reducing the risk of expropriation is to share ownership with foreign private or official partners from the very beginning. Such shared ownerships are known as joint ventures. Local debt: The risk of expropriation as well as the losses from expropriation can be reduced by borrowing within the countries where investment occurs. If the borrowing is denominated in the local currency, there will often also be a reduction of foreign exchange risk. Activity 2 Analyse the techniques used to reduce country risk. Put them down on a chart. Hint: Some of the techniques are joint ventures and local debt.
9. The economic evaluation is based on the actual and projected growth in GNP. (True/False) 10. Risk of expropriation as well as the losses from expropriation can be reduced by borrowing within the countries where investment occurs. (True/ False)
12.7 Governance of Country Risk Assessment

The country risk management strategy depends upon the type of risk and the degree of risk the investment will have. Investment in a country will prove to be profitable if it is managed right from the start. An MNC should not wait for a problem to arise but should go with a cautious approach.
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12.7.1 Incorporating Risk in Capital Budgeting

(i) Integration of risk in capital budgeting: If there is a chance of country risk, the discount rate should be increased taking care that it is in the starting years itself when the project may not be acceptable in a new country. The risk can be reduced by reducing the investment flow from parent company to subsidiary and the subsidiary can borrow from the host country. This will create a degree of acceptability of the subsidiary in the host country as it cannot run after using so much of funds in a project. A trade-off has to be struck between higher financing cost and lower country risk. (iii) Planned divestment: The company can plan to transfer the ownership title and control of the business to the local shareholders. This reduces the risk of expropriation. (iv) Insurance of risk: Investing firm can take an insurance against country risk.
12.7.2 Preventing Host Government Takeover

Forced disinvestment: Government may put pressure on firms to disinvest. Forced disinvestment may take place for various reasons such as: Government may believe that it may make better use of the assets. Takeover may improve the image of the government among the people of the country. Government wants to control these assets for strategic and developmental reasons. An example of forced disinvestment is the takeover of oil exploration. In India, most of the oil producing companies is nationalized though a few private players like Reliance have come up in the market. These forced disinvestments are legal under international law as long as they are accompanied by adequate compensation. Such takeovers do not involve the risk of total loss of assets. Forced disinvestments are practiced in two forms. (i) Takeover/nationalization: These are done as a matter of political philosophy. The government announces a policy for takeover or nationalization with a compensation package. The company owners are asked to withdraw from the management for the announced compensation which usually does not match with the expectation of the owners. Takeovers and nationalizations are usually done when the ideological
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base of the government changes from right or centralist to socialist or to communist ideology. (ii) Confiscation/expropriation with or without compensation: This is another form of forced disinvestment. In this form, the government expropriates a legal title to the property or the stream of income the company generates. Governments may also constrain the property owners in the way they use their property. Confiscation may be with a minimal compensation or even without compensation. This step may be taken by governments because of political rivalry among nations or because of idealistic shift in governments political philosophy. Undesired regulations: These regulations reduce the profitability of MNCs. In this type of risk, the government expropriates legal title to property or the stream of income the company generates. Governments may also constrain the property owners in the way they use their property. Confiscation may be with a minimal compensation or even without compensation. This step may be taken by governments because of political rivalry among nations or of idealistic shift in governments political philosophy. Interface with operations: This refers to any government activity that makes it difficult for business to operate effectively. This risk includes things as governments encouragement of unionization, governments expression of negative comments about foreigners and discriminatory government support to locally owned and operated business. Governments generally engage in these kinds of activities when they believe that a foreign companys operation could be detrimental to the local development or would harm the political interest of the government. Political risk: Political risk due to government interface with business is difficult to assess and manage because the actions are done in a subtle way. Forced disinvestment and undesired regulations have identifiable and immediate impact on foreign business but the interface with operations may be less obvious and the effects are unclear. Social strife: In any country, there may be social strife arising due to ethnic, racial, religious, tribal or civil tensions. Natural calamities such as drought and floods may also cause economic dislocation. It means general breakdown of government machinery leading to economic disturbance giving rise to political risk.
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Negotiating agreements with the host government: It would be advisable if an investing company talks with the government of the host country before starting a project so that issues that might cause hostility are dealt with in the initial stages. It will also create a degree of acceptability among the government as an agreement is already signed. Joint-ventures and concession agreements: In a joint-venture agreement, local shareholders who are influential can force the government to take decisions to their advantage. For example, when Maruti Suzuki entered India, they entered into a joint venture with the Government of India, so that there would be no hindrance to the project. Political support: A host country will act in favour of MNCs if it gets a strong financial backing from them. Structure operating environment: Country risk can be reduced by creating linkage of dependency between the operation of the firm in a high-risk country and the operation of other units of the same firm. Anticipatory planning: Investing company should take necessary precautions against country risk before or after the investment has been made by chalking out different courses of action for the possible situations that might arise. 1. Goal conflicts with economic policies: Conflicts between the objectives of MNC and host governments have risen over such issues as the firms impact on economic development, perceived infringement on national sovereignty, foreign control of key industries, sharing of ownership and control with local interests, impact on host countrys balance of payment, influence on the exchange rate and control over export market and the use of domestic versus foreign executives. Economic policies of a government aim at achieving sustainable rate of growth in per capita, gross national product, full employment, price stability, external balance and fair distribution of income. The policies through which these objectives are to be achieved are as follows: o Monetary policies and goal conflicts: Through monetary policies, the government controls the cost and availability of domestic credit and long-term capital as a means of achieving national economic priorities. MNCs can circumvent the policy by turning to the parent. If credit flow is restricted and it has become costlier, the MNC can implement its spending plans with the help of the parent company.
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Local competitors then face the crunch, thus changing the competitive position of the domestic companies. o Fiscal policies and goal conflicts: To attract FDI, the government commits tax concession and sometimes even provides subsidies. After some time, when the government wants to achieve revenue targets, the MNCs are insulated because of the commitments, and therefore the achievement falls short of targets. o Trade policies and economic protectionism: Nationalistic economic policies are often made to protect the domestic industry. To protect the domestic industry from competition tariff and nontariff barriers are used. o Balance of payment problems: Repatriation by MNCs puts pressure on the much needed foreign exchange resources. The outflow is in the form of dividend management fees, royalty, etc. which puts pressure on the balance of payment. o Economic development policies and goal conflicts: The government puts protective tariffs or restrictions on foreign investment to protect the companies that are in the infant stage or old industries as the case may be. 2. Corruption: Political corruption and blackmail contribute to the risk. Corruption is endemic to developing countries. If these bribes are not paid, the projects are either not cleared or delayed through bureaucratic system.
11. A trade-off has to be struck between higher financing cost and____________ 12. Through__________, the government controls the cost and availability of domestic credit and long-term capital as a means of achieving national economic priorities. 13. ___________by MNCs puts pressure on the much needed foreign exchange resources.
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12.8 Case Study

Cases of Political Risk in Host Countries Rich in Minerals Political risks such as law and order problems, widespread conflict and corruption are causing a lot of problems for a number of Indian companies who are looking forward to invest in several African and Latin American countries. Some of these companies are Vedanta Resources, Essar Group and Jindal Steel & Power. Moreover, the host countries have also imposed royalties and raised taxes in order to continue their hold over their minerals. Most of the mining projects do not receive protection guarantees from multilateral agencies. Attempt is made to minimize the chances of incidents that have taken place in the past. For instance, Jindal Steel & Power was forced to file a claim in the International Court of Arbitration against the Bolivia Government for not sticking to a pact that was signed between the company and the Bolivia Government. Under this pact, the Indian majors were granted land for $ 2billion iron ore mining project. However, the Bolivian government encashed the bank guarantee without providing the land to the Jindals. On another occasion, Essar Group was faced with delay in the completion of the revival programme for state-owned Zimbabwe Iron & Steel. The company acquired the deal for an amount of $ 750 million in 2010. Through the deal, the company was to receive an 80 per cent stake in an iron ore mine with one of the largest deposits in the world. However, some ministers in Zimbabwe did not accept the grant of control to the mines resulting in delay. The Indian companies that are operating in these countries are demanding for political risk cover but the re-insurers are not willing to provide this or are increasing the premium. A total of around 6-7 Indian Insurance companies offer political risk insurance policy and in most of the companies the finance professionals carry out the risk assessment. Mapping of risk is conducted by variables such as exposure, threat and vulnerability. Indian companies are also better equipped in dealing with factors such as socio-political complexity and uncertainty. However it is also true that most of the companies do not have a structured approach to handling risks. The issue of risk perception about investing in resource-rich countries is making the Indian firms set up dedicated risk management teams that can forecast potential threats and decrease the impact.
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Questions 1. What are the risks that are faced by the Indian companies in mineralrich host countries? 2. Do you think the measures taken by the Indian companies will minimize the risk of investing in mineral-rich countries? Source: Compiled by Author
12.9 Summary
Let us recapitulate the important concepts discussed in this unit: Country risk can be defined as the risk of losing money due to changes occurring in a countrys government or regulatory environment. The frequency of changes in the government of a country, the level of violence in the country, etc dictates the political stability of a country. Risk assessment agencies provide country risk indices which are used to assess the political stability of a country. The qualitative approach involves examination and interpretation of diverse secondary facts and figures. On the past trends of events, future trends are assessed (Kramer, 1981). Risks that are faced by MNCs on an overseas direct investment are those related to the local economy. The aim of economic policies of a government is to achieve sustainable rate of growth in gross national product, per capita, full employment, external balance, price stability and fair distribution of income.
12.10 Glossary
Fiscal: Of or related to government finances, especially tax revenues Risk Assessment: The process of determination of the likelihood that a specified negative event will occur Calamities: An event leading to terrible loss, lasting distress, or severe affliction; Insurrection: The act or an instance of open revolt against civil authority or a constituted government
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Confiscate: Seize private property for the public treasury Currency inconvertibility: Inability of a local currency to be exchanged for another currency Strife: Heated, often violent dissension

1. Define political stability. 2. What are the factors that determine the political risk for a country? Discuss. 3. What is a country risk index? Explain the categories classified by the business environment risk information (BERI). 4. Discuss the approaches to country risk management. 5. Explain the techniques adopted by MNCs to reduce country risk. 6. What is the main aim of economic policies? State the objectives through which they are achieved.

1. Political stability 2. Controlled exchange rate system 3. Countrys government 4. True 5. True 6. False 7. Defensive 8. Defensive approach, integrative approach 9. True 10. True 11. Lower country risk 12. Monetary policies 13. Repatriation
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1. Political stability means the frequency of changes in the government of a country, the level of violence in the country, etc. A country is called politically stable if there are no frequent changes in the government and the level of violence is low or nil. For further details, refer to Section 12.3. 2. The factors determining the extent of political risk for a country are broadly classified into: o Country-related factors o Company-related factors For further details, refer to Section 12.3. 3. The country risk index tries to incorporate the economic, geographical and social aspects and measures overall business climate of a country. Business Environment Risk Information (BERI) classifies countries into different categories on the basis of risk perception: o Low-risk countries o Medium-risk countries o High-risk countries o Prohibitive-risk countries For further details, refer to Section 12.4. 4. There are two approaches to Country Risk Management. They are: o Defensive approach o Integrative approach For further details, refer to Section 12.5. 5. The techniques of reducing country risk are: o Keeping control of crucial elements of corporate operations o Programmed stages of planned divestment o Joint ventures o Local debt For further details, refer to Section 12.6.
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6. Economic policies of a government aim at achieving sustainable rate of growth in per capita, gross national product, full employment, price stability, external balance and fair distribution of income. The policies through which these objectives are to be achieved are as follows: o Monetary policies and goal conflicts o Fiscal policies and goal conflicts o Trade policies and economic protectionism o Balance of payment problems o Economic development policies and goal conflicts For further details, refer to Section 12.7.2.
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing. Kumar, Neelesh. International Financial Management. Delhi: Vikas Publishing.
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Structure
International Taxation
13.1 Caselet 13.2 Introduction Objectives 13.3 Bases of International Tax System 13.4 Principles of Taxation 13.5 Double Taxation 13.6 Tax Havens 13.7 Transfer Pricing 13.8 International Tax Management Strategy 13.9 Indian Tax Environment 13.10 Case Study 13.11 Summary 13.12 Glossary 13.13 Terminal Questions 13.14 Answers Reference/e-Reference
13.1 Caselet
Indian finance minister Palaniappan Chidambaram to review tax law that landed Vodafone with $2bn bill A review of retrospective tax laws that landed British mobile phone giant Vodafone with a $2.2bn bill have been ordered by Indias new finance minister Palaniappan Chidambaram. The overseas firms which use tax havens for the completion of deals involving Indian companies have been targeted by the controversial legislation of the country. In the year 2007, Vodafone purchased a 67 per cent stake in Hong Kongbased Hutchison Whampoas Indian cellular unit. The deal was finalized between the Dutch subsidiary of Vodafone and a company that is based in the Cayman Islands, a tax haven, holding the India assets of Hutchison Whampoa. Under the laws that are present now, Vodafone has been hit with a $2.2bn (1.4bn) tax bill. Chidambaram stated that any apprehension or distrust that the investors might have should be removed as investment requires
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faith and trust. He also stated that factors such as a stable tax regime, a non-adversarial tax administration, clarity in tax laws and an independent judiciary will also offer great assurance to the investors. However, Vodafone argues that it is illegal of India to apply tax law changes. They are also looking for international arbitration. He also said that the government would try to lessen the cost of borrowing for easing the strain on businesses and consumers. We are conscious that current interest rates are high, he said. High interest rates inhibit the investor and are a burden on every class of borrowers. Sometimes it is necessary to take carefully calibrated risks in order to stimulate investment and to ease the burden on consumers. We will take appropriate steps in this regard. Source: Adapted from http://www.telegraph.co.uk/finance/newsbysector/ mediatechnologyandtelecoms/telecoms/9457831/Indian-finance-ministerPalaniappan-Chidambaram-to-review-tax-law-that-landed-Vodafone-with2bn-bill.html Accessed on 13 August 2012
13.2 Introduction
In the previous unit, you learnt about the country risk factors and the assessment of country risk factors. You also studied about the techniques of accessing country risk. You understood how country risk is measured and how risk is incorporated in capital budgeting. The topics related to the governance of country risk assessment and preventing host government takeovers were also discussed. Uncertainty from business cannot be undermined, but that should not be a deterrent for being a showstopper. But in reality a business can be managed in such a way that it transforms into a planned uncertainty. Certain risks can be managed by hedging, tax planning and insurance. For this, we need to understand the environment of tax system. In this unit, you will learn about the bases of international tax system and the principles of taxation. You will study about double taxation, tax havens and transfer pricing. You will also learn about international tax management strategy and Indian tax environment.
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Objectives
After studying this unit, you should be able to: define the bases of international tax system and the principles of taxation discuss double taxation, tax havens and transfer pricing assess international tax management strategy and the Indian tax environment
13.3 Bases of International Tax System

The international tax system is expected to be neutral and equitable. Being neutral means it should not affect the economic efficiency. Moreover, a firm should not be taxed twice for the same income. Let us understand these concepts in detail.
13.3.1 Tax Neutrality

The concept of neutrality of international taxation is based on the concept of economic efficiency. An MNC gives importance to the calculation of tax when it is considering the distribution of capital among different countries. In case the tax is neutral, it will not be affected either by the location where the investment is made or by the nationality of the investor who makes the investment. An MNC will benefit if it transfers its investment from a country with lower return to a country with higher return, thereby increasing World welfare. Domestic neutrality provides equal treatment to the residents and nonresidents. The key issue to be seen is whether the marginal tax burden is equalized between home and host countries and would such equalization be desirable. This form of neutrality involves: Uniformity in both the applicable tax rate and determination of taxable income Equalization of all taxes on profits Foreign neutrality in taxation means that the tax burden placed on the foreign subsidiaries of a firm should equal that imposed on foreign-owned competitors operating in the same country. Horst (1980) has explained tax neutrality in terms of capital-export neutrality and capital-import neutrality. Capital-export neutrality means that the rates of taxes should be the same between domestic and foreign investment. Investors
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are indifferent to domestic and foreign investment. This is possible when pre-tax and post-tax returns on capital are the same between the capital exporting country and the capital importing country. Capital-import neutrality occurs when the same tax rate is applied to the income of all firms competing in the same capital-importing country so that no firm, neither domestic nor foreign, enjoys any competitive advantage. As tax bases are different, it is not easy to achieve capital-import neutrality.
13.3.2 Tax Equity

The principle of tax equity is based on the fact that all the similarly situated tax payers should participate in the cost of operating the government according to the same rules. This can be understood in two ways. One is that the contribution of each payer should be in conformity with the amount of public services he or she receives. The other is that each tax payer should pay taxes according to his or her ability to pay. It means that a person with greater ability should pay a greater amount of tax. But when there is more than one tax jurisdiction, it becomes difficult to define the concept of equity. Activity 1 Make a report of the differences between tax neutrality and tax equity. Hints: The concept of neutrality is based on the concept of economic efficiency. The principle of tax equity is based on the fact that all the similarly situated tax payers should participate in the cost of operating the government according to the same rules.
1. The concept of ____________ of international taxation is based on the concept of economic efficiency. 2. ____________ means that the rates of taxes should be the same between domestic and foreign investment. Investors are indifferent to domestic and foreign investment.
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13.4 Principles of Taxation

Two common principles of international taxation are the residence principle and the source principle. The residence principle calculates the tax liabilities by considering the place where the tax payer resides and the source principle law considers the source of income of the tax payer as the basis of assessing tax liabilities. Residence principle: Residents of a country are taxed uniformly on their world-wide income, regardless of the source of that income whether it is domestic or of foreign origin. Non-residents who earn in home country are not taxed by the home country on their income originating in that country. Source principle: Income originating in the home country is uniformly taxed, regardless of the residency of the receiver of the income. Residents of the home country are not taxed by the home country on the foreign source of income. Countries may adopt any of the two principles in their pure form. They may also use a mixture of these two principles. A mixture of these two principles, either within the same country or among different countries, may involve double taxation on the same income. Double taxation is removed by a system of domestic tax credits for foreign taxes. If all countries stick to the same pure principle, i.e., either residence or source principle, there will be no double taxation. If both home country and foreign country adopt the residence principle, then all the four categories of income will be taxed only once. The categories are follows: Income of home country residents originating in home country is taxed only by home country. Income of residents of home country originating abroad is taxed only by the home country. Income of residents of a foreign country originating in the home country is taxed only by the foreign country. Income of the residents of a foreign country originating in the foreign country is taxed only by the foreign country. For tax purposes, countries treat individuals differently than corporations. In most developed countries, individuals are taxed according to the residence principle, i.e. home country taxes their foreign source income while foreign country usually exempts non-residents or withholds tax at relatively low rates.
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The international operations of a firm have to bear three kinds of taxes: Income tax: Major part of the tax revenue in a country is that of tax on personal income as well as corporate income tax. This tax is levied on income arising out of a firms operation but the rate of tax varies from one country to another. Value-added tax: It is a tax levied on the value added at different stages of production of a commodity or services. VAT is an indirect tax and is preferred to direct income tax as it discourages unnecessary consumption and is easier to collect. Withholding tax: It is a tax levied on passive income earned by an individual or a corporate body. Passive means that the income arises in some other country. Let us take an example that an MNC in India gets dividends from its subsidiary operating in London and pays tax on the dividend income to the Government of India. The dividend income is a passive income. The tax on such income is called the withholding tax as the MNC receiving the dividend withholds the tax borne by the shareholder and passes the tax amount to the tax authorities. Passive income may be in the form of dividend income, income from royalty and technical service fees and income from interest.
3. Withholding tax is a tax levied on the value added at different stages of production of a commodity or services. (True/False) 4. Two common principles of international taxation are the residence principle and the source principle. (True/False)
13.5 Double Taxation

Double taxation is one of the risks associated with doing business outside the home country. Business transactions may be subject to tax both in the country of their origin as well as of their completion. An item of income can be subjected to tax in one country on the basis of residential status and in another country on the basis of the fact that income was earned in that country. Corporate income tax is levied when a firm earns income but if the posttax income is remitted to foreign countries, the recipient of such income is taxed again. Double taxation reduces the incentive of an MNC to invest. For this
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purpose, the entire income from foreign sources should be exempted from tax. We will discuss different methods used to avoid double taxation later in the unit. Tax burdens differ in various countries because: Statutory tax rates differ across countries. Differences exist in the definitions of taxable corporate income. Interpretation of how to achieve tax neutrality differs. Treatment of inter-company transactions. Tax system like single tax, double tax and partial double tax. Treatment of tax deferral privilege. However, relief against such hardships can be provided. The following are the two ways: 1. Bilateral relief: The two sovereign states concerned can come to a mutual agreement through which relief against double taxation can be worked out. This agreement can be of two kinds. One kind of agreement states that the two countries concerned come to the conclusion that certain incomes that are likely to be taxed in both countries will be taxed in only one of them. It further states that only a specified portion of the income should be taxed by each of the two countries. The other agreement states that though the income is subjected to tax in both the countries, the assessee is given a deduction from the tax payable by him in the other country. It is usually the lower of the two taxes paid. 2. Unilateral relief: Unilateral relief takes place when no agreement exists for relief against double taxation. Section 91 of the Income Tax Act provides for such kind of relief. Bilateral relief is always not sufficient to meet all cases. Thus, at such times, unilateral relief is provided irrespective of the fact whether the country concerned has any agreement with the other country or has provided for any kind of relief related to double taxation.
5. ___________is levied when a firm earns income but if the post-tax income is remitted to foreign countries, the recipient of such income is taxed again. 6. ____________takes place when no agreement exists for relief against double taxation.
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13.6 Tax Havens

A tax-haven country is one that has zero rates or a very low rate of income tax and withholding tax. MNCs are accused of (MIS) using tax havens to shield income from the local tax collector. R. Gordon (1981) has given the following features of tax-haven countries: Strict rules on secrecy and confidentiality with respect of business transactions Relative importance of banking and other financial activities Lack of currency controls Governmental measures promoting tax-haven status Alworth (1988) groups the tax havens into four types: (i) Those having no income or corporate gain tax: The countries that can be covered under this head are Bahamas, Bermuda, The Cayman Islands, Nauru, New Hebrides and Turks and the Caicos Islands. Governments of these countries do not impose any specific rate of taxes but has fixed a small amount of tax. This ensures that MNCs get a long-term guarantee against taxes. (ii) Those having a very low rate of tax: The countries that can be covered under this head are British Virgin Islands, Netherlands, Antilles, Montserrat, Gersey, Guernsey and Isle of Man. Tax rates are low in these countries. Also, special tax privileges are provided to shipping, aviation and holding companies. (iii) Those exempting from tax all income from foreign sources: Thecountries that can be covered under this head are Costa Rica, Hong Kong, Liberia and Panama. The governments of these countries tax only locally generated income and not the income coming from the foreign sources. (iv) Those allowing special tax privileges in specific cases: The countries that can be covered under this head are Luxembourg, Netherlands, Switzerland, Liechtenstein, Gibraltar, Barbados and Grenada. In the first four countries, special tax privileges are provided to qualified holding companies, while in the latter three countries, low rates of taxes are applicable to special-status companies or to international business companies.
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Before selecting the type of tax haven to use, MNCs must develop a framework to evaluate its projected needs and what benefits would it get by the use of tax havens. Factors considered in choosing a tax haven include: The political and economic stability of the country and the integrity of its government Attitude of a country towards tax-haven business Taxes other than income tax Tax treaties Banking facilities Infrastructure facilities Liberal incorporation laws that would minimize both the cost of incorporation and the length of time it takes to incorporate The long-range prospects for continued freedom from taxation It has become a practice among many companies to avoid paying taxes to the government. But ever since the governments of different countries have started cracking down these unlawful activities, many countries that were earlier considered to be a tax haven have started sorting things at their ends. Take the example of Switzerland. It has developed a negative image by helping the corporate to avoid tax.
7. A tax-haven country is one that has zero rates or a very low rate of income tax and withholding tax. (True/False) 8. Tax haven is a factor considered in choosing a tax treaty. (True/False)
13.7 Transfer Pricing

Transfer pricing is a method of pricing of goods and services between parent and subsidiary or between two subsidiaries. It is a technique used to transfer funds from one location to another. It helps in positioning the funds at a desired location. It is a pricing technique for inter-corporate transactions. There are different subsidiaries of an MNC that operate in some or different countries that may be linked due to vertical or horizontal linkages.
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Example 13.1: A garment manufacturing unit may be buying the raw material from its subsidiary. This is a vertical linkage. Raw material will be charged at a transfer price from the subsidiary. Determination of transfer prices Transfer prices are set on the basis of arms length prices. These are the prices prevailing in transactions between unrelated parties engaged in similar or the same trade under similar conditions in the open market. There are two components involve (a) Market price (b) Cost of production When a firm can sell its output either to its subsidiary or to any other firm in the market, it is an open market. When there is an open market, arms length price is equal to the market price. Figure 13.1 gives an example of an open market.
Subsidiary A
Subsidiary B Parent Subsidiary C
Subsidiary D
Figure 13.1 Example of Open Market Source: Compiled by Author
Transfer Price = Market Price Subsidiary A will sell its product to Subsidiary B at the market price, because if Subsidiary B does not buy from it, it can sell the product to other companies in the market. If it sells at less than the market price, it will be decreasing its profit. Here, we can clear the concept of the uncontrolled market price and resale price.
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Uncontrolled market price: It is the direct way of calculating arms length price. Uncontrolled sales are made to an unrelated party outside the firms own network. Resale price is the price at which the product that has been bought from a subsidiary is resold to an independent buyer. The reseller margin (cost + profit) will be deducted to find the arms length price. This method is used when a comparable uncontrolled market price does not exist or the reseller margin is not much. A multinational company can help achieve the goal by shifting profits from high-tax to low-tax jurisdictions. For example, take Hungary, with a corporate tax rate of 16 per cent, and France, with a tax rate of 35 per cent. An MNC with divisions in these two locales will benefit by shifting more profit toward Hungary and less to France. Each division is controlled by corporate headquarters, which can set a transfer price to benefit the entity as a whole.
9. ____________is a technique used to transfer funds from one location to another. It helps in positioning the funds at a desired location. 10. ____________is the price at which the product that has been bought from a subsidiary is resold to an independent buyer. 11. When a firm can sell its output either to its subsidiary or to any other firm in the market, it is an __________.
13.8 International Tax Management Strategy

The strategy for an international firm is to minimize overall tax burden of the firm so that it can increase the profits. For this, an international firm has to decide whether the profits of the subsidiaries should lie with them, thereby delaying their repatriation to the parent in order to evade taxes at home. In this way, the profits would be reinvested in profitable channels and the corporate wealth of the subsidiary will increase but if the repatriation is delayed, the parent will not get net cash inflow and this will be against the basic purpose of investment in the subsidiary. The MNC has to trade-off between the repatriation of dividend and retention of earning with the subsidiary. The objective of minimization of tax burden also depends on the cost allocation between different units of the firm. If a firm allocates more cost in a
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high-tax country and shows greater profits in a low-tax country, the total tax burden would be reduced. But there are limits to cost allocations, for which the firm has to adopt the transfer pricing principles. The tax management strategy helps the firm to decide whether the foreign operation should take the form of either a branch or a subsidiary. If it is expected that foreign operation will incur huge losses in the near future, it would be better to operate through branches. Whatever strategy is adopted by a firm, it needs to consider the tax provisions in home as well as the host country. An MNC has the flexibility to plan international taxation in such a way so as to structure its foreign operations and to plan remittance policy in order to maximize global after-tax cash flows.
12. The strategy for an international firm is to minimize overall tax burden of the firm so that it can increase the profits. (True/False) 13. If a firm allocates more cost in a high-tax country and shows greater profits in a low-tax country, the total tax burden would increase. (True/ False)
13.9 Indian Tax Environment

The Income Tax Act in India has provisions for taxation of income from foreign sources. It provides tax incentives to those investing in India. It also has norms for avoiding double taxation. All these have been designed to attract scarce foreign exchange for the Indian economy. The tax laws first determine the resident status of an individual. This status for an individual depends on the duration of his stay in India. A company is treated as a resident or a non-resident depending upon whether the control and management of the company is wholly in India or outside. The tax liability on earnings is fixed in the following manner. Any person who was a resident in the previous year is liable to pay tax in India on the total income it earns. The income comprises: Income received or deemed to be received in India Income accrued or deemed to have accrued in India
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Income that accrues outside India Non-residents are taxed only in the first two cases, i.e. income received or accrued or deemed to have received and accrued in India. The Act provides tax subsidies to residents with respect to income from foreign sources, and at the same time, provides incentives to non-resident Indians with regard to their investments in India. Tax incentives for residents on earnings from foreign sources The residents get tax deductions on some forms of income as follows: The profits of newly established industrial units in EPZ/SEZ/100 per cent EOU are completely exempted from tax provided their export accounts for at least 75 per cent of the total sales. Any resident enterprise involved in infrastructure projects or in assembly/ installation of machinery and plant outside the country can claim 50 per cent deduction while computing taxable income. 30 per cent of the profits from export made directly or through export houses are granted tax deductions. Taxes for foreign enterprises in India NRIs enjoy tax exemptions on their income accrued in India. The income may be in the form of business profit, salary, royalty, fees, interest and other payments. The provision of the Act is that the income accruing in India from news agency, royalty, fees, purchase of goods for export purpose and interest on bonds and securities are exempted from tax in India. Companies resident in India are subject to the Indian tax on their income, generally on an accrual basis, from all sources inside or outside India and whether or not remitted to India. Branch income The income of all foreign branches is taxed in India as part of the Indian companys worldwide taxable income. Similarly, the losses of all foreign branches are deductible in computing the worldwide taxable income. In computing the income or loss of a foreign branch, a deduction is generally allowed for all expenses incurred wholly and exclusively for the purpose of the business that are not of a capital or personal nature. Income is taxed whether or not repatriated. If the branch income incurs tax in the foreign country, credit is given in India to the extent of the lesser of the foreign tax paid or the Indian tax on the foreign income, either unilaterally or under treaty.
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Foreign subsidiary income Dividends of foreign subsidiaries when declared (and interim dividends when they are made unconditionally available) are included in the worldwide taxable income of the Indian company. Profits not distributed by the foreign subsidiary are not taxed in the hands of the Indian company. Treaties often provide for lower foreign withholding tax. No credit is given for underlying tax paid by the foreign subsidiary. Income Tax Act, 1961 [Section 43 (5)1] Speculative transaction refers to a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity. Provided that for the purpose of this clause: (a) A contract in respect of raw materials or merchandise entered into by a person in the course of his manufacturing or merchandising business to guard against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him; or (b) A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations. Section 73 Losses in speculation business 1. Any loss, computed in respect of a speculation business carried on by the assessee, shall not be set off except against profits and gains, if any, of another speculation business. 2. Where for any assessment year any loss computed in respect of a speculation business has not been wholly set off under sub-section (1), so much of the loss as is not so set off or the whole loss where the assessee had no income from any other speculation business, shall, subject to the other provisions of this chapter, be carried forward to the following assessment year, and: It shall be set off against the profit and gains, if any, of any speculation business carried forward to the following assessment year; and
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If the loss cannot be wholly set off, the amount of the loss not so set off shall be carried forward to the following assessment year, and so on. 3. In respect of allowance on account of depreciation or capital expenditure on scientific research, the provisions of sub-section (2) of Section 72 shall apply in relation to speculation business as they apply in relation to any other business. 4. No loss shall be carried forward under this Section for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed. Explanation: Where any part of the business of a company (other than a company whose gross total income consists mainly of income which is chargeable under the heads Interest on securities, Income from house property, Capital gains and Income from other sources or a company the principal business of which is the business of banking or the granting of loans and advances) consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares. Activity 2 Examine how the Income-Tax Act 1961 has affected the tax environment in India. Hint: The Income-Tax1961Act provides for levy, administration, collection and recovery of Income.
14. The___________in India has provisions for taxation of income from foreign sources. It provides tax incentives to those investing in India. 15. ___________refers to a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity.
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13.10 Case Study

Indian IT industry: New Tax Rules Reduce Litigation The PMs move of setting up a panel in order to clarify taxation policies that are related to the IT industry has been welcomed by the IT industry, IT sector analysts and taxation experts. This move states that a taxation regime in line with the best international practices would lead to an improvement in the investor confidence. In the Finance Bill in 2010, Safe harbour provisions were announced whose aim was to resolve disputes and provide certainty to the taxpayers. Though the framework prepared for the safe harbour provisions have been finalized by the Central Board of Direct Taxes (CBDT), it has still not been operationalized. Both the taxpayers and the tax authorities are benefited by the Safe harbour provisions in the determination of transfer price international transactions. Safe harbour defines circumstances where the revenue authorities would accept the transfer pricing that has been declared by the assessee. This generally takes place without much scrutiny. The taxpayers are also provided with certainty and relief from compliances and associated costs. At the same time, the tax authorities will also be relieved of much of their administrative burden. Senior director in Deloitte India, stated that the step taken can lead to much needed litigation relief to the taxpayers who are faced with aggressive transfer pricing audits in India. He also said that the move is a positive one as it leads to an increase in the confidence of foreign companies in the setting up or in the expansion of their operations in India. In fact, the safe harbour regulations proposed by the industry did not see much traction and it is important that India comes out with a clear position on the safe harbour rules and make it attractive for companies to come under the regime rather than litigate with the tax authorities, said the head of tax disputes resolution, KPMG. Activities such as analytical work, software development and product development are conducted by a number of MNCs through captive entities in India. In India, over 750 MNCs have such centres in India. Transfer pricing margin is specified by safe harbour rules for such transactions which are repetitive in nature and in case where the foreign parent company uses India as a development centre.
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He also stated that at present, the tax authorities have an aggressive approach to transfer pricing margins and they compare such development centres to a fully fledged company comprising all kinds of associated risks. Questions 1. Do you think the move taken for setting up a panel to clarify taxation policies is a beneficial one? 2. What do you understand by safe harbour? Source: Adapted from http://articles.timesofindia.indiatimes.com/2012-0731/software-services/32961047_1_safe-harbour-tax-authorities-transferprice Accessed on 8 August 2012
13.11 Summary
Let us recapitulate the important concepts discussed in this unit: The international tax system is expected to be neutral and equitable. The concept of economic efficiency forms the basis of the concept of neutrality of international taxation. An MNC gives importance to the calculation of tax when it is considering the distribution of capital among different countries. The principle of tax equity is based on the fact that all the similarly situated tax payers should participate in the cost of operating the government according to the same rules. Residence principle and the source principle are the two common principles of international taxation. The difference between the residence principle and the source principle may be viewed as the difference between taxing the net national product (NNP) and taxing the net domestic product (NDP). A country with a zero rate or a very low rate of income tax and withholding tax is known as a tax-haven country. Corporate income tax is levied when a firm earns income but if the posttax income is remitted to foreign countries, the recipient of such income is taxed again. Provisions for the taxation of income from foreign sources are provided by the Income Tax Act in India.
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13.12 Glossary
Equitable: Marked by or having equity Marginal: The total cost incurred to a company for producing one more unit of a product Jurisdiction: The right, power and authority of interpreting and applying law Arbitrary: Not restrained or limited in the exercise of power Accrual: The adding together of interest or different investments over a period of time

1. Define capital-export neutrality and capital-import neutrality. 2. Explain the two principles of international taxation. 3. Discuss the kinds of taxes that the international operations of a firm have to bear. 4. What is double taxation? Discuss. 5. Explain a tax-haven country. State the features of tax-haven countries. 6. Define transfer pricing. 7. State some forms of income on which the residents receive tax deductions.

1. Neutrality 2. Capital-export neutrality 3. False 4. True 5. Corporate income tax 6. Unilateral relief 7. True
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8. False 9. Transfer pricing 10. Resale price 11. Open market 12. True 13. False 14. Income Tax Act 15. Speculative transaction

1. When the rates of taxes are the same between domestic and foreign investment, it leads to Capital-export neutrality. Capital-import neutrality occurs when the same tax rate is applied to the income of all firms competing in the same capital-importing country so that no firm, neither domestic nor foreign, enjoys any competitive advantage. For further details, refer to Section 13.3.1. 2. Two common principles of international taxation are the residence principle and the source principle. For further details, refer to Section 13.4. 3. The kinds of taxes that the international operations of a firm have to bear are: Income tax Value-added tax Withholding tax For further details, refer to Section 13.4. 4. Double taxation is one of the risks associated with doing business outside the home country. It reduces the incentive of an MNC to invest. For further details, refer to Section 13.5. 5. A tax-haven country is one that has zero rates or a very low rate of income tax and withholding tax.
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The features of tax-haven countries presented by R. Gordon (1981) are as follows: Strict rules on secrecy and confidentiality with respect of business transactions Relative importance of banking and other financial activities Lack of currency controls Governmental measures promoting tax-haven status. For further details, refer to Section 13.5. 6. Transfer pricing is a method of pricing of goods and services between parent and subsidiary or between two subsidiaries. For further details, refer to Section 13.6. 7. The residents get tax deductions on some forms of income as follows: The profits of newly established industrial units in EPZ/SEZ/100 per cent EOU are completely exempted from tax provided their export accounts for at least 75 per cent of the total sales. Any resident enterprise involved in infrastructure projects or in assembly/installation of machinery and plant outside the country can claim 50 per cent deduction while computing taxable income. For further details, refer to Section 13.7.
Kaur, Dr. Harmeet. International Financial Management.Delhi: Vikas Publishing.
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Structure
Foreign Direct Investment, International Portfolio and Cross-Border Acquisitions
14.1 Caselet 14.2 Introduction Objectives 14.3 Flow of Foreign Direct Investments (FDI) 14.4 Cost and Benefits of FDI 14.5 ADR and GDR 14.6 Concept of Portfolio 14.7 Cases on Cross Border Acquisitions 14.8 Case Study 14.9 Summary 14.10 Glossary 14.11 Terminal Questions 14.12 Answers Reference/e-Reference
14.1 Caselet
GOI & RBI to announce GDR guidelines: UK Sinha SEBI Chairman UK Sinha stated in an interview that SEBI has never been influenced by politics and he further asserted this statement by saying that the track record of the market regulator proves it. He also said that capital market regulator SEBI is aware of its responsibility towards conducting reforms and working towards a strong financial market. When asked about the crucial issue of misusing global depository receipts (GDR), it was stated by UK Sinha that the Reserve Bank of India and the government are likely to announce GDR guidelines soon. He also informed that the recommendations on GRD guidelines have already been presented by the SEBI to the government. According to Sinha, the GDR proceeds are being misused by several firms for trading purposes. Following this, in recent times, the SEBI has also banned many firms that were found to be manipulating share prices after issuing GDRs.
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There has also been a concern about the vacancies of whole-time members in the SEBI board and addressing this issue, UK Sinha stated that the government would be appointing members by the book. Source: Adapted from http://www.moneycontrol.com/news/business/ govtrbi-to-announce-gdr-guidelines_741012.html Accessed on 7 August 2012
14.2 Introduction
In the previous unit, you learnt about the bases of international tax system as well as the principles of taxation. You also learnt about double taxation, tax havens and transfer pricing. In addition to this, you also studied about international tax management strategy and Indian tax environment. In this unit, you will learn about the flow, cost and benefits of Foreign Direct Investment. You will also study about ADR and GDR as well as the concept of portfolio. In addition to these, you will also study about cases on cross border acquisitions.
Objectives
After studying this unit, you should be able to: define the concept of FDI describe ADR and GDR assess the concept of portfolio explain cases on cross border acquisitions
14.3 Flow of Foreign Direct Investments (FDI)

When an investor based in one country acquires an asset in another country so as to manage that asset, it is known as Foreign Direct Investment (FDI). FDI inflows into a country by a foreign investor are with long-term commitment. Given the appropriate host-country policies and a basic level of development, it has been shown that FDI triggers technology spillovers, assists human capital formation, contributes to international trade integration, helps create a more competitive business environment and enhances enterprise development. All these contribute to a higher economic growth. Beyond the initial macro-economic stimulus for actual investment, FDI influences growth by increasing total factor
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productivity. Technology transfers through FDI generate positive externalities in the host country. The benefits from FDI do not accrue automatically and evenly across countries and sectors. In order to reap the maximum benefits from FDI, there is a need to establish a transparent, broad and effective enabling policy environment for investment and to put in place appropriate framework for their implementation. Such an environment must provide incentives for innovations and improvement of skills and contribute towards improved competitiveness. FDI is needed for promoting economic growth of the host country. It increases the domestic savings and lowers the cost of production. The company that comes to the country will bring technical know how to the country and promotes employment. FDI indirectly promotes the specialization of labour and induces the implementation of rational policies. Factors for low FDI inflow into India According to the latest AT Kearney report on FDI Confidence Index, some of the most prominent deterrents for companies to invest in India are bureaucracy (Lengthy FDI approval process), political stability and physical infrastructure development. Also maintaining the lower cost advantage vis--vis other countries seems to be an area of concern of companies looking at India as a destination. Though economic reforms welcoming foreign capital were introduced in the 1990s it does not seem so far to be really evident in the inflow of FDI. There is a lingering perception abroad that foreign investors are still looked at with some suspicion. Besides, the Made in India label is not conceived by the world. Most of the problems for the investors arise because of domestic policy, rules and procedures and not FDI policy per se or its rules and procedures. India has one of the most transparent and liberal FDI regimes between the emerging and developing economies. Problems for slow growth of FDI in India In addition to Indias poor performance in terms of competitiveness, quality of infrastructural skills and productivity of labour, there are several other factors that make it a far less attractive ground for direct investment than the potential it has. Some of the major deterrents are discussed. Domestic policy framework affects all investments, whether the investor is Indian or foreign. Among the policy problems that have been identified by surveys as acting as additional hurdles for FDI are laws, regulatory systems and government monopolies that do not have contemporary relevance. Corporate tax rates in East Asia are generally in the range of 1530 per cent, compared with a rate of 48 per cent for foreign companies in India. This is definitely a major disincentive to foreign corporate investment.
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Taxes levied on transportation of goods from state to state (such as Octroi and entry tax) adversely affect the economic environment for export production. Such taxes impose both cost and time delay on movement of inputs used in production of export products as well as in transport of the latter to the ports. The FDI regime in India is still quite restrictive. In order to ease FDI, the government needs to loosen the restrictions on FDI outflows so that Indian enterprises are allowed to enter into joint ventures. The government needs to take steps to deregulate FDI in industry and simplify the FDI procedures in infrastructure. Many of the reforms have already been implemented and it has yielded good result in terms of removing the entry barriers. However, the liberalization of exit barriers is still needed. In fact, it is really because of lack of exit barriers that large volumes are not flowing in. Export policy needs to be revised in order to attract FDI. The export zones lack dynamism because of the governments general lack of decision about attracting FDI. Labour laws discourage the entry of green field FDI because of the fear that it would not be possible to downsize if and when there is downturn in business. In context of FDI, poor infrastructure has a greater effect on export production than the production for the domestic market. FDI directed at the domestic market suffers the same handicap and additional costs as domestic manufacturers that are competing for the domestic market. Despite India being a latecomer to the FDI scene in comparison to other East Asian countries, its liberalized policy regime and significant market potential has sustained its attraction as a favourable destination for foreign investors. A transparent, investor friendly and liberal FDI policy has been drafted by the Government of India. In India, up to 100 per cent of FDI is allowed under automatic route for most of the sectors/activities, where the investor does not require any prior approval. Activity 1 Assess the problems for slow growth of FDI in India. Make a report. Hint: The FDI regime in India is still quite restrictive
1. _________ directly promotes the development of the financial sector.
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2. _________discourage the entry of green field FDI because of the fear that it would not be possible to downsize if and when there is downturn in business.
14.4 Costs and Benefits of FDI

When direct investment flows from one country to another, it creates benefits for both the home country and the host country but at a certain cost. We will discuss the benefits derived and the costs incurred on the FDI to both the countries involved. Benefits to the host country Availability of scarce factors of production: FDI brings in capital and supplements the domestic capital, and in return can use the factors of productions that are cheap in comparison to the host country. Improvement in the balance of payments: The inflow of investment is credited to the capital account. The host country is able to produce those items that were being imported earlier. Building of economic and social infrastructure: Due to foreign investment the basic economic infrastructure, social infrastructure, financial markets and the marketing system of the host country develop fast. Fostering of economic linkages: Foreign firms have forward and backward linkages. They train the local labour with technical knowledge that increases the earning capacity; but it also increases the purchasing power. Strengthening of government budget: Foreign firms are a source of tax income for the government. They pay not only income tax, but also import tariff; thus they help the government in reducing its expenditure. Cost to the host country The outflow of money from the host country on account of imports and the payments of dividends, technical service fees, royalty, etc. deteriorate the balance of payments. Overexploitation of raw material is detrimental to the host country as in future it may lose its advantageous position. Parent company supplies technology to the subsidiary but does not disseminate it to the host market so the host country remains dependent on the MNC.
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The MNC shows reluctance to train local people and uses capital-intensive production techniques that increase unemployment. Since the foreign company is technologically more superior to the domestic companies, the sales of the domestic companies decreases, thus domestic industry fails to grow. Foreign companies infuse foreign culture into the industrial set-up and also into the society. They become so powerful that sometimes they may even subvert the government. Benefits to the home country The home country gets supply of raw material that was not earlier available. The balance of payment improves as the parent company gets dividend, royalty, technical service fees and other payments. The parent company makes an entry into new financial markets through investment abroad. Government of the home country generates revenue through taxing the dividend and other earnings of the parent company. FDI is a complement to foreign aid and helps in developing closer political ties between the home country and the host country which is beneficial for both the countries. Cost to the home country Making investment abroad takes away capital, skilled manpower and managerial professionals from the home country. Outflow of these factors of production may disturb the home countrys interest. Subsidiaries of MNCs operating in different countries may adopt various techniques that may not be in the interest of the home country.
3. The inflow of investment is credited to the capital account. (True/False) 4. Foreign firms have forward and backward linkages. (True/False) 5. Overexploitation of raw material is advantageous to the host country as in future it may lose its advantageous position. (True/False)
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14.5 ADR and GDR

A depository receipt is a financial instrument whereby investors in one country can buy, hold, or sell the securities issue by companies in another country. The Depository receipt is a certificate on which is indicated the following information: Name of the issuing company in the foreign country Name of the Registered holder The number of depository shares held representing ordinary shares of a specified par value of the company The name of the custodian and that of the local depository A summary of the depository agreement and The benefits and the responsibilities of the holder Instruments There are two types of DRs; they are discussed in detail in the following subsections.
14.5.1 Global Depository Receipt (GDR)

They are used in Global Equity offering to international investors. It can be considered as global finance instrument that allows an investor to raise capital at the same time from two or more markets. Depositing receipts helps in crossborder trading and settlement helps to reduce transaction costs and increases the investment base among the institutional investors. GDR is a negotiable certificate that represents a companys publicly traded equity or debt. They are created when a broker purchases the companys shares on domestic stock market and deliver them to the depositorys local custodian bank who instructs the depository bank to issue GDRs. They are traded on a stock exchange where they are listed and in OTC market. Let us understand the concept of GDR with the help of an example. Consider an European investor who wants an exposure in Indian securities. He can do so in two ways. The two ways are as follows:
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1. First one is to enter the Indian stock market and buy the companys stock on one of the Indian markets. The investors get exposed to the exchange risks and other compulsory rules and regulations that are formulated for the purchase and sale of securities in the Indian markets. 2. Second route is through GDRs that would give the investor ownership of the Indian Companys stock without being subject to Indian stock market regulation. GDRs are considered same as selling equity in the Euromarkets. Features of GDRs The following are the features of GDR: GDRs can be listed on any American and European Stock exchange One GDR can represent more than one share The holder of the GDRs can get them converted into shares The holder of the GDR has not right to vote in the company. However, the shareholders do have this right. The dividend on the GDRs is quite like the dividend on shares GDRs are in the US dollar Structure of GDR When GDRs are structured with a Rule 144 (a) offering for the US and a Regulation S offering for non-US investors, there are two possible options for the structure. Those are as follows: 1. Unitary structures: A single class of DRs is offered both to QIBs in the US and to off-shore purchasers outside the issuers domestic market, in accordance with regulations. All DRs are governed by one Deposit Agreement and all are subject to deposit, withdrawal and resale restrictions. 2. Bifurcated structures: Under this structure, Rule 144 (a) GDRs are offered to QIBs in the US and Regulation SDRs are offered to off-shore investors outside the issuers domestic market. Benefits for raising GDRs The following are the benefits of raising GDRs: Once the issuing company has exploited the domestic capital market, the company will not benefit by expanding its base in domestic market. The
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company will turn to International Capital markets to expand the base of investors. Since there are many restrictions in the issue of shares in the domestic market, the company can explore international markets. It will help the company in creating an international recognition among the public. It will bring foreign exchange to the country that will help in the development of the economy. International capital is available at a lower cost through the Euro equity. The funds raised through such instrument do not add to the foreign exchange exposure. The investors would be able to diversify their risk and return. Disadvantages of GDR As GDR is raised through public issues and hence, it is more expensive in terms of administrative expenses. GDRs have a foreign exchange risk if the currency of the issuer is different from the currency of the GDR, i.e., normally US dollar.
14.5.2 American Depository Receipt (ADR)

It represents ownership in the shares of a non-US company and trades in the American stock markets. ADRs enable American investors to buy shares in foreign company without any issue of cross-border and cross-currency transactions. ADRs carry price in American dollar, pay dividend in the same currency and can be traded like any other share of US-based companies. Each ADR is issued by a US depository bank and can represent one share. The owner of ADR has the right to obtain the foreign stock it represents, but US investors are more interested in owning ADR as they can diversify their investments across the globe. ADR falls within the regulatory framework of the US and requires registration of the ADRs and the underlying shares with the SEC. Features of ADRs The following are the features of ADR: ADR can be listed on American Stock Exchange. A single ADR can represent more than one share. One ADR can be two shares or any fraction also. The holder of the ADRs can get them converted into shares. The holders of ADR have no right to vote in the company.
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ADRs in US dollar The dividend on ADRs is similar to the dividend on share that are paid in the home currency. Process of issue of ADR Investors can purchase ADRs from brokers. These brokers obtain ADR s for their clients in two ways. They can either purchase already issued ADRs on a US exchange. This is similar to buying a share in secondary market or they can create a new ADR. Let us understand this with the help of an example. To create an ADR, a US based broker purchases shares of the issuer in the issuers home market. The US broker then deposits those shares in a bank in that market. The bank then issues ADRs representing those shares to the brokers custodian which can then apply them to the clients account. Types of ADRs ADR facilities may be established as either unsponsored or sponsored. The type of ADR programme employed depends on the requirements of the issuer. It is broadly classified as follows: Unsponsored ADR programme: This facility is created in response to a combination of investor, broker-dealer and depository interest. It is initiated by a third party. Depository is the principal initiator of a facility because it perceives US investor interest in a particular foreign security and recognizes the potential income that may be derived from a facility. Sponsored ADR programme: This facility is established jointly by an issuer and a depository. Sponsored ADR facilities are created in the same manner as unsponsored facility except that the issuer of the deposited securities enters into a deposit agreement with the depository and signs the registration statement. The deposit agreement sets out the rights and responsibilities of the issuer, the depository and the ADR holder. Like unsponsored ADR facilities, sponsored ADR facilities usually involve the use of a foreign custodian to hold the deposited securities. Benefits of ADRs There are different benefits to issuers and investors.
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Benefits to the issuing company For issuers, there are several reasons for launching and managing an ADR programme. They are as follows: An ADR programme can make the investors interested in them. It also increases the companies visibility, broaden its shareholder base and increase liquidity. It enables a company to tap US equity markets. The ADR offers a new avenue for raising capital but at highly competitive costs. ADRs can provide increased communications with shareholders in the US. They provide an easy way for US employees of non-US companies to invest in their companies employee stock purchase plan. Did you know! An Indian depository receipt is an instrument denominated in Indian Rupees in the form of a depository receipt created by a domestic depository (custodian of securities registered with the Securities and Exchange Board of India) against the underlying equity of issuing company to enable foreign companies to raise funds from the Indian securities markets. Activity 2 Find out the Indian ADRs listed on USA stock exchanges. Write them down on a chart and analyse their financial status. Hint: The investors in the US wishing to invest in individual Indian Stocks usually buy Indian ADRs listed on US stock exchanges.
6. A _________ is a financial instrument whereby investors in one country can buy, hold, or sell the securities issue by companies in another country. 7. GDRs are considered same as____________ in the Euromarkets. 8. __________ also increases the companies visibility, broaden its shareholder base and increase liquidity. 9. __________ is created in response to a combination of investor, brokerdealer and depository interest.
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14.6 Concept of Portfolio

MNC makes two types of investment decisions that are as follows: Portfolio investment decisions Foreign direct investment decisions Portfolio is the combination of assets so as to reduce the risk by diversification. There are two major types of risks that are as follows: 1. Systematic risk: It is also known as market risk. It is the risk common to all securities and all companies. These risks cannot be diversified away and some examples are interest rates, recessions and wars. Technically speaking, it is that part of the total variability of return caused by external variables such as factors arising out of market, nature of industry and the state of economy. These are the uncontrollable factors thus the risk arising out of these is undiversifiable risk. 2. Unsystematic risk: It is also called as the specific risk that is specific to the individual asset and can be diversified away as we increase the number of assets in our portfolio. This risk is due to the known and controllable factors like internal variables of the company. It is also known as diversifiable risk as we can reduce it by adding or reducing the number of securities to the portfolio. Diversification It is a risk management technique that uses a wide variety of investments in order to reduce the impact that any one security will have on the overall performance of the portfolio. It means combining the securities into a portfolio is such a way so as to reduce portfolio risk without the impact on the return. Portfolio policy selecting securities and markets Portfolio return and risk measured are specific to the currency of investment. The return on a portfolio is a weighted sum of returns on the assets comprising the portfolio, the weights being the initial value of the share or asset in the portfolio. The return on the assets has two components: Dividend Capital gain
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Each of these components depends on certain factors which have been summarized as follows: 1. Global-specific variables, such as global economic trends, the world business cycle, trends in world trade, world income, and so on. 2. Nation-specific variables, such as national income, national economic trends, business cycles, nationwide cost factors such as labour negotiations. 3. Industry-specific factors such as labour negotiations. 4. Firm-specific factors 5. Currency in which returns are earned and the behaviour of exchange rate and forex markets. If the investor has an internationally diversified portfolio then the rupee returns on security depends on world factors, national factors, investors country factors, firm-specific factors and exchange-rate movements. If these factors are measurable, then with econometric techniques, we can estimate the expected returns of the portfolio. Risk-averse investors will have a preference for portfolio that has lower variance of returns. Diversification of portfolio will lower the variability of the portfolio. International diversification will be advantageous if the earnings are not perfectly positively correlated. Risk reduction and international portfolio diversification As per the portfolio theory, the investors have to choose between lower expected returns for lower risks. Whenever there is an imperfect correlation between returns on different securities, the risk is reduced by diversification of portfolio. The lower is the correlation among returns the greater benefits is in Portfolio Diversification Solnik has shown that the internationally diversified portfolio is less risky than a purely domestic portfolio. A risk-averse investor would hold a well diversified portfolio than a single security in the same market. The extent to which risk is reduced depends upon the correlation between the returns of the securities held in the portfolio. The less correlated are the returns on the securities included in the portfolio, the less risky is the portfolio. Let a portfolio in which the security returns are highly correlated and another securities is added, this also has returns correlated to the returns of earlier held securities. In this case, the risk reduction is minimum. If the securities return is not correlated with the earlier held securities, the risk reduction is greater. Correlation of stock returns intra-market is high as compared to inter markets, therefore if the securities of different national markets are held the risk reduction is greater. We know that as an investor increases the number
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of securities in the portfolio, the risk will decrease if they are not positively correlated. The risk in domestic market can be reduced to a minimum level by increase in number of stocks in the portfolio. There have been few studies that describe the benefits that a company gets from international diversification as compared to diversification in the domestic market.
10. Portfolio is the combination of assets so as to reduce the risk by diversification. (True/False) 11. Unsystematic risk is the risk common to all securities and all companies. These risks cannot be diversified away and some examples are interest rates, recessions and wars. (True/False) 12. Diversification of portfolio will lower the variability of the portfolio. (True/ False)
14.7 Cases on Cross Border Acquisitions

Given below are few cases of international acquisitions in order to understand the phenomenon and the principles involved: 1. Daiichi Sankyo of Japan buys 34.8 per cent stake in Ranbaxy of India Daiichi Sankyo is Japans century old second largest drug maker and it focuses in the areas of cardio-vascular disease and cancer and has a strong research and development setup. Ranbaxy was founded in 1937 and has been Indias largest generic drug maker. Ranbaxy has presence in more than 100 countries and in 2007; the companys sale was `7,000 crore. On June 11, 2008, Daiichi bought the Ranbaxy promoters 34.8 per cent stake and made an open offer to acquire another 20 per cent of the public shareholding at a price of `737 per share. The important question that arises is about the benefits of this acquisition for the two companies. The main points are: For Ranbaxy shareholders, it was a very lucrative offer to sell shares at `737 per share where the share price had been in the range of `500 to `550.
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In the pharmaceutical sector, giant MNCs are operating and there is fierce competition. The joining of Daiichi and Ranbaxy strength will provide synergy to take advantage of the market place. Ranbaxy was in the generic drug making and in this area; huge investment in R&D is required. The two firms together can sustain R&D effects. Japan is a big market for generic drugs and Ranbaxy was not able to penetrate due to regulatory constraints. Now, through Daiichi, it would be able to exploit this market. Daiichi will have increased share in the market of generic drugs. The quality of these drugs can be improved by its strong R & D. Daiichis presence will improve in the international market due to wider international spread of Ranbaxys drugs. Earnings per share in the combined firm will improve. This may lead to higher market price of shares in the combined firm. Leveraged buyout deal of Tata and Tetley This case provides the concept of leveraged buyout and its use as a financial tool in acquisitions with specific reference to Tata Teas takeover of global tea major Tetley. This deal which was the biggest ever cross border acquisition, was also first ever successful leveraged buyout by an Indian company. In June 2000, Tata Tea acquired the UK heavyweight brand Tetley for 271 million pounds. The acquisition of Tetley pushed Tata tea to a position similar to global big companies Unilever and Lawrie. Tata Tea became the second largest tea company in the world, the first being Unilever owned by Brooke Bond and Lipton. Leveraged buyout (LBO) method of financing had never been used before. LBO mechanism allowed Tata Tea to minimize its cash outlay on making the purchase. In LBO, the acquiring company could float a special purpose vehicle (SPV) which was a 100 per cent subsidiary of the acquirer, with minimum equity capital. The SPV leveraged this equity to gear up significantly higher debt to buyout the target company. This debt was paid off by the SPV through the target companys cash flows. The target companys assets were pledged with lending institutions. Once the debt was cleared, the acquiring company had the option to merge with the SPV. Main benefit Tetley: Good price for shareholders Main benefit Tata Tea: Well known brand with access to international markets.
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13. Ranbaxy was founded in ____________ and has been Indias largest generic drug maker. 14. In ____________ ____________, the acquiring company could float a special purpose vehicle (SPV) which was a 100 per cent subsidiary of the acquirer, with minimum equity capital.
14.8 Case Study

Tata steel of India buys Corus of UK Corus, which was created by the merger of British Steel and Dutch Steel Co., was Europes second largest steel producer with the revenue of 9.2 billion pounds in 2005. Tata Steel, Indias largest private sector steel company, was established in 1907. Tata Steel falls under the Tata Sons and is financially very strong. Corus decides to sell Total debt of Corus was 1.6 billion pounds Corus needs supply of raw materials at a lower cost Corus facilities were relatively old with high production cost Employees cost was 15% Tata decides to buy Tata looking for manufactured finished products in European markets Presently manufactures low value long and flat steel products while Corus produces high value stripped products A diversified product mix will reduce risk and higher end products will improve bottom line Corus holds a number of patents with strong R&D Cost of acquisition is lower compared to setting up a new facility and marketing/distribution channels Tata known for efficient management would aim to reduce employee cost at Corus and improving productivity It will move from 55th position in steel manufacture to 5th position
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In April 2007, the acquisition was completed. The enterprise value of Corus was 13.7 trillion US dollars. Synergies: Tata steel is the lowest cost steel producer in the world and Corus is a large player with significant presence in value added steel segment and strong distribution network in Europe. One of the benefits for Tata steel was that it would be able to supply semi-finished steel to Corus for finishing at its plants which were located closer to high value markets. The road ahead: Before the acquisition, the major market for Tata steel was India and it accounted for about 70 per cent of companys total sales. About half of Corus steel production was sold in Europe (other than UK). After the acquisition, Europe (including UK) would consume about 80 per cent of the combined entitys steel production. Questions 1. State the benefits that Tata Steel derived from the acquisition. 2. How do you think the market for Tata Steel changed after the acquisition? Source: Adapted from http://www.business-standard.com/india/news/tatasteel-acquires-corus-group-plc-uk/273185/ Accessed on 18 July 2012
14.9 Summary
Let us recapitulate the important concepts discussed in this unit: When an investor based in one country acquires an asset in another country so as to manage that asset, it is known as foreign direct investment (FDI). The benefits from FDI do not accrue automatically and evenly across countries and sectors. It is necessary to establish a transparent, broad and effective enabling policy environment for investment and to put in place appropriate framework for their implementation to reap the maximum benefits from FDI. According to the latest AT Kearney report on FDI Confidence Index, some of the most prominent deterrents for companies to invest in India are bureaucracy (Lengthy FDI approval process), political stability and physical infrastructure development. While the reforms implemented so far have helped remove the entry barriers, liberalization of exit barriers has yet to take place. This is a major deterrent to large volumes of FDI flowing to India.
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Though India has been a latecomer to the FDI scene in comparison to other East Asian countries, it has managed to become a favourable destination for foreign investors due to its liberalized policy regime and significant market potential. GDR is a negotiable certificate that represents a companys publicly traded equity or debt. Through AD`, American investors can buy shares in foreign company without the problem of cross-border and cross-currency transactions. As per the portfolio theory, the investors have to choose between lower expected returns for lower risks. Whenever there is an imperfect correlation between returns on different securities, the risk is reduced by diversification of portfolio.
14.10 Glossary
Deterrent: Something immaterial that interferes with or delays action or progress Deregulation: The reduction of governments role in controlling markets, which lead to freer markets, and presumably a more efficient marketplace Ambivalence: Simultaneous and contradictory attitudes or feelings (as attraction and repulsion) toward an object, person, or action Tariff Custodian: A bank, agent, trust company, or other organization responsible for safeguarding financial assets Formulated: To express in systematic terms or concepts Variability: The extent to which data points in a statistical distribution or data set diverge from the average or mean value.

1. Define the benefits of FDI. 2. State the cost of FDI to the home country. 3. What is GDR? State the ways through which an investor waning exposure in Indian securities can attain the same. 4. Discuss ADR. What are the different types of ADR?
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5. Define diversification. 6. What are systematic risk and unsystematic risk?

1. FDI 2. Labour laws 3. True 4. True 5. False 6. Depository receipt 7. Selling equity 8. Unsponsored ADR programme 9. ADR programme 10. True 11. False 12. True 13. 1937 14. Leveraged Buyout (LBO)

1. FDI influences growth by increasing total factor productivity. Technology transfers through FDI generate positive externalities in the host country. The benefits from FDI do not accrue automatically and evenly across countries and sectors. For further details, refer to Section 14.4. 2. Cost to the host country: The outflow of money from the host country on account of imports and the payments of dividends, technical service fees, royalty, etc. deteriorate the balance of payments.
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Overexploitation of raw material is detrimental to the host country as in future it may lose its advantageous position. For further details, refer to Section 14.4. 3. GDR is a negotiable certificate that represents a companys publicly traded equity or debt. For further details, refer to Section 14.5.1. 4. ADRs enable American investors to buy shares in foreign company without the problem of cross-border and cross-currency transactions. The types of ADR are: Unsponsored ADR programme Sponsored ADR programme. For further details, refer to Section 14.5.2. 5. Diversification is a risk management technique that uses a wide variety of investments in order to reduce the impact that any one security will have on the overall performance of the portfolio. For further details, refer to Section 14.6. 6. Systematic risk: It is also known as market risk. It is the risk common to all securities and all companies. Unsystematic risk: It is also called as the specific risk that is specific to the individual asset and can be diversified away as we increase the number of assets in our portfolio. For further details, refer to Section 14.6.
Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas Publishing.
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International Financial Management

Sikkim Manipal University

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Subject Code: MF0015 / MBF404 / IB0010 Revised Edition: Spring 2010

Book ID: B1759

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International Financial Management

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MF0015 / MBF404 / IB0010 International Financial Management Course Description

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International Financial Management

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International Financial Management

Sikkim Manipal University

Directorate of Distance Education

Subject Code: MF0015 / MBF404 / IB0010 Revised Edition: Spring 2010

Book ID: B1759

Sikkim Manipal University

International Financial Management

Sikkim Manipal University

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MF0015 / MBF404 / IB0010 International Financial Management Course Description

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International Financial Management

International Financial Management

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International Financial Environment

International Financial Management

International Financial Management

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International Financial Management

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International Financial Management

1.4 Multinational Corporations and Transnational Corporations

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International Financial Management

International Financial Management

International Financial Management

1.5 Objectives of MNCs

International Financial Management

1.6 International Financial Management and Domestic Financial Management

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International Financial Management

1.7 Goals of International Financial management

International Financial Management

1.8 International Monetary System

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International Financial Management

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International Financial Management

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International Financial Management

International Financial Management

International Financial Management

1.9 Case Study

International Financial Management

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