International Economy and Finance

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JNU, JaipurFirst Edition 2013

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Index

ContentI. ...................................................................... II

List of FiguresII. ........................................................ VII

List of TablesIII. ........................................................VIII

AbbreviationsIV. .........................................................IX

Case StudyV. .............................................................. 165

BibliographyVI. ......................................................... 168

Self Assessment AnswersVII. ................................... 170

Book at a Glance

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Content

Chapter I ....................................................................................................................................................... 1The World of International Economy and Finance .................................................................................. 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction to International Economics and the International Finance .................................................. 21.2 Growing Importance of International Finance ......................................................................................... 21.3 International Financial Management ....................................................................................................... 3 1.3.1 Globalisation and International Finance .................................................................................. 3 1.3.2 Scope of International Financial Management (IFM) ............................................................. 3 1.3.3 Role of the International Financial Manager ........................................................................... 41.4 Theories of International Trade ................................................................................................................ 5 1.4.1 The Mercantilist’s Views on Trade .......................................................................................... 5 1.4.2 Trade Based on Absolute Advantage - Adam Smith ................................................................ 5 1.4.3 Comparative Advantage – David Ricardo ............................................................................... 6 1.4.4 The Hecksher Ohlin Theory ..................................................................................................... 6 1.4.5 National Competitive Advantage – Porter’s Diamond ............................................................ 71.5 Dynamics of Entering Foreign Markets ................................................................................................... 7 1.5.1 Different Modes of Entry to Foreign Markets ........................................................................ 81.6 Global Financial Markets ......................................................................................................................... 91.7 Classification of Financial Markets ....................................................................................................... 10 1.7.1 Details of Offshore Markets................................................................................................... 10 1.7.2 Evolution of Offshore Markets ...............................................................................................111.8 Interest Rates in Global Money Markets ............................................................................................... 121.9 International Trade Policies ................................................................................................................... 14Summary ..................................................................................................................................................... 17References ................................................................................................................................................... 17Recommended Reading ............................................................................................................................. 17Self Assessment .......................................................................................................................................... 18

Chapter II ................................................................................................................................................... 20The Foreign Exchange Market ................................................................................................................. 20Aim .............................................................................................................................................................. 20Objectives .................................................................................................................................................... 20Learning outcome ........................................................................................................................................ 202.1 Introduction to Foreign Exchange Market ............................................................................................. 212.2 Functions of the Foreign Exchange Market ........................................................................................... 212.3 Forex Market Participants ...................................................................................................................... 212.4 Foreign Exchange .................................................................................................................................. 232.5 Spot Market ............................................................................................................................................ 232.6 Exchange Rate Quotations ..................................................................................................................... 23 2.6.1 Direct v/s Indirect Quote ........................................................................................................ 23 2.6.2 American vs. European Quote ............................................................................................... 24 2.6.3 Bid and Ask Rate ................................................................................................................... 24 2.6.4 Inter Bank Quote and Merchant Quote .................................................................................. 242.7 Market Mechanism and Conventions .................................................................................................... 25 2.7.1 Inverse Quotes ....................................................................................................................... 26 2.7.2 Cross Rates ............................................................................................................................ 272.8 Types of Transactions ............................................................................................................................. 29 2.8.1 Forward Quotes ...................................................................................................................... 30 2.8.2 Discount and Premium ........................................................................................................... 30 2.8.3 Forward Rates vs. Expected Spot Rates ................................................................................ 32 2.8.4 Broken-date Forward Contracts ............................................................................................. 32

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2.8.5 Option Forwards .................................................................................................................... 32 2.8.6 Swaps ..................................................................................................................................... 332.9 Settlement Dates .................................................................................................................................... 34 2.9.1 Short Date Contracts .............................................................................................................. 34 2.9.2 The First Quote ...................................................................................................................... 352.10 Quotes for Various Kinds of Merchant Transactions ........................................................................... 35 2.10.1 Spot TT Buying Rate ........................................................................................................... 35 2.10.2 Spot TT Selling Rate ............................................................................................................ 36 2.10.3 Forward TT Buying Rate ..................................................................................................... 36 2.10.4 Forward IT Selling Rate....................................................................................................... 36 2.10.5 Bill Buying Rate .................................................................................................................. 37 2.10.6 TC Buying Rate ................................................................................................................... 37 2.10.7 TC Selling Rate .................................................................................................................... 372.11 The Indian Forex Markets .................................................................................................................... 37 2.11.1 Forward Exchange Contracts ............................................................................................... 38 2.11.2 Other Regulations ................................................................................................................ 38 2.11.3 Early Delivery/ Extension or Cancellation of Forward Exchange Contracts ...................... 39Summary ..................................................................................................................................................... 40References ................................................................................................................................................... 40Recommended Reading ............................................................................................................................. 40Self Assessment ........................................................................................................................................... 41

Chapter III .................................................................................................................................................. 43Introduction to Currency and Interest Rate Swaps and Future and Options in Foreign Exchange . 43Aim .............................................................................................................................................................. 43Objectives .................................................................................................................................................... 43Learning outcome ........................................................................................................................................ 433.1 Introduction to Currency and Interest Rate Swaps ................................................................................ 443.2 Interest Rate Swap ................................................................................................................................. 44 3.2.1 Bank as an Intermediary ........................................................................................................ 463.3 Currency Swaps ..................................................................................................................................... 473.4 Comparison of Swap and Forward Contracts ........................................................................................ 48 3.4.1 Swap Spreads ......................................................................................................................... 493.5 Commodity Swaps ................................................................................................................................. 503.6 Swap Market in India ............................................................................................................................. 51 3.6.1 Cross Currency and FX Interest Rates Swaps in India .......................................................... 52 3.6.2 MIFOR Swap Market ............................................................................................................ 533.7 Futures and Options on Foreign Exchange ............................................................................................ 56 3.7.1 Currency Future Markets ....................................................................................................... 57Summary ..................................................................................................................................................... 64References ................................................................................................................................................... 64Recommended Reading ............................................................................................................................. 64Self Assessment ........................................................................................................................................... 65

Chapter IV .................................................................................................................................................. 67Balance of Payments .................................................................................................................................. 67Aim .............................................................................................................................................................. 67Objectives .................................................................................................................................................... 67Learning outcome ........................................................................................................................................ 674.1 Introduction to Balance of Payments (BOP) ......................................................................................... 684.2 Grouping of Balance of Payment Accounts ........................................................................................... 68 4.2.1 The Current Account .............................................................................................................. 68 4.2.2 The Capital Account .............................................................................................................. 69 4.2.3 Official Reserves Account ..................................................................................................... 704.3 The Balance of Payments Identity ......................................................................................................... 70

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4.4 The Currency Convertibility .................................................................................................................. 714.5 The Balance of Payments of India ......................................................................................................... 72 4.5.1 India’s Balance of Payments on Current Account ................................................................. 72 4.5.2 Balance of Payments on Capital Account .............................................................................. 72Summary ..................................................................................................................................................... 75References ................................................................................................................................................... 75Recommended Reading ............................................................................................................................. 75Self Assessment ........................................................................................................................................... 76

Chapter V .................................................................................................................................................... 78International Monetary System ................................................................................................................ 78Aim .............................................................................................................................................................. 78Objectives .................................................................................................................................................... 78Learning outcome ........................................................................................................................................ 785.1 Introduction to International Monetary System ..................................................................................... 795.2 Evolution of the International Monetary System ................................................................................... 79 5.2.1 Bimetallism Before 1875 ....................................................................................................... 79 5.2.2 The Gold Standard ................................................................................................................. 79 5.2.3 The Bretton Woods System .................................................................................................... 80 5.2.4 Post Bretton Woods System (The Current System) ............................................................... 845.3 The European Monetary Union.............................................................................................................. 855.4 Exchange Rate Mechanisms .................................................................................................................. 88 5.4.1 Fixed Exchange Rate System ................................................................................................ 88 5.4.2 Floating Exchange Rate System ............................................................................................ 89 5.4.3 Hybrid Mechanism ................................................................................................................ 895.5 Financial Crises in the Post Bretton Woods Era .................................................................................... 89 5.5.1 Third World Debt Crisis ......................................................................................................... 90 5.5.2 Mexican Currency Crisis of 1995 .......................................................................................... 91 5.5.3 The Brazilian Crisis ............................................................................................................... 91 5.5.4 Argentinean Crisis ................................................................................................................. 92 5.5.5 The Asian Crisis of 1997........................................................................................................ 94 5.5.6 Lessons from the Asian Currency Crisis ................................................................................ 97Summary ..................................................................................................................................................... 98References ................................................................................................................................................... 98Recommended Reading ............................................................................................................................. 98Self Assessment ........................................................................................................................................... 99

Chapter VI ................................................................................................................................................ 101Economic Theories of Exchange Rate and the Purchasing Power Principle ..................................... 101Aim ............................................................................................................................................................ 101Objectives .................................................................................................................................................. 101Learning outcome ...................................................................................................................................... 1016.1 Economic Theories of Exchange Rate Determination ......................................................................... 1026.2 Prices and Exchange Rates .................................................................................................................. 1026.3 The Asset Approach to Exchange Rate ................................................................................................ 1036.4 Interest Rate Parity (IRP) ..................................................................................................................... 1046.5 International Fisher Effect ................................................................................................................... 1056.6 Exchange Rate Forecasting ................................................................................................................. 105 6.6.1 The Demand – Supply Approach ........................................................................................ 105 6.6.2 The Institutional Setting ....................................................................................................... 105 6.6.3 Fundamental Analysis .......................................................................................................... 105 6.6.4 Confidence Factors .............................................................................................................. 105 6.6.5 Expected Theory of Forward Rates ..................................................................................... 106 6.6.6 Events ................................................................................................................................... 106 6.6.7 Technical Analysis ............................................................................................................... 106

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6.6.8 Fundamental and Technical Forecasting .............................................................................. 106 6.6.9 The Monetary Approach ...................................................................................................... 107 6.6.10 Portfolio Balance Approach ............................................................................................... 107Summary ................................................................................................................................................... 109References ................................................................................................................................................. 109Recommended Reading ........................................................................................................................... 109Self Assessment ..........................................................................................................................................110

Chapter VII ...............................................................................................................................................112Exchange Risk Management ....................................................................................................................112Aim .............................................................................................................................................................112Objectives ...................................................................................................................................................112Learning outcome .......................................................................................................................................1127.1 Foreign Exchange Risk .........................................................................................................................1137.2 Business Risk ........................................................................................................................................1137.3 Defining Exposure and Risk .................................................................................................................1137.4 Classification of Currency Exposure ....................................................................................................115 7.4.1 Transaction Exposure ............................................................................................................115 7.4.2 Translation Exposure ............................................................................................................116 7.4.3 Operating Exposure ..............................................................................................................116 7.4.4 Strategic Exposure ................................................................................................................1167.5 Management of Exchange Risk ............................................................................................................117 7.5.1 Forward Market Hedge .........................................................................................................117 7.5.2 Hedging through Futures ......................................................................................................118 7.5.3 Money Market Hedge ...........................................................................................................119 7.5.4 Option Market Hedge .......................................................................................................... 120 7.5.5 Hedging Recurrent Exposure with Swap Contracts ............................................................ 121 7.5.6 Exposure Netting ................................................................................................................. 121 7.5.7 Hedging via Lead and Lag ................................................................................................... 121 7.5.8 Hedging through Invoice Currency ..................................................................................... 121Summary ................................................................................................................................................... 122References ................................................................................................................................................. 122Recommended Reading ........................................................................................................................... 122Self Assessment ......................................................................................................................................... 123

Chapter VIII ............................................................................................................................................. 125The International Financial Market and Instruments ......................................................................... 125Aim ............................................................................................................................................................ 125Objectives .................................................................................................................................................. 125Learning outcome ...................................................................................................................................... 1258.1 Introduction to International Financial Market .................................................................................... 1268.2 Origin of the International Financial Market ....................................................................................... 1268.3 India’s Presence in International Markets ............................................................................................ 1278.4 International Money Market ................................................................................................................ 127 8.4.1 Euro Currency Market ......................................................................................................... 128 8.4.2 Euro Credits ......................................................................................................................... 128 8.4.3 Euro Notes ........................................................................................................................... 129 8.4.4 Euro Medium Term Notes ................................................................................................... 130 8.4.5 Euro Commercial Paper ....................................................................................................... 1308.5 Instruments Available in International Capital Markets ...................................................................... 130 8.5.1 Debt Instruments .................................................................................................................. 130 8.5.2 Types of Debt Instruments ................................................................................................... 131 8.5.3 International Bond and Market Credit Ratings .................................................................... 133 8.5.4 Euro Market Structure and Practices ................................................................................... 1338.6 Equity Instruments ............................................................................................................................... 135

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8.6.1 Global Depository Receipts ................................................................................................. 135 8.6.2 American Depository Receipts ............................................................................................ 141Summary ................................................................................................................................................... 143References ................................................................................................................................................. 143Recommended Reading ........................................................................................................................... 143Self Assessment ......................................................................................................................................... 144

Chapter IX ................................................................................................................................................ 146Export-Import Financing and Guidelines for India ............................................................................. 146Aim ............................................................................................................................................................ 146Objectives .................................................................................................................................................. 146Learning outcome ...................................................................................................................................... 1469.1 Introduction to Export and Import Financing ...................................................................................... 1479.2 Letter of Credit (LC) ............................................................................................................................ 147 9.2.1 Parties to a Letter of Credit .................................................................................................. 148 9.2.2 Duties and Responsibilities of Parties to an LC .................................................................. 149 9.2.3 How a Letter of Credit Operates .......................................................................................... 149 9.2.4 Different Kinds of Letters of Credit (LC) ............................................................................ 150 9.2.5 Documents under a Letter of Credit .................................................................................... 152 9.2.6 Further Information on the Procedure ................................................................................. 1569.3 Other Financing Mechanisms .............................................................................................................. 1569.4 Historical Perspective of the Export-Import Policy ............................................................................. 1579.5 Objectives of the Exim Policy 2002-07 ............................................................................................... 1589.6 Highlights of the EXIM Policy 2002-07 (As amended up to 31.03.2003) .......................................... 158Summary ................................................................................................................................................... 162References ................................................................................................................................................. 162Recommended Reading ........................................................................................................................... 162Self Assessment ......................................................................................................................................... 163

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List of Figures

Fig. 1.1 Scope of international financial management .................................................................................. 4Fig. 1.2 Determination of national competitive advantage ............................................................................ 7Fig. 1.3 Determination of interest rates ....................................................................................................... 13Fig. 3.1 Commodity price swap ................................................................................................................... 50Fig. 3.2 Comparative advantage .................................................................................................................. 51Fig. 6.1 Interest rate and exchange rate linkages ....................................................................................... 107Fig. 7.1 Schematic picture of currency exposure ........................................................................................115Fig. 8.1 Source of external finance ............................................................................................................ 127Fig. 8.2 The time line depicting the FRA examples................................................................................... 129Fig. 8.3 International capital markets ........................................................................................................ 130Fig. 8.4 Structure for a GDR transaction ................................................................................................... 136Fig. 9.1 Use of a third party for export import ........................................................................................... 147Fig. 9.2 Forfeiting mechanism ................................................................................................................... 156

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List of Tables

Table 2.1 Exchange rate quotes.................................................................................................................... 23Table 3.1 Difference between swap and hedge ............................................................................................ 47Table 3.2 Debt servicing cash on flow ........................................................................................................ 48Table 3.3 Cash flow under forward contract ................................................................................................ 48Table 3.4 Currency swap dollar outflows .................................................................................................... 49Table 3.5 Difference between currency swap and forward contract ............................................................ 49Table 3.6 MIOCS rate .................................................................................................................................. 52Table 3.7 Differences between forward and future contract ........................................................................ 56Table 4.1. Balance of payment items under capital A/c and unilateral transfer account ............................. 73Table 4.2 Key indications of India’s balance of payments .......................................................................... 74Table 7.1 Table showing gains and losses from forward hedging at different spot exchange rates ...........118Table 7.2 Table shows how the £10 million receivable is exactly offset by the £10 million payable leaving a net cash flow of $ 14,600,918 on maturity date ........................................................ 120Table 8.1 Typical characteristics of the international bond market instruments ........................................ 133

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Abbreviations

ADRs - American Depository ReceiptsAds - Authorised DealersAEZ - Agri Export ZonesAMEX - American Stock ExchangeASEAN - Association of South East Asian NationsBIFR - Board for Industrial and Financial ReconstructionBOP - Balance of PaymentCAD - Canadian DollarCAP - Common Agricultural PolicyCBCE - Chicago Board Option ExchangeCBOT - Chicago Bond of TradeCCFF - Contingency Financing FacilityCDs - CertificateofDepositCFR - Cost and FreightCHIPS - Clearing House Interbank Payments SystemCIP - Carriage and Insurance Paid toCME - Chicago Mercantile ExchangeCPT - Carriage Paid ToDAF - Delivered at FrontierDDP - Delivered Duty PaidDDU - Delivered Duty UnpaidDEPB scheme - Duty Exemption Pass Book SchemeDEQ - Delivered Ex Quay (duty paid)DES - Delivered Ex ShipDFRC - DutyFreeReplenishmentCertificateSchemeDIR - Defence of India RulesDR - Depository ReceiptDRAM - Dynamic Random Access Memory ChipsDTC - Depository Trust CompanyDTP - Domestic Tariff AreaECB - European Central BankECU - European Currency UnitEEC - European Economic CommunityEEFC - Exchange Earners’ Foreign CurrencyEHTP - Electronic Hardware Technology ParkEMI - European Monetary InstituteEMS - European Monetary SystemEMTNs - Euro Medium Term NotesEOU - Export Oriented UnitEPCG - Export Promotion Capital Good SchemeESCB - European System of Central BanksEU - European UnionEuro MTNs - Euro Medium Term NotesFAS - Free Alongside ShipFCA - Free CarrierFDI - Foreign Direct InvestmentFDIC - Federal Deposit Insurance CorporationFEDAI - Foreign Exchange Dealers Association of IndiaFEMA - Foreign Exchange Management ActFERA - Foreign Exchange Regulation Act

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FIDDMA - Fixed Income Money Market and Derivatives AssociationFIIs - Foreign International InvestorsFOB - Free on BoardFRA - Forward Rate AgreementFRC - Forward Rate ContractFRNs - Floating Rate NotesGAAP - General Accepted Accounting PrincipalGAB - General Arrangements to BorrowGBP - Great Britain PoundGDRs - Global Depository ReceiptsHDFC - Housing Development Finance Corporation LtdIBRD - International Bank for Reconstruction and DevelopmentICC - International Chamber of CommerceIEC - Importer-Exporter CodeIMF - International Monetary FundISMA - International Securities Market AssociationLC - Letter of CreditLERMS - Liberalised Exchange Rate Management SystemLIBID - London Inter Bank Bid RateLIBOR - London Inter Bank Offer RateLIFFE - London International Financial Future ExchangesMIBOR - Mumbai Interbank Offered RateMIFOR - Mumbai Interbank Forward Offer RateMIOCS - Mumbai Inter Bank Offered Currency SwapMNEs - Multinational EnterprisesNAFTA - North American Free Trade AgreementNCDs - NegotiableCertificatesofDepositsNYSE - : New York Stock ExchangeOECD - Organisation of Economic Cooperation and developmentOPEC - Organisation of the Petroleum Exporting CountriesOTC - Over the CounterPBOT - Philadelphia Board of TradePHLX - Philadelphia Stock ExchangePPP - Purchasing Power ParityQIBs - QualifiedInstitutionalBuyersSAD - Single Administrative DocumentSDRs - Special Deposit ReceiptsSEZ - Special Economic ZoneSTP - Software Technology ParkSTPI - Software Technology Park of IndiaTSE - Tokyo Stock ExchangeTT - Telegraphic TransferUCPDC - Uniform Customs and Practice for Documentary CreditsUSAID - United States Agency for International Development

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Chapter I

The World of International Economy and Finance

Aim

The aim of this chapter is to:

discussinternationaleconomicsandinternationalfinance•

explainfinancialmanagement•

definedomesticmarketsandoffshoremarkets•

Objectives

The objectives of this chapter are to:

discuss theories on international trade•

definescopeofinternationalfinancialmanagementandroleofinternationalfinancemanager•

analyse dynamics of entering foreign markets•

Learning outcome

At the end of this chapter, the students will be able to:

classifyfinancialmarkets•

talk about the details and evolution of offshore markets and their evolution•

state interest rates in the global money markets•

defineintern• ational trade policies

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International Economy and Finance

1.1 Introduction to International Economics and the International FinanceInternational economics deals with economic interdependence among countries and includes factors which affect as well as shows the effects of such interdependence.

It is a branch of economics which studies economic interactions among different countries, including foreign trade (exports and imports), foreign exchange (trading currency), balance of payments, and balance of trade. While much of the interaction among countries is largely an extension of basic economic principles, complications do arise because nations are distinct political entities, with different laws and cultures, and with little or no overall governmental oversight. The guiding principle in the study of international economics is comparative advantage, which indicates thateverycountry,irrespectiveoftheirlevelofdevelopment,canfindsomethingthatitcanproducecheaperthananother country. The study of international economics focuses on two related areas namely international trade and internationalfinance.

Internationalfinancesimplymeans theeconomic interactionamongdifferentnationswhich involvesmonetarypaymentsandexchangeofcurrency.Thecornerstoneofinternationalfinanceisforeignexchange,includingforeignexchange markets and exchange rates. International trade, the study of trade between nations, is a related area of international economics. A summary of international trade undertaken by a particular nation is given with the balance of payments.

1.2 Growing Importance of International FinanceInternationalfinance springs from increasing importanceof internationalflowofgoodsandcapital.Twomainreasons for the growing importance of international trade are:

Liberalisation of trade and investment has occurred via reductions in tariffs, quotas, currency controls, and •otherimpedimentstotheinternationalflowofgoodsandcapital.Muchofliberalisationhascomefromthedevelopment of free-trade areas like EU, NAFTA, ASEAN and so on.An unprecedented shrinkage of “economic space” has occurred via rapid improvements in communication •and transportation technologies and cost reduction as a result. For example, cost of telephone calls, cost of internationalfinancespringsfromincreasingimportanceofinternationalflowofgoodsandcapital.

Rewards of international tradeincreasedprosperitybyallowingnationstospecialiseinproducinggoodsandservicesatwhichtheyareefficient,•Comparative AdvantageThere is more to successful international trade than comparative advantage which is based on productive •efficiencies.That is due to competitive advantage based on dynamic factors rather than static productionpossibilities. For example, Hong Kong’s growth with limited resources, French success in wine and cheese, German in beer andfinely engineered automobiles,British in cookies, Italian success in fashion,U.S. inentertainment.Insomecountries,thepresenceofconsumer’ssophisticatedtasteshasforcedfirmstoproducefirst-classproducts,andafterbecomingsuccessfulathome,theywereabletosucceedabroad.

Risk of international tradeRewards accompany risk:• Most obvious risk of international trade arises from uncertainty about exchange rates.Unexpectedchangesofexchangerateshaveimportantimpactonsales,prices,andprofitsofexportersand importers.Country risk:• Thisincludestheriskasaresultofwar,revolution,orotherpoliticalorsocialeventsafirmmay not be paid for its exports. This applies to foreign investments and to credit granted in trade. Some times foreign buyers may be willing but are unable to pay because their government unexpectedly imposes exchange restrictions. Moreover, uncertainty is due to imposition or change of import tariffs or quotas, subsidies to local producers, and non-tariff barriers.Practices have evolved to cope with risk. For example, special types of foreign exchange contracts have been •designed to hedge or cover some of the risks from unexpected changes in exchange rates.

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Export credit insurance schemes are established to help country risk and letters of credit developed to reduce •other risks of trade.

Increasedglobalisationoffinancialandreal-assetmarketsThere has been unprecedented growth of foreign versus domestic investment in the money market, the bond market, the stock market, the real-estate market and the market for operating business. At times, the importance of overseas investments and investors has swelled to overshadow that of domestic investment and investors.

Increased volatility of exchange ratesExchange risk has risen greatly because exchange rates have become increasingly volatile. This has been resulted from tension in Middle East or some other politically sensitive parts in the world, at times by news on economic conditionsofmajorcountryandmanysuchrelatedfactors.Thisvolatilityismeasuredbyusingcoefficientofvariationintheexchangerates.Someattributetheincreasedvolatilitytoflexibleexchangeratesystemadoptedin1973.

Increased importance of multinational corporations and transnational alliances Themultinationalisationofbusinessisnoteasiertomeasurethantheglobalisationoffinancialmarkets,corporateinvestment across borders, which is the essence of corporations’ becoming multinational. The power held by these massive, stateless enterprises has long been a source of government and public concern. The fear has been that by extendingtheiractivitytheycouldinfluencegovernmentsandexploitworkersandconsumers,especiallyinsmallernations that might control fewer resources than the corporations themselves.

1.3 International Financial ManagementInternationalfinancialmanagementmaybedefinedasthemanagementofvariousfinancialoperationsrelatingtointernationalbusinessorganisations.Itdealswithcrossbordermanagementofassets,liabilitiesandcashflows.Internationalfinancialmanagementdealswithdecisionstakingintoaccountsimultaneously:

theconditionsprevailingintwoormorefinancialmarkets•regulatory and institutional barriers to the international movement of funds •the changes in the exchange rates of national currencies•

Internationalfinancialmanagementreferstothefinancialfunctionofanoverseasbusiness.Itdealswithinvestmentdecisions,financingandmoneymanagementdecisions.

1.3.1 Globalisation and International Finance

At present the world economy is becoming a single, huge and complex organism with highly interdependent •constituents. Supersonic transport, satellite communications and computer technology have shrunk the world. Inaddition,thephenomenalgrowthininternationalexchangeofgoods,services,technologyandfinancehasknit several national economies into a vast network of economic relationships. Hence no nation at present can survive as an independent nation for a long time.The volume of international trade has rapidly increased after the Second World War as a result of removal of •theobstaclestothefreeflowofgoodsandservicesacrossnations.Alongwiththerapidgrowthofworldtrade,therehasbeenfasterincreaseincrossbordercapitalflows,especially•foreign direct investments. Hence several multinational corporations came into existence, with production and marketingfacilitiesspreadallovertheworld.Anothersignificantdevelopmentthathastakenplaceisthatofinternationalfinancialmarkets.Significantrevolutionhastakenplaceinthemoneymarketsandcapitalmarketsallovertheworld.Adynamicandcomplexinternationalfinancialmarketthatexiststodayhasbeentheresultof liberalisation, integration and innovation.

1.3.2 Scope of International Financial Management (IFM)The scope of IFM has been steadily increasing on account of development of new tools and techniques. However, broadly it includes:

foreign exchange market•

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International Economy and Finance

Balance of Payments

International Financial Management

International Monetary System

Foreign Exchange Market

Currency Convertibility

International Financial Markets

exchange rate determination•exchange rate risk and its management•investment decisions of Multinational Enterprises (MNEs)•international working capital decisions•financingdecisionsofMNEs•international accounting and control decisions•international indebtedness•

Internationalfinancialmanagementmaybestudiedfromtwoperspectiveswhichareeconomicperspectiveandbusiness perspective. From the point of view of economic perspective it is necessary to deal with macro economic issues such as:

balance of payments•establishment of internal and external equilibrium•internationalfinancialadjustmentprocess•determination of exchange rates•international reserves and transfer problems•inflationandinterestratesinvariouscountriesandsoon•

From thepoint of viewof business perspective, it is essential to study international business and itsfinancialimplications,problemsofinternationalinvestments,theirsourcesanduses,financialinstrumentsusedandsoon.

Environmentofinternationalfinancialmanagement

Fig.1.1Scopeofinternationalfinancialmanagement

1.3.3 Role of the International Financial ManagerThemaintasksofinternationalfinancialmanagersmaybesummarisedasfollows:

Forecastingthefinancialenvironment:• Prices,inflationrates,interestratesandexchangerates.Exchange risk management:• Measuring the effects of exchange rate changes on balance sheets, income, cash flowsandmanagingtheirrisks.Management of assets:• From cash management to international capital budgeting, both at home and abroad, in terms of domestic and foreign currencies.Management of liabilities:• Borrowing relationships and decisions, in domestic and foreign currencies and markets, short term and long term.

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Performance evaluation and control:• Accounting for outsiders, the tax authorities and for management, and doing so across countries and currencies without distortion.

ChallengesofinternationalfinancialmanagersFivekeycategoriesofemergingchallengescanbeidentified.

Tokeepupdatingthesignificantenvironmentalchangesandanalysetheirimplicationsforthefirm.Thevariables•to be monitored include - exchange rates, credit conditions at home and abroad, changes in industrial tax and foreign trade prices, stockmarket trends, fiscal andmonetary developments, emergence of newfinancialinstruments and products etc.To understand and analyse complex relationships between relevant environmental variables and corporate •responses - own and competitive, to the changes in them.Havetheabilitytoadaptthefinancefunctionwiththesignificantchangesinthefirm’sownstrategicposture.A•majorchangeinthefirm’sproductmix,diversification,andsooncallformajorfinancialrestructuring,findinginnovative funding strategies, changes in dividend policies etc. . Responses may be required.To avoid mistakes and part failures and to minimise their adverse impact. For example a wrong takeover decision, •alargeforeignloaninafastappreciatingcurrency,floatingratefinancingobtainedwhentheinterestrateswerelow and so on, errors of judgment which may take place under uncertain conditions. Hence, ways must be found to reduce the damage caused by such deviations.To design and implement effective solutions for taking advantage of opportunities offered by markets and •advancesinfinancialtheory.Increaseincomplexityandpaceofenvironmentalchangescallsforgreaterrelianceonfinancialanalysis, forecastingandplanning,greatercoordinationbetween the treasurymanagementandcontrol functions and extensive use of computers and information technology.

Thus, a manager has to remember that the success of the management of an international organisation depends on cost competitiveness and the ability to manage the bottom-line. Financial tools are basics for the manager in future.

1.4 Theories of International TradeThe various theories related to international trade are discussed below:

1.4.1 The Mercantilist’s Views on TradeMercantilists maintained that the way a nation became rich and powerful was to export more than it imported. The resultingexportsurpluswouldthenbesettledbyaninflowofbullionorpreciousmetals,primarilygoldandsilver.Thus, the government had to do all in its power to stimulate the nation’s exports and discourage and restrict imports (particularly the import of luxury consumption of goods).

CriticismThe theory viewed trade as a zero sum game, a gain by one results in a loss by another. Adam Smith and David •Ricardo showed the short-sightedness of the approach and demonstrated that trade is a positive sum game or, asituationwhereallthecountriesbenefit.Mercantilist measured the wealth of a nation by the stock of precious metals it possessed. In contrast, today we •measure the wealth of a nation by its stock of human, man-made and natural resources available for producing goodsandservices.Thegreaterthestockofusefulresources,thegreateristheflowofgoodsandservicestosatisfy human wants and increase the standard of living of the nation.

1.4.2 Trade Based on Absolute Advantage - Adam SmithAccording to Adam Smith, every country should specialise in producing those products, which it can produce at less cost than that of other countries and exchange these products with other products. The other products are produced absolutely at less cost by other countries. According to Smith, “whether advantage which one country has over another by natural or acquired, is in this respect of no consequence”.

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International Economy and Finance

CriticismAccording to this theory, every country should be able to produce certain products at low cost compared to other •countries and should produce certain other products at comparatively high costs than other countries. International trade takes place only under such conditions. But in reality, most of the developing countries do not have absolute advantage of producing a commodity at the lowest cost, yet they participate in international business.

1.4.3 Comparative Advantage – David RicardoAccording to the Comparative Cost theory, countries in the long run will tend to specialise in the business (production and marketing) of those goods in whose business they enjoy comparative low cost advantage and import other goods in which the countries have comparative cost disadvantage, if free trade is allowed. This specialisation helps in the mutual advantage of the countries participating in international business.David Ricardo illustrated the comparative cost theory in the year 1817. He used the two countries, two-commodity model. The conclusions of his model are:

tradebetweentwocountriesisprofitablewhenacountryproducesonegoodatalowercostthananothercountry•and that the other country produces another good at a lower cost than the former countrytradebetweentwocountriesisalsoprofitablewhenonecountryproducesmorethanoneproductefficiently,but•whenitproducesoneoftheseproductscomparativelyatgreaterefficiencythantheotherproductboth the nations can engage in international trade when one country specialises in production in which it has •greaterefficiencythantheother

Assumptions of the theorythe only element of cost of production is labour•production is the subject to the law of constant returns•there are no trade barriers•trade is free from cost of transportation•

Derivatives of the theoryThe advantages desired from this theory are:

efficientallocationofglobalresources•maximisation of global production at the lowest possible cost•product prices become more or less equal among world markets•demand for resources and products among world nations will be optimised•

1.4.4 The Hecksher Ohlin TheorySwedish economist Eli Hecksher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowment. By factor endowments they meant the extent to which a country is endowed with such resources as land, labour and capital. Nations have varying factor endowments and different factor endowments explain differences in factor costs. The more abundant a factor, the lower the cost is. The H.O. Theory predicts that countries will export those goods that make intensive use of factors that are totally scarce, thus the H.O. Theory attempts to explain the pattern of international trade in the world economy.

CriticismSomecriticsholdthatthefactorproportionstheoryofOhlinisunrealisticbecauseitisbasedonover-simplified•assumptions.To critics differences in relative factor endowments are one of the many possible explanations for the commodity •price differences underlying international trade. Commodity prices may differ even when there are either differing factor qualities, differing production techniques, increasing returns to scale or differences in the consumer’s demand for the products in two countries.

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1.4.5 National Competitive Advantage – Porter’s DiamondIn 1990, Michael Porter of Harvard Business School published the results of an intensive research effort that attempted to answer why some nations succeed and others fail in international competition. Porter and his team looked at 100 industries in 10 nations. The book containing the results of the work, the Competitive Advantage of Nations, has made an important contribution to thinking about international trade.Porter’stheorystatesthatthefourbroadattributesofanationshapetheenvironmentinwhichlocalfirmscompeteand these attributes promote or impede the creation of competitive advantages, these attributes are:

Factor endowments• : A nation’s position in factors of production such as skilled labour or the infrastructure necessary to compete in a given industry. Poster recognises hierarchies among factors distinguishing between basic factors (for example: natural resources, climate, location and demographies) and advanced factors (for example: communications, infrastructure, sophisticated and skilled labour, research facilities and technical knowhow).Hearguesthatadvancedfactorsarethemostsignificantforcompetitiveadvantageandthesearetheproduct of investment by individuals, companies and governments. Government’s investments in basic and high education, by improving the general skill and knowledge level of the population and by stimulating advanced research at higher education institutions, can upgrade nation’s advanced factors. Demand conditions• : The nature of home demand for the industrial product or services. Porter emphasises the role demand plays in upgrading competitive advantage, for example: Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models. Relating and supporting industries• : The presence or absence of supplier industries and related industries that are internationally competitive, for example: Swedish strength in fabricated steel products such as ball bearings and cutting tools has drawn on strengths in Sweden’s speciality steel industry.Firm strategy, structure and rivalry• : The conditions governing how companies are created, organised and managed and the nature of domestic rivalry.

Fig. 1.2 Determination of national competitive advantage

1.5 Dynamics of Entering Foreign MarketsCompanies desiring to enter foreign markets must analyse the following decision factors to decide the mode of entry into a given overseas location:

Ownership advantage:• Thesearethebenefitsdesignedbyacompanybyowningresources.Theyprovidecompetitive advantage to the company over its competitors. These advantages are both tangible and intangible.Location advantage:• Certainlocationfactorsgrantbenefittothecompanywhenthemanufacturingfacilitiesare located in the host country rather than in the home country. These location factors include:

customer needs, preferences and tastes �logistic requirements �

Firm Strategy, Structure and Rivalry

Demand Conditions

Related and supporting Industries

Demand Conditions

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cheap land acquisition cost �cheap labour �political stability �low cost raw materials �climatic conditions �

If the company has location advantage, it enters the foreign market through direct investment. On the other hand, if the location of manufacturing facilities in the home country is advantageous than in the host country, the company enters foreign markets through exporting. Example: McDonald’s built a factory in Cairo, Egypt in 1996. It was frustrated in dealing with the Egyptian rules wherein bureaucrats in Egypt required the company to obtain more than a dozen signatures each time it imported hamburger buns in Egypt.

Internationalisation advantage:• These are the benefits that a companygets bymanufacturing goods orrendering services in the host country by itself rather than through contract arrangements with the companies in the host country. Example: Toyota enters foreign markets through direct investment and joint ventures, as thelocalcompaniesinforeigncountriescannotproduceasefficientlyasToyota.

1.5.1 Different Modes of Entry to Foreign Markets There are many different ways which are used to enter the foreign markets. Some of the important modes are explained below:

Exporting:• This is the simplest and most widely used mode of entering foreign markets and the advantages are -needforlimitedfinance,lessriskandopportunitiesavailableinthehostcountry.Formsofexportingincludeindirect exporting, direct exporting and intra corporate transfers.

Indirect exporting � isexportingtheproductseitherintheoriginalformorinthemodifiedformtoaforeigncountry through another domestic company, for example: various publishers in India sell their products i.e. books to UBS publishers in India, which in turn exports these books to various foreign countries.Direct exporting � is selling the products in a foreign country directly through its distribution arrangements or through a company in the host country. For example: Baskin Robbins initially exported its ice cream to Russia in 1990 and later opened 74 outlets with Russian partners. Finally in 1995, it established its ice cream plant in Moscow.Intra corporate transfers � aresellingofproductsbyacompanytoitsaffiliatedcompanyinthehostcountry(another country), for example: selling of products by Hindustan Lever to Uni Lever in USA is treated as exports in India and imports in USA.

Licensing:• In this mode of entry, the domestic manufacturer leases the right to use its intellectual property, i.e. technology, work methods, patents, copyrights, brand names, trade marks, etc. to a manufacturer in a foreign countryforafee.Thecompaniesshouldclearlydefinetheboundariesofagreementsi.e.rightsandprivileges.The arrangement is similar to leasing.Franchising:• It is a form of licensing and the franchiser can exercise more control over the franchised compared to that in licensing. Under franchising, an independent organisation called the franchisee operates the business under the name of another company called the franchiser. Under this agreement, the franchisee pays a fee to the franchiser. The franchiser provides services to the franchisee as trade marks, operating systems, product reputations, continuous support like advertising, employee training, reservation services, quality assurance programmes, etc.Special modes:• These are not connected with long term investments or long term contracts to enter into foreign markets but through specialised strategies like contract manufacturing, management contract and turnkey projects.

Contract manufacturing � is adopted by companies to concentrate on marketing and outsourcing their manufacturing either completely or in parts. For example: Nike has contracted with a number of factories in South East Asia to produce its athletic footwear and it concentrates on marketing. Management contract � is an agreement between two companies where one company provides managerial assistance, technical expertise and specialised services to the second company for a certain period in return for monetarycompensation.Themonetarycompensationmaybeaflatfee,percentageoversales,performancebonusbasedonprofitability,salesgrowth,productionorqualitymeasures.

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Turnkey project � isacontractunderwhichafirmagreestofullydesign,constructandequipamanufacturing/business / service / facility and turn the project over to the purchaser when it is ready for operation for a fixedpriceorpaymentoncostplusbasis.

Foreign direct investment without alliances:• Through this route, companies enter international markets by foreign direct investment (FDI), invest their money, establish manufacturing and marketing facilities through ownership and control without any help from any other company. Normally companies enter foreign markets through exporting, licensing, franchising, and so on, get knowledge and awareness of the foreign markets, culture of the country, customer preferences, political situation of the country, and then establish manufacturing facilities by ownership in the foreign countries, for example: Baskin Robbins in Russia followed this strategy. ThemodeofFDIwithoutalliancesisthegreenfieldstrategy.Thetermgreenfieldreferstostartingwithavirgingreen site and then building on it.Foreign direct investment with strategic alliances:• Strategic alliance is a co-operative and collaborative approach to achieve the larger goals. Alliance is a strategy to explore a new market, which the companies individually cannot explore. For example - Xerox of USA and Fuji of Japan collaborated to explore new markets in Europe. Two companies join hands in order to align their distinctive and different strengths. Dunlop and Pirelli – the two tyre making companies joined together to synergise the strength of marketing capabilities of Dunlop and R and D capabilities of Pirelli.

The modes of foreign direct investment through alliances are: Mergers �Acquisitions �Joint ventures �

Domestic companies enter international business through mergers and acquisitions i.e. a domestic company selects a foreign company and merges itself with the foreign company. Alternative - the domestic company may purchase the foreign company and acquire its ownership and control. For example, Coca Cola entered the Indian market instantly by acquiring Parle and its bottling units.

In joint ventures,twoormorefirmsjointogethertocreateanewbusinessentitythatislegallyseparateanddistinctfrom its parents. For example: American Motor Corporation entered into a joint venture with Beijing Automotive Works called Beijing Jeep to enter the Chinese market by producing jeeps and other vehicles.

1.6 Global Financial MarketsDuringthemid1980’stherebeganaprocessofintegrationoftheworld’sfinancialmarkets.Theideawastohaveavastglobalfinancialmarket.Thefinancialmarketsacrosstheworldareintegratedwhichcanbeexaminedbythefollowing different perspectives:

The presence of legal barriers that prevent borrowers in one country from accessing markets in another and •investors in one country from acquiring foreign assets in another. Further, non-resident entities may be totally deniedaccesstoacountry’sfinancialmarketsormaybepermittedcontrolledaccess.Similarly,acountrymaytotally or partially prevent its residents from borrowing in foreign markets and investing in foreign assets. Also theremayberestrictions,whichkeepforeignbanksandfinancialinstitutionsoutofsomeorallsegmentsofthedomesticfinancialmarkets.Asecondfactorcausingsegmentationevenintheabsenceofanyformalrestrictionsoncrossbordercapitalflows•is the differences in generally accepted accounting principles, disclosure norms, regulatory structure, market practices, and so on, which create informational asymmetries between resident and non-resident investors. Thusnon-residentinvestorsmayfinditdifficulttoacquireandinterpretinformationaboutpotentialissuersina country even though the local government places no restrictions on foreign investors.The most important consideration involves the exchange risk factor. The exchange rate movements do not •compensate fordifferences in inflation ratesacrosscountries. Inaglobally integratedmarket,all investorswho have identical expectations should place an identical value on a given asset for example: stock/ shares of General Motors. Because of real exchange rate risk, this will not hold good.

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Fromthesethreeissues,onecansaythatrestrictionsoncrossbordercapitalflowsarebeingprogressivelyremovedinmostmajorfinancialmarkets.Similarly,thereisasignificantincreaseinthepresenceofnon-residentfinancialinstitutions in the markets of OECD countries and to some extent even in developing countries. Informational disadvantages faced by non-resident investors can be easily overcome with time. However, there still remain significantdifferencesacrosscountriesinaccountingandreportingpracticesaswellasregulatorypolicies.Finally,valuation divergence caused by real exchange rate uncertainties will probably continue to segment the world’s financialmarketsforalongtimetocome.

1.7ClassificationofFinancialMarketsFinancialmarketscanbeclassifiedinvariousways.Forthepurposeofinternationalfinance,wewillfollowtwomain divisions:

Domestic or onshore market•Offshore markets•

Domestic markets are traditional national markets subject to the regulatory jurisdiction of the countries’ monetary and securities market authorities and trading assets denominated in the countries’ currency. Thus, the markets for government and corporate debt, bank loans, the stock market and so on, in India are the Indian domestic market and denominated in rupees. Similar markets exist in most countries though many of them in developing and emerging market economies are not that developed. In many countries, non-resident entities are allowed to raise funds in the country’s domestic market, which gives the market an international character. Thus, an Indian company (for example; Reliance industries) can issue bonds in the US bond market and a Japanese company can list itself on the London Stock Exchange.

Offshore or external markets are markets in which assets denominated in a particular currency are traded, but the markets are located outside the geographical boundaries of the country of that currency. Thus, a bank located in London or Paris can accept a time deposit denominated in US dollars from another bank or corporation – an ‘offshore dollar deposit’. A bank located in Paris might extend a loan denominated in British pound sterling to an Australianfirm–anoffshoresterlingloan.AnIndiancompanymightissueinLondonbondsdenominatedinUSdollars – an offshore US dollar bond.

The main characteristic of these offshore markets is that, they are not subject to many of the monitoring and regulatory provisions of the authorities of their country of residence or of the country of currency in which the asset is denominated.

For example; a bank in US accepting a deposit would have to meet the reserve requirements laid down by the Federal Reserve and also meet the cost of deposit insurance. However, the London branch of the same bank accepting a dollar deposit is not subject to these requirements. An Indian company making a US dollar bond issued in the US would be subject to a number of disclosures, registration and other regulations laid down by the Securities ExchangeCommission.DollarbondsissuedinLondonfacenosuchrestrictionsandthefirmmayfindthismarketmore accessible.

Since both investors and issuers are generally free to access both the domestic and off shore markets in a currency, it is to be expected that the two segments must be closely tied together. In particular, the interest rates in the two segmentscannotdiffersignificantly.Ofcourse,therewillbesomedifferenceduetothefactthatonesegmentismorerigorously regulated (as also protected against systematic disasters) but unless the authorities impose restrictions onfundsflowacrossthesegments,thedifferenceswillbeverysmall.

1.7.1 Details of Offshore MarketsTheeurocurrencymarketorsimplytheeuromarketwasthefirstoffshoremarkettoemergeduringtheearlypostwaryears.Itblossomedintoaglobalfinancialmarketplacebytheendofthe1980’s.

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A Euro currency deposit is a deposit in the relevant currency with a bank outside the home country of that currency. Thus, a US dollar deposit with a bank in London is a euro dollar deposit. Note that what matters is the location of the bank – not the ownership of the bank or the ownership of the deposit. Thus a dollar deposit belonging to an American company held with the Paris branch of an American Bank is still a euro dollar deposit. Similarly, a euro dollar loan is a dollar loan made by a bank outside the US to a customer or another bank.

The term ‘Euro’ has now become outdated since such deposits and loans are regularly traded outside Europe, for example; in Singapore and Hong Kong (these are sometimes called Asian dollar markets). While London continues to be the main offshore centre, loans negotiated in London are often booked in tax haven centres such as Grand Cayman and Nassau for tax reasons. It must be noted that every offshore deposit has its counterpart in a deposit in the home currency of the relevant currency.

For instance if suppose, Microsoft wishes to place USD 50 million in a 91day deposit, it obtains rate quotations fromvariousbanksintheUSandinLondon;itfindsthattherateofferedbyBarclaysBankinLondon,8%ismostattractive. It instructs CITI bank, New York to remit USD 50 million to Barclays. Barclays London maintains an account with Chase New York. CITI debits the Microsoft account and credits the Barclay’s account with Chase. This transfer will take place via an interbank clearing system such as “Clearing House Interbank Payments System (CHIPS) in the US. Barclays create a deposit account in the name of Microsoft in London and credits it with USD 50 million. A Eurodollar or offshore dollar deposit has been created but ‘physically’, the dollars have not left the US. At maturity 91 days, Barclays will calculate interest payable as 50,00,0000 x 0.08 x (91/365) = $ 997, 260, 27(assume year is considered as 365 days) and credit it to Microsoft’s deposit account.

SupposeMicrosoftwishestoextendthedepositforafurtherperiodof91days,andfindsthatCommerzBank,Frankfurt is offering the best rate. It instructs Barclays London to transfer the money to Commerz Bank. Commerz bank maintains an account with Bank of America, New York. Barclays instructs Chase to debit its account and transfers the funds to the account of Commerz Bank with Bank of America, so the process goes on.

It may also be noted that Barclays is not going to keep the funds idle for 91 days. It might keep some amount as reservesandfindaprospectiveborrowerforthebalance.Suppose,aFrenchfirmwishestodetain90-dayloanofUSD45MillionandfindsthatBarclaysrateisthemosteconomical.ItdrawstheloanandinstructsBarclaystotransfer funds to its bank BNP Paris. BNP maintains an account with Bank of America in Los Angeles. Barclays instructs Chase to transfer the funds to BNP’s account with Bank of America. BNP creates an offshore or euro dollar depositinthenameoftheFrenchfirm.Anothereurodeposithasbeencreated.

It can be observed that BNP can and probably would repeat the process, which will lead to the creation of further euro dollar deposits. Just as in the case of a fractional reserve domestic banking system, euro banks can create multiple deposits based on an initial injection of funds into the system. But the funds never leave the home country of the currency in question (if at any period in the chain, the borrower wishes the loan proceeds to be transferred to an account in the US, the deposit expansion process will come to a halt).

Over the years, these markets have evolved a variety of instruments other than time deposits and short term loans forexample:CertificateofDeposit(CDs),EuroCommercialpaper(ECP)mediumtolongtermfloatingrateloans,Eurobonds(inkeepingwiththedefinitionofeurodeposits,adollarcommercialpaperoradollarbondissuedsayin London becomes, respectively, Euro dollar commercial and euro dollar bond). Floating Rate Notes (FRNs) and Euro Medium Term Notes (EMTNs).

1.7.2 Evolution of Offshore MarketsThe euro currency market especially the euro dollar market is said to have originated with the Russian authorities wishing to have dollar denominated deposits outside the jurisdiction of the US Government. Banks in Britain and France obliged and the Eurodollar market was born. The subsequent enormous growth of the euro dollar market is the result of the following factors:

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Throughout the 1960’s and 1970’s, American banks and other depository institutions were subject to ceiling •ontherateofinteresttheycouldpayondeposits(RegulationQwhichspecifiedamaximumrateofinterestpayable on savings deposits). These restrictions were not applicable to banks outside the US and a number of American banks began accepting dollar deposits in their foreign branches. The dollars were often reinvested in the US. Most of these restrictions were lifted by mid 70’s.Further reserve requirements and deposit insurance implied higher effective cost of funds for US domestic •deposits. Since outside branches of US banks are not required to observe these restrictions, they could offer slightly higher rates to depositors and slightly lower rates to borrowers. Hence it was attractive to accept dollar deposits in foreign brackets rather than at home.DollarbecameavehiclecurrencyininternationaltradeandfinanceandthereforemanyEuropeancorporations•havecashflows indollarsandhence temporarydollarsurplusesand theneed tomakepayment indollars.Hence, the need to have deposits denominated in dollars. Convenience of the same time zone as well as greater familiarity with European banks, made these companies prefer European banks, a choice made more attractive by the higher rates offered by euro banks.These factors were reinforced by the demand for euro dollar loans by non–US Corporations and by US •multinationalstofinancetheirforeignoperations.Duringthe1960s,becauseofdeteriorationofUSbalanceofpayments,thegovernmentimposedaseriesofrestrictions,whichmadeitextremelydifficultandmoreexpensivefor US entities to borrow in the US. The voluntary foreign credit restraints of 1963, followed by mandatory controls on foreign landing and the interest equalisation tax (a tax on interest earned by US residents from foreigners) induced channelising of funds through the euro dollar markets where these regulations did not apply.Another contributing factor was the restrictions imposed by UK authorities sometime in the 1950’s, which •preventedUKbanksfromprovidingtradefinanceinSterling.

The emergence of offshore markets in currencies other than dollars can also be attributed to similar circumstances though better rates and familiarity perhaps played a more important role in these cases. As exchange controls were eased and offshore banking was encouraged by authorities, offshore markets developed in many other countries including the Far East.

1.8 Interest Rates in Global Money MarketsThe spectrum of interest rates existing in an economy at any point of time is the result of complex interaction between several forces. Fig.1.3 below provides a schematic picture of interest rate determination.

Asseeninthefigure,shorttermmoneymarketratesinadomesticmoneymarketarelinkedtotheriskfreenominalrate, usually the yield offered by short term government securities like treasury bills. In the euro currency market, which is primarily an inter bank deposit market, the benchmark is provided by the inter bank borrowing and lending rates. The most widely known benchmark is the London Inter Bank Offer Rate (LIBOR). This is an index rate, whichafirstclassbankinLondonwillchargeanotherfirstclassbankforashort-termloan.FurtherLIBORisnotnecessarily the rate charged by any particular bank. It is only an indicator of demand supply conditions in the inter bank deposit market in London. Another term often referred to is the LIBID (London Inter Bank Bid Rate), the rate at which a bank is willing to pay deposits accepted from another bank. Further, LIBOR would vary according to thetermoftheunderlyingdeposit.Thefinancialpressnormallyprovidesquotationsfor3to6monthsLIBORs.Inthe market, deposits range in maturity from overnight upto one year. LIBOR also varies depending on the currency in which the loan or deposit is denominated.

The relationship between interest rates in the domestic and euro segments of the money market - while not strictly comparable, they serve to bring out the close connection between the two markets. Arbitrage by borrowers and investors with access to both the markets should serve to keep the rates close together. Consider this example:

In theUSdomesticmarketsay90dayCD(CertificateofDeposit) ratesare rulingat9.5%.There isa reserverequirementof 6%against funds raisedwithCD’s and adeposit insurancepremiumof4%,by the regulatingauthorities. This means that the US bank can raise funds in the US domestic market at an effective cost of –[(9.5%+0.04)/(1–004)]%=10.15%

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Fig. 1.3 Determination of interest rates

(Depositpremiumof4%willraisethecostbutbecauseofreserverequirementof6%,94%oftheamountraisedwill be available at the bank’s disposal).

Supposethebidratefor90-dayUSdollardepositinLondonis11.5%.BankswithaccesstoUSdomesticmoneymarketcanraisefundsthere,andplacetheminLondonforanarbitrageprofitof1.35%(11.5-10,15).Thiswouldbid up the CD rates in the US domestic market and put downward pressure on 90 day US dollar LIBID bringing the two rates together so that the arbitrage opportunity disappears.

Now let us understand the links between interest rates for different currencies in the euro market. At any given point of time, LIBORs for different currencies differ substantially. Consider a borrower who wishes to borrow funds in the euro market for six months. Among the different currencies available, he will consider the currency which gives him the least overall cost i.e. not only difference in interest rates but also expected behaviour of exchange rates [i.e. the exchange rate will vary during the six month period and how at what cost one can hedge (cover) the exchange fluctuation].

For a more concrete example, assume that the depositor’s functional currency is Indian rupees. After taking the loan in a foreign currency, he converts it into rupees and uses the funds. To repay the loan with interest, he will need the foreign currency six months later. To eliminate the uncertainty of the rates at which he will be able to buy the currency at that time, he enters into a contract with his bank in which the bank agrees to sell him the foreign currencyspecifiednowwhichiscalledForwardExchangeRate

Suppose, as on the date of transaction, the following further details are available:PoundSterling6monthLIBOR4.31%p.a.•JapaneseYen6monthLIBOR10.4%p.a.•Spot Exchange Rate Rupees vs. yen 0.3665•

Economy rating

Default Risk Market

Expected Inflation

Nominal Risk Free Rate T. Bill Etc.

Money Market Rates CD, CP Etc

Long-term Risk Free Rates

Other Long-term Rates

Special Feature

Maturity Premium

Required Real Rate

Money growth

Real output growth

Expectations Liquidity

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6 month Forward Exchange Rupee vs. Yen 0.3940•FundrequirementRs.25crores,InterestinPoundSterling4.31%•InterestinJapaneseYen0.104%•

Following are the steps:A loan in pounds would require a principal amount of (2500, 00,000/68) or 3676470.59 pounds. The repayment •obligations6monthslaterwouldbe:36,76,470.59[1+(0.0431)/2]=37,55,698.53poundsTo buy this at the forward rate of Rs. 69.35 per pound would require an outlay of 37, 55,698.53 x 69.35 = Rs. •26047693.10 six months later.Theprincipalamountoftheloanwouldbe[2500,00,000/0.3665]or682128240.10yen.Therepaymentwould•be682128240.10x[1+(0.00104/2)]=682482946.80yen.TobuythisatforwardwouldrequireanoutlayofRs. (6824882946.80 x 0.3940) = Rs. 268898281

Hence six months later, yen loan outlay required is Rs. 8 million more than with a pound loan though apparently the yen loan looked more attractive at the interest rate than the pound sterling loan.

The key lies to the effective cost of the loan that consists of two components, viz. the interest rate and the loss or gain on currency conversion, which in turn depends on the exchange rate at the start and the rate at which conversion is done at the time of loan repayment.

Forinstance:AUSBankfacesthefollowingmarketconditions.ThreemonthCDrateis9%,three-montheurodollarbidrateis11.0%,theFIDCpremiumis0.037%,andCDReserveRequirementsare6%.

Determine whether an outward or inward arbitrage incentive exists.•Howmuchprofitcanthebankmakefromarbitrage(outwardarbitrageistoborrowfundsathomeandinvest•abroad, inward arbitrage is the reverse).

Solution: The US Bank’s funding cost via a domestic CD is,Interest+FDICpremiumi.e.on100USDCDcostis9.037Because of CD Reserve required, one can use only 94 USD (out of 100 USD). Therefore effective cost is; 9.037/0.94=9.6138%ItcanthereforeraisefundsathomebyusingCD’sandlendintheEuro$marketat11%foranetgainof 1.3862%

1.9 International Trade PoliciesFrom the review of trade theories of Smith, Ricardo and Heckscher, Ohlin, it can be concluded that in a world without any obstacles, trade patterns are determined by the relative productivity of different factors of production in different countries.Countrieswillspecialiseinproductsthattheycanmakemostefficiently,whileimportingproductsthattheycanproducelessefficiently.Further,incaseoffreetrade,asituationwhereagovernmentdoesnotattemptto restrict what its citizens can buy from another country or what they can sell to another country, the theories of Smith, Ricardo and Heckscher–Ohlin predict that the consequences of free trade include both static economic gains (becausefreetradesupportsahigherlevelofdomesticconsumptionandmoreefficientutilisationofresources)anddynamic economic gains (because free trade stimulates economic growth and the creation of wealth).

International trade policies deal with the policies of the national governments relating to exports of various goods and services to various countries either on equal terms and conditions or on discriminating terms and conditions. For example, China imports goods from Pakistan on preferential terms like lower rates of tariffs, and so on.

Trade policies also aim at protecting domestic industry from the competition of advanced countries through imposing quotas. Trade policies of some countries aim at building competencies of the domestic companies by providing subsidies.

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Government announces their trade policies with regard to the following from time to time. These are called instruments of trade policy. They are:

tariffs•subsidies•import quotas•voluntary export restraints•local content requirements and•administrative policies•anti dumping duties•

TariffsA tariff is a tax which is levied on imports. Tariffs fall into two categories:

Special tariffs• areleviedasafixedchargeforeachofthegoodimported,forexampleatariffofRs.1000oneach TV imported. Ad Valorem tariffs• are levied as a proportion of the value of the imported goods. For example, imposition of 30%onthevalueofcomputersimported.

A tariff raises the cost of imported products. In most cases, tariffs are put in place to protect domestic producers from foreign competition. The tariff also raises government revenues. Two conclusions can be derived from a more advanced analysis:

First, tariffs are pro-producer and anti-consumer while they protect producers from foreign competition, the •restriction of supply raises domestic prices. Second,tariffsreducetheoverallefficiencyoftheworldeconomy.•

Theyreduceefficiencybecauseaprotectivetariffencouragesdomesticfirmstoproduceproductsallthetime,whichintheorycouldbeproducedmoreefficientlyabroad.Theconsequenceisinefficientutilisationofresources.Forexample, tariffs over import of rice in South Korea have caused rice farmers to utilise land in an unproductive manner. It would make sense for South Koreans to purchase their requirement of rice from low cost foreign producers and toutilisethelandnowemployedforriceinsomeotherfoodstuffthatcannotbeproducedefficientlyelsewhere.

SubsidiesA subsidy is a government payment to a domestic producer in the form of cash grants, low interest loans, tax advantage and government equity participation, to enable them lower the production costs, so as to compete against foreign imports and help them gain export markets.

Subsidiesarepaidbythegovernmentbytaxingindividuals.Therefore,whethersubsidiesgeneratematerialbenefitsthat exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. Instead they tend to protect the inefficiency, rather thanpromotingefficiencyandpromoteexcessproduction.

The Indian Government has already started withdrawing subsidies on fertilisers, pesticides, prices of agricultural output, output of small-scale industries etc. Withdrawal of these subsidies with regard to the agricultural sector and small-scale industrial sector led to the closure of certain small-scale industrial units. It led to increased losses to the Indian farmers and also suicide deaths of Indian farmers owing to indebtedness.

Import quotasImport quota is a direct restriction on the quantity of goods which are imported into a country. These restrictions areimposedbyusingimportlicensesforcertainfirmsandindividualstoimportacertainquantityofgoods.Indiahad imports of various goods like cars, motorcycles, milk, and so on, up to 31st March 2001. Import quotas provide protectiontothedomesticfirmsfromforeigncompetition.

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Voluntary export restraintA voluntary export restraint is a quota on trade imposed by the exporting country, typically on the request of the importing country’s government. For example, Japanese automobile exporters had such restraints in 1981 due to the request of the US Government. Foreign exporters mostly accept the voluntary export restraint as its violation leads to the imposition of import tariffs, import quotas, and many such restraints. Voluntary export restrictions help domesticfirmsbyprovidingprotectionfromforeigncompetitors.

Local content requirementsAlocalcontentrequirementisarequirementthat,somespecificfractionofagoodcanbeproduceddomestically.Therequirement can be expressed either in physical term (for example 75 per cent of component parts for this product must be produced locally) or in value terms (for example 75 per cent of the value of this product must be produced locally). Local content requirements have been widely used by developing countries to shift their manufacturing bases from the simple assembly of products whose parts are manufactured elsewhere, into the local manufacturers of component parts. They have also been used in developed countries to try to protect local jobs and industry from foreign competition.

Fromthepointofviewofdomesticproducerofpartsgoingintoafinalproduct,localcontentregulationsprovideprotection the same way an import quota does by limiting foreign competition.

Administrative trade policiesThesearebureaucraticrulesthataredesignedtomakeitdifficultforimportstoenteracountry.Formaltradebarrierslike tariffs and quotas are lowest in Japan. Japan mostly uses administrative policies.

Aswithallinstrumentsoftradepolicy,administrativeinstrumentsbenefitproducersandhurtconsumers,whoaredenied access to possibly superior foreign products.

Anti-dumping policiesInthecontextofinternationaltrade,dumpingisdefinedassellinggoodsinaforeignmarketatbelowtheircostsofproduction, or as selling goods in a foreign market at below their “fair” market value.

Anti-dumpingpoliciesaredesignedtopunishforeignfirmsthatengageindumping.Theultimateobjectiveistoprotect domestic producers from “unfair” foreign competition. Although anti-dumping policies vary somewhat from country to country, the majority are similar to the policies used in the United States.

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SummaryInternational economics deals with economic interdependence among countries and includes factors which •affect as well as shows the effects of such interdependence.Internationalfinance:Theeconomicinteractionamongdifferentnationsinvolvingthemonetarypaymentsand•the exchange of currency.Growing importance of internationalfinance: importance of internationalfinance springs from increasing•importanceofinternationalflowofgoodsandcapital,rewardsofinternationaltrade,riskofinternationaltrade,increasedglobalisationoffinancialandreal-assetmarkets,increasedvolatilityofexchangerates,andincreasedimportance of multinational corporations and transnational alliances.Internationalfinancialmanagementmaybedefinedasthemanagementofvariousfinancialoperationsrelating•to international business organisations. It deals with cross border management of assets, liabilities and cash flows.The scope of IFM has been steadily increasing on account of development of new tools and techniques.•Roleoftheinternationalfinancialmanager:forecastingthefinancialenvironmentexchangeriskmanagement,•management of assets, management of liabilities, performance evaluation and control.The Mercantilist’s views on trade: Mercantilist maintained that the way a nation became rich and powerful was •to export more than it imported.Trade based on absolute advantage-Adam Smith:• According to Adam Smith, every country should specialise in producing those products, which it can produce at less cost than that of other countries and exchange these products with other products.Comparative advantage – David Ricardo:• According to the comparative cost theory, countries in the long run will tend to specialise in the business (production and marketing) of those goods in whose business they enjoy comparative low cost advantage and import other goods in which the countries have comparative cost disadvantage, if free trade is allowed.The Hecksher Ohlin theory (HO):• Swedish economist Eli Hecksher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowment.Porter’s theorystates that the fourbroadattributesofanationshape theenvironment inwhich localfirms•compete and these attributes promote or impede the creation of competitive advantages.Domestic markets are traditional national markets subject to the regulatory jurisdiction of the countries’ monetary •and securities market authorities and trading assets denominated in the countries’ currency.Offshore or external markets are markets in which assets denominated in a particular currency are traded, but •the markets are located outside the geographical boundaries of the country of that currency.

Referenceshttp://glossary.econguru.com/economic-term/international+finance.Lastaccessedon16• th December, 2010.http://economics.about.com/cs/taxpolicy/a/tariffs.htm. Last accessed on 16• th December, 2010. http://financial-dictionary.thefreedictionary.com/Offshore.Lastaccessedon16• th December, 2010.

Recommended ReadingKenneth A Reinert (2004). • Windows on the World Economy: An Introduction to International Economics. South-WesternCollegePub;firstedition.Geoffrey R. D. Underhill (1997). • The New World Order in International Finance (International Political Economy Series). Palgrave Macmillan.Hendrik Van den Berg (2010). • International Finance and Open-economy Macroeconomics: Theory, History, and Policy.WorldScientificPublishingCompany.

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Self Assessment

__________is a direct restriction on the quantity of goods which are imported into a country.1. Import quotasa. Export quotasb. Import tariffc. Export tariffd.

WhichofthefollowingdefinesIntracorporatetransfers?2. Sellingofproductsbyacompanytoitsaffiliatedcompanyinthehostcountry.a. Selling the products in a foreign country directly through its distribution arrangements or through a company b. in the host country.Exportingtheproductseither in theoriginalformor in themodifiedformtoaforeigncountry throughc. another domestic company.Mode of entry, the domestic manufacturer leases the right to use its intellectual property. d.

Whichofthefollowingtheoryoninternationaltradeisbasedonnationalfactorendowment?3. National Competitive Advantage – Porter’s Diamonda. Comparative Advantage – David Ricardob. Trade Based on Absolute Advantage: Adam Smithc. The Hecksher Ohlin Theory (HO)d.

WhichofthefollowingisnotanassumptionofDavidRicardoTheoryofinternationaltrade?4. The only element of cost of production is labour.a. Production is the subject to the law of constant returns.b. There are trade barriers.c. Trade is free from cost of transportation.d.

WhichofthefollowingstatementisFALSE?5. Voluntaryexportrestrictionshelpdomesticfirmsbyprovidingprotectionfromforeigncompetitors.a. Trade policies of some countries aim at building competencies of the domestic companies by providing b. subsidies.Anti-dumpingpoliciesaredesignedtopunishforeignfirmsthatengageindumping.c. A tariff decreases the cost of imported products.d.

LIBORstandsfor?6. LondonInterBankOfficialRatea. London Inter Bank Offer Rateb. London Intra Bank Offer Ratec. London Inter Bank Offer Ratingd.

Whichofthefollowingcurrencybecamevehiclecurrencyduringtheevolutionofoffshoremarkets?7. Euroa. Dollarb. Yenc. Rupeed.

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In 8. ______________,twoormorefirmsjointogethertocreateanewbusinessentitythatislegallyseparateanddistinct from its parents.

Mergersa. Acquisitionsb. Joint venturesc. Treatyd.

________alliance is a co-operative and collaborative approach to achieve the larger goals.9. Strategica. Competitiveb. Workingc. Businessd.

____________________ is adopted by companies to concentrate on marketing and outsourcing their 10. manufacturing either fully or in part.

Foreign direct investmenta. Contract manufacturingb. Turnkey projectc. Management contractd.

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Chapter II

The Foreign Exchange Market

Aim

The aim of the chapter is to:

describe foreign exchange•

definespotmarket•

analyse market mechanism•

Objectives

The objectives of this chapter are to:

explain the structure of the forex market and its participants•

describe exchange rate quotations•

understand Indian forex markets•

Learning outcome

At the end of this chapter, students will be able to:

analyse settlement dates•

describe the various types of transactions•

state quo• tes for various kinds of merchant transactions

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2.1 Introduction to Foreign Exchange MarketThe mechanism through which payments are made between two countries having different currency systems is called foreign exchange.

The existence of a number of currencies gives rise to the need to transact these currencies for settling international payments. We know that in international transactions, at least one of the parties would be dealing in a foreign currency.

For example; if an Indian exporter sells some goods to someone in the US and the price is determined in dollars, the exporter would be dealing in a foreign currency. Similarly, if an Italian resident makes an investment in the German money market, he would deal with the German currency Euro which would be a foreign currency to him. Sometimes, the transaction currency may be a foreign currency to both the parties involved.

Thisfactresultedinthedevelopmentofamarket,whichdealsspecificallyincurrenciescalledtheForeign Exchange Market or Forex or FX. This is an OTC (over the counter) market, i.e., there is no physical marketplace where the dealsaremade.Itisanetworkofbanks,brokersanddealersspreadacrossvariousfinancialcentresoftheworld.These players trade in different currencies through (and are linked to each other by) telephones, faxes, computers and other electronic networks. These traders generally operate through a trading room. The deals are mostly on an oralbasiswithwrittenconfirmationslater.

2.2 Functions of the Foreign Exchange MarketThe foreign exchange market performs the following important functions:

to effect transfer of purchasing power between countries: transfer functions•to provide credit for foreign trade: credit functions•to furnish facilities for hedging foreign exchange risks: hedging functions•

Transfer functions: The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments such as telegraphic transfers, bank drafts and foreign bills.

Credit functions: Another function of the foreign exchange market is to provide credit both national and international, to promote foreign trade. When foreign bills of exchange are used in international payments a credit for about 3 months, till their maturity, is required.

Hedging function: A third function of the foreign exchange market is hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may begainorlosstothepartyconcerned.Underthiscondition,apersonorafirmundertakesagreatexchangeriskifthere are huge amounts of net claims or net claims or net liabilities which are to be met in foreign money. Exchange risks should be avoided or reduced. For this, the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three monthsisacontracttobuyorsellforeignexchangeagainstanothercurrencyatsomefixeddateinthefutureataprice agreed upon.

2.3 Forex Market ParticipantsThe market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. FXmarketparticipantscanbecategorisedintofivegroups:

International banks:• International banks provide the core of the FX market. Approximately 200 bank’s activity ‘make a market’ in foreign exchange i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers in conducting foreign commerce or makinginternationalinvestmentinfixedassetsthatrequireforeignexchange.

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Bank customers:• Bank customers include MNC’s, money managers and private speculators. Retail or bank clienttransactionsaccountforapproximately15%ofFXtradingvolume.Theother85%oftradingvolumeisfrom interbank trades between international banks or non-bank dealers.Non-bank dealers:• Non-bankdealersarelargenon-bankfinancialinstitutionssuchasinvestmentbanks,wheresize and frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs.FX broker: • FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Brokers have knowledge of the quotes offered by many dealers in the market. Consequently, interbank trades will use a broker primarily to disseminate a currency quote to many dealers as quickly as possible. In recent years, since the introduction and increased usage of the automated dealing system, the use of brokers has declined.Central banks:• The Central Bank (national monetary authority) of a particular country frequently intervenes in theforeignexchangemarketinanattempttoinfluencethepriceofitscurrencyagainstthatofamajortradingpartner,oracountrythatit“fixes”orpegs”itscurrencyagainst.Interventionistheprocessofusingforeigncurrency reserves to buy one’s own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively selling one’s own currency for foreign currency in order to increase its supply and lower its price.

The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another called correspondent banking accounts. The correspondent bank account networkallowsforefficientfunctioningoftheforeignexchangemarket.

In India, all dealings in foreign exchange are required to comply with the foreign Exchange Management Act, 1999 (FEMA). The Reserve Bank of India is the regulatory authority for the Act. According to FEMA, only those entities can deal in foreign exchange as authorised to do so by RBI. The Act provides for entities to be authorised either as authorised dealers or as money changers. Authorised dealers are generally commercial banks and form a large part oftheinterbankmarketsinIndia.Moneychangerscanbeeitherfull-fledgedmoneychangersorrestrictedmoneychangers. While the former are authorised to both buy and sell foreign currency from their customers, the latter can only buy the same. Money changers are allowed to deal only in notes, loans and travellers cheques. Authorised dealersontheotherhandareallowedtodealinalltheitemsclassifiedasforeignexchangebyFERA.Thus,theyare permitted to deal with all documents relating to exports and imports.

The authorised dealers have to operate within the rules, regulations and guidelines issued by the Foreign Exchange DealersAssociationofIndia(FEDAI)fromtimetotime.Theoffices/branchesofauthoriseddealers(AD’s)areclassifiedintothreecategories.Theseare:

Category A:• Theseareoffices/brancheswhichkeepindependentforeigncurrencyaccountswithoverseascorrespondent banks / branches in their own names.Category B:• These are the branches which do not maintain independent foreign currency accounts but have powerstooperatetheaccountsmaintainedabroadbytheirheadofficeorthebranchescategorisedA.Category C:• The branches, which fall in neither of the above categories and yet handle Forex business through a category A or B branch, fall under Category C.

The Indian Forex market consists of three tiers:The • firsttier consists of all the transactions between the authorised dealers and the RBI. The • second tier is the interbank market referred to earlier i.e. the market in which the authorised dealers deal with one another. Money changers are required to offset their positions created by dealing with their customers, in this interbank market. The • third tier is the retail segment, where authorised dealers and money changers deal with their customers.

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2.4 Foreign ExchangeForeignexchangeisdefinedintermsofsection2ofFEMA,1999asaforeigncurrencyincluding:

all deposits, credits, balance payable in any foreign currency •any drafts, traveller’s cheques, letters of credit and bills of exchange expressed or drawn in Indian currency and •payable in foreign currencyany instrument, giving anyone the option of making it payable either partly or fully in a foreign currency•

Here the term currency in “foreign currency” includes coins, bank notes, postal notes, postal orders and money orders. In other words, foreign exchange includes all kinds of claims of the residents of a country to foreign currency payable abroad.

2.5 Spot MarketThe spot market involves almost the immediate sale of foreign exchange. Typically cash settlements are made within one / two days.

2.6 Exchange Rate QuotationsAn exchange rate quotation is the price of a currency stated in terms of another currency. It is similar to the expression of the price of a commodity. Yet there is a peculiarity attached to exchange rate quotes. In of commodity, there is only one way of expressing price which is, number of units of money needed to buy one unit of the commodity.

For example: We always say Rs.10/- per kg, of potatoes; we never say 100 gm. of potatoes for a rupee. In case of an exchange rate quotation, both the items involved are in the form of money i.e., both are currencies. So the price of any one of them can be quoted in terms of one unit of the other. Due to this, there exist a number of ways to express the exchange rate between a pair of currencies. The Economic Times gives the quotes on 15.7.2005 as below:

Table 2.1 Exchange rate quotes(Source: Economic Times on 15.7.2005)

It can be noticed that various methods of expressing exchange rates have been used. Exchange rates will be mentioned in terms of A/B, where currency B is being bought or sold with its value being expressed in terms of currency A. In such a quote, currency B is referred to as the base currency.

2.6.1 Direct v/s Indirect QuoteA direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency.Example: INR/USD = 43.85 means IUSD = 43.85 INRAn indirect quote is where the exchange rate is expressed in terms of the number of units of the foreign currency forafixednumberofunitsofthedomesticcurrency.Example of an indirect quote would be: $/100 Rs. = 2.3175 / 2.3195Here the bank would be buying dollars @ $ 2.3175 / Rs.100 and selling dollars @ 2.2904.

Country USD AUD GBP CAD Euro

US - 1.3328 0.5687 1.2135 0.8272

Australia 0.7503 - 0.4867 0.9105 0.6206

Britain 1.7585 203437 - 2.1339 1.4546

Canada 0.8241 0.0983 0.4686 0 0.6817

Euro land 1.2089 1.6112 0.6875 1.4670 -

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The corresponding direct quote will be: Rs/$ = 43.15 / 43.66Here the bank will be buying dollars @ Rs. 43.15 $ and selling dollars @ Rs. 43.66Before August 2, 1993, the indirect methods of quoting exchange rates were followed in India. Since that date, the direct quote is being used.

2.6.2 American vs. European QuoteMost currencies in the interbank market are quoted in European terms that are the US dollar is priced in terms of the foreign currency (an indirect quote from the US perspective). Example: For British pounds £ / $ = 0.5687 (quotation as on 15th July, 2005).By convention however, it is a standard practice to price certain currencies in terms of the US dollar or what is referred to as American terms (a direct quote from the US perspective).Example: For British pounds $ / £ (quotation as on 15th July, 2005 as above)In almost all the countries, most of the exchange rates are quoted in European terms. The British Pound, the Irish Pound and the South African Rand are a few examples of currencies quoted in American terms.

2.6.3 Bid and Ask RateThe rate at which the bank is ready to buy currency will be different from the rate at which it stands ready to sell that currency. These rates are called the bid and the ask rates respectively. The difference in these rates represents the cost the bank incurs in these transactions, a small return on the capital employed and the compensation for the risk it takes. The risk arises because of the possibility of the exchange rate moving in an unfavourable direction before the bank is able to offset the transaction.

The difference between the bid rate and the ask rate is called the bid-ask spread or simply the spread. This spread is higher in the retail market than in the inter bank market. This is because of the higher volumes and greater liquidity in the inter bank market (lower the liquidity, higher the risk of the transaction being set off at a disadvantageous rate and hence higher the spread). An additional reason is that the counter-party risk (the risk of the other party not fulfillingitscommitment)islowerintheinterbankmarket,sincemostoftheplayersarelargecommercialbanks.Thus the bid-ask spread arises due to the presence of transaction costs, the absence of these costs would result in a single rate being quoted by banks for both buying and selling the currency.

Let us again look at the bankers quote on 15th July 2005:

Here the US Dollar is being bought and sold with its price quoted in Indian Rupees. In this quote, bid rate is the rateatwhichthebankisreadytobuyonedollar,whichisthefirsttermfromthelefti.e.,Rs.43.15.Inotherwords,it is the number of rupees that a bank is ready to pay in exchange for one dollar. The bank is bidding for the dollar at this rate. The ask rate is the rate at which the bank stands ready to sell one dollar in exchange for rupees. It is the number of rupees the bank is ready to accept for, or is asking for selling a dollar. This rate is Rs. 43.66. The bid rate is always lower than the ask rate. This is because the bank will be ready to pay less for a unit of currency than itreceives,inordertomakeaprofit.

2.6.4 Inter Bank Quote and Merchant QuoteMerchant quote is the quote given by a bank to its retail customers. On the other hand, a quote given by one bank to another / or to any other customer in the inter bank market is called an inter bank quote. It has also been mentioned that the quote is invariably the bankers’ quote. The question arises, since both the parties involved in the inter bank marketarebanks,whichquotewillbetaken?Theconventionisthatthebankrequestingthequoteisthecustomerand the quote will be taken as that of the bank giving the quote i.e. the one, which is acting as the market maker.

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2.7 Market Mechanism and ConventionsLet us now see how deals are struck in the inter bank market. Suppose a bank requires £ 1,000,000. The dealer approaches another bank and asks for a quote in the sterling, without mentioning whether he wants to buy or sell. The market making bank gives him a two-way quote (i.e., both the bid and ask rates for sterling). If the ask rate for the pound is acceptable to the banker, he says – “One mine” – implying that he has bought £ 1,000,000. The trade willenterthebooksofboththebanksandwrittenconfirmationsofthetradewouldbesentlater.Thesettlementofthe trade will take place through any of the available electronic money transfer systems (like CHIPS). Suppose the bank wanted to sell pounds and found the quoting bank’s bid rate acceptable, it would instead have said – “One yours” – implying that it has sold £ 1,000,000 to the market making bank.

While giving a two way quote, banks keep the bid and ask rates at such levels which both buyers and sellers of the relevantcurrencyarelikelytofindattractive,andhencethebankexpectstoreceivebothbuyandsellordersfromthe market. If the bank is getting orders for only one side of the transaction, it would mean two things – either the rates quoted by the bank are out of alignment with the rates being quoted by other players in the market, or there is too much buying or selling pressure in the market for that particular currency (i.e., the bank is only buying the currency), without being able to sell. It would mean that the market is getting a competitive rate for selling currency to the bank, but the bank’s selling rate is too high to attract buyers. On the other hand, it could also mean that there are too many sellers in the market. In both the cases, the bank will have to reduce its rates on both the buy and sell side. The lower bid rate will attract a fewer number of sellers, while the lower ask rate would encourage customers to buy from the bank. In case the bank is getting too many orders to sell currency to customers, it would have to increase both the bid and the ask rates, in order to attract more customers interested in selling the currency and fewer interested in buying it.

The quotes are generally given in the market as: Euro / $ = 1.2089 / 1.2094It is also a practice to state the same quote as: Euro / $: 1.2089 / 94With 94 representing the last two digits of the ask rate, the rest of the digits being common with the bid rate.Sincethedealersincurrencieswouldanywaybeawareofthegoingrate,thebigfiguresarenotspecified.Intheinter bank market, the quote is generally further shortened to:Euro: 89 / 94There are a few currencies which are quoted in 100s, rather than 1s or 2s. The reason is that their value is too small to be quoted otherwise. An example is the Japanese Yen. Its quote generally looks like:¥ / $: 112.031 / 06When the quote is given with such currencies as the base currency, the quote is for 100 units of the currency rather than one unit. For example, the corresponding $ / ¥ quote will be:$ / 100 ¥: 0.8950 / 52The last after-decimal digit of a quote is known as a point and the last two as a $/¥.The quotes given by different banks for the same pair of currencies may not necessarily be the same, but they have to be within certain limits to prevent arbitrage. Let us see an example to understand these limits. Suppose there are two banks A and B. Their quotes for the Euro / $ rates are:A – Euro / $: 1.2089 /1.2094B – Euro / $: 1.2084 / 1.2087

As A’s bid rate is greater than B’s ask rate, there is a risk-free arbitrage opportunity available (Arbitrage is the process ofbuyingandsellingthesameassetatthesametime,toprofitfrompricediscrepancieswithinamarketoracrossdifferent markets when it does not involve any commitment of capital or the taking on of risk, it is referred to as risk-free arbitrage). Dollars can be bought from B at Euro 1.2087 / $ and sold to A at Euro 1.2089 / $, thus making a gain of Euro 0.0002 per dollar. Thus, any bank’s bid rate has to be lower than the other bank’s ask rate, and it’s ask rate greater than other bank’s bid rate. Sometimes, banks deliberately maintain their rates out of alignment with the rest of the market, because they require only one type of transactions to come to them. For example, a bank may have an overbought position in euro (i.e. it may have bought more Euro than it sold). In such a case, it may like to keep it’s ask rate lower so as to attract customers who want to buy Euro.

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2.7.1 Inverse QuotesFor every quote (A/B) between two currencies, there exists an inverse quote (B/A), where currency A is being bought and sold, with its price expressed in terms of currency B. For example, for a ∈ / $ quote. Let the ∈/ $ quote in Frankfurt be:

∈ / $: 1.2089 / 1.2094

The (∈/$) bid rate is the rate at which the bank is ready to buy dollars (which also means the rate at which it is ready to sell ∈, which will be the ask rate in the $ / ∈ quote). Hence, the (∈/ $) bid rate would correspond to the ($ /∈) ask rate. In ∈/$, terms, this rate is 1.2094 which is equal to 0.8268/∈ (1 / 1.2094). Hence to calculate the implied inverse quote, the bid and the ask terms of the given quote have to be reversed and their reciprocals calculated. For this particular example, the calculations can be shown as:

Implied ($/∈) bid = 1/ (∈/ $) ask (Eq. 1)Implied ($/∈) ask = 1/ (/$) bid (Eq. 2)So, the implied inverse rate is:$ /∈ : 0.8268 / 0.8272These equations can be generalised as:

Implied (B / A) quote:

(Eq. 3)

Now suppose that the actual B/A quote differ from the implied inverse quote. The result may be an arbitrage opportunity similar to the one when two banks quote widely different rates for a pair of currencies. Let the $ /∈ quote in New York be: $ /∈: 0.8254 / 0.8259

In this scenario, there is a possibility of buying ∈ in New York for 0.8259/∈ and selling them in Frankfurt for $ 0.8268 /∈,thusmakingarisklessprofitof$0.0009/∈. This arbitrage activity involving buying in one market and sellinginanotheristermedastwo-wayarbitrage.Sucharbitrageopportunitiesquicklygoawayonprofitmakingby arbitrageurs. As they buy ∈ in New York, the ask rate of the $ /∈ quote goes up, and as ∈ is sold in Frankfurt, the ask rate of the ∈/$ quote will go up till its reciprocal becomes lower than the increasing ask rate of the $/∈ quote. Hence, to avoid arbitrage opportunities, the ask rate of the actual B/A quote should be higher than the bid rate of the implied B/A quote and the bid rate of actual B/A quote should be lower than the ask rate of the implied B/A quote (i.e., the two quotes must overlap).

It is observed, the synthetic inverse rate acting only as a limit on the actual inverse rate, is due to the presence of transaction costs (the costs to be incurred by a player in the market for buying or selling a currency) as a difference between the bids and ask rates. One more transaction cost is the lump sum payment required to be made to the dealer, from whom a currency is bought or sold, as his fees or commission. These transaction costs make the arbitrage activitylesseffective,asprofitstandsreducedbytheamountofthecostsrequiredtobeincurredbythearbitrageur.Hence, the actual inverse rates can differ from the synthetic inverse rates by the amount of the transaction costs. In the absence of such transaction costs, the inverse rates would have to be exactly equal to the synthetic inverse rates. If there were no spread between the bid and the ask rates for a currency (i.e., a person could buy a currency at the same price at which he could sell it) and there was no commission or fees to be paid to the dealer, the $/E price in New York would have to be the exact reciprocal of the E/$ price in Frankfurt. Let us assume that the E/$ rates in Frankfurt were E/$ 1.2089

Then the $/E rate in New York would be 1/1.2089, i.e., $ 0.8272E. Otherwise, an arbitrageur would have the opportunity ofmakingprofits, and in the process,woulddrive the rates in the twomarkets towardsequalisation.

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2.7.2 Cross RatesIn the foreign exchange markets, it is a practice to quote most of the currencies against the dollar; and to calculate the exchange rates between other currencies with the dollar as the intermediate currency.

For example, the E/£ rate will be calculated through the E/$ quote and the $/Pound quote. The E/£ rate thus calculated is called a cross rate or the synthetic rate. Though generally the third currency used is the dollar, the cross rate between two currencies can be calculated using any other currency as the intermediate currency. These synthetic rates can be calculated using a process similar to the one we used in calculating the implied inverse quote. Let us assume that we need to calculate the Switzerland franc/Canadian dollar (SFr/Can$) rate from given SFr/$ and $/Can$ quotes. Let the given quotes be: SFr/$: 5.5971/5.5978 $/Can$: 0.7555/0.7562

For calculating the synthetic rates, we shall have to see how the arbitrageur will operate if he wishes to operate in the markets giving the SF, /$ and the $/Can$ rate, instead of using the direct SFr/Can$ quote. The (SFr/Can$) bid rate the number of francs which a bank would be ready to pay to buy one Can$. The arbitrageur says X, can sell 1 Can$ for $0.7555.The bank will be ready to buy one dollar for: SFr 5.5971Hence, for selling one Can$, X will get 0.7555 X 5.59071 = 4.2286 francsThat is, for buying one Can$, the bank would be ready to pay SFR4.2286Hence, the synthetic (SFr/Can$) bid rate = 4.2286 = 5.5971 x 0.7555 = (SFr/$) bid x ($/Can$) bid

Similarly, the (SFr/Can$) ask rate will be the number of francs the bank will require to pay for selling one Can$. In terms of the $, Can$ rates, a bank would take 0.7562 dollars to sell one Can$. To be able to pay these dollars, X would need to buy them in the SFr/$ market. X can buy a dollar in that market for SFr 5.5978. Hence, X can buy one Can$ for 5.5978 X 0.7562 = 4.2330 francs.In other words, the bank would be ready to sell one Can$ for: 4.2330 francsSo, the synthetic (SFr/Can$) ask rate = 4.2330 = 5.59078 x 0.7562 = (SFr/$) ask x ($/Can$) askHence, the synthetic quote is SFr/Can$ 4.2286 / 4.2330These rates can be generalised as:Synthetic (A/C) bid = (A/B) bid x (B/C) bid (Eq.4)Synthetic (A/C) ask = (A/B) ask x (B/C) ask (Eq.5)Where A, B and C are three currencies.

These synthetic rates can also be calculated if the inverse quotes are available for any of the required rates. For example, if instead of the (B/C) rates, the (C/B) quote is available, the implied inverse rate can be calculated and used. In such a case, the synthetic rates can be calculated as:Synthetic (A/C) bid = (A/B) bid x 1/(C/B) ask (Eq.6)Synthetic (A/C) ask = (A/B) ask x 1(C/B) bid (Eq.7)

As in case of implied inverse rate, the synthetic quote and the actual quote between a pair of currencies should overlap (i.e., the bid rate of one should always be lower than the ask rate of the other). There are two reasons for this:

First, if the actual rates are too much out of line with the cross rates, the market players in genuine need of a •currency would buy and sell through the markets giving them more favourable rates. The second reason is the arbitrage opportunity, which would arise in case of a misalignment of actual and cross •rates.

In both the cases, the resultant demand-supply mismatch would force the synthetic cross rates and the actual rate to come in line with one another. Let us see how the arbitrage process works. As we have seen, the synthetic quote between the franc and the Can$ is SFr/Can$: 4.2286/4.2330This synthetic quote has been calculated from the following quotes given below:

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SFr/$: 5.5971 / 5.5978 $/Can$: 0.7555/0.7562

Now suppose that the actual quote between the franc and the Can$ is SFr/Can$ 4.2333/4.2343

Aswesee,thesyntheticaskrateislessthantheactualbidrate,givingthearbitrageursachancetomakeaprofitbythree-pointarbitrage(theprocessofmakingarbitrageprofitsinvolvingthreemarkets,wherethreetransactionshavetobeenteredtoachievethedesiredresults).Tomakeprofits,apersonshouldbuylowandsellhigh.Therateat which the arbitrageur, say X can sell one Can$ against the franc is SFr 4.2333/Can$. The rate at which X can buy one Can$ (through the synthetic market) is SFr 4.2330/Can$. Let us say that XC starts with one franc.

With one franc, he can buy:

Since 0.7652 dollars fetch one Can$, with 1/5.5978 dollars X can buy:

These Can$ can then be sold by X in the SFr / Can$ market for:

= SFR 1.000058.Thus,XmakesaprofitofSFR0.000058foreveryfrancboughtandsold.

Now, let us see what will happen if the actual rates are: SFR / Can$: 4.2278 / 4.2283.The actual ask rate is now lower than the synthetic bid rate. X can now buy Can$ at SFR 4.2283 / Can$ and sell them through the synthetic market at SFR 4.2286 / Can $. In the Fr/Can $ market, X can sell one franc for:

As each Can$ can be sold for 0.7555 dollars, X can sell the Can$ for:

Since each dollar fetches 5.5971 francs, X can sell the dollars for:

= SFR. 1.000073 francsSo,Xmakesaprofitof0.000073francsforeveryfrancboughtandsold.These arbitrage processes will adjust the rates in both the cases in all the three markets in such a way that the actual SFR/Can$ rates will come in alignment with the synthetic rates. We can write the conditions for no arbitrage possibility as (A/C) bid (actual) (A/C) ask (synthetic) (Eq. 8) (A/C) ask (actual) (A/C) bid (synthetic) (Eq. 9)

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Using equations, we can rewrite the above equations as:(A/C) bid (A/B) ask x (B/C) ask (Eq. 10)(A/C) ask (A/B) bid x (B/C) bid (Eq. 11)Where, all the rates are actual rates.

Equations 10 and 11 are called the no-arbitrage conditions. These signify the limits imposed by the synthetic rates on the actual quote for a pair of currencies (upper and lower limits for the bid and the ask rates respectively). The actual rates only have to be within these limits but they need not necessarily be the same as the synthetic rates. In fact, the synthetic rate having been calculated from two quotes includes the bid-ask spread of both the quotes. This results in the synthetic rate having a very high bid-ask spread. In reality, a bank giving direct quotes between two such currencies may be able to quote at much lower spread, provided its business volumes in these currencies is high. In the example given above, the actual SFR/Can$ quote may be something like:SFR / Can$: 4.2298 / 4.2313

As in the case of inverse rates, transaction costs allow the actual A/C quote to deviate from the synthetic cross rates to some extent. As mentioned earlier, in the absence of such costs, the bid and the ask rates will be the same. These single rates will force the actual A/C quote to be exactly equal to the synthetic cross rates.According to Eq. 10,(A/C) bid (A/B) ask x (B/C) ask

It can be rewritten as:

2.8 Types of TransactionsForeignexchangetransactionscanbeclassifiedonthebasisofthetimebetweenenteringintoatransactionanditssettlement.Theycanbasicallybeclassifiedintospot and forward contracts. Spot transactions are those, which are settled after 2 business days from the date of the contract. A forward contract (also called an outright forward) is one where the parties to the transaction agree to buy or sell a commodity (here, a currency) at a predetermined future date at a particular price. This future date may be any date beyond two business days. The price and the terms ofdeliveryandpaymentarefixedatthetimeofenteringintothecontract.IntheForexmarkets,forwardcontractsgenerally mature after 1, 2, 3, 6, 9 or 12 months.

A forward contract is normally entered to hedge oneself against exchange risk (i.e., the uncertainty regarding the future movements of the exchange rate). By entering into a forward contract, the customer locks-in the exchange rate at which he will buy or sell the currency.

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2.8.1 Forward QuotesForward quotes are given just like spot quotes given earlier. The same rules regarding calculation of implied inverse rates,syntheticcrossrates,etc.alsoapplytotheforwardrates.Theconditionstobefulfilledforensuringthatthereis no scope for two-way arbitrage and three-way arbitrage are also the same. For example, the three month forward rate between the £ and the ¥ may look like 3-m ¥/£: 182.70/75The implied inverse rate would be:

2.8.2 Discount and PremiumA currency is said to be at premium against another currency if it is more expensive in the forward market than in the spot market. In this case, its forward rate will be higher than its spot rate. This happens when the future spot rate is expected to be higher than the current spot rate. Conversely, a currency is said to be at a discount if it is cheaper in the forward market than in the spot market. In this case, its forward rate will be lower than its spot rate. This happens when the future spot rate is expected to be lower than the current spot rate. Let us assume the Rs. / $ quotes to be Rs. / $ : 45.42/44After 3m Rs. /$: 46.62/70

Here, the bank is ready to give only Rs. 45.42 currently in exchange for a dollar, while it is ready to give Rs. 46.62 after 3 months. Similarly, the bank is charging only Rs. 45.44 for selling a dollar now, while it is charging Rs. 46.70 for a delivery 3 months later. So the dollar is expected to be more expensive in the future, and hence is at a premium against the rupee. On the other hand, the rupee is expected to be cheaper in the future and hence it is at a discount against the dollar.Let us now assume the $ / £ quotes to be $/£: 1.6721/26 3-m $/£ 1.6481/92

Here the dollar is at a premium against the pound, while the pound is at a discount against the dollar. It is possible that a currency may be at a premium against one currency, while being at a discount against another at the same time. It is also possible that a currency be at a premium against another for a particular forward maturity, while being at a discount against the same currency for another forward maturity. Example the $ / £ quotes may be: $/£: 1.6721/262-m $/£:1.6726/343-m $/£:1.6481/92

Here, the pound is at a premium against the dollar for the 2 months maturity, but at a discount for the 3 months maturity. It is also possible to have such a situation where a currency is at a premium against another for a particular forward maturity, but a discount between two forward maturities. Example, the $/£ quotes may be: $/£: 1.6721/261month $/£: 1.6730/372 month $/£: 1.6726/35

Here the pound is at a premium against the dollar for both the forward maturities, but at a discount between the 1 month and the 2 month maturities.

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The difference between the spot rates and the forward rates can be expressed in terms of swap points. In the rupee-dollar example, the swap points will be 120/126 (46.62 – 45.42 and 46.70 – 45.44). In the dollar – pound example, the 3 months swap points would be 240/234 (1.6721 – 1.6449 and 1.6726 – 1.6492).

From this we can observe the following rules:When the swap points are low / high (as in the rupee – dollar example given above), currency B is at a premium, •A is at a discount. Add swap points to the spot rate to get the outright forward rate, deduct swap points from the outright forward rate to get the spot rate.When the swap points are high / low (as in the dollar-pound example given above), currency B is at a discount •and A is at a premium. Deduct the swap points from the spot rate to arrive at the outright forward rate, add them to the outright forward rate to arrive at the spot rate.The bid side swap points (i.e., on the left side of the swap points quote) are to be added to or subtracted from •the spot bid rate (depending on whether the currency is at premium or discount) to arrive at the forward bid rate. The ask side swap points added to or subtracted from the spot ask rate, give the forward ask rate.

The annualised percentage premium on currency B can be calculated as follows:

Where, m is maturity of the forward contract in months.

Anegativefiguresignifies thatcurrency isata forwarddiscountandAisatapremium,withapositivefiguresignifying the opposite.

In the rupee – dollar example, the annualised percentage premium on the dollar can be calculated as follows:

Similarly, in the $ / £ example, the annualised discount on the pound for the 3 months maturity works out to 5.67%.

Animportantpoint thatneedstobenotedhereis that thepoundbeingat5.67%,annualiseddiscountdoesnotnecessarilymeanthatthedollarwillbeat5.67%annualisedpremiumagainstthepound.Letusverifywiththehelpof an example. The implied inverse quotes in the Rs. /$ example would be: $/Rs: 0.022007/0.0220163 months $/Rs: 0.021413/0.021450

Hence,

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Thus,whilethedollarisata10.82%premiumagainsttherupee,therupeeisata10.53%discount.

2.8.3 Forward Rates vs. Expected Spot RatesIf the speculators in the market were risk-neutral and there were no transaction costs, then the forward rate would be equal to the market’s expected future spot rate. This is so, because otherwise it would be possible to buy in one marketandsellintheotherinordertomakeprofits.

Let us take the case where the forward rate is lower than the expected spot rate. In such a case, the speculator would buy a forward contract expecting to sell in the spot market in the future at a higher price. The resulting increased demand in the forward market would increase the forward rate and drive it towards equalisation with the expected future spot rate.

If the forward rate is higher, speculators would sell in the forward market, thus pushing the forward rate down. In reality, however, there is also the risk of the spot rate turning out to be different from the expected spot rate and the speculators are not really risk-neutral. They expect to be compensated for the risk that they take on. In addition, there is the presence of transaction costs to be contended with. These two factors result in the forward rate being different from the spot rate to some extent.

2.8.4 Broken-date Forward ContractsA broken-date contract is a forward contract for a maturity which is not a whole month or for which a quote is not readily available. For example: If the quotes are available for a 6-month forward and a 9-month forward, but a customer wants a quote for a 7-month forward, it will be a broken-date contract. The rate for a broken-date contract is calculated by interpolating between the available quotes for the preceding and the succeeding maturities.

2.8.5 Option ForwardsOption Forward Contract or the Option Forward, under this contract, the customer of the bank has the option to ask for the contract to be settled anytime during a particular period, referred to as the option period.

For example, a customer enters into an option forward contract on September 29 for selling dollars to the bank. The contract matures on December 31. The customer has the option to sell dollars to the bank anytime in December. Here the month of December is the option period. Giving quotes for this kind is not as straightforward as giving a quote foranoutrightforwardcontract.Thisisbecausetherateatwhichexchangeofcurrencieswilltakeplaceisfixedwhile the timing of the exchange is not. To avoid possible loss, banks follow the following for giving a quote:

When the bank is buying currency, it will add on the maximum premium possible (when the currency is at a •premium) and deduct the maximum discount possible (when the currency is at a discount) from the spot rate. This would result in the bank quoting the rate applicable at the beginning of the option period when the currency is at a premium and the rate applicable to the end of the option period when the currency is at a discount.

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When the bank is selling a currency, it will add the maximum premium possible when the currency is at a •premium and deduct the minimum discount possible when the currency is at a discount from the spot rate. This would result in the bank quoting the rate applicable to the end of the option period when the currency is at a premium and the rate applicable to the beginning of the option period when the currency is at a discount. Thus, the bank considers the applicable quotes for the beginning and the end of the quote period and gives a quote whichisdisadvantageoustotheclient,whichineffectisthecostincurredbytheclientfortheflexibility.

Suppose the Euro / Swiss Franc rate is given below:Spot Euro / S Fr 1.2245 / 49•3 months forward 10 / 15•4 months forward 15 / 25•

The Swiss franc is at a premium. If the bank contracts to sell SFR, with the option to take delivery exercisable by the customs anytime during the month, the bank will load the maximum premium to the spot rate. It will be assumed that the customer will demand delivery when the currency is most expensive and hence will charge the maximum rate.SoitwillquotetherateEuro1.2249+25i.e.Euro1.2274/SFR.

If the contract was to buy Swiss franc with the option to give delivery exercisable by the customer anytime during the 4th month, the bank would assume that the customer will exercise the option when S Fr is at the cheapest i.e. at thebeginningofthe4thmonth.HenceitwillquoteEuro1.2245+0.0010ie.Euro1.2255/Sfranc.

2.8.6 SwapsA transaction whereby two currencies are exchanged by the parties involved, only to be exchanged back later is termed as currency swap. The quantity exchange of one of the currencies remains constant in both the legs of the swap, though the quantity of the second generally changes.

A currency swap is a combination of two transactions – one spot and one forward – with an exchange of currencies taking place at predetermined exchange rates. The forward leg is in the opposite direction of the spot leg, i.e., the party selling currency A in the spot leg buys it in the forward leg and vice versa. As mentioned, the price of the currencies is different in the spot leg from that of the forward leg. This happens because of the expected depreciation/ appreciation of the currency with respect to the other currency.

Aswaptransactionwherebytheforeigncurrencyisboughtinthefirstlegandsoldinthesecondlegagainstthelocal currency is called a swap-in or buy-sell swap.

Uses of swapOne of the uses of swaps is for hedging by entities investing or borrowing abroad. Hedging is the process through •which an attempt is made to eliminate risk (or at least reduce it to tolerable levels) in a transaction.Swaps can also be used in place of option forwards.•

While option forward is likely to be more expensive than a swap transaction, it removes the exchange risk completely. On the other hand, in such situations the risk is not completely removed in a swap transaction, due to the uncertainty of the total cost of hedging.

The most important players in the swap markets are the banks. They use the swap markets to hedge their positions arising from merchant transactions.

For example, if a bank sells more spot dollars than it has purchased, it creates a short (oversold) position. If the bank does not cover its open position, it may lose the dollar appreciates since it will have to buy the dollar at a higher price. To cover its position, the bank can buy dollars in the inter bank spot market. A bank having a long (overbought) position can cover itself by selling dollars in the interbank spot market. But if the bank has sold forward more dollars

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than it has bought forward (or vice-versa), it will have to cover its position in the inter bank forward market. While itiseasytofindacounterpartyinthespotmarket,itisdifficulttofindacounterpartywithanexactlyoppositeexposure having a matching maturity. Hence, banks prefer hedging by using swaps instead of outright forwards.

Anotherreasonforbankspreferringswapsisthatswapshavefinerratesthanoutrightforwards.Bankhavinganoverbought forward position will enter into a swap to sell forward in the relevant maturity and buy the currency spot. Then the bank can sell the currency spot to counter the spot buying. Conversely a bank with an oversold forward position can enter into a sell-buy swap, whereby it buys in the relevant forward maturity and sells spot. To cover the spot sale, it can buy spot in the inter bank market. In the inter bank markets, the delivery week for the forward legoftheswapcanbespecified.Banksgenerallyuserolloverstocovertheresultantintra-weekexposures.

The difference in the spot and the forward leg prices of a swap are given as swap points, just as in the case of a forward quote. In fact, the swap points applicable to outright forwards and swaps are the same.

2.9 Settlement DatesThe settlement date of a forex transaction, also called its value date, is the day on which the transaction is settled by a transfer of deposits. The settlement date for a spot transaction is generally the second business day from the date of the transaction, except for transactions between the US dollar and the Canadian dollar, and those between the US dollar and the Mexican peso. In these two cases, the settlement takes place the next business day. This gap betweenthetransactiondateandthesettlementdateisneededinordertoenablethebankstoconfirmandclearthedeals through the communication networks.

The term business day implies that neither of the days between the transaction date and the settlement date (including the settlement date) should be a holiday, either in any of the settlement locations, or in the dealing location of the market-making bank (i.e. the bank who gave the quote). The settlement locations are the countries whose currencies are involved in the transaction, and the dealing locations are the countries in which the banks involved in the transaction are located.

The settlement date for a forward contract depends on two things:the settlement date for a spot transaction entered on the same date as the forward contract and•the maturity of the forward contract is in months•

Forarrivingatthesettlementdateforaforwardcontract,firstthesettlementdateforthecorrespondingspottransactionis calculated and then the relevant numbers of calendar months are added to it.

The maturities of forward contracts are generally in whole months. Yet, banks generally stand ready to offer forward contractsofmaturitiesinaccordancewiththespecificneedoftheclient.Thisquiteoftengivesrisetocontractswith broken-date maturities.

2.9.1 Short Date ContractsThe settlement date for a spot transaction is two business days after the transaction date. There are some transactions, which are an exception to this rule i.e., where the settlement date is less than two business days after the date of the transaction. Such transactions, for which the settlement date is before the spot settlement date, are referred to as short-date contracts.

These transactions can be in the form of either outright contracts or swaps. The various swaps available in the market are: between today and tomorrow (called the cash/tom, C/T; it is also referred to as the overnight swap, O/N), between today and spot day (cash/spot, C/S), between tomorrow and the next day i.e., the spot day (tom/next, T/N or tom/spot, T/S) and between spot and the next day (spot/next, S/N). Strictly speaking, the S/N is not a short-date contract since the settlement does not take place before the spot day.

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As in the case of swaps, the inter bank market gives swap points for these contracts. A bank buying a currency has to pay the higher of the swap points as premium, and gets the lower of the swap points as discount. On the other hand, a bank selling a currency to the market will get the lower of the premium points, but will have to pay the higher of the swap points if the currency is at a discount. Here again, the spot rate to/from which these points are added / subtracted becomes irrelevant.

2.9.2 The First QuoteAtthestartoftheday,whenabankisrequiredtogivethefirstquote,thedealerhastoconsideranumberoffactors,which affect the exchange rate between two currencies. Factorsaffectingthefirstquoteare:

Thefirstwouldbethepreviousnight’sclosingrate.Thatratewouldserveasthestartingpoint,whichwould•be adjusted for expected changes on account of other factors.Anotherimportantfactoristheexpecteddemand-supplypositioninthemarketonthatday.Thisfactorreflects•the effect of a number of other factors.In addition to these factors, the banks own overnight position as to whether it is net long in the foreign currency •or is net short, also affects the quote it gives to the market. A net short position would result in the bank trying to buy the foreign currency, and hence a higher rate. A net long position will have the opposite effect on the quote.The bank’s view regarding the cross currency market would also affect the bank’s quote.•

2.10 Quotes for Various Kinds of Merchant TransactionsThere are different kinds of purchase and sale transactions in the retail market. The simple is the outward or inward remittance. In this kind of transaction, the bank has to simply receive or send a currency through Telegraphic Transfer (TT), demand draft, postal order or Mail Transfer (MT). Since the work involved in such transactions is the least, a bank offers better rates for them. These rates are called the TT buying and TT selling rates. While the TT selling rate is applied for outward remittances in foreign currency (not being proceeds of import bills) and to cancellation of an earlier booked forward purchase contract, the TT buying rate is applied to inward remittances and for cancellation of a forward sale contract.

In India, TT buying and selling rates have to be determined in accordance with FEDAI rules. These rates are to be based on the base rate, which may be derived from the ongoing market rate. This base rate is marked up to cover the dealer’smargin(profit).ThemaximumpermissiblemarginwasearlierprescribedbyFEDAI.Nowitislefttothediscretion of the ADs, subject to restrictions on the maximum spreads and other provisions relating to the calculation ofexchangeratesasspecifiedbyFEDAI.BankmanagementsgenerallyspecifytheguidelinestotheirADsinthisregard.TheADsarealsorestrictedfromloadingtoohighamarginbythecompetitionthatexistsinthisfield.Themargins prescribed by FEDAI, which are now indicative, are:TTpurchase0.025%to0.080%TTsale0.125%to0.150%

The maximum permissible spreads between the TT buying and TT selling rate are as follows:US$ 1.00 percent of the mean rate (the mid-rate)Pound, DM, Yen, French franc, Swiss franc, Dutch Guilders and Australian dollars: 2.00 percent of the mean rate.Other currencies: No limit at present but ADs is instructed to keep the spread to a minimum.The TT rates are to be arrived at in the following manner:

2.10.1 Spot TT Buying RateTake the base rate and deduct the appropriate margin from it. For example, if the base rate for dollars is Rs.45.42 andtheADwishestocharge0.08%margin,thespotTTbuyingratewouldbe:Base rate 45.42Less:Margin@0.08%0.036Spot TT Buying Rate 45.384

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2.10.2 Spot TT Selling RateTake the base rate and add the appropriate margin to it. For example, if the base rate for dollars is Rs.45.50 and the ADwishestochargeamarginof0.15%,thentheTTsellingratewouldbe:

Base rate 45.50Add:Margin@0.15%0.068Spot TT buying rate 45.432

2.10.3 Forward TT Buying RateTake the base rate. Add (Deduct) the on-going forward premium (discount) to (from) the base rate, depending upon the delivery period. From this, deduct the appropriate margin. For example, if a customer wants to sell dollars one month forward, with the base rate at Rs.45.42 and one-month premium on dollar being 15 paisa, the forward TT buying rate would be calculated as:Base rate 45.42Add: Premium 0.15 45.57Less:Margin@(0.08%)0.0364Forward TT buying rate 45.5336

2.10.4 Forward IT Selling RateTake the base rate. Add (Deduct) the on-going forward premium (discount) to (from) the base rate, depending upon the delivery period. To this, add the appropriate margin. For example, with the base rate for the dollar at Rs.45.50 and the one-month forward premium at 20 paisa, the one-month forward TT selling rate will be:Base rate 45.50Add: Premium 0.20 45.70Less:Margin@0.15%)0.0688Forward TT buying rate 45.6312

In addition to these rates, the ADs are required to charge the following amounts from their customers for various kinds of transactions:

No additional charge for inward remittances for which credit has already been made to the nostro account of •the AD.Anadditionalmarginof0.125%tobechargedontheTTbuyingrateandinteresttoberecoveredfromthe•customer@15%for10days’transitperiod,forinwardremittances(forexampleDDs)wheretheamounthasnot been credited to the nostro account of the AD and the reimbursement has to be obtained from the overseas drawee bank (in case of a DD) or the overseas correspondent bank (in other cases). Oninwardremittancesbywayofcustomer’spersonalcheque,anadditionalmarginof0.15%ontheTTbuying•rate is to be charged. In addition, interest for transit period of 15 days is to be recovered from the customer at domestic commercial rate of interest.Forallforeigncurrencyoutwardremittances(notbeingproceedsofimportbills),aminimumflatchargeof•Rs.100 is to be made.On all outward rupee remittances the charge is to be:•

UptoRs.10,000 0.25%subjecttoaminimumofRs.10 �OverRs.10,000 0.125%subjecttoaminimumofRs.25 �

The second kind of merchant rate is the bill buying and bill-selling rate. These rates are applied to transactions in foreign currency denominated bills of exchange. As for TT rates, the bill buying and selling rates have to be calculated in accordance with FEDAI guidelines. The base rate is loaded with a margin, which is left to the discretion of the AD. The indicative exchange margins given by FEDAI are:

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Billbuying 0.125%to0.150%Billselling(overtheTTsellingrate) 0.175%to0.200%

2.10.5 Bill Buying RateThis rate is applied when the AD is giving the rate for an export transaction. The transaction can be either in the way of realisation of a collection bill (where the amount has already been credited to the ADs nostro account and the AD is only required to convert it into rupees), or in the form of purchase or discounting of an export bill (where theADwillbeprovidingfinancetotheexportertillthebillgetscollectedandthenconverttheamountreceivedinto rupees).

2.10.6 TC Buying RateTake the one month forward buying rate given by RBI as the base rate. If the RBI rate is not available, take the on-goingmarketrate.Deductmarginfromthebaserate@1%.TheresultantratewillbetheTCbuyingrate.Forexample, if the one-month forward rate is Rs. 45.55, the TC buying rate would be:

Base rate: 45.55Less:Margin@1%:0.4555TC buying rate: 45.0945

2.10.7 TC Selling RateTaketheTTsellingrateandaddamarginof0.5%toit.AddingthemarginisoptionalfortheAD.Onthisgrossamount,acommissionisadded(againattheoptionoftheAD)atamaximumrateof1%.IftheTCisissuedagainstforeigncurrencyremittance,thenthecommissionwillbecharged@0.25%.ThisgivestheTCsellingrate.Fore.g.,if the TT selling rate is Rs. 42.7641/$as calculated earlier, the TC selling rate would be:

TT selling rate: 45.5682Add:margin@0.5%: 0.2278 45.7960Add:Commission@1%0.4579TC Selling rate 46.2539TheTCbuyingandsellingratesthusarrivedat,mayberoundedofftothenearest5paisatogetthefinalTCbuyingand selling rates.

2.11 The Indian Forex MarketsPriorto1992,theIndianforexmarketsweretotallyregulated.ThevalueoftheIndianrupeewasfixed,firstintermsof the pound and later the US dollar. This value was revised once in a while when the regulator felt the need. All inward and outward remittances were required to be converted at this rate of exchange. The liberalisation of the forex markets started in 1992. In March 1992, a dual exchange rate system was put into place. This was known as Liberalised Exchange Rate Management System (LERMS). Two exchange rates were prevailing during this period, one determined by the market. This was the beginning of a movement towards a market-oriented rate. Under this system,40%ofcurrentaccountreceiptswererequiredtobeconvertedatanofficialrateandthebalancecouldbeconvertedatmarket-determinedrates.ThiswaslatermodifiedtobecometheUnifiedExchangeRateSystem,which came into effect from March 1, 1993. Under this system, all forex transactions are required to be routed through the ADs at market-determined rates. The RBI also announces its rates (which act as reference rates) based on market rates. As mentioned earlier, only permitted people can deal in foreign exchange (Ads, etc.). Hence, any other person desiring to buy or sell foreign exchange can do so only through these permitted people, and only for permissible transactions.

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In August 1994, RBI announced relaxations on current account transactions and delegated further powers to ADs. They can now allow remittances for various purposes like travel, studies, medical treatment, gifts and services to theextentspecifiedbyRBIunderthevariousprovisionsoftheExchangeControlManual.Fromtimetotime,RBIbrings out rules regarding the various players who are allowed to operate in the forex market, the various permissible instruments (like forward contracts, swaps, etc.), the conditions in which these instruments can be used, etc. It thus regulates the operations of the market. Some of the important regulations and the relevant FEDAI guidelines as on January 7, 1999 are given below:

2.11.1 Forward Exchange Contracts

Can be booked only for genuine transactions and where there is exposure to exchange risk, not for speculative •purposes.Cannotbebookedforanticipatedtransactions,onlyforfirmexposure.•Can be booked in the currency in which the importer is exposed to exchange rate or in any other permitted •currency, i.e., any freely convertible currency.Value of the forward cover should not exceed the value of the goods contracted for.•The period and the extent of the exposure to be covered are left to the choice of the importer. However, the •last date of delivery of the forward contract should not exceed six months from the date of shipment/ expected shipment date (in case of contracts booked for covering exports or imports).Rollover forward covers are permitted to be booked as necessitated by the maturity dates of the underlying •transactions, market conditions and the need to reduce costs to the customers. Each time a forward contract is rolled over, the new contract can be for a maximum period of six months.In case of merchandising trade transactions (i.e., transactions where some good is imported only to be exported •elsewhere,inthesameorarefinedform),forwardcontractswillhavetobebookedsimultaneouslyforbothlegsofthetransactionsorforthenetamountofexpectedprofit.No ready sale or purchase should be made for a transaction for which a forward contract has already been •booked.Forward contracts can be cancelled by the party concerned whenever required. The exposure can be covered •again by the customer through the same or another AD subject to genuine exposure risk and permissibility of the transaction. However, for non-trade transactions, contracts once cancelled cannot be re-booked. Corporate can roll over such contracts on maturity at ongoing rates.Forward cover can be taken by resident corporate clients in respect of dividend due to overseas investors who •have made a direct foreign investment in India. The cover can be provided only after the Board of Directors has decided upon the rate of dividend.Forwardcovercanalsobetakenforforeigncurrencyloanstoberaised,anytimeafterthefinalapprovalforthe•loan arrangements have been obtained from RBI.ForGDRissues,forwardcovercanbeobtainedoncetheissuepricehasbeenfinalised.•On each forward sale / purchase contract booked, the ADs are required to charge a minimum commission of •Rs.250 (FEDAI rules).

2.11.2 Other Regulations

Exporters and certain other recipients of forex, at their option, can retain a portion of the proceeds in forex in •a foreign currency account opened with ADs in India. This account is known as Exchange Earners’ Foreign Currency deposit.Cross currency exposures can be covered in the overseas market through ADs, without necessarily covering the •rupee / dollar leg of the transaction.All actual out of pocket expenses of the bank such as postage, telex charges including those of the corresponding •bank shall be recovered from the customer.

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R – Returns are required to be submitted by ADs to the Exchange Control Department RBI – pertaining to the •transactions in foreign exchange, and in rupee with overseas banks during each fortnight. These returns serve as the principal source of information for compilation of BOP data. They also help RBI to check whether the powers delegated to ADs have been correctly exercised.

2.11.3 Early Delivery/ Extension or Cancellation of Forward Exchange ContractsIn many cases, a customer books a forward contract on the basis of an estimation regarding the time when he would need to deal in the foreign currency. With the uncertainties prevailing in international trade, in many cases customers mayfindthemselvesreceivingexportproceedsbeyondtheestimatedduedate,orpreferringtopayfortheirimportsbefore the due date to take advantage of a depreciating foreign currency or for any other reason. The actual date of delivery or purchase of foreign currency may vary from the date for which the forward contract is booked for a variety of reasons. In such circumstances, forward contracts may be extended or cancelled, or the customer could request an early delivery, if the bank is willing to accommodate him. In these cases, customers will have to bear the losses arising out of mature/ extended performance or cancelling of the contract. FEDAI Rule No. 8 regulates the charges that the customer has to pay to the bank. The rule says that:

Customers can request for an early delivery / extension / cancellation of a forward contract on or before the •maturity date of the contract.The bank will charge a minimum sum of Rs. 100 for entertaining any such request from the customer.•Early Delivery: • Ifabankacceptsorgivesearlydelivery,inadditiontotheflatchargeofRs.100,thebankhasto charge / pay the swap charges for the early delivery period from/ to the customer, irrespective of whether the bank actually enters into a swap or not. This swap cost/gain may be recovered from/ paid to the customer, eitheratthebeginningoftheswapperiodoratitsend,asthebankmaydeemfit.Asaresultoftheswap,ifthebank faces an outlay of funds, it has to charge interest from the customer at a rate not less than the prime lending rate,fortheperiodoftheswap.Ifthereisaninflowoffunds,thebankmay,atitsdiscretion,payinteresttothecustomer at the rate applicable to term deposits with maturity equal to the period of the swap. The timing of thiscashflowtooislefttothediscretionofthebank.Extension: • An extension of a contract entails cancelling an existing contract and re-booking a corresponding forward contract. The cancelling is required to be done at the relevant TT buying or selling rate as on the date of cancellation, and the re-booking would be done on the ongoing rate for a new forward contract. The bank is required to collect / pay the difference between the rate at which the original contract was entered, and the rate at which it is cancelled, from / to the customer. This may be done either at the time of cancellation or at the timeofmaturityoftheoriginalcontract.Thiswouldbeinadditiontotheflatcharge.Cancellation:• In case of cancellation of a contract, it is required to be cancelled at the appropriate TT selling or buying rate and the difference between the contracted rate and the cancellation rate is to be collected from/paidtothecustomer.Inaddition,theflatrateisrequiredtobecollected.Any amount to be collected/ paid by the bank on account of early delivery/extension/ cancellation of a forward •contract(exceptfortheflatcharge)shallbeignoredifitislessthanorequaltoRs.50.

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SummaryThe mechanism through which payments are effected between two countries having different currency systems •is called foreign exchange.The foreign exchange market performs some important functions like,•

to effect transfer of purchasing power between countries: transfer functions �to provide credit for foreign trade: credit function �to furnish facilities for hedging foreign exchange risks: hedging function �

The spot market involves almost the immediate sale of foreign exchange. Typically cash settlements are made •within one / two days.An exchange rate quotation is the price of a currency stated in terms of another currency.•A direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic •currency per unit of foreign currency.An indirect quote is where the exchange rate is expressed in terms of the number of units of the foreign currency •forafixednumberofunitsofthedomesticcurrency.The rate at which the bank is ready to buy currency will be different from the rate at which it stands ready to •sell that currency. These rates are called the bid and the ask rates respectively.Cross Rates: In the foreign exchange markets, it is a practice to quote most of the currencies against the dollar •and to calculate the exchange rates between other currencies with the dollar as the intermediate currency.Foreignexchangetransactionscanbeclassifiedonthebasisofthetimebetweenenteringintoatransactionand•itssettlement.Theycanbasicallybeclassifiedintospotandforwardcontracts.A currency is said to be at premium against another currency if it is more expensive in the forward market than •in the spot market. A broken-date contract is a forward contract for a maturity which is not a whole month or for which a quote is •not readily available.Option Forward Contract or the Option Forward, under this contract, the customer of the bank has the option to •ask for the contract to be settled anytime during a particular period, referred to as the option period.A transaction whereby two currencies are exchanged by the parties involved, only to be exchanged back later •is termed as currency swap.The settlement date of a forex transaction, also called its value date, is the day on which the transaction is settled •by a transfer of deposits.

Referenceshttp://www.investopedia.com/terms/s/spotmarket.asp• . Last accessed on 24th December, 2010.http://www.tutorsonnet.com/homework_help/foreign_exchange_management/forex_market_•mechanisms_conventions_assignment_help_online_tutoring.htm. Last accessed on 24th December, 2010.http://finance.mapsofworld.com/foreign-exchange-market/india.html• . Last accessed on 24th December, 2010.

Recommended ReadingJames Chen (2009). • Essentials of Foreign Exchange Trading (Essentials Series). Wiley.Ashraf Laïdi (2008). • Currency Trading and Inter-market Analysis: How to Profit from the Shifting Currents in Global Markets (Wiley Trading). Wiley; New edition.Rudi Weisweiller (1990). • How the Foreign Exchange Market Works (New York Institute of Finance). New York Institute of Finance; second Sub edition.

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Self Assessment

An extension of a contract entails cancelling an existing contract and re-booking a corresponding ________1. contract.

option forwarda. broken dateb. forwardc. backwardd.

WhatdoesLERMSstandfor?2. Liberalised Exchange Rate Management Systema. London Exchange Rating Management Systemb. Liberia Exchange Rate Management Systemc. Liberalised Exchange Rate Market Systemd.

A ________ quote is the quote where the exchange rate is expressed in terms of number of units of the domestic 3. currency per unit of foreign currency.

indirecta. directb. inversec. forwardd.

A currency is said to be at ___________against another currency if it is more expensive in the forward market 4. than in the spot market.

discounta. inverseb. premiumc. optiond.

The rate at which the bank is ready to buy currency is known as5. Ask ratea. Bid rateb. Spot ratec. Cross rated.

WhichofthefollowingstatementisFALSE?6. ForGDRissues,forwardcovercanbeobtainedoncetheissuepricehasbeenfinalised.a. Value of the forward cover should not exceed the value of the goods contracted for.b. Forward contracts can be cancelled by the party concerned whenever required.c. Ready sale or purchase should be made for a transaction for which a forward contract has already been d. booked.

The settlement date of a forex transaction is also called its7. Value datea. Opening dateb. Broken datec. Booked dated.

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The settlement date for a spot transaction is ________ business days after the transaction date.8. threea. twob. onec. fourd.

Merchant quote is the quote given by a bank to it’s9. Financersa. Retail customersb. Shareholdersc. Businessmend.

The _______market involves almost the immediate sale of foreign exchange.10. forexa. swapb. forwardc. spotd.

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Chapter III

Introduction to Currency and Interest Rate Swaps and Future and Options in Foreign Exchange

Aim

The aim of this chapter is to:

state currency and interest rate swap•

explain commodity swap•

discuss futures and options on foreign exchange•

Objectives

The objectives of this chapter are to:

describethebasicstructuresoffinancialswaps•

discuss swap market in India•

explain application in hedging foreign exchange movements•

Learning outcome

At the end of this chapter, the students will be able to:

differentiate between swap and forward contracts•

analyse the state of curren• cy future marketsunderstand the Indian Swap market•

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3.1 Introduction to Currency and Interest Rate SwapsSwapisdefinedasafinancialtransactioninwhichtwocounterpartiesagreetoexchangestreamsofpayments,orcashflows,overtimeonthebasisagreedatthebeginningofthearrangement,itislikeaseriesofforwardcontracts.

Under a forward exchange contract, the counter parties agree to exchange ‘A’ units of one currency for ‘B’ units of anothercurrency.Forwardratecontract(FRA),futureLIBORisexchangedforaratespecifiednow.Swapinvolvesaseriesofsuchexchanges,atspecifiedfuturedates.

Swapscanbroadlybeclassifiedintotwocategories:interest rate•currency •

In addition, commodity swaps and tax rate swaps are being introduced and are gaining momentum.

Interest rate swap:Thisconceptactuallymeansanexchangeofinterestpaymentsonaspecificprincipalamount.Interest rate swaps are of two types:

couponswapsorexchangeoffixedrateforfloatingrateinstrumentsinthesamecurrency•basisswapsortheexchangeoffloatingrateforfloatingrateinstrumentsinthesamecurrency•

Currency swap: When two counter parties agree to exchange interest and principal in one currency for interest and principal in another currency is known as current swap.

These exchanges are generally done at the spot exchange rate ruling at the time when swap was entered into and would involve the following:

an initial exchange of principal in the two currencies •exchange of interest and repayment obligation (in instalments) or in the form of re-exchange of the principal •amount , i.e. bullet repayment (i.e. repayment at one go) debt service obligation alone •

Theinterestofthetwocountrieswoulddifferandmaybefixedorfloating.

Note: Currency swap should not be confused with buy/ sell or sell / buy short term foreign exchange swaps, which involve buying A for B for one maturity and an equal amount of currency B for A for a different maturity, both contracts are being entered simultaneously. This is also referred to as a swap in the foreign exchange market.

Asset swaps are also part of the swap markets.

3.2 Interest Rate SwapIninternationalcapitalmarkets,generally,fixedratelendersareindividualsorinstitutionslikeinsurancecompaniesor pension funds which buy bonds – a relatively narrow market. The pricing of funds, therefore, depends on the acceptability of the borrowing company credentials to the investors in the bond market, based on its credit rating and otherfactors.Ontheotherhand,inthefloatingratemarket(sayLIBORlinked),thelendersareinternationalbankswhich study the commercial, political and other risks relevant to a given loan and price it accordingly (their view may not always be in line with that of rating agencies). In general, a greater premium is demanded from a lower rated orunfamiliarborrowerinthefixedrate(saybond)marketthaninthefloatingrate(saysyndicatedloan)market.

A typical interest rate comparison between AAA (triple A highest safety for timely payment of interest and principal) borrowerfromanindustrialcountryandfirstclasscompanysayfromIndiawilllookasfollows-

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It will be noticed that the Indian company pays a higher rate of interest than an AAA company in an industrial country,inbothcases,thepremiumis1.875%(2%minus1/8%)p.a.inthefloatingmarketbutamuchhigher2.5%(3%-1/2%)p.a.inthefixedratemarket.

IfanIndiancompanytypicallywantsafixedrateloan(saytofinancecapitalexpenditure),ithastopayahighercost.However,itcanreducethecost,byborrowinginthefloatingratemarketwhereitenjoysacomparativeadvantage(i.e., lower premium than the benchmark) and utilise the swap market to exchange the interest liability with a suitable counterpartytogetineffect,fixedratefundingatlessthan3%overUStreasuryyields.

For instance: Let us consider the transaction sequence as given below. Let us refer to Indian company as ABC.ABCrequiressevenyearsfixedratefunding.•ABCraisesasevenyearsfloatingratedebtat2%overLIBOR(i.e.inthemarketwhereithasacomparative•advantage or a lower disadvantage).ABClocatesXYZ,atripleAratedcompanyfromanindustrialcountrywhichneedssevenyearsfloatingrate•funds(sameamountandsamerepaymentpatterns)andhasacomparativeadvantage,overABCinthefixedrate market.XYZraisesevenyearsfixedratedebtat6.5%p.a.(UnitedStatestreasuryyieldbeing6.00%p.a.).•XYZ and ABC swap interest liabilities: XYZ agrees to pay interest at say LIBOR to ABC and ABC agrees to •payinterestatsay6.75%toXYZ.XYZhasnowgotfloatingratefundsataneffectivecostofLIBOR–0.25%(itpaysLIBORtoABCbutmakes•profitof0.25%onthefixedratesystem)or0.375%belowwhatitwouldhaveotherwisepaidforfloatingratefunds.ABChasnowgotfixedratefundsataneffectivecostof8.75%p.a.(itpays6.75%toXYZandmakesaloss•onthefloatingside)or0.25%belowwhatitwouldhaveotherwisepaidforfixedratefunds.

Diagrammatical representation:

ItmaybenotedthatinpracticetheonlydifferencebetweenLIBORand6.75%wouldbeexchangedbetweenABCand XYZ.Now cost comparison post swap and without swap will look as follows:

Itisevidentthatbothcounterpartieshavereducedtheircostofborrowingbyatotalof0.625%.

Thecitedswap,LIBORagainstfixedrateof6.75%canalsobelookeduponasbeingconceptuallysimilartoa

Floating rateFixed rate

AAA borrower from an industrial country1/8%(0.125)overLIBOR½ & over United States treasury yields

First class companyfrom India2%overLIBOR3%overUStreasuryyield

Pays2%overLIBOR to tenders

ABC raises floatingratemoney

ABC raises floatingratemoney

Pays6.5%totenders

LIBOR

6.75%

Cost without swapCost post swap

ABC9.00fixed8.75fixed

XYZLIBOR+1/8%LIBOR–0.25%

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seriesofforwardrateagreementsonthefutureLIBORatafixedpriceof6.75%.Ineffect,ABChasnothedgedtheLIBORfluctuationriskthroughtheswap.

TheprincipalbetweenaseriesofFRA’sontheLIBORandinterestrateswap(receiveLIBOR,payfixed)are:in general FRA’s are for relatively shorter duration, swaps are for longer•the forward rates under FRAs would in several cases be different for different maturities, while the swap is •identical for all maturities

It is also to be noted that the exchange of interest payments are on an agreed principal amount (which may be constant throughout the life of the swap or may reduce with instalment payments) and on agreed dates. The principal amount on which interest calculations are to be made is referred to as the “notional principal”. Therefore, the counter parties not only need to have differing but mutually complementary needs but also for identical amount and maturities.

3.2.1 Bank as an IntermediaryInpracticeitisdifficultforacorporatetolocateacounterpartyforaswapwiththeidenticalrequirements.Itisalsonecessarytobesatisfiedaboutthecounterparty’sfinancialstrengthovertheperiodofswaptomeetitsobligations.The role is taken by the international bank which acts as an intermediary between (with ABC and XYZ).

Aswapbankisagenerictermtodescribeafinancialinstitutionthatfacilitatesswapsbetweencounterparties.Asmentioned, a swap bank is an international commercial bank, an investment bank, a merchant bank or an independent operator. The swap bank serves as either a broker or dealer. As a broker, the swap bank matches counter parties but does not assume any risk of the swap. The swap broker receives a commission for the service. Today, most swap banks serve as dealers or market makers. As a market maker, the swap bank stands willing to accept either side of the currency swap and then later lay it off or match with a counter party. In this capacity, the swap bank assumes a position in the swap and therefore assumes certain risks. The dealer capacity is more risky and the swap bank would receiveaportionofthecashflowspassedthroughittocompensateitforbearingtherisk.In our transaction between ABC and XYZ, with an intermediary, the comparative advantage gets split in three ways –XYZ, ABC and the intermediate bank.

Diagrammatical representation:

Post swap costs are shown below:

Thestructureofbasicswapissimilar.InsteadofexchangingLIBORforafixedrate,theswapcouldbeLIBORforT-bill rate (or CD rate).

Asdiscussedearlier,banksthat‘runbooks’inswapshavetocarrytheswapontheirbooksuntilitcanbeoffloadedto another counter party. Interest and currency swap can also be hedged through appropriate transaction in the money and exchange markets. A few specimen hedges are as follows.

ABC post swap cost8.875%

Bank swap spread¼%

XYZ post swap costLibour-0.125%

Pays2%overLIOR to lenders

ABC raises floatingratemoney

6.75% 6.625%

LIBOR -1/8%

LIBOR

Bank

XYZ raises fixedratemoney

Pays6.5%to lenders

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Swap Hedge

payfixedreceivefloating•payfixed rate sterlingand sterlingprincipal,•receive floating rate dollar and dollar principal

borrow at floating rate interest in fixed rate•bondborrowfloatingratedollars,buypound,interest•infixedratepoundbond

Table 3.1 Difference between swap and hedge

3.3 Currency SwapsCurrencyswapinvolvesexchangeofcashflows(onprincipalandrepaymentsorrepaymentsalone)betweentwocurrencies. In such cases, the ruling spot rate is used between the two currencies. Such swap when related to the repayment obligation under an existing loan, enables the corporate borrower to change the liability currency to one thatismoresuitedtoitscashflowsandriskrewardperception.Anotheralternativeistoraisefundsinthemarket(currency, interest rate, etc.) in which it has a comparative advantage and use currency and / or interest rate swap to have the desired liability portfolio at the lower cost than otherwise. In other words, currency swap transforms an asset or liability from one currency to another with of course the change in the interest payments. Let us examine how the transaction takes place.

For instance:Considerashippingcompanywherecashflowsareindollarsandhasabillionyenloanat6%p.a.forpurchaseofashipfromaJapaneseshipyard.Thereisyen-dollarexchangefluctuationrisk;henceaconservativemanagementwillprefertohaveadollarloantoeliminatetheyen-dollarexchangefluctuationrisk.

A currency swap is the solution. Assume that the loan is repayable in 10 equal half yearly instalments of JPY 100 MN (million) each, and a spot exchange rate of JPY 100 to a dollar, the swap would involve receiving JPY 100 MN andpaymentUSD/MNeverysixmonthsforthenextfiveyears.

Now coming to the determination of interest on the loan, it will have a bearing on the ‘benchmark’ interest rates forthetwocurrencies.ThebenchmarkforallthefixedinterestratesistherulingyieldonGovernmentBondsofidentical maturity. Suppose the following is the ruling rate as on that particular date:

4%p.a.forJPYbondsoftheJapanesegovernment•6%p.a.forUSDbondsoftheUnitedStatesgovernment•

SincetheexistingJPYloanhasaninterestratehigherby2%thanthebenchmark,thedollarswapwouldcarryaninterestrateatasimilarpremiumoverthedollarbenchmarki.e.say8%plus(the‘plus’wouldcoverthebank’smargin and compensation for the counter party risk it is taking).

Considering8%interestonthedollarloan,thecashflowexchangeeverysixmonthswillbeasfollows:

Bank

Lenders Shipping company

USD 1 mm plus interest at 8%p.a.Onreducingbalance

JPY 100 mn plus interest at 6%p.a.Onreducingbalance

JPY 100 mn plus interestat6%p.a.On reducing balance

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Note:Itmaybenotedthatgovernmentbondshavebulletrepaymentwithdifferentcashflows.Henceusingtheyieldon Government Bonds with the same maturity as the benchmark may not be correct. One needs to use the yield on a bond whose duration and maturity is equal to the duration of the loan.

3.4 Comparison of Swap and Forward ContractsAcurrencyswapissimilartoaserviceofforwardcontracts.Debtservicingcashonflowundertheexistingloanwill look as follows:

Table3.2DebtservicingcashonflowTo eliminate the JPY = USD exchange risk and to convert the exposure into a dollar one, one can enter into 10 forwardcontracts,buyingyenagainstdollar,thefirstforJPY130MNmaturitysixmonthsandthelastforJPY103MNmaturityfiveyears.Theforwardrateswouldvaryanddependoninterestdifferentialsof2%i.e.(6%and8%).ForexampletheJPY/USDexchangerateduringthe1stinstalmentrepaymentwillbe103/104=0.9904,2nd(103/104) ^2 =0.9809 and so on.

Thefollowingtablesummarisesthedollaroutflowunderthetenforwardcontracts:

Table3.3Cashflowunderforwardcontract

Instalment No.

Principal Repayment JPY (mn)

Interest Maturity Principal JPY (mn)

Total JPY (mn)

1 100 30 1302 100 27 1273 100 24 1244 100 21 1215 100 18 1186 100 15 1157 100 12 1128 100 9 1099 100 6 10610 100 3 103

InstalmentNo

Principal Repayment

(JPY)

Interest outstanding or principal (JPY)

Total (JPY)

Forward JPY/USD Ex. Rate per 100

JPY

Total (USD)

Principal ($) equivalent at forward rate

Interest (USD)

equivalent forward rate

1 100 30 130 99.04 1.3126 1.0097 0.3029

2 100 27 127 98.09 1.2947 1.0195 0.2752

3 100 24 124 97.14 1.2765 1.0294 0.2471

4 100 21 121 96.21 1.2577 1.0394 02183

5 100 18 118 95.28 1.2385 1.0495 0.1890

6 100 15 115 94.37 1.2186 1.0597 0.1589

7 100 12 112 93.46 1.1984 1.0700 0.1284

8 100 9 109 92.56 1.1776 1.0804 0.0972

9 100 6 106 91.67 1.1563 1.0909 0.0654

10 100 3 103 90.79 1.1345 1.1014 0.0331

NDV@8%$mn10,000 Total 12.2654 10.5499 1.7155

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Iftheyendollarexposuresaretobeeliminatedthroughacurrencyswap,thedollaroutflowswouldbeasfollows:

Table3.4Currencyswapdollaroutflows

Whilethepresentvalueofthedollarcashoutflowunderbothmechanismscurrencyswapsandtenforwardcontractsareidentical,butthereareimportantdifferencesbetweenthestructuresofcashflowsasfollows:

Currency swap Forward contract

outflowishigherinearlieryears•total interest cost is higher at USD 2.20mn•total capital cost is lower at USD 10mn•

outflowishigherinlateryears•total interest cost is lower at USD 1.7155•total capital cost is higher at USD 10.55mn•

Table 3.5 Difference between currency swap and forward contract

Thesedifferenceshaveimplicationsforthecompany’scashflowonayeartoyearbasisandalsoonthereportedprofits.Themechanismtobeusedwoulddependonacasetocasebasis.

3.4.1 Swap SpreadsOnemajorinfluencingfactorontheswapspreadi.e.premiumoverGsecyields,isthedemand–supplyinthemarket.Ifthereisgreaterdemandfor‘payfloating,receivedfixed’interestrateswaps,theswaprate(i.e.thefixedrate)andhencethespreadwouldtendtofall.Againdemandforsuch‘payfloating,receivefixed’swapsfromthecorporate sector for hedging debt interest expenses increases with the steepness of the yield curve. The steeper the yieldcurve,greateristhedifferencebetweenthefixedandfloatingrateandhenceattractionofthelatter.

Contrarilywhentheyieldcurveisflat,corporatedemandsfor“payfixed,receivefloating”swapincreaseswithmoresupplyoffixedratepayers,higherswapspreadshavetobepaidtoattractcounterparties.Againfactorsinfluencingthedemand-supplyofGovernmentbondsalsoinfluenceswapspreads.Increaseinsupplyofgovernmentdebtreducesthespread.Theresultisthatthespreadkeepsfluctuating.(Yield curve: the relationship between yields on money market instruments and bonds and their maturities).

Currency swap marketMost interest rate swaps are traded over the counter (OTC). Two derivative exchanges, the London International Financial Future Exchanges (LIFFE) and the Chicago Bond of Trade (CBOT) have introduced futures contracts on 2-, 5- and 10- years swap rates. But these have not proved popular.

Installment No Principal Repayment USD (mn)

Interest on outstanding purchase at 8% p.a. USD

mn

Total USD (mn)

1 1 0,40 1,402 1 0,36 1,363 1 0,32 1,324 1 0,28 1,285 1 0,24 1,246 1 0,20 1,207 1 0,16 1,168 1 0,12 1,129 1 0,08 1,0810 1 0,04 1,04

Total 10 2,20 12,20

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Netting of swapsWith growing volume in the OTC market, there are concerns about the level of counter party exposures. One major failure could lead to a series of defaults and systematic risk.

3.5 Commodity SwapsAswapinwhichexchangedcashflowsaredependentonthepriceofanunderlyingcommodityisknownasacommodity swap. A commodity swap is usually used to hedge against the price of a commodity. While interest and currency swaps are common, some other types of swaps are also being reckoned; e.g., commodity swap.

Letustakeanairlinecompanywithfloatingrateborrowings.Itscashflowwillbeaffectedbymovementininterestratesasalsothepriceofjetfuel.Internationalbanksofferacommoditypriceswapbyexchangingfloatingpricesforafixedpriceasfollows:

Fig. 3.1 Commodity price swap

In effect with this commodity price swap, the Airline Company has entered into a forward contract on the fuel price.

Another variation would be to link the loan repayment amount to the price of jet fuel: the former falls, when the latterrisesandviceversa.Ineffectsucha“swap”reducesthevolatilityofcashflowsoftheairlinebycreatingcompensation for higher fuel prices through lower debt service obligations.

Comparative advantageComparative advantage occurs because of various factors. Some of the important ones are as follows:

acceptability of the borrower in a particular market as mentioned in the interest rate swap•toomanyrecentfluctuations•special facilities available to a particular type of borrower but not to all •

Example of special facilities available to a particular type of borrower but not to all involving an Indian counter party is that of Housing Development Finance Corporation Ltd. (HDFC).

UnderUSlaw,ahousingfinancecompanyfromadevelopingcountryiseligibletoraisedollardebtintheUSdomestic market with the guarantee of the United States Agency for International Development (USAID). HDFC lendslongtermfixedraterupeestohousebuyers.Henceitsrepaymentisforlongtermfixedraterupee.Ontheotherhand,ithasaccesstocheapfloatingratedollarsandwiththeguaranteeoftheUSGovernment;HDFCcanborrowdollarsataveryfinerate.Inthisway,HDFChasraisedseveralfloatingratedollarloansandswappedthemwithIndianBanksandfinancialinstitutionsforfixedraterupees.Intheprocess,thecounterpartieshavesecuredfloatingratedollarsataratetheywouldnothavebeenabletoraiseontheirown,simultaneously,HDFChasaccesstofixedraterupeesthatitwouldotherwisenothavegot.

AirlineRuling fuel price every quarter

Fixed fuel priceBank

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Fig. 3.2 Comparative advantage

3.6 Swap Market in IndiaInterest rate swap: Interest rate derivatives started trading in India only in 1999-00. Swaps as well as forward rate agreements have proved popular, only a couple of banks are active in the market.

Thecommonlyusedfloatingratebenchmarksinthedomesticswapmarketare:MIBOR (Mumbai Interbank Offered Rate) – the overnight, interbank call money rate•MITOR (MumbaiInter−bankTomOfferRate) –theovernightinterbankrateimpliedbytheFederalFunds•rate in NEW York added to the cash / tom(terminology used) forward margin in the exchange marketMIFOR (Mumbai Interbank Forward Offer Rate) – the period interbank rate implied by the USD LIBOR •for the corresponding period added to the annualised forward margin in the exchange market

Currency swap: The reserve bank has given general permission to authorised dealers to arrange and undertake currency swaps with one currency leg being the Indian rupee. The relevant provision in A.D. (M.A. series) Circular No.1 of January 19, 2000 is as follows:

Authorised dealer may offer the undernoted products to corporate either on a back-to-back or by booking the •transaction overseas with the branch of an authorised dealer in India:

interest rate swaps �currency swaps �coupon swaps �interest rate caps / collars (purchase) �forward rate agreements �

Before entertaining any request for any of these facilities, the authorised dealer should ensure that:•theReserveBankhasaccordedfinalapprovalfortheconclusionoftheunderlyingloantransaction �the notional principal amount of the hedge does not exceed the outstanding amount of foreign currency loan. �the maturity of the hedge does not exceed the remaining life to maturity of the underlying loan �the board of Directors of the corporate has drawn up a risk management policy, laid down clear guidelines �for concluding transactions, and institutionalised arrangements for a quarterly review of operation and annual audit of transactions to verify compliance with the regulationsthehedgedresultsinreductionoftheriskofexposureandthereisnonetinflowofpremium,director �implied in cases where option components are built-in to hedge strategy

Corporate may be permitted to unwind a hedge transaction.•Areportoftransaction(booked/cancelled),verifiedbytheauthoriseddealershouldbesubmittedtotheconcerned•regionalofficeoftheReserveBankwithinaweekofitsconclusion.Authorised dealers should obtain from the concerned corporate, copies of the quarterly reviews and annual •audit reports.

HDFC borrows floatingrate dollar

Indian Bank Rupee resources

BankHDFCInterest and Principal in Rupee

Dollar interest and principal

Payment of interest and principal

Rupee EquivalentDollar principal

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Payment of upfront of premia, if any, as well as all other charges incidental to the hedge transaction may be •affected without the prior approval of the Reserve Bank.

3.6.1 Cross Currency and FX Interest Rates Swaps in IndiaBanks in India act as intermediaries between international markets and their corporate customers in India thus work on a fully hedged basis, charging a spread of their ser vices over the quotations that they get from their correspondents abroad, who run swap books for major currencies.

USD-INR Swap: market has been growing in the last few years. FIMMDA, the Fixed Income Money Market and Derivatives Association, also publishes daily indicative quotes for such swaps. The quotations on February 17, 2004 were as follows:

Table 3.6 MIOCS rate

FIMMDA describes MIOCS as follows:Mumbai Inter Bank Offered Currency Swap (MIOCS):- FIMMDA – returns USD / INR•Currency swap rates benchmark has 11market participants. The participants are polled at 1700IST. The quotes •are then released on page (CRS01). The rates are then averaged without eliminating the layer (without removing the high and low). The page will also enlist the average rate at the bottom of the page.

While activity in such swaps has been growing, it is not still a very liquid market, partly because of the Reserve Bank restrictions on hedging such swaps in the spot / forward exchange market (there are no restrictions, if swaps are done on a back-to-back basis). At present, the principal restriction is a limit of USD 50 MN on short USD positions taken for hedging INR:USD swaps. There are currently no limits on long USD positions arising from suchswaps.ThisimpliesthatbankshavegreaterflexibilityinofferingpayUSD,receiveINRswaps;thanreceiveUSD, pay INR swaps.

The pricing depends on the yield curve in the government securities market in India, and demand-supply situation for fundsfromtimetotime.Thelattergetsreflectedinthepremiumovergovernmentsecurityyields,whichcorporateissuers of bonds need to pay.

To understand the calculations involved, consider that a bank has been asked to quote for a dollar-rupee swap, principalplusinterest,underwhichitsinflowsandoutflowsareasfollows:

interest on notional principal in dollars calculated at the spot exchange rate at LIBOR, payable every six •monthsnotionalprincipalindollarsattheendofsaythreeyearsinflows•interestinrupeesatx%p.a.,payableeverysixmonths,calculatedonthenotionalprincipalinrupees•the notional principal rupees at the end of three years•

(These inflowsandoutflows typically relate to the swappingofdollardebt serviceobligations into INR,by acorporate client of the bank).

Tenure in Years Bid Offer2 2,58 2,633 3,09 3,145 3,71 3,767 3,96 4,13

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The key variable is of course “x”, i.e., the rupee interest rate. In principal, the hedge for such a swap would be to borrow three-year rupees in the market and buy dollars for placement in the international markets at LIBOR or LIBORlinkedrate.Withthishedge,thedollarinflowswillbeusedforpayingoutdollarsundertheswap,andtherupeeinflowswillbeutilisedforservingtherupeeborrowing.Therefore,“x”woulddependontherateatwhichthebank can raise three-year money in the interbank market. In practice, of course, the bank may not raise three-year money for the swap but could use other resources for buying the dollars. Even if this were done, the pricing would still depend on the cost of three-year rupees. Also, the cost would need to be structured in the rupee book.

An alternative to buying dollars in the spot market would be to hedge the swap through purchase of dollars in the forward market, when the forward margin is cheaper than the interest differential. Since the forward market in India is not very active beyond one year, the initial hedge may have to be limited to the period for which forward dollars areavailable.Inthatcase,thebankisexposedtothepremiumfluctuationriskatthetimeofrolloverattheendofone year. This could be hedged in the MIFOR swap market.

3.6.2 MIFOR Swap MarketThe MIFOR swap market was born to overcome some of the weakness of the forward market in India:

The term inter bank money market is not very liquid. There are also limits on the amount of dollars the bank •can borrow. As a consequence,The forward market is not liquid beyond one year, nor does interest parity with the forward margin prevail •always. The forward margin is often a function of demand-supply.

At the time of writing, for example, the forward premium on the dollar is much lower than dictated by interest differential.TheMIFORswapmarket,whichexchangesrupeeinterestflowsbutwiththefloatingratebenchmarkbased on forex market variables, is perhaps unique to India. The MIFOR is proxy for the term interbank rupee market. To quote from the FIMMDA site, “Mumbai Interbank Forward Offered Rate (MIFOR) – Reuters has for more than a year now, been issuing the benchmark annualised premium levels for one, three, six and 12 months maturities at 12:30 p.m. everyday. These levels are available on page (INSWAP01) and also moved to (INRANFWD). These rates are then added to the USD interest rates.

Dollar-rupee swap reference – premia levels sourced from the market USD interest rate- the BBA rates from Reuters page (FRASETT1) after it updates are at 1700 IST Spot dollar/ rupee rate.”

Reserve Bank of India’s reference rate from Reuter’s page (RBIB) for the same day, since the day’s level is updated after noon. The rupee rates are arrived at from the above rates after adjustment for the day-count basis.

Formula used for calculation:=+((1+LiborRate*noofdays/36000)*(1+USD/INRANU.FWRDS(IN%)*noofdays/36500)-1)*36500/noofdaysThisisthebenchmarkfloatingrateforthefloatingtofixedexchangeintheMIFORswapmarket.

Hedging MIFOR swapConsiderfirstpayMIFOR,receivefixedthree-yearswap.Thebasic,elementalhedgewillbe:Step 1: Borrow three-year moneyStep 2: Buy USD spotStep 3: Deposit for one year at LIBORStep 4: Sell forward, one yearStep 5: Rollover the transaction twice by repeating the steps 1,2 and 4Step 6: At the end of three-years, use rupee generated by USD sale to repay borrowings as in step 3

ThefixedrateinflowcannowbedeterminedonthebasisofthecostofA.ThefloatingMIFORiscapturedbyCand D together.

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Thereisaresidualelement:interestonrupeefundsasinfloworoutflow,asthecasemaybeatthetimeofrollovers.The actual amount will be compensated by the difference in rupee amounts between the original spot rate and the spot rate at the time of second rollover on the one hand, and between F and A on the other.A variation with better economics will be possible if one year rupee investment yields more than MIFOR. In that case, instead of B, C and D, one could undertake the one year rupee investment, and use the surplus over MIFOR toreducethecostofborrowingasperA,andhencethefixedrate.Forexample,if

three-yearrupeescost,say,5%p.a.andoneyearinvestmentyields3%p.aand•oneyearUSDLIBORis1.3%andforwardpremiumonthedollarzero(I.e.,MIFORalso1.3%)•

ThensurplusoverMIFORinyear1is1.7%,reducingthecostofborrowingto,say,and4.4%p.a.

At the end of one year, MIFOR can once again be compared with one-year rupee yields and the more economic option between rupee and dollar market investment, chosen.

For the reverse swap (receive MIFOR, pay Fixed), the basic hedge will be:Step A: Borrow USD for one-year LIBORStep B: Buy spot INRStep C: Invest INR for three-yearsStep D: Buy USD one-year forwardStep E: Rollover the transaction twice by repeating A, B and DStep F: At the end of three-years, use proceeds of C to pay for the dollar purchase

TheMIFORinflowspayforthecostofAandforwardpremiumonD.ThefixedrateINRpaymentwillbebasedon yield on C.

If MIFOR is greater than cost of one-year INR borrowing, then borrow INR instead of A, B and D and invest proceedsasperC.ThedifferencebetweenMIFORandborrowingcostwillhelpquoteahigherfixedrupeeoutflowunder the swap.

Using MIFOR swapsIn the Indian market, MIFOR swaps are also used to hedge long-term USD / INR currency swaps, even in the absence of a long-term forward exchange market. For example, consider that a bank wants to price and hedge a three year maturity swap as follows:

pay USD LIBOR every year and USD principal at the end of three years; and•receiveINRfixedrateeveryyearandINRprincipalattheendofthreeyears.•

The steps would be:Step 1: Buy USD forward for one yearStep 2:EnterintoaMIFORswap;receiveone-yearfloating,payfixedforthreeyearsStep 3: Rollover A, twice

The premium on USD paid under A and the LIBOR to be paid to the counter party will be received under B. The fixedratepaymentunderBwillbethebaseforquotingtheINRfixedratetothecounterparty.There is a residual risk, namely, the USD: INR exchange risk on the LIBOR amount, which will be received in INR but will have to be paid out in USD.

Principal only swap:Such currency swap is becoming popular in recent years. In effect, these hedge (or create) exchange risk on the principal amount alone, leaving the interest payments in the original currency.

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Consider a USD 100 5-year bullet repayment loan, the spot rate being INR 50 /USD. The borrower desires a principal only swap into INR at the spot rate.

The exchange of currencies is as follows:initial exchange of principal•bank pay INR 5000•borrower / client pays USD 100•on loan maturity•bank pays USD 100•borrower / client pays INR 5,000•

Below are the steps how the bank would hedge and price the transaction:

Step A: Bank invests a part of the USD 100 it receives in the initial exchange, in a 5-year zero coupon bank paper (or,say,AAAbond)withafacevalueofUSD100.Iftheyieldis4%p.a.,thisrequiresUSD82.035(i.e.,100/1.02^10).Step B: The balance amount of USD 17.965 is sold in the market at INR 50 to get INR 898.25.Step C: The remaining amount of INR is generated by short selling a 5-year zero coupon INR bond issued by a bank(orAAAcorporatebond),yielding,say8%p.a.,foramarketpriceofRs.4,101.75(facevalueRs6,071.58attheassumedyield,i.e.,4101.45*(1.04^10)).Step D:Thusonmaturity,thebankcashflowsare:

Receive USD 100 from proceeds of zero coupon purchased per A.a. Pay USD 100 to borrower / client under swap.b. Receive INR 5,000 from borrower / client.c. Pay INR 6071.58 being the face value of the INR zero coupon short sold.d. (iii) and (iv) together means a shortfall of INR 1071.58, which can be recovered by pricing the swap at e. 3.92%p.a.Payablehalfyearly,onthenotionalprincipalofINR5000.

This would be the methodology to be used for pricing and hedging principal only swaps. The alert reader would havenoticedthatthisstillleavesoneriskuncovered–reinvestmentyieldon3.92%p.a.receivedhalfyearly.Themathematicsofyieldcalculationsassumesthatthereinvestmentisalsoat3.92%p.a.

It can be seen that even if there is no initial exchange of principal, the pricing remains the same. The steps for hedging the transaction would be:Step A: Short sale on INR 5-years USD coupon as above with a face value of INR 6071.58 to generate INR 4101.75Step B: With the rupee proceeds, buy USD 82.035 with which to buy a 5-year coupon USD with a face value of USD 100Step C: Since you receive only INR 5000 under the swap on its maturity and need INR 6071.58 being the face value ofthebondshortsold,thebalanceamountcanbegeneratedbyquotingapremiumof3.92%payablehalfyearly,on the notional principal of INR 5000.

With the hedge in place, we can pay out on maturity of the swap, USD 100 being the proceeds of the zero coupons andreceiveINR5000whichtogetherwiththepremiumof3.92%p.a.,isusedtopayoutthefacevalueoftheINRbond short sold.

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If instead of bullet payment, instalment payments are involved, each instalment can be conceptually considered separately and hedged and priced like a bullet repayment loan.

3.7 Futures and Options on Foreign ExchangeFutures and option contracts are important risk management tools but when used arbitrarily and for speculative purposescanbeveryriskyinvestments.Aforwardcontractisdefinedasavehicleforbuyingorsellingastatedamountofforeignexchangeatastatedpriceperunitataspecifiedtimeinthefuture.Bothforwardandfuturecontractsareclassifiedasderivativeorcontingentclaimsecuritiesbecausetheirvaluesarederivedfromorcontingentuponthe value of the underlying security. But while a future contract is similar to a forward contract, there are many distinctions between the two.

The major differences between futures and forward contracts are as follows:

Future Contract Forward Contract

Trading location:• traded comparatively on an organised exchangeContractual size:• standardised amounts of underlying assetsSettlement:• daily settlement or marking to market, done by the future clearing house through the participants’ margin accountExpiration date:• standardised delivery dateDelivery date:• delivery of the underlying asset is seldom made; usually a reversing trade is transacted to exit the marketTrading cost:• ask spread plus brokers’ commission

Trading location:• traded by bank dealers via a network of telephones, fax machines and computerised dealing systemContractual size:• tailor-made to the needs of the participantSettlement: • participant buys or sells the contractual amount at the underlying asset from the bank at maturity at the forward contractual priceExpiration date:• tailor-made delivery dates that meet the need of the investorDelivery date: • delivery of the underlying asset is commonly madeTrading cost:• ask spread plus indirect bank charges via company balance repayment

Table 3.7 Differences between forward and future contract

Two types of market participants are necessary for a derivative markets to operate: Speculators:• Aspeculatorattemptstoprofitforachangeinthefutureprices.Inthisregard,thespeculatorwilltake a long or short position in a futures contract depending upon his expectation of future price movement.Hedgers:• A hedger on the other hand, wants to award price variation by locking in a purchase price of the underlying asset through a long position in the futures contract or a sales price through a short position. In effect the hedger passes the risk of price variation to the speculator, who is better able, or at least more willing, to bear this risk.

In future markets, a clearing house serves as the third party to all transactions i.e. the buyer of the futures contract effectively buys from the clearing house and the seller sells to the clearing house. This feature of the futures market facilitates active secondary market trading because the buyer and the seller do not have to evaluate each other’s credit worthiness. The clearing house is made up of clearing members. Individual brokers who are clearing members

must deal through a clearing member. In the event of default of one side of a future trade, the clearing member stands in for the defaulting party and then seeks restitution from the defaulting party. The clearing liability is limited because a contract holder’s position is market to market daily. Therefore, it is necessary to maintain the future margin accounts for the clearing members. Frequently, a futures exchange may have a daily price limit on the future price, i.e. limit on how much the settlement price can increase or decrease from the previous day’s settlement price.

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3.7.1 Currency Future MarketsOnMay16,1972tradingfirstbeganatChicagoMercantileExchange(CME)incurrencyfuturescontracts.Thetrading has increased manifold. Most CME currency futures trade in a March, June, September and December expiration cycle, with the delivery dates being third Wednesday of the expiry month. The last day of trading is the second business day prior to the delivery date. Regular trading in CME currency futures contracts takes place each business day from 7.20 am to 2.00 PM, Chicago time. Extended trading on the GLOBEX2 trading system runs from 2.30 pm to 7.05 am, Chicago time. On Sunday, trading begins at 5.30 pm. GLOBEX2 is a worldwide automated, orderly and matching system for futures and an option that facilitates trading after the close of regular exchange trading.

The basic CME currency contract speculations are given below:

Cross rate futures (underlying currency / price currency)

The Philadelphia Board of Trade (PBOT), a subsidiary of Philadelphia Stock Exchange, introduced currency futures trading in July, 1986. The PBOT contracts trade in the same expiration cycle as the CME currency future, plus two additional near term months. The delivery date is also the third Wednesday of the expiration month, with the last date of trading being the proceeding Friday. The trading hour of PBOT contracts are 2.30 AM to 2.30 PM ET, except for Canadian dollar, which trades between 7.00 AM and 2.30 PM ET.

In addition to CME and PBOT, currency futures trading takes place on the Mid American Commodities Exchange in the Tokyo International Financial Futures Exchange and the London International Financial Futures Exchange. None of these exchanges comes close to the trading volume of CME.

Reading future quotationsLet us examine how at CME, Currency Contract Quotation is shown for a particular currency, Canadian dollar on a particular date in July of a year X , ( Courtesy the Wall Street Journal) .

CurrencyPrice quoted in US dollar

Contract Size Exchange

Australian dollar AD 100,000 CME, PBOT

Brazilian Real BR 100,000 CME

British Pound L 62,500 CME, PBOT

Canadian dollar CD 100,000 CME, PBOT

Japanese Yen Y 12,500,000 CME, PBOT

Mexican peso MP 500,000 CME

New Zealand dollar NE 100,000 CME

South Africa rand RA 100,000 CME

Swiss franc SF 125,000 CME, PBOT

Euro FX Euro 125,000 CME

Euro FX / British Pound EUR 125,000 CME

Euro FX / Japanese Yen EUR 125,000 CME

Euro FX / Swiss trance EUR 125,000 CME

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If we see December, Canadian dollar contracts opened for trading at price of $0.6835/CD and traded in the range of $0.6818/CD (low) to $ 0.6840/CD throughout the day. During its lifetime, the December contract has traded in the range of $0.6320/CD (low) to $ 0.6930/CD high. The settlement (closing) price was $0.6815/CD. The open interest, or the number of December contract outstanding was 2570.

At the settlement price of $ 0.6815, the holder of a long portion in one currency is committing itself for paying $68150 per CD 100 on the delivery date say 15th December, if it actually takes delivery.

Note that the settlement price decreased $0.0036 from the previous day. Thus it fell from $06851/CD to $0.6815/CD. Both the buyer and seller of the contract would have their accounts marked to market by change in the settlement prices. That is one holding a long portion from the previous day would have $360 (=0.0036 X CD 100,000) subtracted from his margin account and the short would have $360 added to his account. Suppose the spot price on the last dayoftradingis$0.6700/CD.Thiswillalsobethefinalsettlementpricebecauseofpriceconvergence.FromJunethroughDecember15,thelongwouldhaveacumulativeadditional$1150[=($0.06815-$0.6700)XCD100,000]subtracted from his margin account Y he continues to hold the portion open. If he takes delivery, he will pay out of pocket$67,000fortheCD100,000.Theeffectivecosthoweveris$68150[=$67000+$1500]includingtheamountsubtracted from the margin money.

Currency future as a hedging toolCurrency futures contract can be used as a hedging tool as an alternative to the forward market. Example- A United Kingdom importer has to pay $ 160, 000 to his creditors on April 20 for imports made in January. In February he is worried that the dollar may appreciate against the pound and desires to cover the exchange risk in the futures market. The amount of London International Financial Futures Exchange (LIFFE) dollar contract is £25000 and the maturity the second Wednesday of June. The current spot rate in the cash market is USD1.50 per pound, the forward rate delivery April 20 is USD 1.48 and the June contract is being traded at say USD 1.45.

He therefore decides to sell four June contracts at $1.45. On April 20, the spot rate in the cash market is USD 1.40 and the June futures contract is now trading at say $ 1.36. The purchase of USD 160,000 in the cash market will now costhimGBP114285.71(160,000/1.36)oralossofGBP6177.61[(160,000/1.48)-pound-114.285.71]comparedto the forward rate of $1.48 rupees when he decided to hedge the risk.

Inthefuturesmarket,hecannowbuybackthefourcontractssoldat$1.45atthecurrentpriceof$1.36,oraprofitof9centsperpoundorUSD9000.Thisprofitisequaltopound6428.57($9000/1.4)atthecurrentspotrateandcompensateshimfortheloss.Theexamplealsoshowsthatthehedgeisnotperfectandprofitandlossdonotmatchbecause the amounts and maturities are not the same. The spot rate and future contract price have not moved by the same amount nor was the entire $ 160,000 hedged.

Basic risk and hedge ratiosBasic risk arises when the prices of the hedge and the underlying exposure do not move equally. This can arise because of maturity difference or for other reasons like the exposure (say LIBOR) and the hedge (say Treasury bill future) being in different markets /and asset classes.

Canadian Dollar (CME) 100,000 Dollar; $ per Can $ whichever is low

Currency life time

Open High Low Settle Change High Low OpenInterest

Sept .6820 .6841 .6804 .6806 .0036 .7080 .6310 58022

Dec .6835 .6840 .6818 .6815 .0036 .6930 .6320 2570

Mar .6825 .0036 .6940 .6425 542

June .6836 .0036 .6950 .6547 185

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Basic risk is mitigated by keeping the ratio of the amount of the hedge to the amount of the underlying exposure different from 1:1. Such a hedge ratio can also be calculated as to minimise the likely difference between the price change in the hedge and in the underlying, having regard to the historical correlation between the two variables (i.e. prices and their respective volatiles).

Interest futuresOne of the most popular contracts is the 3 month Eurodollar contract. These are future contracts on the 3 months LIBOR expected to rule on maturity of the contract. On the CME for example, such contracts have maturities extended up to 10 years.

Euro dollar future prices are stated as an index number of three month LIBOR calculated as F=100-LIBOR. For example suppose that the June 2005 contract (with hypothetical delivery on June 21, 2005) had a settlement price of 93, 96 on July 6, 2004. The implied three month LIBOR yield is thus 6.04 percent (100-93.96). The minimum price change is one basis - point (bp). On $1000,000 of face value, a one basis- point change represents $ 100 on an annual basis. Since the contract is for a 90 days deposit, one basis point corresponds, to a $25 price change. As an example, of how this contract can be used to hedge interest rate risk, consider the treasurer of an MNC who on July6,2004learnedthathisfirmexpectstoreceive$20,000,000incashfromalargesaleofmerchandiseonJune21, 2005. The money will not be needed for a period of 90 days. Thus the treasurer should invest the excess fund for this period in a money market instrument such as a Eurodollar deposit.

The treasurer notes that three month LIBOR is currently 5.31percent. The implied three month LIBOR rate in June 2005contractisconsiderablyhigherat6.04%.Additionallythetreasurernotesthatthepatternoffutureexpectedthree month LIBOR rates implied by the pattern of Euro Dollar prices indicates that it is expected to increase through time. Nevertheless the treasurer believes that a 90 days rate of return of 6.04 points is a decent rate to “lock in”, so he decides to hedge against the lower three month LIBOR in June, 2005. By hedging this, the treasurer is locked inacertainreturnof$302,000(=$20,000,000*0604*90/360)forthe90dayperiodinrespectofexcessfindsof$20,000,000).

To have the hedge, the treasurer has to buy or take a long position in Euro dollar future contract, since a decrease in the implied three month LIBOR yield causes the Eurodollar futures price to increase. To hedge the interest rate risk in a $20,000,000 deposit, the treasurer will need to buy 20 June 2005 contracts.

Assume that on the last day of trading in June 2005, contract 3 months LIBOR is 5.5 percent. At 5.5 percent a 90 day Eurodollardepositof$20,000,000willgenerateonly$275,000ofinterestincome(20,000,000*0.0550*90/360)or$27,000(302,000-275,000) less than at a rate of 6.04 percent. In fact the treasurer will have to deposit excess funds at 5.5percent.Buttheshortfallwillbemadeupbytheprofitsfromthelongfuturesposition.Attherateof5.5percent,thefinalsettlementpriceonJune,2005contractis94.50(=100-5.50).Theprofitearnedonthefuturespositioncalculatedas(94.50-93.96)*100bp*$25*20contracts=$27,000.Thisispreciselytheamountoftheshortfall.

Option contractsAn option is a contract giving the owner the right, but not the obligation, to buy or sell a given quantity of an asset at aspecifiedpriceatsometimeinthefuture.Likeafutureorforwardcontract,anoptionisaderivativeorcontingentclaimssecurity.Itsvalueisderivedfromitsdefiniterelationshipwiththeunderlyingasset,inthiscontext,foreigncurrency or some claimants.

An option to buy the underlying asset is a call and an option to sell the underlying asset is a put. Buying or selling the underlying asset via the option is known as exercising the option. The stated price paid (or received) is known as the exercise or striking price. In option technology, the buyer of an option is frequently referred to as the long and the seller of an option is referred to as the writer of the option or short. Because the option owner does not have to exercise the option if it is to his disadvantage, the option has a price or premium.

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There are two types of options:American:• an American option can be exercised at anytime during the contractEuropean:• A European option can be exercised only at the maturity or expiry date of the contract

There is one more option known as Bermudian option, an option exercisable only during a predetermined portion of its life.

Option or spot exchange are traded in the interbank over the counter markets as well as number of organised exchanges including the Philadelphia stock exchange (PHLX), the London Stock Exchange (LSE), Chicago Board Option Exchange (CBCE) and many others. Exchange traded options are standardised as to amounts of underlying currencyandmaturitydates.OTCoptionsaretailor-madebybankstothespecificationsoftheirclients.

In the Indian market, the RBI has permitted banks to write cross currency options i.e. options between two foreign currencies since January, 1994. Options against the rupee will have to wait till capital account convertibility is in place.

Call option: A call option gives the option buyer the right to purchase a currency Y against a currency X at a stated price say K units of X per unit of Y on or before a stated date. For exchange traded option, one contract represents a standard amount of the currency Y. The writer of the call option must deliver currency Y in exchange for X at the rate K, if the option buyer chooses to exercise his option.

Put option:AputoptiongivestheoptionbuyertherighttosellcurrencyYagainstacurrencyXataspecifiedpriceKonorbeforeaspecifieddate.ThewriterofaputoptionmusttakedeliveryofYanddeliverXiftheoptionis exercised.

Strike Price:ThepriceKspecifiedintheoptioncontractatwhichtheoptionbuyercanpurchasethecurrency(calloption) or sell the currency (put option) Y against X.

Premium (option price, option value)The fee that the option buyer must pay the option writer up-front i.e. at the time the contract is initiated. If the option lapses unexercised, the buyer loses the amount.

American Option: • An option call or put that can be exercised by the option buyer on any business day from contract date to maturity.European Option:• An option that can be exercised only on maturity date.Intrinsic value of the option: • Given its throw away features. The value of an option can never fall below zero. Consider an American call option on Swiss franc (CHF) with a strike price of $ 0.5865. If the current spot rate CHF/$ is 0.6005, an option holder can realise an immediate gain of $ (0.6005-0.5865) by exercising the call and selling the currency in the spot market. Therefore the value of the call must be at least equal to this. The intrinsicvalueofanoptionisthegaintotheholderonimmediateexercise.Foracalloptionitisdefinedasmax[(S-.K),0]whereSisthecurrentspotrateandkisthestrikeprice.Thenotationmax[A,.B]means“greaterof A and B”. If S>K, the call has a positive intrinsic value. If S=K, intrinsic value is zero. Similarly for a put option,intrinsicvalueismax[(K-S),0].ForEuropeanoption,theconceptofintrinsicvalueisonlynotionalsince it cannot be prematurely exercised.

Time value of the option: The value of an American option at any time before expiry must be at least equal to its intrinsic value. In general it will be larger. This is because there is some probability that the spot price will move further in favour of the option holder. Suppose you hold a call option on Great Britain Pound (GBP) at a strike price of $ 1.5600. The current spot rate is GBP/USD 1.5900 and the option has one month to expire. The value of the option must be at least $ 0.03 ($1.5900-1.5600) but will be larger than this since within the remaining month, the GBP might ever move higher than 15900.

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The difference between the value of an option at anytime t and its intrinsic value at the time is called the time value of the option. The European option can at times have a value less than (S-K) (assuming that this is positive) and a European put can have a value less than (K-S). The lower limit on European option values is zero.

At the money, in the money and out of the money optionA call option is said to be at-the-money if S = K, in-the-money if S>K and out-of- the-money if S<K. Conversely, a put option is at-the-money S=K, in-the money S<K and out-of-the-money S>K. An option will be exercised, if at all, only when it is in-the-money. Thus an option is at-the-money if its intrinsic value is zero, in-the-money if it is positive and out-of-the-money if negative. A call (put) on USD at the strike of CHF 1.5000 is at-the-money if the spot rate USD/CHF is 1.5000, in-the-money (out-of-the-money) if it is greater than 1.5000 and out-of-the-money (in-the-money) if it is less than 1.5000.

Explanation of call option strategies:Consider a trader who buys a call option on Swiss Franc (as compared to US dollar) with a strike price of 0.67$ and pays a premium of 1.98 cents ($0.0198).

For spot rate up to $0.67, the option buyer will let the option lapse since Swiss Franc can be bought at a lower price in the spot market. The loss is limited to the premium paid ($0.0198). If spot rate is $0.6800, he will recover part of the premium and the loss will be restricted to $0.0098. If the spot rate is $0.6898, there will be a break-even situation andprofitwillbezero.Theprofitwillstartifthespotexchangeisgreaterthan$0.6898.IfwedenotestrikepriceasK, the call option premium by c and spot rate Sk, symbolically we can state as:Profit=-CforSr<=KAgainprofit=Sr–K–CforSr>KLet us see the table below (based on the example)

AndcalloptionwritersprofitProfit=C,forSr<=KAgainprofit=-(Sr–K–C)forSr>K

Explanation of put option strategies:A trader buys a June put option on pound sterling at a strike price (X) of $ 1.7500, for a premium of $ 0.07 per sterling.So long as spot rate is more than 1.75, the option will not be exercised since sterling has a higher price in the spot market and loss will be restricted to the premium amount.Forspotrateof1.68,theoptionwillbeexercisedbuttherewillbebreakevensituationandnoprofit/lossForspotrate<1.68,theoptionwillbeexercisedandleadtonetprofit.

Spot Rate (Sr) Gain (+) / Loss (-)0.6000 -$ 0.01980.6500 -$ 0.01980.6600 -$ 0.01980.6700 -$ 0.01980.6800 -$ 0.00980.6898 $ 0.000.6900 +$0.00020.6950 +$0.00520.7000 +$0.0102

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If we denote put premium by P we have:-Putoptionbuyer’sprofit:Profit=-PforSr>XAgainprofit=X–Sr–PforSr<=XPutoptionwriter’sprofit:Profit=PforSr>XAgainprofit=-(X-SR-P)forSr<=XFor better appreciation let us see the following table.

Using options for hedgingWhen a corporate treasurer has strong views about a currency, it is desirable to have hedging strategy permitting to drive gains, at the same time providing downside protection if the forecast doesn’t materialise. Options are an ideal hedging vehicle in such cases. Let us look at some examples.

Hedging a foreign currency payable with callsIn late February, an American importer anticipates a yen payment of JPY 100 million to a Japanese supplier sometime in late May. The current USD /JPY spot rate is 129.220 (which imply a JPY / USD rate of 0.007739). A June yen call option on the PHLX, with a strike price of $ 0.0078 per yen, is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million. Premium per contract is therefore: $ (0.000108 x 6250000) =$ 675Thefirmdecidestopurchase16callsforatotalpremiumof$10800.Inaddition,thereisabrokeragefeeof$20percontract.Thustotalexpenseinbuyingtheoptionsis$11,120.Thefirmhas,ineffect,ensuredthatitsbuyingrate for yen will not exceed: $0.0078+$(11120/100,000,000)=$0.0078112peryen

Thepricethefirmwillactuallyenduppayingfortheyendependsuponthespotrateatthetimeofpayment.Wewill consider two scenarios:

Yen depreciates to $0.0075 per yen ($ / Y =133.33) in late May when the payment becomes due.•Thefirmwillnotexerciseitsoption.Itcansell16callsinthemarketprovidedtheresalevalueexceedsthebrokerage commission it will have to pay (Recall that June calls will still command some positive premium). It buys yen in the spot market. In this case the price per yen it will have paid is: $0.0075+$0.0000112-$[(salevalueofoptions-320)/100,000,000]If the resale value of options is less than $320, it will simply let the option lapse. In this case, the effective rate will be $0.0075112 per yen or Y 133.33 per dollar. It would have been better to leave the payable uncovered. A forwardpurchaseat$0.0078wouldhavefixedtherateatthatvalueandwouldbeworsethantheoption.

Spot Rate (Sr) Gain (+) / Loss (-)

1.6500 +$0.0300

1.6600 +$0.0200

1.6800 +$0.00

1.6900 +$0.0100

1.7300 +$0.0500

1.7500 +$0.0700

1.7700 +$0.0700

1.8000 +$0.0700

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Yen appreciates to $0.80.•Nowthefirmcanexercisetheoptionandprocureyenatthestrikepriceof$0.0078.Inaddition,therewillbetransaction costs associated with the exercise. Alternatively it can sell the options and buy the yen in the spot market. Assume that June yen calls are trading at $0.00023 per yen in late May. With the latter alternative, the dollar outlay will be:$800000-$(0.00023x16x6250000)+$320=$777320Includingthepremium,theeffectiveratethefirmhaspaidis$(0.007732+0.0000112)=$0.0077844(Weareagain ignoring the interest foregone on the premium paid at the initiation of the option).

Hedging a receivable with a put optionACanadianfirmhassuppliedgoodsworthPounds26milliontoaBritishcustomer.Thepaymentisdueintwomonths. The current GBP /CAD spot rate is 2.8356 and two-month forward rate is 2.8050. An American put option on sterling with 3-month maturity and strike price of CAD 2.8050 is available in the inter bank market for a premium ofCAD0.03persterling.ThefirmpurchasesaputoptiononPound26million.ThepremiumpaidisCAD(0.03x26000000) =CAD 7, 80,000. There are no other costs.

Effectively,thefirmhasputaflooronthevalueofitsreceivablesatapproximatelyCAD2.7750persterling(=2.8050 –0.03). Again, consider two scenarios:

The pound sterling depreciates to CAD 2.7550:• thefirmexercisesitsputoptionanddeliversL26milliontothebank at the price of 2.8050. The effective rate is 2.7750. It would have been better off with a forward contract.Sterling appreciates to CAD 2.8575:• theoptionhasnosecondarymarketandthefirmallowsittolapse.Itsells the receivables in the spot market. Net of the premium paid, it obtains an effective rate of 2.8275 which is better than the forward rate. If the interest foregone on premium payment is accounted for, the superiority of the option over the forward contract will be slightly reduced.

Hedging a receivableAnAmericanfirmhasa90daysreceivableofJPY1.5billion.Thespotrateis135.00yenperdollar($0.007407per yen) and the 90-day forward is 139.50 ($0.007168 per yen). Yen has been weak in recent months. The treasurer howeverisconfidenttheyenwillrebound.

Ifthereceivableiscoveredforward,therewillbeacertaincashinflowofUSD(1500/139.50)millionorUSD10,752,688.17.

European put options on yen with a strike price of JPY 139.50 per USD and 90- days to expiration are available for a premium of 2.00 cents per 100 yen or USD 3, 00,000 for the entire amount of the exposure. The treasurer decides to buy the put. To evaluate her decision, let us consider two alternative scenarios:

90-days later, the yen strengthens to 130.00 per dollar i.e. $0.007692 per yen. The treasurer lets the option lapse •and sells the yen in the spot market.

Thefirm’scashinflowsare:USD[(1500/130.00)-0.3]million=USD11,236,461.54•Which exceeds the forward contract payoff by USD 483773.37 (11,236,461.54 – 10752, 688.17)•Suppose the yen does weaken to 140.00. Now, the treasurer exercises the put and delivers the yen at the strike •priceof139.50.Thecashinflowis:USD[10,752,688.17–300,000]=USD10,452,688.17

This is less than the forward by the amount of the put premium viz. USD 300,000. Notice that in both calculations, we are ignoring interest cost of the premium which must be paid up-front.

The option hedged performs better than the forward does if the yen strengthens beyond $ 0.007368 i.e. (0.007168 +0.0002)perdollar.Thustheoptionhedgepermits‘controlledspeculation’–possiblytogainifthemarketmovesin your favour but limited loss if it does not. Option hedges are particularly useful for contingent exposures i.e. exposures which will arise only under certain conditions. A classic exposure is a tender binding situation in which exposureswillariseonlyifthebidissuccessfulandthefirmisawardedthecontract.

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SummarySwapisdefinedasafinancialtransactioninwhichtwocounterpartiesagreetoexchangestreamsofpayments,•orcashflows,overtimeonthebasisagreedatthebeginningofthearrangement,itislikeaseriesofforwardcontracts.Swapscanbebroadlyclassifiedintotwocategories: interestrateandcurrency.•Interestrateswap:Anexchangeofinterestpaymentsonaspecificprincipalamount.•Currency swap: When two counter parties agree to exchange interest and principal in one currency for interest •and principal in another currency.A swap bank is a generic term to describe a financial institution that facilitates swaps between counter•parties. Aswapinwhichexchangedcashflowsaredependentonthepriceofanunderlyingcommodity.Acommodity•swap is usually used to hedge against the price of a commodity. Aforwardcontractisdefinedasavehicleforbuyingorsellingastatedamountofforeignexchangeatastated•priceperunitataspecifiedtimeinthefuture.Speculators:Aspeculatorattemptstoprofitforachangeinthefutureprices.•Hedgers: A hedger on the other hand, wants to award price variation by locking in a purchase price of the •underlying asset through a long position in the futures contract or a sales price through a short position.An option is a contract giving the owner the right, but not the obligation, to buy or sell a given quantity of an •assetataspecifiedpriceatsometimeinthefuture.

Referenceshttp://www.investorwords.com/2547/interest_rate_swap.html#ixzz18j1VSWmY• . Last accessed on 21st December, 2010.http://www.allbusiness.com/glossaries/coupon-swap/4950499-1.html• . Last accessed on 21st December, 2010.http://acronyms.thefreedictionary.com/MIBOR• . Last accessed on 22nd December 2010http://www.investopedia.com/terms/c/commodityswap.asp• . Last accessed on 22nd December, 2010.

Recommended ReadingTim Weithers (2006). • Foreign Exchange: A Practical Guide to the FX Markets. Wiley.Ghassem A. Homaifar (2003). • Managing Global Financial and Foreign Exchange Rate Risk.Wiley;firstedition.Robert Kolb (2007). • Futures, Options, and Swaps.Wiley-Blackwell;fifthedition.

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Self Assessment

The value of an American option at any time before expiry must be at least equal to its _______________.1. extrinsic valuea. intrinsic valueb. optional valuec. maximum value d.

A call option is said to be at-the-money when2. S=Ka. S>Kb. S<Kc. Sd. ≠K

___________isdefinedasavehicleforbuyingorsellingastatedamountofforeignexchangeatastatedprice3. perunitataspecifiedtimeinthefuture.

Future contracta. Forward contractb. Option contractc. Put optiond.

A____________is ageneric term todescribeafinancial institution that facilitates swapsbetweencounter4. parties.

interest swapa. currency swapb. commodity swapc. swap bankd.

WhatdoesLIFFEstandsfor?5. London International Financial Fixed Exchangesa. London International Finance Future Exchangesb. London International Financial Future Exchangesc. London International Facility Future Exchangesd.

WhichofthefollowingstatementisFALSE?6. Aspeculatorattemptstoprofitforachangeinthefutureprices.a. Swapscanbebroadlyclassifiedintotwocategoriesthatisinterestrateandcurrency.b. In practice it is difficult for a corporate to locate a counter party for a swap with the identical c. requirements.Interestrateswapisanexchangeofinterestpaymentsonaspecificinterestamount.d.

Whichofthefollowingoptioncanbeexercisedonlyonmaturitydate?7. American optiona. European optionb. Bermudian optionc. Future optiond.

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An option to buy the underlying asset is a call and an option to sell the underlying asset is a _____.8. forwarda. putb. contractc. swapd.

When two counter parties agree to exchange interest and principal in one currency for interest and principal in 9. another currency is known as

Interest swapa. Currency swapb. Commodity swapc. Future swapd.

The principal amount on which interest calculations are to be made is referred to as10. Notional principala. Key principalb. Principalc. Future principald.

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Chapter IV

Balance of Payments

Aim

The aim of the chapter is to:

introduce balance of payments•

discuss currency convertibility•

explain balance of payments identity•

Objectives

The objectives of this chapter are to:

analyse India’s balance of payments on current account•

explain the grouping of balance of payment accounts•

learnthereservefordeficitincapitalaccount•

Learning outcome

At the end of this chapter, students will be able to:

state the three modes of international transactions•

explain the importance of balance of payments•

analyse capital account in detail•

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4.1 Introduction to Balance of Payments (BOP)Balance of payment (BOP) is a record of all transactions made between one particular country and all other countriesduringaspecifiedperiodoftime.BOPcomparesthedollardifferenceoftheamountofexportsandimports,includingallfinancialexportsandimports.

Importance of balance of payments The balance of payments provides detailed information concerning the demand and supply of a country’s •currency. For example, if India imports more than it exports, the supply of rupee is likely to exceed the demand in the foreign exchange market. This means that the Indian rupee would be under pressure to depreciate against other currencies.A country’s balance of payment data may signal its potential as a business partner for the rest of the world. If •acountryisfacingmajorbalanceofpaymentdifficulty,itmaynotbeabletoexpandimportsfromtheoutsideworld.The balance of payments data can be used to evaluate the performance of the country in international economic •competition.Supposeacountryisexperiencingtradedeficitsyearafteryear,thistradedatamaysignalthatthecountry’s domestic industries lack international competitiveness.

International transactions include import and export of goods and services and cross border investments in business, bank accounts, bonds, stocks and real estate. Since the balance of payments are recorded over a certain period of time (i.e. a quarter or a year), they have the same time dimension as national income accounting.

4.2 Grouping of Balance of Payment AccountsThe country’s international transactions can be grouped into the following three key types:

the current account•the capital account•theofficialreserveaccount•

4.2.1 The Current AccountThe current account is the record of the export and import of goods and services, whereas the capital account includes all purchase and sale of assets such as stocks, bonds, bank accounts, real estate and business. The structure of the current account in India’s BOP statement is given below:

The structure of current account in India’s BOP statement is given below:

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Merchandise trade covers all transactions relating to movable goods, where the ownership of goods changes from resident to non-resident (exports) and from non-resident to resident (imports). The valuation should be on FOB basis so that international freight and insurance are treated as distinct services and not merged with the value of goods. Imports valued at CIF are the debt entries. Exports are the credit entries. The difference between the total ofcreditsanddebitsappearsinthe“Net”column.Thisisthebalanceonmerchandisetradeaccount,adeficitifnegative and a surplus if positive.

Invisibles account includes services such as transportation and insurance, income payments and receipts for factor services and unilateral transfers.

Credits under invisible consist of services rendered by residents to non-residents, income earned by residents from theirownershipofforeignfinancialassets(interest,dividends)incomeearnedfromtheuse,bynon-residents,ofnon-financialassetssuchaspatentsandcopyrightsownedbyresidentsandtheoffsetentriestothecashandin-kindgifts received by residents from non-residents. Debits consist of the same items with the roles of residents and non-residents reversed.

Transfersincludeforeignaid,repatriations,officialandprivategrantsandgifts.UnlikeotheraccountsinBOP,transfershaveonlyonedirectionalflows,withoutoffsettingflows.

The net balances between the credit and debit entries under the heads merchandise, non-monetary gold movements and invisibles taken together is the current account balance.

The current account balance, especially the trade balance, tends to be sensitive to exchange rate changes.

4.2.2 The Capital AccountCapital account deals with payments of debts and claims. It consists of all such items as may be employed in financinginbothimportsandexports,namelyprivatebalanced,assistancebytheinternationalinstitutionalagenciesandspecieflowandbalancesheldongovernmentaccount.

The structure of capital account in India’s BOP is given below:

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The total capital account consists of three major items and two other minor items shown under “rupee debt service” and other capital.

Thefirstmajorsub-grouprelatestoforeignequityinvestmentsinIndiaeitherintheformofdirectinvestments,for example: Toyota starting a Car Plant in India – or portfolio investments such as purchase of Indian Company’s stock by foreign institutional investors. The next group is loan. Under this are included concessional loans received by the government or public sector bodies, long and medium term borrowings from the commercial capital markets in the form of loans, bond issues and short term credits such as trade related credits. Remittances received by Indian resident entities are credit items while repayments and loans made by Indians are debits. The third group separates out the changes in foreign assets and liabilities of the banking sector. An increase (decrease) in assets is debits (credits) while increase (decrease) in liabilities is credits (debits). Non-resident deposits with Indian banks are shown separately.

4.2.3OfficialReservesAccountOfficialreserveaccountformsaspecialfeatureofthecapitalaccount.Thisaccountrecordsthechangesinthepartof the reserves of other countries that is held in the country concerned. These reserves are held in three forms: in foreign currency, but not always the US dollars, as gold and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do not have to be held by the country. Indeed most of the countries hold a proportion of the reserves in accounts with foreign central banks.

The other accounts are:The remaining accounts in India’s BOP relate to transactions in reserve assets.•The IMF accounts contain purchases (credits) and repurchase (debits) from the IMF. SDRs are a reserve asset •created by IMF and allocated from time to time to member countries.Within certain limitations, it can be used to settle international payments between monetary authorities of •member countries.An allocation is a credit while retirement is a debit.•The reserves and monetary gold account records increases (debit) and decreases (credits) in reserve assets.•Reserve assets consist of RBI (Reserve Bank of India) holdings of gold and foreign exchange (in the form of •balance with foreign central banks and investments in foreign government securities) and government holdings of SDRs.

4.3 The Balance of Payments IdentityWhen the balance of payments accounts are recorded correctly, the combined balance of the current, the capital account and the reserves account must be zero, that is:

BCA+BKA+BRA=O

Where BCA = balance on the current accountBKA = balance in capital accountBRA = balance in the reserve accountThebalanceonthereserveaccount(BRA)representsthechangeintheofficialreserves.

Thebalanceofpaymentsequationindicates thatacountrycanrunabalanceofpaymentssurplusordeficitbyincreasingordecreasingitsofficialreserves,underthefixedexchangerateregime,countriesmaintainofficialreservesthatallowthemtohavebalanceofpaymentsdisequilibriumthatisBCA+BKAisnon-zerowithoutadjustingtheexchangerate.Underthefixedexchangerateregime,thecombinedbalanceonthecurrentandcapitalaccountswillbeequalinsize,butoppositeinsignsothechangeintheofficialreserves:

BCA+BKA=-BRA

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Forexample,ifacountryrunsadeficitonoverallbalancethatisBCA+BKAisnegative,centralbankofthecountrycansupplyforeignexchangeoutofitsreserveholdingsbutifthedeficitpersists,thecentralbankwilleventuallyrun out of its reserves and the country may be forced to devalue its currency. This is roughly what happened to the Mexican peso in December 1994.

Underthepureflexibleexchangerateregime,centralbankswillnotinterveneintheforeignexchangemarkets.Infact,centralbanksdonotneedtomaintainofficialreserves.Underthisregime,theoverallbalancethenmustnecessarily balance.

That is, BCA = -BKA

Inotherwords,acurrentaccountsurplusordeficitmustbematchedbyacapitalaccountdeficitorsurplusandviceversa.

In practice, depending upon the context and purpose for which it is used, several concepts of ‘balance’ have evolved. These are as follows:

Trade balance:• This is the balance in the merchandise trade account i.e. item I in the current a/c.Balance on goods and services• : This is the balance between exports and imports of goods and services. In terms of above, it is net balance on item I and sub items 1 – 6 of item II taken together.Current account balance• :Thisisthenetbalanceontheentirecurrentaccount–itemsI+II.Whenthisisnegative,wehaveacurrentaccountdeficit,whenitispositiveacurrentaccountsurplusandwhenthisiszero,we have a balanced current account.Balance on current account and long-term capital:• This is sometimes called basic balance. This is supposed toindicatelong-termtrendsintheBOP,theideabeingthatwhileshort-termflowsarehighlyvolatile,long-termcapitalflowsareamorepermanentinnatureandindicativeoftheunderlyingstrengthorweaknessoftheeconomy.

4.4 The Currency ConvertibilityCurrency convertibility is the ability to exchange money for gold or other currencies. Some governments which do not have large reserves of hard currency foreign reserves try to restrict currency convertibility, since they are not in a position to handle large currency market operations to support their currency when necessary.

Currencies like US Dollars, Japanese Yen are said to be fully convertible while that of Burmese Kyat or Cuban Peso are said to be non-convertible. In India, the debate is that of whether to make the rupee convertible.

Convertibilityofacurrencyisamatterofdegree.IMFdefinesacurrencytobeconvertibleifitisfreelyconvertibleinto a foreign currency and vice versa for all transactions included in the current account of BOP. This does not mean that there are no restrictions on foreign trade which include import and export duties, quotas, prohibitions, etc. These are matters of trade restrictions and not currency convertibility. What current account convertibility means is that, provided a current account transaction does not violate any provisions of trade control (or any other relevant legislation), the time currency can be freely converted into any foreign currency and vice versa in settling such a transaction.

In this sense, the Indian rupee became (almost fully) current account convertible in August 1994. There are still some restrictions on items such as travel. For transactions falling under the capital account such as foreign currency borrowing and investment, joint ventures, holding foreign bank accounts, etc. prior approval from the Central Bank of India and RBI are needed. The Tarapore committee recommended that rupee should be made convertible on capital account in three phases from 1997 to 2000. However, following the Asian currency crisis, political uncertainty, Russia’scollapseandtheresultantturmoilinglobalfinancialmarkets,doubtsareraisedabouttheadvisabilityoffull convertibility, particularly for a developing country.

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4.5 The Balance of Payments of IndiaThebalanceofpaymentsofIndiaisclassifiedintotwocategoriesnamely;

Balance of payments on current account •Balance of payments on capital account•

4.5.1 India’s Balance of Payments on Current Account

DuringtheFirstPlanPeriod,inspiteofpersistenttradedeficit,therewasasurplusinnetinvisibles,resulting•in India’s adverse balance of payments of only Rs. 42 crores.DuringtheSecondPlan,thebalanceoftradeexperiencedadeficitofRs.2339crores.Theinvisiblepositive•balancereducedthisdeficittoRs.1725crores.ThecurrentaccountdeficitduringtheThirdFiveYearPlanwasRs.1941crores.•The Fourth Five Year Plan (1969-70 to 1973-74) experienced a surplus position of Rs.100 crores. The reason •was the export promotion measures taken by the government and increase in the invisible receipts.DuringtheFifthPlan(1975-76to1978-79)thetradedeficitincreasedtoamaximumofRs.3179croresbecause•of increase in oil prices. However, the increase in net invisibles to Rs.6221 crores, the balance of payment experienced a surplus balance of Rs.3082 crores.TheSixthFiveYearPlan(1980-85)setadifferenttrendofexperiencingheavydeficits.Thetradedeficitwas•Rs.30,456,butthenetinvisibles(Rs.19,072)helpedtoreducethedeficitofbalanceofpaymenttoRs.11,384crores.DuringtheSeventhPlan(1985-86to1989-90),thetradedeficitwasRs.54,204crores.Thenetinvisiblesof•Rs.13,157croresreducedthedeficitofbalanceofpaymentstoRs.41,047crores.During1992-93to1996-97(EighthPlan),thedeficitincurrentaccountaggregatedtoRs.62,914crores.The•currentseconddeficithascontinuedin1997–98and2000–01.

The current account of the balance of payments of India includes three items:Visible trade relating to imports and exports•Invisible items viz. receipts and payments for such services as shipping, banking, insurance, travel, etc. •Unilateral transfers such as donations. The current account shows whether India has a favourable balance or •deficitbalanceofpaymentsinanygivenyear.Thebalanceofpaymentsincapitalaccountshowstheimplicationsofcurrenttransactionsforthecountry’sinternationalfinancialposition.Forinstance,thesurplusandthedeficitofthecurrentaccountarereflectedinthecapitalaccount,throughchangeintheforeignexchangereservesofacountry, which are an index of the current strengths or weakness of a country’s international payments position, are also included in the capital account.

4.5.2 Balance of Payments on Capital AccountCapital account is divided into three parts namely:

Private capital:• Private capital is further divided into long term and short term. Long-term private capital is with a maturity period of more than one year and short-term capital is with a maturity period of one year or less.Long-term private capital • includes:

Foreign investments – both direct and portfolio �Long term loan �Foreign currency deposits �Estimatedportionoftheunclassifiedreceiptsallocatedtothecapitalaccount �

Banking capital:• Bankingcapitalcoversmovementsintheexternalfinancialassetsandliabilitiesofcommercialand co-operative banks authorised to deal in foreign exchange.Officialcapital:• Reserve Bank of India’s holdings in terms of foreign currency and special drawing rights held by the government are categorised into loans, amortisation and miscellaneous receipts and payments.

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Capitaloutflowfromthehomecountrytoaforeigncountryistreatedasadebititemandtheinflowofcapitalfundfrom a foreign country to the home country is treated as a credit item. For example, if Reliance Petrochemicals invests Rs. 1 billion in the kingdom of Saudi Arabia, it will be represented as a debit item in our balance of payments and a credit item in the balance of payments of the kingdom of Saudi Arabia. There would be other interest payments or dividend payments in the capital. The interest received would be a credit item for India in the current account of its balance of payments and in case of UAE; it would be shown in the debit side of its current account of UAE. The debit items and credit items of balance of payments under capital account are presented below:

Balance of payment items under capital A/c and unilateral transfer account is as follows:

Capital account credits Capital account debits

foreign long• term investments in the home country (less redemption and repayments)

direct investments with home country �foreign investment in domestic securities �other investments of the foreigners in the �home countryforeign government loans to the home �country

long term investments abroad (less redemption •and repayments)

direct investments abroad �investments in foreign securities �other investments abroad �government loans to foreign countries �

foreign short term investments in the home •country unilateral transfers account

private remittances received from abroad �pension payments received from abroad �government grants received from abroad �

officialsettlementaccounts•officialsalesofforeigncurrenciesorother �reserve assets abroad

short term investments abroad unilateral •transfer account

private remittance abroad �pension payments abroad �government grants abroad �

officialsettlementsaccounts•officialpurchaseofforeigncurrenciesor �other service assets

Table 4.1. Balance of payment items under capital A/c and unilateral transfer account

4.5.3ReserveforDeficitinCapitalAccountCapitalaccountstructurehaschangedconsiderablyoverthetimeperiod.Mostofthedeficitwasfinancedthroughtheinflowofconcessionalassistanceduringtheperiod1956-57to1979-80.Thisreducedthedebt-servicingburden.Butduring1980-81to1997-98theentiredeficitwasfinancedthroughloansatthemarketrateofinterest.Theloansat concessional interest rates were nearly 90 per cent of the total in 1980 and it declined to 35 per cent in 1990.

the average maturity period of loans was 40.8 years in 1980, it reduced to 29.1 years in1990•interest rates were increased during 1980-81 to 1998-99 compared to those of 1956-57 to 1979-80•declineinthequalityofexternalfinancingduring1980-89to1998-9•total debt increased from Rs.19, 470 crores in 1980-81 to Rs.336, 646 crores in 1996-97•substantialamountofcurrentaccountdeficithasbeenfinancedfromtheinflowofcapitalsince1984-85•currentaccountdeficitwasfinancedfromthefundsdrawnunderextendedfundfacilityfromIMFduring1980-•81 to 1984-85. It was SDRs 5 billion.

Further, the Government of India has drawn substantially from the IMF in 1990-91 consequent upon deteriorating balance of payments position due to the impact of the Gulf war.

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Inaddition,IndiahasdrawnRs.3,334croresfromIMFunderthecompensatoryandcontingencyfinancingfacility(CCFF) in 1990 – 91. India also received Rs.2, 077 crores in 1991 – 92 and Rs.3, 363 crores in 1992-93 under the stand by arrangements from the fund.

Theincreasingtradedeficits,decliningprivateremittancesanddecreasingconcessionaidtofinancethebalance•ofpaymentsdeficit,madeIndiaresorttohighcostofsourcesoffinance,likecommercialborrowings,NRIdeposits and loans from IMF.Increasingoutflowofforeigncapitalanddeclininginflowduring1990–91to1992–93seriouslyaffectedthe•foreign exchange reserves position. This in turn downgraded India’s credit rating.There has been a slight improvement in India’s external debt position. It declined from US $ 99.00 billion at •the end of March 1995 to US $ 92.2 billion at the end of March 1997.Thereisastructuralchangeinthecapitalaccount.Thischangerelatestoreductionindebtcreatingflowsand•anenhancedresourcetonon-debtcreatingforeigninvestmentflowssince1993-94.

The following table presents the key indications of India’s balance of payments:

Table 4.2 Key indications of India’s balance of payments

TC = Total Capital Flows•FER = Foreign Exchange Reserve•ECB = External Commercial Borrowings•Astotalcapitaloutflowsarenettedaftertakingintoaccountsomecapitaloutflows,theratiosagainst3,4and•5 in some case, add up to more than 100 percent.

(*Source:GovernmentofIndia,EconomicSurvey,2001–02.)

1990-1991

1992-1993

1993-1994

1994-1995

1995-1996

1997-1998

1998-1999

1999-2000

2000-2001

Exportsas%ofimports 66.2 77.6 84.8 74.0 69.7 69.7 72.1 67.8 75.8

Currenta/cdeficitas%of GDP -3.2 -1.8 -0.4 -1.7 -1.2 -1.4 -1.0 -1.1 -0.1

ECB/TC(%) 26.8 -8.5 6.1 42.0 27.3 42.6 55.4 2.9 47.7

NRIdeposits/TC(%) 18.3 47.4 12.2 37.1 32.1 12.0 22.1 14.2 27.6

External Assistance/TC (%) 26.3 44.0 19.2 29.7 10.8 9.7 10.4 8.3 5.1

Debt service payment as %ofcurrentreceipts 35.3 27.5 25.6 24.3 21.2 19.1 18.0 16.2 17.1

Import cover of FER (No. Of months) 2.5 4.9 8.6 6.0 6.5 6.9 8.2 8.2 8.6

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SummaryBalance of payment (BOP) is a record of all transactions made between one particular country and all other •countriesduringaspecifiedperiodoftime.International transactions include import and export of goods and services and cross border investments in •business, bank accounts, bonds, stocks and real estate.The country’s international transactions can be grouped into the following three key types: the current account, •thecapitalaccountandtheofficialreserveaccount.The current account is the record of the export and import of goods and services, whereas the capital account •includes all purchase and sale of assets such as stocks, bonds, bank accounts, real estate and business. Capital account deals with payments of debts and claims. It consists of all such items as may be employed •infinancingbothimportsandexports,namely,privatebalanced,assistancebytheinternationalinstitutionalagenciesandspecieflow,andbalancesheldongovernmentaccount.Officialreserveaccountformsaspecialfeatureofthecapitalaccount.Thisaccountrecordsthechangesinthe•part of the reserves of other countries that is held in the country concerned.Currency convertibility is the ability to exchange money for gold or other currencies.•TheBalanceofPaymentsofIndiaisclassifiedintotwocategoriesnamely:balanceofpaymentsoncurrent•account and balance of payments on capital account.Capitalaccountisdividedintothreepartsnamely:privatecapital,bankingcapitalandofficialcapital.•

Referenceshttp://www.investopedia.com/terms/b/bop.asp• . Last accessed on 23rd December, 2010.http://bms.co.in/official-reserves-account-in-bop/• . Last accessed on 23rd December, 2010.http://www.investorwords.com/1241/currency_convertibility.html#ixzz18vow7URe• . Last accessed on 23rd December, 2010.

Recommended ReadingJohn McCombie (2004). • Essays on Balance of Payments Constrained Growth: Theory and Evidence (Routledge Studies in Development Economics).Routledge;firstedition.John M. Letiche (1967). • Balance of Payments and Economic Growth. Harvard University Press; New issue of 1959 edition.Mario I. Blejer (1999). • Balance of Payments, Exchange Rates, and Competitiveness in Transition Economies. Springer;firstedition.

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Self Assessment

______________1. includes services such as transportation and insurance, income payments and receipts for factor services and unilateral transfers.

Invisibles Accounta. Creditb. Transferc. Merchandised.

Long-term private capital is with a maturity period of more than _______________.2. One yeara. 1 monthb. 6 monthc. 2 yearsd.

BOPcomparesthe_______differenceoftheamountofexportsandimports,includingallfinancialexportsand3. imports.

Yena. Rupeeb. Dollarc. Poundd.

Whichofthefollowingistheabilitytoexchangemoneyforgoldorothercurrencies?4. Balance of paymentsa. Currency convertibilityb. Capital accountc. Capitaloutflowd.

The balance on the reserves account (BRA) represents the change in the _______.5. long term investmenta. capital accountb. current accountc. officialreserved.

WhichofthefollowingstatementisFALSE?6. There has been a slight improvement in India’s external debt positiona. Convertibility of a currency is a matter of degreeb. Capital account deals with payments of debts and claimsc. Officialreserveaccountformsaspecialfeatureofthecurrentaccountd.

Capital account deals with payments of ______and claims7. capitala. moneyb. debtsc. currencyd.

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Which of the following are reserves assets created by IMF and allocated from time to time to member 8. countries?

SDRsa. BOPb. CIFc. FOBd.

Balanceofpaymentshavethesametimingdimensionasof?9. Capital account structurea. National income accountingb. Unilateral transfersc. Invisibles Accountd.

Capitaloutflowfromthehomecountrytoaforeigncountryistreatedas?10. Credit itema. Transferb. Fundsc. Debt itemd.

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Chapter V

International Monetary System

Aim

The aim of this chapter is to:

introduce evolution of the international monetary system•

describe the European Monetary Union•

explain exchange Rate Mechanisms•

Objectives

The objectives of this chapter are to:

explainfinancialCrisisinthePostBrettonWoodsEra•

classify the four stages of evolution of international monetary system •

describethefixedexchangeratesystem,floatingexchangeratesystemandhybridmechanism•

Learning outcome

At the end of this chapter students will be able to:

explain third world debt crisis and Argentinean crisis•

talk about Mexican currency crisis of 1995•

describe the Brazilian crisis•

introduce the Asian crisis of 1997 and • the lessons from the Asian currency crisis

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5.1 Introduction to International Monetary SystemTheinternationalmonetarysystemcanbedefinedastheinstitutionalframeworkwithinwhichinternationalpaymentsare made, movements of capital are accommodated and exchange rates among currencies are determined. It is a complex range of agreements, rules, institutions, mechanisms and policies regarding exchange rates, international paymentsandtheflowofcapital.Theinternationalmonetarysystemhasevolvedovertimeandwillcontinuetodoasin the future as the fundamental business and political conditions underlying the world economy continue to shift.

5.2 Evolution of the International Monetary SystemThe International Monetary System went through several distinct stages of evolution. These stages are summarised as follows:

bimetallism•gold standard•bretton woods system•flexibleexchangerateregime•

5.2.1 Bimetallism Before 1875The international monetary system before the 1870’s can be characterised as ‘bimetallism’ in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents, around 1870.

For example, the exchange rate between the British pound, which was fully on a gold standard and the French franc, whichwasofficiallyabimetallicstandard,wasdeterminedbythegoldcontentofthecurrencies.Ontheotherhand,the exchange rate between franc and the German Mark was determined by their exchange rates against the franc. It is also worth noting that due to various wars and political upheavals, some major countries such as United States, Russia and Austria, Hungary had irredeemable currencies at one time or another during the period 1848 – 79. One might say that the international monetary system was less than fully systematic until the 1870’s.

5.2.2 The Gold StandardThe gold standard had its origin in the use of gold coins as a medium of exchange, limit of account and store of value – a practice that dates back to ancient times. When international trade was limited in volume, payment for goods purchased from another country was made in gold or silver. However, as the volume of international trade expanded inthewakeoftheIndustrialRevolution,amoreconvenientmeansoffinancinginternationaltradewasneeded.Shippinglargequantitiesofgoldandsilveraroundtheworldtofinanceinternationaltradeseemedimpractical.Thesolution was to arrange for payment in paper currency and for governments to agree to convert the paper currency intogoldondemandatfixedrates.

Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the world’s trading nations including Great Britain, Germany, Japan and the United States had adopted the gold standard, given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine.

The strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance of trade equilibrium by all countries. A country is said to be in balance of trade equilibrium when the income of its residents earned from exports is equal to the money its residents pay to people in other countries for imports (the current account of its balance of payments is in balance). Suppose, under the gold standard, when Japan (its trade withUnitedStates)hasatradesurplus,therewillbenetflowofgoldfromtheUnitesStatestoJapan.ThisgoldflowwillreducethemoneysupplyofUSandswellJapan’smoneysupply.Anincreaseinmoneysupplywillraiseprices in Japan, while a decrease in the US money supply will push US prices downward. The rise in the price of Japanese goods will decrease demand for these goods, while fall in prices of US goods will increase demand for these goods. Thus, Japan will buy more from the United States and the United States will buy less from Japan, until the balance of equilibrium is established.

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The Gold standard worked reasonably well until the start of World War I in 1914. During the war, several governments financedpartoftheirmassivemilitaryexpendituresbyprintingmoney.Thisresultedinallroundinflationwhenthe war ended in 1918. The United States returned to the gold standard in 1919, Great Britain in 1925 and France in 1928.

Great Britain returned to the Gold standard by pegging the pound to gold at the pre-war gold parity level despite substantialinflationduring1914–1925.ThisresultedinBritishgoodsbeingoutofforeignmarketsresultingintoadeepdepression.WhenforeignholdersofpoundslostconfidenceinGreatBritain’scommitmenttomaintainitscurrency value, they began converting their pound holdings into gold. The British government said it could not satisfy the demand of gold without seriously depleting its gold reserves, so it suspended convertibility in 1931.

The US followed suit and left the gold standard in 1933 but returned to it in 1934, raising the dollar price of gold byaround70%.Sincemoredollarswerenecessarytobuyoneounceofgoldthanbefore,thedollarwasworthless. This resulted in devaluation of the dollar relative to other currencies. By reducing the price of US exports and increasing the price of imports, the government was trying to create employment in the United States by boosting output. However, a number of other countries adopted a similar tactic and in the cycle of competitive devaluation, no country could win.

Thenetresultwastheshatteringofanyremainingconfidenceinthesystem.Insteadofholdingontoanothercountry’scurrency, people often tried to change into gold immediately lest the country devalue its currency. This put pressure on the gold reserves of various countries forcing them to suspend gold convertibility. By the start of World War II, the gold standard was dead.

5.2.3 The Bretton Woods SystemIn 1944, when the World War II was at its peak, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. With the collapse of the gold standard and the great depression of the 1930’s fresh in their mind, these statesmen wanted to have an enduring economic order that would facilitate post war economic growth.The general consensus was as follows:

Fixed exchange rates were desirable•The participants wanted to avoid the competitive devaluations of the 1930’s.•

The agreement which reached at Bretton Woods contained the following:Two multinational institutions: The International Monetary Fund (IMF) and the World Bank were created. The •IMF embodied an explicit set of rules about the conduct of international monetary policies and was responsible for enforcing these rules. The other institution The International Bank for Reconstruction and Development (IBRD) betterknownastheWorldBankwaschieflyresponsibleforfinancingindividualdevelopmentprojects.Each country established a par value in relation to the US Dollar, which was pegged to gold at $ 35 per ounce. •All participating countries agreed to try to maintain the value of their currencies within 1 percent of the par value by buying or selling currencies (or gold) as needed. The US dollar was the only currency that was fully convertible to gold, other currencies were not directly convertible to gold. Countries held US dollars as well as gold, for use as an international means of payment.A commitment was made by member countries not to use devaluation as a weapon of competitive trade policy. •However, if a currency became too weak to defend, a devaluation of upto 10 percent would be allowed without any formal approval by the IMF. Larger devaluations require IMF approval.

The role of IMF:The aim of the Bretton Woods Agreement, of which IMF was the main custodian, was to try to avoid a repetition ofthatchaosthroughacombinationofdisciplineandflexibility.

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Discipline:Theneedtomaintainafixedexchangerateputsabreakoncompetitivedevaluationsandbringsstabilitytothe•world trade environment.Afixedrateregimeimposesmonetarydisciplineoncountries,therebycurtailingpriceinflation.•

Flexibility:Lending facilities:• The IMF was ready to lend foreign currencies to members tide with them over a short periodofbalanceofpaymentsdeficits,whenarigidtighteningofmonetaryorfiscalpolicywouldhurtdomesticemployment. A pool of gold and currencies contributed by IMF member’s funds would buy time for countries tobringdowntheirinflationratesandreducetheirbalanceofpaymentsdeficits.Thebeliefwasthatsuchloanwould reduce pressures for devaluation and allow for a more orderly and less painful adjustment.Adjustable parities:• The system of adjustment parities allowed devaluation of a country’s currency by more than 10 percent if the IMF agreed that a country’s balance of payments was in “fundamental equilibrium”. The term“fundamentaldisequilibrium”wasnotdefinedintheIMF’sArticlesofAgreement,butitwasintendedtoapply to countries that had suffered permanent adverse shifts in the demand for their products.

Role of World Bank:TheofficialnamefortheWorldBankistheInternationalBankforReconstructionandDevelopment.The bank lends money under two schemes:

Under the IBRD Scheme, money is raised through bond sales in the international capital market. Borrowers pay •what the bank calls a market rate of interest. The bank’s cost of funds plus a margin for expense. This “market rate” is lower than commercial bank’s market rate. Under the IBRD Scheme, the bank offers low-interest loans to risky customers whose credit ratings are often poor.The second scheme is overseen by the International Development Agency (IDA), an arm of the bank created •in 1960. Resources to fund IDA loans were raised through subscriptions from wealthy members such as ULS, Japan and Germany. IDA loans go only to the poorest countries.

The failure:Under this system, the member countries had the option of pegging their currencies to either gold or to the dollar, the only reserve asset mentioned in the agreement establishing the system was gold. However, as the gold stocks did not increase substantially in the year following the agreement, this provision acted as a bottleneck to the growth ofinternationaltrade.Increaseintradenecessitatedincreaseinofficialreservesheldbyvariouscountriesinorderto facilitate payment for these trades. To get around the problems, countries started holding dollar reserves. They held reserves in the form of interest bearing securities issued by the U.S. Govt. This was encouraged by the US. Since US could pay for its increased imports just by printing additional money, without suffering a reduction in its reserves. Since other governments were ready to hold dollar reserves and not convert them into gold, the US started following a system of fractional reserves. The total number of dollars issued by the Federal Reserves (The American Central Bank) was far in excess of the value of the gold held by it. This created a paradox in the system known as TriffinparadoxortheTriffindilemma,afteraYaleUniversityProfessor,RobertTriffin,whofirstspokeaboutitin1960.Accordingtohim,itwasnecessaryfortheUStorunBalanceofPayments(BoP)deficitstrategytosupplytheworldwiththeadditionaldollarreservesneededforincreasedinternationaltradeyet,asitsdeficitincreasedthevolume of dollar reserves held by other countries grew without a simultaneous increase in US’s gold reserves, its ability to honour its commitment (converting dollars into gold) would decrease. Such a situation would result in decreasedconfidenceinthesystemandultimatelythesystembreakingdown.

Another problem with the system was that it had become too rigid, despite the aim of the members being otherwise. As the system provided for realignment of exchange rates in case of fundamental disequilibrium, predicting exchange rate movements became very easy. This put currencies at the mercy of private speculation. If a country started facing regularBoPdeficits,peoplewouldstartfacingregularBoPdeficits,peoplewouldstartexperiencingadevaluationofitscurrency.Attemptingtoprofitfromsuchascenario,privatespeculatorswouldstartsellingthecurrencyforgold or some other currency which was expected to remain strong in the hope of buying later at a reduced price withthesecapitaloutflows,thereservesofthecountrywouldgodown,eventuallyforcingittodevalueitscurrency.

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Theseoutflowscouldonlybestoppedbyfirmcommitmentbytheconcernedgovernmentattheverybeginningofnotdevaluingsuchcurrency.Aftermakingsuchacommitment,thecountrywouldfinditverydifficulttogofordevaluation, since the latter would make it lose its creditability and the possibility of controlling the market next time would be very bleak. The country cannot adopt other adjustment mechanisms which are generally not acceptable to them (which imply a contraction of the economy, thus resulting in increased unemployment), but to devalue it in a catch 22 situation. A country whose currency faces an upward pressure would also face a similar problem as the inflationresultingfromanattempttostopitscurrencyfromappreciatingmaynotbeacceptableandtheonlyotheroption left would be to revalue the currency.

In the early 50’s, the US was running the BoP surplus and there was shortage of dollars in the international markets. By the late 50s however, the US BoP situation had reversed and there was excess supply of dollars. So much so, that there was a considerable reduction in US. Gold holdings and the general belief that the dollar had become over valued and a connection in its value were due. This situation occurred due to two reasons:

Devaluation of other currencies vis-à-vis the dollar in the previous decade, which made American goods less •competitive in the international markets. HighinflationrateprevailingintheUS.•

In1960,thevalueofgoldflaredupinLondonwheremostoftheprivategoldtradingtakesplace.Topreventthemarketsfromgoingtoofarofffromtheofficialpriceof$35perounce,theUSarrivedatagoldpoolarrangementwith 7 other countries, under which they sold gold in London. This helped in controlling the gold prices in the short run.Ataroundthesametime,USinflationstartedcomingdownanditsBoPsituationstartedimproving.Bytheearly60’s,USwasenjoyingacurrentaccountsurplus.ThiswasbeingbalancedbycapitalflowsoutofUS,mostlyon account of US companies investing in Europe. In an attempt to reduce unemployment in the US, monetary tighteningwasnotintroduceddespitetheoverallBoPfigureremainingnegative.BelievingthattheincreasingtrendinthecurrentaccountbalancewouldcontinueandtheBoPdeficitwasashort-termphenomenon,thegovernmentlookedatshort-termarrangementsfortidingovertheBoPdifficulties.Ittriedtopersuadeforeigngovernmentsnottoconvert their dollar holdings into gold, opened credit lines with foreign central banks and drew small amounts from IMF. It also entered into the General Arrangements to Borrow (GAB), an agreement with 9 other major countries to form the Group of Ten (G – 10). The members of this group agreed to lend their currencies to IMF in case any one of them needed to draw a huge sum from it.

Despiteallthesesteps,theBoPpositiondidnotturnpositiveascapitaloutflowscontinued.ThemainreasonwasthecontinuinghighinflationrateintheUSeconomy.WiththeUSneedingalotofmoneytofinanceitscommitments(to provide money for the reconstruction of the various wars ravaged economies) under the Marshall Plan and its ownexpensesduetotheVietnamWar,themoneysupplyincreaseddrastically,thuspushingtheinflationtohighlevels.TheUSgovernmentthenstartedimposingvariousrestrictionsoncapitalflows.An‘interestequalisationtax’was introduced on purchase of foreign securities by US citizens and its citizens were prohibited from holding gold either within the country or outside. In 1965, American banks and companies were told to voluntarily restrict loans to foreigners, and foreign direct investments respectively. In 1968, these controls were made compulsory. By then, however, the current account had also weakened. The pressure on the dollar started building up.

Otherdeficitcountrieswerealsofacingproblems.BritainstartedfacingaBoPdeficitintheearly60sandwantedtodevalue the pound. The US objected as it felt that pound devaluation would fuel expectations of dollar devaluation and speculators would start taking positions against it, forcing it to be devalued. Due to the US objection, UK held on for some time, borrowing heavily from other governments and IMF to defend the pound’s exchange rate. It finallygaveupin1967andthepoundwasdevalued.In1968,capitalstartedflowingoutofFranceduetocertainpolitical disturbances there. In order to stop these disturbances, the French government had to increase wages, which resulted in making the French industry less competitive. This resulted in a pressure on the value of the French franc especially the DM. Neither France nor Germany took any action, as both of them wanted the other one to change thevalueofitscurrencywithrespecttothedollar.In1969,thefrancwasfinallydevalued.

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These problems put a lot of strain on the system. The pound devaluation did have the expected effect on the outlook for the dollar, and the pressures on that currency increased so much that even interventions by the gold pool group could not have the desired effect. In 1968, the sales by the gold pool in the private market were abandoned and the dollar was made non-convertible into gold for private market players. The Fed decided to convert only Central Bank’s dollar holdings into gold.

After the franc’s devaluation, there was increased speculation, especially regarding the DM. When the German authoritiescouldnomorestoptheircurrencyfromappreciating,theyletitfloattemporarily,ratherthanimportingUSinflationviathepriceadjustmentmechanism.ThiswasthefirstbreakintheBrettonWoodssystemafter1950,inwhichyeartheCanadiandollarwasallowedtofloat.TheGermanauthoritiesletthemarkappreciateby10%atwhich level they re-established the peg with the US dollar.

As the system started facing these problems and the pressure on the dollar increased, a new reserve asset was created by the IMF in 1967. Named SDRs (Special Drawing Rights), this international currency was allocated to the IMF membercountriesinproportiontotheirquotas.ThebiggestbenefitofSDRswasthattherewouldbeaprovisionforinternationalmoneytobecreatedwithoutanycountryneedingtorunaBoPdeficitortominegold.Itsvaluelay not in any backing by a currency or a real asset (like gold), but in the readiness of the IMF member countries to accept it as a new form of international money. Any member country, when facing payment imbalances arising outofBoPdeficits,coulddrawontheseSDRs,aslongasitmaintainedanaveragebalanceof30%ofitstotalallocations. It could then sell these SDRs to a surplus country in exchange for that country’s currency, and use it for settlement of international payments. Every member country was obliged to accept up to 3 times its total allocations asasettlementofinternationalpayments.Itisaninterest-bearingsourceoffinance,i.e.countriesholdingtheirSDRs receive interest, and the ones drawing on them pay interest. This interest rate is determined on the basis of the average money market interest rates prevailing in France, Germany, Japan, the UK and the US. Only the member countriesofIMFandspecificofficialinstitutionsareeligibletoholdSDRs.SDRisalsotheunitofaccountforallIMF transactions.

The value of an SDR was initially determined as equal to that of the dollar, i.e., one ounce of gold was equalised to 35 SDRs. Later its value was revised and put equal to the weighted average value of 16 major currencies. Again, the basketofcurrencieswassimplifiedandreducedto5currencies–USDollar,Yen,PoundSterling,DMandFrenchFranc. Both the times, the weights were based on the importance of the respective countries in world trade. Both the basketandtheweightsaresupposedtoberevisedeveryfiveyearstoreflectthechangedscenarioininternationaltrade and the various countries’ importance in it. An important advantage of the SDR is that its value is more stable than that of individual currencies. This happens because it derives its value from a number of currencies, whose values are unlikely to vary in the same direction and to the same extent. This feature makes it a better unit of account than a single currency.

Despite the introduction of SDRs, the crisis continued to deepen. By this time, US’s gold holdings had reduced considerably(bothasanabsolutefigureandasaproportionofitsforeignliabilities).By1979,itsreservepositionturnednegativeastheBoPdeficitincreaseddrastically.Inthefirstthreemonthsof1971,hugepressurebuiltupagainst the dollar, especially with respect to the mark. A number of countries had to buy a lot of dollars to defend their exchange rates. Germany, not intending to increase its money supply to unmanageable proportions, once againfloateditscurrency.InApril1971,theUSsufferedatradedeficitforthefirsttime,butitcouldnotfollowcontraction policies as it was simultaneously suffering from high unemployment. The only option left to it was to devalue. Even that it could not do on its own, as the increasing price of gold in terms of the dollar would not have had the desired effect due to other currencies being pegged to the dollar directly (rather than through gold prices). Also, an unexpected devaluation of the dollar would have penalised those countries, which were trying to help the USbyholdingontodollarsinsteadofconvertingthemintogold.Mostofthecountriesheldontodollarsinthefirsthalf of 1971. In the beginning of August, France needed gold to repurchase francs from the IMF, which it had sold earlierinhardertimes.Itfulfilledthisneedbyconvertingitsdollarholdingsintogold.AsgoldreservesoftheUSfell and rumours spread about Britain also trying to follow the same route as France, panic spread in the international markets about US’s ability to honour its commitment to convert all dollar holdings into gold. This caused a run on its gold reserves as all countries rushed to get their dollar holdings converted when they could. This precipitated the

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matterssomuchthattheUSdecidedtostopconvertingdollarsintogoldandletitscurrencyfloatonAugust15,1971.ToimproveitsBoPposition,itsimultaneouslyimposedanadditional10%tariffonimports.Hence,thetwomostimportantpillarsofthesystemweregone–fixingofpricesofcurrenciesintermsofgoldandtheirconvertibilityintogold.Asareactiontothisdevelopment,manyofthecountrieslettheircurrenciesfloat.

TheintentionoftheUSbehindthesestepswasnottoshiftfromapeggedexchangeratesystemtoafloatingratesystem, but to seek a realignment of exchange rates. Therefore, it called for a meeting of the 10 largest IMF member countries, which was held in December 1971, at the Smithsonian Institute in Washington, and considered the issue of realignment. As a part of the agreement, many of the countries revalue their currencies in terms of the dollar, while the dollar was devalued by raising the price of gold from $ 35 to $ 38 per ounce. The other part of the system i.e., the facility of conversion of dollars into gold, however, was not re-established. The band around the parity rates wasincreasedfromonepercentto2.25percentoneachside,thusprovidingthecentralbanksmoreflexibilityinthemanagement of exchange rate and monetary policy. It was also agreed to liberalise trade policies and to introduce moreflexibilitytoexchangerates.

When the demand curve for exports is relatively inelastic, a devaluation of a country’s currency does not immediately lead to an improvement in its current account balance. In the initial period, the reduction in the price of the exports is much more than the increase in the volumes and hence there is a net reduction in exports. In the long run, however, the volumes pick up and the net exports start rising. The current account curve, thus traces a J – shape. It firstbecomesworsethanitspositionbeforethedevaluation,andthenimproves.ThisiscalledtheJ–curveeffect.The US’s BoP behaved in a similar manner after the Smithsonian agreement. It was misinterpreted to mean that the devaluationofthedollarwassmallerthanitshouldhavebeen.Inmid1972,theUKfloatedthepoundasaresponseto BoP problems. This again fuelled speculation against the dollar, with dollar being abandoned in favour of the mark and yen. In February 1973, the dollar came under extreme selling pressure due to these factors and the high inflationrate,whichcontinuedtoreignintheUS.Itwascontemplatingdevaluingthedollaronceagain,butwaspre-emptedbySwitzerland,whichfloateditscurrency.Thedollarwas,nevertheless,devaluedbyraisingthepriceof gold to $41.22 per ounce. In mid March, 14 major industrial countries followed Switzerland by abandoning the systemandfloatingtheircurrencies.Withthis,thesystemcametoanend.

5.2.4 Post Bretton Woods System (The Current System)AstheBrettonWoodsSystemwasabandoned,mostcountriesshiftedtofloatingexchangerates.ThisfactwasfinallyrecognisedbytheIMFandthearticleswereamendedinitsagreement.Theamendmentwasdecideduponin Jamaica in 1976 and became effective on April 1, 1978. This was the second amendment to IMF’s articles. Under thenewarticles,countriesweregivenmuchmoreflexibilityinchoosingtheexchangeratesystemtheywantedtofollowandinmanagingtheresultantexchangerates.Theycouldeitherfloatorpegtheircurrencies.Thepegcouldbe with a currency, with a basket of currencies or with SDRs. The only restriction put was that the pegging should notbedonewithgold.Neitherwasthemembercountryallowedtofixanofficialpriceforgold.Thiswasdonetoreduce the role of gold and to make SDRs more popular as a reserve asset. For the same reason, the value of an SDRwasredefinedintermsofabasketofcurrency(tomakeitmorestableandhencepreferableasareserveasset),rather than in dollar terms. Also, the members were no longer required to deposit a part of their quota in gold, and IMF sold off its existing gold reserves. In order to make SDRs more attractive as a reserve asset, they were made interest bearing. It was allowed to be used for different types of international transactions. The member countries were also left free to decide upon the degree of intervention required in the forex markets, and could hence make it compatible with their economic policies. Secondly, IMF was given increased responsibility for supervising the monetary system. As a part of these increased responsibilities, IMF was required to identify those countries which were causing such changes in the exchange rates through their domestic economic policies, which proved disruptive to international trade and investment. It could then suggest alternate economic policies to these countries. IMF was also responsible for identifying any country which was trying to defend an exchange rate which was inconsistent with the underlying economic fundamentals. This was to be done by a constant monitoring of the reserves position of various countries. Lastly, the new articles made it easier for countries facing short-term imbalances in their BoP accounts to access IMF’s assistance.

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While countries were free to determine their exchange rate policies, under Article IV of the Agreement, they were requiredtoensurethattheeconomicandfinancialpoliciesfollowedbythemweresuchastofoster‘orderlyeconomicgrowth and reasonable price stability’. They also had to follow principles of exchange rate management, adopted by IMF in April 1977. According to these principles:

A member country neither should manipulate the exchange rates in such a way as to prevent a correction in the •BoP position, nor should it use the exchange rates to gain competitive advantage in the international markets.A member country was required to prevent short-term movements in the exchange rates, which could prove •disruptive to international transactions, by intervening in the exchange markets.While intervening in the forex markets, a member country was required to keep other countries’ interests in •mind, especially the country whose currency it chooses to intervene in.

These principles attempted to bring some stability in the forex markets and to prevent another attack of competitive devaluations.

5.3 The European Monetary UnionThe basis of the European Monetary Union was the American desire to see a United Western Europe after World War II. This desire started taking shape when the Europeans created the European Coal and Steel Community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonise domestic policies (economic, social and other policies which were likely to have effect on the said integration), the ultimate aim was economic integration. The European countries desired to maketheirfirmsmorecompetitivethantheirAmericancounterpartsbyexposingthemtointernalcompetitionandgiving them a chance to enjoy economies of scale by enlarging the market for all of them.

The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non-member countries to protect the regional industry from lower external prices. An important roadblockintheEuropeanunificationwas,thepowergivenunderthetreatytoallthemembercountries,bywhichthey could veto any decision taken by other members. This hindrance was removed when the members approved the Single European Act in 1986, making it possible for a lot of proposals to be passed by weighted majority voting.Thispavedthewayfortheunificationofthemarketsforcapitalandlabour,whichconvertedtheEECintoa common market on January 1, 1993. Meanwhile, a number of countries joined EEC. Denmark, Ireland and the United Kingdom joined in 1973. By 1995, Austria, Finland, Greece, Portugal, Spain and Sweden had also joined, thus bringing the membership to 15.

The structure of the EEC consists of the European Commission, a Council of Ministers and a European Parliament. The Commission’s members are appointed by the member countries’ governments and its decisions are subject to the approval of the Council, where by convention, either the Finance Ministers or the heads of the Central Bank represent their respective countries. The Members of the Parliament are directly elected by the voters of the member countries. In December 1991, the Treaty of Rome was revised drastically and the group was converted into the European Community by extending its realm to the areas of foreign and defence policies. The members also agreed to convert it into a monetary union by 1999.

AstheBrettonWoodssystemwasbreakingdownin1973,sixoutoftheninemembersoftheEECjointlyfloatedtheircurrenciesagainstthedollar.WhileBritainandItalydidnotparticipateinthejointfloat,Francejoinedanddroppedoutrepeatedly.Thecurrenciesoftheparticipatingcountrieswereallowedtofluctuateinanarrowbandwithrespecttoeachother(1.125%oneithersideoftheparityexchangerate),andthepermissiblejointfloatagainstothercurrencieswasalsolimited(to2.5%oneithersideoftheparity,bytheSmithsonianagreement).Thisgavethe currency movements the look of a ‘snake’, with the narrow internal band forming the girth and the movements against other currencies giving the upward and downward wriggle. The external bank restricting the movement of

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these European currencies on either side, gave the impressions of a ‘tunnel’ thus giving rise to the term ‘snake in the tunnel’. The idea of creating a monetarily stable zone started taking shape in 1978, which resulted in the creation of the European Monetary System in 1979. The system was quite similar to the Bretton Woods System, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was createdforthepurpose.ItwasnamedtheEuropeanCurrencyUnit(ECU)andwasdefinedasaweightedaverageofthevariousEuropeancurrencies.EachmemberhadtofixthevalueofitscurrencyintermsoftheECU.Thishadthe effect of pegging these currencies with each other. Since each currency could vary against the ECU and against othercurrencieswithacertainbandoneithersideoftheparityrate(2.25%forothersand6%forPoundSterling,Spanish peseta and Portuguese Escudo), a certain grid was formed which gave the limits within which these currencies could vary against each other. Whenever the exchange rate between two of the member currencies went beyond the permissible limit, both the countries had to intervene in the forex markets. This co-operation between the countries was expected to make the system more effective. Another important feature of this system was that the members could borrow unlimited amounts of other countries’ currencies from the European Monetary Cooperation Fund in order to defend their exchange rates. This was expected to ward off any speculative activities against a member currency. Though the countries involved were also expected to simultaneously adjust their monetary policies, this burdenwasputmoreontheerringcountry.Itwaseasiertofixtheblame,asatthetimeofthefluctuationintheexchange rate of two members, the erring country’s exchange rate would also be breaching its limits with respect to the ECU and other member currencies. When these parity rates became indefensible, they could be realigned by mutualagreement.Thesystemwas,thus,muchmoreflexiblethantheBrettonWoodssystem.

The ECU also served as the unit of account for the EMS countries. It served another important purpose in that, loans among EMS countries (including private loans) could be denominated in the ECU. The ECU’s value being the weighted average of a basket of currencies, it was more stable than the individual currencies. This made it more suitable for international transactions.

Anumberofrealignmentstookplaceinthefirstfewyearsofthesystem.However,the1980’ssawthesystembecomingmorerigid.TheGermanCentralBank,theBundesbank,wascommittedtoalowinflationrate,andhenceto a tighter monetary policy. Some other countries (especially France and Italy, who had meanwhile joined the EMS) triedtocontroltheirdomesticinflationbynotrealigningtheircurrency’sexchangeratewiththeDMandinsteadfollowing the same monetary policy as the Bundesbank. The UK, which joined the EMS in 1990, also followed the same policy. This resulted in a high unemployment rate in such countries. This cost was acceptable to these countries,tillthesituationchangeddrasticallywiththeeffectsofthe1990Germanunificationslowlybecomingvisible.AstheformerWestGermanyboretheexpensesoftheunification,itsbudgetdeficitstartedrising,increasingtheGermanpricesandwages.Tokeepinflationundercontrol,theBundesbankhadtoincreasetheinterestratestoan even higher level. If the DM had been allowed to appreciate at that time, the Bundesbank would not have had to increase the interest rates too much, as German prices would have reduced in response to the higher DM. But as some other member countries of the EMS refused to let the DM appreciate, they had to increase their domestic interest rates in response. This happened at the time when many of the European countries were experiencing very high unemployment rates and Britain was going through a recession.

The situation became worse with the decision of the EC countries to go ahead with monetary union. In 1989, the report of a committee chaired by the president of the European Commission, Jacques Delor, was published. It recommended that the members of the EC abolish all capital controls and follow one common monetary policy. This monetary policy was proposed to be formulated by a European Central Bank (ECB), and followed by the central banks of all the member countries, which would become a part of the European System of Central Banks (ESCB). It also recommended the irrevocable locking of the EC Exchange Rates and the introduction of a common currency forthemembernations.Inthesameyear,thefirststageoftheprocessofeconomicintegrationbegan,andmostof the recommendations of the Delor Committee report were accepted. However, it was decided that, to make the integration long lasting, member countries were to achieve a high degree of economic convergence before being allowed to merge their economies with the rest of the group.

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In December 1991, as a follow up to the Delor’s report, the Treaty of Rome was revised extensively to provide for the monetary union. As these revisions were adopted in the Dutch town of Maastricht, they collectively came to be known as the Maastricht Treaty. The treaty laid down the timetable for the monetary union. According to thetimetable,theunionwastobecompletedby1999,andthequalifyingcountrieshadtofulfilcriteriaregardinginflationrates,exchangerates,interestratesandbudgetdeficits.Asthemarketsbelievedthesecriteriatobetoohardfor some countries to achieve, speculative pressure against the currencies of these countries started building up. By September1992,thepressurereacheditspeak.ThefirstcountrytobearthebruntofthespeculativeattackswasItaly.Evenasitsgovernmentannouncedasetoffiscalreformstobeabletomeettheconvergencecriteria,pressuresagainst the lira continued. Finally, Germany and Italy entered into a deal under which Italy devalued the lira and Germany reduced its interest rates. The UK was also facing a similar attack on its currency, and had to withdraw from the EMS soon after the Italian devaluation. Despite having already devalued its currency, Italy followed Britain and pulled its currency out of the EMS. Immediately afterwards, French voters approved the Maastricht Treaty. Yet, this approval could not stop an attack against the French franc. Even Bundesbank and the Banque de France (the French central bank) together could not postpone the inevitable for long. In July 1993, there was another attack on the franc as it became clear that the French and German interest rates would not converge. The French unemployment rates being very high and continuing to rise, it could be foreseen that a further possibility of interest rates rising there did not exist. At the same time, the German government could not be expected to reduce the interest rates as inflationwasstillnottotallyundercontrol.Itbecameclearthatthefranchadtobedevaluedvis-à-vistheDM,butneither of the countries was ready to adjust the parity rates of their currency. Finally, the EMS countries decided tochangethebandfrom2.25%to15%.GermanyandtheNetherlandskeptthebandbetweentheircurrenciesat2.25%.Thebandforpesetaandtheescudocontinuedat6%.Thoughthischangeinthebandsuccessfullywardedoff the speculative attacks against the franc, the monetary convergence got a severe setback as there was no more needforcountriestoconvergetheirmonetarypolicies.Withthebandbecomingsowide,therewasnorealfixedexchange rate system left to talk about.

Despite these developments, the desire of the European countries to form a monetary union did not fade. After being ratifiedbyallmembercountries,theMaastrichtTreatycameintoeffectfromNovember1,1993.Thus,theEuropeanandMonetaryUnioncameintobeing.Thefirststageoftheunioncontinueduptotheendof1993.Duringthisstage,capitalflowsandthefinancialsectorwerefullyliberalised.Thememberswerealsorequiredtokeeptheircurrencieswithina2.25%bandoftheparityrates.ThesecondstagebeganinJanuary1994,withtheestablishmentoftheEuropean Monetary Institute (EMI) in Frankfurt, which was the precursor to the ECB. Its job was to manage the EMS, co-ordinate national monetary policies and to prepare for the creation of the ESCB. It’s most important function was to monitor economic convergence among the member countries, a job to be shared by the EC, the Bundesbank and the Banque de France. In this stage, the governments were not allowed to borrow from their central banks at concessional rates and had to do so at market determined rates. They were required to systematically reduce their fiscaldeficitsandbringothereconomicindicatorsinline.InDecember1995,asummitwasheldinMadrid,wherethesingleEuropeancurrencywasnamedtheeuro,andastricttimetablefortheEMUwasfinalised.InDecember1996, the Dublin summit was held and it was decided to give full autonomy to the ECB. The rules which the ECB would have to follow for regulating monetary policy and to ensure exchange rate stability were also formulated. In May 1998, the heads of the member governments met in Brussels and presented the reports of the various agencies responsible for monitoring the convergence of the various members. In accordance with the Maastricht Treaty, the membercountrieswererequiredtofulfilthefollowingcriteriabytheendof1997:

Fiscaldeficitshouldbewithin3%ofGDP.•Publicdebtshouldnotexceed60%ofGDP.•The inflation rate should not bemore than 1.5% higher than that of three countries having the lowest•inflation.The long term interest rates should not exceed the long term interest rates of the above mentioned 3 countries •bymorethan2%.The currency should have stayed within the ERM band for a minimum period of two years without any •realignment.The central banks should be autonomous.•

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According to the reports prepared by these agencies, the heads of states voted for selecting the countries which were eligible to join the EMU. 11 countries were allowed entry into the union, they being Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Britain, Denmark and Sweden opted out of choice despite being eligible and Greece was found ineligible. At the same time, the ECB was established. The day-to-day management of the ECB is the responsibility of an executive board. The board has a total of six members including a president and a vice-president. These members are appointed by consensus and enjoy an eight year, non-renewable term. The managing body of the ECB is the governing council which consists of the executive board and the governors of the central banks of the EMU countries. The main functions of the ECB are to:

determine the monetary policy and to implement it•support the member countries in implementing their economic policies, if that does not entail going against its •main aim of maintaining price stabilityhelp the member countries in managing their forex reserves and to conduct forex operations•ensure a smoothly operating interbank payments system•

ThemostsignificantdevelopmentwastheintroductionofasinglecurrencyfortheparticipantsoftheEMU–theeuro.On January 1, 1999, the euro came into being. On this date, the exchange rates of the currencies of the participating nationswiththeeurowereirrevocablyfixed.Therewillbeatransitionperiodofthreeyearsduringwhichthesecurrencies will exist along with euro. However, from this date, all inter bank payments will be in Euros, there will be no inter bank quotes between the dollar and local currencies, all new government debt will be denominated in Euros, the ECB will conduct repo transactions in Euros, and all stock exchange quotations for equities and trades and settlements of government debt and equity will be in euro. On the retail level, the bank statements and the creditcardbillswillbegivingtheeuroequivalentsofthenationalcurrencyfigure.Aboveall,fromthesamedate,the ECB started formulating a common economic policy for the participating nations. Between January 1, 1999 and December 31, 2002 all retail transactions will be settled in the national currencies. As planned, euro notes and coins were introduced on January 1, 2002. The next 6 months will be the dual currency period in which both euro and the national currencies will be phased out and from July 2002, euro will be the only legal tender. As there will be a singleEuropeancurrencyandhencenofluctuationofexchangerates,theintroductionofeuroisexpectedtoresultinamoreefficientsinglemarket,andstimulatetrade,growthandemploymentintheregion.Thesinglecurrencyresults in elimination of transaction costs, which results from the need to convert one currency into another.

5.4 Exchange Rate MechanismsTheexchangeratecanbeformallydefinedasthevalueofonecurrencyintermsofanother.Therearedifferentwaysinwhichexchangeratescanbedeterminednamelyfixed,floatingorwithlimitedflexibility.Differentsystemshavedifferent methods of correcting mismatch between international payments and receipts.

5.4.1 Fixed Exchange Rate SystemUnderthefixed(orpegged)exchangeratesystem,thevalueofacurrencyintermsofanotherisfixed.Theseratesare determined by the governments or the Central Banks of the respective countries. There is some provision for correctingthesefixedratesincaseoffundamentalmismatch.Thevariationsofthefixedratesystemare:

Currency bound system•Target zone agreement•Monetary union•

Current bound systemUnderacurrencyboundsystem,acountryfixestherateofitsdomesticcurrencyintermsofaforeigncurrency,and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged. Due to the pegging, the monetary policies and economic variablesofthecountryofthereferencecurrencyarereflectedinthedomesticeconomy.Ifthefundamentalsofthedomestic economy shows a wide disparity from that of the reference countries, there is a pressure on the exchange ratetochange.Thismayleadtoarunonthecurrency,thusfixingtheauthoritiestoeitherchargeoraltogetherabandon the peg. To prevent such an event, the monetary policies are kept in line with the reference country by the Central Monetary Authority, called the currency board.

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Target zone arrangementUnder this arrangement, a group of countries sometimes get together and agree to maintain the exchange rates between theircurrencieswithinacertainbandaroundfixedcountries’exchangerates.Convergenceofchronicpolicies of the participating countries is a pre-requisite for the sustenance of this system. An example of this system is the European Monetary System under which twelve countries came together in 1979.

Monetary unionThis is the next logical step of target zone arrangement, under which a group of countries agree to use a common currency instead of their individual currencies. An independent common Central Bank is set up which has the sole authority to issue currency and to determine the monetary policy of the group as a whole.

5.4.2 Floating Exchange Rate SystemUnder this system, the exchange rates between currencies are variable. These rates are based on demand and supply forthecurrenciesintheinternationalmarket.These,inturn,dependontheflowofmoneybetweenthecountries,whichmayeitherresultduetointernationaltradeingoodsorservices,orduetopurelyfinancialflows.Henceinthecaseofdeficitorsurplusinthebalanceofpayments,(differencebetweentheinflationrates,interestrates,economicgrowth of the countries are some of the factors which result in such imbalances) the exchange rates get automatically adjusted and this leads to a correction in the imbalance.Floating exchange rates may be of two types:

Freefloat:• Theexchangerateissaidtobefreelyfloatingwhenitsmovementsaretotallydeterminedbythemarket. There is no intervention at all either by the governments or by the Central Bank.Managedfloat:• The exchange rates do not depend on the market but there is intervention by either the government ortheCentralBank.Themanagedfloatcantakethreeforms:

The Central Bank may occasionally enter the market to smoothen transition from one rate to another, while �allowing the market to follow its own trend.Some events may have only a temporary effect on the markets. Here the intervention may take place to �preventtheseshortandmediumtermeffects,whilelettingthemarketsfindtheirownequilibriumrates,inthe long run.Thoughofficially,theexchangeratemaybefloating,inrealitytheCentralBankmayinterveneregularly �inthecurrencymarket,thusunofficiallykeepingitfixed.

5.4.3 Hybrid MechanismCrawling pegAcrawlingpegsystemisahybridofthefixedandflexibleexchangeratesystem.Underthissystem,whilethevalueofthecurrencyisfixedintermsofareferencecurrency,thepegitselfkeepschanginginlinewitheconomicfundamentals, thus letting the market forces play a role in the determination of the exchange rate. There are several bases, which could be used to determine the direction of the change in the exchange rate. One could be the actual exchangeraterulinginthemarket.Anotherbasecouldbetherecentfigureforthedifferencebetweendomesticinflationandtheinflationrateintheanchorcurrencycountry.Theotherbasecanbeonthebalanceoftradefiguresor changes in the external debt of the country.

The advantages of a crawling peg is that, though it gives a relatively stable exchange rate (changes in which are fairly predictable), the rate is never too much out of line with the underlying fundamentals of the economy.

5.5 Financial Crises in the Post Bretton Woods EraAnumberoffinancialcriseshaveoccurredoverthelastquarterofacentury,manyofwhichhadIMFinterferenceand involvement.

A currency crisis occurs when a speculative attack on the exchange value of the currency forces authorities •to spend large amounts of international currency reserves and sharply increase rates to defend the prevailing exchange rate.

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Abankingcrisisreferstothelossofconfidenceonthebankingsystemthatleadstoarunonbanks,ascompanies•and individuals withdraw their deposits.A foreign debt crisis is a situation in which a country cannot service its foreign debt obligation whether private •sector or government debt.

The crises mentioned above tend to have the following common micro-economics causes:highrelativepriceinflationrates•awideningcurrentaccountdeficit•excessive expansion of domestic borrowing•assetpriceinflationsuchassharpriseinshareandpropertyprices•

FourcriseshavebeenofparticularsignificanceintermsofIMFinvolvement,thethirdworlddebtcrisisofthe1980s, the crisis experienced by Russia which moved towards a market based economic system, the 1995 Mexican currencycrisisandthe1997Asianfinancialcrisis.Allfourof thesecriseswere theresultofexcessiveforeignborrowings,aweakorpoorlyregulatedbankingsystemandhighinflationrates.Theseresultedinsimultaneousdebt and currency crises.

5.5.1 Third World Debt CrisisTheThirdWorldDebtCrisiscanbetracedbacktotheOPECoilpricehikeof1973and1979.Therewasahugeflowof funds from major oil importing countries like Germany, Japan and the United States to the oil producing nations of OPEC. Commercial banks stepped in to recycle the money, by borrowing from OPEC countries and lending to governments and businesses around the world. The commercial banks on the basis of optimistic assessments of the growth prospects lent a lot of money to various Latin American and African nations. This did not materialise. Ratherthirdworldeconomicgrowthsloweddownintheearly1980’sduetohighinflation,risingshortterminterestrates (which increased the cost of servicing the debt) and recession condition in industrialised nations (which were the market for third world goods).

The consequence was a third world debt crisis of huge proportion. At one point of time, commercial banks had more than $ 1 billion of bad debts on their books (debts which the debtor nations had no hope of paying off). Against this backdrop, Mexico announced in 1982 that it could no longer service its $ 80 billion international debt without a bail off new loan of $ 3 billion. Brazil followed suit, revealing that it could not meet the required payments on its borrowed $ 87 billion loan. Then Argentina and several other countries followed suit. Thus the international monetary system faced a crisis of enormous dimensions.

IMF together with several Western Governments stepped in to resolve the debt crisis. The deal with Mexico contained three aspects:

rescheduling of Mexico’s old debt•new loans from the IMF, the World Bank and Commercial Banks•Mexico government’s agreement to comply by a set of IMF dictated macroeconomic prescriptions for its economy, •which included tight control over the growth of the money supply and major cuts in government spending.

The IMF’s solution to the debt crisis was based on the assumption that there will be rapid resumption of growth in member countries; with the result that the capacity to pay will improve and the crisis would be resolved. By the mid 1980s it became clear, that this was not going to happen. The IMF’s dictated macro chronic policies did bring downthetradedeficitsandinflationratesofmanydebtornationsundercontrol,butthechronicgrowthratesdidnot go up.

By 1989, it became clear that the debt problem was not going to be solved merely by rescheduling of debts. In April of that year, the IMF has come up with a new approach, that debt reduction was a necessary part of the solution. TheessenceoftheplanwasthatIMFandWorldBankwouldassumeleadroleinfinancingitandthatIMF,theWorld Bank and the Japanese government would each contribute 10 billion towards debt reduction. To get these

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funds, the debtor nation has to agree to follow imposed conditions for macro chronic policy management and debt repayment.ThefirstapplicationwastheMexicandebtreductionof$15billion(outof$107billion)in1989.Till1995 this action was widely regarded as a success.

5.5.2 Mexican Currency Crisis of 1995The Mexican Peso had been pegged to the dollar from early 1980’s as part of the condition of IMF while lending moneytotheMexicanGovernmenttobailthecountryoutofthe1982financialcrisis.Thepesohadbeenallowedto trade within a tolerance band of plus or minus 3 percent against the dollar. The band was also permitted “crawl” down daily, allowing for an annual peso depreciation of about 4 percent against the dollar. The IMF believed that the need to maintain the exchange rate within a fairly narrow trading band would force the Mexican government to adoptstringentfinancialpoliciestolimitgrowthinthemoneysupplyandcontaininflation.

Until the early 1990’s, it looked as if the IMF policy had worked. However, the strains were beginning to show by 1994. Since the mid 1980’s till the period, Mexican producer prices had risen 45 percent more than prices in US, andyettherehadbeennoadjustmentintheexchangerate.Bylate1994,Mexicowasrunningatradedeficitof$17billion,whichamountedto6%ofthecountry’sgrossdomesticproductandtherehadbeenrapidexpansioninthecountry’spublicandprivatesectordebt.Inspiteofthepressures,Mexicangovernmentofficialshadbeenstatingpublicly that they would support the peso’s dollar peg at around $ 1 = 3.5 pesos by adopting appropriate monetary policies and by intervention in the currency markets. Encouraged by such public statements, $ 64 billion of foreign investment money was poured into Mexico between 1990 and 1994 as corporations and mutual fund money transfer sought to take advantage of the booming economy.

However, currency traders began to dump peso on the foreign exchange market. The government tried to bide the time by buying pesos and selling dollars but it didn’t have the foreign currency reserves to halt the speculative tide. In mid December 1994, the Mexican government announced devaluation abruptly. Immediately many of the short-terminvestmentmoneythathadflowedintoMexicoinsharesandbondsduringtheyearreverseditscourse.Thisenhanced the sale of peso and contributed to a rapid 40 percent drop in value.

The IMF together with the US government and the Bank for International Settlements promised nearly $ 50 billion to help Mexico stabilise the peso and to redeem $ 47 billion of public and private sector debt that was set to mature in 1995. As usual, the IMF insisted on tight monetary policies and further cuts in public spending, both of which pushed the country into a deep recession. However, the recession was short-lived and by 1997 the country was once more on the growth path, had reduced its debt and had paid back the $ 20 billion borrowed from the US government ahead of schedule.

The future outlook of Mexico will depend not only on the performance of the US economy but also on the progress of the Mexican banking system. The volume of bank credit in 1998 was much below the pre-crisis level of 1994. Hence additional support was announced to bank debtors in 1998. The Congress in late 1998 agreed to the establishment of a deposit insurance agency for dealing with the non-performance loans taken off bankbooks in recent years. It is expected that this agreement will lead to the expansion of credit and equity in the banking industry.

5.5.3 The Brazilian CrisisBrazilisthelargestcountryinSouthAmericaandfifthlargestintheworldcovering3.3millionsquaremileswithapopulation of 151 million people of Portuguese heritage. Brazil is strategically located with borders touching most of the nations in South America.

The1980decadestartedwithinflationatanaveragerateof200percent.Itbeganwiththecountryundermilitaryrule but civilian leadership was re-established in 1985.

Brazil’s economic strife is a puzzle because the country has huge deposits of natural resources, large investment opportunities and a vast pool of managerial talent. Inspite of all these, the nation has to face chronic crises one after another.

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The main handicap of the Brazilian economy is the existence of a planned economy, through which bureaucracy operatesmorethan60%ofthecountry’sindustrialoutputthroughineffectivepublicsectorunits.

In 1992, Brazil was Latin America’s largest debtor nation with excessive foreign debt of $ 118 billion. The IMF agreed to extend a $ 2.1 billion standby loan on the conditions that Brazil should adopt strict macro economic measurestocontrolinflationandstabiliseitseconomy.PresidentFernandoCollordeMellointroducedeconomicand trade reforms, overhauling the monetary system, reducing government spending, opening Brazilian international bondstomeetmargincallselsewhere,contributedsignificantlytothefinancialcrisisandthuscapitaloutflowswereaccelerated.

In 1997, partial moratorium by the state government increased the pressure and the authorities abandoned the long standing exchange rate regime.

The government attempted limited and controlled devaluation with a large stock of foreign exchange reserves and an international support programme already in place. Secondly, the corporate and banking sectors were not highly exposed as they had hedged their positions against sudden changes in interest rates and exchange rates. A major weaknesswasthevulnerabilityofthegovernmentdeficittodevaluationcoupledwithhighinterestrates,giventhelargestockofdollarlinkedandfloatingtreasurybillsandthecentralbank’sshortpositionintheexchangeratefuturesandforwardmarkets.Underthesecircumstances,theRealdepreciatedby40%withintheperiodoftwomonthsfollowingtheadoptionofthefloatingregime.

In the context of devaluation two issues were important. Firstly, internal debt GDP ratio was to be lowered. Hence, in order to prevent continuous downward pressure in the currency and upward pressure on interest rates, strict correctiveactioninthefiscalareawasannouncedinMarch1999.Inadditiontothemeasuresalreadyagreedwiththe IMF, further restraint on spending and tax increases were adopted to bring the public sector primary surplus to over3%ofGDPin1999.

Thesecondconcernwastocontrolinflation.Sotheauthoritiestightenedmonetarypolicyandinterestrateswereallowedtorisefrom30%in1998to45%in1999toreversetheweakeningoftheexchangerateandtolimittheimpactofinflation.Asexchangeratesstrengthened,thecentralbankwasallowedtolowerinterestratesfromMarch1999onwardsandinflationlevelledat1.3%inMarch1999,itattractedforeigninvestment.

5.5.4 Argentinean Crisis Argentina is one of the Latin American countries with 1.1 million square miles having a population of over 32.3 million.Mostofitswealthoriginatesfromland–agriculture,mineralsandoil.Argentina’seconomyflourishedinthebeginningofthetwentiethcentury,growingatanannualrateof5percentforthreeyears.Itattractedafloodof British and Spanish capital and was rated as one of the world’s richest countries – even ahead of France and Germany. However, it has been downhill since then. When Juan Peron ruled the country from 1946 to 1955, he institutedprotectionistmeasuresandprintedmoneytofinancegenerousbenefitsforworkers.Stateinterventioninallsectorsledtopoorproductivityandstructuralweaknessintheeconomy.Inflationplaguedthecountry;thereweretwoboutsofhyperinflationinthe1980sandtwobankingcollapses.Asaresult,Argentineslosttrustinthepeso and invested in US dollars or shipped their capital abroad.

In 1989, Carlos Menem took control of the country and set out to implement free market reforms and to restructure monetaryandeconomicpolicies.Heprivatisedmanystate-runcompanies,tightenedfiscalmanagement,andopenedup the country’s borders to trade. Probably the most important policy he established was the Convertibility Law, which pegged the Argentine peso 1:1 with the US dollar and restricted the money supply to its hard dollar currency reserves. This monetary arrangement was called a currency board and was established to impose discipline on the centralbank.Thenewcurrencyboardaccomplishedwhatitsetouttodo:Ithaltedinflationandattractedinvestment.Investors felt that there was little risk anymore in investing in the peso, since it was pegged to the dollar. The sentiment that “the peso is as good as the dollar” was strong throughout the country. Because there was a stable money supply, thisreducedinflationtonearly0percentthroughtherestofthe1990sandkepttheexchangerateataconstantvalue.Real GDP grew by 6.1 per cent from 1991 to 1997 compared to 0.2 per cent from 1975 to 1990.

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In spite of these positive developments, the currency board also had its drawbacks. It reduced the Argentine government’s ability to respond to external shocks by allowing its exchange rate and monetary policy to be determined de facto by the United States. Interest rates were in reality set by the U.S. Federal Reserve; plus there was a risk-margin for investing in Argentina. This arrangement was put to the test in 1995, when the Mexican peso devalued. Investors got nervous about Latin America in general and pulled investments out of Argentina. Its economy shrank by 4 percent, and many banks collapsed. The government responded by tightening bank regulation and capital requirements, and some of the larger banks took over weaker ones. Argentina increased exports and investment, and the country returned to 5.5 per cent growth.

Unfortunately, the government wasn’t so lucky with its results at the end of the 1990s. Commodity prices, which Argentina relied heavily on, declined; the U.S. dollar strengthened against other currencies; Argentina’s main trading partner, Brazil, devalued its currency; and the emerging economy’s cost of capital increased. Argentina soon fell into a recession, with GDP falling to 3.4 percent in 1999 and unemployment increasing into the double digits. Argentina, because of its hard link to the dollar, was unable to compete internationally, especially in Brazil, because of its high prices. One way to correct this problem would be to devalue the currency to bring the value closer to its fundamental value. Argentina couldn’t devalue unless it cancelled the currency board’s popularity and past success. The only wayforArgentinatobecomemorecompetitivewasforpricestofall.Asdeflationsetin,thegovernment(andsomeprivatecompanies)founditdifficulttopayitsdebtbecauseitwasnotcollectingasmuchrevenue.Bankshadbeenlending dollars at 25 percent interest rate even though the risk was supposed to be low.

Argentina was acquiring a burgeoning public debt. When the recession hit, tax revenue fell and spending increased to pay for such things as higher unemployment. Tax evasion is extremely high in Argentina; but government did little totackletheproblem.Thebudgetwentfromasurplusof1.2percentofGDPin1993toadeficitof2.4percentin2000.Increasedinterestratepaymentsalsoaddedtotheincreasingbudgetdeficit.From1991to2000,theamountof interest rate payments increased from $2.5 billion to $9.5 billion annually. This drained the economy more as most of this money went to overseas investors. This currency “mismatching”, meaning most of the debt is taken out in one currency but assets are held in another, were large in Argentina and would later prove disastrous.

Politiciansfoundlittletheycoulddotohelpthestrugglingeconomy.Theyfiddledwithtariffsandfinallythecurrencyboard. They pegged the peso half to the dollar and half to the euro for exporters. The idea of devaluation scared investors and caused interest rates to rise even more. Unable to pay its interest payments and unwilling to declare a debt default, the government turned to the banks. The Menem government had strengthened the banking system, particularly the central bank, but his successor, Fernando de la Rua, sent a crushing blow to the sector. He strong-armed the banks into buying government bonds. This triggered a bank run, and Argentines withdrew over $15 billion between July and November 2001. In a desperate attempt to save the industry, Mr. De la Rua imposed a ceiling of $1,000 a month on bank withdrawals on December 1. Within days, the country defaulted on $155 million in public debt, the largest such default in world history. As rioters and looters took to the streets, Mr. De la Rua resigned.

Argentinastruggledtofindapresidentwhowasfitforthejob;itwentthroughatotaloffivepresidentsinfourmonthsendingfinallywithEduardoDuhalde.ThegovernmentabandonedthecurrencyboardinJanuary2002andletthepesofloatagainstthedollar.Thepesobeganfallingquickly,sothegovernmentspentaround$100milliona day – to a total of $1.2 billion – to prop up the value. More money was leaking out of the banking system too (around $50 million a day) –, because the courts had overturned the freeze on withdrawals. In March 2002, Mr. Duhalde imposed new restrictions on the foreign exchange market. Individuals could buy no more than $1000 a day and companies no more than $10,000 a day. Bank businesses had restrictions on the number of dollars they could hold and how much money could be shipped abroad. Currency exchanges could only operate three to four hours each day – versus typical seven hours. However, the courts kept overturning policies set by the government andhadpolicearrestbankmanagerswhodidn’tfollowtheirrulings.Stillunabletopreventtheincreasingflowofmoney out of the system, Duhalde closed all banks for a week. In the meantime, he proposed to forcibly convert billions of dollars in bank deposits into low-interest bonds. The senate refused the president’s bond proposal, thus sending him back to the drawing board.

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As Argentina tries to repair its economy, it is waiting for help from the International Monetary Fund (IMF). However, the IMF continues to turn down Argentina’s requests for help until it implements some sweeping changes in its exchangeratepolicy,fiscalpolicybankingsystem.Inanattempttofindsomeonetoblame,itstartedcriticisingforeign owned banks for not infusing more cash into the system from their headquarters. The central bank has been printingpesostokeepbankssolvent,butthisledtoincreasedinflation.Thenationalandprovincialgovernmentisalso using bond notes, quasicurrency, to pay many of their debts. This note is being swapped in everyday transactions andhassurprisinglyhelditsvalueagainstthepeso.OfficialspromiseArgentinathatonceadealissignedwiththeIMF; they will gather up this currency and swap it for pesos at face value.

Progress is slow with the IMF. Many of the measures required by the IMF are extremely unpopular with the provincial government and the courts. As a result, Duhalde has had to abandon some of his required cost cutting in order to pleasethecountry.OneofthelastmeasuresDuhaldehasimplementedisthatofpesificationwhichturnedbank’sdollar assets and liabilities into devalued pesos. This again has put a severe strain on the banking system. People do not trust the banks anymore. They blame the banks for the bank freezes even though the government ordered them. Two foreign banks left the country, and others are threatening to do the same.

Argentina’s economy, though still deeply damaged, has started stabilising. The peso was trading around 27 cents in thelatterhalfof2002,inflationdeclinedandthecentralbank’sreservesincreasedalittlepartlyduetothefactthatthe nation’s banks aren’t paying their debts. Some economists believe that Argentina should go with full dollarisation of its currency, not at 1:1 but more like 4:1. This would be even more binding than its previous policy, but it would bringconfidencebacktotheeconomy.Othersargueforasystemofmanagedfloatingplus”asthatwouldgivethegovernmentflexibilitytoalteritsmonetarypolicybutstillstaywithincertaintargetsandreduceitscurrencymismatching. The world is waiting to see what the IMF will do to support the country and what Argentina’s next move will be.

5.5.5 The Asian Crisis of 1997The seeds of this crisis were sown in the previous decade when these countries were experiencing unprecedented economic growth. Exports had long been the engine of economic growth in these countries. From 1990 to 1996, the value of exports from Malaysia had grown by 18 percent annually. Thai exports 16 percent per year, Singapore by15 percent, Hong Kong by 14 percent and those of South Korea and Indonesia by 12 percent annually. The nature of these exports had also shifted from basic materials and products such as textiles to complex and increasingly high technology products such as automobiles, semi conductors and consumer electronics.

Thewealthcreatedbyexportledgrowthhelpedfindaninvestmentboomincommercialandresidentialproperty,industrial assets and infrastructure. The value of commercial and residential real estate in cities like Hong Kong and Bangkok started to soar. This led to a building boom, which had never been seen in Asia. Heavy borrowing frombanksfinancedmuchoftheconstruction.Asforindustrialassets,thesuccessofAsianexportersencouragedthem to make bolder investments in industrial capacity. This was demonstrated most clearly by South Korea’s giantdiversifiedconglomerates,orChaebol,manyofwhichhadambitionstobuildamajorpositionintheglobalautomobile and semi conductor industries.

An added factor behind the investment boom in most South East Asian economies was the government. Since in many cases, governments had embarked on huge infrastructure projects. In Malaysia, a new government administrative centre was constructed in Putrajaya for M $ 20 billion (U.S. $ 8 billion at the pre-July 1997 exchange rate) and the government was funding the development of a massive high technology communications corridor and the huge Bakun dam (most expensive power generation plant of M $ 13.6 billion). Throughout the region, the government also encouraged private businesses to invest in certain sectors of the economy in accordance with “national goals” and “industrialisation strategy”. In South Korea, the government urged the Chaebol to invest in new factories as a way of boosting economic growth. South Korea enjoyed an investment led economic boom in the 1994–95 periods, but at a cost. The Chaebol always reliant on heavy borrowings built up massive debts that were equivalent, on average to four times their equity.

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In Indonesia, President Suharto had long supported investments in a network of an estimated 300 businesses owned by his family and friends with a system known as “crony capitalism”. Many of these businesses were granted lucrative monopolies by the President. To support the ventures, a consortium of Indonesian banks was “ordered” by the government to offer almost 700 million in startup loan to the companies.

Bythemidof1990’s,SouthEastAsiawasinthemidstofanunprecedentedinvestmentboom,muchofitfinancedwith borrowed money. Between 1990 and 1995, gross domestic investment grew by 16.3 percent annually in Indonesia,16percentinMalaysia,15.3%inThailandand7.2%inSouthKorea.Bycomparisoninvestmentgrewby4.1percentannuallyoverthesameperiodinUSand0.8%inallhighincomeeconomies.

Insubsequentyearsmanyoftheseinvestmentsdeclinedsignificantlysincesomeoftheinvestmentsweremadeonthebasisofunrealisticprojectionsaboutfuturedemandconditions.Thishasresultednowinsignificantexcesscapacity e.g. DRAM manufacturers (dynamic random access memory chips). Another example, a building boom in Thailand resulted in excess capacity in residential and commercial property.

By early 1997, what was happening in the South Korean semi conductor industry and the Bangkok property markets was being repeated elsewhere in the region. To make matters worse, much of the borrowing had been in US dollars as opposed to local currencies. Throughout the region, local currencies were pegged to the dollar and interest rates on dollar borrowings were generally lower than rates on borrowings in domestic currency. Thus, it often makes economic sense to borrow in dollars if the option was available. However, if governments could not maintain the dollar peg and their currencies started to depreciate against the dollar, this would increase the quantum of debt burden, when measured in local currency. Currency depreciation would raise borrowing costs and could result in companies defaulting on their debt obligations.

Thefinalcomplicatingfactorwasthatbythemid1990s,althoughexportswerestillexpandingacrosstheregion,imports were too. The investments in infrastructure, industrial capacity and commercial real estate were sucking in foreign goods at unprecedented rates. To build infrastructure, capital equipment and materials were brought from America, Europe and Japan. Many South East Asian states saw the current accounts of their balance of payments shiftstronglyintotheredduringthemid1990’s.By1995,Indonesiawasrunningacurrentaccountdeficitthatwasequivalentto3.5percentofitsGDP,Malaysia’s5.9percentandThailand’s8.1percent.Withdeficitslikethese,itwasincreasinglydifficultforthegovernmentsofthesecountriestomaintaintheircurrenciesagainsttheUSDollar.

TheAsianmeltdownbeganinmid1997inThailandwhenitbecameclearthatseveralkeyThaifinancialinstitutionswere on the verge of default. These institutions had been borrowing dollars from international banks at low interest rates and lending Thai Baht at higher interest rates to local property developers. However, due to speculative overbuilding, these developers could not sell their commercial and residential property, forcing them to default on theirdebtobligations.Inturn,theThaifinancialinstitutionsseemedincreasinglylikelytodefaultontheirdollardenominateddebtobligationstointernationalbanks.Sensingthecrisis,foreigninvestorsfledtheThaiStockmarket,selling their positions and converting them into US Dollars. The increased demand for dollars and increased supply of Thai baht pushed down the dollar Thai baht exchange rate and the stock market plunged.

Further, foreign exchange dealers and hedge funds started speculating against the baht, selling it short. For the previous 13 years, the Thai Baht had been pegged to the US Dollar at an exchange rate of about $ 1 = Bt 25. The Thai government tried to defend the peg but only succeeded in depleting its foreign exchange reserves. On July 2, 1997,theThaigovernmentabandoneditsdefenceandallowedthebahttofreelyfloatagainstthedollar.ByJan.1998,$ 1 = Bt 55 i.e. 55 percent decline in the value of the baht against the dollar doubled the amount of baht required toservethedollardenominateddebtcommitmentstakenonitbyThaifinancialinstitutionsandbusinesses.Thisincreased the probability of corporate bankruptcies and further pushed down the stock market. The Thailand Stock market index declined from 787 in January 1997 to a low of 337 in December of that year, as top of 45 percent decline in 1996.

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Withitsforeignexchangereservesdepleted,Thailandlackedtheforeigncurrencyneededtofinanceitsinternationaltrade and service debt commitments and therefore approached IMF for help. It also needed to restore international confidenceinitscurrency.TheIMFagreedtoprovideThaiGovernmentwith$172billioninloansbutwithsomeconditions. The conditions were to increase taxes, cut public spending, privatise several state owned businesses and raise interest – all steps needed to cool Thailand’s overheated economy. The IMF also required Thailand to close illegalfinancialinstitutions.InDecember1997,theGovernmentclosed56financialinstitutions,layingoff16,000people and further deepening the recession that now gripped the country.

Following the devaluation of the Thai Baht, wave after wave of speculation hit other Asian currencies. The Malaysian ringgit, Indonesian rupiah, and the Singapore dollar were all marketed lower. With its foreign exchange reserves downto$28billion,MalaysialettheringgitfloatonJuly14,1997.Beforethedevaluationtheringgitwastradingat $ 1 = 2.525 ringgit, 6 months later it had declined to $ 1 = 4.15 ringgit. Singapore followed on July 17 and the Singapore dollar quickly dropped in value from $ 1 = 1.495 before the devaluation to $ 1 = S $ 2.68 a few days later.NextwasIndonesia,wheretherupiahwasallowedtofloatfromAugust14.Thecurrencyfellfrom$1=2400rupiah in August 1997 to $ 1 = 10,000 rupiah in January 6, 1998, a loss of 75 percent.

With the exception of Singapore, whose economy is probably the most stable in the region, these devaluations were driven by identical factors of that of Thai – combination of excess investment, high borrowings much of it in dollar denominated debt and a declining balance of payments position. Though Malaysia and Singapore were able to halt the slide in their currencies and stock markets without the help of IMF, Indonesia could not. Indonesia was struggling with a private sector, dollar denominated debt of close to $ 80 billion.

On Oct. 31, 1997, the IMF announced a rescue deal for $ 37 billion for Indonesia in conjunction with the World Bank and Asian Development Bank. In return the government agreed to a number of restrictions e.g. close a number of troubled banks, reduce public spending, remove government subsidies on basic food stuffs and energy, balance the budget and unravel the irony capitalism that was so widespread in Indonesia. But the government of President Suharto backtracked several times on commitments made to the IMF. This precipitated a decline in the Indonesian currency and stock markets. Ultimately, Suharto agreed and removed costly government subsidies, only to see the country dissolve into chaos as the population took to the streets to protest the resulting price increases. This led to a chain of events and Suharto’s removal from power in May 1998.

ThefinalaxefellonSouthKorea.Duringthe1990’sSouthKoreancompanieshadbuiltupahugedebtastheyinvested in developing new industrial capacity. They found that the industrial capacity that was built up could not generate revenue to service their debt. Here also South Korean Banks and companies borrowed in dollars and that too in the form of short-term debt that would become due within one year. Thus, when the South Korean Won started to decline in 1997 in sympathy with the problem elsewhere in Asia, debt obligations ballooned. Several largecompanieswereforcedtofileforbankruptcy.ThistriggeredadeclineintheSouthKoreancurrencyandstockmarketthatwasdifficulttostoporhalt.TheCentralBanktriedtokeepthedollar/Wonexchangerateabove$1=1,000 but found that it only depleted its foreign exchange reserves. On November 17, the Central Bank gave up the defence of the Won, which quickly fell to $ 1 = 1500.

With its economy on the verge of collapse, the South Korean government on November 21, requested $ 20 billion in standby loans from the IMF. Among other problems, the country’s short term foreign debt was found to be twice as large as previously thought at close to $ 100 billion while the country’s foreign exchange reserves were down to less than $ 6 billion. On December 3, the IMF and South Korean Government reached a deal to lend $ 55 billion to the country. The agreement put forward some conditions which are:

opening up the economy and banking system to foreign investors•pledged to restrain theChaebol by reducing their share of bankfinancing and requiring them to publish•consolidatedfinancialstatementsandundergoannualindependentexternalauditscomply with its commitments to the World Trade Organisations to eliminate trade related subsidies and restrictive •importlicensingandwouldstreamlineitsimportcertificatesprocedures,soastoopentheeconomytogreaterforeign competition.

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5.5.6 Lessons from the Asian Currency CrisisLiberalisationoffinancialmarketswhencombinedwithaweak,underdevelopeddomesticfinancialsystemtendstocreateanenvironmentsusceptibletocurrencyandfinancialcrises.InterestinglybothMexicoandKoreaexperiencedamajorcurrencycrisiswithinafewyearsafterjoiningtheOECD,whichrequiredasignificantliberalisationoffinancialmarkets.Itseemssafetorecommendthatcountriesfirststrengthentheirdomesticfinancialsystemandthenliberalisetheirfinancialmarkets.

Anumberofmeasuresshouldbetakentostrengthenanation’sdomesticfinancialsystem.Amongotherthings,thegovernmentshouldstrengthen itssystemoffinancialsectorregulationsandsupervision. Inaddition,banksshould be encouraged to base their lending decisions solely on economic merits rather than political considerations. Furthermore,firms,financialinstitutionsandthegovernmentshouldberequiredtoprovidethepublicwithreliablefinancialdatainatimelyfashion.Ahigherlevelofdisclosureoffinancialinformationandtheresultanttransparencyabout the state of the economy will make it easier for all the concerned parties to monitor the situation better and mitigate investor panic, accentuated by the lack of reliable information.

Even if a companydecides to liberalise itsfinancialmarketsby allowingcrossborder capitalflows, it shouldencourage foreign direct investments and equity and long term bond investments, it should not encourage short terminvestmentsthatcanbereversedovernight,causingfinancialturmoil.

Afixedbutadjustableexchangerateisproblematicinthefaceofintegratedinternationalfinancialmarkets.Suchanarrangementofteninvitesspeculativeattackatthetimeoffinancialvulnerability.Countriesshouldnottrytorestorethesamefixedexchangeratesystemunlesstheyarewillingtoimpose‘capitalcontrols’.Accordingtotheso-called“trilemma” that economists talk about, a country can attain only two of the following three conditions:

afixedexchangerate•freeinternationalflowsofcapitaland•an independent monetary policy•

If a country would like to maintain monetary policy independence to pursue its own domestic economic goals and stillwouldliketokeepafixedexchangeratebetweenitscurrencyandothercurrencies,thenthecountryshouldrestrictfreeflowsofcapital.ChinaandIndiawerenotnoticeablyaffectedbytheAsiancurrencycrisisbecauseboth countries maintain capital controls, segmenting their capital markets from the rest of the world. Hongkong and ArgentinawerelessaffectedbythecrisisbecausetheyhavefixedtheirexchangeratespermanentlytotheUSDollarviacurrencyboardsandallowedfreeflowsofcapital;inconsequence,theygaveuptheirmonetaryindependence.Acurrencyboardisanextremeformofthefixedexchangerateregimeunderwhichlocalcurrencyis“fully”backedby the dollar (or another chosen standard currency). Hongkong and Argentina have essentially dollarised their economies.Toavoidacurrencycrisis,acountrycanhaveareallyfixedexchangerateorflexibleexchangeratebutnotafixedyetadjustableexchangerate,wheninternationalcapitalmarketsareintegrated.

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SummaryTheinternationalmonetarysystemcanbedefinedastheinstitutionalframeworkwithinwhichinternational•payments are made, movements of capital are accommodated and exchange rates among currencies are determined.The International Monetary System went through several distinct stages of evolution namely bimetallism, gold •standard,Brettonwoodssystem,andflexibleexchangerateregime.The international monetary system before the 1870’s can be characterised as ‘bimetallism’ in the sense that both •gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents, Around 1870. The gold standard had its origin in the use of gold coins as a medium of exchange, limit of account, and store •of value – a practice that dates back to ancient times. When international trade was limited in volume, payment for goods purchased from another country was made in gold or silver. In 1944, when the World War II was at its peak, representatives from 44 countries met at Bretton Woods, New •Hampshire, to design a new international monetary system. With the collapse of the gold standard and the great depression of the 1930’s fresh in their mind, these statesmen wanted to have an enduring economic order that would facilitate post war economic growth.The aim of the Bretton Woods Agreement, of which IMF was the main custodian, was to try to avoid a repetition •ofthatchaosthroughacombinationofdisciplineandflexibility.AstheBrettonWoodsSystemwasabandoned,mostcountriesshiftedtofloatingexchangerates.Thisfactwas•finallyrecognisedbytheIMFandthearticleswereamendedinitsagreement.Theamendmentwasdecidedupon in Jamaica in 1976 and became effective on April 1, 1978. The basis of the European Monetary Union was the American desire to see a United Western Europe after •World War II. Underthefixed(orpegged)exchangeratesystem,thevalueofacurrencyintermsofanotherisfixed.•Underthefloatingexchangeratesystem,theexchangeratesbetweencurrenciesarevariable.Theseratesare•based on demand and supply for the currencies in the international market.Acrawlingpegsystemisahybridofthefixedandflexibleexchangeratesystem.•

Referenceshttp://www.nber.org/papers/w6833• . Last accessed on 27th December, 2010.http://www.encyclopedia.com/doc/1E1-intlmone.html• . Last accessed on 27th December, 2010.http://www.uiowa.edu/ifdebook/faq/faq_docs/EMU.shtml• . Last accessed on 27th December, 2010.

Recommended ReadingBarry Eichengreen (2008). • Globalizing Capital: A History of the International Monetary System. Princeton University Press; Second edition.Jaime Reis (1995). • International Monetary Systems in Historical Perspective. Palgrave Macmillan.Peter B. Kenen (1994). • The International Monetary System. Cambridge University Press.

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Self Assessment

_________currencies to gold and guaranteeing convertibility is known as the gold standard.1. Pegginga. Floatingb. Crawlingc. Pricingd.

A___________systemisahybridofthefixedandflexibleexchangeratesystem.2. floatingpega. crawling pegb. fixedpegc. gold pegd.

A country is said to be in balance of trade equilibrium when 3. theincomeofitsresidentsearnedfromexports≤themoneyitsresidentspaytopeopleinothercountriesa. for importsthe income of its residents earned from exports b. ≠ the money its residents pay to people in other countries for importsthe income of its residents earned from exports = the money its residents pay to people in other countries c. for importstheincomeofitsresidentsearnedfromexports≥themoneyitsresidentspaytopeopleinothercountriesd. for imports

Theexchangerateissaidtobefreelyfloatingwhenitsmovementsaretotallydeterminedbythe4. marketa. Central bankb. currencyc. IMFd.

The basis of the ____________ was the American desire to see a United Western Europe after World War II.5. International Monetary Funda. International Bank for Reconstruction and Developmentb. Asian Development Bankc. European Monetary Uniond.

When international trade was limited in volume, payment for goods purchased from another country was made 6. in_______.

dollarsa. gold or silverb. foreign exchangec. yend.

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UndertheBrettonWoodsSystemInternationalBankforReconstructionandDevelopment(IBRD)waschiefly7. responsible for

international monetary policies and their enforcement.a. international means of payment.b. demand and supply for the currencies.c. responsibleforfinancingindividualdevelopmentprojects.d.

WhichofthefollowingstatementisFALSE?8. The aim of the Bretton Woods Agreement was to try to avoid a repetition of that chaos through a combination a. ofdisciplineandflexibility.The basis of the European Monetary Union was the American desire to see a United Western Europe after b. World War II.Underthefixed(orpegged)exchangeratesystem,thevalueofacurrencyintermsofanotherisvariable.c. The International Monetary System went through several distinct stages of evolution.d.

Acurrencyboardisanextremeformofthefixed__________regimeunderwhichlocalcurrencyis“fully”9. backed by the dollar.

exchange ratea. foreign currencyb. monetary policesc. demand and supplyd.

What does OPEC stands for10. Organisation of the Petroleum Exporting Councila. Organisation of the Price Exporting Countriesb. Organisation of the Petroleum Exporting Currenciesc. Organisation of the Petroleum Exporting Countriesd.

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Chapter VI

Economic Theories of Exchange Rate and the Purchasing Power Principle

Aim

The aim of this chapter is to:

explain the law of one price•

discuss the asset approach of exchange rates•

state the interest rate parity•

Objectives

The objectives of this chapter are to:

classify absolute and the relative form of purchasing power parity•

statetheinternationalfishereffect•

explain exchange rate forecasting•

Learning outcome

At the end of this chapter, students will be able to:

state demand supply approach•

describe the portfolio balance approach•

talk about the mon• etary approach

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6.1 Economic Theories of Exchange Rate DeterminationAt the initial level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another.

For example: if the demand for dollar outstrips the supply and if the supply of Japanese yen is greater than the demand for it, the dollar– yen exchange rates will change. The dollar will appreciate against the yen (or the yen will depreciate against the dollar). However, the differences in relative supply and demand explain the determination of exchange rates to some extent but not fully.

If we understand how exchange rates are determined, we will be able to forecast exchange rate movements. Since futureexchangeratemovementsinfluencesexportopportunities,theprofitabilityofinternationaltradeandinvestmentdeals, and the price competitiveness of foreign imports, this is also a valuable information for an international business. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among economists, who study the phenomenon every day.

Most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a country’s currency:

thecountry’spriceinflation•its interest rate •market psychology•

6.2 Prices and Exchange RatesLet’s closely study the concept of prices and exchange rate by reading the explanation which is provided below:

The law of one priceThe law of one price states that “in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency”.The application of the law of one price is contingent upon certain conditions. They are:

a competitive market must be present in both the countries for the goods and services•the law is only applicable to the goods that can be traded between the countries•transport expenses and other transaction expenses must be checked since they are considered hindrances in •trading

For example: if the exchange rate between the British Pound and the US Dollar is £ 1 = 1.8$, a jacket that is sold in the retail market for $ 72 in New York, should sell for £ 40 in London. Suppose, if the jacket costs £ 35 in London (corresponding to $ 63 in US Currency), it would pay a trade to buy jackets in London and sell them in New York (aprocesswhichisknownasarbitrage).Thetradercaninitiallymakeaprofitof$9(buying£35atLondonandselling at New York @ $ 72), (we are assuming no transportation costs and trade barriers).

In this process, the increased demand for jackets in London would raise the price in London and the increased supply of jackets in USA will lower the price there. This would go on until prices are equalised.

The Absolute form of Purchasing Power Parity (PPP)Purchasing Power Parity theory of exchange rate is a theory, which establishes the fact that the exchange rates between currencies are in equilibrium in the event of equality in the purchasing power of each of the countries. Thispreciselymeansthattheratioofthepricelevelofafixedamountofgoodsandservicesofthetwocountriesand the exchange rate between those two countries must be equivalent.

If the law of one price were to hold good for each and every commodity, then it will follow that:

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S(A/ B)

Where, PA and PB are the prices of same basket of goods and services in countries A and B respectively and S (A/B) = Exchange rate between two countries A and B.

Thus, if the basket of goods costs $ 200 in the United States and Y 20,000 in Japan, PPP theory provides that the dollar / yen exchange rate should be $ 200 / Y 20,000 or $ 0.01 per Japanese Yen ($ 1 = ¥ 100).

Absolute PPP makes the same assumptions as the law of one price. It also makes a few additional assumptions which are:

no transaction costs in the foreign currency markets•Basket of commodities: It also assumes that the same basket of commodities is consumed in different countries, •with the components being used in the same proportion

The Relative form of Purchasing Power Parity (PPP) This theory states that the purchasing power of two currencies differs by the same proportional rate. This differs from the absolute form of purchasing power parity, which says that the purchasing power between two currencies is the same.Here it is argued that the exchange rate will change if relative prices change.Forexample:imaginethereisnopriceinflationinUSwhilepricesinJapanareincreasingby10percentayear.Asper this statement, at the end of the year, the basket of goods still costs $ 200 in US but it costs ¥ 22,000 in Japan. The PPP theory provides that the exchange rate should change as a result.Thus,¥1=$0.0091(or$1=¥110).Becauseof10percentpriceinflation,theJapaneseYenhasdepreciatedby10%againstthedollar.Reasons for PPP not holding good:

constraints on movement of commodities•price index construction is based on different baskets of commodities•effect of the statistical method employed by ignoring the fact that there is a two-way link between the spot rate •andinflationrates

6.3 The Asset Approach to Exchange RateExchange rates are relative prices of two assets. The current values of an asset depend on what that asset is expected to be worth in the future.

For example the more valuable a stock is expected to be worth, the more it is worth now. Similarly, the more a currency is expected to be worth in the future, the more it is worth now. It follows that today’s exchange rate depends on the expected future exchange rate. In turn, the expected future exchange rate depends on what is expected to happentoallthefactorsreflectedinfuturebalance-of-paymentaccounts.

The asset approach to exchange rates, which has been articulated most clearly by Michael Musa, looks at the current spotexchangerateasareflectionofthemarket’sbestevaluationofwhatislikelytohappentotheexchangerateinfuture. All relevant information about the future is incorporated into the current spot rate. Because new information is random, and could as easily be good as bad for one currency versus the other, the path of the exchange rate should containa randomcomponent.This randomcomponentfluctuates around theexpectedchange in theexchangerate.

Theassetapproachholdsimplicationsfortheeffectoffiscalpolicyaswellasmonetarypolicy.Forexample,itpredicts thathighfiscaldeficitscanresult inanimmediatedepreciation.Thiswouldhappenif thefiscaldeficitcaused people to expect future expansion of the money supply as the government printed money to make interest payments on the growing debt.

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The asset approach offers an explanation for departure from PPP. Because expectation about the future is relevant to the current exchange rate, there is no necessity for the spot exchange to ensure PPP at every moment. For example if a countryisexpectedtoexperiencerapidinflation,poortradeperformanceorsomethingelseleadingtoadepreciation,the current rate of that country’s currency is likely to be below its PPP value.

6.4 Interest Rate Parity (IRP)Interestrateparityisanarbitrageconditionthatmustholdwheninternationalfinancialmarketsareinequilibrium.IRP has an immediate implication for exchange rate determination.

Where,F = Forward rate forB = foreign currencyA = domestic currencyrA = return on domestic depositsrB = return on foreign currency denominated securities

Example: SpotRs.45/F;returnondomesticdeposits14%returnondollardeposits5%,ingestiblefunds=Rs.1000.Whatwillbetheforwardcoverafter1year?Solution: If the investor invests in a rupee deposit, at the end of the year, he would haveRs.1000(1+0.14)=Rs.1140If instead he wants to invest in dollar deposits, he has to convert his investment in dollar deposit at spot rate i.e. $ 22.22.Attheendoftheyear,thiswouldfetch22.22(1+0.5)=$23.33.Thishastobeconverted

Hence forward rate of exchange =

Reasons for deviations from IRP:Although IRP tends to hold quite well, it may not hold precisely all the time for the following reasons:

Transaction costs:• It is the transaction costs which are involved in money market operations i.e. the investment and borrowing rate.Political risks:• Risk of any change in the foreign country’s laws or policies that affects the returns on the investment.It may take the form of a change in the tax structure or a restriction on repatriation of proceeds of the investment •orasuddenconfiscationoftheforeignassetsamongotherthings.Taxes:• Taxes can affect the parity in two ways:

through withholding taxes �through differential tax rates on capital gains and interest income �

Liquidity preference:• An asset’s liquidity is measured by the quickness with which it can be converted into cash at the least possible cost.Capital controls:• Capital controls include restrictions on investing or borrowing abroad and as repatriation of investments made by foreign residents. It also includes restrictions on conversion of currencies. As a result of these controls, the interest rates in the euro market (where these regulations do not apply) are more in line with the parity than the domestic market rates in different countries.

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6.5 International Fisher EffectWeknowthatthenominalinterestratecomprisesofarealinterestrateandanexpectedrateofinflation.Thenominalrateofinterestadjustswhentheinterestrateisexpectedtochange.Itisfinallyexpressedasfollows:1+nominalinterestrate=(1+realint.rate)(1+inflationrate)Thatis1+rn =(1+rr)(1+i)wherern = normal interest rate, Rr isrealrateofinterestandiistheinflationrate.If the international capital markets are perfect, then the equivalent risk investments in two countries should offer the same expected real rate of return. This is ensured by arbitrage. The international Fisher effect states that “the nominalinterestratedifferentialmustbeequaltotheexpectedinflationratedifferentialintwocountries”.Thus,Nominalinterestdifferential=Expectedinflationratedifferential

where,rA = interest rate in domestic currencyrB = interest rate in foreign currencyiA=inflationrateindomesticcountryiB=inflationrateinforeigncountry

6.6 Exchange Rate Forecasting Aplethoraoffactorsaffectthelevelofandmovementsinexchangerates,ofteninaconflictingmanner.Anumberoftheories were developed to explain these effects. Though a consistent prediction of the exact level of future exchange rates is impossible, these theories help in forecasting the possible direction of the movements.The following modes of exchange rate forecasting are being discussed as under:

6.6.1 The Demand – Supply Approach A currency’s exchange rate is determined by the overall supply and demand for that currency. According to this, new changes in exchange rates can be forecast by analysing the factors that affect the demand and supply of a currency. However,veryfewcurrenciesintheworldfloatfreelywithoutanygovernmentintervention.Mostaremanagedtosome extent, which implies that government needs to make political decisions about the value of their currencies. Managers of multinational organisations need to monitor the following factors the government follows in order to try to protect values.

6.6.2 The Institutional SettingThe institutional setting would include the following aspects:

Doesthecurrencyfloat,orisitmanaged,andifso,isitpeggedtoanothercurrency,toabasket,ortosome•otherstandard?Whataretheinterventionpractices?Aretheycredible?Sustainable?•

6.6.3 Fundamental AnalysisThe institutional setting would include the following aspects:

Does the currency appear undervalued or over valued in terms of PPP, balance of payments, foreign exchange •reservesorotherfactors?Whatisthecyclicalsituationintermsofemploymentgrowth,savings,investmentsandinflation?•Whataretheprospectsforgovernment,monetary,fiscalanddebtpolicy?•

6.6.4ConfidenceFactorsThese factors help to determine the market views and expectations with respect to the political environment, as well as to the credibility of the government and Central Bank.

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6.6.5 Expected Theory of Forward RatesRelationship between the forward rates and the expected spot rates in the future is, suppose you are an exporter who is expecting to receive US dollars in the future, we have two choices:

either to wait until we receive dollars and then convert them into rupees•thesecondalternativeisthatwecanfixthepriceofthedollartodayandselltheUSdollarsforward•

Thus, we are able to avoid the risk of a possible fall in the value of the dollar. In the case of an importer, who is required to make payment in US dollars in the future, the situation is just the opposite. He will buy the US dollars forward to avoid the risk of possible appreciation in the value of the dollar in the future. If both the exporters and the importers are in large numbers, the forward rate of US dollars relative to the Indian rupee will be very close to the expected future spot rate. This is the expectation theory of exchange rates. The expected future spot rate depends on the expectations of the forex market participants. If the participants can hedge their forex risk or risk neutral, then the forward rate must be equal to the expected future spot rate.

Thus, Forward and current spot rate differential = Expected and current spot rate differentiali.e.,Where E (S A/B) is the expected future exchange rate (unit of domestic currency per unit of foreign currency)F A/B is the forward rateIn simple terms, the forward rate must be equal to the expected future spot rate. Thus,Forward rate = Expected future spot rateF A/B = E (S A/B)

6.6.6 EventsEvents will include the national or international incidents in the news, the possibility of crisis or emergencies, governmental or other important meetings coming up (such as that of the G7 for example).

6.6.7 Technical Analysis

Whattrendsdothechartsshow?Arethesesignsoftrendreversals?•Atwhatratesdothereappeartobeimportantbuyandsellorders?Aretheybalanced?Isthemarketoverbought?•Oversold?Whatarethethinkingandexpectationsofothermarketplayersandanalysts?•

6.6.8 Fundamental and Technical ForecastingManagers can forecast exchange rates by using either of the two approaches:

fundamental forecasting•technical forecasting•

Fundamental forecasting uses past trends in exchange rates themselves to spot future trends in rates. Technical forecasters,assumethatifcurrentexchangeratesreflectallfactsinthemarket,thenundersimilarcircumstances,future rates will follow the same patterns.

However, all forecasting is imprecise. Good treasurers and bankers develop their own forecasts of what will happen to a particular currency and use fundamental or technical forecasts of outside forecasters to incorporate them. Doing this helps them to determine whether they are considering important factors and whether they need to revise their forecasts in the light of outside analysis.

Itishardtopredictwhatwillhappentocurrenciesandtousethosepredictionstoforecastprofitsandestablishoperating strategies.

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Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is based on the premise that there are analysable market trends and waves and that previous trends and waves can be used to predict future trends and waves.

6.6.9 The Monetary ApproachThis theory assumes that PPP holds good i.e. an increase in the price level results in the depreciation of a country’s currency and vice versa.

6.6.10 Portfolio Balance ApproachThis approach states that the value of a currency is determined by two factors:

the relative demand and supply of money •the relative demand and supply of bonds•

According to this approach, people can hold assets across different countries, denominated in different currencies (mainly in the form of currencies and bonds). Hence any change in exchange rates, changes the wealth of the balance of these assets, which becomes an instrument for maintaining equilibrium in money and bond markets.

Asperthistheory,interestratesandexchangeratesarelinkedinthemannershowninthefollowingfigure:

Fig. 6.1 Interest rate and exchange rate linkages

In the above, interest rates are shown on the Y axis and the exchange rate on the X axis, with a movement towards therightreflectingdepreciationofthehomecurrency.Curvebbrepresentsthecombinationofinterestratesandexchange rates for which the bond market is in equilibrium and curve mm representing combination of interest rates and exchange rates for which the money markets are in equilibrium. As interest rates rise, the demand for bonds increases, with the supply of bonds not changing, this results in excess demand. This demand can be reduced by reducing the wealth of the portfolio holders. A reduction in the wealth would induce portfolio holders to demand loss of everything, including bonds. This is achieved through an appreciation of the domestic currency. The appreciation reduces the real wealth of the portfolio holders in domestic currency terms. Hence, appreciation of the domestic currency is accompanied by an increase in interest rates in order to maintain equilibrium in the bond market. This makes curve bb onward sloping.

Nom

inal

In

tere

st R

ate

Exchange Rate

b

b

bi

bi

mi

mim

m

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Similarly an increase in interest rates means a lower demand for money with money supply being constant, this result in excess supply of money. To bring the money market back to equilibrium, the demand for money needs to be increased. This can happen if the real wealth of portfolio holders increases through a depreciation of the domestic currency. Hence depreciation of the domestic currency accompanies an increase in interest rates, to maintain the equilibrium in the money markets. This makes the curve more upward sloping.

The equilibrium level of interest rates and exchange rates are determined by the interplay of money market and bond markets and the intersection of two curves. The theory assumes that any change in money supply is effected via open market operations by the government (or the Central Bank), thus changing the supply of bonds. Suppose there is a reduction in the money supply which would be done by the government selling bonds in the market, the reduced money supply would shift the mm curve upwards, since the interest rate would increase for every level of exchange rate. The increase in bond supply would shift curve bb to the right since at every level of exchange, portfolioholderswouldrequireincreasedinterestrate.Thereductioninthemoneysupplywilldefinitelyresultinan increase in interest rates, the effect on exchange rates would depend upon the degree to which the two curves would shift and hence could be in any direction. If curve bb shifts more than curve mm, then there would be a depreciation of the currency.

The theory provides an explanation for a change in the value of currency arising from a change in the real GNP. A higher real GNP results a higher demand for both money and bonds. The higher demand for money increases interest rates and hence shifts the mm curve upwards. The higher demand for bonds reduces the interest rates and hence shifts curve bb to the left. Both the shifts result in an appreciation of the currency, which is higher than that predicted by the monetary theory. But here, the effect on interest rates is ambiguous and depends on the quantum by which the two curves shift.

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SummaryThe law of one price states that “in competitive markets free of transportation costs and barriers to trade (such as •tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency”.Purchasing Power Parity theory of exchange rate is a theory, which establishes the fact that the exchange •rates between currencies are in equilibrium in the event of equality in the purchasing power of each of the countries.Theassetapproachtoexchangerateslooksatthecurrentspotexchangerateasareflectionofthemarket’sbest•evaluation of what is likely to happen to the exchange rate in future.Interest rate parity is an arbitrage condition thatmust holdwhen international financialmarkets are in•equilibrium.The international Fisher effect states that “the nominal interest rate differential must be equal to the expected •inflationratedifferentialintwocountries”.Confidencefactorshelptodeterminethemarketviewsandexpectationswithrespecttothepoliticalenvironment,•as well as to the credibility of the government and Central bank.The monetary approach assumes that PPP holds good i.e. an increase in the price level results in the depreciation •of a country’s currency and vice versa.The portfolio balance approach states that the value of currency is determined by two factors namely: the relative •demand and supply of money and the relative demand and supply of bonds.

Referenceshttp://www.economywatch.com/economics-theory/purchasing-power-parity-theory-of-exchange-rate.•html. Last accessed 24th December, 2010.http://financial-dictionary.thefreedictionary.com/Relative+Purchasing+Power+Parity• . Last accessed 24th December, 2010.http://www.parasoft.com/jsp/aep/aep_practices.jsp?practice=ConfFact• . Last accessed 24th December, 2010.

Recommended ReadingRonald MacDonald (2007). • Exchange Rate Economics: Theories and Evidence. Routledge; Second editionHans Visser (2006). • A Guide to International Monetary Economics, Exchange Rate Theories, Systems and Policies. Edward Elgar Publishing; Third editionRoman Frydman (2007). • Imperfect Knowledge Economics: Exchange Rates and Risk. Princeton University Press; illustrated edition

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Self Assessment

Which of the following theory states that “the purchasing power of two currencies differs by the same proportional 1. rate”?

The relative form of purchasing power paritya. The absolute form of purchasing power parityb. Expected theory of forward ratesc. The asset approach to exchange rated.

Interest rate parity is an arbitrage condition thatmust holdwhen international financialmarkets are in2. __________.

stabilitya. equilibriumb. speculationc. absolute stated.

The _________future spot rate depends on the expectations of the forex market participants. 3. predicteda. expectedb. requiredc. internationald.

Portfolio balance approach assumes that any change in __________is effected via open market operations by 4. the government (or the Central Bank), thus changing the supply of bonds.

exchange ratea. interest rateb. money supplyc. demandd.

According to the international Fisher effect the nominal interest rate differential must be equal to5. theexpecteddeflationratedifferentialintwocountriesa. theexpectedinflationratedifferentialinthreecountriesb. thefutureinflationratedifferentialintwocountriesc. theexpectedinflationratedifferentialintwocountriesd.

WhichofthefollowingstatementisTRUE?6. Technical analysis uses price and volume data to determine future trends, which are expected to continue a. into the future.Technical analysis uses price and volume data to determine current trends, which are expected to continue b. into the future.Technical analysis uses claims and debt data to determine past trends, which are expected to continue into c. the future.Technical analysis uses price and volume data to determine past trends, which are expected to continue into d. the future.

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Fundamental forecasting uses past trends in ________themselves to spot future trends in rates.7. exchange ratesa. expectedinflationb. interest ratec. foreign exchanged.

A currency’s exchange rate is determined by the overall supply and _________for that currency.8. requirementa. useb. demandc. valued.

WhatdoesPPPstandsfor?9. purchasing power portfolioa. purchasing power parityb. purchasing power pricec. price power parityd.

The nominal interest rate comprises of a real interest rate and an expected rate of ________.10. supplya. demandb. inflationc. exchanged.

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Chapter VII

Exchange Risk Management

Aim

The aim of the chapter is to:

discuss the concept of risk•

classify currency exposure•

explain management of exchange risk•

Objectives

The objectives of this chapter are to:

discuss two types of business risks •

defineexposureandrisk•

analyse various ways of hedging transaction exposure•

Learning outcome

At the end of this chapter, students will be able to:

explain four types of exposure •

discussfourtypesoffinancialcontracts•

classify fo• ur operational techniques

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7.1 Foreign Exchange RiskForeign exchange exposure results in foreign exchange risk due to anticipated variability in exchange rates. As businessbecomesincreasinglyglobal,moreandmorefirmsfinditnecessarytopaycarefulattentiontowardsforeignexchange exposure and to design and implement appropriate strategies to handle such risks.

For example: US dollar substantially depreciates against the Japanese Yen, the change in exchange rate can have significanteconomicconsequencesforbothUSandJapanesefirms.

Changesinexchangeratescanaffectnotonlyfirmsthataredirectlyengagedininternationaltradebutalsopurelydomesticfirms.

7.2 Business RiskEvery business is subject to risk. Broadly speaking, business risk can be divided into two categories:

core business risks •environmental risks•

Core business risks: are operational risks such as an unsuccessful new product launch, a new technology which does notperformuptoexpectations,interruptioninrawmaterialsupplies,labourproblems,cyclicaldemandfluctuationsand so forth.

Environmental risks:ariseoutofunpredictablefluctuationsinfinancialvariablessuchasexchangerates,interestrates and stock prices, macroeconomic shocks such as a sudden steep rise in prices of important commodities like crude oil, shifts in government policies and so on. Financial risks are thus a subset of environmental risks.

Whilecorebusinessrisksarepeculiartoaparticularfirm,environmentalrisksarepervasiveandaffectallfirmsoratleastallthefirmsinagivenindustry.However,thedirectionandmagnitudeoftheimpactsdovaryfromfirmtofirm.Thusadepreciationoftheexchangeratemighthaveabeneficialimpactontheexportingfirmwhileithurtsanimportingfirm.

7.3DefiningExposureandRiskTheimpactoffluctuationinfinancialpricescanbeillustratedbyanumberofsituations:

An appreciation of the value of a foreign currency (or equivalent, a depreciation of the domestic currency) •increasesthedomesticcurrencyvalueofafirm’sforeigncurrencyassetsandliabilitiessuchasforeigncurrencyreceivables and payables, bank deposits and loans, etc. Itwillalsochangedomesticcurrencycashflowsfromexportsandimports.•Anincreaseininterestratesreducesthemarketvalueofaportfoliooffixedratebondsandmayincreasethe•cashoutflowonaccountofinterestpayments.Accelerationintherateofinflationmayincreasethevalueofsoldstocks,therevenuesfromfuturesalesaswell•as the future costs of production.

Theabovedemonstratesthatthefirmis“exposed”tounforeseenexchangeinanumberofvariablesinitsenvironment.These variables are also called risk factors.

Uncertaintiesarisingoutoffluctuationsinexchangerates,interestratesandrelativepricesofkeycommoditiessuchascrudeoil,copper,etc.createstrategicexposureandriskforafirm.

Thelongtermresponseofthefirmtotheseriskscaninvolvesignificantchangesinthefirm’sstrategicposture.Choice of product - market combinations, sourcing of inputs, choice of technology, location of manufacturing activities, strategic alliances and so forth.

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The terms exposure and risk though often used interchangeably are not identical. Exposure is a measure of the sensitivityofthefirm’sperformance,howevermeasuredtofluctuationintherelevantriskfactor.Whileriskisameasure of the extent of variability of the performance measure attributable to the risk factor.

Followingaretheimportantpointsaboutthedefinitionofexposureandrisk:Valueofassetsandliabilitiesoroperatingincomeisdenominatedinthefunctionalcurrencyofthefirm.Thisis•theprimarycurrencyofthefirminwhichitsfinancialstatementsarepublished.Formostfirmsitisthedomesticcurrencyofthefirm.Exposureisdefinedwithregardtotherealvaluesi.e.,valuesadjustedforinflation.Whiletheoreticallythisis•thecorrectwayofassessingexposure,inpracticeduetothedifficultyofdealingwithanuncertaininflationrate,this adjustment is often ignored i.e., exposure is estimated with reference to changes in nominal value.Thedefinitionstressesthatonlyanticipatedchangesintherelevantriskfactoraretobeconsidered.Thereason•being that, markets have already considered allowance for anticipated changes. From the operational point of view, how do we separate a given change in exchange rate or interest rate into •anticipated and unanticipated components since only the actual change can be observed. One possible option of estimatingwhatwillbetheexchangerateafter3monthsfromthetransactiondateistoconsiderafirmwhichhas a 90 day payable amounting to US$ 500,000, arising out of a raw material import transaction. The current spot rate is Rs. 43.60 per dollar and the three months’ forward rate is Rs. 43.80. Three months later, the spot rate turns out to be Rs. 44.00. Thus the unanticipated depreciation of the rupee is 44-43.80 or Rs. 0.20 per dollar. The loss on account of the increase in the rupee value of the payable is Rs. 100,000.

Exchange rate risk: Exchange rate risk is a measure of variability of the value of an item attributable to the fluctuationsintheunderlyingexchangerate.Itdependsuponthesizeoftheexposure(transaction)andtheextentoffluctuationexpectedintheunderlyingexchangerate.Exchangerateriskcanbecapturedbyanalysingthe“bestcase” and “the worst case” scenarios to gauge the maximum possible variation in the value of the item under consideration. In the most formal way, we must use the statistical concept of variance or standard deviation to measurefinancialrisk.

Example: AfirmexportsdenimjeanstotheUS,sellingapairofjeansatUSD50.TheexchangerateisRs.44/00,itsoperating costs are Rs.1600 per pair of jeans. Thus its operating margin on export sales is Rs.2200-Rs.1600.00=Rs.600 perpair.Overthenextyear,USinflationisexpectedat5%pa,Indianinflationisat10%perannumandbytheyearend,theexchangeratedepreciatestoRs.45.00.AssumethatitraisesitspriceintheUSmarketby5%(basedoninflationrateof5%)toRs.52.50anditsoperatingcostsgoupby10%(theIndianrateofinflation)toRs.1760.Itsoperating margin per unit is now (52.50 X 45)-1760=2362.50-1760=602.50.

In real terms adjusted for inflation at 10%, the operatingmargin has shrunk fromRs.600 to (602.50/1.1)Rs.547.72.

Itisobservedthatinthepresentcasetheimpactofexchangeratefluctuationsintheoperatingcashflowdependsupon several factors such as:

change in price•quantity response to price change•changes in unit costs and•changes in exchange rate•

Unlikethecaseofcontractuallyfixeditemslikeaforeigncurrencyreceivableorpayable,wecannotaccesstheimpactofexchangeratefluctuationsonthefirm’sfuture,cashflowandprofitabilityunlessweknowthestructureofthemarketinwhichthefirmsells,pricesensitivityofdemand,currencycompositionofitsoperatingcostandthestructureofthemarketinwhichitbuysitsinputs.Theseinturnwillhaveabearingonthefirm’scompetitiveposition in the output markets.

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Intheabovesituation,preciseassessmentofexposureoffuturecashflowandprofitispossibleby:Constructinganalternativescenarioinwhichtherelevantriskfactore.g.exchangeratetakesspecificvaluesand•alternatefuturecashflowsforeachscenario.Thiswillgiveanestimateastohowsensitivefuturecashflowsaretofluctuationsintheexchangerate.Thisrequiresathoroughunderstandingofthefirm’sbusinessincludingits competition, customers and cost structure.Alternatively,onecanadoptastatisticalapproachusingpastdatatoaccesstheinfluenceoftherelevantrisk•factoronatargetperformancevariablesuchascashflow.

7.4ClassificationofCurrencyExposure

Fig. 7.1 Schematic picture of currency exposure

Figure7.1presentsaschematicpictureofcurrencyexposure.Thefirstgroupofexposuresknownasaccountingexposuresrelatetoitemsthatcurrentlyappearinthebalancesheetandincomestatementofthefirm.

Within this group we have two further categories, e.g. transaction exposure and translation exposure.

7.4.1 Transaction ExposureThis is a measure of the sensitivity of the home currency value of assets and liabilities which are denominated in foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated. The foreigncurrencyvaluesoftheseitemsarecontractuallyfixedi.e.theydonotvarywithexchangerate.Thisisalsoknown as contractual exposure.

Some examples that lead to transaction exposure are:A currency has to be converted in order to make or receive payment for goods and services.•A currency has to be converted to repay a loan or make an interest payment (for foreign currency loan) or receive •a repayment of loan or an interest on loan and advances (denominated in foreign currency).A currency has to be converted to make a dividend payment, royalty payment (to overseas shareholders or •overseascollaborators).Inallthecases,theforeigncurrencyvalueoftheitemisfixed,theuncertaintypertainstohomecurrencyvalue.Forexample,ifafirmhasenteredintoacontracttosellcarstoforeigncustomersatafixedpricedenominatedinforeigncurrency,thefirmwouldbeexposedtoexchangeratemovementstillitreceives the payment and converts the receipts into the domestic currency. The exposure of a company in a particularcurrencyismeasuredinnettermsi.e.afternettingofpotentialcashinflowswithoutflows.

Current Exposure

Short term

Accounting (Translation)

Contractual (Transaction)

Anticipated

Cashflow Operating Strategic

Long term

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7.4.2 Translation ExposureTranslation exposure arises from the need to “translate” foreign currency assets or liabilities into the home currency forthepurposeoffinalisingtheaccountsforthegivenperiod.

Atypicalexampleofatranslationexposureisthetreatmentofforeigncurrencyloan(mediumterm)tofinance.The import of capital goods was worth US $ 1 million. When the import materialised, the exchange rate was Rs 43/-per$.TheimportedfixedassetwascapitalisedinthebooksofthecompanyatRs.430/-lakhs.Intheordinarycourse and assuming no change in the exchange, the company would provide depreciation on the asset values at Rs.430/-lakhsforfinalisingtheaccountsfortheyearinwhichtheassetwaspurchased.

7.4.3 Operating ExposureThe operating exposure is also known as economic exposure. The second group of exposure consists of contingent and competitive exposures and together they are known as operating exposures. The principal focus is on items whichwillhaveanimpactoncashflowsofthefirmandwhosevaluesarenot(yet)contractuallyfixedinforeigncurrency terms.

Of the two categories, contingent resources have a much shorter time horizon. Typical situations giving rise to such exposure are:

Animportorexportdealisbeingnegotiated.Quantitiesandpricesaretobefinalised.Fluctuationinexchange•ratewillprobablyinfluencebothandthenitwillbeconvertedintotransactionexposure.Thefirmhassubmittedatenderbidonanequipmentsupplycontract.Ifthecontractisawarded,transaction•exposure will arise.Afirmimportsaproductfromabroadandsellsitinthedomesticmarket.Suppliesfromoverseasarereceived•continuouslybutformarketingconveniencethefirmpublishessellingpriceinhomecurrencywhichholdsgoodfor six months. While the sales proceeds in domestic currency may be more or less certain, costs measured in homecurrencyareexposedtocurrencyfluctuations.

Inallthesecases,currencymovementwillaffectfuturecashflows.Competitive exposure is the most crucial dimension of currency exposure. Its home horizon is longer than that of transactionexposure,sayaroundthreeyears.Thefocusisonfuturecashflowsandhencealongrunsurvivalandvalueofthefirm.

7.4.4 Strategic ExposureCompetitiveexposureisoftenreferredtoas“StatisticExposure”becauseithassignificantimplicationsforsomestrategic business decisions. It influences thefirm’s choice ofmarkets, products, source of inputs, locationofmanufacturing activity and decisions as to whether foreign operation should be started.

A number of examples from recent history clearly brings out the nature of operating exposure:Theincreaseindollarduringthe1sthalfof1980’serodedthecompetitivepositionofmanyUSfirmswhere•the costs were dollar denominated. E.g. Kodak found that their sales were spread all over the world whereas thecostsweredollardenominated.TheyfacedstiffcompetitionfromJapanesefirmssuchasFujibothintheUS market as well as third country markets.Further when the dollar started falling against the yen and deutsche mark around mid 1985 and continued to •fall for over two years, Japanese and German car makers found their operating margins being squeezed. They responded by starting manufacturing in the US and partly by moving up into premium priced luxury cars where consumer sensitivity to price increases is relatively less.Athome,IndianmanufacturersofcarsandtwowheelerswithsignificantimportcontentdenominatedinYen•found that strengthening of Yen resulted in cost increase which they would not allow to pass on to the consumer because of depressed demand conditions and competitive consideration.

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Inallthesecases,exchangeratechangescoupledwithconcomitantchangesinrelativecosthadasignificantimpactonthefirm’sabilitytocompeteeffectivelyinparticularproductmarketsegments,toundertakegoodinvestmentprojects and thus to enhance their long run growth potential.

7.5 Management of Exchange RiskTransaction exposure:Afirmissubjecttotransactionexposurewhenitfacescontractualcashflowsthatarefixedinforeigncurrencies.SupposethataUSfirmsolditsproducttoaGermancustomeronthreemonthcredittermsandinvoicedinEuro.WhentheUSfirmreceivesEurointhreemonths,itwillhavetoconvert(unlessithedges)theEuro into Dollar at the spot exchange rate prevailing on the maturity date, which cannot be known in advance. As a result the Dollar receipt from this export sale becomes uncertain; should the Euro appreciate (depreciate) against the dollar, the dollar receipt will be higher (lower).

The various ways of hedging transaction exposure are as follows:Financial contracts•

Forward market hedge �Future market hedge �Option market hedge �Money market hedge �

Operational techniques•Exposure netting �Heading and lagging �Hedging by choosing the currency of invoice �Hedging through sourcing �

7.5.1 Forward Market HedgeThisisthemostdirectandpopularwayofhedgingtransactionexposure.Generallyspeakingthefirmmaysell(buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. Let us consider a business situation:

Suppose Boeing Corporation exported a Boeing 747 to British Airways and billed pound million payable in one year. The money market interest rate and foreign exchange rates are given as follows:-TheUSinterestrate 6.10%paTheUKinterestrate 9.00%paThe spot exchange rate $1.50/poundThe forward exchange rate $1.46/pound (1 year maturity)

In the above situation, in order to hedge foreign exchange exposure, Boeing may supply sell forward its pounds receivables, 20 Million pounds for delivery in one year, in exchange for a given amount of the US dollar. On the maturity date of the contract Boeing will have to deliver 20 million pounds to the bank, which is the counter party of the contract and in return take delivery of $29.2 million ($1.46 x 20 million) regardless of the spot exchange rate that may prevail on the maturity date. Boeing will use the 20 million pounds that it is going to receive from British Airwaystofulfiltheforwardcontract.Underthismethod,Boeingpoundreceivableisexactlyoffsetbythepoundpayable (created by the forward contract, the company’s net pound exposure becomes zero).

Suppose that on the maturity date of the forward contract, the spot rate turns out to be $1.40/pound which is less than the forward rate $1.46/pound. In this case, Boeing would have received $28.0 million rather than $29.2 million had it not entered into the forward contract. Thus one can say that Boeing gained $1.2 million from forward hedging. If the spot rate is say $1.50/pound on the maturity date, then Boeing could have received $30.0 million by not hedging. Of course forward hedging costs Boeing $0.80 million. The gains and losses from forward hedging at different spot exchange rates on the maturity date are given below:

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Table 7.1 Table showing gains and losses from forward hedging at different spot exchange rates on the maturity date

From the above one can observe that the gain will be positive as long as forward exchange rate is greater than the spot rate on the maturity date.

It is important to note that the above analysis is ex-post in nature, and no one can guess what the future spot rate will bebeforehand.Thefirmhastodecidewhethertohedgeornottohedgeex-ante(earlier).Tohelpthefirmdecide,it is necessary to consider the following three alternative scenarios.

Sr = F �Sr < F �3.Sr > F �

Underthefirstscenario,wherethefirm’sexpectedfuturespotrate(Sr)isapproximatelysameasforwardrate(F).The expected gains of loss are approximately zero. But forward hedging eliminates exchange exposure. Under this scenariothefirmwouldbeinclinedtohedgesolongasitisaversetorisk.

Underthesecondscenario,wherethefirm’sexpectedfuturespotexchangerateislessthantheforwardrate,thefirmexpectsapositivegainfromforwardhedging.Sincethefirmexpectstoincreasethedollarproceeds,whileeliminating exchange exposure, it would be even more inclined to hedge under this scenario.

Underthethirdscenario,wherethefirm’sexpectedfuturespotexchangerateismorethantheforwardrate,thefirmcan eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds from theforeignsale.Thusthefirmwouldbelessinclinedtohedgeunderthisscenario,otherthingsbeingequal.Whetherthefirmactuallyhedgesornotdependsuponthedegreeofriskaversion,themoreriskaversethefirmis, more likely it is to hedge.

7.5.2 Hedging through FuturesThe second way to hedge exposure is through futures. The rule is the same as in the forward market.Example:ABritishfirmordersfarmequipmentworthUSD5millionfromaUSsupplier.Thepaymentisdueinthree months. The market rates are:

Pound/USD spot 1.7225 90 days forward 1.7165

LIFFE September Pound Future 1.7170 Thefirmdecidestohedgebyselling47sterlingcontracts(thisisequivalenttobuyingdollarfutures)withatotalvalue of Pound 2937,500 = USD 5043687.5 at USD 1.7170/Pound. It pays a brokerage fee of 50 pound per contract or Pound 2350 for the total amount.

Spot Exchange Rate On the Maturity Date

Receipts from British Sale

(1) Unhedged Portion(2) = (1) × 20,000,000

Forward Hedge(3) = 1.46 × 20,000,000

Gain or loss from hedge (4) = (3)-(2)

$1.30 $26,000,000 29,200,000 3,200,000$1.40 $28,000,000 29,200,000 1,200,000$1.46 $29,000,000 29,200,000 0$1.50 $30,000,000 29,200,000 (-) 800,000$1.60 $32,000,000 29,200,000 (-) 2800,000

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On the maturity date, the following prices rule:

USD/Poundspot1.6680Septemberfutures1.6650.ThefirmbuysUSD5millionattherulingspotandclosesoutits future position.

SterlingoutflowonspotpurchasingUSD5million=50,000,000/1.6680=Pound2,997,601.9

Gain on future=USD (1.7170-1.6650)(2937500) =USD52750=Pound 91576.74 at $1.6680/Pound

Totalsterlingoutlay=2997601.90+2350.00$-91576.74=Pound2908,375.20AffectiveUSD/Poundrateobtainedbythefirmis=50,000,000/2908375.20=1.7191

The hedge through future turns out to be better than a forward hedge. The effective rate with the latter would have been 1.7165. This is despite the adverse basis movement (as usual we have ignored the effect of marking to market).

7.5.3 Money Market HedgeTransaction exposure can also be hedged by lending and borrowing in the domestic and foreign markets.

Generally speaking thefirmmayborrow (lend) in foreign currency to hedge its foreign currency receivables(payables), thereby matching its assets and liabilities in the same currency. Again using the same situation of Boeing itcaneliminatetheexchangeexposurearisingfromtheBritishsalebyfirstborrowinginpounds,thenconvertingtheloan proceeds into dollars which then can be converted at the dollar interest rate. On the maturity date of the loan, Boeing is going to use the pound receivables to pay off the pound loan. If Boeing borrows a particular pound amount so that the maturity value of this loan becomes exactly equal to the pound receivable from the British sale, Boeing’s netpoundexposureisreducedtozeroandBoeingwillreceivethefuturematurityvalueofdollarinvestment.Thefirstimportant step in money market hedging is to determine the amount of pounds to borrow. Since the maturity value of borrowing should be the same as the pound receivable, the amount to borrow can be computed as the discounted presentvalueofthepoundreceivablethatispound10million/(1.09)(rateofinterest@9%)=£9174,312.Thestepby step procedure of money market hedging can be illustrated as follows:

Step 1- Borrow £9174, 312 in the UKStep 2- Convert £ 9174,312 into $ 13761.468 at the current spot exchange rate of $ 1.50 /£Step 3- Invest $13,761,468 in the USStep 4- Convert £ 10 million from British Airways and use it to repay the pound loanStep 5- Receive the maturity value of the dollar investment i.e. $14,600,918=$13761, 468 (1.061) which is the guaranteed dollar proceed from the British sale

Thefollowingtableshowsthat thenetcashflowiszeroat thepresent time, implyingthatapart frompossibletransactioncosts,themoneymarkethedgeisfullyself-financing.Thetablealsoclearlyshowshowthe£10millionreceivableisexactlyoffsetbythe£10millionpayable(createdbyborrowing)leavinganetcashflowof$14,600,918on maturity date.The maturity value of dollar invested from the money market hedge turns out to be nearly identical to the dollar proceeds from forward hedging.

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Table 7.2 Table shows how the £10 million receivable is exactly offset by the £10 million payable leaving a netcashflowof$14,600,918onmaturitydate

7.5.4 Option Market HedgeOne shortcoming of both forward and money market hedge is that these methods completely eliminate exchange exposure.Hence thefirmcannot take theopportunityof benefiting from favourable exchange rate change.Toelaborate this point, let us assume that the spot rate turns out to be $1.60 / £ at the time of maturity date of the forward contract.Asalreadyseen,theforwardhedgingwouldcostthefirm$1.4millionintermsofforeigndollarreceipts.Withitspoundreceivable,Boeingideallywouldliketoprofititselfonlyifthepoundweakens;whileretainingtheopportunitytobenefitifthepoundstrengthens.Currencyoptionprovidessuchaflexible“optional”hedgeagainstexchangeexposure.Generallyspeaking,thefirmmaybuyaforeigncurrencycall(orput)optiontohedgeitsforeigncurrency payables (receivables).

It shows how the option works, suppose that in the over-the-counter market, Boeing purchased a put option on £ 10 million with an exercise price of $ 1.46 and one year expiration. Assume that the option premium (price) was $0.02 per pound. Boeing thus paid $ 200,000 (=$0.02x10 million) for the option. This transaction provides Boeing with the right but not the obligation, to sell up to £ 10 million for $1.46/ £ regardless of the future spot rate.

Now assume that the spot rate turns out to be $1.30 on the expiration date. Since Boeing has the right to sell each pound for $1.46, it will certainly exercise its put option on the pound and convert £ 10 million into $14.6 million. Themainadvantageofoptionhedgingisthatthefirmcandecidewhethertoexercisetheoptionbasedontherealisedspot exchange rate on the expiration date. Boeing has paid $ 200,000 up front for the option. Considering the time value of money, this is equivalent to $200,000x1.61 i.e., $212,200 as on the expiration date. Thus under the option hedge, the net dollar proceeds from the British sale becomes $14600, 000-$212,000=$14387, 800.

Since Boeing is going to exercise its put option whenever the future spot exchange rate falls below the exercise rate of $ 1.46, it is assured of “minimum dollar receipt” of $ 14,387,800 from the British sale.

Next, let us consider an alternative scenario where the pound appreciates against the dollar and the spot exchange rate on the date of maturity works out to be $1.60 per pound. Boeing in that case would have no incentive to exercise the option. It will let the option expire and convert £ 10 million into $ 16 million at the spot rate. Subtracting $212,200 from the cost of option the net proceeds will become $15,787,800 ($ 16 million - charges $212,200).

Asseen,theoptionhedgeallowsthefirmtolimitthedownsideriskwhilepreservingtheupsidepotentialwithachange of option premium.The break-even spot rate, which is useful for choosing the hedging method, can be determined as follows:£ 10,000,000 x break-even spot rate -$212,200= $ 14,600,000

Solvingtheequation,wegetbreak-evenspotrate$1.48/£.Thebreak-evenanalysissuggeststhatifthefirm’sexpectedfuture spot rate is greater (less) than the break-even rate, then the option (forward) hedge might be preferred.

Transaction CurrentCashflow Cashflowatmaturity

1. Borrow pounds ₤9174,312 -₤10,000,000

2. Buy dollar spot with pounds $13,761,468₤-9174,312-$13,761,468

3. Invest in the US $14,600,918

4. Convert pound receivable net ₤10,000,000

5.Netcashflow 0 $14,600,918

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A put optionAputoptiongivestheoptionbuyertherighttosellacurrencyYagainstacurrencyXataspecifiedpriceKonorbeforeaspecifieddate.ThewriteroftheputoptionmusttakedeliveryofYanddeliverXiftheoptionisexercised.

7.5.5 Hedging Recurrent Exposure with Swap ContractsFirms often have to deal with a “sequence” of account payable or receivable in terms of a foreign currency. Such recurrentcashflowsinaforeigncurrencycanbestbehedgedusingacurrencyswapcontract,whichisanagreementto exchange one currency for another at a predetermined exchange rate i.e., the swap rate on a sequence of future dates. As such, a swap contract is like a portfolio of forward contracts with different maturities.

Suppose that Boeing is scheduled to deliver an aircraft to British Airways at the beginning of each year for the nextfiveyears,BritishAirwaysinturnisscheduledtopay£10,000,000toBoeingonDecember,1ofeachyearforfiveyears.Inthiscase,Boeingfacesasequenceofexchangeriskexposures.Aspreviouslymentioned,Boeingcanhedge this type of exposure using a swap agreement by which Boeing delivers £ 10,000,000 to the counter party of the contract in December of each year for 5 years and takes delivery of the predetermined dollar amount each year. If the agreed swap exchange rate is $1.50 / £, then Boeing will receive $15 million each year, regardless of thefuturespotandforwardrates.Notethatasequenceoffiveforwardcontractswouldnotbepricedatuniformrate $ 1.50 / £, the forward rate will be different for different maturities. In addition, longer term forward contracts are not readily available.

7.5.6 Exposure NettingExposure netting involves creating exposure in the normal course of business which offsets / balances the existing exposures. The exposures so created may be in the same currency as the existing exposures or in any other currency but the effect should be that any movement in exchange rates that results in a loss on the original exposure that should result in a gain on the new exposure. This may be achieved by creating an opposite exposure in the same currency or a currency, which moves in tandem with the currency of the original exposure. It may also be achieved by creating a similar exposure in a currency which moves in the opposite direction to the currency of the original exposure.

7.5.7 Hedging via Lead and LagHedging and lagging can also be used to hedge exposures in “lead” means to pay or collect early whereas to “lag” meanstopayorcollectlate.Thefirmwouldliketoleadsoftcurrencyreceivablesandlaghardcurrencyreceivablestoavoidthelossfromdepreciationofthesoftcurrencyandbenefitfromtheappreciationofthehardcurrency.Forthesamereason,thefirmwillattempttoleadthehardcurrencypayableandlagsoftcurrencypayables.

Thelead/lagstrategycanbeemployedmoreeffectivelytodealwithintrafirmpayablesandreceivablessuchasmaterial cost, rents, royalties, interests and dividends among subsidiaries of the same multinational corporation. Since,managementsofvarioussubsidiariesofthesamefirmarepresumablyworkingforthegoodoftheentirefirm,thelead/lagstrategycanbeappliedmoreaggressively.

7.5.8 Hedging through Invoice CurrencyThefirmcanshift,shareordiversifyexchangeriskbychoosingthecurrencyofinvoice.Inourexample,ifBoeinginvoices $ 15 million rather than £ 10 million for the sale of the aircraft, then it does not face exchange exposure anymore. Note however that, the exchange exposure has not gone; it has merely shifted to the British importer. British Airways now has an account payable in US dollars. Instead of shifting exchange exposure entirely to British Airways, Boeing can share the exposure with British Airways by invoicing half of the bill in US dollars and the remaining half in British pounds that is $ 7.5 million and £ 5 million.

Anotherwayofusingthechoiceofinvoicingcurrencyasahedgingtoolrelatestotheoutlookofthefirmaboutvarious currencies. This means invoicing exports in a hard currency and imports on soft currency. The currency so chosen may not be domestic currency for either of the parties involved and may be selected because of its stability (like the dollar, which serves as an international currency).

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SummaryForeign exchange exposure results in foreign exchange risk due to anticipated variability in exchange rates. •Changesinexchangeratescanaffectnotonlyfirmsthataredirectlyengagedininternationaltradebutalso•purelydomesticfirms.Core business risks are operational risks such as an unsuccessful new product launch, a new technology which •does not perform upto expectations, interruption in raw material supplies, labour problems, cyclical demand fluctuationsandsoforth.Environmentalrisksariseoutofunpredictablefluctuationsinfinancialvariablessuchasexchangerates,interest•rates and stock prices, macroeconomic shocks such as a sudden steep rise in prices of important commodities like crude oil, shifts in government policies.Exposure isameasureof thesensitivityof thefirm’sperformance,howevermeasuredtofluctuationin the•relevant risk factor.Risk is a measure of the extent of variability of the performance measure attributable to the risk factor•Exchangeraterisk isameasureofvariabilityof thevalueofan itemattributable to thefluctuations in the•underlying exchange rate.Transaction Exposure: this is a measure of the sensitivity of the home currency value of assets and liabilities •which are denominated in foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated.Translation exposure arises from the need to “translate” foreign currency assets or liabilities into the home •currencyforthepurposeoffinalisingtheaccountsforthegivenperiod.Competitive exposure is the most crucial dimension of currency exposure. Its home horizon is longer than that •oftransactionexposure,sayaroundthreeyears.Thefocusisonfuturecashflowsandhencealongrunsurvivalandvalueofthefirm.Competitiveexposureisoftenreferredtoas“StatisticExposure”becauseithassignificantimplicationsfor•some strategic business decisions.Forward Market Hedge: this is the most direct and popular way of hedging transaction exposure. Generally •speakingthefirmmaysell(buy)itsforeigncurrencyreceivables(Payables)forwardtoeliminateitsexchangerisk exposure.Exposure netting involves creating exposure in the normal course of business which offsets / balances the •existing exposures.Hedging and lagging can also be used to hedge exposures in “lead” means to pay or collect early whereas to •“lag” means to pay or collect late.

Referenceshttp://www.kshitij.com/risk/fxmgmain.shtml• . Last accessed on 27th December, 2010.http://www.bizterms.net/term/Money-market-hedge.html• . Last accessed on 27th December, 2010.http://www.florin.com/valore/currencyrisk.html• . Last accessed on 27th December, 2010.

Recommended ReadingDonald R. Van Deventer (2004). • Advanced Financial Risk Management: Tools & Techniques for Integrated Credit Risk and Interest Rate Risk Managements. Wiley.Brian Coyle (2002). • Foreign Exchange Markets: Currency Risk Management (Risk Management Series). Global Professional Publishing; Revised edition.Laurent L. Jacque (1997). • Management and Control of Foreign Exchange Risk.Springer;firstedition.

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Self Assessment

Exchangeraterisk isameasureof_________of thevalueofanitemattributable to thefluctuations in the1. underlying exchange rate.

variabilitya. hedgingb. laggingc. swappingd.

Which of the following is a measure of the sensitivity of the home currency value of assets and liabilities which 2. aredenominatedinforeigncurrency?

Translation exposurea. Transaction exposureb. Competitive exposurec. Exchange exposured.

___________isameasureofthesensitivityofthefirm’sperformance.3. Riska. Exchangeb. Exposurec. Hedgingd.

One shortcoming of both forward and money market hedge is that these methods completely eliminate 4. ______________.

translation exposurea. transaction exposureb. competitive exposurec. exchange exposured.

WhichofthefollowingstatementisFALSE?5. Foreign exchange exposure results in foreign exchange risk due to anticipated variability in exchange a. rates.Changesinexchangeratescanaffectnotonlyfirmsthataredirectlyengagedininternationaltradebutalsob. purelydomesticfirms.The terms exposure and risk though often used interchangeably are identical.c. Competitive exposure is the most crucial dimension of currency exposure.d.

Which of the following is an agreement to exchange one currency for another at a predetermined exchange 6. rate?

Currency exchange ratea. Currency swap contractb. Transaction exposurec. Translation exposured.

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________is a measure of the extent of variability of the performance measure attributable to the risk factor.7. Exchange ratea. Riskb. Exposurec. Laggingd.

The most direct and popular way of hedging transaction exposure8. Forward Market Hedgea. Hedging through Futuresb. Money Market Hedgec. Option Market Hedged.

Exposure ________ involves creating exposure in the normal course of business which offsets / balances the 9. existing exposures.

hedginga. laggingb. nettingc. swappingd.

Transaction exposure is also known as10. Exchange exposurea. Swapping exposureb. Contractual exposurec. Competitive exposured.

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Chapter VIII

The International Financial Market and Instruments

Aim

The aim of the chapter is to:

explaintheoriginofinternationalfinancialmarket•

describe international money market•

analyse instruments available in international capital markets•

Objectives

The objectives of this chapter are to:

discuss euro currency market, euro credits, euro notes, euro medium term notes and euro commercial paper•

explain international capital market instruments •

Learning outcome

At the end of this chapter students will be able to:

explain equity instruments•

analyse international bond market indexes•

discuss do• cumentation of euro equity

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8.1 Introduction to International Financial MarketThe gap between savings and investment is widening gradually in developing countries. The growing demand forcapitalinflowsinthedevelopingcountriesforcesthemtodependmoreonexternalsourcesfordebtorequitycapital.

The need for external borrowing in the country’s economy can be gauged from the national income and balance of payment position. Based on balance of payment position of a country the source of external funds can be broadly classifiedintothefollowingcategories:

external assistance in the form of aid•commercial borrowings•short term credit•non-resident deposits•foreign direct investment•

Theflowofexternalfundsintoacountrydependsuponvariousfactorslike:policy guidelines of the country on commercial borrowings by individual entities•the exchange control regulation of the country•theinterestrateceilingsinthefinancialsector•he structure of taxation•

Theintegrationoffinancialmarketsacrosscountrieshasopenedupinternationalmarketsandtosealthechangingneedsoftheinternationalinvestors,alargevarietyoffinancialinstrumentshaveemerged.

Thefinancialmarketacrosscountries facilitates thefinancial intermediation/dis-intermediationand transferofsurplusfundsfromthesaverstothedeficitunit.Thegradualliberalisationofthefinancialsectorindevelopingcountries in the early 70’s has further strengthened the above process.

8.2 Origin of the International Financial MarketThe need for the present international market can be traced back to the 1960’s when there was a real demand for high quantity dollar dominated bonds from wealthy Europeans (and others) who wished to hold their assets outside their home countries or in currencies other than their own. The twin concerns were avoidance of taxes in their home country and protection from the falling value of domestic currencies.

Till1970,theinternationalcapitalmarketfocusedondebtfinancingandequityfinancingwasraisedbycorporateprimarily in the domestic currency. This was due to the restrictions on cross-border equity investments. Investors too preferred to invest in domestic equity issues due to perceived risks implied in foreign equity issues.

Since 1970’s major changes have occurred. During this period, exchange control restrictions were removed in countries likeUK,FranceandJapanwhichgaveafurtherboosttofinancialmarketoperations.Inadditiontheapplicationofnewtechnologytofinancialservices,theinstitutionalisationofsavingsandderegulationofmarketsplayedanimportantroleinchannelisingfundsfromthesurplusunitstodeficitunitsacrosstheglobe.Theinternationalcapitalmarketsalsobecameamajorsourceofexternalfinancefornationswithlowinternalsavings.

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ThevarioussourcesofexternalfinanceandvariouschannelsforaccessingexternalfundsaregiveninFig.8.1.

Fig.8.1Sourceofexternalfinance

8.3 India’s Presence in International MarketsIndia has made its presence felt in the international market to a very small extent. There has been a total turnaround in the market sentiment for India since 1991-92.

Earlier the traditional revenues for raising capital abroad was through bank borrowings, syndicated loans, lines of credit,bondsandfloatingratenotes.Accesstotheinternationalcapitalmarketwasonlythroughdebtinstrumentsandwasonlylimitedtofinancialinstitutionsandpublicsectorunitswithfewcasesofprivatecompanies.Withthe downward revision of Indian credit rating to the non-investment grade, borrowing in the international capital market dried up. The picture has since changed. There are a variety of reasons for international market to view India differently. Some of the reasons are:

better percentage of India’s economic reform being implemented with utmost sincerity•improved export performance•modest to healthy economic indicators•inflationcontainedtosingledigit•improved forex reserves position•improved performance of Indian companies•improvedconfidenceofForeignInternationalInvestors(FIIs)inthecountry•lack of investment opportunities worldwide•decline in the rate of return on investments in developed markets•

In March 1992, the government terms permitted a few Indian companies to tap the international equity market and till date a number of Indian companies have successfully taken the equity / equity related route.

8.4 International Money MarketInternational money market is that where exchange is used for trading currency and interest rate futures contracts and options. Established in 1972 in wake of the monetary upheaval caused by collapse of the Bretton Woods System, it operates as a division of Chicago Mercantile Exchange (CME).

IMFIFC

ADBCountry Funds

Global Mutual FundsPension Funds

Commercial Banks etc.

Surplus units Deficitunits

International Finance Market

Money Market Capital Markets

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8.4.1 Euro Currency MarketA Euro currency is the time deposit of money in an international bank located in a country different from the country that issued the currency.

For example, Euro dollars are deposits of US dollars in banks located outside the US, Euro sterling are deposits of BritishpoundsinbanksoutsideUK,EuroYenaredepositsofJapaneseyeninbanksoutsideJapan.TheprefixEurois somewhat a misnomer since the bank in which deposit is made need not be located in Europe. The depository bank would be located in Europe, the Caribbean or Asia.

The origin of the Euro currency market can be traced back to the 1950’s and early 1960’s when the former Soviet Union and Soviet block countries sold gold and commodities to raise hard currency. Because of anti Soviet sentiment, these communist countries were afraid of depositing their US dollars in US banks for fear that the deposits could be frozen or infringed. Instead, they deposited their dollars in the French bank whose telex address was Euro-Bank. Since that time, dollar deposits outside the US have been called Euro dollars and banks accepting Euro currency deposits have been called Euro Bank.

The Euro currency market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency. Both banking systems seek deposits and give loans to customers from deposit funds. In United States, banks are subject to the Federal Reserve recognition in specifying reserve requirements on time deposits. Additionally, US banks are required to buy FDIC insurance premium on deposit funds. Euro dollars are not subject to reserve requirements or deposit insurance; hence the cost of operations is less. The Euro currency market has grown spectacularly since its inception.

The Euro currency market operates on the inter bank and / or wholesale level and represents a sum of $ 1 million or more. Euro banks with surplus funds will tend to lend to Euro banks of the inter bank offered rate with a spread of1/8of1%formostmajorEurocurrencies.

LondonhashistoricallybeenandremainsthemajorEurocurrencyfinancialcentre.LondonInterBankOfferedRate(LIBOR) is the reference rate in London for Euro currency deposits. To be clear there is LIBOR for Euro dollar, Euro Canadiandollar,EuroYenandsoon.Inotherfinancialcentres,otherreferencesareused.Forexample;SIBORistheSingapore inter bank offered rate, PIBOR for Paris inter bank offered rate, and BRIBOR in the Brussels inter bank offered rate. Because of competition, the various inter bank rates for a particular Euro currency is very close.After the advent of the Euro currency on January 1, 1999, among the eleven countries of the European Union comprising economic and monetary union, created a need for a new inter bank offered rate. EURIBOR is the rate at which inter bank deposits of the Euro are offered by one prime bank to another in countries that comprise EMU EU countries and major prime banks in non- EU countries.

Inthewholesalemoneymarket,EurobanksacceptEurocurrencyfixedtimedepositsandissuenegotiablecertificatesof deposits (NCDS). In fact these are the preferable ways for Euro banks to raise loanable funds, as the deposits tend to be for a lengthier periods and the acquiring rate is often slightly less than the inter bank rate. Denominations are at least $500,000 but sizes of $1000, 000 or larger are more typical. Rates on Euro currency deposits are quoted for maturities ranging from one day to several years, however more standard maturities are 1, 2,3,6,9 and 12 months. Approximately95%ofwholesaleEurodepositscomefromfixedtimedeposits,theremainderfromNCDs.Thereisaninterestpenaltyfortheearlywithdrawalsoffundsfromfixedtimedeposits.NCDsontheotherhandbeingnegotiablecan be sold in the secondary market of the depositor suddenly needing funds prior to scheduled maturity.

8.4.2 Euro CreditsThese are short to medium term loans of Euro currency extended by Euro banks to corporate, sovereign governments, non-prime banks or international organisations. The loans are denominated in currencies other than the home currency of the Euro bank. These loans are normally large for a single bank to handle, Euro bank will form a bank lending syndicate to share the risk.

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The credit risk on these loans is greater than on loans to other banks in the inter bank rate. Thus the interest rate on the Euro credit must compensate the bank, or banking syndicate for the added credit risk. On Euro credits originating inLondon,thebaselendingrateisLIBOR.ThelendingratesonthesecreditsarestatedasLIBOR+xpercentwherexisthelendingmargindependingonthecreditworthinessoftheborrowers.Additionally,rolloverfinancingiscreated on Euro credit so that Euro banks do not end up paying more on Euro currency time deposit than they earn from the loans. Thus a Euro credit may be viewed as a series of shorter term loans, where at the end of each time period (generally 3 or 6 months), the loan is rolled over and the base lending rate is re-priced to current LIBOR over the next interval of the loan.

The major risk Euro banks face in accepting Euro deposits and in extending Euro credits is interest rate risk resulting from a mismatch in the maturities of the deposits and credits.

For example if deposit maturities are larger than credit maturities, and interest rate falls, the credit rates will be adjusted downwards while the bank is still paying a larger rate on deposit. Conversely, if deposit maturities are shorter than credit maturities and interest rates rise, deposit rates will be adjusted upwards while the bank is still receiving lower rates on credits. Only when deposit and credit maturities are perfectly matched, roll over features of Euro credits allow the bank to earn the desired deposit loan rate spread.

Forward rate agreement (FRA) is an inter bank contract that allows the Euro bank to hedge the interest rate risk in mismatched deposits and credits. A FRA involves two parties, a buyer and a seller, where the buyer agrees to pay the seller the increased interest cost on a notional amount if interest rates fall below an agreed rate and the seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate. FRAs are structured to capture the maturity mismatch in standard length Euro deposits and credits.

For example the FRA might be on a six months interest rate for a six month period beginning 3 months from today and ending nine months from today, this would be a “three against nine” FRA. The following time line depicts the FRA examples:

Fig. 8.2 The time line depicting the FRA examples

The payment amount under an FRA is calculated as the absolute value of – Notional amount x { (SR-AR) x days /360}{1+(SRxdays/360)}

Where,SR denotes the settlement rateAR denotes the agreement ratedays denote the length of the FRA period

8.4.3 Euro NotesEuro notes are short term notes underwritten by a group of international investment or commercial banks called a group ‘facility’. A client borrower makes an agreement with a facility to issue Euro notes in its own name for a period of time generally 3 to 10 years. Euro notes are sold at a discount from face value and are payable the full facevalueatmaturity.Euronoteshaveamaturityof3to6months.BorrowersfindEuronotesattractivebecausetheinternalexposureisusuallyslightlylesstypicallyLIBORplus1/8%incomparisontosyndicatedEurobankloans.Thebanksfindthemattractivetoissuebecausetheyearnasmallfeefromtheunderwritingorsupplyoffunds and earn the interest return.

Start Agreement period 3 months

FRA period 6 months

End Cash settlement

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8.4.4 Euro Medium Term NotesEuroMediumTermNotes(EuroMTNs)aretypicallyfixedratenotesissuedbyacorporationwithmaturitiesrangingfromlessthanayeartoabove10years.Likefixedratebonds,EuroMTNshaveafixedmaturityandpaycouponinterest on periodic dates. Unlike a bond issue in which the entire issue is brought to the market at once, a Euro MTN issue is partially sold on a continuous basis through an issuance facility that allows the borrower to obtain fundsonlyasneededonaflexiblebasis.Thisfeatureisveryattractivetoissuers.EuroMTNshavebecomeaverypopularmeansofraisingmediumtermfundssincetheywerefirstintroducedin1986.

8.4.5 Euro Commercial PaperEuro Commercial Paper, like domestic commercial papers is an unsecured short term promissory note issued by a corporate or a bank and placed directly with the investment public through a dealer. Like Euro note, Euro commercial paper is sold at a discount from face value. Maturities typically range from one to six months.

8.5 Instruments Available in International Capital MarketsTheclassificationoftheinternationalcapitalmarketisbasedoninstrumentsusedandmarketsassured.

Fig. 8.3 International capital markets

8.5.1 Debt InstrumentsA foreign bond issue is one offered by a foreign borrower to the investor in a national capital market and denominated in that nation’s currency.

As for example a German MNC issuing dollar denominated bonds to US investor. A Euro bond issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency

The markets for foreign bonds and Euro bonds operate in parallel with the domestic national bond markets and all three market groups compete with each other.

Inanygivenyear,ithasbeenseenthatover85%ofnewinternationalbondsareEurobondsratherthanforeignbonds. Euro bonds are known by the currency, in which they are denominated,

For example; US dollar Euro bonds, Yen Euro bonds and Swiss franc Euro bonds or correspondingly Euro dollar bonds, Euro Yen bonds and Euro SF bonds.

Inanygivenyear,ithasbeenseenthatover85%ofnewinternationalbondsareEurobondsratherthanforeignbonds. Euro bonds are known by the currency in which they are denominated, for example; US dollar Euro bonds, Yen Euro bonds and Swiss franc Euro bonds or correspondingly Euro dollar bonds, Euro Yen bonds and Euro SF bonds.

International Capital Markets

International Bond Markets

Foreign Bonds Euro Bonds Foreign Equity Euro Equity

International Equity markets

- Yankee Bonds- Samurai Bonds- Bulldog Bonds

- Euro Dollar- Euro Yen- Euro Pound

- ADR- IDR/EDR

- GDR

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Foreign bonds, on the other hand, frequently have colourful names that designate the country in which they are used. For example, Yankee bonds are dollar denominated foreign bonds originally sold to US investors, Samurai bonds are Yen denominated foreign bonds sold in Japan and bulldog are pound –sterling denominated foreign bonds sold in the UK.

Bearer bonds and registered bondsEuro bonds are usually bearer bonds. A bearer bond possession is evidence of ownership. The issue does not keep any records indicating who the current owner of a bond is.

With registered bonds, the owner’s name is on the bond and it is also recorded by the issuer. When a registered bondissold,anewbondcertificateisissuedwiththenewowner’snameorthenewowner’snameisassignedtothe bond serial number.

US security regulation requires Yankee bonds and US corporate bonds sold to US citizens requires to be registered. Bearer bonds are very attractive to investors desiring privacy and anonymity. One reason is that they enable tax evasion. Consequently investors will generally accept a lower yield on bearer bonds than on registered bonds of comparable terms, making them a less costly source of funds for the issuer to service.

Foreign bonds have to meet security regulation of a country in which they are used.For example, Yankee bonds must meet the same regulations as US domestic bonds. The US securities Act •requires full disclosure of relevant information relating to a security issue. The expense of the registration process, the time delay it creates in bringing a new issue to the market, the disclosure of information that many foreign borrowers considered private have made it more desirable for foreign borrowers to raise the bonds in the Euro bond market.Some nations have imposed withholding tax on the interest which becomes cheaper to go for Euro bonds.•

Global bondsA global bond issue is a very large international bond offering a single borrower i.e., simultaneously sold in North America, Europe and Asia. Global bonds follow the registration requirements of domestic bonds but have the free structureofEurobonds.Globalbondofferingsenlargetheborrowers’opportunitiesforfinancingatreducedcosts.Purchasers, mainly institutional investment desire increased liquidity of the issue and are willing to accept lower yields.

8.5.2 Types of Debt InstrumentsThe international bond markets have been more innovative than the domestic bond market in the types of instruments offered to investors.

Straightfixedrateissues•Straightfixedratebondissueshaveafixedmaturitydateatwhichtheprincipalvalueofthebondispromisedtoberepaid.Duringthetenureofthebonds,fixedcouponpaymentswhichareapercentageoffacevaluearepaidasinterest to the bond holders. In contrast, domestic bonds make semi-annual coupon payments. The reason is that Euro bonds are usually bearer bonds and annual coupon redemption is more conversant for the bond holders and less costly for the bond issuer since the bond holders are scattered geographically.

Floating rate notes•Floating rate notes (FRNs) are typically medium term bonds with coupon payments indexed to some reference rate. Coupon reference rates are either 3 months or 6 months.

Nations LIBOR. Coupon payment on FRNs is quarterly or semi annually and in accordance with the reference rate. Forexample;considerafiveyearFRNwithcouponreferencedto6monthsdollarLIBORpayingcouponinterestsemi annually. At the beginning of every 6 month period, the next semi annual coupon payment is reset to be 0.5 x (LIBOR+xpercent)offacevalue,wherexrepresentstheriskpremiumoverLIBOR.Theissuermustpaybasedon its creditworthiness.

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Asforexample,ifxequals1/8percentandthecurrent6monthLIBORis6.6%,thenextperiodcouponratesona$1000facevalueFRNwillbe0.5x(0.066+.00125)x$1000=$33.625.IfonthenextresetdatesixmonthLIBORis5.7%,thesemiannualcouponwillbesetat0.5x(0.057+0.00125)x$1000=$29.125.

Equity related bonds•There are two types of equity related bonds; convertible bonds and bonds with equity warrants.

Convertible bond � allows the investor to exchange the bond for a predetermined number of equity shares of theowner.Thefloorvalueofaconvertiblebondisstraightfixedratebondvalue.Convertibleusuallysellat a premium above the straight debt value and their conversion value. Additionally, investors are usually willingtoacceptalowercouponrateofinterestthanthecomparablestraightfixedcouponbondratebecauseof attractive terms of the conversion.Bonds with equity warranty � canbeviewedasstraightfixedratebondswiththeadditionofacalloption(or warrant) feature. The warrant entitles the bond holder to purchase a certain number of equity shares of a pre stated price over a predetermined period of time

Zero coupon bonds•Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest over the tenure. At maturity, the investor receives the full face value. Alternatively, some zero coupon bonds are originally sold for face value and at maturity the investor gets something for the use of the money. Another form of zero coupon bonds is stripped bonds. A stripped bond is a zero coupon bond which results from stripping the coupon and principal from a coupon bond. The result is a series of zero coupon bonds represented by individual coupon and principal payments.

Dual currency bond•AdualcurrencybondisastraightfixedratebondissuedinonecurrencysaySwissfrancthatpayscouponinterestinthe same currency. At maturity the principal is repaid in another currency say US dollars. Coupon interest is frequently atahigherratethancomparablestraightfixedratebonds.Theamountofthedollarprincipalrepaymentatmaturityis set at inception, the amount allows for some appreciation in the exchange rate of a stronger currency. From the investor’s perspective, a dual currency bond includes a long-term forward contract. If the dollar appreciates over the life of the bond, the principal repayment will be worth more than the payment of the principal in Swiss francs. The market value of a dual currency bond in Swiss francs should equal the sum of the present value of the Swiss francs coupon stream discounted at the Swiss market rate of interest plus the dollar principal repayment, converted to Swiss francs at expected future exchange rate and discounted at the Swiss market rate of interest.

Corporate currency bonds•Corporate currency bonds are denominated in a currency basket. They are frequently called currency cocktail bonds. Theyarebasicallystraightfixedratebonds.AcompositecurrencybondisanattractivetypeoffinancingforMNCswith sales receipts in a variety of currencies. From the international investor’s standpoint, currency cocktail bonds are likely to have less exchange rate risk than bonds denominated in a single currency.

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Summary of the typical characteristics of the international bond market instruments is given below:

Table 8.1 Typical characteristics of the international bond market instruments

8.5.3 International Bond and Market Credit RatingsThecreditratingorganisationclassifiesbondissueintocategoriesbasedoncreditworthinessoftheborrower.Theratingsarebasedonanalysisofcurrentinformationregardingthelikelihoodofdefaultandspecificationofdebtobligation.Theratingonlyreflectsthecreditworthinessandnotexchangerateuncertainty.FitchIBCA,Moody’sInvestor service and Standard and Poors (S&P) have for years provided credit ratings on domestic and international bonds.Theratingagencieshaveratingcategories9to11outofwhichthefirst4areregardedasinvestmentgraderatings.

S&P also gives ratings for sovereigns, municipalities, corporations, utilities and supranational. In rating a sovereign government, S&P analysis centres around an examination of the degree of political risk and economic risk. In assessing political risk, S & P examines the stability of the political system, the social environment and international relationswithothercountries.Factorsexaminedforassessingeconomicriskincludethesovereign’sexternalfinancialposition,balanceofpaymentsflexibility,economicstructureandgrowth,managementoftheeconomy,andeconomicprospects. The ratings assigned to a sovereign are particularly important because it usually represents the ceiling for rating. S&P will assign an obligation of an entity domiciled within that country.

8.5.4 Euro Market Structure and PracticesEurobondsectoraccountsfor80%ofnewofferings.BelowarethedetailsoftheEurobondmarketstructureandpractices:

Primary marketA borrower desiring to raise funds by issuing Euro bonds to the investing public will contact an investment banker to serve as lead manger of an underwriting syndicate to issue the bonds in the market. The underwriting syndicate is a group of investment banks, merchant banks and the merchant banking arms of the commercial banks that specialise in some sphere of public issue. The lead manager will usually invite co-managers to form a managing group to help negotiate terms with the borrowers, ascertain market conditions and manage the issue.

The managing group along with other banks will serve as underwriters for the issue i.e. they will commit themselves to buy from the borrower at a discount from the issue price. The discount or underwriting spread is typically in the 2to2.5%range.Fordomesticissuethespreadaveragesabout1%.Mostoftheunderwriters,alongwithotherbanks, will be part of the selling group that sells the bonds to the investing public. The various members of the underwriting syndicate will receive a portion of the spread, depending on the number and type of work they have performed. The lead managers will receive the full spread but the bank serving only a member of the selling group will receive a smaller portion. The total time from the decision date of the borrower to issue Euro bonds till the net proceedsfromsalearereceivedistypicallyfivetosixweeks.

Investment Frequency of interest payment

Size of coupon payment

Payoff at maturity

Straightfixedrate Annual Fixed Currency of issue

Floating rate note Quarterly or semi annual

Variable Currency of issue

Convertible bond Annual Fixed Currency of issue or conversion to equity shares

Straightfixedratewithequity warrants

Annual Fixed Currency of issue plus equity shares from exercise of warrants

Zero coupon bonds None Zero Currency of issueDual currency bond Annual Fixed Dual currency

Composite currency bond Annual Fixed Composite currency of issue

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Secondary marketThe secondary market of Euro bonds is an over-the-counter market with principal trading in London. However, important trading is also done in other major European money centres such as Zurich, Luxembourg, Frankfurt and Amsterdam.

The secondary market comprises market makers and brokers connected by an array of telecommunication equipment. Market makers buy or sell on their own accounts by quoting two-way bid and ask price. Market makers trade directlywithoneanother,throughabrokerorwithretailcustomers.Thebidaskspreadrepresentstheirprofit,noother commission is charged.

Euro bond makers and dealers are the members of the International Securities Market Association (ISMA) a self-regulatory body based in Zurich. Market makers tend to be the same investment banks, merchant banks and commercial banks those serving as lead Managers in an underwriting contract. Brokers on the other hand accept buy or sell from market makers and then try to fund a matching party for the other side of the trade, they may also trade for their own account. Brokers charge a small commission for their services to the market maker that engaged them. They do not directly deal with the retail clients.

Clearing proceduresEuro bond transaction in the secondary market requires a system for transferring ownership and payment from one party to another. Two major clearing systems are:

Euro clear•Cedel clear•

These have been established to handle Euro bond trade.Euro clear is based in Brussels and operated by Morgan Guaranty. Cedel located in Luxembourg was formed by a group of European banks active in Euro bonds market.

Both clearing systems operate in a similar manner with Euro clear handling approximately twice the trading volumes ofCedel.Eachclearingsystemhasagroupofoperatingbanksthatphysicallysharebondcertificates.Membersofeither system hold cash and bond accounts. When a transaction is made, book entries are made to transfer ownership of the bond from the seller to the buyer and transfer funds from the purchaser’s bank account to the seller’s. Physical transfer of the bond seldom takes place.

EuroclearandCedelperformotherfunctionsfortheefficientoperationoftheEurobondmarket.Theseare:Theclearingsystemwillfinanceupto90%oftheinventorythataEurobondmakerhasdepositedwiththe•system.Additionally, the clearing system will assist in the distribution of new bond issue. The clearing systems will take •physicalpossessionofthenewlyprintedbondcertificatesinthedepositoryandcollectsubscriptionpaymentsfrom the purchase and record ownership of the bonds.The clearing system will also distribute coupon payments. The borrower pays to the clearing system, the coupon •interest due on the portion of the issue bid in depository, which in turn credits the appropriate amounts to the bond owner’s cash accounts.

International bonds market indexesThe investment-banking arm of J.P.Morgan Company provides some of the best international bond market indexes that are frequently used for performance evaluation. J.P.Morgan publishes a Domestic Government index for 18 individual countries, a Euro Zone Government, A Global Government Bond Index and an Emerging Market Bond Index.

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8.6 Equity InstrumentsTill1970’s,InternationalCapitalMarketsfocusedondebtfinancingandequityfinancewasraisedbycorporatesprimarily in the domestic market due to the following:

Restrictions on cross border equity investments prevailing until then in many countries.•Investors also preferred to invest in domestic equity issues due to perceived risks in foreign equity issue due to •foreign currency exposure or apprehensions of restrictions on such investments by the national authorities.

Early 1980’s because of liberalisation of many domestic economies, issue of dollar / foreign currency denominated equity shares were allowed to access international equity markets through the issue of an intermediate instrument called “Depository Receipts”.

ADepositoryReceipt(DR)isanegotiablecertificateissuedbyadepositorybankwhichrepresentsthebeneficialinvestors in shares issued by a company. These shares are deposited with a local “custodian” appointed by the depository, which issues receipts against the deposit of shares.

According to the placements planned, DR’s are referred to as (1) Global Depository Receipts (GDRs) (2) American Depository Receipts (ADRs) (3) International Depository Receipts (IDR). Each of the depository receipts represents aspecifiednumberofsharesinthedomesticmarketsusuallyincountrieswithCapitalaccountconvertibility,theGDRs and domestic shares are convertible (may be redeemed) mutually. This implies that, an equity shareholder maydepositthespecifiednumberofsharesandobtaintheGDRandviceversa.TheholderoftheGDRisentitledto a dividend in the value of the underlying shares of the GDR (issued normally in the currency of the investor country).

As far as Indian companies are concerned, dividends are announced as a percentage of the value of GDR same premium in rupees term converted at the prevailing exchange rate.

However until the GDR / ADR / IDR’s are converted, the holder cannot claim voting rights and also there is no foreign exchange risk for the company. The company will be listed at the preferred stock exchanges providing liquidity for the investment.

8.6.1 Global Depository ReceiptsThe advent of GDRs in India has been mainly due to the balance of payments crisis in the early ‘90s. At that time India did not have enough foreign exchange balance even to meet the requirements of fortnight imports. International institutions were not willing to lend because of non-investment credit rating of India. Out of compulsions, rather thanchoice,thegovernment(acceptingtheWorldBanksuggestionsontidingoverthefinancialpredicament)gavepermission to allow fundamentally strong private corporates to raise funds in international capital markets through equityorequityrelatedinstruments.Theforeignexchangeregulationact(FERA)wasmodifiedtofacilitateinvestmentbyforeigninvestorsupto51%oftheequitycapitalofthecompanies.Investmentsevenbeyondthislimitarealsobeing permitted by the government on a case to case basis.

Prior to this, companies in need of the foreign exchange component or resources for their projects had to rely on thegovernmentofIndiaorpartlyonthegovernmentandpartlyonthefinancialinstitutions.Theseforeigncurrencyloanswereutilisedbythecompanies(whetherthroughthefinancialinstitutionsorthroughthegovernmentagency)to pay the government allocation from the IMF, World Bank or other Governments credits. This in turn, created liability for the remittance of interest and principal, in foreign currencies which was to be met by way of earning, through exports and other grants received by the government. However, with a rapid deterioration in the foreign exchange reserves consequent to the Gulf war and its subsequent oil crisis, companies were asked to get their own foreign currencies which led to the advent of GDRs.

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The instrumentAs mentioned earlier, GDRs are essentially those instruments which possess a certain number of underlying shares in the custodial domestic bank of the company. That is, a GDR is a negotiable instrument which represents publicly tradedlocal-currency-equityshare.Bylaw,aGDRisanyinstrumentintheformofadepositoryreceiptorcertificatecreated by the Overseas Depository Bank outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company. Usually a typical GDR is denominated in US dollars whereas the underlying shares would be denominated in the local currency of the issuer. GDRs may be at the request of the investors - converted into equity shares by cancellation of GDRs through the intermediation of the depository and the selling of underlying shares in the domestic market through the local custodian.

GDRs, per se, are considered common equity of the issuing company and are entitled to dividends and voting rights since the date of their issuance. The company effectively transacts with only one entity which is the overseas depository for all the transactions. The voting rights of the shares are exercised by the depository as per the understanding between the issuing company and the GDR holders.

The procedureThe sequence of events to be followed for the issue of GDR takes the same procedure and documentation as that of other equity instruments which are globally issued. The overall structure typically followed in an issue of GDR isgiveninthefigurebelow.

Fig. 8.4 Structure for a GDR transaction

Issuance of GDRThe following is the sequence of activities that takes place during the issuance of GDRs:

Shareholder approval needed:• The issuance of an equity instrument like the GDR needs the mandate of the shareholders of the company issuing it. The terms of the issue will be decided before such a mandate is sought fromtheshareholders.ThereshouldbeanauthorisationfromtheboardofdirectorsforfloatingaEuroissueandfor calling a general meeting for the purpose. A committee of directors is generally constituted and conferred with necessary powers for the approval of:

Shares GDRsDepositor

Custodians

Luxembourg Listing Agent

Euro Clear Cedel and DTC

Investors

Lead Managers

and Syndicate

Indian Legal Counsel

English Legal Counsel

PR Consultants Auditors

The Company

Luxembourg Stock Exchange

English legal Counsel

Listing Agreement

Subscription Agreement

Depository Agreement

Indian Legal Counsel

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the offering memorandum �fixationofissueprice �opening of bank account outside India and operation of the said account �for notifying the stock exchange about the date of board meeting when the proposal will be considered and �also inform it about the decisions taken

After all this, the shareholders should approve the issue by a special resolution passed at a general meeting as per Section 81 of the companies Act, 1956. It stipulates that, if a company proposes any issue of capital after two years from the formation of the company or at any time after one year from the allotment of shares that the company hasmadeforthefirsttimeafteritsformation–whicheverisearlier-thecompanyhastooffersuchissuefirsttotheshareholdersofthecompany.Forissueofsharestootherthanexistingshareholders,thecompanyhastofulfilcertaincomplianceandthefirststepistogetapprovalfromtheshareholders.

Appointment of lead manager: • Lead manager is an important cog in the wheel of the Euro –issue and the vital link between the government and investors with the issuers. Practically, it is the lead manager who is responsible for eventual success or failure of a Euro issue when all the other factors are same. Hence the choice of a suitable lead manager is selected after preliminary meetings with merchant bankers. The merchant bankers are evaluated on various parameters such as:

marketing ability �marketing research capability �market making capability �track record �competitive fee structure and �placement skills �

Basedonthepresentationsmadebythevariousmerchantbankers,thecompanydecidesonthefinalchoiceoftheleadmanageraftertheyarefilteredbytheaboveparameters.Thefinalappointmentoftheleadmanagerisdoneafter the approval by the Government. The lead manager advises the company in the following areas after taking into consideration the needs of the company,

the industry in which the company is engaged, �the international monetary and security markets, �the general economic conditions and �the terms of issue viz. �

Quantum of issue, type of security needed to be issued (GDR in this case), stages of conversion, price of equity, shares on conversion, rate of interest, redemption date, etc.

Finalisation of issue structure: • On completion of formalities of issue structure in consultation with the lead manager,thecompanyshouldobtainthefinalapprovalfromthegovernment.Forthispurpose,thecompanyshould furnish the information about the entities involved in the GDR issue and the following parameters to the government:

lead manager �co-lead manager �currency �issue price (approximate range in case of gdr) �form and denomination �negative pledge provisions �taxation �

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commissions �reimbursable expenses �governing laws �overseas depository institution �Indian custodian �issue structure and denomination of underlying shares represented by the gdrs �issue amount �green shoe option �warrants attached, if any �listing modalities �selling commission �underwriting commission �legal expenses, depository fees, and other out-of-pocket expenses �taxation procedure �

Thegovernment,afterconsideringalltheaboveinformationwillgiveafinalapprovalfortheIssue-ifsatisfied.

The documentationDocumentation of Euro equity is complex and elaborates process and consists of the following main documents:

Prospectus: • As in domestic equity market, the prospectus is major document containing all the relevant information concerning the issue like the investment considerations, terms and conditions, use of proceeds, capitalisation details, share information, industry review and overall description of the issuing company. As a marketingstrategy,companiesgenerallyissueapreliminaryprospectuswhichisreferredtoaspathfinderwhichwill judge the potential demand for the equity that is being launched in the markets.Depository agreement:• This is the agreement between the issuing company and the overseas depository providing a set of rules for withdrawal of deposits and for their conversion into shares. Voting rights of a depositor y are alsodefined.Usually,GDRsorEuroconvertiblebondsareadmittedtotheclearingsystem,andsettlementsare made only by book entries. The agreement lays down the procedure for the information transmission to be passed on to the GDR holders Underwriting agreement:• As in domestic equity market, underwriters play the role of ‘assurers’ for picking the GDRs at a predetermined price depending on the market response. The agreement is for this purpose. Between the company (guided by its lead manager) and the underwriterSubscription agreement:• The lead manager and the syndicated members form the part of the investors who subscribe to GDRs or Euro convertible bonds as per this agreement. There is no binding, however, on the secondary market transaction on these entities i.e. market making facility. Custodian agreement:• It is an agreement between the depository and the custodian. In this agreement the depository and the custodian determine the process of conversion of underlying shares into depository receipts and vice versa. For the process of conversion of the GDRs into shares, (popularly termed as Re-materialisation) shares have to be released by the custodian.Trust deed and paying and conversion agency agreement:• While the trust deed is a standard document which provides for duties and responsibilities of trustees, the paying and conversion agreement enables the paying and conversion agency which performs a typical banking function by undertaking to service the bonds until the conversion, and arranging for conversion of bonds into GDR or shares, as necessary.Listing agreement:• As far as the listing is concerned, most of the companies which issue a GDR prefer Luxembourg Stock Exchange as the listing requirements in this exchange are by far, the most simplest. The New York Stock exchange (NYSE) and the Tokyo Stock Exchange (TSE) have the most stringent requirements. London StockExchangeandtheSingaporeStockExchangefitinthemiddlewithrelativelylesslistingrequirementsthan the NYSE and TSE

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Thelistingagentshavetheonusoffulfillingthelistingrequirementsofachosenstockexchange.TherequirementsoftheLondonStockExchangeareprovidedinthe48hourdocuments.The48hourdocumentsarethefinaldocumentsthat have to be lodged at the exchange not later than mid-day, at least two business days prior to the consideration of the application for admission to listing. These documents, among other things, should include the following:

an application for admission to listing•declaration of compliance in the appropriate form issued by the exchange•three copies of the listing particulars / equivalent offering document relating to the issue. the contents of these •documents should meet the relevant requirementsa copy of any shareholders’ resolution that is relevant to the issue of such securities•a copy of the board resolution authorising the issue, the application for listing and publication of the relevant •documentsincaseofanewcompany,acopyoftheincorporationcertificate,memorandumofcertificateandarticlesof•association

The launchTwo of the major approaches for launching of a Euro–Issue are Euro–Equity Syndication and Segmented syndication. Euro – Equity syndication attempts to group together the placement strength of the intermediaries, without any formal regional allocations. Segmented syndication, on the other hand, seeks to form a geographically targeted syndicate structure, so as to achieve broader distribution of paper by approaching both institutional and retail investors. As compared to Euro syndication, segmented syndication can be expected to achieve orderly and coordinated placement byrestrictingthechoiceofsyndicatememberswithdefinitestrengthsinspecificmarkets.

MarketingIt is not only the Indian issue which thrives on suave marketing, but also the GDR and other international bond offerings.Ajudiciousmixoffinanceandmarketingwouldhelpinraisingtheinvestor’sinterestintheissue.Mostof the marketing activities are handled by the lead manager in consonance with the advertising agencies. A back-up materialconsistingofpreliminaryofferingcircular,recentannualreport,interimfinancialstatements,copiesofnewspaper articles about the business of the company and a review of the structure and performance of the Indian stock market, among other things is prepared.

Road shows form a predominant facet of the launch of any GDR. They are a series of face-to-face presentations with fund managers and analysts and are a vital part of the marketing process. Road shows, which involve much more than just informing about the company, are getting increasing attention from investors and the fund managers. Road shows for Euro equity acquire considerable relevance as investors, who are invited, participate in the ownership and assumeagreaterdegreeofriskthanunderanyotherfinancialinstrument.Roadshowsarebackedbythefinancialsandoperationsandaviewregardingthefutureprofitabilityandgrowthprospects.Thisgivesanopportunitytotheinvestors (generally, fund managers) to interact with the senior management of the issuing company and understand the activities of the issuer company which may eventually lead to the investment company. These are normally conductedatthefinancialcentresoftheglobelikeLondon,NewYork,Boston,LosAngeles,Paris,Edinburgh,Geneva, Hong Kong, etc.

The back-up material prepared will support presentations made by the company’s senior personnel inviting the fund managers to invest in the company. The price that is preferred for a particular number of shares is noted by thebook-runnerateachofsuchpresentationsandtheeventualpricethatismostlikelytofindfavourwiththefundmanagerisfinalised.Thiswillgoalongwayinmakingtheissueaccepted.

Pricing and closingThis forms the most vital part of the whole process of a GDR issue. The pricing is the key to the overall performance of a GDR after the same has been listed. The price is determined after the underwriters’ response has been considered and an inference of the response may be drawn.

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ThefinalpriceisdeterminedaftertheBookRunnerclosesthebooksafterthecompletionoftheroadshows.Thebook-runner keeps the book open for 1-2 weeks, for the potential investors to start placing their orders / bids with details of price and quantity. After analysing all the bids at the end of the book building period, lead managers in consultationwiththeissuer,willfixaparticularpricefortheissuewhichwillbecommunicatedbacktothebidders/investorsandafreshdemandfigureisarrivedat.Ifthereisexcessdemand,thecompanycangoinfor‘greenshoeoption’ where it can issue additional GDRs in excess of the target amount.

At the end of the issue, various documents will be signed with all the fund managers at New York or London. Pursuant to this, the agreed number of depository receipts will be delivered and the payments in lieu of such delivery will be received by the issuer.

Atombstoneadvertisementwillbeissuedinthefinancialpresstopublicisesyndicateloansandotherfundingdeals.Following this, the GDR will get listed in the notifying stock exchange signalling the consummation of the process of the issue of stock exchange.

The time period that is generally needed for a typical GDR issue is given in the following table. The table is arranged sequentially so as to convey information on the step-by-step process that is followed.

Indicative time table

Costs

Stage Administrative work involved Time in weeks

Initial Decision Meeting between issuer and lead manager and planning of an issuei.

Issuestructurefinalisedwithdueregardtodomesticregulatoryenvironmentii.

Draft Documentationiii.

Due diligence processiv.

Board meeting proceeds by shareholders approvalv.

Fixing parties to issue (including depository / custodian)vi.

1 and 2

Approval and drafts finalisation

Officialapprovals–stepsinitiatedi.

Comfortandconsentletterfinalisedwithauditorsii.

Legalopinionformatsdraftedandfinalisediii.

Approvals obtainediv.

3 and 4

Pre-launch formalities Road show preparations and presentationsi.

Pathfinderprospectusfinalisedii.

Listingpreparationsinthefinalstageiii.

7 and 8

Launch of issues xiv. Road shows organised

xv. Documentation circulated among syndicate

xvi. Investors contract

Pricing and closing Finaltermsfixedi. Allocation of securities to investorsii. Final prospectus to be kept readyiii. Final listing documents lodged with stock exchangeiv. Subscription agreement signedv. Deliveryofglobalcertificatesvi. Closing documents signedvii.

Payments to the issuerviii. Tombstone advertisementix.

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Thecostincurredbythecompanyisproportionaltotheissuesize.Theleadmanager,justifiably,takesthelion’sshare in the issue expenses of the GDR. With the increased acceptance of marketing as a vital tool for the success of the issue, the cost that is incurred on marketing is fast increasing. The following table gives an indication on the total expenses incurred by a GDR issue.

GDR issues: Fees and expenses

Other expenses include lead manager’s expenses, printing costs, accounting fees, listing fees, road show expenses, etc.

8.6.2 American Depository ReceiptsUntil 1990, companies had to issue separate receipts in the US (ADRs) and in Europe (IDRs) to access both the markets. The weakness was that there was no cross border trading possible as ADRs had to be traded, settled and cleared through the Depository Trust Company (DTC) in the US, while the IDRS could be traded and settled via Euro clear in Europe. It was in April 1990, when changes in rule 144A and regulations of the SEC of the US allowed non US companies to raise capital in the US market without having to register the securities with the SEC orchangingthefinancialstatementstoreflecttheUSaccountingprinciples.Rule144AisdesignedtofacilitatecertaininvestmentbodiescalledQualifiedInstitutionalBuyers(QIBs)toinvestinoverseas(nonUS)companieswithout those companies needing to go through the SEC registration process.

The instrumentADRisadollardenominatednegotiablecertificate,itrepresentsnonUScompanies’publicitytradedequity.Itwasdevised in the late 1920s, to help Americans invest in overseas securities and to assist non US companies wishing to have their stock traded in the American Markets. ADRs are divided into 3 levels based on the regulation and privilege of each company’s issue.

ADR Level –I:• ItisoftenthefirststepforanissuerintotheUSequitymarket.Issuercanenlargethemarketfor existing shares and thus diversify the investor base. In this instrument only minimum disclosure is required to the SEC and the issuer need not comply with US GAAP. This type of instrument is traded in the US OTC market. The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges.ADR Level –II:• Through this level of ADR the company can enlarge the investor base for the existing shares to agreaterextent.However,significantdisclosurehastobemadetotheSEC.Thecompanyisallowedtolistinthe American Stock Exchange (AMEX) or New York Stock Exchange (NYSE) which implies that the company must meet the listing requirements of the particular exchange.ADR Level –III:• This level of ADR is used for raising fresh capital through public offering in the US capital markets. The company has to be registered with the SEC and comply with the listing requirements of AMEX / NYES while following the US GAAP.

The reason for this may be attributed to the stiff disclosure requirements and accounting standards as per the US GAAP.

Item Percent of issue amountUnderwriting Fee 0.60.1.00Management Fee 0.60.1.00Selling Commission 1.80.3.00Total Fees 3.00.5.00

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Intermediaries that are involved in the ADR issue perform the same work as in the case of a GDR issue. Additionally theintermediarieswillliaisonwithqualifiedInstitutionalbuyersforinvestinginADRs.Someofthewell-knownintermediaries for ADR / GDR are Lehman Brothers International, Robert Flemming Inc, Jardine Flemming, CS First Boston, TP Morgan, etc.

Regulatory FrameworkThe regulatory framework for the ADRs is provided by the Securities and Exchange Commission which operates through two main statutes, the Securities Act of 1933 and the Securities Exchange Act of 1934. The Securities Exchange Act provides the disclosure and its periodic updating.

Rule 415 of the Securities Exchange Act, 1934 refers to shelf registration and applies to the issue of ADRS. Under this rule, select foreign companies are offered the facility to register the necessary documents before the actual issuance of securities. For this, the prospectus is prepared in two parts, basic and supplementary. While the basic prospectushastobefiledatthetimeofshelfregistration,thesupplementaryprospectushastobefiledatthetimeofthe actual issuance of the securities. Wrapping around the basic prospectus, the supplementary prospectus records thelatestdevelopmentinadditiontofillingadetailedfinancialconditionstatement.Underwritingarrangements,thecertificationofauditorsandlegalcouncilarerequiredfortheactualissueofsecurities.Incasetheissuerseekstoraiselargeramountsthanoriginallyindicated,newshelffilingsarerequired.Theissueralsohastheoptiontogoin for de novo registration.

Shelf registration has been found useful to the issuer as it reduces the incidence of fees considerably. Further shelf registration allows the issuer opportunities for quickly accessing the markets as the offering process is substantially completed.

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SummaryThe need for external borrowing in the country’s economy can be gauged from the national income and balance •of payment position.Theintegrationoffinancialmarketsacrosscountrieshasopenedupinternationalmarketsandtosealthechanging•needsoftheinternationalinvestors,alargevarietyoffinancialinstrumentshaveemerged.Theflowofexternalfundsintoacountrydependsuponvariousfactorslikepolicyguidelinesofthecountryon•commercial borrowings by individual entities, the exchange control regulation of the country, the interest rate ceilingsinthefinancialsector,thestructureoftaxation.Eurodollar is U.S. dollar bank deposits held outside the United States. Included within the Euro dollar market •are the Asia dollar market and other markets outside Europe.Euro currencies are bank deposits held outside the home countries of the currencies. The Eurocurrency market •is also known as the offshore currency market.Firmsmustdecideonthecurrencyoftheissueofbonds.Allforeignpaybondsarebydefinitioninaforeign•currencyforthefirm,andmanyEurobondsarealsoinaforeigncurrencyforthefirm.Bond issuers should consider costs and sizes of bond issues when determining the country of issue.•Ifcapitalmarketsaresegmented,itpaystoraiseequityinthecountryinwhichthefirmcansellitssharesfor•the highest price. It may also pay to consider selling equity simultaneously in several countries. Such shares are called Euro equities.

Referenceshttp://www.investorwords.com/7361/international_monetary_market.html#ixzz19OOTbXRd• . Last accessed on 28th December, 2010.http://www.scribd.com/doc/6683278/Instruments-of-Finance-in-International-Money-Markets• . Last accessed on 28th December, 2010.http://www.appuonline.com/appu/investment/bond.html• . Last accessed on 28th December, 2010.

Recommended ReadingMoorad Choudhry (2010). • Capital Market Instruments: Analysis and Valuation. Palgrave Macmillan; Third Edition editionBob. Steiner (2007). • Mastering Financial Calculations: A step-by-step guide to the mathematics of financial market instruments. FT Press; Second editionFrank J. Fabozzi CFA (2002). • The Handbook of Financial Instruments.Wiley;firstedition

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Self Assessment

A __________currency is the time deposit of money in an international bank located in a country different from 1. the country that issued the currency.

Americana. Eurob. Asianc. Presentd.

ADR is a dollar denominated negotiable certificate, it represents non US companies’ publicity traded 2. ________.

debta. currencyb. equityc. moneyd.

WhatdoesFERAstandsfor?3. The foreign exchange regulation acta. The foreign equity regulation act b. The foreign exchange regulatory actc. Thefiscalexchangeregulationactd.

The Eurocurrency market is also known as4. offshore currency marketa. offshore debt marketb. offshore euro marketc. offshore U.S marketd.

WhichofthefollowingstatementisFALSE?5. AcompositecurrencybondisanattractivetypeoffinancingforMNCswithsalesreceiptsinavarietyofa. currencies.Euro bonds are usually bearer bonds.b. Thefloorvalueofaconvertiblebondisflexibleratebondvalue.c. A foreign bond issue is one offered by a foreign borrower to the investor in a national capital market and d. denominated in that nation’s currency.

A_________bondisastraightfixedratebondissuedinonecurrencysaySwissfrancthatpayscouponinterest6. in the same currency.

convertible a. composite currencyb. foreignc. dual currencyd.

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Zero coupon bonds are sold at a discount from face value and do not pay any _________interest over the 7. tenure.

salesa. futureb. couponc. fixedd.

Euro notes are short term notes underwritten by a group of international investment or commercial banks 8. called

A group ‘facility’a. A country ‘facility’b. A bank ‘facility’c. A coupon ‘facility’d.

Straightfixedratebondissueshaveafixedmaturitydateatwhichthe__________valueofthebondispromised9. to be repaid.

actuala. principalb. futurec. presentd.

Floating rate notes (FRNs) are typically medium term bonds with coupon payments indexed to some __________10. rate.

exchangea. couponb. referencec. interestd.

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Chapter IX

Export-Import Financing and Guidelines for India

Aim

The aim of the chapter is to:

describeexportandimportfinancing•

explain letter of credit•

Objectives

The objectives of this chapter are to:

classify different kinds of letter of credit•

defineobjectivesoftheEximpolicy2002-07•

discuss how a letter of credit operates•

Learning outcome

At the end of this chapter, students will be able to:

explain parties to a letter of credit•

talk about highlights of the Exim policy 2002-07 after the amendment in 2003•

state the d• ocuments which under letter of credit

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9.1 Introduction to Export and Import FinancingInternational trade is important for a country. In modern times it is virtually impossible for a country to produce domestically everything its citizens need or demand. Even if it could, it is unlikely that it could produce all items more efficientlythanproducersinothercountries.Withoutinternationaltrade,scarceresourcesarenotputtoeffectiveuse.

For example:ConsideraUSfirmexportingtoadistributorinUK.TheUSbusinessmanmaybeconcurredthatifhe ships the produce to UK before he receives the payment; the UK businessman may take delivery of the products and not pay. Conversely, the UK Businessman may think that if he pays for products before they are shipped, the USfirmmaykeepthemoneyandnevershiptheproductsormightshipdefectiveproducts.Thislackoftrustagainincreases because of difference between the two parties – in space, language and culture and due to an underdeveloped international legal system to enforce contractual obligation.

Due to lack of trust between the two parties, each party will have its own preferences for the transaction to be configured.Tomakesurethatthefirmgetspaid,theUSfirmwouldprefertheUKdistributortopayfortheproductsbeforetheseareshipped.AlternativelytheUKfirm,tobesurethatitreceivestheproducts,wantstomakepaymentonly after satisfactory receipt of the products. Thus, each party has a different set of preferences. Unless there is some way of establishing terms between the two parties, the transaction might never take place.

This problem is solved by using a third party trusted by both, normally a reputable bank to act as an intermediary. The process can be summarised as follows:

First the importer obtains a bank’s promise to pay on its behalf knowing the exporter will trust the bank. This promise is known as a letter of credit. Having seen the letter of credit, the exporter ships the products. Title to the products is given to the bank in the form of a document called a bill of lading. In return the exporter asks the bank to pay for the products and the bank pays. The document for requesting this payment is referred to as a draft. The bank, having paid for the products, now passes the title of the goods to the importer whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank. The process is shown below:

Fig. 9.1 Use of a third party for export import

9.2 Letter of Credit (LC)Adocumentary/letterofcreditmaybedefinedas“anarrangementbymeansofwhichabank(IssuingBank)actingattherequestofacustomer(Applicant),undertakestopaytoathirdparty(Beneficiary)apredeterminedamountbya given date according to agreed stipulations and against presentation of stipulated documents.” In simple terms, an LCmaybedefinedasanarrangementwherepaymentismadeagainstdocuments.Underdocumentarycredits,allthe parties concerned deal with documents and not with goods, services or performances to which the documents may relate.

1. Importer obtains Banks promise to pay on importer’s behalf

5. Bank gives merchandise to importer

3. Exporter ships to the bank trusting banks promise to pay

4. Bank pays exporter

6. Importer pays bank

Import Bank Exporter

2. Banks promises exporter to pay on behalf of importer

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The Uniform Customs and Practice for Documentary Credits (UCPDC) guidelines which govern the operations oflettersofcreditdefinesdocumentarycreditas“anyarrangement,howevernamedordescribed,wherebyabank(the “Issuing Bank”), acting at the request and on the instructions of a customer (the “Applicant”) or on its own behalf:

istomakeapaymenttoortotheorderofathirdparty(thebeneficiary),oristoacceptandpaybillsofexchange•(“draft”(s)drawnbythebeneficiary).

orauthorises another bank to effect such payment, or to accept and pay such bills of exchange (draft(s)).•

orauthorises another bank to negotiate against stipulated documents, provided that the terms and conditions of •the credit are complied with.

9.2.1 Parties to a Letter of CreditThe principal parties to a letter of credit are:

The applicant (opener of the LC / importer):• The applicant of an LC is normally the buyer of the goods who is to make payment to the seller. It is at his request and instructions that the issuing bank opens the LC. Incidentally, an LC issuing bank could itself be an applicant (For its own use, it can be an applicant, as well as an issuer).Issuing bank (the bank which opens the LC):• The issuing bank is the bank, which opens the LC in favour ofthebeneficiary.ByopeningtheLC,theissuingbankundertakestheresponsibilitytomakepaymenttotheseller on compliance of required terms and conditions.Thebeneficiary(whoistheseller/exporter)oftheunderlyingLC:• Thebeneficiaryisthesellerofgoodswho is to receive payment from the buyer. The LC is opened in his favour to enable him to receive payment on submission of the stipulated documents.Advising bank:• Theadvisingbankadvisesthecredittothebeneficiary.Advisingofcreditisdoneonlyafterverifying the authenticity of the credit. When a bank advises a credit, it implies that it authenticates the signatures oftheissuingbank.Theadvisingbankisusuallysituatedinthecountryofthebeneficiary.ConfirmingBank:• The advising bank or any other bank so authorised by the issuing bank may assume the roleofaconfirmingbankandadditsconfirmationtotheLCopenedbyanissuingbank.ThebankwhichhasbeenaskedtoconfirmanLCisundernoobligationtoconfirmit.Itcanindependentlychooseeithertoconfirmornot,butitshouldadviseitsdecisiontotheissuingbank.Aconfirmingbank,forallpracticalpurposesentersinto the shoes of the issuing bank and assumes primary responsibility of effecting payment under the LC to the beneficiary,uponhiscomplyingwiththetermsoftheLC.Nominated bank:• Nominated bank is the bank that is nominated and authorised by the issuing bank to

pay if the LC is a payment LC �incur a deferred payment undertaking �accept drafts, if the credit stipulates so �negotiate �

Whereacreditisspecifiedasfreelynegotiable,anybankcannegotiatethedocumentsundersuchanLC.However,wherecreditisrestrictedfornegotiation,theissuingbankspecifiesthebankswhicharethenominatedbanksandto whom documents have to be presented for negotiation, etc. Bills under an LC with “restricted for negotiation” clause cannot be negotiated by any bank other than the nominated bank in the LC.

Reimbursement bank:• Reimbursement bank is the bank, which is authorised to honour the reimbursement claim in settlement of negotiation / acceptance/ payment lodged with it by the paying, negotiating or accepting bank. It is normally the bank with which the issuing bank has an account, from which payment is to be made.

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9.2.2 Duties and Responsibilities of Parties to an LCTherightsandresponsibilitiesofeverypartyassociatedwithanLChavebeendefinedintheUCPDC500.Itisnecessary that the party dealing with an LC keeps them informed about these responsibilities. A brief summary of these rights is given below:

All parties dealing with an LC are dealing only with documents and not with goods / services, or performances •to which the documents may relate.Exporter/BeneficiaryofLChavearighttoreceivepaymentagainstsubmissionofprescribeddocumentsunder•the LC. It is the exporter’s duty to ship the goods as per the LC and submit the documents within the stipulated time for registration.Negotiating Bank: • Once documents under the LC are submitted, the negotiating bank has to ascertain that they appear on their face to be in accordance with the terms and conditions of the credit and if found agreeable, should effect payment as per the LC terms and dispatch documents to the opening bank as instructed. Once the amountundertheLCispaidtothebeneficiary,thenegotiatingbankisentitledtogetreimbursementfromtheopening bank for the payment, provided documents are in conformity with LC terms.Opening Bank: • Once documents under the LC are received from the negotiating bank, it should scrutinise themwithin7daysfromthedateofreceipt.Ifitfindsanydiscrepancyinthedocuments,itmustconveythesame to the negotiating bank through the fastest means available, advising that it is holding documents in want of disposal instructions.Advising Bank: • Once LC opening instructions are received from the opening bank, the advising bank should if itsodesiresto,actasadvisingbank,verifytheveracityoftheLCandadvisethebeneficiaryabouttheLCandits terms. It is entitled to receive advising charges for having advised the LC from the LC opening bank.ConfirmingBank:• If, at the request of the issuing bank, the advising bank chooses to add its conformity to theLC,itistakinguponitself,theresponsibilityofpayingthebeneficiaryagainstpresentationofstipulateddocuments. Upon payment, it is entitled to receive reimbursement from the issuing bank. It is also entitled to receiveconfirmationcharges.Applicant to the LC: • The importer is responsible for making payment under the LC, against release of stipulated documents, to the opening bank.

9.2.3 How a Letter of Credit OperatesThe process of how the letter of credit operates is as follows:Step1: In order to make payment to the overseas supplier, the buyer of goods approaches his bank for opening a letter of credit in favour of the supplier.

Step 2:Afterconsideringtherequestofthebuyerandfulfilmentofthenecessaryformalities,theissuingbank(i.e.,the buyer’s bank) opens the letter of credit in favour of the supplier.

Step 3: The letter of credit is transmitted to the advising bank (usually an intermediary bank located in the supplier’s country)witharequesttoadvisethecredittothebeneficiary.Afterbeingsatisfiedwiththeauthenticityofthecredit,theadvisingbankadvisesthecredittothebeneficiary(i.e.,thesupplier).

Step 4:Thebeneficiaryverifiestheletterofcreditandchecksforanydiscrepanciesvis-à-visthesalecontract.Ifany discrepancies are noticed, the buyer is asked to incorporate the necessary changes/ amendments to the LC. The supplier then proceeds to ship the goods.

Step 5: Shipment of goods is followed by submission of the necessary documents by the supplier to the negotiating bank in order to obtain payment for the goods. The negotiating bank, upon receipt of commercial documents and the bill of lading from the exporter, scrutinises the documents in relation to the LC and if found to be in order, negotiates the bill and makes payment to the supplier.

Step 6: The negotiating bank then claims reimbursement from the issuing bank by mailing the documents to it or any other bank authorised for the said purpose.

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Step 7: The commercial invoice and other documents are presented by the issuing bank to the buyer of goods, who, on receipt of the same, checks the documents and accepts / pays the bill. On acceptance / payment, the shipping documents covering the goods purchased are handed over to him.

9.2.4 Different Kinds of Letters of Credit (LC)Various types of LCs are in operation depending upon the need. Based on the nature and function, LCs may be categorised as:A. Based on Scope for Cancellation

Revocable Letter of Credit:• A revocable letter of credit is one, which can be revoked (either cancelled or amended), by the issuing bank without giving notice to any of the parties concerned. Here the issuing bank reserves the right of revocation. A revocable letter of credit is disadvantageous from the exporter’s point of view.Byopeningarevocableletterofcredit,theissuingbankdoesnotmakeadefiniteundertakingtoeffectpaymenttotheexporter.However,ifanominatedbankhasmadepaymenttothebeneficiary,priortoreceiptofthe notice of cancellation or amendment, then the issuing bank will be responsible to reimburse the claim that has been presented to it.Every letter of credit should clearly specify whether it is revocable or irrevocable. According to the UCPDC guidelines, if no such indication is observed, the credit will be deemed to be an irrevocable letter of credit.Irrevocable Letter of Credit:• Almost all LCs opened in the course of international trade are irrevocable letters of credit. Cancellation or any amendment to such an LC cannot be made without the prior acceptance of all the partiestothesaidLCliketheapplicant,theconfirmingbank,ifanyandthebeneficiary.Itisimportanttonotethat cancellation or amendment can be made only if all the parties consent to the same. An irrevocable letter of credit is more desirable from the exporter’s point of view.ConfirmedLetterofCredit:• Here,inadditiontotheissuingbank,anotherbankwilladditsconfirmationtotheLC.Inotherwords,aconfirmedletterofcreditwillhavetheguaranteeofnotonlytheissuingbankbutalsooftheconfirmingbank.Itshouldbenotedthatonlyirrevocablelettersofcreditcouldbeconfirmed.Theconfirmingbankwilladditsconfirmationonlyifrequestedbytheissuingbank.Confirmingbanksareusuallylocatedinthecountryofthebeneficiary.

B. Based on Mode of PaymentPayment credit:• Underthiscredit,paymentwillbemadetothebeneficiaryonsubmissionoftherequireddocuments provided they are in compliance with the LC terms. Payment credits do not usually call for drawing of bills. Under payment credit, the issuing bank nominates a bank in the exporter’s country to effect payment on its behalf if the documents are in conformity with the LC. The bank, which paid the amount under the LC, gets reimbursement from the issuing bank.Deferred payment credit:• This type of credit is a usance credit, where payment is made on the due dates specifiedinthecredit.Thebeneficiarymayormaynotberequiredtodrawdrafts.However,underthiscredit,the maturity dates at which payment has to be made and how much maturity should be determined should be clearlyindicated.Thedrawerbankitselfmaydrawpromissorynotesandpassontothebeneficiaryforclaimingpayments on due date.Acceptance credit:• Thiscreditisausancecredit,whereitismandatoryforthebeneficiarytodrawadraftonthedrawer/specifiedtenure.Thedrawerbankwillacceptsuchdraftsandmakepaymentontherespectiveduedates on presentation of the relevant bill of exchange. Negotiation credit: • This credit may be a slight credit or a usance credit. Under a sight credit, payment is made immediately,whileunderausancecreditpaymentismadeafteraspecifiedtenure.Anegotiationcreditmaybefreelynegotiableinwhichcasethebeneficiarymayapproachanybankforthepresentationofdocuments.Thisimplies that when a credit is freely negotiable, any bank is a nominated bank.

On the other hand, when a credit is restricted for negotiation, the issuing bank authorises certainly specify banks asthenominatedbanks.Insuchacase,thebeneficiaryisrequiredtopresentthestipulateddocumentsonlytosuchbanks as they alone are authorised to negotiate the documents under LC.

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When a bank nominated to make payment refuses to do so, and then it is the responsibility of the issuing bank to make such payment. Hence, in a negotiation credit, under all circumstances, it is the responsibility of the issuing bank to pay, and it cannot avoid its responsibility by stating that the negotiating bank is required to pay. A nominated bank,whicheffectivelynegotiatesdocuments,buysthesamefromthebeneficiary,thusbecomingaholderinduecourse.C. Based on Tenure

Sight credit:• Where payment is made on sight (either on demand or presentation), such credit is called a sight credit. Drawing of drafts is not compulsory under sight credit. Under a sight payment credit (if drawing a draft is not required) payment can be made against submission of stipulated documents.Usance credit:• AlsoreferredtoasTermCredit,thiscreditrequiresdraftstobedrawnonthedrawee/specifiedbank indicating the tenure. Such drafts will be accepted by the drawee and paid for at the end of the usance period.

D. Based on Availability StyleRevolving credit:• AletterofCreditwherebythecreditavailabletothebeneficiarygetsreinstatedtotheoriginalamount once a drawing is made it is called revolving credit. The amount under this credit may revolve in relation to time or value. Revolving credit may be of two types.

Inthefirsttype,theamountgetsreinstatedimmediatelywhenthebeneficiarymakesadrawing. �Inthesecondtype,theamountwillberevivedonlywhentheissuingbankgivesaconfirmation.Thismay �takeplaceaftertheissuingbankreceivesdocumentsandpaymentismade,ortheissuingbankconfirmsthe fact of receipt of documents.

Instalment credit:• Itstipulatesthatshipmentsmaybemadeininstalmentsatspecifiedperiodsoftime.Instalmentcredit differs from simple credit, which permits partial shipments in the sense that under instalment credit, the time as well as the quantity is stipulated. On the other hand, under a simple credit, which permits partial shipments, there is no stipulation as to the time and quantity.Deferred credit:• This credit is mostly used in those trades where a portion of goods is paid for by the buyer afterverificationofgoodsorafterassessingthevalueofthegoods,takingintoaccountthequality,shortages,etc.Thedateforpaymentoftheundrawnbalancemayormaynotbespecified.Hencesuchtypeofcreditiscalled deferred credit. Transit credit:• Normally,whenanLCisopened,itwillbeadvisedtothebeneficiarybyabankthatitisbasedinthebeneficiary’scountry.Howeverintransitcredit,theservicesofabanksituatedinathirdcountrywillbeused.Insuchcredit, theadvisingbankwillbesituatedinacountryotherthanthebeneficiary’s.Sucharequirement may be called for in cases where the opening bank has no corresponding relations with any bank in thebeneficiary’scountry.Transitcreditmayalsobeopenedbycountrieswhosecreditmaynotbereadilyacceptedinthebeneficiary’scountry.Insuchacase,abankinathirdcountrymayberequestedtoopentheLC.Reimbursement credit:• When credit is denominated in the currency of a third country, such credit is termed as reimbursement credit. This is in contrast to the normal letters of credit, which are denominated in the currency ofeithertheapplicant’scountryorthebeneficiary’scountry.Sometimes,creditswhereapaying/accepting/negotiating bank is reimbursed in a manner other than by debit to the Vostro Account of the opening bank or by credit to the Nostro Account of the paying / accepting / negotiating bank is reimbursed in a manner other than by debit to the Vostro Account of the opening bank or by credit to the Nostro Account of the paying / accepting / negotiating bank held with the opening bank are also referred to as reimbursement credits.Anticipatory credit: • Payment under a letter of credit is usually made at the post shipment stage (i.e. on submission of relevant shipping documents). However, under anticipatory credit, payment is made to the exporter at the pre-shipment stage in anticipation of export of goods and submission of bills at a later stage. The advances so made will be recovered from the proceeds of bills to be submitted under the letter of credit. Where the bills are not presented, recovery will be made from the opening bank.

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OthersStandby Letter of Credit:• Inastandbyletterofcredit,thecreditispayableuponcertificationofaparty’snon-performance of the agreement, of course upon adducing evidence to the effect that payment has indeed beendefaulted.StandbyLCismostlyusedincountrieswherefinancialguaranteesareprohibitedbylaw,likein the USA.Transferable credit:• Atransferablecreditisone,whichcanbetransferred(i.e.fromtheFirstBeneficiarytoaSecondBeneficiary).Itshouldbenotedthatsuchcreditcanbetransferredonlyonce.Thesecondbeneficiarycannotinturntransferthesametoathirdbeneficiary.Atransferablecreditwillbesubjecttotheoriginaltermsand conditions of the credit, excepting the amount of credit, unit prices, percentage of insurance terms, period of validity and shipment. According to Article 48(b) of the UCPDC, a credit will be rendered as transferable, onlyifitisspecificallystipulatedassuchinthecredit.Back to Back credit:• This credit is one that is opened against the security of another credit called the main credit. Under this credit, an LC is opened by the buyer in favour of his actual supplier / manufacturer against the securityofthemaincredit.Bydoingso,thefirstbeneficiarycanobtainreimbursementbypresentingdocumentsreceived under back to back credit under the main LC.

9.2.5 Documents under a Letter of CreditIn case of shipment under letter of credit, the supplier should prepare documents strictly in accordance with the terms and conditions of the letter of credit and submit them to his bank for negotiation. The negotiating bank will examine these documents and if found in order, negotiate the same.

If there are any discrepancies in the documents presented by the exporter, the guidelines which the negotiating banks then need to follow are:

mayreturnthedocumentstotheexportersforrectificationofdefects•may refuse to negotiate the documents and advise the exporter to send them on collection basis or•contact the issuing bank for authorisation for negotiation in case of minor discrepancies or•make payment ‘under’ reserve against the exporter’s indemnity and send the bills to the issuing bank•

The documents to be submitted by the exporter to his banker would include a commercial invoice, transport document whichisusuallythebilloflading(orseawaybillorairwaybill),insurancedocument,certificateofinspection,packinglistandinsomecasesacertificateoforiginofgoodsaswell.Guidelines to be kept in mind with respect to individual documents are enumerated below:

A. InvoiceA commercial invoice is a prima facie evidence of the contract of sale and purchase. It is a document made by the exporter on the importer indicating details like description of the goods consigned, consignor’s name, consignee’s name, name of the steamer, number and date of bill of lading, country of origin, price, terms of payment, amount of freight, etc. The important aspects of the invoice are:

The invoice should be made out in the name of the applicant.•Itshouldbesignedbythemaker.Descriptionofgoodsspecifiedintheinvoiceshouldcorrespondtothedescription•given in the letter of credit. Similarly, other conditions like quantity of goods, unit price, delivery terms, etc. should conform to those stipulated in the Letter of Credit.TheinvoiceshouldbedrawninthesamecurrencyofLCunlessotherwisespecified.•The invoice should not include any charges not stipulated in the LC. Also, the gross value of invoice should •not exceed the credit amount.Final amount of invoice or the percentage of drawing as permitted in the LC hold corresponds with the draft •amount.If partial shipments are effected, amount of drawings should preferably correspond to proportionate quantities •shipped (where only quantity is mentioned without unit price).

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If invoice is issued for an amount in excess of the amount permitted by the credit, the drawings should not •exceed the amount of credit.Detailsstatedontheinvoiceshouldcorrespondtodetailsspecifiedinallotherdocuments.Also,theinvoice•should certify to facts like origin of goods, etc. as stipulated in the LC.

B. Bill of LadingA bill of lading is a document issued by the shipping company or its agent, acknowledging the receipt of goods for carriage which are deliverable to the consignee or his assignee in the same condition as they were received.

There is a close relationship between bills of lading and the letter of credit. The possession of the original bill of lading enables the holder to claim the goods from the carrier.

The bill of lading must satisfy certain requirements. Every bill of lading must:Show the name of the carrier and must be issued by a named carrier or his agent. The bill of lading must also •be signed by the named carrier or his agent.Bear a distinct number.•Indicate the date and place of issuance.•Indicate the name of consignor and consignee.•Indicate a brief description of goods being carried.•Indicateportofloadingortakingincharge(incaseofmarinebillofladingitmustshowadefiniteportof•loading and in other cases it can be shown as an “intended” port).Indicateportofdischarge(incaseofamarinebillofladingitmustindicateadefiniteportofdischargeandin•other cases it can be shown as an intended port).Be presented in full set of originals (full set comprises of two or more originals issued to consignor of goods, •all of which are made as “originals” and signed. The number of copies of originals is indicated on the bill of lading itself).Meet all other stipulations of the credit.•Must indicate whether freight is prepaid or is payable.•

C. Insurance documentIn international trade, when goods are in transit they are exposed to marine perils. Insurance is affected to protect the insured against risk of loss or damage to goods due to marine perils.The key points in regard to insurance document are mentioned as under:

Insurance documents should be issued and signed only by insurance companies or underwriters or their •agents.Covernotesissuedbybrokerswillnotbeacceptedunlessspecificallyauthorisedbythecredit.•The insurance document should be signed by the issuer and dated. Date of the issuance must be on or before •thedateofshipmentoritmustbeevidencedbyspecificnotationthatthecoveriseffectivefromthedateofshipment. The insurance document must be expressed in the same currency as the letter of credit.The insurance document must indicate the name of the assured and also give brief details of the goods •insured.The mode of conveyance of goods should also be indicated. Further, it should also indicate the nature of risks •covered,whichshouldbethosespecifiedintheLC.The insurance document should be in a negotiable form.•Unlessotherwisespecified,itshouldbeissuedforanamountof110%ofCIF/CIPvalueofthegoods.Ifsuch•value is not determinable from the documents on their face, it should be for a minimum amount of negotiation requested for or the amount of invoice value which of the two is higher.If the insurance document is issued in more than one negotiable copy, all copies must be submitted.•

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The document should be endorsed in blank by the assured if required as per the terms of the LC.•It should indicate the port of shipment and destination or point of insurance coverage and point of termination •of insurance.It should not contain any clause affecting the interest of the assured / assignees.•ItmustcoveralltheadditionalrisksasspecifiedintheLC.•If the goods are on “DECK”, deck shipment should be covered.•

D.CertificateofOriginManycountriesrequireacertificatefromthesupplierofgoodsstating theoriginof thegoodsandcertifiedbytheChamberofCommerceoranyotherrecognisedauthorityintheexporter’scountry.Certificateoforiginisanimportant document in case of imports into India to determine the origin of goods for methods of payment purpose as required by the Exchange Control Authorities.

It must be issued and signed by an independent authority such as chamber of commerce, etc. indicating the •origin of goods.ThecountryoforigincertifiedmustbeaspertheLCrequirementandconsistentwiththedeclarationgivenby•thebeneficiaryinhisinvoice/otherdocuments.It must indicate the description of goods and should be consistent with other documents.•It must indicate the name of the consignor/seller and name of consignee/ buyer.•

Incoterms – an acronym for International Commercial Terms – are a series of 13 trade terms used in international sales contracts to clearly divide the risks and responsibilities of buyers and sellers with regard to the movement of goodsbetweenbothparties.Theywerefirstintroducedin1936inEuropetopreventmisunderstandingsanddisputesthatmayarisebecauseofdifferenttradingpracticesamongcountries.Theyhavebeenrevisedperiodicallytoreflectcurrent trading practices and the most recent is the Incoterms 2000.

EXW Ex Works (… named place)•It means that the seller has delivered if he places the goods at the disposal of the buyer either at the seller’s premises or any other named place (works, factory, warehouse, etc.). This term represents the minimum obligation for the seller. All the expenses and risks involved in taking the goods from the seller’s premises will have to be borne by the buyer.

FCA Free Carrier (… named place)•“FreeCarrier”(FCA)meansthatthesellerfulfilshisobligationtodeliverwhenhehashandedoverthegoods,cleared for export, into the charge of the carrier named by the buyer at the named place or point. If no precise point is indicated by the buyer, the seller may choose within the place or range stipulated where the carrier shall take the goods into his charge.

FAS Free Alongside Ship (… named port of shipment)•Free alongside Ship means that the seller delivers when the goods are placed alongside the vessel at the named port of shipment. This means that the buyer has to bear all costs and risks of loss of or damage to the goods from that moment. Free alongside ship does not include charges for loading the goods on board the vessel. It also does not include ocean freight charges and marine insurance premium. The FAS term requires the seller to clear the goods for export. This is in contrast to the earlier requirement where the buyer was required to arrange for clearance of the goods.

FOB Free on Board (… named port of shipment)•The seller is said to have delivered once the goods cross the ship’s rail at the named port of shipment. From that point onwards all the risks and expenses are to be borne by the buyer. The FOB price is inclusive of ex-works price, packing charges, transportation charges up to the place of shipment, wharf age and portage, customs dues, export duties, cost of checking of quality measure, weight or quantity, if any which an exporter incurs while delivering the goods to the buyer on board the ship.

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CFR Cost and Freight (… named port of destination)•“Cost and Freight” (CFR) means that the seller must pay the costs and freight necessary to bring the goods to the named port of destination but the risk of loss of or damage to the goods, as well as any additional costs due to events occurring after the time the goods have been delivered on board the vessel, is transferred from the seller to the buyer when the goods pass the ship’s rail in the port of shipment.

CPT Carriage Paid To (… named place of destination)•“Carriage Paid To…” (CPT) means that the seller pays the freight for the carriage of the goods to the named destination. The risk of loss of or damage to the goods as well as any additional costs due to events occurring after the time the goods have been delivered to the carrier, are transferred from the seller to the buyer when the goods have been delivered into the custody of the carrier.

“Carrier” means any person who, in contract of carriage, undertakes to perform or to procure the performance of carriage, by rail, road, sea, air, inland waterway or by a combination of such modes.

If subsequent carriers are used for the carriage to the agreed destination, the risk passes when the goods have been deliveredtothefirstcarrier.

CIP Carriage and Insurance Paid To (… named place of destination)•“Carriage and Insurance Paid to …” (CIP) means, that the seller has the same obligations as under CPT (Carriage Paid To) but, with the addition that the seller has to procure cargo insurance against the buyer’s risk of loss of or damage to the goods during the carriage. The seller contracts for insurance and pays the insurance premium. The buyer should note that under CIP terms, the seller is only required to obtain insurance on minimum coverage. The CIP terms require the seller to clear the goods for export. This term may be used for any mode of transport including multimodal transport.

DAF Delivered at Frontier (… named place)•“DeliveredatFrontier” (DAF)means that theseller fulfilshisobligation todeliverwhen thegoodshavebeenmade available, cleared for export, at the named point and place at the frontier, but before the customs border of the adjoining country. The term “frontier” may be used for any frontier including that of the country of export. Therefore,itisofvitalimportancethatthefrontierinquestionbedefinedpreciselybyalwaysnamingthepointandplace in the terms. The terms are primarily intended to be used when goods are to be carried by rail or road, but may be used for any mode of transport.

DES Delivered Ex Ship (…named port of destination)•“DeliveredExShip”(DES)meansthatthesellerfulfilshisobligationtodeliverwhenthegoodshavebeenmadeavailable to the buyer on board the ship un-cleared for import at the named port of destination. The seller has to bear all the costs and risks involved in bringing the goods to the named port of destination. This term can only be used for sea or inland waterway transport.

DEQ Delivered Ex Quay (… named port of destination)•“DeliveredExQuay(dutypaid)”(DEQ)meansthatthesellerfulfilshisobligationtodeliverwhenhehasmadethe goods available to the buyer on the quay (wharf) at the named port of destination, cleared for importation. The seller has to bear all risks and costs including duties, taxes and other charges of delivering the goods thereto.

DDU Delivered Duty Unpaid (… named place of destination)•“DeliveredDutyUnpaid”(DDU)meansthatthesellerfulfilshisobligationtodeliverwhenthegoodshavebeenmade available at the named place in the country of importation. The seller has to bear the costs and risks involved inbringingthegoodsthereto(excludingduties,taxesandotherofficialchargespayableuponimportationaswellas the costs and risks of carrying out customs formalities). The buyer has to pay any additional costs and to bear any risks caused by his failure to clear the goods for import in time.

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DDP Delivered Duty Paid (… named place of destination)• “DeliveredDutyPaid”(DDP)meansthatthesellerfulfilshisobligationtodeliverwhenthegoodshavebeenmadeavailable at the named place in the country of importation. The seller has to bear the risks and costs, including duties, taxes and other charges of delivering the goods thereto, cleared for importation. While the EXW (ex works) term represents the minimum obligation for the seller, DDP represents the maximum obligation.

9.2.6 Further Information on the ProcedureFollowing are the guidelines issued by the International Chamber of Commerce so as to ensure uniformity across the trading partners and which are accepted by the local courts in settling trade disputes:

Uniform customs and practices for documentary credits 1993 revision ICC publication no. 500 is applicable •to all documentary credits (including to the extent in which they may be applicable, standby letter(s) of credit where they are incorporated into the text of the credit.).Theuniformrulesforcollection1995revisionICCpublicationno.522isapplicabletoallcollectionsasdefined•in article 2 where such rules are incorporated into the text of the collection instructions referred to in article 4 and are binding on all parties thereto unless otherwise expressly agreed or contrary to the provisions of a natural state or local law and / or regulation which cannot be departed from.The uniform rules for bank-to-bank reimbursement under documentary credit ICC publication 525 is applicable •to all reimbursements’ applicability transaction between the using bank, reimbursing bank and claiming bank. It provides step-by-step guidance to each party and includes detailed explanation of the principles behind each part of a reimbursement transaction.

9.3 Other Financing MechanismsCross border leasing:• Equipment such as aircraft, ships, oil drilling rigs, etc. are leased by international leasing firms.Therearesomemerchantbanks,whichspecialiseincrossborderleasing.Foreignbanksofimportersusually specialise in such leasing activities.Forfeiting:• Itisaspecifiedformoftradefinance,whichhelpstheexportertoofferextendedcredittotheimporter.Under forfeiting, the importer gives the exporter a bundle of bills of exchange or promissory notes covering the principal amount and interest. Each transaction of the notes falls due at different points of time in the future e.g. every six months, extending up to several years (For instance importers in India may be able to avail credit extending up to 7 years). The notes are backed by a guarantee or Aval provided by a reputed bank in the importer’s country. The exporter can then discount these notes without recourse to banks that specialise in the forfeiting business togenerateimmediatecashflow.Theforfeiterinturn,mayholdthenotesinhisownportfolioorselldifferenttrenches in the secondary market. Fig.9.1 shows a schematic picture of the forfeiting mechanism. Forfeiting tends to be a specialised business each underlying export import transaction generally has unique features.

Fig. 9.2 Forfeiting mechanism

Notes

ImporterExporter

Notes Notes paid over time

Discounted payment

Goods

Forfeiter

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Buyers’Credit isaformofeurocurrencyloandesignedtofinanceaspecifictransactioninvolvingimports•of goods and services. Under this arrangement, lending bank(s) pay the exporter on presentation of shipping documents. The importer works out a deferred payment arrangement with the leading bank, which the bank treats as a loan. Large loans are club loans or syndicated loans. Many provisions in the loan agreement are quite similar to a general-purpose syndicated credit. A number of formalities have to be completed before the exporter can draw funds. Interest rate is linked to a market index such as LIBOR. In some cases a state export creditagencyfromtheexporter’scountrymaypayasubsidytothebankssothatanattractivefindinglistcanbe offered to the importer.Line of credit:• Lines of credits are like buyers’ credits but much wider in scope. A typical buyer’s credit involves one transaction between one supplier and one buyer. A line of credit may lower several purchase transactions with the buyer importing different items from different suppliers. Many buyers may be involved if the ultimate credit risk is that of a single buyer or guarantor.Supplier’s credit: • Under supplier’s credit arrangements, the exporter extends credit to the importer by allowing it to pay on the basis of deferred payment. Promissory notes issued by the importer evidence the credit. The supplier can discount the paper with a bank. The payments made by the buyer under the promissory notes are assigned to the lenders and may be routed to them directly or through the supplier. The supplier may have to share the responsibility of pursuing payment on the bank’s behalf in the case of default by the buyer.EXIM bank:• The EXIM Bank of India set up in 1982, is the principal institution in the country for co-ordinating theworkingofinstitutionsengagedintradefinance.IthasavarietyofprogrammesdesignedtoprovidelongtermandshorttermfinancetoforeignbuyersofIndiangoodsandservices,enablingIndianexporterstoextendcredittotheiroverseascustomers.Italsoassistscommercialbanksinprovidingexportfinanceandfinanceforimportofbulkgoodsandimportsofrawmaterialsforexportproduction.Apartfromfinanceitalsoprovidesinformation and advisory services to exporters to assess international opportunities and risks.

CounterpartsofEXIMIndiainothercountriessuchasEXIMUSAareanimportantsourceoffinance,includingterm credits for importers in India.

9.4 Historical Perspective of the Export-Import PolicyTheoriginofimporttradecontrolinIndiadatesbacktotheSecondWorldWar,whenforthefirsttime,restrictionsunder the Defence of India Rules (DIR) were imposed on imports into India. However, at that time the main aim was to reduce the pressure on the limited available shipping space. Starting with consumer goods, the restrictions weregraduallyextendedtocoverunmanufacturedaswellassemi-finishedgoods.InSeptember1946,withthelapse of the DIR, import trade control continued under the Emergency Provisions (Continuance) Ordinance, 1946. The ordinance was replaced by the Imports and Export (Control) Act, 1947 which was also replaced by the Foreign Trade (Development and Regulation) Act, 1992. Presently, import trade control is administered in India under the purview of Foreign Trade (Development and Regulation) Act, 1992, Foreign Trade (Regulations) Rules, 1993 and Foreign Trade (Exemption from application of rules in certain cases) Order, 1993.

Exports and Imports come under the purview of the Ministry of Commerce and it is the Director General of Foreign Trade functioning under the Commerce Ministry who is empowered to exercise control over exports/imports.

Previously, the policy was being announced on an annual basis. However, in order to bring about continuity and stability in the policy, there was a shift from the usual annual policy to a three-year policy from April 1985. Beginning 1stApril,1992thepolicyisbeingannouncedonafive-yearbasisandthepolicycurrentlyineffectistheexportandimportpolicy1stApril,2002to31stMarch,2007.Revisionsduringthefive-yearperiodgenerallyarepublishedon1stAprilofsubsequentyearsduringthefive-yearperiod,althoughchangesmaybemadeandannouncedbymeansof public notices/amendment orders at any time.

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9.5 Objectives of the Exim Policy 2002-07The major thrust of the new Exim policy for the period 2002-07 is the acceleration of India’s exports. In this direction, the policy has laid down a wide range of measures to restructure the various export promotion schemes. It has also advocatedsimplificationandstreamliningofproceduressoastoinjectgreatertransparencyintothesystem,besidesensuring ‘speed’ in carrying out transactions. Continuing with the process of trade reforms and liberalisation, the policy aims at consolidating the achievements made possible during the preceding 5-year Exim policy for 1997-2002. The need to ease controls as well as procedural bottlenecks was realised. Another focus area of the new Exim Policy was to enable domestic industry realise its full potential and improve its competitiveness in the global arena.

Puttingitbriefly,themajorobjectivesofthenewEximpolicycanbeenumeratedasunder:Facilitatingthesustainedgrowthinexportsinordertocaptureashareofatleast1%oftheglobaltradefrom•thepresentlevelof0.67%.Stimulating sustained economic growth by providing access to essential raw materials, intermediates, components, •consumables and capital goods, derived from augmenting production.Enhancing the technological strength and efficiency of Indian agriculture, industry and services, thereby•improving their competitiveness while generating new employment opportunities.Encouraging the attainment of internationally accepted standards of quality and providing consumers with good •quality products at reasonable prices.

TheEximpolicy 2002-2007basically aims at imparting operational flexibility to the exporters.The changesbrought about will enable exporters to tap new markets, and help them improve exports both in terms of quality and quantity.

9.6 Highlights of the EXIM Policy 2002-07 (As amended up to 31.03.2003)Service exports

Facilitating duty free import for the service sector having a minimum foreign exchange earning of Rs.10 •lakhs.

Agro exportsEncouragement to the corporate sector for sponsoring the Agri Export Zones (AEZ) to boost agro exports.•DEPB rates for the selected agro products to factor in the cost of preproduction inputs such as fertilisers, •pesticides and seeds.

Status holderDutyfreeimportentitlementfortheholderofincrementalgrowthof25%inFOBvalueofexports(inforeign•exchange).Annual advance license facility to be introduced to enable them to plan their imports and bulk purchase.•The input-output norms are to be timed on priority basis within 60 days.•Status holder in STPI shall be permitted free movement of professional equipment like laptops, computers.•

Hardware/SoftwareHardware shall be eligible for duty free import for testing and development purposes in order to promote exports •in embedded software.100%depreciationtobeallowedoveraperiodof3yearsforcomputersanditsperipheralsforunitsEOU/•EHTP/STP/SEZ.

Gem and Jewellery sectorDiamond dollar accounts for exporters engaged in purchase/sale of diamonds and diamond studded jewellery •so that they can retain their proceeds in dollars.

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Nominated agencies to accept payments in dollars for cost of import of precious metals from EEFC account •of exporters.Units in SEZ and EOU can bring their proceeds in kind as against the present provision of bringing only in •cash.

Export clustersEmphasis on infrastructure up gradation of the existing clusters under the DIPP scheme to increase their overall •strength.EffortstobemadeundertheASIDEschemetobridgethetechnologyandproductivitygapsintheidentified•clusters.

Rehabilitation of sick unitsIn order to revive sick units, the export obligation period is to be extended based on the BIFR rehabilitation •schemes.

Removal of quantitative restrictionsImportof69itemscoveringanimalproducts,vegetablesandspices,antibioticsandfilmsareremovedfrom•the restricted list.Export of 5 items namely paddy except basmati, cotton linters, rare earth, silk cocoons, and family planning •devices except condoms are removed from the restricted list.

Special Economic Zones Scheme (SEZ)Sales from Domestic Tariff Area (DTA) to SEZ to be treated as export. This will entitle the domestic suppliers •toDrawback/DEPBbenefits,CSTandservicetaxwaiver.Foreign passengers will now be allowed to take goods from SEZ to promote trade, tourism and export.•Domestic sales by SEZ units will now be exempt from SAD.•Restriction of one-year period for remittance of export proceeds removed for SEZ units.•Netting of export permitted for SEZ unit provided it is between the same exporter and importer over a period •of 12 months.SEZ units permitted to take job work abroad and export goods from there.•SEZ units can capitalise import payables.•Wastage for sub-contracting/exchange by gem and jewellery units in transactions between SEZ and DTA will •now be allowed.Export/import of all products through post parcel/courier by SEZ units will now be allowed.•The value of capital goods imported by SEZ units will now be amortised uniformly over 10 years.•SEZ units will now be allowed to sell all products including gems and jewellery through exhibitions and duty •free shops or shops set up abroad.Goods required for operation and maintenance of SEZ units will now be allowed duty free.•

Export Oriented Unit Scheme (EOU)Agriculture/Horticulture processing EOUs will now be allowed to provide inputs and equipment to contract •farmers in DTA to promote production of goods as per the needs of importing countries.Foreign bound passengers will now be allowed to take goods from EOUs to promote trade, tourism and •exports.The value of capital goods imported by EOUs will now be amortised uniformly over 10 years.•Period of utilisation of raw materials prescribed for EOUs increased from 1 year to 3 years.•Gems and jewellery EOUs are now being permitted sub-contracting in DTA.•

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Wastage for sub-contracting/exchange by gem and jewellery units in transactions between EOUs and DTA will •now be allowed as per norms.Export/Import of all products through post parcel/courier by EOUs will now be allowed.•EOUs will now be allowed to sell all products including gems and jewellery through exhibitions and duty free •shops or shops set up abroad.Gems and jewellery EOUs will now be entitled to advance domestic sales.•

Export Promotion Capital Good Scheme (EPCG)The scheme shall now also allow import of capital goods for preproduction and post-production facilities.•The Export Obligation under the scheme shall now be linked to the duty saved and shall be 8 times the duty •saved.To facilitate up-gradation of existing plant and machinery, import of spares shall also be allowed under the •scheme.To promote higher value addition in exports, the existing condition of imposing an additional Export Obligation •of50%forproductsinthehigherproductchaintobedoneawaywith.Greaterflexibilityforfulfilmentofexportobligationundertheschemebyallowingexportofanyotherproduct•manufactured by the exporter.This shall take care of the dynamics of the international market.•Capital goods up to 10 years old shall also be allowed under the scheme. •Tofacilitatediversificationintothesoftwaresector,existingmanufacturerexporterswillbeallowedtofulfil•export obligations arising out of import of capital goods under the scheme for setting up of software units through export of manufactured goods of the same company.Royalty payments received from abroad and testing charges received in free foreign exchange to be counted •for discharge of export obligation under EPCG scheme.

Duty Exemption Pass Book Scheme (DEPB)Facility for provisionalDEPB rate introduced to encourage diversification and promote export of new•products.DEPB rates rationalised in line with general reduction in customs duty.•

Advance licenseStandardInputOutputNormsfor403newproductsnotified.•Anti-dumping and safeguard duty exemption to advance license for deemed exports for supplies to EOU/SEZ/•EHTP/STP.

DutyFreeReplenishmentCertificateScheme(DFRC)DutyFreeReplenishmentCertificate scheme extended to deemed exports to provide a boost to domestic•manufacturer.ValueadditionunderDFRCschemereducedfrom33%to25%.•

Reduction of transaction costOn-line issuance of Importer-Exporter Code (IEC) number by linking the DGFT EDI network with the Income •Tax PAN database.Applicationsfiledelectronicallythroughthewebsiteshallhavea50%lowerprocessingfeeascomparedto•manual applications.

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MiscellaneousReductioninpenalinterestratefrom24%to15%foralloldcasesofdefaultunderEximPolicy.•Restriction on export of warranty spares removed.•IEC holder to furnish on-line return of imports/exports made on yearly basis.•Exportoffreeofcostgoodsforexportpromotion@2%ofaverageannualexportsinprecedingthreeyears•subject to ceiling of Rs.5 lakhs permitted.

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SummarySpecial procedures have evolved for dealing with extra risks of international trade and national and international •institutionshavebeenestablishedtofinanceandregulateinternationaltrade.Adocumentary/letterofcreditmaybedefinedas“anarrangementbymeansofwhichabank(IssuingBank)•actingattherequestofacustomer(Applicant),undertakestopaytoathirdparty(Beneficiary)apredeterminedamount by a given date according to agreed stipulations and against presentation of stipulated documents.” TherightsandresponsibilitiesofeverypartyassociatedwithanLChavebeendefinedintheUCPDC500.Itis•necessary that the party dealing with an LC keeps them informed about these responsibilities.A revocable letter of credit is one, which can be revoked (either cancelled or amended), by the issuing bank •without giving notice to any of the parties concerned. Almost all LCs opened in the course of international trade are irrevocable letters of credit.•Banker’sacceptanceisameansofshort-termtradefinancingtypicallyupto6months.Forfeitingisameansof•medium-termtradefinancing,withatypicaltermof5years.Forfeiting involves the sale by an exporter of promissory notes issued by an exporter and usually availed by •the importer’s bank. The forfeiter has no recourse to the exporter in the event that for whatever reason, the forfeiter is not paid.The majority of trade occurs between countries which are members of customs unions or free-trade agreements •the trend toward the establishment of trading blocs could threaten globally free trade.The major thrust of the new Exim policy for the period 2002-07 is the acceleration of India’s exports. In this •direction, the policy has laid down a wide range of measures to restructure the various export promotion schemes.

Referenceshttp://banking.about.com/od/businessbanking/a/letterofcredit.htm• . Last accessed on 28th December, 2010.http://www.prlog.org/10534168-different-types-of-letter-of-credit.html• . Last accessed on 28th December, 2010.http://pib.nic.in/archieve/eximpol/eximpolicy2002/eximpolicy2002.html• . Last accessed on 28th December, 2010.

Recommended ReadingBelay Seyoum (2008). • Export-Import Theory, Practices, and Procedures. Routledge. Second edition.David K. Horvat (2011). • The Export-import Bank. Nova Science Pub Inc.Carl A. Nelson (2000). • Import/Export: How to Get Started in International Trade. McGraw-Hill; Third edition.

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Self Assessment

WhatdoesUPCDCstandsfor?1. Uniform Customs and Practice for Documentary Councila. Uniform Customs and Practice for Documentary Creditsb. Uniform Customs and Price for Documentary Creditsc. Uniform Customs and Practice for Documents Creditsd.

Whencreditisdenominatedinthecurrencyofathirdcountry,suchcreditistermedas?2. Instalment Credita. Deferred Creditb. Transit Creditc. Reimbursement Creditd.

____________is the principal institution in the country for co-ordinating the working of institutions engaged 3. intradefinance.

Confirmingbanka. Nominated bankb. Reimbursement bankc. Exim bankd.

Banker’sacceptanceisameansofshort-termtradefinancingtypicallyupto4. 5 yearsa. 1yearb. 6 monthsc. 3 monthsd.

___________involves the sale by an exporter of promissory notes issued by an exporter and usually availed 5. by the importer’s bank.

Forfeitinga. Anti-dumpingb. Streamliningc. Exportingd.

WhichofthefollowingstatementisFALSE?6. The major thrust of the new Exim policy for the period 2002-07 is the acceleration of India’s imports.a. The rights and responsibilitiesof everypartyassociatedwithanLChavebeendefined in theUCPDCb. 500.Almost all LCs opened in the course of international trade are irrevocable letters of credit.c. TheEximpolicy2002-2007basicallyaimsatimpartingoperationalflex.d.

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_________ means that the seller pays the freight for the carriage of the goods to the named destination.7. DFRCa. DEPBb. DDUc. CPTd.

Free alongside ship means that the seller delivers when the goods are placed alongside the vessel at the named 8. port of ________.

deliverya. officeb. shipmentc. godownd.

TheEximpolicy2002-2007basicallyaimsatimpartingoperationalflexibilitytothe_________.9. importersa. exportersb. governmentc. bankersd.

Certificateoforiginisanimportantdocumenttodeterminetheoriginofgoodsformethodsofpaymentpurpose10. as required by the __________.

ExchangeConfirmingAuthoritiesa. Exchange Control Authoritiesb. Export Control Authoritiesc. Exchange Council Authoritiesd.

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Case study I

Exchange risk management

Problem: You are planning to hedge a payable exposure in dollars and have calculated the following information:Spot Rs./$ 42.50 / 42.603 months forward (Rs. /$) 43.50 / 43.70Interestrate $6% Rs.15%If the exposure matures in 3 months and there are no restrictions on trading in forward / money market instruments, whichcoveryouwouldprefer-forwardcoverormoneymarketcover?Shownecessarycalculations.

Solution: Suppose we need $ 1000 after 3 months.Forwardcoveroutflow1000x43.70=Rs.43,700Money market cover

Investment today

Rupee needed today $ 985.22 x 42.60 = Rs.41970Rupeeoutflowafter3months=41,970x(1+0.15/4)=43544Moneymarketisbetterasitinvolveslesserrupeeoutflowattheendof3monthswhenexposurewillmature.

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Case study II

Foreign Exchange Market

Problem: An Indian exporter has bagged a contract to supply garments to a departmental store in UK. The buyer has agreed to invoice in sterling or in dollars. The sterling price per garment will be 4. The contract will be executed one month from now. It is expected that from the time of shipment to negotiation of LC, another month will lapse. If the following are the relevant spot rates and interest rates and the exporters total costs are Rs. 200 per garment, whichcurrencywouldyouchooseforinvoicing?

Interestrates £8%;$5%, Rupee15%Spot rate Rs. 59/£, Rs. 35.50/$1 month forward rate Rs. 60.00/£ Rs. 35.75 / $2 month forward rate Rs. 61.00/£ Rs. 36.00/$

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Case study III

International Financial Market

Problem:YouaretheCFOofaCanadianfirmthatisconsideringbuildinga$10millionfactoryinRussiatoprocesscow-milk.Theinvestmentisexpectedtoproducenetcashflowof$3millioneachyearforthenext10years.Laterthe investments have to close because of technological obsolescence. Scrap value will be zero. The cost of capital willbe6%iffinancedthroughtheEurobondmarket.However,thereisanoptiontofinancetheprojectbyborrowingfundsfromaRussianbankat12%.ItisexpectedthatduetohighinflationinRussia,theRussianRoubleisexpectedto depreciate against the Canadian dollar. Further there is a high probability occurrence of violent revolution in Russia within the next 10 years. How would you incorporate these factors into your evaluation of the investment opportunity?Whatwouldyourecommendthefirmtodo?

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Recommended ReadingAshrafLaïdi(2008).CurrencyTradingandInter-marketAnalysis:HowtoProfitfromtheShiftingCurrentsin•Global Markets (Wiley Trading). Wiley; New edition.Barry Eichengreen (2008). Globalizing Capital: A History of the International Monetary System. Princeton •University Press; Second edition.Belay Seyoum (2008). Export-Import Theory, Practices, and Procedures. Routledge; Second edition•Bob.Steiner(2007).MasteringFinancialCalculations:Astep-by-stepguidetothemathematicsoffinancial•market instruments. FT Press; Second edition.Brian Coyle (2002). Foreign Exchange Markets: Currency Risk Management (Risk Management Series). Global •Professional Publishing; Revised edition.Carl A. Nelson (2000). Import/Export: How to Get Started in International Trade. McGraw-Hill; Third •edition.David K. Horvat (2011). The Export-import Bank. Nova Science Pub Inc.•Donald R. Van Deventer (2004). Advanced Financial Risk Management: Tools & Techniques for Integrated •Credit Risk and Interest Rate Risk Managements. Wiley.Ethan Kapstein (1996). Governing the Global Economy: International Finance and the State. Harvard University •Press.Francisco L. Rivera-Bati (1993). International Finance and Open Economy Macroeconomics. Prentice Hall; •Second edition.FrankJ.FabozziCFA(2002).TheHandbookofFinancialInstruments.Wiley;firstedition.•George Kenwood (1999). Growth of the International Economy 1820-2000: An Introductory Text. Routledge; •fourth edition.GhassemA.Homaifar (2003).ManagingGlobal Financial andForeignExchangeRateRisk.Wiley; first•edition.Hans Visser (2006). A Guide to International Monetary Economics, Exchange Rate Theories, Systems and •Policies. Edward Elgar Publishing; Third edition.Jaime Reis (1995). International Monetary Systems in Historical Perspective. Palgrave Macmillan.•James Chen (2009). Essentials of Foreign Exchange Trading (Essentials Series). Wiley.•John M. Letiche (1967). Balance of Payments and Economic Growth. Harvard University Press; New issue of •1959 edition.John McCombie (2004). Essays on Balance of Payments Constrained Growth: Theory and Evidence (Routledge •StudiesinDevelopmentEconomics).Routledge;firstedition.LaurentL.Jacque(1997).ManagementandControlofForeignExchangeRisk.Springer;firstedition.•Mario I. Blejer (1999). Balance of Payments, Exchange Rates, and Competitiveness in Transition Economies. •Springer;firstedition.Moorad Choudhry (2010). Capital Market Instruments: Analysis and Valuation. Palgrave Macmillan; Third •Edition edition.Peter B. Kenen (1994). The International Monetary System. Cambridge University Press.•RobertKolb(2007).Futures,Options,andSwaps.Wiley-Blackwell;fifthedition.•Roman Frydman (2007). Imperfect Knowledge Economics: Exchange Rates and Risk. Princeton University •Press; illustrated edition.Ronald MacDonald (2007). Exchange Rate Economics: Theories and Evidence. Routledge; Second edition.•Rudi Weisweiller (1990). How the Foreign Exchange Market Works (New York Institute of Finance). New York •Institute of Finance; second Sub edition.Tim Weithers (2006). Foreign Exchange: A Practical Guide to the FX Markets. Wiley.•

170/JNU OLE

International Economy and Finance

Self Assessment Answers

Chapter Ia1. a2. d3. c4. d5. b6. b7. c8. a9. b10.

Chapter IIc1. a2. b3. c4. b5. d6. a7. b8. b9. d10.

Chapter IIIb1. a2. b3. d4. c5. d6. b7. b8. b9. a10.

Chapter IVa1. a2. c3. b4. d5. d6. c7. a8. b9. d10.

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Chapter Va1. b2. c3. a4. d5. b6. d7. c8. a9. d10.

Chapter VIa1. b2. b3. c4. d5. d6. a7. c8. b9. c10.

Chapter VIIa1. b2. c3. d4. c5. b6. b7. a8. c9. c10.

Chapter VIIIb1. c2. a3. a4. c5. d6. c7. a8. b9. c10.

172/JNU OLE

International Economy and Finance

Chapter IXb1. d2. d3. c4. a5. a6. d7. c8. b9. b10.