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 INTERNATIONAL FINANCE

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NMIMS © contiNuiNG EDUCATION
Deamned tobe UNIVERSITY
 COURSE DESIGN COMMITTEE

TOC Reviewer Content Reviewer

CMA Mr. Nijay Gupta CMA Mr. Nijay Gupta
Visiting Faculty, NMIMS Global Access - Visiting Faculty, NMIMS Global Access -
School for Continuing Education School for Continuing Education
Specialization: Banking, Forex, Treasury & Specialization: Banking, Forex, Treasury &
International Business/Finance International Business/Finance

Chief Academic Officer

Dr. Sanjeev Chaturvedi
NMIMS Global Access — School for Continuing Education

Author: N. Murugesan
Reviewed By: CMA Mr. Nijay Gupta

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NMIMS Global Access - School for Continuing Education

 C ON TENT S

CHAPTER NO. CHAPTER NAME PAGE NO.

1 An Introduction to International Finance 1

2 International Financial Markets 33

3 International Monetary System 77

4 Balance of Payments 119

5 International Parity Relations 173

Introduction to Foreign Exchange Transactions, Markets

6 5 205
and Risk Management

Hedging and Risk Management and

7 ae 277
Use of Derivatives

Export Promotion and Payment Instruments in Foreign

8 323
Trade

9 Short Term International Financing 361

10 Long-Term International Financing 393

11 Case Studies 419

NMIMS Global Access - School for Continuing Education

 INTERNATIONAL FINANCE

CURRICULUM

International Capital Market: International Debt/Bond Market — International Mutual Funds, In-
ternational Equity Markets, International Credit and Money Markets, Concepts regarding Nostro/
vostro Accounts, EEFC Accounts & Mirror accounts, Role of Clearing Corpon of India — FX Clear

International Monetary System: Historical perspective on exchange rate, Gold Standard, In-
ter-war instability, Bretton woods— Role of IMF - Fixed vs. Floating, Exchange rates - Managed
floating — Evolution of Exchange rate Mechanism in India, Eurocurrencies, Eurodollars, European
Currency Unit, International capital — flows, shocks and Quantitative Easing’s, International Debts
problems and management - its origin, history and status, International liquidity and SDR’s, Role
of World Bank, IFC, ADB, WTO, New Development Bank, AITB Bank

Balance of Payments: India’s economy in global perspective - Role of RBI - FEMA 1999, PMLA
and its important provisions, LRS, Balance of Payments Concepts, India’s external debt, Forex
Reserve, Current A/c & Capital A/c transactions, NRI, FII, FDI investments, Capital Account Con-
vertibility - Tarapore committee recommendations — Implementation of recommendations

International Parity Relations: Theories of Exchange Rates, PPP theorem — its limitations, De-
mand Supply and elasticity’s in Foreign exchange rate determination, Balance of Payment theory
— Interest Rate Parity (IRP) — Fisher Effect — Arbitrage

Introduction to Foreign Exchange Transactions, Markets and Risk Management: Exchange Rate
System in India, Important aspects of differences — Functions of an authorized dealer, Exchange
Rate Determination — Direct & indirect quotations — Cross rates - Merchant TT & bill rates, For-
eign Exchange Markets — Market conventions & practices —- Spot & forward rates — factors affecting
spot & forward rates, Basic of currency trading, foreign exchange dealers, Clearing, Hedging, spec-
ulation in Foreign exchange markets, Forward exchange rate, forward against spot exchange rate,
Factors causing exchange rate fluctuations, Behaviour of Exchange Rates (including intra-day be-
havior) — Dealing Room Operations — Front office, Back office & Mid office Functions — Exchange
Position/Cash Position, Managing Foreign Exchange Rights, Forecasting Exchange Rates, Mea-
suring Exposure to Exchange Rate fluctuations, Managing Transaction Exposure, Operating, Eco-
nomic and Translation Exposure of firms, Leads and Lags, Natural Hedge Use

Hedging and Risk Management and Use of Derivatives: Forwards, Currency Futures, Currency
Options, Currency Swaps and other complex Derivatives

NMIMS Global Access - School for Continuing Education

 Export Promotion and payment Instruments in International Trade Role of DGFT: Foreign Trade
Policy, Export Promotion Schemes, strategy, measures and policy, Economic Unions and Trade Agree-
ments, INCOTERMS - 2010, Payment Terms, DP/DA, Letters of Credits — Types of L/Cs — Introduction
to UCP 600 — Rights & Responsibilities of Parties under an L/C, Documents used in Export Import
Trade, Role of SWIFT and Correspondent Banking, Offshore Banking, Exim Bank of India, Export
Credit Guarantee Corporation (ECGC)

Short — Term International Trade Financing: Financing — Short -Term Working Capital — financing
by Banks in India —- Pre-shipment (PCFC/INR), Post-shipment, Discounting/Negotiation of export bills
and Crystallization of Bills, Buyer’s Credit, Supplier’s Credit

Long-term International Trade Financing: Euro-Bonds, ADR’s, GDR’s and IDR’s, Financing Long-
Term — ECB, FCCB, FCEB and other International Bonds/Instruments like Dim-sum bonds, Bull-dog
Bonds, Samurai Bonds and Masala Bonds.

7 NMIMS Global Access - School for Continuing Education

AN INTRODUCTION TO INTERNATIONAL FINANCE

CONTENTS

Introduction
Concept of International Finance
Need for International Finance
Scope of International Finance
Role of International Finance
Self Assessment Questions
Activity
1.3 International Trade
1.3.1 Methods of International Trade
1.3.2 Theories of International Trade
1.3.3 International Trade Barriers, Trading Blocks
Self Assessment Questions
Activity
1.4 Impact of Globalisation
Self Assessment Questions
Activity
1.5 Growth of Multinational Firm
Self Assessment Questions
Activity
1.6 Summary
1.7 Descriptive Questions
1.8 Answers and Hints
1.9 Suggested Readings for Reference

NMIMS Global Access - School for Continuing Education

2 INTERNATIONAL FINANCE

INTRODUCTORY CASELET

CORPORATE INDIA IS ON A ROLL

The buzz in India’s corporate board rooms in recent times is evi-

dently that of confidence and pride. Indian companies are explor-
ing the world and in the same way the global investors are flock-
ing into India. The growth of Indian MNCs has become a subject
of discussion in corporate board rooms in the US and Europe. It
is now a Harvard Business School case study.

Indian brands may not have instant recall in the global markets,
but Indian companies are well on the way. They are already mak-
ing great strides into territories o -established foreign com-
panies. For example, India’s B ge is the world’s second
largest forging company, Ran ng world’s top ten ge-
neric pharmaceutical player 1 by Sun Pharma) and
rrigation company in
the world. These are ap he world class companies, to
ries, Tata Group, Infosys, etc.

considered 3,000 companies with an annual

for 2004-2006, asserts that the next wave of

adian companies are expected to use their competi-

low cost, and high quality products, to win major ac-
ns in global markets. They are likely to emerge as import-
omers, business partners and competitors for the world’s
largest companies. As against 43 such companies in China, India
already has 21 companies with global players, such as TCS, In-
fosys, Wipro, Suzlon, Hindalco, Sun Pharma, Reliance and Ma-
hindra & Mahindra. These companies from China, India and few
others from other Asian nations, form nearly 70% of the list of
companies, poised to become 21* century multinationals.

The Indian companies’ global foray is not restricted to a few sec-

tors, such as IT or pharmaceutical industries alone. Owing to op-
erational efficiencies resulting from efficient management of cost,
resources, logistics and markets, companies from various sectors
have set up facilities abroad. This includes companies from other
sectors, such as automobiles, telecom, auto ancillaries, paints and
paper. Similarly, the global expansion of Indian companies is not
restricted to a few geographies or countries alone. It also includes
a large number of countries across continents in both developed
and developing markets including countries, such as Africa, Chi-
na and CIS.

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 3

INTRODUCTORY CASELET

Indian corporates have started believing in the mantra of “Think

Big, Act Big”. Already seven Indian companies from different
sectors have made it to the Fortune 500 list including companies,
such as Indian Oil, State Bank of India, Bharat Petroleum, Reli-
ance Industries and Tata Motors. The Reliance Industries, cur-
rently ranked at 158th, has a vision to reach the top ten soon.

Indian companies have realised that home markets do not have the
scale or resources to allow them to deliver the levels of sharehold-
er value and competitive advantage they would like to achieve.
The government has largely been supporting this trend with the
Reserve Bank of India (RBI) playing an accommodative role in

production strategies that are on

the major challenges for corporates
al plans, involve financial decision

and global investors tha consider a myriad of

factors concerning intern ce requiring an in-depth
knowledge in the fie al finance. The corporate fi-
nance is no more r ancial decision making in the
context of domestic ma
(Source: Going Global: The India inational. IBEF Essay, India Brand Equity Foun-
www.ibef.org.)

NMIMS Global Access - School for Continuing Education

4 INTERNATIONAL FINANCE

NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

2— Explain the concept of international finance
_—
List knowledge areas pertaining to the field of international
finance
List and explain the various methods of international trade
Explain the theories of international trade
ryt
Discuss international trade barriers and trading blocs
Explain the impact of globalisation on financial activities of
firms
Discuss the factors that hav he phenomenal growth
Y

of MNCs a

1B INTRODUCTION
As the introductory caselet says, “Think Big, Act Big”, it has become
the mantra for a host of ambitious Indian conglomerates who aim to
gatecrash into the Fortune 500 list. They have realised that the Indian
markets do not have the scale or the resources to allow them to deliver
the levels of shareholder value and competitive advantage they want
to achieve.
This phenomenon of corporates going global, aided by the world-wide
integration of economies and financial markets, has greatly enhanced
the significance and importance of international finance. With fewer
barriers to international trade and capital flows, along with the ad-
vances in technology making the world a smaller place, the field of
financial management has expanded to include the subject of inter-
national finance as one of the major pillars. As the domestic financial
market gets integrated with the world financial centres and markets,
financial managers are increasingly expected to possess expertise on
international finance and this is applicable even for companies that
may not be strictly into international trade. Apart from corporate
finance, the subject of international finance is also important for fi-
nance executives and managers from financial services sectors, such
as commercial banks, investment banks, credit rating agencies, etc.
In this introductory chapter, you will study the basic aspects of in-
ternational finance in terms of its relevance, need, importance, scope
and role. You will also study the concepts referred to in this chapter in
more elaborate terms in the subsequent chapters.

1a CONCEPT OF INTERNATIONAL FINANCE

As we deal with the subject of international finance, two natural and

basic questions arise. Why do we talk about ‘international’ finance?

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 5

NOTES

What does the term ‘international’ imply and why is it necessary for
the finance managers to have expertise on this subject? Secondly,
have we not already studied financial management concepts in the
basic courses on general financial management subject? Are those
concepts and basic principles of financial management not sufficient
to deal with the problems related to international finance?

To answer the first question, we should be able to understand and

differentiate between problems associated with domestic finance and
international finance. What kind of particular/exceptional problems
arise when dealing with international finance as compared to domes-
tic finance? The first question will be answered as we study the next
section on the need for international finance. As for the second ques-
tion, we need to understand what different concepts, tools and tech-
niques are required to solve the problems of finance in international
settings as compared to domestic finance. This question will be partly
answered as we analyse the need for international finance in the next
section. We shall further deal with this question as part of the section
on scope of international finance. Finally, in the section on the role of
international finance, we shall study the functions associated with the
role of international finance.

1.2.1 NEED FOR INTERNATIONAL FINANCE

Before we study what makes international finance different or why

we need to study international finance, let us understand the concept
of international finance. The subject of international finance needs
to be viewed from both perspectives—international trade and global
financing trends. With respect to international trade, if every country
produces all goods necessary for itself, there will be no need for in-
ternational trade and hence international finance. As we would study
later from the theories of international trade, no country can have all
resources sufficient for itself and this international trading between
countries could promote efficiency and betterment of the world econ-
omy.

With regard to the other dimension of global financing, by which we

mean the movement of capital between countries, it will be surprising
to note that finance has always been ‘international’ in character. Cap-
ital has been moving freely across borders since historical times with
gold serving as the international currency. There has always been a
need for capital beyond the domestic resources available for countries.
This was more so as the era of industrial development took off in Eu-
rope. Large financing needs triggered the emergence of cross-border
financial firms and financial centres. Initially, international finance
was handled by merchant traders cum financiers—the reason for the
origin of the term ‘merchant bankers’.

Though there were no organised financial markets, institutions or

regulations, the merchant traders acted as investment bankers mo-

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6 INTERNATIONAL FINANCE

NOTES

bilising capital from various entities and financing other merchants,

governments and various other entities. In 14th to 16th centuries,
city states of Venice, Florence, Naples and Genoa became mercantile
centres dominating the trade between Europe and the Orient. These
were later superseded in 17th and 18th centuries by the rise of Am-
sterdam, Lisbon, London, Madrid and Paris, with the establishment
of colonial empires across the Americas, Africa and Asia by Europe-
an powers. This process of integration of global finance took major
growth during the period of 1860 to 1900s. Until World War I, inter-
national trade and finance flourished mainly before the effects of the
war broke the established international trade prevailing till then, with
countries starting to embark on protecting their domestic economies
by manipulating their currency values. This led to the Bretton Woods
System, which later gave way to a full-fledged global financial market
from 1980s onwards with complete globalisation of economies.

The history shows that there has always been trade and investment
between countries requiring movement of goods and capital across
borders. This trend has finally culminated into the highly globalised
and integrated world economy we currently live in. Especially, in de-
veloped countries, most of the universally available products are more
likely to be manufactured with components sourced from plants locat-
ed across the world. In many of the electronic goods you use, it is very
likely that the components forming a part of the product have been
manufactured in more than one country. Free international trade and
globalisation of finance have made the profession of finance to be in-
creasingly viewed from the international perspective.

How ‘international finance’ differs from the finance concepts you have
studied in other courses? Why do we need international finance? The
subject of international finance has its own special problems that are
different from the problems of general financial management. There
are several factors that make the subject of international finance more
involved than the general financial management. We shall now dis-
cuss these factors:
Q Currency: The first and foremost factor that differentiates domes-
tic finance from international finance is the involvement of multi-
ple currencies. As each country has its own currency, internation-
al trade or investments requires dealing with multiple currencies.
These currencies have specific exchange rates associated with
them whose value can vary with various market factors leading to
foreign exchange risk. The uncertainty about the movement of for-
eign exchange rates leads to currency risk that requires methods
to mitigate them through various hedging mechanisms. This is the
primary challenge for corporates that are involved only in foreign
trade, viz., imports and exports. The problem becomes more sig-
nificant in the case of Foreign Direct Investment (FDI), where the
companies invest in manufacturing plants in foreign countries or
acquire companies abroad. These foreign operations lead to multi-

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 7

NOTES

ple risks beyond the transaction risk. It might require techniques

for managing economic exposure, transaction exposure and trans-
lation exposure about, which, we will study in subsequent chap-
ters.

Q Legal and regulatory framework and political risk: The foreign

exchange risk is the major challenge for companies involved in
international trade operations. For companies that have further
interests through investment in assets abroad. The second major
aspect of international finance comes into picture, namely, the
challenge of political risk and regulatory frameworks. This refers
to the risk of unanticipated changes in governmental policies that
could affect the earnings and valuation of foreign operations. For
example, many countries might have regulations with regard to
repatriation of profits of foreign companies. As the countries have
rights to legislate their own regulations, they might try to enforce
new regulations that are favourable to domestic companies jeop-
ardising the interests of the multinational corporations. Consider-
ing that this is a great risk, which could greatly inhibit the inter-
national trade and globalisation, countries around the world had
adopted various agreements, such as GATT/WTO, etc., to mitigate
political risks. Thus, unlike the usual risks that are analysed as a
part of investment and valuation exercises of financial manage-
ment, these additional risks should also be considered when it
comes to international finance.
Q Institutional framework: Associated with the involvement of
multiple countries/currencies is the institutional framework and
related financial market infrastructure. International finance
could involve dealing with multiple international financial cen-
tres, such as London, New York, Singapore, etc. A company is no
more restricted to its domestic geography to mobilise capital or to
make investments. It is free to access capital from anywhere in the
world where it might get it cheaper and at a lower cost. It can also
list its equity shares in any of the international stock exchanges
and thereby can broaden its shareholder base. These possibilities
require knowledge related to multiple financial markets, financial
instruments and related expertise that make international finance
a specialised subject.
Q Accounting rules and valuation: Another major distinction is the
difference in accounting rules, practices and reporting standards.
As each country has its own accounting standards and practices,
when it comes to international operations, the companies might
have to deal with multiple accounting standards and practices.
This becomes more significant and important when it comes to
foreign exchange-related transactions and valuations. For exam-
ple, separate guidelines are issued by International Accounting
Standards bodies, such as Financial Accounting Standards Board
(FASB), International Accounting Standards (IAS), etc. These
help in dealing with the translation of financial statements into

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8 INTERNATIONAL FINANCE

NOTES

different currencies when operations in multiple countries are

involved and for the accounting practices related to foreign ex-
change exposure. Similarly, valuation exercises assume different
dimensions when it comes to international operations. The usual
financial management practices, such as capital budgeting, cash
management, design of capital structure, etc., have to be analysed
from the international perspective considering various other fac-
tors, such as exchange rates, interest rates, inflation rates, market
risks, economic risks, etc.

Q Global opportunities: Finally, the trend of globalisation offers

financial managers an expanded set of opportunities when mak-
ing crucial financial decisions. If an Indian Chief Financial Offi-
cer (CFO) decides to raise debt, the decision is no more just about
the type of instrument, quantum of debt and cost associated, etc.,
but also the various possible international financial markets from
where he can possibly raise it at lower cost and on better terms.
Similarly, when he needs to make a decision regarding capital in-
vestments, such as setting up anew manufacturing plant or inor-
ganic growth through mergers and acquisitions, he has an expand-
ed set of global opportunities where from he can target in terms
of location of new plants or acquisition candidates. This would
involve taking into account the related risks pertaining to interna-
tional finance.

From this discussion, you must have got a fair idea of the difference
between international finance and domestic finance. We will now con-
sider the important areas, problems and challenges that are tackled
by international finance. As you would have noticed, the various fac-
tors discussed indicate a different set of challenges and opportunities
when dealing with cross-border transactions and operations.

Now, we will discuss the various areas where expertise in internation-

al finance will be needed:
Q Understanding of international macro-economic environment:
For a modern CFO, a good knowledge of international macro-eco-
nomic environment, such as factors affecting the world economy,
global monetary systems, exchange rate systems, foreign exchange
theories, etc., are essential. It is no more sufficient to remain both-
ered about just the domestic markets and related risk factors. For
example, consider HEG, a leading Indian manufacturer of graph-
ite electrodes. Graphite electrodes are used in electric arc furnace
steel production and hence the prospects of this manufacturer are
highly linked to the steel industry. When China, a major global
steel producer, increased its percentage of exports from domes-
tic steel production to various parts of the world, the steel prices
dropped worldwide. This resulted in a drop in steel production in
rest of the world. This resulted in negative growth rate in the steel
industry, which adversely affected exports from HEG. Moreover,
as China tries to revive its economy by devaluing Yuan for boost-

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 9

NOTES

ing exports, the prospects of the steel industry would further af-
fect the prospects of HEG. In this case, international factors, such
as commodity prices, status of a related economy, exchange rate
system followed. Moreover, the movements of the exchange rate
in a different country, prospects of related industry in internation-
al markets have all become important factors in determining the
profitability of HEG. A CFO of such a company would require con-
sidering all these international factors while making any financial
decision.
Q Exploiting wider opportunities for raising funds: Globalisa-
tion has resulted in wider opportunities even for domestic com-
panies. For example, Indian companies have been raising a huge
amount of debt from foreign markets at cheaper rates. Similarly,
companies planning to go global through acquisitions or green
field plants can rely on raising funds from international financial
markets. For example, Tata Steel financed its takeover of Corus,
an Anglo-Dutch MNC, through two foreign investment banks. If
the companies have good credit rating, they can get better rates
in international markets as compared to that from the domestic
markets. For example, the Indian petroleum major, the Reliance
Industries, has a higher international credit rating than the US
MNCs, such as General Motors or Ford. This allows it to raise
funds easily in international markets.
Companies from emerging markets are now able to get cheap fi-
nance abroad as against the earlier times when stiff terms and
higher costs prohibited them. For example, Tata Motors was able
to issue a 5-year convertible yen notes at zero rate of interest and
redeemable after 5 years at 15% discount, by structuring it as con-
vertible into equity shares at a 30% premium to issue day price.
Q Managing foreign exchange exposure: Management of foreign
exchange exposure of a firm is the central aspect of internation-
al finance. This includes not only the management of exchange
rate uncertainty in the case of export/import operations but also
includes management of three kinds of exposures, viz., transac-
tion exposures, translation exposures and economic exposures.
The nature of exposure depends on the operations of the firm and
the nature of its international activities. Table 1.1 shows the typical
exposures faced by some major Indian corporations:

TABLE 1.1: TYPICAL EXPOSURES FACED BY SOME MAJOR

INDIAN CORPORATIONS
Company Nature of Exposure
Reliance Industries All export revenues are in foreign curren-
cies requiring hedging for exchange risk.
Prices in domestic markets are based on
import parity prices.

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10 INTERNATIONAL FINANCE

NOTES

Company Nature of Exposure

TCS Revenues denominated in USD, GBP Euro,
ete.

Reliance Communications Has two-thirds of its total debt denominated

in USD.
Jindal Stainless Twenty per cent of the long-term debt in
foreign currency. Also, exposed to fluctua-
tions in commodity prices.
Jindal Photo Imports key raw materials thereby highly
exposed to depreciating rupee.
Dr. Reddy’s Labs Export earnings in foreign currency, im-
ports goods.

Q Financial management in the international settings: The next

major area where expertise on international finance can become
crucial is when the company sets up green field plant abroad or
when it acquires foreign companies. This would require more
than the conventional financial management analysis techniques
as more comprehensive evaluation would be required in terms of
international factors, such as exchange rate movements, interest
rates, inflation, economic growth rates, etc. These traditional man-
agement techniques in the context of international finance are in-
ternational capital budgeting, international capital structure deci-
sion, global cash management, etc.

There are several instances of Indian companies setting up green field

projects/making acquisitions abroad. Some of such examples are:
Q Infosys invested $5 million in China for a software development
centre.
Q Mahindra and Mahindra is manufacturing 10,000 tractors annu-
ally in its two US-based green field projects in Atlanta and Texas.
Q > Bajaj Auto has set up a joint venture (J.V) in Indonesia to assemble
three wheelers and motorcycles to tap the south-east Asian mar-
kets.

Q Sundaram Fasteners has set up $5 million green field plant in

China in 2004.

Q ONGC acquired firms in Brazil, Colombia, Sudan, Angola and

Syria.
Q = Tata Steel acquired National Steel of Singapore, Millennium Steel
of Thailand.
Q Tata Motors acquired truck assets of Korea’s Daewoo Motors.

Many of these green field projects and acquisitions have been fi-
nanced by Foreign Currency Convertible Bonds (FCCBs) and Exter-
nal Commercial Borrowings (ECBs). For companies that do not have
a natural hedge in terms of revenue in foreign currency earnings or

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 11

NOTES

that could not fully hedge the forex risk involved, rupee depreciation
would greatly increase the interest cost and could severely affect the
bottom line. The problem could be more compounded, if the Indian
stock markets do not meet the growth expectations. All these factors
and related analysis require in-depth knowledge of concepts related
to international finance.

1.2.2 SCOPE OF INTERNATIONAL FINANCE

Contrary to the general perception and as corroborated in the previous

sections, the field of international finance is not just about handling
foreign exchange risks associated with international trade operations,
such as imports and exports. The scope of international finance has
now widened to include most of the topics that form part of general
financial management.

The subject of international finance broadly involves the following

major areas:
Q Macro-economic foundational concepts: Deal with global mone-
tary systems, exchange rate systems, balance of payments, inter-
national trade theories and related concepts.
Q International financial markets: Include global banking and
money markets, international equity markets, international fixed
income markets, international derivatives markets and the related
world financial institutions.
Q Foreign exchange management concepts: Include concepts, such
as exchange rate determination, foreign exchange (FX) arithme-
tic, FX instruments, FX-related theories, FX-based hedging and
FX exposure management.
Q Foreign trade-related concepts: Deal with exports/imports regu-
lations, related instruments, means of short-term trade financing,
etc.

Q International financial management concepts: From the per-

spective of international operations of MNCs, such as internation-
al capital budgeting, international capital structure, international
cost of capital, multinational cash management, etc.

Apart from these, more involved topics in the areas of FX exposure

management, related accounting standards, international tax envi-
ronment, international reporting standards, advanced FX derivatives
and hedging mechanism, etc., also form part of international finance.

1.2.3 ROLE OF INTERNATIONAL FINANCE

As mentioned, the expertise on international finance is required even

for financial managers working in companies that are not involved in
foreign trade operations. This is because due to the global integration

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12 INTERNATIONAL FINANCE

NOTES

of economies and financial markets, even the domestic operations are

invariably impacted by global developments. For example, for many
manufacturing companies, the raw material costs can account for more
than 60% of the total costs involved in manufacturing operations. For
such companies, hedging the price risk associated with commodities
has become a necessity. However, since the world markets are inte-
grated, the commodity prices are affected by developments in inter-
national markets, such as commodity prices in other markets, impact
of interest rates and foreign exchange rates in the associated markets,
etc. For example, if steel prices take a beating in the world markets,
then companies that traditionally procured steel from domestic com-
panies may decide to import from abroad. However, such a decision
would involve proper analysis in terms of forecast of commodity pric-
es, movement of foreign exchange rates and related exposure.

Apart from import/export operations and hedging of risks associated

with foreign exchange, knowledge of international finance can help
a financial manager to analyse how international events can impact
their bottom line and what decisions are required to be made to ef-
fectively handle them. The global developments regarding changes in
exchange rates, interest rates, inflation rates, etc., can have a signifi-
cant impact on the profitability of domestic operations of companies.
Thus, the financial management functions are required to be execut-
ed increasingly from the perspective of international settings with the
ever-increasing possibility of global factors affecting domestic opera-
tions.

With regard to the actual expertise required in international finance,

how do the concepts of international finance differ from general fi-
nancial management? Are general financial management concepts
insufficient to deal with the problems arising from international op-
erations, apart from the factor of exchange rates? You should be clear
by now that the obvious answer is that there are major differences as
we have been discussing in the previous sections. The general finan-
cial management concepts and techniques are insufficient to handle
the problems related to international finance though they continue to
form the basic foundation of financial management.

In traditional practice, the export/import department handled foreign

trade operations and its members were expected to be knowledgeable
about foreign exchange operations. However, it is now necessary for
the entire finance department to have relevant expertise in interna-
tional finance. This includes the CFO who needs to have expertise
on international finance for making strategic financial decisions, the
treasury department that deals with raising long-term funds to effi-
ciently scout for cheap capital from across the world financial mar-
kets, the finance/cost manager who takes care of the working capital
for sourcing and managing inventory, and for efficient cash manage-
ment operations (especially when there are operations in multiple
countries/currencies), and finally, the accounting department for com-

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 13

NOTES

plying with various international accounting standards and reporting

requirements.

ROLE OF INTERNATIONAL FINANCE IN FINANCIAL SERVICES:

We have mainly discussed the role of international finance from the

perspective of financial management of corporates. International fi-
nance is an equally important subject on the other side, namely, finan-
cial services. After all, services for corporates are provided by finan-
cial intermediaries in the financial services sector, namely, commercial
banks, investment banks and other intermediaries. While the finance
manager takes the decision pertaining to international finance, it is
executed through the financial intermediaries. For example, if the
CFO of a company decides to raise debt from abroad, it will invari-
ably be executed through an investment bank. Similarly, if he decides
to hedge a forex transaction, it would involve commercial banks and
forex dealers. Or if he lists his shares in international exchanges, it
would involve a host of other financial services intermediaries.

Looking at the subject from the other side of financial services, the
subject matter remains same and is as important for finance execu-
tives working in financial service intermediaries, such as forex de-
partments of commercial banks, investment banks, credit rating agen-
cies, brokers and dealers operating in international environment, etc.
Owing to the fact that all of them provide services to corporates or
retail/wholesale investors pertaining to the same problems we have
discussed in earlier sections. The knowledge and expertise required
for finance managers and executives working in investment banks
and other service intermediaries are same as the subject matter elab-
orated in the earlier sections. The emphasis would, however, differ as
investment banks or commercial banks would only be helping the cor-
porates to manage risk and they may not have full foreign exchange
risks applicable in their balance sheets as compared to corporates (ex-
cept when investment banks trade on proprietary basis). They may
not also take financial management decisions pertaining to interna-
tional finance, such as capital budgeting. However, as service provid-
ers, they are required to have as much expertise (and in fact more in
the case of knowledge of financial markets, exchanges, instruments,
etc.) in managing international finance-related problems. The actu-
al roles and responsibilities of managers in foreign desks of financial
services companies could differ depending on the nature of their busi-
ness, but the subject matter covered in this book is applicable to them
also. Specialist investment bankers involved in international finance
might have to supplement the subject matter covered in this book
with more knowledge on other related areas, such as different types of
more complex derivative instruments meant for forex hedging and re-
lated financing engineering concepts, hedging mechanisms, financial
market operations and trading procedures, listing regulations, etc.
Similarly, the emphasis for forex managers of commercial banks could

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14 INTERNATIONAL FINANCE

N OT ES

be in terms of structuring hedging deals, such as forward contracts

and options, and managing associated open risk positions of the bank
through swaps, managing the nostro accounts, etc. In all these cases,
the fundamental concepts related to international finance remains the
same as those discussed in this book.

&e SELF ASSESSMENT QUESTIONS

1. International finance differs from domestic finance on all

these factors except:
a. Currency risk
b. Global opportunities
ce. Accounting
d. Basic principles of financial management
2. International finance is necessary only for companies that
have dealings in foreign exchange. (True/False)
3. Which of the following is the most suitable example of political
risk pertaining to international finance?
a. Tariff barriers
b. Subsidies for domestic producers
ce. Restrictions on imports
d. Regulations restricting repatriation of profits
4. The institutional framework pertaining to international
finance makes it different from domestic finance in which of
the following aspects?
a. Possibility of mobilising debt from any of the international
financial centres
b. Possibility of listing shares in multiple countries
ce. Possibility of mobilising capital in any currency
d. All of the above

5. A CFO whose company has only domestic operations need

not have the knowledge of which of the following aspects of
international finance?
a. Understanding of international macro-economic environ-
ment
b. How to mobilise capital from international financial cen-
tres

c. International accounting standards

d. All of the above

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 15

NOTES

6. The core task(s) in international finance for the CFO of a

domestic export-based company include(s):
a. Hedging risks associated with currency
b. Short-term financing for exports
c. Dealing with export regulations
d. All of the above

7. International finance will have a role in which of the financial

functions in finance department of an Indian company that
has operations abroad.
a. Import/export section
b. Treasury department
Cash management
9

All of the above

2

The role of international finance has now expanded beyond dealing

with currency risks. Conduct a research on the factors that have
promoted the rapid increase in importance of international finance.
Prepare a report.

ee INTERNATIONAL TRADE

The term international trade traditionally refers to export / import op-

erations. However, the era of globalisation has expanded the opportu-
nities for international trade / business. In this section, we shall study
the various methods of exploiting international opportunities and also
some theories pertaining to international trade.

1.3.1 METHODS OF INTERNATIONAL TRADE

The global integration of markets and gradual elimination of trade

barriers have provided huge opportunities for companies to under-
take international business. Apart from exports, companies now have
a wide array of methods to expand their markets and customer base.
The various methods of international trade from the broader per-
spective of international finance are:

Q Exports and imports

Q Licensing
Q Franchising

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16 INTERNATIONAL FINANCE

NOTES

Q Joint ventures (J.V)

Q Mergers and acquisitions (M & A)

Q Green field plants

The first two methods (exports and imports, and licensing) do not re-
quire any FDI by a company. Therefore, there is no need to commit
long-term capital and handle the associated financial risks. The next
two methods (franchising and joint venture) require minimal direct
investment. The last two methods would require major FDI. We shall
briefly discuss each of these, as the challenges related to international
finance varies depending on the mode of the international business:
Q Exports and imports: This refers to selling products in various for-
eign territories through exports and importing raw material when
required or whenever cheaply available abroad. These tradition-
al foreign trade operations involve only currency risk or foreign
exchange (forex) risk. Companies have a wide range of hedging
tools to mitigate the forex risk. Since companies do not have their
capital at stake, this method of international trade does not involve
much risk as compared to foreign direct investment.
Q Licensing: If the products of a company are not amenable for sell-
ing in a wider geography due to the nature of the products or due
to trade barriers, the company can still expand its revenue base
through licensing agreements. The company can license its tech-
nology to a foreign manufacturer in exchange for licensing fees.
This would allow the company to gain additional revenue without
making any direct investments abroad or exporting its products.
The financial risk associated with this method is the forex risk as-
sociated with the licensing fees.
Q Franchising: This is another route taken by multinational com-
panies to penetrate into other markets without committing major
capital investments. It involves providing franchising rights to for-
eign companies who can use the technology and the brand rights
associated with the products. This is the favoured route for many
multinational food chains, such as pizza and fast food companies.
Similar to licensing, franchising also does not entail any major in-
ternational finance expertise.
Q Joint ventures: For companies that are new to the foreign coun-
try and its environment, but who foresee a major demand for its
products, the method of joint venture is more effective for making
an entry. It involves setting up a company that is jointly owned and
operated through a local firm. Generally, the domestic firm is ex-
pected to complement the advantages of the venture and provide
expertise related to the local market environment. For example,
most of the MNCs resorted initially to the joint venture route to
penetrate the Indian market. This mode of entry will, however, en-
tail more risk from the perspective of international finance. This is

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 17

NOTES

because the company will have to face all the three types of risks,
namely, the transaction risk, translation risk and operational risk.
We shall study about these in subsequent chapters.
Q Mergers and acquisitions (M&A): Companies that want to make
a foray into the international markets can acquire other similar
firms abroad instead of setting up green field operations. This is
an easy and quick route to acquire market share in foreign coun-
tries. For example, India’s largest automotive component manu-
facturer, Amtek Auto, has followed the inorganic growth strategy
of acquiring more than 21 companies from across the globe in the
recent years. Similarly, the world’s largest steel company was cre-
ated by Mittal Steel by taking over Arcelor, a major European steel
producer. This method of expansion into foreign countries would
require substantial expertise on the international finance as it in-
volves all possible financial risks.
Q Green field operations: Companies that are willing to commit
huge capital and have long-term strategic plans can resort to set-
ting up new manufacturing plants abroad. This method would al-
low the foreign company to have complete control over the opera-
tions. However, economic exposure or operational risk associated
with forex will be greatest in this method, apart from other risks.

1.3.2 THEORIES OF INTERNATIONAL TRADE

As we have studied earlier, international trade was prevalent even in

historic times. Why do companies seek opportunities abroad? What
can make the international trade advantageous to the world econo-
my? Why should there be any advantages for a foreign company in a
country that cannot be exploited by some domestic company itself?

Generally, international trade is said to happen due to reasons, such

as unequal distribution of resources across countries, differences in
capabilities pertaining to production technology or due to relative cost
advantages. This can be seen in the world economy as different coun-
tries have different patterns of what they export or import. However,
still these generic reasons do not fully explain the variations between
what each country produces and imports. Researchers from the field
of economics have tried to answer these questions by proposing vari-
ous theories.

The three widely known theories of international trade are:

Q Theory of absolute advantage: This theory, first propounded by a
well-known economist Adam Smith, says every nation is expect-
ed to produce those goods in which it has absolute advantage. It
would then trade these domestically produced goods with other
countries that produce other essential goods that are not produced
domestically. For example, the oil-rich Arab countries export pet-
rol and import the essential agricultural and electronic products

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18 INTERNATIONAL FINANCE

NOTES

as they have an absolute advantage in oil resources and it would

not make sense for them, if they deploy their resources on manu-
facturing other products. As per this theory, the world economy
would benefit when countries fully focus on their distinct advan-
tages, so that goods are produced where they can be done so at
the cheapest level. For example, countries, such as Africa, Mexico,
India, etc., that have advantage in terms of labour cost would focus
on goods that are labour intensive as compared to countries, such
as Japan or America that can focus on technology intensive capital
or electronic goods.
Theory of comparative advantage: The theory of absolute ad-
vantage cannot explain all variations in the trading patterns be-
tween countries. This is because the countries are not so distinctly
unique in their natural advantages. For example, there could be
countries that do not have any absolute advantage on any of the
factors of production. However, they still do export goods to coun-
tries that have an absolute advantage on the same product. This
is explained by the theory of comparative advantage proposed by
David Ricardo. As per this theory, if a country has absolute ad-
vantage over two products as compared to another country that
has no advantage in either of the products but has relative advan-
tage over one of the goods, the former country can produce goods
on which it has maximum an absolute advantage while the latter
can focus on goods in which it has relative advantage. This would
benefit the world economy as the former country is allowed to
deploy all its resources on goods on which it has absolute advan-
tage while procuring the second good from another country that
has a relative advantage on that good. This scenario is better than
both the countries producing the two goods on their own, which
might obviate the need for international trade. Thus, the theory
of comparative advantage implies that a country can benefit from
international trade even if it is absolutely more efficient than oth-
er countries in production of all goods by focussing on good on
which it has more advantage. It also implies that each country will
benefit from international trade, if it imports those goods that cost
more to produce domestically. For example, America might have
absolute advantage in manufacturing capital goods and also in
producing software products. India may not have an absolute ad-
vantage in either capital goods or in producing software products
(say Oracle or Microsoft). However, India has relative advantages
in IT services industry due to its cheap labour cost and availability
of skilled manpower. Hence, it would be better for America to out-
source IT-related work from India and deploy all its resources on
capital goods or for making software products, such as Oracle ERP
or Microsoft Windows.

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 19

NOTES

If the trade has been due to absolute advantage of India in soft-

ware, then India would be exporting software products, such as
operating systems and ERP products while America would be
focussing entirely on capital goods.

It is necessary for the finance managers to study these differences

across countries and understand the dynamics of world markets
before making decisions regarding international investments.
Q Imperfect markets theory: If the markets are perfect, then all fac-
tors of production will be easily transferable and would flow where
they are in demand. Such unrestricted mobility of factors would
remove comparative advantages since the movement of factors
of production would make all countries equal in terms of trade
advantages barring any need for international business. Howev-
er, this is possible only in theory as all the factors of production
can neither be freely mobile nor an unbridled movement is pos-
sible between countries due to trade and other natural barriers.
Hence, as long as such market imperfections are present, there
will be need for international trade. An understanding of market
imperfections could significantly change the financial decisions
pertaining to foreign investments. For example, when MNCs, such
as Nike, decide on setting up operations abroad owing to labour
cost advantages, may decide on changing their policy with respect
to raw material, by utilising the foreign country’s resources rather
than depending on their usual supply chain. The costs associated
with procuring the raw material through their usual supply chain
could be more than that required for ensuring quality levels using
the in-country resources. In general, finance managers deciding
on expanding to foreign markets should analyse on sustainability
of the cost advantages over a longer term. The market imperfec-
tions that provide trade advantages may not last forever and might
require to be replaced by more permanent advantages.
Q Product life cycle theory: As per this theory, as firms mature in
their domestic markets, they would resort to expanding the mar-
ket for their products in foreign countries by setting up manufac-
turing plants abroad. This leads to international business that cre-
ates foreign competition in those new markets that can improve
the efficiency, thereby, benefiting the world economy. A firm can
successfully expand the markets for its products as long as it is
able to maintain its advantages over the local competitors.

1.3.3 INTERNATIONAL TRADE BARRIERS, TRADING

BLOCS

The theory of comparative advantage maintains that countries can

benefit from specialisation and efficient division of labour, countries

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20 INTERNATIONAL FINANCE

NOTES

generally strive to protect their domestic industries by enacting trade

barriers for international trade. As per the theory, free trade is ex-
pected to benefit countries and the world economy by increasing the
production and consumption possibilities due to mutually beneficial
division of labour among countries. However, countries still resort to
various protection mechanisms due to domestic compulsions. The
various trade barrier measures could include:
Q Restrictions on imports and exports through regulations
Q = Tariffs on imports making the cost of imported goods unviable
Q Subsidies for domestic producers making foreign goods more
costly
Q Regulations and quotas that hamper free trade
Q Non-tariff barriers that make it difficult for foreign exporters and
companies

Such protectionism has kept the world closed during the early part of
the 20th century. The divisive world wars and consequent economic
collapses made countries circumspect, even while the industrial era
came into prominence promoting higher possibility of international
trade.

Based on the experiences after the World Wars, most developed coun-
tries decided that international measures are required to promote
free international trade. The co-ordinated international efforts to
promote free trade resulted in the General Agreement on Tariffs and
Trade (GATT) that was signed by several countries in 1947. GATT
Was meant to encourage free trade between countries by regulating
and removing unjustified trade barriers listed earlier in this section. It
was also meant to serve as a common international mechanism for re-
solving disputes between countries with regard to international trade.
Towards these objectives, the GATT signatories met frequently and
have negotiated new trade agreements to promote free trade over the
years. The Tokyo round of GATT, in 1979, reduced non-tariff barriers
to trade. The Uruguay round, in 1986, established the World Trade Or-
ganisation (WTO) in 1995, to replace the GATT agreement. The WTO
has the following underlying principles:
Q Nations should work towards lowering trade barriers
Q All trade barriers should be applied on a non-discriminatory basis
across nations

Q When a nation happens to increase its tariffs beyond the agreed

levels, it must compensate its trading partners for any consequent
economic injury
Q Trade conflicts should be resolved through consultations and ar-
bitrations

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 21

NOTES

Table 1.2 shows how world exports have changed over the years with
globalisation and removal of trade barriers:

TABLE 1.2: HOW HAS GLOBALISATION INCREASED THE

SHARE OF ASIAN COUNTRIES
World merchandise exports by region and selected
economy 1948:1953:1963:1973:1983:1993:2003 and 2013
1948 1953 1963 1973 1983 1993 2003 2013
value
World 59 84 157 579 1838 3684 7380 18301
share
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1000
North America 281 248 199 173 168 180 158 aa
United States 217 188 «149 128 112 126 98
Canada 55 52 43 46 42 39 3.7Q ™
Mexico 09 O07 O06 O04 14 14 22 21
SouthandCentral 113 97 64 43 45 30 eS
America Mim
Brazil 20 18 09 11 12
Argentina 28 13 09 06 vais ea
Europe 35.1 394 478 50.9 435 459 36.3
Germany a 145393 —_ ‘aah 2 79
France 3.4 4.8 5.2 5.2 3.2
Italy 18 18 saan ae 41 2.8
United Kingdom 11.3 5.1 49 4.1 3.0
Commonwealth of — - a* Y 15 26 48
Independent States
(CIS) b
Africa 73 5.7 45 25 24 38
South Africa ¢ 2.0 7: 1010 «0.7 «(05005
U ku» East 20 27 82 41 67 35 41 74
Asia 140 184 125 149 191 260 261 315
China 09 12 418 10 12 25 59 121
Japan 04 15 385 64 80 98 64 39
India 22 138 10 05 05 06 O08 Li
AustraliaandNew 37 32 24 21 14 14 «12 16
Zealand
Six East Asian 34 30 25 36 58 96 96 96
Traders
Memorandum item:
EUd - - 24.5 37.0 31.3 37.3 42.4 33.2
USSER, Former 2.2 3.5 4.6 3.7 5.0 - - -
GATT/WTO Mem- 63.4 69.6 75.0 84.1 77.0 89.0 94.3 97.1
bers e
a. Figures refer to the Fed. Rep. of Germany from 1948 through 1983.
b. Figures are significantly affected by including the mutual trade flows of the Baltic States
and the CIS between 1993 to 2003.

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22 INTERNATIONAL FINANCE

NOTES

e. Beginning with 1998, figures refer to South Africa only and no longer to the Southern
African Customers Union.
d. Figures refer to the EEC(6) in 1963, EC(9) in 1973, EC(10) in 1983, EU(25) in 2003 and
EU(28) in 2013.
e. Membership as of the year stated.
Note: Between 1973 and 1983 and between 1993 and 2003 export shares were significantly influ-
enced by oil price development.

(Source: International Trade Statistics 2014. Published by World Trade Organisation (WTO).)

Apart from GATT/WTO, there are also regional trade agreements that
are meant to resolve regional trade disputes between nearby countries.
These include the North American Free Trade Agreement (NAFTA),
European Union (EU) and the Association of Southeast Asian Nations
(ASEAN), etc. These regional trading agreements are termed as trad-
ing blocs and its members can also be the signatories of multilateral
trade mechanisms, such as WTO.

There is a debate among economic observers whether such regional

arrangements can undermine the global multilateral system for free
trade. Some believe that such regional arrangements can threaten
the multilateral system as these arrangements may not have arisen
as a result of coming together of ‘natural trade partners’. They might
rather constitute political blocs, while others believe that these ‘trad-
ing blocs’ can provide a positive and necessary drive to globalisation
and free trade. They believe that the regional arrangements or trading
blocs have greatly helped the global trade in recent years. In fact, as
per the latest WTO data, most countries of the world form a part of
either one or the other formal regional trading arrangements, such as
NAFTA, etc.

One of the recent developments in respect of trade barriers is the grow-

ing importance of non-tariff barriers (NTBs) and standards (UNCTAD,
2008). Even though there has been a decline of tariffs in a major way
after various GATT rounds, it is found to have been associated with
the rising importance of NTBs. As per the United Nations Conference
on Trade and Development (UNCTAD) report, apart from traditional-
ly applied NTBs, such as anti-dumping and countervailing measures,
the government mandated measures, such as testing and certification
requirements have increased seven times worldwide during the peri-
od of 1994-2004. In many developed countries, such NTBs related to
protection of environment, public health and safety, and higher stan-
dards for the domestic market than existing international standards,
have entailed greater compliance costs for the developing countries.

&e SELF ASSESSMENT QUESTIONS

8. FDI is not involved in which of the following methods of

international trade?
a. Joint ventures b. Franchising
ce. Acquisitions d. Exports

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 23

NOTES

9. Maximum exposure to foreign exchange risk is involved in

which of the following methods of international trade?
a. Joint ventures b. Exports and imports
ce. Green field plants d. Franchising
10. Which of the following theories is not meant to explain
international trade?
a. Theory of absolute advantage
b. Theory of comparative advantage
ce. Product life cycle theory
d. Interest rate parity theory
11. Nigeria is endowed with rich petroleum resources. India
has technology for refining and producing petroleum-based
products efficiently. Hence, Nigeria will export petrol and
India will produce petroleum products. Which theory explains
this international trade?
a. Theory of absolute advantage
b. Theory of comparative advantage
c. Product life cycle theory
d. Imperfect markets theory
12. The term trade bloc refers to which of the following?
a. Trade embargos
b. Trade arrangements of countries that are not a part of
WTO
c. Regional trade agreement between countries over and
above WTO
d. None of the above

Conduct research on the common modes of international trade ad-

opted by various Indian firms and make a report of your findings.

1S IMPACT OF GLOBALISATION

The term globalisation refers to the interdependence of different

countries due to the increasing integration of trade, finance, people
and ideas into one global market place. The globalisation process
accelerated after World War II due to movement towards free trade
between countries through multilateral mechanisms and also due to

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24 INTERNATIONAL FINANCE

NOTES

the rapid advancement of technology. This movement towards free

trade was promoted by international institutions, such as World Bank,
GATT, WTO, International Monetary Fund (IMF) and other regional
trade agreements as discussed earlier. The impact of globalisation has
given rise to an increase in the market share of international trade of
emerging countries especially the East Asian Economies. Similarly,
the share of Brazil, Russia, India and China (BRIC) countries in inter-
national trade has increased dramatically after the 1990s. For exam-
ple, India’s trade sector has increased from 10% of GDP in 1970 to over
45% in 2009. Similarly, China’s trade sector has doubled from 1985 to
2000. China’s accession to the WTO in 2001 has catapulted it into a
major player in the world economy.

Globalisation has expanded the international trade flows dramatical-

ly, at a rate faster than global output. As per the UNCTAD report, the
dollar value of world merchandise exports reached US $11.98 trillion
as compared to US $5.17 trillion in 1995. The factors that have played
a major role in this dramatic expansion of trade are (UNCTAD, 2008):

Q Liberalisation of tariffs and other barrier to trade

Q FDI through trade and investment negotiations

Q Autonomous unilateral structural reforms

Q Technological innovations in transport and communications

Q_ International solidarity through supportive measures
Q Strategic use of policies, experimentation and innovation

Globalisation has also resulted in financial market openness, a crucial

pillar of international finance. It has made countries to remove con-
trols and restrictions not only on the trade-related aspects, but also on
the movement of capital across borders. This has led to tremendous
changes in the international financial markets through market inte-
gration and financial innovations catering to challenges pertaining to
international finance. This has also changed the way the MNCs man-
age their business and financial risks, the method and instruments
they use for raising capital whether in the form of debt or equity.

Some of the financial developments and innovations pertaining to

globalisation and international finance are the emergence of well-in-
tegrated international financial markets, the concept of global stock
exchanges that cater to multiple geographies beyond the country bor-
ders that enable companies to list shares in different countries (ex-
changes). These also include the possibility of raising cheap debt from
anywhere around the world, the advent of complex derivative securi-
ties for hedging different kinds of international risk, etc. Globalisation
has also increased the risk associated with international trade and in-
vestments. The close integration of financial markets and economies
make room for contagion effect whereby problems in one financial

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 25

NOTES

market could seriously impact the investors in an entirely different

market.

While the impact of globalisation has driven a closer integration and

advancement of world financial markets greatly benefitting the world
economy. It has also played a significant role in economic and finan-
cial crises. In a policy brief, UNCTAD points out the paradox of fi-
nance-driven globalisation (UNCTAD, 2012). It says, though many de-
veloping countries have experienced spurts of economic growth over
the past thirty years, some have fallen behind the advanced econo-
mies, unable to enjoy a sustained economic growth. It concludes that
“only countries that have rejected the dominant economic wisdom of
trusting their growth prospects to financial markets, and instead have
pursued innovative and heterodox policies, tailored to local condi-
tions” were able to sustain strong performance (UNCTAD, 2012).

While trade-driven globalisation has resulted in unprecedented accel-

eration of economic growth, the prime concern of policymakers has
been to identify strategies to maximise the development benefits of
globalisation and trade, and to minimise their economic, social, hu-
man and environmental costs (UNCTAD, 2008).

1431030
The Concept of IFCs: Can Mumbai become an IFC?

Globalisation has resulted in the integration of world financial mar-

kets and economy. Most of the international financial services are
now offered globally without geographic limitations through Inter-
national Financial Centres (IFCs), such as London, New York and
Singapore. If Mumbai becomes an IFC, a South African railway
project can issue a bond in Mumbai in the primary market. It would
wish to do so because of Mumbai’s sophisticated securities markets,
along with several asset managers in Mumbai running global port-
folios. If the INR bond market gets developed, the South African
bond issue can be INR denominated. Global investors would buy
these bonds and trade them on the secondary market in Mumbai.
Each of these three steps—primary market bond issuance by the
South African entity, primary bond purchases by global players—
would generate revenues from the export of financial services from
Mumbai. Creating an IFC in India requires that Mumbai must be
viewed as competitive in the eyes of global bond investors, when
compared with alternatives, such as Singapore or London.

The international financial service market in the 21* century is

one in which competition is driven by rapid innovation in finan-
cial products, services, instruments, structures and arrangements
to accommodate and manage the myriad requirements, risks and
a ceaseless quest for cost reduction. Competitive advantage in IFS
provision depends on seven key factors.

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26 INTERNATIONAL FINANCE

NOTES

1. An extensive national, regional, global network of corporate

and government client connections possessed by financial
firms participating in an IFC.
2. High-level human capital specialised in finance, particularly
quantitative finance, supported by a numerate labour force
providing lower level para-professional accounting, book-
keeping, compliance and other skills.
3. World-class telecommunications infrastructure with
connectivity around the clock and around the world.
4. State-of-the-art IT systems, capability to help develop,
maintain and manage the highly sophisticated and expensive
IT infrastructure of global financial firms, trading platforms
and regulators; systems that are evolving continuously to help
firms retain their competitive edge.
5. A well-developed, sophisticated, open financial system
characterised by: (i) a complete array of proficient, liquid
markets in all segments, i.e., equities, bonds, commodities,
currencies and derivatives; (ii) extensive participation by
financial firms from around the world, (iii) full integration
of market segments, i., an absence of artificially
compartmentalised, isolated financial markets that are barred
from having operational linkages with one another; and (iv)
absence of protectionist barriers and discriminatory policies
favouring domestic over foreign financial firms in providing
financial services.
6. A system of financial regime governance (i.e., embracing
legislation, policies, rules, regulations, regulatory agencies,
etc.) that is amenable to operating on global ‘best-practice’
lines and standards.
7. A‘hinterlandadvantage’ in terms of either anationalorregional
economy (preferably both) whose growth is generating rapid
growth in demand for IFS.
(Source: Mumbai—An international financial centre. High Powered Expert Committee,
Ministry of Finance, Government of India, 2007. Sage Publications India Pvt. Ltd, New
Delhi.)

& SELF ASSESSMENT QUESTIONS

13. Globalisation has expanded the international trade flows
dramatically, at a rate faster than global output. (True/False)

Make a group of your friends and discuss the financial impact of

globalisation.

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 27

NOTES

iy GROWTH OF MULTINATIONAL FIRM

One of the most important developments of globalisation is the phe-

nomenal growth of the Multinational Corporations (MNCs). A multi-
national corporation is a company incorporated in one country having
manufacturing and selling operations in several other countries. This
might imply a single firm that procures raw materials from one coun-
try, raises capital from another financial market, manufactures goods
through setting up a manufacturing plant in some other country and
finally sells goods in the global market place. It can also mean a single
firm having several manufacturing plants in different countries oper-
ating through the subsidiaries, etc. For example, Coca Cola operates
in more than 200 countries. It has set up its own bottling plants in
many of the countries where it sells its drinks. On the international
finance front, the growth of MNCs are responsible for the emergence
of well-integrated financial markets that now allows MNCs to obtain
financing from any of the international financial centres in whichever
currency they want to finance their strategic plans.

UNCTAD, which incidentally uses the terminology of Trans National

Corporations (TNCs) instead of MNCs, in its world investment report,
2009 (UNCTAD, 2009) states that there are now around 82,000 TNCs
with 8,10,000 foreign affiliates. As per the report, the exports of for-
eign affiliates of TNCs are estimated to account for about a third of
total world exports of goods and services, and they employ around 77
million people worldwide as of 2008. This number is quite significant
as it is more than the total labour force of a developed economy, such
as Germany. Among the top 100 TNCs of 2007, majority of them were
a part of the manufacturing sector. TNCs belonging to the services
sector constitute around 26% of the list. The recent global economic
and financial crisis, which is also related to the phenomenon of global-
isation and close integration of world markets, has slowed down the
internationalisation of the largest TNCs.

Among the top 100 TNCs, there were only seven TNCs belonging to
the developing nations. However, the list of top 100 TNCs from de-
veloping economies shows that they are going much faster than the
TNCs of developed economies during the last 15 years due to rapid
globalisation. However, among the top 100 TNCs of developing econ-
omies, there were only two companies from India, viz., Tata Steel and
ONGC.

The major feature of the growth of MNCs that could greatly benefit
the world economy is that they help transfer of capital, managerial
expertise and technology to the countries where they have set up their
plants instead of manufacturing everything in the country where they
are incorporated.

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28 INTERNATIONAL FINANCE

NOTES

MNCS FROM INDIA

UNCTAD reports on top 100 TNCs worldwide are based on the asset
size of the companies in which no Indian company could find a place.
Using another measure called Transnationality Index (TNI), also
developed by UNCTAD, a joint study by Indian School of Business
(ISB) and Brazilian Business School—Fundacao Dom Cabral (FDC)
suggests that India’s top transnational companies are comparable to
those of the top transnational corporations of developed countries
(Wharton, 2013). The TNI index uses a combination of three measures
to determine the degree of internationalisation of companies—per-
centage of international assets, percentage of international revenues
and percentage of foreign employees. The average of these three mea-
sures reflects the TNI of the firm.

The report says that the world’s top 100 non-financial TNCs earned
83% of their revenues, owned 79% of their assets and employed 61%
of their employees outside of their home country in 2011. In contrast,
the top 15 Indian TNCs with assets of $500 million or more earned
75% of their total revenues from international operations, held 57% of
their total assets overseas and employed 20% of their total workforce
abroad. The major factor that brings down the TNI index of Indian
TNCs is the percentage of foreign employees working in Indian TNCs.
Another significant feature of India’s global growth story is that the
Indian corporates are taking the route of acquisitions to become TNCs
rather than setting up green field ventures abroad (Wharton, 20138).

& SELF ASSESSMENT QUESTIONS

14. A is a company incorporated in one country having

its manufacturing and selling operations in several other
countries.

Conduct research using the Internet to make a list of top 10 MNCs

in the world in terms of market capitalisation.

A SUMMARY
Q The phenomenon of globalisation has expanded the global oppor-
tunities for Indian companies. This has made international finance
an important field.
Q International finance differs from domestic finance in various
ways. The factors that make international finance different from
domestic finance are—currency, legal and regulatory framework
and political risk, institutional framework, accounting rules and
valuation and the presence of global opportunities.

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 29

NOTES

Q The study of international finance is required for—i) understand-

ing the macro-economic environment in the international setting,
ii) for exploiting wider opportunities for raising capital, iii) manag-
ing foreign exchange exposure and iv) performing financial man-
agement in an international settings.
Q The scope of international finance includes—i) macro-economic
foundation, ii) knowledge about international financial markets
and instruments, iii) foreign exchange exposure management, iv)
export/import dealings, regulations and financing and v) interna-
tional financial management that involves making financial man-
agement decisions in the international context.
Q = Role of international finance has widened to include most of the
functions of financial management. Knowledge of internation-
al finance is becoming necessary for CFOs of even the domestic
companies that has no currency exposure, due to globalisation and
integration of financial markets.
Q The methods of international trade include exports and imports,
licensing, franchising, joint ventures, mergers and acquisitions
and setting up green field plants.
Q There are four theories that explain why the world economy re-
quires international trade. These include the theory of absolute
advantage, theory of comparative advantage, imperfect markets
theory and product life cycle theory.
Q The international mechanisms, such as GATT and WTO have
greatly reduced the trade barriers, which were erected by coun-
tries to protect their domestic industries. Apart from multilateral
mechanisms, such as the WTO, there are also regional trade agree-
ments, called trade blocs that serve to promote regional trade.
Q Globalisation, apart from greatly expanding international trade
flows, has also greatly integrated the financial markets and has led
to financial innovations making global financial markets a single
place.
Q An MNC is incorporated in one country but has manufacturing
and selling operations in several other countries. Globalisation
has greatly promoted the emergence of MNCs and the consequent
increase in international flow of trade, capital and technology. In-
dia has two companies in the global top 100 TNCs of developing
economies. Indian companies are now expanding globally and are
trying to become transnational corporations.

Q Foreign Direct Investment (FDI): The controlling ownership

of a business firm in one country by another business firm based
in another country.

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30 INTERNATIONAL FINANCE

NOTES

Foreign exchange exposure: Presence of an asset or liability in

a currency different from the home currency.
Globalisation: Interdependence of different countries due to
increasing integration of trade, finance, people and ideas result-
ing into one global market place.
International finance: Finance in the context of international
operations and context.
Multinational corporation: A company incorporated in one
country having manufacturing and selling operations in several
other countries.

DESCRIPTIVE QUESTIONS
1. Discuss how international finance differs from domestic finance.

2. Explain the need and importance of studying international

finance.
List the various knowledge areas pertaining to international
finance and briefly explain their need.
Explain the theories of international trade.
What are the various methods of international trade? What kind
of foreign exchange risks are involved in these methods?
Discuss the phenomenon of globalisation and explain how it has
impacted international finance.

ie ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic (2 Cos Answer

Concept of International ie d. Basic principles of financial
Finance management
2. False
3 d. Regulations restricting repa-
triation of profits
4. d. All of the above
ie ce. International accounting
standards
6 d. Allofthe above
7 d. All of the above
International Trade 8 d. Exports
9 e. Green field plants

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 AN INTRODUCTION TO INTERNATIONAL FINANCE 31

NOTES

Answer
10. d. Interest rate parity theory
11. a. Theory of absolute advantage
12. ce. Regional trade agreement
between countries over and
above WTO
Impact of Globalisation 13. True
Growth of Multinational 14. Multinational corporation
Firm

HINTS FOR DESCRIPTIVE QUESTIONS

1. International finance differs from domestic finance in various
ways apart from the currency difference. Refer to Section
1.2 Concept of International Finance.
2. Study of international finance provides wider understanding of
international macro-economic environment, allows exploiting
greater global opportunities, helps manage forex exposures and
allows making financial management decisions in international
settings. Refer to Section 1.2 Concept of International Finance.
3. The scope of international finance includes—i) macro-economic
foundation, ii) knowledge about international financial markets
and instruments, iii) foreign exchange exposure management,
iv) export/import dealings, regulations and financing, and
v) international financial management that involves making
financial management decisions in the international context.
Refer to Section 1.2 Concept of International Finance.
4. There are four major theories of international trade. Refer to
Section 1.3 International Trade.
5. There are six methods of international business or trade. Refer
to Section 1.3 International Trade.

6. Globalisation has greatly increased the free flow of trade and

capital. It has also increased financial openness. Refer to Section
1.4 Impact of Globalisation.

mz SUGGESTED READINGS FOR

=) REFERENCE

SUGGESTED READINGS
Q Cheol S. Eun, Bruce G. Resnick. International financial manage-
ment. India, New Delhi: Tata McGraw Hill Publishing Company
Ltd. Gert Bekaert, Robert Hodrick. International financial man-
agement. USA, NJ: Pearson Education Inc.Jeff Madura. Interna-
tional financial management. USA: Thomson South-Western.

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32 INTERNATIONAL FINANCE

N OT ES

a Michael Connolly. International business finance. USA, NY: Rout-

ledge.
Q Maurice D. Levi. International finance. USA, NY: Routledge.

E-REFERENCES
a United Nations Conference on Trade and Development (UNCT-
AD) (2008). Globalization for development: The international per-
spective. United Nations Publication, accessed on 16th September
2015.

United Nations Conference on Trade and Development (UNCT-

AD) (2012). The paradox of finance-driven globalization. Policy
Brief, United Nations Publication, accessed on 16th September
2015.

United Nations Conference on Trade and Development (UNCT-

AD) (2009). World investment report. United Nations Publication,
accessed on 16th September 2015.
Wharton (2013). Indian transnationals expected to increase their
global footprint. http://knowledge.wharton.upenn.edu/article/in-
dian-transnationals-expected-to-increase-their-global-footprint/,
accessed on 16th September 2015.
Knowledge@Wharton (2015). Indian transnationals expected to
increase their global footprint—Knowledge@Wharton. Retrieved
19 November 2015, from http://knowledge.wharton.upenn.edu/ar-
ticle/indian-transnationals-expected-to-increase-their-global-foot-
print/.
India Brand Equity Foundation (IBEF). Going global: The Indi-
an multinational. http://www.ibef.org/download/ibef_essay.pdf, ac-
cessed on 16th September 2015.
Ministry of Finance, Government of India (2007). Mumbai—An in-
ternational financial centre. High powered expert committee on
making Mumbai an international financial centre. Sage Publica-
tions India Pvt Ltd., New Delhi, http://finmin.nic.in/mife/mifcre-
port.pdf, accessed on 16th September 2015.

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INTERNATIONAL FINANCIAL MARKETS

CONTENTS

2.1 Introduction
2.2 Concept of International Financial Markets
Self Assessment Questions
Activity
2.3 Types of International Financial Markets
2.3.1 Foreign Exchange Markets
International Money Markets
2.3.3 International Credit Markets
International Bond Markets
2. International Equity Markets
Self Assessment Questions
Activity
2.4 Accounts in Foreign Transactions
2.4.1 Nostro Accounts
2.4.2 Vostro Accounts
2.4.3 Loro Accounts
2.4.4 Mirror Accounts
2.4.5 EEFC Accounts
2.4.6 FCNR (B) Account
2.4.7 NRE and NRO Accounts
2.4.8 Diamond Dollar Account (DDA)
2.4.9 RFC and RFC Domestic Account
2.4.10 ACU USD and Euro Account
Activity
2.5 Summary
2.6 Descriptive Questions
2.7 Answers and Hints
2.8 Suggested Readings for Reference

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34 INTERNATIONAL FINANCE

INTRODUCTORY CASELET

GREENKO - AN INDIAN COMPANY LISTED ABROAD

Greenko Group Plc is a Hyderabad-based clean energy company.

It is a market leader among the companies operating clean en-
ergy projects in India. It is involved in renewable energy sectors
such as wind, hydropower, natural gas and biomass. It has oper-
ations in many Indian states like Andhra Pradesh, Chhattisgarh,
Himachal Pradesh, Karnataka and Maharashtra. What is unique
about this public limited company is that it is not listed in any
of the Indian bourses. It has been incorporated in Luxembourg
and registered in the Isle of Man. It is listed on London Stock Ex-
change’s Alternative Investment ] et (AIM).

The operating capacity of the 715 MW, of which 235

MW comes from hydropo omes from wind. The
company has expanded : i pacity mainly through

AIM to mainstream London

s greatly helped the company in

c markets. For example, the borrower has access toa

of investors. Apart from this, the company can also get
If listed on major indices and may also acquire foreign capi-
tal for overseas acquisitions. These advantages attract companies
from emerging markets like India to international equity markets.

Many Indian firms believe that the benefits from listing abroad
outweigh the greater compliance costs and currency risks that
are incurred in domestic listings. In international equity markets,
valuations are generally higher and companies also get greater
analyst coverage. Major international investors do not invest di-
rectly into India in several key sectors because of restrictions on
emerging market exposure. As a result, Indian firms are expected
to continue to move towards their natural investor base in order
to achieve higher valuations by accessing international equity
markets (Trust Sources, 2010).

Traditionally, the London Stock Exchange (LSE) has attracted

Indian mining and energy private sector companies. For large
firms from India, there is an additional incentive of getting rep-
resentation in the Financial Times Stock Exchange (FTSE) 100
index, which brings additional prestige and better valuations as

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 INTERNATIONAL FINANCIAL MARKETS 35

INTRODUCTORY CASELET

against index funds. LSE is a major international stock exchange

with around 650 companies from around 70 countries. There are
around 20 Indian companies currently listed on the LSE.

Raising funds through LSE or being part of FTSE requires size

and reputation. For small growing companies that do not have
the size or track record, London offers the AIM exchange. This
exchange is solely devoted for small companies. At present, AIM
includes companies belonging to more than 100 countries and 40
different sectors. The combined market capitalisation of these
companies is over GBP 70 billion.

The valuations given to the renewable energy sector are higher in

foreign markets than in India. Many companies belonging t
sector get listed in the AIM market, and from there they
move to the LSE. For example, Great Eastern Energy,
in coal bed methane, has recently been transferred fr
LSE.

About 33% of the Indian companies listed o

real estate firms and funds. The rest belo
energy, private equity, media and infra

Guemsey.

Greenko has ambitious pla it pacity to 5000 MW by

2020 from the current level ing such growth plans
becomes easier when t access to an internation-
al investor base. For f the private investors that
have invested in Gre ast include TPG capital, Stan-
dard Chartered, Gove of Singapore Investment (GIC), GE
Energy Finance and Globa vironment Fund (Maryland-based
PE firm).

According to analysts, companies belonging to metal, energy and

mining that are listed in AIM or LSE get wider research coverage
and better valuations, and are able to attract reputed global inves-
tors even in case of small companies.

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36 INTERNATIONAL FINANCE

NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

»— Discuss the concept of international financial markets
2— Explain the various types of international financial markets
»— Describe the various types of foreign accounts frequently
used in international transactions

rai INTRODUCTION

In the previous chapter, you studied the basic concepts of interna-

tional finance, international trade and globalisation. This chapter will
explain the basic core concepts related to the international financial
markets and different types of accounts used for international trade
and operations.

Knowledge of international financial markets is crucial for the coun-

tries, individuals and business houses, especially multinational com-
panies because their profitability depends on the financial markets
and various instruments used in these markets. Due to the global in-
tegration of financial markets, developments in one country or in fi-
nancial market impact asset prices in all the domestic markets of the
world. The importance of international markets becomes greater, if a
company has an international presence; in such cases, the company
is required to keep track of developments in major international mar-
kets and analyse events for possible impact on the company.

The managers of MNCs and companies having significant interna-

tional operations require more in-depth knowledge of international
financial markets, including the purpose they serve, the various mar-
ket participants involved, the market instruments, the types of trans-
actions, etc. Similarly, knowledge of international financial markets
is essential for investment banking professionals who help corporate
houses raise finance from international financial markets.

This chapter discusses the concept and types of international financial

markets in detail. It also describes different types of foreign accounts
used in international financial transactions.

CONCEPT OF INTERNATIONAL
FINANCIAL MARKETS

International financial markets are places where big corporate houses

and MNCs raise funds, list their shares and manage their risks. These
markets provide companies necessary depth and breadth required for
carrying out their global operations. These markets also serve the fi-
nancial needs of major corporates, banks, financial institutions and

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 INTERNATIONAL FINANCIAL MARKETS 37

NOTES

governments that cannot be fully served by domestic financial mar-

kets. It can also help small companies to attract the attention of global
investors.

The following are the main characteristics of the international finan-

cial markets:
Q International financial markets facilitate flow of trade and capital
Q They facilitate hedging and diversification of risks
Q They help mobilise resources (for example, raising credit from the
international credit market)

Q They promote innovation in terms of diverse types of investment

instruments

Q International financial markets help in effective flow of informa-

tion, which leads to improved market efficiency
Q International financial markets widen investment opportunities
for companies

Historically, London served as the major international financial cen-

tre. However, from the early twentieth century, the importance of Lon-
don started diminishing and simultaneously the prominence of US as
an international financial market increased rapidly. The US financial
markets were based in and operated from New York. The London
market became prominent predominantly due to the emergence of
Eurodollar markets in the 1950s. At that time, Europe had many small
and fragmented financial markets, which started to integrate with the
advent of the single Euro currency. Access to the London and US fi-
nancial markets is mainly limited to the developed western countries.
However, these financial markets also serve the large funding needs of
companies in the emerging markets such as Brazil, Russia, India and
China. For example, Russia does not have a well-developed domestic
financial market due to which big firms from the country depend on
international financial markets for raising funds. For example, RUS-
AL, a Russian mining company, raised $177 million through a Global
Depository Receipt (GDR) by listing itself on NYSE Euronext, Paris,
in 2010; it was the first GDR in that market. Several Indian companies
have also listed their shares in the international stock exchanges, such
as NYSE and LSE. Indian companies also source debt financing from
international debt markets.

The world’s financial markets are getting bigger and closely integrat-
ed due to several factors like free international trade, globalisation,
privatisation, advancement of technology, etc. Large companies now
have a choice of obtaining financial services from competing interna-
tional financial centres. Top international financial service centres are
New York, London, Hong Kong, Singapore, Tokyo, Zurich, Seoul, San
Francisco, Chicago and Boston. The two biggest centres viz., London
and New York, compete with each other for the top position.

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38 INTERNATIONAL FINANCE

NOTES

As per a McKinsey report on global capital markets (McKinsey, 2011),

the total size of the world’s stock of equity and debt was $212 trillion
collectively as of 2010 and the total stock market capitalisation was $54
trillion. The total equity issuance as of 2010 was $387 billion. The size
of the debt market is always larger than the size of the stock market. It
increased from $78 trillion in 2000 to $158 trillion in 2010.

In the case of secondary markets trading, the share of Foreign Ex-

change (Forex) markets is the largest. The daily trading volume of the
FX market is approximately $5 trillion.

Global investment banks are major players operating in the major

international financial centres, helping MNCs mobilise capital and
manage risks. Examples of top global investment banks are Goldman
Sachs, JP Morgan Chase, Morgan Stanley, Citigroup, UBS, Deutsche
AG, HSBC, Bank of America Merrill Lynch, Credit Suisse, Nomura
Holdings and Barclays Capital.

&e SELF ASSESSMENT QUESTIONS

1. International financial markets facilitate:

a. Movement of capital across borders
b. International trade
c. Mobilisation of finance
d. All of the above

2. The size of the global equity market is larger than the global
debt market. (True/False)

Indian companies are now increasingly accessing international fi-

nancial markets. Using the Internet, find out the names of at least
five Indian companies that got themselves listed on foreign stock
exchanges.

23 TYPES OF INTERNATIONAL FINANCIAL

we MARKETS

You are aware of the various kinds of financial markets that operate in
a domestic economy. These include money markets, capital markets,
debt market, etc. Similarly, there are various types of financial mar-
kets that operate at the global or international level. These include the
following:
Q Foreign exchange markets: These include markets for foreign ex-
change transactions, such as currency conversions, hedging, spec-
ulation, etc.

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 INTERNATIONAL FINANCIAL MARKETS 39

NOTES

Q International money markets: These include international mar-

kets for short-term deposits and borrowings.
Q International credit markets: These include international mar-
kets for syndicated loans and other bank borrowings.
Q International bond markets: These include international mar-
kets in which long-term debt can be raised by issuing bonds.
Q International equity markets: These include international mar-
kets for raising equity.

Let us now discuss these international financial markets one by one in

more detail in the subsequent sections of the chapter.

2.3.1 FOREIGN EXCHANGE MARKETS

Every country has its own currency that is used as a medium of ex-
change for buying and selling goods and services. For example, if you
are a resident of the US, you will use US dollars to buy any product
or service such as a pizza or a haircut. Similarly, if you are resident
of Japan, you will use Yen for making purchases and would accept
Yen, when you sell anything. Now assume that a resident of the US
needs to travel to Japan; in such a case, the person cannot use US dol-
lars to purchase goods in Japan. He would require selling US dollars
and buying foreign exchange, i.e., Yen, which he/she can use in Japan.
Similarly, ifa US automobile manufacturer imports some components
from Japan and if the Japanese manufacturer wants the payment to
be made in Yen, then the USD that the importer has needs to be con-
verted into Yen. In both cases, the foreign exchange markets facilitate
the exchange of currencies from one country to another. The rate at
which USD is converted into Yen is called the Exchange Rate (ER).

Foreign Exchange (FX) markets are used for various transactions

such as the following:
Q Transaction involving conversion of one currency into another
Q Transactions for managing currency risk through trading in for-
ward contracts and currency derivatives
Q Transactions for managing FX positions of banks
Q For speculative transactions
Q For arbitrage transactions

FX markets can be broadly classified into two tiers:

Q Interbank or wholesale market
Q Retail market

The interbank market refers to the market in which FX transactions

between two commercial banks take place. On the other hand, the

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40 INTERNATIONAL FINANCE

NOTES

retail market is the market in which FX transactions between a com-

mercial bank and non-bank clients (like exporters, importers, institu-
tions or individuals) take place. Transactions in interbank market take
place due to demands from the retail segment, i.e., customers of the
bank. This could include demand for forex for hedging currency risks
from exporters and importers. However, apart from this, transactions
pertaining to the bank itself also take place in the interbank market.
Transactions relating to the management of FX positions of banks,
speculation and arbitrage pertain to this segment. Only 15% of the
transactions in the FX market arise due to the retail segment. Around
85% of the transactions in the FX market are inter-bank transactions
or wholesale forex market transactions.

Commercial banks are major players in the FX market. However,

there are other participants also. The various participants in the FX
are:
Q Commercial banks

Q Investment banks and non-bank dealers (Authorised Dealers or

ADs)

Q FX brokers

Q Central banks

Q Bank customers (individuals/corporate)

The participants who are allowed to transact in the FX market may be

regulated by the central bank of the relevant country. For example, in
India, only ADs are allowed to participate in FX markets. Traditional-
ly, they transact through commercial banks and form part of the retail
segment of the market. However, advent of online electronic trading
in FX markets allows even retail clients to directly participate in the
FX market in many countries where regulations permit the same.

The authorised dealers or commercial banks act as market makers

for the forex market by buying and selling currencies in which they
specialise. As in other markets, market making provides liquidity to
the market and the market makers make profit due to the spread be-
tween the bid and the ask price. The major currencies in which the FX
market is most liquid include USD, Euro, Yen and GBP It means that
most forex transactions take place in these currencies.

Commercial banks participate in FX markets in order to serve the

needs of their corporate clients who are involved in foreign trade.
They also participate to manage their FX positions and risk.

Investment banks are recent entrants into FX markets and they might
provide direct service to their clients or do transactions for their own
portfolio by indulging in speculation or arbitrage. These banks also
provide prime brokerage services. Prime brokerage involves forex
desks of investment banks catering to the needs of clients such as

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 INTERNATIONAL FINANCIAL MARKETS 41

NOTES

hedge funds that like to speculate or manage risk. Multinational cor-

porations can use investment banks instead of commercial banks for
their forex needs.

FX brokers are those who intermediate between financial institutions

and FX markets. They do not trade for their own needs and, unlike
commercial banks, they do not need to take positions in foreign cur-
rency. FX brokers derive their revenue solely from commission. The
emergence of electronic trading, however, has reduced the need for
FX brokers. Central banks might also trade in the FX market when
they intervene to support their currency so that it does not appreci-
ate or depreciate drastically. They trade in the FX markets using the
country’s forex reserves in order to change the demand-supply dy-
namics in the markets for managing the currency position or volatility.
Central banks normally trade through commercial banks.

Although the primary motive of interbank transactions is managing

the inventory positions of various currencies of the banks themselves,
banks also trade forex for speculation and arbitrage. Speculation re-
fers to an activity that market participants undertake to forecast ex-
change rate movements as accurately as possible and thereby make
profit from it. Arbitrage refers to an activity of market participants to
make profit due to different currency prices or interest rates between
two markets. These two types of transactions, namely arbitrage and
speculation, constitute a major volume of trade in the FX market.

There is no central market in the case of forex markets. The term FX

market does not refer to any particular location or exchange. The
transactions are carried out between the forex desks of various mar-
ket participants across the world through electronically. Traditionally
the FX market was earlier called the Over-The-Counter (OTC) mar-
ket as there was no exchange or central marketplace involved and
transactions were done through the telephone between forex dealers
of various commercial banks. However, today, with advancement in
technology, forex transactions are carried out electronically and the
practice is known as electronic trading.

Banks all over the world are linked through a network to facilitate
trade round the clock. The three major market segments that facil-
itate trade across the world 24x7 are Australasia (trading desks of
banks from cities including Sydney, Tokyo, Hong Kong, Singapore,
and Bahrain), Europe (Zurich, Frankfurt, Paris, Brussels, London,
Amsterdam) and North America (New York, Montreal, Toronto, Chi-
cago, San Francisco, Los Angeles). The two major trading centres,
London and New York, account for a major share of the world’s total
FX trading volume. A majority of forex transactions are now carried
out over computerised or electronic trading systems. Two most pop-
ular electronic FX trading systems are EBS trading platform, provid-
ed by Intercapital (ICAP), and FXall provided, by Thomson Reuters.
Currency prices are displayed in the trading platforms, which are con-

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42 INTERNATIONAL FINANCE

NOTES

nected to the other participating forex dealers worldwide, and deals

may be completed by manual entry or an automatic deal matching
system. Most FX market transactions take place through either of the
trading platforms mentioned above, with EBS accounting for a major
share in EUR-USD and USD-Yen transactions while Reuters accounts
for a major share in GBP-USD transactions.

The concept of ECNs (Electronic Communication Networks) has great-

ly increased the volume of electronic trading in FX markets. More
than 50% of the trading volume in spot markets is carried out through
electronic forex trading platforms. The ECN collects and matches the
buy and sell orders and removes the traditional banking intermediary.
For example, a mutual fund can transact with a pension fund without
need for any intermediary dealer by using electronic trading platforms
such as Currenex or FXConnect. These platforms enable anonymous
trading and also facilitate Straight Through Processing (STP) where
back office operations like verifications, settlement, accounting, etc.,
are handled automatically.

FX market transactions can be classified into two major categories:

spot transactions and forward transactions. Spot transactions refer to
the immediate purchase or sale of foreign currency. An account of a
domestic bank with a foreign bank is called as a nostro account. Nos-
tro accounts are required for the actual fund transfer that takes place
between the banks involved in forex transactions. Therefore, cash set-
tlements for spot transactions are usually made in two business days
after the transaction date.

The forward transaction refers to a transaction that involves two par-

ties entering into an agreement for future purchase or sale of a foreign
currency. It basically involves the use of a derivate such as a forward
contract wherein two parties buy or sell a decided amount of foreign
currency at a predetermined exchange rate. For example, consider
a US exporter who sells goods to a London-based importer with the
invoice prepared in GBP The export proceeds in GBP are expected to
be received only after a fortnight by the US exporter. The GBP value
of the invoice should be determined by using the current prevailing
exchange rate between GBP and USD (at time of deal). However, ex-
change rates are determined by so many factors that there is always
uncertainty with regard to them as they can change very quickly. If
the value of the USD per GBP increases during the period, the US
exporter would receive more USD for the invoiced amount. Howev-
er, if the value of GBP weakens against USD in the period, then the
exporter would receive less USD per GBP This adverse movement
could be sufficient to erode all the profit margins built into the in-
voice. Hence, the exporter faces currency risk due to exchange rate
uncertainty. If the exporter could ensure a fixed rate at which he/she
can convert the GBP proceeds into USD, then he/she need not have
to be worried about the uncertainty of the exchange rate. Hence, the
exporter enters into a ‘forward’ transaction with his/her bank, which

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NOTES

would enable him/her to sell the GBP on a future date on which he/
she is expected to receive the proceeds at a particular exchange rate
fixed now.

Such a transaction means the exporter is entering into a forward con-

tract with the bank to sell the future proceeds in GBP and receive
USD. The bank would quote an exchange rate that is different from
the spot rate, that is, the rate at which the exporter can sell GBP today.
The exchange rate quoted for forward contracts is referred to as ‘for-
ward exchange rates’ and it could be at a premium or discount to the
spot rate (forward rates will be determined by the short-term interest
rate differential between the US and UK markets.)

The forward transaction discussed above is termed as the ‘outright

forward transaction’. In a forward transaction, the exchange rate risk
is transferred to the bank. The bank hedges this risk by using another
type of transaction called a ‘swap transaction’. Swaps, forwards and
other derivatives would be introduced in Chapter 7 of this book. For
now, just remember that the volume of spot transactions in the FX
market is much less than the volume of forward and swap transac-
tions. The spot market generally constitutes around 30%, outright
forwards around 10% and swap transactions around 60% of the total
volume. The swap market is huge because banks usually enter into
swap agreements instead of outright forward contracts to ensure that
their positions are hedged.

2.3.2 INTERNATIONAL MONEY MARKETS

Money markets refer to financial markets that enable short-term lend-

ing and borrowing. The short-term instruments used in international
money markets could include deposits, loans and various other mon-
ey market instruments with a maturity less than or equal to a year.
The borrowers in money markets include corporates, banks and gov-
ernments, while the lenders or investors include pension funds, in-
surance companies, corporations, governments and retail investors.
Similar to FX markets, commercial banks are major players in money
markets. In the domestic money markets, short-term lending and bor-
rowing take place in local currency. The major instruments in the do-
mestic money market are short-term deposits, call money, notice mon-
ey, short-term loans, and commercial papers, certificate of deposits,
treasury bills, repos and reverse repos. The major transactions that
take place in domestic money markets are carried out to even out the
short-term demand-supply mismatches of commercial banks as they
strive to meet the cash reserve requirements apart from the short-
term needs of corporates.

In contrast, international money markets have nothing to do with

transactions pertaining to reserve requirements of commercial banks.
International money markets refer to markets where cross-border
borrowing and lending of funds in different currencies can be done

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for the short-term needs of the participants. As big companies involve

themselves in international trade and financing activities, they might
require short-term funds in currencies other than their domestic cur-
rency. For this, they might need to borrow foreign currency from the
international money market. Similarly, corporates and financial insti-
tutions that have short-term surplus in foreign currencies and that do
not foresee any exchange rate risk might decide to invest the surplus
in foreign currency deposits.

Consider the MNCs in Asian countries. Many of the international trade

transactions taking place in Asian countries are invoiced in US dol-
lars. In order to pay for their imports (payment is to be made in USD),
corporates in these countries may borrow USD instead of converting
their domestic currencies. Similarly, manufacturers who have excess
Japanese Yen receivables may decide to invest them in Japanese Yen
deposits in banks instead of converting them into domestic currency
through the FX market. This business of short-term foreign curren-
cy lending and borrowing is performed in the Asian money markets
through international financial centres located in Hong Kong and Sin-
gapore, where international banks accept deposits and make loans in
different foreign currencies. For example, assume that an Indian com-
pany has an excess of Japanese Yen and expects the value of Yen to
appreciate in the near future or anticipates some expenditure in Yen
in the near future. In such a scenario, the company would not be inter-
ested in converting the Japanese Yen into INR because after the Yen
appreciates, the company would receive less INR per Yen converted.
Additionally, if the company has to pay to any party a sum in Yen, it
would have to unnecessarily bear the transaction charges involved in
currency conversion. It would like to make an investment for the short
term in Japanese Yen by the currency in a Yen-designated account in
any Indian bank. However, it is possible that the Indian bank may not
have the facility to accept deposits in Japanese Yen or may not offer a
good return in that currency. In that case, the company can decide to
invest in Japanese Yen deposits in international banks situated in Sin-
gapore or Hong Kong of the Asian money markets. For example, the
international bank situated in Singapore may create an account des-
ignated in Japanese Yen in the name of the Indian manufacturer. This
international bank located in Singapore would in turn credit its nostro
account that it holds with its ‘correspondent bank’ in Japan with an
equivalent amount of Japanese Yen. What happens in reality is that
the importer transfers Japanese Yen proceeds in exporter’s account
(Singapore bank) and these proceeds are transferred from the export-
er’s bank account to the above mentioned Japanese bank. Thus, the
Japanese Yen does not move out of the Japanese bank but a Japanese
Yen deposit gets created in the books of the bank in Singapore in the
name of the Indian manufacturer.

Similarly, international banks in Europe accept US dollar deposits

and make loans in USD. This market is called the Eurocurrency mar-
ket. It is the largest international money market.

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Eurocurrency markets originated in the 1950s-60s when the countries

of the erstwhile Soviet Bloc deposited their currency denominated
in USD with French banks because they feared that their deposits in
US banks were not safe due to the prevailing anti-Soviet sentiments.
Dollars that were deposited outside the US began to be called Euro-
dollars and banks that accepted Eurocurrency deposits were called
Eurobanks.

Since the US dollar was predominantly used as a medium for in-

ternational trade, there was a persistent need for dollars in non-US
countries such as those in Europe. US MNCs trading with European
partners deposited their USD proceeds with Euro banks. These banks
could further lend these deposits to other corporates in Europe that
were in need of US dollars. Foreign subsidiaries of US MNCs started
depositing US dollars in Eurobanks because these banks offered bet-
ter interest rates on USD deposits than the banks in the US

Another reason that contributed to the growth of USD deposits in

Eurobanks was the trade in oil by OPEC countries. These countries
invoiced their oil exports in USD and the proceeds, called ‘petrodol-
lars’, were deposited with the European banks, which they had lent to
importers who had bought oil from OPEC countries.

Therefore, US dollar deposits with European banks were called Euro-

dollars (as explained earlier, there was no movement of dollars from
US but a dollar deposit gets created in the books of European banks
or Eurobanks) and the market for Eurodollars was termed the Euro-
currency market.

Similarly, GBP deposits can be created in various European banks

outside of UK similar to USD deposits explained above. These are
called Eurosterling deposits. Similarly, Euroyen or Eurofrancs time
deposits with European banks were also possible. Note that the term
‘Euro’ has nothing to do with the Euro currency of the European
Union. Thus, the Eurocurrency markets basically consist of time de-
posits of money in international banks located in a country different
from the country that issued the currency.

Some important characteristics of the Eurocurrency markets are as

follows:
Q It consists of time deposits in a foreign currency.
Q Eurocurrency markets act like an external banking system that
runs along with the domestic banking system of a country.
Q There is no actual movement of currency from the banks of the
country from where it was issued as is the case with all foreign ex-
change transactions, but a deposit gets created in a bank outside
the country.
Q These deposits are not regulated by the country of the currency in
which the deposit is denominated.

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Q There are no reserve requirements for such deposits unlike depos-

its in domestic currency where reserve requirements have been
stated by the central bank.
Q The majority of the transactions in Eurocurrency markets are in-
terbank or wholesale transactions.

The rate offered by banks that are willing to lend is referred to as the
interbank offer/offered rate. The rate at which banks accept foreign
currency deposits is called the interbank bid rate. The reference rate
(or base rate) is the rate that forms the basis for deciding some other
rate. For example, if the reference rate in India for loans is 10%, then
the actual interest rate charged on loans from the customers would
be something like the base rate or reference rate plus 2%. Different
types of markets (credit market/bond market/money market) have
different types of reference rates. The reference rate in London, the
biggest Eurocurrency financial centre, is called the London Interbank
Offered Rate (LIBOR). There are separate LIBOR rates for Eurodol-
lars, Euroyens, etc. Similarly, Euro Interbank Offer Rate (EURIBOR)
is the rate at which interbank deposits of Euro are offered by banks in
Eurozone.

Apart from time deposits and loans, Eurocurrency markets also of-
fer other money market instruments like commercial papers. These
are similar to domestic commercial papers, i.e., unsecured short-term
promissory notes sold at a discount to the face value, and denominat-
ed in Eurocurrency. These are issued by corporations and invested
by banks and various financial institutions. Most of these papers are
USD denominated. These short-term money market instruments can
also be traded in the secondary markets.

2.3.3 INTERNATIONAL CREDIT MARKETS

Money markets cater to the short-term borrowing needs of corporates.

Credit markets refer to markets where medium and long-term loans
can be obtained and where the maturity of the loans is more than one
year. Such credit is provided by commercial banks in terms of various
loan products like term loans, medium term notes, consortium loans,
syndicated credits, etc.

Apart from domestic credit markets, large corporates can also access
credit from international markets. International financial markets
that provide such credit to corporates are called international credit
markets. For example, US MNCs can access the Eurocredit market
for loans denominated in dollars or other currencies. The Eurocredit
market refers to the credit markets that constitute international banks
of Europe. Similarly, Indian companies can access international credit
markets for loans that are denominated in a currency other than INR,
popularly termed External Commercial Borrowings or ECB.

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The medium term loans available in the Eurocredit market carry

floating interest rates based on LIBOR. For example, if loans carry an
interest rate of three months LIBOR + 2%, the interest rate will be
reset every three months along with the changes in the three months
LIBOR. The three months LIBOR is the rate offered on interbank de-
posits of three month duration. The 2% margin represents the credit
risk, which depends on the creditworthiness of the borrowing corpo-
rate. The loans that are offered in Euro are based on EURIBOR.

If the loan size required by a corporate so large that no single bank

can bear the entire credit risk, a bank may take a lead and form a syn-
dicate of various banks that then collectively disburse the loan. The
group of such banks is called a syndicate, and the loan offered by the
syndicate is called a syndicated loan. Each bank that forms a part of
the syndicate will offer to participate in the syndicated loan to the ex-
tent it is willing to share the risk.

The characteristics of a syndicated loan are as follows:

Q The bank that organises the syndicate or consortium is called the
lead bank.

Q The lead bank negotiates the terms and conditions of the loan with
the borrower. It also prepares a placement memorandum.
Q The lead manager invites other banks to participate in the syndi-
cate. The banks that collectively provide funds are called partici-
pating banks.
Q The lead manager might require the participating banks to under-
write the loan. Underwriting refers to the guarantee of making up
for the shortage of funds to the extent of the underwritten amount
in case of a shortage. The lead manager normally underwrites a
major portion of the loan. Alternatively, the loan could be on the
‘best efforts’ basis, in which case there is no need for the lead bank
to guarantee the full amount of the proposed loan.
Q There is a paying agent bank, which would receive the service pay-
ments from the borrower and distribute them to the participating
banks.

Q The purpose of including many banks in the syndicate is to spread

the credit risk or default risk. Any default in loan repayments will
be considered to be against all of the participating banks.
Q Syndicated loans a carry floating rate of interest that is linked toa
base rate such as LIBOR, which is reset every six months or every
year.
Q Syndicated loans may carry various other fees apart from the usu-
al interest rate such as lead manager fees, underwriting fees, com-
mitment fees, etc.
Q Syndicated loans are available in a variety of currencies.

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Apart from syndicated loans, international credit markets in Europe

(the Eurocredit market) offer several other loan products, some of
which are as follows:
Q Eurocredits: These refer to the short to medium term loans given
by Eurobanks in currencies other than the home currency of the
Eurobank. Unlike Eurodollar deposits, which are predominantly
traded between banks, Eurocredits are large in size and are lent
to corporates, and the lending rate includes a margin over LIBOR
for credit risk representing the credit worthiness of the borrower.
Q Euronotes: These are short-term negotiable promissory notes
with a maturity of three to six months issued by the borrower and
subscribed by the banks. It is a facility where the banks commit to
distribute Euronotes of maturities ranging between 1 to 12 months
for a specified period of 3 to 10 years. They are sold at a discount to
face value. The facility could be organised by a syndicate of banks.
If the notes are underwritten, the participating banks in the syn-
dicate would stand ready to buy them at previously guaranteed
rates. This facility is also called Note Issuance Facility (NIF). Eu-
ronotes are considered more flexible and cheaper than other prod-
ucts like Floating Rate Notes (FRNs) or syndicated loans.
Q Euro Medium Term Notes (MTNs): Euro MTNs bridge the matu-
rity gap between commercial papers and long-term loans. These
are issued by corporates directly to the market. Some characteris-
tics of MTNs are as follows:
@ MTWNs are offered periodically rather than all at once.

¢ Firms issuing MTNs need not disclose the amount and timings
of the sales of the notes. This is unlike public issue of bonds
where such disclosure is required. This allows firms to raise
debt quickly and discreetly.

¢ MTWNsare issued in small denominations as compared to Euro-

bonds or Eurocredits.

@ The cost of MTN issuance is much less than a similar Euro-

bond issue.

@ MTNs are not underwritten.

2.3.4 INTERNATIONAL BOND MARKETS

Bond markets allow corporates to raise long-term debt funds. Apart

from domestic bond markets, companies can also raise long-term debt
from international bond markets. More than 20% of all bonds out-
standing worldwide constitute international bonds. Though interna-
tional bonds can theoretically be issued in any currency, most interna-
tional bond issues are denominated in one of these three currencies:
USD, GBP and Euro.

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International bond markets can be classified into two groups: Euro-

bonds and foreign bonds. A Eurobond is a bond that is issued in a
particular currency but sold to investors belonging to a country other
than the country in whose currency the bond is denominated. For ex-
ample, if a US MNC issues USD denominated bonds to investors in
Eurozone, then these are Eurobonds. Eurobonds can be denominated
in any of the currencies like GBP Swiss Francs and Yen. For example,
if a Japanese manufacturer issues bonds denominated in Yen to US
and European investors, these are called Euroyen bonds. Similarly, if
a UK manufacturer issues GBP denominated bonds to international
investors in New York, Paris, Tokyo, etc., these are called Eurosterling
bonds. More than 80% of all new international bond offerings belong
to the Eurobond segment of the international bond markets. A foreign
bond, on the other hand, is a bond that is issued by a foreign borrow-
er/company to the investors in national capital markets in which they
operate. For example, if a European manufacturer issues USD de-
nominated bonds to investors in the US, then these bonds are termed
foreign bonds. In general, a foreign bond is issued by a borrower of
a different nationality to the country in which the bond currency is
denominated, while Eurobonds are issued by international bond syn-
dicates to investors of several national markets.

For an investor belonging to a particular country, the bonds in do-

mestic currency can be either domestic bonds or foreign bonds. For
example, US dollar bonds issued in the US might be issued to domes-
tic corporates or an external borrower. To differentiate the two bonds,
USD bonds issued by borrowers of a different nationality are called
Yankee bonds. Similarly, foreign bonds issued in different countries
are given specific names. For example, foreign bonds issued in Japan
are called Samurai bonds; those issued in the UK are called Bulldogs;
in Netherland, they are called Rembrandt; in Spain, Matador; in Can-
ada, Maple; in Australia, Kangaroo bonds.

The Eurobond segment has grown tremendously in the international

bond market due to several reasons. One major reason for this growth
is that these bonds are bearer bonds. A bearer bond is one that need
not be registered (owner’s name is not printed/associated in the bond)
and the ownership is decided by possession. Bearer bonds have a
number of additional advantages with respect to privacy, anonymi-
ty, taxation, etc. Eurobonds are issued in markets other than the do-
mestic markets in whose currency the bonds are denominated. They
are not restricted by national regulations and are sold across national
boundaries. There is also no withholding tax on interest applicable for
Eurobonds. Domestic or foreign bonds might have to undergo several
local regulations like full disclosure, registration of a prospectus with
securities market authority like SEC in the US, etc., all of which leads
to delay in bringing out the new issue to the market; however, there
are no such restrictions in Eurobonds. All these features make Euro-
bonds more attractive for investors.

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The various types of bond instruments actively issued and traded in

international bond markets include the following:
a Straight fixed-rate bonds: These are bearer bonds carrying fixed
interest rates paid annually.
a Euro-medium term notes: These bonds carry a fixed rate with a
maturity of one to 10 years.

Floating Rate Notes (FRNs): These are medium-term bonds with

floating interest rates linked to a reference rate like LIBOR, EU-
RIBOR, etc., paying a coupon on a quarterly or semi-annual basis.
Equity-related bonds: These are bonds that are fully or partially
convertible into equity shares.
Zero Coupon Bonds (ZCBs): These bonds are issued at a discount
and redeemed at face value without coupon payments; these are
predominantly denominated in USD or Swiss franc.
Dual currency bonds: These are straight fixed-rate bonds issued
in one currency in which interest is paid but the principal is re-
deemed in a different currency.
Dim-sum bonds: These bonds are issued in Hong Kong and are
denominated in Chinese yuan and are subjected to Chinese reg-
ulations. It is a good option for the foreign investors who want to
have exposure of yuan-denominated assets. However, the organ-
isation based in China or Hong Kong and foreign companies are
allowed to issue these bonds but largely the organisation based in
China or Hong Kong deals in these bonds.
Samurai Bonds: These bonds are issued in Tokyo by any non-Jap-
anese company in yen-denomination and are subject to Japanese
regulations. The issuers can raise funds to finance investment pro-
posals available in Japan by issuing these bonds. They are also
used for hedging foreign exchange rate risk.
Bull Dog Bonds: These bonds are traded in the UK. The investors
interested to earn revenue in British pound or sterling can invest
in these bonds. The non-British institutions are allowed to raise
funds in the UK by issuing the bonds. These bonds can also be
purchased by the U.S. investors but in that case they would be ex-
posed to the risk if the value of the sterling gets changed.
Masala Bonds: The RBI permitted 2 multilateral institutions of
India, the International Financial Corporation (IFC) and the Asian
Development Bank (ADB) in 2014 so that they can raise funds in
the offshore capital market by issuing rupee denominated bonds
called masala bond. Any Indian corporate, Real Estate Investment
Trusts and Infrastructure Investment Trusts are allowed to issue
masala bonds. In addition, banks, Non-banking Financial Com-

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NOTES

panies (NBFCs), infrastructure or investment holding companies

and companies in the service sector are also allowed to raise capi-
tal by issuing Masala Bonds. The minimum maturity period of the
bond is 5 years.

The Eurobond market has an active secondary market. Eurobonds

subscribed in the primary market from the issuing syndicate can be
resold to other investors in the secondary market. It is an OTC mar-
ket with trading in London, Zurich, Luxembourg, Frankfurt, etc., with
London being the primary centre for investment banks and acting as
a market maker.

EXHIBIT

Global Companies Binge on Euro Bonds

From Coca-Cola to China’s State Grid Corporation, most of the

global companies are engaged in a euro borrowing binge as the cost
of financing in Europe slides to a record low. According to Dealogic,
as of March 2015, US companies have offered $28 billion of bonds
in Euros putting sales of so-called ‘reverse Yankee’ bonds at a new
high and on course to exceed last year’s $50 billion.

US debt markets remain the most popular place for international

companies to raise money via bond sales. But more are lured by
cheaper financing options as euro zone bond yields drop and the
euro has depreciated against the dollar.

In February, Coca-Cola set a record by selling €8.5 bn of bonds, the

biggest euro bond sale by a US issuer. The deal attracted investor
demand for more than €20 bn, in spite of yields that offered just
1.65 per cent on debt that will mature in 20 years.

Since the European Central Bank (ECB) announced plans to start

a programme of aggressive bond buying in the euro zone to accel-
erate inflation and boost confidence, prices for bonds in the region
have jumped, sending yields to record lows and in some cases be-
low zero. Borrowing in Euros can be used to manage currency ex-
posures or to finance deals and operations in the region. Low yields
mean ultra-low borrowing costs while the dollar’s strength against
the euro makes the cost of converting back into dollars far cheaper.

It is not just the US, companies from India, South Korea and Chi-
na have also turned to euro debt in the hope of diversifying their
pools of investors and cutting costs. However, by the end of 2014,
mainland-based Chinese companies had not raised any money in
euro-denominated debt.
(Source: Financial Times, (March, 2015), “Global companies binge on euro bonds”, by
Elaine Moore, http:/ /www.ft.com/intl/cms/s/0/ba1605e2-c7da-11e4-8210-00144feab7de.
html#axzz3mGmmnnEgh, accessed on 22° September, 2015.)

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INTERNATIONAL DEBT FINANCE FOR INDIAN CORPORATES

Indian companies can access international bond markets subject to

Reserve Bank of India (RBI) regulations. As per the regulations pre-
vailing as on September, 2015, Indian companies have the following
modes of international debt financing:
Q External Commercial Borrowings (ECBs): These are borrowings
from international credit and bond markets in the form of bank
loans, floating rate notes, fixed-rate bonds, preference shares,
buyers’ and suppliers’ credit with a minimum average maturity of
three years.
Q Foreign Currency Convertible Bonds (FCCBs): FCC bonds are
issued by an Indian company denominated in foreign currency. In
FCCBs, the interest and principal are payable in foreign curren-
cy. Such bonds can be subscribed by a non-resident individual/
company. Such bonds are convertible into ordinary shares of the
issuing company either completely or partially as per the terms
and conditions of the bonds. Separate policy guidelines are issued
by RBI in this regard.
Q Preference shares: These can be non-convertible, optionally con-
vertible or partially convertible shares and are subject to regula-
tions pertaining to ECBs. Such shares are denominated in INR.
Rupee interest rates are based on LIBOR plus basis, i.e., LIBOR
plus a certain percentage.

Q Foreign Currency Exchangeable Bonds (FCEBs): These are sim-

ilar to FCCBs but convertible into equity shares of another com-
pany.

EXHIBIT

Indian Pharma Majors use Loans to Fund US Acquisitions

Acquisition-related loans from India are finally picking up. Earlier

loans were used for refinancing purposes majorly. Cipla and Lupin,
two of the biggest drug firms in the country by sales, are seeking
loans worth as much as $1.25 billion to back recent acquisitions in
the US.

According to a banker who specialises in South Asian loans, phar-

ma is one of the most upcoming sectors in the world because the
population is getting older globally and therefore this industry is
going to do well. He also states that money is cheap right now and
valuations are lowest, so acquisitions are happening across the
board.

Pharmaceutical companies operate in an industry that needs con-

stant investment in research and development and new facilities
have to be set up frequently. Therefore, these companies are always

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NOTES

on the lookout for suitable acquisition targets. But recently, Indian

firms are leading the charge. A big reason for this is the expira-
tion of generic drug patents in the US. Patents for drugs worth $92
bn are expected to expire between 2014 and 2016, up from $65 bn
during 2010-2012, according to CARE Ratings, an Indian credit rat-
ing agency. A large portion is expiring this year and next, but the
numbers are predicted to fall after 2016. This has opened up room
for companies to swoop into the market sooner rather than later.

Under US law, the first company to file an Abbreviated New Drug

Application (ANDA) with the US Food and Drug Administration
has the exclusive right to market the generic drug for 180 days, pro-
vided certain conditions are met. This is also known as “‘first-to-
file”.

Indian pharma names have been active in filing ANDAs and are
eager to expand their business in the US. For example, Cipla, which
is buying US-based InvaGen Pharmaceuticals, will gain access toa
market size of about $8 bn in revenue by 2018. This is because In-
vaGen has five “first-to-file products”, analysts at India Ratings &
Research, part of Fitch, wrote in a report in September 2015.

Cipla is seeking a loan of around $500 mn to finance the acquisition

of InvaGen and Exelan Pharmaceuticals. The purchase consider-
ation is $550mn. Its move reflects its plan to bolster its front-end
presence in the US, considered a high-margin geography.

Through the acquisition, Cipla would be able access large wholesal-

ers and retailers in the US. Cipla is not the only one seeking rich-
es abroad. Lupin, another heavyweight in India’s drug industry, is
looking to refinance roughly $800 mn bridge loan obtained from JP
Morgan with a term loan. The bridge loan was raised to support its
July acquisition of Gavis Pharmaceuticals and Novel Laboratories
(Gavis), a transaction that valued Gavis at $880 mn on a cash free
and debt free basis.

Bankers involved in negotiations with Lupin reckon that refinanc-

ing will be for around $750 mn. The deals for both Cipla and Lupin
are expected to hit the wider syndicated market early next quarter,
say sources.
(Source: Global Capital, (September, 2015), “Indian pharma majors look to loans to fund
US acquisitions”, http:/ / www.globalcapital.com/ article /tc9rxf3zmyq0/indian-pharma-ma-
jors-look-to-loans-to-fund-us-acquisitions, accessed on 22** September, 2015)

As already discussed, an important mode of international debt financ-

ing is the ECB. ECBs may or may not require prior approval from
the RBI. ECBs for which prior approval is not required are said to be
ECBs through automatic route whereas the ECBs which require prior
approval are said to be ECBs through the approval route. The major
characteristics of ECBs under the automatic route are as follows:

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NOTES

Q ECBs can be accessed through two routes viz., automatic route and
approval route. The borrowings for sectors such as the industrial
sector, infrastructure sector, and specified service sectors do not
require RBI/Government of India approval. This means that they
form part of the automatic route. The eligible borrowers under
the automatic route are specified by RBI and include companies
of specific industries, Non-Banking Finance Companies (NBFCs)
pertaining to infrastructure finance and asset finance, housing fi-
nance companies, etc.

According to RBI regulations, ECBs can be raised from international-

ly recognised sources such as international banks, international capi-
tal markets, multilateral financial institutions, and export credit agen-
cies, suppliers of equipment, foreign collaborators and foreign equity
holders, subject to related regulations.

The maximum amount of ECB allowed for a corporate is USD 750

million (for corporates in the services sector like hotels, hospitals and
software, it can be up to USD 200 million). However, ECB proceeds
cannot be used for the acquisition of land.

For ECBs up to USD 20 million, the minimum average maturity is

three years whereas for ECBs above USD 20 million, the minimum
average maturity is five years.

ECBs denominated in INR are now allowed.

There are restrictions on the cost of ECBs that can be raised. For ECBs
with a maturity period of three years, the ceiling for cost of ECB is six
month LIBOR plus 350 basis points. For ECBs with maturity more
than five years, the ceiling is six month LIBOR plus 500 basis points.

The regulations specify the end-use applicable for ECBs. ECBs can
be used for import of capital goods, new projects, modernisation proj-
ects, and expansion activities. However, ECBs cannot be used for in-
vestment in capital markets, money market funds or for acquiring a
company in India.

Separate guidelines have been provided for ECBs eligible through the
approval route. Indian companies that raise money through FCCBs
are also subject to all the regulations that are applicable for ECBs. The
minimum maturity for FCCBs is five years. In addition, no call or put
option (type of derivative instruments) can be exercised before five
years. No warrants can be attached with the FCCBs.

Figure 2.1 gives a snapshot of the top ten companies that have raised
international debt in the month of July, 2015 alone:

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NOTES

TABLE 2.1: QUANTUM OF SO ee RAISED

BY INDIAN CORPORATES IN
Data on ECB/FCCB for the month of July 2015
I AUTOMATIC ROUTE*
ECB/ Borrower Equivalent Purpose Maturity
FCCB Amount in Period
USD (Appx)
1 ECB JSW Steel Lim- 15,00,00,000 Overseas 5 Years
ited# Acquisition 6 Months
2 ECB Hospira Health- 10,00,00,000 Rupee Ex- 5 Years
care India Pri- penditure 10 Months
vate Limited# Loc. CG a
3 ECB Idea Cellular 7,20,00,000 Refinancing 2 Years
Limited# of Earlier 10 Months
ECB
4 ECB Bharat Oman 7,00,00,000 Refinancing 4
Refineries Lim- of Earlier
ited# ECB
5 ECB L&T-MHPS 4,80,36,206 Refinancing 6 Years
Turbine Gen- of Earlier 1 Month
eraters Private ECB
Limited #

Ww
6 ECB Shree Cement 4,00,00,000
Limited La
7 ECB Hyosung T&D 2,80,00,000 New Project 7 Years
India Private 1 Month
Limited
8 ECB General 7 Years
Corporate 9 Months
Purpose
9 ECB TVS Motor 2,00,00,000 Modernisa- 3 Years
Company Lim- tion 5 Months
ited
10 ECB Cofee Day Glob- 2,00,00,000 Rupee Ex- 5 Years
al Limited # penditure
Loe. CG
Automatic 57,30,36,206
Route Total
II APPROVAL ROUTE
1 ECB Adani Ports and 52,10,00,000 Refinancing 5 Years
Special Econom- of Earlier
ic Zone Limited ECB
2 ECB Housing Devel- 50,00,00,000 On-lendin/ 5 Years
opment Finance Sub-lending. 1 Month
Corporation
Limited

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ECB’ Borrower Equivalent Purpose Maturity

FCCB Amount in Period
USD (Appx)
3 ECB Rural Electrifi- 30,00,00,000 On-lendin/ 5 Years
cation Corpora- Sub-lending.
tion Limited
4 ECB’ AdaniPortsand 12,90,00,000 Ports 5 Years
Special Econom-
ic Zone Limited
5 ECB IBC Solar 3,08,134 General 7 Years
Projects Private Corporate 7 Months
Limited Purpose
Approval Route 1,4 134
Total
Grand Total 2,02,33,44,341

2.3.5 INTERNATIONAL EQUITY MARKETS

In the previous section, you studied that companies have access to

debt financing from investors across the world. Do companies have
similar access to equity financing? Can companies mobilise equity
capital from anywhere in the world? In this section, we will discuss
how to raise equity finance from international equity markets.

A company can mobilise equity capital through the following means:

Q Domestic capital markets: For countries with well-developed fi-
nancial markets, the traditional means of raising capital from do-
mestic equity investors is sufficient for meeting the equity finance
requirements of the domestic companies of the concerned country.
For example, for companies in advanced countries like the US, the
domestic equity market is sufficient to fulfil the equity financing
requirements of the domestic companies of the US. However, com-
panies from underdeveloped countries may not be able to fulfil
their equity needs solely from the domestic markets.
Q Foreign Institutional Investors (FII) or Foreign Portfolio Inves-
tors (FPI): Companies can also raise equity from foreign investors
through domestic capital markets. If the domestic investors do
not have the breadth for major equity offerings, the issues can be
subscribed by foreign institutional investors. For example, Foreign
Institutional Investors (FIIs) constitute a major segment of inves-
tors in the domestic equity markets in India. These FIIs need not
wait for Indian companies to list their shares in international stock
exchanges because they are allowed to directly invest in the local
markets. Investment of FIIs in domestic public offerings and their
trading in secondary markets are regulated by the stock market
authority Securities Exchange Board of India (SEBI).
Q Cross-listing: As mentioned before, MNCs in well-developed fi-
nancial markets like the US, can fulfil their equity financing re-

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NOTES

quirements through their domestic capital markets. However,

many of them would still like to list their shares in the stock ex-
changes of other countries. When a company lists its shares in a
stock exchange outside its domestic financial markets, it is called
‘cross-listing’ of shares. For example, the US MNC Coca Cola had
listed its shares in the Frankfurt Stock Exchange of Germany.
It listed its shares on the Swiss Stock Exchange also. Similarly,
shares of many non-US MNCs are listed on the New York Stock
Exchange. A number of foreign companies are listed in major in-
ternational stock exchanges. As of August, 2015, there are about
520 non-US companies listed in NYSE through various modes like
cross-listing, direct listing, depository receipts, global shares, etc.
India, an emerging BRIC (Brazil, Russia, India and China) nation,
has 11 companies listed in NYSE. Cross-listing is more common in
MNCs of developed countries since the companies from emerging
markets that are interested in tapping international equity mar-
kets take the route of depository receipts. There are several rea-
sons why companies cross-list themselves on foreign exchanges.
Some of these can be listed as follows:
@ Expanding shareholder base: Cross-listing of shares widens
the shareholder base of MNCs. It allows investors from other
countries to directly purchase stocks through their domestic
stock exchanges. Some researchers are also of the opinion that
cross-listing increases market demand, valuation and liquidity
of the stock.
¢ Visibility and name recognition: Cross-listing increases the
visibility of a company and in addition, the name of the compa-
ny also gets recognition in the country on whose exchange the
company is cross-listed. This is important became the compa-
ny sells its products, has customers or operates in that country.
This could prove important for the company’s future growth
prospects in that country. For example, the German software
major, SAP is listed in NYSE in order to strengthen its com-
mercial profile.

¢ Future capital needs: Though MNCs can get their equity fi-
nancing needs fulfilled through their domestic markets or
foreign institutional investors operating in their country, but
cross-listing also allows them to be better positioned to raise
equity from other capital markets as and when the situation
demands. However, companies from emerging markets choose
the route of depository receipts, which is an indirect mode of
cross-listing.

¢ Market integration: As global financial markets get integrat-

ed and MNCs widen their operations into various countries,
listing shares in foreign markets make MNCs truly global. In
fact, some market participants, like UBS AG, believe that clos-
er integration of world markets could lead to a requirement of

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NOTES

stocks being traded in multiple markets, which could reduce

cost to investors and improve liquidity. As the risk is shared
globally, liquidity and market demand also increases and com-
panies can get better valuations.

¢ Corporate governance: When companies list their shares in

more efficient markets with associated characteristics like in-
creased investor protection, better disclosure and corporate
governance practices, it provides a positive indication to inter-
national investors and customers about the quality of manage-
ment and vision of the companies.

¢ Mitigate take-over risks: Due to cross-listing, the risk of a

hostile takeover of companies is reduced considerably. Though
there are advantages to cross-listing as discussed above, there
are several factors that inhibit cross-listing. These include the
following:
vy Need to comply with the listing regulations of the con-
cerned stock exchange
vy Need to comply with the regulations of the concerned secu-
rities market authority like submission of accounts, greater
disclosure, different accounting practices, etc.
¥ Costs associated with the listing process
vy Recurrent annual costs associated with cross-listing like
listing fees, compliance costs, etc.
¥Y Controlling shareholders may not like the MNCs to be list-
ed elsewhere, which leads to their giving up some of the
private control benefits.
Q Depository Receipts (DRs): The most widely used route to cross-
list shares on a foreign stock exchange is the mode of Depository
Receipts. Most of the foreign listings in NYSE are DRs as com-
pared to direct cross-listing of ordinary shares. Most international
listings in major stock exchanges are by companies from emerg-
ing markets and they prefer the mode of depository receipts. The
two major international markets where companies from emerging
markets can mobilise equity capital are the US and European mar-
kets. The privatisation of the Latin American and East European
government-owned companies has enabled these companies to
list their shares in US equity markets. Another factor is the grow-
ing capital needs of companies from BRIC countries, which could
not be satisfied by their domestic markets. Similarly, many compa-
nies from emerging markets such as India can also get themselves
listed on European stock exchanges. In fact, the Luxembourg
stock exchange has more foreign listings than the number of do-
mestic companies. A DR is a negotiable security certificate that
represents a specific number of original shares held in custody by
a financial institution in the country of the exchange. Instead of

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NOTES

trading on the original shares in a foreign exchange like NYSE,

a depository receipt representing a particular number of shares
is traded between members. The listing and regulatory require-
ments for DRs depend on the exchange concerned. DRs are traded
similar to the original shares in domestic markets where the orig-
inal shares were issued. The price of the DR will be quoted in the
currency of the concerned exchange based on the prevailing ex-
change rate. The price of a DR changes along with the price of the
shares in the domestic market of the issuer. The two well-known
depositary receipts are American Depository Receipts (ADRs) and
Global Depository Receipts (GDRs). ADRs are DRs listed on US
stock exchanges while GDRs refer to DRs listed on multiple stock
exchanges across the world except the US. DRs provide various
benefits for foreign investors. These include the following:

@ DRs allow global portfolio diversification for investors in coun-

tries like the US.

@ They remove the need for currency conversion and exchange

rate risk involved in the investment.

@ The investor does need to bother about market conventions

and practices regarding the concerned foreign market like set-
tlements, custodial services, tax conventions, ete.

@ DRs that are issued in a foreign market are subjected to the lo-
cal regulations of the foreign market and these regulations are
known to a foreign investor. Investors would be more familiar
with the local trading practices and need not worry about sec-
ondary market practices of foreign countries.

Note that these advantages are also applicable for cross-listing of

shares in general since DR is just another mode of cross-listing.

DRs also provide various benefits or advantages for the DR issuer.

All the benefits of cross-listing mentioned above are applicable for
the DR issuer also. Some DR programs might involve fewer regula-
tory requirements as compared to the actual cross-listing of the orig-
inal shares. For example, ADR programs do not require full compli-
ance and disclosures, all of which may be mandatory in the case of
cross-listing.

There are two types of ADR programs: sponsored ADRs and unspon-
sored ADRs. Sponsored ADRs are rolled out by the issuing company
itself through a depository bank appointed by it in the concerned for-
eign market through a deposit agreement. Sponsored programs may
or may not involve creation of new shares. Using ADRs, a foreign com-
pany can list its shares on the foreign stock exchange and also raise
capital when required.

Unsponsored ADRs, on the other hand, are issued by depository

banks. These banks issue them whenever there is market demand for

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NOTES

a particular foreign security. There is no formal agreement with the

concerned foreign issuer. It does not involve either listing or any new
creation of the foreign shares.

Sponsored ADR programs are of three types, as follows:

Q Sponsored level I program: This is the simplest depository receipt
program and involves no listing of shares. The DRs are traded in
Over-The-Counter (OTC) markets outside the recognised stock
exchanges like NYSE or NASDAQ. The issuer need not have to
comply with the registration and disclosure requirements of the
US Securities and Exchange Commission (SEC).
Q Sponsored level II program: This involves listing in major stock
exchanges like NYSE, NASDAQ or AMEX. The issuer has to satis-
fy the listing regulations of the concerned stock exchange, and cer-
tain SEC regulations must be complied with. The program does
not involve raising any new equity capital.
Q Sponsored level III program: This involves listing in a major
stock exchange and raising of additional equity from US investors.
It, hence, requires full SEC compliance including US GAAP rec-
onciliation of financials.

The second type of DR is Global Depository Receipts (GDRs). These

are similar to ADRs but are not specific to US equity markets. They
can also be listed in many stock exchanges across the world like Lon-
don’s LSE, the Luxembourg stock exchange, NYSE Euronext, etc.

As per a Bank of New York Mellon (BNY) report 2015 report, there
are now around 3742 DR programs available from over 75 countries.
Of these, around 300 are listed in the LSE and Luxembourg stock ex-
changes. Around 385 are listed in the US markets (ADRs) and 850 are
traded in OTC markets. The rest belong to the unsponsored category.
The top 5 DR programs listed in the US belong to Alibaba (China),
Baidu (China), Petrobas (Brazil), Vale (Brazil) and BP (UK).

As of 2010, India accounted for more outstanding DR programs than

any other country. Companies from BRIC countries issue most of the
DR programs. Many of the Indian companies are listed on the Lux-
embourg stock exchange rather than on London or New York stock
exchanges. Eight ADRs listed on the NYSE have been issued by Indi-
an companies, namely Dr. Reddy’s Laboratories, HDFC Bank, ICICI
Bank, Infosys, Vedanta, Tata Motors, Wipro and WNS.
Q Globally Registered Shares (GRS): The concept of Globally Reg-
istered Shares (GRS) or Global Shares (GS) came into existence
when the German auto major, Daimler-Benz AG merged with US
auto major, Chrysler Corporation, creating a new entity, Daimler-
Chrysler AG, in 1998. The two companies agreed to implement a
global share applicable for all the shareholders of the new entity. A
new Globally Registered Share (GRS), with the symbol DCX, was

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NOTES

listed and traded in 20 exchanges worldwide. These shares pur-

chased from one stock exchange could be sold on any other stock
exchange where it is listed. This feature is called fungibility. A spe-
cial feature of GRS is that all shareholders across the globe enjoy
the same status and voting rights. However, it requires a global
registrar and associated clearing/settlement facilities. Due to the
expenses, regulatory issues and related additional work involved
in GRS, MNCs usually prefer ADR/GDRs over GRS. Currently,
Deutsche Bank AG and UBS AG are two major MNCs whose GRS
are listed in NYSE along with other major international stock ex-
changes.
Q Direct international listing: Emerging market companies have
another option to access international equity markets. They can
directly issue shares in an international stock exchange. Remem-
ber the introductory caselet, which discussed the concept of alter-
native stock exchange mechanisms for small growth companies.
London’s AIM market provides opportunities to small companies
across the globe for getting listed on an international exchange,
and thereby providing visibility and access to a global investor
base. Though many of them are also listed on their own domestic
stock exchanges, but the market has served greatly for companies
that would like to list in major international stock exchange and do
not have the required size and eligibility.

Greenko is an example of a company that has listed directly in a for-

eign exchange without having a listing in the domestic market in or-
der to access the global investor base for higher valuations.

The concept is not restricted to small companies alone. For example,

three Indian companies—Amira Nature Foods Ltd., (Basmati Rice
Exporter), Genpact Ltd (BPO) and Eros International Ple (Media)—
have directly listed their shares in NYSE and these are not listed in
either Bombay Stock Exchange (BSE) or National Stock Exchange
(NSE).

&e SELF ASSESSMENT QUESTIONS

3. The FX retail market refers to a market where:

a. Small FX transactions take place between banks
b. FX transactions take place between banks and the deal-
er-broker
c. FX transactions take place between a bank and a corpo-
rate or an individual
d. None of the above

4. FX transactions of the constitute the major volume

of the market.

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5. The international financial market where short-term deposits

and borrowings take place is called:
a. International FX market
b. International bond market
c. International credit market
d. None of the above
6. Eurocurrency markets are those markets where trading in
bonds denominated in Euro is done. (True/False)

7. The following instruments form part of the international

credit market, except:
a. Syndicated loans
b. Eurocredits
Euro medium-term notes
9

Eurodollar deposits
2.

Forex trading is not driven by telephone conversations anymore;

instead, they are carried out over electronic platforms such as Cur-
renex. Using the Internet, list the major electronic trading plat-
forms. Also, describe the purpose and features of each of these
platforms.

yx ACCOUNTS IN FOREIGN TRANSACTIONS

In this section, we will study about important accounts that commer-
cial banks maintain for foreign transactions.

Commercial banks carry out various transactions in FX markets. Con-

sider a US importer who imports some goods from an Indian exporter.
The Indian exporter has invoiced his/her goods in US dollars. He/she
holds a current account and an export financing account in HDFC
Bank. Commercial banks (such as HDFC Bank, in this case) in every
country maintain cash reserves and accounts in their domestic cur-
rency. The accounts the exporter maintains with HDFC Bank will be
in the domestic currency because this is the currency in which he/
she can withdraw cash. Now, the exporter wants to collect the export
proceeds in USD, which would be transferred by the US importer into
the exporter’s HDFC account. But how does this transfer take place?
Can the exporter give his/her HDFC current account number to the
US importer for crediting the export proceeds? Or should the export-
er ask his/her bank (HDFC) to open a USD account like any other INR

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NOTES

current account, where he/she can receive the payment against the
exports he/she has made?

In order to understand how foreign exchange transactions are carried

out by commercial banks, we need to study the concept of correspon-
dent banking relationships. Remember, the US importer will have
accounts in USD with some commercial bank in US (say Citibank).
The importer is faced with the same question, that is, how should he/
she transfer the invoice amount in USD to the exporter’s account in
India? What is required in this situation is that the USD amount for
the imported goods or the invoiced amount in USD should be debit-
ed from the importer’s account with Citibank, and the exporter’s ac-
count with HDFC bank should be credited.

Now, consider a similar situation in the domestic environment. Sup-

pose you want to transfer some money from your account in Bank A
to someone else’s account in Bank B and both these accounts are de-
nominated in domestic currency. Normally, this transfer of money is
done through a process called ‘clearing’. Banks generally maintain a
clearing account with the central bank of their country. So, BankA will
credit the amount as requested by its customer (Mr X) to the clearing
account of Bank B maintained with the central bank by transferring
the amount from its (Bank A’s) own clearing account with the central
bank. Bank B will transfer the amount from its clearing account with
the central bank to the account of the customer in whose account Mr
X wanted to transfer the amount. This is the basic clearing process.
Many other payment mechanisms are also operated by the central
bank of each country for client transactions between different banks.
In an international situation, there is nothing like a central account or
a common clearing account maintained by Citibank and HDFC Bank
through which they can clear the net payments at the end of the day.
Hence, the concept of domestic clearing or payment process is not
possible in an international situation.

There is another type of clearing process that can be followed in a

domestic situation. Suppose Bank B maintains an account with Bank
A. Then Bank A will debit its customer’s account and simply make
an internal transfer entry by crediting the amount to the account of
Bank B maintained with it (Bank A). After the amount has been cred-
ited, Bank A will inform Bank B about it. Additionally, Bank A will
also inform Bank B that the amount transferred to its account has
been transferred for a particular customer of Bank B. In this way, the
required transfer of funds between two different customers maintain-
ing their accounts with two different banks is achieved. However, this
would require every bank to maintain an account with every other
bank in the country. To avoid this, each bank maintains a single clear-
ing account with the central bank of the country. A similar approach
is adopted in international foreign exchange transactions. Let us un-
derstand this with the help of an example.

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Suppose HDFC Bank does not have a branch in the location where
the importer has maintained an account with Citibank. Also, assume
that HDFC Bank has several customers who are exporters and they
invoice in USD. In such a case, HDFC Bank can decide to maintain
an account denominated in USD with any of the banks in the US.
However, it is important for the US bank with which HDFC opens a
USD account to be a part of the Society for Worldwide Interbank Fi-
nancial Telecommunication (SWIFT) network. The SWIFT network
is a secure international communication network used by commercial
banks all over the world for carrying out FX transactions. Assume that
HDFC Bank has a USD account in JP Morgan Chase. HDFC Bank can
now inform its customer (Indian exporter) that his/her US importer
should credit the export proceeds denominated in USD to HDFC’s ac-
count with JP Morgan Chase. Following this, the US importer will give
an instruction to his banker, Citibank, to debit the importer’s account
and credit the amount to HDFC Bank’s JP Morgan Chase account.
Once this transfer is complete, HDFC Bank will transfer an equivalent
amount of INR to the exporter’s account or deal with it as per the in-
struction of the exporter.

In the above case, in order to facilitate the FX transactions of its cus-

tomers, HDFC Bank had decided to maintain an account with JP Mor-
gan Chase. We say that HDFC Bank has entered into a correspondent
banking relationship with JP Morgan Chase. HDFC Bank may have
similar correspondent banking relationships with many other banks.
For example, to facilitate transactions in GBP it may enter into a cor-
respondent banking relationship with a bank in London, say, Lloyds
Bank. Similarly, HDFC Bank may also hold a Swiss Franc account,
with Union Bank of Switzerland (UBS). This means that HDFC Bank
need not have branches in every country where its customers have
international trade relations or operations; instead, it can rely on the
correspondent banking relationships.

Now, let us consider the reverse situation. An American bank (say Citi-
bank) may also like to maintain an INR account with HDFC Bank to
facilitate rupee transactions of its US customers. In such a case, Citi-
bank will open an INR account with HDFC and HDFC would serve as
its correspondent bank in India.

Let us now study the different types of accounts used in FX transac-

tions by commercial banks in the upcoming subsections.

2.4.1. NOSTRO ACCOUNTS

The term nostro account literally means ‘our account with you’. A nos-
tro account refers to an account that a domestic bank holds with a
foreign bank and the account is usually denominated in the foreign
currency (domestic currency of the foreign bank). Let us try to under-
stand it in a better manner. In the above example, the HDFC Bank’s

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NOTES

USD account with JP Morgan Chase maintained for facilitating FX

transactions can be called a nostro account for HDFC Bank. Similar-
ly, HDFC Bank can have nostro accounts in various currencies (and
countries) through which it facilitates FX transactions for its clients.
Hence, it will have separate nostro accounts maintained with foreign
banks in different countries and in different currencies, such as a GBP
nostro account with Lloyds, a Swiss France (CHF) nostro account with
UBS, etc.

2.4.2 VOSTRO ACCOUNTS

The term ‘vostro account’ means ‘your account with us’. Here, ‘your’
refers to a foreign bank and ‘us’ refers to the domestic bank. Thus,
an account denominated in domestic currency that is maintained by
a foreign bank with a domestic bank is called a vostro account. Note
that a vostro account for a domestic bank is a nostro account for the
foreign bank. For example, an INR account of a US bank maintained
with HDFC Bank is a vostro account for HDFC.

2.4.3 LORO ACCOUNTS

A loro account means ‘his account with them’. Loro accounts are
accounts that are maintained with a foreign bank but denominated
in domestic currency. For example, Citibank’s INR account of State
Street bank of the US maintained with HDFC Bank in India would be
a loro account for Citibank.

2.4.4 MIRROR ACCOUNTS

We have already seen that domestic banks maintain nostro accounts

with foreign banks in foreign currency. Now, it is important for the do-
mestic bank to keep track of its transactions in a nostro account. For
this purpose, domestic banks use mirror accounts. A mirror account is
an account that is maintained by a domestic bank for keeping track of
inflows and outflows of foreign exchange taking place in its nostro ac-
count. For example, the USD nostro account of HDFC Bank is main-
tained in the books of Citibank. To keep track of inflows and outflows
in its nostro account, HDFC Bank will open a mirror account, which
would reflect the transactions occurring in Citibank’s nostro account.

Such an account is called the mirror account as it is only a shadow

or mirror of the original nostro account maintained with a foreign
bank. A mirror account is maintained by a domestic bank (HDFC) in
both the currencies (For example, in USD and INR in our case). For
keeping track of accounting flows, transactions in a nostro account
reported by a foreign bank are periodically tallied with the entries
maintained in the mirror account in order. This process of reconcilia-
tion between the nostro account and mirror account is called ‘nostro
account reconciliation’.

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2.4.55 EEFC ACCOUNTS

According to RBI, Exchange Earners’ Foreign Currency Account

(EEFC) is an account maintained in foreign currency with an Autho-
rised Dealer i.e. a bank dealing in foreign exchange. It is a facility pro-
vided to the foreign exchange earners, including exporters, to credit
100 per cent of their foreign exchange earnings to the account, so that
the account holders do not have to convert foreign exchange into Ru-
pees and vice versa, thereby minimizing the transaction costs.

Assume that a domestic bank’s nostro account has been credited with
foreign currency for payment against one of its customer’s export. In
the introduction of this section, we mentioned that the domestic bank
(HDFC) can either transfer an equivalent amount of INR to the ex-
porter’s account or deal with it as per the instruction of the exporter.
We did not consider what exactly the exporter would like to do with
the USD proceeds. He/she might ask HDFC Bank to sell the USD ex-
port proceeds in the FX market at the prevailing exchange rates and
credit the INR proceeds to his/her current account. In such a case,
HDFC bank will sell USD in the FX market to another bank and ask
Citibank to debit its nostro account and give credit to whichever bank
purchased the USD. Alternatively, the exporter may want to retain the
export proceeds in USD itself as he/she might expect the rupee to de-
preciate or might need the USD proceeds for other foreign exchange
requirements in the future. Hence, he/she would like HDFC bank not
to sell the USD proceeds and keep the amount in USD.

In the above case, the exporter can ask HDFC bank to open a USD
account and credit the export proceeds coming from Citibank. RBI
now allows 100% of the foreign currency proceeds to be maintained
in foreign currency accounts. Such an account is called an Exchange
Earners Foreign Currency (EEFC) account.

In India, foreign exchange management regulations provide guide-

lines with regard to FX. For example, there are restrictions on how
much a resident of India can keep cash denominated in a foreign
currency. Similarly, RBI provides guidelines with regard to FX
proceeds. These guidelines have been made more liberal in recent
years.

As per RBI regulations, any person resident in India who earns for-
eign currency (including special economic zones, software technology
parks, export processing zones and status account holders) can open
and maintain an EEFC account with an authorised dealer in India.
He/she can forward 100% of his/her foreign currency earnings to this
account.

These accounts are not deposit accounts but are similar to current ac-
counts and do not earn any interest. The amount present in an EEFC

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NOTES

account can be used for other transactions pertaining to export and

imports.

2.4.6 FCNR(B) ACCOUNT

FCNR (B) Account or Foreign Currency Non-Resident (Bank) Account

is an account that can be opened in foreign currency by a Non-Resi-
dent Indian (NRJ) or a Person of Indian Origin (PIO) or an Overseas
Citizen of India (OCI). FCNR (B) scheme was introduced by RBI with
effect from May 15, 1998 to replace the prevailing FCNR (A) scheme.
In FCNR (A) the foreign currency risk was borne by RBI and subse-
quently the Government of India.

Following are some of the important features of FCNR (B) Account:

Q Deposits in FCNR (B) can be made in any major currencies, such
as USD, GBR EURO, CAD, JPY, or AUD.
Q This account currently accepts only term deposits and the period
of deposit varies from one year to five years.
Q Account holders can transfer from their existing NRE accounts to
FCNR (B) accounts and vice versa, without the prior approval of
RBI.
Q The interest on the deposits accepted under the scheme is paid on
the basis of 360 days to a year.
Q The interest on FCNR(B) deposits can be calculated and paid at
intervals of 180 days each and thereafter for the remaining actual
number of days.
Q Premature withdrawal of depositions is permitted in this account;
however, premature withdrawal is subject to penalties imposed by
banks.

Q Interest earned on FCNR (B) deposits is exempted from income

tax in India.
Q Account holders can avail foreign currency loans and rupee loans
against their FCNR (B) deposits.
Q There is no ceiling on the amount of deposit.

2.4.7 NRE AND NRO ACCOUNTS

NRE and NRO accounts allow NRIs to maintain rupee denominated

accounts in India. There are mainly two reasons of opening these ac-
counts — 1) to repatriate money earned overseas back to India and 2)
to keep India-based earnings in India.

NRE account or Non Resident Rupee account is a convertible/repatri-

able account denominated to Indian rupee in the form of savings, cur-
rent and recurring or fixed deposit accounts. Following are the main
features of an NRE account:

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NOTES

Q NRE account can be opened by an Indian citizen or a foreign citi-

zen of Indian origin residing outside India.
Q The account holder needs to maintain an average monthly balance
of ¥75000 in the NRE account.
Q The interest earned in an NRE account is exempted from income
tax in India.
Q Income originating in India cannot be deposited in the NRE ac-
counts. Such funds need to be deposited to NRO account only.
Q NRE account cannot be jointly held with a resident India. Howev-
er, it can be jointly held with another NRI.

Following are the primary reasons of holding NRE accounts:

Q Remitting overseas earnings and converting them into Indian ru-
pee
Q Maintaining savings in Rupee while keeping them liquid
Q Opening joint account with an NRI

An NRO account or Non Resident Ordinary Rupee account is a sav-

ings account denominated in Indian rupee, in which an NRI, PIO, or
OIC can deposit their India-based income, such as rent, dividends,
pension, ete. Following are the main features of an NRO account:
Q. An NRO account provides limited repatriability as compared to an
NRE account. The upper limit of permitted remittance is USD 1
million in a financial year.
Q Interest earned in NRO account is subject to income tax in India.
Q The account holder can deposit income originating in India, such
as salary, rent, dividends, etc. in the NRO account.
Q An NRO account can be hold as a joint account with a resident
Indian as well as an NRI.

The following are the main reasons of opening NRO accounts:

Q Parking India-based earnings in India
Q Maintaining deposit of India-based earnings, such as rent, divi-
dends, etc.
Q Maintaining joint account with resident Indians.

2.4.8 DIAMOND DOLLAR ACCOUNT (DDA)

DDA refers to USD denominated current account opened by compa-

nies dealing in purchase / sale of rough or cut and polished diamonds
/ precious metal jewellery plain, minakari and / or studded with / with-
out diamond and / or other stones, with a track record of at least 3
years in import / export of diamonds / coloured gemstones / diamond

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NOTES

and coloured gemstones studded jewellery / plain gold jewellery, and

having an average annual turnover of %5 crore or above during pre-
ceding three licensing years.

RBI provides the following terms and condition regarding opening of

DDA:
a. The exporter should comply with the eligibility criteria stipulated
in the Foreign Trade Policy of the Government of India, issued
from time to time.
b. The DDAshallbe opened in the name of the exporter and maintained
in US Dollars only.
c. The account shall only be in the form of current account and no
interest should be paid on the balance held in the account.
d. No intra-account transfer should be allowed between the DDAs
maintained by the account holders.
e. Anexporterfirm/company shall be permitted to open and maintain
not more than 5 DDAs.
f. The balances held in the accounts shall be subject to Cash Reserve
Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements.
g. Exporter firms and companies maintaining foreign currency
accounts, excluding EEFC accounts, with banks in India or abroad,
are not eligible to open Diamond Dollar Accounts.
(Source: Opening of Diamond Dollar Accounts — Liberalisation, Circular No 51, RBI)

2.49 RFC AND RFC DOMESTIC ACCOUNT

The Resident Foreign Currency (RFC) scheme was introduced by RBI

in 1992 for NRIs residing in abroad for a continuous period not less
than one year and who have become residents of India on or after
18.04.1992. RFC accounts can be opened in the form of savings ac-
count, current account and term deposits. In addition, RFC accounts
are treated as residents’ account for all practical purposes. Therefore,
interest earned in the RFC accounts is taxable in India. An NRI inter-
ested in opening RFC account can do so by direct inward remittance,
cheque, drafts, traveller’s cheques, or by conversion of existing NRE/
FCNR (B) accounts. RFC accounts are accepted and maintained in
any permissible currency, such as USD, GBR EUR, CAD and AUD.

RFC Domestic account refers to an account denominated in foreign

currency that a person resident in India can open, hold or maintain
with an AD in India. Foreign currency acquired in the form of cur-
rency notes, bank notes, and traveller’s cheques from the following
sources:
a. Was acquired by him while on a visit to any place outside India by
way of payment for services not arising from any business in or
anything done in India; or

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70 INTERNATIONAL FINANCE

NOTES

b. Was acquired by him, from any person not resident in India and
who is on a visit to India, as honorarium or gift or for services
rendered or in settlement of any lawful obligation; or

c. Was acquired by him by way of honorarium or gift while on a visit

to any place outside India; or
d. Represents the unspent amount of foreign exchange acquired by
him from an authorised person for travel abroad.
(Source: RBI)

2.4.10 ACU USD AND EURO ACCOUNT

Asian Clearing Union (ACU) was set up at Tehran, Iran on 9th De-
cember 1974 by the initiative of the United Nations Economic and
Social Commission for Asia and Pacific (ESCAP) to promote great-
er regional cooperation. The original participants of the union were
the central banks of Iran, India, Bangladesh, Nepal, Pakistan, and
Sri Lanka. Central Bank of Myanmar joined the union at a later date.
The establishment of the union was a result of the increasing need of
a multilateral clearing arrangement among countries in this region
to facilitate trade among the regional countries. The union provides
solution (albeit, partial) to the two major problems related to payment
in international trade faced by the Asian nations. These problems are:
1) Shortage of foreign exchange and 2) non-convertibility of curren-
cies. The union serves the following purposes:
a. To provide a facility to settle, on a multilateral basis, payments
for current international transactions among the territories of
participants.
b. To promote the use of participants’ currencies in current
transactions between their respective territories and thereby
effect economies in the use of the participants’ exchange reserves;
c. To promote monetary co-operation among the participants and
closer relations among the banking systems in their territories
and thereby contribute to the expansion of trade and economic
activity among the countries of the ESCAP region , and;
d. To promote currency swap arrangement among the participants
so as to make Asian Monetary Units available to them temporarily.

The common unit of account of ACU is Asian Monetary Unit (AMU)

denominated as ‘ACU Dollar’ and ‘ACU Euro’, equivalent to one USD
and one euro respectively. All payment instruments are denominated
in AMUs. AD category-I banks can make settlement for such instru-
ments through operations on ACU dollar and ACU euro accounts.

The main idea behind the settlement procedure of ACU is that a sub-
stantial part of the transaction is settled directly through the accounts
maintained by AD Category-I banks with banks in the other partici-
pating countries and vice-versa. AD Category-I banks are permitted

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NOTES

to settle commercial and other eligible transactions in the way other

normal foreign exchange transactions are settled.

The procedures for opening letters of credit, negotiation of documents,

etc., in respect of trades in convertible currencies are also applicable
for the trades conducted through the ACU mechanism. In order to
facilitate these transactions, AD Category -I banks can open ACU dol-
lar and ACU euro accounts with their branches/correspondents. In
addition, AD Category-I banks also need to ensure that at all times,
the balance maintained in the ACU dollar and ACU euro accounts are
sufficient to meet the requirements of their normal exchange business
and funds rendered surplus.

In the ACU mechanism, payments for export from India will be re-
ceived by debit to the ACU dollar and ACU Euro accounts of the com-
mercial banks of other participant countries maintained with ADs in
India or by credit to the ACU dollar and ACU Euro accounts of ADs
maintained with correspondent banks in the other participant coun-
tries. The reverse will be the case for imports into India from any of
the ACU countries (except Nepal and Bhutan).

Select any leading commercial bank and find out the currencies in
which it facilitates FX transactions for its customers. List the for-
eign banks with which it maintains nostro accounts for achieving
the same.

rae SUMMARY
Q International financial markets are places where big corporate
houses and MNCs raise funds, list their shares and manage their
risks. These markets provide companies necessary depth and
breadth required for carrying out their global operations.
Q Historically, London served as the major international financial
centre. However, from the early twentieth century, the importance
of London started diminishing and simultaneously the prominence
of US as an international financial market increased rapidly.
Q Various international financial markets include FX markets, in-
ternational money markets, international credit markets, interna-
tional bond markets and international equity markets.
Q FX markets can be classified into interbank (wholesale) and retail
segments. The retail segment refers to FX transactions between
the bank and corporate clients while inter-bank market refers
transaction between commercial banks. The inter-bank market
constitutes major volume of the FX market.
Q Foreign Exchange (FX) markets are used for various transactions
such as those involving conversion of one currency into another;

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72 INTERNATIONAL FINANCE

NOTES

transactions for managing currency risk through trading in for-

ward contracts and currency derivatives; transactions for manag-
ing FX positions of banks, etc.
The major participants in FX markets are commercial banks, in-
vestment banks, FX brokers, central banks and bank customers.

FX markets can be broadly classified into two tiers, interbank or

wholesale market and retail market. The interbank market refers
to the market in which FX transactions between two commercial
banks take place. On the other hand, the retail market is the mar-
ket in which FX transactions between a commercial bank and
non-bank clients (like exporters, importers, institutions or individ-
uals) take place.
FX market transactions can be classified into two major catego-
ries: spot transactions and forward transactions. Spot transactions
refer to the immediate purchase or sale of foreign currency. The
forward transaction refers to a transaction that involves two par-
ties entering into an agreement for future purchase or sale of a
foreign currency.
The Eurocurrency market is the largest segment of the interna-
tional money market. It consists of time deposits in currencies out-
side the country where the currency is issued.
The interest rates on international money markets are floating
rates based on reference rates like LIBOR.
Credit markets refer to markets where medium and long-term
loans can be obtained and where the maturity of the loans is
more than one year. Such credit is provided by commercial banks
in terms of various loan products like term loans, medium term
notes, consortium loans, syndicated credits, etc.

International bond markets allow the issue of bonds denominated

in international currencies. The two major groups of international
bonds are foreign bonds and Eurobonds.
Foreign bonds are denominated in a local currency but issued by
the borrower of a different nationality.
Indian companies can raise foreign debt through External Com-
mercial Borrowings (ECBs) and Foreign Currency Convertible
Bonds (FCCBs) subject to RBI regulations in this regard.
The major modes of international listing include cross-listing, de-
pository receipts, globally registered shares and direct interna-
tional listing.
Some key accounts that are frequently referred in FX transac-
tions are nostro accounts, vostro accounts, mirror accounts and
Exchange Earners’ Foreign Currency (EEFC) accounts.

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NOTES

KEY WORDS

Q American Depository Receipt (ADR): It is a type of depository

receipt that is issued in American exchanges.
Q Euro Interbank Offer Rate (EURIBOR): It refers to interbank
rate used in European markets.
Q Eurobond: It refers to a bond that is issued in a particular cur-
rency but is sold to investors belonging to a country other than
that in which the bond is denominated.
Q Global Depository Receipt (GDR): It is a type of depository re-
ceipt that is issued in exchanges other than American exchanges.
Q London Inter Bank Offered Rate (LIBOR): It is used as base
rate in the international credit market.

[5G DESCRIPTIVE QUESTIONS

1. Discuss Eurocurrency markets.
2. Describe the characteristics of a syndicated loan.
3. Explain what you understand by cross-listing. List the advantages
of cross-listing.

ram ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Concept of International : d. All of the above

Financial Markets
2. False
Types of International Finan- 3. ce. FX transactions between
cial Markets bank and corporate or an
individual
4, Wholesale segment
Be d. None of the above.
6. False
To d. Eurodollar deposits

HINTS FOR DESCRIPTIVE QUESTIONS

1. International banks in Europe accept US dollar deposits and
make loans in USD. This market is called the Eurocurrency
market. It is the largest international money market. Refer
Section 2.3 Types of International Financial Markets.

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74 INTERNATIONAL FINANCE

NOTES

2. The characteristics of a syndicated loan are as follows:

The bank that organises the syndicate or consortium is
called the lead bank; the lead bank negotiates the terms and
conditions of the loan with the borrower. It also prepares a
placement memorandum; the lead manager invites other banks
to participate in the syndicate; etc. Refer Section 2.3 Types of
International Financial Markets.
3. When a company lists its shares in a stock exchange outside its
domestic financial markets, it is called ‘cross-listing’ of shares.
Refer Section 2.3 Types of International Financial Markets.

28 | SUGGESTED READINGS FOR

REFERENCE

SUGGESTED READINGS
Q Cheol S. Eun, Bruce G. Resnick, (2012). International financial
management, Tata McGraw Hill Publishing Company Ltd., New
Delhi
Gert Bekaert, Robert Hodrick, (2013). International financial man-
agement, Pearson Education Inc., publishing as Prentice Hall,
New Jersey
Jeff Madura, (2008). International financial management, Thom-
son South-Western, USA

E-REFERENCES
a BNY Mellon, (2015), “The Depository Receipt: Market Review,
January 2015”, The Bank of New York Mellon Corporation, https://
www.bnymellon.com/_global-assets/pdf/our-thinking/business-in-
sights/depositary-receipt-market-review.pdf, accessed on 22nd
September, 2015
Financial Times, (March, 2015), “Global companies binge on euro
bonds”, by Elaine Moore, http://www.ft.com/intl/cms/s/0/ba1605e2-
c7da-11e4-8210-00144feab7de.html#axzz3mGmnnEgh, accessed
on 22nd September, 2015
Global Capital, (September, 2015), “Indian pharma majors look to
loans to fund US acquisitions”, http://www.globalcapital.com/arti-
cle/te9rxf3zmyq0/indian-pharma-majors-look-to-loans-to-fund-us-
acquisitions, accessed on 22nd September, 2015
McKinsey Global Institute, (2011), “Mapping global capital mar-
kets 2011”, McKinsey & Company

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 INTERNATIONAL FINANCIAL MARKETS 75

NOTES

Q Live mint, (September, 2015), “Greenko Group plans to increase

capacity to 5000MW by 2020”, http:/Awww.livemint.com/Compa-
nies/A35ubovin382aLI5iFW0bO/Greenko-Group-plans-to-in-
crease-capacity-to-5000MW-by-2020.html, accessed on 22nd Sep-
tember 2015
Q London Stock Exchange (LSE),(2015), “A Guide to AIM”

Q New York Stock Exchange (NYSE), (2015), “Current List of all

non-US Issuers”, https://www.nyse.com/publicdocs/nyse/data/
CurListofallStocks.pdf, accessed on 22nd September, 2015
Q Reserve Bank of India (RBI),(2015), “Master Circular on External
Commercial Borrowings and Trade Credits”, Master Circular No.
12/2015/16, https://rbi.org.in/Scripts/BS_ViewMasCirculardetails.
aspx?id=9840, accessed on 22nd September, 2015
Q Trust Sources, (2010), “Emerging markets — International capital
raising trends”, City of London Economic Development
Q www.greenkogroup.com

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INTERNATIONAL MONETARY SYSTEM

CONTENTS

3.1 Introduction
3.2 Concept of International Monetary System
Self Assessment Questions
Activity
3.3 Exchange Rate Regimes
3.3.1 Classical Gold Standard (1876-1913)
3.3.2 Bretton Woods System (1946-1971)
3.3.3 Flexible Exchange Rate Regime (1973 onwards)
Self Assessment Questions
Activity
3.4 Evolution of Exchange Rate Mechanism in India
3.4.1 Foreign Exchange Dealers’ Association of India (FEDAI)
Self Assessment Questions
Activity
3.5 International Financial Institutions
3.5.1 World Bank Group (WBG)
3.5.2 International Monetary Fund (IMF)
Self Assessment Questions
Activity
3.6 International Liquidity and Special Drawing Rights (SDRs)
3.6.1 Quantitative Easing, Monetary Stimulus by Major Central Banks and
Sub-Prime Crisis
Self Assessment Questions
Activity
3.7 Other Financial Institutions
3.7.1 International Finance Corporation (IFC)
3.7.2 Asian Development Bank (ADB)
3.7.3 World Trade Organisation (WTO)
3.7.4 New Development Bank (NDB) BRICS
3.7.5 Asian Infrastructure Investment Bank (AIIB)
Self Assessment Questions
Activity
3.8 Summary
3.9 Descriptive Questions
3.10 Answers and Hints
3.11 Suggested Readings for Reference

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78 INTERNATIONAL FINANCE

INTRODUCTORY CASELET

CHINA’S CURRENCY DILEMMA

The (as of August, 2015) decision of China to devalue its currency,

the renminbi, by 2 per cent against the US Dollar, is intended to
give its slowing economy a boost. However, the decision is likely
to be seen by lawmakers in the US and other countries as cur-
rency manipulation. It aims to increase Chinese exports at the
expense of producers in other countries.

A weaker currency benefits China as it lowers the cost of its goods

to consumers in foreign markets. In the last several decades, the
country has developed a thriving facturing industry, partial-
ly by artificially suppressing t its currency. This has
hurt businesses and workers in nd other countries by
reducing demand for thei

against the dollar since tl r now buys 6.33 renminbi,

compared with 8.2 bi in July 2005. The latest devaluation
comes as concern Chinese economy. The Inter-
national Mone n [F) has estimated that China’s growth
rate will dec ent in 2015 and 6.3 per cent in 2016,
down from 7 r 2014. Exports fell 8.3 per cent in July
from th i year earlier. The country’s exports to Eu-
icularly sharply. This is partly because the

frequently do not fully consider the prices at which investors buy

or sell renminbi the previous day. Now, the government says that
it will base its official rate more closely on trades in the market.

It would be a positive step for the global economy, if the govern-

ment reduces its interference in the foreign exchange market.
However, it is still unclear how willing the Chinese officials are
to relax their tight grip over the renminbi until investors bid up
the value of the currency when trading it in the market. Will offi-
cials allow the renminbi to appreciate against the dollar by, say 2
per cent from the day before, if new data shows that the Chinese
economy is growing faster than expected?

Chinese officials would also like to persuade the IMF to include

the renminbi in its currency basket, which other economies can
use as reserve currencies and in transactions with the fund. Only

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 INTERNATIONAL MONETARY SYSTEM 79

INTRODUCTORY CASELET

four currencies now have qualified to be on the list. These cur-

rencies include the Dollar, Euro, Pound and Yen. The fund’s staff
said in a report last week that the renminbi should not be added
to the list right now. This is because it is not widely used and trad-
ed in international transactions. The fund’s board is expected to
decide whether China has taken enough steps for its currency to
be included.

China needs to stop fixing its exchange rate. It cannot maintain

tight control over the renminbi and should allow it to be consid-
ered and used as a global currency along the lines of the dollar or
the euro.

s
(Source: The Economic Times (12th August, 2015). China’s currency dilemma: It n
stop fixing its exchange rate. New York Times.)

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NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

»— Discuss the concept of international monetary system and
its important functions
»— Explain the various international exchange rate regimes
that prevailed since the 1800s
2— Describe the features of classical gold standard
»— Explain the Bretton Woods System and elaborate on the rea-
sons of its failure
»— Discuss the various exc ate arrangements currently
prevailing in different
Explore the evolution te mechanism in India
ry

Discuss the vari nancial institutions and

their activities fr ve of international finance

sai INTRODUCTION

In the first chapter, you have studied the concept of international fi-
nance, its need, role and functions. Moreover, you studied the concept
of international trade and various international trade theories. In the
second chapter, you studied about various financial markets that are of
importance to international finance apart from the foreign exchange
market, which is central to international finance. You must have noted
in the second chapter that the modern CFO has wider global opportu-
nities whether it pertains to the need for short-term money, long-term
debt or international equity financing.

Before studying the core aspects of international finance in terms of

exchange rate theories, exchange rate determination, currency risk
management and hedging methodologies, we need to understand the
international monetary system. The global financial system has been
evolving ever since the countries around the world moved towards
greater international cooperation for freer international trade. The
core aspects of the global financial system are the various exchange
rate mechanisms adopted by countries at different times. These as-
pects also include the international agreements and regulations per-
taining to the same and the related global financial institutions that
have been entrusted with the task of overseeing the global financial
system. A good understanding of the global financial system is essen-
tial for any finance manager or an investment banker to best tackle
the challenges of international finance.

In this chapter, you will study the concept of international monetary

system, the various exchange rate regimes that have evolved over the
century, the different exchange rate regimes followed by different

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 INTERNATIONAL MONETARY SYSTEM 81

NOTES

countries, the global financial institutions that are of importance to

world trade, exchange rate regulations and international finance.

CONCEPT OF INTERNATIONAL
3.0 MONETARY SYSTEM

In simple words, international monetary system refers to the global

framework of trade and financial flow. The international monetary
system can be defined as the global financial environment constitut-
ing international agreements, policies, rules and mechanisms, and the
associated international financial institutions that govern the inter-
national trade and capital flow among nations. It is the institutional
framework and policy environment within which the international
trade is conducted, payments are made, movement of capital occurs
and exchange rate among currencies are determined. Therefore, in-
ternational monetary system pertains to the flow of funds across na-
tional borders and determination of the relative values of currencies
of different economies in the international market.

If you wonder why we need an international monetary system beyond

the national economic systems, financial institutions and related na-
tional regulations, consider the following events:
Q The classical gold standard, traditional method of payments for
international trade, crumbled in the early part of the 20th century.
Q The Great Depression, in the US threatened the world economy
as a whole and many banks in developed countries faced an exis-
tential crisis.
Q After the world war, many countries experienced hyperinflation
with Germany experiencing price index increasing trillion times
that of the pre-war level.
Q Countries suffered major trade imbalances and resorted to ‘beg-
gar-thy-neighbour’ policies that threatened the effective function-
ing of international trade. This is an economic policy adopted by a
country, which has adverse economic effects on the neighbouring
countries.
Q An international system (Bretton Woods System) that was de-
signed to take care of these events broke down in 1970s.
Q Two oil price shocks and related impact on international trade led
many countries around the globe into recession.
Q The 1990s witnessed periodical currency turmoil occurring one af-
ter another, which posed significant threat to the global financial
system. This includes Mexican peso crisis, Asian Thai-baht crisis,
Russian crisis leading to the demise of Long-Term Capital Manage-
ment (LTCM), etc.

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NOTES

Q The 2000s continue to witness financial crisis that seems to in-

crease in frequency and impact as the world’s financial markets
get more closely integrated.

Most of these events had the capacity to drive the entire world econo-
my into depression, which could result in tremendous pain and agony
to most of the world population. These events, which were a result of
global trade and capital movements, happened in spite of the exist-
ing and evolving international monetary system. While free interna-
tional trade and globalisation have brought tremendous benefits to
the world economy, including that of the developing and poor nations,
it has also been found to be associated with the risk of global crises
that could threaten the world economy. Hence, an international insti-
tutional framework involving standard policies and procedures that
could govern the international trade and capital movement has be-
come a necessity. International monetary system serves the interna-
tional institutional framework that intends to promote global econom-
ic stability and prosperity.

The primary functions of the international monetary system can be

described as follows:
Q Facilitate monetary cooperation between countries: To ensure
sustainable and all-round economic growth in all economies, it is
necessary to have a central institutional framework that allows
collaboration and consultation among nations. In addition, this
should allow greater cooperation between countries in resolving
their monetary problems as most of the economic problems of dif-
ferent countries have international factors underlying them.
Q Ensure stability of the financial system: The financial stability
of the world economic system depends on the actions of various
participants from different countries across the world. Therefore,
it is essential that there is a centralised system that oversees the
world’s financial environment. This would ensure that failure in
any one country does not get transformed into a major interna-
tional problem. In such events, the presence of a centralised in-
stitution can help countries to tide over the problems and prevent
transformation of a national problem into a global catastrophe.
Q Facilitate greater international trade and movement of capital:
Without international cooperation, agreements and rules concern-
ing international trade and capital movements, countries might
resort to unfair trade practices to protect their domestic econo-
mies through tariff barriers, competitive devaluations, etc. The in-
ternational monetary system should promote greater internation-
al trade and capital movements by preventing practices, such as
competitive devaluations, unfair restrictions on current or capital
account transactions, etc.

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Q Ensure orderly payment mechanism: The growth in internation-

al trade between countries depends on an efficient and systematic
payment mechanism. It requires commonly accepted rules, poli-
cies and conventions regarding exchange rate regimes and pay-
ment mechanisms. The internal monetary system sets a level play-
ing field for all participant economies by promoting and suggesting
necessary mechanisms, such as exchange rate regimes and pay-
ment mechanisms related to international trade and movement of
capital across borders.
Q Ensuring global liquidity: In the absence of an international cur-
rency, countries depend on various reserve currencies for inter-
national trade. The international monetary system ensures ample
global liquidity in terms of the availability of reserve currencies for
countries to freely participate in international trade.
Q Ensuring confidence in global financial system: To ensure partic-
ipation of different nations in global trade and cross-border move-
ment of capital, they must be confident about the global financial
system. For building such confidence, some central mechanism is
required, which ensures monitoring and tracking of global eco-
nomic and financial developments and taking preventive actions.
In addition, the mechanism needs to have necessary resources and
authority to tackle any challenges. International monetary system
acts as one such mechanism.

It is essential for managers to understand the international mone-

tary system—the global context in which international finance is con-
ducted. The currently prevailing international monetary system has
evolved over decades as a result of changes in world economy and
related political environments, and the challenges related to interna-
tional trade and global capital movements.

To understand the current monetary system, it is also necessary to

trace the history of institutional and economic developments related
to international trade and the evolution of various exchange rate re-
gimes over the decades. We shall study these aspects in the subse-
quent sections of this chapter.

& SELF ASSESSMENT QUESTIONS

1. The international monetary system:

a. helps crisis-ridden large corporates
b. manages the world economy
facilitates monetary cooperation among economies
e

None of the above

a.

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2. International monetary system comprises which of the

following:
a. Agreements, rules and conventions regarding internation-
al finance
b. International institutional framework
ce. Policy environment for conduct of trade and payment
mechanisms
d. All of the above

3. The function of ensuring global liquidity through international

monetary system might involve which of the following:
a . Provision to borrow reserve currencies
b. Ample liquidity in major trading currencies
Creation of an international reserve currency
e

All of the above

2.

Visit the IMF website and read the IMF charter. Form a group of
friends and discuss the various duties and responsibilities of the
IMF with respect to the objective of ensuring the stability of the
world’s financial system.

5s EXCHANGE RATE REGIMES

A study of the evolution of the current international monetary system
is largely centred on the study of the evolution of various exchange
rate regimes. The evolution of the exchange rate regimes can be clas-
sified into the following three phases:
1. Classical gold standard (1876-1913)

2. Bretton Woods System (1946-1971)

3. Flexible exchange rate regimes (1973 onwards)

Let’s study each of these phases in detail in the subsequent sections.

3.3.1 CLASSICAL GOLD STANDARD (1876-1913)

The classical gold standard is the phenomenon of decades following

1875. Prior to 1875, most economies followed ‘bimetallism’, which in-
volved the usage of both gold and silver as the medium of exchange.
For example, UK was using both gold and silver coins as a currency
till 1816. In case of the US, bimetallism was the prevailing standard for
trade till 1873. France was in bimetallism till 1878. In bimetallism, the

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exchange rates of different currencies were determined by the con-

tent of gold or silver in that particular currency. For example, the ex-
change rate between British pound and French Franc was determined
by the amount of gold in the two currencies.

Meanwhile, countries, such as India, Germany and China, etc., fol-

lowed the silver standard.

In British India, silver rupee of 180 grains troy was instituted as the
uniform currency in 1835. This currency prevailed till 1893.

The gold as the medium of exchange, though prevailing since ancient

times, became the only prevailing standard since around 1875. During
this period, most of the countries around the world adopted gold stan-
dard. Some of the important aspects of the gold standard as a medium
of exchange were:
Q Currency issued by the country had to be backed by gold in a stat-
ed ratio.
Q Gold alone was permitted for coinage.
Q Two-way convertibility between gold and the national currency
was allowed only at the stated ratio.
Q Free export or import of gold was allowed.
Q Existence of sufficient gold reserve with the central bank of the
country backing the issue of currencies.
Q Domestic money stock rose and fell as gold flowed in or out of the
country.

Under a gold standard, the exchange rate between two currencies was
determined by the amount of gold content in the respective curren-
cies. Suppose British Pound is pegged to gold at 6 pounds per ounce
and the US dollars at 29.04 dollars per ounce, then the dollar-sterling
exchange rate will be $(29.04/6) = $4.84 per pound. Therefore, the ex-
change rate between two currencies did not change as long as they
were pegged to a fixed amount of gold. This ensured that exchange
rates were highly stable, which allowed countries to undertake global
trade and investment.

In the classical gold standard, since gold was exchangeable with cur-
rencies of the central banks and since cross-border flow of gold was al-
lowed, any misalignment in exchange rates was automatically aligned.
For example, in the given case, if the dollar-sterling exchange rate was
$6 per pound instead of $4.84, people can convert pound into dollars
and then exchange it with gold from the central bank of the US. They
can again repurchase pounds in exchange for gold with the Bank of
England. When they sell $6 to the Federal Reserve, they would get

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0.2066 ounces of gold, which if they exchange with the Bank of En-
gland would get GBP 1.2397, thereby making profits of GBP 0.2397
per dollar. This possibility ensured that the exchange rates under the
gold standard remained stable.

Under the classical gold standard, the domestic money stock was sup-
posed to rise or fall along with the inflow or outflow of gold as men-
tioned earlier. The gold standard corrected trade imbalances because
of this property. For example, suppose US exports more to the UK
than it imports from that country. Now, as both countries are follow-
ing gold standard, the net movement of gold from the UK to US due
to this trade imbalance will result in a fall in the price level in the UK.
The reduced price level in the UK will increase its exports to the US,
thereby automatically correcting the trade imbalance. However, this
automatic adjustment mechanism depends on the changes in money
stock affecting the price levels.

The UK was on a gold standard since 1816, the year it abolished free
coinage of silver. It adopted a full-fledged gold standard in 1821. From
that year onwards, people could freely convert notes issued by the
Bank of England with gold. Other countries that were in bimetallic
standard moved to gold standard during this period—France in 1878,
Germany in 1875, the US in 1879, and Russian and Japan in 1897. In-
dia adopted the gold standard from 1893 onwards. Though it was a
binding on the government to accept gold and give rupee in exchange,
it was not a binding on them to provide gold against rupee.

The gold standard served the international monetary system as the

medium of exchange for international transactions till 1914. The gold
standard has the following disadvantages because of which this ex-
change rate regime was not sustainable:
1. The central banks were supposed to maintain gold reserves in a
particular ratio to the amount of currency issued. This extended
the role of currency beyond its core function as the medium of
exchange.
2. The growth of world trade and investment depended on the
supply of newly minted gold—the two entirely unrelated factors.
3. Lack of monetary reserves due to the absence of gold supply,
which is supposed to back it, could seriously hamper the world
trade and result in deflationary pressures across countries.
4. The gold standard failed to create automatic adjustment of trade
imbalances as theoretically envisaged.

FALL OF CLASSICAL GOLD STANDARD

The classical gold standard fell apart during the inter-war period of
1915-1944. During this period, major countries imposed restrictions
on gold exports. They also suspended the redemption of currencies

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with gold; thereby, ending the classical gold standard as a method of

international trade. Now, as currencies were not pegged with gold
anymore, the exchange rates between currencies started fluctuating.
In addition, many countries resorted to competitive devaluations in
order to promote domestic exports.

An attempt to restore the gold standard after the end of the war did
not fully succeed. The US lifted restrictions on gold exports and re-
turned to the classical gold standard in 1919. Similarly, other coun-
tries, such as the UK, Switzerland and France restored gold standard
by 1928. However, since many countries took initiatives to stabilise
their domestic economies, the automatic adjustment mechanism of
the gold standard was not allowed to have its effect. This meant that
the prevailing gold standard did not really support in promoting fair
international trade. Moreover, the Great Depression in the US and its
effects world-over greatly impacted the determinants of the prevailing
exchange rate regime. The political instabilities, failure of large banks
and flight of capital across countries also increased the difficulty of re-
storing the classical gold standard. For example, the UK experienced
a massive outflow of gold to the point where it was not possible for it
to maintain the gold standard anymore. By around 1931, UK dropped
the gold standard altogether and allowed pound to float. This was
followed by other countries, such as the US, France, Japan, Sweden,
Canada, etc. Thus, the inter-war period led the gold standard to be
slowly replaced by paper currency standards.

3.3.2 BRETTON WOODS SYSTEM (1946-1971)

As discussed in the previous section, the world wars and the conse-
quent collapse of the classical gold standard led to serious disruptions
in the international trade. These disruptions included:
Q The breakdown of prevailing international monetary relations
Q Absence of clear ground rules and mechanisms for international
trade
Q Trade imbalances between economies leading to excessive protec-
tionism
Q Economic nationalism resulting in destructive “beggar-thy-neigh-
bour” policies
Q Competitive devaluations and adoption of deflationary policies

Owing to these reasons, there was an urgent need to reconstruct a

post-war international monetary system. Towards this objective, over
700 delegates from 44 nations gathered at Bretton Woods, New Hamp-
shire, the US in July 1944, to design such an international monetary
system. The US was represented by Harry Dexter White while the
UK was represented by the well-known economist John Maynard
Keynes. The delegates successfully ratified an agreement for the cre-

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ation of the International Monetary Fund (IMF), which would be en-

trusted upon the task of formulating international monetary policies.
Along with the IMF a sister institution—the International Bank for
Reconstruction and Development (IBRD), now popularly known as
the World Bank, was also created. The IMF was created to ensure the
smooth flow of capital across national boundaries, reduce currency
volatility and provide macro-economic stability. On the other hand,
IBRD was developed for the purpose of financing development proj-
ects in the participating countries.

In Bretton Woods, the delegates from the UK and the US proposed

two different proposals. John Maynard Keynes, representing the UK,
suggested the creation of an international clearing union and an in-
ternational reserve asset called bancor. The new reserve asset, to be
created, was meant to be used as the currency for settling interna-
tional transactions. The clearing union was also supposed to provide
liquidity and allow the member countries to borrow in bancor. The US
team led by Harry Dexter White proposed a currency pool to which
member countries would make contributions and borrow to overcome
their temporary Balance of Payment (BoP) difficulties. In the final
agreement, the US proposals were mostly incorporated into the Arti-
cles of the Agreement of the IMF. According to this, a system of fixed
but adjustable exchange rates was proposed and adopted. In addition,
the member countries committed themselves to make their curren-
cies convertible for current account transactions as soon as possible.

The salient features of the exchange rate regime established through

the Bretton Woods agreements are given as follows:
1. The Bretton Woods System aimed for exchange rate stability
without restoring the classical gold standard.
2. It was a “dollar-based gold-exchange standard” where only the
US dollar was fully convertible to gold from the central bank of
the US, i.e., the Federal Reserve.

3. Under the system, US dollar was pegged to gold at $35 per ounce.
Other currencies were not directly pegged to gold as in the case
of the classical gold standard.
4. The currencies of other countries were pegged to the US dollar
called the par value in relation to the USD.
5. Each country was liable to maintain its exchange rate within
+1 per cent of the par value, by buying and selling the domestic
currency.
6. Amember country was allowed to make a change in the par value
of the currency in case of any ‘fundamental disequilibrium’.
7. Countries could hold both the USD and gold as reserves as
means of international payment.

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The Bretton Woods System provided a credible alternative to the pre-

vailing international monetary system during the post-war period. In
addition, it was able to provide a stable exchange rate environment
that facilitated international trade and investment. The system how-
ever failed by 1973 due to several reasons. The main reasons behind
the failure of the Bretton Woods System were as follows:
Q High demand for USD: Since the US dollar was the international
reserve currency under Bretton Woods System, the central banks
of all countries maintained their reserves, meant for foreign ex-
change transactions, in USD. This led to persistent international
demand for the USD.
Q High current account deficit of the US: Under the Bretton Woods
System, USD was pegged to gold at a fixed rate of $35 per ounce
and it could not depreciate as it was the international reserve cur-
rency. In such a situation, increasing demand for the USD resulted
in large currency account deficits of the US with the rest of the
world. Economists, such as Professor Robert Triffin believed that
large and persistent US current account deficits could lead to a
crisis of confidence in the world’s reserve currency.
Q Requirement of maintaining high gold reserve by Fed: The via-
bility of the ‘dollar-based gold-exchange standard’, the core aspect
of the Bretton Woods System, became a matter of concern when
the US gold stock, pegged at the fixed rate of $35 per ounce, fell
short of the foreign dollar holdings. Since USD was the interna-
tional reserve currency and Fed was required to exchange USD
with gold, Fed was required to maintain enough gold reserves.
With the expansion of world trade and growth of economies across
the world, this requirement of the Bretton Woods System became
increasingly infeasible.
The US was actually experiencing current account surpluses in
the years after World War II. In addition, the US had 70% of the
world’s gold reserves in 1945. The post-war reconstruction of Eu-
rope with the help of the US aid (Marshal Aid package) led to the
economic growth of Europe and Japan. In 1949, the European
countries, such as the UK, France and Scandinavia were allowed
to devalue their currencies with the approval of the IMF. By 1950s,
the European countries, such as West Germany and Japan started
running trade surpluses.
Q Speculation on the USD: When it was clear that the US Balance
of Payment deficits were quite large and the US dollar liabilities
exceeded the gold reserves with the Fed, the foreign central banks
started converting their dollar reserves into gold. This led to wide-
spread concern and speculation about the stability of the USD.
The value of gold in the private market exceeded the official USD
price. The US trade balance itself got into deficit for the first time
in 1971 and there was a massive capital outflow in anticipation of
the devaluation of the dollar (Keith Pilbeam, 2006). Speculation

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against dollar led Bundesbank to purchase $2 billion in just two

days and halting of foreign exchange trading for a week. Owing to
massive speculation and related problems, in August 1971, the US
declared that dollar was no longer convertible into gold and an-
nounced a 10% tariff on all US imports. An effort to save the Bret-
ton Woods System by ten major countries (Group of Ten) through
the Smithsonian agreement did not bear fruit. This is because ma-
jor countries had to float their currencies within a year, marking
the end of the Bretton Woods System.

IP 4S 103UY
The Triffin’s Paradox
The Triffin’s paradox is normally considered as a major cause for
the breakdown of the Bretton Woods System. As per Triffin, to meet
the international demand for dollar reserves, the Bretton Woods
System depended on the US running deficits with other countries
running surpluses. As the stock of US dollar liabilities increases at
a higher rate than the yearly addition of gold reserves, the ratio of
US dollar liabilities to gold held by the Federal Reserve would de-
teriorate to an extent that convertibility of dollars into gold would
become impossible. The paradox is that while the US deficits un-
dermine the Bretton Woods System, any effort to curb the deficits
would lead to a shortage of world reserves, which could undermine
the growth of world trade and lead to deflationary pressures. The
US could not devalue the dollar since this would undermine con-
fidence in the whole system. Moreover, devaluation of the dollar
against gold will not help the US, if other countries maintained
their exchange rate parities against the dollar.

3.3.3 FLEXIBLE EXCHANGE RATE REGIME (1973

ONWARDS)

After the decline and eventual fall of the Bretton Woods System, most
of the currencies were floating by default without any pegging to dol-
lar or gold after 1973. The major currencies, such as the dollar, mark,
pound and yen were fluctuating against each other and the general
expectation was that this phenomenon might continue till a new mon-
etary order gets established. However, the possibility of a return to
fixed exchange rate regime was becoming more and more remote due
to a number of events related to exchange rates that greatly affected
the world economy. For example, the huge oil price hike at the end
of 1973 due to the Arab-Israeli conflict greatly hit the oil importing
countries whose current account deficits increased manifold. The oil
shock also led many countries into inflation, recession and negative
growth rates.

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In 1976, IMF members met in a conference in Jamaica to discuss the

new set of rules for the international monetary system and arrived at
the Jamaica Agreement’. The agreement officially abandoned gold as
an international reserve. In addition, the agreement formally ratified
a flexible exchange rate regime that allows the central banks to in-
tervene in the foreign exchange markets. Moreover, under the agree-
ment, the non-oil exporting countries and less developed countries
were allowed greater access to IMF funds.

In another amendment of 1978, member countries were given a large

degree of discretion in choosing their exchange rate arrangements.
Each member was only obliged to notify the exchange rate arrange-
ment, but could freely choose the methodology like pegging to anoth-
er currency, fixed rate, floating rate, etc. The role of IMF remained
that of overseeing the international monetary system and monitoring
the exchange rate policies of the member countries. Members were
required to provide the IMF with the necessary information required
for surveillance. In addition, the amendment stated that the members
should avoid manipulating their exchange rates to adjust the balance
of payments or to gain any unfair competitive advantages. They were
required to intervene in the markets to counter any unnecessary ex-
change rate fluctuations or disruptive short-term movements while
taking into account the interests of other members.

The flexible exchange rate regime does not mean that all countries
allowed their currencies to float freely against other currencies. As the
countries were free to choose the exchange rate regimes; the method-
ology chosen varied between two extremes—fixed exchange rates to
freely floating ones.

As per the 2014 IMF report, there are four major types of exchange
rate arrangements together constituting ten different types of ex-
change rate categories that are currently prevailing with the member
countries. These four different types are:
1. Hard pegs: In this type of exchange rate arrangement, the
country has either no separate legal tender (i.e., own currency)
or the domestic currency is hard pegged with another currency.
Former is termed as ‘exchange arrangement with no legal
tender’ and the second category is termed as ‘currency board
arrangement’.
2. Soft pegs: This includes five categories, viz., conventional peg,
pegged exchange rates within horizontal bands, stabilised
arrangement, crawling peg and crawl-like arrangement.
3. Floating regimes: This involves market determined rates and
has two categories—floating and free floating.
4. Residual: This includes other managed arrangement
methodologies.

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Each of these ten exchange rate methods falling under the four types
of currently prevailing exchange rate regimes is explained as follows
(IMF 2014):
1. No separate legal tender: Countries that have adopted this
arrangement have some other currencies circulating as the
sole legal tender. This implies complete surrender of the
country’s monetary authorities’ control over domestic monetary
policy. There are currently 13 countries that have adopted this
arrangement. Some examples are Ecuador, El Salvador, Palau
and Zimbabwe.

Though Euro Zone countries do not have their sole legal ten-
der any more (e.g., Greece), the common Euro currency is re-
ferred to as the Joint Currency Arrangement by IMF.

Currency board: This is the second type of hard peg arrangement.

It is a monetary arrangement based on an ‘explicit legislative
commitment to exchange domestic currency for a specified
foreign currency at a fixed exchange rate’. It also involves
restrictions on the issuance authority to ensure the fulfilment
of its legal obligation. With this type, the domestic currency is
usually backed by foreign assets and eliminates traditional
central bank functions, such as monetary control and lender of
last resort. It leaves little room for discretionary monetary policy
for the country’s authorities (IMF, 2014).
There are currently 12 countries that have adopted this
arrangement. Some examples are Hong Kong, Dominica and
Grenada.
Conventional peg: Countries adopting conventional peg,
formally peg their currencies at a fixed rate to another currency
or a basket of currencies. The basket is formed from the
currencies of major trading or financial partners and weights
reflect the geographic distribution of trade, services or capital
flows. The country authorities stand ready to maintain the fixed
parity through direct intervention. There is no commitment to
irrevocably keep the parity (IMF 2014).
The conventional peg arrangement is adopted by 44 countries.
Some examples are Jordan, Saudi Arabia, Denmark, Libya and
Nepal.
Stabilised arrangement: In this arrangement, there is a spot
market exchange rate that remains within a margin of 2% for
six months or more. The required margin of stability is met
either with respect to a single currency or a basket of currencies.
The exchange rates remain stable as a result of official action.

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However, exchange rate determination does not involve a policy

commitment on the part of country authorities.
There are 21 countries that followthis exchangerate arrangement.
Some examples are Maldives, Singapore, Bangladesh and Egypt.
5. Crawling peg: In this arrangement, the currency is adjusted in
small amounts at a fixed rate or in response to changes in selected
quantitative indicators, such as inflation differentials. The rate
of crawl can be set to generate inflation-adjusted changes in the
exchange rate or set at a pre-determined fixed rate and/or below
the projected inflation differentials. Two countries that have
adopted this method are Nicaragua and Botswana.
6. Crawl-like arrangement: In this arrangement, the exchange
rate must remain within a narrow margin of 2% relative to a
statistically identified trend for six months or more. There are 15
countries including countries, such as China, Jamaica, Croatia
and Argentina that follows this exchange rate arrangement.
Many of these countries maintain a de facto exchange rate
anchored to the US dollar.
7. Pegged exchange rate within horizontal band: The value of the
currency is maintained within certain margins of fluctuation of
at least 1% around a fixed central rate or a margin between the
maximum and minimum value of the exchange rate that exceeds
2%. Tonga is the only country following this arrangement.
8. Floating arrangement: In this exchange rate arrangement,
the exchange rate is largely market-determined without any
ascertainable or predictable path for the rate. Countries
following this arrangement do not have policies targeting any
specific level of exchange rates. However, they might intervene
in the foreign exchange market to prevent undue fluctuations in
the exchange rate. There are 86 countries that follow the floating
rate arrangement. This includes India, Afghanistan, Ukraine,
Uruguay, Thailand, South Africa, Brazil, etc.
9. Free floating arrangement: This is a floating exchange rate
arrangement in which intervention by the government in
foreign exchange markets occurs only in exceptional cases. In
this arrangement, intervention of the government takes place to
address the disorderly market conditions. For an exchange rate
arrangement to qualify as free floating, there must not be more
than three government interventions in a period of six months
and the duration of each intervention must not exceed three
days.
There are 29 countries that have declared free floating
arrangement for their currencies. This includes most of the
developed countries, such as the US, UK, Germany, European
Monetary Union, France, Australia, etc.

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10. Other managed arrangement: This category of arrangement

is a residual category and is used when the exchange rate
arrangement does not meet the criteria of any other categories.
This includes countries that have frequent shifts in policies.
There are 18 countries in this category including countries, such
as Cambodia, Liberia, Iran and Russia, etc.

EXHIBIT

Development of Euro Currency, ECU, ECM

The Eurozone comprises 28 member countries. Out of these 28, 19

countries use a common official currency called Euro [EUR (€)].
However, euro was not the official currency of these 19 states till
2002. The 19 member countries are Austria, Belgium, Cyprus, Esto-
nia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lith-
uania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia,
Slovenia and Spain.

Euro was initially launched as the accounting currency (electronic)

on January 1, 1999. Initially, the domestic currencies of participat-
ing countries were fixed in terms of Euro and with each other. They
were not allowed to fluctuate against Euro and against each other.
Later, Euro replaced old domestic currencies of 12 European coun-
tries on January 1, 2002 and became a legal tender. This marked the
beginning of a centralised monetary policy for member countries
that was decided by the European Central Bank.

European Currency Unit (ECU)

Prior to the introduction of Euro, European Currency Unit or the

ECU was used from 1979 till 1999. ECU was a basket currency. It
was based on currencies of 15 member countries of the Eurozone.
The value of the ECU was based on the weighted average of curren-
cies of member states. Each member state was given a weightage
according to their relative share in the Gross National Product
(GNP) of EU. ECU was in existence till 1999 when it was replaced
by euro on a one-to-one basis.

Euro Currency Market (ECM)

During the 1960s-70s, US dollar was the internationally accept-

ed currency for trade. At the same time, companies that were ex-
panding their operations in Europe also required dollars. For this,
European banks started accepting US dollar deposits from US
companies as they required it for lending. These dollars that were
deposited in European banks came to be known as Eurodollars
or Eurocurrency. The market in which euro-currency is traded is
known as Euro Currency Market (ECM).

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SELF ASSESSMENT QUESTIONS

4. The classical gold standard required the central banks to

exchange their currencies for gold. (True/False)
5. The classical gold standard differs from the Bretton Woods
System in many ways; though, both are based on the gold
standard. One of the points of difference is that the Bretton
Woods System:
a. required only the US central bank to maintain gold reserve
to back the USD
b. required all currencies to be pegged to gold
c. classical gold standard allowed exchange rates to fluctuate
d. none of the above
6. Which of the following is a key shortcoming of the classical
gold standard?
a. Central banks were supposed to maintain gold reserves in
a fixed ratio with the amount of currency issued
b. Growth of the world trade was dependent on the supply of
newly minted gold
ce. Lack of monetary reserves severely hampered the world
trade
d. All of the above

7. Which of the following reasons led to the advent of the Bretton

Woods System?
a. Breakdown of the international monetary relations
b. Trade protectionism
ce. Economic nationalism
d. All of the above
8. As per the Articles of Agreement of IMF, a system of fixed but
adjustable exchange rates was adopted. (True/False)
9. Which of the following is not a feature of the Bretton Woods
System?
a. Only the US had an obligation to exchange the USD for
gold
b. USD was pegged to gold at a fixed price of $35 per ounce
c. Member countries were allowed to make a change in par
value of the currency in case of fundamental disequilibri-
um
d. All of the above

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European countries that are a part of the European Monetary

Union (EMU) do fall under any of the ten types of exchange rate
arrangements categorised by IMF The export and import trade be-
tween the European countries that are a part of EMU, do not entail
any exchange rate risk due to the adoption of the single euro cur-
rency. Make a group of your friends and discuss the advantages and
disadvantages arising out of this arrangement.

Pv EVOLUTION OF EXCHANGE RATE

m=) MECHANISM IN INDIA
India moved from silver standard to the gold standard in 1893 when
the British government notified that the Indian mints would be ac-
cepting gold in exchange for rupees at the rate of 7.53344 grains of
fine gold. The corresponding exchange rate was 15 rupees per British
Pound or 1 shilling and 4 pence per rupee. This arrangement was not
really the classical gold standard but a kind of gold exchange standard
as the government was not obligated to provide gold against rupees.
However, since India was under British rule, rupee could be converted
into sterling, which was on the classical gold standard. The exchange
rate of rupee varied from the 1s-4d-level due to several domestic and
international reasons. When UK dropped the gold standard in 1931,
the link between rupee and sterling alone remained.
After independence in 1947, India followed a fixed exchange rate re-
gime with Indian rupee pegged to the pound sterling in line with the
Bretton Woods System. The value of rupee was fixed in terms of gold
as the equivalent of 0.268601 grams of fine gold and pegged to pound
sterling. In 1975, after the downfall of the Bretton Woods System, ru-
pee was delinked from the pound sterling in 1975. During the period
of 1975 to 1992, the rupee exchange rate was determined by the Re-
serve Bank of India (RBI) within a nominal band of +5 per cent of
the weighted basket of currencies of India’s major trading partners.
In addition, there was a widespread rationing of foreign exchange
through regulatory means, such as licensing, quantitative restrictions
and exchange control. During the period of 1975 and 1992, India had a
pegged exchange rate regime and high restrictions even on payments
related to current account transactions.
India was facing high current account deficits in early 1990s and was
financing the deficits through debt, which created short-term capital
flows. The official exchange rate maintained by the RBI was not in
alignment with the market fundamentals. In addition, a number of
international events during this period, such as oil price hike leading
to burgeoning import bill, suspension of remittances from gulf region
due to the gulf crisis, disruption of trade with eastern bloc countries
and recessionary conditions in developed countries, led to a serious
balance of payment crisis for India. Government was increasingly

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 INTERNATIONAL MONETARY SYSTEM 97

NOTES

unable to finance the current account deficit. Moreover, the foreign

currency reserves depleted rapidly and became insufficient to handle
even one month of imports. This finally led India to the liberalisation
programme. A high level committee on balance of payments in 1993
recommended liberalisation of current account transactions and full
current account convertibility. In order to maintain export compet-
itiveness and bring the rupee in line with the fundamentals, the ex-
change rate of rupee was adjusted downward by a two-step devalua-
tion of 9% and 11% in 1991.

EXHIBIT
Chronology of the Indian Exchange Rate
Year The Foreign Exchange Market and Exchange Rate.
1947-1971 | Par value system of exchange rate. Rupee’s external par val-
ue was fixed in terms of gold with the pound sterling as the
intervention currency.
1971 Breakdown of the Bretton Woods System and floatation of
major currencies. Rupee was linked to the pound sterling in
December 1971.
1975 To ensure stability of the rupee, and to avoid the weaknesses
associated with a single currency peg, the rupee was pegged
to a basket of currencies. Currency selection and weight as-
signment was left to the discretion of the RBI and not an-
nounced publicly.
1978 RBI allowed the domestic banks to undertake intra-day
trading in foreign exchange.
1978-1992 | Banks began to start quoting two-way prices against the ru-
pee as well as in other currencies. As trading volumes in-
creased, the ‘Guidelines for Internal Control over Foreign
Exchange Business’ were framed in 1981. The foreign ex-
change market was still highly regulated with several re-
strictions on external transactions, entry barriers and trans-
action costs. Foreign exchange transactions were controlled
through the Foreign Exchange Regulations Act (FERA).
These restrictions resulted in an extremely efficient unoffi-
cial parallel (hawala) market for foreign exchange.
1990-1991 | Balance of payments crisis.
July 1991 | To stabilise the foreign exchange market, a two- step down-
ward exchange rate adjustment was done (9% and 11%).
This was a decisive end to the pegged exchange rate regime.
March To ease the transition to a market determined exchange rate
1992 system, the Liberalised Exchange Rate Management Sys-
tem (LERMS) was put in place, which used a dual exchange
rate system. This was mostly a transitional system.
March The dual rates converged and the market-determined ex-
1993 change rate regime was introduced. All foreign exchange
receipts could now be converted at market-determined ex-
change rates.
(Source: Reserve Bank of India (February, 2010). Exchange rate policy and
modelling in India.)

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In March, 1992, LERMS, which involved a dual exchange rate system,

was instituted. Under this exchange rate management system, 40% of
the export proceeds and inward remittances were purchased at the
official exchange rate set by the RBI. In addition, the authorised deal-
ers were required to surrender 40% of their purchases of foreign ex-
change to the RBI at the official rate. The rest of the receipts and pay-
ments were allowed to be converted at the market rate of exchange.
The market rates were also used for the permissible capital account
transactions. Subsequently, the convergence of the dual exchange
rate was made effective in 1993 and the rupee exchange rate move-
ments became more market related. In 1994, India accepted Article
VIII of the Articles of Agreement of IMF, which stipulated full current
account convertibility.

In 1991, FERA (1947), which governed the regulation of foreign ex-

change in India so far, was replaced by the Foreign Exchange Man-
agement Act (FEMA). India’s foreign exchange policy measures have
since then shifted its focus from one of ‘conserving foreign exchange
by government enforced regulations’ to ‘facilitating international
trade and payments, and orderly development and maintenance of
foreign exchange market’. Having achieved full convertibility in cur-
rent account transactions and greatly liberalised regulations concern-
ing foreign inflow of capital, India has been moving slowly towards
full capital account convertibility and greater integration with rest of
the world.

The current exchange rate arrangement followed by India is classified

under ‘Floating Rate Arrangement’ by IMF. This is because though the
exchange rate of rupee is mainly market determined, it is not entirely
free floating as the RBI is authorised to intervene in the exchange rate
mechanism, as and when required.

3.4.1 FOREIGN EXCHANGE DEALERS’ ASSOCIATION OF

INDIA (FEDAIT)

FEDAI was formed in 1958. Initially, it was set up as an association of

all banks in India, which dealt in foreign exchange. It is a self-regula-
tory body of all the ADs of India and it has been incorporated under
Section 25 of the Companies Act, 1956. The main area of work of FE-
DAI is related to the creation of rules that govern interbank foreign
exchange transactions. It also works in association with the Reserve
Bank of India (RBI) for bringing reforms and development in the for-
eign exchange market. FEDAI makes rules for the efficient function-
ing of the foreign exchange market. In addition, FEDAI also provides
advice regarding foreign exchange market and transactions and as-
sists its members by training personnel.

The major role and responsibilities of FEDAI include the following:

Q Formulating FEDAI rules and guidelines for conducting forex
business

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Q Providing forex training to bank personnel

Accrediting (approving) forex brokers
U

Q Advising and assisting member ADs to resolve any issues that they
face during forex transactions
Q Serving as a representative of its member banks in the govern-
ment/RBI or any other relevant bodies.
Q Announcing forex rates on a daily and periodic basis.
Q Developing guidelines and rules that are important for various or-
ganisations such as Fixed Income Money Market and Derivatives
Association (FIMMDA), the Forex Association of India and any
other organisation participating in the forex market.
Q Working with the International Chamber of Commerce
Communicating forex policies and decisions to its members
O

Q Formulating rules for transit period, crystallisation, forward cov-

ers, etc.

Let us now study various rules made by FEDAI.

FEDAI RULES

There are 14 major FEDAIT rules as follows:

Rule-1-Hours-Of-Business
Oooocovoo oO

Rule-2-Export-Transactions
Rule-3-Import-Transactions
Rule-4-Merchanting-Tradeing
Rule-5-Clean-Instruments
Rule-6-Guarantees
Rule-7-Exchange-Contracts
Rule-8-Early-Delivery-Extension-And-Cancellation-Of-Forward
-Exchange-Contracts
Rule-9-Schedule-Of-Charges
oOo oO

Rule-10-Business-Through-Exchange-Brokers
Rule-11-Inter-Bank-TT-Settlement-And-Dispatch
Rule-12-Inter-Bank-TT-Settlement-Of-Inter-Bank-TTs-And-Des-
oO

patch Fedai
Rule-13-Abolition-Of-Sterling-Rates-Schedule
UO

Rule-14-Clarification-Explanatory-Notes-Certain-Other-Import-
oO

ant-Information

You can study these rules in detail from the official website of FEDAI.
But we will briefly discuss the relevance of these rules here.

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100 INTERNATIONAL FINANCE

N OT ES

Rule 1 is regarding the hours of business. According to this rule, the

exchange trading hours for inter-bank forex transactions are from 9.00
a.m. to 5.00 p.m. No customer transaction can be undertaken by the
ADs after 4.30 p.m. on working days. Time limit of 5.00 p.m. is not ap-
plicable for cross-currency transactions. Saturday is not treated as a
working day. According to Rule 2, a bank can purchase only approved
bills. The decision regarding what constitutes an approved bill is tak-
en by the buyer bank. Rule 3 defines import bills and their treatment.
Rule 5 relates to the application of exchange rates, interest rates and
charges related to forex. Rule 8 relates to the early delivery, extension
of contracts and cancellation of forward contract by ADs.
CARD RATE

Card rate refers to the exchange rates offered by a particular AD (or

bank). It includes buying and selling rates for TT (telegraphic trans-
fers, bills, currency notes, travel cards and travelers cheques). An ex-
ample of card rate is shown in Figure 3.1.

Forex card rates

Date: 11-12-2015
Curren ite Bank Rate
- |Trav-| Trav- | TT | Bills | Cur- |Travel| Trav- | De-
b el elers |selling|selling)rency| card | elers |mand
ite tes | card |cheques| rate | rate | notes icheqi draft
United States Dollar 65.26 | 65.26 | 64.73] 65.06} 65.06 | 68.22 | 68.22 | 69.32 | 67.98 | 67.98 | 67.95
(USD)
Euro (EUR) 71.24 | 71.24 | 70.73 | 71.09] 71.09 | 74.69 | 74.69 | 75.31 | 74.47 | 74.47 | 74.51
Great Britain Pound 98.69 | 98.69 | 97.98] 98.58) 98.58 | 103.5 | 103.5 |104.36/103.35] 103.35 |103.05
(GBP)
Australian Dollar 47.22 | 47.22 | 46.42] 47.05] 47.05 | 49.55 | 49.55 | 50.11 | 49.72 | 49.72 | 49.65
(AUD)
Canadian Dollar (CAD)| 47.73 | 47.73 | 45.94] 47.56] 47.56 | 50.08 | 50.08 | 50.98 | 50.25 | 50.25 | 50.17
Singapore Dollar 46.32 | 46.32 | 45.06 | 45.25 - 48.61 | 48.61 | 49.77 | 49.58 - 48.61
(SGD)
Japanese Yen (JPY) 53.15 | 53.15 | 51.89]53.15] 53.15 | 56.16 | 56.16 | 55.78 | 55.54 | 55.54 -
'U.A.E Dirham (AED) 17.19 | 17.19 [17.07 | 17.29 - 19.16 | 19.16 | 19.31 | 19.04 - -
Swiss Frane (CHF) 65.93 | 65.93 | 63.46 | 65.69 - 69.17 | 69.17 | 69.27| 69 - -
) Saudi Riyal (SAR) 16.03 | 16.03 | 16.01 | 16.03 - 18.76 | 18.76 | 19.10 | 18.76 - -
Qatari Riyal (QAR) 17.34 | 17.34 [16.49] - - 19.32 | 19.32 [19.68] - - -
Swedish Kronor (SEK)| 7.41 7.41 - 7.41 - 8.25 | 8.25 - 8.25 - -
Danish Kroner (DKK) | 9.25 | 9.25 : : : 10.31 | 10.31 : : - :
Norwegian Kroner 7.29 7.29 - - - 8.12 | 8.12 - - - -
(NOK)
New Zealand Dollar(N-| 43.93 | 43.93 - - - 46.10 | 46.10 - - - -
ZD)
Hong Kong Dollar(H- | 8.15 | 8.15 | 7.66 - - 9.08 | 9.08 | 9.39 - - -
KD)
Kuwaiti Dinar (KWD)_| 208.09 | 208.09 |202.27] - - 232.1 | 232.1 |233.31 - - -
Thai Baht (THB) 1.75 | 1.75 | 17 : : 1.95 | 1.95 | 2.09 : - :
South African Rand 4.1 41 - 4.1 - 4.57 | 4.57 - 4.57 - -
(ZAR)
Omani Riyal (OMR) 164.05 | 164.05] - : - 182.76|182.76| - - - -
Russian Rouble (RUB) | 0.91 0.91 - - - 1.02 | 1.02 - - - -
Korean Won (KRW) 0.0534 | 0.0534] - - - 0.0596] 0.0596] - - - -
Chinese Yuan (CNH) 9.69 9.69 - - - 10.79 | 10.79 - - - -

Note: 1. Japanese Yen (JPY) rate is for 100 units of JPY.

2. Card rates are subject to change, based on market volatility. The final rate applicable will be the
card rate prevailing at the time of debit/credit to customer account. Card rate will be applicable
for all customer forex transactions at branches.
3. Card rates are for foreign currency conversion to INR.

Figure 3.1: Card Rate Example

(Source: https://itreasury.icicibank.com/forexatclick/forms/MicroCardRateView.aspx)

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 INTERNATIONAL MONETARY SYSTEM 101

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REVALUATION RATES

Revaluation refers to calculating a new exchange rate (value) of a cur-

rency against a base currency on the basis of some adjustments. This
rate is used by traders to assess if they have realised profit or loss. It is
also used for the revaluation of balances in mirror accounts and out-
standing forward contracts.

Revaluation rates calculated by FEDAI as on 30th November 2015 are

shown in Figure 3.2:

CODE| SPOT; DEC.| JAN.| FEB.| MAR.| APR.| MAY.) JUN.| JUL.| AUG. NOV.
2015 2016 2016 2016 2016 2016 2016 2016 2016 2016
USD _| 66.6750] 67.0025] 67.3400] 67.6900] 68.0400] 68.4100] 68.7700] 69.1050] 69.4300] 69.8000] 70.8300
GBP _|100.0950|100.6050/101.1100]101.6350 | 102.1675 | 102.7300 | 103.2775 | 103.8000 |104.3075 | 104.8825 | 106.4875
EUR | 70.4625] 70.8875] 71.3000] 71.7300] 72.1700] 72.6350] 73.0875] 73.5350] 73.9725] 74.4600] 75.8400
*JPY | 54.1625} 54.5000] 54.8050] 55.1200) 55.4575] 55.8125] 56.1600] 56.5025) 56.8375] 57.2125] 58.2700
CHF | 64.6700} 65.1500] 65.5750] 66.0100] 66.4700] 66.9525] 67.4275
AUD | 48.0025] 48.1550] 48.3275] 48.5075] 48.6925] 48.8900] 49.0775
CAD | 49.8200] 50.0825] 50.3150] 50.5750] 50.8400] 51.1175] 51.3875
SGD_| 47.2000] 47.3825] 47.5700| 47.7650] 47.9800] 48.2050] 48.4250
SEK 7.6575] 7.7050] 7.7500] 7.7975] 7.8450] 7.8975] 7.9475
DKK 9.4450] 9.5050] 9.5650] 9.6250] 9.6875] 9.7525] 9.8150
NOK 7.6525] 7.6875] 7.7225] 7.7625) 7.8025] 7.8425] 7.8850
HKD 8.6025] 8.6475] 8.6925] 8.7375] 8.7850] 8.8325] 8.8825
MYR | 15.6525] 15.7075] 15.7825] 15.8225] 15.8825] 15.9475] 16.0100
NZD _| 43.6550
THB 1.8600
BHD [176.8450
AED | 18.1525
“KES | 65.2725
“IDR 0.4825 For FE.D.A. I.

QAR | 18.3075
OMR [173.1825

Figure 3.2: FEDAI Revaluation Rates as of 30th November 2015

FOREX MARGIN

In foreign exchange transactions, margin refers to the amount of mon-

ey that a trader must keep in account to trade in the market. For ex-
ample, if a trader is trading at leverage of 40:1 and the open trade val-
ue is $10,000. In this case, the margin amount trader needs to maintain
in his account 10,000/40 = 250.

&e SELF ASSESSMENT QUESTIONS

10. After independence, India followed a fixed exchange rate

regime with Indian rupee pegged to the in line with
the Bretton Woods System.

Make a group of your friends and discuss the evolution of exchange

rate mechanism in India.

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INTERNATIONAL FINANCIAL
5)
INSTITUTIONS

International financial institutions refer to the institutions that have

been set up to monitor and facilitate all cross-border financial trans-
actions, such as flow of funds and exchange rate mechanism and in-
ternational trade. The IMF and the World Bank Group (WBG) are the
two major international financial institutions. These were the direct
results of the Bretton Woods Agreement, and are called Bretton Woods
Institutions. Let us study these two international financial institutions
in detail in the subsequent subsections.

3.5.1 WORLD BANK GROUP (WBG)

The World Bank was conceived in 1944 as a part of the Bretton Woods
System with the primary objective of reconstructing war-torn Europe.
It has now transformed into one of the world’s largest sources of de-
velopment assistance, with a mission to fight poverty and promote
economic development.

The WBG, now consisting of five international institutions, has be-

come one of the world’s largest sources of funding and knowledge for
poverty eradication in developing countries. The group consists of five
institutions as shown in Table 3.1:

TABLE 3.1: INSTITUTIONS UNDER THE

WORLD BANK GROUP
Activity
International Bank for Recon- Lends government of middle
struction and Development income and credit-worthy
(IBRD) low-income countries
International Development Provides interest-free loans
Association (IDA) and grants to governments of
the poorest countries
3. International Finance Corpo- Provides loans, equity and
ration (IFC) technical assistance to stimu-
late private sector investment
in developing countries
4, Multilateral Investment Guar- Provides guarantees against
antee Agency (MIGA) losses caused by non-com-
mercial risks to investors in
developing countries
5. International Centre for Settle- Provides international facili-
ment of Investment Disputes ties for conciliation and arbi-
(ICSID) tration in case of investment
disputes
(Source: World Bank (2007). A guide to World Bank, 2°4 Edition.)

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The WBG, through its five institutions, uses financial resources and
its knowledge base to help developing countries reduce poverty, in-
crease economic growth and improve standards of life (World Bank,
2007). IMF follows the following strategies to attain its goals:
Q Supporting the creation of a favourable investment climate and
Q Empowering poor people

The WBG has set the following Millennium Development Goals (MDG)
that direct the group’s priorities:
Q Eradicate extreme poverty and hunger
Achieve universal primary education
DO

Promote gender equality and empower women

ODO

Reduce child mortality

OO

Improve maternal health

Combat HIV/AIDS, malaria and other diseases
OOO

Ensure environmental sustainability

Develop a global partnership for development

WBG is currently the largest source of educational programmes all

over the world and the largest source of external funding for erad-
icating HIV/AIDS. In addition, it plays a prominent role in fighting
corruption, supporting debt relief and funding diversified projects, in-
cluding water supply and sanitation.

The five institutions of WBG have their own Articles of Agreement,

which articulate their respective purpose, organisation and opera-
tions. A country can become a member of the institution by signing
these documents. Each institution is owned by its member countries.
The number of member countries varies with IBRD having 185 mem-
bers, and ICSID having 148 as of 2007. Each country has voting power
depending on the shares held by it. As of 2006, the US is the largest
shareholder (16.39%) with maximum voting power. The group is head-
quartered in Washington, DC.

3.5.2 INTERNATIONAL MONETARY FUND (IMF)

IMF was a creation of the Bretton Woods Conference that was con-
vened in 1944 for designing the post-war international monetary sys-
tem. The delegates from 44 countries that participated in the confer-
ence agreed to build a framework of economic cooperation that would
monitor and prevent competitive devaluations, which was one of the
major reasons of the Great Depression of the 1930s.

The primary purpose of IMF is to ensure the stability of the interna-

tional monetary system, which includes the system of exchange rates

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NOTES

and international payments. It enables different countries to transact

with each other (IMF, 2015). This mandate was updated in 2012 to in-
clude all macroeconomic and financial sector issues that affect global
stability.

IMF, head quartered in Washington, DC, currently has 188 member

countries. It is governed by an executive board consisting of 24 direc-
tors each representing a single country or a group of countries. It has
a total quota of US $327 billion and additional pledged resources or
committed resources of US $885 billion. Its biggest borrowers as of
2015 are Portugal, Greece, Ireland and Ukraine. Its original objectives
were to:
Q Promote international monetary cooperation
Q Facilitate the expansion and balanced growth of international
trade
Q Promote foreign exchange stability
Q Assist in the establishment of a multilateral system of payments
Q Make resources available (with adequate safeguards) to members
experiencing balance of payment difficulties (IMF 2015)

Some of the important events reflecting the contribution of IMF to-

wards the stability of the international monetary system over the
years are given as follows:
1. Cooperation and reconstruction (1944-1971): Aftermath of the
great depression of the 1930s, countries raised major barriers to
foreign trade, devalued their currencies for promoting export
competitiveness and curtailed freedom to hold foreign exchange.
These protectionist measures resulted in sharp decline in the
volume of world trade. This in turn had adverse effects on the
economic growth and living standard of the people in different
countries of the world. This led to the realisation of the need for
international monetary cooperation and the creation of IMF. The
Bretton Woods Conference envisaged IMF to play an active role
in ensuring exchange rate stability and greater international
trade.
During the period between 1945 and 1971, most countries followed
the Bretton Woods System of exchange rate mechanism. IMF was
entrusted with the responsibility of overseeing the international
monetary system envisaged by the conference. Therefore, IMF
worked towards ensuring stability in exchange rate and removing
protectionist measures that hampered international trade.
2. The end of the Bretton Woods System (1972-1981): The Bretton
Woods System collapsed in 1973. Consequently, IMF member
countries were allowed to freely choose their own exchange rate
arrangements. This period was marked by oil price shocks and
the resulting impact on current account deficits of oil importing

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NOTES

countries. IMF helped the oil importing countries to deal with

the oil price shocks. In mid-1970s, IMF helped poor countries
in managing their balance of payment difficulties by providing
concessional finance through the creation of the Trust Fund. In
1986, IMF created a new concessional loan programme called
the Structural Adjustment Facility (SAF) and later the Enhanced
SAF in 1987 (IMF, 2015).
The critiques of IMF, however, maintain that the IMF assistances
were associated with macroeconomic policy prescriptions and
conditions that forced these countries to liberalise their financial
market. This exposed them to exchange rate volatility. In addition,
these prescriptions included deflationary macroeconomic
policies and elimination of various subsidy programmes meant
for the disadvantaged sections of the society. These policies
provoked resentment among the people of developing countries
receiving the IMF’s assistance for managing the balance of
payment difficulties.
3. Debt and painful reforms (1982-1989): The oil crisis led to
inflation and economic recessions across many countries, which
ultimately led to an international debt crisis. During this period,
petrodollars of OPEC countries were lent to the oil importing
developing countries through floating rate loans. When the
interest rates soared coupled with recession, developing
countries resorted to further borrowings leading to a debt crisis.
During the Mexican crisis in 1982, IMF played an active role in co-
ordinating a global response and defusing a potential full-fledged
international financial crisis. Moreover, IMF played a significant
role in the consequent painful reform process initiated in various
debtor countries.
4. Demise of the Soviet Union and Asian Upheaval (1990-2004):
The demise of the Soviet Union and creation of the new eastern
bloc countries increased the membership of IMF from 152 to 172
in 1991. IMF was expanded to include directors from countries,
such as the Russia Federation. IMF played a significant role in
the economic transformation of the countries from erstwhile
Soviet Union from centrally planned economies to market-
driven capitalist economies.
During this period, when Asian Financial Crisis broke out, the
role of IMF became crucial as many countries required external
financial assistance. IMF came into severe criticism during this
period as there were divergent views on how to cope with the
crisis. IMF has admitted that it drew several lessons on how to
alter its responses to future events. It took several initiatives
based on the experiences of the Asian Financial Crisis.
5. Globalisation and financial crisis (from 2005): The globalisation
and free movement of capital across international borders
associated with global economic crisis triggered by the subprime

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NOTES

mortgage crisis in the US created new challenges for the financial

stability of the international monetary system. According to the
IMF the latest global crisis exposed the fragility in the advanced
financial markets and has resulted in the worst global downturn
since the Great Depression. The role of IMF has become more
crucial with many countries seeking financial and policy support.
To ensure effective utilisation of its funds, which currently
stands at $ 750 billion, IMF has overhauled its lending policies
and embarked on other reforms tailored to help the low-income
countries.

F7 SELF ASSESSMENT QUESTIONS

11. All of the following institutions are a part of the World Bank
Group except:
a. IBRD b. IFC
c. MIGA d. ADB
12. The original objectives of IMF did not include which of the
following:
a. Promote exchange rate stability
b. Assist in the establishment of a multilateral system of pay-
ments
c. Facilitate the expansion and balanced growth of interna-
tional trade
d. Address macroeconomic and financial sector issues that
bear on global stability

With the help of the Internet, conduct a research on the MDGs of

the World Bank and their progress in India. Make a note of your
findings.

PY; INTERNATIONAL LIQUIDITY AND

we) SPECIAL DRAWING RIGHTS (SDRS)

The fixed exchange rate regime of the Bretton Woods System relied
on the international liquidity of reserve assets. However, the inter-
national supply of two key reserve assets under this system proved
inadequate to be able to support the world trade and financial devel-
opment. This problem necessitated the creation of a new internation-
al reserve asset. Therefore, IMF created the Special Drawing Right
(SDR) as an international reserve asset in 1969. SDR was meant to
supplement the member countries’ official reserves and support the

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fixed exchange rate arrangement of the Bretton Woods System. It was

designed as a basket currency comprising major individual curren-
cies. The SDR is neither a currency nor a claim on the IMF It is only
a potential claim on the freely usable currencies of the IMF members.
Therefore, SDR plays the role of a supplementary reserve asset (IMF,
2015). Initially, it was based on the weighted average of 16 currencies
of those countries whose shares in world exports exceeded more than
one per cent. It was allotted to the member countries for usage among
themselves or with the IMF. Under the Bretton Woods System, central
banks of countries were maintaining reserves in either USD or gold.
With the introduction of SDR, these countries were expected to use
SDR reserves for making international payments. However, with the
collapse of the Bretton Woods System and the emergence of an inter-
national monetary system where major currencies float freely against
each other and growth in the international capital markets that could
cater to the needs of governments, have greatly lessened the need for
the SDR. In 1981, SDR was modified to include only five major cur-
rencies—US dollar, German mark, Japanese yen, British pound and
French franc. Currently, it is based on four key currencies due to the
advent of Euro—USD, Euro, Japanese yen and British pound. The
value of SDR in terms of the US dollar is determined daily and provid-
ed on the IMF’s website—imf.org.

Each member country of the IMF is allocated SDR in proportion to

the member country’s quota in IMF. SDR provided the member coun-
tries a costless and unconditional international reserve asset. As of
2015, SDR 204.1 billion equivalent to $280 billion were created and
allocated to member countries.

3.6.1 QUANTITATIVE EASING, MONETARY STIMULUS BY

MAJOR CENTRAL BANKS AND SUB-PRIME CRISIS

All Most all countries of the world keep facing one or the other type of
shock or problem. A shock refers to an event that occurs due to natural
calamities or the significant movement of trade activities in domestic
and international markets. The shocks that occur due to movements
in financial markets are called economic shocks. These are unpredict-
able shocks that may be positive or negative for an economy and in-
volve mass job layoffs, winding up of many businesses, frequent trade
shocks, etc.

Economic shocks can be realised in the form of supply shocks or de-

mand shocks or due to unanticipated devaluation of currency. Sup-
ply shocks involve decrease in supply and increase in prices. Demand
shocks involve a huge change in the demand of a product.

In case a country faces shocks for a continuous period of time and

the monetary policy adopted by the central bank fails to achieve price
stability and economic growth in a country, the central bank of the
country will have to take certain critical measures to bring back econ-

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108 INTERNATIONAL FINANCE

NOTES

omy in a good condition. These measures may include expansionary

monetary policy and quantitative easing. An expansionary policy is
adopted when the ordinary monetary policy made by the central bank
fails. Under this policy, the central bank buys government and other
securities (long term as well as short term) from open market in order
to lower interest rates and increase money supply. Due to lower inter-
est rates, financial activities in the market get a boost.

A specific type of expansionary policy is quantitative easing. Under

this policy, the central bank buys long-term government and other
securities from the open market in order to lower interest rates and
increase money supply. This is done to increase money supply in the
financial system.

Let us discuss the sub-prime crisis of 2008.

SUB-PRIME CRISIS OF 2008

Sub-prime crisis of 2008 is also known as the sub-prime mortgage cri-

sis or the mortgage mess. The US economy had suffered the dotcom
bubble in 2000 and was at the risk of a deep recession. The US was
also shocked by the 9/11 terrorist attack in 2001 on the World Trade
Tower. As US is the main trading currency, anything that affects the
US dollar also affects all countries and currencies of the world. The
whole world including all central banks of countries wanted to stim-
ulate economic activities for which they lowered interest rates. Since
the rate of interest was lowered, investors wanted to make better re-
turns by making riskier investments and lenders (banks and FIs) also
took risks by approving sub-prime mortgage loans to borrowers with-
out checking their credit position. No prior credit history checks re-
sulted in huge demand for credit by individuals for purchasing houses
which led to housing bubble of 2005 that ended in 2006. All these sub-
prime lending resulted in lending to those individuals who could not
repay their loan amounts. As a result, various large lenders (banks
and FIs including Lehman Brothers) and hedge funds had to declare
themselves bankrupt.

After the crisis, the existing borrowers were paying their loans from
their savings and banks were not lending, which led to the dilution of
economic growth all over the world. The subprime crisis of the US af-
fected all countries. For instance, the Bank of England had to roll out
a QE programme.

& SELF ASSESSMENT QUESTIONS

13. Initially, SDR was based on the weighted average of

currencies of those countries whose shares in world exports
exceeded more than one per cent.

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NOTES

Make a group of your friends and discuss the role of SDR in main-
taining international liquidity.

5 OTHER FINANCIAL INSTITUTIONS

In addition to IMF and WBG, there are a number of international

institutions in the world that play an important role in the interna-
tional monetary system. These institutions include the International
Finance Corporation (IFC), Asian Development Bank (ADB), World
Trade Organisation (WTO), New Development Bank (NDB), Asian
Infrastructure Investment Bank (AIIB). Let us now study the role of
these institutions in the international monetary system.

3.7.1 INTERNATIONAL FINANCE CORPORATION (IFC)

International Finance Corporation (IFC) is one of the five institutions

forming a part of the WBG as discussed earlier. IFC was set up in 1956
and currently it has 179 countries as its members. It was created to
facilitate lending to the private enterprises, as World Bank can lend
only to governments. Currently, IFC is the largest multilateral source
of funds for private enterprises in developing countries.

The mission of IFC is promoting sustainable private sector investment

in developing countries to reduce poverty and improve the living stan-
dards of people. IFC mobilises capital from international financial
markets, facilitates trade, helps clients improve social and environ-
mental sustainability, and provides technical assistance and advice to
governments and businesses (World Bank, 2007).

Since its inception, IFC has committed more than $56 billion of its
own funds for investment in private sector enterprises of the devel-
oping world. In addition, it has mobilised an additional $25 billion in
syndications. The nature of assistance provided by the IFC includes
providing equity, long-term loans, loan guarantees, structured finance
and risk management products, and advisory services. It targets re-
gions and markets that have limited access to capital. Such markets
may be generally considered too risky for investment by other private
sector commercial investors. IFC is a major international player in
project financing and advisory services meant for private businesses
in developing countries.

IFC considers the following five as the key pillars of its strategy:
1. Focusing on the frontier markets
2. Building long-term relationships with emerging global companies
in the developing countries

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NOTES

3. Promoting environmental and social sustainability

4. Addressing the constraints faced by the private sector growth in
infrastructure
5. Developing financial markets through designing innovative
products and building institutions

3.7.2. ASIAN DEVELOPMENT BANK (ADB)

The Asian Development Bank (ADB) was founded in 1966 with a vi-
sion to make Asia and Pacific poverty-free and help developing mem-
ber countries to improve the living standards and quality of life of their
people. ADB is dedicated to improve people’s lives in Asia and the Pa-
cific—home to 1.4 billion poor people, living without access to essen-
tial goods, services, assets and opportunities. It provides assistance to
countries in these regions in the form of loans, grants, policy dialogue,
technical assistance and equity investments. ADB also plays a crucial
role in development thinking and practice, disseminating information
through regional forums and publication of specialised papers, serials
and books (adb.org, 2015).

Currently, ADB has 67 countries as its members, with a subscribed

capital of $153.05 billion. It is headquartered in Manila, Philippines.
ADB has entered into partnership with member governments, inde-
pendent specialists and other financial institutions to deliver projects
that create economic and development impact. Towards this objec-
tive, it had $22.93 billion in approved financing in 2014.

Some of the projects completed by ADB in several poorest countries

during 2014 are:
Q > Building or upgrading educational facilities for the benefit of over
17 million students
Building or upgrading 25,000 km of roads
UO

Making clean drinking water accessible to 1 million households

vo

Installing 230 megawatts of new generation capacity

o

Reducing greenhouse gas emissions by 600,000 tons of carbon di-

oO

oxide equivalent per year

3.7.3 WORLD TRADE ORGANISATION (WTO)

WTO is an international organisation that deals with the norms of

global trade among nations. WTO ensures that the international trade
flows occur smoothly, predictably and freely.

WTO was founded in 1995 as a successor to the existent General Agree-

ment on Tariffs and Trade (GATT). Presently, WTO has 160 members
with 25 others negotiating for membership. The WTO secretariat is

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NOTES

based in Geneva and it does not have branch offices outside Geneva.
The WTO secretariat does not have the decision-making role as the
members themselves make the decisions. The WTO achieves its ob-
jective of ensuring free and fair trade flow by:
Q Administering trade agreements
Acting as a forum for trade negotiations
UO

Settling trade disputes

oO

Reviewing national trade policies

oOo

Assisting developing countries in trade policy issues through as-

O

sistance and training

Q Cooperating with other international organisations

The multilateral trading system under GATT was developed through

a series of trade negotiations or rounds. The WTO rules are the re-
sult of negotiations among its member countries. The initial rounds
dealt with tariff reductions, while the later ones on areas, such as an-
ti-dumping and non-tariff measures. The last round in 1986-1994 held
at Uruguay led to the creation of WTO. The current set of WTO rules
was the outcome of the Uruguay Round. The complete set of WTO
rules runs to around 30,000 pages of documents consisting of about
30 agreements and separate commitments made by individual mem-
bers. Through these agreements, WTO members operate a non-dis-
criminatory global trade system with clearly stated rules, rights and
obligations.

As a part of the WTO negotiations, the talks on agriculture and ser-

vices started in 2000. The recommendations were incorporated into
a broader work programme—the Doha Development Agenda (DDA)
launched at the 4th WTO ministerial conference in Doha, Qatar, in
2001. The agenda includes negotiations on non-agricultural tariffs,
trade and environment, WTO rules on anti-dumping and subsidies,
investment, competition policy, trade facilitation, intellectual proper-
ty, etc.

The decisions in WTO are made through a consensus between mem-

ber countries. These decisions are ratified by the parliaments of in-
dividual member countries. The apex decision-making authority of
WTO is the Ministerial Conference, which holds meeting at least once
every two years. The next level of decision-making happens through
General Council. Further down, the Goods Council, Services Coun-
cil and Intellectual Property (TRIPS) Council report to the General
Council.

3.7.4 NEW DEVELOPMENT BANK (NDB) BRICS

The BRICS countries—Brazil, Russia, India, China and South Afri-

ca comprise more than 41% of the world’s population. In addition,

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112 INTERNATIONAL FINANCE

NOTES

these countries cover more than a quarter of the world’s land area
over three continents, and account for more than 25% of the global
GDP An idea of creating a development bank operated by the BRICS
countries was first proposed by India at the 4th BRICS summit held
in Durban, South Africa, in 2013. It was the main theme on the agenda
for the summit. The leaders stressed on setting up an international
bank at par with Asian Development Bank, IMF and World Bank.

An agreement on the New Development Bank was signed by BRICS

countries on July, 2014. The New Development Bank BRICS (NDB
BRICS), formerly referred to as the BRICS Development Bank, was
formally launched on 21st July, 2015, in Shanghai with KV Kamath,
the former chairman of ICICI bank, as its first president. On inaugu-
ration, KV Kamath declared that the objective of the bank is not to
pose a challenge and alter the existing system, but to improve and
complement the system.

The NDB BRICS was created as a multilateral development bank to

be operated by the BRICS countries to promote cooperation among
these nations in financial development. Therefore, the NDB BRICS is
meant to provide an alternative to the existing US-dominated World
Bank and IME As per the Articles of Agreement, the NDB BRICS will
not have the voting power based on capital share (as is the case with
IMF and World Bank Group), but share equal voting rights. Also, none
of the countries will have any veto power.

3.7.5 ASIAN INFRASTRUCTURE INVESTMENT BANK (AITIB)

Asian Infrastructure Investment Bank (AIIB) was an initiative of Chi-

na, which wanted to establish a multilateral development bank for the
Asian countries. The bank was envisaged to promote interconnectivity
and economic integration in this region and work in cooperation with
the existing multilateral development banks. In 2014, 22 Asian coun-
tries gathered in Beijing to sing the Memorandum of Understanding
(MOU) to establish AIIB.

AIIB will focus on developing the infrastructure and other productive

sectors, such as energy and power, transportation and telecommuni-
cations, rural infrastructure, agricultural development, water supply
and sanitation, environmental protection, urban development, and
logistics, etc., in Asia. It will complement and cooperate with the exist-
ing MDBs to jointly address the infrastructure and economic develop-
ment needs in Asia.

Current, the core philosophy, principles, policies, value system and

operating platform of the bank are in the development stage. The pro-
cess of setting up the bank is still in progress and is expected to com-
mence operation by the end of 2015.

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NOTES

&e SELF ASSESSMENT QUESTIONS

14. In which of the following respects does IFC differ from the
World Bank:
a. It lends for developmental projects of governments
b. It lends for infrastructure projects of governments
It lends to private sector companies
9

None of the above

a.

Make a group of your friends and discuss the relevance of AIIB.

se. SUMMARY
Q. The international monetary system is essential for global stability
and a good understanding of the international financial environ-
ment requires a study of the prevailing global monetary system.
Its functions include facilitating monetary cooperation, ensuring
the stability of world financial system, facilitating greater interna-
tional trade and movement of capital, ensuring orderly payment
mechanism, providing global liquidity and ensuring confidence in
global financial system.
Q The world monetary system has evolved from the classical gold
standard in the period of 1876-1913 to the Bretton Woods System
(1946-1971) to the current flexible exchange rate regime.
Q The classical gold standard involved pegging of currencies to the
price of gold.
Q The Bretton Woods System involved a US dollar-based gold-ex-
change standard. This involved USD being pegged to gold while
all other currencies pegged to USD.
Q The fall of Bretton Woods System is normally attributed to the
Triffin’s paradox.
Q The flexible exchange rate regime allows each individual country
to freely choose its exchange rate regime.
Q The currently prevailing exchange rate regimes range from the
fixed rate arrangement to freely floating arrangement.
Q There are currently four different types of exchange rate arrange-
ments prevailing in different countries, viz., hard pegs, soft pegs,
floating regimes and residual.

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NOTES

Q The four types include ten different categories of exchange rate

arrangements.
Q India follows the (managed) floating exchange rate arrangement.
Q India has allowed market determined exchange rates and 100%
current account convertibility. It is moving towards full capital ac-
count convertibility.
Q The World Bank Group consists of five different institutions. The
IFC, which is a part of the WBG is involved in lending to private
sector enterprises.
Q The IMF was created as a part of the Bretton Woods System. It is
now responsible for the global financial stability and international
monetary cooperation among others.
Q IMF created Special Drawing Rights (SDRs) as a new artificial
international reserve asset to supplement the dollar and gold
reserves of the central banks during Bretton Woods era. Its im-
portance and relevance has lessened after the demise of Bretton
Woods System.
Q New Development Bank BRICS (NDB BRICS) and Asian Infra-
structural Investment Bank (AIIB) are some of the new financial
institutions created in the recent years that are a part of the inter-
national monetary system.

KEY WORDS

Q Asian Development Bank (ADB): A financial institution found-

ed in 1966 with a vision to make Asia and Pacific poverty-free
and help developing member countries to improve the living
standards and quality of life of their people.
Q Bimetallism: The exchange rate regime that allows the usage
of both gold and silver as the medium of exchange.
Q BRICS: The acronym for Brazil, Russia, India, China and South
Africa.
Q Currency board: A monetary arrangement based on an ‘explic-
it legislative commitment to exchange domestic currency for a
specified foreign currency at a fixed exchange rate’.
Q General Agreement on Tariffs and Trade (GATT): A multilat-
eral agreement regulating the international trade between 1948
and 1995.
Q International monetary system: Global financial environment
constituting international agreements, policies, rules and mech-
anisms, and the associated international financial institutions
that govern the conduct of international trade and capital flow
among nations.

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NOTES

DESCRIPTIVE QUESTIONS
1. Explain the importance of International Monetary System (IMS).
What are the functions of IMS?
2. Explain the various exchange rate regimes that prevailed since
1876.
3. Elaborate on the features of the Bretton Woods System. Explain
why the system failed.
4. List the various exchange rate regimes currently prevailing in
different countries.
5. Write a short note on the roles of IMF and the World Bank Group
(WBG).
6. Describe the role of IFC in the international monetary system.

Sate ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Answer
Concept of International
Monetary System mon)
d. All of the above
.
Walaa tnearove
w

a~

Exchange Rate Regimes 4 . a. True

a. uired only US central
ank to maintain gold re-
serve to back USD
6. d. All of the above
» 4 d. All of the above
8. b. True
9. d. All of the above
Evolution of Exchange Rate 10. Pound sterling
Mechanism in India
International Financial 11. d. ADB
Institutions
12. d. Addressing macroeconomic
and financial sector issues
that bear on global stability
International Liquidity and i133, 16
Special Drawing Rights
(SDRs)
Other Financial Institutions 14. ce. It lends to private sector
companies

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NOTES

HINTS FOR DESCRIPTIVE QUESTIONS

1. The international monetary system is essential for global
stability. Its functions include facilitating monetary cooperation,
ensuring stability of world financial system, etc. Refer to Section
3.2 Concept of International Monetary System.
2. The exchange rate regimes can be classified into three phases,
viz., classical gold standard, Bretton Woods System and flexible
exchange rate arrangements. Refer to Section 3.3 Exchange
Rate Regimes.
3. Bretton Woods System is based on dollar-based gold-exchange
standard. Its failure is generally explained by Triffin’s paradox.
Refer to Section 3.3 Exchange Rate Regimes.
4. There are four types and ten categories of exchange rate
arrangement currently prevailing in different countries as per
IMF Refer to Section 3.3 Exchange Rate Regimes.
5. IMF and the World Bank Group (WBG) are some of the important
global institutions. Refer to Section 3.5 International Financial
Institutions.
6. International Finance Corporation (IFC) is one of the five
institutions forming a part of the World Bank Group. IFC was
set up in 1956 and currently, it has 179 countries as its members.
It was created to facilitate lending to the private enterprises,
as World Bank can lend only to governments. Refer to Section
3.7 Other Financial Institutions.

abl SUGGESTED READINGS FOR

=e REFERENCE

SUGGESTED READINGS
Q Cheol S. Eun, Bruce G. Resnick, International financial manage-
ment. New Delhi: Tata McGraw Hill.

Q Keith Pilbeam (2006). International finance. 3rd Edition. New

York: Palgrave Macmillan.

E-REFERENCES
Q International Monetary Fund (IMF) (2014). Annual report on ex-
change arrangements and exchange restrictions. IMF, Washing-
ton, DC.

Q Narendra Jadhav (2005). Exchange rate regime and capital flows:

The Indian experience. Chief Economists’ Workshop, Bank of En-
gland.

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 INTERNATIONAL MONETARY SYSTEM 117

NOTES

Q Reserve Bank of India (2010). Exchange rate policy and model-

ling in India. http:/$www.rbi.org.in/scripts/Publications
View.aspx-
?id=12252, accessed on 26th September, 2015.

Q The Economic Times (12th August, 2015). China’s currency dilem-

ma: It needs to stop fixing its exchange rate. New York Times, http://
economictimes.indiatimes.com/news/international/business/chi-
nas-currency-dilemma-it-needs-to-stop-fixing-its-exchange-rate/
articleshow/48450958.cms, accessed on 26th September 2015.
Q World Bank (2007). A guide to the World Bank. 2nd Edition, World
Bank Publication.
Q World Trade Organization (WTO) (2014). The World Trade Organi-
zation in brief. WTO, Switzerland.

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 BALANCE OF PAYMENTS

CONTENTS

4.1 Introduction
4.2 Concept of Balance of Payments (BOP)
Self Assessment Questions
Activity
4.3 Components of the BOP
4.3.1 Current Account
4.3.2 Capital Account and Financial Account
4.3.3 Changes in Official Reserves Account
4.3.4 BOP Classification in India
Self Assessment Questions
Activity
4.4 Accounting Principles of BOP
Self Assessment Questions
Activity
4.5 Importance of BOP
Self Assessment Questions
Activity
4.6 Limitations of BOP
Self Assessment Questions
Activity
4.7 BOP and Money Supply
Self Assessment Questions
Activity
4.8 India’s BOP
Self Assessment Questions
Activity
4.9 Capital and Current Account Convertibility
4.9.1 Role of IMF in Convertibility
4.9.2 Role of RBI — FEMA 1999, PMLA 2002 and LRS
4.9.3 Tarapore Committee Recommendations
Activity

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CONTENTS

4.10 India’s External Debt

4.11 FII, FDI and NRI Investments in India
4.12 Summary
4.13 Descriptive Questions
4.14 Answers and Hints
4.15 Suggested Readings for Reference

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INTRODUCTORY CASELET

ECONOMISTS SEEK TO EASE FEARS ON CHINA'S

RECORD CAPITAL OUTFLOW

Capital is flowing out of China at a record pace, sparking fears

over financial stability and complicating efforts by the central
bank to support a slowing economy with lower interest rates.

China ran a balance of payments deficit of $80 bn in the first

three months of the year, 2015 the largest quarterly net outflow
on record, according to official data. The outflows are all the more
striking because China’s trade surplus remained strong over the
period. As falling commodity prices slashed the country’s import
bill, it recorded a $79bn current-account surplus — the largest in
nearly five years.

But this was overwhelmed by outflows on capital and financial

accounts worth a record $159bn. The lure of China’s surging stock
market also failed to counter the outflow trend.

Although the outflows signal investor concern about China’s

economy, which grew at its slowest pace in six years in the first
quarter, a rising US dollar and declining Chinese interest rates
also helped draw funds out of the country.

“All things considered, Beijing would rather not have confi-

dence-sensitive capital going out”, said Tim Condon, head of Asia
research for ING Financial Markets in Singapore. By some mea-
sures, outflows have been continuing for more than a year. The
central bank’s holdings of foreign assets have dropped for seven
consecutive quarters — the longest run of declines on record.

But economists say that as yet, capital outflows have not accel-
erated to a level that would threaten the stability of the finan-
cial system. That such relatively small outflows even set a record
largely reflects the tight control Beijing has long maintained over
cross-border capital flows. And, even if the $80bn quarterly out-
flow is maintained for the entire year — an unlikely scenario — it
would still represent only 3 per cent of 2014 gross domestic prod-
uct and 9 per cent of foreign exchange reserves.

All this explains why Chinese officials do not appear overly con-
cerned. “Recent capital outflows represent an adjustment that is
within expectations. One can’t equate them with illegal and secret
capital flight,” Guan Tao, the Head of the Balance of Payments
Department at the State Administration of Foreign Exchange,
said last month.

According to analysts, it is also important to distinguish between

outflows of so-called “hot money” — purely financial investments

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INTRODUCTORY CASELET

— and foreign direct investment flows linked to a real economic

activity, which the government is actively encouraging. China has
a huge manufacturing sector and it’s looking for places to do busi-
ness cheaper. That’s cold money — there are goods and services
associated with it, said Mr Condon. Economists say even some
purely financial flows should be considered a healthy move by
Chinese savers to diversify into foreign assets rather than a sign
of panic about China’s slowing economy.

They also reflect recent reforms to loosen capital controls and

cautiously encourage financial outflows through initiatives such
as the Shanghai-Hong Kong Stock Connect, which allows main-
land Chinese to invest in foreig ities. Nevertheless, capital
outflows are complicating effort le’s Bank of China to
support the economy throu ng. For the past de-
cade, the central bank p hange inflows, which
is the main source of bas in the China’s banking
system. Now, with out threatening to shrink the money sup-
ply, the central ban ew mechanisms to expand it.
(Source: Extrac r eek to ease fears on China’s record capital out-
flow”, May, 19, 20 S
00144feabde0.html, accessed on 3rd October, 2015.
inancial Times Limited 2015.)

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NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

Explain the concept of balance of payments (BoP)
ry

Discuss the components of BoP

ryrrryr

Describe the accounting principles of BoP

Explain the importance of BoP
List the limitations of BoP
Relate BoP and Money Supply
State the importance of India’s BOP
Distinguish between capital and current account conv:
ibility
Describe India’s external debt
ry

Discuss FII, FDI and NRI investments in India 4

ZS INTRODUCTION

In the last chapter, you have studied about the international monetary
system. Let us now move forward to the concept of Balance of Pay-
ment (BoP).

The liberalisation and globalisation of the world economy have inte-

grated countries into a global hub. Nowadays, it has become a normal
practice for individuals or organisations or government to invest glob-
ally. However, it is of paramount importance for every country to make
optimal investments/expenditures at a global level.

If every country imports some goods and also exports, what should be
the quantum of such international trade? Suppose a country imports
a great deal of goods but exports minimum amount of products, what
kind of impact will it have on its economy? Intuitively, such practice
cannot last indefinitely. What about the reverse situation when anoth-
er country continues to export goods much more than what it imports
resulting in a consistent trade surplus? Should it be an issue at all for
the country? All these situations can create an imbalance in transac-
tions across the borders.

To tackle all kinds of problems related to imbalance in internation-

al trade, every country makes the statement of all the international
transactions that is called balance of payment (BoP). In simple words,
BoP of a country is a record of various transactions (payments and
receipts) between the country’s residents and the residents of other
countries. Based on the accounting principle, the two sides of BoP
(debit and credit) must be equal.

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NOTES

In this chapter, you will study about the concept of BOP its compo-
nents, accounting principles, its importance and limitations. Further,
you will study about a relationship between BoP and money supply. In
addition, the India’s BoP is explained in detail. Towards the end, var-
ious important concepts, such as Capital and Current Account Con-
vertibility, India’s External Debt and FII, FDI and NRI investments in
India are discussed.

ew CONCEPT OF BALANCE OF PAYMENTS

To analyse the level of international trade and related transactions

between countries, data is required pertaining to trade and capital
movement between countries. The profitability and financial sound-
ness of a company can be determined by analysing various financial
statements, such as balance sheet and profit and loss statement. These
financial statements provide insight into the assets, liabilities and
profits earned during a particular period by the company, etc. It is not
very different when it comes to analysing the economic transactions of
a country. The level of trade and financial soundness of a country can
be analysed through the formal statements published by the country.

Similar to the financial statements of companies, there are national

accounts pertaining to countries that measure their economic activ-
ities. They are generally referred to as The System of National Ac-
counts (SNA). The international SNA standard provides a framework
for accounting of national income that encompasses transactions,
stocks and other changes affecting the level of assets and liabilities.
The SNA covers transactions between ‘residents and residents’ and
‘residents and non-residents’.

With respect to transactions between ‘residents and non-residents’,

there are two important statements published by a country. These are:
Q BoP statistics

Q International Investment Position (IIP) statistics

These two statements are inter-related and are a subset of national

accounts. The BoP statement is a flow statement while the IIP is a
statement of position reflecting the stock of assets and liabilities per-
taining to transactions across borders. BoP isa statistical statement
that provides information pertaining to the following transactions:
Q Export of goods and services to other countries
Q Import of goods and services from other countries
Q Unilateral transfers to/from the country
Q Income payable and receivable with respect to other countries
Q Increase and decrease in foreign assets or liabilities

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NOTES

The International Monetary Fund (IMF) defines BoP as a statistical

statement that systematically summarises, for a specific time period,
the economic transactions of an economy with the rest of the world.
Transactions, for the most part between residents and non-residents,
consist of those involving goods, services, and income; those involving
financial claims on, and liabilities to, the rest of the world; and those
(such as gifts) classified as transfers, which involve offsetting entries
to balance—in an accounting sense—one-sided transactions.

From the above definition, the following viewpoints can be drawn re-
garding BoP:
Q It is a statistical statement of systematic summarisation: BoP
is a statistical statement published by each country using a set of
accepted standards and conventions. A detailed explanation of
these conventions is discussed later in the chapter. To facilitate
standardisation and comparison of BoP statements from different
countries, IMF issues a standard manual providing international-
ly accepted standards and rules for publishing data pertaining to
BoP The latest manual is called “Balance of Payments and Inter-
national Investments Position Manual” and was issued as the sixth
edition of the manual in 2009 (BPM6).
Q Itis for a specific time period: The BoP statement is prepared for
a specific time period as it is a flow statement like the trade and
profit and loss statement. It records transactions that occurred
during a particular time period. A country may issue a BoP state-
ment with a frequency of monthly, quarterly, half-yearly and/or an-
nually.
Q It includes economic transactions of a country with the rest of
the world: The statement records the value of all economic trans-
actions between residents, businesses and government with the
rest of the world for a specific period of time. The IMF manual
provides more detailed information on each of these categories
(for example, the concept of residence is not based on nationality
or legal status but based on the centre of economic interest. Sim-
ilarly, what constitute the rest of the world or non-resident is also
defined in the manual).

Note that BoP is not just about exports and imports of companies.
It also involves the transactions of individuals. For example, if a
Non-resident Indian (NRI) makes foreign currency deposit with
his bank in India, the transaction will be included in the BoP state-
ment.

Q The economic transactions include those involving goods, ser-

vices and income: As mentioned earlier, it includes the exports
and imports of goods, exports and imports of services and related
income (apart from capital account transactions mentioned next).

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It includes financial claims on, and liabilities to rest of the world:

Each export or import is done by exchanging a financial asset. For
example, when an Indian corporate exports goods to the US and
invoices it in US Dollars (USD), he expects the US importer to
make payment in USD as per the invoice amount. The BoP state-
ment records both the export transaction and the related financial
claim. For example, if the importer credits the exporter with USD
amount by depositing the amount in the USD Nostro account be-
longing to the Indian Bank where the exporter holds his account,
then it is considered as an increase in the financial claim of India
on the US (i.e. rest of the world).

Similarly, if a Foreign Institutional Investor (FII) belonging to the

US invests in the Indian stock market, he would deposit an equiv-
alent amount of USD into the Nostro account of an Indian bank
that would provide him with the required amount of Indian cur-
rency to purchase Indian stocks. This increase in dollar deposit in
the Nostro account of the Indian bank will lead to an increase in
the financial claim of India on the US. Similarly, the asset (stocks,
in this case) purchased by FII represents an increase in foreign
claim on Indian assets. Similarly, when an Indian corporate bor-
rows abroad in Euro currency, India’s liability to rest of the world
increases.
Q It includes transfers and gifts: The BoP statement also includes
transfer transactions that do not involve an exchange. Similarly,
gifts made in cash or kind between residents and non-residents
also form part of the BoP statement. The transfers can be current
or capital in nature.

& SELF ASSESSMENT QUESTIONS

1. statement also records increases and decreases in

foreign assets and foreign liabilities during a particular time
period.

Suppose a company has a subsidiary in another country. Should

the subsidiary’s transactions with the parent company be part of
the resident’s transactions? Download the latest BPM manual and
go through various terminologies and definitions.

LS COMPONENTS OF BOP

A particular format is followed by countries for preparing a BoP state-

ment. There are two major components of the BoP statement, which

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NOTES

need to be considered while preparing the BoP statement. These com-

ponents are:
Q Current account

Q Capital and financial account

There is also another important component that is part of the finan-

cial account called Official Reserves Account or Official Settlements
Account. This component is important for countries that have fixed
or managed floating exchange rate arrangement. Let us discuss these
components in detail.

4.3.1 CURRENT ACCOUNT

The first and foremost information that can be extracted from the BoP
statement pertains to the following:
Q What is the total export of goods from the country during the time
period?
Q What is the quantum of overall import done during the period?
Q What is the quantum of the inflow or outflow due to services like
consulting, IT services, financial services, etc.?
Q Is the value of total exports more than imports?
Q Is there a deficit in the trade account? Has there been more out-
flow of foreign exchange during the period?
Q What is the overall balance (deficit or surplus) arising out of var-
ious international economic transactions pertaining to the time
period?

The current account section of the BoP statement provides informa-

tion that can answer the above questions. Why is it called the current
account? The transactions that form part of this section pertain to the
current time period concerned and do not record those transactions
that involve a change in asset or liability (as you might be aware, an
asset or liability has future connotations. For example, an asset is ex-
pected to provide a series of cash flows in the future). However, an
import or an export transaction by itself does not have any such im-
plications.

In other words, the current account section only records economic

transactions pertaining to the movement of goods and services across
borders during the concerned time period. For example, an export
will also involve an inflow of foreign exchange into the country there-
by creating or increasing the claims of India on rest of the world. But,
that leg of the export transaction is not recorded as part of the current
account.

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N OT ES

Suppose a company borrows money abroad and imports some capital

goods and pays to the exporter through a loan obtained in foreign cur-
rency. In this case, the following transactions would take place:
Q Creation of a loan in foreign currency in the name of importer
Q = Value of goods imported
Q Payment by the importer to the exporter through bank transfers

Though all of these transactions form part of the BoP statement, the
current account segment will include only transactions pertaining to
the value of goods (as listed above). The net balance on the current
account segment gives exactly the difference between the exports and
imports of goods and services (and transfers) — an important informa-
tion pertaining to the international trade.

In terms of the standard presentation of the BoP statement (BPM6),

the Current Account (CA) segment will consists of transactions per-
taining to the following:
Q Flow of goods: This is the main segment of the current account
section and the most important part of the BoP statement. It in-
cludes all the exports and imports of goods between the residents
of the country and rest of the world. It is referred to as the mer-
chandise trade segment.
The exports are recorded with a positive sign (more on this in
accounting section) while imports with a negative sign. The dif-
ference between the exports and imports of goods is termed as
trade balance, which is applicable for the time period. If the trade
balance is positive, the country is said to have a trade surplus but
if the imports are higher, the country is said to have a trade deficit.
Q_ Flow of services: This includes export and import of non-tangible
items i.e. services, also called invisibles. There is no physical move-
ment of goods but the transaction might involve a service provided
by a resident to the rest of the world (or vice versa) in return for a
financial asset, say foreign currency. For example, if an investment
banker from the US provides financial consulting services to an
Indian company to raise External Commercial Borrowing (ECB)
abroad, the fee charged by the investment banker will form part of
the current account (with negative sign as its equivalent of import
of goods/services).
The services account (or invisibles account) might involve the ex-
port/import of services pertaining to the following areas:

¢ Transportation
¢ Travel

@ Telecommunications

+ Computer and information services

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Construction services
&

Insurance and pension services

“rf + &

Financial services
Charges for the use of intellectual property
+

Maintenance and repair services

Other business services

Personal, cultural and recreational services, etc.

Q Flow of primary income: This segment of the current account

involves inflows or outflows arising out of economic transactions
that are not part of merchandise trade or services. For example, if
an Indian MNC raises debt from international financial markets,
it has to pay interest on the loan on a recurrent basis. Similarly, if
the Indian government borrows money from some external agen-
cy, it needs to pay interest every year. These transactions can alter
the balance of flow of foreign exchange between countries. Thus,
these are also included as a part of the current account.
The flow of primary income includes the following transactions:

¢ Receipts and payments arising from external financial assets

and liabilities as mentioned above.

¢ Transactions take place between residents and non-residents

including the compensation of employees, which is received
from or paid to non-resident workers.
Q Flow of secondary income: This heading includes transfers. As
mentioned before, there are economic transactions that do not
involve an exchange but are unilateral in nature. For example,
a non-resident might gift some money to a resident without any
counter transaction in exchange. Such transactions are included
in this segment. A transfer is defined as an entry that takes place
corresponding to the provision of a good, service, financial asset
or other non-produced asset by an institutional unit to another in-
stitutional unit where there is no corresponding return of an item
of economic value. The transfer might be made in cash or kind
(involving the transfer of ownership of a good/asset or provision
of service.)

As mentioned before, the balance in the flow of goods (i.e. net ex-
ports-imports of goods) is termed as trade balance. When the balance
of other three segments viz., the services account, primary and sec-
ondary income accounts are included, the net balance is called Cur-
rent Account Balance (CAB).

CAB = Trade balance + Balance in services account (or invisibles

trade) + Balance in the primary and secondary income

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CAB = Trade balance + Invisibles balance

CAB could be positive or negative (irrespective of the trade balance).

If the CAB is positive, then the country is said to have a Current Ac-
count Surplus, else a Current Account Deficit (CAD). In general, the
CAD is referred to as the Balance of Payments Deficit.

Balance of payments deficit (or surplus) = Trade deficit (or Surplus)

+ Invisibles account deficit (or surplus) = Current account deficit (or
surplus)

For example, the trade balance of India for the year 2011-12 was US$
(-189,759) million indicating a deficit. The balance in the invisibles ac-
count was US$ +111,604 mn indicating a surplus. The overall current
account balance was US$ -78155 mn. Hence, India had a current ac-
count deficit (CAD) of US$ 78155 mn. In other words, for the year 2011-
12, India had a trade deficit of US$ 189,759 mn, CAD of US$ 78155 mn
and BoP Deficit in the current account of US$ 78155 mn.

Generally, when we say a country has BoP deficit problem, we only

refer to the CAD of the country. This current account deficit will be
financed through the Capital Account about which we will be discuss-
ing next.

Note that unlike the current account transactions, there cannot be

any concept of deficit in the case of capital account transactions (Do
you understand why? You will understand it better once you study the
concept of capital accounts and the accounting concepts behind the
BoP statement).

4.3.2 CAPITAL ACCOUNT AND FINANCIAL ACCOUNT

In the previous section, you have studied only about the movement of
goods and services (along with income and transfers) between coun-
tries. But, the BoP statement should reflect all economic transactions
that have happened between the residents of a country and rest of the
world during the time period concerned. What are the other transac-
tions apart from the current account transactions already recorded?

First and foremost, the current account only records the value of
goods and services but not related payments. If an Indian manufac-
turer imports capital goods worth $ 10 mn, it is recorded as imports
in the current account. With just this transaction alone, the CAD of
India would be $ 10 mn. How does the importer pay this $ 10 mn?
This payment transaction will be recorded in the capital and financial
account segment of the BoP statement. For example, suppose the im-
porter instructs his banker, HDFC Bank, to purchase $ 1 mn from the
foreign exchange market by debiting his bank account and credit to
the exporter’s bank account abroad. This transaction will be recorded
in the capital account. In other words, accounting entry representing

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NOTES

the import of goods will impact both the current account and the cap-
ital account. The value of goods inflow/outflow will be recorded in the
current account while the corresponding payment will be recorded
in the capital and financial account (In the above example, where we
consider only one import transaction for the entire period, the CAD
will be $ 10 mn while the capital account will have a surplus of $ 10
mn).

Apart from entries pertaining to the current account, there can also
be several other transactions which are ‘Capital’ in nature. Remem-
ber, a capital transaction would result in increase/decrease of assets/
liabilities. A capital transaction will have implications for the future
years, for e.g., in terms of interest and principal repayments. On the
other hand, current account transactions related to the consumption
of exports and imports (includes however capital goods) would affect
the current disposable income of the country concerned. For exam-
ple, financial transactions that involve acquisition of financial assets
or disposal of financial liabilities would form part of capital and finan-
cial accounts. Similarly, the transactions pertaining to acquisition and
disposal of non-financial assets would also fall under the capital and
financial account heading.

Apart from the offsetting entries pertaining to the current account

that are recorded in the financial accounts, unique transactions per-
taining to capital and financial accounts are:
1. Direct investments
Portfolio investments
NW

Financial derivatives
Oo PF WwW
Ao

External assistance

Transactions related to non-produced non-financial assets

Capital transfers between residents and non-residents
Transactions pertaining to changes in foreign exchange reserves

Under the heading of ‘Capital and Financial Accounts’, the transac-

tions pertaining to first four items are categorised under the heading
of ‘Financial Accounts’, the next two transactions (5 and 6) under the
heading of ‘Capital Accounts (using the new terminology for capital
account)’ and the last set of transactions (7) under ‘Official Reserves
Account’. A detailed explanation of the Official Reserves Account is
given in the next section.

CAPITAL ACCOUNT (AS PER NEW TERMINOLOGY OF BPM6)

The capital account comprises of capital transfers receivable and pay-

able between residents and non-residents, and the acquisition and
disposal of non-produced, non-financial assets between residents and

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NOTES

non-residents. As mentioned above, the capital account comprises of

transactions pertaining to:
Q Non-produced, non-financial assets and
Q Capital transfers between residents and non-residents

The first item involves acquisition and disposal of non-financial and

non-produced assets. These do not involve financial assets or liabil-
ities, which will be considered in the capital account. The non-pro-
duced non-financial assets include natural resources (like mineral
rights, lands fishing rights, spectrum etc.), contracts, leases and li-
cences and marketing assets (and goodwill). The second item above
involves any transfers between residents and non-residents which are
capital in nature.

FINANCIAL ACCOUNT (CAPITAL ACCOUNT IN TRADITIONAL

TERMINOLOGY)

According to BPM6, a financial account should record transactions

relating to financial assets and liabilities that take place between res-
idents and non-residents. It would include transactions pertaining to
the acquisition and disposal of financial assets. All financial transac-
tions that are capital in nature involving increase or decrease in finan-
cial assets and financial liabilities during the period will form part of
this account.

The most vital concept with regard to the capital and financial ac-
count is that the sum of capital account and financial account balance
should be equal in magnitude and opposite in sign to that of the cur-
rent account balance.

This is because the BoP statement is prepared on the basis of dou-

ble-entry accounting principles that are followed in the field of finan-
cial accounting. This means every transaction that arises out of the
seven categories listed above will have two legs: debit and credit —
both of them posted within the capital and financial account segment
of the BoP statement. Hence, the net balance that arises out of the
capital and financial transactions will be zero as the debit balance will
be equal to the credit balance. However, the offsetting entries arising
out of the current account will result into a debit balance or credit
balance depending on CAB. If CAB is in deficit (or debit balance), the
balance that arises out of the corresponding offsetting entries in the
capital and financial account will be surplus i.e. credit balance.

Hence, the following identity holds good for BoP accounting:

Current account balance = Capital and financial account balance

CAB deficit (or Surplus) = Capital and financial account surplus (or
deficit)

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If we segregate individual categories of the capital and financial ac-

count, then the following equation would take place:

Current account balance = Capital account balance + Financial ac-

count balance + Changes in the official reserves account

What is the role of official reserves account (part of the capital and
financial account as per conventions) and why does it find a place in
the above identity? The importance of official reserves account is ex-
plained in detail in the next section.

4.3.3 CHANGES IN OFFICIAL RESERVES ACCOUNT

The central banks of countries hold reserve assets. It would consist of

financial instruments used by central banks for financing or absorb-
ing imbalance of payments or for regulating the size of such imbalanc-
es. Such instruments normally include gold, foreign currency assets
in terms of cash, foreign currency deposits, bonds and other securities
of other governments, Special Drawing Rights (SDR) of IME etc. The
Reserves Account gives the balance of foreign exchange reserves held
by the central bank of a country. For example, the Foreign Exchange
Reserves of India as on 2015 is approximately $ 700 bn.

The central bank of a country may carry out transactions that have
impact on the balance on foreign exchange reserves for the following
purposes:
Q To absorb any imbalance of payments in forex markets
Q = To intervene in forex markets to influence the exchange rate of the
domestic currency

When the central bank carries out such transactions, the balance in
official reserves would change. The changes in reserves would then
form part of the BoP statement under the heading of Changes in Of-
ficial Reserves Account.

For example, consider our first hypothetical example of a single eco-

nomic transaction of import for $1 mn. We assumed that the importer
will instruct his banker to purchase USD from forex markets and the
banker will purchase it from another commercial bank. If no banker is
willing to transact and provide the required USD, then the bank might
approach the central bank to purchase $ Imn. The central bank will
provide this forex out of its foreign exchange reserves. The decrease in
official reserves implies a change in the official reserves balance and
hence will become part of the BoP statement. Thus, the only counter
transaction in the capital and financial account in our example will
be that of a decrease in reserve assets. As per accounting principles,
a decrease in asset account implies a credit and thus this credit to
official reserves (that decreases the official reserves balance) will au-
tomatically be the second leg of the import transaction of the current

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NOTES

account. Thus, the CAD has been financed by a surplus in the capital
account financed by the central bank in this example.

In general, the net change in official reserves account (also called the
official settlements account) is an important element of the BoP state-
ment for countries that have fixed or managed floating exchange rate
arrangement. In these countries, the central bank might have to fre-
quently intervene in the forex markets in order to maintain the fixed
rate or manage the floating rate arrangements. The consequent inflow
or outflow of foreign exchange will then become an important balanc-
ing figure in the BoP statements.

In the case of countries with free floating exchange rate arrangements,

the exchange rate will find its own level in order to match the cur-
rent account deficit or surplus. There will be no need for the central
authorities to intervene in forex markets. Hence, a change in official
reserves account is an important component of BoP statement mainly
for those countries that do not allow their exchange rates to float free-
ly. For example, the CAB of the United States for the year 2000 (in $
billions) was a deficit of $ 444.60. The balance in capital and financial
account was a credit of $ 444.26 (excluding statistical discrepancies).
The change in the balance in Official Reserve Account was a meagre
debit of $0.80. This will be the case for all developed economies where
the currencies allowed to float freely.

In the case of India, for the year 2011-12, the CAB was a deficit of
$78155 mn. The capital and financial account balance was a credit of
$ 65323 mn. This implies that the current account deficit was financed
by the capital account transactions only to an extent of $ 65323 mn.
The rest of the amount was reflected in changes in official reserves.
The balance in the changes in official reserves Account was the exact
balancing figure of $ 12831 mn. This implies that the Reserve Bank of
India has injected foreign exchange into the market to the tune of $
12831 mn during the year by using foreign exchange reserves. But it is
not necessary that foreign exchange reserves should decrease. In the
case of year 2013-14, India’s CAD was $ 32397 mn. The credit balance
in capital and financial account was $ 47905. This means that there
was a net addition to foreign exchange reserves as the capital account
surplus was greater than the current account deficit. Thus, changes
in the official reserves account of the BoP statement were a debit bal-
ance of $ 15508 mn implying net addition to the forex reserves of the
country. This means RBI might have intervened to mobilise foreign
exchange so that rupee does not appreciate from the targeted policy
level exchange rate.

4.3.4 BOP CLASSIFICATION IN INDIA

India is currently following the 5" edition of Balance of Payments

Manual of the IMF and has partially implemented the standards of
BPM6. BPM6 requires detailed classifications under the heading of

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NOTES

general merchandise. However separate classifications of non-mon-

etary gold, separate transactions in capital accounts, etc. are yet not
implemented.

The current practice of compilation of BoP in India is broadly in line

with the international best practices except for the presentation. The
capital account part of ‘capital and financial account’ is subsumed in
the current account, and the financial account is called capital ac-
count of India’s BoP The basic structure of the capital account of In-
dia’s BoP consists of assets and liabilities covering direct investment,
portfolio investment, loans, banking capital, short term credits and
other capital.

The data on exports and imports are gathered through customs and
banking channels. The exports and imports data are mainly based on
the reports submitted by the Authorised Dealers (ADs) on various for-
eign exchange transactions. The data regarding FDI, ADR, GDR, NRI
deposits, etc. are also obtained from the reporting of ADs like com-
mercial banks and other foreign exchange dealers.

ee SELF ASSESSMENT QUESTIONS

2. The two major segments of the BoP statement are:

a. Current account and financial account
b. Capital account and financial account
Current account & capital and financial account
9

Export and import

2

Visit the RBI website, download the latest BoP statement and study
the various components. Comment on the balance in the official
reserves account. How and why is it changing every year?

(FE AccOUNTING PRINCIPLES OF BOP

The BoP statement is prepared on the basis of the principles of the
double-entry accounting system. As per these principles, each trans-
action recorded in the statement should have two entries viz., a debit
entry for the value of the transaction and a credit entry for an equal
value. The rules for determining the credits and debits are based on
the same principles, which are as follows:
Q The asset account will have a debit balance. An increase in asset
value implies a debit entry. For example, if cash is used to purchase
an asset, then the asset account will be debited and the cash asset

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NOTES

will be credited. This is because the asset size increases while cash
asset decreases.
Q = The liability account will have a credit balance. To increase the
liability, we need to credit a liability account.
Q A revenue/income account is credited with sales similar to a lia-
bility account. For example, a sales transaction will involve cred-
iting the revenue account and debiting the cash account as cash
increases.
Q The expense or purchase account is debited with purchases. The
other entry will go to an asset or liability account. For example,
purchase of goods will imply debiting the purchase account and
crediting the cash account.

The transactions in the BoP statement will use the above financial ac-
counting principles. The accounting transactions based on the above
principles will involve either debit or credit as follows:
Q Credit (Cr.) entries: The credit entries are posted for the following
aspects of transactions:

+ Exports of goods and services

+ Income receivable
¢ Unrequited transfer receipts

@ Reduction in foreign assets

+ Increase in foreign liabilities
Q Debit (Dr.) entries: A debit entry for the transaction value is post-
ed for the following aspects of transactions:

¢ Imports of goods and services

+ Income payable

+ Unrequited transfer payments

¢ Increase in foreign assets

+ Reduction in foreign liabilities

The capital and financial accounting transactions record increases or

decreases in the asset or liability accounts. Hence, the first two prin-
ciples above will be used for posting entries. In the case of capital ac-
count transactions, both the legs of transactions will be part of some
accounts in the capital and financial account category itself.

In the case of current account, there is no asset or liability account as

transactions are considered to be pertaining only to the current pe-
riod. Hence, the current account is treated like sales and purchasing
account. Any export is similar to a sale while an import is a purchase.

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Only the one leg of the accounting entry is posted in the current ac-
count while the other leg goes to the capital account.

When goods and services are exported, the relevant merchandise or

services account is credited. The corresponding debit entry will affect
the asset or liability account that forms part of the capital account
as discussed before. Similarly, when goods or services are imported,
the current account is debited and a corresponding asset or liability
account in the capital account is credited for an equal value. Thus,
when the imports of goods and services are greater than the exports
of goods and services, the current account will have a debit balance
implying a current account deficit. The counterpart entries posted in
the capital account will show an equivalent capital account surplus
with a credit balance.

The transactions pertaining to the income and transfers also utilise

similar financial accounting principles. An interest income received
on foreign investments of the residents implies increase in the balance
of income account which is similar to a revenue account. Hence, the
income account is credited for receipts and debited for payments (e.g.
interest payments on foreign borrowings). The corresponding cash or
deposit or other liability account in the capital account is posted with
the other leg of the accounting entry.

In the case of unilateral transfers, the transaction does not involve an

exchange of financial assets. Transfers could be current or capital in
nature. A current transfer is one that directly affects the level of dis-
posable income and influence the consumption of goods and services.
A capital transfer does not affect the disposable income. Only current
transfers are included in the current account. These are accounted
similar to receipts and payments.

mt,
| => NOTE

Some books suggest the following rules for posting BoP entries:
1. Credit transactions that result into the increment of conceptual
inflows or sources of foreign exchange.
2. Debit transactions that result into the increment of conceptual
outflows or uses of foreign exchange. These rules are more
applicable when the transactions involve foreign exchange.

There are cases where it may not be so:

1. When invoicing and payments are done in local currency
2. When two countries have the same currency for transactions
like EMU countries. You can still however use the above
rules if you assume that the transactions are always done ina
foreign currency.

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NOTES

ee SELF ASSESSMENT QUESTIONS

3. All the following transactions will have debit entries in the

BoP statement except:
a. Import of goods and services
b. Income receivable
Increase in foreign assets
9
2. Reduction in foreign liabilities

The European Monetary Union countries have adopted a common

Euro currency. When they trade among themselves, there is neither
any exchange rate risk involved nor inflow/outflow of foreign ex-
change. When countries trade on a single currency, does it anyway
alter the importance of BoP statement? Discuss.

ZS IMPORTANCE OF BOP

Let us recall the questions with which the chapter began:

Q. The theories of international trade and practice in the real world
indicate that international trade between countries is inevitable
and advantageous to the world economy as a whole. The data on
world trade shows every country imports some goods and exports
some other goods in varying trade balance between countries
across the world. What should be the nature of current account
balance of countries?
Q Japan runs a consistent current account surplus since 1980 while
the US runs a persistent current account deficit. Should the US or
Japan worry about their current account balance?
Q Countries like China and Japan are net creditor nations while the
US is a net debtor nation. What kind of implication do these facts
indicate for the respective nation?

All the above questions are some of the most important ones in the
open macroeconomics (especially in the global set-up) and have a
great bearing on the economic future of these countries. An answer to
these questions would involve applying open macroeconomic theories
and concepts related to international trade.

What is the role of BoP statistics in this context? First and foremost,
remember that, even to raise the above questions on the economic
future of countries, we require BoP statistics. Each of the above ques-

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NOTES

tions is based on the respective BoP statistics of the countries involved.

With the BoP statistics, you can find out the current account balance
of the respective countries and how it has varied over the years and
analyse its impact on the various other macroeconomic factors. Apart
from current account data, BoP also gives the statistics on capital
flow across the borders. While the first two questions listed above are
concerned with the current account, the third question deals with the
capital account.

The capital account segment of the BoP statement actually gives only
the net flow in assets and liabilities across the borders. As we have
studied, capital account transactions record the increases or decreas-
es in assets and liabilities due to the economic transactions between
residents and rest of the world. In order to answer the third question,
we also need the current position of the assets and liabilities owned
by the residents and non-residents of countries. This data is given by
another statement called International Investment Position (IIP). IMF
also requires the IIP statement to be submitted by countries along
with the BoP statement. In fact, in order to signify the importance of
this data, IMF has titled the sixth edition of BoP standards manual as
‘Balance of Payments and International Investment Position Manual’.

IMF has defined the IIP statement as a statistical statement that shows
at a point in time the value and composition of a) financial assets of
residents of an economy that are claims on non-residents and gold
bullion held as reserve assets, and b) liabilities of residents of an econ-
omy to non-residents. The difference between the financial assets and
liabilities of IIP is the net International Investment Position (IIP) of a
country, which could be positive or negative. Thus, the net ITP in the
case of Japan is positive while it is negative for the US.

The net IIP position is independent of the current account balance

for any particular year. However, as Japan is running consistent cur-
rent account surplus, it is able to invest most of foreign assets in other
countries thereby making it a net creditor nation as foreign financial
assets exceed liabilities. Thus, the IIP statistics should be read in con-
junction with the BoP data.

The BoP statistics with its data on current account balance and move-
ment of capital flows is also important from the domestic monetary
policy perspective. Remember the current account balance is a com-
ponent of the national income account. A study of the composition,
nature and impact of current account deficit/surplus on the national
economy is an important exercise in macroeconomic analysis. Thus,
by feeding the current account data to the System of National Ac-
counts (SNA), the BoP statistics serve as an important role in the eco-
nomic analysis of a country.

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&e SELF ASSESSMENT QUESTIONS

4. The BoP statement can provide information on whether a

country is a net debtor or net creditor. (True/False)

The IMF has titled the 6 edition of BPM as ‘Balance of Payments

and International Investment Position Manual’ to emphasise the
importance of ITIP Discuss the importance of IIP in conjunction
with BoP statistics.

ca LIMITATIONS OF BOP
Apart from many benefits of BoP there are some limitations of the
BoP statement, which are:
Q The BoP data is gathered from many data sources like customs,
banks, authorised dealers, etc. Unlike financial accounting where
each transaction involving both entries is made at the same time,
in the case of BoP data, the data pertaining to different legs of
transactions are obtained through different means. For example,
the export data is obtained through customs and reports of banks.
However, the corresponding capital flow data is obtained separate-
ly. This could lead to inaccurate recording of data.
Q It is not necessary that the central bank of the country will be able
to obtain all the relevant data applicable for the period. Some data
might not get included in the BoP statistics due to non-availability.

Due to reasons above and related causes, the debits and credits total
of BoP statement normally does not match. The difference is normally
accounted as a separate data item. This is normally called ‘Errors and
Omissions’ or ‘Statistical Discrepancies’. This is the balancing figure
after considering balances in all the accounts including the official re-
serves account. Hence, the BoP total is given by the following equation:

Total balance = Current account balance + Capital and financial ac-

count balance + Changes in official reserves + Net errors and omissions

The above total should be zero and the net errors and omissions figure
is the balancing figure.
Q The BoP data is obtained with a lag and utility of the data dimin-
ishes to that extent
Q The BoP data of a particular time period may not reflect compre-
hensively all the transactions of that time period. An import/export

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NOTES

or other transactions done in a particular period might have its

corresponding or related payment transaction reflected in another
period. This might occur due to inefficiencies in collecting all the
relevant data of a particular time period. This could distort the
BoP statistics applicable for the period.
Q The BoP statement by itself does not give much information on the
net debtor or creditor position of a country — though it provides
capital account flows — as it is mainly constructed to ascertain the
trade balance. The BoP statement should be read in conjunction
with the IIP statement in order to understand the net debtor/cred-
itor status of the country.

&e SELF ASSESSMENT QUESTIONS

5. A limitation of BoP statement is that it does not allow

ascertaining the net capital flow during a particular period
but only net current account deficit. (True/False)

The BoP statement is designed specifically for ascertaining the cur-

rent account balance. It does not give much information in terms
of capital account transactions unless read in conjunction with the
IIP statement. Do you agree? What are the advantages of the IIP
statement?

Zi BOP AND MONEY SUPPLY

In this section, let us discuss a link between the BoP statistics and
national accounts. The macroeconomic identity concerning national
accounts is given by the following equation:

GDP =C+G+I+X-M (1)

Where

GDP = Gross Domestic Product

C = Consumption

G = Government consumption

I = Gross capital formation

X = Exports of goods and services

M = Imports of goods and services

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The above equation includes only imports and exports and not related
income and transfers of current account. In order to include primary
income (e.g. foreign interest income) and secondary income (transfers)
which are part of the BoP current account data in the above equation,
Gross National Income (Gross National Income) is considered instead
of GDP

GNI = GDP + Net Foreign Income .(2)

GNI = GDP + Primary income + Secondary income

GNI=C+G+I+xX-M+BPI+BSI (3)

Where BPI is balance on primary income and BSI is balance on sec-

ondary income

From the BoP statistics, we know that current account balance, CAB
is given by:

CAB = X-M + BPI + BSI (4)

Substituting (4) in (8),

GNI=C+G+I1+CAB (5)

Also, Gross Savings, S is given by,

S=GNI-C-G (6)

Substituting (6) in (5) and rearranging,

CAB=S-I (7)

The identity (7) directly relates the current account balance parame-
ter to the important domestic economic parameters namely gross sav-
ings and investments.

This implies that the current account will be in deficit whenever do-
mestic gross savings is less than gross capital formation (or invest-
ments). A deficit/surplus in CAB thus implies net capital inflow/out-
flow from the country respectively.

For example, in the case of Japan, which runs consistent surplus on

CAB, the equation (7) implies that the domestic savings are more than
gross capital formation. This excess savings are invested in foreign
assets thereby making Japan a net creditor nation.

CAPITAL AND FINANCIAL ACCOUNT

We have already noted earlier that the current account balance should
be same as the capital account balance with the opposite sign.

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CAB = - (KAB + NFA) -.(8)

Where CAB is the Current Account Balance, KAB is capital account

balance and NFA is the net financial account balance (The negative
sign on the RHS of (8) is meant to indicate that the two sides will be
equal in magnitude and opposite in sign).

NFA = CAB - KAB (9)

NFA is the same as the net lending/borrowing.

The equation (9) can be used to ascertain the net lending or borrowing
of the country with the rest of the world during the period.

CURRENT ACCOUNT AND BUDGET DEFICITS

To analyse the CAB data of the BoP statement from the perspective of
budgetary deficits, we need to modify earlier equations to include tax
expenditure.

The Disposal Income, YD is given by Gross National Income less Tax

From equation (5):

GNI =C+G+I1+CAB
YD =GNI-T=C+G+I1+CAB-T ..-(10)
YD =C+G+I1+CAB-T
CAB =YD-C-G-I+T
CAB = YD-C-I+(T-G) .(11)

The term (YD-C) represents the private savings of the country and the
term (T-G) represents government deficit/surplus.

CAB = (S-I) + (F-G)

CAB = Private savings — Gross capital formation +Government defi-

cit/surplus

CAB = Net private savings +Government deficit/surplus .(12)

The equation (12) interprets the current account balance in terms of

net private sector savings and the government deficits/surplus.

The equation (12) implies an important relationship with regard to the

current account deficit. It says a deficit in the current account deficit
could be due to either:
1. Deficit in net private savings and/or
2. Government budgetary deficit

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The equation is an identity and does not say anything about causation.
It only says that the deficit in the current account has a counterpart in
either private dissaving and/or in a government deficit. It is quite pos-
sible that the Current Account Deficit (CAD) may be responsible for
the lack of private savings or budgetary deficit. Table 4.1 gives some
real world data representing the equation (12) for the year 2006:

TABLE 4.1: ECONOMIC DATA OF FEW COUNTRIES

Country Net Budget Current
(2006, $ bn) Private Savings Deficit Account Balance
United States 2.2 —4,2 -6.4

United Kingdom +1.1 a> -3.3 2.2

Germany +7.4 —2.7 +4.7

Japan 10 ss +37
Table 4.1 shows that Japan and Germany had a current account sur-
plus in 2006 while also having budget deficits. On the other hand, the
UK had net positive private sector savings but still had a current ac-
count deficit.

CURRENT ACCOUNT BALANCE AND MONEY SUPPLY

The equation (12) established a relationship between the current ac-

count balance and budget deficits. You must be aware that budget
deficits have a direct implication for the money supply. In general, a
large government deficit is normally associated with a large current
account deficit. If the government finances its budget deficits through
the issuance of additional public debt or printing money, it would lead
to higher money supply and the resultant inflationary pressures in the
economy.

In this respect, the monetary policy of the central bank of a country

plays an important role in managing the current account balance. If
the CAB deficit is due to deficit in domestic savings, it implies an ex-
cess of domestic spending over income due to higher investments over
available domestic savings. This could be due to an expansionary mon-
etary policy adopted by the central bank. In such cases, the central
bank should ensure that the real interest rates of the economy are suf-
ficiently high enough to induce private savings. The level of domestic
expenditure should be maintained in line with the productive capacity
of the economy. From the perspective of BoP analysis, the objective of
monetary and fiscal policies should be to limit domestic spending to
what is available from domestic resources and foreign financing.

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SELF ASSESSMENT QUESTIONS

6. An increase in the current account surplus will lead to a

budget deficit thereby increasing money supply and inflation.
(True/False)

Download data related to budget deficits and current account

balance of India over the last 10 years. Discuss the reasons for
persistent current account deficits.

EF INDLAs BOP
India’s international trade has increased manifold in size during the
last 10 years. The quantum of merchandise trade increased from US$
195.1 billion in 2004-05 to US$ 764.6 billion in 2013-14. However, In-
dia’s share in global exports and imports is still only around 1.7% and
2.5 % respectively, though its ranking among leading exporters and
importers has improved from 30 and 23 in 2004 to 19 and 12 in 2013.
The major chunk of India’s imports is constituted by petroleum, oil
and lubricants (POL) imports, which were around 36.6% of total im-
ports in 2013-14 and 28.7% in 2014-15. The major share of exports from
India is from the sector of manufactured goods accounting for over
63% (petroleum and coal, 20% and agricultural products, 13.7%). In-
dia’s total merchandise trade was around 41.8% of GDP in 2013-14.

The current account of India’s BoP data over the years shows that
India has been consistently posting trade deficits over the years. The
quantum of trade deficit was US$ 147.61 bn in 2013-14. The net in-
visibles (services, incomes and transfers) account shows a significant
positive balance over the years. The surplus in the invisibles account
has greatly reduced the quantum of current account deficits (CAD).
For the year 2013-14, the CAD was US$ 32.39 bn due to a surplus of
US$ 115.21 bn in the invisibles account.

In the case of capital and financial account, there was a net capital
inflow of US$ 48.79 bn in 2013-14. The major capital inflow was due
to Foreign Direct Investments (FDD, portfolio investments, external
commercial borrowings and non-resident deposits. The surplus in
capital account was more than sufficient to finance the CAD and has
led to an increase in official reserves assets by US$ 15.50 bn. Figure 4.1
shows the BOP position of India according to the Economic Survey
2013-14:

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SL Item 2009-10 2010-11 2011-12F® 2012-13F® 2013-14"

No.
I Current account
1 Exports 182442 256159 309774 306581 318607
2 Imports 300644 383481 499533 502237 466216
3 Trade balance -118202 -127322 -189759 -195656 -147609
4 Invisibles (Net) 80022 79269 111604 107493 = 115212
A. Services 36016 44081 64098 64915 72965
B. Transfer 52045 53140 63494 64034 65276
C. Income -8038 -17952 -15988 -21455 = -23028
Current account balance -38180 -48053 -78155 -88163 -32397
II Capital account
i. External assistance 2890 4041 2296 982 1032
ii. External commercial 2000 12160 10344 8485 11777
borrowings
iii. Short-term debt 7558 12034 6668 21657 -5044
iv. Banking capital of which 2083 4962 16226 16570 25449
Non-resident deposits 2922 3238 11918 14842 38892
v. Foreign investment 50362 42127 39231 46711 26386
A. FDI 17966 11834 22061 19819 21564
B. Portfolio investment 32396 30293 17170 26891 4822
vi. Other flows -13259 -12484 -7008 -5105 = -10813
Capital account balance 51634 63740 67755 89300 48787
Capital account (ineluding 51622 61104 65323 91989 47905
errors & omissions)
III Errors & omissions -12 -2636 -2432 2689 -882
IV Overall balance 13441 13050 -12831 3826 15508
V Reserves change -13441 -13050 12831 -3826 -15508
(-indicates increase,
+indicates decrease)
Source: Reserve Bank of India (RBI).
| Notes: PR. partially revised; P: preliminary
~

Figure 4.1: India’s BoP Position

(Source: Reserve Bank of India, Economie Survey 2013-14)

India has a healthy foreign exchange reserves, which is important, as

it follows a managed floating exchange rate arrangement. The foreign
exchange reserves were at US$ 304.2 bn at the end of March 2014. Af-
ter Brazil, India is the second largest foreign exchange reserve holder
among major economies with CAD.

&e SELF ASSESSMENT QUESTIONS

7. India’s BoP statement shows major capital flows through FDI,

FII and ECBs. (True/False)

India’s BoP statement shows variations in changes in official re-

serves account. It was a negative figure in 2011 but positive in 2012.
Prepare a report on the changes in the official reserves account of
India’s BoP and the importance and relevance of Foreign exchange
reserves.

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CAPITAL AND CURRENT ACCOUNT

CONVERTIBILITY

Convertibility of a currency refers to the freedom, for both residents

and non-residents, to freely purchase, use and exchange currency for
whatever purpose they desire. This means that there are no restric-
tions enforced on the convertibility or usage of the currency by the
authorities of the country that has issued the currency. Many of the
developed countries like the US have their currency freely convertible
for various purposes like international trade, financial investments,
remittances, etc.

The transactions that require convertibility of currency need not per-

tain only to exports and imports. A resident or a non-resident may like
to purchase financial assets, make foreign direct investments, etc. If
a currency is fully convertible, it should be possible to carry out any
such transactions. However, the degree of convertibility varies across
countries. In some countries, there could be restrictions even for trade
transactions or on the usage of foreign exchange proceeds. In other
countries, there may not be any restrictions on export and import re-
lated transactions but convertibility for the purpose of investment ac-
tivities could be restricted.

For the purpose of promotion of international trade, it is necessary

that countries make their currencies convertible for at least trade and
related transactions. However, free convertibility for such transac-
tions might imply an implicit floating exchange rate arrangement. For
developing countries, it may not be possible to allow free convertibil-
ity for trade transactions as it might be undesirable for them to allow
exchange rates to be determined by market forces. Such countries
may not have sufficient foreign reserves to maintain a fixed exchange
rate also. Hence, the degree of convertibility varies across countries.

At present, many countries have their currency fully convertible for

trade-related transactions but not for the purchase or sale of financial
assets. In other words, there are two types of currency convertibility:
current account convertibility and capital account convertibility.

Using BoP terminologies, we can differentiate these two types of con-

vertibility. Current account convertibility means that there are no re-
strictions imposed by the authorities for the following transactions:
Q Merchandise exports and imports
Q Export and import of service (or invisibles trade)
Q Receipt and payment of income related to investments
Q Transfers

All the above transactions form part of the current account segment of
the BoP statement. If a country allows all the above transactions to be

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freely carried out between its residents and rest of the world, then the
country’s currency is convertible under the current account.

Similarly, capital account convertibility means that there are no re-

strictions imposed by authorities for carrying out following transac-
tions by its residents and non-residents:
Q Foreign direct investments from abroad
Q Direct investments by residents abroad
Q Portfolio investments by residents and non-residents
Q Short-term investments and loans

If a currency is fully convertible under the capital account, then any

individual — whether resident or non-resident (i.e. both ways) - will be
able to undertake any of the above transactions without any restric-
tions or a need for approval from any government authorities.

4.9.1 ROLE OF IMF IN CONVERTIBILITY

As discussed in the previous chapter, one of the important reasons

behind the institution of the Bretton Woods regime was that countries
were involved in protectionism and economic nationalism in the post-
war period. Countries were putting trade restrictions and currency
exchange controls in order to prevent imports and promote exports.
Towards this twin objective of removing trade barriers and unfair ex-
change control practices, the Bretton Woods conference instituted the
International Monetary Fund (IMF) and GATT (presently WTO).

With respect to regulating the international practices on exchange

control arrangements, the dollar based gold exchange standard was
established and followed by countries. However, the exchange rate
arrangement was mainly for the purpose of conducting international
trade through an orderly payment mechanism. There were not any
rules and regulations that were enforced with respect to the exchange
control restrictions, apart from the Bretton Woods exchange rate ar-
rangement.

However, IMF’s Articles contained a legal framework to provide the

basis for actively promoting the liberalisation of countries’ current ac-
count transactions.

The relevant sub-sections of Article VIII of IMF are given below:

Q Article VIII: Section 2. Avoidance of restrictions on current pay-
ments

a. Subject to the provisions of Article VII, Section 3(b) and Arti-

cle XIV, Section 2, no member shall, without the approval of
the fund, impose restrictions on the making of payments and
transfers for current international transactions.

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b. Exchange contracts involve the currency of any member and,

which are contrary to the exchange control regulations of
that member maintained or imposed consistently with this
Agreement shall be unenforceable in the territories of any
member. In addition, members may by mutual accord, coop-
erate in measures for the purpose of making the exchange
control regulations of either member more effective, provid-
ed that such measures and regulations are consistent with
this Agreement.
Section 8. Avoidance of discriminatory currency practices
No member shall engage in, or permit any of its fiscal agencies
referred to in Article V, Section 1 to engage in, any discriminatory
currency arrangements or multiple currency practices, whether
within or outside margins under Article IV or prescribed by or
under Schedule C, except as authorised under this Agreement or
approved by the Fund. If such arrangements and practices are en-
gaged in at the date when this Agreement enters into force, the
member concerned shall consult with the Fund as to their progres-
sive removal unless they are maintained or imposed under Article
XIV, Section 2, in which case the provisions of Section 3 of that
Article shall apply.
The sub-section 2 of Article VIII requires that no IMF member
should impose restrictions on the making of payments and trans-
fers for current international transactions. Sub-section 3 further
talks about the avoidance of discriminatory currency practices.
The above rules basically require member countries to make their
currency freely convertible for current account transactions.

As mentioned before, allowing even current account convertibility

requires some basic economic infrastructure and financial market
mechanisms that may not be available in the case of less developed
and developing countries. Hence, IMF through the Article XTV al-
lowed countries to avail transitional arrangements, which meant
countries can accept to abide by Article III at a later point in time,
when their economy is considered to be ready. This means though
many countries are the members of the IMF it is not necessary
that all of them have their currency freely convertible for their cur-
rent account.

As a consequence of globalisation and financial market integra-

tion, IMF had seriously considered advocacy of capital account
convertibility as a policy goal for developing countries in the 1990s.
An IMF meeting in 1997 considered the possibility of incorporat-
ing rules regarding capital account convertibility applicable for
developing countries into its Articles. However, the adverse effect
of financial globalisation in terms of rapid movement of capital
across borders with short-term objectives has greatly questioned
the feasibility and soundness of such a policy initiative.

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Many of the financial crises across developing and emerging econ-

omies were considered to have been originated from the unbri-
dled movement of capital across borders. The emerging Asian
countries did not have a sound economic foundation and financial
market infrastructure that could take such financial shocks arising
out of the free movement of capital. When countries allow a free
movement of capital under the capital account of BoP they run the
risk of their economies being unduly affected by external market
factors and global developments that may not have any bearing on
the soundness of the domestic economy. Even when a country is
strong enough, both economically and financially, to allow the free
movement of capital for its residents and non-residents, it will be
more prudent to allow the same, only under effective supervisory
system and related policy and market infrastructure. The current
challenge of the IMF is to manage the impact of financial global-
isation, free movement of capital and the related global financial
crises.

Let us now explain the Indian scenario related to convertibility.

India had a very restricted foreign exchange regime through the For-
eign Exchange Regulations Act (FERA), 1947. The rupee was not con-
vertible even for current account transactions and many transactions
under current account required prior approval from RBI. After eco-
nomic liberalisation and related reform measures, India declared its
compliance with Article VIII of the IMF in August, 1994. A legal frame-
work through Foreign Exchange Management Act (FEMA), 1999 was
established to facilitate free convertibility under the current account.

As the reforms process continued, India had allowed convertibility

for many of the capital account transactions. For example, many of
the capital account transactions of the BoP statement like foreign di-
rect investments, foreign portfolio investments, raising capital from
abroad by residents of India etc., are now allowed. However, rupee
is not yet fully convertible for capital account transactions as there
are still many approval mechanisms stipulated by RBI and the gov-
ernment for carrying out capital account transactions. For example,
Indian companies can raise capital abroad but only with some restric-
tions. These restrictions (e.g. minimum maturity should be 3 years)
are enforced through RBI regulations concerning the relevant trans-
actions. There are separate regulations issued by RBI for raising ex-
ternal commercial borrowings. Similarly, foreign investors can make
portfolio investments in stock markets subject to relevant regulations
but any investments in government debt securities are restricted.

4.9.2 ROLE OF RBI — FEMA 1999, PMLA 2002 AND LRS

As already discussed in the previous section, the central bank of a

country plays a pivotal role in ensuring a healthy money supply in

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the economy, which leads to the favourable position of BoP In India,

RBI plays a crucial role in building a healthy regulatory framework by
making and implementing various schemes and policies. Many a time,
the Acts are issued to provide a legal ground to critical issues. Let us
discuss some important Acts and schemes made by RBI to ensure a
healthy money flow through the foreign exchange across the globe.

FOREIGN EXCHANGE MANAGEMENT ACT (FEMA) 1999

FEMA was enacted by the Parliament of India on 29" December 1999

and this Act replaced the Foreign Exchange Regulation Act (FERA),
1973. It came into effect on 1st July 2005 which is an act to consolidate
and amend the law relating to foreign exchange with the objective of
facilitating external trade and payments and for promoting the orderly
development and maintenance of foreign exchange market in India.

A key feature of this Act is that everything was prohibited unless spe-
cifically permitted (a person is guilty until proven innocent) as against
the usual acts under which everything is permitted unless specifically
prohibited (a person is innocent until proven guilty). This Act stated
that all offenses related to the foreign exchange would be treated as
civil offenses while in FERA, they were treated as criminal offenses.
This Act endeavours to consolidate and strengthen laws relating to
foreign exchange and facilitate international trade and payments. It
also aims to develop and maintain a healthy foreign exchange market.
The Act extends to all over India and all its residents. In addition, it is
also applicable to all branches, offices and agencies outside India that
are owned or controlled by a resident of India.

Enforcement Directorate (ED) looks after all the matters related to

FEMA violations. The headquarters of ED is in New Delhi and is head-
ed by a Director. Presently, Karnal Singh is the director of ED. The ED
also has five zonal offices located in Delhi, Mumbai, Kolkata, Chennai
and Jalandhar, each headed by a Deputy Director. Each zonal office
also has seven sub-zonal offices also.

The main provisions of the FEMA Act are:

A. FEMA permits only authorised persons to deal in foreign
exchange or foreign security. Such an authorised person, under
the Act, means authorised dealer, money changer, off-shore
banking unit or any other person for the time being authorised
by Reserve Bank. FEMA prohibits different persons from dealing
in foreign exchange — persons who:

¢ Deal in or transfer any foreign exchange or foreign security

to any person not being an authorised person;

@ Make any payment to or for the credit of any person resident

outside India in any manner;

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@ Receive otherwise through an authorised person, any pay-

ment by order or on behalf of any person resident outside
India in any manner
¢ Enter into any financial transaction in India as consideration
for or in association with acquisition or creation or transfer
of a right to acquire, any asset outside India by any person;

# is resident in India which acquire, hold, own, possess or

transfer any foreign exchange, foreign security or any im-
movable property situated outside India.
B. FEMA Act regulates the ‘Capital Account Transactions’ and
‘Current Account Transactions. The provisions of FEMA with
respect to these transactions are as follows:
1. According to the Act, ‘Capital account transaction’ means a
transaction which alters the assets or liabilities, including con-
tingent liabilities, outside India of persons resident in India or
assets or liabilities in India of persons resident outside India,
and includes the following transactions referred in the Act:
vy Transfer or issue of any foreign security by a person res-
ident in India;
yY Transfer or issue of any security by a person resident out-
side India;

yY Transfer or issue of any security or foreign security by

any branch, office or agency in India of a person resident
outside India
y¥ Any borrowing or lending in rupees in whatever form or
by whatever name called;
vy Any borrowing or lending in rupees in whatever form or
by whatever name called between a person resident in
India and a person resident outside India;
v¥ Deposits between persons resident in India and persons
resident outside India;

vy Export, import or holding of currency or currency notes

vY Transfer of immovable property outside India, other than
a lease not exceeding five years, by a person resident in
India;

vy Acquisition or transfer of immovable property in India,

other than a lease not exceeding five years, by a person
resident outside India;

vy Giving of a guarantee or surety in respect of any debt, ob-

ligation or other liability incurred (i) By a person resident
in India and owed to a person resident outside India; or
(ii) By a person resident outside India.

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NOTES

2. FEMA also defines the term ‘current account transaction’ as

a transaction other than a capital account transaction and
without prejudice to the generality of the foregoing such
transaction includes: (i) payments due in connection with for-
eign trade, other current business, services, and short-term
banking and credit facilities in the ordinary course of busi-
ness; (ii) payments due as interest on loans and as net income
from investments; (iii) remittances for living expenses of par-
ents, spouse and children residing abroad; and (iv) expenses
in connection with foreign travel, education and medical care
of parents, spouse and children.
C. The Act has empowered the Reserve Bank of India (RBI) to
specify, in consultation with the Central Government, the
permissible capital account transactions and the limits up to
which foreign exchange may be drawn for such transactions.
However it shall not impose any restriction on the drawl of
foreign exchange for payments due on account of amortisation
of loans or for depreciation of direct investments in the ordinary
course of business.
D. Any person may sell or draw foreign exchange if such sale or
drawl is a current account transaction. Under the Act, Central
Government may, in public interest and in consultation with the
Reserve Bank, impose such reasonable restrictions for current
account transactions as may be prescribed.
E. Every exporter of goods shall (i) furnish to the Reserve Bank or
to such other authority a declaration in such form and in such
manner as may be specified, containing true and correct material
particulars, including the amount representing the full export
value or, if the full export value of the goods is not ascertainable
at the time of export, the value which the exporter, having regard
to the prevailing market conditions, expects to receive on the
sale of the goods in a market outside India; (ii) furnish to the
Reserve Bank such other information as may be required by it
for the purpose of ensuring the realisation of the export proceeds
by such exporter.
F The Reserve Bank may, at any time, cause an inspection to be
made, by any officer specially authorised in writing by it in this
behalf, of the business of any authorised person as may appear
to it to be necessary or expedient for the purpose of (i) verifying
the correctness of any statement, information or particulars
furnished to the Reserve Bank; (ii) obtaining any information or
particulars which such authorised person has failed to furnish
on being called upon to do so; (iii) securing compliance with the
provisions of this Act or of any rules, regulations, directions or
orders made thereunder.
G. If any person contravenes any provision of this Act, or
contravenes any rule, regulation, notification, direction or order

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issued in exercise of the powers under this Act, or contravenes

any condition subject to which an authorisation is issued by the
Reserve Bank, he shall, upon adjudication, be liable to a penalty.
(Source: http://www.archive.india.gov.in/business/legal_aspects/fema.php)

PREVENTION OF MONEY LAUNDERING ACT (PMLA), 2002

In India and throughout the world, people are involved in business or

jobs to earn money ethically. However, there are certain individuals
and organisations that generate revenues by using illicit, unethical or
criminal means and such money is usually referred to as black mon-
ey. This money cannot be deposited in banks or other investment op-
tions. This is because the source of such money becomes questionable.
Therefore, these individuals who possess black money try to process
and invest this money in such a way that its origin or source cannot be
traced. Black money may be earned by means such as sales of drugs,
prostitution, sale of illegal arms, crimes such as murders, insider trad-
ing, misappropriation of funds, bribes, cyber frauds, illegal lotteries,
robberies, etc. The aim of individuals earning money through illegal
means is to legitimise their money.

White money: Any money that an individual/corporate earns

through legal and legitimate means and pay tax on it.
Q Black money: Any money that is obtained by using illegal or
wrong practices or the money on which tax is not paid.

Money laundering is a problem that is faced by all the countries of

the world since many years. To tackle the growing menace of money
laundering, the Financial Action Task Force (FATF) was established
by the G-7 summit held in Paris in 1989. The very first work done by
FATF was to develop recommendations that the governments of var-
ious countries must implement along with effective anti-money laun-
dering acts. India is also an active member of FATF.

Prevention of Money Laundering Act was the 15* Act of 2003 and was
enacted on 17th January, 2003. This law came into force from 1st July
2005. After the law was passed, it has been amended twice. Preven-
tion of Money Laundering (Amendment) Act, 2009 became effective
from 1st June 2009 and the Prevention of Money Laundering (Amend-
ment) Act, 2012 became effective from 15th February 2018. This Act
is applicable to entire India. The objective of this Act has been clear-
ly mentioned in its preamble which reads as: An Act to prevent mon-
ey-laundering and to provide for confiscation of property derived from,
or involved in, money-laundering and for matters connected therewith
or incidental thereto. Additionally, there are provisions for punishing
those who are found involved in money laundering. All offenses related

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NOTES

to money laundering are investigated by the Enforcement Directorate

(ED), Ministry of Finance. The Financial Intelligence Unit (FIU) is the
agency that is responsible for the collection, analysis and dissemina-
tion of information regarding various suspicious transactions.

The complete Act is very elaborate and it is divided into 10 chapters

and 75 sections. The various definitions are covered in Section 2 of the
Act as follows:

1. In this Act, unless the context otherwise requires

a. “Adjudicating Authority” means an Adjudicating Authority
appointed under sub-section (1) of section 6
b. “Appellate Tribunal” means the Appellate Tribunal estab-
lished under section 25
ce. “Assistant Director” means an Assistant Director appointed
under sub-section (1) of section 49
d. “Attachment” means prohibition of transfer, conversion, dis-
position or movement of property by an order issued under
Chapter ITI
e. “Banking company” means a banking company or a co-op-
erative bank to which the Banking Regulation Act, 1949 (10
of 1949) applies and includes any bank or banking institution
referred to in section 51 of that Act
f. “Bench” means a Bench of the Appellate Tribunal
g. “Chairperson” means the Chairperson of the Appellate Tri-
bunal
h. “Chit fund company” means a company managing, conduct-
ing or supervising, as foreman, agent or in any other capacity,
chits as defined in Section 2 of the Chit Funds Act, 1982 (40 of
1982)
i. “Co-operative bank” shall have the same meaning as as-
signed to it in clause (dd) of section 2 of the Deposit Insurance
and Credit Guarantee Corporation Act, 1961 (47 of 1961)
j. “Deputy Director” means a Deputy Director appointed under
sub-section (1) of section 49
k. “Director” or “Additional Director” or “Joint Director” means
a Director or Additional Director or Joint Director, as the case
may be, appointed under sub-section (1) of Section 49
1. “Financial institution” means a financial institution as defined
in clause (c) of Section 45-I of the Reserve Bank of India Act,
1934 (2 of 1934) and includes a chit fund company, a co-oper-
ative bank, a housing finance institution and a non-banking
financial company

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m. “Housing finance institution” shall have the meaning as as-

signed to it in clause (d) of section 2 of the National Housing
Bank Act, 1987 (53 of 1987)
n. “Intermediary” means a stock-broker, sub-broker, share
transfer agent, banker to an issue, trustee to a trust deed,
registrar to an issue, merchant banker, underwriter, portfolio
manager, investment adviser and any other intermediary as-
sociated with securities market and registered under Section
12 of the Securities and Exchange Board of India Act, 1992
(57 of 1992)
o. “Member” means a Member of the Appellate Tribunal and
includes the Chairperson
p. “Money-laundering” has the meaning assigned to it in Sec-
tion 3;

q. “Non-banking financial company” shall have the same mean-

ing as assigned to it in Clause (f) of Section 45-I of the Reserve
Bank of India Act, 1934 (2 of 1934);
r. “Notification” means a notification published in the Official
Gazette;
s. “Person” includes
i. an individual
ii. a Hindu undivided family
ili. a company
iv. a firm
v. an association of persons or a body of individuals,
whether incorporated or not
vi. every artificial juridical person not falling within any of
the preceding sub-clauses, and
vii. any agency, office or branch owned or controlled by any
of the above persons mentioned in the preceding sub-
clauses
t. “Prescribed” means prescribed by rules made under this Act
u. “Proceeds of crime” means any property derived or obtained,
directly or indirectly, by any person as a result of criminal ac-
tivity relating to a scheduled offence or the value of any such
property
v. “Property” means any property or assets of every description,
whether corporeal or incorporeal, movable or immovable,
tangible or intangible and includes deeds and instruments
evidencing title to, or interest in, such property or assets,
wherever loc ted

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w. “Records” include the records maintained in the form of

books or stored in a computer or such other form as may be
prescribed
x. “Schedule” means the Schedule to this Act
y. “Scheduled offence” means
i. the offences specified under Part A of the Schedule; or
ii. the offences specified under Part B of the Schedule if the
total value involved in such offences is thirty lakh rupees
or more

EXHIBIT

SCHEDULE TO PMLA

The scheduled offences have been classified into two parts, Part A
and Part C. Part A includes offences under Indian Penal Code (IPC),
offences under Narcotic Drugs and Psychotropic Substances, of-
fences under Explosive Substances Act, offences under Unlawful
Activities (Prevention) Act, offences under Arms Act, offences un-
der Wild Life (Protection) Act, offences under the Immoral Traffic
(Prevention) Act, offences under the Prevention of Corruption Act,
offences under the Explosives Act, offences under Antiquities &
Arts Treasures Act etc.

Part C includes trans-border crimes. Before February, 2013, the Act

also contained Part B that required that the total money involved
in money laundering must be at least thirty lakhs in order to initi-
ate investigations. After February 2018, Part B had been included
in Part A which means that there is no threshold limit to initiate
investigations for money laundering offenses.

The various Acts covered in the Schedule to PMLA include:

Indian Penal Code, 1860
OoovovoOvOcoO oO

NDPS Act, 1985

oO

Unlawful Activities (Prevention ) Act, 1967

Prevention of Corruption Act, 1988

Customs Act, 1962

SEBI Act, 1992

Copyright Act, 1957
Trade Marks Act, 1999

Information Technology Act, 2000

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Explosive Substances Act, 1908

ovoOvoOvO
Wild Life (Protection) Act, 1972

Passport Act, 1967

Environment Protection Act, 1986
Arms Act, 1959
UO
z. “Special Court” means a Court of Session designated as Spe-
cial Court under Sub-section (1) of section 43
za. “transfer” includes sale, purchase, mortgage, pledge, gift,
loan or any other form of transfer of right, title, possession or
lien
zb. “value” means the fair market value of any property on the
date of its acquisition by any person, or if such date cannot be
determined, the date on which such property is possessed by
such person.
Any reference, in this Act or the Schedule, to any enactment or
any provision thereof shall, in relation to an area in which such
enactment or such provision is not in force, be construed as a
reference to the corresponding law or the relevant provisions of
the corresponding law, if any, in force in that area.

However, here we will explain/reproduce some important parts of this

as follows:
a Section 3 of the Act states that Whosoever directly or indirectly at-
tempts to indulge or knowingly assists or knowingly is a party or is
actually involved in any process or activity connected with the pro-
ceeds of crime including its concealment, possession, acquisition
or use and projecting or claiming it as untainted property shall be
guilty of offence of money laundering.
Section 4 of the Act states that whoever commits the offence of
money-laundering shall be punishable with rigorous imprison-
ment for a term which shall not be less than three years but which
may extend to seven years and shall also be liable to fine which
may extend to five lakh rupees: Provided that where the proceeds
of crime involved in money-laundering relates to any offence spec-
ified under paragraph 2 of Part A of the Schedule, the provisions of
this section shall have effect as if for the words “which may extend
to seven years”, the words “which may extend to ten years” had
been substituted.
Section 5 of the Act states that the property involved in money
laundering may be attached under the specified conditions.
Section 6 of the Act relates to the Adjudicating Authorities, their
composition, and powers.

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Q Section 8 of the Act states that if the Adjudicating Authority has

reason to believe that any person has committed an offence un-
der Section 3, it may serve a notice of not less than thirty days on
such person calling upon him to indicate the sources of his income,
earning or assets, out of which or by means of which he has ac-
quired the property attached. During this period, the person ac-
cused of money laundering can submit his reply and present his
defence in front of Adjudicating Authority.
Q Section 10 of the Act relates to management of confiscated prop-
erties
Q Section 10 of the Act lays out the obligations of banking compa-
nies, financial institutions and intermediaries, banking compa-
nies, financial institutions and intermediaries to maintain records
of financial transactions.
Q All the Scheduled Offences are Predicate Offences. It is important
that predicate offence must occur because without this, the inves-
tigation for money laundering cannot be initiated.
Q Police, Customs, SEBI, NCB and CBI, etc. may investigate predi-
cate offenses.

Q Sections 48 & 49 authorise the ED and its officials to investigate

money laundering offenses and they also have the authority to
confiscate the property.
Q There are special designated courts for pursuing the cases of mon-
ey laundering.
Q The various types of action that can be taken against the persons
involved in money laundering are as follows:
@ Attachment of property (Section 5)

¢ Seizure/ freezing of property (Section 17 or 18)

¢ Imprisonment in range of three-seven years along with fine
(Section 4)

@ The person who is arrested shall be produced before Judicial

Magistrate or a Metropolitan Magistrate within twenty four
hours after the arrest (Section 19)

@ The seized property/records cannot be seized or freezed be-

yond a period of 180 days unless the Adjudicating Authority
under PMLA permits. (Sections 20 and 21)

¢ Ifa woman is accused of money laundering, she cannot be ar-

rested by anyone except a female officer (Section 18).

¢ Section 23 states that where money-laundering involves two

or more inter-connected transactions and one or more such
transactions is or are proved to be involved in money-launder-

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NOTES

ing, then for the purposes of adjudication or confiscation under

section 8, it shall, unless otherwise proved to the satisfaction of
the Adjudicating Authority, be presumed that the remaining
transactions form part of such inter-connected transactions.

LIBERALISED REMITTANCE SCHEME (LRS)

Prior to 2004, all individuals required approval for remitting money

across the border. However, in 2004, a scheme called the Liberalised
Remittance Scheme (LRS) was introduced to enable individuals to
remit money without prior approvals. This was necessary because
the money remitted outside India decreases the foreign exchange re-
serves of India, which leads to lowering the value of the rupee against
dollars. It was introduced in 2004 but after that it has been revised
many times. According to the current LRS (effective from 1* June
2015), all the resident individuals are allowed to freely remit $250,000
overseas in a given financial year (April-March) for permissible cur-
rent account or capital account transactions or a combination of both.

The permitted remittances include overseas education, travel, med-

ical treatment, purchase of shares, property, gifting, donations, and
maintenance of relatives, travel for business or conferences, etc. Indi-
viduals may also open foreign currency accounts with overseas banks
for carrying out transactions. The remittances that are not permitted
include remittances for trading on foreign exchange markets, margin
calls to foreign exchanges, purchase of Foreign Currency Convertible
Bonds (FCCBs) issued abroad by an Indian company. Additionally,
the Financial Action Task Force has also identified some countries
as non-cooperative and terrorist countries and money cannot be sent
to these countries. These countries are listed in the FATF blacklist
(list of “Non-Cooperative Countries or Territories”). Currently, some
countries in this list include Algeria, Angola, Iran, Yemen, Papua New
Guinea, Afghanistan, Iran, Iraq, Bosnia, Uganda, Panama, etc.

Introduction of LRS has been done to decrease unnecessary stringent

controls on remittances while preserving essential controls. It endeav-
ours to decrease controls on the movement of foreign exchange in and
out of the country. It has made it easier for various individuals and
students to go abroad and study. In fully efficient and free markets,
there should be no controls; however, in countries such as India, it is
important to have certain controls on critical points because India is a
country dependent on imports and the usual trend has been that the
imports outweigh exports resulting in the negative Balance of Trade
(BoT) and freeing up the remittances can possibly have a negative
impact on exchange rates.

As mentioned earlier, after its introduction in 2004, LRS has been re-
vised so as to modify it as per the existent conditions. For example,
in 2013, India was facing a huge current account deficit and due to
this, RBI decreased the remittance limit to $75,000 only. However, to-

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NOTES

day the limit of remittance is $250,000. A lot of capital controls have

been put on remittances being made outside India but this needs to
be phased out gradually because it provides Indians an opportunity
to invest in different options available all over the world and not just
India. Until all the capital controls are phased out, LRS is an excellent
and the only legitimate means of making outward remittances.

4.9.3 TARAPORE COMMITTEE RECOMMENDATIONS

The Tarapore Committee is also known as the Committee on Capital

Account Convertibility. This committee was formed by RBI to pre-
pare a report on the feasibility of Full Capital Account Convertibility
in India. The committee was also asked to provide a framework using
which FCAC can be implemented. It was essential because there was
no clear definition of Capital Account Convertibility. The committee
was headed by S.S. Tarapore (the Chairman of the Committee), the
former Deputy Governor of RBI, and included five members. The
committee submitted its report to RBI in June, 1997.

As per the committee, CAC refers to the freedom to convert local fi-
nancial assets into foreign financial assets and vice versa. It is associ-
ated with changes of ownership in foreign/domestic financial assets
and liabilities and embodies the creation and liquidation of claims on,
or by, the rest of the world. CAC can be, and is, coexistent with restric-
tions other than on external payments.

The report stated that India adopted CAC in 1994 and there was cap-
ital account convertibility for foreign investors; however, Indian citi-
zens and corporates had to face various restrictions when they wanted
to send capital abroad. There were restrictions on the transfer of cap-
ital to banks and NBFCs. The report suggested that the CAC would
definitely benefit in international investments; however, it should not
be implemented before certain conditions are met as it would weaken
the domestic monetary policy.

In the report, the committee members pointed that three conditions

must be met in order to achieve FCAC, which includes fiscal consoli-
dation, a mandated inflation target and strengthening of the financial
system. The committee prepared a framework for three years using
which FCAC could be achieved by 2000. The pre-conditions required,
the following:
Q Gross fiscal deficit to GDP ratio was 4.5% in 1997-98 and commit-
tee recommended that it should come down to 3.5% till 1999-2000.

Q Setting up of a sinking fund in order to meet government’s debt

payment requirements. The sinking fund would be financed by in-
creasing the transfer of RBI’s profit and funds from divestment to
government.

Q The rate of inflation must remain between 3 and 5% during three

years, 1997-2000.

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Q The gross Net Performing Assets (NPAs) of the public sector banks
were 13.7% in 1997 and the committee recommended that they
must be brought down to a level of 5% by 2000.
Q The average Cash Reserve Ratio (CRR) for 1997 was 9.3% and the
committee recommended that it should be brought down to 3% by
2000.

Q RBI should maintain transparency of Real Effective Exchange

Rate (REER).
Q RBI should also have a band in the range of +5% to monitor ex-
change rate.
Q Design of foreign policies and external sector policies in such a
manner to increase current receipts to GDP ratio so that the debt
service ratio decreases to 20% from 25% in 1997.

The report suggested that FCAC can be achieved in a phased manner

as follows:
Q Phase I (1997-98)
Q > Phase II (1998-99)

Q Phase III (1999-2000)

There was a set of conditions, which should be achieved in one phase
in order to move to the next phase. The conditions were related to the
management of the fiscal deficit, keeping inflation under control and
reforms in the financial sector. The report also suggested the intro-
duction of FEMA and omission of FERA.

The major recommendations of the committee regarding the phased

implementation of CAC were as follows:
i. Indian Joint Ventures/Wholly Owned Subsidiaries (JVs/WOSs)
should be allowed to invest up to $50 million in ventures
abroad at the level of the Authorised Dealers (ADs) in Phase I
with transparent and comprehensive guidelines set out by the
RBI. The existing requirement of repatriation of the amount of
investment by way of dividend, etc., within a period of 5 years
may be removed. Furthermore, JVs/WOSs could be allowed to
be set up by any party and not be restricted to only exporters/
exchange earners.
ii. Exporters/exchange earners may be allowed 100 per cent
retention of earnings in Exchange Earners Foreign Currency
(EEFC) accounts for complete flexibility in operation of these
accounts including cheque writing facility in Phase I.
iii. Individual residents may be allowed to invest in assets in financial
market abroad up to $25,000 in Phase I with progressive increase
to $50,000 in Phase II and $100,000 in Phase III. Similar limits
may be allowed for non-residents out of their non-repatriable
assets in India.

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iv. SEBI registered Indian investors may be allowed to set funds

for investments abroad subject to overall limits of $500 million in
Phase I, $ 1 billion in Phase II and $2 billion in Phase III.

v. Banks may be allowed much more liberal limits in regard to

borrowings from abroad and deployment of funds outside India.
Borrowings (short and long term) may be subject to an overall
limit of 50 per cent of unimpaired Tier I capital in Phase I, 75 per
cent in Phase II and 100 per cent in Phase III with a sub-limit for
short-term borrowing. In case of deployment of funds abroad,
the requirement of section 25 of Banking Regulation Act and the
prudential norms for open position and gap limits would apply.
vi. Foreign direct and portfolio investment and disinvestment should
be governed by comprehensive and transparent guidelines, and
prior RBI approval at various stages may be dispensed with
subject to reporting by ADs. All non-residents may be treated on
par for purposes of such investments.
vii. Inorder to develop and enable the integration of forex, money and
securities market, all participants in the spot market should be
permitted to operate in the forward markets; FIIs, non-residents
and non-resident banks may be allowed forward cover to the
extent of their assets in India; all India Financial Institutions
(FIs) fulfilling requisite criteria should be allowed to become full-
fledged ADs; currency futures may be introduced with screen
based trading and efficient settlement systems; participation in
money markets may be widened, market segmentation removed
and interest rates deregulated; the RBI should withdraw from
the primary market in Government securities; the role of primary
and satellite dealers should be increased; fiscal incentives should
be provided for individuals investing in Government securities;
the Government should set up its own office of public debt.
viii. There is a strong case for liberalising the overall policy regime
on gold; Banks and FIs fulfilling well defined criteria may be
allowed to participate in gold markets in India and abroad and
deal in gold products.
(Source: http://www.capitalmarket.com/Macro/MacroEcoDis.asp?SID=2401&Scap=Convert-
ibility%200f%20Rs%200n%20Capital%20A/c.-%20A%20Report&Sscap=Press%20Note%20
on%20the%20report%20issued %20by %20the%20RBD

The recommendations of the Tarapore committee (constituted in

1997) could not be implemented fully. However, certain positive ac-
tions were taken such as:
Q Indian corporates could fully convert amounts up to $500 million
via automatic route in overseas ventures.
Q Limited companies were allowed to invest in foreign countries
Q Indian corporates could prepay loans of more than $500 million via
automatic route.
Q Gold could be imported in any quantity.

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Since India could not achieve FCAC by 2000 as per first Tarapore
committee’s report; RBI constituted a second committee again under
S.S. Tarapore to analyse FCAC and its implementation. This report
was made public in September, 2006. The report suggested that FCAC
can be introduced by following three phases:
Q Phase I (2006-07)
Q Phase II (2007-09)
Q Phase III (2009-11)

The major recommendations of this committee are as follows:

Q Raising the ceiling for ECBs under an automatic route.
Q NRIs should be allowed to invest in capital markets
Q Disallowing investment through money raised by using participa-
tory notes.
Q Allowing corporates to own a stake in public banks and allowing
them to open new banks
Q Allowing greater presence of foreign banks
Q Revenue deficit of the central and state government must be elim-
inated and the centre and states must strive to become a revenue
surplus at least (1% surplus) by 2011.

JOR RXeunss
With the help of the Internet, gather data pertaining to the scheme
issued by the central bank of the following countries:
Q China
Q US
Q Pakistan
Q UK
Analyse the impact of the schemes on the economy of the afore-
mentioned countries.

ZSUR INDIAS EXTERNAL DEBT

As discussed earlier, important information with regard to interna-

tional trade and capital flow between countries is the net debtor or
creditor position of an economy. Countries that post consistent cur-
rent account deficits finance their deficiency through the inflow of for-
eign capital. On the other hand, countries like Germany or Japan use
their current account surplus to make investments in foreign assets
abroad making them net creditor nations. Thus, BoP deficits can have
direct implications for the net debtor or creditor position of a coun-
try. CAD and net investment position of a country can also seriously

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NOTES

impact the exchange value of its currency and the performance of the
domestic economy. Persistent CAD and net debtor situation can lead
to inflation, currency depreciation and recessionary pressures though
there are also other factors that are involved.

However, the net debtor or creditor position of a country is not solely

determined by the current account balance or international trade sce-
nario of any particular year. The current account balance of a partic-
ular year indicates the net effect of international trade on the overall
net debtor/creditor position of the country.

In this section, we shall review the India’s external debt situation from
the perspective of international finance and BoP statistics. We shall
first review the external debt of India and then we shall take up the
Net International Investment Position (IIP) statistics. The major fea-
tures of India’s external debt are given below:
Q India’s total external debt was US$ 440.6 billion at the end of March
2014. This is equal to 23.3 % of India’s GDP
Q India’s external debt has higher, long-term debt as compared to
short-term debt. The total long-term debt was US$ 351.4 billion.
Q NRI deposits are also a part of the external debt and it has a signif-
icant share in total external debt.
Q Out of the total external debt, the sovereign debt stood at 18.5% as
of March 2014.
Q Majority of the external debt was denominated in US Dollars con-
stituting 61.8% of total debt followed by rupee denominated debt.
Q India’s debt-service ratio was at 5.9% in 2013-14.
Q The above parameters compare well with the other indebted de-
veloping nations.

India’s position was third in absolute external debt stock in the World
Bank’s ranking after China and Brazil. However, the ratio of external
debt to Gross National Income was at 20.8% as compared to 9.2% of
China.

The statistics presented above pertains only to the external debt situ-
ation of India. In order to understand whether India is a net debtor or
creditor nation, we also need to take into account foreign investments
in India and vice versa. As you are aware, capital account transactions
present an increase and decrease of various financial assets and liabil-
ities for a period. The capital account segment of the BoP statement
provides net capital inflow/outflow for the period. The IIP statistics is
a ‘Stock or Positional Statement’ similar to a balance sheet as it shows
the current position of assets and liabilities as on a particular date as
against the capital account of BoP which is a ‘flow statement’ like cash
flow statement. Like cash flow statement, the capital account of the
BoP statement explains the difference between IIP statistics of two
periods.

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N OT ES

International Investment Position (IIP) is a statistical statement that

shows the value and composition of the following:
a. financial assets of residents of an economy that are claims on on-
residents, and gold bullion held as reserve assets; and
b. liabilities of residents of an economy to non-residents.

Table 4.2 shows the IIP statistics for India:

(US $ billions)
TABLE 4.2: OVERALL INTERNATIONAL INVESTMENT PO-
SITION OF INDIA
Period Mar-13. Jun-13 Sep-13 Dec-13 Mar-14
(PR) (PR) (PR) (PR) (P)
Net IIP -326.7 -313.2 -302.0 -318.8 -331.6
A. Assets 447.8 4345 436.7 «458.3 0483.2
1. Direct Investment 119.5 119.5 120.1 119.8 128.7
2. Portfolio invest W413 13 ll
ment

2.1 Equity a 1.2 1.2 1.2 0.9

2.2 Debt Securities ~~ 0.2 0.1 02 0.1
3. Other Investment 34.8 31.2 38.0 43.2 49.2
3.1 Trade Credits> 3.9 6.3 82 109 8.7
3.2 Loans 3.7 5.7 5.6 6.9
ax” 13.1 8.0 10.8 13.9 17.9
3.4 Other Assets 12.9 13.3 13.3 12.9 15.7
4, Reserve Assets 292.1 282.5 2772 2939 304.2
B. Liabilities 7745 47.7 7387 777.0 8148
‘1.Direct Investment 233.7 «219.8 218.1 226.6 = 242.7
2. Portfolio Invest- 2013 186.5 1739 179. 193.0
ment

2.1 Equity Securities 1395 1316 1243 1324 139.7

2.2 Debt securities 61.8 54.9 49.6 47.3 53.4
3. Other Investment 339.5 341.4 346.6 370.9 379.1
3.1 Trade Credits 89.0 91.4 89.6 88.4 83.9
3.2 Loans 167.0 1664 1688 1706 41781
3.3 Currency & De- 71.0 71.3 75.2 98.8 104.0
posits
3.4 Other Liabilities 12.6 12.3 13.1 13.1 13.0
Memo item: Assets to 57.8 58.1 59.1 59.0 59.3
Liability Ratio (%)
R: Revised PR: Partially revised P: Provisional; The sum of the constituent
items may not add to the total due to rounding off.
(Source: Reserve Bank of India, (June 30, 2014), “India’s International Investment Position
(IP), March 2014”)

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NOTES

As can be seen from the above statistics, India was a net debtor na-
tion with Net International Investment Position of US$ 331.6 bn as
of March, 2014. However, as we saw earlier, the total external debt of
India was US$ 440.6 bn. This difference was because of external debt
statistics that do not consider foreign equity investments, foreign di-
rect investments, etc. and also the overseas investments of India.

For the year ending March 2014, the actual liabilities of India was
much more than the external debt figure of US$ 440.6 bn if we consid-
er foreign direct investments, portfolio equity investments, etc. The
total liabilities as on March 2014 were US$ 814.8 bn. Of this external
debt alone was US$ 440.6 bn (approx.).

On the assets side, Indian resident’s financial assets abroad stood at

US$ 483.2 bn of which direct investments were at US$ 128.7 bn. The
RBI's reserve assets in foreign currencies constitute a major chunk at
US$ 304.2 bn. Thus, overall India’s had a net debtor position of US$
331.6 bn as of March, 2014.

With the help of the Internet, gather the data of external debt in
China for the last 10 years and analyse the pattern.

2385 FU, FDI AND NRI INVESTMENTS IN INDIA

Total liabilities can be segregated into debt and non-debt liabilities.
FII and FDI form part of the non-debt foreign liabilities of India. The
non-debt liabilities include foreign investments in equity securities
and foreign direct investments. As can be seen from IIP statistics, the
total FII investments at the end of March, 2014 was US$ 193 bn. This
includes both equity and debt securities. It constitutes 23.7% of total
foreign liabilities. The total FDI investments were US$ 242.7 bn form-
ing 29.8% of total foreign liabilities.

Though the foreign direct investments could be stable one, capital

movements due to portfolio investments can impact the exchange rate
and the overall BoP and IIP position of a country. The share of debt
and non-debt liabilities is given in Table 4.3:

TABLE 4.3: SHARE OF EXTERNAL DEBT AND NON-DEBT

LIABILITIES OF INDIA (IN %)
Period Mar-13. Jun-13 Sep-13 Dec-13 Mar-14
(PR) (PR) (PR) (PR) (P)
Non-Debt Liabilities 46.8 45.6 44.9 44.8 45.6
Debt Liabilities 53.2 54.4 55.1 55.2 54.4
Total 100.0 100.0 100.0 100.0 100.0
(Source: Reserve Bank of India, India’s International Investment Position)

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NOTES

The segment 3.3 on currency and deposits of IIP statement include

the liability arising out of NRI deposits and constitute a significant
chunk of overall external debt of India at 23.6% of overall external
debt (on total debt liabilities). It increased from US$ 47.9 bn in 2010
to US$ 103.8 bn in March, 2014 with a 46.6% increase during the year
2013-14 due to some specific FCNR (B) deposit mobilisation schemes
operated by commercial banks during this period. RBI offered this
scheme so that the critical position of BoP can be balanced in the ini-
tial part of the year.

It is also important to note that foreign investment inflows to a coun-

try are part of the liabilities segment of IIP statistics. The use of ADR,
GDR and IDR by firms in India will appear in the liabilities section as
portfolio equity investments. The portfolio equity investments of US$
139.7 bn (section 2.1 of the IIP table) as of March, 2014 would include
foreign inflows arising out of ADR, GDR and IDRs.

As per the data made available in RBI website, the total net portfolio
investment flow was at US$ 4.82 bn for the year 2013-14. Of this, for-
eign investment inflows through depository receipts were only US$ 20
mn as compared to FII Portfolio investments of US$ 5009 mn.

With the help of various resources, analyse the rate of growth in

FII, FDI and NRI investments in India from pre-liberalisation to
the post-liberalisation era.

eSra SUMMARY
Q BoP is an important statement that provides a lot of information
on international trade of a country. Without BoP statistics, it will
not be possible to properly analyse the quantum of trade (and cur-
rent) deficit/surplus, its causes, how it is financed, its impact on
the domestic economy, etc.
Q The balance in current account, which includes goods and ser-
vices, income and transfers, gives the quantum of BoP deficit or
surplus for a particular period.
Q = The capital and financial account shows how the deficit is financed
or surplus was utilised.
Q Acurrent account is normally segregated into trade balance and
invisibles balance. The invisibles balance includes services, in-
come and transfers. The invisibles account can have a surplus
while the trade account is in deficit.
Q_ Traditionally, capital account meant all financial transactions oth-
er than those pertaining to current account transactions. However,
as per IMF standards, the capital account now includes two cate-
gories: capital account and financial account.

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NOTES

Q The capital account includes transactions pertaining to capital

transfers and non-produced non-financial items.
Q For countries with fixed exchange rate arrangement or managed
floating rate arrangement, changes in official reserves account
shows difference in foreign exchange assets during a period due to
central bank transactions.
Q Transactions like exports, income receivables, transfer receipts,
reduction in foreign assets and increase in foreign liabilities are
credited. Transactions, involving imports of goods and services,
income payable, transfer payments, increase in foreign assets and
reduction in foreign liabilities, are debited.
Q Since every transaction has both a credit entry and a debit entry,
the BoP should always balance i.e. total debit balance should be
equal to the total credit balance.
Q Foreach current account transaction, one leg of the entry is posted
in the current account while the other leg on the financial account.
This ensures that the current account balance is equal to the capi-
tal and financial account balance.
Q The BoP statement is an important part of the national accounting
system as it enables the study of foreign trade transactions, cur-
rent account deficits, its causes and related capital account trans-
actions. In conjunction with International Investment Position
(IIP) statement, it allows to ascertain the net debtor/credit position
of an economy and the changes in this regard to due foreign trade.
Q The BoP statement also has its limitations mainly due to difficul-
ties in collecting accurate and comprehensive data. Its main pur-
pose is to ascertain the current account balance and how it is fi-
nanced or utilised.
Q The current account balance data of BoP statement is an import-
ant component of the national income accounts and plays a crucial
role in economic analysis.
Q India’s BoP shows that India has a deficit in its trade balance and
a surplus in its invisibles balance. On the capital and financial ac-
counts, India has a net capital inflow which finances the current
account deficit.
Q Acurrency is convertible under the current account, if all transac-
tions pertaining to the current account can be freely undertaken
between residents and non-residents. A currency is convertible
under the capital account, if the currency can be freely used and
exchanged for the purpose of capital account transactions.
Q India has accepted Article VIII of IMF in 1994, which stipulates
current account convertibility for member countries. However,
there are restrictions in India with regard to capital account trans-
actions.

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170 INTERNATIONAL FINANCE

NOTES

Q The ADR and GDR investment inflows are part of the portfolio in-
vestments segment of the non-debt liabilities of the IIP statement.
The quantum of ADR and GDR is very less as compared to other
portfolio equity investments of FIIs.

KEY WORDS

Q Capital account: It comprises of capital transfers receivable

and payable between residents and non-residents and the ac-
quisition and disposal of non-produced non-financial assets be-
tween residents and non-residents.
Q Current account deficit: A debit balance in the current account
includes goods, services, income and transfers.

Q Financial account: It comprises transactions relating to finan-

cial assets and liabilities that take place between residents and
non-residents.
Q Foreign institutional investor: It is an institution that is es-
tablished outside India so that investment can be made in the
security market of India.
Q Trade deficit: It indicates a debit balance due to the import of
goods exceeding the export of goods.

DESCRIPTIVE QUESTIONS
1. Explain the concept of BoP and its various components.
2. Distinguish between current account and capital account of BoR
3. Discuss capital account and current account convertibility.

ZSES ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic (2 ay Cos Answers

Concept of Balance of Payments 1. BoP
Components of BoP 2. e. Current and Capital &
Financial
Accounting Principles of BoP 3: b. Income receivable
Importance of BoP 4. False
Limitations of BoP 5. False
BoP and Money Supply 6. False
India’s BoP 7. True

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NOTES

HINTS FOR DESCRIPTIVE QUESTIONS

1. BoP shows balance in current account and how it is financed.
The two major components of BoP are current account and
capital and financial account. Refer to Section 4.2 Concept of
Balance of Payments.
2. The current account section only records economic transactions
pertaining to the movement of goods and services across borders
during the concerned time period. On the other hand, a capital
account includes transactions that result in increase/decrease of
assets/liabilities. Refer to Section 4.3 Components of BoR
3. Convertibility refers to freedom for both residents and non-
residents to use and exchange currency for various types of
transactions. Refer to Section 4.9 Capital and Current Account
Convertibility.

SUGGESTED READINGS FOR

4.15
REFERENCE

SUGGESTED READINGS
QO Cheol S. Eun, Bruce G. Resnick, International Financial Manage-
ment, Tata McGraw Hill Publishing Company Ltd., New Delhi
Q Keith Pilbeam, (2006), International Finance, 3° Edition, Palgrave
Macmillan, New York

Gert Bekaert, Robert Hodrick, International Financial Manage-

ment, Pearson Education Inc., publishing as Prentice Hall, New
Jersey
Jeff Madura, International Financial Management, Thomson
South-Western, USA

E-REFERENCES
QO Financial Times, “Economists seek to ease fears on China’s record
capital outflow”, May, 19, 2015, By Gabriel Wildau in Shanghai,
http://www.ft.com/intl/cms/s/0/a20a3ad8-fd2f-11e4-b072-00144fe-
abdc0.html, accessed on 3°¢ October, 2015.
International Monetary Fund (IMF), (1996), “Balance of Payments
Text Book”, IMF Washington D.C.
International Monetary Fund (IMF), (2009), “Balance of Payments
and International Investment Position Manual”, 6th Edition, IMF,
Washington D.C.
Ministry of Finance, (2014), “India’s External Debt — A Status Re-
port, 2013-14”, Government of India

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172 INTERNATIONAL FINANCE

N OT ES

Q Ministry of Finance, “Economic Survey 2014-15”, Government of

India
Q Reserve Bank of India, (2010), “Balance of Payments Manual for
India”, RBI, Mumbai
Q Reserve Bank of India, (June 30, 2014), “India’s International In-
vestment Position (IIP), March 2014”, RBI, Mumbai
Q www.imf.org
Q wwwrbi.org

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INTERNATIONAL PARITY RELATIONS

CONTENTS

Introduction
Exchange Rate Determination
Purchasing Power Parity (PPP)
Interest Rate Parity
Real Interest Parity
International Fisher Effect
Self Assessment Questions
Activity
5.3 Summary
5.4 Descriptive Questions
5.5 Answers and Hints
5.6 Suggested Readings for Reference

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174 INTERNATIONAL FINANCE

INTRODUCTORY CASELET

WHY CHINA'S CENTRAL BANK IS WEAKENING ITS CURRENCY

The exchange rate system of Chinese Yuan has long been a source
of controversy with American politicians who are outraged by
cheapness of Yuan resulting into massive trade deficit of US with
China. But the price of Chinese currency itself has never been a
source of uncertainty. The volatility of Yuan is far less than the
volatility of currencies of developed countries. Even though Chi-
nese Yuan has been de-pegged from US dollar, it is still not a free
floating currency. It has been allowed to float within a narrow
band based on a benchmark basket currency rate published by
central bank (Central Bank of th blic of China). It has been
appreciating against USD since’ 0 severe pressure from
US, and most people assume float upwards as it is
still undervalued.

But in recent times, this umption has been tested by Chinese

ded on February 18th, 2014,
the Chinese centr d to weaken Yuan in an unprece-
hmark rate and in a space of few

fluctuations have mostly been one way (up-

has huge Current Account Surplus. But irrespec-
act, it attracts more foreign direct investments than
. The situation of sizeable current account surplus and
y movement of currency attracted a net USD 22 billion
in the last quarter of 2013. Most of this can be accounted as be-
ing meant for wherein currency speculators borrowed dollars at
cheap rates and lent in Yuan. They expected to get benefit from
the higher Chinese interest rates and the Yuan’s continued its ap-
preciation.

This put pressure on Yuan and it rose by 2.8% against dollar be-
tween last quarter of 2013 and January in 2014, despite the Chi-
nese central bank’s heavy intervention in forex markets purchas-
ing US Dollar against Yuan. This resulted in lowering of Chinese
competitiveness as Yuan rose by 13% between last quarter of 2013
and January in 2014 and by 2.6% in January 2014 alone.

The Chinese authorities intervened to weaken its currency by

circulating additional Yuan into the financial system. The central
bank tried to restrict this additional circulation by issuing securi-
ties to banks. However, it did not prevent lowering of the interest
rates.

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INTRODUCTORY CASELET

The main objective of Chinese authorities trying to weaken the

currency was to reverse the phenomenon of speculators invest-
ing in China hoping that Yuan will continue to appreciate. At the
meeting where it was decided to weaken the currency, the central
bank also enlarged the trading band. A more flexible Yuan was
meant to give the central bank a freer hand in setting the mon-
etary policy. Despite its cruelty to the carry traders, the Chinese
authorities intend to keep the door wide open for foreign capital
but other than that for hot money meant for speculation.

The Chinese case above illustrates the dynamics of interest rate

parity, currency movement, exchange rate system and role of cen-
tral bank of a country in determining the exchange rate of its eur

defying the interest rate parity conditions. On the

carry traders with hot money cannot hope to make

floating or when it is managed by the central be

(Source: Adopted from: The Economist,. (2014). . Retrie
http://www.economist.com/news/finance-and-economics
bank-weakening-its-currency-one-way-

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176 INTERNATIONAL FINANCE

NOTES

(@)} LEARNING OBJECTIVES

After studying this chapter, you will be able to:

2— Explain the various theories and concepts related to the ex-
change rate determination

ssi INTRODUCTION

In the previous chapter, you studied about the concept and importance
of Balance of Payments (BoPs). The concept of BoP provides crucial
statistics that allows us to understand and analyse the international
financial transactions of a country with the Rest of World (ROW). The
first four chapters of this book dealt with the macro-economic and in-
ternational settings pertaining to international finance. This chapter
would discuss the concept and theories of exchange rates.

As a student of finance, you must have observed that the exchange

rates between two currencies or a pair of currency keep on chang-
ing every day. While travelling abroad, a person requires to get Indi-
an currency (INR) converted to a currency of the country he is visit-
ing. For example, if an Indian is travelling to USA, he would get INR
converted to US Dollars (USD). For determining the exchange rates,
we need to understand the various theories related to exchange rate
determination. This chapter focuses on theories namely: Purchasing
Power Parity (PPP), Interest Rate Parity (IRP), Real Interest Parity
and International Fisher Effect (IFE). After 1971, the world adopted
the floating exchange rate system wherein the exchange rates fluctu-
ate on a daily basis. These changes or fluctuations can be explained by
various theories. The Fisher equation describes the relation between
the nominal interest rate, the real interest rate and the inflation in a
country. Law of One Price states that in the absence of transaction
costs, the price of identical products anywhere in the world should be
same. According to PPP theory, the exchange rate between currencies
of two countries should be equal to the ratio of the price levels prevail-
ing in the two countries whereas IRP theory establishes the relation
of interest rates in two countries with the prevailing exchange rates.
According to the IFE, the expected change in spot rates will be equal
to the expected inflation differentials between the countries.

swag EXCHANGE RATE DETERMINATION

The price of one currency in terms of another currency is called ex-

change rate or foreign exchange rate. Exchange rate system refers to
the system or mechanism through which the foreign exchange rate
between a pair of currency is determined. Various researchers have
put forward different theories related to the exchange rate determina-
tion. However, a few theories have gained significance and somehow

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 INTERNATIONAL PARITY RELATIONS 177

NOTES

are successful at explaining how the exchange rate is determined. The

study of exchange rate is important because exchange rates have ma-
jor implications for the international trade and capital movements.

Let us consider the level of exchange rates. You must have observed
the exchange rates that are determined on a daily basis, for example,
a USD costs INR 66.3 whereas one pound sterling costs INR 99.3609.
In other words, we can say that the goods and services that can be
bought with US$ 1 in USA can be bought in India at INR 66.3. Sim-
ilarly, whatever goods and services cost INR 99.3609 in India would
cost GBP 1 in Great Britain. If these conditions are not met, they give
rise to arbitrage opportunities. Assume that a product costs US$ 150
in US and INR 6630 in India. A US citizen can easily convert US$ 100
into INR 66380 (because the exchange rate is US$ 1 = INR 66.3) and
purchase the product from India and sell the same in US at US$ 150.
In this entire process, the US citizen makes an arbitrage profit of US$
50. When products are identical and there are no transaction costs,
US citizens would keep importing the product from India till the ex-
change rate between INR and US$ adjusts or till price level changes
in either country in such a way that no arbitrage profit can be made.
It can be said that the price levels (of identical products) between two
countries have direct implications for the prevailing level of exchange
rates.

EXCHANGE RATE VARIATIONS

During 2010-2015, the INR/USD exchange rate has moved from US$
1 = INR 44.47 to US$ 1 = INR 65.3. This means for an Indian exporter
who has been exporting goods to US during these five years, now in
2015 each USD is worth 46.84% more keeping other factors constant.
If his annual exports to US have been USD 1 million, then his export
proceeds in INR would be INR 65.3 million in 2015 as against INR
44.47 mn he would have received in 2010. It can be said that the ex-
porter’s profits have increased by 46.84% due to the depreciation of
INR. However, it may not necessarily be true. The price of the goods
he exports to US could have decreased in USD terms during the peri-
od thereby decreasing his profit. Alternatively, the cost of manufactur-
ing in India might have increased during the period 2010-15. In either
case, his profits due to exchange rate depreciation would be much
lesser. The situation would have been reverse for an Indian importer.
His cost of imports would have increased by 46.84% during this period
assuming same price level in US.

In real world, the price levels could have changed in both the coun-
tries. The Indian exporter might have reduced his price in order to
improve his export competitiveness and increasing the quantum of
exports. Similarly, the depreciation could have led to reduction of total
imports from US unless the price levels have decreased in US. The
Indian importer might have decided to import the same product from
another country against whose currency INR has not depreciated.

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NOTES

From the above paragraphs, it can be comprehended that there are

linkages between the exchange rates and the goods market where the
price levels, exchange rates and the trade balance between countries
are all interlinked.

We saw the impact of exchange rates on products and services; how-

ever, exchange rates have similar implications for the products in fi-
nancial assets market. For this, we need to consider the interest rates
in the same way we considered the price level in goods markets. The
price of financial assets is given by the interest rates (or returns). Like
the exchange rates and price levels, the interest rates vary between
countries. Suppose an investor has US$ 10 million and he/she wants
to invest it for three months. He/she is free to invest in bank depos-
its of any of the countries. Assume that a three month deposit earns
an annual interest rate of 7% p.a. in India whereas it earns only 2%
p.a. in US. Since interest rates are very low in US, the investor de-
cides to invest his money in India because he/she can get return that
is 3.5 times more than the return offered in by US bank deposits. If
an investor wants to do so, he/she first needs to convert the USD into
INR and then deposit the same in an Indian bank. On maturity, the
investor may convert his principal and interest amount back to USD
at the exchange rate prevailing at that time. Now the question arises,
will a the amount that the investor converts back to USD be greater
than what he might have earned on deposits in USA? Since, there is
a conversion of currency involved, we need to take into account, not
only the interest rates but also the exchange rates (along with the ex-
change rate risks) in order to ascertain the actual return of the foreign
investor. The interest rate level prevailing in different countries has a
direct impact on determining the exchange rate movements between
currencies. The flow of goods depends on price level; similarly, the
flow of capital between countries depends on the interest rates offered
by various financial markets. From above paragraphs, it can be con-
cluded that the price levels and interest rate levels both are linked to
the exchange rate between a pair of currencies.

As mentioned earlier, there are several theories that try to explain the
linkages between factors such as interest rates, price levels, exchange
rates etc. Let us now study these theories in the upcoming Subsec-
tions.

5.2.1 PURCHASING POWER PARITY (PPP)

Earlier, we discussed that USD 1 costs INR 63.6 whereas GBP 1 costs
INR 99.3609. Why is this so? One way to answer the question is that
USD 1 or GBP 1 would purchase the same amount of goods and ser-
vices in US or UK as the INR 63.60 or INR 99.4609 would in India. In
trying to answer this, we are actually trying to compare the purchas-
ing power of the two currencies.

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NOTES

The prevailing exchange rates actually indicate the degree of purchas-

ing power of each individual unit of currency. If we consider the INR/
USD currency pair, the exchange rate of 63.60 implies that one USD
can purchase more goods than one unit of rupee. Similarly, in case of
GBP one GBP can purchase more goods than both one unit of USD
and one unit of INR.

Given that one unit of USD or GBP has more purchasing power than
one unit of Indian currency, we want to know how much more. If we go
by the current exchange rates, this would mean that one unit of GBP
would purchase as much goods as INR 99.3609 rupee would purchase.
This explanation of exchange rate levels is based on purchasing power
of the currencies and forms the basis of PPP theory of exchange rate.

The theory of PPP states that the exchange rate between currencies of
two countries should be equal to the ratio of the price levels prevailing
in the two countries.

If ER denotes Exchange Rate between INR and USD, then

_ Price Levelof India
ER Price Level of US

However, what is meant by price level? If one USD can purchase as

many goods in US as INR 63.60 would purchase in India, we would
like to know what exactly those goods are. Obviously, it cannot refer
to any single good. Coffee in India might cost much less than that in
US or UK, if we go by the exchange rates. Another product could cost
more in India than that indicated by the exchange rates. Therefore,
instead of considering the price of one product, it is more meaningful
to consider the price of a basket of products. We call it the price of
standard commodity basket (or standard consumption bundle).
ER= Price of a Standard Commodity Basket in India
Price of the same Commodity Basket in US
The price of the standard commodity basket or consumption bundle is
considered to represent the price level in each country. The standard
commodity basket is calculated by calculating the weighted average
of the nominal prices of goods and services consumed in the economy.
The weights are the percentage share of the goods and services in the
basket. If food and beverages constitute 40% of the typical consumer’s
budget, then the price of food and beverages would receive a weight
of 40% in the basket.

If P (t, Cx) represents the price of the standard commodity basket in

currency at time , then

P(t,C)= SWi x p (t,i,Cx)

Where represents the weight and p (t, i, C), the price of individual
good, , in the basket in currency Cr.

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NOTES

Hence, as the theory of PPB the Exchange Rate ER between Currency

X and Currency Y, will be given by

_ Swi x p(t, i, Cx)

ER(t, x/y)
YW x p(t, 3, Cy)
The above form of PPP theory is termed as the absolute form of theory
of PPP If we formulate a standard consumption bundle and calculate
the weighted average prices of the bundle in India and US, then the
ratio should be equal to the current exchange rate as per the absolute
form of PPR

ert INR ) - SWi x p(t, i, INR)

"USD ) — S'Wjx p(t, j, USD)
INR _ P(t, INR)
"USD ~ P(t, USD)

If PPP holds good, then the above expression should give the actual
nominal exchange rate as follows:

(.m2) = _P(GINR) = 63.60 INR/USD

USD) P(t, USD)

The above theory remains valid as long as the goods market does not
allow existence of any arbitrage profit opportunities. If the arbitrage
opportunities can be exploited fully, then whenever the exchange rate
deviates from USD 1 = INR 63.60, the standard consumption bun-
dle would be purchased from the country where the price levels are
cheaper. Arbitrage therefore affects both the price levels and the ex-
change rate so that the exchange rate correctly represents the price
level difference between the countries.

The absolute form of PPP is based on the Law of One Price. Two iden-
tical products should cost the same irrespective of the country they
are purchased from. For example, the cost of Petrol or Gold is nearly
identical in all countries. If the cost of petrol is cheaper in US than
in OPEC countries, people would import petrol from US rather than
from OPEC countries. This would continue till the cost and/or ex-
change rate changes in order to make the price of petrol equal in US
and OPEC countries. The law of one price assumes that the markets
are perfectly competitive and there are zero transportation costs.

However, the absolute form of PPP does not hold in the real world.
The reason is obvious. All products are not same like petrol or gold.
The standard consumption basket described earlier would include
many other products that cannot be easily traded between countries
even if the price differences are huge. If all countries have all products
available with them at the same price, international trade would cease
to exist. As per the theories of international trade, it is better to import

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some products rather than manufacture them within the country. This
implies there are cost advantages and differences between countries
that cannot be eliminated through goods arbitrage. Hence, the abso-
lute form of PPP equation described above need not give actual ex-
change rate prevailing in the foreign exchange markets.

The violations of law of one price affects the absolute form of PPR
and this may be attributed to tariffs and quotas, transaction costs of
transferring goods from one country to another, imperfect markets
that prevent prices from being dictated by the market and sticky pric-
es (which means prices cannot alter with as much frequency as the
exchange rates or external market price differences) lead to arbitrage
opportunities.

Even if the law of one price holds good, there could be problem in
standardizing the consumption bundle. The share of each individual
goods in the basket could vary between countries. For example, the
amount of petrol consumed per person in India could be far less when
compared to the equivalent value in US or UK. When the prices of
individual products vary, the weighted average price of the standard
basket can vary significantly due to the different weights of the prod-
ucts in different baskets which make it difficult to compare the price
level between countries. Similarly, there are non-traded goods such as
housing whose costs could vary substantially between countries.

The exchange rate calculated using the absolute PPP is termed as PPP
Exchange Rate. For example, if the price of a litre of coke is 2.5 Euros
in Germany, and 2 dollars in US, then the PPP for Coke between Ger-
many and US is 1.25 Euros per US Dollar (2.5/2 = 1.25). Then, we can
say the PPP exchange rate between Germany and US is 1.25 based
on Coke. Using similar logic, The Economist magazine calculates the
implied PPP exchange rates between various countries based on the
price of a McDonald’s Big Mac sandwich. If we assume that price of a
Big Mac represents a standard consumption bundle, then the Big Mac
PPP would give the PPP exchange rates between countries based on
the absolute form of PPP theory. Table 5.1 presents The Economist
magazine’s Big Mac PPP data:

TABLE 5.1: THE ECONOMIST MAGAZINE’S BIG MAC

PPP DATA
Country Local Dollar Dollar PPP Dollar Valuation
Price of Exchange Price
Big Mac Rate
India 116.25 63.43 1.83 24.27 —61.74
Russia 107 56.82 1.88 22.34 — 60.68
Malaysia 7.65 3.81 2.01 1.60 —58.04
South Africa 26 12.41 2.09 5.48 —56.28
Egypt 16.93 7.83 2.16 3.53 —54.86
Indonesia 30500 13344.50 2.29 6367.43 —52.28
Hong Kong 19.2 7.75 2.48 4.01 —48.28

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Country Local Dollar Dollar PPP Dollar Valuation

Price of Exchange Price
BigMac Rate
Latvia 2.45 0.91 2.68 0.51 — —43.96
China 17 6.21 2.74 3.55 —-42.84
Vietnam 60000 21810.00 2.75 12526.10 42.57
Colombia 7900 2708.90 2.92 1649.27 -39.12
Japan 370 123.94 2.99 77.24 = -87.67
Mexico 49 15.74 3.11 1023 -85.01
Hungary 900 282.88 3.18 187.89 —33.58
Saudi Arabia 12 3.75 3.20 251 — - 33.20
Euro area 3.7 0.91 4.05 0.77 —15.37
Belgium 3.7 0.91 405
§ 0.77 - 15.37
Ireland 3.7 0.91 4.05 0.77 = -15.37
Brazil 18.5 315, “aes 282 —10.59
Britain 2.89 0.64 4.51 0.60 -5.79
Israel 175 378 463 365 -3.31
United States 4.79 1.00 4.79 1.00 0.00
If Big Mac represents accurately the standard consumption bundle,
the price of a dollar should be INR 24.27 (116.25/4.79) as against the
actual exchange rate of INR 63.43. In other words, the exchange rate
as per the absolute form of PPP theory should be 24.27 INR/USD. To
purchase a Big Mac in US requires INR 303.83 (USD 4.79 X63.43) as
per the actual exchange rate whereas it costs only INR 116.25 in In-
dia. This means the purchasing power of INR is 61.74% less in the US
markets. Hence, as per absolute form of PPP the INR is undervalued
by 61.74% when compared to value of dollar. The percentage of over-
valuation / undervaluation for the selected countries is given in the
last column of the above table.

If the exchange rate as per PPP theory is 24.27 INR/USD, then theo-
retically it is expected that the Indian rupee would appreciate over a
period of time. On the flip side, we can consider the USD to be over-
valued with respect to INR, which would make it depreciate with re-
spect to INR. Over a period of time, the exchange rate is expected to
reach an equilibrium rate as per the absolute PPP theory.

In the real world, though PPP rates help to understand the degree
of variation of actual exchange rates with respect to price level in the
goods market, its prediction with regard to overvaluation or under-
valuation may or may not be realised. This is because the law of one
price, which is the basis of PPP theory considers only the internation-
al trade of goods and services. The exchange rates are not affected just
by the demand and supply of currencies arising out of trade in goods
market alone. The demand and supply of currencies are influenced
by many other factors such as financial asset markets, interest rates,
inflation, currency speculation, methods of exchange rate arrange-
ment applicable, government interventions and overall capital flows
between countries. This makes the exchange rates highly volatile and

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even if an equilibrium exchange rate exists (in accordance with PPP

theory), its value itself could keep changing due to the above factors.

The PPP exchange rates are widely used for comparison between
GDPs of countries (though the method of calculation differs from the
PPP equation above. The standard basket includes entire goods and
services of the economy including imports and exports). To understand
why PPP exchange rates are used for comparing the GDP of two coun-
tries, let us go back to the Big Mac example. Suppose both India and
US produce and consume only one product, i.e., Big Mac. Let us say, in
a particular year, India produces 100 million Big Macs. At the price of
INR 116.25, the GDP of India would be INR 11,625 million. We shall as-
sume that US also produced the same quantity of Big Macs. The GDP
value of US would be USD 479 million. If we want to compare the GDP
of US and India, we need to convert the GDP value into a common
currency. Let us compare it on the basis of USD. The value of Indian
GDP would be USD 183.27 million (if we use the actual exchange rate
of 63.43). This means though both India and US produced the same
amount of goods, India’s GDP at USD 183.27 million is being quoted at
much lesser value than the US GDP of $479 million. This is obviously
wrong as the GDP should represent the value of actual goods produced
during a particular period. However, if we use the PPP exchange rate
of 24.27 INR/USD, then the Indian GDP would be 11625 / 24.27 = $479
million. Thus, the PPP exchange rate can be used as a deflator for the
difference in price levels between GDP of countries.

OECD publishes the GDP based PPPs for various countries. Table 5.1
gives the data for various countries:

TABLE 5.1: PPP BASED ON GDP PUBLISHED BY OECD.

Country a, PPP
Australia 1.44
Austria —_ 0.84
Germany 0.81
Greece 0.70
Hungary 126.00
Iceland 125.00
Ireland 0.89
Israel 3.96
Italy 0.78
Japan 115.00
Korea 825.00
Luxembourg 0.91
Mexico 7.43
Netherlands 0.84
United Kingdom 0.66
United States 1.00
Euro area (18 countries) 0.80
(Source: https://stats.cecd.org/Index.aspx? DataSetCode=PPPGDP)

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By using the above GDP based PPP the GDP of different countries
can be compared using USD as the common currency.

The above table can also be used for comparing the price levels and
cost of living between countries. If you have an option of working in
Samsung either in South Korea or in US, your salary in terms of Kore-
an currency should be 825 times bigger than that offered by Samsung
US, in order to compensate for the higher price level of goods prevail-
ing in Korea as per OECD data above.

RELATIVE FORM OF PPP

The absolute form of PPP theory gives the exchange rate applicable at
any particular point of time based on the price level prevailing in two
countries. The relative form of PPP takes into account the changes in
price levels between countries over a period of time. The relative form
of PPP says if there is price increase (or inflation) in both the coun-
tries, then the exchange rate between the currencies would adjust to
maintain the PPP

Suppose if inflation in India is 10% whereas it is 5% in US and the

current price of standard basket of consumption goods (here assume
that it is a Big Mac) is 116.25 INR and 4.79 $, respectively, making the
absolute PPP exchange rate equal to 24.27 INR/USD. If the Big Mac
price increases by 10% in India and 5% in US over a year, then the
prices will be INR 127.88 and US$ 5.08 after a year.

With the change in prices in both the countries, the PPP exchange
rate cannot remain at the same level of 24.27. It has to change in order
to reflect the change in price levels. The relative form of PPP says that
the exchange rate will change in order to maintain the PPP As per
relative form of PPP it should change as per the equation given below:

(1 +Inflation in Country x)
1+e(x,y)=
(1 +Inflation in Country y)

Where e(x,y) indicates the rate of change in PPP exchange rate re-
quired to maintain the PPP

(1+ Inflation in Country x)

e(x, y)= -
( ¥) (1+Inflation in Country y)

For our example, the rate of change in exchange rate should be:

_(1+10%) -
e(x, y)= 15%) 1= 1.476 —1=4.7619%

This means the new exchange rate should be 24.27X(1 + 4.7619%) =

25.425 INR/USD. This is nothing but the ratio of the new price levels
between the countries.

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Due to higher inflation in India, the new exchange rate implies that
rupee will depreciate. Each rupee will purchase lesser amount of
goods in US or it costs more to purchase each USD.

The new absolute PPP exchange rate will be 127.88/5.03 = 25.4762.

_ YWixp(t, i, INR) 127.88

E(t, INR/USD) = = = 25.4762 INR/USD
SWjx p(t, i, USD) 5.03

If the exchange rate does not change as above, there will be a arbi-
trage opportunities as per the absolute form of PPP The relative form
of PPP says that in order to maintain PPP between currencies of two
countries, the currency of the country with higher inflation must de-
preciate as shown in the example above.

CONCEPT OF REAL EXCHANGE RATE

The theory of PPP has given rise to the concept of real exchange rate.
The relationship between real and nominal exchange rates is given by:

Nominal Exchange Rate Ge

ne = P(t INR) x Real Exchange Rate
USD} P(t, USD)

The real exchange rate is equal to 1, if absolute PPP holds good. The
value of real exchange rate is one because when PPP is valid, there is
PPP between the two countries. In terms of Big Mac example, when
PPP holds good, one Big Mac costs same in both US ($4.79) and India
(INR116.25) at the PPP exchange rate of 24.27 INR/USD.

If the nominal exchange rate is different from PPP exchange rate, we

can find out the real exchange rate using the above equation

INR P(t,USD)
Real Exchange Rate} t,—— |= x Nominal Exchange Rate
USD P(t, INR)
_ 63.43 _ 4 gy
Real Exchange Rate( 0 |
USD 24.27
The real exchange rate of 2.61, which is greater than 1 implies that ei-
ther price levels in India is higher or that price in USD is overvalued.

5.2.2. INTEREST RATE PARITY

The PPP theory of exchange rate determination requires the ex-

change rate to be determined by the price levels between countries.
However, the exchange rates are determined not only by the interna-
tional trade but also due to capital movements between countries. In
other words, the exchange rates are also impacted by the price levels
and interest rates of the financial assets markets. The interest rates,

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inflation and price levels are all inter-related and the exchange rates
are determined on the basis of interaction of all these factors. The
theory of IRP explains how the interest rates in different countries
impact the exchange rate movements between currencies.

The theory of IRP relates the interest rates in two countries with the
prevailing exchange rates. Unlike PPP theory, IRP does not explain
the determination of spot exchange rate between two currencies. It
deals with the exchange rate risk and consequent impact on the ex-
change rate movements. Therefore, we need to understand the con-
cept of exchange rate risk and forward exchange rates before studying
IRP

Earlier, we saw an example where an investor faces a situation of 7%

interest rate in India and 2% interest rate in US. In such scenarios
where some countries offer more interest rate than others; ideally, ev-
ery global investor would move his funds from his home country to
the country offering better interest. However, the interest rates vary
across different countries in the real world and still investments are
made in all countries and not only in countries offering better interest.
How can this phenomenon be explained? The answer is that the dif-
ference in interest rates between countries does not matter in perfect
financial markets. Let us discuss this.

When we deal with the financial assets in international markets, we

also face exchange rate risk. Let us say the current exchange rate is
63.43 INR/USD. A US investor decides to invest USD1 million in Indi-
an money markets in a particular money market instrument that has
maturity of 3 months. For this, he would first convert his USD1 mil-
lion into INR. This would give him INR 63.48 million, which he would
invest in the money market instrument. After 3 months, his maturity
proceeds would be equal to = 63.43 X (1+7%/4) = INR 64.54 million.
Now, he would like to convert this amount into USD. Assuming that
the investor is able to convert the maturity proceeds at the same ex-
change rate at which he initially sold USD,then his proceeds would
be 64.54 / 63.43 = $ 1.0175 million. This implies that he has got an an-
nualised return of 7% on his investments (((1.0175-1)/1X4)X100 = 7%.

But in real world, the exchange rate changes on a daily basis and it is
unlikely that the investor will be able to convert his maturity proceeds
of INR 64.54 million at the old exchange rate of 63.43 INR/USD. The
exchange rate is applicable when he converts his maturity proceeds
after three months could be less than or more than 63.48. Suppose,
rupee has depreciated by 3% during this three month period and the
exchange rate applicable is 65.33. At this rate, his USD maturity pro-
ceeds would be only $ 0.9879 million (64.54 million /65.33), which is less
than investor’s principal of USD 1 million. Due to the rupee depreci-
ation, he would face a capital loss rather than an additional interest
income. His entire return has been wiped out due to the rupee depre-
ciation. He would have been far better, if he had invested in USD bank

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deposits where he would have got an assured 2% interest rate. This

situation of uncertain returns owing to uncertain future exchange
rates leads to exchange rate risk. Thus, because of exchange rate risk,
investors are generally sceptical of investing in another currency even
if it offers higher interest rate. However, a US investor might still de-
cide to invest in Indian money market, if he is sure of the direction of
exchange rate movement, this is an example of rupee appreciation.
However, that would form part of speculation and not investment ac-
tivity.

If there exists an exchange rate risk, then it greatly restricts trade and
movement of capital across border unless otherwise for speculative
purposes. However, we know that there exists a vibrant foreign ex-
change market that this foreign exchange market is largest in terms of
trade volume. There are certain instruments that allow investors and
traders to hedge the foreign exchange risks. Let us discuss forwards
or forwards contract, an instrument that allows hedging of exchange
rate risk. Now, consider again our example of US investor, if he wants
to eliminate the exchange rate risk involved in his investment in In-
dian money markets, he would like to fix the exchange rate at which
he can convert his maturity proceeds after three months. Suppose his
banker says he will allow him to convert his INR maturity proceeds
at a predetermined amount of 64 INR/USD irrespective of the actual
exchange rate prevailing at that point of time. His return will be as
follows:

INR maturity proceeds = 64.54 million

USD proceeds after conversion = 64.54 / 64.00 = $ 1.0084 mn

Actual rate of return = (1.0084 — 1.0000) / 1) x 4 X 100 = 3.36% p.a.

Thus, he will be able to get an assured return of 3.36% p.a. as against

the US short term interest of 2% p.a.

The above contract, which the US investor enters into with his banker
wherein he is able to “forward-purchase USD” (or forward-sell INR)
at a future date at a fixed (pre-determined) exchange rate is termed a
forward contract. The exchange rate at, which the banker agrees to
purchase INR three months, hence, is called “three month forward
exchange rate”. The difference between the currently prevailing ex-
change rates (at time of investment and maturity/conversion), i.e., spot
exchange rate of 63.43 and the 3 month forward rate (64.00 INR/USD
in our case) is termed as the “forward premium / discount”. If the for-
ward exchange rate is greater than the spot exchange rate, then there
exists a forward premium or else a forward discount. In the above
case, there is a forward premium of (64 — 63.43 = 0.57). We shall study
more about forward contracts in Chapter 6.

Now, that you know there exist forward contracts, which can protect
an investor from a potential forex risk, let us reconsider whether in-

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vestors should invest their capital to countries that offer higher inter-
est rates or not. We previously answered (in Sub-section 5.2.2) that
the interest rates do not matter in perfect markets. However, we can
clearly observe that the US investor made an additional return over
and above 2%. How do we explain this kind of additional return? First
of all, we assume an arbitrary forward exchange rate of 64 INR/USD.
If forward contracts can be entered at this rate which would allow any
US investors to make additional return, then every US investor will
invest in Indian money markets rather than in US money markets.
In fact, US investors will borrow in US markets and invest in Indian
markets. In perfect financial markets, such an arbitrage opportunity
cannot exist for long. As more and more investors move their funds
to India and enter into forward contracts, the forward premium will
keep increasing and would reduce the possible USD maturity pro-
ceeds. This process will continue till the return offered by Indian mon-
ey market becomes same as that offered by US money markets. In the
above example, the forward exchange rate will reach a rate at which
the maturity proceeds will exactly equal the USD maturity proceeds
that would have been obtained, if the investor had invested his money
in the US money markets. We can find out this rate at which there will
be no arbitrage opportunity.

Assume that x is the maturity proceeds received in INR and converted

to USD, forward rate of INR/USD should be such that the return on
investment in USD terms should be 2%.

Rate of Return = 2% = (X—1 million) /1 million X 4 x 100

X =2/(4 X 100) + 1 = USD 1.005 million

This means that the forward rate should be:

INR Maturity Proceeds / Forward Rate = $1.005 mn

Required Forward Rate =INR 64.54 million / $1.005 million = 64.2189

INR/USD

The forward premium = 64.2189 — 63.43 = 0.7889

In terms of percentage on spot rate, forward premium

= 0.7889
/ 63.43 = 1.2437%

In other words, the 3-month forward premium of Indian currency

over USD should be at 1.2437%, if the US 3-month interest rate is 2%
p.a. and Indian interest rate is 7% p.a. in order to prevent arbitrage
opportunities arising out of differential interest rates. This is the con-
cept behind the Covered IRP theorem.

As per the Covered IRP theorem, the percentage spread (difference)

between the spot and forward exchange rates is determined by the in-
terest rate differential between two currencies for the forward period

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concerned. Mathematically, it is represented as follows:

Forward Rate (1+interest rate of currency x)
Spot Rate (1+interest rate of currency y)
If F denotes forward rate in terms of currency x/y, S is the spot rate
and i is the interest rates, then the above equation can be written as:

F (1+i,)
S (1+i,)
Therefore, Covered IRP theorem can be expressed as:

(1+i,)
F= — x $
(1 +i,)

Let us calculate the value of forward rate using Covered IRP equation
as follows:

asi) (a)
1%

F=
(4) 2)
=< x § = +—_——~ x 63.4300 = 64.2189

4
INR/USD

Unlike the PPP theorem, which does not hold well in the real world;
the Covered IRP theorem is the way forward premiums and discounts
are determined in foreign exchange markets in practice. The interest
rates in the equation above are the rates applicable for inter-bank de-
posits such as LIBOR. For example, for the Eurodollar deposits, LI-
BOR of required maturity for USD is applicable. If the forward rates
deviate from the value calculated using Covered IRP theorem, then
the market participants would try to exploit the resulting arbitrage
opportunities thereby adjusting the exchange rates toward the re-
quired forward rate.

If there exist arbitrage opportunities such that the return on Indian

markets is more than that in US; arbitrage opportunities would devel-
op and the following adjustments might occur:
Q Interest rates in US may increase
Q Interest rates in India may fall
Q Rupee may appreciate in the spot market
Q Rupee may depreciate in the forward market

If there still exist persistent deviations in forward premiums/discounts

from that specified by the IRP theorem, it would be minimal and can
be accounted for as a result of transaction costs that would render
arbitrage unprofitable. Other reasons for deviations in forward ex-
change rate include default risks, which could alter lending rates and
exchange control arrangements and restrictions that may not allow
free movement of the exchange rates.

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We call it as “Covered” Interest Parity” Theorem as the equation im-

plies that the investor enters into a forward contract to hedge the risk
or he “covers” exchange rate risk by hedging.

Illustration: If S = 65 INR/USD, 3-month interest rates in US and

India are 2% p.a. and 10% p.a., respectively, find out the 3-month for-
ward rate that would make an investor indifferent between investing
in either INR or USD money market instruments.

Solution: Using the Covered IRP relationship,

pallies
(1+i,)

re (1+ 10% /4) we

(1+2%
/ 4)
= 66.2935 INR/USD

COVERED INTEREST ARBITRAGE

If the Covered IRP does not hold, then there will be arbitrage oppor-
tunity between the two markets. A FX market participant can make
risk-free profits by exploiting arbitrage opportunities. We shall now il-
lustrate the Covered Interest Arbitrage process that ensures the Cov-
ered IRP theory holds good in real world.

In the above example, let us assume that Covered IRP does not hold

se
good in the market. In other words,

Let us say the 3-month forward rate in the above example was 66.50
instead of 66.2935.

A higher forward rate implies that the USD proceeds will be lesser as
the rupee is expected to depreciate beyond the rate indicated by Cov-
ered IRP relationship. In this case, US investor will get USD 1.005, if
he invests in US money markets but only 66.625/66.5 = $1.00188 if he
invests in Indian money markets.

A FX market participant can make risk-free profits, if such a situation

prevails in the forex markets. He can construct an Arbitrage Portfo-
lio that gives him risk-free profit. An arbitrage portfolio is one that
requires no initial investment but provides assured positive non-zero
returns.

In the above case, given the spot and forward rates prevailing in the
FX markets, the interest rates of INR deposits is lower as compared
to interest rates prevailing for USD deposits after taking into consid-
eration the exchange rates as USD 1.005 > USD 1.00188. Hence, the

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investor can make profits by borrowing from Indian money markets

and lending in US money markets.

The arbitrage portfolio consists of borrowing in INR in Indian money

markets, converting the proceeds into USD and lending in US money
markets. The portfolio should be hedged with a forward rate contract
to sell USD. The various steps involved in exploiting the arbitrage op-
portunities and making risk free profit are summarised as follows:
1. Borrow required INR for three months to purchase USD 1 at
interest rate, say =10%, i.e., INR 65 @ 10% p.a.
2. Convert the amount into USD at spot rate of 65 INR/USD, i.e., $1

3. Enter into a forward contract to sell USD 1.00188 at 66.5 INR/

USD after 3 months.

Note that the investor would require to convert only USD

1.00188 ( 66.625/66.5) in order to close his rupee loan of INR 65
whose maturity value along with interest will be 65 X (1+10%/4)
= 66.625
4. Lend USD 1 for 3 months in US money markets @ 2% p.a. and
receive maturity proceeds of $1.005 after three months
5. Sell USD 1.00188 using forward rate of 66.5 INR/USD and using
the maturity proceeds of 1.00188 X 66.5= 66.625 and close the
Rupee Loan.

Any investor who exploits the deviation from the covered IRP rela-
tionship through the above arbitrage process will receive a risk-free
net profit. In our example, the risk-free net profits is 1.005 — 1.00188
= USD 0.00312.

Table 5.2 shows the transactions in terms of day zero and maturity date:

TABLE 5.2: TRANSACTIONS IN TERMS OF DAY ZERO AND

MATURITY DATE
Arbitrage Steps Day 0 After 3 months
1. Borrow INR 65 +INR 65
2. Buy USD —INR 65
+USD1
3. Enter into Forward contract to sell 0
USD at 66.5 INR/USD
Lend USD 1 —USD1
Receive USD Loan Maturity Pro- USD 1.005
ceeds
6. Sell $1.00188 @ 66.5 INR 66.625
—USD 1.00188
7. Close the INR loan — INR 66.625
Net Cash Flow/ Risk Free Profit 0 USD 0.00312

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In the above arbitrage transaction, the investor had no cash outflow on

day zero. He simply borrowed some amount and lent the same in an-
other market. On maturity date, he received the redemption amount
from his USD loan and used it to close his rupee loan. In the process,
he received USD 1.005 after three months but had to pay only USD
1.00188 for closing the rupee loan and netted a risk free profit of USD
0.00312.

HYPOTHESIS OF UNCOVERED INTEREST PARITY

In the example of covered interest parity discussed above, we said that

the returns to the US investor will be uncertain due to the uncertainty
associated with the exchange rate movements. Therefore, he would
enter into a forward contract to fix the future exchange rate. Howev-
er, according to the Uncovered Interest parity hypothesis, the inves-
tors ‘expected return’ from the foreign currency investment would be
same as the domestic investment even if he does not cover or hedge
the exchange rate risk (no use of forward contract). This would be
possible, if the spot exchange rate of the currency with higher interest
rate depreciates to the extent of the interest rate differential.

Expected Future Spot Rate » ( 1+interest rate of currency x)

Spot Rate ( 1+interest rate of currency y)
1+interest rate of currency x)
Expected Future Spot Rate = x Spot Rate
1+interest rate of currency y)

( 1+i )
eS) a) x Spot Rate

In other words, the expected spot rate is same as the forward rate
applicable, if investor enters into a forward contract. Hence, even if
he does not cover his foreign currency investment, his return will be
same as the return offered in the domestic markets, if the hypothesis
of Uncovered IRP holds good. In practice, the Uncovered IRP hypoth-
esis is helpful only in ascertaining possible direction of movement of
the exchange rate. For example, with Indian interest rates remaining
at higher levels than those of US for many years, we can say the rupee
will depreciate against dollar. However, the amount of depreciation
may be less or more than that indicated by the Uncovered IRP hy-
pothesis.

Considering the direction of movement of rupee, an exporter may de-

cide not to hedge the exchange risk as suggested by the Uncovered
IRP hypothesis. However, this is not very dissimilar from currency
speculation.

5.2.3 REAL INTEREST PARITY

Before describing real interest parity, it is essential to discuss the

concepts of nominal and real interest rates. Assume that an investor
would like to invest USD 100 million. He/she has a choice that he can

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 INTERNATIONAL PARITY RELATIONS 193

NOTES

invest in real assets either in India or in US. The investment in a man-

ufacturing plant in India is expected to yield an annual return of 12%
p.a. Assume that investment made in similar manufacturing plant in
US also yields annual return of 12% p.a. We ignore exchange rate risks
for now. Based on this data, an investor may be indifferent about in-
vesting in either country. Now, assume that the investor gets to know
that the price levels are expected to increase at the rate of 10% in India
while it is unlikely that price levels in US would increase, i.e., rate of
increase in price level would be 0 % p.a. in US. If you ignore inflation,
i.e., rate of change of price level, then your real return from the invest-
ment in India will be much lower than that from US. For example, if
a USD 100 million investment offers USD 12 million as return every
year, then USD 12 million can purchase much more goods in US than
it would in India because the price levels are expected to increase in
India at a much faster rate. The purchasing power of the investor’s
returns would be reduced due to higher inflation in India. Therefore,
in such situations, an investor seeks to know what real return he/she
would receive in either country (India, US) after accounting for infla-
tion. The overall return is generally termed as nominal return while
the return that is adjusted for inflation is termed as real interest rate.
Investors are usually interested in real returns rather than the nomi-
nal returns.

Alternatively, we can say that nominal interest rate refers to the inter-
est rate that is usually offered by the commercial banks and financial
institutions on various financial instruments. For example, if FD. with
6 month maturity offers 7% return in India, then this 7% return is the
nominal interest rate. However, when this interest rate is adjusted for
including inflation, the result is the real interest rate.

Suppose, maturity value of an investment of USD100 million in US

at 12% is USD 112 million. At the price level of USD 1 per unit, you
would be able to purchase 112 million units of goods in US after a year,
with zero expected inflation rate. If the expected inflation rate is 10%
in India, then each unit would cost USD 1 X (1+10%) = USD 1.1 after
a year. Then to purchase the same 112 million units of goods in India,
your maturity proceeds from the investment should be equal to 112 X
1.1 = USD 123.2 million.

In other words, your total return from the investment of USD 100 mil-
lion in India should be as follows:

= (123.2 — 100)/100 = 23.2%

Alternatively, a return of 12% in US with zero inflation rate is equiva-
lent to 23.2% in India with 10% inflation. The overall return of 23.2% is
called nominal rate of return while the 12% is termed the real interest
rate. Mathematically,

(1+ Nominal Rate of Return) = (1 + Real Rate of Return) Xx

(1+ Inflation Rate)

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N OT ES

Nominal Rate of Return = [(1 + Real Rate of Return) X

(1+ Inflation Rate)]-1

Nominal Rate of Return = [(1 + 0.12) X (1+ 0.10)]-1 = 1.232-1=

23.2%

The above relationship, which relates the real rate of return with nom-
inal rate of return and the inflation rate is termed Fisher’s theory on
real interest rates or the Fisher equation.

Now, that you are aware of the interplay between the real interest
rate, nominal rates and inflation, let us state what Real Interest Parity
is. According to Real Interest Parity, the real interest offered by differ-
ent countries should be same and the nominal interest rate differen-
tial between countries is due to expected inflation rates. The exchange
rates and interest rates should adjust in such a way that the real inter-
est rates offered by different countries are equal.

5.2.4 INTERNATIONAL FISHER EFFECT

We can use the above Fisher’s equation between nominal and real in-
terest rates and inflation for exchange rate prediction. As studied ear-
lier, as per the uncovered interest parity hypothesis:

E(S)= (1+4,) x Spot Rate

(1+i,)

If we substitute, Fisher’s relationship for interest rates discussed in

Section 5.2.3 above, then:

x (1+
(1+) x(1+ Fe) x Spot Rate
x (1+ Sy)

Where,

r = real rates of interest

f = expected inflation rates

As per real interest parity,

(1+r,)=(1+7,)

E(S)= (1+ £2) x Spot Rate

(1+F,)

It implies that if the real interest rates are equal between countries,
then the expected future spot rate will be determined solely by expect-
ed inflation rate differentials.

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NOTES

In terms of % expected change in spot rate,

E(S)_ (1+ fe)

Ss

ae ot ae gt
+
—
S+E(A)_
nts
a
+
_
+
—
=
+
14 FA _
_
+
—

ae
E(A)
—~
_

>
+

—
I
~—~
_
a
—

If E(e) is the rate of change in spot rate,

E(e)= (1+ f.) -1

(1+f,)

E(e) = (1+ f,) -1

(1+f,)

The above equation can be presented in simplified form as follows

(refer note below):

E(e)=f.- Sy
The above equation states that the expected change in spot rates will
be equal to the expected inflation differentials between the countries
of the two currencies. This is known as the IFE.

SELF ASSESSMENT QUESTIONS

According to fisher effect, the expected inflation rate is approxi-

mately equal to the difference between the nominal and real inter-
est rates.

(1+ Nominal Rate of Interest) = (1 + Real Rate of Interest) X (1+ Ex-

pected Inflation Rate)
(1+Nominal Rate of Interest)
E ted Inflati te =
xpeere anyon rare (1+Real Rate of Interest)

(1 + Nominal Rate of Interest) —(1 + Real Rate of Interest)

Expected Inflation rate =
(1+ Real Rate of Interest)

(Nominal Rate of Interest -Real Rate of Interest)

Expected Inflation rate =
(1+ Real Rate of Interest)

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NOTES

The denominator (1+ Real Rate of Interest) on the RHS will be nearly
one for short terms, so we can approximate expected inflation rate as
follows:

Expected Inflation rate = (Nominal Rate of Interest- Real Rate of Interest)

INTERNATIONAL PARITY CONDITIONS

We have now studied four different theories related to exchange rates.

These theories involve use of price levels, inflation and interest rates
prevailing in the two countries.

1. Relative PPP theory

This theory relates the inflation existing in two countries with the
changes in exchange rates.

(1 +Inflation in Country x)
ER (x,y) = i
(x ) (1+ Inflation in Country y)

In its simplified form, the above relationship states that the change in
exchange rates is approximately equal to the inflation differentials.
Also, if PPP holds good, then this is the required change to maintain
the PPP when the price levels change in two countries.

2. Covered IRP theory

As per Covered IRP theory, the forward exchange rates are deter-
mined by the interest rates prevailing in two countries.

If F denotes Forward Rate in terms of currency x/y, S spot rate and i,

nominal interest rates, then,

(1+i,)
tal

(1+i,)

3. Uncovered IRP Hypothesis

As per Uncovered IRP hypothesis, the expected future spot rate de-
pends on the interest rates existing between the two countries:

eS) Oa) x Spot Rate

Referring to both Covered IRP and Uncovered IRP we can say:

F _E(S)
ss
The above relationship says the forward exchange rate is given by the
expected future spot rate. This idea is also referred to as “Unbiased-

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NOTES

ness Hypothesis” meaning that the forward rates are considered to be

the Unbiased Predictors of Future Spot Rates.

4. International Fisher Effect (IFE)

The IFE differentiates the real and nominal interest rates and assumes
that the real interest rates between countries should be equal in the
long term. Based on this assumption, it says the expected change in
spot rate is given by the inflation differentials.

(1+ f,)
E(e)= -1
(1+f,)
The above equation in simplified form is approximated as:

Ee)=f,- f,
This relationship is same as the Relative PPP equation, we started
with.

MISCELLANEOUS ILLUSTRATIONS

Illustration: If interest rates in India and US are 5% and 3%, respec-

tively, the spot rupee exchange rate is 63.48 INR/USD and expected
inflation rates are 9% and 6.924% respectively in the two countries,
establish the international parity relationships using the Covered IRR
Uncovered Interest Parity and IFE.

Solution: Using the Covered IRP theorem

(1+%,)
Fe
s (1+i,)
F
The forward rate, F can be calculated as follows: 3 (1+i,)

_ (1+i,) xs
(1+i,)

(1+5%)
F =~—_~ x 63.43 = 64.6617
(1+3%)

As per Uncovered Interest Parity Hypothesis, the Forward rate is

same as the Expected Future Spot Rate:

F =E (S) = 64.6617

The expected change in future spot rate is:

E (e) = (64.6617 — 63.43)/63.43 = 0.019417

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NOTES

Using the International Fisher Equation:

E(e) -= 0.019417 =_ (+f)

(i s,) 1

3) = _ (1+ 9%) _
(e) = 0.019417 (+s)

This implies the US inflation rate, f, to be 6.924% (as given in question)

Illustration: If one year interest rate in UK and Japan are 1.044% and
0.266%, respectively; the spot exchange rate is 182.69 JPY/GBR

What is the forward premium or discount?

If the expected inflation rate in UK is 0.08%, what is the expected in-

flation rate in Japan?

Solution: Using the covered IRP theorem

F (1+i,)
Ss D (1+i,)

The forward rate, F can be calculated as follows:

F= (1+4,) xs
(1+i,)

F _= —_“7
(1+0.266%)
s 182.69
(1+ 1.044%)
= 181.2834

As per Uncovered Interest Parity Hypothesis, the Forward rate is

same as the Expected Future Spot Rate:

F =E (S) = 181.2834 JPY/ GBP

The expected change in future spot rate is E (e)

= (181.2834 — 182.69)/182.69 = -0.007699

The JPY is quoting at forward discount to GBP of — 0.7699%

Using the IFE,

1
E(e) = 0.007699 = (14+ fe) _
(1+)
1+
E(e) = -0.007699 = (+h) 1
(1+ 0.08%)
This implies an expected Japanese inflation rate, fy of 0.8565%.

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NOTES

& SELF ASSESSMENT QUESTIONS

1. If absolute form of PPP holds good, and if the standard

consumption bundle costs 700 GBP in UK and 1000 Euros in
Germany, then the exchange rate between UK and Germany
should be 0.7 GBP /EUR. (True/False)
2. The absolute form of PPP does not hold good in the real world
because
a. Due to inflation
b. It is not possible to exploit all arbitrage opportunities in
order to ensure law of one price
c. Mainly because of tariffs and quotas
d. It is difficult to standardize consumption bundle
3. If coca-cola costs INR 100 per litre in India and USD 1.2 in US,
and if coca-cola represents a standard consumption bundle
that represents the price level between countries and if PPP
theory holds good, then
a. Indian currency is undervalued
b. US currency is undervalued
c. Spot exchange rate should be 83.33 INR/USD
d. None of the above
4. The concept of trade weighted real exchange rate is used
because
a. Price level ratio between different countries are different

b. A country does not trade with every other country in the

world
ce. When acurrency appreciates or depreciates, it does not do
so in same proportion with every other currency
d. None of the above
5. The Covered IRP theory
a. Explains how spot rate is determined
b. Is a better theory than PPP theory of exchange rate deter-
mination
c. Explains how forward rate gets determined by the market
d. None of the above

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NOTES

6. IfCovered Interest Parity Theory holds good, US interest rates

are higher than Indian interest rates, and also the investor
can avail forward contract, then:
a. It is advisable to invest in US markets and take forward
cover
b. It is advisable to invest in Indian markets and take forward
cover
c. Itis advisable to invest in Indian market with forward cov-
er if inflation rate in India is higher
d. It does not matter as returns will be same

7. The International Fisher Effect assumes that real interest rate

between all countries are equal. (True/False)

Od RXeuune
Visit any website that provides the current spot and forward ex-
change rates for different pairs of currencies. Verify whether Cov-
ered Interest Parity Theorem holds good or not for these currency
pairs for 3-month and one-year maturity forward contracts for fol-
lowing currency pairs: INR/USD and EUR/GBR

i SUMMARY
Q The absolute form of PPP theory is based on Law of One Price,
which states that identical goods should sell for same price world-
wide.
Q. As per absolute form of PPP the exchange rates are determined by
the price levels between countries. If the PPP exchange rate does
not hold good, then arbitrage of goods between countries would
ensure that prices or exchange rates change to abide by law of one
price.
Q If PPP holds good, the price levels adjusted for exchange rates
should be equal between countries and one unit of currency will
have same purchasing power globally.
Q The relative form of PPP takes into account the changes in price
levels between countries over a period of time. The relative form of
PPP says, if there is price increase (or inflation) in both the coun-
tries, then the exchange rate between the currencies would adjust
to maintain the purchasing power parity.
Q Real exchange rate is nominal exchange rate adjusted for inflation
rates applicable for the countries.
Q The Covered interest rate parity theorem states that the forward
rates will be determined by the interest rate differentials between
countries so that there are no arbitrage opportunities between
money markets.

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NOTES

Q The Uncovered Interest Rate Parity hypothesis maintains that

the return of an uncovered foreign money market investment has
same expected return as the domestic money market investment.
It is based on the unbiasedness hypothesis, which states that the
forward rate is the unbiased indicator of the expected future spot
rate.

Q Real Interest Parity states that the real interest rates between var-
ious economies should be equal in the long term.
Q The International Fisher Effect says that the rate of change of spot
rate is dependent on the interest rate differential between two
countries. In its approximate form, the expected change in the
spot rate, as per IFE, is given by the difference between the infla-
tion rates.
Q The PPP theory, Relative PPP theory, Covered Interest Rate Pari-
ty Theorem, Uncovered Interest Rate Parity Hypothesis and Inter-
national Fisher Effect together provides the international parity
conditions that explain exchange rate determination in the foreign
exchange markets.

KEY WORDS

Q Consumption bundle: A country’s consumption bundle refers

to the collection of all those goods and services that are con-
sumed in its economy.
Q Depreciation of currency: It refers to reduction in value or pur-
chasing power of a currency with respect to another currency.
Q Expected Future Spot Rate: It refers to exchange rate that is
expected to prevail on a future date.
Q Foreign exchange risk: It refers to uncertainty related to future
exchange rates that lead to increase in the risk involved in ex-
pected future returns or currency proceeds while investing in
foreign markets.
Q Forward rate: It refers to an exchange rate applicable for a fu-
ture transaction, but which is fixed at a prior date to eliminate
foreign exchange risk by entering into a contract.
Q Interest Rate Parity (IRP): It refers to the relationship between
interest rates of two countries and the exchange rates
Q Purchasing Power Parity (PPP): It implies that the prices of
identical products should be same across the countries due to
law of one price.
Q Real exchange rates: Nominal exchange rate adjusted for price
level difference between countries.
Q Spot rate: It refers to the current exchange rate prevailing in
the spot forex market.

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N OT ES

DESCRIPTIVE QUESTIONS
1. Explain the rationale behind the absolute form of Purchasing
Power Parity (PPP) Theory. Why is it not applicable in real world
situations?
2. Explain the Interest Rate Parity Theories with examples. Does
Covered Interest Rate Theory hold well in real world? List some
reasons as to why actual forward rates might deviate from those
predicted by IRR
3. Explain the concepts behind International Fisher Effect (IFE).

so ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Exchange Rate De
nation a
2. b. Not possible to exploit all arbi-
trages
3. ce. Spot rate is 83.33 INR/USD
4. ce. due to different proportion of
depreciation or appreciation
p> ce ec. explains how forward rates are
» determined
6. d. because Covered IRP holds good
> 7. a. True

HINTS FOR DESCRIPTIVE QUESTIONS

1. The PPP theory is based on law of one price. There are several
reasons why it does not hold in real world. Refer to Section
5.2 Exchange Rate Determination.
2. Interest rate parity theories predict forward exchange rates
based on interest rates and inflation rates. Refer to Section
5.2 Exchange Rate Determination.
3. The International Fisher Effect differentiates the real and
nominal interest rates and assumes that the real interest rates
between countries should be equal in the long term. Refer to
Section 5.2 Exchange Rate Determination.

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NOTES

Pa SUGGESTED READINGS FOR

we) REFERENCE

SUGGESTED READINGS
Q Bekaert, G., & Hodrick, R. (2009). Upper Saddle River, N.J.: Pear-
son Prentice Hall.
Q Eun, C., Resnick, B., & Zhao, Y. (2018). Beijing: Ji xie gong ye chu
ban she.

Q Madura, J. (2003). Mason, Ohio: Thomson/South-Western.

Q Pilbeam, K. (1992). Basingstoke: Macmillan.

E-REFERENCES
Q Moneycontrol.com,.(2015). Retrieved 19 November 2015, from
http://www.moneycontrol.com
Q In.reuters.com,. (2015). Retrieved 19 November 2015, from http://
in.reuters.com/finance/currencies/quote
Q = Stats.oecd.org,. (2015). Retrieved 19 November 2015, from https://
stats.oecd.org/

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 INTRODUCTION TO FOREIGN EXCHANGE
TRANSACTIONS, MARKETS AND RISK MANAGEMENT

CONTENTS

6.1 Introduction
6.2 Foreign Exchange Transactions
6.2.1 Spot Transactions
2.2 Forward Transactions
6.2.3 Swap Transactions
Self Assessment Questions
Activity
6.3 Exchange Rate Quotations
Self Assessment Questions
Activity
6.4 Spot Rate Quotations
Self Assessment Questions
Activity
6.5 Mechanism of Interbank Trading
6.5.1 Bank Treasury Operations
6.5.2 Factors Causing Exchange Rate Fluctuations
Self Assessment Questions
Activity
6.6 Arbitrage in Spot Markets
6.6.1 Two-Point Arbitrage
6.6.2 Three-Point Arbitrage
Self Assessment Questions
Activity
6.7 Forward Quotations
6.7.1 Outright Forward Quotations
6.7.2 Discount and Premium in Forward Market
6.7.3 Option Forward
6.7.4 Short Date and Broken Date Forward Contracts
Self Assessment Questions
Activity
6.8 Overview of FOREX Risk

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206 INTERNATIONAL FINANCE

CONTENTS
6.8.1 Nature of Foreign Exchange Risk
6.8.2 Benefits of Forex Risk
Self Assessment Questions
Activity
6.9 Definition of Exposure
6.9.1 Nature of Exposure
6.9.2 Sources of Exposure
Self Assessment Questions
Activity
6.10 Types of Exposure
6.10.1 Transaction Exposure
6.10.2 Translation Exposure
6.10.3 Economic Exposure
6.10.4 Operating Exposure
Self Assessment Questions
Activity
6.11 Classification of Foreign Exchange Risk
6.11.1 Position Risk
6.11.2 Mismatch Risk
6.11.3 Translation Risk
6.11.4 Operational Risk
6.11.5 Credit Risk
Self Assessment Questions
Activity
6.12 Techniques to Manage Forex Risk
6.12.1 Diversification
6.12.2 Currency Derivatives
6.12.3 Internal Hedging
6.12.4 Pricing
Self Assessment Questions
Activity
6.13 Corporate Internal Hedging Strategies
6.13.1 Leading and Lagging Strategies
6.13.2 Netting and Offsetting Strategies—Natural Hedge
6.13.3 Risk Sharing Strategies
6.13.4 Invoicing Strategies
Self Assessment Questions
Activity
6.14 Exchange Risk Management Process
Self Assessment Questions
Activity
6.15 Measurement of Exchange Risk
Self Assessment Questions
Activity
6.16 Summary
6.17 Descriptive Questions
6.18 Answers and Hints
6.19 Suggested Readings for Reference

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INTRODUCTION TO FOREIGN EXCHANGE TRANSACTIONS, MARKETS AND RISK MANAGEMENT 207

INTRODUCTORY CASELET

WHAT CFO SHOULD KNOW ABOUT FOREIGN

EXCHANGE RISKS

The Foreign exchange risks can affect the revenue and bottom
line of MNCs in significant ways. In January 2015, Procter & Gam-
ble stated that the strong dollar could bring down its net earnings
by as much as $1.4 billion (12%) after taxes. MNCs like P&G use
long-term hedging to manage exchange rate volatility.

Hedging forex risks require a good understanding of the currency

exposures of the company and the impact of exchange rate vol-
atility on the overall company financials. It ensures that CFOs
neither under hedge nor over hedge their currency expos
For example, many MNCs have the uncertainty of the curr
exposure. When foreign sales or the amount of raw mate
be imported itself is uncertain, it is difficult to hedge
sures. Companies like P&G face such anticipated bu
currency exposures that can lead to overestimati

holistic view on the compan

operating and economic e devise proper ways
to manage them. An e s management policy
framework might be required to t > these currency exposures.

A comprehensive ris] t framework can help CFOs to

properly analyse vario to manage forex exposures. For ex-
ample, corporates mostly rward contracts to hedge exchange
rate risks. However, currency hedges like forward contracts are
not the only tools available for hedging. Forward contracts pro-
tect against adverse movements of the exchange rate against the
exposure but leave corporates with locked-in rate when the cur-
rency movement is favourable. A clear understanding of various
hedging tools, methods and techniques of managing exposures
of the company can help CFOs to effectively manage forex risks.
(Source: Based on “What CFOs should know about foreign exchange risks”, Kristina
Narvaez, CFO.com, http://ww2.cfo.com/risk-management/2015/05/cfos-know-foreign-ex-
change-risks/, accessed on 15th October, 2015.)

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208 INTERNATIONAL FINANCE

NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

Describe foreign exchange transactions

ry
Explain exchange rate quotations

rrrryr
Discuss spot rate quotations
Describe the mechanism of inter-bank trading
Explain arbitrage in spot market
Discuss forward quotations
Explain the concept of FO risk
Describe of exposure
rr

Explain the types of e

Explain the classi i i xchange risk
yy

e foreign exchange risk

edging strategies
rYy

anagement process

i INTRODUCTION

The previous chapter discussed international parity relations. In this

chapter, you will learn about foreign exchange transactions. This
chapter is meant to give you a strong foundation on foreign exchange
transactions and foreign exchange exposure management. It is essen-
tial to understand the basics of various foreign exchange transactions
that are normally carried out in forex markets, the related market
conventions and practices, ete.

In the modern era of globalisation, all the economies across the world
have formed an international market where the currency of one coun-
try can be traded against another’s in a profitable manner; this is
called the FOREX market. International business between countries
is basically done through two media — merchandise of goods and ser-
vices, and finance. The FOREX market deals in the transactions of
financial securities, bonds and currencies and is an integral part of
the international monetary market. It is the market in which the ex-
change values of different currencies are analysed relatively to buy
and sell one currency against another in a profitable manner. The pair
of currencies is traded on the basis of the demand and supply of the
currency in the international market, and the exchange value of the
currency.

FOREX exposure is the percentage of the investment that covers the

market risk and the uncertainty of losing the investment in case of un-

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INTRODUCTION TO FOREIGN EXCHANGE TRANSACTIONS, MARKETS AND RISK MANAGEMENT 209

NOTES

favourable market conditions. This can be better explained with the

help of an example. Suppose a trader is investing assets worth $50,000
and half of the assets constitute commodity stocks. In this case, the
trader has a 50% market exposure of the commodity market and an
adverse situation in the commodity exchange will cause a loss to the
trader. The loss in the commodity stock will result in a decline in the
overall net worth of the assets of the trader. In order to overcome such
problems and to trade profitably, the study of FOREX exposure, mea-
surement of the level of the exposure and accessing the exposure in
the investment is necessary.

The chapter covers different types of foreign exchange transactions.

The chapter also covers exchange rate quotations, spot rate quota-
tions and mechanism of inter-bank trading. The chapter also dis-
cusses arbitrage in spot market and forward quotations. You will also
study about exposure and its types. The chapter also covers foreign
exchange risk and the techniques to manage foreign exchange risks.
Corporate internal hedging strategies are also discussed in detail. The
chapter also covers the exchange risk management process and mea-
surement of exchange risk.

(2) FOREIGN EXCHANGE TRANSACTIONS

International trade and investments require financial transactions
across borders. One of the important differentiating factors of such
international financial transactions is the involvement of multiple cur-
rencies. The core aspect of international finance is the risk that aris-
es due to involvement of foreign currencies in trade and investment.
This currency risk requires financial managers to be equipped with
risk management techniques.

International financial transactions involve more than one country

and each of these countries might have its own currency in which it
transacts domestically. This gives rise to the need for exchange of cur-
rencies as per the exchange rate determined by various economic and
market forces. The need for exchange of currencies has given rise to
the Foreign Exchange (FX) markets.

Each country has its own forex market consisting mainly of commer-
cial banks that transact in foreign currencies with themselves and
with foreign banks, on behalf of their domestic corporate and retail
clients, through correspondent banking relationships with banks
outside the country. The forex markets operate in two-tiers with the
transactions between banks forming the wholesale segment of the
forex market and the transactions between banks and their clients in
the retail segment. Though the transactions carried out by banks on
behalf of their clients are the primary driver of the forex markets, the
banks also transact with themselves for managing nostro accounts,
managing currency exposure, exploiting arbitrage transactions and

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210 INTERNATIONAL FINANCE

NOTES

making speculative trade. Such trades that form part of the wholesale
or inter-bank segment of the forex market constitute the major chunk
of the total volume of trade.

The Forex transactions also involve the following three major catego-
ries:

Q Speculation: It is the acceptance of high risk by traders in the mar-

ket for making large profits in a very short span of time. A forex
trader in a bank may decide to take a speculative position based
on his\her predictions regarding movement of exchange rates, in-
terest rates, forward rates, etc. Forex trades involving speculative
motives and taking risky positions form part of this category.
Q Hedging: This involves reducing the risks arising out of uncertain-
ty of exchange rate movements. This may arise out of requests of
bank customers who would like to hedge their forex exposures or
bank’s own currency position. The hedging tools include forward
contracts and swaps apart from spot transactions.

Q Arbitrage: Arbitrage refers to an act of buying something, which

in our case is currency, in one market and then selling it in another
market and making profits in this process. In general, arbitrage
transactions generate risk-less profits resulting out of market im-
perfections.

The forex markets involve three major types of transactions. These

are as follows:
Q Spot transactions
Q Forward transactions
Q FXswaps

Around 30% of all transactions fall under the spot category, 10% of
transactions are outright forwards and the remaining 60% transac-
tions are the FX swaps. We shall now study about each of these trans-
actions.

6.2.1 SPOT TRANSACTIONS

The spot transactions are carried out in the spot exchange segment,
also termed cash market segment, of the forex markets. A spot trans-
action involves the direct exchange of currencies between the coun-
tries in quick succession. These transactions involve immediate pur-
chase or sale of foreign currencies. These transactions are carried out
at the current exchange rate for immediate delivery. However, owing
to the nature of the forex markets, the “immediate” delivery does not
necessarily mean same day delivery. For successful completion or set-
tlement of any forex purchase or sale transaction, both the seller and
buyer should receive their respective currencies into their bank ac-
counts. Ifa bank in India purchases USD from another bank on behalf

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NOTES

of its corporate client, it would like the selling bank to credit the USD
proceeds into its nostro account maintained with its correspondent
bank in US. This requires the selling bank to instruct its own cor-
respondent bank in US to transfer the required USD amount to the
nostro account of the correspondent bank of the buying bank. This is
done through the SWIFT communication network. In general, it takes
two days to complete the cash settlement after the transaction date.

The transaction date is called the “Trade Date” and the cash settle-
ment date is called “Value Date”. The value date is normally the trade
date + 2 days exclusive of any holiday in either of the currency market
during these two day period. The value date is also the date on which
the bank accounts of the respective bank clients are debited for pur-
chase or sale of foreign currency. Suppose if a bank customer wants
to purchase $ 1 mn in the spot market on 14th October, 2015. The spot
rate applicable was INR 65/USD. His rupee bank account will be deb-
ited for INR 65 mn (ignoring transaction costs) and his foreign cur-
rency account will be credited for $1 mn on the value date of 16th
October, 2015. Thus, spot transactions involve delivery, in general, two
days after the transaction date. There are also some spot transactions
that settle in a single business day depending on the FX trade centres
and the payment mechanism available, for example, the forex trades
between banks in US, Mexico and Canada settle on the same day.

As against the spot transactions where the transaction is carried out

based on the current spot exchange rate quotation, the forward trans-
actions are meant for future delivery and are based on forward rates
about which we will study later.

Apart from spot and forward transactions, there are also concepts
like “Cash” and “Tom” transactions. Cash transactions refer to settle-
ment on the same day. For example, you can purchase FX from money
changers authorised by RBI on the same day in terms of currencies
or travellers cheques. The “Tom” transactions refer to delivery of FX
made on the next date after the date of transaction, i.e., these involve
T+1 settlement as against the T+2 settlement of spot transactions.

When a corporate client requires FX for immediate use, it would ask

its banker to buy or sell the currency as per its requirement. Such
transactions are carried out in the spot exchange market. For exam-
ple, an exporter might have received invoice proceeds in terms of a
foreign currency like GBR He/she would ask his/her banker to sell the
GBP and credit the equivalent INR amount into his/her account. The
applicable FX rates would involve margins, commissions and/or flat
fees. These are called merchant transactions and the rates quoted for
merchant transactions will be less/more than the spot rates quoted in
the interbank market for purchase/sale of foreign currency. In terms of
export and import transactions, the rates quoted for merchant trans-
actions are termed TT buying, TT selling, bill buying, bill selling rates
and are used for trade transactions like collection of demand bills and

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usance bills, negotiation of export bills etc. We shall study these in de-
tail in later chapters. Any delivery or receipt of FX arising out of these
transactions is carried out through the spot FX market.

Apart from client based spot transactions, there also inter-bank spot
transactions carried out by banks themselves for purposes like spec-
ulation, arbitrage and hedging as mentioned earlier. In fact, the trade
volume of spot transactions between banks on their own behalf is
much more than the spot transactions carried out on behalf of bank
customers.

6.2.2 FORWARD TRANSACTIONS

The forward market segment of the forex market involves contracts

to purchase or sell FX for future delivery. These are the financial ex-
change transactions in which the transaction between the parties is
done at a rate of exchange fixed on the transaction date, but settle-
ment takes place at a future date. As against the spot transactions,
forward transactions are meant for hedging exchange rate risk.

Consider an exporter who exports goods to Germany and invoices

the amount in Euro. He agrees that the importer can make the pay-
ment after 90 days. While invoicing, he would arrive at the invoice
amount by converting the INR amount to EUR amount based on the
prevailing exchange rate. Let us say his cost of manufacturing the
goods is INR 10,00,000 and he adds 15% profit margin and the total
INR invoice amount is INR 11,50,000. This is the competitive price the
exporter has quoted and agreed by the importer. Let us say the cur-
rent exchange rate for Euro with respect to INR is INR 75/EUR. The
EUR invoice amount would be EUR 15333. He expects to receive EUR
15333 after 90 days.

When he receives the EUR amount after 90 days, he can ask his bank-
er to sell the EUR in the spot market. However, the spot exchange rate
after 90 days will not be the same as the current exchange rate of INR
75/EUR. Suppose the exchange rate is INR 65/EUR after 90 days. The
net proceeds after spot sale will be 15333 X 65 = INR 9,96,667 which
implies complete erosion of profit margin as the invoice amount in
terms of Indian rupee is INR 11,50,000. However, if the rupee depreci-
ates to say INR 80/EUR during this period, he would receive INR pro-
ceeds of INR 12,26,667, which will include much more than his prof-
it margins. Thus, the exporter faces uncertainty with regard to how
much amount ultimately he would be able to realise from his export
trade.

Suppose his banker gives a solution whereby he agrees to purchase

the EUR proceeds after 90 days at an exchange rate that will be fixed
now. This would require the exporter to enter into a contract with
his/her banker whereby the exporter agrees to sell EUR 15,333 after
90 days (or on some specific future date or period) at a specific ex-

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change rate mutually agreed now. Such a contract is termed the “For-
ward Contract” and the exchange rate agreed for such transactions is
termed the “Forward Exchange Rate”.

The forward exchange rate can be greater or less than the current
exchange rate. This depends on the interest rate differential between
the two countries. In this case, the forward rate will depend on the in-
terest rate differential for 90 days between India and Germany (EUR
deposit markets). Remember the Covered Interest Rate Parity Theo-
rem we studied in the previous chapter. The bank will quote the for-
ward rate based on the Covered Interest Rate Parity Theorem.

The forward contract whereby the exporter sells FX to the banker on

a future date based on an exchange rate fixed now is termed the For-
ward Purchase contract as the bank purchases the FX from its client.
Similarly, the banker can enter into a Forward Sale Contract with an
importer to sell FX at a future date on pre-fixed forward exchange
rate.

By entering into a forward contract, the exporter or importer is ba-

sically shifting the exchange rate risk to his banker. The banker will
hedge this risk by entering into an offsetting forward or swap con-
tracts with other bankers in the interbank forex market. For example,
the banker in the above example may immediately enter into a for-
ward contract to sell after 90 days EUR 15,333 with another bank in
the interbank forex market.

These forward contracts executed in the interbank forex markets, on

behalf of bank clients, are usually termed “Outright Forwards” and
constitute around 10% of the total turnover of the forex markets.

We shall now understand how the banks hedge their risks arising out
of the forward contracts entered with their clients. Let us consider
the above example of exporter transferring his EUR related exchange
rate risk to his banker. The banker has agreed to purchase EUR 15,333
after 90 days at a fixed exchange rate. He may have to purchase EUR
in the spot market and deliver to his customer on the maturity date
but the exchange rate movement could cause him a loss. In general,
bankers never take exchange rate risk in their books and they always
hedge whatever risks they undertake in order to avoid potential and
damaging losses. In the above case, the bank has the following op-
tions:
1. Find another FX market participant who has an opposite
exposure and enter into an offsetting forward contract. For
example, there could be another bank whose importer has
entered into a forward contract to buy EUR after 90 days at the
fixed forward rate. If the bank finds such counterparty, it will
enter into a forward sale contract to sell EUR after 90 days which
will offset the risk. In other words, after 90 days, the bank only
needs to receive the EUR proceeds from his exporter and sell it

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to the other bank with whom it has entered into a forward sale
contract. The spread between the forward buy rate at which it
has entered into a contract with his exporter and the forward sell
rate at which he has entered into a forward sale contract with
another bank will be its profit.
2. If there are no forward buyers for EUR and if the bank cannot
offset its risk in the FX market, it might refuse to undertake
the forward contract for the exporter. However, it has another
option whereby it can help its exporter hedge his risk without
also taking risk into its book. It involves the following steps:
1. Borrow EUR in European money markets for 90 days whose
redemption value (i.e., principal + interest) is same as the
amount of forward purchase contract it would like to enter
with his exporter.
2. Sell the borrowed EUR against INR in the spot exchange
market and lend the INR proceeds received for 90 days in the
Indian money markets.
3. The forward rate quoted to his exporter will be based on the
maturity value of the INR investment (or money lent in the
Indian money market). It will be:
Forward Purchase Rate = Maturity value of Indian Invest-
ment in INR / Maturity value of EUR Loan
4. On the maturity date, receive the EUR proceeds from the
exporter and close the EUR loan. Receive the maturity pro-
ceeds of INR loan lent in Indian money markets and deliver
it to the exporter.
If the bank takes the above steps, it will not incur any FX risk its
net cash flow will be zero. It may decide to include some profit
margin when quoting the forward purchase rate.
4. Enter into a FX swap transaction consisting of spot purchase
of EUR and forward sale of EUR with another bank. The spot
purchase of EUR will be squared with a spot sale of EUR. The net
effect will be the forward sale contract that offsets the forward
purchase contract agreed with the exporter. We shall explain
swap transactions in the next section.

6.2.3 SWAP TRANSACTIONS

A swap transaction is the simultaneous purchase or sale of spot FX

against a forward sale or purchase for an equivalent amount of foreign
currency. This means that there are two transactions involved in a
swap. There is a spot transaction and also a forward transaction in the
opposite direction and both the transactions are done with the same
counterparty. Thus, we can say that swap transaction is the hybrid of
the spot and forward transactions in the opposite direction, meaning

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that the two parties agree to exchange the currencies for a fixed peri-
od of time and to reverse the transaction at the future date.

For example, if bank A sells EUR 10 mn against INR at spot exchange

rate (for immediate delivery) along with a forward contract to buy
back EUR 10 mn against INR at a future date and at a specified for-
ward rate with another bank B, then the bank A is said to have en-
tered into a FX swap contract with bank B.

As against outright forward transactions, most FX swap transactions

are interbank transactions carried out between banks. These trans-
actions constitute more than 50% of the total volume of FX market
transactions. Banks do FX swap transactions in order to hedge their
risks.

CONCEPT BEHIND FX SWAPS

The primary driver of FX swap transactions is the concept of interest

rate arbitrage. As per the Covered Interest rate parity theorem, for-
ward exchange rates are determined by the interest differential be-
tween two currencies:

( 4 _ (1+%,)
s)" (vi,)
Where F is the forward rate, S is the spot exchange rate and i is the in-
terest rates in the respective countries for the forward maturity period.

In the previous section, we talked about forward contract entered by

the bank with his exporter. The forward exchange rate quoted will be
based on the market forward rates that are determined by the interest
rate differential as per the equation above. If the above equation holds
good, then the forward rate determined by the bank in the option (2)
in Section 6.2.2 will be same as the forward rate quoted in the market.
The bank has to choose the option (2) only when forward quotes or a
counterparty for the offsetting contract does not exist in the market.

Also, if you remember the covered interest arbitrage process explained

in the previous chapter, the steps taken by the bank in option (2) are
similar to the steps involved in covered interest arbitrage. In the cov-
ered interest arbitrage process, instead of entering into a contract with
exporter, the bank will enter into a contract with another bank.

A bank might undertake covered interest arbitrage when it finds that

the prevailing interest differential is not reflected in the spot and for-
ward exchange rates. This would allow him to make risk-less arbi-
trage profits.

If the bank finds the Indian interest rates higher, the differential in-
terest rates between Indian and European money markets are not re-

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NOTES

flected in forward rates properly, the steps it will take for arbitrage are
as follows:
1. Borrow EUR in European money markets for the forward
maturity period whose forward rates are not in alignment with
interest rates

2. Sell the borrowed EUR against INR in the spot exchange market
and lend the INR proceeds received for the relevant maturity
period in the Indian money markets.
3. Enter into a forward purchase contract with a bank to purchase
EUR for an amount equal to the redemption value of EUR loan.
4. Onthe maturity date, receive the EUR proceeds from the forward
contract and use it to close the EUR loan. Receive the maturity
proceeds of INR loan lent in Indian money markets and deliver
it to the counterparty.

Since the Indian interest rates are higher, the INR maturity amount
will be greater than the INR amount to be paid to the forward coun-
terparty. This difference will be the riskless profit for the bank. If you
carefully observe the steps in above arbitrage process, you will find
that it requires a FX Swap transaction of Spot sale and Forward Pur-
chase. The two transactions of spot sale and forward purchase should
be carried out simultaneously in order to ensure that the exchange
rates do not change adversely. Hence, the bank would prefer to enter
into FX swap constituting both the transactions with a single counter-
party.

For executing the above arbitrage process, the bank A might look for a
counterparty who wants to enter into a forward purchase of EUR. Let
us say, the bank of our exporter in the previous example, say Bank B,
is the counterparty. In this case, Bank A would like to sell EUR Spot
and Forward Purchase EUR from Bank B. In other words, the Bank A
would like to enter into a FX swap transaction with the Bank B. The
Bank B however needs to only offset its forward long (i.e.. buy) posi-
tion. There is no need for it to enter into a FX swap transaction. How-
ever, Bank A may not be interested in entering only into an Outright
Forward contract which is the requirement of Bank B. Hence, the
Bank B will accept a FX swap transaction of Purchasing EUR Spot
and Sell EUR forward. It will however need to immediately square off
the spot EUR purchase with a spot EUR sale.

In forex and money market terminology, a long position is a surplus

of purchases over sales of a given currency. A short position is a
surplus of sales over purchases of a given currency. Both long and
short positions lead to exchange rate risk. A bank will suffer losses
if the currency weakens when having a long position and vice versa.

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Apart from interest arbitrage, the FX swap transactions may also

be suitable for managing the currency portfolio positions of banks.
Many cases of hedging of spot (or cash) short / long positions might
be combined with hedging of forward long/short positions of the same
currency through FX swap transactions. Most of the forward transac-
tions carried out in interbank markets on behalf of corporate clients
are part of the FX swap transactions as explained in the previous ex-
ample.

SELF ASSESSMENT QUESTIONS

1. Apart from purchase or sale of foreign exchange for their
clients, the forex transactions of banks also involve these
three categories: ; , and

2. The three major types of forex transactions in interbank

market are : , and

3. transaction is a hybrid of spot and forward

transactions in the opposite direction.
4. A bank customer expects to receive 1 million pound sterling
after 3 months. In this case, the customer would enter into a
contract with his banker to:
a. Spot sell GBP 1 mn at spot rate
b. Forward Purchase GBP 1 mn at spot rate
ce. Forward Sell GBP 1 mn at some expected future rate
d. Forward Sell GBP 1 mn at forward rate
5. What will happen, if a bank enters into a forward purchase
contract with its customer?
a. It will enter into a forward sale contract with another bank
b. It will enter into a forward purchase with another
customer
ce. It will enter into a sell-buy FX swap with another bank
d. It will do nothing else as there is no risk exposure in the
forward contract

The Bank of International Settlements (BIS) publishes statistics

periodically on the volume of global FX turnover. Visit the website
of BIS and download the latest statistics. Study and comment on
the various segments of forex turnover.

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EXCHANGE RATE QUOTATIONS

Since the forex market involves participants from different countries
having different currencies and markets, there is a need to standardise
the market operations. This requires adoption of standard symbols,
conventions and market practices. It is essential to be knowledgeable
on these standards and conventions in order to understand the forex
transactions.

An exchange rate quotation is the rate at which the currency of one

country is converted into the currency of another country. The cur-
rency that is priced for exchange is called ‘quote currency’ and the
currency to which it is converted is called ‘base currency’. When we
convert the currency of country X into the currency of country Y, it
simply means the price of currency X per unit currency Y or price of
currency Y per unit currency X. For example, if the exchange rate of
the U.S. dollar and the Euro is 1.2290, it means that one unit of Euro is
equal to 1.2290 USS. dollar. In this case, the quote currency is the U.S.
dollar and the base currency is the Euro.

FX quotations are similar to price quotations. The price of a commod-

ity is generally expressed as “currency amount per unit of commod-
ity”, e.g., INR 70 per litre of petrol. The FX markets treat currencies
similar to a commodity — the difference being price of one currency
is expressed in terms of another currency. The forex quotations give
price of a currency in terms of another currency.

Suppose you want to purchase US dollars. The price of US dollars will

be different in different currencies. So, you need to indicate in which
currency you would like to pay for your purchase of US dollars. Sup-
pose you would like to pay in Indian Rupees. Then, you would be giv-
en the price of dollars in terms of Indian rupee, i.e., amount of Indian
currency required to purchase a unit of US Dollar. Since all currencies
are treated like commodities, in the FX markets, you basically want
to exchange one commodity or currency for another. Hence, the price
of a currency is termed “Exchange Rate” — the rate at which you can
exchange one currency with another. For example, if you are given the
price of US dollars as INR 65/USD, it means you have to pay INR 65
for each US dollar.

The currency which you want to purchase or sell is generally called

the “Base Currency”. In the above case, the commodity which you
would like to buy is USD and is called the “Base Currency”. The cur-
rency in which the price is expressed (and which will be exchanged) is
termed the “Quote Currency”.

In every forex buy or sell transaction, there is a buyer and a seller. In

the above case, the person who purchases USD is a buyer and one
who sells USD is the seller. But this is only from the perspective of

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USD currency. In the same transaction, from the perspective of Indian

Rupee, the one who purchases USD is also considered to be selling
Indian Rupee and the one who sells USD is also a purchase of Indian
Rupee. Hence, the above exchange rate of INR 65/USD can also be
given in the opposite direction. The exchange rate between USD and
INR can also be indicated as USD 0.01538/INR, which would mean
each unit of INR costs USD 0.0153.

Since forex markets involve exchange of currencies where a person is

considered to buy one currency and sell another currency, the ques-
tion arises how to express the price quotation, i.e., whether as INR 65/
USD or USD 0.01538/INR. It will be highly confusing to use both kinds
of terminologies especially since there are so many other currencies
and any currency can be theoretically exchanged with any other cur-
rency. Hence, there is a need to standardise the FX quotations.

There are two major standards that are widely followed in FX price
quotations. These are as follows:

DIRECT AND INDIRECT QUOTES

As mentioned earlier, the exchange rate can be specified by keeping

either of the currency as the base currency. In the INR/USD conver-
sion, the base currency can be either INR or USD. When two persons
exchange INR and USD among themselves, both of them are simul-
taneously buyers and sellers depending on the currency perspective.
If a resident Indian is exchanging USD witha US citizen, then for the
US citizen the commodity that is purchased is INR and he may like
the price of INR to be given in terms of USD as explained before.

The two ways of quotes can be differentiated in terms of which of the

currency is domestic and which one is foreign. An Indian citizen who
wants to purchase US dollars would like the exchange rate to be spec-
ified in terms of domestic currency, i.e., INR. When the exchange rate
is specified in terms of “Domestic Currency per Unit of Foreign Cur-
rency”, the quotation is termed “Direct Quote”. When the exchange
rate is specified in terms of “Foreign Currency per Unit of Domestic
Currency”, it is termed “Indirect Quote”.

However, remember that whether a quote is direct or indirect is deter-

mined from whose perspective you are looking at. The quote INR65/
USD is a direct quote only from the perspective of an Indian citizen.
The quote USD0.01538/INR will be the direct quote for the US Citizen.

In the forex markets, both the direct and indirect quotes are not giv-
en for each currency pair. Different currencies adopt different meth-
ods. In Indian forex markets, the forex quotations are always given
in terms of “Direct Quotes”, i.e., all exchange rates are expressed in
terms of Indian currency per unit of foreign currency.

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AMERICAN AND EUROPEAN QUOTES

Even after the demise of the Bretton Woods System, the US Dollar
continues to be the major international currency in which most of the
international trade and forex transactions are done. As per BIS statis-
tics, more than 90% of all currency trading in the world involves USD
on one side of the transaction. Hence, most of the forex transactions
price and trade currencies are against the US Dollar.

The above fact allows exchange rate quotations to be differentiated

in terms of whether or not the quote has USD as the base currency.
Since most of the forex transactions involve USD, it is easier to ex-
press the value of various currencies in terms of per unit of USD. In
other words, most of the exchange rate quotations express the quan-
tity of foreign currency that can be purchased by one unit of USD (or
price of one USD expressed in various currencies). These exchange
rates and quotations are termed “European Quotes”. Thus,

European Quote: “Expressed or Priced in terms of US Dollars”

Note that a European Quote is an “Indirect Quote” from the perspec-

tive of US as it expresses exchange rate in terms of foreign currency,
Le., “Foreign Currency per unit of domestic currency”

Another practice is to give quotes with USD as the base currency.

These quotes are termed “American Quotes”. Thus,

American Quote: “Quote currency expressed in terms of USD as base

currency”.

Table 6.1 differentiates and summarises the concepts discussed above:

TABLE 6.1: SUMMARISATION OF MAJOR STANDARDS

FOLLOWED IN FX PRICE QUOTATIONS
pe Method Example
Direct or Indirect Whether exchange rate Domestic Currency: Di-
Quote is expressed in domes- rect Quote (for India):
tic currency or foreign INR 65/USD
currency Foreign Currency: In-
direct Quote (for US):
CAD 1.5/USD
American or European Whether exchange rate Expressed in USD:
is expressed in USD American Quote: USD
(or whether USD isthe 1.75/GBP
base currency) Expressed with USD as
base currency: Euro-
pean Quote: CAD 1.5/
USD

Most of the currencies in the interbank markets are quoted in terms

of European Terms of “Number of units of foreign currency per Unit

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of USD”. However, by convention some currencies are always quot-

ed in American terms. These include Euro, Pound Sterling, New
Zealand dollars, Australian Dollars etc. For these currencies, the ex-
change rates are expressed in terms of number of units of US dollars
applicable.

&e SELF ASSESSMENT QUESTIONS

6. The currency that you want to purchase or sell is generally

called the
7. An is the rate at which the currency
of one country is converted into the currency of another
country.

8. FX quotations are different from price quotations. (True/

False)

Visit the forex pages of websites like Thomson Reuters, Bloomberg

and Oanda and study the quotes in terms of method of quotation
adopted for various currencies.

9 Spor RATE QUOTATIONS

Spot rate quotations refer to the quotation in which the number of
the foreign currency is equated with the number of the domestic cur-
rency. The exchange rates are denoted in a number of different ways
such as INR 65 / USD, 65 INR/USD etce., where the denominator cur-
rency is the base currency. In other words, the denominator currency
is the commodity that is meant to be sold or purchased. Alternatively,
the price expressed is the number of currency units required to pur-
chase the base currency. We have already seen the different methods
of quoting this exchange rate. When the FX market quotes are pub-
lished, they may be given in terms of following notations: Base Cur-
rency/Foreign Currency (e.g. EUR/USD) or Base Currency Foreign
Currency (EURUSD) or Base Currency-Foreign Currency (e.g., EUR-
USD) etc. The first symbol in the quote is the currency that is meant
to be purchased or sold. The price of the currency to be purchased or
sold is given in terms of the other currency which is to be exchanged.

For example, EUR/USD = 1.1278 means one unit of EUR equals 1.1278
US Dollars. Remember that this quote is a “Direct Quote” from the
perspective of US, and indirect quote from the perspective of Europe-
an Union countries. It is also an “American Quote”. Similarly, a quote
like GBP/USD = 1.5369 means One GBP equals 1.5369 US dollars.

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Table 6.2 is extracted from the currency page of Reuters India:

TABLE 6.2: CURRENCY TABLE

Currency Latest Day High DayLow %Change Bid Ask
Exchange
Rate Quote
EUR/USD | 1.1278 1.1292 1.1265 +0.00% 1.1278 1.1281
GBP/USD 415369 1.5374 1.5340 -+0.15% 1.5369 1.5374
USD/JPY a 120.12 120.15 119.82 » +0.16% 120.12 120.13

USD/CHF «0.96690 0.96790 0.96130 « +0.15% 0.96690 0.96710

USD/CAD ¥ 1.2958 1.3021 1.2955 © -0.44% 1.2958 1.2968

AUD/USD 0.72900 _0.72920 0.72480, «40.48% 0.72900 0.72910
(Source: www.reuters.com)

The first column of the above table lists the six major currency pairs of
the global FX markets. The second column gives latest exchange rate
quote in terms of value of the first currency of the pair in terms of the
second currency. Thus, the quote of USD/JPY(Japanese Per Yen) =
120.12 means One USD equals 120.12 JPY and it is a direct quote from
the perspective of Japan while it is also an European Quote as it is not
expressed in terms of US Dollars. The third and fourth columns give
day’s high and low and the fifth column gives the % change.

The last two columns are important. They introduce two important
terminologies: “Bid” and “Ask”. The term “Bid” refers to “Buy” or
somebody’s willingness to buy and the term “Ask” refers to “Sell” or
somebody’s willingness to sell. The buy or sell is with respect to the
commodity whose price is quoted. The base currency is the commodi-
ty that is being bought or sold and it is given as the first symbol in the
above quotes. Hence, a bid quote of 1.1278 in the first row above means
somebody is “willing to buy” EUR at the exchange rate of 1.1278 US
dollars and the ask quote of 1.1281 USD means somebody is willing to
sell EUR currency at that exchange rate.

One important thing to remember is that forex quotes are always in-
ter-bank quotes. This means these are the exchange rates at which
the banks trade amongst themselves. So, if a bank wants to sell EUR
against USD, which rate is applicable? It has to find the exchange rate
at which some bank is ready to buy. Hence, the applicable rate will be
the bid rate of USD 1.1278/EUR.

If the transaction does not pertain to the base currency but the other
currency of the quote, then the inverse of the quote will be applica-
ble. For example, if a bank wants to buy/sell USD against EUR, and it
would like to know the number of EUR it would get per unit of USD,
then the inverse quote of (1/1.1278) will be applicable. The applicable
quote will, if represented in the following way:
Q USD/EUR Bid: (1/Ask = 1/1.1278=EUR 0.8867/USD)
Ask: (1/Bid = 1/1.1281 =EUR 0.8864/USD)

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Note that the inverse of Ask rate of EUR is the Bid rate of USD when
USD is the base currency. In other words, a bank willing to buy EUR
at USD 1.1281/EUR also means it is selling USD at the inverse rate
of (1/1.1281=) EUR 0.8864/USD! Hence, the ask rate becomes the bid
rate when the base currency is interchanged.

The second point to observe is the number of decimals with which

the quotes are given. Most of the quotations are carried out up to 4
decimals places. This is so in both American and European terms.
However, for some currencies it could be less than 4 decimal places
and for few other currencies it could be more than 4 decimal places.
In the above example, note that the JPY is quoted with only 2 decimal
places.

The third thing to observe in the above quotes is the difference be-
tween the bid rate and ask rate. First of all, note that the bid rate will
always be less than the ask rate. This is because since the both the
quotes are applicable for the same bank, the exchange rate at which it
sells a currency should be more than the rate at which it buys in order
to ensure that it does not make loss. The difference between the ask
and bid rates is called the “Bid-Ask Spread”. It is the profit the bank
makes by making market in that particular currency.

Since the exchange rates change every second, when traders commu-
nicate among themselves, they refer to the quote up to first two dec-
imal places (1.12) as the “big figure” which is assumed to be known
by all traders and the second two digits to the right of the decimal
place as the “small figure”. Thus, the quote for EUR/USD above will
be communicated just as “78-81” when asked for the EUR quote.

The bid-ask spreads are also expressed in terms of the trader’s jargon
as “pips”. A “pip” means “Price Interest Point” and it refers to the
smallest unit with which currency quotations can change. For curren-
cies that are quoted with 4 decimal places, the quotations can change
by a minimum value of up to 0.0001. The bid-ask spread for the EUR/
USD quote can also be expressed as “3 pips”.

Though the bid-ask spread is very low, especially in recent times due to
increasing competition and electronic trading, if you take into account
the volume of transactions, the profits to the market makers could be
significant. For example, the standard size of forex transaction trade
is US dollar equivalent of $10 mn or “ten dollars” in trader’s jargon.

As mentioned before, the bid-ask quotes given above are applicable

for inter-bank trades. The banks will quote with higher spreads for
the retail segment of the market. These transactions in the retail seg-
ment with the corporate clients are normally termed as “Merchant
Transactions”, since they involve an underlying trade transaction and
the quotes are termed “Merchant Quotes”, which might also involve

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margins and commissions apart from the spread. We will discuss these
in the next section.

If an exchange rate quote is not available in the market between a

pair of currencies, a synthetic quote can be created using available
quotes that contain one of the currencies. These quotes are termed
“Cross Currency Quotes” or “Cross-Exchange Quotes” and they do
not involve US dollar on either side. The USD is generally used as the
intermediate currency for arriving at the cross exchange rate as most
of the currencies have their quote with USD on one side. For example,
if GBP — USD and USD — JPY are given as follows:

GBP — USD Bid = 1.5369 Ask = 1.5374

USD — JPY Bid = 120.12 Ask = 120.13

We need the GBP-JPY quote, which means the price of GBP in terms
of JPY. Using one GBP we can purchase 1.5369 USD (by selling one
GBP). For 1.5369 USD, we can purchase JPY using the bid rate of
120.12 for USD, i.e., 1.5369
X 120.12 = 184.61 JPY. This means one GBP
is equal to 184.67 JPY. We can offer to purchase one GBP using the
proceeds of 184.61 JPY. This implies the bid rate for GBP-JPY will be
JPY 184.61/GBR

In mathematical notation it implies:

GBP — JPY = JPY/GBP = (USD/GBP) x(JPY/USD) =1.5369

x 120.12
= 184.61 JPY

Similarly, the ask rate for GBP-JPY can be calculated by multiplying

the ask rate of GBP — USD and ask rate of USD — JPY to get ask rate
of GBP — JPY as 184.69.

In the above example, we multiplied the bid rates because of the

nature of the quotes of the currency pair GBP and USD. Otherwise,
it could have been the product of bid and ask rates for a different
currency pair.

CROSS RATE AND CHAIN RULE

At times, the unavailability of the direct quotes for certain pairs of cur-
rencies hampers the dealing in the exchange market. For instance, an
individual transacting in the exchange market may find the quote for
INR/USD and another for USD/GBR However, INR/GBP may not be
readily quoted. In this kind of situation, the dealer arrives at INR/GBP
rates by making use of the cross-rate mechanism and the chain rule.

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CALCULATION OF CROSS-RATES

Suppose that there are two exchanges taking place with the involve-
ment of three currencies. The cross rate can be determined by using
simple mathematics. That is, given A/B and B/C, we can always find
what A/C will be, as follows:

Where, X, Y and Z are the exchange rates of any three countries.

It is important to note that if there is absence of consistency between

the cross-rate and actual market rate, this mispricing would be arbi-
traged by the market. This arbitration would continue till the time the
mispricing is eliminated.

For instance, suppose that there are three quotes in the market that is
X/Y, Y/Z and X/Z. Firstly the cross rate would be determined by using
the aforementioned formula. After that, the comparison of this cross
rate will be done with the actual quoted rate. If diserepancy is found
between the quoted rate and the cross-over rate, the arbitration would
take place in the market by applying the chain rule method as follows:

Convert 1 unit of X to Y and then Y to Z and then Z to X. If the result

obtained is greater than 1, it indicates the chances of profit from im-
plementing this strategy. If the obtained value is less than 1, make con-
version of 1 unit of X to Z and then Z to Y and then Y to X for earning
profit for sure.

FORWARD CALCULATIONS

Forward rates are quoted in terms of points in foreign exchange mar-

kets, and referred as pips. These points show the variation between
the forward exchange rate quote and the spot exchange rate quote. It
is important to note that the base currency is traded at forward pre-
mium when the forward rate is more than the spot rate. On the other
hand, the base currency is traded at discount when the spot rate is
higher than the forward rate.

Example: Calculate the three-month forward rate from the following

table:

Maturity Spot Rate/Forward Points

Spot 1.3055
One week -0.3
Three months -5.3
Solution: 1.3055 + (-5.3/10000) = 1.30497

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ee SELF ASSESSMENT QUESTIONS

9. A refers to the smallest unit with which

currency quotations can change.
10. If an exchange rate quote is not available in the market
between a pair of currencies, a synthetic quote can be created
using available quotes that contain one of the currencies.
(True/False)
11. quotes are always inter-bank quotes.

Visit the US, UK and Indian pages of the currency section of Thom-
son Reuters. Verify the cross currency rates for applicable currency
pairs.

a MECHANISM OF INTERBANK TRADING

As we studied earlier, commercial banks are the primary participants

of the FX markets and most of the trades are inter-bank transactions.
These inter-bank FX transactions could be executed either on their
own behalf for speculation, arbitraging or hedging or on behalf of
their clients like corporations and individuals. Though most of the
trade happen between dealing desks of banks, the FX market also
includes broker-dealers. When banks want anonymity, they might use
the services of a broker-dealer.

The FX market is an Over-the-Counter (OTC) market. An OTC mar-

ket is one where there is no centralised trading place or exchange for
trading to take place. A centralised exchange or trading has many dis-
tinct features that are absent in an OTC market. For example, if you
like to buy the shares of Reliance Industries, you can see the quote
from one of the national stock exchanges like BSE or NSE. This quote
will give you the last traded price along with best bid and ask prices
along with volume. These quotes cover the entire market trading com-
munity on the concerned stock. However, in a decentralised trading,
theoretically the price quotes can differ between trading centres in
the sense that a quote offered by a trading platform is applicable or
based on the trading community subscribing to that particular plat-
form. Secondly, the centralised exchanges like stock exchanges would
offer online quotes that are traded on the basis of “anonymous and
automatic order-matching process”. This means the trading platform
will automatically match the buyers and sellers anonymously based
on their respective bid and offer prices. In contrast, OTC markets are
not driven by a centralised order book but the trades are of the nature
of bilateral negotiated trades that happens over the phone.

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The FX market has traditionally been an OTC market where trades

happen over telephone between two FX dealers. In recent times, these
telephone conversations have been replaced by electronic conversa-
tions that happen through a common FX trading platform to which
both the dealers have subscribed. These proprietary FX platforms like
Reuters, link trading desks of thousands of banks and other market
participants. They allow (indicative and sometimes dealable) quotes
to be streamed from various FX market participants so that market
developments can be monitored online. The quotes are updated ev-
ery second with the latest market information. The quotes include the
best available quote of the market for the currency pair and the best
quote available to the dealing bank based on its credit relationships
with counterparties.

Though the forex trades are still predominantly (electronic) conver-

sation and RFQ (request for quotation) based, the major platforms
also offer order matching book services where anonymous trade can
be executed. This segment was also fast growing one with nearly $2
trillion volume of trades per month happening in 2006. However, due
to the very nature of forex trading and counterparty credit and limit
relationships, the electronic conversations based dealing systems con-
stitute major share of the global forex trading volume.

These proprietary trading platforms, apart from providing ancillary

services like market information, pre-trade analysis, market analytics,
market aggregation, portfolio analysis, etc., also provide back-office
operations like post-trade settlement through Straight-Through-Pro-
cessing (STP) through which verifications and fund transfer instruc-
tions are automated. These trading platforms, unlike online stock
market trading platforms of exchanges, has major role only after the
trading is agreed between two dealers who are known to each oth-
er. The two major FX trading platforms which cover majority of in-
ter-bank trading volume of banks from all over the world are Thomson
Reuters Dealing 3000 and ICAP’s EBS Direct. Both these platforms
mainly cater to trades based on electronic conversations.

Apart from these proprietary trading platforms that link the FX mar-
kets participants and constitute the major trading volume of FX mar-
kets, the concept of Online FX Trading has also taken off. There are
online forex websites that allow trading anonymously similar to online
trading of shares. These online trading platforms are also connected
to the main trading that happen between banks through the propri-
etary platforms like Reuters, etc. These platforms are termed “Dealer
to Client Online Trading Platforms” as they allow banks to extend the
interdealer market to customers outside the inter-bank market. All
major banks have their own electronic trading platform to serve their
customers. Examples are CitiFX of Citibank, DealStation of ABN
Amro, dbmarkets-etrade.com of Deutsche bank etc. These are termed
single dealer platforms. This includes private players like Oanda and

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GAIN Capital. Multidealer platforms provide online forex trading by

connecting to multiple dealing banks. The four major players are FX-
all, FX Connect, Currenex and Hotspot FX.

The FX dealing desks of commercial banks form the main market par-
ticipants in FX markets. Most of the FX market turnover happens
between commercial banks. A major feature that distinguishes this
inter-bank FX market is the size of the deals. The minimum size of the
inter-bank market deals are in the range of $10,000,000, simply termed
‘tens’. Obviously, none other than the big commercial banks can par-
ticipate in this kind of market. Trading volume of less than ten biggest
banks constitute major share of overall global FX market turnover.

The forex division of the commercial banks will have separate FX

dealers specializing in particular currency pair (with USD being on
one side of the pair). Thus, a major bank will have separate desks in
the FX dealing room for each of the major currency pairs like EUR-
USD, GBP-USD, USD-JPY, USD-CHF etc. It is pertinent to note that
different FX trading platforms have market share in different curren-
cy pair, for example, Reuters has major market community trading in
USD related Paris while EBS with EUR related pairs — a distinctive
feature of a decentralised OTC market.

These FX dealers of commercial banks maintain their own currency

portfolio and provide bid-ask quotes, the spread being his profit sim-
ilar to market makers in a centralised exchange. Being an OTC mar-
ket, a dealer interested in buying or selling a currency would contact
a dealer of another bank (by telephone or through electronic screen
based conversation mode) with his indication of interest. If their in-
terests match, they might agree to trade on that particular currency
pair based on the agreement of the bid/ask quote, quantum of trade,
value date and settlement detail. The data may later be entered into a
clearing and settlement platform which will confirm, match and settle
the trade by issuing relevant settlement instructions.

Considering the rapid speed with which the exchange rates move and
the magnitude of risks involved, the forex trading is usually a highly
tension filled, noisy and stressful profession. However, since the actual
trades are stereotypical and run on standard terms, the FX traders
normally use short forms or jargons to denote standard trade terms
which forms part of any typical trade conversation between any two
dealers. For example, it is unnecessary for two traders who deal in
particular currency pair to quote the exchange rates to four decimal
places. The first two digits and the two digits next to the decimal plac-
es are assumed to be known to both of them. Hence, when they quote,
they only refer to the next two digits after decimal place, called the
‘small figure’. Similarly, there are several other conventions which are
used by dealers that make their trading conversation and negotiation
simple and easy.

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A sample screenshot of the Reuters Dealing system is as follows:

‘Settle Through | No Prime Broker|=

4 GBPIUSD 1) 1.50936@) te 1.5037 / 39150 mu @ 1x1 8 15037/39150 9 1«

2 AUDIUSD 1) 0.77746 @ tee 0.7769/73 0.77 TRINH 1x1 0.77 69.173 0.77 35+%
2 USDICAD 4) 1.22067
@ ves 1.22 % ' 9 22 tam txt 4.2237 1391220 1%
< USDIMXN 4| 18.4406
( Tr 18. 4240 / 4310 18. Tam txt 18. 4240 4310 18. ox
6 USDICNH 1 TR 6.1932/ 41619 TM @ 1x1 9 e19s2/41619 9 3x
6 EURIGBP 1 0. Raa 0.71 350 | 370 0.71 TRM 8 1x1 0.71 365 1370 0.71 1
7 UsDISGD 4) 1.04886
@ ree 12459/ 691.24 mem @ 1x1 8 124¢64/69184 1K
[eo | | || onzouso 4 ain Trae a a J i a TRU 4x1 a8 ot 2 8 4x

(Source: www.reuters.com)

The left-hand part of the screen highlights the GBP-USD pair and
provides the current bid and ask rates. The numbers ‘37/39’ are the
‘small figure’ referred earlier. The bottom right hand corner allows
the dealers to establish contact with any particular bank and start a
conversation. For example, the conversation in the screenshot refers
to request for quote for buying 10 mn Euros in terms of US dollars in
the short form “EUR IN 10 PLS”. The reply “31 32” refers to the EUR-
USD quote in terms of ‘small figure’ (Remember that the exchange
rate quote for EUR/USD implies that EUR is the base currency being
purchased and the quote is expressed in terms of US dollars). Once
the trade is completed, the pre-settlement matching, verification
and issue of settlement instructions are generally automated by the
back-office component of the trading platforms.

Trading in FX OTC markets is technically termed “decentralised,

continuous, open-bid, double-auction market”. The term “open bid”
refers to the fact that banks are market-makers and when they call
other banks, they need not necessarily specify their buy/sell intention
or quantum which they would like to buy (it depends on the offer and
their view on currency movements). The term “double-auction” im-
plies that banks call each other for price quotations and either bank
can buy or sell, the concluding trade could be either way.

The actual settlement of funds due to the trades in different curren-

cies happens between the nostro accounts maintained by the banks
with their correspondent banks. The settlement date or value date is
the date on which the actual transfer of funds between the nostro ac-
counts of the respective banks happens. This happens two days after
the trade date in the case of spot transaction (subject to holidays). The
transfer instructions to respective correspondent banks of the dealing
banks, where the nostro accounts are maintained, is done through the

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SWIFT (Society for Worldwide International Financial Telecommu-

nications) network, which is a secure satellite linked electronic com-
munication network where only member banks can communicate be-
tween themselves. Each bank is provided with a secure SWIFT ID
and Bank ID, and related secure transmission mechanisms for send-
ing and receiving the communications, which used to happen through
telex in earlier days. The SWIFT mechanism offers standardised
messages to communicate fund transfer instructions between banks
and removes errors that can happen due to different languages, con-
ventions, practices between banks / countries. On confirmation of the
transfer instructions through SWIFT, the actual debit or credit to the
bank customer account is done on the value date for trades that are
undertaken on behalf of the bank customers.

The settlement of funds between banks for USD inter-bank FX trans-

actions happens through CHIPS (Clearing House Interbank Payment
System), the clearing house for setthement of USD funds between
member banks. CHIPS is based on New York. Similarly, for settle-
ment of funds in GBR the CHAPS (Clearing House Automated Pay-
ment System) based in London is used. TARGET (Trans-European
Automated Real Time Gross Settlement Express Transfer System), a
network of 15 RTGS networks of various European countries is used
for EURO payments.

In the Indian Forex Markets, FX-Clear operated by CCIL (Clearing

Corporation of India Ltd) and Reuters Dealing System are two trading
platforms mainly used. FX-Clear is an inter-bank forex dealing sys-
tem that allows trades in both order-matching and negotiation modes.
FX-Clear also provides a platform for settlement of funds between
banks for FX transactions. The transactions done through FX-Clear
are routed to CCIL, which offers guaranteed settlement when done
through the order matching mode (where CCIL acts as a counterpar-
ty). For trades done in the negotiated mode (open-bid double-auction
mode), the trades are manually reported to CCIL for settlement.

6.5.1 BANK TREASURY OPERATIONS

Treasury refers to all the funds, revenues, cash and other liquid assets
of a bank. The management of these funds is done by the treasury de-
partment of the bank and is called treasury management.

The various roles played by the treasury department are as follows:

Q Independent forex role: It includes functions such as merchant
dealing, corporate forex dealing, proprietary trading and deriva-
tives (non-INR) trading.

Q Independent role: It includes Assets Liability Management (ALM)

and term money management, FCNR swap management, over-
seas investments and borrowings, arbitrage, and derivatives (INR)
trading.

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Q Independent investment role: It includes functions such as fund

management, liquidity management, SLR/CRR management, se-
curities trading and equity trading.

The major functions of the treasury department are as follows:

Managing reserves
DO

Managing the investments of the bank

DO

Managing liquidity
vO

Managing the assets and liabilities (ALM)

vo

Managing the overall risk of the bank

ooo

Trading in derivatives
Engaging in arbitrage trade
Maintaining capital adequacy as per the RBI norms
Oooo

Creating a pool of highly liquid assets

Managing interest rate risks
Investing excess cash and earning returns on it

The treasury department operations of a bank are divided into three

parts: front-office operations, middle-office operations and back-of-
fice operations.

All the banks engage in some proprietary trading along with general
treasury activities. However, at times, this function may be included
in the treasury management function, or a separate trading unit may
be created for the same. This unit must function as an investment
management fund.

The front-office is responsible for executing a bank’s investment, trad-

ing and hedging strategies. The front-office is further sub-divided into
money market desk, corporate desk and foreign exchange desk. The
money market desk makes investments in short-term money market
instruments, whereas the corporate desk deals with long-term in-
struments such as corporate equity and bonds. The foreign exchange
(forex) desk deals with all foreign exchange transactions and trading.

The main functions of middle-office include:

Q Managing compliance as per the present government and RBI

norms
Q Overseeing the overall treasury risk management and related re-
porting requirements
Q Overseeing the entire treasury management
Q Collaborating with the front-office to manage the bank’s forex and
cash positions

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N OT ES

Q Collaborating with the back-office to ensure that all statutory and

regulatory reporting requirements are met by the bank

The main functions of back-office include:

Processing, checking, settling and confirming all transactions

oOUOUD DU
Monitoring all transactions
Managing collaterals
Handling fund transfers
Maintaining IT and communication infrastructures
Providing the required data to the middle-office
UO

6.5.2 FACTORS CAUSING EXCHANGE RATE FLUCTUATIONS

The various factors that affect exchange rates and cause fluctuations
in the forex market are shown in Figure 6.1:

Inflation
1

JUUUUUUU
Interest Rates

Government Debt
Lf Li} ty bf) Ly

Political and Economic Stability

Terms of Trade

Current Account Deficit/Surplus

Recession

Speculation

Figure 6.1: Factors Affecting Exchange Rates

Let us discuss each of these factors as follows:

Q Inflation: Countries having higher rates of inflation usually face

depreciation in the value of their currencies, whereas low inflation
leads to the appreciation of a currency.
Q Interest rates: The interest rate offered by a country also affects
foreign exchange rates. Usually, high interest rates lead to the ap-

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NOTES

preciation of a currency, whereas low interest rates lead to its de-

preciation.

Inflation rate, interest rate and foreign exchange rate are all cor-
related. Fluctuations in these three types of rates affect one an-
other. Any change in any one of these has a direct impact on the
other two. There is no standard relation to predict how much
change in one factor will bring about what quantity of change
in another. It is because these factors are highly correlated and
their relationship is also highly dynamic.

Q Government debt (public debt): It refers to the quantum of debt a

country owes to other countries and to world financial institutions.
If a country is highly indebted, it usually leads to a condition of
high inflation, which in turn leads to the depreciation of the home
currency. On the contrary, if the country has a low level of debt, it
usually leads to the lowering of inflation, which leads to the appre-
ciation of the currency.
Q Political and economic stability: Investors usually refrain from
investing in the countries that are going through or are likely to go
through political and economic instabilities because the investors
risk losing their investments and even lives. Due to lower invest-
ments, the currency levels of such countries keep on decreasing.
Similarly, countries that are politically and economically stable en-
joy currency appreciation.
Q Terms of trade: These refer to the ratio of export prices to the
import prices. If export prices increase at a rate greater than the
increase in the price of imports, the currency appreciates. On the
contrary, if import prices increase at a rate greater than the in-
crease in the price of exports, the currency depreciates.
Q Current account deficit/surplus: Current account deficit refers
to the difference between the total value of exports and imports
(exports minus imports) of a country. If the value of the current
account is negative (deficit), the currency of the country usually
depreciates. Similarly, if the value of the current account is posi-
tive (surplus), the currency usually appreciates.
Q Recession: Recession refers to a condition of consistently low
growth, high inflation and high unemployment for a period of two
consecutive quarters. In the condition of recession, the interest
rate of a country usually lowers, leading to the depreciation of its
currency.
Q Speculation: Traders and speculators in the forex market usually
invest keeping in view the future value of a currency. Ifa trader ex-
pects that the value of a currency to increase/decrease in the near
future, he/she will buy/sell the currency in order to make profits.

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The expected increase in the value of a currency either creates

more demand or lowers the existing demand. When the demand
increases, the exchange rate appreciates, and when the demand
decreases, the exchange rate depreciates.

& SELF ASSESSMENT QUESTIONS

12. Tradingin FX OTC markets technically termed “decentralised,

continuous, open-bid, double-auction market. (True/ False)
13. is an inter-bank forex dealing system that allows
trades in both order-matching and negotiation modes.
14. Give examples of banks that have their own electronic trading
platform to serve their customers.

JBd Bixee
Visit the websites of Thomson Reuters, Bloomberg and ICAP Dis-
tinguish the features of the three trading platforms.

(9 ARBITRAGE IN SPOT MARKETS

Forex markets are quote driven markets. Exchange rate quotations
refer to the exchange rates stated for a pair of currencies. For exam-
ple, a forex quotation or quote may be written as GBP/USD = 1.5283;
it means that 1GBP = USD 1.5283. These forex quotations (quotes)
are issued by various banks. When banks offer quotes, they consider
many factors other than the internal considerations in the country. At
any point of time, a spot forex quotation for a currency pair will not be
very different between different banks in different locations. Theoret-
ically, the law of one price (you studied in chapter 5) applies to foreign
exchange markets also. If the price of a currency is different in two
places, then the arbitrage opportunity will allow market participants
to make riskless profits. An arbitrageur can purchase a commodity at
a lower price and sell immediately at a higher price — all within a few
seconds — through electronic dealing systems, thereby making risk-
free profits. Hence, if markets are efficient and if capital can move
freely across borders, the exchange rates should be consistent across
banks, currency pairs and locations.

If the exchange rates are not consistent across currencies and mar-
kets, then there are two possible arbitrage opportunities. Or we can
say that there exists two types of arbitrage as follows:
1. Two-point arbitrage: This type of arbitrage opportunity is
generated when the quotations for a currency pair varies in two
markets or locations.
2. Three-point arbitrage: This type of arbitrage opportunity is
generated when the quoted prices are inconsistent for three

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NOTES

currencies. This involves analysing three pairs of currencies. For

example, if there are three currencies namely X, Y and Z; then
three-point arbitrage can be analysed by examining currency
pairs: X/Y, Y/Z and Z/X.

Let us now discuss these two types of arbitrages in detail in the up-
coming sub-sections.

6.6.1 TWO-POINT ARBITRAGE

When the exchange rates quoted for a currency pair are different in,
different markets or locations, two-point arbitrage opportunity is gen-
erated. An arbitrageur will buy currency from the location where it is
quoted low and sell it at the market where it is quoted high. Today, the
forex markets are highly globalised and interconnected due to which
it is unlikely that the exchange rates for a currency pair are different
in different markets or financial centres such as New York, London,
and Tokyo etc. However, such discrepancies cannot be ruled out and
may offer arbitrage opportunity even if it may exist only for very short
time period. Let us understand this with the help of an example:

The exchange rate quotations for the currency pair GBP/USD in two
different markets are presented in Table 6.3:

TABLE 6.3: EXCHANGE RATE QUOTATIONS FOR CURREN-

CY PAIR GBP/USD IN TWO DIFFERENT MARKETS
Market/Financial Centre —_ Bid (Buy : Ask (Sell) Price
London (Bank A) 1.5369 1.5372
New York (BankB) =» 1.5375 st—~S~=«*02*S TB
If the above quotes persist, an arbitrageur will buy a certain quantity
of GBR say GBP 10 million, from Bank A in London at its quoted ask
rate of USD 1.5372/GBR This will cost him USD 15.372 million. He will
immediately sell GBP 10 million in the New York market to Bank B at
its quoted bid rate of USD 1.5375/GBR He will receive 10 X 1.5375=
USD 15.375 million. Therefore, in this entire trade, he makes a risk-
free profit of USD (15.375 -15.372) = USD 30,000. However, the arbitra-
geur will be able to book a profit only when he is able to sell the GBP
in, New York market before the quotes change adversely.

Arbitrage trades ensure that rate discrepancies or inconsistencies in

exchange rate quotes of different foreign exchange markets do not
persist for long.

6.6.2 THREE-POINT ARBITRAGE

Three-point arbitrage is also known as triangular arbitrage. In spot

markets, triangular arbitrage can occur in the case of cross currency
quotes. As discussed already, the quotes are available for particular
currency pairs alone. And most of the currency pairs have one of the

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major currencies such as USD, EUR, GBP and Yen; these are also
called as the base currencies or quote currencies. The price of curren-
cies with different base currency/quote currency can be arrived at or
calculated using cross currency exchange rates.

Let us understand triangular arbitrage with the help of an example.

Assume that exchange quotes are available for EUR-USD and GBP-
USD pairs. Using these two quotes, we can calculate the EUR/GBP or
GBP/EUR quote. The given information is represented in Table 6.4:

TABLE 6.4: EXAMPLE OF TRIANGULAR ARBITRAGE

Bid Ask
EUR-USD 1.1278 1.1281
GBP-USD 15369 6 1.5874
Using the above rates, we can calculate the exchange quote for the
EUR/GBP pair, i.e., the quote price of EUR in terms of GBP The steps
involved in this process are illustrated as follows:
1. Remember that we are given EUR-USD and GBP-USD pairs.
Sell one Euro and purchase USD. For one Euro, we get USD
1.1278.

2. Purchase GBP for USD 1.1278 at the ask rate of GBP-USD pair
of USD 1.5374. Hence, we get (1.1281/1.5374=) 0.733771 GBP
3. Thus, One Euro equals GBP 0.7338. Therefore, the GBP-EUR
cross rate should be GBP 0.7338/EUR. An arbitrageur would buy
EUR if the quote is below 0.7338.

Suppose, a cross-currency dealer quotes a EUR-GBP bid rate of GBP

0.7334/EUR. In this case an arbitrageur can make a riskless profit by
selling GBP and buying Euros. For this, he/she can buy one Euro at
the rate of GBP 0.7334. Then he/she can sell one Euro and buy USD
1.1278. He can sell USD 1.1278 and buy GBP; the arbitrageur will get
GBP 0.733576. This amount is more than the amount the arbitrageur
started with; he/she initially had GBP 0.7334 but end up with GBP
0.733576. Therefore, he/she booked a profit of GBP 0.000176 (0.733576-
0.7334).
Therefore, a discrepancy in cross currency rates can be used to make
riskless profits. It is called triangular or three-point arbitrage as it
involves three currencies and we traverse three points to reach the
same initial position in terms of a certain currency. However, to make
arbitrage profits through triangular arbitrage, it is essential to verify if
any arbitrage opportunity exists or not. This is done by analysing the
three currency pairs. If inconsistency exists, the arbitrageur needs to
decide and select a profitable sequence in terms of buying currencies
at cheaper rates and selling them at a higher rate to reach the same
initial position. The profit however depends on the existence of the
same quotes till all the trades are completed and sufficient spread to
take care of any transaction costs involved.

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& SELF ASSESSMENT QUESTIONS

15. The quotes of GBP/JPY offered by banks in London and

Tokyo markets, respectively, are as follows: London: GBP/
JPY — 184.05-184.13 and Tokyo: GBP/JPY — 184.09-184.15.
The above quotes imply:
a. There is a three-point arbitrage opportunity
b. There is a two-point arbitrage opportunity
ce. There is no arbitrage opportunity
d. There is a arbitrage profit of 0.04 JPY per GBP
16. In spot markets, triangular arbitrage can occur in the case of
cross currency quotes. (True/False)
17. and are the two types of arbitrage.

Visit the Reuters currency pages for three different countries viz.,
US, UK and Switzerland. Verify the presence of opportunities for
three-point arbitrage for currency pairs involving USD, GBP and
CHE

FORWARD QUOTATIONS
We briefly described the concept of forward contracts in Chapters 2
and 5. Forward contract is a type of contract (legal and formal) in which
two parties enter into and one party agrees to buy a certain quantity
of foreign exchange at a predefined foreign exchange rate while the
other party agrees to sell that quantity to the buyer. In other words,
foreign exchange markets allow contracting for future purchase or
sale of foreign exchange. As discussed before, foreign customers of a
bank like to enter into a forward rate contract in order to hedge their
exchange rate risks because in the absence of such a contract the po-
tential profit of the customer may be completely eroded or may also
result into losses. In forward contracts, bank customers enter into an
agreement with the bank for purchase or sale of foreign exchange at
a forward exchange rate. This forward exchange rate depends on the
maturity period of the contract. The forward rates quoted also depend
on the interest rate differential between the two currencies.

More specifically, forward rates should satisfy the following relation-

ship:

1+i,)
_—

F= xs
1+i,
~—
—

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Where F is the applicable forward rate between currencies x and y

S is the spot exchange rate between currencies x and y

i, and i, are the interest rates applicable for the maturity period in
countries with currency x and y, respectively.

The forward rates between currencies x and y will be more than the
spot rates if the interest rate in the country of currency x is more than
the interest rate in the country of currency y (i.e., ). In this case, there
exists a forward premium as the forward rate is higher than the spot
rate, which implies that the expected future spot rate is higher than
the current spot rate. The forward premium indicates that the base
currency is appreciating and quote currency is depreciating.

On the contrary, if the interest rate in the country of the base currency
is higher than the interest rate in the country of the quote currency,
then forward exchange rate will be less than the current spot rate. In
this case, it is said that there exists a forward discount as the forward
rates are less than the spot rates. This implies that the base currency
is expected to depreciate while the quoted currency is expected to ap-
preciate. All these relationships are based on the International Parity
Conditions we studied in the Chapter 5.

6.7.1 OUTRIGHT FORWARD QUOTATIONS

The forward quotations are normally given in terms of spot rate and
the associated discount or premium points for the applicable matu-
rity period. Since the exchange rates are generally quoted up to four
decimal places, each point in the forward premium or discount will be
equal to 0.0001 in value. The outright forward quotations are derived
by adding/subtracting the spot rate with the given forward premium/
discount points.

For example, if the spot rate is INR 65.1250/USD, and the forward pre-
mium for 6 months maturity is 25 points, then the outright forward
quote applicable for 6 month forward contract will be INR 65.1275/
USD. An importer who has a requirement to purchase US dollar after
6 months will enter into a contract to purchase USD at INR 65.1275
per USD. If he could purchase at the spot rate, he need to pay only
65.1250, but since he would like to fix the rate for the future, he is will-
ing to pay a premium of 25 points (0.0025 rupee) for each dollar. How-
ever, if the rupee is expected to appreciate, then cost of dollar would
come down and the forward rate would be quoted at a discount to the
current spot rate. Assume that the forward discount for 3-month ma-
turity is 25 points; then outright forward quote for 3-month forward
contract will be INR 65.1225/USD. In such a case, an importer who
needs to purchase USD after 3 months will have to pay less for future
purchase as the forward rate will be at a discount to spot rate.

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Table 6.5 presents the forward rates quoted by a forex dealer:

TABLE 6.5: FORWARD RATES FOR USD/INR PAIR

QUOTED BY A FOREX DEALER
USD/INR Bid Ask
Spot Rate 64.7400 64.8700
USDINR 1M FWD 35.75 37.5
USDINR 2M FWD 72.5 74.5
USDINR 3M FWD 107.75 109.75
USDINR 4M FWD 147.75 149.75
USDINR 5M FWD 179.25 181.25 a
USDINR 6M FWD 216.25 218.25
USDINR 7M FWD 253.75 255.75 |e
USDINR 8M FWD 289.5 291.5
= .
Forward Rates Bid Ask
USDINR 9M FWD 324 yAAS
USDINR 10M FWD 363 365
USDINR 11M FWD 395 <0 397
USDINR 1Y FWD 429.5 431.5
USDINR 2Y FWD 777.398 802.99
USDINR 3Y FWD 1138.855 1186.896
USDINR 4Y FWD 1489216 «556.028
USDINR 5Y FWD 1836.171 1908.604
*M = Month, Y = Year A wD
From the above quotes, the outright forward quote for USD/INR six-
months contract is:

Spot Exchange Rate: Bid: 64.7400 Ask: 64.8700

Six Month Forward: Bid: 216.25 = Ask: 218.25

Outright Forward Bid Rate = 64.74 + (216.25/10000) = 64.7616

Outright Forward Ask Rate = 64.87 + (218.25/10000) = 64.8918

Now, the above table contains the points for forward premium and
discount both. However, nowhere it has been mentioned that if the
given points are for premium or for discount and whether these for-
ward points should be added to or subtracted from the spot rate.

When the forward rates are quoted, if the forward rates are at a dis-
count to the spot rate, the convention is not to specify forward points
as “discount” or to mention the forward points in negative values. In-
stead, the thumb-rule is to verify the forward bid and ask points and

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if the forward bid points are greater than the forward ask points, it is
understood that the forward rates are being quoted at a discount to
the spot rate. Hence, the forward points need to be subtracted from
the spot exchange rates whenever the forward bid points are less than
the forward ask point. For example, if the spot rates are as follows:

Spot Exchange Rate: Bid: 64.7400 Ask: 64.8700

Six Month Forward: Bid: 218.25 Ask: 216.25

In the above example, the forward bid points are greater than the for-
ward ask points. As per convention, it means that the forward rates
are at discount to the spot rates. The outright forward rates can be
calculated below as follows:

Outright Forward Bid Rate = 64.74 — (218.25/10000) = 64.7182

Outright Forward Ask Rate = 64.87 — (216.25/10000) = 64.8484

The bid-ask spread for the spot rates = 64.87 — 64.74 = 0.1300

The bid-ask spread for forward rates = 64.8484 — 64.7182 = 0.1302

6.7.2 DISCOUNT AND PREMIUM IN FORWARD MARKET

As per the Interest Rate Parity (IRP) theorem and parity conditions,
if the interest rates of the quote currency are higher than the interest
rate applicable for the base currency, the forward rates should be at a
premium to spot rate. This will ensure that the return offered by both
the currencies is equal after taking into account the spot and forward
rates.

In any currency pair A/B, A refers to the base currency and B refers
to the counter currency.

Conversely, if the interest rates of the quote currency are lower than
the interest rate applicable for the base currency, the forward rates
should be at a discount to spot rate. Whenever the forward value of
the base currency is at discount to the spot rate, the forward points
are subtracted from the spot rates. As explained earlier, this can be
identified by comparing the bid and ask points in the forward quote.
If the forward bid points are more than the forward ask points and if
they are subtracted from the spot rates, then the forward rates will be
less than the spot rate depicting the discount.

The forward points as shown in Table 6.5 are usually referred to as

swap points in foreign exchange market. The forward outright ex-
change rates are determined by adding/subtracting these swap points
(as discussed in the examples above). The term swap points is used

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NOTES

instead of forward bid or forward ask points because these forward

rates are used extensively in the FX swap contracts rather than for
the outright forward contracts. A typical forward quotation when the
forward rates are discount to spot rates is given as follows:

GBP-USD Spot 1.5330-1.5333

One-Month FWD 3.04-2.93

Three-Month FWD 6.84-6.35

Six-Month FWD 12.69-11.99

In the above quote, GBP is the base currency and is trading at dis-
count to USD in the forward market. It costs USD 1.5333 to buy a GBP
in inter-bank spot market but only USD 1.5321 in the six-month for-
ward markets. Alternatively, the USD is quoting at premium to GBP
in the forward markets. This can be observed if we express the quotes
with USD as base currency (i.e., in the form of USD/GBP).

6.7.35 OPTION FORWARD

The forward contracts have a maturity period associated with them.

For example, the maturity date for a 3-month forward contract will
be 3 months from the contract execution date. The settlement date
or the value date will be three months from the value date applicable
for a spot transaction done on the contract date. Contract date is the
date on which the actual delivery of foreign exchange will occur. The
forward rate will be used on the maturity date to settle the contract
irrespective of the spot rate prevailing on the maturity date.

For example, if an exporter enters into a 3-month forward contract to

sell USD (which he/she will receive as payment against his exports) to
his/her banker on 12th October 2015, then the settlement date is three
months from the value date applicable for a spot transaction done on
12th October. The value date for a spot transaction done on 12th will
be 14th (assuming no holidays). The maturity date for the contract will
be 14th January 2016. Assume that the exporter is uncertain about
the date on which he/she will receive his/her payment in USD. He/she
expects to receive it any time after December 15th, 2015 but before
14th January 2016. His/her forward contract will be useless if he/she
receives the proceeds earlier than the maturity date of 14th January
2016 as a forward contract has a fixed settlement date. Therefore, in
such a case, the exporter would like to have an option of selling USD
at any time from December 15th to January 14th at a contracted for-
ward rate. In such a case, he/she will be able to settle the contract at
any time between 15th December 2015 and 14th January 2016. Such
forward contracts with an associated option are allowed by bankers
and are called “Option Forwards”. In an option forward, the forward
rate remains the same for settlement on any date during the option
period. When quoting the forward rates for option forwards, banks

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will only quote the forward rates applicable for start date of the option
period.

Banks also allow cancellation, early delivery and extensions of the

forward contract. However, the bank charges a fee and makes adjust-
ments in the net proceeds depending on the exchange rate difference
between the initially contracted forward rate and the forward rate ap-
plicable for the new contract.

6.7.4 SHORT DATE AND BROKEN DATE FORWARD

CONTRACTS
The outright forwards (and FX swap transactions) might also involve
short-term maturity contracts (with maturity less than a month).
These short-term maturity contracts are usually termed short dates
involving overnight (ON, swaps/forward contracts from today to to-
morrow), Tom-Next (TN, from tomorrow until the next day spot), spot-
next (SN, from spot until the next day) or spot-a-week (SW, spot until a
week later). These are termed short dates, and the forward contracts
based on these forward rates are called short-date forward contracts.
Figure 6.2 presents an overview of short date forward contract rates
for USDINR pair:

Name Bid Ask High Low Chg. Time

USDINR ON FWD 2.5000 4.0000 3.5000 3.5100 1.6000 8:46:00
USDINRTN FWD 1.0000 1.5000 1.0000 1.5000 -2.0000 9:30:00
USDINR SNFWD 3.0000 4.0000 3.0000 4.0000 2.0000 9:30:00
USDINR SW FWD 7.5000 9.5000 7.5000 9.5000 0.0000 9:30:00

Figure 6.2: A Sample of Short-Date Forward

Contract Rates for USD/INR Pair
(Source: http://in.investing.com/currencies/usd-inr-forward-rates)

The forward contracts have standard maturity periods such as one-

month, 3-months, 6-months forward contracts, etc. If a customer
requires forward rate quotes for a non-standard period (say for a
5-month period), standard forward quotes will not be available. Banks
allow customers to enter into broken-date forward contracts also. It
means that the customers can enter into a forward contract a with
non-standard maturity period. The forward rate applicable for the
broken date forward contracts is calculated by interpolating the for-
ward rates applicable for the standard contracts. Let us understand
this with the help of an example:

The spot and the quoted standard forward rates for 3-months and
6-months forward contracts are given as follows:
USD-INR Spot 64.74-64.87

3-months 107.75-109.75

6-months 216.25-218.25

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Now, assume that a bank needs to quote forward rates for a broken
date contract of maturity period 5 months for a certain customer;
then, the bank can interpolate the forward bid rates for the given pe-
riod as follows:

Forward premium for 3 months — 107.75

Forward premium for 6 months — 216.25

Forward premium (bid) for 5 months = Forward premium for 3 months

+ Forward premium for next 2 months

= 107.75 + (216.25-107.75)
x (2/3)

= 107.75 + 72.33

= 180.08

This is the forward bid rate for the 5-month forward contract. Sim-
ilarly, the forward ask rates can be calculated by interpolating the
3-month and 6-month forward ask premiums as follows:

Forward premium for 3 months — 109.75

Forward premium for 6 months — 218.25

Forward premium (ask) for 5 months = Forward premium for 3 months

+ Forward premium for next 2 months

= 109.75 + (218.25-109.75)
X(2 /3)
= 107.75+72.33
= 182.08
The forward points (or swap points) quoted by the bank for 5 months
maturity would be: 180.08-182.08. The corresponding outright for-
ward quotes will be 64.74+180.08/10000 and 64.87+182.08/10000, i.e.,
64.7580-64.8882.

ee SELF ASSESSMENT QUESTIONS

18. The forward quotes for rupee against dollar are given as
follows:
USD-INR spot: 65.25-65.50
3-month FWD rate: 200-160

The 3-month forward rate applicable for forward sale contract

for USD in inter-bank market will be:
a. 65.2300 b. 65.2700

c. 65.4840 d. 65.5160
19. When bid swap points are greater than ask swap points, it
implies a forward discount. (True/False)

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20. The term ‘short date contracts’ refers to:

a . Forward contracts for period less than a month

b. Broken forward contracts

Forward contracts that are terminated prematurely

e
d. None of the above

ACTIVITY

Prepare a detailed report on short date forward contracts.

(3) OVERVIEW OF FOREX RISK

Till now, we have completed the basics of foreign exchange markets,
forex transactions and instruments used to cover forex risks. Let us
now see how the forex risks can be managed.

6.8.1 NATURE OF FOREX RISK

In a closed economy, for a company that manufactures goods and sells

it domestically, there is no foreign exchange rate risk. However, for ev-
ery company that is part of an open economy that interacts with ROW
and has trade and financial transactions with them, there is always a
possibility of foreign exchange risk.

Consider a company that is part of an open economy like India, which

manufactures and sells goods domestically with no import/export
dealings. Do you think that this company would ever face any forex
risks? The answer is Yes. In the following text, we will see how. Con-
sider Vedanta Group that is involved in the business of metals and
mining. The group acquired the public sector company, Balco, which
manufactured aluminium products. Even though Balco did not import
any bauxite ore and manufactured the alumina and related products
in-house, it faced a situation where the company had to be shut down
due to huge losses. This is because the price of alumina products fell
so steeply that many of the Indian companies found imports cheaper
than buying it from Balco. It was not the fault of Balco as the situation
was driven by world-wide fall in the prices of bauxite ore due to dump-
ing of aluminium products by China, which found its growth decel-
erating. If the Purchasing Power Parity conditions had held good the
prices of bauxite ore or the cost of manufacturing should have been
same after adjusting for exchange rate differences between Chinese
and Indian currencies, and it looked like either PPP condition did not
apply in the real world. However, the deteriorating cost structure and
price of products did not allow Balco to withstand the pressure for
long and finally led to closure of the manufacturing plants by Vedanta.
This is an example how international trade in an open economy can
affect even domestic companies that have no foreign operations.

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Now, consider an Indian company that exports goods to other coun-

tries. It faces the exchange rate risk with regard to realisable invoice
proceeds due to uncertainty in the exchange rate movements. The
risks are much more for Indian companies that import in huge quan-
tities because as a trend, the Indian currency seems to depreciate
rather than appreciate against major trading currencies such as USD,
GBB etc. In the earlier sections, we illustrated how forward contracts
are used for hedging foreign exchange risks.

Companies that have operations abroad face more risk than any do-
mestic company that faces risks associated with their import and ex-
ports. Such companies face risks related to the value of assets and
liabilities denominated in foreign currencies in addition to the usual
import/export forex risk. These risks or exposures can greatly impact
the valuation of the firm itself, thereby affecting its future prospects.

International macro-economic factors that affect all companies in an

open financial environment remain the same. However, the degree of
impact of these factors is different on various companies in various
parts of the world. If the Chinese currency appreciates against US dol-
lars, it implies different things to different Indian companies. A com-
pany that imports raw material from China will be adversely affect-
ed, while a company that exports to China will be greatly benefited.
The impact will also be different depending on the nature of risk. Its
impact will be different for a company that exports/imports goods to
China as compared to companies that have set up operations in China.

6.8.2 BENEFITS OF FOREX RISK

As long as there is an uncertainty related to the future value of receiv-

ables, liabilities or assets of a company, no benefit can be generated
attributable to forex movements. However, there are situations where
the company may benefit from exchange rate movements. For exam-
ple, any Indian exporter would find the movement of exchange rate
with respect to dollar to be beneficial as deprecation of rupee will get
him/her more rupees per dollar. As an observable trend, the rupee
has been mostly depreciating against dollar since the last five years.
Therefore, the exporter may not even be interested in forward sale
contract if he/she is willing to speculate or take the risk involved be-
cause he assumes that the rupee will continue to depreciate. However,
prudent corporate managers do not indulge in currency speculation
because the shareholders’ money is meant to be deployed in produc-
tive operations to create wealth rather than investing in speculative
activities. Hence, irrespective of the currency movements, financial
managers are interested in removing all sorts of uncertainties with
regard to future value of foreign proceeds, and assets and liabilities.
This is because a single instance of an adverse movement of curren-
cy can greatly impact the financial situation of a company that has a
bearing on the long-term financial stability of the company.

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ee SELF ASSESSMENT QUESTIONS

21. With regard to foreign exchange risk, which of the following

statement is false?
a. Ifis applicable to the companies involved in exports and
imports
b. Ifis applicable to all domestic companies
ce. It affects different companies differently
d. None of the statements is false
22. Foreign exchange risk can be beneficial for some companies.
(True/False)

Construct a hypothetical case study that demonstrates how an

importer or exporter makes huge profits by exploiting foreign ex-
change risks.

(J DEFINITION OF EXPOSURE
We can define exposure as the amount exposed to risk due to uncer-
tainties related to foreign exchange. It is necessary to understand the
degree of exposure in terms of magnitude of capital or operations at
risk and also the nature of risks involved to clearly understand the
risks involved and take steps to hedge or mitigate them. It also rep-
resents the sensitivity of the future value of any physical or financial
asset to random variations in the future domestic purchasing powers
of the foreign currencies at some specific future date (Adler and Du-
mas, 1984).

The term “exposure” is generally differentiated from “risk” as the for-

mer refers to the quantum of value at risk a while the latter is the
degree of uncertainty involved. For example, consider two identical
companies in terms of nature of business operations. One has higher
exports in its overall revenue compared to the other whose domestic
revenue is higher. The degree of uncertainty with regard to value of
the firm or profitability of firm A will be more than firm B. This is be-
cause firm A is exposed to forex risk more than firm B. Now, assume
that firm A and firm B export the same products but to different coun-
tries; the currency of the latter is more volatile against domestic cur-
rency than the formers. In this case, the “risk” involved for firm B is
more as the uncertainty related to foreign exchange risks is relatively
higher as compared to firm A. Thus, the two terms indicate different
measures.

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Forex exposure may be defined as the amount of changes in the profit-

ability, the net value of the assets and the cash flow of the organisation
due to fluctuations in the exchange value of the currency.

Forex exposure contains three important elements — profitability,

net value of assets and net cash flow. These elements determine the
growth and success of the organisation. The lesser the exposure of
these elements, more secured will the assets be and greater will be
the amount of gain. In case of more exposure, less secured will be the
assets and greater will be the amount of loss.

6.9.1 NATURE OF EXPOSURE

The nature of exposure refers to how the firm will be affected by the
forex risks. Though the uncertainty related to macroeconomic fac-
tors like exchange rates, interest rates and inflation are common to
all firms, it might affect different companies differently. For example,
the value exposed to forex-related risks might be same for two com-
panies but the nature of risks could be quite different. When domestic
currency depreciates against a particular currency, its impact on an
importer may be limited to the changes in quantum of imports. The
company may decide to shift to another importer in a different coun-
try whose currency and pricing are favourable. However, for a firm
that has liabilities denominated in foreign currency, the same event of
currency depreciation has different implications. The company’s in-
terest costs could significantly affect its profitability. However, anoth-
er company, which has debt in the same foreign currency, might have
reduced the effective exposure to that currency by having significant
share of exports to that country, thereby creating a natural hedge.

Also, the same forex-related factors could affect different companies

in different sectors or industries. The impact of currency uncertainty
is different for a banking company as compared to a manufacturing
company. The nature of resulting risks and the way these can be man-
aged will also be different.

In general, the nature of exposure could be in terms of components of

the profit and loss account like sales and cost of manufacturing or the
components of balance sheet like foreign assets and liabilities. These
again need to be differentiated in terms of the nature of business un-
dertaken by the company as discussed above.

6.9.2 SOURCES OF EXPOSURE

The sources of exposure depend on the operations of the company. For

a company that is involved in purely domestic operations, this might
be related to domestic and foreign competition, cost and price struc-
ture of industry, etc., which are sensitive to the forex-related factors.
Suppose the competitor has a new and cheaper source of raw mate-

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rial, which he/she starts importing from another country that greatly
reduces his/her cost structure; this will impact the other company that
has purely domestic operations. A price inflation in the country of a
foreign competitor can greatly affect the capability to compete with
the domestic firm. Thus, in these cases, the exposure is not quantifi-
able and is related to several industry and macro-economic factors,
which a financial manager is supposed to track and monitor.

For other companies, there could be quantifiable exposure that might

give rise to different degrees of uncertainty related to various forex
related factors. For these companies, sources of exposure are related
to their business operations. We saw earlier in the first chapter that
international trade is possible in many modes such as:
Q Exports and imports
Licensing
OvoOO vO

Franchising
Joint ventures
Mergers and acquisitions
Green field plants
Oo

The important sources of the exchange rate exposure are as follows:

Q Changes in the interest rate: These are the changes in the inter-
est rate of the currency that affect the value of the organisation.
The higher is the fluctuation in the interest rate of the currency
(domestic or foreign), higher would be the degree of the currency
exposure. The monetary authority of the country controls the in-
terest rate of the currency to regulate the smooth flow of curren-
cy trading, thereby eliminating the currency exposure to a certain
extent.
Q Tax rate: The tax rate varies from country to country and affects
the profitability of the organisation due to the translation exposure
(discussed in the next section). The organisations having more for-
eign subsidiaries are affected if the tax rate is high in that country,
leading to exposure and results in increased cash outflows.
Q = Rate of inflation: The rate of inflation is one of the major sources
of forex exposure. The rate of inflation affects the exchange rate
of the currency. The higher the inflation rate, the lower will be the
value of the currency. In such a case, cash outflow for the imports
would be more, and less cash would be received (inflow) for ex-
ports. The imbalance between the cash flow, due to the change in
the value of the currency gives rise to exposure.

The exposure to forex risk depends on the nature of international

business mode undertaken by a company. The forex risk involved for
companies that have operations in foreign countries is not same as the
companies that only do trade transactions like import and exports.

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Apart from the nature of business operations, the sources of exposure

also depend on the financing structure of the companies. A firm which
is not involved in any international operations but has borrowed in
international financial markets in different currencies will still be ex-
posed to various forex related risks.

&e SELF ASSESSMENT QUESTIONS

23. Exposure can be defined as:
a. Amount exposed to risk due to uncertainties related to ex-
change rate risk
b. Amount of foreign currency revenue
ce. Sensitivity of the future value of an asset to exchange rate
variations
d. Bothaandc
24. The nature of exposure:
a. Depends on the type of company / industry
b. Depends on the type of business transaction involved
ce. Could affect profit & loss statement or balance sheet
d. All of the above

25. Which of the following is true with regard to sources of

exposure?
a. It depends on the business operations
b. Could be external

Depends on nature of international operations

e

All of the above

2.

Prepare a report on the topic: “The relationship between Inflation

and Foreign Exchange Exposure.”

St TYPES OF EXPOSURE
In the previous section, we explained the meaning, source and nature
of foreign exchange exposure. There exposures can be classified into
four types, as follows:
Q Transaction exposure
Q. Translation exposure

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N OT ES

Q Economic Exposure
Q Operating Exposure

Let us study these four types of exposure in detail.

6.10.1 TRANSACTION EXPOSURE

Transaction to exposures arise due to contracts denominated in for-

eign currencies that might result in uncertain cash flows due to varia-
tions or movements in exchange rates. Transaction exposure leads to
a risk that the value of foreign currency receivables on converting into
home currency will fall or that the value of foreign currency payments
on converting into home currency will rise between the invoicing date
and the date of receipt or payment.

Transaction exposure is not applicable to all international trade trans-

actions but only when the currency of invoice is different. This means
there will be no transaction exposures for companies in European
Union when they trade among themselves in same Euro currency.
Similarly, there will be no transaction exposure for companies that
export or import using home currency as the invoicing currency. How-
ever, the exposure in such cases gets transferred to the other side.
For example, when an Indian company exports to US using USD as
invoicing currency, the Indian company would face transaction expo-
sure but the US importer will not face any transaction exposure.

The transaction exposure arises in the following cases:

Q When a trade transaction involves foreign currency (such as ex-
ports and imports). The concerned company faces transaction ex-
posure if it needs to convert foreign currency amount into domes-
tic currency.
Q When there are receivables or payables denominated in foreign
currency. If an Indian firm has taken a loan denominated in for-
eign currency and the interest is payable in foreign currency such
as EUR, then the quantum of cash outflow for the said interest
payment in terms of rupee will be determined by variations in ex-
change rate between rupee and EUR.
Q When a company receives dividends from investors or pays divi-
dend to investors from other countries in different currency.

In the case of transaction exposures, the quantum of exposure is

known in foreign currency and the equivalent value in terms of do-
mestic currency will depend on the exchange rate applicable.

Transaction exposure can be defined as sensitivity of the value of the

payments, receipts, payables and/or receivables, denominated in for-
eign currency, due to unexpected changes in exchange rates in an un-

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favourable direction. Thus, there is no transaction exposure for a re-

ceivable or payable denominated or invoiced in domestic currency of
the company as its sensitivity to any exchange rate movement would
be nil.

We have already discussed how forward contracts can be used to hedge

or cover the risks associated with transaction exposures in Section 6.7.
The transaction exposures have this distinct feature that the value of
exposures in terms of foreign currency is known and the company can
analyse the risks involved and take appropriate actions.

6.10.2 TRANSLATION EXPOSURE

The translation exposure arises for companies that have overseas op-
erations involving foreign currency transactions as reflected in their
financial statements. Translation exposure refers to a potential risk
that a company’s consolidated financial statements would be affected
by changes in foreign exchange rates.

In the field of accounting, the process of “conversion” of foreign cur-

rency values into home currency for the preparation of financial state-
ments is termed “translation”. The amount of foreign currency that
requires to be converted, and whose values are associated with the
uncertainty related to exchange rates, is the translation exposure ap-
plicable to the company. In other words, the exposure that an MNC
faces with regard to its consolidated financial statements being affect-
ed by the exchange rate fluctuations is termed the translation expo-
sure. It is basically an accounting exposure.

When the financial statements are prepared, various foreign currency

assets and liabilities belonging to the parent company or its subsid-
iaries have to be converted into the balance sheet currency (currency
used in home country of company). This requires selecting the ap-
propriate exchange rate applicable for conversion. Depending on the
exchange rate chosen, the company’s accounting profits and balance
sheet liabilities / assets differ significantly. This might give a wrong
picture about the financial soundness of the company to the investors.
It might also make comparison between companies difficult. There
are international financial accounting standards published by various
accounting bodies that provide guidelines on the method of choos-
ing appropriate exchange rate. The different translation methods re-
quired to be followed by companies following international account-
ing standards are:
Q Current/non-current method
Q Monetary/non-monetary method
Q Temporal method
Q Current rate method

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For multinational companies with subsidiaries abroad, the effect of

translation exposure on the consolidated financial statements can be
significant depending on the type of translation method and exchange
rates chosen.

The amount of translation exposure shows the level of foreign curren-

cy assets and liabilities that have a direct bearing on the valuation of
the firm. The translation exposure does not affect cash flows or cash
profits of the company. However, it can affect the valuation of a firm.
Apart from its potential to affect firm valuation, it directly impacts
the accounting profitability and balance sheet values. It might also
indicate the potential future transaction and economic exposures ap-
plicable to the company.

Translation exposure is not something that can be hedged with for-

eign exchange hedging tools and instruments such as derivative prod-
ucts (forward contracts, options, etc.). For example, if a firm has real
or financial assets in a foreign country, its liquidation value depends
on the future exchange rates and the company’s strategic plans might
depend on the values of these assets and liabilities. Hence, when an-
alysing such companies, analysts cannot only take into consideration
the balance sheet figures that just show the translated values. It is
necessary for the investors to ascertain the total translation exposure
faced by the company, which includes the value of assets and liabil-
ities denominated in foreign currencies. The value of an MNC firm
that has operations in a stable emerging economy cannot be equated
with another MNC that has operations in a country whose currency
is highly volatile. The value of foreign assets held by a company can
become insignificant in no time when the exchange rates are highly
volatile or uncertain.

If a company would like to reduce the translation exposure, it can re-

sort to balance sheet hedge by trying to offset the exposure. For ex-
ample, if an Indian company has majority of assets denominated in
foreign currency say USD, then it is exposed to translation exposure
because the value of assets in USD would be more than the value of
liabilities in USD. The company can decide to shift some of the oth-
er foreign currency liabilities into liability denominated in USD. In
this way, a natural balance sheet hedge can be created. However, this
might lead to transaction exposure.

6.10.3 ECONOMIC EXPOSURE

Economic exposure refers to a risk that a company’s cash flows, for-

eign investments and earnings may get affected because of volatility
in the foreign exchange rates. Unlike the transaction exposure that
deals with contractual amount at risk and the translation exposure
that pertains to balance sheet values, the economic exposure consid-
ers the exposure of the entire value of the firm to exchange rate un-
certainty. Adverse and volatile exchange rate movements can greatly

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impact the competitive market position of the firm in global markets

thereby impacting its overall valuation.

Economic exposure also impacts the future cash flows of the firm. The
forex related factors that can affect the future cash flows of the firm
include exchange rates, interest rates, price levels and inflation in dif-
ferent countries. All of these factors are related to foreign exchange
and can impact the future cash flows, and hence also affect the value
of the firm. Thus, the economic exposure goes beyond ascertaining
the impact of exchange rate uncertainty for a single transaction or a
period by considering the possible impact of exchange rate uncertain-
ty on cash flows of future periods. Economic exposure also concerns
the impact of exchange rates on the present value of the future cash
flows of the firm.

In transaction exposure, we were bothered only about the changes in

value of the contractual obligations due to uncertainty related to ex-
change rates. However, the changes in exchange rates can have wider
implications for the value of the firm. For example, if the home cur-
rency depreciates, it has much more impact than just affecting the
future export proceeds. If depreciation is the result of higher infla-
tion, it implies proportional increase in cost of manufacturing, which
would offset the gains realised in terms of higher export proceeds. In
other words, any exchange rate variation that is due to adjustment of
purchasing power parity conditions will not greatly impact the profit-
ability and hence valuation of the firm. However, if the depreciation is
not associated with price level increase, the firm can reduce its pric-
es, thereby gaining a higher market share in the global market which
could significantly affect its competitive market position globally. Sim-
ilarly, if the importer finds that the home currency is appreciating, he/
she may decide to import more at cheaper prices, thereby reducing
his/her cost outlays. Thus, the exchange rate variations can have lon-
ger term impact on the future cash flows of the firm affecting the value
of the firm. Such impact on firm valuation due to foreign exchange-
related factors is part of the economic exposure.

The level of economic exposure depends on the operations of the firm.

Unlike transaction exposure, economic exposure is not restricted to
transactions in foreign currencies; as explained earlier, even a pure-
ly domestic company can face economic exposure arising out of its
competitor that has operational exposure. Apart from direct impact of
exchange rates, other variables such as interest rates and price levels,
which are all related by parity conditions, can also change the eco-
nomic exposure. An interest rate change can greatly impact the val-
uation of the foreign currency borrowings. If a firm has floated fixed
rate foreign currency debt instruments in a foreign country and if the
interest rates come down, the market value (or replacement value)
of the debt burden will greatly increase affecting the balance sheet
and debt capacity. Similarly, a decision to invest or borrow in foreign
country can be greatly impacted by adverse interest rate movements,

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which might delay the investments or projects of the company, there-

by affecting the value of the firm.

6.10.4 OPERATING EXPOSURE

In the previous sub-section, we discussed economic exposure wherein

we referred to future cash flows of a firm, also including the operating
cash flows. The operating exposure specifically deals with the risks
associated with operating cash flows of a company due to exchange
rate movements.

Operating cash flows determine the operating profits of a company,

which are determined by the productive business operations of the
company. The operating cash flows are determined by revenue, op-
erating costs and net cash flows. The exchange rate risks can undu-
ly affect any of these components. When a company decides to price
its products, change its cost structure or marketing strategy, it has to
take into account the operating exposure. The transaction exposure is
completely ascertainable and the economic exposure is not quantifi-
able. In contrast, the operating exposure can largely be predicted and
is less ambiguous than economic exposure, though not fully quantifi-
able like transaction exposure. It is applicable to the companies that
have foreign currency transactions and / or operations.

Consider a company that has significant export revenues. For manu-

facturing the products that it exports, it also requires to import some
raw materials. The company has the option of changing the revenue
structure in terms of exports being replaced by domestic sales and
can also change the quantum of imports. It can also change the price
at which it sells in foreign countries and can also get credit in foreign
currencies. In such a scenario, the operating cash flows of the firm
depends on various variables such as its market share abroad, price
flexibility, market share in domestic economy, percentage cost of im-
ported raw material, its sensitivity to exchange rate movements, avail-
ability of import substitutes, etc. All these variables are also impacted
by the exchange rate movements of different currencies against the
domestic currency. For example, if the domestic currency appreciates,
the company might decide on an entirely different set of variables fol-
lowing a different strategy. When the company makes decisions that
could impact operating cash flows, it needs to forecast the exchange
rate movements and ascertain the operating exposure and according-
ly take decisions. This will ensure that its profitability is not unduly
affected by unanticipated exchange rate movements.

In reality, for any company that has exposure to foreign currency

transactions and operations, every decision it takes needs to be anal-
ysed with respect to the changes in operating exposure and the risks
associated with it due to uncertainty related to exchange rate move-
ments and other forex-related factors such as interest rate, inflation
and price levels, etc.

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The risks associated with operating exposure will be higher if the

company cannot let the ‘exchange rate pass-through’, which means
that the risk must be transferred to the customers. For example, if the
price level in India increases and rupee does not depreciate propor-
tionately, the only way an exporter can retain his/her profitability is by
increasing the price at which he/she exports the goods. However, an
increase in price may not be feasible in the foreign market if the price
is a competitive factor. Similarly, if an Indian importer cannot pass on
his/her higher import costs to the customer his/her bottom-line can be
affected greatly due to exchange rate movements.

A company that has operations in multiple countries would face max-

imum challenges with respect to operating exposure. Its operations
will be impacted by the various economic variables of several coun-
tries and the company would require great flexibility in managing its
operating exposure. For example, if the supply chain of a company
spans multiple countries that have different exchange rate volatilities,
labour costs and macro-economic environment, its operating cash
flows will be determined by various factors and each of these factors
needs to be managed. It is necessary for such companies to proper-
ly analyse the operating exposure and suitably manage the same. We
shall see some strategies regarding managing transaction and operat-
ing exposure in Section 6.12.

& SELF ASSESSMENT QUESTIONS

26. Which of the following exposures can be hedged with forward

contracts?
a. Transaction exposure
b. Operating exposure
ce. Translation exposure
d. Economic exposure
27. Which of the following is false with regard to translation
exposure?
a. It is an accounting exposure
b. It can be hedged with forward contracts
ce. It can involve real or financial assets denominated in for-
eign currency
d. It arises when converting foreign currency assets/liabili-
ties into balance sheet currency
28. A company has taken a foreign currency loan which has
principal and interest repayments pending. In sucha situation,
the company is faced with transaction and translation
exposure both. (True/False)

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Prepare a report on the types of accounting methods used for trans-

lation exposure, namely current / non-current method, monetary /
non-monetary method, temporal method and current rate method.

i388 CLASSIFICATION OF FOREX RISKS

Till now, you have studied forex risks from the perspective of corpo-
rates. It is important to note that the transfer of foreign currency takes
place by forex dealers as well, such as banks and other institutions.
These dealers also face various types of forex risks.

Unlike in the case of corporates, for whom forex risks arise as a result
of their business operations, in the case of banks, forex risks are the
primary aspect of banks’ foreign exchange operations. Though com-
mercial banks closely supervise and ensure that there are no risks
inherent in their currency portfolio, they may be willing to take risks
in order to make profits. For example, forex dealers and proprietary
trading desks of investment banks may maintain open positions as
they speculate on currency movements. Let us now discuss the classi-
fication of forex risks in the next sections.

6.11.1. POSITION RISK

The forex dealers of banks keep buying and selling foreign exchange
on behalf of their corporate customers and their own portfolio for the
purpose of speculation, arbitrage and hedging. In general, whenever
a bank sells foreign exchange to a corporate customer, it will imme-
diately replenish its balance with the purchase of equivalent amount
of foreign exchange from other banks. From the perspective of forex
transactions undertaken for the sake of clients, banks ensure that the
net effect on the balance of currency position is nil at the end of the
day.

If the bank does not cover its sales of foreign exchange to its customers
with a purchase, then it will have oversold position in that particular
currency. Similarly, when the bank does not sell to cover its purchase
of foreign exchange from customers, its currency position will be in
an overbought position. An oversold position implies that the bank is
short of foreign currency that it needs to buy from the market sooner
or later. Such position also implies that the bank has to sell foreign
currency in order to avoid the excess position.

When the bank is in overbought or oversold position, it faces position

risk. The position risk means that the bank faces potential losses from
the movement of exchange rates. For example, if the bank has pur-
chased $1 mn from its customers at INR 65/USD and it does not cover
its purchase with a sale of $ 1 mn, its position is overbought by $ 1 mn.

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If on the next day, the currency moves to INR 60/USD, the bank faces
a loss of INR 5 per dollar, which translates into 5 million rupees.

Unless dealers take a conscious decision to keep their currency posi-

tion as overbought or oversold based on their confidence with regard
to the direction of the movement of currency, they are expected to
square off their position at the end of the day. This implies that ev-
ery sale or purchase for customers is replenished immediately with
a counter-trade from the interbank market. If a dealer fails to ensure
that his/her position is squared off, he/she faces the position risk.

In order to manage a position risk, the following steps are instituted in

the forex divisions of banks:
Q Portfolio positions are always netted to ensure that overall over-
bought or oversold status is monitored and tracked.
Q Positions are re-valued continually by adopting marking to mar-
ket. This ensures that profit or loss due to currency movements
are monitored against expectations.
Q Position limits are set for each trading position depending on the
instrument and the expertise of the dealer.
Q Limits are also set for the maximum size of transactions, intra-day
positions, overnight positions, overall risk considering various po-
sitions, etc.

6.11.2 MISMATCH RISK

Mismatch risk refers to the mismatch of the currency position in terms

of the maturity period, liquidity level and interest rates. For example,
banks maintain separate desks for spot and forward/swap transac-
tions. Spot and swap dealers maintain their own books for each cur-
rency. When a swap deal is executed, it involves both spot and forward
transactions. The effect of spot transactions (that is part of a swap deal
on the overall spot position of the currency) needs to be considered.
The currency position should be squared off in both spot and forward
positions or at every maturity period. In other words, the currency po-
sition should not be overbought or oversold either in a spot portfolio
or at other forward maturities.

Another aspect related to position mismatch is the basis risk. This re-
fers to the risk that the prices of two instruments will not move exactly
in line. For example, when swap deals are executed, the dealer takes
a view on interest rate movements. However, when exchange rates
move, the movements in the forward segment may not be in line with
the movement of spot rates. A narrowing of forward premium might
be associated with the appreciation of spot exchange rates. Hence,
banks need to monitor the profitability position of their portfolio after
taking into consideration the different maturities of the instrument
and the net present value of their projected cash flows.

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6.11.3 TRANSLATION RISK

You have already studied the concept of translation risk in the previ-
ous section. In the current context, translation risk refers to the cur-
rency conversion done for the purpose of financial reporting, which
may affect the reported accounting profitability of the bank. For ex-
ample, when investments and portfolio positions are valued for the
translation purpose, the exchange rate chosen can greatly impact the
realised and unrealised losses or gains.

Higher the exposure to various currencies, greater is the sensitivity of

the realised gains/losses and their effect on the reported profitability.
Several standard accounting guidelines are mandated for the purpose
of translating (i.e., converting) foreign currency assets and liabilities
into those of home currency.

6.11.4 OPERATIONAL RISK

Banks have to take some risks in order to make profits. However, op-
erational risks are the ones that banks would like to completely elim-
inate. Operational risks are related to losses that may arise due to er-
rors or mistakes in foreign exchange operations. For example, if a deal
reported to back office for settlement is not same as the deal actually
agreed with the counterparty, it might lead to potential losses. Banks
strive to avoid operational risks by instituting risk management pro-
cesses both in front-office and back-office operations.

At the front-office level, each deal has to be confirmed or matched

with the counterparty and should be subject to counterparty limits,
dealer limit, position limit, etc. At the back-office level, verification
and matching of the forex transactions and checking on overall po-
sition limits, counterparty limits, etc., are done in order to ensure
that there are no errors or mistakes before the transaction is fed into
back-office applications where the settlement instructions to banks of
the counter-party will be generated.

6.11.5 CREDIT RISK

A bank may face a risk of losses even if it properly squares off its books
and ensures that the net position of various currencies is nil and that
currency positions are not sensitive to the exchange rate movements.
This is because of credit risks. This is the risk that is generated when
the counterparty does not fulfil its obligations or default on its payment
obligations. Every foreign exchange transaction requires exchange of
currencies from one bank to another. When settlement occurs, it is
quite possible that the counterparty is not able to settle its part of the
obligations, which could lead to potential losses. This is why banks
are particular about other banks with which they deal with. Many of
the banks from the developing countries are considered risky and big
MNC banks may not transact with these banks for big ticket forex

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transactions. In order to avoid credit risk, banks maintain credit rela-

tionships with various banks and set counter-party limits based on the
creditworthiness of various counter-party banks.

Credit risks are prominent in the case of forward or swap contracts

where the other bank has to deliver foreign exchange on a future date
and might fail to deliver on that date. In the case of spot transaction
too, there is a possibility that banks might face potential losses. It is
quite possible that the exchange of currencies does not happen simul-
taneously and when one bank has fulfilled its obligations, the other
bank might not be in a position to do the same. This is termed as set-
tlement risk or Herstatt risk. Such risks do not occur if banks follow
delivery against payment clearing mechanisms.

F7 SELF ASSESSMENT QUESTIONS

29. A bank may face the risk of losses even if it properly squares
off its books and ensures that the net position of the various
currencies is nil and that currency positions are not sensitive
to the exchange rate movements. This is because of
30. A forex dealer entered into a swap transaction for $ 10 mn.
There was no other transaction during the day. In such a case,
he/she faces:
a. Position risk b. Mismatch risk
ce. Basis risk d. All of the above
31. A forex dealer sold one million euros to his/her corporate
customer. He/she covered it immediately in the inter-bank
market with purchase of one million euros. The dealer faces:
a. Position risk b.. Basis risk
ce. Credit risk d. Translation risk
32. A deal was concluded with another bank and the same was
input into the back office system. The deal passed through the
verification and settlement instructions. Later, it was found
that the amount was $1.5 mn instead of $1.05 mn. Any loss due
to this error is termed arising out of:
a. Settlement risk b. Position risk
ce. Credit risk d. Operational risk

Basel III provides guidelines with regard to bank risk management

and capital adequacy. Download the latest applicable guidelines in
this regard and identify where the risks discussed above are ad-
dressed in the framework.

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TECHNIQUES TO MANAGE FOREX RISK

Corporates face different types of foreign exchange exposures and
risks associated with them. It is necessary to manage exposures prop-
erly in order to reduce the impact of exchange rate risks. Some of the
major benefits of managing foreign exchange exposures and resultant
risks are given as follows:
Q Minimise the impact of exchange rate risk on profit margins
Q Improve the predictability of expected cash flows in the future
Q Eliminate the need of accurately forecasting exchange rate move-
ments

Various techniques to manage forex risks are as follows:

Q Diversification: Companies that are dependent on a single foreign
market for their revenues face concentrated risks arising out of
foreign exchange exposure. If the currency in which a firm is in-
voicing its products appreciates against the other currency, then
the cost of products sold in the other market increases, which
could lead to reduced sales. A reduction in price proportionate to
currency appreciation may not always be possible if profit margins
are thin. In such cases, the operating exposure can be hedged by
diversifying into other markets where the real exchange parity is
maintained.
For example, consider an Indian automobile component manufac-
turer who exports to Malaysia and South Africa and invoices both
exports in Indian rupee. Suppose if Malaysian ringgit depreciates
significantly against Indian rupee, then the cost of Indian import
will become very high for Malaysian automobile manufacturers
that could lead them to search for different suppliers. In such situ-
ations, if the South African currency remains stable against rupee,
then the exporter may switch more exports to the South African
market in order to compensate for reduction in sales in Malaysia.
If the firm can further diversify into different markets such that
any appreciation (or depreciation) is associated with depreciation
(or appreciation) in other currencies in which it transacts, it will
have a natural hedge against economic and operating exposures.
Q Currency derivatives: You have studied how forward contracts
can be used to hedge payables and receivables. In the case of
transaction exposure where the magnitude of exposure is known,
such forward contracts can be of great use in hedging the risk.
Where forward contracts are not available, the firm can go for
money market hedge. This involves steps similar to interest rate
arbitrage, which we have discussed earlier, to cover the exchange
rate risk wherein the currency in which future payment is to be
done is purchased in the spot market and invested in respective

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currency markets. If the company does not have sufficient cash to

purchase a foreign currency spot, it can borrow in the domestic
currency. If the uncovered parity theorem proves right, the inter-
est differential cost will be compensated by the expected future
spot exchange rate.
Apart from forward contracts and money market hedges, firms
can also use currency derivatives viz., futures and options. Futures
are similar to forward contracts but are standardised and traded
on derivative exchanges. These contracts can also be traded in the
secondary market unlike the forward contract, which is an over-
the-counter product.
In the case of forward contracts, if the currency movement turns
out to be favourable (i.e., when the home currency depreciates for
an exporter having receivables in foreign currency or when the
home currency appreciates for the importer), the firm will have to
forego additional profits due to fixed forward rate. If the firm, in-
stead of entering into a forward contract where it necessarily have
to take the forward rate, enters into a contract whereby it gets a
‘right to buy’ or ‘right to sell’ foreign currency, then it can avail
of any favourable currency movement. For example, if an Indian
exporter with US dollar receivables finds the spot rate on the ma-
turity date of the forward contract higher than the forward rate, it
may decide not to execute its ‘right to buy’ foreign exchange and
use the spot market to realise its foreign exchange proceeds. Such
contracts are called currency options where firms are expected to
pay option premium. You will study about various derivatives in
detail in the upcoming chapters of the book.
Q Internal hedging: It is a method of managing operating and trans-
action exposures when they are not amenable for hedging with
traditional financial hedging tools. You will study these techniques
in detail in the next section.
Q Pricing: It involves managing economic and operating exposures
by having pricing policies suited to macroeconomic variables in
such a way that exposures are properly hedged. This involves pric-
ing differently in different markets in order to adjust deviations in
the real exchange rate and purchasing power parity. This requires
evaluating markets where the company has operating exposure in
terms of various variables like price level, interest rates, inflation
and direction of exchange rate movements, and deciding the pric-
ing policy accordingly.

Pricing might also involve pricing-to-market where the same product

may be sold at different invoice prices in different countries depend-
ing on demand and supply and related factors. This implies that the
exporter might price less than the fully competitive price in some mar-
kets while charging very high profit margins in other foreign markets.
The pricing will depend on the demand curve, real exchange rates

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NOTES

and currency appreciation/depreciation. This may provide a natural

hedge against currency exposure and exchange rate fluctuations.

os SELF ASSESSMENT QUESTIONS

33. Diversification is a good strategy for managing economic

exposures. (True/False)

34. Currency derivatives that can be used for hedging forex

exposure are:
a. Money market hedges
b. Forward contracts
ce. Currency futures and options
d. Swaps
35. Companies can use different pricing policies in different
countries suited to macro-economic variables like real
exchange rates, inflation, interest rate, and exchange rates for
managing operating and economic exposures. (True/False)

Study the currency future products traded in the National Stock

Exchange (NSE). Compare and contrast the utility of forward con-
tracts and currency futures for hedging the exchange rate risk.

CORPORATE INTERNAL HEDGING

6.13
STRATEGIES
In this section, you will study various internal hedging strategies.
These strategies do not involve any hedging tools like forward con-
tracts or currency derivatives. Let us discuss various corporate inter-
nal heading strategies in the next sub-section.

6.13.1 LEADING AND LAGGING STRATEGIES

Consider an Indian exporter who has some foreign currency receiv-

ables that he could not hedge with a forward contract. If the exporter
finds that the domestic currency might appreciate against the invoice
currency and he cannot have a proper hedge, he can ask the importer
to make the payments early (i.e., before the currency actually appre-
ciates). In order to ensure that the importer accepts his request, he
might offer an incentive in terms of discount, thereby minimising loss-
es. If the importer makes the payment early, the exporter can convert
proceeds before rupee appreciation and thus avoid the losses due to
the exchange rate risk. The operational technique of collecting receiv-
ables early in order to avoid exchange rate-related losses is called lead
strategy.

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Similarly, an importer can ask for extra time for payment of foreign
currency payables if he is confident that the rupee will appreciate
against the foreign currency shortly. This will ensure that his invoicing
calculation (which might have been done based on an assumption of
favourable currency exchange rate) does not lead to losses or reduced
profit margin. Since the invoice is denominated in foreign currency,
the exporter will not face an exchange rate risk, though he might lose
some interest due to delayed payment, which the importer can com-
pensate if he expects that appreciation will be sufficient enough. This
strategy of delaying the payment is called lag strategy.

6.13.2 NETTING AND OFFSETTING STRATEGIES—

NATURAL HEDGE

For companies that have receivables and payables in multiple curren-

cies, it may not be necessary to enter into forward contracts for each
transaction. For example, if a company has both exports and imports
in US dollars, it may not always be necessary to hedge each of these
transactions separately. The net residual exposures can be found for
different time periods and it may be sufficient to hedge only the net
exposure. Similarly, companies can make payments in foreign curren-
cies based on receivables in the same currency.

For companies that have taken external commercial borrowings in

foreign currencies, there will be a natural hedge for risks involved in
the exchange rate for making interest payments if the company also
exports products to those countries. Similarly, the exposure is in two
different countries that are expected to move together. One of them
is receivable and the other is payable. It may not be necessary to
hedge either. The payment in one currency can be used to purchase
payment in another currency. Thus, netting allows offsetting ex-
posures and risks involved when there are payments in multiple
currencies.

6.13.3 RISK SHARING STRATEGIES

When companies decide on invoicing on currencies whose exchange

rates are likely to fluctuate, they also take into account the impact
such fluctuations can have on profit margins. A company exporting
and invoicing in a foreign currency can decide to lower price if it is
sure of depreciation in home currency. However, if its expectations
fail, then its profit margins can be greatly eroded. In such cases, the
exporter may decide to enter into risk sharing agreement with the im-
porter wherein the actual contractual invoice payment may be linked
to the projected fluctuation in the exchange rate. In the above case,
the exporter can specify a cut-off exchange rate on the pre-specified
date above which the invoice price can be higher in proportion to
home currency appreciation.

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6.13.4 INVOICING STRATEGIES

Invoicing strategies aim to manage transaction exposure by changing

the invoicing currency. If an exporter can invoice in his/her home cur-
rency, he/she will not face any exchange rate risk. Hence, wherever
possible, it is advantageous to invoice in home currency for exports.
Alternatively, the exporter can share risks in terms of invoicing partly
in home currency and partly in foreign currency in agreement with
the importer.

Another invoicing strategy is to use a foreign currency for invoicing in

which the exporter has payables. If an Indian exporter has payables
in pound sterling but his/her exports are to the US, he/she might in-
voice his exports to the US in pound sterling, thereby offsetting his/
her pound sterling exposure.

& SELF ASSESSMENT QUESTIONS

36. A company is exporting to Switzerland and faces exposure to

the Swiss frances. It already has payable in Swiss francs. In this
case, it can remove risk due to volatility in Swiss franc against
rupee:
a. By insisting on invoicing in rupee
b. By invoicing partly in Swiss francs and partly in rupee
c. By giving credit terms that match with payables
d. Bothb andc
37. A company has payables in euro. The company finds that
euro is likely to depreciate against rupee during the period in
question. Its hedging strategy in order to remove any possible
loss should be:
a. Entering into an option forward for purchase of euro
b. Asking for additional time to make payment
ce. Spot purchasing euro and making immediate payment
d. Bothaandb
38. A company has euro receivables and yen payables. It is now
exporting to a Japanese company and would like to invoice it
in part euro and part yen. This strategy is a part of:
a. Lead/lag strategy b. Pricing strategy
c. Risk sharing strategy d. Netting strategy

Find information on how companies with exposures in multiple

currencies should go about hedging their currency risks.

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6.14 EXCHANGE RATE RISK MANAGEMENT

m PROCESS

The steps involved in managing exchange rate risk are as follows:

1. Establishing company-wide strategic corporate policy
for managing forex exposures: This involves setting up an
organisation-wide strategic policy for identifying, measuring
and managing forex exposures. This provides standardised
policy parameters, tools and techniques for managing risks
across the organisation. This might also include several factors
to be considered while making important decisions related to
economic and operating exposures of the company.
The strategic policy should deal with the following questions:

¢ How and when to identify forex exposures?

@ What are the policy parameters with regard to identifying
and measuring exposures?
¢ What are the approved tools, methods and instruments that
can be used and under what circumstances?

¢ Whois given the responsibility of managing forex exposures?

¢ How will exposure management activities be evaluated?

¢ What are the standard reporting requirements in this re-

gard?
2. Developing operational-level policies for managing exposures
and hedging exchange rate risks: This step involves defining
various exposures, tools and related policy parameters. The
operational-level policy should explain in detail how to identify
exposures and manage the risks involved. For example, it might
specify how to identify pre-transaction exposure, transaction
exposure and accounting exposure. For example, if some
exposures need to be managed before invoicing, they should
be handled at that stage using invoicing strategies as explained
earlier. Similarly, guidelines may be required regarding the
timing of handling transaction exposures. An operational-level
policy should also provide detailed policy guidelines on the usage
of various tools.
3. Identifying forex exposures: This step involves the periodic
review of economic and operating exposures and recognising
the occurrence of various exposures at different divisions of the
company. It also involves identifying the exposures at various
stages of the value chain process. For example, if a possible
exposure is identified at the business planning or design stage,
appropriate steps to mitigate the economic/operating exposure
can be taken e.g. deciding on where to source raw material.

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NOTES

Similarly, identifying exposures at both pre-transaction and post

transaction stages can help manage exposures better.
4. Measuring and deciding on managing exposures: This step
involves evaluating the identified exposures and taking decisions
regarding hedging the exposure using various tools discussed
in the previous section. For example, if there are two exposures
identified in different divisions which can be netted/offset, the
amount of exposure to be hedged and the related costs could
be minimised. It may not always be necessary to hedge the
entire transaction exposure when the overall exposure of the
organisation is taken into account.
5. Using the exposure management policy and related tools for
managing and hedging risks: Once the exposures are identified
and measured, a decision is taken for managing those exposures.
This step involves the actual execution of various management
and hedging strategies as per policy guidelines and monitoring
the same.
6. Evaluating the results periodically and taking corrective
actions: The exposure management policy needs to be evaluated
with regard to its success in identifying and managing associated
risks. A periodical evaluation process should provide pointers
towards improving the policy and hedging tools.

&e SELF ASSESSMENT QUESTIONS

39. The exchange rate risk management process involves:

a. Studying the volatility of exchange rates
b. Finding out overall exposures and hedging tools
c. Finding out a sensitivity of exposures to interest rate vola-
tility
d. Applying a systematic approach to company-wide risk
management process

Od Rte
A risk manager of a a corporate firm comments, “It is ineffective
to hedge only transaction exposures. The exposure management
should start with analysing economic and operating exposures”.
Why should an analysis of economic and operating exposures re-
duce the requirement of hedging transaction exposures? Discuss.

S6y MEASUREMENT OF EXCHANGE RISK

The exchange risk in terms of the volatility of exchange rate is the same
for all companies. But the quantum of exposure decides the overall
risk faced by any company. Hence, it is necessary to measure various

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NOTES

exposures and then ascertain the risk in terms of how the variability of
exchange rates can affect the certainty of the home currency value of
cash flows. Following are the ways of measurement of exchange risks
in various exposures:
Q Transaction exposure: It can be measured by calculating the total
amount of inflows and outflows in various foreign currencies and
determining the net exposure that requires to be hedged. As men-
tioned before, if there are receivables and payables in the same
foreign currency for the same magnitude, the net exposure will be
zero.
After the company’s net transaction exposure to different curren-
cies is measured, the risk involved can be ascertained. This means
equal exposure to different currencies does not imply equal risk at
any particular point of time, though it can be dynamic. For exam-
ple, some currencies may be highly volatile, while other currencies
may be stable. Hence, the measurement of overall risk requires
consideration of variability of each individual currency.
Similarly, if high positive or negative correlation between currency
movements can be identified, then the overall risk will accordingly
get reduced or magnified. The variability can be measured by his-
torical and projected standard deviations of exchange rates. The
covariance of currency movements can be measured in terms of
correlation coefficients between exchange rate movements. Using
the standard deviation and correlation coefficients, the variability
or standard deviation of the portfolio of exposures in different cur-
rencies can be calculated.
Q Translation exposure: It depends on the magnitude of business
conducted in foreign countries, locations of the foreign operations
and the accounting methods followed. The impact on the consoli-
dated financial statements can be analysed using different scenar-
ios of exchange rates.
Q Economic and operating exposures: These are not quantifiable
into a single amount like transaction exposures. However, the ef-
fect of economic exposure on the profitability and value of the firm
can be ascertained by methods like scenario analysis and sensitiv-
ity analysis.

Scenario analysis involves forecasting the profit and loss and balance
sheet components for future periods by using scenarios of possible ex-
change rates against different currencies. These scenarios can include
changes in selling prices, impact on volume of sales, cost of raw ma-
terial imported, etc. Sensitivity analysis involves analysing the sensi-
tivity of profitability of the firm for varying input factors including ex-
change rates. For companies with huge economic exposure, the value
of the firm will be greatly affected by minor currency movements and
exchange rate variations. The economic exposure can also be studied
using the historical performance of the company in terms of doing a

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NOTES

regression of firm value (or earnings) with the past exchange rates
over the historical time period.

The measurement and analysis of economic and operating exposure

are similar. The risk involved due to operating exposure is restricted
to the sensitivity analysis of operating cash flows for various exchange
rate scenarios. However, economic exposure will take into account the
value of the entire firm over many future periods and would take into
account many other factors like projected inflation and interest rates
across different countries and geographies.

ee SELF ASSESSMENT QUESTIONS

40. Measurement of exchange rate risk means:

a. Estimating the volatility of exchange rates
b. Measuring exposure in various currencies
c. Finding out the correlation of various exposures
d. All of the above
41. Economic exposure can be evaluated by:
a. Measuring volatility of exchange rates
b. Measuring the exposure in various currencies
Finding out the correlation of various exposures
e

d. Performing scenario analysis

42. depends on the magnitude of business conducted in
foreign countries, location of the foreign operations and the
accounting methods followed.

Different countries have different exchange rate arrangements.

For example, the currencies of major pairs of forex trading are of
free floating type. However, there are also other major economies
that have their currencies either fixed or managed floating type,
like China and others. Prepare a report on how the exchange rate
arrangements will affect exchange rate risks of companies’ transac-
tion in different countries. Discuss the same with respect to expo-
sure management and risk measurement process with your friends.

mt SUMMARY
Q International financial transactions involve more than one coun-
try, and each of these countries might have their own currencies
in which they transact domestically. This gives rise to the need of
exchange of currencies as per the exchange rate determined by
various economic and market forces.

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NOTES

Q = The forex market involves three major types of transactions. These

are:

@ Spot transactions
@ Forward transactions

@ Foreign Exchange (FX) swaps

Q An exchange rate quotation is the rate at which the currency of
one country is converted into the currency of another country.
Q Spot rate quotations refer to the quotations in which the number
of the foreign currency is equated with the number of the domes-
tic currency. The exchange rates are denoted in a number of ways
such as INR 65 / USD, 65 INR/USD etc., where the denominator
currency is the base currency.
Q The commercial banks are the primary participants of the foreign
exchange market, and most of the trades are inter-bank transac-
tions. These inter-bank FX transactions could be executed either
on their own behalf for purposes such as speculation, arbitraging
or hedging or on behalf of their clients like corporations and indi-
viduals.
Q Ifa bank does not cover its sale of foreign exchange to its custom-
ers with a purchase, it will have an oversold position in that par-
ticular currency.
Q Mismatch risks refer to the disparity of currency positions in terms
of maturity period, liquidity level and interest rates.
Q Another aspect related to position mismatch is the basis risk. This
refers to the risk that prices of two instruments will not move ex-
actly in line.
Q Abank might face a risk of losses even if it properly squares off its
books and ensures that the net position of various currencies is nil
and that currency positions are not sensitive to the exchange rate
movements. This is because of credit risks.
Q Various techniques to manage forex risks are diversification, cur-
rency derivatives, internal hedging and pricing.
Q Corporate internal hedging strategies include leading and lagging
strategies, netting and offsetting strategies, risk sharing strategies
and invoicing strategies.

Q Exchange rate: It is the market rate or value of the assets that

are traded in the exchange market.
Q Forex exposure: The changes in the value of an organisation
due to changes in the exchange value of the underlying assets.

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NOTES

a Hedging: The method of reducing the degree of exposure of the

underlying assets by investing in similar assets in the opposite
direction.
Inflation: The decrease in the value of a currency resulting in a
decrease in the purchasing power of the currency.
Tax rate: The rate at which tax is levied on the assets of an or-
ganisation traded in the exchange market.

DESCRIPTIVE QUESTIONS
Explain forward transactions in detail.
Describe exchange rate quotations.
we NY
OP

What do you mean by spot rate quotations?

Explain the mechanism of inter-bank trading.
Explain the speculation, hedging and arbitrage related to the
forex transactions.
Write a note on spot transactions.
Discuss the concept of arbitrage in spot markets.
mon

Explain the two types of arbitrage with examples.

What are outright forward quotations? Explain in detail.
10. Explain the concept of short date and broken date forward
contracts.

11. Write a short note on the nature of forex risks.

12. Briefly describe the four types of exposure.
13. Explain various types of forex risks.
14. What do you understand by position risk?
15. Discuss various techniques to manage forex risks.
16. List the benefits of managing foreign exchange exposures.
17. Define invoicing strategies.
18. Differentiate between leading and lagging strategies.
19. Explain the exchange rate risk management process.
20. How does the measurement of transaction exposures take place?

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NOTES

BES ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic 2 a (os Answer

Foreign Exchange Transac- 1. Arbitrage, speculation and
tions hedging
2. Spot, forward and swaps
3. Swap
4. d. Forward Sell GBP 1 mn at
forward rate
5. a. It will enter into a forw
sale contract with ano
bank .
Exchange Rate Quotations 6 Base currency
7 Exchange rate quotation 4
8. False
Spot Rate Quotations 9 Price interest pot 4

1 rome QAO
10. True

Mechanism of Inter-Bank 12. True

Trading

13,
FXClear
14, Examples are CitiFX of Cit-
ibank, DealStation of ABN
Amro, dbmarkets-etrade.com
of Deutsche bank, ete.
Arbitrage in Spot Market 15. e. No arbitrage
16. True
Siz. Two-point, three-point
Forward Quotations 18. a. 65.2300

19. True
20. a. Forward contracts for peri-
od less than a month
Overview of Forex Risk 21. d. None of the statements
false
22. True
Definition of Exposure 23. d. Bothaande

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NOTES

Jk Cs Answer
24, d. All of the above
25. d. All of the above
Types of Exposure 26. a. Transaction exposure
rte b. It can be hedged with for-
ward contracts
28. True
Classification of Forex Risks 29. Credit risks
30. d. All the above
31. e. Credit risk
32. d. Operational risk
Techniques to Manage Forex Bh True
Risk :
34, e. Currency futures and
options

88. a. True
Corporate Internal Hedging 36. d. Bothbande
Strategies

. ~~. ~A 37. d. Bothaandb

38. d. Netting strategy
Exchan ik Manage- 39. d. Applying a systematic ap-
proach to company-wide risk
management process
Measurement of Exchange Risk 40. d. Allofthe above
D> - 41. d. Performing scenario anal-
ysis
42. Translation exposure

HINTS FOR DESCRIPTIVE QUESTIONS

1. The forward market segment of the forex market involves
contracts to purchase or sell foreign exchange for future delivery.
Refer to Section 6.2 Foreign Exchange Transactions.
2. An exchange rate quotation is the rate at which the currency of
one country is converted into the currency of another country.
Refer to Section 6.3 Exchange Rate Quotations.
Spot rate quotations refer to the quotations in which the number
of the foreign currency is equated with the number of the
domestic currency. Refer to Section 6.4 Spot Rate Quotations.
Commercial banks are the primary participants of the foreign
exchange market, and most of the trades are interbank
transactions. Refer to Section 6.5 Mechanism of Interbank
Trading.

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NOTES

5. Speculation is the acceptance of high risk by traders in the

market for making large profits in a very short span of time.
Refer to Section 6.2 Foreign Exchange Transactions.
6. A spot transaction involves direct exchange of currencies
between countries in a quick succession. Refer to Section
6.2 Foreign Exchange Transactions.
7. If the price of a currency is different at two places, then the
arbitrage opportunity will allow market participants to make
riskless profits. An arbitrageur can purchase a commodity at a
lower price and sell immediately at a higher price — all within a
few seconds. Refer to Section 6.6 Arbitrage in Spot Market.
8. Two types of arbitrage include two-point arbitrage and three-
point arbitrage. Refer to Section 6.6 Arbitrage in Spot Market.
9. Forward quotations are normally given in terms of spot rate and
the associated discount or premium points for the applicable
maturity period. The outright forward quotations are derived by
adding/subtracting the spot rate from the given forward premium/
discount points. Refer to Section 6.7 Forward Quotations.
10. The outright forwards (and FX swap transactions) might also
involve short-term maturity contracts (with maturity less than a
month). These short-term maturity contracts are usually termed
short dates involving overnight (ON, swaps/forward contracts
from today to tomorrow). The forward contracts based on these
forward rates are called short date forward contracts. Refer to
Section 6.7 Forward Quotations.
11. With every company that is part of an open economy, interacts
with ROW and has trade and financial transactions with them,
there is always a possibility of foreign exchange risk. International
trade in open economy can affect even domestic companies that
have no foreign operations. Refer to Section 6.8 Overview of
Forex Risk.
12. Four types of foreign exchange exposures include transaction
exposure, translation exposure, economic exposure and
operating exposure. Refer to Section 6.10 Types of Exposure.
13. Different types of foreign risks include position risk, mismatch
risk, translation risk, operational risk and credit risk. Refer to
Section 6.11 Classification of Forex Risks.
14. Whenevera bank sells foreign exchange to its corporate customer,
it will immediately replenish its balance with a purchase of
equivalent amount of foreign exchange from other banks. Refer
to Section 6.11 Classification of Forex Risks.
15. Various techniques to manage risks are diversification, currency
derivatives, internal hedging and pricing. Refer to Section
6.12 Techniques to Manage Forex Risk.

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16. The benefits of managing foreign exchange exposures are

minimisation of the impact of exchange rate risk on profit
margins and improvement in the predictability of expected cash
flows in the future. Refer to Section 6.12 Techniques to Manage
Forex Risk.
17. Invoicing strategies aim to manage transaction exposures by
changing the invoicing currency. Refer to Section 6.13 Corporate
Internal Hedging Strategies.
18. Ifthe exporter finds that the domestic currency might appreciate
against the invoice currency and he/she cannot have a proper
hedge, then he can ask the importer to make the payments early,
this is called leading strategy. On the other hand, an importer
can ask for extra time for payment of foreign currency payables
if he/she is confident that the rupee will appreciate against the
foreign currency shortly, this is called lagging strategy. Refer to
Section 6.13 Corporate Internal Hedging Strategies.
19. The exchange rate risk management process involves various
steps, such as establishing a company-wide strategic corporate
policy for managing forex exposures and developing operational-
level policies for managing exposures and hedging exchange rate
risks. Refer to Section 6.14 Exchange Rate Risk Management
Process.
20. Transaction exposures can be measured by calculating the total
amount of inflows and outflows in various foreign currencies and
determining the net exposure that requires to be hedged. Refer
to Section 6.15 Measurement of Exchange Risk.

SUGGESTED READINGS FOR

aL REFERENCE

SUGGESTED READINGS
Q Cheol S. Eun, Bruce G. Resnick, (2012). International Financial
Management, Tata McGraw Hill Publishing Company Ltd., New
Delhi
Q Gert Bekaert, Robert Hodrick, (2013). International Financial
Management, Pearson Education Inc., publishing as Prentice Hall,
New Jersey
Q Jeff Madura, (2008). International Financial Management, Thom-
son South-Western, USA

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NOTES

E-REFERENCES
Q (2015). Retrieved 21 November 2015, from http://www.in.reuters.
com
Q Bis.org,. (2015). Bank for International Settlements. Retrieved 21
November 2015, from http://www.bis.org
Q Bloomberg.com,,. (2015). Bloomberg Business. Retrieved 21 Novem-
ber 2015, from http://www.bloomberg.com

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HEDGING AND RISK MANAGEMENT AND
USE OF DERIVATIVES

CONTENTS

7.1 Introduction
7.2 Concept of Derivatives
7.2.1 Role of Derivatives
Self Assessment Questions
Activity
7.3 Reasons for Booming Derivatives Markets
Self Assessment Questions
Activity
7.4 Types of Derivatives
7A.1 Forwards
7.4.2 Futures
7.4.3 Options
TAA Swaps
7A5 Other Complex Derivatives
Self Assessment Questions
Activity
7.5 Summary
7.6 Descriptive Questions
7.7 Answers and Hints
7.8 Suggested Readings for Reference

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INTRODUCTORY CASELET

INDIAN BUSINESSES HAVE NOT MANAGED CURRENCY

RISKS WELL ENOUGH

In August 2015, the rupee crossed historic 68.85 levels against the
dollar and depreciated against other major currencies. The vola-
tility of the rupee is expected to increase due to a host of external
and domestic forces. This has raised the importance of currency
risk management and the associated hedging methods beyond
forward contracts. For companies with significant international
transactions, an error in currency risk management can adverse-
ly affect the bottom line and competitiveness.

When it comes to currency ris ent, Indian corporates

have traditionally relied only tracts. Although the
regulatory authorities had iu ange-traded currency
futures and options in Indi tools have yet not be-
come popular. Earlier, I s, encouraged by banks,
C) derivative contracts but

ithout any exit point. These OTC de-

been wrongly used for speculation by In-
were banned by the RBI later. Similarly, In-
e significant exchange rate risks with regard

transaction exposure, Indian corporates also face

tion risk with regard to their unhedged liabilities in foreign
currencies. These can force companies to report marked-to-mar-
ket losses and affect their valuation in terms of lower share prices.

The above scenario implies that Indian corporates need to move

beyond forward contracts and develop a new approach to protect
market share and profitability by efficiently managing currency
risks. They need to shift to a portfolio of forex derivatives includ-
ing currency options and futures to manage these risks. For ex-
ample, they may need to increase the proportion of hedging with
vanilla put and call options.

Similarly, they need to systematically plan their hedging strate-

gies by properly categorising various exposures into time periods
and adopting different hedging tools and strategies for exposures
of different maturities. Short-term exposures may be fully cov-
ered with forward contracts, while partial hedging may be used to
deal with longer-term exposures. Options and futures can provide
more flexibility in handling currency risks when compared to tra-
ditional forward contracts. For example, call options may be used

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INTRODUCTORY CASELET

for uncommitted import exposures. This can allow taking advan-

tage of the favourable movement of exchange rates.

The global situation in terms of Euro Debt Crisis, financial uncer-

tainty in Euro Zone, downgrading of Japanese debt, high oil pric-
es, etc., indicates a strong dollar. The domestic scenario in terms
of factors like high inflation, trade deficit, growth slowdown, fiscal
deficit, etc., implies a depreciating rupee against the dollar. This
declining trend of rupee can be seen as an opportunity by Indian
corporates for expanding exports to new international markets.
Currency risk management can play a crucial role in exploiting
this potential.

On the contrary the depreciating rupee will pose a major

lenge for importers and for those corporates who have
foreign currency loans. This can also hurt exporters, if
foreign markets like US and Europe insist on Indian e
cut their prices.
(Source: Based on “Hedging against falling rupee”, The Hindu
June, 1, 2012, By Harkirat Singh, Professor, IIFT, http://www.theh:
opinion/hedging-against-a-falling-rupee/arti
aecessed on 21* October, 20

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© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

2— Explain the concept of derivatives
2— Discuss how forward contracts can be used to hedge foreign
exchange risks
2— Describe how futures contracts can be used to hedge foreign
exchange risks
»— Discuss how option contracts can be used to hedge foreign
exchange risks
»— Explain the concept of cy swaps and their role in
managing forex expos —_—_

(AS INTRODUCTION
In the previous chapter, you were introduced to foreign exchange
transactions, markets and risk management. In this chapter, you will
study about the concept of derivatives.

As you studied in the first chapter, international trade among world

countries grew tremendously in post-war decades. With the globalisa-
tion and integration of capital markets, the free movement of capital
between countries also became a significant aspect of global monetary
system. This phenomenal growth in international trade and finance
resulted in new challenges for global MNCs in terms of exchange rate
risks. This was especially so after the demise of Bretton Woods system
and fixed exchange rate mechanism. The subsequent free-floating
exchange rate arrangements of currencies of developed economies
required global corporates to search for new and advanced tools for
managing foreign exchange exposures and the related risks.

A derivative helps in reducing the complexities and uncertainty of a

financial market. The roles of various derivatives include hedging,
speculation and price discovery. Mainly, there are four types of de-
rivatives such as forwards, futures, options and swaps. Apart from
these, there are many other complex derivatives such as commodity
swaps, Forward Rate Agreements (FRAs), interest rate futures, exotic
options, forward swaps and swaptions.

This chapter covers the concept of derivatives. The basis for their
classification and the roles played by them are discussed in detail. In
addition, various reasons behind booming derivatives markets are ex-
plained. Towards the end, you learn about different types of deriva-
tives.

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(Py CONCEPT OF DERIVATIVES

Derivatives are financial instruments whose value and returns are de-
rived from underlying assets. These underlying assets could be phys-
ical or financial. Physical assets include commodities like agricultural
products, energy products or animal products, whereas financial as-
sets, on which derivative instruments are created, include currencies,
bonds, equity, interest rates or indices of financial assets. The value
and returns on derivative instruments are based on the movement of
price of underlying assets.

Derivative products can be classified—based on their characteristics

like purpose, structure, market mechanism, etc.—in the following
way:
Q Risk management: Although derivatives can be used for many
purposes, as we will discuss in the next section, they are primarily
used for hedging risks. There are various derivative techniques
that can be used to manage risks. What’s important is an accurate
identification of associated risks to use the right control technique,
such as:
@ Foreign exchange risks: To manage these risks, the right de-
rivatives include currency forwards, currency options, curren-
cy futures and currency swaps.

@ Interest rate risks: To manage these risks, the right deriva-

tives include forward rate agreements, interest rate futures, in-
terest rate swaps, interest rate options and interest rate swap
options.
¢ Price risks: To manage these risks, the right derivatives in-
clude commodity futures, commodity options, index futures
and options.

@ Credit risks: To manage these risks, the right derivatives in-

clude credit derivative products like credit default swaps.
Q Underlying assets: Derivative products can also be classified
based on underlying assets:
@ Foreign exchange or currencies: It involves currency futures
and currency options.

¢ Interest-bearing assets: These include interest rate futures,

credit derivatives, etc.

¢ Commodities: These include commodity futures, commodity

options, etc.

¢ Equities and bonds: These include equity futures, equity op-

tions, bond futures, etc.

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Q Nature of contract: Pricing, return and risk management charac-

teristics determine the nature of a contract, based on which, deriv-
atives can be classified as:

Forward rate agreements

“--tfef©
Futures

Options
Swaps
¢ Complex derivatives like swaptions, credit default swaps, etc.
Q Market mechanism: Derivative products can also be classified on
the basis of market mechanism into two major categories:

1. Exchange-traded derivatives
2. OTC derivatives

7.2.1 ROLE OF DERIVATIVES

Besides in risk hedging, derivative products are highly useful in spec-

ulating price movements of the underlying asset. The benefit of price
discovery is also attributed to derivative instruments. The role of de-
rivatives in these finance-related activities is discussed as follows:
Q Hedging: It generally refers to managing, mitigating, reducing or
offsetting a risk by taking an exposure on the opposite side of the
concerned transaction. For example, consider an exporter with
an exposure to foreign currency (i.e., he has export receivables
in a foreign currency) and expecting to receive the proceeds after
three months. He is not sure about the exchange rate that will be
applicable after three months when he will be converting the for-
eign currency into home currency. Thus, he faces the exchange
rate risk. Suppose the current exchange rate is INR 65/USD. Let
this also be the rate he used to convert his INR invoice amount
into USD amount. If the exchange rate becomes INR 60/USD af-
ter three months, he will lose five rupees for every dollar worth of
goods exported. There is an uncertainty with regard to the total
amount of INR proceeds he can realise after three months. In this
case, his exposure is the expected receipt of the foreign currency
three months hence. His loss due to the exposure depends on the
exchange rate after three months. If he wants to eliminate the ex-
change rate risk, he can resort to a hedging transaction, i.e., take
an exposure on the opposite side. Since his current exposure is of
receipt of USD after three months, he can take an exposure on the
opposite side by a contract to sell USD after three months. Sup-
pose that he could find some other importer who expects to pay an
equivalent amount of USD to his exporter. He faces the risk that
the exchange rate could become, say, INR 67/USD, which means
his cost would increase by two rupees for every dollar worth of

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NOTES

goods imported. He faces an uncertainty that the exchange rate

could turn adverse similar to the case of exporter. Suppose that
the exporter can enter into an agreement with the importer to sell
USD after three months for INR 65/USD irrespective of future
spot exchange rates. This means the exporter takes an opposite
exposure of commitment to sell USD after three months, while the
importer would face the opposite exposure of receipt of USD after
three months. By this contract, both of them can eliminate the ex-
change rate risk. The transaction or contract by which they take
the opposite position in the future spot market for eliminating the
risks involved in their current exposure is termed a hedging trans-
action.
Q Speculation: Derivatives markets are also a great place for spec-
ulation. In the above example, we assumed that there would be
another importer who would have an exactly opposite exposure.
This ensures that banks can offset exposures by performing the
function of an intermediary. However, it is possible that there is no
counterparty having an opposite exposure. In financial markets, it
is still possible to hedge transactions.

Financial markets have participants with different risk capabilities

and risk averseness. Some investors would like to completely elimi-
nate all risks, while some may be interested in taking on additional
risks, if higher returns are possible. Let us say that the future spot
rate expected by market participants after three months is INR 68/
USD. This means if an investor purchases USD now at INR 65/USD
and sells it after three months, he will gain three rupees per USD (ig-
noring the interest he will receive on USD). However, there is a risk
that the exchange rate may turn adverse to INR 60/USD. However, if
an investor is interested in taking risks as he is confident about the
exchange rate to be above INR 68/USD, he might decide to purchase.
Thus, he is trying to make profits by speculating on the movement of
exchange rates. Such an investor might be interested in entering into
a forward contract with the exporter above to purchase, say, at INR
65/USD after three months. After three months, he will purchase USD
at the stated rate of INR 65/USD and sell it in a spot market. If the fu-
ture spot exchange rate turns out to be, say, INR 68/USD, he will sell
USD and make a profit of three rupees per USD. This transaction of
entering into a contract to buy or sell the underlying asset at a future
date on a price fixed now, without having any current exposure to the
underlying asset, is termed a speculative transaction.

Note the difference between hedging and speculation. In the case of

hedging, the exporter already had a risk exposure that he wanted to
eliminate or reduce. In the case of speculation, there is no underlying
asset involved. Thus, hedging is for the purpose of mitigating risks,
while speculation is meant for making profit by undertaking risks.
Q Price discovery: Derivatives markets are supposed to help in the
price discovery process of financial markets. Price discovery means

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a process by which underlying assets are priced according to their

actual Intrinsic Value. Through hedging, speculating and arbi-
trage transactions, market participants are involved in predicting
the future spot prices of underlying assets. In the above example,
the speculator expects the exchange rate to be above INR 65/USD.
However, another speculator may expect the exchange rate to be at
INR 70/USD based on his own fundamental analysis and exchange
rate forecasting on which he is willing to take risk. Similarly, dif-
ferent market participants can have different expectations about
the movement of exchange rates. Suppose many people expect the
exchange rate to be at INR 69/USD, then the future exchange rate
at which the exporter can sell his export proceeds increases. This
possible higher profit out of speculation due to higher demand for
USD in a three-month maturity will affect both the three-month
forward rate and the spot rate of USD against INR. (Note: Forward
rates are determined by the covered interest rate parity theorem
that is based on the currently prevailing interest rates in any of the
two countries. However, as we discussed in the previous chapter,
it is not necessary that the future expected spot rate will be the
same as the current forward rate. The actual spot rate after three
months will be determined by several other factors prevailing af-
ter that period. Speculation involves predicting these factors and,
hence, the future expected spot rate.)

Transactions in derivatives markets are based on the expected future

spot prices of underlying assets. This affects both derivatives prices
and current spot prices. This ultimately ensures that the price of an
underlying asset in a spot market correctly reflects the expectations
of market participants. By the financial theory, if markets are efficient,
the transactions that result as per the expectations of market partici-
pants should correctly value the asset in spot markets. Thus, deriva-
tives markets help the price discovery mechanism by allowing market
participants with differing risk perceptions and risk-taking capabilities.

& SELF ASSESSMENT QUESTIONS

1. Returns from a derivative instrument can be independent of

the price of the underlying asset. (True/False)
2. One major difference between forward contracts and futures
contracts is that forwards cannot be traded at a later point of
time. (True/False)

3. Derivative products can be classified on the basis of all these

except:
a. Types of risks that can be hedged
b. Whether the underlying asset is physical or financial, etc.
c. Structure of agreement
d. Market mechanism
e. Their usage for hedging or speculation

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4. Price discovery refers to:

a. Hedging and speculation
b. Pricing of derivatives based on underlying
ce. An efficient movement of spot prices towards their intrin-
sic value due to derivative trading on future prices
d. A process of managing, mitigating, reducing or offsetting a
risk by taking an exposure on the opposite side
5. A market participant expects the rupee to appreciate by 5%
over the next three months. Hence, he purchases a currency
futures contract. This activity is referred to as:
a. Hedging b. Speculation
c. Investment d. Price discovery

Indian financial markets began trading in currency derivatives many

years ago. Visit the website of National Stock Exchange (NSE) and
study the contract specification and volume of trade of various types
of exchange-traded derivatives. Describe the information found.

REASONS FOR BOOMING DERIVATIVES

a3 MARKETS

Derivatives markets had grown to tremendous size in the recent de-

cades. One of the major reasons behind this boom is the increased
risks associated with asset markets. This increase in the volatility of
asset prices can be attributed to several reasons. As mentioned earlier,
the demise of Bretton Woods system and the consequent free floating
of exchange rates of major currency pairs greatly increased the un-
certainty associated with exchange rates. Corporates involving them-
selves more and more in international trade transactions required ef-
fective tools to hedge exchange rate-related risks.

Similarly, integration of global markets and greater movement of

capital across country borders tremendously increased international
trade and finance transactions. This also led to speculation and arbi-
traging activities, which added to the volatility of price of assets across
financial markets. This further boosted the need for derivative trans-
actions.

Although commodity derivatives are said to have their origin since an-
cient times, the emergence of an organised financial derivative trading
is a phenomenon of recent decades after the financial infrastructure
of markets saw a marked improvement in the 1970s. The availability

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of derivative exchange-related settlement and clearing mechanisms

made the usage of financial derivatives easy and simple for corporate
risk management. The largest futures market Chicago Board of Trade
(CBOT) has been in existence since 1848. Financial derivatives mar-
kets came into existence in 1972 with the launch of currency futures
by Chicago Mercantile Exchange (CME).

The increased risks associated with exchange rate volatility were

compounded by the uncertainty over interest rates that were chang-
ing frequently with monetary policies of major economies. This fur-
ther increased the need for innovative risk management products
for corporates looking to manage risks and led to the development of
standardised risk management products like futures and options on
various underlying assets.

Advancement in financial engineering and communications technolo-

gy also enabled the structuring of derivative products that could meet
the hedging needs of corporates. This was also greatly helped by the
emergence of global investment banks that helped MNCs to structure
deals using advanced derivative products.

Apart from risk management needs, the motives of speculation, made

easy by margin-based trading that allowed high leveraged trading,
also led to booming derivatives markets. In fact, speculative transac-
tions constitute the major share of the overall trading volume of deriv-
atives markets.

& SELF ASSESSMENT QUESTIONS

6. The integration of global markets and greater movement

of capital across country borders led to speculation and
arbitraging activities, which also added to the volatility of
price of assets across financial markets. (True/False)

Visit the website of BIS.org. Download the latest report on glob-

al trends in derivative trading in international financial markets.
Study the percentage share of volume of different derivative prod-
ucts and the reason for the same.

(2S TYPES OF DERIVATIVES

In this section, you will study about various derivatives, their purpose
and how they are used for hedging foreign exchange risks.

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7.41 FORWARDS

A forward can be defined as a customised contract that takes place be-

tween two parties pertaining to buying and selling an asset at a spec-
ified price on a future date. It is used for hedging or speculation. The
non-standardised nature of forwards makes them particularly apt for
hedging.

As you studied in the previous chapter, transaction exposures pertain

to specific and quantifiable foreign exchange exposures and hence
can be easily hedged using financial derivatives. The simplest case
of transaction exposures are the exposures arising out of exports and
imports where the receivables and payables, respectively, might lead
to transaction exposures, if the invoice currency is not in home cur-
rency. In both of these cases, there is an uncertainty with regard to
the exchange rate being applicable at a future date when the foreign
exchange is purchased or sold.

One simple and straightforward way to remove this uncertainty is to

undertake the future transaction. For example, if an importer has an
exposure to pay $1 mn after three months, his problem will be the ex-
change rate that will be available for purchasing the dollar after three
months. He can remove this uncertainty by purchasing USD now it-
self. He can then invest it in money markets at applicable US money
market interest rates. His borrowal amount should be such that the
maturity amount of the investment matches the USD payables occur-
ring after three months. He might need to borrow rupee in order to
make the USD purchase in spot markets. However, the interest he
needs to pay for rupee loan would be compensated by the interest he
gets in the USD investment, which reduces the amount that needs to
be borrowed. Alternatively, he can borrow the exact USD amount of
payables and convert the USD interest into rupee after three months
to pay for the rupee loan at the future spot rate. If the uncovered in-
terest parity theorem holds good, the interest he needs to pay for the
rupee loan will be the same as the amount received by converting the
interest received from USD investment.

A similar process can also be adopted for the exporter expecting mon-
ey from the receivables. Suppose, a corporate expects to receive USD
receivables after three months. His problem will be the uncertainty
regarding the exchange rate at which he will be able to convert the
USD receivables after three months. To remove this uncertainty, he
can borrow in USD for an amount whose maturity value is exactly
equal to the dollar receivables such that when the receivables are re-
alised, they can be used to pay off the USD loan along with the interest
payable. The dollar amount borrowed can be sold in spot markets,
and the resulting rupee proceeds can be invested in money markets.
If the uncovered interest parity theorem holds good, the maturity
amount received from his rupee investment will be exactly equal to

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the amount that would have been received, if the USD receivables had
been converted into the future spot exchange rate.

The above process is called money market hedge, and we have gone
into the above concept at several instances before (during our discus-
sion on covered interest parity theorem and later in forward contracts
and swaps).

You must have understood by now that the above process of resorting
to the two money markets of the two currencies is cumbersome and
not required, if there exists an active forward market for the maturity
and currency pair. If the forward market exists, the importer would
simply enter into a forward purchase contract for USD at the forward
rate. Similarly, the exporter would enter into a forward sale contract
for USD on a three-month maturity. The resultant effect on their real-
isation of rupee proceeds/payables will be the same as that achieved
through the money market hedge discussed above, if the covered in-
terest parity theorem holds good.

INTERBANK TRADING MECHANISM

Majority of the transactions pertaining to bank-to-bank derivatives

take place in the interbank broker market, which makes this market
one of the most crucial segments of the Foreign Exchange (FX) deriv-
atives market. Interbank brokerage firms participate in the FX de-
rivatives market to deal on behalf of the bank. These brokerage firms
work through their teams that integrate them with the international
derivatives market, as shown in Figure 7.1:

Bank A
Trading
Desk Bank B
Trading
Desk

¢ 1 4
Interbank Broker
Bank D
Trading

f 4 f
Desk

Figure 7.1: The Interbank Broker Structure

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The categorisation of brokers can be done on the basis of currency

blocks such as G10 majors or Asia EM. They can also be classified on
the basis of option types such as vanillas and exotics.

Let us discuss the interbank trading mechanism through an illustra-

tive example. The trader at bank A wants to enter into a particular va-
nilla contract and make request for the price quotation from its broker
working at one of the interbank brokerages. This is termed the ‘inter-
est of trader A’ on which the broker starts to search for a suitable deal
for that specific vanilla. It should be noted that a broker may work
simultaneously for various traders having multiple interests.

Now, broker A will contact the other brokers concerning the interest
of the transaction. The brokers will further contact the relevant trad-
ers of other banks in the market requesting a price for the interest.
Thus, brokers play the main role not only in trading by an individual
but also in interbank trading. On the basis of the size of a transaction,
the commission is paid to the brokers.

We will now see some illustrated examples of hedging through for-

ward contracts.

Illustrative Example 1

A US company has exported goods worth GBP 10 million, receivable

after three months, to a UK-based company. The forward rates are
given below:

Exchange rate quotation:

GBP-USD 1.2055-1.2150

Three months 50-35

Questions:

1. Explain whether the US company faces any exchange rate risk,

and if so, how it can use forward contracts to hedge the same.
2. Isthe GBP quoting at discount or premium to the dollar? What is
the forward rate applicable at which the US company will enter
into a forward contract?
3. Suppose USD is appreciating. Should the US exporter go for
hedging the risk? If he hedges the risk with a forward contract
and the actual spot rate turns out to be the same as the currency
spot rate, what is his notional profit/loss?
4. Ifthe exporter expects to receive his proceeds any time after two
months but not later than three months, how should he hedge
his exposure? What forward rates will be applicable?

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Solution:

1. The US company would receive GBP 10 million after three

months. When it converts the GBP proceeds after three months,
the exchange rates between the dollar and pound can be either
way. Hence, there is an uncertainty with regard to the final USD
amount it will realise from its export transaction. Hence, the
US company is facing transaction exposure and the resultant
exchange rate risk. It can hedge this exchange rate risk by fixing
a rate at which it can convert the GBP proceeds by entering into
a forward contract with its banker.
Exchange rate quotation:
GBP-USD 1.2055-1.2150

Three months 50-35

2. In the exchange rate quotation, the first currency represents the
base currency and the second currency represents the quote
currency. Hence, a quote of 1.2055 means each GBP would cost
1.2055 dollars. The first quote of 1.2055 dollars is the bid rate, i.e.,
the rate at which banks are willing to purchase the base currency,
i.e., GBR Similarly, the rate of 1.2150 dollars is the amount that
needs to be paid for purchasing GBP from banks.
In our case, the US company has receivables and would like
to sell GBP to bankers. Hence, the rate at which the banks are
willing to purchase GBP is the bid rate of USD 1.2055/GBR
What is the forward rate at which the US company can enter
into a contract? The forward bid-ask points are given in terms of
forward points or swap points. To arrive at the forward rate, we
need to add or subtract the points from the spot exchange rate.
You must remember the thumb rule that forward (or swap) points
should be added if forward bid points are less than forward ask
points, and vice versa. In the above case, the forward bid points
are greater than the forward ask points. This means the amount
at which GBP can be purchased is coming down in the forward
market, i.e., GBP is weakening and is quoting at a discount to the
dollar in forward markets. The applicable forward rate will be:
Outright forward rates : Bid (1.2055-50/10000) Ask
(1.2150-35/10000)
Outright 3-month forward —: 1.2005-1.2115
The forward rate at which the banks are willing to buy GBP is the
forward bid rate of USD 1.2005/GBR The US company can enter
into a forward contract to sell GBP at a three-month forward
rate of USD 1.2005/GBP.
3. In the above case, USD is strengthening as per the indications
of forward rates, but the exposure of the US company is in GBP
Hence, as GBP is weakening, its conversion proceeds will be
lesser at a future date. Hence, the company further faces the risk

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of realising much lesser proceeds. Hence, it is necessary for it to

enter into a forward contract in order to prevent any losses.
If USD had not appreciated during the period, i.e., the uncovered
interest parity did not hold and the actual spot rate remained the
same at USD 1.2055/GBP and the US company had not hedged
the risk by entering into a forward contract, it would have
converted GBP 1 mn at the rate of USD 1.2055/GBP. which is
greater than the forward rate of USD 1.2005/GBP Hence, there
is a notional loss equivalent to the swap points per GBP The
company’s notional loss (i.e., the additional export proceeds lost)
for having hedged the risk is:
Notional loss = GBP 10,000,000 X (1.2055-1.2005) = GBP 50,000
However, if the exchange rate had turned adverse, say to USD
1.15/GBP and the company had not hedged the risk, its export
proceeds would have been lesser by:
Notional profit = GBP 10,000,000 x (1.15-1.2005) = -GBP 505,000
In other words, in the above case of USD 1.15/GBR by hedging
the risk, the company would have made a notional profit of GBP
505,000.
This is why it is always prudent for corporates to hedge their
forex exposure and not speculate on currency movements.
4. Ifthe exporter is not sure about the date on which it will receive
the export proceeds and it could be anywhere between two
months and three months from today, it should approach its
banker for option forward contracts of three-month maturity
with one month option period. The option period of one month
starting from the end of the second month (from today) will allow
it to sell USD at any time after two months. The forward rates
quoted by the banker will be applicable for a two-month forward
instead of a three-month forward.

Illustrative Example 2

Consider the data of the above example. From the perspective of the
UK importer, answer the following questions:
1. What kind of exposure and risk does the UK company face?
Should the company hedge the risk?
2. If the US company had invoiced the exports in EUR, what kind
of risk would the UK company have faced?

Solution:
1. The UK company imports goods in the home currency of GBP
and does not face any foreign exchange exposure or transaction
risk. Hence, it will not enter into any forward contract.

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N OT ES

If the US company had invoiced the exports in EUR, the UK

company would have faced transaction exposure in EUR as well
as the transaction risk related to the uncertainty of exchange
rates related to GBP-EUR.

Illustrative Example 3

Consider the data of Example 1. Instead of the invoice amount of GBP

10 mn, assume that the invoice amount is EUR 10 mn. With the quotes
of EUR-GBP as given below, answer the following questions:
EUR-GBP 1.8600-1.3610
Three months 52-37

Explain how the UK company can hedge its risk related to the
above import transaction.
What are the outright forward rates applicable for three months?
What is the forward rate applicable for hedging?
Is the expected currency appreciation or depreciation as per
interest parity conditions favourable to the exporter?
If the currency movement is expected to be favourable, should
the importer hedge? If the importer hedges the risk with forward
cover and the spot rate remains the same after three months,
what is its notional loss or profit?
If the exchange rate is 1.3450 after three months, what is the
notional loss or profit due to entering into a forward contract?

Solution:

1. The UK company has payables in a foreign currency and hence

faces transaction exposure and related exchange rate risks. It can
hedge the risks by fixing the rate at which it needs to purchase
EUR after three months. So, it can do the same by entering into
a forward purchase contract of EUR 10 mn with its banker at the
applicable forward rate.
The forward bid-ask points are given in decreasing order. Hence,
the base currency is quoting at discount to the quote currency or
home currency. In this case, the forward rates applicable will be:
Forward rates : Bid (1.3600-52/10000) Ask
(1.3610-37/10000)
Outright 3-month forward — : 1.3548-1.3573
The UK company will have to purchase the base currency (EUR)
after three months. Banks are willing to sell EUR at the forward
ask rate of 1.3573. Hence, this is the rate applicable for hedging
the transaction exposure.
3. As per the forward rates, the invoice currency is expected
to weaken against the home currency. As per interest parity

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conditions, in a three-month time, each home currency can

purchase more units of invoice currency, which in this case is
the base currency. This means the UK company will require
less amount of home currency to meet the payables after three
months. Hence, the expected currency movement as per interest
parity conditions is favourable to the UK company.
4. Even though the currency movement is expected to be
favourable to the importer, there is still uncertainty regarding
the future movements. It is not always necessary that the future
spot rate would be the same as predicted by interest parity
conditions because exchange rates are dependent upon so many
other variables. Hence, in order not to speculate on currency
movements, it is prudent for the importer to hedge the risk and
remove the uncertainty by entering into a forward purchase
contract for EUR 10 mn at the rate of EUR 1.3573/GBR
If the spot rate after three months had remained the same as the
current rate and the importer had not hedged the risk, it would
have paid higher amount and hence there would have been a
notional loss.
Amount of GBP required with forward cover = 1.3573 X 10,000,000
= GBP 13,573,000

Amount of GBP required, if no forward contract applicable =

Future spot rate X 10 mn
= 10,000,000 1.361 = GBP 13,610,000
Hence, if the company had not entered into a forward contract
and the spot rate had remained the same, it would have paid an
additional amount of GBP 37000. Thus, there would have been
a notional profit of GBP 60,000 due to hedging by the forward
contract.

5. Ifthe spot rate on the maturity date after three months turned
out to be 1.3450, the amount of GBP required would be: GBP 10
mn* 1.3450 = GBP 13.45 mn.

However, since the company entered into a forward contract, it had

to pay 18.573 mn. Hence, there is a notional loss of GBP 1.23 mn. The
company would have been better off by GBP 1.23 mn, if it had left the
exposure uncovered. However, as mentioned before, it is not advisable
for corporates to speculate on currency movements.

7.4.22 FUTURES

The forward contracts discussed above are tailor-made contracts that

are entered into by corporate clients with their bankers. These are
not derivative instruments that can be sold in secondary markets.
Suppose an exporter entered into a forward purchase contract with
the maturity date being after 3 months. If his underlying exposure
was not applicable any more (i.e., the export transaction was can-

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celled or he was unlikely to receive the foreign currency amount after

3 months), in the case of forward contracts, he would have to ask his
banker to cancel the forward contract. The forward contract would be
cancelled, and the required adjustments would be done based on the
prevailing exchange rates on the date of cancellation. Another way to
cancel a forward purchase is to square off the forward position with
counter-exposure. For example, the exporter can square off the for-
ward purchase with a forward sale contract with the same amount
and maturity date. This is theoretically same as selling the forward
purchase contract already entered into. Such things are not possible
in forward markets as forward contracts are not really instruments
that can be traded and also because these contracts are tailor made
to meet the individual requirements that makes squaring off with the
opposite transaction difficult.

If the contracts can be standardised in terms of all applicable parame-

ters like contract amount, maturity period, future price, etc., it will be
easy to trade these contracts with other counterparties. Derivative ex-
changes serve this need of standardising derivative contracts so that
they can be traded easily in derivatives exchanges. This also allows
buying or selling derivative contracts for speculative purposes as dis-
cussed in the previous section. The standardised forward contracts
are the currency futures in derivatives exchanges. Table 7.1 differen-
tiates between forwards and futures:

TABLE 7.1: DIFFERENCE BETWEEN FORWARDS AND

FUTURES
Cl 5 teristi Forward Contracts Currency Futures
Contract type Can be tailor-made to Standardised contracts:
suit corporate needs may not match exactly
with corporate exposure
Trading No secondary market Can be traded in deriva-
> trading tives exchange
Counterparty Banks are counter par- _— Derivatives exchange is the
ties to forward contracts. counterparty; actual coun-
terparty is anonymous.
Settlement Daily settlement by Settlement on maturity
MTM mechanism
Expiration date Standard contracts avail- Standardised delivery
able, but itis possible to dates
meet the specified date
requirement.
Delivery Delivery of underlying is No delivery of underlying
common. asset; only cash settlement
Trading costs Bid-ask spread plus Bid-ask spread and broker-
commissions charged by age for trading in exchange
the bank

The very nature of standardisation and exchange trading leads to sev-

eral other differences between how hedging can be done with forward

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contracts and futures contracts. In order to understand the same, let

us further study the characteristics of currency futures.

A currency futures contract (also termed FX futures) is a contract to

exchange one currency for another at a specified future date at an ex-
change rate (price) that is fixed on the trade date. A futures contract
is applicable between the market participant and the exchange, with
exchange acting as the intermediary to both the counterparties so that
the trades are anonymous. Thus, when you purchase a futures con-
tract from the exchange, there will be another market participant that
will be selling the same futures contract through the exchange. The
buying or selling of a futures contract is done through brokers who are
members of the derivatives exchange. The settlement of the contract
is done through a clearing house attached to the derivatives exchange.
The broker may also act as the clearing member or may clear through
another broker who is a member of the clearing house.

Table 7.2 gives an extract of currency futures quotes from the NSE website:

TABLE 7.2: EXTRACT OF CURRENCY FUTURES QUOTES

FROM NSE WEBSITE
Best Bid BestAsk Chng % LTP
tracts Chng

USDINR TA VU
Qty Price Price Qty

USDINR 168 64.8625 64.865 61 -0.08 -0.12 64.8625 19,10,403 604453

281015
USDINR 65 65.22 65.225 101. -0.0 1 SBE 421,542 98417
261115
USDINR 684 65.5775 65.59 244 -0.1 -0.15 65.56 1,01,012 3379

EURINR wy
291215

EURINR 20 73.6475 73.655 10 -0.09 -0.13 73.6475 42,509 29286

281015
EURINR 10 74.0325 74.05 11 0.02 -0.03 74.1 17,130 1885
261115
EURINR 8 74.3775 74.4175 3 -0.03 -0.04 74.4575 1,858 50
291215
GBPINR
GBPINR 1 100.295 100.2975 5 -0.01 -0.01 100.2925 34,191 18580
281015
GBPINR 8 100.73 100.75 5 0.01 0.01 100.76 8,786 1158
261115
GBPINR 2 101.155 101.205 2 0.08 0.08 101.25 882 82
291215
JPYINR
JPYINR 21 54.3175 54.325 11 -0.22 -0.39 54.3225 7,594 7772
281015
JPYINR 33 54.5875 54.605 105 -0.21 -0.38 54.575 1,432 632
261115
JPYINR 25 54.71 55.0975 25 -0.55 -099 54.82 208 2
291215
(Source: www.nse.com)

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In Table 7.2, futures contract details for four major currency pairs that
are traded in NSE derivatives exchange are given. The first column
gives the contract symbols. The table contains quotations for three
contracts each for the four major currencies of USD, EUR, GBP and
JPY against INR with the contracts expiring on 28 October 2015, 26
November 2015 and 29 December 2015 respectively. It also gives other
details like best bid and ask prices and respective quantities, last trad-
ed price, open interest (number of outstanding contracts) and volume
of contracts, etc.

The features of currency futures listed in NSE derivatives exchange

are given as follows:
Q.= The unit of trading is 1000 USD for USDINR currency future con-
tracts. This means each future contract has a standard size of 1000
USD. A purchase of one futures contract means the contract in-
volves purchasing 1000 USD at the purchase price. (Similarly, it is
1000 euros, 1000 pounds and 100000 JPY respectively for the other
currencies.)
Q The currency futures price is quoted in terms of exchange rate
at which the rupee will be exchanged with the foreign currency
(direct quote). A purchase of currency futures at a price of INR
64.865/USD means it is the exchange rate at which INR will be
exchanged with USD on the maturity date.
Q. A purchase of one currency futures contract implies that the con-
tract involves the purchase of 1000 USD at INR 64.865/USD. In
other words, a purchase of one currency futures contract implies
that the investor contracts to pay INR 64,865 for receiving USD
1000 in return on the maturity date.
Q The contract symbol USDINR281015 implies that the futures con-
tract has an expiry date of 28 October 2015. This is called the final
settlement date.
Q Mode of settlement will be in INR. For calculating the daily settle-
ment price, the weighted average price of last half an hour is taken
as a base.
Q The final settlement price will be based on the “RBI Reference
Rate”. This is the rate published by RBI in its press release.

In currency futures or in the case of any futures derivative product,

there is no actual delivery applicable on the maturity date. For example,
in the case of forward purchase contracts, the corporate client is expect-
ed to purchase the foreign currency on the maturity date at the agreed
forward rate. However in the case of futures contracts, a settlement of
the profit or loss accruing to the contract is done instead of delivery.
This is done through the Mark-to-Market (MTM) margining process.

In order to understand the MTM settlement process, it is necessary

to understand the concept of margins. When an investor purchases a

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currency futures contract, he agrees contractually to deliver a foreign

currency of certain standard contract size as against another curren-
cy. However, he might fail to meet his commitment on the maturity
date. The exchange along with clearing house, however, guarantees
settlement for every trade. This means the exchange will honour the
commitment on behalf of the investor by purchasing/selling the cur-
rency in the spot market on the maturity date. This would lead to a
loss for the exchange depending upon the spot price of the asset on
the maturity date. The exchange would then need to recover the loss
from the investor who failed to meet his commitment. In order to facil-
itate this, the exchange requires every investor to deposit a collateral
amount known as security. This is called initial margin, applicable for
futures contracts. This margin, a percentage amount on the contract
size, say, 2%, is required to be deposited by the investor in cash (or
treasury bills) when he purchases or sells the futures contract.

The initial margin is applicable on the contract size purchased or sold

based on the purchase/sale price. However, futures prices change ev-
ery day. If a futures price turns adverse the next day, the quantum of
margin deposited with the exchange will be less than the stipulated
percentage on the contract amount. Thus, the exchange would re-
quire an additional margin to be deposited depending upon the move-
ment of the futures price. This requires the contract to be valued on
everyday basis based on the applicable daily settlement price. This
valuation process is called ‘marking to market’ as the contract amount
is ‘marked’ or revalued to the applicable current futures price. As a
futures price changes continuously, instead of asking the investor
to deposit additional margin for every small changes, the exchange
might specify a maintenance margin, which means only when the ini-
tial margin comes below that level, a variation margin might need to
be deposited to bridge the gap in the initial margin applicable.

When a market participant purchases a currency futures contract, he

is said to have taken a long position in the market. If he sells a curren-
cy futures contract, he is said to have taken a short position. These
margins are applicable for both longs and shorts. The margins are
applicable on an open position, which means marked-to-market value
of the contract based on the latest applicable price.

On the expiry date of the contract, the final marking-to-market will

be done on the final settlement price (In the case of NSE derivatives
exchange, it is the RBI reference rate) and that will be nothing but the
difference between the purchase price and settlement price showing
the overall loss or profit for the market participant. Thus, the mark-
ing-to-market mechanism obviates the need for actual delivery as the
process mimics the squaring-off of the contract on the maturity date
at the final settlement price.

Another important characteristic of exchange-traded derivatives is

that the market participant do not have to wait till the expiry date.

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He can square off the contract at any time before the maturity date of
the contract. For example, if he has purchased a USDINR currency
futures contract expiring after one month, he can square off the po-
sition, if the exchange rate turns adverse by selling the contract any
time before. Similarly, if he has sold a currency futures contract, he
can square off the position by purchasing back the currency futures
contract and settle the contract at the applicable settlement price (i.e.,
exchange rate).

The concept of easy exchange trading of currency futures based on

margining system, which requires very minimum initial investment,
had led to more speculative trading in derivative exchanges than trad-
ing for hedging forex exposures.

HEDGING WITH CURRENCY FUTURES

Currency futures contracts can be used to hedge forex exposures in

the same manner forward contracts are used for the purpose. The
main difference is the contract size that is a standard one and may
not necessarily match with the actual exposure. The second major dif-
ference is the maturity date of a futures contract that may not coin-
cide with the actual cash flow pertaining to the exposure. Finally, the
margining and resulting settlement mechanism make hedging with
futures different from that with forwards.

Suppose today is 5 October 2015 and an exporter has receivables of $1

million that he expects to receive by the end of the month. If each US-
DINR currency futures contract is of size $1000, in order to hedge the
exchange rate risk, he needs to sell 1000 currency futures contracts
that expire at the end of the month. Similarly, if he is an importer and
his payables are in USD, in order to hedge the exchange rate risk, he
needs to purchase 1000 contracts of USDINR currency futures.

In the above case, we have assumed that the contract expiry date is
the same as the date of payment or receipt of the foreign exchange.
Suppose that the futures contract listed in the derivatives exchange
expires at the end of the October month. However, the exporter is like-
ly to receive his USD proceeds by 20th of October. In this case, he can
still go ahead and sell 1000 contracts of USDINR currency futures.
However, on 20th October, he has to square off his position by selling
the contract. The exchange rate applicable on this date will be differ-
ent from the price (i.e., exchange rate) at which he sold the contracts,
but whatever profit/loss occurs due to this difference will be nullified
by the loss/gain due to the squaring off of transaction.

If the expiry date of the futures contract is different from the trans-
action exposure date, the hedge will be the same as the hedge where
the expiry date is the same as the transaction exposure date, only if
the spot price is the same as the futures price on the day the contract
is squared off. However, the spot rate will be the same as the futures

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rate only on the contract expiry date. The difference could lead to ad-
ditional loss/profit, which would make the hedge imperfect. This is
called basis risk, the basis being the difference between the spot price
and futures price on the transaction exposure date. In such cases, for-
ward contracts, if available, would be a better hedging tool than cur-
rency futures.

Let’s understand better through some illustrated examples:

Illustrative Example 4

An Indian company imports machinery from Japan. The Japanese

manufacturer invoices the shipment in Japanese Yen (JPY), and the
amount is JPY 5 million. The importer needs to pay the amount by 30
October 2015. The data regarding the futures contract as on 10 Octo-
ber 2015 is:

Interbank Spot Market

JPY-INR 54.2725-54.2775

NSE futures:

JPYINR281015 54.3175-54.3250

Exchange rates for JPY are quoted per 100 JPY, and the standard con-
tract size is 100,000 JPY. The initial margin applicable is 3% (Ignore
margin and transaction related costs).

Questions:

Explain the process of hedging with currency futures for the above
case, if the spot rate turns out to be INR 53.1250 on 28th October. What
is the notional loss/profit of the Indian company when compared to
the actual spot rate on October 28th? (Assume that the futures set-
tlement rate is the same as the spot rate on the contract expiry date.)

Also, if the spot rate was 55.6250 on the expiry date, what would be the
company’s notional profit for having decided to hedge the exposure?

Solution:

The importer needs to pay JPY 5 mn for the value date, 30th Octo-
ber. This means it would need to purchase JPY in the spot market on
28th October. It faces the uncertainty of how much rupee would be re-
quired to purchase JPY 5 mn. If the rupee depreciates against JPY, its
import cost will increase. Hence, it would like to hedge the exchange
rate risk.

The company can hedge the risk using currency futures. If it purchas-
es JPY currency futures contract expiring at the end of October, the-
oretically, it implies that the comapny is entering into a contract to

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purchase JPY at the futures price of October contract quoted now. In

the above example, the applicable futures price for JPY is 54.3250. It
means you are entering into a contract to purchase JPY at the end of
October (i.e., on 28th October for this contract) at an exchange rate
of 54.3250. This is the same as entering into a forward contract at a
rate of 54.3250. However, the actual operation of futures trading and
hence, the hedging process are different as the settlement is different
from that of a forward contract as explained earlier. The various steps/
transactions involved in the hedging process will be as follows:
1. Since the importer needs to purchase JPY at a future date, it will
purchase currency futures.
Its liability is JPY 5 mn. The standard contract size is 1,00,000.
Hence, it needs to purchase (5000000/100000=) 50 futures
contracts.

The initial margin applicable is 3%. The notional contract

amount is calculated as follows:
Notional INR contract amount = 50X 100000 X(54.3250/100) =
INR 27,16,250
Margin applicable = 3% of 27,16,250 = INR 81488
On the expiry date of 28th October, the contract will be settled
at the spot rate of 53.1250. Since it is also the futures contract
settlement price on the expiry date, this is equivalent to saying
that the futures contract will be sold (or squared off) at 53.1250.
The profit/loss from futures transaction will be:
Profit/loss due to futures transaction
= Sale price — Purchase price
=50X 100000 X(53.1250/100) — 27,16,250
= 26,56,250 — 27,16,250
= INR -60,000
(Alternatively, the MTM value of the contract on the expiry date
is INR 26,56,250. The loss on the long position is INR 60,000. The
margin amount released will be 81488-60,000 = INR 21,488)

Thus, there is a loss of INR 60,000 in the case of currency futures

transaction.

For paying the import bill, the importer will purchase JPY in the
spot market rate of 53.1250.
Amount of INR required = 5000000 X53.1250/100 = INR 2656250
Total amount of INR spent for the import bill = Spot purchase +
Loss on futures
= 2656250 + 60000

= 2716250

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5. The effective exchange rate at which the importer purchased

its JPY requirement is (2716250/5,000,000=) 0.54325 per JPY or
INR 54.3250 per 100 JPY. Thus, the effective exchange rate is the
same as the futures rate contracted at 54.3250.
The loss due to futures transaction is compensated by the
lesser spot exchange rate applicable on the expiry date. Hence
effectively, the importer has fixed the future exchange rate at the
futures price of 54.3250.
6. JPY has depreciated against INR during the period. This means
for a payables position, the importer would have been better off
(in hindsight) if it had not hedged its exposure. If so had been, it
would have purchased JPY in the spot market on 28th October at
the rate of 53.1250 instead of its effective hedged rate of 54.3250.
Hence, its notional loss is given as follows:
Notional loss due to hedging = 5000000 X(54.3250-53.1250)/100
=INR 60,000
This is the same as its loss in the futures market.

7. If the spot rate turns out to be 55.6250 on the expiry date, the
Indian company will square off the futures contract at this rate.
Profit/Loss due to futures transaction = Sale price — Purchase
price
=50 X 100000 (55.6250/100)
— 27,16,250
= INR 65,000
Thus, there is a profit of INR 65,000 in the case of currency futures
transaction.

However, this would be nullified by the higher spot rate that would
have to be used for purchasing foreign currency in the spot market.

If the importer had not hedged its position, it would have incurred a
loss of INR 65000.

It would have purchased JPY at a higher spot rate of 55.6250 instead of

the futures contract price of 54.3250. Notional loss, if the importer had
not hedged = 5000000 X(55.6250-54.3250)/100 = INR 65,000.

By hedging its exposure, it would have paid INR 65000 less for pur-
chasing JPY.

Illustrative Example 5

In Example 4, change the data as follows: The importer needs to make

payment for the import bill on 17th October. The spot and futures
prices on 15th October are as given below:

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Interbank Spot Market

JPY-INR 54.3500-54.3525

NSE JPY currency futures:

JPYINR281015 54.3925-54.3975

Questions:
1. How does this problem differ from the previous case of settlement
on expiry? What is the additional risk faced by the importer?
2. What is the effective exchange rate at which the import bill
payment will be made? What is the total cash outflow for the
importer?
3. What is the resulting notional profit or loss for the importer when
compared to unhedged position?

Solution:
1. This problem differs from the previous problem on the date on
which the import bill needs to be paid. In the previous case, the
contract expiry date is the same as the import bill payable date.
This is similar to hedging using forward contracts. The effective
exchange rate applicable will be the same as the price at which
the futures contract was purchased in such cases.
In this case, there is a mismatch between the contract expiry date
and the payable date. A mismatch of this kind can lead to basis
risk. A basis risk can be defined as the differentiation between
a futures settlement price and a spot price. For example, when
the contract closure date is less than the expiry date, the futures
settlement price will be the futures price applicable on that date,
which will be different from the spot rate, as shown in Table 7.3:

TABLE 7.3: RELATIONSHIP BETWEEN VARIOUS

PRICES AND DATES
When settlement date is When settlement date
equal to expiry date. is less than expiry date.
Futures settle- Futures settlement price Futures price on settle-
ment price (F) ment date
Spot rate on Spot rate on expiry date Spot rate on closure
closure date (S) date
Basis risk, F-S 0 Not equal to zero

Due to the basis risk, the effective rate at which the importer
hedged its risk will not be the same as the futures price it had
contracted. Hence, perfect hedging similar to forward contracts
is not possible in this case of closure date less than the contract
expiry date.

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2. We can calculate the effective exchange rate based on purchase

and sale prices of the futures as before. The futures contract will
be squared off or sold on 15th October at the futures bid price of
54.3925.

Profit/Loss due to futures transaction

= Sale price —- Purchase price

= 50X 100000 (54.3925/100) — 27,16,250
= 27,19,625 — 27,16,250
= INR 3,375
Thus, there is a profit of INR 3375 in the case of currency futures
transaction.
5 million JPY will be purchased on the spot market at the rate of
54.3525.
Cash outflow = 5000000 X0.543525 = INR 2,717,625
Net cash outflow = 2,717625 — Profit/Loss in futures = 2,717,625-
3375 = INR 2,714,250
Effective exchange rate = 2,714,250/5000000X
100 = 54.285
Thus, the effective exchange rate is different from the original
contracted futures price of 54.325, unlike in the case of the
previous example where the effective exchange rate was the
same as the futures purchase price.
3. If the importer had not hedged with futures, it would have
purchased JPY from the spot market on 15th October and its
cash outflow would be INR 2,717,625. Hence, there would be
a notional loss of INR 3375, which is the additional amount he
would pay as compared to a hedged position.

7.4.33 OPTIONS

When hedging with currency futures, we saw that there could be a

notional loss or profit depending upon the actual exchange rate move-
ments. If an exporter sells currency futures to hedge his receivables,
and on the maturity date, if the home currency depreciates against
the foreign currency more than that accounted for in the futures price
contracted, the exporter cannot exploit the currency depreciation
because his effective exchange rate will be the same as the rate at
which he has contracted the currency futures irrespective of the spot
exchange rate on the contract expiry date.

For example, if the current exchange rate is INR 65/USD and the ex-
porter has receivables in six months, he will sell currency futures be-
cause he faces uncertainty with regard to the exchange rate on the
expiry date. Suppose that he expects the future spot exchange rate
to be INR 68/USD and the futures price for six months is also around
that range. If he decides not to leave the position uncovered (because

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NOTES

it is also possible that the rupee might appreciate and the future spot
rate could be INR 60/USD, which he would like to avoid), he will hedge
the uncertainty by selling currency futures at INR 68/USD. However,
if on the contract expiry date the spot exchange rate turns out to be
INR 72/USD, he loses INR 4/USD because he has an obligation to sell
currency futures at INR 68/USD. If he had left the position uncovered,
he would have been able to sell his export proceeds at INR 72/USD.
Hence, there is a notional loss of INR 4/USD.

Ideally, the exporter would like to keep an option of exercising the cur-
rency futures on the expiry date or ignore the futures contract and
buy the foreign currency in the spot market so that he can exploit any
favourable currency movement. In other words, hedging should be ap-
plicable only if the currency turns unfavourable. If the exchange rate
turns favourable, he should be able to transact in the spot market and
should have no obligation to exercise the futures contract. In the above
example, the exporter would be interested in not settling his futures
contract and would allow it to expire without any transaction and sell
export proceeds in the spot market at INR 72/USD. However, this is
not possible because currency futures is a contract to purchase or sell
currency at a future date, and every buy/sell transaction will have a
counterparty that would like to close his position on the expiry date.

It is possible, however, to purchase ‘right but not obligation’ to buy cur-

rency in a spot market or currency futures in a futures market of the
derivatives exchange. A derivative instrument that gives market par-
ticipants the right to purchase or sell a currency (or currency futures)
but does not involve an obligation to do the same is called options. If
the underlying is a currency, it is termed as currency option, and if the
underlying is currency futures, it is a currency futures option.

Options exist in both Over-the-Counter (OTC) markets and deriva-

tives exchanges. OTC options are generally created tailor-made by
banks to meet specific corporate needs. Standardised options, like fu-
tures, trade on derivatives exchange. The market for OTC derivatives
is bigger than that for exchange-traded options.

An option can be defined as a contract that gives the owner the right,
but not the obligation, to buy or sell a given quantity of an asset at a
specified price at some future date. It is a derivative instrument, and
the underlying asset could be equity, commodities, currencies, etc. An
option to buy an underlying asset is termed a call option, and the op-
tion to sell an underlying asset is termed a put option. The option pur-
chaser is called the option buyer, and the option seller is termed the
option writer. The price at which the option allows the buyer to buy
the asset is called exercise price or strike price. The price of the option
is called option premium.

It is not necessary that the right can be exercised only on the option
contract expiry date. There are options that allow exercising before
the maturity date. The options that can be exercised only on the expiry

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date of the contract are called European options, and the options that
can be exercised any time before the contract expiry date are termed
American options. However, it is not necessary that an option can be
settled only by exercising it (i-e., buying or selling the underlying asset).
Like futures, it is possible to sell/buy options in derivatives exchange
and thus an option can be settled by a reverse transaction or squaring
off transaction. Similarly, margins are applicable for options also.

Options are traded at an option price or option premium. It is the pre-

mium that the writer gets for giving (or buyer pays for getting) the
right to buy or sell the underlying asset. There are financial models
that can value options based on volatility of prices of the underlying
asset.

The first exchange-traded currency options came into existence in

December 1982 at Philadelphia Stock Exchange (PHLX) in the Unit-
ed States. Currently, it is one of the largest option exchanges in the
world trading in seven major currencies. Currency futures options are
traded at Chicago Mercantile Exchange (CME). The underlying asset
is the currency futures contract.

In India, currency futures began to be traded in NSE in August 2008

and currency options in USD in October 2010. The currency options
for USDINR contracts maturing in different months can be traded in
NSE derivatives exchange.

Table 7.4 gives sample option prices for 20 October 2015:

TABLE 7.4: ASAMPLE OF OPTION PRICES

USDINR Calls Maturing 28 October 2015
n 20 October 2015
Strike LTP Bid Qty. Bid Price AskPrice Ask Qty
Price
64.50 0.5225 19 0.515 0.52 75
64.75 0.3150 200 0.305 0.3125 121
65.00 0.1625 300 0.1625 0.165 1,278
65.25 0.0900 500 0.09 0.0925 269
65.50 0.0525 74 0.0525 0.055 2,787
65.75 0.0300 1,399 0.0275 0.03 446
66.00 0.0225 6,678 0.0225 0.025 2,153
USDINR Puts Maturing on 28 October 2015
NSE Prices as on 20 October 2015
64.50 0.0275 953 0.0275 0.03 845
64.75 0.0750 459 0.0725 0.0775 383
65.00 0.1700 131 0.1675 0.17 412
65.25 0.3525 250 0.3525 0.3575 154
65.50 0.5550 20 0.5575 0.565 6

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Strike LTP Bid Qty Bid Price AskPrice Ask Qty

Price
65.75 0.8925 107 0.7825 0.7975 20
66.00 1.0300 10 1.03 1.0425 70
(Source: www.nse.com)

Each option contract listed in NSE derivatives exchange is for 1000

USD. Note that a call option to buy USD is the same as a put op-
tion to sell INR. As per the table above, a call option contract of US-
DINR-280CT15 for the strike price of 65.00 gives the buyer the right,
but not the obligation, to buy 1000 USD at the exchange rate of INR
65/USD on the maturity date of 28th October. Since the options in
NSE are European type, they can be exercised only on the maturity
date. However, they can be traded or squared off at any date prior to
the maturity date. The last trading price of the above call option at the
strike price of 65.00 is INR 0.1625/USD. Hence, for one USDINR call
option contract, the price or option premium applicable is INR 1625.
Similarly, the USDINR put option at the strike price of 65.00 gives the
buyer the right, but not the obligation, to sell 1000 USD at 65.00 on the
contract expiry date, and its last trading price is 0.1700 INR per USD
or 1700 INR per contract.

An important characteristic of an option is the downside risk. When a

call option is purchased, the buyer pays the option price, also termed
option premium. In the above case of call option with a strike price of
65, he has an option to buy 1000 USD at the exchange rate of 65. If the
actual exchange rate on the contract expiry date is 70, he will exercise
the option to buy USD at 65. Thus, he would make a profit of five ru-
pees per USD on the expiry date by exercising the option, ie., he will
use his right to purchase 1000 USD at 65 and then sell it immediately
in a spot market at the prevailing rate of 70, thereby making a profit
of INR 5 per USD. His net profit would be less than the extent of the
premium paid.

Option investment = Option premium = 1000X0.1625 = 1625

Cash outflow on exercising option on expiry date = 100065 = 65,000

Cash inflow by selling 1000 USD in spot market = 100070 = 70,000

Net cash flow/Profit = 70,000-65000-1625 = INR 3375

On the contrary, if the exchange rate on the expiry date is INR 60/
USD, he has no incentive to purchase USD at the contracted call op-
tion strike price of 65 and hence, he would not exercise the option and
let it to expire (as he has no obligation to exercise). In this case, he has
net cash flow equal to the option premium of 1625, which would be his
loss. Hence, the maximum downside risk in the case of options is only
the option premium, while the upside profit potential only depends
upon the price of the underlying asset on the expiry date. Similarly,

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the scenario will be reverse for a put buyer. His maximum loss will be
the put option premium of INR 1700 for a put with the strike price of
65. His profit is limited only by how much the rupee can appreciate on
the expiry date.

Note that in both the above cases, it is not necessary for the option
buyer to wait till the expiry date to realise his profit. He can do it at
any time before the contract expiry date, if the currency movement
is favourable. If he would like to realise profit at any time before the
contract expiry date, he needs to square off his position by reversing it
in the option exchange by an opposite trade.

It is possible, however, to take delivery of the underlying asset before

the expiry date only in the case of American options. However, most
of the options are generally cash-settled, and the delivery, if required,
can be undertaken in the spot market of the underlying asset.

The risk-return characteristics of an option seller is, however, the re-

verse of those of an option buyer. The maximum profit for an option
seller is the premium received, but his downside risk is unlimited. You
can read more about option pay-off characteristics for various types of
options and option strategies from any standard text on options and
futures. They are the same irrespective of the underlying assets in-
volved.

HEDGING WITH OPTIONS

Foreign transaction exposures can also be hedged with currency op-

tions. Options are especially useful in the case of hedging anticipated
forex transaction exposure. When an exporter invoices in foreign cur-
rency, there is an occurrence of transaction exposure and the resul-
tant risks associated with uncertainty in exchange rate movements. As
against these current exposures that need to be hedged, there can also
be anticipated exposures in need of hedging. For example, if a compa-
ny bids for a foreign project at a fixed invoice amount, it will face forex
exposure that would materialise only when the project is awarded. It
cannot hedge these anticipated forex transaction exposures with usu-
al hedging mechanisms like forward contracts and currency futures.
Such exposures can be hedged effectively with currency options.

Another important benefit of options is the flexibility they offer with

regard to hedging. As explained in the previous paragraphs, if cur-
rency movement turns favourable and making purchases/sales in spot
markets becomes more advantageous than hedging in futures mar-
kets, the market participant would like to have the option of taking
whichever course of action as more favourable to him. In such cases,
options are the right hedging tools. Although options involve initial
cost or down payment (unlike futures) in terms of option premium to
be paid that is the downside risk, they offer unlimited upside potential
for taking advantage of any favourable currency movements.

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Illustrative Example 6

On 20 October 2015, an exporter expects to get his $10 million receiv-

ables on 29 December 2015. He receives an advice from a forex adviso-
ry service that rupee is expected to depreciate over next three months
and that there is very minimal probability of appreciation. They also
advise that hedging with futures will not affect the rupee depreciation
potential as the current price of the futures contract does not correctly
reflect currency movements. The export manager suggests that the
company should leave the exposure uncovered as rupee is anyway
going to depreciate. The finance manager, however, feels that it is not
advisable to leave the position uncovered and decides to explore oth-
er alternatives. The forex advisory service suggests use of currency
options and provides the following quotes for most liquid contracts
available:

Spot exchange rate 64.8250-64.8325

Currency futures USDINR291215 65.5775-65.5925

USDINR291215-Call Option @66.00 0.0230

USDINR291215-Put Option @66.00 1.0350

Questions:
1. Explain how currency options can be used to hedge transaction
exposure.
2. What would the exporter do, if the settlhement spot rate on
29th December is 63.5 or 68.95 and what would be the effective
exchange rate at which he realises the export proceeds?
3. For the above cases, is the option strategy better than the futures
strategy? How much more profit/loss would the exporter make
by deciding to hedge with options as compared to futures?

Solution:

1. The exporter will receive $10 million on 29 December 2015.

He would like to sell these dollars at a maximum possible
exchange rate. In order to take maximum advantage of currency
depreciation while hedging the transaction, he would like to
have the option of selling USD at the spot exchange rate if the
rate turns more favourable than the rate applicable for hedging.
The currency put option will give him the right, but not the
obligation, to sell USD at the strike price chosen. If the exchange
rate depreciates and the rate is above the strike price, he will
decide to let the option expire. On the flip side, if the currency
turns adverse and moves to a rate less than the strike price, he
will exercise the option at the strike price.

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The sequence of transactions/steps involved in the hedging process is:

1. The exporter can purchase currency put options with the strike
price of 66. Since each contract is for $1000, he needs to purchase
10,000 options.
Premium to be paid for Put @66 = 1.035x 1000000
= INR 10,350,000
2. On the contract expiry date of 29 December 2015, the pay-off
from the option contract depends on the spot exchange rate.
a. Spot exchange rate is 63.5
If the exporter sells USD in the spot market, he will get only
63.5 per USD. Hence, he would exercise his option to sell USD
at 66 (in practice, settle at spot or settlement rate). His profits/
pay-off from option settlement will be (66-63.5)x 1000 x 10000
= INR 25,000,000
He will sell his export proceeds in the spot market at 63.5.
Cash inflow = 10,000,000*63.5 = INR 635,000,000
Ignoring opportunity cost of the option premium invested:
Net cash flow = Inflow on export proceeds + Profit/Loss on
options — Premium cost
= 635,000,000 + 25,000,000 — 10,350,000
= 649,650,000
Effective exchange rate = 649,650,000/10,000,000 = 64.965
The effective exchange rate is less than the December futures
price. Hence, the option strategy is inferior to futures strat-
egy. One reason is the high premium cost of options for the
strike price of 66.
b. Settlement and spot exchange rate on expiry is 68.95
The option strike price is 66, which gives the right to sell one
USD at INR 66. However, the spot rate is 68.95. So, it is more
advantageous to sell in the spot market. Hence, the exporter
will let the option to expire by not exercising it.
He will sell his export proceeds in the spot market at 68.95.
Cash inflow = 10,000,000X68.95 = INR 689,500,000
Ignoring opportunity cost of the option premium invested:
Net cash flow = Inflow on export proceeds + Profit/Loss on
options — Premium cost
= 689,500,000 + 0 — 10,350,000
= 679,150,000
Effective exchange rate = 67.9150

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The effective exchange rate is much greater than the December fu-
tures price of 65.5775. Hence, the option strategy is superior to the
futures strategy, even considering the high premium cost, if the spot
rate on the expiry date is 68.95.

7.44 SWAPS

The next major derivative products, after futures and options, are
swaps. A swap is a different kind of derivative instrument as com-
pared to both a future and an option in terms of its structure and util-
ity. Where futures and options can only be used for hedging a single
transaction exposure, swaps deal with several cash flows over a period
of time. The structure of swaps differs accordingly. The underlying as-
set in a swap can be interest-bearing instruments, currencies, equity,
commodities, etc. All of these swaps have a role in international finan-
cial management for tackling different kinds of risks. In this section,
you will study the most important type of swap from the perspective of
managing foreign exchange risk, viz., currency swaps.

A swap can be defined as a contract in which two parties exchange

their cash flows based on a predetermined series of payments. The
exchange of cash flows can be with regard to:
Q Series of interest payments on a notional principal
Q Series of interest payments with differing characteristics like fixed
to floating, etc.
Q Series of payments that are denominated in different currencies

Depending upon the nature of exchange of cash flows, swaps can be

classified into interest rate swaps and currency swaps (also termed
cross currency swaps). Interest rate swaps might involve only ex-
change of interest with no principal exchange with both payments
in the same currency. In the case of currency swaps, exchange is be-
tween two different currencies.

Swaps thus involve several cash flows over a period of time and can
be used for hedging multiple transaction exposures resulting out of
an asset or liability unlike futures and options. The maturity period of
swaps can extend even beyond five years.

CURRENCY SWAPS

Currency swaps are derivative contracts between two parties that

agree to exchange interest payments on loan in one currency with
interest payments on loan in a different currency. The loans can be
of either fixed interest type or floating interest type. Unlike interest
rate swaps where only interest payments are swapped, in the case of
currency swaps, the principal is also exchanged at the beginning and
at the end. The exchange of principal in the beginning, however, de-
pends upon the agreement.

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Figure 7.2 shows the process of a currency swap:

Exchange of
Principal

Firm A with Loanin [4 Exchange of [| Firm B with Loanin

Currency X «| Interest Payments | 4 Currency Y

-— Exchange of = [>>|
<— Principal |_|

Figure 7.2: Currency Swap Process

HEDGING WITH CURRENCY SWAPS

Currency swaps can be used to hedge forex exposures arising out of

converting loans from one currency into another currency. Consider
an Indian firm that has loans in USD but receivables in EUR. The firm
has to convert its export proceeds from euros into Indian currency that
involves exchange rate risk. At the same time, it has to convert rupee
into USD for making interest and principal payments in USD. If the
firm can have its payables also in EUR, it can eliminate the two forex
transaction exposures at the same time. However if it could not get
loans in EUR or if it can get USD loans at a cheaper rate, it may have
to go ahead with USD loans. In this case, currency swaps can be used
to hedge the risks involved. If it can find a counterparty having a loan
exposure in EUR but wants it to be converted into USD exposure, the
two parties can enter into an agreement to swap the loans. The Indian
firm will make interest and principal payments to the counterparty
in EUR, which the other party can use to pay for the loan. The Indian
firm will, in return, be paid interest and principal payments in USD,
which it can use to make direct payments to its USD lender. Thus,
both the firms can eliminate their respective currency risks. Currency
swaps are contracts that are structured to achieve the above objective
of the two firms.

Currency swaps can also involve various kinds of interest payments.

In the above case, it is possible that the euro loan is of floating interest
type, while the USD loan of the Indian firm is of fixed rate type. Such
swaps are called cross currency interest rate swaps.

Let’s understand better through some illustrated examples:

Illustrative Example 7

An Indian firm is able to get cheap euro commercial borrowing of $10

mn with a fixed interest rate of 4% and maturity period 5 years. The
loan is meant to import machinery from Germany, and the payables

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will be in euro. The firm is a major exporter, and most of its exports
are to France, and the invoicing is done in euro. The firm believes that
the fixed interest rate is relatively higher and prefers floating interest
rate in euro so that it can have a natural hedge in terms of its euro
receivables.

Question: Explain how the firm can hedge its forex exposure over five
years.

Solution: The firm can approach its bank for structuring a cross cur-
rency interest rate swap deal. As per the deal, the firm will make in-
terest and principal payments in euro to the bank, while the bank will
make payments in USD for an equivalent amount. Initially, if the ex-
change rate between euro and dollar is 1.25 dollars per euro, the firm
will exchange the principal at this rate. The bank will pay 8 million eu-
ros to the firm. The firm will use this amount to import the machinery
from Germany. The firm will make $10 million to the bank. Later, as
per the interest rate frequency, the bank will make fixed interest pay-
ments on the dollar loan to the firm, which the firm will use to make
payments to the ECB lender. The firm will make interest payments in
euro based on a floating rate or a reference rate like EURIBOR with
the spread mutually agreed between the parties as per the swap con-
tract. The spread will be decided based on the current yield curve for
various maturities in such a way that the present value of future cash
flows of the fixed rate loan is equal to the present value of future cash
flows of the floating rate loan. Through this swap deal, the firm will be
able to convert all its exposures into euro so that it has a natural hedge
through its euro receivables.

745 OTHER COMPLEX DERIVATIVES

We have so far discussed only about the major types of derivatives that
ean be used for hedging forex exposures. However, there are several
other complex derivative products used by corporates that are also
useful in international financial management. Some of these are brief-
ly explained below:
Q Commodity swaps: Counterparties make payments based on a
fixed amount of the underlying commodity in which one party
pays the fixed price for the commodity and the other party pays
the market rate over the swap period.
Q Forward Rate Agreements (FRA): These are forward contracts
with interest rate as the underlying. One party agrees to make the
fixed interest payment, while the other party makes payment at
the floating interest rate as on the expiry date of the contract. The
floating rate applicable is based on reference rates like LIBOR.
Q Interest rate futures: These are contracts to buy or sell a standard
quantity of an interest-bearing asset on a predetermined future

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date and at a price agreed upon between parties. The underlying

assets can be treasury bonds, treasury bills, etc.
Q Exotic options: These are OTC options having complex pay-off
structures with pay-offs depending upon whether a value exceeds
or is less than the strike price. Examples are Asian options, barrier
options and lookback options.
Q Forward swaps: These are like deferred swaps in, the commence-
ment date of a normal swap is fixed on a future date so that swap
rates are locked for later use.
Q Swaptions: These are options written on swaps wherein the (call)
swaption holder has the right, but not the obligation, to enter into
a swap in future as per the terms agreed on the purchase date. In
the case of a put swaption, the buyer gets the right to get into a
swap as a floating rate payer.

ee SELF ASSESSMENT QUESTIONS

7. Money market hedges can be used for managing forex

exposures. However, as compared to forward contracts:
a. Money market hedges cannot serve as perfect hedges
b. Money market hedges are applicable only when the cov-
ered interest rate parity holds good
c. Money market hedges involve more than one transaction
in different money markets
d. The spread of forward bid and ask points should take place
8. We can find out whether a currency is quoting at discount or
premium based on:
a. The spread of forward bid and ask points
b. The spread of spot bid and ask points
c. The comparison between the spreads of spot and forward
quotes
d. None of the above

9. Acompany needs to make payment in euro after three months

to hedge this risk:
a. It can purchase the euro now so that it can make payment
after three months
b. It can purchase the euro after three months from a spot
market
c. It can enter into a contract to purchase euros after three
months
d. It can enter into a forward sale contract with its bank

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10. A company expects the rupee to depreciate against the pound

sterling over next six months. It has payables in pound sterling.
In this case:
a. As rupee is depreciating, no need to hedge the risk
b. It should enter into a forward contract to sell pounds
c. As rupee is depreciating, it should necessarily hedge the
risk
d. It can enter into a contract to purchase the euro after three
months
11. Futures contracts are generally settled by the physical delivery
of the underlying currency. (True/False)
12. Ifa futures contract is purchased for hedging an anticipated
risk exposure and the risk exposure does not materialise,
the futures contract can be sold immediately, if the currency
movement demands so. (True/False)
13. Consider a USDINR281015 futures contract listed in NSE. Ifa
market participant purchases this contract at a price of 64.50,
he has:
a. Contracted for selling INR on 28 October 2015 at 64.50
b. Contracted for purchasing USD on 28 October 2015 at
64.50
c. Contracted for exchanging INR with USD on 28 October
2015 at 64.50
d. All of the above
14. A market participant purchased a USDINR281015 on 10th
October for 64.50. After a week, he finds that the price of the
contract is 66.00 (size of contract, $1000). In this case:
a. He can sell the contract and realise a profit of INR 1500
b. He can wait till 28th October, if he expects further depreci-
ation
ce. He can take immediate delivery of USD at 66.00
d. Bothaandb
15. On 5th October, a firm finds that it needs to make JPY payment
on 20th October. The futures contract has an expiry date of
29th October. If the firm decides to use futures for hedging
this risk,
a. It cannot have perfect hedge with futures
b. It faces basis risk
c. It can use futures for perfect hedge
d. Bothaandb

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16. With regard to futures and options, the marking-to-market

mechanism ensures that:
a. Sufficient security is available with the exchange
b. The positions are valued on everyday basis
c. The settlement is simple and straightforward
d. All of the above
17. A firm may have to import machinery payable in GBP after
three months with payments likely after six months. The right
hedging tool in this case is:
a. Forwards b. Futures
c. Options d. All of the above
18. A firm has receivables in USD and finds that the rupee has
been depreciating significantly of late against the dollar.
Instead of leaving the position uncovered, it can use:
a. Futures b. Call options
c. Put options d. Any of the above
19. A USDINR put option contract maturing on December end
is quoted at 0.5 rupees for a strike price of 65 (contract size,
$1000). This implies that the contract gives:
a. The right to buy USD at 65
b. Thee obligation to sell USD at 65
ce. The right to buy INR at 65
d. None of the above
20. A firm has receivables in euro. It decides to use options to
hedge the exposure. In this case:
a. It can use a put option, and the maximum loss is option
premium
b. It can use a call option, and the maximum loss is option
premium
ce. It can use a put option, but the maximum loss is not re-
stricted
d. It can use a call option, and the benefit is unrestricted
21. When deciding between futures and options, the following
point needs to be considered:
a. Quantum of option premium
b. Likely quantum of currency movement over the period
Liquidity of option strike price
e

. All of the above

Q.

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N OT ES

22. It is always beneficial to use futures instead of options since

an option involves an initial cost. (True/False)
23. With regard to swaps as a derivative hedging tool:
a. They are a more useful hedging instrument than futures
and options
b. They are meant for long-term hedging when compared to
futures and options
c. Futures and options can also be used where swaps are re-
quired
d. Bothbandd

24. A currency swap does not involve exchange of principal.

(True/False)
25. The contracts discussed above are tailor-made contracts
that are entered into by corporate clients with their bankers.
26. A is a contract to exchange one currency for another on
a specified future date at an exchange rate (price) that is fixed
on the trade date.
27. Initial margin is applicable on the contract size based on
the purchase/sale price.
28. If the expiry date of a futures contract is different from the
transaction exposure date, the hedge will be the same as the
hedge where the expiry date is the same as the transaction
exposure date, only if the spot price is the same as the futures
price on the day the contract is squared off. (True/False)

An importer decides to cover his $1 million payables using options.

He purchases call options at a strike price of 65 for a premium of
0.25 rupees per dollar ($1000 contracts). Calculate the gain or loss
from the call option for the exchange rates from 60 to 70 on the set-
tlement date. Draw a graph of option gain/loss vs. various exchange
rates on the expiry date. How will the graph differ, if a receivable
exposure is hedged with a relevant option?

(ee SUMMARY
Q Derivatives are financial instruments whose value and returns are
derived from underlying assets. These underlying assets can be
commodities or financial assets like currencies.

Q Forward contracts differ from derivative instruments in terms

of pricing and returns. They are tailor-made for hedging specific

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transaction exposures, though the forward rates are derived from

the underlying spot rates. They are OTC products and cannot be
traded in an exchange.
Q Derivatives like futures and options are standardised contracts
that can be traded in derivatives exchanges. They can also be used
for hedging transaction risks like forward contracts.
Q Derivative products can be classified on the basis of their usage in
risk management, underlying assets, nature of contract and mar-
ket mechanism.
Q Derivative products are chiefly used for hedging and speculation.
They also help in price discovery.
Q Advent of floating exchange rate regime after the fall of Bretton
Woods system, globalisation and tremendous growth of interna-
tional trade and finance, and the increasing volatility of asset pric-
es are the primary reasons for the booming derivatives markets.
Q The four major types of derivatives are forwards, futures, options
and swaps. Forwards are used to fix the exchange rate now for
a future currency transaction, thereby eliminating the exchange
rate uncertainty. Futures are also used for fixing a price at which a
future currency purchase or sale can be made, but they are stan-
dardised contracts that can be sold any time before the contract
expiry date. Options give right but not obligation to purchase or
sell foreign currency.
Q Forward contracts can serve as a perfect hedge since they are tai-
lor-made. In contrast, futures contracts may not match with the
characteristics of the transaction exposure. If the transaction ex-
posure date is less than the contract expiry date, a firm might face
basis risk. A basis risk can be defined as the differentiation be-
tween a futures settlement price and a spot price, which is always
the case when the settlement date is less than the expiry date.
Q Options can be used effectively for anticipated exposures. If the
anticipated exposure does not materialise, the option can be al-
lowed to expire with loss only being the premium paid. Options
also allow exporters and importers to take advantage of the fa-
vourable currency movements, even while hedging the exposures.
Q Swaps allow hedging more than one transaction exposure arising
out of a series of cash flows of a loan. They allow exchange of cash
flows that differ in interest rate and/or currency attributes. They
can be used to convert an exposure from one currency into anoth-
er currency by swapping the loan with another.

Q Exchange traded derivatives: The derivative having the char-

acteristics of standardisation and liquidity is an exchange-trad-
ed derivative. It further results into the reduction of default risk.

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Q Initial margin: It is the percentage of the purchase price of se-

curities that is paid by an investor in cash while buying the se-
curity.
Q Mark-to-Market (MTM): It is a measure of the accounting fair
value that changes over time, such as assets and liabilities. It
provides a realistic appraisal of the current financial situation
of an organisation.
Q Over-the-Counter (OTC) market: It is a decentralised market
that does not have a central physical location.
Q Speculation: It refers to the act of making a financial transac-
tion pertaining to an asset in the expectation of a substantial
gain.

DESCRIPTIVE QUESTIONS
1. Explain the concept of derivatives.
2. Discuss the role of derivatives in the financial markets.

3. Explain the difference between forwards and futures in terms of

hedging currency risks.
4. Describe how options can be used for hedging. What are the
additional benefits of options over other derivative instruments?
Differentiate between hedging and speculation.
SS aaa 2

Explain the various reasons for the booming derivatives markets.

Write a short note on forwards.
Discuss how hedging with currency futures takes place.
Write a short note on options.
10. Delineate various other complex derivatives.
11. What are currency swaps?
12. Discuss how hedging with options takes place.

(7 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS:

J ke (ea Cos Answer

Concept of Derivatives 1. b. False
2 a. True
Se d. Their usage for hedging or
speculation

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 HEDGING AND RISK MANAGEMENT AND USE OF DERIVATIVES 319

NOTES

Answer
4, ce. An efficient movement of
spot prices towards their
intrinsic value due to deriva-
tive trading on future prices
oe b. Speculation
Reasons for Booming Deriva- 6. a. True
tives Markets
Types of Derivatives 7. ce. Money market hedges in-
volve more than one trans-
action in different money
markets a
8. ce. The comparison between the
spreads of spot and forward
quotes
9. e. It can enter into et 4
to purchase euro: e
months
10. c. As rupee is depreciating, it
should necessarily hedge the
risk
lb. ~A V
12. a. True
13. dy Allof
the above
14. d. Botha andb
15, a. Botha andb
16 '
ee
d. All of the above

18. ec. Put options

\]) ce. The right to buy INR (is
the same as the right to sell
USD)
20. a. It can use a put option, and
the maximum loss is option
premium
21. d. All of the above
22. b. False
2B d. Bothbandd
24, a. False
25. Forward
26. Currency futures contract
ile Purchased or sold
28. True

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320 INTERNATIONAL FINANCE

NOTES

HINTS FOR DESCRIPTIVE QUESTIONS

1. Derivatives are instruments whose value and returns are
determined by the prices of underlying assets. Refer to Section
7.2 Concept of Derivatives.
Derivatives can be used for hedging and speculation. The benefit
of price discovery is also attributed to derivative instruments.
Refer to Section 7.2 Concept of Derivatives.
Forwards can be tailor-made contracts and hence can serve as
a perfect hedge. On the flip side, futures may or may not serve
as a perfect hedge as these are standardised contracts. Refer to
Section 7.4 Types of Derivatives.
Options can be used for hedging current and anticipated
exposures. They do not involve any obligation and hence, can
be useful, if currency movements turn favourable even when the
exposures are hedged. Refer to Section 7.4 Types of Derivatives.
In the case of hedging, the exporter already has a risk exposure
that he wants to eliminate or reduce. In the case of speculation,
there is no underlying asset involved. Refer to Section
7.2 Concept of Derivatives.
Derivatives markets have grown to a tremendous size in the
recent decades. One of the major reasons behind this boom is the
increased risks associated with asset markets. Refer to Section
7.3 Reasons for Booming Derivatives Markets.
A forward can be defined as a customised contract that takes
place between two parties pertaining to buying and selling an
asset at a specified price on a future date. It is used for hedging
or speculation. The non-standardised nature of forwards makes
them particularly apt for hedging. Refer to Section 7.4 Types of
Derivatives.
Currency futures contracts can be used to hedge forex exposures
in the same manner forward contracts are used for the purpose.
The main difference is the contract size, which is a standard one
and may not necessarily match with the actual exposure. Refer
to Section 7.4 Types of Derivatives.
Hedging should be applicable only if the currency turns
unfavourable. If the exchange rate turns favourable, the
exporter/importer should be able to transact in the spot market
and should have no obligation to exercise the futures contract.
Refer to Section 7.4 Types of Derivatives.
10. These include commodity swaps, Forward Rate Agreements
(FRAs), interest rate futures, exotic options, forward swaps and
swaptions. Refer to Section 7.4 Types of Derivatives.

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NOTES

11. Currency swaps are derivative contracts between two parties that
agree to exchange interest payments on the loan in one currency
with interest payments on the loan in a different currency. Refer
to Section 7.4 Types of Derivatives.
12. When an exporter invoices in foreign currency, there is an
occurrence of transaction exposure and the resultant risks
associated with uncertainty in exchange rate movements. As
against these current exposures that need to be hedged, there
can also be anticipated exposures in need of hedging. Refer to
Section 7.4 Types of Derivatives.

78 SUGGESTED READINGS FOR

wy) REFERENCE

SUGGESTED READINGS
Q Cheol S. Eun, Bruce G. Resnick, International Financial Manage-
ment, Tata McGraw Hill Publishing Company Ltd., New Delhi
Q Keith Pilbeam, (2006), International Finance, 3rd Edition, Pal-
grave Macmillan, New York
Q Gert Bekaert, Robert Hodrick, International Financial Manage-
ment, Pearson Education Inc., publishing as Prentice Hall, New
Jersey
Q Jeff Madura, International Financial Management, Thomson
South-Western, USA

Q DonM. Chance, An Introduction to Derivatives Risk Management,

Thomson South-Western
Q John C. Hull, Options, Futures and Other Derivatives, Prentice
Hall of India (P) Ltd, New Delhi

E-REFERENCES

QO www.nse.com

Q www.bis.org
Q “Hedging against falling rupee”, The Hindu Business Line Online,
June, 1, 2012, By Harkirat Singh, Professor, IIFT, http://www.the-
hindubusinessline.com/opinion/hedging-against-a-falling-rupee/
article3480366.ece, accessed on 21st October, 2015

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EXPORT PROMOTION AND PAYMENT INSTRUMENTS
IN FOREIGN TRADE

CONTENTS

8.1 Introduction
8.2 Institutional Framework for Export Promotion
Self Assessment Questions
Activity
8.3 Export Promotion Councils (EPC)
Self Assessment Questions
Activity
8.4 Export Incentives and Benefits
Self Assessment Questions
Activity
8.5 Foreign Trade Policy
Self Assessment Questions
Activity
8.6 Incoterms
Self Assessment Questions
Activity
8.7 Instruments of Payments in Foreign Trade
Self Assessment Questions
Activity
8.8 Letter of Credit (LC) - UCP 600
8.8.1 Steps in Issuing the Letter of Credit
8.8.2 Types of Letter of Credit
8.8.3 Risks Involved in the Letter of Credit Transactions
Self Assessment Questions
Activity
8.9 Export-Import Documents in International Trade
8.9.1 Functions of Various Documents
Activity

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CONTENTS

8.10 Indian Financial Institutions Promoting Foreign Trade

8.10.1 EXIM Bank
8.10.2 ECGC LTD
Activity
8.11 Summary
8.12 Descriptive Questions
8.13 Answers and Hints
8.14 Suggested Readings for Reference

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 EXPORT PROMOTION AND PAYMENT INSTRUMENTS IN FOREIGN TRADE 325

INTRODUCTORY CASELET

D/P D/A AND THEIR USE IN INTERNATIONAL SALES

TRANSACTIONS

An exporter from China sold a container of goods to a US compa-

ny on D/P terms. The Chinese company prepared paperwork for
the international commercial transaction as per the standards in-
cluding an original bill of lading, sight draft (bill of exchange) and
the original invoice. The sight draft would be payable through the
exporter’s bank and drawn in the US bank of the importer.

The Chinese company duly faxed a copy of the bill of lading

and invoice to the importer confirming that the goods would be
shipped on the specified date (May 16th) via United Shipping.
The goods were to arrive at a bonded warehouse in New York on
June 15th. The shipping company picked up the goods from the
Chinese company and an official of the shipping company signed
and stamped the original bill of lading and returned it to the ex-
porter. The bill of lading along with other original documents and
sight draft were sent to the First Commercial Bank, the import-
er’s bank in the US.

With transaction on D/P terms with a sight draft, the Chinese

company contacted its bank to determine whether the payment
has been received. As the payment has not been made, the ex-
porter’s bank wired the importer’s bank with regard to the status
of transaction. Since the importer must have received the docu-
ments by that time, why has he not yet accepted the sight draft?
Has he obtained the original bill of lading from the bank?

However, to the surprise of the Chinese company, even though no

payment has been made to the importer’s bank, it was found that
the US company already got the goods released from the bonded
warehouse. Even after five months since the goods arrived in the
US, the Chinese exporter did not receive any payment or corre-
spondence from the importer’s bank in the US.

The Chinese exporter placed the account for collection with

ABC-Amega, a leading commercial debt collection agency in the
US. When ABC-Amega started investigating the case, it was found
that the US importer has not only got the goods released but con-
sumed goods but has subsequently filed for bankruptcy and was
now out of business. On verification with the shipping company, it
was found that goods have been released after the presentation of
the original bill of lading. How come the bank released the origi-
nal bill of lading without payment when the transaction is on D/P
terms?

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326 INTERNATIONAL FINANCE

INTRODUCTORY CASELET

On investigating the transaction with the importer’s bank, it was

found that the sight draft remained with the bank and was not
signed by the buyer. The buyer’s account has also been closed
recouping their security interest.

In the above case, the importer’s bank did not follow the appro-
priate procedures applicable for D/P transactions. It had released
the original bill of lading without collecting payment for immedi-
ate remittance from the exporter’s bank. ABC-Amega filed a suit
against the bank on the counts of breach of fiduciary trust, neg-
ligence and for actual damages of $1.2 million being value of the
goods. At the end of the trial, the court granted Judgement to the

damages, $ 10,000 interest, $550,000 rney’s fees and $ 2,200

costs.

The above case illustrate /P m international commer-

cial transaction and b h a standard and secure mode

also hints the s a Letter of Credit (LC) Transac-

tion can give as the importer’s bank cannot afford
to be so negli ransaction is based on LC.
(Source ega IN lecember, 2011, “D/P D/A and Their Use in International
Sales T. ww.abe-amega.com/articles/credit-management/d-p-d-a-
ar rnational-sales-transactions, accessed on 25th October, 2015)

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 EXPORT PROMOTION AND PAYMENT INSTRUMENTS IN FOREIGN TRADE 327

NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

2» Discuss the institutional framework established in India for
export promotion
Explain the functions of export promotion councils
YYyf

List export incentives and benefits

Describe the purpose and components of Foreign Trade
Policy
Explain various Incoterms used in international commerce
ry

Describe the instruments of payments used in foreign tra

Discuss the letter of credit transactions
YY

State the purpose of various documents used in internat

al trade
Explain the role of Indian financial institutions p
Y

foreign trade

i INTRODUCTION

In the previous chapter, you have studied how derivative instruments

are used for risk management in the international financial transac-
tions. Now, let us move forward and study the context of international
trade in India, the institutional framework that governs, regulates and
promotes foreign trade from India, the foreign trade policy measures
adopted by the Indian government and some basic terminologies and
general procedures pertaining to exports and imports.

Before the 1990s, India was a closed economy and all export and im-
port activities were regulated by the government. The government in-
stitutional framework and regulations of the country were pertaining
to ‘control and regulation’ of foreign trade rather than promoting for-
eign trade. This is because the main objective was to become self-suf-
ficient in all the sectors. Export and import activities were controlled
by License Raj where most business transactions required abiding by
rules and regulations and prior approval from the government. With
the liberalisation of the economy in the 1990s, the focus changed to the
promotion of free trade. Most sectors became liberalised allowing free
imports and exports without the need to go through the government
regulated procedures for the same.

The government had taken many steps with regard to export promo-
tion in terms of changes in the institutional framework, regulations
and export/import financing. The Government of India publishes the
‘Foreign Trade Policy’ applicable for every five years, detailing the
policy measures related to international trade. However, companies
are required to follow standard procedures and prepare standard doc-

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328 INTERNATIONAL FINANCE

NOTES

uments for international transactions. It is necessary to understand

basic export/import terminologies like Incoterms, DP/DA, documen-
tary credits, UCP regulations, etc.

In this chapter, you will study the institutional framework for export
promotion in India, various export incentives and benefits, foreign
trade policy of the government, Incoterms used in international trade
and the instruments of payment in foreign trade. In addition, the
chapter will discuss important topics such as export-important docu-
mentation and Indian financial institutions promoting foreign trade.

INSTITUTIONAL FRAMEWORK FOR

EXPORT PROMOTION

The Ministry of Commerce and Industry, also called the Department

of Commerce, is responsible for the development and promotion of
India’s international trade. It formulates international trade and com-
merce policies and ensures a successful implementation of the same.
The main objective of the Department of Commerce is to create an
environment and infrastructure that is conducive for the accelerated
growth of international trade. The central driver of trade promotion
is Foreign Trade Policy (FTP), which acts as the basic framework of
policy and strategy. A detailed explanation of FTP is given later in the
chapter.

Other responsibilities of the department include multilateral and bi-

lateral commercial relations, Special Economic Zones (SEZs), state
trading, export promotion and trade facilitation, and development
and regulation of certain export-oriented industries and commodities.
The department has nine divisions including international trade poli-
cy division, foreign trade territorial division, export products division,
exports industries division, etc. The following are some of the main
responsibilities and functions of the Department of Commerce:
Q Formulating international trade and commercial policies includ-
ing tariff and non-tariff barriers and coordinating with interna-
tional agencies like UCTAD, WTO, EEC, International Customs
Tariff Bureau, etc.
Q Addressing all the matters related to foreign trade, import and ex-
port trade policy and control
Q Establishing policies of state trading and performance of related
organisations and various commodity boards
Q Managing cadre of Indian trade service, Indian supply service and
Indian inspection service
Q Resolving all the matters relating to the development, operation
and maintenance of SEZs
Q Ensuring the development and expansion of export production
and administering related organisations

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NOTES

To perform the above mentioned functions, apart from nine divisions,

the Department of Commerce has administrative control of the fol-
lowing institutions that are involved in foreign trade regulation and
export promotion:
Q Three attached offices

@ Directorate General of Foreign Trade (DGFT),

@ Directorate General of Supplies and Disposal (DGS&D),

@ Directorate General of Anti-Dumping & Allied Duties (DGAD)

Q Sub-ordinate offices

@ Directorate General of Commercial Intelligence and Statistics

(DGCI&S)

¢ Office of Development Commissioner of Special Economic

Zones (SEZs)

@ Pay and Accounts Office (Supply)

@ Pay and Accounts Office (Commerce & Textiles)
Q Ten autonomous bodies

@ These are ten separate trade regulation and promotion bodies

for various commodities viz., Coffee Board, Rubber Board, Tea
Board, Tobacco Board, Spices Board, Marine Products Export
Development Authority (MPEDA), Agricultural and Processed
Food Products Export Development Authority (APEDA), Ex-
port Inspection Council (EIC), Indian Institute of Foreign
Trade (IIFT) and Indian Institute of Packaging (ITP)

Q Five public sector undertakings

@ State Trading Corporation of India Ltd (STC), MMTC Ltd.,

PEC Ltd., Export Credit Guarantee Corporation of India Ltd
(ECGC) and India Trade Promotion Organisation (ITPO),

Q Advisory bodies
@ Board of Trade (BoT)

@ Inter State Trade Council

Q 14 export promotion councils

@ There are 14 export promotion councils as of 2015 registered as

non-profit organisations
Q Other organisations

@ Federation of Indian Export Organisations (FIEO),

@ Indian Council of Arbitration (ICA),

@ Indian Diamond Institute (IDD,

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NOTES

@ Footwear & Development Institute (FDDD,

@ National Centre for Trade Information (NCTI)

@ Price Stabilisation Fund Trust

The functions of some important bodies are as follows:

a Directorate General of Foreign Trade (DGFT): This is an import-
ant organisation, attached to the Office of the Ministry of Com-
merce and Industry, with regard to export/import promotion in In-
dia. DGFT was involved in the regulation and trade promotion till
1991. After liberalisation and reforms, DGFT has been assigned a
role of ‘facilitator’. Its role has become of facilitation instead of reg-
ulation and control. It is a nodal organisation for the formulation
and implementation of FTP It also provides authority to exporters
and monitors their obligation through its 36 regional offices across
India. Regional offices provide facilitation to exporters with regard
to development in WTO regulations and agreements, rules of ori-
gin, anti-dumping issues, ete.
Directorate General of Commercial Intelligence and Statistics
(DGCI&S): This is a premier organisation that collects, compiles
and disseminates the India’s trade statistics and commercial infor-
mation. This information can be related to monthly foreign trade
statistics, quarterly foreign trade statistics, etc.
Office of the Development Commissioner of SEZs: It administers
the SEZ scheme meant for generating additional economic activ-
ity, promotion of exports, promotion of investment from domestic
and foreign sources, creation of employment opportunities along
with the development of infrastructure facilities. It is administered
as per the SEZ Act, 2005 and SEZ Rules, 2006.
Statutory boards for export promotion: Various boards like cof-
fee board, rubber board mentioned earlier focus their activities
in the areas of research and development; regulation of industry;
quality up-gradation and improvement of methods of production,
processing, marketing, etc.; economic and market intelligence;
promotion of exports; financial assistance; labour welfare and so
on for respective commodities/products.
Indian Institute of Foreign Trade (IIFT): It is a deemed universi-
ty meant for imparting education in the field of international busi-
ness. It was set up as an autonomous organisation to help profes-
sionalise foreign trade management and develop human resource
and conduct research.
State Trading Corporation of India: It arranges imports of essen-
tial items of mass consumption and exports of a large number of
items. The corporation handles mainly bulk agro commodities. It
has also diversified into exports of raw steel materials, gold jewel-
lery, imports of bullion, minerals, etc.

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 EXPORT PROMOTION AND PAYMENT INSTRUMENTS IN FOREIGN TRADE 331

NOTES

Q Federation of Indian Export Organisations (FIEO): It is an apex

body of various export promotion organisations and institutions
in India. It renders an integrated package of services to various
organisations connected with export promotion and provides con-
tent, direction and thrust to India’s export effort. As per FTP a sta-
tus holder exporter is required to get a Registration Cum Member-
ship Certificate (RCMC) from FIEO for availing various benefits
under the policy. Various activities undertaken by FIEO include
export promotion activities like trade fair, exhibition, workshops
and seminars, issue of Certificate of Origin, market development
assistance, dissemination of commercial intelligence and recogni-
tions to members and export facilitators, etc.
Q National Centre for Trade Information (NCTI: It provides val-
ue-added information in the field of electronic trading opportuni-
ties, live trade leads from the World Trade Point Federation, trade
data analysis and organises export awareness seminars.

ee SELF ASSESSMENT QUESTIONS

1. The formulation and implementation of the foreign trade

policy is carried out by which of the following organisations?
a. Ministry of foreign trade
b. Directorate General of Foreign Trade
ce. Directorate General of commercial intelligence and
statistics

d. None of the above

Visit the website of the Department of Commerce. Perform re-

search on various organisations involved in export promotion in
India. Make a report based on your findings.

EXPORT PROMOTION COUNCILS (EPC)

EPCs are the organisations of exporters set up with an objective to
promote and develop Indian exports. There are 14 export promotion
councils registered as non-profit organisations under the Companies
Act/Societies Registration Act and are part of the institutional frame-
work of the Department of Commerce as mentioned before. They per-
form advisory and executive functions and their role and functions are
guided by FTP The following are the major export promotion councils
in India:
Q Project Exports Promotion Council of India (PEPC)

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NOTES

Basic Chemicals, Pharmaceuticals & Cosmetics Export Promotion

U
Council (CHEMEXCIL)
CAPEXIL

UovovoOUoOoOOO DO
Council for Leather Exports

oO
Sports Goods Export Promotion Council
Gem and Jewellery Export Promotion Council
SHEFEXIL (formerly Shellac Export Promotion Council)
Cashew Export Promotion Council of India
The Plastics Export Promotion Council
Pharmaceutical Export Promotion Council of India
Indian Oilseeds and Produce Export Promotion Council (IOPEPC)
Services Export Promotion Council

Each council is responsible for the promotion of its respective group

of products/projects/services and functions as the registering author-
ities to issue Registration-cum-Membership Certificate (RCMC) to
its members. The major functions of EPCs as per DGFT (Exim, 1997-
2002) are:
a. To provide commercially useful information and assistance to
their members in developing and increasing their exports;
b. To offer professional advice to their members in areas such
as technology upgradation, quality and design improvement,
standards and specifications, product development, innovation,
etc.;

ce. To organise visits of delegations of its members abroad to explore

overseas market opportunities;

d. To organise participation in trade fairs, exhibitions and buyer-

seller meets in India and abroad;
e. To promote interaction between the exporting community and
the Government both at the Central and State levels; and
f. To build a statistical base and provide data on the exports and
imports of the country, exports and imports of their members, as
well as other relevant international trade data.

& SELF ASSESSMENT QUESTIONS

2. There are five export promotion councils in India as of 2015.

(True/False)

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NOTES

Visit the website of the Department of commerce. Study the activi-

ties of any one of the 14 export promotion councils.

[EY9 EXPORT INCENTIVES AND BENEFITS

In this section, we will discuss about some export incentive schemes
and benefits from FTP 2015-20.
Q Exports from India schemes: FTP provides two schemes to re-
ward exporters in order to offset infrastructure inefficiencies and
associated costs involved and provide exporters a level playing
field. These schemes are Merchandise Exports from India Scheme
(MEIS) and Service Exports from India Scheme (SEIS). These two
schemes grant duty credit scrip as rewards. The scrip can be used
for:
@ Payment of customs duties for import of inputs or goods, includ-
ing capital goods as per related regulations

@ Payment of exercise duties on domestic procurement of inputs or

goods, including capital goods as per related regulations

@ Payment of service tax on procurement of services

@ Payment of customs duty and fee

Q Duty exemption/remission schemes: These schemes enable du-
ty-free import of inputs for export production, including replen-
ishment of input or duty remission. The two applicable schemes
are:
¢ Duty exemption scheme: It consists of advance authorisation
and duty-free import authorisation.

¢ Duty remission scheme: It consists of the duty drawback

scheme administered by the department of revenue.
Q Export Promotion Capital Goods (EPCG) scheme: This scheme
facilitates the import of capital goods for producing quality goods
and services and enhances India’s export competitiveness. The
scheme also allows the import of capital goods for pre-production,
production and post-production at zero customs duty.
Q Schemes related to Export Oriented Units (EOUs) and technol-
ogy parks: FTP also provides several schemes for EOUs and tech-
nology parks, such as:
@ Electronics Hardware Technology Parks (EHTP)
@ Software Technology Parks (STP)
@ Bio-technology Parks (BTP)

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NOTES

The objective of these schemes is to promote exports, enhance for-

eign exchange earnings, and attract investment for export production
and employment generation. The above schemes refer to duty-free
enclaves. The companies set up under the schemes are treated as be-
longing to foreign territories for tariff purposes. The rest of the coun-
try (other than SEZ) is known as Domestic Tariff Area (DTA). Any
transaction with DTA is treated similar to imports. The companies in
SEZ areas have to export their entire production for a certain num-
ber of years to avail benefits. Some of the benefits offered by these
schemes include:
Q Duty free import/domestic procurement of goods for development,
operation and maintenance of SEZ units
100% income tax exemption on export income as per relevant reg-
o

ulations
Exemption of minimum alternate tax
Ovo UO

Exemption from central sales tax

Exemption from service tax
Single window clearance for central and state level approvals
UO

ee SELF ASSESSMENT QUESTIONS

3. Which of the following export promotion schemes provide
duty credit scrip?
a. Duty Remission scheme
b. Service Exports from India scheme
EPCG scheme
3

None of the above

2

Visit the website of the Department of Commerce. Study the activ-

ities of any one of the fourteen export promotion councils. Make a
note of your findings.

ei FOREIGN TRADE POLICY

The Foreign Trade Policy (FTP) of a country involves policies related
to the import and export of goods and services. It is notified under
Section 5 of the Foreign Trade (Development & Regulation) Act, 1992
[FT (D&R) Act]. The Ministry of Commerce and Industry is responsi-
ble for the notification of FTP This policy is applicable for a five-year
period and is updated every year and improvement and modification
become effective from that year onwards. The focus of FTP is to pro-

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NOTES

vide a framework of rules and procedures for exports and imports and
a set of incentives for promoting exports. The vision of FTP 2015-20 is
to make India a significant participant in world trade by the year 2020
and enable the country to assume a position of leadership in the inter-
national trade discourse. The policy aims to increase India’s exports
from $ 465.9 billion in 2013-14 to approx. $900 billion by 2019-20 with a
share of 3.5% of world exports.

DGFT is committed to function as a facilitator of exports and imports,

notifies the Handbook of Procedures (HBP). This handbook lays down
procedures to be followed by an exporter/importer for the purpose of
implementing provisions of FT (D&R) Act and FTR

FTP is to be read in conjunction with the FTP statement and HBR

which gives the detailed procedures pertaining to FTP The eight main
components of FTP are pertaining to policy measures regarding vari-
ous subjects given below:
1. Legal framework for FTP and trade facilitation: This section
explains the legal basis of FTP and the role of DGFT as a
facilitator of exports and imports. It gives basic regulations and
provisions pertaining to exports and imports and other import/
export facilitating mechanisms operated and governed by DGFT.
2. General provisions regarding exports and imports: The general
provisions deal with various issues, which are as follows:
¢ FTP provides export policy and import policy applicable for
the five year period. It specifies a list of items exported/im-
ported without any authorisation subject to terms and condi-
tions. It also provides a list of prohibited and restricted items
for export and import.
Procedures for licensing where the applicable,
¢ Policy regulations pertaining to basic procedures of export
and import like the issue of IEC number, mandatory export/
import documents, etc. The FTP 2015-20 has reduced manda-
tory documents required for the export and import of goods
from/into India. These are given below:
y¥ The mandatory documents required for exports are:
e Bill of lading/airway bill/lorry receipt/railway receipt/
postal receipt
@ Commercial invoice cum packing list
e@ Shipping bill/bill of export
vy Mandatory documents required for imports are:
e Bill of lading/airway bill/lorry receipt/railway receipt/
postal receipt
Commercial invoice cum packing list
Bill of entry

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336 INTERNATIONAL FINANCE

NOTES

¢ Regulations and notifications concerning restrictions on ex-

port and import
Export and import through state trading enterprises
Trade instructions and restrictions pertaining to specific
countries
Rules governing export/import of specific goods
Regulations governing payments and receipts on imports /
exports

@ Non-realisation of export proceeds

@ Role of export promotion councils
¢ Policy interpretation and relaxation and exemptions
Exports from India schemes: This section lists various schemes
that are meant to provide rewards to exporters to offset
infrastructure inefficiencies and associated costs involved. It
also provides exporters a level playing field. Export from India
schemes include:
@ Merchandise Exports from India Scheme (MEIS)
@ Service Exports from India Scheme (SEIS)
Duty exemption/remission schemes: This section lists schemes
that enable the duty-free import of inputs for export production,
including the replenishment of input or duty remission. The
applicable schemes are:
¢ Duty exemption schemes, namely advance authorisation and
duty free import authorisation
# Duty remission schemes viz., Duty Drawback (DBK) scheme
Export Promotion Capital Goods (EPCG) scheme: This part
provides policy guidelines regarding the EPCG scheme meant
for facilitating the import of capital goods for producing quality
goods and services to enhance India’s export competitiveness.
Policy measures pertaining to Export Oriented Units (EOUs),
Electronic Hardware Technology Parks (EHTPs), Software
Technology Park (STPs) and Bio-technology parks (BTPs).

Policy measures regarding ‘Deemed Exports’ meant to provide

a level playing field to domestic manufacturers: ‘Deemed
Exports’ refer to those transactions in which goods supplied do
not leave the country and payment for such supplies is received
either in Indian rupee or in free foreign exchange.
Mechanisms and policies regarding quality complaints and
trade disputes: FTP is accompanied by a detailed FTP statement,
which explains the vision, goals and objectives underpinning the
policy and lays down a road map. It describes the market and
product strategy developed and the measures required not just

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for export promotion, but also for the enhancement of the entire
trade ecosystem.

Some important and basic procedures detailed in HBP are given be-
low:
Q Every exporter or importer from India should obtain the Import-
er-Exporter-Code (IEC). It is a ten-digit numerical code allotted
by the licensing authority that has jurisdiction over the importer/
exporter depending on the location of Head/Registered Office. The
IEC number is based on the Permanent Account Number (PAN)
allotted by the Income Tax Department. Every year the IEC hold-
er has to furnish the returns of import/export made by him in the
previous year.
Q Every exporter should register with one of the EPCs in order to
obtain any benefits under FTP If the export product is not covered
by any of the 14 EPCs, he can register with FIEO. A registration
cum membership certificate (RCMC) is issued to exporters.
Q In order to encourage exporters by recognising their achieve-
ment and help them build the marketing infrastructure and ex-
pertise, the government has created five categories of status hold-
ers, namely export house, start export house, trading house, star
trading house and premier trading house. The status holders are
granted additional benefits.
Q HBP provides information regarding the Indian Trade Classifica-
tion (Harmonised System) [ITC (HS)] of exports and imports. It
is a compilation of codes for all merchandise/goods for export/im-
port. It is aligned at six-digit level with the International Harmo-
nized System goods nomenclature.

& SELF ASSESSMENT QUESTIONS

4. The foreign trade policy is notified every three years. (True/

False)

Download the latest FTP statement from the website of the Depart-
ment of Commerce. Make a group of your friends and discuss var-
ious strategies envisioned by the government for the current five-
year period.

EE incoTERMS
Incoterms, a short form of International Commercial Terms, are a se-
ries of pre-defined commercial terms published by the Internation-
al Chamber of Commerce (ICC). These are standardised terms used

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in international commercial transactions or procurement processes.

When commercial trade transactions happen between different coun-
tries, there is a need for common interpretation of terminologies used.
When an invoice is raised, several questions arise because of different
trade practices between countries, which are as follows:
Q What is the mode of delivery of goods?
Q What constitutes delivery?
Q How the invoice price is calculated?
Q What are the various incidental charges that are included in the
invoice amount?

Does the invoice price contain freight charges?

U

Is the consignment insured, if so, who bears the insurance premi-

U

um? 9

Q Is the contract governed by the laws of exporting or importing

country?
Q How to resolve differences in interpretation of terms or inade-
quate information?

In order to provide a standard terminology that addresses all the above

questions and remove trade friction due to misunderstanding and dis-
putes, the International Chamber of Commerce (ICC) published the
first version of INCOTERMS in 1936 as a set of international rules
for the interpretation of trade terms. The Incoterms provide interpre-
tation of the main terms used in foreign trade contracts. By stating
that the terms of contract abide by Incoterms of ICC, both the parties
can be assured of standard and common interpretation of commercial
terms of the trade transaction.

As per the latest ICC publication (2010), there are currently 11 Inco-
terms defined by the ICC that would serve all the different types of
cross-border transactions. The terms pertain to two different classes,
which are:
1. Incoterms applicable for any mode(s) of transport: It includes
the following seven Incoterms:
EXW Ex Works
Oo

FCA Free Carrier

e+e
“rf

CPT Carriage Paid To

+ +

CIP Carriage and Insurance Paid To

DAT Delivered At Terminal
DAP Delivered At Place
DDP Delivered Duty Paid

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N OT ES

2. Incoterms applicable for sea and inland waterway transport:

It consists of the following four terms:
@ FAS Free Alongside Ship
@ FOB Free on Board
¢ CFR Cost and Freight
¢ CIF Cost Insurance and Freight

EXHIBIT

DEFINITIONS OF VARIOUS INCOTERMS

Incoterms applicable for any mode(s) of transport
EXW Ex Works
‘Ex Works’ means that the seller delivers when it places the goods at
the disposal of the buyer at the seller’s premises or at another named
place (i.e., factory, warehouse, etc.). The seller does not need to load
the goods on any collecting vehicle, nor does it need to clear the goods
for export, where such clearance is applicable.
FCA Free Carrier

“Free Carrier” means that the seller delivers the goods to the carrier
or another person nominated by the buyer at the seller’s premises or
another named place. The parties are well advised to specify as clear-
ly as possible the point within the named place of delivery, as the risk
passes to the buyer at that point.
CPT Carriage Paid To
“Carriage Paid To” means that the seller delivers the goods to the car-
rier or another person nominated by the seller at an agreed place (if
any such place is agreed between parties) and that the seller must
contract for and pay the costs of carriage necessary to bring the goods
to the named place of destination.
CIP Carriage And Insurance Paid To
“Carriage and Insurance Paid to” means that the seller delivers the
goods to the carrier or another person nominated by the seller at an
agreed place (if any such place is agreed between parties) and that
the seller must contract for and pay the costs of carriage necessary to
bring the goods to the named place of destination.
‘The seller also contracts for insurance cover against the buyer’s risk
of loss of or damage to the goods during the carriage. The buyer should
note that under CIP the seller is required to obtain insurance only on
minimum cover. Should the buyer wish to have more insurance pro-
tection, it will need either to agree as much expressly with the seller
or to make its own extra insurance arrangements.”

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N OT ES

DAT Delivered At Terminal

“Delivered at Terminal” means that the seller delivers when the goods,
once unloaded from the arriving means of transport, are placed at the
disposal of the buyer at a named terminal at the named port or place
of destination. “Terminal” includes a place, whether covered or not,
such as a quay, warehouse, container yard or road, rail or air cargo
terminal. The seller bears all risks involved in bringing the goods to
and unloading them at the terminal at the named port or place of des-
tination.

DAP Delivered At Place

“Delivered at Place” means that the seller delivers when the goods
are placed at the disposal of the buyer on the arriving means of trans-
port ready for unloading at the named place of destination. The seller
bears all risks involved in bringing the goods to the named place.
DDP Delivered Duty Paid
“Delivered Duty Paid” means that the seller delivers the goods when
the goods are placed at the disposal of the buyer, cleared for import
on the arriving means of transport ready for unloading at the named
place of destination. The seller bears all the costs and risks involved
in bringing the goods to the place of destination and has an obligation
to clear the goods not only for export but also for import, to pay any
duty for both export and import and to carry out all customs formal-
ities.

Incoterms applicable for sea and inland waterway transport

FAS Free Alongside Ship
“Free Alongside Ship” means that the seller delivers when the goods
are placed alongside the vessel (e.g., on a quay or a barge) nominated
by the buyer at the named port of shipment. The risk of loss of or dam-
age to the goods passes when the goods are alongside the ship, and the
buyer bears all costs from that moment onwards.
FOB Free On Board

“Free On Board” means that the seller delivers the goods on board the
vessel nominated by the buyer at the named port of shipment or pro-
cures the goods already so delivered. The risk of loss of or damage to
the goods passes when the goods are on board the vessel, and the buyer
bears all costs from that moment onwards.

CFR Cost and Freight

“Cost and Freight” means that the seller delivers the goods on board
the vessel or procures the goods already so delivered. The risk of loss
of or damage to the goods passes when the goods are on board the
vessel. The seller must contract for and pay the costs and freight nec-
essary to bring the goods to the named port of destination.

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CIF Cost, Insurance and Freight

“Cost, Insurance and Freight” means that the seller delivers the goods
on board the vessel or procures the goods already so delivered. The
risk of loss of or damage to the goods passes when the goods are on
board the vessel. The seller must contract for and pay the costs and
freight necessary to bring the goods to the named port of destination.

‘The seller also contracts for insurance cover against the buyer’s risk
of loss of or damage to the goods during the carriage. The buyer should
note that under CIF the seller is required to obtain insurance only on
minimum cover. Should the buyer wish to have more insurance pro-
tection, it will need either to agree as much expressly with the seller
or to make its own extra insurance arrangements.”
Source: International Chamber of Commerce, “The Incoterms rules”, http://www.icewbo.
org/products-and-services/trade-facilitation/incoterms-2010/the-incoterms-rules/

The Incoterms are copyrighted information of ICC. ICC publication

No. 715E, 2010 edition provides detailed rules regarding Incoterms.
It can be obtained from ICC bookstore: http://store.icewbo.org/in-
coterms-2010.

ee SELF ASSESSMENT QUESTIONS

5. Incoterms are:

a. Trade terms to be agreed between exporters and import-

ers
b. Pre-defined standard commercial terms that can be used
in international transactions
ce. Defined for use LC based transactions
d. None of the above

Visit the official website of the International Chamber of Commerce

—icewbo.org and make a comparison between INCOTERMS® 2000
and INCOTERMS® 2010. Make a note of your findings.

INSTRUMENTS OF PAYMENTS IN
8.7 FOREIGN TRADE
International trade is a different business from the domestic trade. In
most of the domestic business transactions, it is possible for the buyer

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and seller to interact directly and ensure that the payment for trans-
actions happen simultaneously with the delivery of goods. Therefore,
in domestic trade neither party faces any undue risk. However, in in-
ternational trade, the buyer and the seller are generally unknown to
each other and both of them face risks with regard to quality delivery
of goods and prompt payment for the same. An exporter would like to
be sure that the importer will make the payment as per sale contract
terms. The importer, on the flip side, would like to ensure that goods
are delivered as per the terms and are of the required quality before
making payment. There are several methods of international transac-
tions with regard to the payment mechanism and each of them differs
in terms of risks shared by the buyer and seller. The different methods
of international transactions as follows:
Q Consignment: This is a contract in which a foreign distributor re-
ceives, manages and sells goods for the exporter who retains the
title to the goods until they are sold. The different methods vary in
terms of risk borne by the two parties to the sale transaction. The
consignment mode of transaction is the most risky from the per-
spective of the exporter and the least risky for the importer. In this
type, the exporter first sends all the goods on a consignment basis
to the importer. The importer acts like a foreign distributor and
sells the goods and then sends the payment to the exporter. Thus,
this mode of transaction requires a reputable and trustworthy for-
eign distributor in order to ensure guaranteed payment.
Q_ Open account: The open account sale is similar to a consignment
sale but it is not meant for resale by a foreign distributor. The im-
porter receives goods for usage even before any payment to the ex-
porter is made. Thus, the exporter faces the risk that the importer
may not make the payment even while goods are consumed. Open
account transactions amount to selling on credit to importers.
When the foreign market is competitive, importers might expect
liberal open account terms and the exporter may have to accept
the same in order not to lose the contract. The exporter can seek
protection by taking export credit insurance.
Q Documentary collections (D/C): One way to remove the payment
risk is to involve the banks of importers and exporters. Though
the importers and exporters may not know each other, but banks
dealing in international transactions are well known around the
world and can be depended upon. In D/Cs, goods are exported as
per contract terms to the port or place of destination but the orig-
inal title to the goods is not sent to the importer. The documents
giving title to the goods is submitted to the exporter’s bank, who,
in turn, sends it to the importer’s bank. The importer’s bank will
be required to release the documents of title to the goods to its
customer as per the contract terms. The terms might require the
importer’s bank to release the title to goods only after the payment
is made by the importer for onward remitting to the exporter’s
bank. The importer in this case cannot receive goods from the port
unless he produces the original title to the goods. Thus, this mode
of the transaction ensures that the risk of non-payment is greatly

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reduced. There are two types of payment methods in the case of

documentary collections - Document Against Payment (DP) and
Document Against Acceptance (DA).

EXHIBIT

DA AND DP MODE OF PAYMENTS

The DA and DP mode of payments are used in the D/C and LC
mode of international trade transactions described earlier. To un-
derstand further, we need to first understand the concept of the bill
of exchange. A bill of exchange or draft is a negotiable instrument
drawn up by the exporter and made payable to him. The bill of
exchange has the equivalent effect of a check written by the buyer
though raised by the seller. There are three parties to the bill of
exchange:
1. Drawer: It is the party issuing the bill of exchange i.e. exporter
2. Drawee: It is the recipient of the bill of exchange for payment
or acceptance

3. Payee: It is the party to whom the bill is payable usually the

exporter’s bank.
Thus, a drawer (exporter) draws the bill of exchange on the drawee
(importer) payable to the payee (exporter’s bank). The bill or ex-
change, also called draft, can be of two types:
1. Sight drafts or demand bills
2. Time drafts or usance bills

The demand bills require payment to be made by the importer on

presentation. Only on payment to the importer’s bank, the title of
goods will be released to the importer. In the case of usance bills, the
bill specifies a time period after which the payment can be made.
Once the importer ‘accepts’ to make payment as per the terms, the
title of goods is released to the importer.
The DA mode of documentary collections is used when the export-
er wants to give a credit period for the importer. The credit period
could be for 30, 60 or 90 days. The number of days could start from
the ‘date of sight’ or ‘shipment date’. If the DA terms are ‘90 days
after sight’, it means 90 days after the date of presentation. If it is ‘90
ays after date’, it could mean 90 days after the ‘bill of lading date’ or
‘shipment date’.
If the documentary collection utilises the DP mode, the payment is
required to be made ‘On Demand’ by the importer. After the pre-
sentation of documents to the importer, if he does not make pay-
ment, the documents will not be released to him (which needs to be
mandatorily presented to the warehouse for taking the delivery of
goods).

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The exporter has a right to recover the goods and resell them, if the
importer refuses to pay.

The time sequence of steps involved in Documentary Collections

using DA/DP mode of payments is given below:
1. The exporter prepares the documentation required for
exports. This means preparation of invoice, Bill of Exchange
and Bill of Lading.
The exporter sends the copy of the bill of lading and copy
of the invoice to the shipping company, which is hired for
transporting the goods to the place of destination at the
importer’s country. The shipping company transports the
goods to the destination bonded warehouse with the copy of
the bill of lading and invoice.
The exporter submits the original bill of lading (which is the
title of goods in the case of ship transport) and bill of exchange
(drawn on importer) to his bank. He also sends the notice of
shipment and a copy of the invoice to the importer.
The exporter’s bank sends the original bill of lading and bill of
exchange to the importer’s bank specified by the exporter.
On receipt of documents, the importer’s bank notifies the
importer. The importer goes to the bank and makes payment
to the bill or accepts the bill (as the case may be) and receives
the bill of lading, so that he can get goods from the bonded
warehouse.
If the bill is of DP type, the buyer pays the bank the amount
indicated before he receives the title to the goods. The payment
is sent to the exporter’s bank by the importer’s bank. The
exporter’s bank transfers money to the exporter and notifies
him. The importer presents the bill of lading and receives
goods from the port/warehouse.
If the bill is of DA type, the importer accepts to make payment
as per the terms by signing on the bill of exchange. The signed
bill of exchange is sent to the exporter’s bank. The bill of
lading is released to the importer so that he can receive goods
from the port.
The exporter bank gives the seller the signed bill of exchange.
The importer makes the payment on a specified date to the
importer’s bank, which will be transferred to the exporter via
his bank.

Q Letters of Credit (LC): In the documentary collections, the im-

porter’s bank only acts as an intermediary and does not take any
risk. If the importer does not make payment as per terms, the ex-
porter cannot make the importer’s bank liable. The contract is
only between the exporter and importer. In the case of LC, the

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importer’s bank makes a commitment on behalf of the importer to

make payment to the exporter, provided the terms and conditions
stated in the LC are met by the exporter. The exporter needs to
worry only about the creditworthiness of the importer’s bank in
the case of LC transactions.
Q Advance payment: In this case, the exporter requires the importer
to make full payment before the ownership of goods is transferred
to him. Since the exporter gets the payment in advance, it is the
most secured mode of payment for him. However, the importer
faces the maximum risk that even after the payment is made, he
may not receive goods.

ee SELF ASSESSMENT QUESTIONS

6. Inthe documentary collections, the importer’s bank only acts

as an intermediary and does not take any risk. (True/False)

Conduct a research using the Internet to find out the two most
widely used instruments of payments in foreign trade in India.

LETTER OF CREDIT (LC) - UCP 600

A Letter of Credit (LC) is the most secured and widely used form of
international trade transaction method. An LC is a commitment on
behalf of the importer by a bank in the importer’s country that the
payment will be made to the exporter, if he meets the terms and con-
ditions as stated in the LC.

LCs are also called Documentary Credits (DCs). The main difference
in DCs as compared to Documentary Collections (D/Cs) is that the
importer’s bank is now responsible for the payment. If the exporter
meets all the conditions of the LC, the importer’s bank has to make
payment to the exporter even if the importer defaults. One important
aspect of the LCs is that banks deal only with documents and not with
goods. This means that the importer’s bank cannot refuse to make
payment, if the quality of goods is found to be bad later. The LC issu-
ing bank needs to verify only the veracity of documents (and not the
quality of the goods) and the compliance with LC terms, which might
however include quality certificates, etc.

The LC contract is a separate contract from the sales contract on

which it is based upon. Thus, the banks are concerned only with the
terms of the LC contract and not the fulfilment of the terms of the
sales contract.

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8.8.1 STEPS IN ISSUING THE LETTER OF CREDIT

The steps involved in an LC transaction are given below:

1. The exporter and importer agree on sale contract terms. The
exporter might insist on the issue of LC by the importer’s bank.
The terms will be mutually agreed between the exporter and
importer.
The importer asks his bank (“issuing bank”) to open an LC in
favour of the exporter for a specific amount and currency.
The issuing bank from the importer’s country, through SWIFT
message, transmits the LC to the ‘Advising Bank’. The ‘Advising
Bank’ notifies the exporter after ensuring its authenticity. It may
be same as the exporter’s bank or a different one.
On receipt of LC, the exporter prepares the documentation as
per the LC terms and forwards the goods and documents to a
freight forwarder.
The exporter submits the documents required by the LC (which
would include documents like the original bill of lading, bill of
exchange, invoice, packing list, quality certificate, etc.) to the
‘nominated bank’. The ‘nominated bank’ is responsible for
verifying the documents and sending it to the LC issuing bank.
The LC issuing bank verifies the document for compliance
with LC terms and presents the documents to the importer. If
the LC involves demand bills (document against payment), the
importer’s account is debited and the original documents are
released to him. The amount is transferred to the nominated
bank for onward credit to the exporter’s account (or as per
reimbursement terms if negotiation credit is applicable). If the
terms involve document against acceptance, the issuing bank
gets acceptance of the bill by the importer before releasing the
title to the goods.
The importer obtains goods on presentation of the documents
at customs. He also makes payment on the due date, if the bills
are of DA type for onward remission to the nominated bank/
negotiation bank.

NEGOTIATION AND REIMBURSEMENT

The ‘nominated bank’, usually the exporter’s bank, can decide to ‘ne-
gotiate’ the bills and make a payment to the exporter, if the documents
comply with the LC terms. The term ‘negotiation’ is used in documen-
tary credits to refer to payment by a bank in exporter’s country, as per
LC terms, to the exporter on verification of the documents for compli-
ance with LC terms. The negotiating bank will then seek reimburse-
ment from the issuing bank. The issuing bank might have specified
a ‘reimbursement bank’ in the exporter’s country, which is normally

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the correspondent bank with whom the issuing bank has its Nostro
account who will reimburse the negotiating bank.

The terms of negotiation depends on LC. Depending on the payment

type, LCs can be classified as Sight LC, Acceptance LC, Deferred Pay-
ment LC or Negotiation LC. The sight LC and acceptance LC are used
when the DCs involve DP and DA bills, respectively. The deferred pay-
ment credit is similar to the acceptance LC but, does not require bills
which might involve additional costs like stamp duties.

If the LC is of ‘Negotiation Credit’ as specified in the relevant clause of

the LC Swift message, the ‘nominated bank’ can negotiate documents
and make direct payments to the exporter. The issuing bank under-
takes to make payment to the ‘negotiating bank’, if the documents are
as per LC terms. LCs may be freely negotiable or restricted to only
banks nominated in this regard by the LC issuing bank. The roles of
advising bank, confirming bank and negotiating bank may all be done
by a single bank.

In the case of negotiation credit, the negotiating bank steps into the
shoes of the issuing bank, and by its act of negotiation, becomes the
rightful owner of the documents and claimant of the amount under
LC from the LC issuing bank.

UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY

CREDITS - UCP 600

The operation of Letters of Credit is governed by the ICC publication

UCPDC 600, which is commonly called UCP 600. The LC might spec-
ify that all parties abide by the terms of UCP 600. This is the latest
publication that has come into force effective from 2007. It has 39 ar-
ticles, which explain various LC terminologies, operational features,
rules and regulations, etc. that govern the LC. The following is a brief
overview of these articles:

Article 1-5: These articles provide various definitions and interpre-

tations and clarify the nature of documentary credits. For example,
the term ‘negotiation’ is defined as ‘purchase by the nominated bank
of drafts (drawn on a bank other than the nominated bank) and/or
documents under a complying presentation, by advancing or agreeing
to advance funds to the beneficiary on or before the banking day on
which the reimbursement is due to the nominated bank’

Article 6-10: These articles specify rules governing availability, expiry

date, place of presentation, obligations of various banks, advising of
credits, amendment of credits, etc. For example, article 6 mandates an
expiry date for presentation. The presentation of documents should
be done before the expiry date.

Article 11-17: These articles specify rules regarding pre-advised cred-

its, nomination, reimbursement arrangements, standard for examina-

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tion of documents, complying presentation, discrepant documents,

waiver notice and original documents and copies.

Article 18-28: These articles specify rules regarding commercial in-

voice, transport documents, bill of lading, non-negotiable sea waybill,
air transport documents, road, rail or inland waterway transport doc-
uments, courier/portal receipt documents that form part of documen-
tary credits and about insurance documents and coverage.

Articles 29-39: These deals with other aspects of the LC operation like
extension, instalment drawings, hours of presentation, disclaimers,
transferability and assignment of proceeds.

The UCP 600 specifies the responsibilities, liabilities and rights of var-
ious parties to the LC transaction. They are briefly given below:
Q Applicant: The applicant of the LC (i.e. importer) should provide
a complete and precise instruction for issue/amendment of LCs.
Q Issuing bank: It should:
¢ verify the creditworthiness of the applicant

@ give definite undertaking to make payment in the case of sight,

accept and pay on maturity in the case of acceptance bills,

¢ undertake to authorise the bank for negotiation and reimburse

the same, if the documents are as per LC terms

@ take the responsibility of examining the documents and de-

termine with reasonable care whether the documents comply
with LC terms

# refuse the documents, if found discrepant within five days of

receipt of documents. The discrepancies should be duly noti-
fied to the bank, which had sent the documents
Q Advising bank: It has the option to advise an LC or not. If it de-
cides to advise, it has the responsibility to ensure its authenticity.
If it decides to advise or not to advise, it should inform the issuing
bank from which it received the LC immediately. It should also
specify, if it is not able to establish the authenticity of the credit
and also inform beneficiary accordingly
Q Confirming bank: It has an option to confirm or not. If it confirms
the credit, it gives definite undertaking to make payment, in addi-
tion to that of the issuing bank, at the request of the issuing bank,
on presentation of documents in accordance with the terms of the
LC. If it decides not to add confirmation, it should inform the issu-
ing bank immediately. It may also decide not to add confirmation
to any amendments and inform accordingly
Q Negotiating bank: It is the responsibility of the negotiating bank
or nominated bank to examine the documents as per UCP and

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take a decision to negotiate the documents, only if they appear on

their face in compliance with the terms and conditions of the LC
Q Reimbursing bank: The reimbursement bank shall reimburse the
claiming bank, amount of claim lodged, subject to the condition
that it has received reimbursement authorisation from the issu-
ing bank and having accepted the same. The reimbursements are
bound by URR 525 (an ICC publication that deals with rules re-
garding reimbursement).

8.8.2 TYPES OF LETTER OF CREDITS

Apart from different LCs that are based on payments methods, like
sight LC, acceptance LC, Negotiation LC and deferred credit LC,
there are several other types of LCs as discussed below:
Q Confirmed LCs: If the exporter is not comfortable with the credit
worthiness of the importer’s bank or his country, he may ask the is-
suing bank to get ‘confirmation’ from a bank in exporter’s country.
This means the ‘confirming bank’ commits to make payment to the
exporter even if the importer’s bank fails to make payment. Such
LCs are termed as Confirmed LCs. The confirming bank steps into
the shoes of the issuing bank and performs all the functions of the
issuing bank.
Q Revolving LCs: LCs can be one-off or it may be issued in a series
of transactions. In such cases, they are termed as revolving LCs.
The issuing bank restores the credit to its original amount each
time it is drawn down.
Q Revocable and irrevocable LCs: By default, all LCs are consid-
ered ‘irrevocable’ unless stated otherwise. This means that the
document may not be changed unless all the parties, such as the
importer, banks and the exporter agree. If the LC is specified as
‘revocable’, the issuing bank can amend or cancel the LC at any
point of time without the consent of any other party. However, if
payment has been made on the revocable LC before receipt of the
cancellation notice by the negotiating bank, then the issuing bank
is liable. The revocable credits are rare and are not part of UCP
600 anymore.

Q Red clause LCs: A ‘Red Clause’ LC authorises the nominated

bank to provide pre-shipment credit (advance before shipment of
goods) to the exporter. It is guaranteed by the issuing bank, in case,
the exporter defaults on submitting the shipment documents.
Q Back to back LC: In this case, the exporter arranges to issue an LC
in the favour of a local supplier on the strength of the LC received
from the issuing bank of the importer. It can be used for procure-
ment of raw material locally or for the import of goods to meet
original LC commitments.

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Q Standby LC: A standby LC is issued as a substitute for bank finan-

cial guaranty. These can be governed by UCP 600 or International
Standard Practices (ISP)-98.

8.8.3 RISKS INVOLVED IN THE LETTER OF CREDIT

TRANSACTIONS

The LCs or documentary credits are the most secure form of inter-
national trade. However, there are also risks involved in LC transac-
tions and these risks mainly pertain to rejection of documents, trade
embargoes, currency restrictions, etc. Though LCs require payments
on acceptance of the documents in compliance with LC terms, but the
payment can be stopped by local court rulings, by non-acceptance of
documents till arrival of goods, by raising disputes related to quality
of goods and by resorting to court stay orders, etc.

In order to mitigate risks, the parties should take relevant care. The
issuing bank should open LCs only for creditworthy customers. The
importer should ensure to get trade and credit reports regarding the
exporter. The banks take adequate precautions like ensuring that the
bill of lading is raised in the name of the bank along with the import-
er’s name and address, ete.

& SELF ASSESSMENT QUESTIONS

7. The operation of Letters of Credit is governed by the ICC

publication commonly called:
a. ACP 6000 b. ICC 600
e. UCS 600 d. UCP 600

Obtain a copy of the latest UCP publication on documentary cred-

its. Study various articles of the UCR Make a note of your findings.

EXPORT-IMPORT DOCUMENTS IN
INTERNATIONAL TRADE

Export and import of goods and services and the corresponding pay-
ment mechanism require an extensive documentation procedure.
There are specific and unique documents that are used in internation-
al trade pertaining to sale contract, title of goods, mode of transport,
etc. The following are the most important documents:
Q Bill of exchange
Q Invoice

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NOTES

Bill of lading
UO

Insurance document
UO

Certificate of origin
oO

Packing list and related documents.

oO

Shipping bill
O

Most of the documentary credits require the above documents to be

submitted in accordance with the UCP provisions and sale contract.
The next subsection provides more information of these documents.

8.9.1 FUNCTIONS OF VARIOUS DOCUMENTS

Let us discuss the functions of various documents:

Q Bill of exchange: The bill of exchange serves as a legal document
reflecting the payment obligation of the drawee owing to the trade
transaction. Earlier, you have studied the bill of exchange in the
context of DA/DP methods of payment. The bill of exchange under
LC is drawn by the beneficiary i.e. exporter, on the issuing bank,
with the relevant LC number under which it is drawn and the issu-
ing bank name, with other details like tenor viz., sight or number
of acceptance days in case of usance bills, the bill amount in LC
currency, date of bill of exchange, etc.
Q Invoice: This is the basic commercial document pertaining to sale
details like description of goods, quantity and value in unit terms
and the total value of goods. Invoice is raised by the exporter in the
name of the importer. It has details like the contract number, order
number or pro forma invoice number related to the transaction.
It also specifies the invoice value along with the Incoterms appli-
cable. If raised under an LC, it should specify the LC number and
abide by both the sales contract and LC terms.
Q Bill of lading: It is the document that shows the movement of
goods from the port of acceptance to the port of destination when
goods are transported by ships. The bill of lading is the receipt
issued by the shipping company or his agent with details regard-
ing shipment like description, quantity, quality, etc. It also speci-
fies the date of shipment, name of the vessel and the name of the
consignee. The bill of lading also contains details regarding the
payment of freight.

The bill of lading is ‘the document of title’ to the goods that are being
shipped. This document is issued by the shipping company to the ex-
porter. The exporter then sends the original bill of lading to the im-
porter’s bank through his banker. The importer needs to produce the
original bill of lading at customs or bonded warehouse without which
he will not get the delivery of goods. Thus, the bill of lading is one of
the most important documents in the international trade transactions.

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If the transaction is under LC, the bill of lading will contain details re-
garding the LC number, which is similar to the invoice. It is drawn to
the order of the shipper and bank endorsed in the favour of the issuing
bank as per the stipulations of the LC.

When a document is blank endorsed, it transforms into a bearer

document from being an order instrument.

Q Insurance certificate: The transport of goods through ships en-

tails risk and hence the insurance of the shipment is necessary.
The insurance certificate or policy is the document issued by an
insurance company evidencing insurance of the voyage of ship-
ment from the port of shipment to the port of destination. It is gen-
erally taken for 110% of the CIF value. The claim is payable in the
country of the applicant. The insurance document provides the
description of the shipment covered for insurance in conformity
with LC terms. It is bank endorsed and sent in original along with
other documents like bill of lading, invoice etc., wherever applica-
ble. The insurance cover is effective from the date of shipment to
the point of termination of coverage mentioned in the policy.
Q Certificate of origin: It is meant for determining the country of or-
igin of goods. It is issued and signed by an independent authority
like the Chamber of Commerce and contain full description relat-
ed to the goods being shipped, invoice value, bill of lading number,
ete.
Q Packing list and related documents: The packing list provides the
detailed description of shipment and accompanies the other doc-
uments like invoice and bill of lading. Other documents include
quality certificate, weight list, etc., some of which may be as per
the demand of LC terms. For example, the importer may ask for
a quality certificate to accompany the documents. The certificate
provides details regarding the quality of the shipment from an au-
thorised quality certification agency.
Q Shipping bill: The shipping bill is the document to be filed with
the customs authority by exporters for making shipments. It is re-
quired for any goods moving out of the country for getting approv-
al from customs. It contains details like order or LC number and
date, invoice number and date, name of the shipper, consignee,
place of receipt of cargo, port of loading, port of discharge, final
destination place, terms of payment, terms of delivery of cargo,
marks and numbers of packages, number of packages, unit price,
FOB value of goods, total value of goods in local currency of the
country. The shipping bill should also provide details regarding
the scheme of export viz., free bill, drawback, DEEC, DEPB, DFRC
or EPCG, ete.

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NOTES

In addition to the aforementioned documents, there are also other

forms/documents traditionally used in export/imports. With the Elec-
tronic Data Interchange (EDI) system, the forms are now filed online.
The number of forms required has also been reduced. For example,
RBI required the submission of declaration forms like GR/SDF/SOF-
TEX towards declaring the amount of foreign exchange expected to
be received by exporters. For EDI- based processing, the Statutory
Declaration Form (SDF) was required to be submitted along with the
shipping bill instead of the GR form. But, as per RBI guidelines issued
in 2015, the filing of a separate SDF form along with the shipping bill
has been dispensed with, in order to reduce the number of documents
required for exports/imports. Now the declaration is required to be
made as part of the shipping bill itself.

Obtain a copy of the UCP 600. Study the responsibilities and liabil-
ities of various parties in the LC transaction. Make a note of your
observations.

8.10 INDIAN FINANCIAL INSTITUTIONS

= PROMOTING FOREIGN TRADE

In this section, we shall study about two important Indian financial

institutions that play a major role in the promotion of international
trade from India.

8.10.1 EXIM BANK

The Export-Import Bank of India (EXIM Bank) is the premier export

finance institution in India launched in 1982 under the EXIM Bank
of India Act, 1981. The EXIM Bank was established with a mandate
to promote exports from India and integrate foreign trade and invest-
ment to spur the economic growth in the country. It is a key player
in the promotion of cross-border trade and investment. It caters es-
pecially to Small and Medium Enterprises (SMEs) with a wide range
of products and services applicable at all stages of the business cycle.
The flagship programs of the bank are briefly explained below:
Q Overseas investment finance: This program helps Indian compa-
nies to invest abroad in terms of setting up manufacturing units,
acquiring companies and accessing raw material, technology, etc.
from foreign markets. As part of this program, the Exim Bank of-
fers the following schemes:

¢ Terms loans to Indian companies up to 80% of their equity in-

vestment in overseas ventures

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¢ Term loans to Indian companies up to 80% of loan extended by

them to overseas ventures

¢ Term loans to overseas JVs toward part financing capital ex-

penditure, working capital, equity investment in another com-
pany, acquisition of another company, etc.
# Guarantee facility to the overseas JV for raising term loans and
working capital (eximbankindia.in)
Q Project exports: Exim Bank extends funded and non-funded facil-
ities for project exporters from India including for projects related
to overseas turnkey projects, civil construction contracts, technical
service contracts, etc. The funded facilities include pre-shipment
credit, post-shipment credit and export project cash flow deficit
financing. Non-funded facilities include advance payment guaran-
tee, performance guarantee, retention money guarantee and other
guarantees.

Q = Line of Credit (LOC): Exim Bank extends support for the export
of projects, equipment, goods and services from India by provid-
ing LOCs. The recipients of LOCs include foreign government and
their agencies, national or regional development banks, overseas
financial institutions, commercial banks abroad and other similar
overseas entities. These institutions act as intermediaries and on-
lend to overseas buyers for import of Indian equipment, goods and
services. These LOCs serve as financing mechanisms that provide
a safe mode of the non-recourse financing option to Indian export-
ers entering into new export markets.
Q Corporate banking: Exim Bank has several financing schemes for
export-oriented units, importers and for companies making over-
seas investments. These programs cater to corporates, small and
medium enterprises and grass root enterprises.
Q Buyers’ credit: This is a deferred payment facility meant for over-
seas importers for importing eligible goods and services from In-
dian exporters.

8.10.2 ECGC LTD

ECGC Ltd. (formerly Export Credit Guarantee Corporation of India

Ltd) is a government of India enterprise that provides export credit
insurance facilities to exporters and banks in India. It is essentially an
export promotion organisation that seeks to improve the competitive
capacity of Indian exporters by giving them credit insurance cover
comparable to those available to their competitors from most other
countries.

Exporters face commercial risks in terms of possible insolvency or

protracted default of buyers, which can be aggravated due to political
and economic uncertainties. The export credit insurance provided by

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NOTES

ECGC is designed to protect exporters from the consequences of the

payment risks, both political and commercial, and enables them to
expand their overseas business without the fear of the risks involved.
Various services provided by ECGC in this regard are:
Q Offering insurance protection against payment risks
Q Providing guidance for export-related activities
Q Ensuring the availability of information on different countries
with its own credit ratings
Q Making it easy to obtain export finance from banks
Q Assisting exporters in recovering bad debts
Q Providing information on the creditworthiness of overseas buyers.

ECGC also offers export credit insurance covers to banks and finan-
cial institutions and enable exporters to obtain better facilities. It also
provides overseas investment insurance to Indian companies invest-
ing in JVs abroad in the form of equity or loan. ECGC has several
insurance schemes to cater to above services. The currently operated
insurance schemes as of 2015 are listed below:
1. Export Credit Insurance for Exporters
a. Short term
vy Turn over based policies
vy Exposure based policies
b. Medium and long-term
vy Construction work’s policy
Specific policy for supply contract
NAN

Specific shipment policy

Specific services policy
NN

Specific services contract policy

Letter of credit confirmation cover
QS

2. Export Credit Insurance for Banks

a. Short term
vY Pre-shipment policies
Y Post shipment policies
v Cover against bank guarantee
b. Medium and long-term
¥ Individual packing credit
Y Individual post shipment
v Cover against bank guarantee

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NOTES

vy Export finance (overseas lending)

vy ECIB cash flow deficit financing
3. Special schemes
Factoring
Buyer’s credit cover

NNN
Line of credit cover
Transfer guarantee
NN Overseas investment insurance

Customer specific covers

National Export Insurance Account (NEIA)
NS

Visit the website of ECGC. Study various policies offered by ECGC

for banks.

eee SUMMARY
Q The Ministry of Commerce and Industry is responsible for the
development and promotion of India’s International trade. It has
many divisions and several organisations attached to it for facili-
tating export promotion in India.
Q Export promotion councils are the organisations of exporters es-
tablished for promoting and developing Indian exports. There are
14 such councils functioning under the Department of Commerce
for various sectors.
Q The government has established several export incentive schemes
for export promotion. They are meant for rewarding exporters and
providing a level playing field for them.
Q FTP is the central policy document that details export and import
policies applicable for each five year period. It also articulates the
vision of the government on export growth and related strategies
for export promotion.

Q Incoterms are the standardised commercial terms published by

ICC for usage in international trade transactions so, that trade
friction and disputes due to differing interpretations between buy-
ers and sellers on commercial terms can be avoided.
Q DP and DA are the two important payment instruments used in
international trade. They are the part of the documentary collec-
tions.

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NOTES

Q In the case of documentary collections, the title to goods is sent

by the exporter to the importer’s bank. The importer’s bank is re-
quired to release the same only after payment or acceptance for
payment.

Q The DA bills are usance bills and extend credit to importers. The
documents are released against the acceptance of the bill.
Q LC transactions, also called documentary credits, are more secure
transactions than documentary collections because the importer’s
bank provides an undertaking to make payment, if the importer
fails to make payment provided LC terms are compiled with by
the exporter.
Q Different types of LCs with respect to payment methods are sight
LCs, acceptance LCs and negotiation LCs, etc.
Q Negotiation LCs can be freely negotiable by any bank or only by a
mandated negotiation bank depending on LC terms.
Q LCs can also be classified in terms of purpose and operation like
transferable LC, back-to-back LC, red clause LC, ete.
Q The ICC’s UCP 600 provides uniform customs and practice for
documentary credits. It has 39 articles that provide various defi-
nitions, guidelines and requirements as per the internationally
agreed standards.
Q The main documents used in export-import are bill of exchange,
invoice, bill of lading, and insurance policy, certificate of origin,
packing list and shipping bill.
Q The two major financial institutions involved in foreign trade in
India are EXIM Bank and ECGC Ltd.

Q EXIM Bank provides various financing schemes for exports/im-

ports. It also provides overseas investment finance.
Q ECGC provides export credit insurance for exporters and banks. It
has several schemes that cater to the different needs of exporters
and financial institutions.

KEY WORDS

Q International Chamber of Commerce (ICC): An international

forum of business organisations which is involved in interna-
tional trade.
Q UNCTAD: It stands for United Nations Conference on Trade
and Development. It is the main body of the United Nations
General Assembly for dealing with trade, investment and devel-
opment issues across the world.
Q Software technology park: A society established by the Minis-
try of Communication and Information Technology to promote
the export of software from India.

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358 INTERNATIONAL FINANCE

NOTES

Q Capital goods: Goods that are bought by business organisations

for the production of consumer goods.
Q Special Economic Zone (SEZ): The designated areas in a coun-
try that have different (generally more liberal) economic poli-
cies as compared to other areas.

DESCRIPTIVE QUESTIONS
1. What is the institutional framework established in India for
export promotion? List organisations and explain briefly about
any two such organisations.
2. Explain the purpose of FTR What are the typical components of
FTP?

8. Describe various Incoterms used in international trade

transactions.

“eB ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

utiona amework for 1. b. Directorate General of For-

f rt F on eign Trade
Export Promotion Councils 2. False
TWentives and Ben- 3. b. Service Exports from India
Scheme
Foreign Trade Policy 4, False
Incoterms oe b. Pre-defined standard
commercial terms that can
be used in international
transactions
Instruments of Payments in 6. True
Foreign Trade
Letter of Credit - UCP 600 7. d. UCP 600

HINTS FOR DESCRIPTIVE QUESTIONS

1. The Department of Commerce is a government body that
is responsible for foreign trade. It has several divisions and
organisations that work towards export promotion. Refer to
Section 8.2 Institutional Framework for Export Promotion.

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NOTES

2. FTP is notified by the Department of Commerce. It explains

various export-import policies and promotional schemes
applicable for the next five years. Refer to Section 8.5 Foreign
Trade Policy.
3. ICC has published 11 Incoterms that cover all possible trade
transactions in its 2010 edition. Refer to Section 8.6 Incoterms.

SUGGESTED READINGS FOR

6.14 REFERENCE

SUGGESTED READINGS
Q Madura, J. (2003). International financial management. Mason,
Ohio: Thomson/South-Western.

Q Mathur, V. (2008). India, foreign trade policy and W.T.O., 1991-2003.

Delhi: New Century Publications.
Q Collyer, G., & Katz, R. ICC Banking Commission opinions, 2009-
2011.

E-REFERENCES
Q = Icewbo.org,. (2015). Incoterms Rules | Incoterms 2010 | Trade Fa-
cilitation | Products & Services | ICC - International Chamber of
Commerce. Retrieved 20 November 2015, from http://www.icew-
bo.org/products-and-services/trade-facilitation/incoterms-2010/
the-incoterms-rules/
Q Eximbankindia.in,. (2015). OIF Retrieved 20 November 2015, from
http://www.eximbankindia.in/overseas-investment-finance-pro-
gramme
Q Howtoexportimport.com,. (2015). Export procedures and docu-
mentation. Retrieved 20 November 2015, from http://howtoexpor-
timport.com/export-procedures-and-documentation-1397.aspx
Q Deft.gov.in,. (2015). Foreign Trade Policy 2009. Retrieved 20 No-
vember 2015, from http://dgft.gov.in/exim/2000/policy/ftp-plcon-
tent-1011.htm

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SHORT-TERM INTERNATIONAL FINANCING

CONTENTS

9.1 Introduction
9.2 Short-term International Financing and Its Sources
9.2.1 Short-Term Financing of International Trade
Self Assessment Questions
Activity
9.3 Internal Financing by MNCs
Self Assessment Questions
9.4 Determination of Effective Financing Rate
Self Assessment Questions
Activity
9.5 Criteria for Foreign Financing
Self Assessment Questions
Activity
9.6 Management of Surplus Cash
9.6.1 Investment of Surplus Funds
9.6.2 Financing Short-Term Deficits
Self Assessment Questions
Activity
9.7 Centralised vs. Decentralised Cash Management
Self Assessment Questions
Activity
9.8 Cash Transmission
Self Assessment Questions
Activity
9.9 Summary
9.10 Descriptive Questions
9.11 Answers and Hints
9.12 Suggested Readings for Reference

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INTRODUCTORY CASELET

CASH POOLING IN MULTINATIONAL CORPORATIONS

For MNCs with operations in several countries, managing cash

across numerous jurisdictions and currencies is a great challenge.
One solution is to pull funds from several corporate treasuries to
the main treasury centre, thereby getting an overview of the cash
available each day, and on how best the funds can be utilised to
serve a given business. Though this looks simple, actual working
processes can be complex.

As against actual sweeping or pooling of cash to the main trea-

sury which has inherent risks atta another method is notion-
al cash pooling. This has been to offer a better way of
mitigating currency risks as t ual movement of cash
from their home countries. f the potential for cost
savings in the case of notiona i wny corporate treasurers

Benoit Desserre, he its and cash management at So-

arge corporates are completely op-

or using notional pooling. It removes the

cies are not exchanged and remain “as is’
nt. The gain comes from the removal of the FX

elements of both standard cash pooling and notional

doling. An example is consulting engineering firm Arup. It
worked with HSBC to develop a hybrid structure that draws its
international funds to the UK. Richard Abigail, group treasurer at
Arup, says, It is a hybrid structure. Money is moved from the other
markets to London but it is not concentrated or commingled. Each
foreign entity opened an account with HSBC UK to act as a mirror
account. When it is in the UK it is notionally pooled. Virtually every-
thing we can currently move is in the pool and we are increasingly
trying to automate it.

The hybrid structure required changes to know how the treasury

was run in each company. Each local jurisdiction has to be edu-
cated on new method. It also required a study about the strengths
and weaknesses of each location. As per Richard Abigail, There
was a lot of work to implement the structure, especially as it is a
hybrid. There are a lot of documents to go through. It takes time in-
ternally to convince people of the value of taking on this new bank-
ing construct.” He further says: ‘Adopting cash pooling has brought
about £1 million in savings each year. It has also allowed the com-
pany to drive treasury further as a function within the business.

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INTRODUCTORY CASELET

The pool has brought about greater awareness of cash balances and
the risks in FX and trading. The group holds around £100 million
in cash, but now has a buffer of just £1.2 million for all pool partici-
pants. Previously the US business had wanted a $5 million buffer to
cover their operations alone.”

The cash pooling is also subject to the individual rules and laws
of the countries involved. Abigail says: “We cannot get access to
India, Brazil and South Africa, and instead have to go through the
standard processes of inter-company settlements.” In spite of these
difficulties, he says, it is still worth pooling the other countries
and working on these separately. It also faced problems in Europe
with respect to regulatory issues. “Implementing pooling in Eua
proved to be the trickiest region,” says Abigail. “There are sp
laws to navigate in Germany and Italy, and Turkey is
difficult country to operate in.” Apart from legal hu
faced technical problems as HSBC was not able to s

porate treasury, the appeal of cash poolin

more attractive. Banks are, however, re

http://www.euromoney.com/artiel

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NOTES

©@ LEARNING OBJECTIVES

After studying this chapter, you will be able to:

Explain short-term international financing and its sources

ry
Discuss internal financing by MNCs
Describe determination of effective financing rate
yy Explain the criteria for foreign financing
Describe the management of surplus cash
Explain centralised vs. decentralised cash management
ry

Explain cash transmission

xP i

‘ai INTRODUCTION
In the previous chapter, we studied about export promotion and pay-
ment instruments in international trade. In this chapter, we will learn
about short-term international financial instruments. In Chapter 2, we
studied different international financial markets and various modes
of international financing available for corporates in those markets.
We saw that corporates now have the option of obtaining financing
for their long-term and short-term financial needs in international fi-
nancial markets like international equity markets, international bond
markets, Eurocurrency markets, etc.

One of the reasons why corporates raise finance from foreign markets
is the inability of domestic markets to cater to their needs. Especial-
ly, for global companies from emerging markets, domestic financial
markets may not be sufficiently large or developed when compared
with international capital markets. Another reason is that they might
have decided to raise finance in the currency in which they have ex-
penditures. Finally, it might be more efficient to mobilise capital from
foreign countries compared to local markets.

It is, however, possible that corporates may decide to mobilise as cap-

ital from foreign markets even when such options are available in
the domestic financial markets itself. Since we have already studied
about the various possible opportunities for raising capital from for-
eign markets in Chapter 2, we shall study in this chapter why or why
not corporates may raise finance from international markets. Another
important financial management decision that has major significance
in the context of international finance is cash management. In this
chapter, we shall also study about cash management in the global en-
vironment.

This chapter discusses short-term international financing and its

sources. It also explores internal financing by MNCs, determination
of effective financing rate, criteria for foreign financing and manage-
ment of surplus cash. Finally, the chapter explains centralised vs. de-

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NOTES

centralised cash management, and the concept of cash transmission is

also discussed in detail.

SHORT TERM INTERNATIONAL

FINANCING AND ITS SOURCES

Short-term financing refers to borrowing funds for a short period

of time. The market that caters to the short-term financing needs of
corporates and financial institutions is termed as money market. Ad-
vanced economies such as the US or the UK have highly developed
domestic money markets. The cost of financing depends on demand-—
supply of funds and the short-term interest rates set and controlled by
the respective central banks of different country. Each market allows
borrowing and lending in domestic currencies and they are subjected
to the reserve requirements of the central bank. Commercial banks
are the main players in money markets. Various short-term instru-
ments available in these money markets are short-term loans, short-
term notes, commercial papers, etc. Commercial papers are the most
widely used instrument for working capital financing needs of corpo-
rates.

When corporates would like to access financing in short-term instru-

ments denominated in a foreign currency, they can access the respec-
tive banking and money markets of the country. These markets are
termed Eurocurrency markets. A Eurocurrency instrument is essen-
tially an instrument denominated in a currency outside the domestic
money market applicable for that currency. Since the instrument is
traded outside the relevant domestic money market, it is also outside
the direct regulatory control of the central bank of that country. This
means there will be no reserve requirements for such deposits done
outside the country. For example, a dollar lent outside the US is termed
as Eurodollar and the market for such Eurodollars is termed as the
Eurocurrency market. However, it is not necessary that only dollar
loans and deposits are available in, Eurocurrency market or that the
market necessarily functions out of Europe. Eurodollar loans and de-
posits may be accessed from London while Euroyen can be accessed
from US or Germany. However, predominantly Eurodollars based out
of London financial markets constitute major part of Eurocurrency
markets.

The interest rates applicable in Eurocurrency markets are based on

London Interbank Offered Rate (LIBOR). It is the rate at which the
banks with excess funds in London lend to each other. The rate at
which banks accept deposits is referred to as the interbank bid rate.
LIBOR is calculated as an average of offer rates (or lending rates) for
short-term interbank funds based on data provided by a panel of ma-
jor banks. There is a separate LIBOR rate for each currency and fora
range of maturities. Before 2014, it was traditionally compiled by the
British Bankers’ Association (BBA) in conjunction with Reuters and
released shortly after 11.00 a.m. London time. From 2014, it is being

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administered by Intercontinental Exchange Benchmark Administra-

tion Limited and termed ICE LIBOR instead of BBA LIBOR.

LIBOR is used as a benchmark reference rate in international finan-

cial markets. It is the rate for all unsecured short-term money market
instruments. It is quoted as an annualised interest rate as per market
convention. It is also used as reference rate in other loan products. For
example, even a medium-term or long-term floating rate loan may be
based on the reference rate of LIBOR prevailing in respective time pe-
riods. The LIBOR is applicable only in inter-bank or wholesale mar-
ket. When corporates access money markets, a spread is added to the
LIBOR called “credit spread” based on the credit rating applicable for
the company. The interest spread is quoted in terms of basis points.
A one percent interest rate corresponds to 100 basis points. Thus, a
short-term corporate loan in US dollars can have an interest rate of
3-month USD LIBOR + 70 basis points. If the 3-month LIBOR appli-
cable for the period is 2% p.a., then the lending rate applicable is 2.7%
p.a.

Table 9.1 gives sample ICE LIBOR rates applicable on 28rd October,
2015. From the table, it can be seen that the 6-month LIBOR applica-
ble for pound sterling is 0.74125% p.a. This is the rate applicable for
spot delivery of pound sterling funds with value date of 2 days after
the transaction date. The principal and interest is paid at maturity of
the loan six months after spot.

TABLE 9.1: LIBOR RATES APPLICABLE ON

23RD OCTOBER, 2015
Publication GBP JPY EUR USD CHF
Time
Overnight 11:45:04 AM 0.4825 0.02786 —0.18143 0.1315 —0.775
»1 Week 11:45:04 AM 0.48563 0.02643 —0.16286 0.1545 —0.796
1 Month 11:45:04 AM 0.506 0.04 —0.135 0.1935 —0.774
2Months 11:45:04AM 0.53788 0.06286 —0.09786 0.2498 —0.756
3 Months 11:45:04AM 0.57938 0.07786 —0.06643 0.3229 —0.731
6 Months 11:45:04AM 0.74125 0.12514 0.00214 0.5269 —0.684
1 Year 11:45:04 AM 1.025 0.23757 0.1 0.8319 —0.583

(Source: ICE LIBOR, www.theice.com)

For firms that decide to approach international markets, there are

several short-term instruments available. Some important short-term
instruments are discussed as follows: (Please note that some of the
instruments have already been discussed in Chapter 2).
Q Bank loans: These refer to the loan and advance facility provid-
ed by banks. Most of the multinational firms have credit arrange-
ments with foreign banks or domestic banks. These firms can take
loans when the other sources of funds are not available or are cost-
lier than a bank loan.

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NOTES

Q Euro credits: These are short to medium-term loans based on LI-

BOR. Euro notes are short-term negotiable promissory notes is-
sued by borrowers and subscribed by banks.
Q Euro commercial paper (short-term notes): The investors of
these commercial papers are institutions seeking higher returns
for their short-term funds. These are unsecured, bearer securities
of short-term maturity taken by major corporations for meeting
their working capital needs. When these commercial papers are
issued in Euro currency, they are called ‘Euro commercial paper’.
The dealers, who assist the companies in the issuance of commer-
cial papers, do so without providing any underwriting facility. It
means that these commercial papers are unsecured and compa-
nies would not get an assured selling price. A commercial paper
can be tailored to suit the requirements of the issuer; the usual ma-
turity period of commercial paper is from one month to one year.
Q Banker’s acceptance and letter of credit: These are short-term
instruments in a normal export-import scenario, where an ex-
porter exports material to some importer in another country and
draws a time draft on the importer’s bank. When the export has
been made, the exporter provides the bill of lading and the time
draft to its bank for redemption at a discounted value. When the
exporter’s bank wants to get the value of the draft, it presents the
draft to the importer’s bank. The importer’s bank then accepts the
draft, thereby creating a banker’s acceptance. The exporter bank
may get it discounted and get the money back. In other cases, it
may resell the draft or may hold it and get it discounted later.
Q Floating rate notes or floaters: It is a short-term security simi-
lar to a bond. It is an interest bearing instrument but the interest
rate is not fixed; it is floating. The rate varies in accordance with
some international benchmark for interest rates such as LIBOR.
For example, if LIBOR rate is 7%, then the rate of interest on the
floating rate note (FRN) may be LIBOR + 1%. The interest or cou-
pon payments are made in various stages. For example, after being
issued they can have monthly, quarterly or half-yearly payments.
The holder receives a minimum risk-free interest. The yield on a
FRN is lower than the yield on the fixed rate bonds, but it has the
benefit of not being sensitive to the interest rate prevailing in the
market. There also exist FRNs which have a ceiling on the max-
imum and minimum interest that can be paid; these are called
capped or floored FRNs.

There are several reasons why corporates may decide to source funds
from foreign markets. Some major reasons are as follows:
Q Foreign currency loans may be used to hedge foreign currency
revenues, assets and liabilities related exposures.
Q Foreign markets might offer cheaper sources of funds for diversi-
fying the funding sources.

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Q Local financial markets may not have size, depth and liquidity
compared to international sources.

9.2.1 SHORT-TERM FINANCING OF INTERNATIONAL

TRADE

In international trade, both suppliers and buyers need short-term

credit from financial institutions. For example, an exporter needs
bank finance to have sufficient cash flow. In some cases, the exporter
(supplier) may finance the entire trade cycle, starting from production
to the receipt of the payment from the buyer. This type of credit is
called supplier’s credit. In other cases, the exporter may not be willing
to finance the entire trade cycle. In such cases, the buyer may need
financing from financial institutions. This type of financing is called
buyer’s credit. Therefore, you can see that short-term financing plays
crucial role in the smooth functioning of international trade. You have
studied short-term trade financing tools like banker’s acceptance and
Letter of Credit (LC) in the chapter. Now, let us study some other
short-term financing tools used in international trade.

SHORT -TERM WORKING CAPITAL

Maintenance of short-term capital of the importer and the exporter is

an important factor in the success of international trade. For example,
an importer may face short-term working capital problem until the
imported goods are sold in the market. Similarly, an exporter needs
sufficient working capital for smooth functions of its manufacturing
processes.

Short-term working capital needs of firms are fulfilled by short-term

international trade finance. In case of banker’s acceptance, an export-
er can receive funds immediately. Banker’s acceptance also allows
the importer to defer payment until a future date. In addition, the ac-
cepting bank may also offer short-term loans for a period greater than
the banker’s acceptance period. This type of credit finances the short-
term working capital needs of the importer and the exporter.

PRE-SHIPMENT AND POST-SHIPMENT EXPORT CREDIT

Export financing was introduced in 1967 by the RBI to make export-

ers avail short-term working capital finance. Export credit is available
in rupee as well as in a foreign currency. Export credit can be availed
by exporters before shipping of goods (pre-shipment export credit) or
after shipping of goods (post-shipment export credit).

Pre-shipment export credit or packing credit is offered to the exporter

for the financing of purchase, processing, manufacturing or packing
of goods before shipment of goods. Export credit is extended to ex-
porters on the basis of the following:

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Q LC issued in favour of the exporter or any other person by an over-

seas buyer
Q A confirmed and irrevocable order for the export of goods from
India

Q Any other evidence of an order for export from India having been
placed on the exporter or some other person, unless lodgement of
export orders or letter of credit with the bank has been waived.

The period for which packing credit is granted depends upon the cir-
cumstances of the individual case, such as the time required for pro-
curing, manufacturing or processing (where necessary) and shipping
the relative goods / rendering of services.

Post-shipment export credit refers to any loan or advance granted or

any other credit provided by a bank to an exporter of goods / services
from India for export of goods/services after the shipment. Post-ship-
ment export credit runs from the date of extending credit after ship-
ment of goods / rendering of services to the date of realisation of export
proceeds and includes any loan or advance granted to an exporter, in
consideration of, or on the security of any duty drawback allowed by
the Government from time to time.

In order to make credit available to exporters at internationally

competitive rates, RBI has permitted authorised dealers to extend
Pre-Shipment Credit in Foreign Currency (PCFC) to exporters for
domestic and imported inputs of exported goods at LIBOR/EURO LI-
BOR/EURIBOR. In addition, under the Post-shipment Export Credit
in Foreign Currency scheme, banks may utilise the foreign exchange
resources available with them in EEFC, RFC, FCNR (B) accounts to
discount usance bills and retain them in their portfolio without resort-
ing to rediscounting. Banks are also allowed to rediscount export bills
abroad at rates linked to international interest rates at post-shipment
stage.

EXPORT BILLS

Export bills are produced when an exporter submits all his/her docu-
ments supporting the export with his/her bank. The exporter’s bank
presents these to the importer’s bank (along with export amount col-
lection instructions). It is the responsibility of the importer’s bank to
release the export documents and give the same to the importer upon
the payment of the export amount. The importer’s bank can also re-
lease the documents (necessary for clearance) to the importer if he/
she gives an undertaking to pay the export amount at a later date. It is
good to note that the exporter’s bank is called the remitting bank and
the importer’s bank is called the collecting bank. This is the case when
export bills are sent for collection (export bill collection).

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Another scenario related to export bills is called export bill discount-

ing or export bill purchase. Banks provide the export bill discounting
facility under which they credit the amount of invoice mentioned in
the documents (after discounting) submitted by the exporter to the
exporter’s account. This is done after the bank receives a request from
the exporter to discount the export bill. However, the bank does not
credit the full amount. An interest payment is charged on the invoice
amount from the date of purchase of the export bill till it is due for
payment.

EXPORT BILL NEGOTIATION

Export bill negotiation is also a kind of service (similar to export bill

discounting) offered by banks to exporters. Export bill discounting
takes place when there is no LC available with the exporter’s bank,
whereas export bill negotiation takes place when there is an LC with
the exporter’s bank.

Export bill negotiation simply means “giving of value”. A bank nego-

tiates the export bill under an LC and pays (credits) to the exporter’s
account with its own funds. The exporter’s bank receives the payment
from the importer’s bank at a later date. Here, negotiating the export
bill under an LC means the bank critically examines all the export
documents and shows its willingness to give value. The value given
by the bank is usually less than the invoice amount. Export bill ne-
gotiation can be with or without recourse to the exporter. When the
bank confirms an LC, the negotiation of the export bill is without re-
course, whereas when the LC is not confirmed by the bank, the nego-
tiation will be with recourse to the exporter. Recourse means, in case
the bank that issued the LC (importer’s bank) refuses to pay or accept
the documents under an LC, the bank reserves the right to reimburse
its full amount along with the interest amount that it extended to the
exporter.

CRYSTALLIZATION OF EXPORT BILLS

As discussed above, exporters usually discount or negotiate export

bills with their banks. For availing these services, they submit the nec-
essary export documents including: bill of lading, airway bill, invoice,
packing list, etc. Banks support exporters and charge very low inter-
est rate as well as provide them loans against their loan documents. A
bank receives the amount from an importer’s bank on due date (ma-
turity date) that is agreed upon by both the buyer and the seller. If the
importer’s bank does not pay for the export bill even after 30 days of
its maturity, the bank draws back its low interest rate offered to the
exporter and starts charging at the commercial rate of interest. This is
called crystallization of export bills. It is also called delinking of export
bills.

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NOTES

BUYER’S CREDIT

In international trade, buyer refers to the importer whereas suppli-

er refers to the exporter. Buyer’s credit refers to the loans that are
taken by a buyer for his imports from a foreign bank or financial in-
stitution. For availing such loan, the importer’s bank must give an
undertaking to the overseas bank. After getting this undertaking, the
overseas bank credits the nostro account of the importer’s bank with
required amount of loan. The importer’s bank uses this amount to
make payment to the exporter against the import bill. The overseas
bank charges a particular rate of interest on the loan amount for the
period. The interest rate is usually quoted in terms of LIBOR such as:
3M LIBOR + 250 basis points.

SUPPLIERS CREDIT

A supplier’s credit refers to the financing (credit) that a supplier (ex-

porter) extends to a foreign importer (buyer) to finance his purchase.
The importers usually pay some amount upfront in cash and promise
to pay the rest of amount later and issue a promissory note for the
same. In this way, the exporter receives a deferred payment from the
importer. The supplier can get the promissory note discounted from
his bank for cash payment. Here also, the interest rate is quoted in
terms of LIBOR.

FACTORING

In international trade, a factor refers to a bank or a financial insti-

tution. The factor helps the exporter purchase the invoice or the
accounts receivable. Factoring refers to an agreement in which the
factor and the exporter agree that the factor will purchase exporter’s
foreign currency receivables for cash at a discount from its face value.
The discounting may or may not be with recourse. This eliminates the
risk of non-payment for the buyer.

FORFAITING

Forfaiting is similar to factoring and it eliminates the risk of nonpay-

ment by buyer after the goods have been delivered to the importer.
Forefaiter is a special department in a bank that conducts the work
of forfaiting. Forfeiting is usually non-recourse financing. Factoring is
usually provided for short-term receivables whereas forfeiting is done
for medium-term receivables. The forfaiter usually works with export-
ers who sell capital goods, commodities, or large projects and they
require credit for 180 days to seven years.

ee SELF ASSESSMENT QUESTIONS

1. The cost of financing does not depend on demand-supply of

funds. (True/False)

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NOTES

Access the ICE website and review the prevailing LIBOR rates. Are
some LIBOR rates negative? Discuss the significance of negative
LIBOR rates.

Hi INTERNAL FINANCING BY MNCS

For multinational corporations (MNCs), international funding in oth-

er currencies might be possible through internal sources. Before seek-
ing external support for sourcing or raising finances, MNCs should
explore internal sources of finance. The excess of surplus cash flow in
the parent organisation or its subsidiaries can be used to cater for the
short-term needs or the operational needs or the working capital re-
quirements. These MNCs might have operations in many geographies
through their various subsidiaries and affiliate companies. It may be
cheaper to look for subsidiaries with excess funds who can lend, in-
stead of searching for external sources of financing. In some cases, it
might also offer mutually beneficial hedging positions.

If the funds for investment are available internally, then the cost of
borrowing funds from the external market and the risk and exposure
involved in raising finances internationally or in foreign currency
transaction will be restricted.

Internal financing assists the organisation in the effective and prop-

er monitoring and control of funds and helps in decreasing the op-
erational cost of transactions. If such control is not imposed on the
subsidiaries, then there are chances that they may borrow funds or
loans at high interest rates from international markets. The external
borrowing may increase the cost of the capital involved in the opera-
tions and may lead to an increase in the liabilities of the organisation.
External borrowing is also subject to market risks. Depreciation in the
value of the domestic currency as against the value of the foreign cur-
rency in which loan has been taken may further increase the liability
of the organisation and decrease its profitability.

Therefore, in order to avoid the market risk and exposure, most of the
subsidiaries and parent companies try to obtain loans from internal
sources.

& SELF ASSESSMENT QUESTIONS

2. assists the organisation in the effective and proper

monitoring and control of funds and helps in decreasing the
operational cost of transactions.

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NOTES

Visit any MNC and meet its financial manager. List down the fac-
tors that affect the organisation’s internal financing.

DETERMINATION OF EFFECTIVE
FINANCING RATE

The foreign currency borrowed by the organisation or parties at one

point of time is subject to the changes that occur over a period of time.
The exchange rate of the currency in the FOREX market is highly vol-
atile and dynamic in nature. It changes with every currency buy and
currency sell transaction that takes place in the market. The amount
that is payable may further increase or decrease, depending upon the
market constraints and the demand and supply of the domestic cur-
rency against the foreign currency.

The cost of financing depends upon three components:

Q Interest rate: It is the interest charged by the bank for lending
money to the borrowers.
Q Credit spread: It is the difference in return between two bonds of
similar maturity but, with different credit quality.
Q Transaction costs: These costs are incurred while making eco-
nomic transactions.

As we have studied in earlier chapters, the fact that interest rates tend
to be different in different countries does not imply opportunities for
sourcing cheaper capital from foreign markets. Sourcing funds in for-
eign currencies involves exchange rate risk. The interest rate advan-
tage is generally offset by the exchange rate risk. If corporates decide
to hedge the exchange rate risk through forward markets, then the
effective interest rate will be the same as the domestic interest rate as
per the following Covered Interest Parity Theorem, which we studied
earlier:

(=) _ (1+i,)
S) (1+i,)
Ifi, is the interest rate in foreign markets and i, is the interest rate in
domestic markets, then the effective interest rate on a loan taken from
the foreign market will be given by:

i, =(1+e,)x(1+i,)-1
where F is the forward rate at which the loan cash outflow has been
hedged and S is the spot exchange rate.

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Illustration 1: If the one year interest rate in US is 3% p.a., spot ex-

change rate is INR 65/USD and the one year outright forward rate is
INR 68/USD, what is the effective interest rate if borrowed in USD? If
the Indian interest rate is 7.753%, which of the market is cheaper? Is
the covered interest parity applicable?

Solution: Assuming the firm requires INR 10 mn, it would need to

borrow USD 153,846 at the prevailing spot exchange rate. The inter-
est applicable will be USD 4615 at 3% for one year. The total amount
payable after one year for closing the USD loan will be USD 158,461.

The firm would have entered into a forward contract for USD 158,461
at INR 68/USD. Hence, it would need INR 10,775,374 to repay the loan
on maturity. The effective interest rate in terms of Indian rupee will
be:

Effective interest rate in INR = (10,775,374/10,000,000 — 1) X 100

= 7.753%

The Indian Interest rate as per covered interest rate parity theorem
will be:

i, -(E}a+4)- 1

===6865 (1-03)
x(1.03)-1
= 0.07753

Since the domestic interest rate is 7.753%, same as the effective inter-
est rate if borrowed in USD, the cost of financing is same in both the
markets. Hence, the firm will be indifferent between the two markets.

Since the effective interest rate is the same as the domestic interest
rate, the covered interest parity theorem holds good between the US
and Indian money markets.

If the corporate does not hedge the exchange rate risk and if the Un-
covered Interest Parity Theorem holds good, then also the effective
interest rate will be the same as the domestic interest rate applicable
for the maturity period. If the corporate does not hedge its risk with
forward cover, then the expected effective interest rate will be given
by:

i, -( 2) x(a+i,)- 1
where E(S) is the expected future spot rate. Since as per the Uncov-
ered Interest Parity Theorem, the expected future spot rate will be
the same as the forward rates indicated by the interest differential,
the effective interest rate will be the same as in the earlier case of a
hedged loan.

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NOTES

However, if the firm does not hedge the risk and if the Uncovered In-
terest Parity Theorem does not hold good, then the effective interest
rate can be greater or lesser than the domestic interest rate depending
on the currency movement during the period.

i, (821 )x(1+i,)- 1

where S,_, is the future spot rate at time t+1, which can be different
from the rate indicated by the forward markets. The above equation
can be re-written as follows:

i, (14S )x(ri,)-1
(Si41-S),
The term —“*——in the first bracket represents the percentage
change in spot exchange rate during the period. If we denote the %
change as

i, =(1+e,)x(1+i,)-1
The term is nothing but the percentage appreciation or depreciation
of the local currency against the foreign currency during the period.
The effective interest rate is thus dependent on the actual apprecia-
tion / depreciation of the currency during the loan period. Remember
that the effective rate can be more or less than the domestic interest
rate depending upon the currency movement. Thus, when the foreign
currency loan is not hedged in the forward market, the effective cost
of loan could be either way.

CREDIT SPREADS

The total effective interest rate depends also on the credit spread. The
credit spread for a borrower depends on his creditworthiness and
should be same in any financial market. However, the credit spread
applicable for different credit ratings can differ in different countries/
financial markets.

The covered interest parity theorem used earlier considers only the
reference interest rate such as LIBOR which is applicable only for
inter-bank borrowing and lending. Theoretically, it should hold good
even for interest rates applicable to corporate lending that includes
the credit spread depending on the credit worthiness. If the credit
spreads applicable for the same borrower in different markets are not
same, then the effective interest cost can be different in different mar-
kets.

In general, credit spreads are expressed in absolute form:

Interest Rate = Base Reference Rate + Credit Spread
When expressed in the above form, the absolute amount of credit
spread need not be the same in order for the Covered Interest Parity

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N OT ES

to hold good. For example, if interest rate in India is 7% and that in

the US is 2% and if the credit spread applicable for a borrower is 0.5%
in India, then the credit spread applicable for the same borrower in
the US should be as follows if the Covered Interest Parity holds good
(assume spot rate of INR 65/USD and forward rate of INR 68/USD).

i, -(E}xa+s,)- 1

i, y = [B }a+75%)- 1
68
= 2.757%

The credit spread in US = 2.757% 2% = 0.757%. However, the cred-

it spread depends on several factors that are unique to the respec-
tive markets and prevailing economic scenario. For example, credit
spreads change as the business cycle changes in an economy. But
there need not be any correlation between two markets in this regard
— credit spread could be higher in one country while it is low in an-
other country for same creditworthiness. The above case gives an ex-
treme scenario of possible recessionary conditions in the US resulting
in very high credit spread (for the borrower of same credit rating). In
the above example, it can also be that the interest rate is 2.5% in the
US resulting in a credit spread of 0.257%, much lesser, compared to
0.5% in India in a different period.

Illustration 2: An Indian firm is evaluating to finance its one year

short term fund requirements through borrowing in US money mar-
kets (assume no regulatory restrictions). The interest rates are 7% p.a.
and 2.279% p.a., respectively, in Indian and US money markets for a
one year loan. The spot exchange rate is INR 65/USD and the one year
outright forward rate is INR 68/USD. The credit spread applicable for
the firm in India is 80 basis points. The investment bank of the firm
says that it will be able to raise the US loan at the same credit spread
as applicable for the firm in Indian markets. Should the firm accept
the deal offered by the investment bank (assume Covered Interest
Parity holds good for corporate loans)? Explain why.

Solution: The investment offers a deal in which the interest rate in

USD loan is 2.279% + 80 basis points = 3.079% p.a.
Since the Covered Interest Parity conditions hold good for corporate
loans, there can be no arbitrage opportunities between the US and
Indian money markets.

The US money market loan should bear an interest rate of:

i, -(£)x(1+i,)- 1

i -( }xtr+z59%)- 1
= 2.757%

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NOTES

Since the equivalent interest rate applicable in US markets should

be 3.044%, which is less than the rate offered by the investment bank,
the firm should not accept the offer. It will be cheaper to raise loans in
Indian money markets at 7.8% instead of raising USD loan at 3.079%.
If the firm raises $1 mn in US money markets, the maturity amount
will be
Maturity amount = 1,000,000 x 1.0379% = $1,037,900

At the forward rate of INR 68/USD, this amounts to INR 70,577,200

If the firm raises loan in Indian money markets, it would have to pay
only:
Maturity amount = (1000,000x65)x1.078 = INR 70,070,000

Hence, the firm should turn down the deal offered by the investment
bank

The two factors discussed above, viz., expectations on currency move-

ments and the possible credit spread difference might allow borrow-
ers to borrow at cheaper cost in different currencies. However, if the
interest parity conditions hold good (or if the loans are hedged) and if
arbitrage prevents any significant credit spread difference, then the
effective cost of borrowing will be the same in different financial mar-
kets.

The ability of borrowers to get financing at cheaper rates in different

currencies, due to above reasons, allows the interest rate swaps and
currency swaps markets to flourish.

SELF ASSESSMENT QUESTIONS

3. A corporate finds that the yearly Indian interest rate is 8%

p.a. and the spot rate is INR 65/USD. It expects the future
spot rate on the maturity date of the one year short-term
loan to be INR 68/USD. The forward rate is INR 69/USD. The
effective interest rate (rupee terms) on an equivalent USD
money market loan, if not hedged in forward markets, will be
(ignoring credit spread):
a. 3.235% b. 12.98%

c. 8% d. None of the above

Indian corporates are not allowed to borrow / invest in short term

money market instruments of foreign markets. Visit the RBI web-
site and ascertain the relevant guidelines in force with regard to
foreign currency financing (for example, ECBs can be of maturity
of minimum 3 years as of 2015 regulations)

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see CRITERIA FOR FOREIGN FINANCING

MNCs use short-term international sources of funds for fulfilling their

domestic needs. They do so to offset the foreign currency inflows.
Organisations use foreign financing to enjoy the low rate of interest
charged on the foreign currency. By using foreign currency finances,
the net receivable position in the foreign cash flows can be offset. The
inflow of the foreign currency in the organisation also helps in limiting
the effect of the exchange fluctuations, as the changes in the exchange
value of the domestic currency will not affect the flow of the foreign
currency.

We can conclude that the criteria for foreign financing should be based
on the following:
Q Interest parity conditions: Interest parity is the relationship in
the exchange rates of currencies between two countries with re-
spect to the interest rate in the local market. If the Covered In-
terest Parity conditions apply, then the effective interest rate for
a hedged loan will be same irrespective of the interest rates in re-
spective foreign countries. Even when the loan is not hedged but if
uncovered interest parity conditions apply, then also the result is
same — there is no arbitrage advantage in financing in currencies
with cheaper interest rates.
However, it is quite possible that interest parity conditions may
not apply for few currencies/markets as discussed in an earlier
chapter. This is especially so when the exchange rate arrangement
applicable to the currency is not free floating or when there are
restrictions on capital movement imposed by the country. In such
cases, it is possible to explore foreign markets for cheaper financ-
ing.
Q Expected currency movements: As long as the loan is hedged in
forward markets and covered interest parity conditions are ap-
plicable, there is no possibility of cheaper financing from abroad.
When the interest parity conditions do not apply, and the Uncov-
ered Interest Parity does not hold good, the effective interest rate
can be higher or lower than the domestic rate.
In such cases, if the corporate is sure about the direction of curren-
cy movement, then it can use forward rate as the benchmark rate
to decide on financing. When the Uncovered Interest Parity does
not hold, i.e. expected future spot rate can be different from that
indicated by the forward rate, the actual spot rate on the future
date will decide the effective cost of the loan. In such cases, the
forward rate will only indicate the direction of movement of the
currency. If the foreign currency trades at the premium to home
currency in forward markets, then the home currency is expected
to depreciate. But the amount of depreciation will not be same as
that indicated by the forward premium. Since the depreciation of

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NOTES

home currency makes a borrowal in foreign currency costlier, if

the actual depreciation is less than the premium indicated by the
forward rate, then any borrowal in the foreign currency will result
in lower cost than the domestic interest rate. In such cases, the for-
ward rate will serve as the benchmark against which the expected
future spot rate will be compared. If the corporate is sure that the
future spot rate will be less than the forward rate, then it can take
the loan and leave it unhedged so that the effective cost is less
than the domestic interest rate. For example, if Rupee vs. Dollar is
considered, the Rupee has always been depreciating against dollar
for at least the last 10 years. It is unlikely for rupee to appreciate
or be less than the exchange rate indicated by the forward market.
Hence, it is not advisable to take an unhedged short term loan in
dollar. However, if a corporate concludes that the rupee will de-
preciate less than that indicated by the forward rate, then it may
decide to go for an unhedged loan in US dollars.
Q Exchange rate forecasts: The capability of exchange forecasting
of an organisation depends on its market information and market
research. Most of the organisations determine their future strat-
egy of investment or borrowing on the basis of the exchange rate
forecasting. There are analytical models available that can fore-
cast the exchange rate movement. If a corporate can forecast the
future exchange rate, it can calculate the expected depreciation/
appreciation percentage instead of using forward rate as bench-
mark and conclude about the possible effective interest rate. If the
effective interest rate is less than the domestic interest rate, it may
decide to source finance in the respective foreign currency. The
expected effective interest rates can be calculated by probability
distribution of various possible rates.

ee SELF ASSESSMENT QUESTIONS

4. Most of the organisations determine their future strategy of

investment or borrowing on the basis of the

Review the literature on exchange rate determination models. Dis-

cuss the pros and cons of making decisions on short-term borrow-
ing in foreign markets based on the exchange rate forecast models.

EG) MANAGEMENT OF SURPLUS CASH

Management of cash is part of working capital management. In the
international context, working capital management in terms of man-
agement of inventory, receivables or payables is not very different

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NOTES

from the basic principles underlying domestic working capital man-

agement though there are some unique aspects. We have already dis-
cussed these unique aspects in other chapters viz., hedging receivable
exposures with exposure in the opposite direction in the same cur-
rency, internal strategies for hedging foreign exchange exposures like
invoicing in different currencies, adopting different pricing policies,
leading/lagging receivables and payables etc. In this chapter, we shall
discuss the management of cash.

The term cash management refers to managing cash in terms of main-

taining optimal transaction cash balances to cover scheduled cash out-
flows for the cash budgeting period and maintaining precautionary
cash balances necessary for meeting unexpected cash requirements.
It also involves investing excess cash for maximum return and bor-
rowing for cash deficits at minimal cost for meeting temporary short-
ages. The cash management discipline has lot more significance in
the international context for all kinds of companies: purely domestic
companies, companies that have exports/imports and companies that
have operations abroad. It becomes.a specialised function in the case
of MNCs that have subsidiaries in different countries. Organisations
with excess cash try to fulfil the basic objectives of organisation which
are:
Q Procuring and controlling cash resources of the organisation
quickly and efficiently.
Q Protecting or securing cash reserves from the market risks and
exposure and maintaining a healthy liquidity position.
Q Utilising cash reserves of the organisation in the best possible
manner.

For domestic companies that are not into foreign trade or operations,
cash management in the international context offers additional op-
portunities. A firm can decide to source short-term funds from foreign
markets if it finds it more attractive or feasible. Similarly, a firm with
surplus cash can decide to invest in foreign money markets. In this
case, it may not even be necessary to convert the cash into different
currencies as in the case of Eurodollars. Many US-based MNCs find
the interest rates on dollar deposits far more attractive in Eurocurren-
cy markets than the domestic money markets. We saw how this pro-
moted the growth of Eurocurrency markets in Chapter 2. In the Indian
context, corporates are not allowed to source short-term funds or in-
vest in foreign markets as per the current RBI regulations. However,
as the government gradually liberalises capital account controls, cor-
porates may be allowed to access foreign money markets in the future.

For companies involved in international trade, cash management ac-

quires significance due to exposure to foreign exchange. The compa-
nies may decide to keep the receivables in foreign currency bank ac-
counts for future operational purposes. They may also decide to invest
in foreign money markets in short-term instruments. If they decide

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NOTES

to convert all receivables immediately into domestic currency, they

will incur transaction costs. However, the decision also rests on future
requirement. If the company has no use for foreign currency balances
but require the funds in domestic currency for operational purpos-
es, they would have hedged the receivables in the forward markets.
They may decide to invest in foreign money markets only if they have
excess cash and find investment in foreign markets more attractive.
Again, the same considerations with regard to exchange rate move-
ment and interest parity conditions applicable for short term foreign
financing are also applicable for short term foreign investment.

In the Indian context, the companies are now allowed to keep 100% of
export proceeds in Exchange Earners Foreign Currency (EEFC) Ac-
counts. These are foreign currency current accounts meant for keep-
ing excess cash. However, as per current RBI regulations, companies
are required to convert the balances accrued over a month within the
end of the next month. Companies are not allowed to invest excess
cash in foreign money markets as rupee is not fully convertible under
capital account.

For MNCs with subsidiaries across many countries, the cash manage-
ment is a specialised function which might even require a separate
division meant for managing cash surplus/deficits of various subsid-
iaries in different currencies.

9.6.1 INVESTMENT OF SURPLUS FUNDS

For corporates with excess cash, the first consideration is whether the
firm will require the funds internally for any purpose. If the firm has
several divisions or subsidiaries, the funds may be profitably moved
around to locations where there is deficiency. However, if the funds
are required in different currencies, then several factors need to be
considered. It may be more profitable to invest the excess funds in
local markets while the deficient unit can borrow in other markets. It
depends on the interest rate and currency movement scenario. It is
not always necessary that a transfer from another subsidiary is more
advantageous than local borrowing — it depends on the interest parity
conditions. However, it will also be necessary to consider additional
factors like credit spread involved in borrowing, availability of funds
for the deficient unit, the transaction costs etc. We shall discuss more
on cash management of MNCs in a subsequent section.

Once the firm decides to invest in foreign money markets, there are
several issues to be considered:
Q Investment avenues
Q Maturity period
Q Currency and related risks involved
Q Total return applicable

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Credit risks involved

UOoOovU
Transaction costs

Ease of investment and liquidity

Political risks and regulations

There are several investment avenues available for corporates dis-

cussed as follows:
Q Euro Certificate of Deposits (CDs): These are one of the import-
ant short-term investment avenues for corporates with excess
cash. These are bank term deposits for which banks issue a certif-
icate that is a negotiable instrument which can be traded in sec-
ondary markets (unlike the usual bank deposits). CDs are a bearer
certificates and the holder has sole title to the principal and inter-
est to be paid on the maturity. These are not discount securities
like commercial papers and are issued at the face value of the cer-
tificate and redeemed with interest applicable. They carry higher
interest rate than the normal bank deposits and are generally for
a higher denomination.
Q Financial and Commercial Papers: These are short-term unse-
cured promissory notes issued by financial institutions in the mon-
ey market, with a maturity period ranging from 30 days to 270 days.
A commercial paper is among the popular investment instruments
used in the money market and is often sold at a discounted rate.
Q Investment in Money Market Instruments and Money Market
Deposits: These are the investments made in government and cor-
porate securities for a short span of time in order to earn a high
rate of interest on the investment. The investment can be made in
government T-bills, saving bonds and gilt-edged securities. Some
banks and brokerages also offer money market deposits; a money
market deposit is almost the same as a savings account but the ac-
cess and services are somewhat limited. The investor is paid back
in the form of high returns after the maturity period and he is also
provided with a check book to draw funds from the account in case
of need.

9.6.2 FINANCING SHORT-TERM DEFICITS

The main objective of the management is to minimise the requirement

of funds to the maximum extent and to raise finance at the lowest pos-
sible cost. Firms can use international money markets for financing
short term deficits, after taking into consideration various factors in-
volved and the effective cost of funding. It should be done in tune with
the overall treasury management objective of minimising borrowing
requirements and the overall cost consistent with current and future
liquidity needs. For MNCs, this means finding out first the internal
sources of funding from subsidiaries with excess cash. In case of exter-
nal borrowing, cash deficit organisations borrow funds from external

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NOTES

sources such as banks or financial institutions in the form of bank

overdrafts, short-term loans, advances, commercial papers and other
money market instruments. The rates of interest imposed by these
external sources are very high compared to the internal sources. It
increases the cost of raising funds and attracting investments for the
organisation and also decreases the profitability of the organisation.
External sources of funds include overdraft facilities, fixed term bank
loans, money market instruments, and so on. Similar to short-term
investments, the following factors should be considered in the case of
short-term borrowings:
Q Overall costs involved
Flexibility in repayment schedule
O

Credit rating requirements

oO

Structure of the facility with respect to corporate needs

oOo

Speed with which funding can be done

O

&e SELF ASSESSMENT QUESTIONS

5. are a bearer certificates and the holder
has sole title to the principal and interest to be paid on the
maturity.

Many of the short term US dollar money market instruments avail-

able for investment/lending in US money markets are also available
in the Eurocurrency markets. List the various instruments avail-
able in both the markets and identify the difference in features for
each of these instruments in the two markets.

CENTRALISED VS. DECENTRALISED

oe CASH MANAGEMENT

The concept of centralised and decentralised cash management tech-

niques are applicable for multinational corporations that have a num-
ber of subsidiaries operating in different countries and currencies.
Each subsidiary will have its own cash management function involv-
ing maintenance of optimal transaction and precautionary balances.
The subsidiaries will also have a number of intra-corporate transac-
tions between themselves, and between subsidiaries and the parent.
The centralised cash management of the parent company helps in
the effective movement of the cash from the cash deficit subsidiary of
the parent to its cash surplus subsidiary. Further, it may also help in
the management of the receivables and payables of the subsidiaries.
Suppose, one subsidiary has a reserve surplus in euro and the other

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NOTES

has cash deficit for the expenses in the euro. With the help of the cen-
tralised cash management system, the cash can be easily transferred
from the surplus to the deficit organisation, maintaining the balance
of the cash flow. These are the benefits associated with the centralised
cash management system. On the other hand, decentralisation of cash
management is also required in an organisation to meet the emergen-
cy needs of cash and to finance the new projects of the subsidiaries.
There are some instances when the subsidiary is in need of emergen-
cy funds to carry out its operations and, the transfer of cross-border
funds may take time due to processing and delay the operations. So, in
order to avoid such situations, decentralisation of the fund is required
to carry out the operations without any interruption. From the parent
company’s perspective, the cash management would involve two ma-
jor functions:
Q Managing Intra-Corporate Transactions: If the MNC has a num-
ber of intra-corporate transactions resulting in cash payments and
receipts between various entities, and if each subsidiary manages
its cash independently, it can result into unnecessary transaction
costs and inefficient management of cash from the perspective of
the parent. In order to manage these payments and receipts, the
concept of Netting can be implemented. Netting involves taking a
holistic picture of the intra-corporate payments and receipts and
reducing the actual number of transactions by making consolidat-
ed net payments and receipts. Netting refers to the international
cash management technique to control the cost of an organisation
by netting off all the payables against the receivables. It cancels
out all the cash outflows against the inflows, and arrives at the net
cash flow of an organisation.
Consider the following payment — receipt matrix in Table 9.2 be-
tween various subsidiaries of an MNC resulting out of intra-corpo-
rate trade and financial transactions:

TABLE 9.2: PAYMENT — RECEIPT MATRIX

Receiving Paying Subsidiary Total Net
Subsidiary United Great India Receipts Receipts /
States Britain Payments
United States -- 1000 2000 3000 -5000
Great Britain 3000 -- 4000 7000 0
India 5000 6000 -- 11000 5000
Total Pay- 8000 7000 6000 21000 0
ments

All payments/receipts are converted into a single common

currency.

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NOTES

As per Table 9.2, the Indian subsidiary has several transactions

with US and UK subsidiaries. As a result, it needs to make a pay-
ment of USD 2000 to US and USD 4000 to UK firms in a particular
period. On the other hand, it has receipts amounting to USD 5000
from US and USD 6000 from UK firm. If normal cash manage-
ment process is followed, this would result into four separate cash
transfer transactions between India and US alone. Instead, it can
net the payments with US and UK firms, and receive only the net
payments of USD 3000 and USD 2000, respectively. Similarly, by
netting process, US will make a net payment of USD 2000 to UK
firm. The UK firm will receive USD 2000 from US and make a net
payment of USD 2000 to the Indian firm. This process reduces the
overall number of transactions. This is called the “bilateral net-
ting” process where each subsidiary considers all its transactions
with another subsidiary.
The above bilateral netting can be further simplified if a cen-
tralised management is introduced. In this case, it will be realised
by the central division that it is unnecessary for UK firm to make
a payment of USD 2000 to Indian firm and receive USD 2000 from
US firm as the net effect on its cash balance is zero. Instead, the
whole set of transactions can be reduced to a single transaction of
US firm making a payment of USD 5000 to Indian firm through
the central cash management division. This process is called “Mul-
tilateral Netting”. This requires a centralised cash management
function which can be located in one of the subsidiaries or at the
parent firm.
The above example was only meant to illustrate how the multi-
lateral netting through a central cash management division can
greatly reduce the intra-corporate transactions — in the above case,
into just a single transaction. In the example, the payment-receipt
matrix consists of amounts in a common currency converted at an
agreed exchange rate. In the above case, for example, the common
currency could be US dollars. However, in the real world, each
payment and receipt would involve different currencies. The final
net settlement for the subsidiaries can be done in their respective
currencies. The number of required foreign exchange conversions
will be reduced due to the netting process. The payment will be
made to the central division which will execute the required FX
deals for making final net payments.
However, multilateral netting need not always be advantageous
due to implications for exposure and exchange rate risk manage-
ment. For example, the Indian firm may prefer receiving separate
payments — one in US dollars from US company and the other in
Pound Sterling from UK firm - instead of receiving a net payment
(in USD or INR) from the central cash management division, if it
has payables in Pound Sterling. Similarly, UK firm might prefer
receiving a payment in US dollars from US firm to hedge its US

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NOTES

dollar exposures. Hence, it may be necessary for the central cash

management division to look into the individual needs of the indi-
vidual subsidiaries where applicable, before netting.
Illustration 3: A multinational corporation has the parent firm lo-
cated in US and subsidiaries in UK and India. During a settlement
period, it is found that the UK subsidiary needs to make payment
to Indian subsidiary GBP 10 mn. The Indian subsidiary requires to
make payment to US parent firm USD 10 mn. The US parent firm
needs to make payment to UK subsidiary GBP 15 mn. The central
cash management division located in US decides to do multilater-
al netting. What would be the resultant payments? (Assume fol-
lowing exchange rates: USD-INR 65; GBP-USD 1.5). What are the
forex deals involved?

Solution: The payment-receipt matrix in respective currencies is

given as follows:

US Fi UK Firm (GBP) _ Indian Firm

US Firm
An 10
aN)
(650)

UK Firm( (225) 15
Indian Firm (10) 975
Total 9 (12.5) 5 325
As per the table above, the US firm will make a net payment of
USD 12.5 mn to central division. The UK firm will receive GBP 5
mn and Indian firm will receive INR 350 mn.

The USD 12.5 mn will be used to purchase GBP 5 mn at GBP-USD

1.5 amounting to USD 7.5 mn. The remaining USD 5 mn will be
converted at INR 65/USD to INR 325 mn and paid to Indian sub-
sidiary. Thus, there will be two FX spot deals involved.
Managing Surplus and Deficits: The next important function
from the perspective of parent firm is the management of cash
surplus and deficits of individual subsidiaries. If each subsidiary
manages its own needs, it may not be an efficient and optimal ap-
proach from the perspective of the parent firm.
Each subsidiary will be performing short term cash planning to
manage its cash outflows and inflows over a period by preparing
cash budgets. These cash budgets will indicate the days on which
it will have excess cash and the days it needs to borrow. On this
basis, it might decide on its short term borrowal/investment plans.
When each subsidiary undertakes such investment/borrowing
based on its own needs, it could be costly and inefficient for the
organisation as a whole. For example, on the days the UK sub-
sidiary has plans for borrowing in US dollars, the US subsidiary
might have excess cash and might be looking out for investment
opportunities. It makes sense if the US subsidiary lends to the UK

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NOTES

subsidiary instead of both of them undertaking money market

transactions.
In order to make such decisions that are beneficial for all parties,
the centralised cash management division can adopt “Cash Pool-
ing” process. In cash pooling, all the subsidiaries will be required
to transfer their extra surplus cash to the central division for on-
ward lending to deficient subsidiaries. Cash pooling facilitates the
merger of all the credit and debit positions of the organisation, in
different accounts, into a single account to avoid the transaction
fees. In addition, it helps the organisation to improve the liquidity
position, by internal transfer of funds from the cash surplus units
to the cash deficit units. The deficient subsidiaries will be required
to first post their requirements to the central division before un-
dertaking money market activities. The borrowing/lending will be
done at mutually agreed interest rates as per corporate policy.
There are two types of cash pooling: Cash Concentration (or Phys-
ical Pooling) and Notional Pooling:
In cash concentration or physical pooling, funds from separate
accounts of different subsidiaries are automatically transferred to
a cash concentration header account. This ensures that the MNC
does not have idle cash flows in its bank accounts and also provide
cash for meeting requirements of deficient units. The sweeping of
funds might involve zeroisation of accounts or based on pre-set
rules regarding minimum balance or amount that can be trans-
ferred etc. The pooling can be done in the same currency across
multiple legal entities located in different countries. The move-
ment of cash will actually be accounted for as inter-corporate
loans.
In the case of notional pooling, there will be no actual transfer of
cash from the bank accounts. Notional pooling is done through a
set of virtual accounts. The cash management service offered by
the bank will provide an interest statement that reflects the net
offset based on notional pooling. It is an agreement for saving the
spread between the debit and credit interest rates. The bank will
not charge interest on gross debit balances nor pay interest on
gross credit balances but pay interest on the net credit balance.
Though cash pooling looks like a simple concept, the actual imple-
mentation involves a number of factors to be considered. These
include presence of multiple currencies, exposure / hedging man-
agement requirements, taxation issues, legal issues, technical is-
sues etc. For example, sweeping the account balances to a header
account for cash concentration would amount to creation of in-
ter-corporate loans as per legislations of some countries which
would require a lot of additional regulatory factors including ac-
counting requirements to be considered. Similarly, multi-curren-
cy cash concentration, if undertaken, would involve a number of

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NOTES

overnight currency swaps to be executed by the bank making it

cost prohibitive. In such cases, multi-currency notional pools can
be an appropriate solution.
Though, it may not be feasible to perform centralised cash plan-
ning for all the firms, the centralised cash management division
can decide on right course of action regarding the investment and
borrowing needs of individual subsidiaries by aggregating their
needs and initiating appropriate actions on their behalf.
Similar to the multilateral netting process, it will be essential for
the central division to consider the forex exposure management
issues in the case of cash pooling also. For example, if the UK sub-
sidiary has excess cash in pound sterling while Indian subsidiary
requires cash in US dollars, it may not necessarily be advisable to
use the extra cash of UK subsidiary for the needs of Indian subsid-
iary. If the interest parity and currency movements are such that it
is more advantageous to borrow in US dollars and invest in Pound
Sterling instead of converting the pound sterling to US dollars to
meet the needs of Indian subsidiary (after considering transaction
costs involved), the central division should take the decision ac-
cordingly whereby the UK firm will invest Sterling money markets
while the USD needs of Indian subsidiary will be met by other
means.
Apart from exposure management issues, the other issues with
centralised cash pooling is the legal restrictions in this regard with
several countries. Many countries may not allow netting or pooling
activities by the parent firm due to capital movement restrictions.
Also, as already mentioned, there could also be tax related regula-
tory issues.

ee SELF ASSESSMENT QUESTIONS

6. refers to the international cash management

technique to control the cost of an organisation by netting off
all the payables against the receivables.

With the help of the Internet, find out the pros and cons of notional
pooling as a cash pooling solutions.

[EE CASH TRANSMISSION

While making payments to creditors or realising receivables, there can
be a time delay between the time a cheque is issued and the funds are
available for transactions. This is termed as the “float”. The unneces-
sary cost of transaction for making payment to the creditors and ac-

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NOTES

cepting the cash back from the debtors is called ‘float’. It is so because
the debtors often make payment in the form of cheques and drafts
which take a minimum time of one or two days for clearance. Cash
management should also aim to minimise the float while receiving
payments and take advantage of the same while making payments.
The float is dependent on the payment mechanism or clearing system
involved.

Clearing house interbank payments system (CHIPS), clearing house

automated payments system (CHAPS), and society for worldwide in-
terbank financial telecommunication (SWIFT) are some of the elec-
tronic networks which are used widely by organisations around the
world to carry out the inter-country as well as the intra-country cash
transactions easily and quickly. CHIPS is widely used in the US.,
CHAPS in the U.K. and SWIFT in the Asian countries such as India.
For the better and effective use of these electronic networks for receiy-
ing and paying the cash easily, the MNCS involved in such operations
need to train their treasurers. The banking system around the world
has also come out with new facilities such as lock-box and direct debit
to serve the clients with better cross-border transactions. The change
and innovation in the technology and implantation of the new tech-
nique has revolutionised the banking system around the world and
has contributed to the efficient cash transmission between the parties.

FZ SELF ASSESSMENT QUESTIONS

7. The unnecessary cost of transaction for making payment to

the creditors and accepting the cash back from the debtors is
called

Compare and contrast the multi-currency cash management ser-

vices offered by top five global banks.

EX] summary
Q Short term financing refers to borrowing funds for a short period
of time. The market that caters to the short term financing needs
of corporates and financial institutions is termed as money market.
Q The various short-term instruments available in these money mar-
kets are short-term loans, short-term notes, commercial papers
etc. The commercial papers are the most widely used instrument
for working capital financing needs of corporates.
Q LIBOR is used as a benchmark reference rate in international fi-
nancial markets. It is the rate for all unsecured short term money
market instruments. It is quoted as an annualised interest rate as
per market convention.

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The excess of surplus cash flow in the parent organisation or its

subsidiaries can be used to cater for the short-term needs or the
operational needs or the working capital requirements. These
MNCs might have operations in many geographies through their
various subsidiaries and affiliate companies. It may be cheaper to
look for subsidiaries with excess funds who can lend instead of
searching for external sources of financing.
The exchange rate of the currency in the FOREX market is highly
volatile and dynamic in nature. Its currency changes with every
currency buy and currency sell transaction that takes place in the
market.
The criteria for foreign financing depends upon interest parity
conditions, expected currency movements and exchange rate fore-
casts.

A firm can decide to source short term funds from foreign markets
if it finds it more attractive or feasible. Similarly, a firm with sur-
plus cash can decide to invest in foreign money markets.
The concept of centralised and decentralised cash management
techniques are applicable for multinational corporations that
have a number of subsidiaries operating in different countries
and currencies. Each subsidiary will have its own cash manage-
ment function involving maintenance of optimal transaction and
precautionary balances. The subsidiaries will also have a number
of intra-corporate transactions between themselves, and between
subsidiaries and the parent.
The unnecessary cost of transaction for making payment to the
creditors and accepting the cash back from the debtors is called
‘float’. Clearing house interbank payments system (CHIPS), clear-
ing house automated payments system (CHAPS), and society for
worldwide interbank financial telecommunication (SWIFT) are
some of the electronic networks which are used widely by organi-
sations around the world to carry out the inter-country as well as
the intra-country cash transactions easily and quickly.

Cash surplus: It is the excess position of cash of an organisation.

Cash deficit: It is the shortage of cash position of an organisation.
Credit spread: Additional spread to be paid by the borrower on
the LIBOR depending on the credit worthiness.
Exchange rate: It refers to the rate at which one currency is
converted into another currency.

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Q Exposure: It refers to the proportion of the market risk affect-

ing apart of the assets or portfolio.
Q Forecasting: It refers to estimating future outcomes on the ba-
sis of the past or recent trends.

DESCRIPTIVE QUESTIONS
1. What do you mean by short term international financing?
2. What is the criteria for foreign financing?
3. Write a short note on cash transmission.

a8 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Answer
Short-term International Financing
and its Sources
Internal Financing by MNCs 2. “Internal financing
Determination of the Effective Fi- 3. Wa V
nancing Rate —
Criteria for Foreign Financing Exchange rate forecasting
Management of Surplus Cash a. se of deposits
Centralised vs. Decentralised Cash 6. Netting
Management
Short-term International a Float
and its Sources

HINTS FOR DESCRIPTIVE QUESTIONS

1. Short term financing refers to borrowing funds for a short
period of time. Refer to Section 9.2 Short Term International
Financing and Its Sources.
2. The organisations use foreign financing to enjoy the low rate
of interest charged on the foreign currency. Refer to Section
9.5 Criteria for Foreign Financing.
3. Clearing house interbank payments system (CHIPS), clearing
house automated payments system (CHAPS), and society for
worldwide interbank financial telecommunication (SWIFT)
are some of the electronic networks which are used widely by
organisations around the world to carry out the inter-country as
well as the intra-country cash transactions easily and quickly.
Refer to Section 9.8 Cash Transmission.

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NOTES

SUGGESTED READINGS FOR

9.12
REFERENCE

SUGGESTED READINGS
Q Apte, P (2002). International financial management. New Delhi:
Tata McGraw-Hill Pub.
Q Eun, C., & Resnick, B. (2007). International financial management.
Boston: McGraw-Hill/Irwin.
Q Madura, J. (2003). International financial management. Mason,
Ohio: Thomson/South-Western.

E-REFERENCES
Q Encyclopedia Britannica, (2015). short-term financing. Re-
trieved 19 November 2015, from http://www.britannica.com/topic/
short-term-financing
Q = Wellsfargo.com,,. (2015). International Financing and Credit — Wells
Fargo Commercial. Retrieved 19 November 2015, from https://www.
wellsfargo.com/com/international/businesses/financing-credit/
Q Www-personal.umich.edu,. (2015). Retrieved 19 November 2015,
from http://www-personal.umich.edu/~steiss/page11.html

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LONG-TERM INTERNATIONAL FINANCING

CONTENTS

10.1 Introduction
10.2 Concept of Long-term International Financing
Self Assessment Questions
Activity
10.3 Sourcing Equity Globally
10.3.1 US Stock Markets
10.3.2 European Stock Markets
10.3.3 Asian Stock Markets
10.3.4 Depository Receipts
Self Assessment Questions
Activity
10.4 Factors Affecting International Equity Returns
Self Assessment Questions
Activity
10.5 Advantages of Sourcing Equity Globally
Self Assessment Questions
Activity
10.6 Sourcing Debt Globally
10.6.1 Forex Risk
10.6.2 Cost of Debt
Self Assessment Questions
Activity
10.7 Summary
10.8 Descriptive Questions
10.9 Answers and Hints
10.10 Suggested Readings for Reference

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INTRODUCTORY CASELET

DOES INDIA NEED TO WORRY ABOUT OVERSEAS

CORPORATE BORROWING?

The past couple of years have been great for bankers working
in the debt-capital market business. Global financial markets are
facing a shortage in supply of funds; yields in developed markets
are at historic lows; and domestic interest rates have been high.
In this scenario, it is not surprising that a number of Indian com-
panies have chosen to borrow internationally through foreign
currency loans and bonds. This is true not just for India but also
for all emerging markets, where overseas borrowings have risen
and the borrowing mix has changed in favour of foreign currency
bonds.

Earlier this week, the Bai 1 Settlements (BIS)

highlighted this increase owings and cautioned
that it could expose co sheets to shocks if such
borrowings are no d. In the course of its anal-
ysis, the BIS no t se of some active debt issuers
such as property hina or energy and utilities firms
in India, foreign ssets and liabilities may not be well
ble “pockets of risk” in these sectors’.
worth analysing further.

ings (ECBs) from India have been on the rise.

e data obtained from Bloomberg, ECBs have risen

3 billion has been raised via ECBs. Foreign currency

uances, which form a part of ECBs, have also increased
from close to $3 billion in 2005 to $16.4 billion in 2018, according
to a recent Moody’s report which quoted data from Dealogic, a
market data provider. In the first seven months of 2014, $15.9 bil-
lion has been raised via such bonds and issuances are set to hit a
record high this calendar year, noted the Moody’s report.

While foreign currency borrowing amounts have risen, they still

constitute a tiny fraction of the overall credit availed by Indian
companies, and most of it is sourced through domestic banks.

Furthermore, these foreign currency borrowings remain tight-

ly regulated by the Reserve Bank of India (RBI), which has im-
posed restrictions on the use of foreign currency borrowings. For
instance, issuers cannot use foreign currency borrowings for do-
mestic acquisitions, for working capital or for repayment of exist-
ing rupee loans. These restrictions narrow the spectrum of com-
panies looking to raise foreign debt.

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INTRODUCTORY CASELET

There is also a restriction on the cost of foreign borrowings via the

all-in-cost ceiling imposed by the RBI, which remains in place de-
spite lobbying from the industry to remove this ceiling. The cen-
tral bank, however, did not yield to those requests and, hence, a
ceiling of 350 basis points over the six-month London Interbank
Offered Rate (LIBOR) is imposed on borrowings between three
and five years. For borrowings with tenures of more than five
years, the ceiling is 500 basis points over LIBOR.

So far, things look quite in balance. Nevertheless, some concerns

have started to creep in—many borrowers have claimed that they
have a ‘natural hedge’, which suggests that dollar assets or earn-
ings adequately cover their dollar liabilities. However, as the BI
points out, it’s not clear whether these assets and liabiliti
well matched, especially in the case of oil and utility fi

The other problem is the growing talk about ‘high-yie

from lower-rated borrowers. So far, only a handfu

India. Moreover, the refinanc companies would

be higher if the repayment of tl ncip ount is due at a
time when markets are not as luc they currently are.

In fact, the risk of re i reign

currency bond borrowings
in for all borrowers, as point-
ed out by the BIS. Just obal markets are currently flush
with funds and investors are chasing yield, this does not necessar-
ily imply that these conditions will last forever. Rolling over loans
tends to be easier than the chunky refinancing requirements in
the case of overseas bonds. All things considered, the cautionary
note from the BIS seems to be just that—a reminder to exercise
caution while considering and analysing foreign currency bor-
rowings.
(Source: “Does india need to worry about overseas corporate borrowing?”
livemint, September 18, 2015.)

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NOTES

© LEARNING OBJECTIVES

After studying this chapter, you will be able to:

»— Discuss the concept of long-term international financing
2— Explore the various factors involved in international financ-
ing decision
2— Describe the mechanism of raising funds from European
and Asian stock markets
»— Explain the factors affecting international returns
»— Discuss the advantages of sourcing equity globally
»— Explain the forex risks i d in sourcing international
debt
2— Describe the compone ebt and the methods of
calculating theme

1088 INTRODUCTION

In the previous chapter, you studied the sources, instruments and fi-
nancing criteria with regard to short-term international financing and
cash management. In this chapter, you will study about long-term in-
ternational financing.

Unlike short-term financing, which primarily involves international

money markets, long-term financing involves both international eq-
uity markets and international debt markets. A corporation can opt
to finance its projects by mobilising funds from international mar-
kets through equity or debt depending on its capital structure deci-
sion. It can do so by accessing various international financial markets
through appropriate financial instruments. We have already studied
about international equity markets and international credit and debt
markets in Chapter 2. In this chapter, we shall study further on the
various opportunities for raising long-term international finance and,
more importantly, the decision criteria.

TY CONCEPT OF LONG-TERM
wy INTERNATIONAL FINANCING
Long-term international financing refers to raising equity capital or
long-term debt from international markets by domestic and multina-
tional companies. Domestic companies might raise funds in foreign
markets to lower the cost of capital or for capital expenditure in for-
eign currencies while MNCs might do so for financing their subsidiar-
ies.

The long-term source of financing from international markets has

arisen due to rapid globalisation and integration of financial markets

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NOTES

in recent decades. MNCs can now raise funds from foreign markets as
easily as they would do it from domestic markets. The mode of raising
equity finance can involve public issues, private placements or Eu-
ro-equity issues. International debt finance could be in the form of
fixed rate loans, floating rate loans, Eurocredits, syndicated loans, Eu-
robonds and foreign bonds.

International equity financing can be analysed from the perspective

of:

1. International investors

2. Market integration
3. Cost of capital and capital structure

Now, let us discuss these perspectives individually:

1. International investors: Why should investors seek to invest
in equities of foreign companies? The obvious answer to this
question is ‘to develop an optimum portfolio’. As per the theory
of portfolio investment and management, an optimum portfolio
is one where the portfolio return per unit of risk is maximum.
This translates into reducing the overall risk on the returns of
the portfolio without affecting the overall targeted return. As
per the portfolio theory, a more diversified portfolio reduces
the risk and increases the return per unit of risk. For large
institutional investors, this implies diversifying beyond the
stocks available in domestic markets. Since the economies of
different countries move in different ways according to their
own growth and business cycles, the correlation between stock
markets is minimal. Moreover, lower correlation between stock
markets leads to higher levels of diversification and overall
returns, and institutional investors find investing in stocks from
different countries useful in creating an optimum portfolio.
Hence, investments in equities of international companies have
become necessary for large institutional investors. However,
international investors can invest in equities of foreign companies
either directly through the respective domestic equity markets
or by subscribing to the international equity issues in terms of
cross-listing, Euro-equity issues or depository receipts. Hence,
for highly rated corporates, international investors are always
available for mobilising equity finance.
2. Market integration: In an ideal world, if global financial
markets are fully integrated, any investor seeking to diversify
his portfolio with blue chip stocks from other countries should
be able to do so by directly investing in those companies through
the respective national stock exchanges. However, in reality,
investors may not be able to invest directly in the equity shares
of companies from other countries due to regulatory and capital
movement restrictions. Moreover, even if they are able to invest,

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NOTES

they may not have the same kind of liquidity and ease of operation
which is available when investing in domestic companies. These
difficulties have led to the development of mechanisms such as
cross-listings, depository receipts, globally registered shares and
Euro-equity issues. Through these mechanisms, investors can
invest in foreign companies with the same ease as in domestic
stocks. Hence, corporates need to decide the mode of raising
international finance once a decision has been made to approach
international markets. In this regard, the mode of depository
receipts is the widely followed method for raising international
equity. We have studied in detail about depository receipts in
Chapter 2.
3. Cost of capital and capital structure: What will be the impact
of international equity financing on the capital structure and the
cost of capital of the firm? As per the finance theory the impact,
this depends on the extent of market segmentation. A market is
termed segmented if the investors of the market can diversify
only with stocks available in the domestic market. Alternatively,
foreign investors cannot diversify their risks by investing in
stocks of these markets. Since the return on stocks depends on
the risk involved, the return on segmented markets will be based
on the risks associated with a particular market. In contrast, if
the markets are integrated, an investor from any country will be
able to invest in stocks of companies from other countries. This
means, in the integrated market scenario, the market risk is not
restricted to the systemic risk of the domestic economy alone.
When stocks are invested by investors from many economies, this
leads to diversification of risks and hence lower cost of capital for
companies. In other words, if the markets are segmented, the
cost of capital for the firm depends on the risks pertaining to the
domestic economy alone. If such a firm is able to raise finance
from international investors, the overall cost of capital can come
down. Hence, as long as the equity markets are segmented, it
should be possible to lower the cost of capital by accessing
foreign markets. In other words, there will be no advantage in
raising equity finance from foreign markets, if investors are able
to invest directly in stocks across borders. Since international
markets are hardly integrated from this perspective, there are
advantages in raising equity finance from foreign markets.

After analysing the factors that affect international equity financ-

ing, let us examine the factors that affect international debt financ-
ing. While in the case of equity finance, the cost of capital depends
on the risk-return profile applicable, the motive for international debt
financing is mainly to seek cheaper sources of funds and to minimise
the currency risks involved. Each country has a different set of factors
that affect the cost of debt financing, viz., economic conditions, gov-
ernment policies, monetary environment, business cycles, etc. Hence,
the cost of debt is different in different countries. However, as we saw

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NOTES

in the case of short-term financing, the cost of debt cannot be evalu-

ated without considering the exchange rate risks involved. We shall
study more about this in a later section.

& SELF ASSESSMENT QUESTIONS

1. Thereason why investors seek to invest in foreign/international

equity or debt is:
a. To gain higher returns
b. To diversify risks
ce. Both of the above
d. None of the above
2. If financial markets are fully integrated, then there will be no
advantage in issuing equities internationally. (True/False)
3. When markets are segmented, corporates can raise
international equity and lower their cost of capital by providing
a means for international investors to diversify their risks.
(True/False)

Ob Rxeewe
Conduct a research and make a note of your findings with regard
to the following:

‘International stock exchanges provide a platform for stock trading

across borders, geographies and time constraints. A wave of con-
solidation of stock exchanges across Europe has led to a common
platform for stock trading across many countries. Can this trend
ultimately lead to investors from anywhere in the world being al-
lowed to invest in stocks of any countries? What are the legal and
regulatory impediments for this to take place and how can they be
overcome?’

SOURCING EQUITY GLOBALLY

In the previous section, we discussed that there will be no advantage
in raising equity finance from international markets if global equity
markets are not well integrated in such a way that an international in-
vestor can directly invest in equities of foreign companies. This would
nullify any cost of capital advantages in foreign equity financing, since
the risk-return profile will be same for all investors. However, since
markets are segmented, companies can find it advantageous to source
equity from international markets and thereby lower the cost of cap-
ital.

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NOTES

The cost of equity capital is defined as the opportunity cost which

investors can earn from alternate investment avenues with a similar
risk profile. If international investors find better alternative invest-
ment avenues in the domestic market that provide higher return for a
given level of risk, they may not find international equity investments
attractive. However, such decisions are made from the perspective of
portfolio returns which require consideration of correlation of stock
returns with portfolio returns. From this perspective, investment by
international institutional investors in foreign equities can become at-
tractive. While the risk aspect depends on the correlation of stock re-
turns with portfolio returns, the return also depends on various other
factors. This includes the risk-free rate and risk premium applicable
for the domestic equity markets. Both these factors are dependent on
the internal economic factors of the country of the firm that issues the
stock. For example, the return of the Infosys stock listed in the US
stock exchange is not dependent on the market risk of the US or of
any world market portfolio, but on the market valuations applicable
for IT stocks in Indian stock markets. The market valuations depend
on the risk premium applicable for Indian stock markets at any time
for the industry and the economy.

For firms that decide to mobilise capital from international markets,

there are multiple routes available. As we have already studied in
Chapter 2, companies now have wide means of raising international
equity finance through various modes as listed below:
1. Foreign Institutional Investment
Cross-listing
eet

Depository Receipt (DR)

Globally Registered Shares (GRS)
Direct International Listing
SO

Equity finance can be raised from foreign institutional investors ei-

ther in domestic capital markets itself or through private placement
in foreign markets. In either case, though the financing is done by
foreign institutional investors, there is no listing of equity shares in
foreign markets. Since all foreign institutional investors may not be
trading actively in local equity markets, they would prefer to trade on
stocks through their domestic stock exchanges. This constraint has
led to the modes of cross-listing and depository receipts. By listing
shares in different equity markets, companies can directly raise equi-
ty finance from investors of the respective foreign markets. This could
be in the form of direct listing or globally registered shares or through
the mode of depository receipts. Direct international listing refers to
listing in foreign markets without presence in the domestic markets.
In Eurocurrency markets, it is possible to issue shares to foreign in-
stitutional investors outside domestic markets through ‘Euro-equity
issues’. These are the issues of equity in multiple financial markets.

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NOTES

In ‘Eurocurrency Markets’ the term ‘Euro’ neither refers to an in-

strument being denominated in the Euro currency nor implies that
the issue is restricted to European Union countries.

International equity financing can take any of the following routes:

Q Issuing shares ina particular foreign stock market underwritten by
institutions from the host country. This can also be done through
a private placement with financial institutions without any public
issue or listing in foreign stock exchanges.
Q Issuing equity to foreign investors in more than one country simul-
taneously through Euro-equity issues.
Q Issuing equity shares of a foreign subsidiary to investors in the
host country.
Q Selling shares to a foreign firm as part of a strategic alliance.

The first two routes mentioned above will be applicable when com-
panies cross-list shares or issue depository receipts or Euro-equity
issues. As we saw earlier in Chapter 2, only Level 3 ADR programme
would involve actual raising of capital. Hence, cross-listing and depos-
itory receipts can also provide means for foreign investors to invest
and trade easily on foreign stocks. Cross-listing also opens the pos-
sibility of directly raising equity finance in the future in the respec-
tive foreign equity markets. Many companies have also found that
cross-listing can significantly increase their overall valuation.

10.3.1 US STOCK MARKETS

The US stock markets are the largest of all stock markets in the world.
The two major US stock exchanges are NASDAQ and NYSE. As of
2010, the total market capitalisation of the US stock markets was
around 30% of the global stock market capitalisation. The US markets
are also one of the largest stock exchanges in terms of the number
of foreign companies cross-listed. As of 2010, NASDAQ had 298 for-
eign companies listed, while NYSE had 518 foreign companies listed.
However, the trading volume of cross-listed shares does not constitute
much of the total trading volume.

Foreign companies planning to access US investors have the option of

either cross-listing their shares directly on NASDAQ / NYSE or issu-
ing American Depository Receipts (ADRs) on these exchanges. Direct
cross-listing would require compliance with the stringent US Secu-
rities and Exchange Commission (SEC) regulations and disclosure
requirements. Though the number of cross-listed shares in US stock
exchanges increased in the 1990s, it fell during the 2000s, which was
attributed by many to the stringent disclosure laws like Sarbanes-Ox-

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NOTES

ley Act. Apart from adhering to the regulations of the SEC, companies
also need to comply with the listing requirements of the respective
exchanges. As of 2015, most of the cross-listed shares in the US stock
markets belong mainly to the Canadian companies.

We have studied about the ADR mode of raising finance in Chapter

2. Table 10.1 below presents the salient features of different types of
ADR programmes:

TABLE 10.1: FEATURES OF ADR PROGRAMMES

Description Stock Exchange Disclosure
Requirements
ADR Level I Unlisted Traded over-the- No GAAP
Programme counter (OTC) requirements
ADR Level II Listed, but n: SDAQ Partial reconcil-
Programme capital r. iation require-
ments for finan-
~ cials
ADR Level III Fresh capital NYSE, NASDAQ’ GAAP reconcil-
Programme raised and listed iation and full
SEC compliance
required
Rule 1 eUS US private place- No GAAP
Pp. ent to ment market requirements
ualified institu-
onal buyers

Rule 144A, as mentioned in Table 10.1 refers to private placement of

equities of foreign companies with qualified US institutional inves-
tors, which are not listed in stock exchanges. It is a safe harbour ex-
emption from the registration requirements of Section 5 of the US
Securities Act for certain offers and sales of qualifying securities by
certain persons other than the issuer of securities. It applies to resale
of securities to qualified institutional buyers as defined by the SEC.

10.3.2 EUROPEAN STOCK MARKETS

The London Stock Exchange (LSE) is the largest of the European

stock exchanges. It has the largest number of cross-listed foreign com-
panies among the global stock exchanges. The AIM (Alternative In-
vestment Market) segment of the LSE provides an avenue for emerg-
ing companies (refer Chapter 2).

After the LSE which has around 6.58% of world stock market capi-
talisation, the Euronext is the next major stock exchange with 5.34%
world market capitalisation. The Euronext was the result of the merg-
er wave among world stock exchanges in recent decades. The stock
exchanges of Amsterdam, Brussels and Paris merged to form the Eu-
ronext in 2000. Later, NYSE merged with Euronext in 2007 leading
to the formation of NYSE Euronext. Similarly, NASDAQ formed the

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NOTES

NASDAQ-OMX group constituting the stock exchanges of Finland,

Sweden, Denmark, Iceland, Latvia, Lithuania and Estonia.

A merger proposal between Deutsche Borse AG and NYSE Euronext

to create the world’s largest exchange was blocked by European regu-
lators in 2012 to prevent monopoly.

LUXEMBOURG STOCK EXCHANGE

The stock exchange of Luxembourg, a small country in Europe, is

ranked the first in Europe in the listing of international bonds. The
Luxembourg stock exchange was the first-ever exchange to list Eu-
robonds in 1963. It is retaining its leadership position in Europe with
more than 3000 issuers, 40,000 securities and 26,000 debt securities
listed on the exchange. More than 70 countries have listed their sover-
eign debt at Luxembourg. The stock exchange is also a major player in
Global Depository Receipts. More than 250 issuers from 17 countries
have listed their GDRs in Luxembourg. It is the leading exchange for
GDRs in Europe, ahead of the London Stock Exchange and the next
only to NYSE in worldwide ranking.

GDRs of Indian companies constitute the majority listed at Luxem-

bourg. Out of 250 issuers, around 171 GDR issuers were from India. It
has a separate GDR index for issues from India, viz., ‘Lux GDRs India
Index’. More Indian companies have listed their GDRs in the Luxem-
bourg stock exchange than in any other stock exchange.

10.3.3 THE ASIAN STOCK MARKETS

The Asian stock markets have been a main source of funds for the
Asian companies. The stock market capitalisation of Asian countries
is comparable to their total banking sector assets, in contrast to the
developed countries, where banking firms mostly function as finan-
cial intermediaries. New equity raised in 2012 through Asian stock
markets amounted to $ 198 billion compared to $ 234 billion in the
Americas and $ 102 billion in Europe, Middle-East and Africa (EMEA)
combined. More than 20,000 companies had been listed in the Asian
stock markets by the end of 2012 (IMF, 2014).

Asia’s stock markets are becoming more and more integrated with
international financial markets with the magnitude of foreign invest-
ment in many of the region’s stock markets growing rapidly. This im-
plies that major corporates from these countries can rely on local capi-
tal markets for accessing foreign institutional investors. Cross-listings
and depository receipts from Asian and other nations have also in-
creased exponentially. Foreign listings in Asian stock markets are
around 2% of the total as compared to 10% in Americas. This is apart
from companies from these regions accessing global capital markets
for equity finance towards lower cost of capital, higher valuations and
visibility.

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NOTES

Some of the major stock exchanges in Asia are located in Hong

Kong, China, Japan, Singapore, Malaysia, Korea, Taiwan, India and
Indonesia.

10.3.4 DEPOSITORY RECEIPTS

A depository receipt (DR) is an instrument in the form of a negotiable

certificate created by the overseas depository bank outside the coun-
try of the issuer and issued to non-resident investors against the issue
of equity shares of the issuing company. A DR represents one or more
shares of the issuing company and is denominated in foreign curren-
cy. The holder of the DR has the option to convert it into the number
of shares it represents. Two-way fungibility (that enables DRs to be
converted into the underlying assets and vice versa) is now possible
for Indian DRs. This ensures that DRs do not quote excessive premi-
um over local stock prices at the foreign bourses where they are listed.

DRs do not carry any voting rights unless converted into ordinary
shares. They are issued by companies to an intermediary abroad
called the Overseas Depository Bank. The equity shares representing
DRs are registered in the name of the Overseas Depository Bank.

DRs issued in the US and listed in the US stock exchanges denominat-

ed in dollars are termed American Depository Receipts (ADRs). DRs
issued to non-US investors in European stock exchanges or elsewhere
are termed as Global Depository Receipts (GDRs). GDRs are generally
denominated in US dollars but can theoretically be denominated in
any currency. GDRs settle and trade through the European clearing
systems and may be listed on any of the European exchanges. The
London and Luxembourg stock exchanges are the two major places
where GDRs are traded. GDRs can access two or more markets like
Europe and the US. GDRs issued with US component are structured
as a private placement under Rule 144A (referred earlier) and the
European component to comply with Regulation S (termed Regula-
tion S GDRs).

We have already discussed features of ADRs and GDRs in the context

of international equity markets in Chapter 2. Refer this chapter for the
features, advantages to investors/issuers and different types of ADR
programmes.

& SELF ASSESSMENT QUESTIONS

4. Which of the following are the modes of international equity

financing?
a. Cross-listing b. Depository receipts
c. Globally registered shares d. All of the above

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NOTES

Conduct research to find out the reasons for the Luxembourg stock
exchange attracting the maximum number of Indian GDRs. Also
analyse the causes.

TY FACTORS AFFECTING INTERNATIONAL

m=) EQUITY RETURNS

Researchers have identified the following as the possible factors that

can affect the international equity returns (Eun and Resnick):
Q Macroeconomic factors

Q Exchange rates
Q Industrial structure

Let us discuss these factors in details:

Q Macroeconomic factors: A study by Solnik (1984) found that in-

ternational monetary variables like exchange rate changes, in-
terest rate differentials and inflation expectations had only weak
influence on equity returns in comparison to domestic variables.
Another study by Asprem (1989) found that factors like changes
in industrial production, employment and imports, the level of in-
terest rates and an inflation measure explained only a small por-
tion of the variability of equity returns for 10 European countries;
however, a significant portion of the variation was explained by an
international market index.
Q Exchange rates: A study by Adler and Simon (1986) on the ex-
posure of a sample of foreign equity and bond index returns to
exchange rate changes found that the changes in exchange rates
generally explained a larger portion of the variability of foreign
bond indices than that of foreign equity indices. They also found
that some foreign equity markets were more exposed to exchange
rate changes than were the respective foreign bond markets. Eun
and Resnick (1988) found that cross-correlations among major
stock markets and exchange markets are relatively low but posi-
tive, implying that exchange rate changes reinforce stock market
movements.

Q Industrial structure: Studies on whether the industrial structure

affects foreign equity returns are inconclusive. Roll (1992) con-
cluded that the industrial structure of a country was important in
explaining a significant part of the correlation structure of inter-
national equity index returns. He found that the industry factors
explained a large portion of the stock market variability than the
exchange rate changes. However, Eun and Resnick (1984) found
that the pair-wise correlation structure of international securi-

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406 INTERNATIONAL FINANCE

NOTES

ty returns could better be estimated from models that recognise

country factors than industry factors.

FZ SELF ASSESSMENT QUESTIONS

5. Studies on whether the industrial structure affects foreign

equity returns conclusively assert that there is a direct
relationship between the two. (True/False)

Conduct a literature survey of the latest findings on factors affect-

ing international equity returns.

10.5 ADVANTAGES OF SOURCING EQUITY

wy GLOBALLY
Firms might raise equity from international equity markets for any of
the following reasons:
Q Limited size of the domestic market: One of the first major inter-
national equity offering was made by British Telecom (BT). When
the UK government decided to privatise BT, it believed that the
UK stock markets were too small to absorb such a large public
offering. Hence, it made an international equity offering simulta-
neously across the UK, Canada and the US and also distributed
across Europe and the Middle East. Similarly, many of the ma-
jor emerging market privatisations like Telmex, Telkom Malaysia,
ete., took the route of international equity offering.
There were also foreign companies like MTS which went public,
ignoring the local equity market by directly listing in the NYSE
and raising GBP 323 million.
Q Access to lower cost of capital and improvement in valuation:
Companies can also achieve higher valuation with international
equity offerings. For example, the Novo Industry A/S, a Danish in-
dustrial enzymes giant, raised equity and listed its stock on the
NYSE and found that its valuation increased dramatically.
When the German government privatised Deutsche Telekom,
it resorted to international equity offerings in order to get a bet-
ter valuation. The IPO raised $13.3 billion in 1996 from domestic
and international investors. Later, the first follow-on issue in 1999
raised $10.2 billion through international equity offering. The sec-
ond follow-on offering raised $14.8 billion through investors from
all EU countries.
Q Increased global reputation of the firm: Many firms also list in
international stock exchanges in order to increase their visibility
and reputation.

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 LONG-TERM INTERNATIONAL FINANCING 407

NOTES

Q Access to a broad investor base: Although Japan had the world’s

second largest stock market in terms of market capitalisation, Toy-
ota Motors made a secondary offering raising $1.2 billion through
an international equity offering by listing in US stock exchanges.
The objective was to broaden the investor base and commit to the
international business standards.
Q Simultaneous trading of shares across borders/geographies:
The concept of globally registered shares (GRS), as discussed in
Chapter 2, allows equity shares to be traded across different stock
exchanges in several countries simultaneously. Some examples of
GRS include Deutsche Bank’s GRS on NYSE and UBS’s GRS on
NYSE and Swiss stock exchanges.
Q Assistance in mergers and acquisitions: International cross-list-
ing is also expected to help in future merger and acquisition plans
of MNCs. For example, Toyota Motor’s international offering in the
US markets made, later on, the acquisition of Daimler Chrysler
easier through a share-swap arrangement.
Q Access to long-term finance in foreign currency: International
equity finance also helps firms raise capital in foreign currency
in which they might have capital expenditure. Many Indian com-
panies resort to GDRs for raising long-term capital in foreign
currency.

&e SELF ASSESSMENT QUESTIONS

6. Firms may also resort to foreign equity financing to meet their

foreign currency capital expenditures. (True/False)

Many Indian companies are raising long-term capital in terms of

equity financing through GDRs/ ADRs. Discuss which of the rea-
sons listed in this section are applicable to Indian companies.

UR SOURCING DEBT GLOBALLY

As we have studied in Chapter 2 that companies can raise long-term
debt from international credit and bond markets through the follow-
ing means:
Q Syndicated loans
Q Eurocredit markets
Q Issue of foreign bonds
Q Issue of Eurobonds

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408 INTERNATIONAL FINANCE

NOTES

Companies need to consider the following while raising long-term

debt globally:
1. Currency of denomination: Companies can issue debt in
different currencies in international financial markets. For a
purely domestic company, raising debt from foreign markets
in a different currency will lead to exchange rate risk. As we
studied in the case of short-term financing, when the loan is
denominated in a foreign currency, the cost of borrowing could
become substantially high if the foreign currency appreciates
against the domestic currency. However, if the company has a
natural hedge in terms of foreign currency receivables, then the
risk will be significantly mitigated.
Interest rate: The concept of interest rate parity conditions are
applicable for long-term financing as well. Firms cannot decide
on raising debt in foreign currencies just because interest rates
are cheaper in those currencies. The exchange rate risk will
nullify any interest rate advantages due to arbitrage between the
markets. However, if the long-term exchange rate and interest
rate movements are expected to be favourable to the company,
then it may decide to raise debt in cheaper currency. Otherwise,
the company needs to hedge the exchange rate risk in forward
markets. Similarly, credit spreads applicable in different
economies could be different and opportunities for currency
swaps can be explored.
Debt portfolios: MNCs operating in different countries issue
debt in several currencies in order to diversify their currency
exposures. These are also expected to act as a natural hedge to
their economic and operating exposures.
Maturity: The maturity of the borrowing will generally depend
on the life of the capital expenditure project. Companies tend
to structure their loan maturity profile in such a way that the
refinancing risks are limited. The maturity periods are also
governed by the standard terms applicable in the respective
international debt markets. For example, Eurobonds have a
maturity period of five years in general and 10 years maximum.
However, an issue in the US corporate markets can go even up to
20 to 30 years.

Nature of interest payments: The nature of interest payments

depends on the debt type, that is, whether the debt is a fixed
rate one or a floating rate one. The choice depends on a number
of factors like the structure of the yield curve and interest
rate expectations. For example, the floating rate debt will be
preferred when the existing interest rates are considered to be
on the higher end.
Method of issue: International debt can be raised in terms of a
private placement to institutional investors or as a public issue.

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 LONG-TERM INTERNATIONAL FINANCING 409

NOTES

Privately placed debt is not traded in the secondary market. It

may be much easier and less costly to privately place a bond
issue than selling it in international markets.

10.6.1 FOREX RISK

Foreign exchange risks associated with long-term debt pertains to the

uncertainty with regard to the exchange rates applicable when the re-
payment of the principal and interest is done. The impact is the same
as discussed in the case of short-term international financing.

For example, consider a UK company that raises a debt of $10 million

at the rate of 5% p.a. for a maturity period of five years. To simplify the
illustration, assume that the loan is similar to zero coupon bond and
the entire interest is payable on maturity. The current spot exchange
rate is $1.5369/GBP

The principal amount received in GBP will be = GBP 6.51 million

The maturity amount payable after 5 years will be: (10X(1+0.05) “5)
= $ 12.763 million

Assume that the dollar appreciates by, say 5%, during these five years,
and the future spot exchange rate is 1.4600.

The loan amount to be repaid after five years with interest in GBP
terms will be GBP 8.7415 million. This implies that the effective inter-
est cost in GBP terms will be 6.083% p.a.

If the firm can get a GBP loan at a rate less than 6.083% p.a., then it
would be much cheaper compared to the US dollar loan. Moreover,
the actual appreciation of the dollar against the pound sterling cannot
be determined and it could be higher than 5%. Hence, if the currency
movements are likely to be adverse, the company opting for interna-
tional debt in foreign currency may have to hedge forex risks involved
in terms of derivative markets.

10.6.2 COST OF DEBT

Though the interest rate is the main component of the cost of debt,
there are several other costs involved in international debt financing.
The overall cost of debt may include the following:
Q Upfront costs like a one-time fee, usually 1% to 2.5% of the credit
to be paid to the lead manager and consortium
Q Periodic costs that include

¢ Interest rate (generally based on reference rates like LIBOR

for floating rate loans and long-term government bonds for
fixed rate loans)

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410 INTERNATIONAL FINANCE

N OT ES

¢ Credit spread
# Commitment fee for credit not drawn, etc.

¢ Agent fee

The main component of the interest rate depends on the long-term

bond yields which vary between different countries. The cost of debt
financing could hence be different in different countries.

Apart from the above costs, it is important to take into consideration

the costs involved due to exchange rate movements. The actual cost of
long-term borrowing should include the expected percentage change
in the exchange rate of the currency borrowed (refer the example in
the previous section). Hence, it is necessary to forecast periodic ex-
change rates for the currency of the bond in order to accurately esti-
mate the overall costs of international borrowing.

The overall costs involved in long-term borrowing should be calcu-

lated on the basis of the present value of future cash outflows after
considering all the above costs. This is generally termed as all-in-cost
(AIC) principle. The AIC is the discount rate ([or Internal Rate of Re-
turn (IRR)] that equates the present value of all cash outflows—fees,
interest payments and principal repayments—with the net proceeds
received by the borrower.

Illustration 1: A US company issues Eurobond with a face value of

GBP 5 billion and a maturity period of five years. It is issued at dis-
count with a price of GBP 950 with the face value of the bond being
GBP 1000. The coupon rate is fixed at 100 basis points above the five-
year government bond yield of 5.5% p.a. There is also an upfront fee of
0.5%. Calculate the effective cost of debt in GBP terms.

Solution: The company will receive the net proceeds from the bonds
as follows:

Net Proceeds = Price at which bonds are sold — Upfront fees

= 0.95 X 5-5 X 0.5%

= GBP 4.725 billion

Periodic interest payments will be equal to 6.5% X 5 billion = 0.325

billion

The overall cost of debt will be calculated as the discount rate that
equates the present value of cash flows with initial proceeds. Alterna-
tively, it is the Internal Rate of Return (IRR) implied in the cash flows.
This rate can be calculated as 6.693%.

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NOTES

The cash flows are given in the following table:

Year Cash Flows (GBP) Present Value of Cash Flows at

6.693%
0 4.725 4.7250
1 0.325 0.3046
2 0.325 0.2855
S 0.325 0.2676
4 0.325 0.2508
5 5 3.6165
Total 0

In the above table, the present value of cash flows at the end of year
1 is calculated as the present value of (0.325) at the discount rate of
6.698% for one year as (0.3046).

Thus, the effective cost of debt is 6.693% p.a.

Illustration 2: The preceding illustration ignores the exchange rate

risks. Assume now that the firm will convert the bond proceeds into
US dollars at the spot exchange rate of $1.5/GBR The expected ex-
change rate after five years is $1.8/GBP (ignore exchange rate risks
for interest payments). Calculate the effective cost of debt in dollar
terms. Comment on the actual effective cost of debt. What would be
the effective cost if the exchange rate is assumed to be the same on the
maturity date (i.e. remains constant at 1.5)?

Solution: The company will receive the net proceeds from the bonds
as follows:

Net Proceeds = Price at which bonds are sold — Upfront fees

= 0.95x5-5x0.5%

= GBP 4.725 billion

The US dollar proceeds will be 4.725 x 1.5 = $ 7.0875 billion

Periodic interest payments in US dollars will be equal to 6.5% x 5 bil-

lion = 0.325 billion

The overall cost of debt will be calculated as the discount rate that
equates the present value of the cash flows with initial proceeds. Al-
ternatively, it is the internal rate of return (IRR) implied in the cash
flows. This rate can be calculated as 10.16%.

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412 INTERNATIONAL FINANCE

NOTES

The cash flows are given in the following table:

Year Cash Exchange Rate Cash Flows Present

Flows ($) Value of Cash
(GBP) Flows at 10.16%
0 4.725 1.5 7.0875 7.0875
1 0.325 1.5 0.4875 0.4425
2 0.325 1.5 0.4875 0.4017
3 0.325 1.5 0.4875 0.3647
4 0.325 1.5 0.4875 0.3310
5 5 1.8 9 5.5476
Total 0

In the above table, the present value of cash flows at the end of year
1 is calculated as the present value of (0.4875) at the discount rate of
10.16% as (0.4425).

The effective cost of debt in this case will be 10.16%. The higher cost
is due to the projected appreciation of the pound sterling. If the inter-
mediate interest payments are assumed to be paid at higher exchange
rates (i.e. with dollar depreciation), then the effective cost of debt will
be much higher. In general, firms would resort to such foreign curren-
cy loans in a scenario of depreciating domestic currency, only if they
have a natural hedge in terms of pound sterling receivables and/or
when the expenditures are in pound sterling, so that they don’t need
to convert dollars for payments, which leads to exchange rate uncer-
tainty.

If the exchange rate is assumed to be constant throughout the period,

then there will be no exchange rate risk involved. This means the ef-
fective cost of debt will be the same as that of the cost in GBP terms
jie. 6.693%. This is shown in the following table:

Year Cash Exchange Rate Cash Present Value of Cash

Flows Flows ($) Flows at IRR 6.693%
(GBP)

0 4.725 1.5 7.0875 7.0875

1 -0.325 1.5 -0.4875 -0.4569
2 -0.325 1.5 -0.4875 -0.4283
5 -0.325 1.5 -0.4875 -0.4014
4 -0.325 1.5 -0.4875 -0.3762
5 -5 1.5 -7.5 -5.4247
Total 0.00

Note that the effective cost will be less than 6.693% p.a. if the pound
sterling depreciates during the five-year period (i.e. the future spot
exchange rate is less than 1.5)

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 LONG-TERM INTERNATIONAL FINANCING 413

NOTES

&e SELF ASSESSMENT QUESTIONS

7. Which of the following factors is not considered while sourcing

debt globally?
a. Currency risk b. Interest rate
ce. Maturity d. All of the above

Study the statistics regarding international debt finance raised in

terms of ECBs vs. equity finance raised through GDRs by Indian
companies. Make a note of your findings.

ive SUMMARY
Q Short-term international financing involves international money
markets, including Eurocurrency markets. Long-term interna-
tional financing involves both international equity markets and in-
ternational debt/credit markets. Whether the company raises debt
or equity depends on its capital structure decision.
Q International equity financing can be analysed from the perspec-
tive of international investors, market integration and cost of cap-
ital and capital structure.
Q International investors seek foreign equity for diversifying their
portfolio risks. As per the theory of portfolio management, diver-
sification leads to higher returns per unit of risk. Since economies
of different countries are not strongly correlated, returns are also
not correlated, and, hence, the portfolio risk is reduced by interna-
tional equity investments.
Q If the international equity markets are truly integrated, then in-
vestors will be able to invest directly in any of the foreign stock
exchanges. This implies that there will be no advantage for com-
panies in terms of lowering cost of capital if they raise equity cap-
ital from abroad because the risk will be accurately priced in the
integrated market. However, if the markets are segmented, there
is an incentive to raise finance from foreign markets, as foreign
investors can reduce their portfolio risk.
Q Ifthe markets are segmented, then companies can decide to raise
equity finance abroad and thereby improve their valuation by re-
ducing the cost of capital.
Q There are a number of routes available for companies who wish to
raise equity finance from abroad. The route of depository receipts
is the most favoured one.
Q The US stock markets allow cross-listing of shares and also ADR
programmes. The level IIIT ADR programme and Rule 144A routes

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414 INTERNATIONAL FINANCE

NOTES

allow both raising of capital and listing of shares in the US stock

exchanges.
Q European stock markets are facing a wave of consolidation. Many
stock exchanges of European countries were merged to form Eu-
ronext which was later taken over by NYSE. However, the London
Stock Exchange still remains the largest stock exchange in Europe.
Q The Luxembourg stock exchange is a leading stock exchange in
Europe next only to LSE in terms of importance. It has many In-
dian GDRs listed.
Q The Asian stock markets have been growing rapidly and are com-
parable to stock exchanges of developed countries in terms of eq-
uity raised. Foreign institutional investors resort to these exchang-
es for investing in Asian corporates.
Q Researchers have evaluated three factors that can possibly af-
fect international equity returns, viz., macroeconomic factors, ex-
change rates and industrial structure.
Q There are several advantages of sourcing equity globally. Different
firms can resort to international equity for different reasons.
Q There are several factors to be considered from the perspective
of international context in sourcing long-term international debt.
These include currency, maturity, interest, debt portfolio, nature
of interest payments and the method of issue.
Q Sourcing debt globally involves foreign exchange risk. The overall
cost depends on the movement of the currency in which the bor-
rowing is denominated against the local currency.
Q The cost of debt includes many other components apart from the
interest rate. The overall cost should be calculated as the discount
rate that equates the present value of cash flows with net proceeds
received from the borrowing.

KEY WORDS

Q New York Stock Exchange (NYSE): The largest stock exchange

in the world in terms of market capitalisation, situated in New
York, USA.

Q London Stock Exchange (LSE): The third largest stock ex-

change in the world in terms of market capitalisation, situated
in London, UK.

Q Swap: A derivative instrument by which two parties exchange

cash flows of their respective financial assets.
Q Merger: Formal combination of two business entities to form a
completely new business entity.
Q Acquisition: A corporate strategy by which a business entity
acquires ownership of another business entity.

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 LONG-TERM INTERNATIONAL FINANCING 415

NOTES

DESCRIPTIVE QUESTIONS
1. Explain the various modes available for sourcing equity abroad.
2. Explain the advantages of sourcing equity globally.
3. Explain the costs involved in raising debt from foreign markets.

ey ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Concept of Long-Term International 1s ce. Both of the abo

Financing aa
2. True

3 Tue
Sourcing Equity Globally 4, d. All of the above
Factors Affecting International Equity 5' se _
Return
Advantages of Sourcing Equity 6. True
Globally
Sourcing Debt Globally _ 7. d. All ofthe above

HINTS FOR DESCRIPTIVE QUESTIONS

1. There are many modes of accessing international stock markets.
Cross-listing and depository receipts are the major modes. Refer
to Section 10.3 Sourcing Equity Globally.
2. There are several advantages of sourcing equity globally. Apart
from raising capital, it can also be used for building reputation
and increasing visibility, etc. Refer to Section 10.5 Advantages of
Sourcing Equity Globally.
3. The cost of debt does not just include the interest rate applicable
on the debt. It includes all costs including fees and issue discount,
if any. In order to calculate the cost of debt, the present value of
all cash flows should be equated with the net proceeds from the
debt. Refer to Section 10.6 Sourcing Debt Globally.

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416 INTERNATIONAL FINANCE

N OT ES

SUGGESTED READINGS FOR

10.10
REFERENCE

SUGGESTED READINGS

Q Eun C., Resnick, B. G. (1995) International financial management.

New Delhi: Tata McGraw Hill Publishing Company Ltd.
Q Bekaert, G., Hodrick, R. International financial management. Pren-
tice Hall, New Jersey: Pearson Education Inc.
Q Madura, J. International financial management. Thomson
South-Western, USA

Q Solnik, Bruno. Capital Markets and International Monetary Vari-

ables. Financial Analysts Journal, 40 (1984), pp. 69-73.

Q = Roll, Richard. Industrial Structure and the Comparative Behav-

ior of International Stock Market Indexes. Journal of Finance, 47
(1992), pp. 3-42.
Q Adler, Michael and David, Simon. Exchange Rate Surprises in In-
ternational Portfolios. The Journal of Portfolio Management, 12
(1986), pp. 44-53.
Q Asprem, Mads. Stock Prices, Assets Portfolios and Macroeconom-
ic Variables in Ten European Countries. Journal of Banking and
Finance, 13 (1989), pp. 589-612.

E-REFERENCES
a Dugal, I. (2014). Opinion. http://www.livemint.com/. Retrieved on
20 November 2015, from http://www.livemint.com/Money/76n6
IGxoQZFuT85DfK6vxK/Does-India-need-to-worry-about-over-
seas-corporate-borrowing.html
Bourse.lu,. (2015). Luxembourg Stock Exchange | Home. Re-
trieved on 18 November, 2015, from https://www.bourse.lu/home
Businesstoday.in,. (2015). Reserve Bank of India relaxes norms
for external commercial borrowings. Retrieved on 18 Novem-
ber, 2015, from http:/\www.businesstoday.in/money/banking/re-
serve-bank-rbi-eases-external-commercial-borrowing-ecb-norms/
story/214163.html
TheFinanceConcept,. (2011). What is ADR and GDR? - TheFi-
nanceConcept. Retrieved 18 November, 2015, from http://thefi-
nanceconcept.com/2011/11/what-is-adr-and-gdr.html

NMIMS Global Access - School for Continuing Education

 LONG-TERM INTERNATIONAL FINANCING 417

NOTES

Q The International Investor,. (2011). What is an American depositary

receipt (ADR) or a Global depositary receipt (GDR)?. Retrieved on
18 November, 2015, from https://the-international-investor.com/
investment-faq/american-depositary-receipt-adr-global-deposi-
tary-receipt-gdr

NMIMS Global Access - School for Continuing Education

 CASE STUDIES

CONTENTS

Case Study 1 USITC evaluates India’s efforts towards

removing trade barriers
Case Study 2 Africa taps global bond markets at rapid rate
Case Study 3 Yuan’s likely entry into IMF’s benchmark
currency basket and its potential impact
Case Study 4 Gold schemes and Current Account Deficit
(CAD) of India
Case Study 5 Chinese Yuan Still Undervalued According to Purchasing Power
Parity
Case Study 6 Extension of exchange trading hours in India
Case Study 7 Strategies of BMW against exchange rate risk
Case Study 8 Introduction of specialised products for
micro, small and medium enterprises by ECGC
Case Study 9 Manipulating LIBOR: A scandal of rigging
benchmark interst rates
Case Study 10 Reasons for cheaper external commercial borrowings for Indian firms
Case Study 11 Preferential Trade Agreements (PTAS) and India
Case Study 12 Capital account convertibility inescapable:
Reserve Bank of India

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420 INTERNATIONAL FINANCE

CASE STUDY 1

USITC EVALUATES INDIAS EFFORTS TOWARDS

REMOVING TRADE BARRIERS

Blea INN le BAI i 9 Ane

ss Le
ae
Paty

(Source: ibtimes.com)

This Case Study focuses on the evaluation of India’s efforts for re-
moving its trade barriers. It is related to Chapter 1 of the book.

According to the Trade and Investment Policies in India, 2014—

2015 report prepared by the US International Trade Commission
(USITC), India has made significant progress in removing its trade
barriers and liberalising international trade. USITC is an indepen-
dent and fact-finding agency of the US government. The report
provides a detailed description of changes in the Indian foreign
trade policies after a new government came into power in India
in May, 2014.

The Indian foreign trade policies, as presented in the report, per-

tain to four important areas—foreign direct investment (FDD;
tariffs and customs procedures; local-content and localisation re-
quirements; and standard and technical regulations.

According to the report, since May, 2014, FDI caps in industries

such as defence and insurance have been raised. In addition,
India has done away with the earlier mandatory requirements of
pre-investment authorisation. Moreover, India has opened cer-
tain segments of the Indian railways for FDI. These changes in
the foreign trade policy have increased confidence in the Indian
market, which is very crucial to attract foreign capital.

The report highlights changes in the tariff and customs proce-

dures in India. Tariff has been reduced in Information, Commu-
nication and Telecommunications (ICT)-related products. This
reduction has enabled US firms to get better access to the Indian
market.

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CASE STUDY 1: USITC EVALUATES INDIA’S EFFORTS TOWARDS REMOVING TRADE BARRIERS 421

CASE STUDY 1

The changes in policies related to local-content requirements and

localisation (as highlighted in the report) include:
Q Expansion of various local-content and localisation require-
ments affecting firms dealing with ICT, electronics, defence
and civil aerospace products.
Q Measures requiring foreign firms to buy inputs from local
firms, operate a portion of the business and certain business
activities in India and comply with India-specific testing and
registration norms.

However, the report also expresses concern with some of the tra
measures of the Indian government, which may increase cos
delay time to market and restrict access of certain US prod
(Source: Adopted from: Fibre2fashion.com,,. (2015). United States Of Ameri
hails Indian steps to remove trade barriers - Textile News United States O

QUESTIONS

2. Based on the case, critica

trade policy for a country.
(Hint: The foreign
significant role development of a country
as it influence eas such as investment, flow
of funds, level petition in the local market, job
opportunities and t exchange rate.)

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422 INTERNATIONAL FINANCE

CASE STUDY 2

AFRICA TAPS GLOBAL BOND MARKETS AT RAPID RATE

This Case Study discusses the rapid entry of sub-Saharan nations

in the international bond market. It related to Chapter 2 of the book.

Various sub-Saharan countries are increasingly tapping the glob-

al bond market. In the three years period 2013-2015, these coun-
tries have issued dollar dominated Eurobonds worth USD 18.1
billion. This figure is almost three times of the USD 7.3 billion
worth of bond issues in the previous 3 years period. The follow-
ing graph shows the country-wise breakup of debt issuance in the
2013-2015 period.

Sub-Saharan Africa Globa n Bond Issuances

Total 2013-2015: $18 Yield: 7.26%.

3,500 | - 12

3,000 | 10
2,500
8
n

3
s 6 8
s
a a
aA2RA 4

| 2

| 0

G9 Issuance Amount
—e— Av. Yield at Issue

The recent trend suggests that every year international investors

purchase sovereign securities worth trillion of dollars in spite of
the fact that the investors prefer stocks over bonds. Sovereign se-
curities, such as US Treasuries and Chinese 10-year bonds, pro-
vide more stable returns than stocks. These securities are import-
ant sources of funds for governments across the world. Moreover,
issuance of sovereign bonds increases accountability of a govern-
ment through credit ratings and variable yields.

Historically, African nations (except South Africa) have been

non-participants in the sovereign bond markets because of very
low credit ratings. Credit ratings are important perquisite for is-
suance of sovereign bonds.

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 CASE STUDY 2: AFRICA TAPS GLOBAL BOND MARKETS AT RAPID RATE 423

CASE STUDY 2

However, the recent growth in bond issuance in Africa is chang-

ing the long-existing economic scenario. Many African nations
are receiving credit ratings from Moody’s and S&P as the gov-
ernments in these countries are showing more transparency and
accountability in their economic decisions. In addition, some Af-
rican nations have been benefitted from the inclusion in standard
indicators like J.R Morgan’s Emerging Market Bond Index Global
(EMBIG).

Many American investors, such as PIMCO and Fidelity, already

have sovereign securities of the African governments in their
investment portfolio. Some reasons behind investment in the
bonds are higher yields, improved risk profiles of these coun
and portfolio diversification.

So far, foreign aids and private loans have been the main
infrastructure development in Africa. Now, the con
global bond market can provide the much ne
frastructure development to the governments
For example, Nigeria is funding electricity proj
USD 1.5 billion bond issuance. Zambia i
ment in healthcare and the railways. E

tric dam.

Amidst the optimism ove

nations, there are critics
can debt crisis. Ho t to suggest alternate ways
of raising funds cr omic development of African
nations, home to 1.1 ple. If African nations want to
get promoted to the ‘em s’ market status from the ‘frontier’
status, they need sovereign | bonds, just like Brazil and China did.

g QUESTIONS

1. On the basis of the case, discuss the needs of issuance of

sovereign bonds by government.
(Hint: Mainly for raising funds to finance projects for
economic development.)
2. Critically evaluate the potential positive and negative
consequences of increasing bond issuance by sub-
Saharan nations.
(Hint: Positive: Inflow of funds for economic development
and subsequent growth in GDP Negative: Potential debt
crisis situation if fiscal prudence is not used.)

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424 INTERNATIONAL FINANCE

CASE STUDY 3

YUAN’S LIKELY ENTRY INTO IMF’S BENCHMARK

CURRENCY BASKET AND ITS POTENTIAL IMPACT

(Source: rt.com)

This Case Study discusses the inclusion of Yuan in IMF *s SDR bas-
ket and its potential impact. It is related to Chapter 3 of the book.

According to the latest reports (as of November, 2015) of the In-

ternational Monetary Fund (IMF), China’s currency Yuan is all
set to make an entry into the coveted benchmark currency basket
of IMF. China has been pushing for the inclusion of Yuan in the
Special Drawing Rights (SDR) basket of the IMF as its long-term
strategy of reducing dependence on dollar and establishing itself
as a major economic power in the world.

IMF reviews the composition of its SDR basket every five years
so that the basket reflects the changing economic scenario of the
world. IMF reviews currency with respect to two criteria — the ex-
port and the freely-usable criteria. China’s Yuan perfectly meets
the first criteria since 2010 as China’s share in global exports has
grown up to 7.5 per cent per annum. However, it has ranked sev-
enth in the second criteria on 2014. According to the freely-us-
able criteria, the Australian dollar and the Canadian dollar are
ahead of the US dollar in the race. However, if the growth rate is
considered, the share of global assets in these two currencies has
remained almost static in the last few years, whereas the share of
global assets in Yuan has grown around 67% in the same period.
Therefore, according to the IMF Yuan meets both the criteria for
inclusion in the SDR basket. Currently, IMF’s SDR basket has
four currencies—US dollars, euro, pound sterling, and Japanese
yen.

Inclusion of Yuan in SDR basket will help in making it a global

currency, a long-cherished economic goal of China. Yuan becom-
ing a global currency will have political repercussions as the po-
litical leverage of dollar will diminish. In addition, countries on
which the US would impose trade sanctions may seek the help of
China. Therefore, inclusion of Yuan in the SDR basket is a step
towards China becoming a very important economic and political
power in the world.

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 CASE STUDY 3: YUAN*S LIKELY ENTRY INTO IMF*S BENCHMARK
CURRENCY BASKET AND ITS POTENTIALIMPACT 425

CASE STUDY 3

In case the inclusion takes place, its effects will be felt across Asian
markets. According to Changyong Rhee, director of the IMF’s
Asia and Pacific Department, the spillovers of the Chinese econo-
my to other regional economies are already larger than expected
and the effects would be intensified if Yuan joins the SDR basket.

After Yuan’s inclusion in the SDR basket, the Yuan-dominated

swap agreements that China has concluded with a number of
trading partners could be qualified as official reserves. This will
increase the general use of the currency within this region. Rhee
commented at an event at the Carnegie Endowment for Interna-
tional Peace, “It’s hard to know how fast it’s going to happen, b
renminbi inclusion in the SDR basket can have an impact on
financial dynamics,”

According to Rhee, the concern was not slowing gr

Chinese economy, but the potential impact on the
growth of countries in the region because of th
with China. According to a calculation of th
growth shock from China could take more
point from overall Asian growth.

Yuan is expected to enter the SDR bas}

currency basket so that it ca r the financial flows

0 IMF for providing
t values less import-

will impact the Yua tage of other currencies

will not be affected muc s to economist Andrew Ken-
e renminbi is completely differ-
ent because despite its inch in the SDR, it’s not really a fully
convertible currency and has very thin, much less liquid markets.
(Source: Data retrieved from: http://www-hindustantimes.com/,. (2015). Inclusion in IMF
reserves can make yuan a global currency.)

RB QUESTIONS

1. How will the inclusion of Yuan in the SDR basket affect

the demand for Yuan?

(Hint: The demand of Yuan will increase because of it

becoming a global currency.)
2. How will Yuan be impacted because of the revised formula
used by the IMF?
(Hint: Its weight in the basket will be less than earlier
anticipated.)

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426 INTERNATIONAL FINANCE

CASE STUDY 4

GOLD SCHEMES AND CURRENT ACCOUNT DEFICIT

(CAD) OF INDIA

(Source: economictimes.indiatimes.com)

This Case Study discusses the potential improvement in the CAD

scenario of India due to the recently launched gold schemes. It is
related to Chapter 4 of the book.
Recently (as of November, 2015), the Government of India
launched the Gold Monetisation Scheme (GMS) with the follow-
ing objectives:
Q Mobilising the gold held by households and institutions in the
country.

Q. Providing a fillip to the gems and jewellery sector in the coun-

try by making gold available as raw material on loans from
banks.

Q Reducing reliance on the import of gold over time to meet the

domestic demand.

Under the GMS, the residents of India will have an option of de-
positing their gracious metal to banks to earn an interest rate up
to 2.5 per cent. Another gold scheme — the Sovereign Gold Bond
Scheme-will allow investors to earn an interest rate of 2.75 per
cent per annum by investing in paper bonds.

This scheme will reduce the physical demand of gold and free up
a large chunk of the 20,000 tonnes of gold worth USD 800 billion
lying idle in Indian households. The scheme is expected to spur
economic growth in the country. In addition, it is expected to re-
duce current account deficit of India by reducing its gold import.
At present, India imports around 1,000 tonnes of gold every year,
causing significant outflow of foreign exchange from the country
and widening its CAD.

According Dr. A. Didar Singh, Secretary General of the Feder-

ation of the Indian Chambers of Commerce and Industry (FIC-
CI), These policies are a step in the right direction and would allow

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 CASE STUDY 4: GOLD SCHEMES AND CURRENT ACCOUNT DEFICIT (CAD) OF INDIA 427

CASE STUDY 4

for channelisation of the unutilized domestic gold reserves towards

supporting the country’s economic growth. He also added that the
past few years have witnessed an exponential increase in gold im-
ports exerting tremendous pressure on our current account. With
the schemes being rolled out, we should be able to reduce our gold
wmoports.

However, in spite of optimism regarding the scheme, building a

robust infrastructure and standardising price and quality are cru-
cial for the success of the scheme. According to Mr. Singh, Also,
establishment of the Gold Board would allow for better management
of gold imports, encourage exports, facilitate infrastructure devel
opment and would ensure that India’s gold market functions effe
tively.
(Source: Information retrieved from: timesofindia-economictimes,. (2015). Gold
to aid economic growth, reduce current account deficit: FICCI

|g QUESTIONS

1. How is the gold scheme expected to i

account deficit scenario in India?
(Hint: By reducing import bill)

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428 INTERNATIONAL FINANCE

CASE STUDY 5

CHINESE YUAN STILL UNDERVALUED ACCORDING TO

PURCHASING POWER PARITY

This Case Study discusses the undervalued Chinese Yuan (CNY)

according to Purchasing Power Parity (PPP). It is related to Chap-
ter 5 of the book.

In August 2015, the value of CNY rapidly declined as a result of

actions by the People’s Bank of China. This also raised a debate
on exchange rates offering unfair trade benefits. However, on
comparing various currencies, it can be observed that yuan is not
the only affected currency.

78.000

FE EES SF
cNY ——— _USDCNY |

PP Index is considered an effective benchmark

the relative fair values of currencies. For the

through the concept of PPP Exchange rates adjust between cur-

rencies; however, the purchasing power of one currency will still
be qualitative, or even quantitative, over- or under-valued relative
to another. In the following chart, it can be observed that the val-
ue of yuan and other key currencies are compared with USD as
per the Big Mac PPP Index:

Purchasing power Parity of Currencies vs. USD

22852828

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 CASE STUDY 5: CHINESE YUAN STILL UNDERVALUED
ACCORDING TO PURCHASING POWER PARITY 429

CASE STUDY 5

The undervaluation of currencies as compared to USD can poten-

tially be attributed to various factors, one of which is expansive
monetary policies being enforced by their central banks. Several
prominent banks, such as Bank of Japan, People’s Bank of China
and European Central Bank, carried out unorthodox stimulus pro-
grammes from traditional rate cuts with an aim to revive growth
and inflation in their economies. While these central banks follow
easing policies, the Federal Reserve System of the USA is moving
closer to a possible rate hike, and the divergence being developed
can be noticed through relative values.

In the following chart of historical data from the Big Mac PP

Index, it can be observed that euro and yen both pushed de
into the under-valued zone as compared to USD as their n
an accommodative policy increased:

‘Big Mac' Purchasing Power Parity of Currencies vs. USD &

sess
“ebegsr

& € FESS
EUR JPY |

The monetary policies of these central banks and primarily the

multiple devaluations of yuan by the Peoples’ Bank of China have
encouraged continuous discussions and debates regarding the
motives behind their actions, may be executing a policy for forex
impact explicitly and obtaining an unfair advantage. The trade
benefits of a devalued currency, mainly against USD, can be eco-
nomically beneficial for a nation’s exports.

While PPP does not provide a definitive assessment of a curren-

cy’s over- or under-valuation as compared to other currencies and
it surely cannot prove the intention, many will keep using it as
evidence of both.
(Source: Adopted from: https://beta.dailyfx.com/forex/market_alert/2015/08/15/Chi-
nese-Yuan-Still-Undervalued-According-to-Purchasing-Power-Parity.html)

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430 INTERNATIONAL FINANCE

CASE STUDY 5

|g QUESTIONS

1. Discuss the reasons behind devaluation of currencies.

(Hint: Expansive monetary policies of central banks.)
2. How does devaluation of yuan help the Chinese economy?
(Hint: It increases the competitiveness of Chinese
exports.)

NMIMS Global Access - School for Continuing Education

 CASE STUDY 6

EXTENSION OF EXCHANGE TRADING HOURS IN INDIA

This Case Study discusses how the extension of trading hours can
affect profitability. It is related to Chapter 6 of the book.

India’s central bank (RBI) and securities market regulator (SEBI)

may allow extending trading hours beyond the time limit of 5 pm.
This measure can go a long way in developing the exchange-trad-
ed currency derivatives market.

In India, when the market closes at 5 pm, the traders turn to over-
seas markets. For example, in Singapore, markets are open for 1
hours. According to a report by the Finance Ministry’s Stand
Council on international competitiveness of the Indian
cial sector, the overlap of trading time with other im
shore destinations for trading the Indian rupee is small.
that after Indian markets close, price discovery for
locations such as Dubai and Singapore.

Many exchanges have been waiting upon

ing them an extended time limit for tradi
extending the trading time was almost i

The extension of trading hours would

adjust and alter their move oreign currencies in
global markets. The exte . woul so mean higher volumes
and profitability for
would benefit forei vestors as they could hedge
their risks because of ability of global information. An
add-on would be the e n of timings of the back offices of
fund houses. Broking firms may have to incur additional costs.
Banking hours would correspondingly have to be extended.

| QUESTIONS

1. How can change in trading hours affect Indian financial

markets?
(Hint: It would help in aligning domestic markets with
international markets, thus increasing profitability.)
2. Apart from profitability, what changes can be expected if
trading hours are extended?
(Hint: Extension of banking hours, increase in back office
jobs, etc.)

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432 INTERNATIONAL FINANCE

CASE STUDY 7

STRATEGIES OF BMW AGAINST EXCHANGE RATE RISK

This Case Study discusses exchange rate risk management strate-

gies adopted by the automobile manufacturer BMW. It is related to
Chapter 7 of the book.

(Source: funmozar.com)

Spreading its manufacturing units across the globe has been a

steady practice of BMW. In 2011, China came out as the fastest
growing market for BMW by accounting for 14% of BMW’s global
sales volume. BMW also explored the territories of India, Russia
and Eastern Europe.

The challenge

The recent trend of increase in sales has been a common scenario

for BMW, but the major portion of the profit was often eroded by
fluctuations in exchange rates. According to the company, it was
found out from its annual reports that the negative effects of ex-
change rates amounted to around €2.4bn between the years 2005
and 2009.

Although the company had a chance to pass on exchange rate

costs to its customers by increasing the prices of products, it did
not go for this option. One of its rivals, Porsche, had done the same
thing but only saw its sales plunging.

The strategy

BMW opted for a two-pronged approach for managing its finan-

cial risks posed by exposure to foreign exchange. It had two strat-
egies: One was natural hedge and the other was financial hedge.
Natural hedge meant that the company would be developing ways
for spending money in the currency of the country where sales
were taking place. This would result in the generation of reve-
nues in the desired currency. Soon, it was analysed that it was not

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 CASE STUDY 7: STRATEGIES OF BMW AGAINST EXCHANGE RATE RISK 433

CASE STUDY 7

possible for the company to offset all the exchange rate costs that
way. Therefore, BMW decided to go for formal financial hedges,
to apply which regional treasury centres were set up at several
locations including the US, the UK and Singapore.

How the strategy was implemented

BMW created a milestone in the 1990s by becoming one of the

first premium carmakers from overseas by setting a plant in the
US—in Spartanburg, South Carolina.

In 2008, BMW made an announcement of investing $750m to ex-

pand its plant in Spartanburg. That approximately resulted in

chain by making it comparatively shorter between

US markets.

The strategies of the company included tappi

chase of $615m in Mexican auto parts i

significantly in the following years.

The company entered into a joi ‘it illiance China

tured in this plant. A loca 7 t up in China so that it

can help its group purchas t in making selection of
competitive supplie resulted in the shortening of
supply chains, leadi ustomer services.

In 2010, BMW made an a cement of investing 1.8bn rupees

in its production plant in Chennai, India. This resulted in an en-
hanced production from 6,000 to 10,000 units in India. Now, the
company has plans of increasing production in Kaliningrad, Rus-
sia.

BMW’s production facilities for cars and its components spread

in 13 countries. In 2000, the overseas production by the company
accounted for 20% of the total production. By 2011, it had risen to
44 per cent.

The company instructs its overseas regional treasury centres for

reviewing the exposure of exchange rates weekly in their regions
and reporting the same to a group treasurer. After that, the con-
solidation of the global risk figures is done by a group treasurer
team, and recommendations are given so that foreign exchange
risks can be mitigated.

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434 INTERNATIONAL FINANCE

CASE STUDY 7

The lesson

The strategy of BMW of exploring foreign markets for boosting

production has resulted in the reduction of foreign exchange ex-
posure. Moreover, working in various countries has contributed
significantly to design the product and make strategies as per the
local market customisation. Outsourcing auto parts from foreign
markets has helped the company in diversifying supply chain
risks.
(Source: Adapted from: Financial Times,. (2015). The case study: How BMW dealt with
exchange rate risk - FT.com.)

|g QUESTIONS

1. Explain the challenges f

NMIMS Global Access - School for Continuing Education

 CASE STUDY 8

INTRODUCTION OF SPECIALISED PRODUCTS FOR

MICRO, SMALL AND MEDIUM ENTERPRISES BY ECGC

This Case Study discusses the plans of ECGC to introduce specialised

products for micro, small and medium enterprises. It is related to
Chapter 8 of the book.

and managing
il Exporters’ Policy
es; Micro Exporters’
Policy for firms having sa
factoring companies actoring facilities by the Cor-
poration will be laun¢ ng concurrence of the regula-
tor, viz., Insurance Reg ry Development Authority.

ECGC, set up in July, 1957 as an export promotion establishment,

provides insurance cover to Indian exporters to protect them
against various unforeseen losses, such as insolvency of the buyer,
default or repudiation by the buyer or risks occurring in the buy-
er’s nation. Further, ECGC provides insurance cover for Indian
banks under the Export Credit Insurance to Banks (ECIB) which
protects them from the risk of non-payment by exporters by avail-
ing packing credit and post shipment because of insolvency and
default of the exporter.

In July 2013, the overall capital of ECGC was enhanced from

~1000 crores to 5000 crores and currently its paid-up capital is
%1100 crores with net worth being approximately %2500 crores.
In September 20138, started its first overseas operation by open-
ing its office in London and currently, it has more than 61 offic-
es globally. In total, there are 5 regional offices, 55 branch offices

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436 INTERNATIONAL FINANCE

CASE STUDY 8

and 1 overseas representative office in London, UK apart from

its head office in Mumbai. In order to offer specialised products
to micro, small and medium enterprises, ECGC intends to open
more branches after a comprehensive analysis of the local need.

Recently, the National Export Insurance Account (NEIA) has

been opened by the Indian government to offer credit insurance
support to both medium and long-term exports. Presently, the
NEIA Scheme is operated by ECGC. Large-sized project exports
to risk nations are covered by ECGC with the aid of NEIA. ECGC
is a member of the Berne Union and thus has certain advantag-
es such as information exchange ations and underwriting
methods with other credit insurer wide. ICRA Limited has
awarded ECGC its highest rati A for its claim paying

agement systems as been registered with the

Insurance Regula Pment Authority (IRDA).

e firms. ECGC has built a Customer Care

2 Mumbai, which is connected online with
svance management system of IRDA. An Apex
ance Committee (ACGC), comprising senior ex-
ead office, is the ultimate in-house appellate au-
any customer complaint in ECGC. A three-member in-
Review Committee has also been formed comprising
nal professionals for review of the complaints.

ECGC is currently in the process of reviewing its Country Risk

Rating Model with the aid of a Consultant. Recently, it has also
upgraded its buyer rating Score Card System with the support of
Dun & Bradstreet, a leading provider of Indian and international
business information. In addition, ECGC has set up a re-insurance
arrangement with 3 re-insurers including 2 foreign re-insurers.
(Source: http://articles.economictimes.indiatimes.com/2014-01-10/news/46066311_1_ea-
credit i . . g rer y d Li yp tauth ity)

g QUESTIONS

1. In the context of the case study, how do you think micro,

small and medium enterprises can be assured of ECGC’s
product offerings?

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 CASE STUDY 8: INTRODUCTION OF SPECIALISED PRODUCTS FOR
MICRO, SMALL AND MEDIUM ENTERPRISES BY ECGC 437

CASE STUDY 8

(Hint: Micro, small and medium enterprises can be

assured of ECGC’s product offerings by reviewing its high
international standards with its product diversification,
buyer and country risk assessment capabilities, claim
settlement policies and procedures and risk management
systems.)
2. Mention some of ECGC’s recent activities.

(Hint: ECGC is currently in the process of reviewing its

Country Risk Rating Model with the aid of a consultant.)

se
NMIMS Global Access - School for Continuing Education
438 INTERNATIONAL FINANCE

CASE STUDY 9

MANIPULATING LIBOR: A SCANDAL OF RIGGING

BENCHMARK INTERST RATES

This Case Study discusses the criminal practice of manipulating

LIBOR for gaining profits. It is related to Chapter 9 of the book.

London Inter-Bank Offered Rate (LIBOR) refers to the costs of

banks’ borrowings. Major banks in London are asked to submit
their borrowing costs, and the average is taken out to set LIBOR.
All the loans, mortgages, student loans and other financial prod-
ucts depend upon LIBOR. In 2015, a LIBOR scandal surfaced in
which it was discovered that the ks were falsely inflating or
n trades.

the Mr. Justice Cooke, The conduct involved here is

out as dishonest and wrong, and a message sent to the
banking accordingly. The reputation of LIBOR is import-
o the City, as a financial sector, and the banking institutions of
this City. Probity and honesty is essential, as is trust. Other traders
involved in rigging LIBOR, Anthony Allen and Anthony Conti,
who worked for Rabobank, had to pay more than $10 billion for
settling charges with regulators.

According to many experts, LIBOR manipulation has eroded

the public interest in the marketplace. As a result of LIBOR rig-
ging, 250,000 people had to pay significant premiums that were
not required. The securities broker and investment bank, Keefe,
Bruyette & Woods, estimated that the banks inspected for LIBOR
rigging could end up paying a fine of $35 billion for settlements.
This poses challenges for maintaining reserves by financial insti-
tutions for another crisis.

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CASE STUDY 9: MANIPULATING LIBOR: A SCANDAL OF RIGGING BENCHMARK INTERST RATES 439

CASE STUDY 9

& QUESTIONS

1. How does manipulation of LIBOR affect financial

markets?
(Hint: Manipulation affects the rates of financial products
such as derivatives, loans, etc.)
2. How does LIBOR affect global borrowing?
(Hint: LIBOR is used as a base rate for setting interest
rates on loans.)

se
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440 INTERNATIONAL FINANCE

CASE STUDY 10

REASONS FOR CHEAPER EXTERNAL COMMERCIAL

BORROWINGS FOR INDIAN FIRMS

This Case Study discusses how external commercial borrowing is

impacted by macro factors. It is related to Chapter 10 of the book.

The cost of borrowing for Indian companies has fallen in overseas

markets to more than two-year lows. This is because now India
is seen positively by international investors of emerging market
economies.

The low cost of funds could be beneficial to Indian companies as

the Reserve Bank of India has e orms on such loans from

he spreads or margins for external com-

Bs) over six-month LIBOR (London In-

012, the spreads touched a high of 4.24% com-

-crisis spreads of less than 1% while global liquid-

dit worthiness is reflected by the spreads on ECB. In

, these spreads also reflect the economic outlook. A high-
1 of spread implies a higher level of risk associated with a
company not fulfilling its repayment commitment.

Currently, Indian firms can raise funds up to three percentage

points above LIBOR for loans up to four years as allowed by the
Reserve Bank of India. If the hedging cost of around 7% is fac-
tored in to the six-month LIBOR rate of around 0.12%, then the
borrowing from overseas markets works out to be cheaper at
around 9% as compared to the borrowing from local banks, which
still could cost 9.25%.

It is also important to note that the absolute amount of funds raised

remained lower than in a previous financial year that reflects the
slow recovery. Despite a cheaper cost of funds, Indian firms got
approval for loans worth only $8.2 billion. The same figure stood
$10.3 billion in the same period a year ago. The Indian market is
also hugely impacted by the foreign exchange rate. If the Indian

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 CASE STUDY 10: REASONS FOR CHEAPER EXTERNAL
COMMERCIAL BORROWINGS FOR INDIAN FIRMS 441

CASE STUDY 10

rupee is weak against the dollar, the borrowing translates into the
higher rupee proceeds into the Indian economy.
(Source: Adapted from: http://economictimes.indiatimes.com/news/economy/finance/
strong-macros-stable-rupee-make-external-commercial-borrowings-cheaper-for-indi-
an-firms/articleshow/49189442.cms)

g QUESTIONS

1. Explain the significance of spreads on the ECB.

(Hint: The perception of lenders regarding the borrowers’
creditworthiness is reflected by the spreads on the ECB.)
2. In the context of the case, discuss reasons behind t
lowering of the amount of funds raised by Indian fi
(Hint: Slow process of recovery for the amount borro
by Indian firms.)

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442 INTERNATIONAL FINANCE

CASE STUDY 11

PREFERENTIAL TRADE AGREEMENTS (PTAS) AND INDIA

This Case Study discusses the potential impact of PTAs on India. It

is related to Chapter 1 of the book.

A trade bloc refers to an agreement under which certain countries

decide to limit or eliminate various kinds of tariff and non-tar-
iff barriers among themselves in order to give a boost to interna-
tional trade among them. These are basically inter-governmen-
tal agreements—a type of Preferential Trade Agreements (PTA).
A group of 12 countries (excluding India and China) signed such
an agreement for the formation of a trade bloc. The agreement
was signed in October 2015 an is agreement is confirmed

tilateral trad i oha recently; however, the effort

o the focus being shifted to PTAs in-

influence the world trade should follow a fully

ut any barriers. However, when a country frees

the same time also increasing trade barriers for oth-

tries. With respect to PTAs, two terms-trade creation and
trade diversion—are used. Trade creation means that as per PTAs,
a new trade relation is created with a certain country who is the
ember of the PTA. However, it may also lead to disruption of an
already established trade relation, leading in a country changing
its trade partner from a member that was not a party to the PTA
to a member that is a party to the PTA (a case of trade diversion).
Trade creation is economically sound, whereas trade diversion is
economically harmful.

Economists of the world are divided on their opinion regarding the

world trade as some economists support multilateral agreements,
whereas others prefer PTAs. According to Jagdish Bhagwati, a
renowned trade economist, a proliferation of PTAs will represent
a “stumbling block” rather than a “building block” towards eventual
multilateral trade liberalisation. Bhagwati further contends that the
criss-crossing tariff preferences and complex rules of origin within
PTAs create a veritable “spaghetti bowl” of preferential arrange-
ments, which are ultimately destructive of the goal of global free
trade.

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 CASE STUDY 11: PREFERENTIAL TRADE AGREEMENTS (PTAS) AND INDIA 443

CASE STUDY 11

There have been various discussions over the motive behind the
formation of PTAs as well. Some economists believe that PTAs
are not created for liberalising the trade; rather they are created
for achieving integration beyond borders in terms of labour, envi-
ronmental standards, regulation of state-owned companies. How-
ever, this deep integration argument does not prove to be sound
because freeing up of trade should ideally be mutually beneficial;
but in the case of integration, the harmonisation of a country’s
regulatory standards related to labour, environment, etc. might
not lead to mutual gain for countries.

If ever India becomes a party to such an agreement (say TPP), i

mean India losing its policy sovereignty to the US. I

the Indian standards would require to be harmonise
US standards which would potentially involve
sources from India to the US, which is in no

(Source: Adopted from: http://mintonsunday.liv

Partnership and India’s trade strategy. Retrie

(Hint: No, India should not join any PTA that is dominated
by the US because it would mean India losing its policy
sovereignty to the US.)

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444 INTERNATIONAL FINANCE

CASE STUDY 12

CAPITAL ACCOUNT CONVERTIBILITY INESCAPABLE:

RESERVE BANK OF INDIA

This Case Study discusses the importance of capital account con-

vertibility for India. It is related to Chapter 4 of the book.

According to the Reserve Bank of India (RBD), with the enhanced

pace of globalisation of the Indian economy, it has become hard to
maintain capital controls for a long period of time, thereby creat-
ing the importance of full capital account convertibility in India.

RBI Executive Director G. Padmanabhan said at a recent lecture

in Mangalore, “Greater opening tal account is inescapable
as the Indian economy grows fu ecomes global in dimen-
sion”.

Full capital account con i there are no restrictions

cy. At present, the Indian
dian currency only on the cur-

1, “India will need to get closely integrated

. So, India needs to continue moving to-

fiscal consolidation, inflation control, low level of

and sustainable current account deficit, strengthening of
al markets, prudential supervision of financial institutions,
has already made visible progress on these fronts”.

RBI Governor Raghuram Rajan had last month said, The central
bank aims to move towards capital account convertibility and also
set up a system where loans could be benchmarked against market
rate, alike London Interbank Offered Rate (Libor).

Under the economic liberalisation in India, continuing from 1991,

economic policies are constantly being liberalised, and the gov-
ernment and the RBI have been progressively lifting curbs on
capital flows. This has resulted in an enhanced quantum of FII in-
vestment into domestic debt that has risen to $31 billion as of now.

Padmanabhan said, “A truly globalised economy, which the Indi-

an economy is likely to become in the not too distant a future, can-
not afford to remain isolated for a very long period of time. There
are of course risks, but it needs to accept these risks and move for-
ward boldly while controlling the risks as far as practicable. Sound
policies, robust regulatory framework promoting a strong and ef-

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CASE STUDY 12: CAPITAL ACCOUNT CONVERTIBILITY INESCAPABLE: RESERVE BANK OF INDIA 445

CASE STUDY 12

ficient financial sector, and effective systems and procedures for

controlling capital flows greatly enhance the chances of ensuring
that such flows foster sustainable growth and do not lead to disrup-
tion and crisis. India has all these in place and we need to keep on
strengthening them”.

While there are risks associated with full capital account convert-
ibility, resisting liberalisation over an extended period may prove
futile and counterproductive. As the economy gets more global-
ised, it will become harder to maintain closed capital accounts.
(Source: Adapted from: http://www.dnaindia.com/money/report-capital-account-convert-
ibility-inescapable-reserve-bank-of-india-2086901)

g QUESTIONS

1. What are the prerequisites for the Indian economy

moving towards capital account convertibility
(Hint: It will depend upon how fast the Indi

of the world.)

NMIMS Global Access - School for Continuing Education

 PROGRAM HIGHLIGHTS

a
Self Instructional Online Lectures
a Personal Contact
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Access to the Learning
Study Material Delivery Program Management System
supported by ebooks & Digital Library

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SVKM’S “SS
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NMIMs
Deemed to bedi} NY VE RS ] TY

AWARDS AND ACCOLADES

* Awarded “Top Distance Learning Institute of India” by Competition Success Review at CSR Awards for Excellence
-— 2013
& 2014

* Ranked 2" among Top B-Schools in India offering Management Program in Distance Learning Mode by Zee Business
— 2011 & 2012

* Ranked 5 among Top Distance Learning Institutes in India that have leveraged methodology, technology, faculty &
infrastructure to provide best experience by DNA - Indus Learning Survey 2012

SVKM’S
Narsee Monjee Institute of Management Studies
Declared as Deemed-to-be University under Section 3 of the UGC Act 1956

University Contact Details: Email- ngasce@nmims.edu

Website- distance.nmims.edu