Depository Receipts

What are Depository Receipts (DRs)?

A DR is a type of negotiable (transferable) financial security traded on a local stock exchange but represents a security,
usually in the form of equity, issued by a foreign, publicly-listed company. The DR, which is a physical certificate, allows
investors to hold shares in equity of other countries. One of the most common types of DRs is the American depository
receipt (ADR), which has been offering companies, investors and traders global investment opportunities since the 1920s.

Since then, DRs have spread to other parts of the globe in the form of global depository receipts (GDRs). The other most
common type of DRs are European DRs and International DRs. ADRs are typically traded on a US national stock
exchange, such as the New York Stock Exchange (NYSE) or the American Stock Exchange, while GDRs are commonly
listed on European stock exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually
denominated in US dollars, but can also be denominated in Euros.

Types of Depository Receipt

1. American Depository Receipt (ADR): Certificates issued by a U.S. depository bank, representing foreign shares
held by the bank, usually by a branch or correspondent in the country of issue. One ADR may represent a portion of a
foreign share, one share or a bundle of shares of a foreign corporation. If the ADR's are "sponsored," the corporation
provides financial information and other assistance to the bank and may subsidize the administration of the ADR
"Unsponsored" ADRs do not receive such assistance. ADRs are subject to the same currency, political, and economic
risks as the underlying foreign share. Arbitrage keeps the prices of ADRs and underlying foreign shares, adjusted for
the SDR/ordinary ratio essentially equal. American depository shares (ADS) are a similar form of certification

2. Global Depository Receipt (GDR): A receipt denoting ownership of foreign-based corporation stock shares, which
are traded in, numerous capital markets around the world.

3. Indian Depository Receipts (IDRs): IDRs are transferable securities to be listed on Indian stock exchanges in the
form of depository receipts created by a Domestic Depository in India against the underlying equity shares of the
issuing company which is incorporated outside India.

How are IDRs different from GDRs and ADRs?

GDRs and ADRs are amongst the most common DRs. When the depository bank creating the depository receipt is in the
US, the instruments are known as ADRs. Similarly, other depository receipts, based on the location of the depository bank
creating them, have come into existence, such as the GDR, the European Depository Receipts, International Depository
Receipts, etc. ADRs are traded on stock exchanges in the US, such as Nasdaq and NYSE, while GDRs are traded on the
European exchanges, such as the London Stock Exchange.

How do DR’s work?

DRs are created when a foreign company wishes to list its securities on another country’s stock exchange. For this, the
issuing company has to fulfill the listing criteria for DRs in the other country. Before creating DRs, the shares of the foreign
company, which the DRs represent, are delivered and deposited with the custodian bank of the depository creating the
DR. Once the custodial bank receives the delivery of shares, the depository creates and issues the DR to investors in the
country where the DRs are listed. These DRs are then listed and traded in the local stock exchanges of the other country.

Why Are They Issued?

They are a means for a foreign company to raise funds. Typically these foreign countries do not have well developed and
accessible domestic financial markets. Once issued, these securities are listed on U.S. equity markets, giving these
relatively unknown companies exposure both in terms of their products and future financing. Obviously, each exchange
has their own rules and requirements about listing these companies.

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Advantages
• Expanded market share through broadened and more diversified investor exposure with potentially greater liquidity,
which may increase or stabilize the share price.
• Enhanced visibility and image for the company's products, services and financial instruments in a marketplace outside
its home country.
• Flexible mechanism for raising capital and a vehicle or currency for mergers and acquisitions.
• Enables employees of U.S. subsidiaries of non-U.S. companies to invest more easily in the parent company.

What about investors?

They allow global investing opportunities without the risk of investing in unfamiliar markets, ensure more information and
transparency and improve the breadth and depth of the market.

Advantages
• Quotation in U.S. dollars and payment of dividends or interest in U.S. dollars.
• Diversification without many of the obstacles that mutual funds, pension funds and other institutions may have in
purchasing and holding securities outside of their local market.
• Elimination of global custodian safekeeping charges, potentially saving Depositary Receipt investors up to 10 to 40
basis points annually.
• Familiar trade, clearance and settlement procedures.
• Competitive U.S. dollar/foreign exchange rate conversions for dividends and other cash distributions.
• Ability to acquire the underlying securities directly upon cancellation.

Types of Depositary Receipt Facilities

Depositary Receipt facilities may be unsponsored and sponsored. Unsponsored Depositary Receipts are issued by one or
more depositaries in response to market demand, but without a formal agreement with the company. Today, unsponsored
Depositary Receipts are considered obsolete and are rarely established due to lack of control over the facility and
potential hidden costs.
Sponsored Depositary Receipts may be issued in different "levels" available in various trading markets and are issued by
one depositary appointed by the company under a Deposit Agreement or service contract. Sponsored Depositary
Receipts offer control over the facility, the flexibility to list on a U.S. or European stock exchange and the ability to raise
capital.

Sponsored Level I Depositary Receipts: A Sponsored Level I Depositary Receipt program is the simplest method for
companies to access the U.S. and non-U.S. capital markets. Level I Depositary Receipts are traded in the U.S. over-the-
counter (OTC) market with prices published in the "Pink Sheets" and on some exchanges outside the United States.
Establishment of a Level I program does not require full SEC registration and the company does not have to report its
accounts under U.S. Generally Accepted Accounting Principles (GAAP) or provide full Securities and Exchange
Commission (SEC) disclosure. Essentially, a Sponsored Level I Depositary Receipt program allows companies to enjoy
the benefits of a publicly traded security without changing its current reporting process.

Sponsored Level II and Sponsored Level III Depositary Receipts: Companies that wish to list their Depositary
Receipts on a U.S. stock exchange (NASDAQ, American or New York), raise capital or make an acquisition using
securities, use Sponsored Level II or Sponsored Level III Depositary Receipts. Level II and Level III Depositary Receipt
programs require SEC registration and adherence to applicable requirements for U.S. GAAP. These types of Depositary
Receipts can also be listed on some exchanges outside the United States. Level II Depositary Receipts are exchange-
listed securities but do not involve raising new capital. Level III programs typically generate the most U.S. investor interest
because capital is being raised.

Privately Placed and Offshore (SEC Rule 144A / Regulation S) Depositary Receipts: A company can also access the
U.S. and other capital markets through SEC Rule 144A and/or SEC Regulation S DR facilities without SEC registration.
Rule 144A programs provide for raising capital through the private placement of DR with large institutional investors (often
referred to as "QIBs") in the United States. Regulation S programs provide for raising capital through the placement of DR
offshore to non-U.S. investors in reliance on Regulation S. A Level I program can be established along side a Rule 144A
program and a Regulation S program may be merged into a Level I program after the restricted period has expired.
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Inherent Sources of Risk: Unlike equity issued by U.S. companies, there is an additional risk in investing in these
companies. The changes in price, quoted in U.S. dollars as they trade on U.S. markets, reflect two sources of risk: the
company's performance as well as fluctuations in the exchange rates. Thus, these two effects on prices can potentially
reinforce each other, or cancel each other.

Issuance: Depositary Receipts are issued or created when investors decide to invest in a non-U.S. company and contact
their brokers to make a purchase. These brokers, through their international offices or through a local broker in the
company's home market, purchase the underlying ordinary shares and request that the shares be delivered to the
depositary bank's custodian in that country. The broker who initiated the transaction will convert the U.S. dollars received
from the investor into the corresponding foreign currency and pay the local broker for the shares purchased. On the same
day that the shares are delivered to the custodian bank, the custodian notifies the depositary bank. Upon such notification,
Depositary Receipts are issued and delivered to the initiating broker, who then delivers the Depositary Receipts
evidencing the shares to the investor. Your broker can also obtain Depositary Receipts by purchasing existing Depositary
Receipts, which is not a new issuance.

Transfer - (Intra-Market Trading): Once Depositary Receipts are issued, they are tradable in the United States and like
other U.S. securities, they can be freely sold to other investors. Depositary Receipts may be sold to subsequent U.S.
investors by simply transferring them from the existing Depositary Receipt holder (seller) to another Depositary Receipt
holder (buyer); this is known as an intra-market transaction. An intra-market transaction is settled in the same manner as
any other U.S. security purchase: in U.S. dollars on the third business day after the trade date and typically through The
Depository Trust Company (DTC). Intra-market trading accounts for approximately 95 percent of all Depositary Receipt
trading in the market today. Accordingly, the most important role of a depositary bank is that of Stock Transfer Agent and
Registrar. It is therefore critical that the depositary bank maintain sophisticated stock transfer systems and operating
capabilities.

Cancellation: When investors want to sell their Depositary Receipts, they notify their broker. The broker can either sell
the Depositary Receipts in the U.S. market through an intra-market transaction or sell the shares outside of the U.S.,
typically into the home market through a cross-border transaction. In cross-border transactions, brokers, either through
their international offices or through a local broker in the company's home market, will sell the shares back into the home
market. In order to settle the trade, the U.S. broker will surrender the Depositary Receipt to the depositary bank with
instructions to deliver the shares to the buyer in the home market. The depositary bank will cancel the Depositary Receipt
and instruct the custodian to release the underlying shares and deliver them to the local broker who purchased the
shares. The broker will arrange for the foreign currency to be converted into U.S. dollars for payment to the Depositary
Receipt holder.

Trading - (Pricing): Once Depositary Receipts are issued and there are an adequate number of Depositary Receipts
outstanding in the U.S. market (usually three percent to six percent of the company's shares in Depositary Receipt form) a
true intra-market trading market emerges. Until this market develops, the majority of Depositary Receipt purchases result
in Depositary Receipt issuances upon the deposit of shares. When executing a Depositary Receipt trade, brokers seek to
obtain the best price by comparing the Depositary Receipt price in U.S. dollars to the dollar equivalent price of the actual
shares in the home market. Brokers will buy or sell in the market that offers them the best price and they can do so in
three ways: by issuing a new Depositary Receipt, transferring an existing Depositary Receipt or canceling a Depositary
Receipt. For example, if the price of the actual shares in the home market is $12.28 per share after allowing for foreign
currency translation, and the Depositary Receipt is selling for $12.30, the broker will buy shares and issue Depositary
Receipts until the price of the ordinary shares increases to $12.30, at which time the broker will simply buy and sell the
existing Depositary Receipts that are outstanding in the market. The broker may also be holding an inventory of ordinary
shares, in which case the local trading price is irrelevant.

The continuous buying and selling of Depositary Receipts in either market tends to keep the price differential between the
local and U.S. markets to a minimum. As a result, about 95 percent of Depositary Receipt trading is done in the form of
intra-market trading and does not involve the issuance or cancellation of a Depositary Receipt.

Equity Offerings: When a non-U.S. company completes an offering of new shares, part of which will be sold as
Depositary Receipts in the U.S. or international market, the company will deliver the shares to the depositary bank's local
custodian at the time of the closing. The depositary bank will then issue the corresponding Depositary Receipts and
deliver them to the members of the underwriting syndicate. With this pool of Depositary Receipts, a regular trading market
commences where Depositary Receipts can then be issued, transferred or cancelled.

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 Methods of payment available to buyers and sellers conducting international transactions

1. Cash in Advance/Prepayment: Cash in Advance/Prepayment occurs when a buyer sends payment in the agreed
currency and through agreed method to a seller before the product is manufactured and/or shipped. Upon receipt of
payment this seller then ships the goods and all the necessary shipping and commercial documents directly to the
buyer.
Prior to manufacturing and/or shipping, through the agreed upon method (cash, wire transfer, check,
Time of Payment
credit card, etc.).
Goods available
After payment is received.
to Buyer
Risks to Seller Product is manufactured and never paid for.
*Seller does not ship as per the order (quantity, product quality, shipping method).
Risks to Buyer
*Seller does not ship when requested.
*When there is no established relationship between the buyer and seller.
*Product is a special ord. and can only be sold to this specific buyer since it contains comp. logo, etc.
When
*Seller is confident that importing country will impose regulations deferring or blocking transfer of
Appropriate
payment.
to Quote or Use
*Seller does not have sufficient liquidity or access to outside financing to extend deferred payment
terms.
Financing Buyer must have cash or financing available.
2. Documentary Collections: Using a documentary collection process requires that a seller ship the product and create
a negotiable document, usually a draft or bill of exchange. The draft and shipping documents are then processed
either through a buyer’s bank (the collecting bank) or through the seller and buyer’s banks. Upon arrival at the buyer’s
bank, the buyer is notified to make payment; then the documents are released and used to clear the shipment through
customs upon arrival.

The primary advantage of documentary collections is that a seller who extends credit terms to a buyer under a D/A
collection obtains an enforceable debt instrument in the form of a trade acceptance. The seller’s rights to payment are
protected under the negotiable instruments law of that buyer’s country. In the event this buyer defaults or delays
payment at maturity, the possession of the trade acceptance may put the seller in a stronger position before the court
than if he/she had sold under open account, in which evidence of indebtedness is provided by the unpaid commercial
invoice alone. In addition, a bank presenting a collection on behalf of a seller may obtain prompt payment from a
buyer who might be inclined to delay payment if the seller were invoicing under open account.

A documentary collection is best used for ocean shipments where original bills of lading are required. An original bill of
lading is a document of title which enables a buyer to gain possession of the goods. When all the originals of a bill of
lading are sent to the collecting bank, it is in the interest of the buyer to effect payment in order to obtain title to the
goods.

Documentary collections may be more competitive than letter of credit terms because they are less costly and do not
require the buyer to tie up his/her local bank credit lines.

There are a variety of terms associated with documentary collections that should be understood:

Buyer = Importer
Seller = Exporter
Remitting Bank = Exporter’s Bank >> receives payment
Collecting Bank = Importer’s Bank >> transmits funds from buyer to seller
Bill of Exchange/Draft – document issued by exporter and used for remittance of funds
Time/usance Bill of Exchange – tenured at 30, 60, 90, 120 or 180 days, etc.

There are four types of processes available to buyers and sellers:

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 1. D/P – Documents against Payment: The export documents and the bill of exchange provided to a collecting
bank are only made available to an importer when payment is made. The collecting bank then transfers the funds to
the seller through the remitting bank.
2. D/A – Documents against Acceptance: The export documents and a time/usance bill of exchange are sent to a
remitting bank. The documents are then sent to a collecting bank with instructions to release the documents against a
buyer’s acceptance of the bill of exchange.
3. Clean Collection: The exporter creates a bill of exchange, which is sent without any export documents to a buyer
for collection through the remitting bank to the collecting bank. There is less security for an exporter since the
documents are sent directly to the importer.
4. Cash against Documents: This process lacks the security and legal protection of a documentary collection since
the exports documents are sent through a remitting bank to a collection bank without a bill of exchange. It is, however,
still a collection through the banking system.

*Either at sight of documents or acceptance as agreed to by the parties (30, 60, 90 days after
Time of Payment
acceptance).
*Upon arrival of goods after payment or acceptance of draft has been made.

Risks to Seller
Goods Available to *Buyer defaults on payment obligation.
Buyer *Delays in availability of foreign exchange and transferring of funds from buyer’s country.
*Payment blocked due to political events in buyer’s country. Risks to Buyer
*Seller does not ship per the order (quantity, product, quality, shipping method).
*Seller does not ship when requested, either early or late.
*Seller and buyer have done some business together and are transitioning away from a
prepayment policy.
When Appropriate to *Seller has some trust that buyer will accept shipment and pay at agreed time.
Quote or Use *Seller is confident that importing country will not impose regulations deferring or blocking
transfer of payment.
*Seller has sufficient liquidity or access to outside financing to extend deferred payment terms.
*Seller finances buyer through deferred payment terms.
Financing *Seller can use trade acceptances, which are negotiable instruments, to obtain financing.
*Leverage /or financing comes from domestic/global business.

Letters of Credit: A letter of credit is a bank instrument that can be used to even the risk between a buyer and a seller
since a buyer is guaranteed to receive payment if when he/she has complied with the exact requirements of this
buyer. A letter of credit offers a seller numerous advantages but only if that seller complies exactly with its terms
and conditions of the transaction. In addition to providing reduced risk for both a seller and a buyer, there are many
variables that can be used with a letter of credit to reduce the political and commercial risks that may accompany
the transaction as well as provide extended terms to a buyer through the letter of credit instrument.

Involved Parties:

1. Applicant = Buyer/ Importer

2. Beneficiary = Seller/Exporter
3. Opening Bank = Importer’s Bank >> Issues L/C
4. Advising Bank= Exporter’s Bank >> Advises L/C
5. Confirming Bank = Advising Bank or 3rd Party Bank >> Confirms L/C
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6. Paying Bank = Any Bank as Specified in L/C >> Pays the Draft

Types of L/Cs:

• Back-to-Back – credit and terms of a transaction rollover to a new transaction upon completion, which eliminates the
need to apply or issue a new L/C for identical shipments
• Confirmed – credit risk taken by bank and agreement to pay (fee charged)
• Straight – payable only at paying bank
• Negotiation – payable at negotiating bank
• Sight – payable at acceptance of documents
• Standby – used by the beneficiary for payment should the applicant not pay the exporter directly
• Transferable – part or all of the proceeds from the L/C may be transferred to another party, used by sales brokers or
agents to disguise buyers and sellers
• Usance – time draft based on invoice, bill of lading, or documents, up to 180 days

•As agreed between the buyer and seller and stipulated in the L/C, at sight of documents or
Time of Payment
acceptance of time draft.

Goods Available
•Upon release of documentation and payment or acceptance of time draft.
to Buyer

•Delays in availability of foreign exchange and transferring of funds from buyer’s country if the L/C is
Risks to Seller not confirmed.
•Payment blocked due to political events in buyer’s country if the L/C is not confirmed.

•Seller creates documents to comply with L/C but does not ship actual product.
Risks to Buyer •Seller does not ship.
•Buyer ties up commercial lines of credit to secure L/C.

A seller should consider a number of factors:

•corporate credit policy and ability to absorb risk
•credit standing of the buyer
•political environment in the importing country
•type of merchandise to be shipped and value of the shipment
When •availability of foreign exchange
Appropriate to •buyer and seller are establishing a new relationship
Quote or Use •when buyer and/or seller’s governments require use of banks to control flow of currencies and
products
•products and/or services comply with quality steps during production and documentation is
presented for payment
•used less frequently in international transactions because of the high bank fees and time-
consuming process

•Often a bank will favorably consider a request for an increase in a credit line to finance production
of the goods. This is done with the knowledge that letters of credit have been opened and advised to
Financing
an exporter for an export order. The bank may further require that the beneficiary assign its interest
in the letter of credit to them.

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3. Open Account: Open account occurs when a seller ships the goods and all the necessary shipping and commercial
documents directly to a buyer who agrees to pay a seller’s invoice at a future date. Open account is typically used
between established and trusted traders.

•As agreed between a buyer and seller, net 15, 30, 60 day terms, etc., from date of invoice
Time of Payment
or bill of lading date.
•Before payment (depending on how the products are shipped and the length of payment
Goods Available to Buyer
option).
•Buyer defaults on payment obligation.
•Delays in availability of foreign exchange and transferring of funds from buyer’s country
Risks to Seller
occur.
•Payment is blocked due to political events in buyer’s country.
•Seller does not ship per the order (product, quantity, quality, and/or shipping method).
Risks to Buyer
•Seller does not ship when requested, either early or late.
•Seller has absolute trust that buyer will accept shipment and pay at agreed time.
•Seller is confident that importing country will not impose regulations deferring or blocking
When Appropriate to Quote transfer of payment.
or Use •Seller has sufficient liquidity or access to outside financing to extend deferred payment
terms.
•Used more regularly in international transactions to avoid high banking fees.
•Seller finances buyer through deferred payment terms.
•Seller may be able to obtain bank financing through pledge of receivables.
Financing
•Selling receivables on a non-recourse basis to a bank.
•Leverage and/or financing from domestic/global business.

4. Combining Methods of Payment: The important thing to remember about methods of payment is that they are not
absolute. They can be combined in many ways to reduce risk for all of the parties involved. For example, should a
new customer require custom-made products, but cannot afford 100% prepayment, an exporter could offer 50%
prepayment to cover the cost of manufacturing and 25% payment at invoice date and 25% payment 90 days after
invoice.

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 Swap

In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for
those of the other party's financial instrument. The benefits in question depend on the type of financial instruments
involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or
coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash
flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates
when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at
least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign
exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties.
Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction
of underlying prices.

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit
swaps, commodity swaps and equity swaps. There are also many other types.

1. Interest rate swaps: The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a
fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this
exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed
rate markets while other companies have a comparative advantage in floating rate markets. When companies want to
borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may
lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a
swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70
basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are
calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each
interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A
and B is slightly lower due to a bank taking a spread.

2. Currency swaps: A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate
swaps; the currency swaps also are motivated by comparative advantage. Currency swaps (These entail swapping
both principal and interest b/w the parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.

3. Commodity swaps: A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged
for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

4. Equity Swap: An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of
stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front,
but you do not have any voting or other rights that stock holders do.

5. Credit default swaps: A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series
of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes
into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing
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 restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with
insurance, because the buyer pays a premium and, in return, receive a sum of money if one of the events specified in
the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also
cover an asset to which the buyer has no direct exposure.

Swap Valuation

The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first
initiated, however after this time its value may become positive or negative. There are two ways to value swaps: in terms
of bond prices, or as a portfolio of forward contracts.

Using bond prices: While principal payments are not exchanged in an interest rate swap, assuming that these are
received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer,
a swap position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e.
making floating interest payments):

Vswap = Bfixed − Bfloating

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Vswap = Bfloating − Bfixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the
swap. Thus, the home currency value is:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the swap, Bforeign is the foreign cash flows of the
LIBOR is the rate of interest offered by banks on deposit from other banks in the Eurocurrency market. One-month LIBOR
is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc.

LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like
the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market.

Arbitrage arguments

As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows
is equal to zero. Where this is not the case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays
a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by
Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is
not the case, an Arbitrageur, C, could:

1. Assume the position with the lower present value of payments, and borrow funds equal to this present value

2. Meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments -
which have a higher present value

3. Use the received payments to repay the debt on the borrowed funds

4. Pocket the difference - where the difference between the present value of the loan and the present value of the inflows
is the arbitrage profit.

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Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as
mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the
proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service
the instrument which he is short

FEMA

Upon review of the Foreign Exchange Regulation Act, 1973 (FERA) in 1993, it was realized that significant changes had
taken place since the promulgation of FERA. Among the major changes noticed were: Large increase in country’s Foreign
Exchange Reserves, substantial growth in Foreign Trade, rationalization of tariffs, current account convertibility,
liberalization of Indian Investments abroad, and enhanced access to external commercial borrowings by Indian corporate
and active and significant participation of Foreign Institutional Investors in Indian stock market. The Central Govt. looking
at such significant developments, decided to bring in Fresh Amendments in the law relating to Foreign Exchange to suit
the new environments. The objective was to facilitate the external trade, ease receipts and payments pertaining thereto
and promoting orderly and fully organized Foreign Exchange markets.

Thus, the Foreign Exchange Management Act, 1999 (FEMA) which seeks to replace the Foreign Exchange Regulation
Act, 1973 (FERA), was brought into effect from 1st June, 2000.

FERA aimed to regulate certain payments, dealings in foreign exchange and securities, transactions indirectly affecting
foreign exchange and the import and export of currency for the conservation of the foreign exchange resources of the
country and the proper utilization thereof in the interests of the economic development of the country.

While FERA sought to 'control' foreign exchange transactions, FEMA seeks to 'regulate' and 'manage' such transactions.
FERA, in its substantive form, prohibited all foreign exchange transactions unless there was a general or specific
permission to do so and subject to conditions as specified. Under FEMA, however, all current account transactions are
permissible by the law itself and, thus, it is a positive law to this extent.

Further, an offence under FERA attracted criminal proceedings, whereas the offence under FEMA is considered as one of
a civil nature.

Under FERA there is presumption of existence of a guilty mind, unless the accused person proves otherwise. Under
FEMA, it is for the prosecution to prove that a person has committed the offence.

Section 35 of FERA empowers the Enforcement Officers to arrest a person, if they had reasons to believe that the person
was guilty of FERA violations. FEMA provides such power of arrest only if penalty levied under section 13 of FEMA is not
paid by the guilty within the given time.

Salient features of FEMA:

• It will facilitate trade rather than prevent misuse of foreign exchange.

• Definitions of capital account transaction and current account transaction have been introduced keeping in mind the
possibility of introduction of capital account convertibility in the near future.

• All current account transactions shall be allowed (subject to reasonable restrictions). Reserve Bank to classify those
capital account transactions that are to be permitted and to regulate transfer and issue of foreign securities by a

10
 resident in/outside India as well as setting up of branches/offices by foreign companies in India.

• All key sections relating to dealings, holding and payments in foreign exchange and exports have been simplified.

• Liberalization in enforcement provisions reflects that the attitude is of putting trust in the persons covered.

Salient feature of Prevention of money laundering act 2002

Money-laundering in India has to be seen from two different perspectives, i.e., Money laundering on international forum
and Money-laundering within the country. As far as the cross-border money-laundering is concerned India’s historically
strict foreign exchange laws and reporting norms have contributed to a great extent to control money laundering on
international forum. However, there has been threat from informal transactions like ‘Hawala’. According to Indian
observers, funds transferred through the hawala market are equal to between 30 to 40 percent of the formal market.

In India, before the enactment of the Prevention of Money Laundering Act 2002, the following statutes addressed scantily
the issue in question:

• The Conservation of Foreign Exchange and Prevention of Smuggling Activities Act, 1974
• The Income Tax Act, 1961
• The Benami Transactions (Prohibition) Act, 1988
• The Indian Penal Code and Code of Criminal Procedure, 1973
• The Narcotic Drugs and Psychotropic Substances Act, 1985
• The Prevention of Illicit Traffic in Narcotic Drugs and Psychotropic Substances Act, 1988

Features of Prevention of money laundering act

1. It seeks to bring certain financial institutions like Full Fledged Money Changers148, Money Transfer Service and
Master Card within the reporting regime of the Act.

2. Provisions to combat financing of terrorism by way of introducing new category of offences which have cross-border
implications.

3. Offences with cross border implication are introduced by way of Part C to the Schedule of the Act with the removal of
monetary threshold limit of Rs. 30 Lakhs149. However, the monetary limit still remains for Part B offences.

4. Provisional attachment period is enhanced from 90 days to 150 days under Section 5 and additional safeguard has
been introduced inasmuch as the property can be attached and a person can be searched only after completion of the
investigation by the investigation agency150.

5. Enforcement Directorate is now more empowered to search the premises immediately after the offence is committed
and the police have filed a report under Section 157 of the Cr.P.C.

6. Protection of tenure of Chairman and Member of Appellate Tribunal151 inasmuch as requirement of consultation with
Chief Justice of India before their removal. Moreover, the retirement age of chairman/member is increased from 62 to
65.

7. The requirement for appointment of member of the Appellate Tribunal that the person should be or has been a Judge
of the High Court has been removed retaining other qualifications152.

11
8. In cases of cross-border money-laundering the present Bill enables the Central Government to return the confiscated
property to the requesting country in order to implement the provisions of the UN Convention against Corruption.

9. Expanded the reach of the Act by adding many more crimes under various legislations153 in Part A and Part B of the
Schedule to the Act.

10. Delegated legislation is provided empowering Central Government to notify, from time to time, an activity for playing
games of chance for cash or kind154 as ‘designated business or profession’ for the purpose of bringing them into the
reporting regime under the Act.

USD dominate despite recession in US

The U.S. dollar is the world's most accepted currency by most measures. It has remained so despite the global recession
of 2008, which germinated in the U.S. If the dollar did not have this role, we believe that the U.S. would not have such
ready access to external financing, interest rates would have to rise to attract higher domestic savings, and potential
growth would fall. The dollar's widespread acceptance stems from the U.S. economy's fundamental strength, which
comes from the economy's size and the flexibility of labor and product markets. As long as inflation is moderate and
stable, financial markets are sound and relatively unfettered, and U.S. government spending is efficient and sustainable,
U.S. dollar will continue to be the key international currency.

The U.S. Dollar's Market Share

One indication of the U.S. dollar's continued primacy is that it dominates foreign exchange trading. Data compiled
triennially by the Bank for International Settlements (BIS) and more recent data compiled by the Bank of England's
Foreign Exchange Joint Standing Committee (FXJSC)indicate that the vast majority of foreign exchange transactions are
quoted with one leg as the U.S. dollar. Both sources show the U.S. dollar in a commanding position, peaking in 2001 at
90% (BIS) and retrenching only modestly since then to 86% in 2007 (BIS). The data suggest the U.S. currency's lead
weakening only slightly during the financial market turmoil in 2008. The most recent year's data from both sources agree
that the euro's share amounts to only about one-half of the U.S. dollar's share.

The U.S. dollar is also a key unit of account for cross-border finance—though its importance has lessened—and in this
category the euro is considerably more competitive. According to BIS data, the euro increased its share of international
debt securities outstanding since its 1999 inception, to a peak of 49% in 2007 from 29% in 1999, and has since stabilized,
decreasing only slightly to 48% in 2009. The U.S. dollar's share fell to a 15-year low of 35% in 2007 from 48% in 1999, but
it then also stabilized, holding at 36% in.

The U.S. dollar plays a significant role in trade as well. Almost all imports and exports to the U.S. are denominated in its
own currency, an attribute no other country enjoys. U.S. dollar use in import and export invoicing has fallen since the
launch of the euro, but this decline is largely confined to Eurozone and EU accession countries, and even for these
countries, trade with the U.S. remains almost exclusively invoiced in U.S. dollars. For countries in Asia, Latin America, or
Australia, a high percentage of trade is invoiced in U.S. dollars. Moreover, for every country surveyed, the share of
exports invoiced in U.S. dollars exceeds the U.S. share in the country's exports—and often by a wide margin.

Another indicator of the extent to which a country's currency is in global use is the share of physical cash (paper
banknotes) in circulation outside the geographic boundaries of the country. By this indicator, also, the U.S. currency
appears to have a larger international role than the euro. The Federal Reserve Bank of New York estimates much more
substantial use of the U.S. currency, with 65% of U.S. banknotes, amounting to $580 billion, in circulation outside U.S.
borders in March 2009.

A final indicator of the dollar's continued primacy is that the bulk of disclosed holdings in the foreign exchange component
of international reserves remains invested in U.S. dollars. The latest available data show the U.S. dollar retaining 62% of
identified reserve holdings as of third-quarter 2009.

12
Why The Dollar's Role Remains Central
1. The U.S. is the world's largest economy at market exchange rates, with 25% of 2009 global GDP, slightly more than
the next three largest national economies (Japan, Germany, and China) combined and still slightly greater than the
entire Eurozone.
2. Prices are generally stable and the relative purchasing power of the dollar has been comparable to other currencies.
3. The U.S. is also one of the world's most important trading partners. Although the Eurozone, as a whole, is the
predominant trading partner, with 28% of both global exports and global imports in 2009, the U.S. is in second place,
with 10% and 13%, respectively. China is third, with 9% and 8%, respectively, and Japan fourth, with 4% of each. The
U.K. has 4% and 5%, respectively; Canada 4% and 3%. Switzerland, Australia, India and Brazil all have significantly
smaller shares of each.
4. In addition, U.S. banking and capital markets to be dynamic and unfettered relative to their peers. The U.S.'s capital
account is open. Unlike the euro, the government of a single, unified state backs the U.S. dollar.
5. Many Asian trading partners, to enhance their own export competitiveness, accumulate dollars to keep their bilateral
nominal exchange rates in check. Many emerging market central banks maintain a high proportion of their reserves in
dollars to match the currency composition of their country's commercial external debt. Many investors who hold their
savings in offshore financial centers value their holdings in U.S. dollars and thus have a bias toward dollar assets.

Distinguish between FDI & FII’s

FDI
1. Long term investment.
2. Primary capital investment.
3. Consists of two routes:
i. Approval ii. Automatic
4. Automatic route is managed by RBI and is based on
sector capital rules. E.g. Telecom sector 74% of paid
up capital, insurance sector 26% of paid up capital, and
manufacturing sector 51% of paid up capital.
5. Under automatic route 1st reporting done by company
while receiving forex, 2nd reporting done by company to
RBI after allotment of shares.
6. ADR/GDR’s are under FDI limit.
7. Approval route is given by FIPB (Foreign Investment
Promotional Board).
8. It is given in consultation with department of industrial
policy and planning (DIPP).
9. Projects exceeding 600 crores and above will have to
be approved by cabinet committee on foreign
investment (CCFI).
10. FDI is not allowed in the case of retail (multi-brand)
sectors, liquor manufacturing, nuclear energy and
defense, SSI sector – 26%
11. There are dividend balancing requirements in certain
cases for repatriating the dividend.
FII
1. It represents foreign institutional investors. They are
mostly mutual funds, Insurance funds, pension funds,
gratuity funds etc registered abroad.
2. Participatory notes (P Notes) can also be registered
with SEBI by following KYC norms.
3. There are two types of FII investments:
i. 100% debt funds
ii. 70% equity and 30% debt funds
4. Debt funds can invest in govt. of India bonds, corporate
bonds etc. subject to a ceiling of 20 billion USD for all
funds put together.
5. Total investment by all FII’s in secondary market is
allowed up to 24% of paid up capital of a company.
Each FII’s will be allowed 10% investment. Ceilings
monitored by RBI on day to day basis.
6. They are short term funds in the secondary markets
and are registered with SEBI.
7. A company can pass resolution in the AGM for allowing
FII’s to invest in the company up to FDI limit.
8. The repatriation of the amount should be through
designated bank account after payment of capital gain
tax, brokerage etc.

Distinguish between ECB and FCCB

ECB(External Commercial Borrowings) FCCB(Foreign currency convertible bonds)

1. It is as international money market product.
2. Interest rates are applied for loans based on LIBOR
(London interbank offered rates).
3. Companies have to pay risk premium over & above
LIBOR. E.g. LIBOR+300bp where 100 bp = 1%
4. There are two routes available
1. The bonds can be issued in any of the foreign markets
to obtain currencies like USD, EUR, and Pound etc.
2. The bonds will be converted into equity shares after 5
yrs at pre agreed ratios.
3. The conversion price is decided in the beginning based
on the market price of shares.
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 i. Automatic route ii. Approval route
5. Under automatic route regulations are framed by RBI.
E.g. loans up to 20 million USD are allowed with 3 yrs
maturity, loans above 20 million USD and up to 500
million are allowed up to 5 yrs avg. maturity.
6. Any prepayment class will have to be approved by RBI.
7. Amt. cannot be used for working cap. purposes or for
investment in real estate or capital markets.
8. Approval is given by ECB division in ministry of finance
in respect of all cases not covered by automatic route.
4. Companies can go for reset class to reprice the shares.
5. There is a call option in the bond for the company and
pull option in the bond for the investors.
6. Coupon rate can be on fixed rate basis or floating rate
basis linked to LIBOR.
7. Secondary markets exist for these bonds so that
investors can discount it.
8. On conversion into equity shares they should fall within
the FDI limits.

Distinguish between Futures and Options

Futures Options
1. Exchange traded product, it can be bought and sold for 1. OTC product (given by bank) or exchange traded
money/several maturities. product (given by sensex).

2. Futures are standardized products. E.g. min size is 2. Confers the right to the buyer but no obligation to
1000$ in India. exercise.

3. Initial margin, mark to market margin, also rotability 3. A call option is a right to buy a currency but no
margins payable by the buyers and sellers of futures. obligation to buy at the contract price.

4. There is no underlying export, import transaction 4. A put option is a right to sell currency but no obligation
required. It is a speculative product. to sell at exercise rate.

5. Settlement of futures in a particular day of month. 5. Two types of options

i. Euro options – executable on date of expiry.
6. Usually futures are knocked out in opposite direction ii. American options – ‘’ any time before maturity.
and difference amount is paid or received by investor.
6. It is a insurance premium product. Therefore, premium
7. The price movements are called the tick size and iti is paid by buyer to seller. Seller also known as writer to
in multiple of 25 bps. product.

7. Different options strategies like

8. Hence it is a price fix product and not a premium based i. Zero cost option
product. ii. Strangle option
iii. Straddle

Are available in world. India encourages plain vanilla

option for hedging.

Distinguish between DFM and IFM

DFM(Domestic Financial Management) IFM(International Financial Management)

1. Involves rupee transactions. 1. Currency is FOREX ($, Yen, Euro) in addition to rupee.
14
2. Domestic laws like transfer of property act, negotiable 2. Therefore there is exchange rate risk to be managed by
instrument act, sales of goods act etc. applicable. corporate.

3. Financial statements are based on ICAI standards. 3. Corporations have transition exposure, transactional
exposure and operating exposure in FOREX business.
4. Income tax and withholding tax, corporate tax, ID tax
etc. are payable locally in INR. 4. International laws like WTO rules, ICC rules, UNO
rules, IMF rules etc. applicable.
5. Buyers, sellers, lenders and borrowers within same
country. 5. Risk management more complicated and involves
hedging their derivative products.
6. Therefore risk management less complex.

6. Different accounting standards like US GAAP, IAS,

7. Financing done by local FI’s like co-op banks, IFRS etc. are applicable in addition to ICAI.
commercial banks, development banks etc.

Distinguish between NRO and NRE

NRO(Non – resident Ordinary Rupee Account) NRE(Non-resident external Rupee Account)

1. These accounts are opened by NRI’s and PIO’s. 1. The account can be opened by an inward remittance of
2. Can be maintained jointly with a resident in India. FOREX to an authorized dealer.
3. All types of A/c’s like FD, CA, SB can be maintained. 2. Principal and interest not subject to any tax.
4. Interest rates payable according to corresponding 3. The interest amount and principal are repatriable
domestic deposits. without approval from RBI.
5. Local credits and debits are allowed. 4. Interest rates are applicable as per RBI rules which are
6. Amts are taxable according to IT and Wealth tax rules. linked to LIBOR.
7. Repatriation permissible with RBI guidelines. 5. Exchange rate risk is borne by account holder.
8. Existing account of resident can be re-designated into 6. Account can be jointly held only with another non-
NRO account on becoming an NRI. resident.
7. Account holder can give power of attorney to a resident
9. TDS applicable is 30% and returns can be filed for for operations on the account.
getting refund. 8. The account can be used for portfolio management
schemes.

9. PMS can be operated initially for 5 years subject to

extension by authorized dealer operating the scheme.

Short Notes

1. Nostro Account

A nostro account is a bank account established in a foreign country for the purpose of holding that countries currency.
Suppose a US bank purchases GBP. That currency has to be delivered somewhere, but US banks are only set up to
maintain accounts in USD. The bank establishes a nostro account at a British bank and instructs its counterparty to
deliver the GBP to that account.

If you maintain a nostro account for a foreign entity, you call it a vostro account. Vostro accounts are local accounts
holding local currency serving as nostro accounts for foreign entities.

15
 This stuff came into play in 1974 with the infamous failure of Germany’s bank Herstatt. On the day Germany
regulators forced the bank into liquidation; it had commitments with US banks to deliver USD against DEM. The US
banks delivered DEM from their German nostro accounts to Herstatt during German business hours. They had to wait
for US banks to open before Herstatt could pay USD from its US nostro accounts. In the interim, German regulators
shut down Herstatt, and the US banks didn’t receive their USD payments.

For example, a European bank will refer to its U.S. dollar account held at its U.S. correspondent bank as a Nostro
account ("our account at your bank"). To the U.S. correspondent, this same account will be referred to as a Vostro
account ("your account at our bank").

2. Vostro Account

A vostro bank account is an account that one party is holding for another party. In a vostro account, the administrators
are not actually the owners of the money. They must keep this account solvent on behalf of its owner. Vostro account
administrators, often banks, frequently pay interest to other parties for the use of their money.

Vostro accounts are just a way of talking about who owns the capital invested in them. To a customer who puts
money into a bank account, that account is a “nostro” account, meaning that it belongs to that person. From the
standpoint of the bank, it is a “vostro” account, meaning that it is not the bank’s own money, but the customer’s, and
the bank bears a responsibility for good accounting of the customer’s money. This makes sense, since “voster” in
Latin or “vuestra” in Spanish means “yours.”

3. Direct Quote

A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words, it involves
quoting in fixed units of foreign currency against variable amounts of the domestic currency.

For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1.

Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

4. Indirect Quote

A foreign exchange rate 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 U.S., an indirect quote for the Canadian dollar would be C$1.17 = US$1.

Conversely, in Canada an indirect quote for U.S. dollars would be US$0.85 = C$1.

5. Letter of credit

A Letter of Credit is a payment term generally used for international sales transactions. It is basically a mechanism,
which allows importers/buyers to offer secure terms of payment to exporters/sellers in which a bank (or more than one
bank) gets involved. The technical term for Letter of credit is 'Documentary Credit'. At the very outset one must
understand is that Letters of credit deal in documents, not goods. The idea in an international trade transaction is to
shift the risk. Thus a LC (as it is commonly referred to) is a payment undertaking given by a bank to the seller and is
issued on behalf of the applicant i.e. the buyer.

The Buyer is the Applicant and the Seller is the Beneficiary. The Bank that issues the LC is referred to as the Issuing
Bank which is generally in the country of the Buyer. The Bank that Advises the LC to the Seller is called the Advising
Bank which is generally in the country of the Seller.

The specified bank makes the payment upon the successful presentation of the required documents by the seller
within the specified time frame. Note that the Bank scrutinizes the 'documents' and not the 'goods' for making
payment. The process works in favor of both the buyer and the seller.

16
 The Seller gets assured that if documents are presented on time and in the way that they have been requested on the
LC, the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these
presented documents and ensure that they meet the terms and conditions stipulated in the LC.

Typically the documents requested in a Letter of Credit are the following:

• Commercial invoice
• Transport document such as a Bill of lading or Airway bill,
• Insurance document;
• Inspection Certificate
• Certificate of Origin

The LC could be 'irrevocable' or 'revocable'. An irrevocable LC cannot be changed unless both the buyer and seller
agree. Whereas in a revocable LC changes to the LC can be made without the consent of the beneficiary. A 'sight' LC
means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct
documents in the required time frame. A 'time' or 'date' LC will specify when payment will be made at a future date
and upon presentation of the required documents.

6. Derivatives: A derivative is a financial instrument that has a value, based on the expected future price movements of
the asset to which it is linked—called the underlying asset such as a share or a currency. There are many kinds of
derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative
investment. A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of
derivatives have been traded on markets before their expiration date as if they were assets.

Derivatives are usually broadly categorized by:

i. The relationship between the underlying asset and the derivative (e.g., forward, option, swap);
ii. The type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives,
commodity derivatives or credit derivatives);
iii. The market in which they trade (e.g., exchange-traded or over-the-counter);
iv. Their pay-off profile.

Types of derivatives
i. Exchange traded derivatives are instruments that are traded via specialized derivatives exchanges or other
exchanges.
ii. Over the counter derivatives are contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary

There are three major classes of derivatives:

i. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today.
A futures contract differs from a forward contract in that the futures contract is a standardized contract written
by a clearing house that operates an exchange where the contract can be bought and sold, whereas a
forward contract is a non-standardized contract written by the parties themselves.
ii. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option)
or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike
price, and is specified at the time the parties enter into the option. The option contract also specifies a
maturity date.
iii. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying
value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

7. World Bank: The World Bank is a vital source of financial and technical assistance to developing countries around
the world. World Bank help governments in developing countries reduce poverty by providing them with money and
technical expertise they need for a wide range of projects—such as education, health, infrastructure, communications,
government reforms, and for many other purposes.
17
 The term "World Bank" refers only to the International Bank for Reconstruction and Development (IBRD) and the
International Development Association (IDA). The term "World Bank Group" incorporates five closely associated
entities that work collaboratively toward poverty reduction: the World Bank (IBRD and IDA), and three other agencies,
the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the
International Centre for Settlement of Investment Disputes (ICSID). The Bank is like a cooperative in which 187
member countries are shareholders.

Under the Articles of Agreement of the International Bank for Reconstruction and Development (IBRD), a country
must first join the International Monetary Fund (IMF) prior to becoming a member of the Bank.

The Board of Executive Directors and the president of the Bank—who serves as chairman of the board—are
responsible for the conduct of the general operations of the Bank, oversee the work of the Bank on a daily basis, and
perform their duties under powers delegated to them by the Board of Governors. The Board of Governors is made up
of shareholders—187 member countries—who are the ultimate policymakers at the Bank. Generally, the governors
are member countries' ministers of finance or ministers of development.

According to the Articles of Agreement, the five largest shareholders, France, Germany, Japan, the United Kingdom,
and the United States, each appoint an executive director, while other member countries are represented by 19
executive directors who represent constituencies in several countries. Each of the directors is elected by a country or
group of countries every two years. It is customary for election rules to ensure that a wide geographical balance is
maintained on the board.

8. IMF

The IMF, also known as the “Fund,” was conceived at a United Nations conference convened in Bretton Woods, New
Hampshire, United States, in July 1944. The 45 governments represented at that conference sought to build a
framework for economic cooperation that would avoid a repetition of the vicious circle of competitive devaluations that
had contributed to the Great Depression of the 1930s.

The IMF’s responsibilities: The IMF's primary purpose is to ensure the stability of the international monetary system—
the system of exchange rates and international payments that enables countries (and their citizens) to transact with
one other. This system is essential for promoting sustainable economic growth, increasing living standards, and
reducing poverty. Following the recent global crisis, the Fund is clarifying and updating its mandate to cover the full
range of macroeconomic and financial sector issues that bear on global stability.

IMF’s main goals:

• promoting international monetary cooperation;

• facilitating the expansion and balanced growth of international trade;
• promoting exchange stability;
• assisting in the establishment of a multilateral system of payments; and
• making resources available to members experiencing balance of payments difficulties.

Membership: 187 countries

Headquarters: Washington, D.C.
Executive Board: 24 Directors representing countries or groups of countries
Staff: Approximately 2,500 from 158 countries
Total quotas: US$328 billion (as of 8/31/10)
Additional pledged or committed resources: $600 billion
Loans committed (as of 8/31/10): US$200 billion, of which US$146 billion have not been drawn (see table)
Biggest borrowers (credit outstanding as of 8/31/10): Romania, Ukraine, Hungary

The work of the IMF is of three main types.

i. Surveillance involves the monitoring of economic and financial developments, and the provision of policy
advice, aimed especially at crisis-prevention.

18
 ii. The IMF also lends to countries with balance of payments difficulties, to provide temporary financing and to
support policies aimed at correcting the underlying problems; loans to low-income countries are also aimed
especially at poverty reduction.
iii. The IMF provides countries with technical assistance and training in its areas of expertise. Supporting all
three of these activities is IMF work in economic research and statistics.

9. WTO: The WTO was born out of the General Agreement on Tariffs and Trade (GATT), which was established in
1947. A series of trade negotiations, GATT rounds began at the end of World War II and were aimed at reducing
tariffs for the facilitation of global trade on goods. The rationale for GATT was based on the Most Favored Nation
(MFN) clause, which, when assigned to one country by another, gives the selected country privileged trading rights.
As such, GATT aimed to help all countries obtain MFN-like status so that no single country would be at a trading
advantage over others.

The WTO replaced GATT as the world's global trading body in 1995, and the current set of governing rules stems
from the Uruguay Round of GATT negotiations, which took place throughout 1986-1994. GATT trading regulations
established between 1947 and 1994 (and in particular those negotiated during the Uruguay Round) remain the
primary rule book for multilateral trade in goods. Specific sectors such as agriculture have been addressed, as well as
issues dealing with anti-dumping.

The Uruguay Round also laid the foundations for regulating trade in services. The General Agreement on Trade in
Services (GATS) is the guideline directing multilateral trade in services. Intellectual property rights were also
addressed in the establishment of regulations protecting the trade and investment of ideas, concepts, designs,
patents, and so forth.

The purpose of the WTO is to ensure that global trade commences smoothly, freely and predictably. The WTO
creates and embodies the legal ground rules for global trade among member nations and thus offers a system for
international commerce. The WTO aims to create economic peace and stability in the world through a multilateral
system based on consenting member states (currently there are slightly more than 140 members) that have ratified
the rules of the WTO in their individual countries as well. This means that WTO rules become a part of a country's
domestic legal system. The rules, therefore, apply to local companies and nationals in the conduct of business in the
international arena. If a company decides to invest in a foreign country, by, for example, setting up an office in that
country, the rules of the WTO (and hence, a country's local laws) will govern how that can be done. Theoretically, if a
country is a member to the WTO, its local laws cannot contradict WTO rules and regulations, which currently govern
approximately 97% of all world trade.

Explain

1. Spot Settlement: A Sport settlement (T + 0) is a transaction where the settlement date or the value date is usually 2
business days ahead. For E.g. a London Bank sells yen against dollar to a Prais Bank on Monday, The London bank
will turn over a yen deposit to the Paris Bank on Wednesday and the Paris Bank will transfer the dollars to the
American Bank on the same day.

The Time gap is necessary to confirm and clear the deal through the communication network such as SWIFT. If the
2nd day after the transaction is a public holiday in either county, then the settlement will happen on the next working
day.

2. Forward Settlement: A Forward settlement (> T + 2) is a transaction where the settlement date for the transaction is
greater than 2 business days. A Forward contract is a non-standardized contract between two parties to buy or sell an
asset at a specified future time at a price agreed today. The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. A forward
contract that is for more than 2 days but less than a month for e.g. 15 day forward is called a short forward. A forward
contract that is more than or equal to 1 month is called a long forward e.g. 1 month forward, 2 month forward.
Forwards are OTC Products.

3. Spread: A spread is the difference between the Ask and Offer price of a currency that is given by a bank to the
customer. In Simple words, spread is the difference between the ask price and the bid price.

19
 For e.g.: A quotation shows participants in a market are willing to pay 1.2635 for the EURUSD, and are conversely
willing to sell the same pair at 1.2638. This creates a 1.2635/38 spread, which is 3 basis points wide.

4. Bid: BID Rate is the rate at which the bank will pay for 1 Unit of another currency.

For e.g. If there is a quotation as follows

1 USD $ = Re. 44.1015 / Re. 44.1115

In the above quotation, the bank will pay Re. 44.1015 when it buys a dollar.

5. Offer Rate: Offer rate is the rate at which the bank expects to be paid for 1 Unit of another currency. For e.g. If there
is a quotation as follows

1 USD $ = Re. 44.1015 / Re. 44.1115

In the above quotation, the bank expected to be paid Re. 44.1115 when it sells a dollar.

Exchange Rate Systems

Floating exchange rate system

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is
allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as
a floating currency (A floating currency is a currency that uses a floating exchange rate as its exchange rate regime).

There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange
rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign
business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations,
fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true,
considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others,
such as the UK or the Southeast Asia countries before the Asian currency crisis.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the
exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might,
for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor".
Management by the central bank may take the form of buying or selling large lots in order to provide price support or
resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.

A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause
serious problems, especially in emerging economies. These economies have a financial sector with one or more of
following conditions:

• high liability dollarization

• financial fragility
• strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of
the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial
system.
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For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the
nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the consequence of
frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the
foreign exchange market.

The number of countries that present fear of floating increased significantly during the nineties.

Fixed Exchange rate system: A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange
rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other
currencies, or to another measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes
trade and investments between the two countries easier and more predictable, and is especially useful for small
economies where external trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency
pegged to it.

Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on
the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too
far below the desired rate, the government buys its own currency in the market using its reserves. This places greater
demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate,
the government sells its own currency, thus increasing its foreign reserves.

Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other
rate. This is difficult to enforce and often leads to a black market in foreign currency.

The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically adjust the balance of
trade.[5] When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which
will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign
goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this
automatic rebalancing does not occur.

Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged
exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or
fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes
and injecting more money in the market), the government risks running into a trade deficit. This might occur as the
purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to
use deflationary measures (increased taxation and reduced availability of money) which can lead to unemployment.
Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of
theirs in defending their exchange rate.

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Managed Float Systems: Governments and central banks often seek to increase or decrease their exchange rates by
buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values.
Government or central bank participation in a floating exchange rate system is called a managed float Government or
central bank participation in a floating exchange rate system..

Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise
or lower the price of their own currency. Typically, the purpose of such intervention is to prevent sudden large swings in
the value of a nation’s currency. Such intervention is likely to have only a small impact, if any, on exchange rates. Roughly
$1.5 trillion worth of currencies changes hands every day in the world market; it is difficult for any one agency—even an
agency the size of the U.S. government or the Fed—to force significant changes in exchange rates.

Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of a country’s
currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order
to prevent a major reduction in net exports. An announcement that a further increase in its exchange rate is unacceptable,
followed by sales of that country’s currency by the central bank in order to bring its exchange rate down, can sometimes
convince other participants in the currency market that the exchange rate will not rise further. That change in expectations
could reduce demand for and increase supply of the currency, thus achieving the goal of holding the exchange rate down.

The Gold Standard

Many countries have adopted gold standard as their monetary system during the last two decades of the 19th century.
This system was in vogue till the outbreak of World War 1. Under this system the parties of currencies were fixed in terms
of gold. There were two main types of gold standard:

1. Gold specie standard: Gold was recognized as means of international settlement for receipts and payments
amongst countries. Gold coins were an accepted mode of payment and medium; of exchange in domestic market
also. A country was stated to be on gold standard if the following condition were satisfied:
a. Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in
unrestricted amounts at the fixed price.
b. Melting gold including gold coins, and putting it to different uses was freely allowed.
c. Import and export of gold was freely allowed.
d. The total money supply in the country was determined by the quantum; of gold available for monetary
purpose.

2. Gold Bullion Standard: Under this system, money in circulation was either partly of entirely paper and gold
served as reserve asset for the money supply. However, par money could be exchanged for gold at any time. As the
monetary authorities did not aspect all the paper currency to be converted into gold, there was no need or they to hold
gold for covering money supply in full.

The exchange was determined by the gold content of the respective currency. E.g. if the gold content in Britain was 3
times US, then automatically pound sterling(GBP) was equivalent of 3 US dollars. This system is also known as ‘Mini
Parity Theory’. After World War 1, all European gold standard countries left in 1936, thus the gold standard era was
effectively over.

The Bretton Woods System: The bitter experience of war year, and danger of the recurrence looming large, forced the
countries to create a free, stable and multilateral money system, which would help in restoration of international trade. As
early as in 1943 USA and Great Britain accepted at the Bretton Woods Conference held in July 1944 and International
Monetary Fund (IMF) was established in 1946.

In this system the member countries require to fix the parities of their currencies in terms US dollar or gold with
fluctuations in their currency within 1% of limit. Due to massive deficit increased the supply of US dollar in international
market and gold reserve held by USA was not sufficient to cover.

Through the Smithsonian Agreement, USA devalued dollar from 35 ounce to 38 per ounce, but could not last long.

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The concept of one single currency of entire European was accepted way back in 1991 under Maastricht Treaty, and has
come into reality effective January 4 1999 and the currency now has established independent currency since January
2001.

Purchasing Power Parity (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that
currencies are valued for what they can buy. Thus if 135 JPY buy a fountain pen and the same fountain pen can be
bought for USD 1, it can be inferred that since 1 USD or 135 JPY can buy the same fountain pen, there fore USD 1 = JPY
135.

For example if country A had a higher rate of inflation as compared to country A then goods produced in country A would
become costlier as compared to goods produced in country B. This would induce imports in to country A and also the
goods produced in country A being costlier, would lose in international competition to goods produced in country B. This
decrease in exports of country A as compared to exports from country B would lead to demand for the currency of country
B and excess supply of currency of country A. This in turn, causes currency of country A to depreciate in comparison of
currency of country B which is having relatively more exports.

After the collapse of PPP system there came the Bretton woods System, and after the collapse of that Smithsonian
Agreement. At present the floating rate system is used in all most countries.

Evolution of Exchange Rate System in India

The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during British regime and till late sixties, most
of India’s trade transactions were dominated to pound sterling. Under Bretton Woods system, as a member of IMF Indian
declared its par value of rupee in terms of gold. The corresponding rupee sterling rate was fixed 1 GBP = RS 18.

When Bretton Woods system bore down in August 1971, the rupee was de-linked from US $ and the exchange rate was
fixed at 1 US $ = Rs 7.50. Reserve bank of India, however, remained pound sterling as the currency of intervention. The
US $ and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian Agreement in December 1971, the
rupee was de-linked from US $ and again linked to pound sterling. This parity was maintained with a band of 2.25%. Due
to poor fundamental pound got depreciated by 20%, which cause rupee to depreciate.

To be not dependent on the single currency, pound sterling on September 25, 1975 rupee was de-linked from pound
sterling and was linked to basket of currencies, the currencies includes as well as their relative weights were kept secret
so that speculators don’t get a wind of the direction of the movement of exchange rate of rupee.

From January 1, 1984 the sterling rate schedule was abolished. The interest element, which was hitherto in built the
exchange rate, was also de-linked. The interest was to be recovered from the customers separately. This not only allowed
transparency in the exchange rate quotations but also was in tune with international practice in this regard. FEDAI issued
guidelines for calculation of merchant rates.

The liquidity crunch in 1990 and 1991 on forex front only hastened the process. On March 1, 1992 Reserve Bank of India
announced a new system of exchange rates known as Liberalized Exchange Rate Management System.

LERMS was to make balance of payment sustainable on ongoing basis allowing market force to play a greater role in
determining exchange rate of rupee. Under LERMS, the rupee become convertible for all approved external transactions.
The exporters of goods and services and those who received remittances from abroad were allowed to sell bulk of their
forex receipts. Similarly, those who need foreign exchange to import and travel abroad were to buy foreign exchange from
market-determined rate.

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From March 1 1993 modified LERMS under which the all forex transactions, under current and capital account, are being
put through by Authorized Dealers at market determined exchange rate.

Various conventions and practices in the forex markets

Some of the common market practices in foreign exchange markets are:

Choice Prices

A choice price is one where the market marker quotes a single rate at which the market user can choose to buy or sell.
This is sometimes done where the amount is small, but the counterparty relationship is a good one. Alternatively, if the
market maker already has a profitable position he may be content either to close that position or to increase it at the same
price.

In practice, choice prices are more frequently used to manipulate the market user. The convention is that it is extremely
bad etiquette to turn down a choice price; the market user is morally obliged to deal. If the market maker is certain that the
customer is a buyer of base currency, for example, he may quote a high choice price. This not only gives the market
marker a deal at a good price. This not only gives the market marker a deal at a good price, but also shows the market
user that his intentions are transparent.

Choice prices are also quoted to counterparties who call persistently for prices but never deal. Market makers do not like
to be used as a market information service by other banks

Liquidity

The market for a currency is said to be liquid when customers can readily buy or sell any quantity of the currency. A
feature of liquid markets is competition between market makers, resulting in narrow spreads between bid and offered
prices. Liquidity in most currencies varies from one FX centre to another, and between the spot and forward markets. For
example, there is a liquid spot market for the Spanish peseta in Madrid, Paris and London , but I other centers, especially
outside Europe ,the peseta market is much less liquid and customers will have more difficulty in finding a bank willing to
buy or sell the currency at a competitive price.

Interbank trading in currencies does have one significant benefit for trade-related and investment-related FX transactions.
The high volume of speculative interbank trading creates much greater liquidity in the market, which narrows the bid-
offer spreads. This offsets to some extent, the problems of volatility in exchange rates created by speculative interbank
trading.

Nostro Accounts
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A bank that trades actively in the FX makers has to maintain currency bank accounts (nostro accounts) in all the
currencies in which it trades, to meet payment requirements as these fall due. Current accounts are therefore maintained
with correspondent banks in other countries. For example, a UK bank will keep a US dollar current account with a US
correspondent bank, a Deutschemark current account with a German correspondent bank, a Hong Kong dollar account
with a correspondent in Hong Kong, etc.

A banks trading desk is ‘long’ in a currency where the total open position (current balance plus money due in at forward
dates: minus money payable at forward dates) is positive, and is ‘short’ in a currency when the total open position is
negative.

A bank’s trading desk is long in a currency where the total open position (although new FX market transactions can be
made to maintain its required position). Buying a currency lengthens the bank’s position in that currency: selling a
currency shortens the position.

Banks do not always want to have a position (long or short) in currencies in which they trade, and can ‘square’ temporary
positions through the FX ‘swap’ transactions. For example, if a UK bank does not wan to be long in Spanish pesetas, but
has a pesetas dealing desk, it can buy a quantity of pesetas ‘spot’ and simultaneously sell them forward. This will give the
bank a working balance in pesetas to meet its short term payments requirements, but the spot purchases and matching
forward sale avoids the need to hold a long position in the peseta.

Dealing Activity

Within each FX centre, a bank will have a specialist spot market trader for each currency in which it deals. For example,
ABC Bank in London will have a spot market trader for each currency in which it deals. For example, ABC Bank in London
will have a spot trader for sterling against US dollars, another for Euros and another for yen. The trader keeps a book of
the purchases and sales of the currency transacted o behalf f the bank. If the aim is to keep a square position, buying and
selling equal quantities of the currency, the trader will adjust bid and offered spot prices according to demand and supply
from customers.

For example, suppose a German bank is quoting 1.3665-1.3670 for the US dollar/euro rate, and wished o maintain its
current position in dollars. If it then transacts a deal involving the sale of, say, USD 5 million in exchange for Euros, it will
want to buy dollars to restore its position.

It could therefore alter its quoted rates to say, 1.3667-1.3672, i.e., raise the value of the dollars against the Euros, hoping
that its new rate will attract sellers of dollars. However, the market is very competitive and banks must avoid the risk of
setting rates that are significantly out of line with other banks..

The job of the spot trader is to make markets in his currency. When a call is received from a customer asking for a
quotation, the call is handled by a customer-dealer, who will ask for a spot price quotation from the trader in the currency.
If the transaction is agreed, the trader is informed, so that he can keep his book up to date.

• If the dealer buys a currency, he will normally look to lay off the purchase, selling the currency to another bank or
corporate buyer.

• Spot prices vary according to supply and demand in the market, so if a dealer wants to lay off a deal to earn a profit,
speed is essential. Dealers will therefore commonly sell currency immediately after buying it, and vice versa.

Speed is critical when deciding which rate to offer.

25
• If a bank is long in the currency, the dealer will offer a spot rate more attractive more attractive to a buyer of that
currency than a seller.(i.e. he will lower the rate).

• If a bank is short in the currency, it will be eager to buy and will offer higher spot rates.

• If the bank already has a square position, the rate being offered will depend on the dealer’s view of how easily and
quickly he can lay off a deal.

Short Notes

1. Swift: The Society for Worldwide Interbank Financial Telecommunication ("SWIFT") operates a worldwide financial
messaging network which exchanges messages between banks and other financial institutions. SWIFT also markets
software and services to financial institutions, much of it for use on the SWIFTNet Network, and ISO 9362 bank
identifier codes (BICs) are popularly known as "SWIFT codes".

The majority of international interbank messages use the SWIFT network. As of September 2010, SWIFT linked
9,000+ financial institutions in 209 countries. SWIFT transports financial messages in a highly secure way, but does
not hold accounts for its members and does not perform any form of clearing or settlement.

SWIFT does not facilitate funds transfer, rather, it sends payment orders, which must be settled via correspondent
accounts that the institutions have with each other. Each financial institution, to exchange banking transactions, must
have a banking relationship by either being a bank or affiliating itself with one (or more) so as to enjoy those particular
business features.

SWIFT is a cooperative society under Belgian law and it is owned by its member financial institutions. SWIFT has
offices around the world. SWIFT headquarters are located in La Hulpe, Belgium, near Brussels. An average of 2.4
million messages, with aggregate value of $2 trillion, was processed by SWIFT per day in 1995.

It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish common standards
for financial transactions and a shared data processing system and worldwide communications network. Fundamental
operating procedures, rules for liability etc., were established in 1975 and the first message was sent in 1977.

2. FEMA Regulations: Some FEMA highlights are:

• It prohibits foreign exchange dealing undertaken other than an authorized person;
• It also makes it clear that if any person residing in India received any Forex payment (without there being a
corresponding inward remittance from abroad) the concerned person shall be deemed to have received they
payment from a non authorized person.

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 • There are 7 types of current account transactions, which are totally prohibited, and therefore no transaction
can be undertaken relating to them. These include transaction relating to lotteries, football pools, banned
magazines and a few others.
• FEMA and the related rules give full freedom to Resident of India (ROI) to hold or own or transfer any foreign
security or immovable property situated outside India.
• Similar freedom is also given to a resident who inherits such security or immovable property from an ROI.
• An ROI is permitted to hold shares, securities and properties acquired by him while he was a Resident or
inherited such properties from a Resident.
• The exchange drawn can also be used for purpose other than for which it is drawn provided drawl of
exchange is otherwise permitted for such purpose.
• Certain prescribed limits have been substantially enhanced. For instance, residence now going abroad for
business purpose or for participating in conferences seminars will not need the RBI's permission to avail
foreign exchange up to US$. 25,000 per trip irrespective of the period of stay, basic travel quota has been
increased from the existing US$ 3,000 to US$ 5,000 per calendar year.

Exchange rate arrangements/regimes

1. Float: A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's
value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate
is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of
exchange for its currency in the exchange market. Floating rates are the most common exchange rate regime today.
For example, the dollar, euro, yen, and British pound all float.

2. Managed float regime: Managed float regime is the current international financial environment in which exchange
rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and
selling currencies. It is also known as a dirty float.

In an increasingly integrated world economy, the currency rates impact any given country's economy through the
trade balance. In this aspect, almost all currencies are managed since central banks or Governments intervene to
influence the value of their currencies.

3. Pegged float: Here, the currency is pegged to some band or value, either fixed or periodically adjusted. Pegged
floats are:
• Crawling bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted
periodically. This is done at a preannounced rate or in a controlled way following economic indicators.
• Crawling peg: Crawling peg is an exchange rate regime usually seen as a part of fixed exchange rate
regimes which allows depreciation or appreciation in an exchange rate gradually. Some central banks use a
formula which triggers a change when certain conditions are met (like need for adjustment for inflation), while
others prefer not to use a preset formula and change exchange rate frequently to discourage speculations.

"For example, in the 1990s, Mexico had fixed its peso with the U.S. dollar. However, due to the significant inflation
in Mexico, as compared to the U.S., it was evident that the peso would need to be severely devalued. Because a
rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system,
and the peso was slowly devalued toward a more appropriate exchange rate."

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 • Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed band (bigger than 1%)
around a central rate.

4. Fixed: A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a
currency's value is matched to the value of another single currency or to a basket of other currencies, or to another
measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This
makes trade and investments between the two countries easier and more predictable, and is especially useful for
small economies where external trade forms a large part of their GDP. It can also be used as a means to control
inflation. However, as the reference value rises and falls, so does the currency pegged to it.

5. Currency board: A monetary regime based on an explicit legislative commitment to exchange domestic currency for
a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the
fulfillment of its legal obligation. This implies that domestic currency will be issued only against foreign exchange and
that it remains fully backed by foreign assets, eliminating traditional central bank functions, such as monetary control
and lender-of-last-resort, and leaving little scope for discretionary monetary policy. Some flexibility may still be
afforded, depending on how strict the banking rules of the currency board arrangement are.

6. Dollarization: Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of
the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of
any foreign currency as the national currency.

Functions of WTO

Some of the functions of WTO are:

• The WTO facilitates the implementation, administration and operation, and furthers the objectives, of this Agreement
and the Multilateral Trade Agreements, and also provide framework for the implementation, administration and
operation of the Plurilateral Trade Agreements.

• The WTO provides the forum for negotiations among its members concerning their multilateral trade relations in
matters dealt with under the agreements and a framework for the implementation of the results of such negotiations,
as may be decided by the Ministerial Conference.

• The WTO administers the Understandings on Rules and Procedures governing the Settlement of Disputes.

• The WTO administers the Trade Policy Review Mechanism (TPRM).

• With a view to achieving greater coherence in global economic policy-making, the WTO cooperates as appropriate,
with the International Monetary Fund (IMF) and with the International Bank for Reconstruction and Development
(World Bank) and its affiliate agencies.

Functions of World Bank

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Some of the main functions of world bank are

• The main function of the World Bank Group is the provision of low interest loans, credit that is interest free as well as
aids to the least developed countries for the development in the field of education health and infrastructure.

• To help member states to reconstruct and develop by facilitating capital investment;

• To promote foreign private investment, and

• To promote the long-range balanced growth of international trade and the maintenance of equilibrium in balances of
payments.

Foreign Exchange Exposure

Foreign exchange risk is related to the variability of the domestic currency values of assets, liabilities or operating income
due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at risk. Foreign currency
exposures and the attendant risk arise whenever a company has an income or expenditure or an asset or liability in a
currency other than that of the balance-sheet currency.

Indeed exposures can arise even for companies with no income, expenditure, asset or liability in a currency different from
the balance-sheet currency. When there is a condition prevalent where the exchange rates become extremely volatile the
exchange rate movements destabilize the cash flows of a business significantly. Such destabilization of cash flows that
affects the profitability of the business is the risk from foreign currency exposures.

Classification of Exposures

Financial economists distinguish between three types of currency exposures – transaction exposures, translation
exposures, and economic exposures. All three affect the bottom- line of the business.

1. Transaction Exposure: Transaction exposure, defined as a type of foreign exchange risk faced by companies that
engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change
the value of a contract before it is settled. Transaction exposure is also called transaction risk.

Once a cross-currency contract has been agreed upon, for a specific quantity of goods and a specific amount of
money, subsequent fluctuations in exchange rates can change the value of that contract.

29
 A company that has agreed to but not yet settled a cross-currency contract that has transaction exposure. The greater
the time between the agreement and the settlement of the contract, the greater the risk associated with exchange rate
fluctuations.

Suppose that a company is exporting deutsche mark and while costing the transaction had reckoned on getting say
Rs.24 per mark. By the time the exchange transaction materializes i.e. the export is affected and the mark sold for
rupees, the exchange rate moved to say Rs.20 per mark.

Some strategy to manage transaction exposure

Hedging through invoice currency: While such financial hedging instruments as forward contract, swap, future and
option contracts are well known, hedging through the choice of invoice currency, an operational technique, has not
received much attention. The firm can shift, share or diversify exchange risk by appropriately choosing the currency of
invoice. Firm can avoid exchange rate risk by invoicing in domestic currency, there by shifting exchange rate risk on
buyer. As a practical matter, however, the firm may not be able to use risk shifting or sharing as much as it wishes to for
fear of losing sales to competitors. Only an exporter with substantial market power can use this approach. Further, if the
currencies of both the exporter and importer are not suitable for settling international trade, neither party can resort to risk
shifting to deal with exchange exposure.

Hedging via lead and lag: Another operational technique the firm can use to reduce transaction exposure is leading and
lagging foreign currency receipts and payments. To “lead” means to pay or collect early, where as “lag” means to pay or
collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from
depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will
attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively
implement the Lead/Lag strategy, the transaction exposure the firm faces can be reduced.

2. Translation Exposure (Accounting Exposures)

Translation exposure is a type of foreign exchange risk faced by multinational corporations that have subsidiaries
operating in another country. It is the risk that foreign exchange rate fluctuations will adversely affect the translation of the
subsidiary’s assets and liabilities – denominated in foreign currency – into the home currency of the parent company when
consolidating financial statements. Translation exposure is also called accounting exposure, or translation risk.

Translation exposure can affect any company that has assets or liabilities that are denominated in a foreign currency or
any company that operates in a foreign marketplace that uses a currency other than the parent company’s home
currency. The more assets or liabilities the company has that are denominated in a foreign currency, the greater the
translation risk.

Ultimately, for financial reporting, the parent company will report its assets and liabilities in its home currency. So when
the parent company is preparing its financial statements, it must include the assets and liabilities it has in other currencies.
When valuing the foreign assets and liabilities for the purpose of financial reporting, all of the values will be translated into
the home currency. Therefore foreign exchange rate fluctuations actually change the value of the parent company’s
assets and liabilities. This is essentially the definition of accounting exposure.

Accounting Exposure Example

Here is a simplified example of accounting exposure. Assume the domestic division of a multinational company incurs a
net operating loss of $3,000. But at the same time, a foreign subsidiary of the company made of profit of 3,000 units of
foreign currency. At the time, the exchange rate between the dollar and the foreign currency is 1 to 1. So the foreign
subsidiary’s profit exactly cancels out the domestic division’s loss.

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Before the parent company consolidates its financial reports, the exchange rate between the dollar and the foreign
currency changes. Now 1 unit of foreign currency is only worth $.50. Suddenly the profit of the foreign subsidiary is only
worth $1,500 and it no longer cancels out the domestic division’s loss. Now the company as a whole must report a loss.
This is a simplified example of translation exposure.

Hedging Translation Risk

A company with foreign operations can protect against translation exposure by hedging. The company can protect against
the translation risk by purchasing foreign currency, by using currency swaps, by using currency futures, or by using a
combination of these hedging techniques. Any one of these techniques can be used to fix the value of the foreign
subsidiary’s assets and liabilities to protect against potential exchange rate fluctuations.

3. Economic Exposure

Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated
changes in exchange rates. An economic exposure is more a managerial concept than a accounting concept. A company
can have an economic exposure to say Yen: Rupee rates even if it does not have any transaction or translation exposure
in the Japanese currency. This would be the case for example, when the company’s competitors are using Japanese
imports. If the Yen weakens the company loses its competitiveness (vice-versa is also possible). The company’s
competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting.
Therefore the company’s exposed to Japanese Yen in an indirect way.

In simple words, economic exposure to an exchange rate is the risk that a change in the rate affects the company’s
competitive position in the market and hence, indirectly the bottom-line. Broadly speaking, economic exposure affects the
profitability over a longer time span than transaction and even translation exposure. Under the Indian exchange control,
while translation and transaction exposures can be hedged, economic exposure cannot be hedged.

4. Operating exposure:

Operating exposure can be defined as “the extent to which the firm’s operating cash flows would be affected by random
changes in exchange rates”. Operating exposure may affect in two different ways to the firm, viz., competitive effect and
conversion effect. Adverse exchange rate change increase cost of import which makes firm’s product costly thus firm’s
position becomes less competitive, which is competitive effect. Adverse exchange rate change may reduce value of
receivable to the exporting firm which is called conversion effect.

Some strategy to manage operating exposure

Selecting low cost production sites: When the domestic currency is strong or expected to become strong, eroding the
competitive position of the firm, it can choose to locate production facilities in a foreign country where costs are low due to
either the undervalued currency or under priced factors of production. Recently, Japanese car makers, including Nissan
and Toyota, have been increasingly shifting production to U.S. manufacturing facilities in order to mitigate the negative
effect of the strong yen on U.S. sales. German car makers such as Daimler Benz and BMW also decided to establish
manufacturing facilities in the U.S. for the same reason. Also, the firm can choose to establish and maintain production
facilities in multiple countries to deal with the effect of exchange rate changes. Consider Nissan, which has manufacturing
facilities in the U.S. and Mexico, as well as in Japan. Multiple manufacturing sites provide Nissan with great deal of
flexibility regarding where to produce, given the prevailing exchange rates. When the yen appreciated substantially
against the dollar, the Mexican peso depreciated against the dollar in recent years. Under this sort of exchange rate
development, Nissan may choose to increase production in the U.S. and especially in Mexico, in order to serve the U.S.
market. This is, in fact, how Nissan has reacted to the rising yen in recent years. Maintaining multiple manufacturing sites,
however, may prevent the firm from taking advantage of economies of scale, raising its cost of production. The resultant
higher cost can partially offset the advantages of maintaining multiple production sites.

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Flexible sourcing policy: Even if the firm manufacturing facilities only in the domestic country, it can substantially lessen
the effect of exchange rate changes by sourcing from where input costs are low. Facing the strong yen in recent years,
many Japanese firms are adopting the same practice. It is well known that Japanese manufacturers, especially in the car
and consumer electronics industries, depend heavily on parts and intermediate products from such low cost countries as
Thailand, Malaysia, and China. Flexible sourcing need not be confined just to materials and parts. Firms can also hire low
cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive.

Diversification of the market: Another way of dealing with exchange exposure is to diversify the market for the firm’s
products as much as possible. Suppose that GE is selling power generators in Mexico as well as Germany. Reduced
sales in Mexico due to the dollar appreciation against the peso can be compensated by increased sales in Germany due
to dollar depreciation against the euro. As a result, GE’s overall cash flows will be much more stable than would be the
case if GE sold only in one foreign market, either Mexico or Germany. As long as exchange rates do not always move in
the same direction, the firm can stabilize its operating cash flow by diversifying its export market.

R&D efforts and product differentiation: Investment in R&D activities can allow the firm to maintain and strengthen its
competitive position in the face of adverse exchange rate movements. Successful R&D efforts allow the firm to cut costs
and enhance productivity. In addition, R&D efforts can lead to the introduction of new and unique products for which
competitors offer no close substitutes. Since the demand for unique products tend to be highly inelastic, the firm would be
less exposed to exchange risk. At the same time, the firm can strive to create a perception among consumers that its
product is indeed different from those offered by competitors. This helps firm to pass-through any adverse effect of
exchange rate on to the customers.

Financial hedging: While not a substitute for the long-term, financial hedging can be used to stabilize the firm’s cash
flow. For example, the firm can lend or borrow foreign currencies as a long term basis. Or, the firm can use currency
forward of options contracts and roll them over if necessary.

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