INTERNATIONAL BUSINESS

FINANCE
IBO-06
MCOM STUDY MATERIAL

Santosh Sharma
(SANTOSH SIR CLASSES)
 Unit-1: International Monetary System and Institutions

International Monetary System

• International Monetary System (IMS) is a system that regulates the valuations and exchange of currencies
across countries.
• It is a well-governed system looking after the cross-border payments, exchange rates, and mobility of capital.
• This system has rules and regulations which help in computing the exchange rate and terms of international
payments.
• In other words, International Monetary System mobilizes the capital from one nation to another.
• There are many participants like MNCs (Multinational Corporations), Investors, Financial Institutions, etc., in
the International Monetary System.
• The main purpose of the International Monetary System today is to enhance high growth in the world with
stable price levels. Earlier the scope was only up to exchange rates.
• Now the system has a broader scope by taking financial stability into consideration.
• International Monetary System has led to establishment of International Monetary Fund (IMF) and the World
Bank in the year 1944.
• International Monetary System is also known as “International Monetary and Financial System” and also
“International Financial Architecture.”

Working mechanism of International Monetary System

1. Classic Gold Standard: The first phase of the International Monetary System was the Classic Gold Standard
from 1816 to 1914. Only a few countries adopted this standard in the initial years of the Gold Standard. Later
almost all countries accepted it. This gold standard gave birth to a fixed exchange rate system with minimal
fluctuations. Because of the most fixed exchange rate, international trade saw a boost during this time. Gold
Standard also made all countries of the world abide by strict monetary policy. This standard was helpful in
correcting trade imbalances in the country. The other name of Classic Gold Standard is International Gold
Standard.
Drawbacks of Classic Gold Standard
• After the end of World War 1, the Classic Gold Standard collapsed.
• During World War, many countries printed more money in order to finance their military requirements.
• As a result of this, the money in circulation exceeded the gold reserves of the country, and so those
countries have to give up on Classic Gold Standard.
• The only United States of America didn’t give up on Classic Gold Standards.

2. Bretton Woods System: The period after World War II gave birth to Bretton Woods System. This monetary
system was in existence from 1945 to 1972. Representatives from 44 countries, in the year 1944, met at
Bretton Woods of the United States and came up with a new International Monetary System. The focus of the
Bretton Woods Agreement was to establish a uniform and liberal International Financial Architecture with
independence on domestic policies. This agreement gave birth to the US Dollar-based Monetary System or
Gold-Exchange Standard.

3. Current International Monetary System: After the downfall of the Bretton Woods System, there has not
been any formal International Monetary System in place. The present-day International Financial
Architecture is a managed float system. All the currencies of all the countries can freely float against one
another in an open market under the managed float system. The government intervenes only when the
currency needs to be stabilized. Managed Float System has been in place since 1976 with the Jamaica
Agreement. Later in 1980, the International Financial Architecture was regulated by G-5 countries. This G-5

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 group has currently turned into G-20, with a group of 20 countries managing the exchange rate on managed
float system.
Advantages of Current International Monetary System
a. IMS enhances financial stability and maintains the price level on a global scale. It also boosts global
growth.
b. International Monetary System mobilizes money across countries and determines the exchange rate.
c. This system encourages the governments of respective countries to manage their Balance of Payment
by reducing the trade deficit.
d. IMS is a well-regulated system that makes the whole process of international trading smooth.
e. This system relocates the capital from one country to another by enhancing cross-border investments.
f. International Financial Architecture provides liquidity to the countries of the world.
g. This system tries and avoids any short or long-run disruptions in the world economy.

Criticisms of Current International Monetary System

a. It is incompetent in avoiding global financial crises. There have been four serious financial crises over
the past few years.
b. Sometimes the current international financial system misaligned. That means managed float system
gets misaligned due to internal or external factors.

International Financial Systems

• International financial system is a mechanism through which financial transactions take place between two
or more countries.
• In simple words, it is the system of monetary interactions between two or more countries.
• It includes two important areas such as FDI and exchange rate.
• These systems are framed by international institutions like WTO, IMF, World Bank.
• It also measures the political and foreign exchange risks associated with MNCs.

Objectives of the Financial System

• To create a structured payment system.
• To give money the time value as it deserves.
• To reduce risks.
• To enable the most efficient economic resource allocation.
• To maintain market stability.

Components of Financial System

1. Financial Institutions: It includes all the banks and other financial institutions which provide financial
assistance to international traders. Financial help in the form of loans is provided to countries, traders, etc.
These loans are generally long-term loans and carries reasonable rate of interest.
2. Financial Markets: In financial markets, the exchange of financial assets is involved in terms of both the
creation and transfer of the same. There are financial instruments involved in it. Interest or dividend is paid
periodically. The financial market again is composed of four units.
3. Money Market: This refers to a market of debts involving financial instruments that are less risky, short-
term and highly-liquid. One can get funds for a day’s span up to a year. Banks, the government and other
financial institutions regulate such a market.
4. Capital Market: This is for long-term investments usually for more than a year.
5. Foreign Exchange Market: This type of market deals in foreign exchange currency. There is a particular
exchange rate, depending on which the funds are transferred from one country to another. This particular
market is the most developed one in the world.

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 6. Credit Market: In this market loans of medium or long-term tenure are given to the individuals or corporate
companies by financial institutions, banks, non-Bank Financial Institutions or NBFCs etc.
7. Financial Instrument: All securities and financial assets fall under the broad category of financial
instruments. Various investors and credit seekers have the demand for various types of loans and deposits.
Bonds, debentures and equity shares are a few financial instruments.
8. Money: One of the most important components of the financial system. Money refers to anything that is used
to pay for the products bought or services used. Money acts as an exchange medium for repayment and a
complete transaction process. Money holds the value of the product or service.

Regional Development Banks

The regional development banks (RDBs) are multilateral financial institutions that provide financial and technical
assistance for development in low- and middle-income countries within their regions. Finance is allocated through
low-interest loans and grants for a range of development sectors such as health and education, infrastructure, public
administration, financial and private-sector development, agriculture, and environmental and natural resource
management.
Types of RDB
There are basically three major regional development banks such as:
1. The Inter-American Development Bank,
2. The Asian Development Bank
3. The African Development Bank.

i) Inter-American Development Bank: It is the earliest of the regional development banks and has 46 member
countries which include not only South American but also developed countries of northern America, West
Europe and Japan. it lends to governments, public and private companies for economic and social development
projects. It provides loans from 15 to 40 years. It’s sources of funds include capital stock and market
borrowings.

ii) The Asian Development Bank: It was founded in 1966 and has 57 member countries. It gives more
importance to smaller and less developed economies. The main functions of this bank are:
a) To give loans to developing countries for economic and social development.
b) To provide technical assistance for the developmental projects.
c) To promote public and private sector investments.
d) To promote economic growth, reduce poverty, support human development, improve status of women
and to protect environment.

iii) The African Development Bank: It was established in 1966 with 53 member countries. The main object is
the economic and social development of African countries. The main functions of this bank are:
a) To give financial assistance to member countries.
b) To promote agriculture, public utilities, transport network and other infrastructure.
c) To promote literacy and skills among people.
d) To reduce poverty, gender inequalities and unemployment.
e) To provide technical assistance for developmental projects.

Role of RDB
1. Financial assistance: RDB provides different types of loans and financial assistance to developing and
underdeveloped countries. These loans are of short term and long terms. Short term loans are provided to
meet the short-term expenditures. While long term loans are provided to buy fixed assets such as machinery,
technology, etc.

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 2. Infrastructure development: These banks provide assistance for the growth of infrastructure in developing
countries. Infrastructure includes transportation, communication, power, etc. A country’s development
depends on the availability of infrastructure facilities.
3. Agricultural development: Developing countries more or less depend largely on agriculture. Therefore, to
develop agricultural sectors, these banks provide a number of facilities. These may be in the form of direct
loans to farmers for buying equipment, seeds, fertilizers, machinery, etc. They also help in marketing their
products in international markets.
4. Environment protection: Pollution has been emerging as the biggest problem for the world. This problem
is more severe in poor and developing countries. So, these banks also advise on how to control pollution
along with sustainable development.
5. Miscellaneous facilities: A country cannot develop only by growing its GDP. It should also decrease
unemployment, poverty, illiteracy, mortality rate, etc. RDB provide all sorts of assistance to improve health
care facilities, schools, training institutes, life skills development, etc. The main object of these banks is to
make the countries self-dependent and achieve international standards to compete with developed
countries.

The Bretton Woods System

• The Bretton Woods Agreement was set up in July 1944 by delegates from 44 countries at the United Nations
Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus, the name “Bretton Woods
Agreement.
• The Bretton Woods System effectively came to an end in the early 1970s when President Richard M. Nixon
announced that the U.S. would no longer exchange gold for U.S. currency.
• The Bretton Woods System included 44 countries. These countries were brought together to help regulate
and promote international trade across borders.
• Gold was the basis for all exchange of currencies.
• It gave rise to formation of International Monetary Fund and World Bank.
• The main aim was to stabilise currency rates and promote international trade.
• Countries were required to monitor and maintain their currency pegs in relation to us dollar.
• No doubt the system worked fairly well until the mid-1960 but the system had some in-built weaknesses and
contradictions, under the pressure of which, it eventually broke down on 15th August 1971.

Factors that led to the collapse of Bretton Wood Conference

1. The Confidence Problem: By the end of 1950’s many European countries were having BOP surpluses and
the USA was running counterpart deficit. For the continued economic expansion, it was essential for the
United States to maintain this deficit as it was the only way through which the growth of international reserves
could be sustained in the absence of any other reserve asset including gold.
2. Seigniorage Problem: It was argued that the Bretton Woods System gave rise to the seigniorage of the United
States over other countries, since dollar became the international reserve currency that conferred some
undue privilege upon the Americans. The question of seigniorage arose because the United States was the
issuing country of dollar. As and when it required dollar, it could issue more dollars.
3. Adjustment Problem: From the long run point of view, a serious weakness in the Bretton Woods System was
the absence of an efficient balance of payments adjustment mechanism. No country can afford to have a
persistent BOP deficit. The principal types of adjustment mechanism include adjustment through changes in
relative incomes, through relative price changes, through the movements in exchange rates and through the
imposition of direct controls over foreign transactions. The Bretton Woods System almost prohibited the use
of direct controls.
4. Triffin Dilemma: A serious inbuilt contradiction in the system was exposed by Triffin as early as 1960. It is
often referred as ‘Triffin dilemma’ i.e., either the United States corrected its deficit and created a liquidity
shortage or it continued to run the BOP deficit. The latter alternative could only cause the crisis of confidence.

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 The existence of this dilemma clearly showed that the system was inherently unstable and was destined to
collapse.
5. Problem of Symmetry: There was a general problem of symmetry between deficit and surplus countries or
between the USA and the rest of the world. Although the Bretton Woods System intended that both deficit and
surplus countries should share the burden of adjustment in payments imbalances, yet the brunt of adjustment
fell practically entirely upon the deficit countries. While the surplus countries could continue to run surpluses
so long as they were willing to accumulate reserves, the deficit countries could not run down their reserves
indefinitely. This asymmetry between the deficit and surplus countries exposed a serious weakness in this
system and became partly responsible for its eclipse.
6. The Liquidity Problem: One of the predominant causes of the breakdown of the Bretton Woods System was
the problem of liquidity. Any system of fixed or stable exchange rate could work efficiently only if there were
sufficient international reserves. During the 1950’s and 1960’s, the U.S. deficits in BOP continued to increase
on account of overseas investments.
7. Conditions of Inflation: An important factor to cause the collapse of the Bretton Woods System was the
domestic inflation in the United States particularly after the escalation of Vietnam War from 1965. Both
Johnson and Nixon administrations were unwilling to finance the war efforts by increased taxes. Instead, easy
money policies were pursued. These policies intensified inflation in the United States and the balance of
current account got weakened. The surplus countries of Europe feared the transmission of inflation to their
own countries, when their balance of payments surpluses had been bringing about an increase in their money
supplies.

Write a short note on WTO.

• Created in 1995, the World Trade Organization (WTO) is an international institution that oversees the global
trade rules among nations.
• The main focus of the WTO is to provide open lines of communication concerning trade among its members.
• The WTO is the successor to the General Agreement on Tariffs and Trade (GATT), which was created in 1947.
• The WTO has 164 members, accounting for 98% of world trade. A total of 25 countries are negotiating
membership.

Objectives of WTO
The WTO has six key objectives:
(1) to set and enforce rules for international trade,
(2) to provide a forum for negotiating and monitoring further trade liberalization,
(3) to resolve trade disputes,
(4) to increase the transparency of decision-making processes,
(5) to cooperate with other major international economic institutions involved in global economic management, and
(6) to help developing countries benefit fully from the global trading system.

Functions of WTO
Its main function is to ensure that trade flows as smoothly, predictably and freely as possible.
a. Administering trade agreements.
b. Acting as a forum for trade negotiations
c. Settling trade disputes
d. Reviewing national trade policies
e. Building the trade capacity of developing economies
f. Cooperating with other international organizations

International Monetary Fund (IMF)

• The International Monetary Fund (IMF) is an international organization that aims to accomplish a number
of different goals.

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 • These include reducing global poverty, encouraging international trade, and promoting financial stability
and economic growth.
• The organization was created in 1945 and is based in Washington, DC. There are a total of 190 member
countries, each of which is represented on the group's board.
• This representation is based on how important its financial position is in the world.
• More powerful countries have a greater voice in the organization than nations which are weaker.

The IMF functions in three main areas:

a. Lending to countries with balance of payments issues.
b. Helping member countries modernize their economies.
c. Monitoring Member Country Economies.

Functions of IMF
1. Economic Surveillance: Primary job is to promote stability in the global monetary system. So, its first
function is to monitor the economies of its 190 member countries. This activity, known as economic
surveillance.
2. Lending: The IMF lends money to nurture the economies of member countries with balance of payments
problems instead of lending to fund individual projects.
3. Technical Assistance: The third main function of the IMF is providing assistance, policy advice, and training
through its various programs. The group provides member nations with technical assistance in the following
areas:

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 Unit-2: International Financial Markets
Meaning of Financial Market
It is a place where financial securities are bought and sold. It comprises of stock market, currency market, bond
market, Derivative market, commodity market and money market. There are a set of rules and regulations to be
followed by all the traders.
Objectives
1. To maximise wealth of the shareholders.
2. To provide financial assistance to importers and exporters.
3. To encourage foreign direct investment.
4. To provide foreign currency exchange services.

International Bonds
International bonds are bonds issued by a country or company that is not domestic for the investor. The international
bond market is quickly expanding as companies continue to look for the cheapest way to borrow money. By issuing
debt on an international scale, a company can reach more investors. It also potentially helps decrease regulatory
constraints.

Types of International Bonds

There are three general categories for international bonds: domestic, euro, and foreign. The categories are based on
the country (domicile) of the issuer, the country of the investor, and the currencies used.
1. Domestic bonds: Issued, underwritten and then traded with the currency and regulations of the borrower’s
country.
2. Eurobonds: Underwritten by an international company using domestic currency and then traded outside of
the country’s domestic market. A Eurobond is a long-term bond. It is issued and sold outside the country
where it has been denominated. Although the implication from the name indicates that Europe is involved,
any country can create a Eurobond. If an organization in the United States were to use a bond that was
denominated in dollars, then sold that bond to investors in the United Kingdom, then it would qualify as a
Eurobond. The same would be true if that company sold that bond to South-Korean investors. Multi-national
companies often issue Eurobonds as a way to finance their global operations. It is very common to issue a
Eurobond from one country where they have a presence, then sell it to another country where there are offices
as well.
3. Foreign bonds: Issued in a domestic country by a foreign company, using the regulations and currency of the
domestic country. A foreign bond is a long-term bond that can be issued by governments or companies which
are outside of their home country. If a U.S. company were to issue a bond that was denominated in Canadian
dollars, then sold to investors in Canada, then a foreign bond would be issued. It is usually denominated in the
currency of where it is expected to be sold. Many companies issue foreign bonds in the U.S. Dollar because
they seek out investors from the United States to fuel their operations. Foreign bonds may be subject to
disclosure requirements, trading regulations, and securities regulations as they are traded on national
markets.

Instruments traded in International Financial Market

1. Foreign Exchange: In international financial market, currencies of various countries are bought and sold
against each other. The foreign exchange market is an over-the-counter market. It is one of the largest
markets in the world.
2. Derivative Products: A derivative is a financial instrument whose value depends on other more basic,
underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold
or copper. Derivatives have become increasingly important in the field of finance.

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3. International Currency Market: Since the 1960s various banks started forming international syndicates.
Multinational banks are responsible for huge international transfers of capital not only for investment
purposes but also for hedging and speculating against exchange rate changes.
4. Eurocurrency Market: This represents the money market in which Eurocurrency, that is currency held in
banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe.
5. Money Market Instruments: The money market is the securities market dealing in short-term debt and
monetary instruments. Money market instruments are forms of debt that mature in less than one year and
are very liquid and relatively risk free. The important instruments traded here are:
i) Treasury bills make up the bulk of the money market instruments.
ii) Commercial Paper: This is an unsecured, short-term instrument issued by a corporation, typically
for financing accounts receivables and inventories. It is usually issued at a discount reflecting
prevailing market interest rates. Maturities on commercial paper are usually up to a maximum
maturity 270 days.
iii) Euro commercial Paper: This is an unsecured, short-term paper issued by a bank or corporation in
the international money market, denominated in a currency that differs from the corporation’s
domestic currency.
iv) Certificate of Deposit: This is a savings certificate entitling the bearer to receive interest. A
Certificate of Deposit bears a maturity date, a specified interest rate and can be issued in any
denomination. CDs are generally issued by commercial banks.
v) Banker’s Acceptance: This is a short-term credit investment created by a non-financial firm and
guaranteed by a bank. Such acceptances are traded at a discount from face value on the secondary
market.
vi) Bond and Note Issues A note is a debt security, usually maturing in one to 10 years. In comparison,
bills mature in less than one year and bonds typically mature in more than 10 years. Often the terms
‘notes’ and ‘bonds’ are used interchangeably.

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 Unit-3: International Banking
International Money Transfer Mechanism.
The Reserve Bank of India allows Indian citizens to transfer money through a process called outward remittance.
Outward remittance can be done through banks, post offices and digital payment platforms. The Reserve Bank of
India allows up to $2,50,000 for transfer from India.

Factors to be kept in mind when you transfer

a. For online transfer it should take 48 to 72 hours.
b. The current exchange rates.
c. The overhead charges if any.
Methods of transfer
i) Bank draft and cashier’s cheques.
ii) International money order.
iii) Online money transfer through swift code of the recipient bank.
iv) Online wire transfer through Western Union bank, book my forex, etc. which is the cheapest way to transfer
funds.

Meaning of Money Market.

• Money market is an organised exchange market where securities are bought and sold.
• It enables companies and banks to fund their cash flow needs by selling their various securities.
• Investors buy these securities to earn money by way of dividends.
• It meets the short-term fund requirement of a company.
• It is a network of financial institutions dealing in short term funds.
• The main participants in money market are commercial banks, financial institutions, government etc.

Significance of Money Market

i) Development of trade and industries.
ii) Development of capital market.
iii) Smooth functioning of commercial banks.
iv) Helps Reserve Bank of India to control other banks.
v) Helps to frame monetary policies.
vi) It is a source of finance for the government.

Constituents of money market

The main constituents of money market are:
1. Treasury Bills
2. Call Money
3. Repo Rate and Reverse Repo Rate
4. Commercial Paper
5. Certificate of Deposit

1) Treasury Bills
• These are issued by RBI to meet short term fund requirements of the companies.
• These are issued for a period of usually 3 months.
• These instruments carry 4.6% interest rate per annum.
• These are the most secured and trusted constituent issued by RBI.
• These are readily liquefied by RBI through discounting or repurchase.

2) Call Money market

• Maturity varies from one day to 14 days. It deals in overnight funds.
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 • It is highly liquid asset.
• It is affected by seasonal variations.
• It helps banks to manage short term fund requirements.
• The rate of interest changes many times during a day.

3) Repo Rate and Reverse Repo Rate

• The Repo Rate is the rate at which a nation’s central bank gives money to commercial banks in the
time of a cash shortage.
• In the time of inflation, central banks increase the Repo Rate to prevent banks from borrowing
from the central bank.
• The current interest rate is 4% which the Reserve Bank of India charges for short-term loans to
commercial banks.
• The Reverse Repo Rate is the rate at which a country’s central bank borrows money from domestic
commercial banks.
• If the Reverse Repo rate increases, commercial banks will be more attracted to deposit their funds
with the RBI, reducing the amount of money available in the market.

4) Commercial Paper (CP)

• CP was introduced by the RBI in 1990 to raise money for short term.
• These are unsecured promissory notes.
• Maturity varies from 3 months to 6 months.
• The value of CP are generally multiples of 5,00,000.
• The minimum value of CP is 25,00,000.
• CP carries high rate of interest.
• The issuing company must have a net worth of ₹5,00,00,000.

5) Certificate of Deposit: These are issued by banks when they have insufficient deposits and the demand of
credit is very high. The maturity period varies from 91 days to one year.

Concept of Loan Syndication

Loan syndication occurs when two or more lenders come together to fund one loan for a single borrower. Syndicates
are created when a loan is too large for one bank or falls outside the risk tolerance of a bank. The banks in a loan
syndicate share the risk and are only exposed to their portion of the loan. A loan syndicate always has a syndicate
agent, which is the lead bank that organizes the loan, its terms, and other relevant information. The Loan
Syndications and Trading Association provides resources on loan syndications within the corporate loan market.
Loan syndication is often used in corporate financing. Firms seek corporate loans for a variety of reasons, including
funding for mergers, acquisitions, buyouts, and other capital expenditure projects. These capital projects often
require large amounts of capital that typically exceed a single lender's resource or underwriting capacity.
There is only one loan agreement for the entire syndicate. But each lender's liability is limited to their respective
share of the loan interest. The agreements between lending parties and loan recipients are often managed by
a corporate risk manager. This reduces any misunderstandings and helps enforce contractual obligations. Bank of
America Securities, JPMorgan, Wells Fargo, and Citi are among the industry’s leading syndicators in the U.S. loan
market.
Process of loan syndication
• The first step in loan syndication is to invite bids from borrowers. in return the borrowers in white bids from
banks.
• The next step is to prepare bid letter which will be addressed to the borrower and signed by the banks
specifying the terms and conditions.

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 • Then after the borrower will carefully examine the bid submitted by each bank. each bank will be then called
up separately to discuss the terms and conditions. the borrower will not reveal the terms of a bid submitted
by one bank to the other bank.
• The borrower then selects the bed that suits it the most.
• That a loan agreement is drafted and signed by all the participating banks and the borrower.

What is Prime lending rate?

PLR or prime lending rate is the interest rate charged by the commercial banks to their credit worthy customers,
especially large organisations. These rates include mortgage rates, small business loans, personal loans, etc. It is
determined by the rate published by Wall Street Journal daily. This rate is generally lower than the market rate. Each
bank has its own PLR.

Approaches or Models of Loan Pricing

The price of a loan is determined by its true cost of loan. Cost of loan is equal to rate plus profit. The main components
of the true cost of alone are interest expenses, administrative cost and cost of capital.
There are different types of loan pricing models such as:
1. Fixed rate model
2. Variable rate model
3. Prime rate model low rate for good customers.
4. Rate of general customers.

Concept of Yield curve.

The Yield Curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the yield
an investor is expecting to earn if he lends his money for a given period of time. The graph displays a bond’s yield on
the vertical axis and the time to maturity across the horizontal axis. The curve may take different shapes at different
points in the economic cycle, but it is typically upward sloping. It summarizes the relationship between the term
(time to maturity) of the debt and the interest rate (yield) associated with that term.

Factors Influencing Yield Curve

1. Inflation: Central banks tend to respond to a rise in expected inflation with an increase in interest rates. A rise
in inflation leads to a decrease in purchasing power and, therefore, investors expect an increase in the short-
term interest rate.
2. Economic Growth: Strong economic growth may lead to an increase in inflation due to a rise in aggregate
demand. Strong economic growth also means that there is a competition for capital, with more options to invest
available for investors. Thus, strong economic growth leads to an increase in yields and a steeper curve.
3. Interest Rates: If the central bank raises the interest rate on Treasuries, this increase will result in higher
demand for treasuries and, thus, eventually lead to a decrease in interest rates.

Importance of the Yield Curve

i) Forecasting Interest Rates: The shape of the curve helps investors get a sense of the likely future course of
interest rates. A normal upward sloping curve means that long-term securities have a higher yield, whereas
an inverted curve shows short-term securities have a higher yield.
ii) Financial Intermediary: Banks and other financial intermediaries borrow most of their funds by selling
short-term deposits and lend by using long-term loans. The steeper the upward sloping curve is, the wider
the difference between lending and borrowing rates, and the higher is their profit. A flat or downward
sloping curve, on the other hand, typically translates to a decrease in the profits of financial intermediaries.
iii) The Trade-off between Maturity and Yield: The yield curve helps indicate the trade-off between maturity
and yield. If the yield curve is upward sloping, then to increase his yield, the investor must invest in longer-
term securities, which will mean more risk.

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 Unit-4: International Transactions and Balance of Payments

Balance of Payments
Balance of Payment is a statement of a country’s receipts and payments in foreign exchange. In other words, it is the
difference between a country’s exports and imports. If exports are more than imports, there is a favourable balance
of payment and vice-versa. And if total of exports is equal to total of imports, it is called equilibrium balance of
payment.

Types of Accounts in Balance of Payments

i) Current Account
ii) Capital Account.

I. Current Account of BOP: It is a statement of actual receipts and payments in the short period. It includes
imports and exports of both goods and services. It includes items like:
1) All material goods exported and imported.
2) Travelling expenses to foreign countries and by foreign tourists.
3) Services of experts.
4) Investment income.
5) Donation and gifts.
6) Government transaction.

II. Capital Account of BOP: It is a statement of receipts and payments of capital items both in short run and long
run. It has no direct effect on income, output and employment of the country. The items included in capital
account are:
1) Buying and selling of gold.
2) Movement of banking capital.
3) Private foreign loan flow.
4) Loans from foreign banks and its repayments.

Steps taken by the government to correct Unfavourable Balance of Payments

1. Monetary Policy (Deflection): Under deflation, prices fall which makes exports attractive and imports
relatively costlier. This eventually leads to a rise in exports and a fall in imports.
2. Exchange Depreciation: Exchange depreciation means the decline in the rate of exchange of one country in
terms of another. For example, assume that the Indian rupee exchanges for 65 Roubles of the Russian
currency. If India experiences an adverse Balance of payments with regard to Russia, the Indian demand for
Rouble will rise.
3. Devaluation: The term Devaluation means a reduction in the official rate at which one currency is exchanged
for another. Devaluation is undertaken when the currency is found to be unduly overvalued. Devaluation
makes the goods cheaper for foreigners. Exports will rise and imports decline.
4. Exchange Control: Restriction on the use of foreign exchange by the central banks is called Exchange
Control. When exchange control is adopted, all the exporters have to surrender their foreign exchange
earnings to the Central Bank. Under exchange control, the central bank releases foreign exchanges only for
essential imports and conserves the rest of the balance. This is a direct method of reducing imports.
5. Fiscal Policy- Import Duties: Under this policy, import tariff duties are imposed so as to make the import
costlier with an overall aim of checking imports. Imports get reduced and balance of payments becomes
favourable.
6. Import Policy (Import Quotes): Under this mechanism, the government fixes a maximum quantity or value
of a commodity to be imported. This in turn reduces imports and the deficit is reduced and thereby the
balance of payments is improved.
7. Stimulating/Improving Export: To correct disequilibrium in the Balance of payments, it is necessary that
exports should be increased, the government may adopt export programs for this purpose. Export promotion
SANTOSH SHARMA 12
 programs include subsidies, tax concession to exporters, marketing facilities, incentives for exporters,
reducing export duties, etc.
8. Foreign Loans: The government can also secure loans from foreign banks or foreign governments to reduce
the deficit in the balance of payments. Since the repayment of these loans is spread over a long period, this
helps the government to remove the deficit in the Balance of payments.
9. Encouragement to Foreign Investment: The government induces the foreigners to make an investment in
the country offering them all sorts of investor’s incentives and concessions. This provides the government
with extra foreign exchanges which are utilized to reduce the deficit in the Balance of payments.
10. Incentives to Foreign Tourist: The government may also encourage foreign tourists to visit the country. It
can provide more infrastructure in tourist places which attract foreign tourists.

Distinguish between BOT & BOP

Balance of trade Balance of payment

It consists of imports and exports of all visible It consists of all imports and exports of visible and
items. non-visible items.
It records only current account items. It records both current and capital account items.
It is not a true indicator of economic growth of a It indicates the economic growth of a country.
country.
It may be of two types such as favourable or Balance of payment is always balanced that means
unfavourable balance of trade. total receipts is equal to total payments.
Balance of trade is a narrow concept. Balance of payment is a wide concept.

How devaluation is the most effective way to correct balance of payment?

• The term Devaluation means a reduction in the official rate at which one currency is exchanged for another.
• It is an alternative to exchange depreciation.
• Devaluation is undertaken when the currency is found to be unduly overvalued.
• Devaluation makes the goods cheaper for foreigners. Exports will rise and imports decline.
Devaluation depends on the following factors:
• The demand elasticity for the exports must be greater than Unity.
• The elasticity of supply for the imports should be greater than Unity.
• Devaluation should not be exceedingly adverse because it will not do anything.
• Devaluation of the country’s “terms of trade” should not be exceedingly adverse otherwise it will not gain
anything from trade.

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 Unit-5: Foreign Exchange Markets

Foreign Exchange Markets (FOREX)

• Foreign exchange market is a market where foreign currencies are bought and sold.
• The traders include firms, foreign exchange brokers, banks, financial institutions, etc.
• In other words, the foreign exchange market is a financial institution that facilitates the exchange of one
country’s currency for that of another.
• Foreign exchange markets are the oldest and most traditional financial marketplaces.
• It is a worldwide over-the-counter (OTC) marketplace that decides currency exchange rates all around the
world.
• Banks, dealers, commercial companies, investment management firms, and hedge funds make up the foreign
exchange markets.
• The currency market is open five days a week, 24 hours a day.
• In the forex market, currency trading entails the simultaneous buying and selling of two currencies.
• In this method, the value of one currency (base currency) is determined by comparing it to another currency
(counter currency).
• The foreign exchange rate is the price at which one currency may be exchanged for another currency.
• The forex market has no physical address. It is an electronically linked network.

Function of Foreign Exchange Market

1. Transfer of money: The primary purpose of the foreign exchange market is to make it easier to convert one
currency into another or to make buying power transfers between nations. A number of credit instruments,
such as telegraphic transfers, bank draughts, and foreign bills, are used to transmit purchasing power. The
foreign exchange market performs the transfer function by making international payments by clearing debts
in both directions at the same time, similar to domestic clearings.
2. Provides credit: Another important role of the foreign exchange market is to facilitate international trade
by providing credit, both domestic and international. When foreign bills of exchange are used in overseas
payments, a credit of around three months is necessary before they mature. The FOREX provides importers
with short-term loans in order to promote the flow of goods and services between countries. The importer
can fund international imports with his own credit.
3. Hedging Function: Hedging foreign exchange risks is a third function of the foreign exchange market.
Hedging is the process of avoiding foreign currency risk. When the exchange rate, or the price of one currency
in terms of another currency, changes in a free exchange market, the party involved may earn or lose money.
If there are large amounts of net claims or net liabilities that must be satisfied in foreign currency, a person
or a company takes on a significant exchange risk.

Advantages of Foreign Exchange Market

i) Flexibility: The forex market offers traders a great deal of freedom. This is due to the fact that the quantity
of money that may be traded is unlimited. Moreover, market regulation is essentially non-existent.
ii) Transparency: The Forex market is enormous in size and spans many time zones. Despite this, information
about the Forex market is freely available. Additionally, neither government nor the central bank has the
authority to corner the market or set prices for an extended period of time. Because of the Temporal lag in
transferring information, some entities may get short-term benefits. The magnitude of the Forex market
makes it fair and efficient.
iii) Options Trading: Traders can choose from a wide range of trading alternatives on the forex markets.
Traders have lots of different currency pairs to select from. Investors can also choose between spot trading
and signing a long-term contract. As a consequence, the Forex market has a remedy for any budgetary and
investor’s risk appetite.

Features of Foreign Exchange Market in India

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 1. Low Transaction Costs: Because of the lower online FOREX trading costs, even small investors will make
good money. Unlike other investment options, FOREX traders only charge a small fee. The spread, or the
difference between buying and selling prices for a currency pair, is where the FOREX commission is limited.
2. Elevated Leverage: In the FOREX market, you can sell on margins, which are technically borrowed funds.
The return on your investment is rising exponentially, so the value of your investment is high. Since the
FOREX market is so unpredictable, trading with leverage (borrowed money) will result in significant losses
if the market goes against you.
3. Extremely Transparent: The foreign exchange market in India is a transparent market in which traders
have complete access to market data and information necessary for successful transactions. Traders who
operate on open markets have more leverage over their investments.
4. FOREX Market Accessibility: If you have an internet connection, you can access your foreign currency
trading account from anywhere. You can trade at any time and from any place.

Types Of Foreign Exchange Market in India

1. Spot Market: In this market, transactions involving currency pairs happen quickly. In the spot market,
transactions require immediate payment at the current exchange rate, also known as the 'spot rate.' The
traders on the spot market are not exposed to the FOREX market's uncertainty, which increases or lowers
the price between trade and agreement.
2. Futures Market: Future market transactions, as the name implies, require future payment and distribution
at a previously negotiated exchange rate, also known as the future rate. These agreements and transactions
are formal, which ensures that the terms of the agreement or transaction are set in stone and cannot be
changed. Traders who conduct major FOREX transactions and pursue a consistent return on their assets
prefer future market transactions.
3. Forward Market: Forward market deals are identical to future market transactions. The main difference is
that in a forward market, the parties will negotiate the terms. The terms of the agreement can be negotiated
and adapted to the needs of the parties concerned. Flexibility is provided by the forward market.

SANTOSH SHARMA 15
 Unit-6: Determination and Forecasting of Exchange Rates

Exchange Rate Mechanism (ERM)

• An exchange rate mechanism (ERM) is a device used by countries to manage the strength of their currency.
• The ERM is a critical feature of any economy’s monetary policy and is frequently utilized by the central banks.
• It is important to place strong controls over domestic currency to stimulate international trade through the
management of domestic currency with respect to international currencies, which are traded on the foreign
exchange market.
• The exchange rate mechanism allows central banks to influence domestic currency prices of currency in
foreign exchange markets.
• Exchange rates that are actively managed through an adjustable peg rate establish a reasonable trading range
for a currency’s exchange rate.

How Do Exchange Rate Mechanisms Work?

• Originally, currencies began as a fixed exchange rate mechanism that tracked gold or other commodities.
• The exchange rate mechanism allows central banks to influence domestic currency prices of currency in
foreign exchange markets.
• Moreover, ERM enables the central bank to adjust the currency peg to exert a material impact on imports and
exports, as well as attract foreign direct investment and foreign portfolio investment.
• The exchange rate mechanism is critical to keeping exchange rates stable and controlling currency rate
fluctuations.
• Reducing foreign currency fluctuation is important, as it allows the market to become more predictable to
outside investors.
• Exchange rates that are actively managed through mechanisms set out to establish a reasonable trading range
for a currency’s exchange rate.
• The range includes a lower bound and an upper bound.
• The country must enforce the range through interventions, usually through the purchase or sale of currency.
• For example. Country A wishes to keep its currency greater than the value of Country B’s currency. To
maintain the desired exchange rate, the central bank will sell foreign currency from its reserves and buy back
domestic currency.

Different Types of Exchange Rate Mechanisms

1. Fixed Exchange Rate: A fixed exchange rate is a type of exchange rate where a currency is fixed against the
value of another currency, basket of other currencies, or gold. One major benefit is that a typical fixed
exchange rate does not change based on market conditions. This allows for improved international trade and
investments. The fixed exchange rate system can be used to control the behaviour of currency by
limiting inflation.
2. Adjustable Peg Rate: An adjustable peg rate floats on the market and changes with respect to economic
conditions. Generally, the central bank will set a degree of flexibility anchored against a specific level or peg.
It is then the central bank’s responsibility to ensure that the target exchange rate remains at the peg. The peg
rate is most notably used by the Chinese, who peg the Chinese yuan to the U.S. dollar. China uses the peg rate
to make its exports more attractive to international buyers relative to other countries supplying the same
goods.

Exchange Rate Forecasting in International Market

• Exchange rate forecasts are quarterly estimations of the future levels of exchange rates over the next four
quarters.

SANTOSH SHARMA 16
 • They are undertaken by economists and currency analysts working for portfolio management firms and
investment banks.
• Exchange rate forecasts are based on expectations regarding macroeconomic variables, interest rate
differentials, sentiment, and even political events.
• Exchange rate forecasting means to estimate the rate which will be any of future date.
• It is just expectation of currency rate. In future, our currency may be depreciated or may be appreciated.
• Whether our currency will be depreciated or will be appreciated, forecasting will be helpful for decreasing our
risk because we will yield the resources in the present time for covering this future exchange rate risk.

Models of Exchange Rate Forecast

Some important exchange rate forecast models are discussed below.

1. Purchasing Power Parity Model (PPP)

• The purchasing power parity (PPP) forecasting approach is based on the Law of One Price.
• It states that same goods in different countries should have identical prices.
• For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions
in the U.S. (considering the exchange rate and excluding transaction and shipping costs).
• That is, there will be no arbitrage opportunity to buy cheap in one country and sell at a profit in another.
• Depending on the principle, the PPP approach predicts that the exchange rate will adjust by offsetting the
price changes occurring due to inflation.
• For example, say the prices in the U.S. are predicted to go up by 4% over the next year and the prices in
Australia are going to rise by only 2%. Then, the inflation differential between America and Australia is: 4%
– 2% = 2%

2. Relative Economic Strength Model

• The relative economic strength model determines the direction of exchange rates by taking into
consideration the strength of economic growth in different countries.
• The idea behind this approach is that a strong economic growth will attract more investments from foreign
investors.
• To purchase these investments in a particular country, the investor will buy the country's currency –
increasing the demand and price (appreciation) of the currency of that particular country.

3. Econometric Model: It is a method that is used to forecast exchange rates by gathering all relevant factors
that may affect a certain currency. It connects all these factors to forecast the exchange rate. The factors are
normally from economic theory, but any variable can be added to it if required.

4. Time Series Model: The time series model is completely technical and does not include any economic theory.
The popular time series approach is known as the autoregressive moving average (ARMA) process.

Why do Central Banks intervene in the foreign exchange market?

• Central banks, especially those in developing countries, intervene in the foreign exchange market in order to
build reserves for themselves or provide them to the country's banks. Their aim is often to stabilize the
exchange rate.
• Currency stabilization may require short-term or long-term interventions.
• Stabilization allows investors to be more comfortable with transactions using the currency in question.
• A central bank or government may assess that its currency has slowly become out of sync with the country's
economy and is having adverse effects on it. They may intervene to keep the currency in line with the
currencies of the countries which import their goods.

SANTOSH SHARMA 17
 Unit-7: Currency Risk Management
Risks which an exporter faces while dealing in foreign currency.
Foreign exchange risks refer to a situation where a trader is affected due to fluctuations of the exchange rates. These
risks can be divided into 3 categories:
1. Transaction Risks
2. Economic Risks
3. Translation Risks

1. Transaction Risks
• These types of risks arise when there is a change in exchange rate before the settlement of the transaction.
• Transaction Risk is the exposure to uncertainty factors that may impact the expected return from a deal or
transaction.
• It can include but is not limited to foreign exchange risk, commodity, and time risk. It essentially encompasses
all negative events that can prevent a deal from happening.
• A deal with a high transaction risk will typically require a higher return.
• Therefore, it is important to consider such risk when evaluating a prospective investment.
• Some of the most common transaction risks that can affect the deal or transaction value include the following:
a. Foreign Exchange Risk: Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which
can affect the expected transaction value. This risk is especially important to consider for cross-border
transactions or deals with countries that have relatively high currency volatility. Foreign Exchange Risk
is also called economic exposure.
b. Commodity Risk: Similar to foreign exchange, commodity risk considers the unexpected fluctuation of
commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in the Oil
& Gas and Mining sectors.
c. Interest Rate Risk: Interest rate risk examines how interest rate fluctuation can affect transaction value.
Depending on the changes in rates, this risk can affect the ability of the purchasing party to raise the
necessary capital for the transaction and can impact the debt obligations of the selling party. For
companies that engage in debt covenant agreements with financial institutions, interest rate fluctuation
can impact the company’s ability to meet its obligations established in the covenant.
d. Time Risk: As market conditions and companies change with time, there is a higher probability that the
initial transaction agreement conditions will become unfavourable the longer the negotiation process is
extended. As a result, deals can fall through due to the favourable conditions no longer being present for
both parties. The longer a deal takes to finalize, the longer the transaction is exposed to the other risks.
e. Counterparty Risk: When engaging in transactions, there is a risk that the counterparty will not
complete their contractual obligations agreed upon in the transaction. In instances where counterparties
default on their contractual obligations, it is often due to the effects of the previously stated transaction
risks.

2. Economic risk
These types of risks arise when there is a change in market value of product due to change in its demand and
supply. These risks can be of three types:
i) Sovereign Risk: This type of economic risk is one of the most critical risks that can have a direct impact on
the investment since the repercussions arising out of these risks can trigger other troubles that are related
to the business. Sovereign Risk is the risk that a government cannot repay its debt and default on its
payments. When a government becomes bankrupt, it directly impacts the businesses in the country.
Sovereign Risk is not limited to a government defaulting but also includes the political unrest and change in
the policies made by the government. A change in government policies can impact the exchange rate, which
might affect the business transactions, resulting in a loss where the business was supposed to make a profit.

SANTOSH SHARMA 18
 ii) Unexpected swing in exchange rate: This can be due to speculation or the news that can cause a fall in
demand for a particular product or currency. Oil prices can significantly impact the market movement of
other traded products. As mentioned above, government policies can also result in a dip or hike in the market
movement. Change in inflation, interest rates, import-export duties, and taxes also impact the exchange rate.
Since this directly impacts trade, exchange rates risk seeming to be a significant economic risk.
iii) Credit risk: This type of sovereign risk is the risk that the counterparty will default in making the obligation
it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness to pay its debts.
The counterparty’s business activities need to be monitored on a timely basis so that the business
transactions are closed at the right time without the risk of counterparty default to make it payments.

3. Translation Risks: These risks occur when a company does business outside the country but its financial
performance is measured in domestic currency. Translation risk arises when foreign financial statements of a
company is converted into domestic currency. This risk may adversely affect firm’s reported financial
statements, or related financial ratios or borrowing covenant compliance, resulting from changes in the rates
at which foreign currency denominated assets and liabilities are translated into the reporting currency.
Translation risk commonly applies to the translation of monetary assets and liabilities. This risk may also apply
to the consolidation of overseas subsidiaries into group financial statements.

What are Derivatives?

• Derivatives are financial contracts between two or more parties that derive their values from underlying asset.
• It can be traded on an exchange or over the counter.
• Prices of derivatives are derived from fluctuations in the underlying asset.
• Common derivatives include future contracts, forwards, options and swaps.
• Common underlying assets are derivatives which includes stocks, bonds, commodities, currencies, interest
rates and market indices.
• Derivatives can be used to hedge a position, speculate or give leverage to holdings.

Differences between Futures and Options

Futures Options
It is an agreement between two parties for the It is an agreement between two parties to purchase
purchase and delivery of an asset at an agreed price and deliver an asset at the current price.
at a future date.
These are standardised contracts that are traded in These are not traded in exchange.
an exchange.
The parties involved are committed to buy and sell There is no obligation on the parties to execute the
the asset at a future date. agreement.

What are International Swaps?

• ISDA- (The international swaps and derivatives association) is a professional organization created by a group
of banks.
• It helps to improve the market for privately negotiated over the counter OTC derivatives by reducing risks in
the market.
• It frames standardised agreement which serves as a template for swap traders.
• It performs three key functions such as:
1. To reduce counterparty credit risk.
2. To increase transparency.
3. To improve infrastructure and derivative industries.

SANTOSH SHARMA 19
 Unit-8: Measuring and Managing Transaction Exposure

Concept of Transaction exposure, Translation exposure and Economic exposure or risk.

Transaction Exposure
• It is the simplest type of foreign currency exposure.
• It deals with actual foreign currency transactions.
• It occurs due to foreign currency Gators of sale, payment of imported goods or services, receipts or payments
of dividends, payment of EMI, etc.
• For example, if you have bought goods from a foreign country to be paid after 3 months. but the value of
foreign currency rises in between that, you end up paying higher than your actual dept.
Translation exposure
• It is also known as accounting exposure.
• It occurs due to translation of books of accounts into the home currency.
• It affects the valuation of assets and liabilities.
• It is equivalent to comparing cash flow accounting treatment with accounting book treatment.
Economic exposure
• It deals with the whole economic system of a country.
• It is not applicable to a single firm rather it affects all the forms of a country.
• The impact of this higher than the other exposures.
• It directly affects the market value of a firm.
• It affects the cash flows and also the assets and liabilities of a firm.

Techniques of managing Transaction Exposure

An exporter can manage the transaction exposure in the following ways:
1. Hedging: Companies will engage in hedging arrangements to reduce the level of potential risk from the price
movement of various assets. Hedging provides companies with protection against adverse changes to asset
prices that can negatively affect investment. Within the context of transactions, companies will often
complete hedging arrangements to reduce the effects of Foreign Exchange and Commodity Risk associated
with the deal.
2. Refinancing: In a fluctuating interest rate environment, companies often look to refinance their debt when
interest rates are declining. Debt refinancing allows companies to reduce their debt obligations and to
borrow at more attractive rates. To ensure that a party is eligible for refinancing, the borrowing party can
include renegotiation clauses in their contracts that allow for refinancing adjustments when notable interest
rate changes.
3. Due Diligence: To reduce the possibility of the counterparty defaulting on their contractual obligations,
parties will undergo an extensive due diligence process to assess various components of the transaction
before coming to an agreement. In situations where the counterparty has a higher risk of defaulting, the
purchasing party may place a default risk premium into the transaction agreement to create an incentive for
taking on more risk.

SANTOSH SHARMA 20
 Unit-10: Corporate Strategy and Foreign Direct Investment

Govt. of India policy towards Foreign Direct Investment

The companies invest abroad due to the following factors:
• To reduce cost of production.
• To diversify the market potential and area.
• To gain economies of scale. That means to produce more goods with minimum cost.
• To promote knowledge sharing and globalization. The main object is to adopt latest technology.
• To increase domestic customers base and supply international quality of goods and services.
Regulations of foreign direct investment.
The department of industrial policy and promotion DIP formulates all regulations on FDI.
• To attract more and more foreign investments.
• Foreign investors can invest directly in India either on their own or through joint ventures.
• Foreign direct investment in the majority of the sectors is under automatic route, no regulatory approval is
required.
• NRI can invest in India except in prohibited sectors.
• The government has put FDI regulations very transparent and easy to attract more and more foreign
investors.
FDI can be made through the following routes such as:
1. Automatic route.
2. Government approval route. For some selected industries like mining, defence, print media, Civil Aviation,
satellites, telecom, etc. need approval of the government.
3. India has among the most liberal and transparent policies on FDI among the emerging economies.

Features of FDI
• FDI up to 100 per cent is allowed under the automatic route in all activities/sectors except.
• Special Economic Zones:100 per cent FDI is permitted under automatic route for setting up of Special
Economic Zone.
• Export Oriented Units (EOUs):100 per cent FDI is permitted under automatic route for setting up 100 per
cent EOU, subject to sectoral norms.
• Industrial Park: 100 per cent FDI is permitted under automatic route for setting up of the Industrial Park.
• Software Technology Park Units: All proposals for FDI/NRI investment in STP Units are eligible for approval
under automatic route.

A short note on FEMA (Foreign Exchange Management Act)

• Foreign Exchange Management Act, 1999 (FEMA) came into force by an act of Parliament.
• This act contains a set of regulations that empowers the Reserve Bank of India to pass regulations and
enables the Government of India to pass rules relating to foreign exchange in tune with the foreign trade
policy of India.
• FEMA was previously known as Foreign Exchange Regulation Act (FERA).
• The main object of this act is to increase the flow of foreign exchange in India without any legal barrier
• As per this act, Indians residing in India, have the permission to conduct a foreign exchange, foreign security
transactions or the right to hold or own immovable property in a foreign country.
• It empowers to the Central Government to regulate the flow of payments to and from a person situated
outside the country.
• All financial transactions concerning foreign securities or exchange cannot be carried out without the
approval of FEMA.
• All transactions must be carried out through “Authorised Persons.”

SANTOSH SHARMA 21
 • In the general interest of the public, the Government of India can restrict an authorized individual from
carrying out foreign exchange deals within the current account.
• It empowers the RBI to place restrictions on the transactions from capital Account even if it is carried out via
an authorized individual.

Role of foreign investment policy (FDI) of India

Foreign direct investment is very important for any country to achieve economic growth and development. As far as
India is concerned, foreign capital plays a very important role for its economic development.
1. Employment opportunities.
2. Economic growth and development.
3. Human resource development.
4. Latest technology.
5. Export growth.
6. Competitive market.
7. Growth of domestic industries.

1) Employment opportunities: Foreign capital helps to establish more and more industries in an economy.
This leads to creation of more job opportunities for the domestic people. A lot of people are employed in
MNCs (Multi-national Corporations). Thus, FDI solves the problem of unemployment to a large extent and
helps in economic development.
2) Economic growth and development: It are measured in terms of GDP and per-capita income of the people
living in a country. Foreign capital can be utilised for developmental purpose and establishment of new
industries. It leads to creation of better infrastructure in the country and as a result more growth and
development can be achieved.
3) Human resource development: It refers to the quality of manpower available in a country. Foreign capital
helps to enhance the skill and talent of the people. More training institutes can be established to provide
training to people. In this way, the quality and productivity of the human resource will be improved.
4) Latest technology: Foreign capital helps to introduce new technology in a country. Latest technology can be
imported from other countries which can be effectively used by the business firms.
5) Growth in exports: With the help of foreign capital more and more goods and services can be produced.
This helps to increase the exports and earn foreign exchange which helps to correct balance the payment of
a country.
6) Competitive market: With the rise of more and more industries in a country, more competitive market can
be developed. As a result, better quality of goods and services at reasonable prices are available in a country.
All these would enhance the standard of living of the people. They can get international products and services
in their home country.
7) Growth of domestic industries: Foreign capital helps to grow and develop domestic industries. MNCs
usually buy raw-materials from local companies which increases the production and profits. These industries
would use latest technology to stand in the international market. More skilful workers will be employed to
increase production add quality of goods and services.

Distinguish between Foreign Direct Investment and Portfolio Investment.

Foreign Direct Investment Foreign Portfolio Investment

Foreign direct investment or FDI pertains to Foreign Portfolio Investment or FPI refers to the
international investment in which the investor obtains investment made in the financial assets of an enterprise,
a lasting interest in an enterprise in another country. based in one country, by the foreign investors.
Direct investments in assets are made. Indirect investments in assets are made.
Investments made are long term in nature. Investments made are short term in nature.
FDI are stable in nature. FPI are volatile in nature.

SANTOSH SHARMA 22
 Unit-11: International Project Appraisal
Meaning of International Project Appraisal
It is a cost and benefit analysis of a project. An entrepreneur needs to appraise various alternative projects before
allocating funds. Appraisal is done on the basis of economic, financial, technical and social aspects. A project has long-
term impact on business operations. It is a process of evaluating a company’s posture relative to its business
competition within and outside the country. It shows the overall performance of a company. It tells about the
strengths and weaknesses of a project.
Steps or processes of Project Appraisal
a. Identifying the strategic factors for success of an organization.
b. Analysing the factors.
c. Determining the strengths and weaknesses.
d. Constructing comparative advantage of the company.

Techniques of Project Appraisal

1. Discounted Cash Flow Technique (DCF)
2. Non-DCF Technique (Non- DCF)
3. ADJUSTED Present Value Technique (APV)

1) DCF techniques of Project Appraisal: DCF stands for discounted cash flow, which is an analysis method of
valuing a project, asset, company, or security using the concepts of the time value of money. It started in the
industry as early as the 1700s or 1800s and was then widely discussed in the 1960s in financial economics
until it became widely accepted by the U.S. courts in the ‘80s and ‘90s. Discounted cash flows are adjusted to
find the time value of money. These are discounted using a discount rate to get the present value estimate,
which is used to evaluate the potential for investment. Discounted cash flows can be calculated using this
formula:
DCF = CF 1/ (1+r) 1 + CF 2/ (1+r) 2 +… CF n (1+r) n
Where: CF = Cash flow and r = Discount rate.

Advantages of DCF
a. Discounted cash flows are most suitable to use for evaluating investment decisions by comparing the
discounted cash inflows and cash outflows.
b. NPV, known as Net Present Value, is a technique for investment appraisal that uses discounted cash flows
to find out if a project is financially feasible.

Disadvantages of DCF
a. DCF requires making a lot of assumptions.
b. An investor would have to correctly estimate the future cash flows from a project or investment. Because
of this, future cash flows would need to rely on various factors, such as the status of the economy, the
market demand, unforeseen obstacles, and more.
c. Making estimates for the cash flow is a risky move and could lead to choosing investments that may not
pay off in the future, and thus hurting profits.
d. Even by estimating cash flows too low can have dire consequences that can end in missed opportunities.
e. Choosing a discount rate also relies on assumptions and will need to be estimated correctly for the model
to be worthwhile.

2) Non-DCF or Undiscounted Cash Flows: Undiscounted cash flows don’t incorporate the time value of money
and is the opposite of discounted cash flows. They solely consider the normal value of cash flows when it comes
to making investment decisions. Because undiscounted cash flows don’t consider the reduction in the value of
money over time, it isn’t used to assist accurate investment decisions. While undiscounted cash flows may
SANTOSH SHARMA 23
 seem to generate a positive NPV at first, they won’t be able to generate the same amount after a few years down
the road. This is because the effect of time and money isn’t applied, therefore, NPV can be heavily overstated.
Furthermore, undiscounted future cash flows are cash flows that are expected to be incurred or generated by
a project which hasn’t been reduced to their present value. This may happen when interest rates are near zero,
or the expected cash flows cover such a short period of time that the use of a discount wouldn’t result in a
different outcome.

Differences between DCF and Non-DCF

DCF Non-DCF
Discounted cash flows are cash flows adjusted to Undiscounted cash flows are not adjusted to
incorporate the time value of money. incorporate the time value of money.
The time value of money is considered in discounted Undiscounted cash flows do not account for the time
cash flows and thus is highly accurate. value of money and are less accurate.
Discounted cash flows are used in investment appraisal Undiscounted cash flows are not used in investment
techniques such as NPV (Net Present Value) appraisal.

3) Adjusted Present Value Method: In this method, different components of the project’s cash flow are
discounted separately. Thus, it provides flexibility to various variables to adjust in the value of the project. It is
also possible to use different discount rates for different segments of the total cash flow. Moreover, the APV
framework enables to test the profitability of each project before preparing the final accounts of all projects. If
the project is not acceptable, then one additional segment is added.
Components of APV
a. Initial Investment
b. Project’s Remit table Cash Flow
c. Contribution of Subsidies and Concessions to project
d. Tax Savings and other Transfers to parent

Issues in International Project Appraisal

1. These projects are subjected to various restrictions that are imposed by the host country.
2. Initial investment in the host country may benefit from partial or total release of blocked assets.
3. Cash flows must be converted into the currency of the parent firm.
4. Profits generated from foreign projects are liable to be taxed in the host country.
5. Foreign investment leads to increase in competition in the host country.
6. Foreign projects may produce diversified benefits to shareholders of the parent company.
7. Terminal value of the project is difficult to assess.

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 Unit-12: Cost of Capital for Foreign Investments

Meaning of Cost of Capital

Cost of capital is the rate of return the firm requires from investment in order to increase the value of the firm. It is
the weighted average cost of their different sources of financing. In simple words, the minimum rate of return
required from investment is known as cost of capital.

Write a short note on CAPM (Capital Asset Pricing Model)

It describes the relation between systematic risk and expected return on an asset. It is used for pricing risky
securities. The basic principle behind ca pm is that an investor makes investment decisions on the basis of risk and
return. The formula to calculate the risk is:
E(R1) = Rf + Bi (E.R.m – Rf)
E(R1) = Capital Asset expected return
Bi= Sensitivity
Rf= Risk free rate of return
E(Rm)= Expected return

Assumptions
a. Investors are price takers.
b. Their expectations are homogeneous.
c. Presence of riskless asset.
d. No taxes, transaction costs, etc.
e. Market is perfect.

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 Unit-13: Political Risk and Tax Aspects

Concept of Political Risk

The term “political risk” refers to the type of risk that corporations, investors, and governments face due to various
political events, decisions or conditions that eventually result in a significant impact on the profitability of the
businesses. Political risk also adversely impacts the expected value of any particular economic activity. Political risk
refers to the risk associated with investment due to frequent change in political environment of a country.

Types of Political Risk

This can be classified into two types:
1. Macro-level Risk
2. Micro-level Risk.

1) Macro-Level Risk: These risks have an effect on all the participants in a given nation. Some of the common
types of macro-level risks include regulatory changes, currency actions, endemic corruption, sovereign credit
default, declaration of war, and changes in the composition of the ruling party. These events hinder portfolio
investments as well as foreign direct investment risks, which can potentially change the business suitability of
any given regions.
2) Micro-Level Risk: Besides macro-level risks, the companies also need to pay attention to the risks at the
industry-level and evaluate their contributions to the local economy. Typically, the micro-level risks arise when
the local governments are more in the favour of the local businesses than that of the international organizations
that operate there. Some of the common types of micro-level risks include project-specific government stance,
nationalization of projects, and assets.

Factors contributing to Political Risks

i) Ideology: Any change in the ideology of the ruling party results in a significant political and economic change
in that country. The new part may have different ideologies than the previous party. This change may create
additional risks for international traders.
ii) Nationalism: It is an idiosyncrasy that is primarily witnessed among the local participants of the developing
nations and as times it gives way to political unrest. For example, communalist feelings among some groups
or using only home-made products restrict foreign traders.
iii) Stability: The political stability of any nation is largely dependent on cultural diversity (in terms of language,
race, and religion) and its acceptance among the people of the nation. If there are frequent elections, political
unrest, demonstration and violence create political risks in the country.
iv) International Relations: The sweetness in the relationship between different countries can be instrumental
or detrimental for ease of doing business in a given country. If two countries have friendly relations, it creates
favourable climate for foreign traders.

Methods of measuring Political Risks

a. Frequency of government changes.
b. Level of violence in the country.
c. Number of armed insurrections in the country.
d. Conflicts with other states or countries.

Strategies to manage Political Risk

1. Avoidance: Many firms avoid to invest in those countries where there is political instability or risk. This is
one of the simplest strategies to avoid political risks.
2. Insurance: Most developed countries sell political risk insurance to cover foreign assets of domestic
companies. Many companies take advantage of this service. In fact, it is mandatory to do insurance in
international trade.

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 3. Negotiation: Sometimes firms tried to reach the host government before undertaking an investment. This is
called concession agreement in which rights and responsibilities of both parties are defined. So, a firm can
negotiate with the government and impose conditions before investment.
4. Structuring the investment Companies tried to increase the cost of interference by the host country to
minimise its exposure to political risk. This can be done by keeping the local affiliate dependent on sister
companies for markets and supplies. Thus, capital is raised from the host country rather than employing
funds in that country.

Multilateral Investment Guarantee Agency (MIGA)

• MIGA is a member of the World Bank Group and membership is open to all World Bank members.
• The MIGA was created in 1988 to promote foreign direct investment into emerging economies to improve
people’s lives and reduce poverty.
• MIGA fulfils this mandate and contributes to development by offering political risk insurance to investors
and lenders, and by helping developing countries attract and retain private investment.
• MIGA provides investment guarantees against non-commercial risks to eligible foreign investors for
qualified investments in developing member countries.
• MIGA’s coverage is against the following risks, transfer restriction, expropriation, breach of contract, war
and civil disturbance.
• MIGA insures new cross-border investments originating in any MIGA member country, destined for other
developing member country.
Role of MIGA
1. Local jobs were created,
2. Tax revenue was generated,
3. Skills and technological know-how were transferred,
4. Local communities often receive significant secondary benefits through improved infrastructure, including
roads, electricity, hospitals, schools and clean water,
5. Foreign Direct Investment supported by MIGA also encourages similar local investments and spurs the
growth of local businesses that supply related goods and services.
6. As a result, developing countries have a greater chance to break the cycle of poverty,
7. MIGA develops and deploys tools and technologies to support the spread of information on investment
opportunities,
8. Through its dispute mediation program, MIGA helps government and investors resolve their differences and
ultimately improve the country’s investment climate,
9. MIGA compliments the activities of other investment insurers and works with partners through its
coinsurance and reinsurance programs to expand the capacity of the political risk insurance industry’s
income.

Write a short note on International Tax Planning

• International tax planning is a foreign taxation element created to implement directives for several tax
authorities.
• It involves cross-border transactions with the knowledge of international tax principles, lawful routing of
business activities and capital flows are covered under international tax planning.
• The planning process comes along with the money flows in the cross-border transactions as it gets passed
from the host country where they move towards the home country.
• Domestic tax planning is basically concerned with the national rules of tax deductions, allowances and
exemptions and the different tax rates that are levied on various sources of income in a single jurisdiction.
• Usually, cross-border activities suffer a higher tax liability worldwide than just domestic or single country
transactions.
• They need to pay tax in more than one jurisdiction. Hence proper tax planning is required.

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 Unit-15: International Cash Management

Meaning of International Cash Management

It is a process of simplifying the movement of cash from one country to another. Its main objective is to minimise
currency exposure risk. It helps to reduce cash requirements without disturbing its smooth operation. It helps to
manage and control cash resources of a firm efficiently. It improves cash collection and payment. Lending or
borrowing money as and when required.

Objectives of Cash Management

1. To maximise total cash and minimise total borrowings.
2. To reduce foreign exchange exposure.
3. To stabilise foreign exchange fluctuations.
4. To minimise transaction costs.

Centralized cash management

When cash is managed at one central location it is known as centralised cash management. It means a process by
which an affiliated group of businesses makes all or most cash management decisions from one location, such as
a headquarters or designated subsidiary. It implies that receipts and payments are managed by one single central
body which is generally the head office of MNC.
Advantages (June 22)
1. A central unit can keep a track of net amounts a firm should pay or receive.
2. It can continuously monitor net open positions and take actions accordingly.
3. It helps to identify all opportunities for netting opportunities.
4. It helps in cross-border pricing decisions.
5. It provides a centralised foreign exchange reporting.
6. It helps to find the net inflow and outflow of each currency separately.
7. It helps in pooling all the cash at one central location.

Decentralization cash management

It implies that receipts and payments are managed by each subsidiary of an MNC individually. This approach is useful
when delays are expected in transfer of funds from countries where banking system is inefficient.
Advantages
1. It is best suited for large organisations like MNCs having presence in many countries.
2. It helps to reduce transaction costs, as there is no transfer of funds from one country to other.
3. It helps to avoid political risks as all the transactions are within the jurisdiction of the home country.
4. It helps in quick liquidity of funds because funds may be used for any investment purpose.
5. A firm can gain by saving taxes.

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 Unit-16: Foreign Trade Financing

Documents required in International Trade

The following is a list of necessary documents in international trade:
1) Air Waybill
2) Certificate of Origin
3) Bill of Lading
4) Combined Transport Document
5) Draft (or Bill of Exchange)
6) Insurance Policy (or Certificate)
7) Packing List/Specification
8) Inspection Certificate

1. Air Waybill an Air Waybill is typically a document in international trade that proves the goods have arrived
and are ready to be shipped by air. There are 3 originals and 9 copies of the document which are signed by
export agents and the air carrier. It is considered as a receipt for the goods being transported.
2. Certificate of Origin A certificate of origin is required by the customs department of the country importing
the goods to decide upon import duty. This document is issued by the Chamber of Commerce of the origin
country and primarily consists of the name and address of the exporter, number and description of the
goods, seal of the chamber etc.
3. Bill of Lading As mentioned in the example earlier, the Bill of Lading is proof that the consignment has been
shipped from one destination to another. It is a document used in import and export business, where the
shipping company gives the document and is signed by the carrier of the vessel. The Bill of Lading is handled
very carefully and ensured it does not fall in the hands of any unauthorised persons.
4. Combined Transport document Combined Transport document or Multimodal Transport document is
issued when the goods need to be shipped through multiple modes of transportation. The contract of the
combined transport operator for the consignment begins from the place of departure till the place of
delivery. The combined transport document needs to clearly mention if the freight charges have been paid
fully already or will be paid on delivery at destination port.
5. Bill of Exchange: A bill of exchange is a unique handwritten document raised by the exporter to the
importer asking for a certain amount of money to be paid in the future and the importer also agrees. This
kind of document is generally used in wholesale trading where a huge amount of money is involved.

Letter of Credit.
A letter of credit or LC is a written document issued by the importer’s bank, on importer’s behalf, assuring that the
issuing bank will make a payment to the exporter for the international trade conducted between both the parties.
The importer is the applicant of the LC, while the exporter is the beneficiary. In an LC, the issuing bank promises to
pay the mentioned amount as per the agreed timeline and against specified documents.

Features of Letter of Credit

1. Negotiability: A letter of credit is a transactional deal, under which the terms can be modified/changed at
the party’s assent. In order to be negotiable, a letter of credit should include an unconditional promise of
payment upon demand or at a particular point in time.
2. Revocability: A letter of credit can be revocable or irrevocable. Since a revocable letter of credit cannot be
confirmed, the duty to pay can be revoked at any point of time. In an irrevocable letter of credit, all the parties
hold power, it cannot be changed/modified without the agreed consent of all the people.
3. Transfer and Assignment: A letter of credit can be transferred or endorsed to other persons. The
beneficiary has the right to transfer the LC. It will remain effective no matter how many times the beneficiary
assigns/transfers the LC. Thus, it is a negotiable instrument.

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 4. Sight & Time Drafts: The beneficiary will only receive the payment upon maturity of letter of credit from
the issuing bank when he presents all the drafts & the necessary documents.

What is Forfaiting?
• Forfaiting is a method of trade financing.
• In this process, exporters sell their foreign receivables, either for a long-term or a medium-term, to a Forfaiter
at a discount.
• The Forfaiter then gets the sum due from the importer on the contracted payment date.
• A forfaiting transaction occurs on a non-recourse basis.
• The term ‘non-recourse’ here means that the Forfaiter has no right to recover payment from the exporter in
case of default by the importer.
• Forfaiting helps exporters improve their cash flow, as they can cash in their receivables immediately without
waiting until the payment date.
• This allows the exporters to enter into long financing terms on their sales to foreign buyers.
• Exporters often pay higher fees with forfaiting since it eliminates virtually all risks of non-payment.
• Forfaiting is primarily used by large and medium-sized institutions and government agencies to export capital
commodities and goods worth US$ 100,000 or more in the US.
• Forfaiting can also be attractive in high-risk markets.
• The payment period for foreign buyers of US exports can range between 180 days and seven years, which is
the period for most forfaiting transactions.

Features of Forfaiting
a. A forfaiting transaction is always done at a discount and on a non-recourse basis.
b. A guarantee from his local bank always backs the importer's payment obligation. The receipt of payment is
usually evidenced by an exchange bill, a promissory note, or an LC.
c. There are two types of financing: fixed rate and floating rate.
d. In general, forfaiting is suited to exports with high value, including capital goods for manufacturing,
consumer durables for consumers, vehicles for transport, and even construction contracts for export.
e. The exporter usually receives the cash immediately after the goods are shipped and only upon submitting
the required documents

Documents required for Forfaiting

The documents required for forfaiting are as under:
1. A letter of guarantee, or aval.
2. A copy of the commercial invoice with signature.
3. A copy of the sales agreement or the payment schedule.
4. A letter of assignment and notification to the guarantor.
5. A copy of the shipping documents, such as the receipts, railway bills, airway bills, and bills of lading,
documents of title.

Types of Forfaiting
There are several types of financial agreements that a Forfaiter can purchase and convert into debt instruments:
i) Promissory notes: Promissory notes are payments issued by importers to exporters as an assurance that
payments will be made.
ii) Bills of exchange: In essence, a bill of exchange is like a promissory note and is a written order binding an
importer to pay an exporter a certain amount.
iii) Account receivables: Account receivables on the balance sheet indicate the amount owed, although they
have not yet been paid.

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 iv) Letters of credit: A bank and guarantees issue an LC that the debt will be paid regardless of the default of
the importer.

Advantages of Forfaiting
1. Forfaiting protects the exporter from the non-payment risk and eliminates the cost of the collection while
providing immediate cash to the exporter.
2. Commercial banks can earn a substantial amount when the currency appreciates by purchasing instruments
yielding a high return.
3. Here, the risk is minimum due to the involvement of both the exporter and importer banks.
4. The forfaiting process converts a credit sale to a cash sale, simplifying the transaction.
5. The Forfaiters have the flexibility to customize the offer according to the needs of sellers of capital goods. It
can also be used for a variety of international transactions.

Disadvantages of Forfaiting
1. Only the major selected currencies are taken into account to facilitate forfaiting, since they possess
international liquidity.
2. In contrast to primary financing provided by banks or financial institutions, forfaiting significantly reduces
the risk for exporters. However, it also results in a higher export cost.
3. Typically, the importer is responsible for the higher export cost factored into the standard pricing.
4. A forfaiting facility cannot be applied to all transactions. Forfaiting is permissible on transactions more
significant than a definite sum.

Meaning of Guarantees or Bonds in the international trade.

A guarantee or bond is a written instrument issued by an importer bank guaranteeing that the exporter will comply
with his obligation under the contract. If he fails to do so the overseas buyer will be indemnified for a specific amount.
It gives the importer an opportunity for receiving pre agreed payments if a supplier fails to meet his contractual
obligations. To avoid such losses the importer may ask the exporter to provide a bond or guarantee for an agreed
amount through an acceptable bank or financial institution. If a problem occurs, the importer would simply demand
the guaranteed amount to be paid immediately by the exporter.

Types of Guarantees or Bonds in the international trade

1. Tender or bid guarantee bonds: It shows the buyer that he will not be wasting time and effort in evaluating
tenders from potential suppliers. It is an assurance given that the client will sign the contract if his tender is
accepted.
2. Performance bonds: It is given in support of a client’s obligation to fulfil a contractual commitment. It is
normally issued before the cancellation of a tender guarantee. it covers faulty completion of the contract.
3. Advance payment bonds: This is a safeguard whereby the seller arranges for his bank to give the
beneficiary, the buyer it's undertaking to refund any advance payment if the goods are not shipped or the
contract is not completed.
4. Retention bonds: It is a type of bond where a contract calls for say 10% of each payment to be withheld
until the project is completed and accepted a guarantee may be issued which enables the contractor to
receive the full amount while assuring the buyer that the issuing bank will refund the retention percentage.
5. Custom guarantee: These are issued where goods are imported temporarily. If the goods are not re-
exported, the guarantee will be implemented and duty paid to the customer authorities will be refunded.
6. Bill of lading indemnitees: This is given to the shipping companies in the absence of negotiable bills of
lading, so that the importer can clear the goods without delay., when the bills of lading are received and
delivered to the shipping company the indemnity is cancelled.

A short note on Countertrade

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A country having unfavourable balance of payments adopts this method to finance its imports. Under countertrade,
imports are paid in terms of goods rather than money or currency. It refers to the reciprocal trade agreements
involving the purchase of goods or services by the seller from the buyer of his product whereby the seller assists the
buyer in reducing the amount of net cost of the purchase through some form of compensatory financing. As the
volume of international trade is rising, more and more of countries are now involved in countertrade.
A countertrade is done under three conditions such as:
1. Financing: When an importer is short of foreign exchange, he uses countertrade.
2. Trading: when an exporter wants to develop a new foreign market.
3. Balancing: In order to correct an unfavourable BOP a country may use this technique.

Forms or Types of Countertrades

1. Counter purchase: The exporter has to undertake that he will purchase goods or service from the country
he exports.
2. Offset: These are reciprocal trade agreements for industrial goods and services on condition of sales and
service. This is mostly done in military-related exports.
3. Buyback: In this method, the exporter of capital goods is obliged to buy a specified quantity of goods
produced for which the importer is using his capital goods.
4. Barter: This is the oldest and simplest method of countertrade where goods are exchanged for goods.
5. Technology Transfer: Whenever a company sells its technology to another company, it also imports output
produced by using such technology.

What is Transfer Pricing?

• It is an accounting practice that represents the price that one division in a company charge to another.
• It occurs when goods and services are exchanged between the divisions of the same company.
• Companies use transfer pricing to reduce the overall tax burden of the parent company.
• Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower
price (increasing profits) for divisions in low-tax countries.
• Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within
businesses and between subsidiaries that operate under common control or ownership.
• Multinational corporations (MNC) are legally allowed to use the transfer pricing method for allocating
earnings among their various subsidiary and affiliate companies that are part of the parent organization.
• The object of transfer pricing is to save tax.
• It is a common practice in multinational corporations.

Methods of Transfer Pricing

1. Comparable uncontrolled method (CUP): CUP compares the price charged or received in controlled
transactions with the price of the comparable uncontrolled transactions. It is price for identical or nearly
identical property traded between the two independent parties under the same or similar circumstance
2. Resale price method (RPM): It evaluates arm’s length character of transfer price of a controlled transaction
taking into consideration the gross margins realized in comparable uncontrolled transaction. This method is
generally used in transactions involving selling and distribution function wherein reseller / distributor does
not add significant value to the product through use of tangible or intangible property.
3. Cost Plus method (CPM): Cost plus method examines the arm’s length nature of transaction entered into
the associated enterprise with reference to the gross mark-up realized in gross profit with direct and indirect
cost of the transaction.
4. Profit Split Method (PSM): Profit split method examined whether allocation of combined profit or loss
att4ributed to a controlled transaction is arm’s length by reference to the relative value of controlled
taxpayer contribution to that combined profit or loss.

SANTOSH SHARMA 32
 Unit-17: Project Export Financing
Meaning of Project Financing
Project financing is a new method of financing in international trade. In this method, the project and its assets are
separated from the promoter or owner in order to avail finance or loans for the project. It is quite popular in the
fields of mining, petrochemical, forest products, steel production, etc. These projects are generally huge in size and
needs large investment.

Advantages of Project Export

1. It is source of earning by utilising minimum of domestic resources.
2. It helps to export technical services and manpower.
3. Purchase of equipment for project can be done in foreign exchange.
4. Credit facilities provided by banks on easy terms.
5. It provides opportunities for skilled and semi-skilled manpower to work in foreign countries.
6. Readymade market for construction and building materials, plants and equipment, etc.
7. It is a vehicle for capital equipment and material exports.
8. It promotes cooperation and good relations with foreign countries.
9. It helps to import latest technology from foreign countries.

Types of Risks in Project Export

The important risks associated with project exports are:
1. Commercial Risk: This type of risk arises when the project buyer fails to make payment even after the
completion of the project. This risk is related to credit-worthiness of the buyer. To reduce this risk, an
exporter can ask for LOC from the importer.
2. Country Risk: The risk that arises due to political, social and economic factors prevailing in the importing
country is known as country risk. These risks include political instability, unrest, social clashes, communal
violence, tax rates, inflation, etc.
3. Exchange & Interest Rate Risk: This type of risk arises when the currency of payment and exchange rate
provided in the contract is different from the current rate of exchange. Here, there can be two situations,
either the importer has to pay more than the contract price or less due to fluctuation in the exchange rates.

How to minimise risks in Project Export? Or conditions necessary for clearance of Project Export
1. Advance Payment: It is one of the most important conditions to execute a foreign project. In this method,
the importer makes an advance payment or a % of down payment to the exporter.
2. Forex outgo: It is the amount paid abroad or in India which is convertible into foreign currency. This includes
agency, royalty payable, freight payable in foreign currency.
3. Agency Commission: A trader has to agency commission to carry out export project. The RBI has fixed such
commission at 10% for deferred payment, 7.5% for civil construction and 12.5% for service projects.
4. Deferred Credit: It refers to making payment on a specified future date. The maximum period of credit for
capital goods varies from 3 years to 11 years depending upon the value of the project. The anticipated life of
the goods, competition and contract value should be considered while fixing deferred credit.

Techniques or sources of Financing Export Projects

1. Government export financing agencies
2. Commercial Banks
3. Institutional Lenders
4. Money Market Funds
5. Insurance Companies
6. Trade Creditors
7. Commercial Sponsors
8. International Agencies like WTO

SANTOSH SHARMA 33
 9. Host government
10. Contractors

Why do companies borrow through bonds rather than taking bank loans?
• Bonds are debt securities issued by the corporations.
• There are many types of bonds such as government bonds, corporate bonds, municipal bonds, etc.
• Government bonds are the safest type of bonds.
• Many companies prefer bonds to bank loans because bonds are less expensive and more attractive.
• The interest paid on bonds is comparatively less than that of the bank loans.
• Companies get greater freedom to use the funds.
• Large amount of money can be raised through bonds.
• Companies need not keep any mortgage or securities of its assets.
• There are quite less restrictions on bonds in comparison to bank loans.

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SANTOSH SHARMA 35