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INTERNATIONALFINANCE

By

Siddharth S. Kanungo

BHAVAN·S CENTRE FOR COMMUNICATION AND MANAGEMENT

BHUBANESWAR (BCCM)



MODULE-3

Foreign Exchange Market

Overview of Foreign Exchange Market

Exchange Rate Mechanism

Forecasting Foreign Exchange Rates

Market for Currency Futures & Options

Transf er Pricing

[2]



Overview of Foreign Exchange Market

Foreign exchange market is a market where foreign currencies are bought

and sold against each other. It is the largest market in the world.

The average daily foreign exchange turnover in April 2007 was US $3210

billion which was 160 times of the daily trading volume of NYSE.

The major foreign exchange market centers are London, New York, Tokyo,

Zurich and Frankfurt handling over two-thirds of the world trading. Hong

Kong, Singapore, Paris and Sydney account for bulk of the rest of the

market. In India, the largest market for foreign exchange is based in

Mumbai.

Majority of the trading is accounted for by hard currencies like US Dollar,

Euro, Yen, Pound Sterling, Swiss Frank, Canadian Dollar, Australian Dollar

and Deutsche Mark.The foreign exchange market is OTC (Over-the-Counter) in nature. This

means there is no physical market place or an organized exchange where

traders meet to buy and sell currencies. The market is actually a

worldwide network of traders consisting primarily of banks, connected

primarily by telephone lines and computers.[3]



Overview of Foreign Exchange Market (Cont.)

The foreign exchange market is a 24-hour market spanning over all time

zones. When it is 3.00 pm in Tokyo, it is 2.00 pm in Hong Kong. When it is

3.00 pm in Hong Kong, it is 1.00 pm in Singapore. When it is 3.00 pm in

Singapore, it is 12 noon in Bahrain, When it is 3.00 pm in Bahrain, it is

11.00 am in London. 3.00 pm in London is 10.00 am in New York. By the

time New York is starting to wind up at 3.00 pm, it is noon at Los

Angeles. By the time it is 3.00 pm in Los Angeles, it is 9.00 am of the nextday in Sydney. Due to the gap in diff erent time zones, the market

functions virtually 24-hours a day. This enables a trader to offset a

position created in one market using another market.

Classifications of Foreign Exchange Market

(i) Based on participants, the foreign exchange market can be classified intoRetail Market & Wholesale Market.

Retail market: This is the market in which travelers and tourists exchange

one currency for another in the form of currency notes or travelers

cheques. The total turnover and the average transaction size are very

small. The spread between buying and selling prices is large.

[4]



Overview of Foreign Exchange Market (Cont.)

Wholesale Market: Wholesale market is often called the inter-bank market.

The major categories of participants in this market are commercial

banks, investment institutions, non-financial corporations and central

banks. The total turnover and the average transaction size are very large.

The spread between buying and selling prices is small.

(ii) Based on timing of delivery, the foreign exchange market can be

classified into Spot Market & Forward Market.

Spot Market: In the spot market, currencies are traded for immediate

delivery (two working days) at a rate existing on the day of transaction. If

a transaction takes place on Thursday and both Saturday and Sunday are

holidays, then delivery of currency shall take place on Monday. In this

case, Thursday is the contract date and Monday is the value date orsettlement date.

Forward Market: In forward market, contracts are made to buy and sell

currencies for future delivery, say, after a fortnight, one month, two

months and so on. The rate at which the delivery of currency will take

place on the value date or settlement date is agreed upon on the

contract date. [5]



Exchange Rate Mechanism

Exchange Rate Q uotations: The rate at which one currency can be

exchanged (bought and sold) for another is known as exchange rate. The

various exchange rates are regularly published i n newspapers and

websites.

(i) Direct & Indirect Q uote: The methods for quoting exchange rates can be

both direct and indirect. The home currency quoted in terms of a foreign

currency is direct quote (Rs. 35.00/US$) while a foreign currency quotedin terms of the home currency is indirect quote (US$ 0.02857/Re.).

(ii) Buying & Selling Rates: Generally, two rates are published buying rate

and selling rate. The buying rate is also known as bid rate. The selling

rate is also known as ask rate or off er rate. The bid rate is always given

first, followed by the ask rate. If the rupee-US$ rate is Rs. 40.00 -40.30/US$, then the former is the bid rate and the latter the ask rate.

Banks buy foreign exchange from customers at buying rate and sell

foreign exchange to customers at selling rate. The diff erence between

these two quotes is the profit/loss also known as spread.

[6]



Exchange Rate Mechanism (Cont.)

(iii) Forward Market Q uotations: The quotes for the forward market are also

published in newspapers and internet. The forward market quotations

may be expressed as outright quote or swap quote.

The outright quote (retail/commercial customers) for US $ in terms of rupee

can be written for diff erent periods of forward contract as follows:

The swap quote (quoted in interbank market as a discount and premium)

expresses only the diff erence between the spot quote and the forward

quote. Decimals are not written in swap quotes. The swap quote for US $

in terms of rupee can be written for diff erent periods of forward contract

as follows:

[7]

Spot 1 Month Fwd 3 Months Fwd

Rs. 40.00 - 40.30 Rs. 39.80 - 40.40 Rs. 39.60 - 40.50

Spot 1 Month Fwd 3 Months Fwd

Rs. 40.00 40.30 Rs. (20) - 10 Rs. (40) - 20




(iv) Forward Premium & Discount: Generally, longer the maturity, the

greater is the change in forward rates. Again, with longer maturity, the

spread too gets wider. This is because of uncertainty in the future that

increases withlengthening of maturity.

The change in forward rates may be upwards or downwards. With such

movements, disparity arises between spot and forward rates. This is

known as forward rate diff erential.

If the forward rate is lower than the spot rate, it is a case of forward

discount. If the forward rate is higher than spot rate, it is a case of

forward premium.

Forward premium or discount is expressed as an annualized percentage

deviation from the spot rate.

[8]

Forward premium/discount

(n-day forward rate spot rate/spot rate) X (360/n)




(v) Cross Rates: Sometimes the value of a currency in terms of another one

is not known directly. In such cases one currency is bought / sold for a

common currency and again the common currency is exchange for the

desired currency. Such trading of currency is known as cross rate trading

and the exchange rate established between the two currencies is known

as cross rate.

Example: Suppose rupee-US$ exchange rate is Rs. 40.00 - 40.30/US$ and theCa$-US$ exchange rate is Ca $ 0.82-0.89/US$. However, the rupee-Ca$

exchange rate is not known. In this case, the exchange rate between

rupee and Ca$ will be found through the common currency US$.

Suggested Further ReadingExchange Rate Regime & Foreign Exchange Market in India

[9]



Nominal & Real Exchange Rates

The nominal exchange rate is the rate at which one currency can be

exchanged for another. If the nominal exchange rate between US$ and

rupee is 40, then one dollar will purchase 40 rupees. Exchange rates are

always represented in terms of the amount of foreign currency that can

be purchased for one unit of domestic currency. Thus, we determine the

nominal exchange rate by identifying the amount of foreign currency

that can be purchased for one unit of domestic currency.The real exchange rate tells how much the goods and services in the

domestic country can be exchanged for the goods and services in a

foreign country.

Real Ex. Rate is given by:

(Nominal Ex. Rate X Domestic Price) / (Foreign Price)If want to determine the real exchange rate for gold between the US and

India and we know that the nominal exchange rate between these

countries is 40 rupees per dollar. We also know that the price of gold in

India is 10000 rupees per ounce and that in the US is $500. Therefore,

the real exchange rate = (40 X 500) / 10000 = 2 ounces of gold in Indianper ounce of gold in the US. [10]



Effective Exchange Rates

It is possible that a particular currency depriciates against one currency and

appreciates against another. Also the depriciation and appreciation

against diff erent currencies may be at diff erent rates.

We may want to know the performance of a particular currency in the

foreign exchange market, on an average. In that case, we may ref er to

the eff ective exchange rate of that currency.

The eff ective exchange rate of a currency is a measure of its average value

withrespect to two or more other currencies.

For the calculation of eff ective exchange rate of a currency, the first step is

to select the right currency basket. All the currencies in the world need

not be taken in the basket. Only those currencies are included which

have a significant influence in the countrys trade.The second step is to assign weights to diff erent currencies in the basket (on

the basis of importance).

The third step is to find out the weighted average of the exchange rates of

the diff erent currencies in the basket.

[11]



Effective Exchange Rates (Cont.)

In the fourth step It is converted into an index using a base period. This type

of indicator is called the "eff ective exchange rate."

Factors Influencing Currency Exchange Rates

Currency exchange rates are determined by supply and demand factors.

Following are the various factors which determine the demand and

supply of a currency.

1. Inflation: If inflation in a country is lower than elsewhere, then its exports

will become more competitive and there will be an increase in demand

for its currency. Also foreign goods will be less competitive and so that

country will supply less of its currency to buy foreign goods. Therefore,

the exchange rate of that currency will tend to increase.

2. Interest Rates: If interest rates in a country rise relative to elsewhere, it

will become more attractive to deposit money in that country. Therefore

demand for its cuttency will rise. This is known as "hot money flows"

and is an important short run determinant of the value of a currency.

[12]



Factors Influencing Currency Exchange Rates (Cont.)

3. Speculation: If speculators believe a particular currency will rise in the

future, they will demand more now to be able to make a profit in the

future. This increase in demand will cause the value to rise. For example,

if markets get the news that interest rates in a country are likely to

increase, the value of its currency will probably rise in anticipation.

4. Change in competitiveness: If the goods and services of a country become

more attractive and competitive this will also cause the value of theexchange rate to rise. This is important for determining the value of its

currency in the long run.

5. Relative strength of other currencies: The relative strength of other

currencies is also an important influencing exchange rates. For example,

INR is the strongest currency in South Asia because the currencies of other countries in the region (Pakistan, Bangladesh, Bhutan, Nepal,

Maldives, Afghanistan, Iran and Sri Lanka) are relatively weaker.

Similarly, when the European Union adopted euro in 2002, pound

appreciated because euro was seen as a weaker currency.

[13]



Factors Influencing Currency Exchange Rates (Cont.)

6. Balance of Payments: A large deficit on the current account means that

the value of imports is greater than the value of exports. If this is not

financed by a suplus on the capital account and the country is struggling

to attract enough capital inflows will see a depreciation in the currency.

For example, in 2006-07, in the backdrop of the Sub-Prime Crisis, when

current account deficit in the US was 7% of its GDP, dollar depriciated

withrespect to all major currencies.7. Public (Government) debt: The relationship between government debt

obligations and its exchange rate is not a direct one. Basically,

government borrowing to finance deficit spending increases inflation,

which aff ects the value of that countrys currency adversely.

8. Political and Economic Stability: Most investors are risk-averse in nature.Accordingly, they will invest their capital where there is a certain degree

of predictability. They tend to avoid investing in countries lacking a

stable government and growing economy. In contrast, they will invest

capital in stable countries that exhibit strong signs of economic growth.

[14]



Determination of Forward Exchange Rates

Determination of forward exchange rate depends on forward premium or

discount. Again, the size of forward premium or discount depends on

current speculation of future events.

Suppose, rupee is expected to depriciate in the future. Then holders of

rupee will start selling forward. This will depress the forward rate.

Suppose, rupee is expected to appreciate in the future. Then holders of

rupee will start buying forward. This will improve the forward rate.

The determination of exchange rate in the forward market is explained by

the theory of Interest Rate Parity (IRP).

Interest Rate Parity Theory: The theory of Interest Rate Parity states that

equilibrium is achieved when the forward rate diff erential is

approximately equal to the interest rate diff erential. In other words,forward rate diff ers from the spot rate by an amount that represents the

interest rate diff erential. In this process the currency of a country with

lower interest rate should be at a forward premium in relation to the

currency of a country with higher interest rate.

[15]



Determination of Forward Exchange Rates (Cont.)

As per the theory of Interest Rate Parity, when we equate the Forward rate

diff erential with the interest rate diff erential, we find the following.

From the above equation, the forward exchange rate can easily be

determined. One has simply to find out the value of forward rate (F).

Example: Suppose interest rates in India and the US are 10% and 7%

respectively. The spot rate is 40. The 90-day forward rate can be

calculated as follows.

40/4 {(1.10/1.07) 1} + 40 = 40.28F = Rs. 40.28/US$

This means that the higher interest rate in India will push down the forward

value of the rupee from 40 to 40.28 a dollar.

[16]

A X (F - S)/S = (1 + rA/1 + rB) - 1

F = S/A {(1 + rA/1 + rB) 1} + S



Market for Currency Derivatives

Currency derivatives can be described as contracts (futures, options &

swaps) between the sellers and buyers, whose values are to be derived

from the underlying assets the currency amounts.

Worldwide, currency derivatives market is bigger than equities with

volumes of $3-billion-a-day while Indias contribution is only one per

cent. Hence, there is a greater prospect for growth.

After the NSE and MCX, USE became the third exchange off ering currencytrading in India on Monday, September 20, 2010. The trading volumes

crossed US $ 4 million in the first hour of trading. By the close of trading

on Day 1, the volumes on the USE were a staggering US $ 9.88 billion

capturing a 52 per cent marketshare and becoming the number one

exchange in the currency futures segment in India.The Exchange has become the first Indian stock exchange to enter the

record-books by creating a world-record for the largest number of

contracts traded by any exchange on the first day of trading. No other

exchange in the world has traded more than 9.88-million contracts on its

first day of trading making this a remarkable f eat for the Indian capital

markets and USE. [17]



Currency Derivatives

What needs to be understood first is the basics of the structure of these

derivative instruments.

The derivatives that will be discussed are: (i) Currency Futures & (ii)Currency Options.

Futures and options represent two of the most common form of 'Derivatives'. Derivatives are financial instruments that derive their value

from an 'underlying asset'. An underlying asset can be a stock issued by acompany, index of a stock exchange, a currency, Gold, Silver etc.

A currency futures contract is an alternative to a forward contract. It calls for

future delivery of a standard amount of currency at a fixed time and

price. These contracts are traded on exchanges with the largest being the

International Monetary Market located in the Chicago Mercantile

Exchange.

If you buy a futures contract, it means that you promise to pay the price of

the asset at a specified time. If you sell a future, you make a promise to

transf er the asset to the buyer of the future at a specified price at a

particular time.

[18]



Currency Derivatives (Cont.)

Example (future): You are an Indian importer. You will require US$ 100000

on 1st December 2010 to make payment to the exporter based in US. As

an importer, you bear the exchange rate risk. You anticipate that the

rupee-US$ Spot rate of 40 (as on 1st September) will go up by December.

In this case, you as an importer can use foreign currency futures to hedge

the exchange rate risk.

Three month dollar futures are being traded at 42 with a lot size of 20000dollars. Fearing that the exchange rate will go up, you buy five futures of

far month delivery.

On 1st December you pay Rs. 43/US$ to buy US$ 100000 as per your

requirement. Now, you are at a loss of Rs. 300000.

Again, for buying the five futures, you had made an eff ective payment of Rs.4200000 in September. At the time of maturity, in December, when the

spot price and the future price will tally, you will receive Rs. 4300000

towards settlement of your account thereby, making a profit of Rs.

100000 from the transaction.

Your net loss becomes Rs. 200000 as you have been able to hedge your lossto the extent of Rs. 100000. [19]




An 'Options' is a contract that gives the buyer of the instrument the right to

buy or sell the underlying asset at a predetermined price. An option can

be a 'call' option or a 'put' option. A call option gives the buyer, the right

but not the obligation to buy the asset at a given price. Here the buyer

has the right to buy and the seller has the obligation to sell. Similarly a

'put' option gives the buyer the right but not the obligation to sell the

asset at a given price. Here the buyer has the right to sell and the sellerhas the obligation to buy. The buyer of the option is the holder and the

seller of the option is termed the writer

There are two types of option maturities: (i) American options may be

exercised at any time during the lif e of the option. (ii) European options

may not be exercised until the specified maturity date.

Example (Option): You anticipate that the rupee-US$ Spot rate of 40 (as on

1st September) will go up by December. In other words, it will

become more expensive for you to buy US dollars. (Cont.)

[20]




In this case, you would want to buy a dollar call option so that you

could stand to gain from an increase in the exchange rate. Suppose you

buy 5 far month call options with a lot size of 20000 dollars each for Rs.

42/US $. You paid an option premium of Rs. 00.50/US $.

On 1st December, the exchange rate rate is 43. Now you will exercise your

option to buy 100000 dollars at Rs. 42/US $. You make a profit of Rs.

100000. On deducting the option premium, your net profit comes to Rs.50000.

You would not have exercised your option if the exchange rate on 1st

December was less than 42.50. In that case, you would have incurred

loss to the extent of option premium paid.

[21]



Transfer Pricing

Transf er pricing is the process of determining the price at which parties

affiliated to each other buy and sell products such that there is no

leakage of tax. Transf er pricing is of relevance to international

transactions where inappropriate transf ers could result in the loss of tax

revenue to one country or another.

As is now well known, countries across the world, including India, appear to

be bound for severe fiscal deficits in the coming years, and taxauthorities will be induced to close all possible loopholes in the fiscal

regimes that they govern.

At the Organisation for Economic Co-operation and Development (OECD),

economists have indicated that nearly 60% of world trade occurs

between diff erent arms of multinational companies.Today, many countries, including India have regulations to help prevent the

use of transf er pricing as a means of evading taxes or similar unethical

and illegal activities.

[22]



Motivations Behind Transfer Pricing

Reducing tax burden: Minimisation of the tax liability for the maximisation

of the overall profit is one of the motivations behind transf er pricing.

The company transf ers a good part of its profit before tax from a unit

higher tax rates to a unit sub ject to lower tax rates. This is done by

over-invoicing imports of the former unit from the latter or under-

invoicing exports to the latter.

Example: Suppose a multinational has its subsidiaries in country A andcountry B. Corporate tax rates in country A and country B are 10% and

25% respectively. The subsidiary in country A produces finished

products which are raw materials for the subsidiary in country B.

Country A exports 50000 units of raw materials to country B at $ 10 per

unit. Because of higher tax rate in country B, the parent company uses

transf er pricing and over-invoices the exports to country B by 30%. As a

result, profit earned by the subsidiary in country B reduces and so also

the tax levy. On the other hand, profit earned by the subsidiary in

country A increases however, tax rate in country A is much less. This

results in the maximisation of the overall profit of the parent company

as follows: [23]



Example

It is clearly evident from the above example that transf er pricing by 30%

leads to the maximisation of profit by 22500 as the tax liability gets

minimised by 22500.

[24]

Income Statement (Before Transf er Pricing)

Particulars Country A ($) Country B ($)

Revenue 500000 800000

Cost of material 300000 500000

Gross margin 200000 300000

Operating expenses 50000 80000

Profit before tax 150000 220000

Tax 15000 55000

Net profit 135000 165000

Total net profit (A+B) = $ 300000

Total Tax paid (A+B) = $ 70000

Income Statement (After Transf er Pricing)

Particulars Country A ($) Country B ($)

Revenue 650000 800000

Cost of material 300000 650000

Gross margin 350000 150000

Operating expenses 50000 80000

Profit before tax 300000 70000

Tax 30000 17500

Net profit 270000 52500

Total net profit (A+B) = $ 322500

Total Tax paid (A+B) = $ 47500



Bank of International Settlements

The Bank for International Settlements (BIS) is an international financial

organisation which fosters international monetary and financial

cooperation and serves as a bank for central banks.

Established on 17 May 1930, the BIS is the world's oldest international

financial organisation.

The head office is in Basel, Switzerland and there are two representative

offices: in the Hong Kong Special Administrative Region of the People'sRepublic of China and in Mexico City.

The BIS functions as: (i) A forum to promote discussion and policy analysis

among 57 member central banks and within the international financial

community. (ii) A centre for economic and monetary research. (iii) A

prime counterparty for central banks in their financial transactions. (iv)Agent or trustee in connection with international financial operations.

As its customers are central banks and international organisations, the BIS

does not accept deposits from, or provide financial services to, private

individuals or corporate entities. The BIS strongly advises caution against

fraudulent schemes. [25]



Bank of International Settlements (Cont.)

BIS is not accountable to any national government. The BIS carries out its

work through subcommittees, the secretariats it hosts, and through its

annual General Meeting of all members.

Two aspects of monetary policy have proven to be particularly sensitive,

and the BIS therefore has two specific goals: (i) to regulate capital

adequacy and (ii) to regulate reserve requirements.

BIS regulates capital adequacy by setting capital adequacy requirements. Inother words, BIS requires the capital / asset ratio of central banks to be

above a prescribed minimum international standard, for the protection

of all central banks involved.

Reserve policy is also important, especially to the domestic economy. To

ensure liquidity and make bank depositing and borrowing saf er forcustomers and reduce risk of bank runs, banks are required to set aside

or maintain "reserve".

The BIS provides the Basel Committee on Banking Supervision (BCBS) with

its twelve-member secretariat, and with it has played a central role in

establishing the Basel Capital Accords of 1988 and 2004.[26]




The Basel Committee on Banking Supervision (BCBS) is an institution

created by the central bank Governors of the G-10 (Belgium, Canada,

France, Italy, Japan, Netherlands, United Kingdom, United States,

Germany and Sweden) nations. It was created in 1974 and meets

regularly four times a year.

The Committee's members come from Argentina, Australia, Belgium, Brazil,

Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy,Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia,

Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United

Kingdom and the United States. The Committee usually meets at the

Bank for International Settlements (BIS) in Basel, Switzerland, where its

12 member permanent Secretariat is located.

The Basel Committee on Banking Supervision (BCBS) formulates broad

supervisory guidelines and recommends statements of best practice in

banking supervision known as Basel Accords in the expectation that

member authorities and other nations' authorities will take steps to

implement them through their own national systems, whether in

statutory form or otherwise. [27]




The Basel Accords ref er to the banking supervision accords

(recommendations on banking laws and regulations) popularly known as

Basel I (issued in 1998) and Basel II (issued in 2004) and Basel III (issued

2010) by the Basel Committee on Banking Supervision (BCBS).

At its 12 September 2010 meeting, the Group of Governors and Heads of

Supervision, of the Basel Committee on Banking Supervision (BCBS),

suggested a s ubstantial strengthening of existing capital adequacyrequirements and the introduction of a global liquidity standard. These

recommendations will be officially presented at the Seoul G-20 Leaders

Summit in November 2010.

Though the Basel Committee on Banking Supervision (BCBS) does not have

the authority to enforce its recommendations in any country, mostmember countries as well as some other countries implement its

recommendations either statutorily or otherwise.

In India, Basel II recommendations on banking laws and regulations are

strictly followed by the RBI and all commercial banks.

[28]



Role of RBI in Financing Foreign Trade

The Reserve Bank of India, Indias central bank plays an active role in the

promotion and support of foreign trade.

From time to time RBI undertakes measures to ensure adequate and timely

availability of credit for foreign trade at competitive interest rates.

Commercial banks under the supervision of RBI provide credit for foreign

trade at pre-shipment and post-shipment stage.

Financing in home currency is provided at rate of interest linked to the

prime lending rate (PLR).

Financing in foreign currency is provided at internationally competitive rate

linked to London Inter-Bank Off er Rate.

RBI adjusts interest rates on foreign trade financing from time to time taking

into account competitiveness and interest rate diff erentials apart fromfactors like inflation and other market developments.

RBI also takes measures to support institutional arrangements for foreign

trade promotion such as liberal policies for the operation of Special

Economic Zones (SEZs).

[29]



Role of RBI in Financing Foreign Trade (Cont.)

Following are the liberal policiy measures taken by RBI for foreign trade

promotion through SEZs.

Exemption from interest rate surcharge and other duties on foreign trade

finance.

Release of foreign currency to domestic firms for buying goods from export

oriented firms operating in SEZs.

Allowing 100% retention of foreign exchange in Exchange Earners Foreign

Currency (EEFC) accounts.

Permitting overseas investment by SEZ units from the Exchange Earners

Foreign Currency (EEFC) accounts in a hassle free way.

Permitting SEZ units to enter into contracts (Spot, Forward, Futures, Options

& Swaps) in overseas exchanges and markets to hedge various riskspertaining to foreign trade.

Suggested Further Reading

Instruments for financing foreign trade

[30]



Institutions Financing Foreign Trade in India

[31]



Trade Finance Institutional Structure

Level-I Institutions

Direct government control

Level-II Institutions

Full or Partial Governmentsupport

Level-III Institutions

Market-based; NoGovernment support

Central Bank Export Credit Insurance

and Guarantee Company

Commercial Banks

Ministry of Finance EXIM Bank Non-Bank Financial

Institutions

Ministry of Trade Other specialized FIs(devt

or SME banks, )

[32]



Trade Finance Institutional Structure (Cont.)

Level-III Institutions: Market-based and private trade finance related

institutions.

(i) Commercial banks: Provide more than 80% of trade financing in most

countries.

(ii) Non-Bank Financial Institutions: These institutions typically do not take

deposits. Provide alternative avenues for trade finance and trade-related

investment financing. Example: Factoring companies.

Factoring is a financial transaction whereby a business sells its accounts

receivable (i.e., invoices) to a third party (called a factor) at a discount in

exchange for immediate money with which to finance continued

business. Factoring diff ers from a bank loan in three main ways. First, the

emphasis is on the value of the receivables (essentially a financial asset),not the firms credit worthiness. Secondly, factoring is not a loan it is

the purchase of a financial asset (the receivable). Finally, a bank loan

involves two parties whereas factoring involves three.

[35]



Financial Swaps

Financial Swaps: a financial swap is a derivative instrument in which the

counterparties exchange certain benefits of one party's financialinstrument for those of the other party's financial instrument. The

benefits in question depend on the type of financial instruments

involved (underlying assets). 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 thedates when the cash flows are to be paid and the way they are

calculated. The cash flows are calculated over a notional principal

amount, which is usually not exchanged between counterparties. Swaps

can be used to hedge certain risks such as interest rate risk and exchange

rate risk.

[36]



Financial Swaps (Cont.)

Interest Rate Swap: The most common type of swap is interest rate swap. It

is the exchange of a fixed rate loan to a floating rate loan. The lif e of the

swap depends on the loan term. The reason for this exchange is to take

benefit from comparative advantage. Some companies may have

comparative advantage in fixed rate markets while others have a

comparative advantage in floating rate markets. When companies want

to borrow they look for cheap borrowing i.e. from the market wherethey 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 eff ect of

transforming a fixed rate loan into a floating rate loan or vice versa.

Example: Company B makes periodic interest payments to Company A

based on a variable interest rate of LIBOR+70 basis points. Company A in

return makes periodic interest payments based on a fixed rate of 8.65%.

The payments are calculated over the notional amount. In reality, the

actual rate received by A and B is slightly lower due to a bank taking a

spread.

[37]



Financial Swaps (Cont.)

Currency Swap: A currency swap involves exchanging principal and fixed

rate interest payments on a loan in one currency for principal and fixedrate interest payments on an equal loan in another currency. Just like

interest rate swaps, the currency swaps also are motivated by

comparative advantage.

Example: Suppose the rupee-US$ exchange rate is Rs. 40/ US$. Company A

has a loan of Rs. 400000 and Company B has a loan of US$ 10000.Company A makes periodic interest payments to Company B based on a

fixed interest rate of 8.65% in rupees and Company B in return makes

periodic interest payments based on a fixed rate of 8.65% in US$. The

payments are calculated over the notional amount. In reality, the actual

rate received by A and B is slightly lower due to a bank taking a spread.

[38]



International Accounting

There was a time when the principles of accounting were being practiced for

domestic operations of the firms. But with growing globalisation,linkages among diff erent countries have increased and the principles of

accounting have attained international dimentions.

At the international level, International Accounting standards Committee

(IASC) has been created to formulate and publish, in public interest, basic

standards to be observed in the presentation of audited accounts andfinancial statements and to promote their worldwide acceptance and

observance.

The Institute of Chartered Accountants of India (ICAI) constituted the

Accounting Standards Board (ASB) in April 1997, in order to standardize

the diverse accounting policies and practices in India and to match withinternational developments in the field of accounting.

Similarly, every country formulates its accounting standards with ref erence

to the applicable international laws and International Accounting

Standards. This enhances coordination in international trade and

commerce.

[39]



International Accounting (Cont.)

Three major factors have led to the emergence of international accounting.

(i) Growth in international trade. (ii) Growth in activities of multinationalcorporations (iii) Expansion in international financial market.

International Indebtness

International indebtness ref ers to external borrowings of a country.

External borrowings helps achieving faster growth rate by bridging the

gap between export and import. However, if borrowed funds are notutilised eff ectively, enough savings will not be generated to repay the

debt. International indebtness will then grow to unmanageable

proportions and may adversely aff ect the process of growth.

A f ew countries have achieved faster growth rate with the help of foreign

borrowings however, in most of the cases, growing indebtness has poseda serious problem. The management of international debt has become

an integral part of international finance since the The Latin American

debt crisis that occurred in 1980s followed by the Mexican Peso Crisis.

The period of the crisis is often known as the "lost decade", when

countries reached a point where their foreign debt exceeded their

earnings. [40]




Debt Structure and Debt Indicators: External debt is a combination of Long-

term debt, short-term debt and IMF credits. Long-term debt forms the

main component of total debt. It is either a public and a publicly

guaranteed debt or a private non-guaranteed debt. Issue of bonds and

borrowings from commercial bannks create private debt while public

debt is concerned with multilateral and bilateral loans taken by the

government.Where a particular amount of debt is burdensome for a poor country, the

same doesnot hold good for a rich country. This is because of the fact

that indebtness is a relative concept. Therefore, it is assessed with

relation to the countrys national income, export earnings and its foreign

exchange reserves. All these factors are directly related to the countrys

ablity to service its debts. Whenever international indebtness is

analysed, following ratios are taken into account. (i) External Debt to

Export Ratio (ii) External Debt to GNP ratio (iii) Debt-Service Ratio (iv)

International Reserves to International Debt Ratio.

[41]




International Taxation

International taxation is the study of tax levied on a person or a business

with respect to the international aspects of the tax laws of the country.

The tax system adopted by a country may by based on territory

(taxation only of in-country income), residency (taxation of all income of

residents and/or citizens), or exclusionary system (specific inclusion or

exclusion of certain amounts, classes, or items of income in/from thebase of taxation). Some countries have tried to overcome the limitations

of each of these three broad systems by enacting a hybrid system with

characteristics of two or more.

(i) Territorial Taxation System: A f ew countries tax only the income earned

within their borders. For example, the Hong Kong Inland RevenueOrdinance imposes income tax only on income earned from a business

or source within Hong Kong. Such systems treat tax residents and non-

residents alike. The key problem with this type of territorial system is the

ability to avoid taxation on portable income by moving it offshore. This

has led governments to enact hybrid systems to recover lost revenue.

[42]




Residential Taxation System: Most income tax systems impose tax on the

worldwide income of residents, and impose tax on the income of nonresidents from certain sources within the country. Prime examples of

such Residential Taxation are the United States and the United Kingdom.

Residency based systems need to define resident and characterise the

income of non-residents. Such definitions vary by country and type of

taxpayer. For example, The U.S. provides lengthy, detailed rules forindividual residency covering: Periods establishing residency & Start and

end date of residency. UK establishes three categories: non-resident,

resident, and resident but not ordinarily resident. Switzerland residency

may be established by having a permit to be employed in Switzerland.

Likewise, companies having permit to do business are residents.

Exclusionary Taxation System: Many systems provide for specific exclusions

from taxable income. For example, several countries, notably Cyprus,

Netherlands and Spain, have enacted holding company reigimes that

exclude certain heads of incomes from the foreign subsidiaries. They also

typically specify the requirements for portion and time of ownership in

order to qualify for exclusion. [43]




Hybrid Taxation System: Some countries have chosen to adopt systems that

are a combination of territorial, residential, and exclusionary. There is nopattern to these hybrids. For example, the US allows individuals earning

income from their personal services outside the US an exclusion of up

to US$80,000 from compensation for such services. Compensation

income in excess of this amount is fully taxable to citizens and residents.

The UK imposes tax on individuals resident but not ordinarily resident inthe UK on income earned in or remitted to the UK. Singapore imposes

income tax on all residents including individuals and companies on

income earned in or remitted to Singapore.

Bases of International Taxation

(i) Tax Neutrality: A government system of collecting revenues such that theflow of the factors of production are unaff ected. In other words, the tax

does not aff ect how firms conduct business. Although a portion of

resources is transf erred to government, there are no secondary eff ects of

taxation.

[44]




(ii) Tax Equity: Tax equity rests on the belief that similar tax payers should

pay the cost of operating the government according to the same rules.The concept of equity takes into account two factors. The contribution of

each tax payer should be in accordance to the amount of public services

he receives. The other is that each tax payer should pay taxes according

to his abilty to pay.

(iii) Avoidance of Double Taxation: Double taxation is the imposition of twoor more taxes on the same income (in the case of income taxes), asset (in

the case of capital taxes), or financial transaction (in the case of sales

taxes). It ref ers to two distinct situations. This includes taxation by two

or more countries of the same income, asset or transaction. For example,

income paid by an entity of one country to a resident of a diff erent

country. The double liability is often mitigated by tax treaties between

countries.

[45]




Types of Taxes

(i) Income Tax: An income tax is a tax levied on the income of individuals or

businesses (corporations or other legal entities). Various income tax

systems exist, with varying degrees of tax incidence. When the tax is

levied on the income of companies, it is often called a corporate tax,

corporate income tax, or profit tax. Corporate income taxes often tax net

income (the diff erence between gross receipts, expenses, and additionalwrite-offs). Various systems define income diff erently, and often allow

notional reductions of income.

(ii) Withholding Tax: Withholding tax is a government requirement to

withhold or deduct tax from the source, and pay that tax to the

government. In most jurisdictions withholding tax applies toemployment income. Many jurisdictions also require withholding tax on

payments of interest or dividends. Governments use withholding tax as a

means to combat tax evasion, and sometimes impose additional

withholding tax requirements if the recipient has been delinquent in

filing tax returns, or in industries where tax evasion is perceived to be

common. [46]




(iii) Value-added Tax: Value Added Tax, popularly known as VAT, is a form of

consumption tax (indirect tax) levied on top of the cost of a product orservice and generates revenue for the government. In other words, it is

levied on the estimated value added to a product or material at each

stage of its manufacture or distribution, ultimately passed on to the

consumer. It diff ers from a sales tax, which is levied only at the point of

purchase.India VAT and Sales Tax: The standard rate of VAT is 12.5%. There are

reduced rates of 4% and 1%. The minimum annual turnover for V.A.T.

registration is INR 500,000. V.A.T. returns are filed on a monthly or

quarterly basis. Sales tax of 2% is imposed on transf er of goods between

Indian states.

Suggested Further Reading

Tax Regime in India

[47]




Tax Havens

A tax haven is a country or territory where certain taxes are levied at a low

rate or not at all.

Individuals and/or corporate entities can find it attractive to move

themselves to areas with reduced or nil taxation levels. This creates a

situation of tax competition among governments. Diff erent jurisdictions

tend to be havens for diff erent types of taxes, and for diff erentcategories of people and/or companies.

In its December 2008 report on tax havens, the U.S. Government

Accountability Office was unable to find a satisfactory definition of a tax

haven but regarded the following characteristics as indicative of a tax

haven: (i) nil or nominal taxes; (ii) lack of eff ective exchange of taxinformation with foreign tax authorities; (iii) lack of transparency in the

operation of legislative, legal or administrative provisions; (iv) no

requirement for a substantive local presence; and (v) self-promotion as

an offshore financial center.

[48]




Tax Havens of the World

Anguilla, Antigua, Antilles, Aruba, Australia, Bahamas, Andorra, Bahrain,

Barbados, Belize, Bermuda, BVI, Canary Isles, Canada, Cayman, Cook

Isles, Costa Rica, Cyprus, Dominica, Gibraltar, Greece, guernsey, Ireland,

Isle Of Man, Jersey, Latvia, Liechtenstein, Malta, Mauritius, Monaco,

Panama, Switzerland, Thailand, Turks-Caicos, UAE, UK, USA, Vanuatu and

W Somoa.

[49]



Country Risk

What Does Country Risk Mean? A collection of risks associated with

investing in a foreign country. These risks include Economic Risk, Transf erRisk, Exchange Rate Risk, Location or Neighborhood Risk, Sovereign Risk,

Political Risk, which is the risk of capital being locked up or frozen by

government action. Country risk varies from one country to the next.

Some countries have high enough risk to discourage much foreign

investment.The United States is generally considered the benchmark for low country

risk and most nations can have their risk measured as compared to the

U.S. Country risk is higher with longer term investments and direct

investments, which are investments not made through a regulated

market or exchange.

[50]



Country Risk (Cont.)

Country Risk Rankings

Least risky countries, Score out of 100

Source: Euromoney Country risk March 2010

[51]

Rank Previous Country Overall score

1 1 Norway 94.05

2 2 Luxembourg 92.35

3 3 Switzerland 90.65

4 4 Denmark 88.55

5 6 Finland 87.81

6 5 Sweden 86.81

7 7 Austria 86.50

8 11 Canada 86.09

9 8 Netherlands 84.86

10 9 Australia 84.16




(ii) Transf er Risk: Transf er Risk is the risk arising from a decision by a foreign

government to restrict capital movements. Restrictions could make itdifficult to repatriate profits, dividends, or capital. Because a

government can change capital-movement rules at any time, transf er risk

applies to all types of investments.

Transf er risk measures typically include the ratio of debt service payments

to exports or to exports plus net foreign direct investment, the amountand structure of foreign debt relative to income, foreign currency

reserves divided by various import categories, and measures related to

the current account status. Trends in these quantitative measures reveal

potential imbalances that could lead a country to restrict certain types of

capital flows.

[53]




(iv) Location or Neighborhood Risk: Location or Neighborhood Risk includes

spillover eff ects caused by problems in a region, in a country's tradingpartner, or in countries with similar perceived characteristics. The crisis

faced by Latin countries in the 1980s is an example of this type of risk.

This risk type provides analysts with one of the more difficult risk

assessment problems.

Geographic position provides the simplest measure of location risk. Tradingpartners, international trading alliances (such as Mercosur, NAFTA, and

EU), size, borders, and distance from economically or politically

important countries or regions can also help define location risk.

[55]




(v) Sovereign Risk concerns whether a government will be unwilling or

unable to meet its loan obligations. Sovereign risk can relate to transf errisk when a government may run out of foreign exchange due to

unfavorable developments in its balance of payments. It also relates to

political risk in when a g overnment may decide not to honor its

commitments for political reasons. The sovereign risk is disignated as a

separate category because a private lender faces a unique risk in dealingwith a sovereign government. Should the government decide not to

meet its obligations, the private lender realistically cannot sue the

foreign government without its permission.

Sovereign risk measures of a government's ability to pay are similar to

transf er-risk measures. Measures of willingness to pay require an

assessment of the history of a government's repayment performance

and an analysis of the potential costs of debt repudiation to the

borrowing government.

[56]




(vi) Political Risk concerns risk of a change in political institutions arising

from a change in government control, social fabric, or othernoneconomic factor. This category covers the potential for internal and

external conflicts, expropriation risk and traditional political analysis.

Risk assessment requires analysis of many factors, including the

relationships of various political groups in a country, the decision-making

process in the government, and the history of the country.Few quantitative measures exist to help assess political risk. Measurement

approaches range from various classification methods (such as type of

political structure, range and diversity of ethnic structure, civil or

external strif e incidents), to surveys or analyses by political experts.

Most services tend to use country experts who grade or rank multiple

socio-political factors. Company analysts may also develop political riskestimates for their business through discussions with local country

agents or visits to other companies operating similar businesses in the

country. In many risk systems, analysts reduce political risk to some type

of index or relative measure.

[57]



International Bond Market

International Bond Market is very big and has an estimated size of nearly

$47 trillion. The size of the US bond market is the largest in the world.The US bond market's outstanding debt is more than $25 trillion.

The International Bond Market has grown double in size since the year

2000. By the end of the year 2006 it has been recorded that nearly $10

trillion of the bonds were outstanding as far as International Capital

Market Association data are concerned. This rapid growth of theInternational Bond Market is due to the bonds that are issued by the

various multi national companies.

In International Bond Market, markets which are looked after by the

government of a particular country are actually taken into account.

These markets are big in size, there is liquidity in the market. These

markets lack credit risk which make them sensitive to the interest rates.

While talking about International Bond Market, the Bond Market

Association deserves special mention.

[58]



International Bond Market (Cont.)

The Bond Market Association was considered as the association for

international trade and bond market industry. Its headquarters weresituated in London, New York and in Washington D.C. Nearly Twenty per

cent of of the total percentage of membership were placed outside

America. while more than 70 per cent were situated outside The City of

New York. The Bond Market Association had worked like the global

representative for those who issue bonds and trade with them andplayed a big role in co-ordinating with the government,corporations and

with the investors as well. Bond Market association in the International

Bond Market also had a code of conduct which the market participants

had to follow very strictly.

In the year 2006, the Bond Market Association was merged with Securities

Industry Association which formed a new institution called the SecuritiesIndustry and Financial Markets Association.

[59]



International Bond Market (Cont.)

The international bond market is divided into three diff erent bond market

groups:1. Domestic bonds: They are issued locally by a domestic borrower and are

usually denominated in the local currency.

Example: Reliance issues a bond in India for placement in the Indian

domestic market, i.e., with investors resident in India. The issue is

underwritten by a syndicate of Indian securities houses. The issue isdenominated in the currency of the intended investors, i.e., INR.

2. Foreign bonds: They are issued on a local market by a foreign borrower

and are usually denominated in the local currency. Foreign bond issues

and trading are under the supervision of local market authorities.

Example: Reliance, an Indian corporation, issues bonds in the US forplacement in the US market alone. The issue is underwritten by a

syndicate of US securities houses. The issue is denominated in the

currency of the intended investors, i.e., USD.

[60]



Characteristics of International Bond

1. Issuers are normally governments and private sector utilities such as the

railway companies, large corporations etc.2. It is a standard practice to underwrite as well as organise underwriting

risk in bond issues.

3. Bond Issues are pledged by the retail investors and the institutional

investors for hedging and investment purposes.

4. Commercial banks and merchant houses (underwriters) connect theinvestors and the issuers to facilitate sales.

5. The structure of an international bond is similar to that of an ordinary

bond in terms of other characteristic f eatures like Maturity, Coupon,

Duration, Yield, Face Value, Par Value etc.

[62]



Future Scenario

The International Bond Market i s set to grow tremendously with the

broadening of the market participation and the availability of a widerange of debt securities.

The following are the trends, which will impact the International Bond

Market in the near future:

1. Expansion of the Retail Trading platform to enable trading in a wide range

of government and non-government debt securities.2. Introduction of new debt instruments with call and put options,

securitised paper etc.

3. Development of the secondary markets for Corporate as well as

Government debt.

4. Introduction of Interest Rate Derivatives based on a wide range of underlying in the International Debt and Money Markets.

5. Development of the Repo Markets where sale of securities takes place

with a commitment to repurchase them on a future specified date, or on

call, at a specified price.

[63]



New Issue

A new bond issue generally involves one or more investment banks known

as "underwriters". The company off ering its bond, called the "issuer",enters a contract with the underwriters to sell its bond to the investors.

The underwriter then approaches investors with off ers to sell these

bond.

A large issue is usually underwritten by a "syndicate" of investment banks

led by one or more major investment banks (lead underwriter). Uponselling the bonds, the underwriters keep a commission based on a

percentage of the value of the bonds sold (called the gross spread).

International issues may have as many as three syndicates to deal with

diff ering legal requirements in both the issuer's domestic market and

other foreign markets. For example, an issuer based in India may be

represented by the main selling syndicate in its domestic market, India,

in addition to separate syndicates or selling groups for US/Canada and

for Europe. Usually, the lead underwriter in the main selling group is also

the lead bank in the other selling groups.

[64]



New Issue (Cont.)

New issues are primarily sold to institutional investors, but some shares are

also allocated to the retail investors.An underwriter selling bonds of a new issue to his clients is paid through a

sales credit instead of a commission. The client pays no commission to

purchase the bonds of a new issue; the purchase price simply includes a

built-in component towards commission called sales credit.

[65]



Depository Receipts

A depository receipt is a certificate issued by a depository (bank), which

purchases securities of foreign companies and deposits it on its account.Depository receipts represent ownership of an underlying number of

shares.

Global Depository Receipts facilitate trade of securities in international

markets, and are commonly used by companies to invest in developing

or emerging markets.Prices of depositary receipts are often close to values of related shares, but

they are traded and settled independently of the underlying share.

Several international banks issue depository receipts, such as JPMorgan

Chase, Citigroup, Deutsche Bank, Bank of New York. Depository receipts

are often listed in the Frankfurt Stock Exchange, Luxembourg StockExchange and in the London Stock Exchange, where they are traded on

the International Order Book (IOB).

[66]



Depository Receipts (Cont.)

ADR: An American Depositary Receipt (ADR) represents securities of a non

US company that trades in US financial markets. The securities of manynon US companies trade on US stock exchanges through the use of ADRs.

ADRs enable US investors to buy securities in foreign companies without

the hazards or inconveniences of cross-border & cross-currency

transactions. ADRs carry prices in US dollars, pay dividends in US dollars,

and can be traded like the shares of US based companies.

GDR: A Global Depositary Receipt (GDR) represents securities of a foreign

company that trades in international financial markets. The securities of

many foreign companies trade on international stock exchanges through

the use of GDRs. GDRs enable International investors to buy securities in

foreign companies without the hazards or inconveniences of cross-

border & cross-currency transactions. GDRs carry prices in local currency,pay dividends in local currency, and can be traded like the shares of local

companies.

[67]



International Capital Budgeting

Capital Budgeting (or investment appraisal) is the planning process used to

determine whether a firm's long term investments such as newmachinery, replacement machinery, new plants, new products, and

research development projects are worth pursuing.

International Capital Budgeting is therefore, the the planning process used

to determine whether a firm's long term international investments such

as direct investments in foreign markets are worth pursuing.International Capital Budgeting has the same theoretical framework as

Domestic Capital Budgeting. The basic steps are: (i) Identify the initial

capital invested. (ii) Estimate cash flows to be derived from the project

over time including an estimate of the terminal value of the investment.

(iii) Identify the appropriate required rate of return to use in valuation.

(iv) Apply traditional capital budgeting decision criteria such as Net

Present Value (NPV) and Internal Rate of Returns (IRR).

[68]



International Portfolio Investment

International portfolio investment represents passive holdings of securities

such as foreign stocks, bonds, or other financial assets, none of whichentails active management. Where such control exists, it is known as

foreign direct investment. Some examples are: (i) Purchase of shares in a

foreign company. (ii) Purchase of bonds issued by a foreign government.

(iii) Acquisition of assets in a foreign country.

Factors aff ecting International Portfolio Investment: (i) Tax rates (investorswill normally pref er countries where the tax rates are relatively low) (II)

Interest rates (money tends to flow to countries with high interest rates).

(iii) Exchange rates (foreign investors may be attracted if the local

currency is expended to strengthen). (iv) Portfolio investment is part of

the capital account on the balance of payments statistics.

Benefits of International Portfolio Investment: (i) Off ers more opportunities

than a purely domestic portfolio. (ii) Attractive overseas investments

avenues. (iii) Impact on efficient portfolio with diversification benefits.

(iv) Investors can participate in the growth of other countries and hedge

their exchange rate risk.

[69]



International Working Capital Management

Working capital management involves the relationship between a firm's

short-term assets and its short-term liabilities. The goal of InternationalWorking Capital Management is to ensure that a firm is able to continue

its international operations and that it has sufficient ability to satisfy

both maturing short-term debt and upcoming operational expenses on

the foreign soil.

International Working Capital is the amount of foreign currency used tomake goods and attract sales and finance other operating activities on

the foreign soil. The less Working Capital used to attract sales, the higher

is likely to be the return on investment. The higher the profit margin, the

lower is likely to be the level of Working Capital tied up in creating and

selling titles. The faster that we create and sell the books the higher is

likely to be the return on investment.

[70]



International Working Capital Management (Cont.)

Net Working Cap = Current Assets ï Current Liabilities

Current assets and current liabilities include three accounts which are of

special importance. These accounts represent the areas of the business

where companies have the most direct impact: (1) accounts receivable

(current asset) (2) Inventory & Cash (current assets), and (3) accounts

payable (current liability)

Types of Working Capital

1. Gross working capital: Total or gross working capital is that working

capital which is used for all the current assets. Total value of currentassets will equal to gross working capital.

2. Net Working Capital: Net working capital is the excess of current assets

over current liabilities. This amount shows that if we deduct total

current liabilities from total current assets, then balance amount can be

used for repayment of long term debts at any time.[71]




3. Permanent Working Capital: Permanent working capital is that amount of

capital which must be in cash or current assets for continuing theactivities of business.

4. Temporary Working Capital: Sometime, it may possible that we have to

pay fixed liabilities, at that time we need working capital which is more

than permanent working capital, then this excess amount will be

temporary working capital. In normal working of business, we dontneed such capital.

International Working Capital Policies

Liquidity policy: Under this policy, the multinational will increase the

amount of liquidity for reducing the risks involved in international

business. If business has high volume of cash and bank balance, then

business can easily pays its dues at maturity. But excess cash is not

producive and aff ects earning and return on investment. So liquidity

policy should be optimized.

[72]




Profitability policy: Under this policy, multinational will keep low amount of

cash in business and try to invest maximum amount of cash and bankbalance. It will ensure that profit of business will increase due to

increasing of investment in proper way but risk of business will also

increase because liquidity of business will decrease and it can create

bankruptcy position of business. So, profitability policy should be made

after seeing liquidity policy and after this both policies will helpful for

proper management of International Working Capital.

[73]



FDI

The Foreign Direct Investment definition says the direct investments in any

productive assets in a country by any foreign company is called foreigndirect investment or FDI.

Foreign Direct Investment includes investments in the infrastructure

development projects including construction of bridges and flyovers,

finance sector including banking and insurance services , real estate

development , retail sector etc.

[74]



FDI (Cont.)

FDI in India is not allowed under the following industrial sectors: (i) Arms

and ammunition. (ii) Atomic Energy. (iii) Coal and lignite. (iv) RailTransport. (v) Mining of metals like iron, manganese, chrome, gypsum,

sulphur, gold, diamonds, copper, zinc.

Examples

Panasonic is planning to line up US$ 200 million investment in India over the by2013 for setting up new units, brand positioning and upgrading its facilities.

Japanese engineering major, Toshiba plans to put up a power boiler plant atEnnore, north of Chennai with an initial investment of around US$ 232.91million in 2011.

Dell would be investing more in India to commensurate with the growth of itsproducts over the next five years.

Intel Corp has signed MOUs with Indian IT majors to create an end-to-end ITsolution for the health sector in the country by investing US$ 40 billion.

[77]



FDI (Cont.)

Advantages of FDI

1. Foreign Direct Investment helps in the economic development of the

particular country where investment takes place.

2. Foreign Direct Investment also permits the transf er of technologies from

one country to another.

3. Foreign Direct Investment also assists in the promotion of thecompetition within the local input market of a country.

3. Foreign Direct Investment helps develop the human capital resources in a

country by getting the man power to receive training on the operations

of a particular business.

4. Foreign Direct Investment can also bring in development of newtechnology and skill sets in a country.

5. Foreign Direct Investment assists in increasing the income that is

generated through revenues realized through taxation.

6. Foreign Direct Investment also opens up the export window. This results

in a strong forex position. [75]



FDI (Cont.)

Disadvantages of FDI

1. Economically backward section of the host country is always

inconvenienced when the stream of foreign direct investment is

negatively aff ected.

2. It has been observed that the def ence of a country has faced risks as a

result of the foreign direct investment in the country.3. Foreign direct investment may entail high travel and communications

expenses.

4. The diff erences of language and culture that exist between the country of

the investor and the host country could also pose problems in case of

foreign direct investment.5. There is a chance that a company may lose out on its ownership to an

overseas company. Chances of hostile takeovers increase.

6. At times there have been adverse eff ects of foreign direct investment on

the balance of payments of a country.

[76]



FII

The term foreign institutional investment denotes all those investors or

investment companies that are not located within the territory of thecountry in which they are investing.

These are actually the outsiders in the financial markets of the particular

country. Foreign institutional investment is a common term in the

financial sector of India.

The type of institutions that are involved in the foreign institutionalinvestment are as follows: 1. Mutual Funds 2. Hedge Funds 3. Pension

Funds 4. Insurance Companies

[78]



FII (Cont.)

Some important facts about the foreign institutional investment in the

Indian markets:The number of registered foreign institutional investors on June 2006 813

has reached to 1042 in 2007.

The total amount of these investments in the Indian financial market till

June 2007 has been estimated at US $53.06 billion.

The foreign institutional investors are pref erring the construction sector,banking sector and the IT companies for the investments.

Most active foreign institutional investors in India are HSBC, Citigroup. US

$6 billion has been invested in equities by these investors.

[79]



Why Investors go for FII·S?

The foreign investment market was not so developed in the past. But once

the globalization took the whole world in its grip, the diversified globalmarket became united. Because of this the investment sector became

very strong and at the same time allowed the foreigners to enter the

national financial market.

The economies like India, which are growing very rapidly, are becoming hot

favourite investment destinations for the foreign institutional investors.These markets have the potential to grow tremendously in the near

foseeable future .

The promise of rapid growth of the investable fund is tempting the investors

and so they are coming in huge numbers to these countries.

These are the prime reasons behind the growing interest of the foreigninvestors towards India. The money, which is coming through the foreign

institutional investment is ref erred as 'hot money' because the money

can be taken out from the market at anytime by these investors.

[80]



[80]

if module-3

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