INTERNATIONAL FINANCE

Evolution of International Trade

By : Anup Mahesh Savale

 Initial trade among communities

• Communities grew in centers favorable for life

• Initial trade among communities was for luxuries

• Trade resulted in
– Specialization

– Increased scale: enhanced productivity

– De-risking

– Spread of technology
Resulting in Explosive growth in human
Wealth

Origin of Wealth:
Eric Beinhocker
International trade accelerated this further

Origin of Wealth:
Eric Beinhocker
 Why International trade ?

• Mercantilism
• Theory of Absolute advantage
• Theory of Comparative advantage
• Factor endowment theory
• International Product life cycle theory
• Internationalization of Firm
 India’s Foreign Exchange reserves
March 31, $ billion
1992 1,799
1993 9,832
1994 19,254
1995 25,186
1996 21,687
1997 26,423
1998 29,367
1999 32,490
2000 38,036
2001 42,281
2002 54,106
2003 75,428

In December 2003, Indian FX reserves crossed $100 b

A growth from 2 billion to 100 billion a base for examining Global trade
 Mercantilism
• Prevailed in 17th and 18th century, Europe
• Mercantilism replaced feudalism
– Feudalism emphasis on local economy, self sufficiency and
agriculture
– Political change – From Feudalism to nationalism
– Cultural change –From Salvation to Happiness of man on earth
• Mercantilism: “Fear of goods; hunger for money”
• Foreign trade as a means to accumulate treasure and increase the power of the
state
• Treasure in the form of gold and silver to increase the power of the king and the
state
• Policy advocated “restricted trade”:
- Restrict imports
- Encourage exports, especially manufactured goods
- Encourage re-export of goods
- Achieve full employment of both human and natural resources

Similar situation in India in 1991

Imports restricted and exports promoted
As India faced an FX crisis
Import surcharge, LC margins
 Theory of Absolute Advantage

• Propounded by Adam Smith in Wealth of Nations (1776)

• Advocated free trade from ‘restricted’ trade
• Export a commodity that can be produced at a lower cost
compared to the importing country
• Import a commodity that is produced by another country at
a lower cost
• Free trade increases the wealth of a country
• Wealth of a country is the wealth of all its citizens not
just the king

Tax benefits and Software Technology Parks created in 1994

An application of theory of absolute advantage?
 Absolute Advantage illustrated
Country Cost of Production Domestic barter
rate
Wine Cloth

Portugal 100(a1) 50(b1) 1 wine = 2 cloth

England 50(a2) 100(b2) 1 wine = .5 cloth
Cost ratio 100/50 50/100
2.0 0.5

• England has absolute cost advantage in wine

• Portugal has absolute advantage in cloth
• England will export wine and import Cloth
• Portugal will export cloth and import wine
Perfect conditions for International
trade
 Theory of Comparative Advantage
• Propounded by David Ricardo, On the theory of Political
Economy and taxation (1817)
• Identified fundamental difference between Domestic trade
and international trade
- Factors of production perfectly mobile within a country but
immobile among countries
- Goods perfectly mobile within and outside the country
• Export goods at which it is comparatively more efficient
and import goods at which it is comparatively less efficient

Development of Auto ancillary industry in India

 Theory of Comparative advantage
Cost of
Proudction for
one unit
Wine Cloth Exchange rate Exchange rate
Domestic rates
Portugal 80 90I wine = 0.89 cloth 1 cloth =1.125 wine
England 120 1001 wine = 01.20 cloth 1 cloth = 0.83 wine
Portugal has lower cost of production than England for both wine & Cloth
Cloth costs more than wine in Portugal
Wine cost more than cloth in England
Therefore, Portugal will export wine and England will export cloth
Exchange rate for Portugal wine and English cloth will be
England will pay for a unit of wine a maximum of 1.20 cloth
Portugal will want for a unit of wine a minimum of 0.89 cloth

Trade will take place at a price between max. 1.2 cloth to a min. of 0.89 cloth at
which both countries benefit from international trade.
 Factor Endowment Theory

• Propounded by HECKSCHER – OHLIN (early 20th

century)
• A country should export goods that uses its most
abundant factor of production most intensively
• A country should import goods that uses its most
scarce factor of production most intensively
• Countries with low interest rates and abundant
capital will have capital intensive industries meeting
global demand
• Countries with large labor pool will have labor
intensive industries meeting global demand
International division of Labor
China for manufacturing & India for
Services
 Leontief paradox
• Leontief won the noble price for his Input-Output analysis, which formed the
basis for testing Factor Endowment theory
• Leontief analyzed the 1947 US data based on 50 industries
- 38 industries had international trade
- Aggregated factors into two –Capital and labor
- US had more capital employed per worker
- As per Factor endowment theory US should have exported capital intensive
goods and imported labor intensive goods
- For 1947, US imported goods that had 30% more Capital intensity
- Second test of 1951 indicated 6% higher capital intensity in imports
- In 1971 third test indicated 27% higher capital intensity in imports compared to
goods exported
 Leontief paradox -2
- for 1959, data for Japan was tested, Japan was labor intensive but on its
total exported capital intensive goods
- A split into exports to developed countries 25% and less developed
countries 75%revealed that, Japan exports to US followed the Factor
endowment theory
- 1962 data for India tested, Indian exports were labor intensive, but Indian
exports to US were capital intensive
- Leontief Paradox partially explained by Factor Intensity Reversal
- For e.g.. if agriculture is traded between India and US, in India agriculture
is labor intensive, and in US it is capital intensive.
- If US exports to India, US exports capital intensive goods in line with
theory; but India imports labor intensive goods
- If India exports to US, India exports labor intensive goods in line with
theory; but US imports capital intensive goods

Factor Intensity Reversal explains Leontief

paradox
Factor Endowment theory explains trade
International Product Lifecycle Theory

• Propounded by Raymond Vernon (1960’s)

• Product life cycle: Introduction, Growth, Maturity, decline
• Introduction: Manufacture for home market & exports
begin
• Growth: Foreign production starts
• Maturity: Foreign producers become competitive in their
local markets
• Decline: Foreign producers enter home market

Shift of semi-conductor manufacturing from

United States to Asia
 Internationalization of firms

Stages of Firms evolution

I stage No regular exports

II stage Export via overseas agents
III stage Establishment of overseas Subsidiary
IV stage Overseas Production

Can we see a parallel in India

Companies acquiring companies globally
 A major factor influencing trade now:
Technology and Wealth Creation

• Wealth = Value in exchange

• Capital + Labor + Technology = Wealth or
Economic Growth
• Capital and Labor are subject to the principle of
marginal diminishing return, whereas
technology can hold marginal diminishing return
• Growth can be led by Technology called
Inspiration led growth or by labor / capital called
Perspiration led growth
 Technology and Growth

Capital deepening = assets used in business

Production = used commercially in manufactur
In Usage = retail consumption
Source: Solomon, Smith
INTERNATIONAL FINANCE

Evolution of Global
Foreign Exchange Markets

J Shankar
IISc, MBA –Second Semester
January 2007
Evolution of international Forex markets

• Trade & trade practices

• Why study evolution of FX markets
• Milestones of evolution
• Gold standard or Mint parity theory
• Gold exchange standard
• Bretton woods or Exchange rates linked to
US$
• Floating rate / market determined
 Trade & trade practices

Type of trade Movement of Payment in

Goods Currency
Local National Local currency
Deemed Exports National Foreign currency

Aided Sale International Local currency

Export International Foreign currency
 Why study evolution of FX Markets
• Often, History repeats itself, especially in moments
of crisis or points of inflections
• Inferences can be drawn from history for e.g.
1. Venue of meeting and power tilts
2. Impact / response of wars / economic
upheavals
3. Policy responses to crisis
• Study of history is fascinating in itself

Look out for color code as we go along

 Milestones of Evolution

• Pre 1870 - Barter sales of luxuries

• 1870 - Gold Standard / Mint parity

• 1922 (Genoa) - Gold exchange standard

• 1944 (Bretton Woods) - IMF / US$ base

• 1967 (Rio de Janeiro) - Introduction of SDR

• 1971 (Washington DC) - US$-Gold link breaks

• 1973 (OPEC induced) - Market based

 Export trade Pre 1870’s
• Pre historic*
– Initial trade between communities was normally for luxuries
not indispensable, through barter trade
• Trade in ancient India (Arthashastra)
– Profit margin allowed on imported goods is 10%
– Foreign merchants shall not be sued in money disputes
unless they are legal persons in the country; their local
partners can however be sued
• Trade till 19th century
– Mainly through travelling merchants, who sold the goods they carried and
bought back with them local goods that could be used in their native land

* What happened in History, Gordon Childe

 1870 -Gold Standard / Mint theory

• Britain -1819 - Resumption Act

– After Napoleonic wars (1793-1815) gold conversion resumed
– Currency notes exchanged to gold at fixed rates
– Simultaneously repealed restrictions on export of gold coins and
bullions from Britain
• Followed by Europe 1870’s, USA -1879
• Exchange rate based on underlying gold
• Principles of Gold standard
1. Currency value fixed w.r.t gold;
2. Currency issue backed by gold
3. Free trade in gold;
 Gold Standard –Theoretical basis

Trade deficit

Leads to Export Gold

Less exports
Reduce
More imports
Money Supply
Increase in
Reduction
Prices
In price
Increases More exports
Money supply Less Imports
Imports
Leads to
Gold

Trade Surplus
 1870 -Gold Standard / Mint theory

• Positives
– free world trade;
– stable price / exchange / economic growth & peace
• Negatives
– volatile economy / depression -1890 1907,
reduction in money supply leads to recession, lower
price does not lead to higher purchases
• 1914 - I World War, gold conversion
suspended in Europe, USA continues Gold
conversion
 1922 - Genoa Agreement

Background –
• Genoa a town in Italy attended by Britain, France, Italy and Japan
• Convertibility to gold stopped in 1914;
• Fiduciary money gains acceptance;
• Gold as settlement currency withdrawn & partial gold standard introduced
• I WW result - High inflation / shortages
Reasons cited for withdrawal of Mint parity -
gold production decline; save freight & storage cost
- UK economy grew by 5% in 19th century, gold production increased only by
3-4%
Results in –
• Currency not backed by gold; for international trade gold as settlement
currency continues, not for domestic conversion
• Sterling as world currency,
• London as World trade centre

II World War brings this system to a halt

Movement from barter to Gold

Barter Money Metals

Coinage

Paper money

Gold standard

For Domestic trade For export trade

 1944 - Breton Woods

Background –
• US the only country on gold standard;
• Left in 1933 at $20.67 and returned in 1934 at $35
• II WW financed by paper money;
• Results in high inflation & shortages
• 44 countries meet in the town in New Hampshire in US
• Harry Dexter White of US Treasury and Lord Keynes of
UK present plans
Accepted –
• Keynesian plan -promote full employment & stable
exchange rates,
• Central banks to co-operation & aid nations in crisis
 International Monetary Fund

IMF formed with 44 member nations–

• Fix gold parity for US$ -$35 for 1 troy ounce ; other
currency rates fixed w.r.t. US$,
• Capital flows can be controlled,
• All countries to reach Capital Account Convertibility as
soon as possible to promote free trade
– US and Canadian $ convertible from 1945
– Europe 1958 - 61, Japan 1964
• Change in parity only for fundamental disequilibrium
• Countries with convertible currency cannot change
exchange rate
Conditions for IMF membership
 International Monetary Fund

• IMF facility to correct disequilibrium

– Quota contributed by members -25% in gold; 75% in
their own currency
-Credit facility 125% of quota
-Extended facility 140% of quota
-Standby facility -IMF guarantee for 3-5 year borrowing
- General Agreement to borrow -1962
– Agreement for IMF to borrow from Industralised nations for
lending to countries in disequilibrium
- Currency swap arrangement -1962

Benefits for IMF members

 Triffin’s paradox predicts
Collapse of Breton Woods system

• 1960’s –Theory “More the US$ is

accepted as international currency of
settlement, sure is the failure of this
system”
– US$ earns interest; gold does not; but exchange rate
is fixed
 1967 - Rio de Janeiro

• Impetus - declining International liquidity

• 1958-60 - US$ 2b gold shifts from US to Europe

• 1960 -1967 12 b gold shifts out of US

• March 1968 two tier price for gold announced

– Price for Central banks fixed at $35

– Open market price of 44.36 in Paris

• Introduced SDR or Special Drawing Rights

 SDR –Special Drawing Rights
• SDR’s allocated to members based on the global needs to supplement existing
reserve assets for liquidity
• SDR’s initially fixed in terms of gold via US$, later through a basket of
currencies
• SDR’s can be used by the member country to buy foreign currencies for their
international trade
• IMF allocates SDRs to members in proportion to their quotas
– Interest is paid to the member if the SDR held by member is higher than original
allotment
– Interest is paid by member if the SDR held by the member is lower than original
allotment
• http://fx.sauder.ubc.ca/SDR.html
• http://www.imf.org/external/np/exr/facts/sdr.HTM
Beginning of the collapse 1967 - Rio
de Janeiro

• Special Drawing Rights (SDRs) -Paper gold upto 3 times their own
SDRs
• SDRs are used in transactions between central banks
• Value 1970 -1 SDR = 1 US$
1974 -linked to 16 currencies 1980 -linked to 5
currencies
• SDR history 1970 US$ 3.4 b 1971 US$ 2.95 b 1972
US$ 2.95 b
• SDR introduced - 1.5% interest on SDRs increased to 5% in 1975
 Triffin’s paradox in action:
Collapse of Breton Woods
• US gold reserve
1944 26 b of total global stock of 33 b
1958 23 b
1971 10 b
• Between 1967-68 20% of gold reserve was
taken out of US; price of gold $44.36 per ounce
vs.$35
• US gold reserve as % of $ held by other central
banks -1963 -100%; 1970 -50%; 1971 -22%
• Bundesbank held 18 b $ in 1972, more than the
entire US gold reserve
1971 -US stops gold conversion
• US budget deficit
1958 -71 US$ 56 b
1971-73 US$ 60 b
• 1958 -71 US had BOP deficit due to
-higher return outside US leading to capital outflows
-Vietnam war & military commitments
• Measures- 1963 -Interest Equilization tax
1965-Voluntary Credit restrain
1968 -Mandatory Credit restrain
1971 –US had $10 b of Gold;
UK wanted to convert $3 b of $ it held for gold
• August 15, 1971 –US stopped gold convertibility
– 10% import surcharge on imports introduced
– 90 days wage and price freeze
 1971 - Smithsonian Agreement

• Group of 10 formed in 1962 meet

• Temporary regime -2.25% range

• US devalues 8.57%;

• Yen 17%, Mark 13.5%, FF & UKP 9% up in 1971

• US devalues 11% in 1973

• Arrangement fails due to oil price hike by OPEC in

1974 of 400%
 Post 1973 -OPEC influence

• Organisation of Petroleum Exporting Countries

• 1973 oil price hike 400%;
• 1978 another increase
• Approach to oil price hike -Japan - hikes local price
-surplus BoP
US -prevents price hike - deficit BoP
• Creates market fiction and total market determined rates
 Market determined prices

• G 7 -US, UK, WG, Japan, France, Italy, Canada

• US$ exchange rate
75 80 85 90 95 98
DM 2.3 1.7 3.3 1.7 1.4 1.6795
UKP 2.0 2.3 1.1 1.7 1.6 1.6627
Yen 305 250 255 148 100 114
• Upto 1980’s trade dominates exchange market
• Post 1980’s capital flows influences market
 Market determined prices

• Capital flows influenced by Interest rates

• Trade flows influenced by Tariffs / trade agreements

• Economic sequence or vicious circle

Economic activity-> Money quantity ->Interest rates

->Exchange rates ->Economic activity

INTERNATIONAL FINANCE

Evolution of Indian
Foreign Exchange Markets

J Shankar
IISc, MBA –Second Semester
January 2007
 Evolution of Indian Rupee
• Indian Currency: Arcot rupee, started by Nawab of Arcot, later adopted by
Europeans and was known as English, French and Dutch arcots; English
used them in Madras, Calcutta and Dacca: 171-177 grains of pure silver
• Sonaut rupee: used in United Provinces; also refers to coins minted three
years and older
• Sicca rupee: used by East India Company from 1793 in Bengal 176 grains of
pure silver and total weight of 192 grains
• Company rupee: introduced by East India Company after 1835
• 1835 Act of Imperial Government: standard rupee for all part of India
under British control: 180 grains of metal; 165 silver
• Paper currency Act of 1861: a legal tender paper currency: notes of Rs.10, 20,
50,100, 500, 1000 and 10,000 declared unlimited legal tender in their circles
• 5 rupee note in 1891, 1 rupee note in 1940
• 1903: Rs.10 and higher notes declared universal legal tender
• 1935 Reserve Bank of India set up as central bank
• 1947 India joins IMF: Indian rupee = 30.225 cents of US$
• April 1957, decimal coinage system introduced
 Evolution of Indian FX markets

• Founder-member of IMF
• 1947 INR -US$ = 3.31; INR-UKP =13.33
• 1949 INR-US$ = 4.75; INR -UKP =13.33
– 75% of Commonwealth countries followed devaluation
– Pakistan did not devalue; India stopped payment; Pak
followed devaluation in 1955
• Wars in 1962 & 1965-66
6.6.66 -57.5% devaluation; US$ =7.5, UKP 21
• 1967 -US$ 7.5; UKP =18 (Pound re-valued)
• 1971 -Pegged to UKP in a band of 2.25% range
 Evolution of Indian FX
Markets
• 1975 - INR pegged to basket of currencies
• 1978 -banks permitted intra day positions
• 1979 -RBI ups margin to 5% from 2.25%
• 1981 -Reuters services permitted in India
• 1987 -RBI sells US$ as well as Rupee; till 1987, pound
was the only currency
• 1991 -LC Margins (200%), devaluation & Exim scripts for
export subsidies
Evolution of Indian FX Markets

• 1992 -LERMS (Exim scripts withdrawn & dual

rate introduce) Official $ rate Rs.26
• US$ replaces UKP as intervening currency
• 1993 -Unified exchange rate introduced;
Direct quote instead of indirect quote
• 1994 -August, current account convertibility
• 1995 -Sodhani committee report
• 1997 -Tarapore committee report
 Sodhani committee recommendations
-1995

• To develop FX markets in India

• Forward Covers based on Projections
• Banks overnight currency limits of Rs.15 cr. to be
replaced
• Interbank borrowing to be excluded for reserve
requirements
• RBI to act through both spot and swap markets
• Corporates to be permitted to sell options
 Sodhani committee recommendations -1995

• Accounting norms for derivatives, both for dealers and

end-users

• Corporates to have Board approved Exchange Risk

Policy and authorisation levels

 Tarapore Committee recommendations
-1997

• June 1997, Road map for Capital Account Convertibility

• Pre-requisites to be achieved by 2000:
– Gross Fiscal deficit to 3.5% from 4.5%,
currently around 5%
– Inflation at 3%-5%, currently in 4-6%
– NPA in banks at 5%,
– CRR at 3%
 Tarapore committee recommendations
-1997

• Balance of Payment, minimum -6 months import

cover $22b -3 month import + 1 month export
+3 month debt service $24b -short term debt + portfolio
money at 60%, any increase to be
held in reserve $31b -NFE assets to Currency ratio
at 70% (current level) min 40% $26b
 Role of RBI in CAC environment

• NREER as indicator for intervention Neutral

Real Effective Exchange Rate
• Intervention to maintain +/- 5% of REER
Direct -purchase / sale in FX market Indirect
-Interest rate signalling Noise level -
Pronouncement / Direction indication /
Recommendatory
1998 -Back to regulated market
• Backdrop: Asian currency crisis
• January 16, 98 INR-US$ touches 40.40
– RBI announces:
– REPO rates 7% to 9%
– CRR increase 10% to 10.5%
– Banks -square /near square position
– Import surcharge increased 15% -30%
Rupee drops to 37.70 vs. US$
1998 -Back to regulated market
• August 19, 98 INR-US$ touches 43.60
– RBI announces:
– CRR rates increased 10% to 11%
– Repo rates from 5% to 8%
– Forward contracts on imports cancellation and
rebooking banned
– Banks to report peak intra day position
Dec 16, 1997 forward cover for loans
could not be cancelled & rebooked
 2003 and onwards - Problems of Plenty

• Options in Indian rupee introduced

• Norms for forward covers liberalized
• Permission given for covers in excess of
documentary evidence based on specific
RBI approvals
• Norms for Acquisition liberalized,
acquisition upto net worth permitted
 Second Tarapore Committee on Fuller
Capital Account Convertibility
• Five year time table 2006-11, in 3 phase
• First phase 2006-07, Second 2001-09, third phase 2009-11
• For Individuals:
– Freely remit up to $50,000 in P-1, and $200,000 in P-3
– Residents can have foreign currency accounts overseas
– Foregin individuals can invest in stocks through PMS & MF
– Retention of 100% of inward remittance in EEFC a/c for all exchange earners
• For Business
– MF can invest up to $3 b in P-1, and $5 b in P-3
– PMS to be allowed to invest in Overseas market
– ECB upper limit to be raised gradually, end use restriction to be removed
– No ceiling on long term or rupee denominated ECB’s
– Companies can invest up to 4 times their capital in overseas subsidiaries / JV in P-
3
 Second Tarapore Committee on Fuller
Capital Account Convertibility
• For Banks:
– P-3 can raise up to 100% of their capital through ECB
– RBI to evolve policies to allow on case by case Industrial houses to hold equity in Indian
banks or promote new banks
– Encouragement to Institutions to set up private banks
– Government holding in state owned banks to 33%
– A single banking law for all banks including PSU banks
• Conditions
– Ban on participatory notes
– Non residents to access FNCR (B), NR (E) RA deposits
– FIIs to set aside reserves in volatile times
– Banks must consolidate
– PSU’s must reign in borrowing
– Reign in Small savings and unfunded pensions
– Center and State should graduate from the present system of computing financial deficit to a
new measure of public sector borrowing requirements (PSBR)
INTERNATIONAL FINANCE

Theories of
Exchange rate determination

J Shankar
IISc, MBA –Second Semester
January 2007
 Why study Exchange rate theories?

• Need to take decisions involving transactions

in which Foreign exchange rate is a critical
input
– Exchange rates fluctuate in a broad range
– Transactions like exports, imports, investments,
loans, project investments are affected
– Often decision is vitiated by exchange rate moves
 Forecasting can be for different time
horizons

Time horizon Dominant force Analytical tool used

Short time –intra Technical / Sentiment factors /

day Speculative Technical views
Medium term – Cyclical Technical factors /
days to months Fundamental views
Long term – Structural Fundamental views
beyond 3/6
months

All three factors are present in all markets,

They are more critical in Foreign exchange markets
Topics we will cover in this class

• Basic Economic concepts

• Exchange rate theories
– Purchasing Power Parity
– Balance of Payment
– Interest rate differentials
– Real Interest rate differentials
 Price -Volume relationship

Price
Supply

Demand

Volume
Law of diminishing marginal utility
 Interest - Money relationship

Interest
Savings

Investments

Volume of Money
 Domestic currency value -Volume of
business relationship

Appreciates

Imports
Domestic
Currency

Depreciates
Exports

Decrease Volume of Business Increase

What determines domestic currency value?

PURCHASING POWER PARITY –Stage 1

• Origin -16th century Spain, 1920 Gustav

Cassel
• Concept - One price for one commodity

Undervalued Exports
DC Increase

Correction
in Value
Overvalued Imports
DC Increase

Concept originally came up in 16th Century in Europe

 One price for one commodity -some
conditions

• Commodity under question tradable

• There are no trade barriers to arbitrage and

trade

• There are no transaction cost

• The goods traded are homogenous

Big Mac theory and PPP

Innovative and Imaginative use by Economist

 Big MAC in practice

• Big Mac theory (in 1986)

– 66 countries; only local items used;
– Has not reflected current exchange rate
– Robert Cumby (1993) researched that 70% gap
bridged in 1 year
Country DC Price PPP Ex rate %
• US 2.53 - - -
• India 47 18.5 37.7 (57)
• Indonesia 4600 1818 3605 (50)
• S. Korea 2300 909 1060 (14)
• Singapore 3.00 1.19 1.58 (25)
November 21, 1997 (during Asian Currency crisis)
 PPP -Stage 2

• Evolution in PPP concepts

Law of One price

Basket of commodities

Inflation differentials -REER

 PPP -Stage 2

• Absolute PPP –equilibrium exchange

rate of two countries determined by
ratio of the two countries price level
• Relative PPP –focuses on change in
price levels rather than absolute levels
 Problems in PPP

• Calculate PPP -CPI, WPI, Wage index, Export PI,

• Basket of Currency -Europe -Mortgage
• Base Period -International – 1973 –floating exchange rate,
1980 –US current account in balance, 1999 –
formation of Euro
– National -1991, 1995, 1996, 1998, 2001
• Elasticity of demand - Price Income
Food low high Industrial RM low high Mfg.
Specialised low high Non specialised High High
• Tradable and non tradable goods
 Balance of Payment theory

• Conceived in 1930’s by Joan Robinson

• Long run equilibrium exchange rate is rate at

which internal & external balance is achieved
• Internal balance -full employment

• External balance -targeted level for current

account balance
 Equilibrium Exchange rate

• Long term equilibrium exchange rate

– Attainment of internal and external balance
– Internal balance = attainment of full employment
• Full employment = Strong demand for goods produced
in economy
– External balance = attainment of some targeted level
for the current account balance
• External balance = Long term balance in current
account, a result of exchange rate led trade flows
 Logical movements

Trade inflows or exports

Less Trade outflows or imports

Equals Current account balance

• Depreciating currency increases exports and reduces

imports resulting in net inflows:

– Depreciating currency = net trade inflows

 Logical movements

Trade inflows or exports

Less Trade outflows or imports

Equals Current account balance

• Appreciating currency decreases exports and increases

imports resulting in net outflows:

– Appreciating currency = net trade outflows

 Logical movements

• Internal balance = full employment

• To reach Full employment = there must be
demand for Domestic output
– Domestic output = Local demand + Exports

• Domestic currency value can be used to

reach full employment
• How?
• How does Domestic currency value affect
employment?
 Some observations

• Internal balance and external balance can be

achieved at a point of time;

• During most occasions: the position will be tilting

towards either Internal balance or external

balance
 IB & EB Equilibrium rate

DOMESTIC OUTPUT = LOCAL + FOREIGN DEMAND

Appreciates Weak demand
CA deficit CA deficit IB
DC
Value
B
Strong demand
Weak demand
CA Surplus C A CA deficit

D
Strong demand EB
CA surplus
Depreciates
CA Surplus

Weak demand
Real domestic demand
Strong demand
 Evolution of BOP theory

• Initial concept - Balance of Trade -Current Account Focus

• Current concept - Balance of Payment: both trade &
capital flows
• Sustained Current account deficit not feasible due to debt
trap
Trade CA External
deficit deficit debt

Debt service
 Real interest rate differentials

• Components of interest
Incentive + Risk premium + inflation
• Risk premium eliminated by Sovereign risk; but country
risk cannot be eliminated
• High inflation indicates domestic competitiveness weak,
weak currency
• Exchange rate movement = Real interest rate
differentials
 Interest rate differentials

• Zero Capital mobility Income = Savings + Consumption

Savings = Investment Current Account balance = Nil
• Capital account mobility Income = Savings +
Consumption Savings is not equal to Investment
Current Account balance = Capital flow
 Interest rate differentials -2

• Current Account balance

Negative = Capital Inflow into economy

Surplus =Capital outflow from economy

• Capital flows influenced by Interest rates

• With free flow of capital, interest rate differentials bridged

by capital flows
 If you were the decision makes, what
type of currency would you like for your
country?

• An appreciating currency or

• A depreciating currency

And why?
INTERNATIONAL FINANCE

Fiscal and Monetary policies:

A look at Mundell Fleming models

J Shankar
IISc, MBA –Second Semester
January 2007
 Mundell-Fleming Model

• Robert Mundell (1963) & J Marcus Fleming (1962)

• Analyze impact of Fiscal / Monetary policy on exchange rates

• Importance of capital mobility

• Classification of economy

Capital mobility -nil, low, high, perfect

Exchange rate -Fixed, Floating

 Mundell-Fleming Model -assumptions

• MF model is based on an open economy this is too small to

influence the interest rate in the rest of the world

• Price is assumed to be fixed in the short run and equilibrium

level of output is below full employment level

• Model assumes exports /imports will rise in response to a

change in value of the domestic currency

 M-F transmission mechanism

Inc. in Dom.
Trade balance
Economic
Deficit
Activity
Inc. Dom.
In Money Currency
Supply depreciation
Decline in
Capital
Dom. Interest
Outflow
Rate
Impact of expansionary Monetary policy

Fixed Exchange rate

• Money Increase = Domestic demand =Imports attractive
due to fixed Ex. Rate
• Foreign exchange reserves are drained; fastest where
there is perfect mobility and slowest with zero mobility,
• Capital moves out in anticipation of currency
depreciation
Capital Mobility FE Res. D.Prdn D Int.
• Zero Modest loss No change No
change
• Low large loss No change No change
• High extensive loss No change No
change
• Perfect Infinite loss No change. No change
Only trade led drain to trade deficit + capital outflow
Impact of expansionary Monetary policy

Floating exchange rate

• Money Increase = Interest rate decline =Capital outflow
=Currency depreciation = higher exports
• Higher freedom for capital flow, faster the currency
depreciates, faster it depreciates higher the domestic
production increase
Mobility D.Cur D.Prdn D Int.
• Zero Small dep. Small inc.
Large dec.
• Low large dep. large inc. Small dec.
• High larger dep. larger inc.
smaller dec.
• Perfect largest dep. Largest inc. No change

Trade and capital flows balance to some extent

 M-F transmission mechanism

• Fiscal policy is the policy with regard to Government spending

Inc. in Dom.
Trade balance
Economic
Deficit
Inc. Activity Impact
In Govt. On
Spending/ Balance of
Investment Payment*
Increase in
Capital
Dom. Interest
inflow
Rate

*If trade dominates, currency depreciates

If capital inflows dominate currency appreciates
 Impact of Expansionary fiscal Policy

Fixed Exchange rate

Zero mobility
• Increased govt. investment met by imports
• Increase in Interest rate does not translate to capital inflows due to Zero
mobility
• Hence, no impact on domestic production
In Perfect mobility
• Domestic expansion financed by capital inflows; output has multiplier
impact of investment; no change in interest rate as increased demand
met by foreign inflows
Capital Mobility FE Res. D.Prdn D Int.
• Zero large loss No change large inc.
• Low small loss small inc. Small inc.
• High small gain large inc.
Smaller inc.
• Perfect large gain larger inc. No change
 Impact of Expansionary fiscal Policy

Floating exchange rate

• In Zero mobility, policy induced demand is met by imports, BOP deficit leads to
currency depreciation leading to higher exports; high interest rates does not attract
capital inflows due to no mobility
• In perfect mobility, policy induced demand brings in capital inflows leading to exchange
rate appreciation and reduces export competitiveness

Capital Mobility D.Cur D.Prdn D Int.

• Zero large dep. large inc. Large inc.
• Low small dep. small inc. Small inc.
• High small app. smaller inc.smaller inc.
• Perfect large app. No change No change
 Combined impact of Monetary / Fiscal policy

In situations of high capital mobility

Expansionary Restrictive
Monetary Policy Monetary Policy
Expansionary Ambiguous Domestic Currency
Fiscal Policy Appreciates

Restrictive Domestic Currency Ambiguous

Fiscal Policy Depreciates

• Restrictive fiscal policy = policy inducted demand reduction leads to

capital outflows leading to DC depreciation
• Expansionary monetary policy = increased imports & capital outflows
• Expansionary monetary policy negates Expansionary fiscal policy
 Combined impact of Monetary / Fiscal policy

In situations of Low capital mobility

Expansionary Restrictive
Monetary Policy Monetary Policy
Expansionary Domestic Currency
Fiscal Policy Depreciates Ambiguous

Restrictive Domestic Currency

Fiscal Policy Ambiguous Appreciates
• Restrictive fiscal policy = Policy inducted demand reduction leads
to reduction in imports
• Restrictive monetary policy = Decrease in domestic demand leading
to current account improvement
• Expansionary fiscal policy negates Restrictive monetary policy
INTERNATIONAL FINANCE

Euro: the birth of a new currency

J Shankar
IISc, MBA –Second Semester
January 2007
 EURO seen as it happened

Genesis of Euro

What is Euro

Global implications of Euro

 Genesis of Euro

1958, Treaty of Rome

Balanced development of economic
activity, created European Investment Bank
1972, Bale agreement, “The Snake”
Currency fluctuation 2.25%
1973, European Monetary Co-op Fund
1979, European Monetary System
European Currency Unit (ECU)
 Genesis of Euro -2
1987, Single European Act
frontier free market by 1992
1990, First phase of EMU in effect
Free capital flows
1990, UK joins EMS
Jan 1, 93 Free capital flows begin
Jan 1, 94 European Monetary Institute
1995 Date for single currency fixed -1999
Dec 1995, Currency named “Euro”
 Genesis of Euro -3

May 1, 1998 Participating countries fixed

Exchange rate between them fixed

Jan 1, 1999 Euro & Domestic Currency co-exist,

Euro = 1.1740 US$

1999-2001 No compulsion no prohibition

Jan 1, 2002 Euro replaces DC as legal tender

 What is Euro?

Eligibility criteria for joining Euro

Inflation <1.5% of average of lowest

three countries
Budget deficit <3% of GDP
Total public debt <60% of GDP
LT interest rates <2% of the average of lowest three
countries
Currency stability within EMS band for 2 years
 What is Euro?
Austria -schillings 13.7603 }
Belgium -francs 40.3399 }
Holland -Gilders 2.20371 }
Finland -markka 5.94573 }
France -Franc 6.55957 } EURO =US$1.1740
Germany -Mark 1.95583 }
Ireland -Punts .787564 }
Italy -Lira 1936.21 }
Luxemburg francs 40.3399 }
Portugal escudos 200.482 }
Spain -pesos 166.386 }
 What does it mean?

Domestic currency -> Euro

Euro effective from January 4, 1999

Euro & Domestic Currency co-exist
“No compulsion, no prohibition”
Upto January 3, 2002
After January 3, 2002 only Euro
 Immediate Implications

In the 11 countries, who are part of Euroland

One currency will exist

One interest rate
One exchange rate -w.r.t Foreign Currencies
Central banks give their Monetary powers to
European Central Bank
 Global Implications of Euro
US Japan Euro
GDP in US$t 8.1 4.0 6.3
Population in m 270 140 290
Unemployment 5% 3.5% 11.75%
Debt market US$ t 5 3.3 5
Savings rate 4% 12% 9.8%
Global % Exports 12.2% -
15.6%
Balance of trade -ve +ve
+ve
 Euro vs. US$
EURO balance sheet
+ Trade surplus
+ Higher unemployment
+ Higher savings
+ Larger market

- Cultural barriers
- Survival of Euro a ?
- Capital markets
- Technology & innovation
 Conclusion

• European Monetary Union

Tarapore Committee report

• Basis for the two

PPP = Inflation & REER

BoP = Budgetary deficit, Reserve levels

IRD = Interest rate range & inflation

INTERNATIONAL FINANCE

Market convention: Forex Markets

J Shankar
IISc, MBA –Second Semester
January 2007
 FX markets and Hedge Instruments

• Contract of sale -some key issues

• FX Market & market players
• Forward Contracts
• Currency Futures
• Pricing difference between Forward
Contracts and Futures
• Swaps
• Options
 Contract of Sale -Some key concepts

• Price -currency value of commodity

• Factors affecting the price, independent of the
market conditions
- Delivery schedule
- Terms of Payment
• Price in any market denotes a delivery schedule
& terms of payment defined by convention or
Law

What are FX market practices

 Market quotes available
• Business Line, February 9, 2007
– Money and Banking page
• Inter-bank rate on February 8th :Thursday
– US$ Opened 44.13/1350, close 44.12/1250, previous close 44.12
• Traveler Rates issued by Thomas Cook on 7th :
– US$ Buying rate: 44.75, Selling rate 48.05
• Exchange rates of SBI on 7th
– US$ Export or buying rate: 44.08, Import or selling rate: 44.17
What are these different rates?
 FX Markets

• Works from Monday to Friday

• INR-US$ market
– 9.00 AM to 4.30 PM; 5.00 PM for banks
• Cross currencies
– Round the clock market (Monday to Friday); due to trading
across the globe
– Hong Kong – Frankfurt –New York –San Francisco
• Market convention is “Two way quotes”
• Spread (difference between buying rate and selling rate) also called
bid –ask rate reflects the liquidity of the market
 A typical market quote
Market Quotes at 5.00 PM on 08/02/2007

Currency EXPORT RATES IMPORT RATES

SPOT RATES 1m 3m SPOT RATES 1m 3m

TT Bill TT Bill

US$ 44.08 44.07 44.18 44.57 44.17 44.20 44.37 44.74

Euro 57.26 57.25 57.33 57.90 57.40 57.44 57.74 58.37

UKP 86.67 86.55 86.80 87.55 86.86 86.92 87.25 87.94

Yen (100) 36.35 36.34 36.40 36.86 36.44 36.46 36.74 37.35

Sing $ 28.74 28.73 28.76 29.06 28.81 28.83 28.98 29.32

Inter US$ bank rate –Rs. 44.13

 FX Markets –Some more practices

• Inter-bank rate, Customer rate, card rate

– Inter bank rate – for trade between banks
– Customer rate – a spread over inter bank rate
(based on volume, credit risk, size of
transaction and relationship)
– Card rate – fixed rate for the day for small value
transactions; say below $10,000
– An area for negotiation;
– Small value transactions can be bunched

Potential for smart risk less profit in negotiating costs

 FX Markets –Some more practices

• Spot, TOM, Cash prices

– Spot -2 working days from transaction day or t+2
– TOM – T+1 (NPV of cash flow considering Risk free rate)
– Cash price – T (NPV of cash flow considering Risk free rate)
- Used for Cash flow management / interest cost management
• Quote on Dec 1 (Friday), Spot date Dec 5, TOM date 4
– Spot rate 44.6550
– Cash /Spot discount 00.0065 (for 4 days)
– TOM/Spot discount 00.0015 (for 1 day)
– Call money rate 06.10%
• Cash Spot discount % 1.33%
• TOM/Spot discount % 1.23%

Potential for smart risk less profit in negotiating costs

 FX Markets –Spot, TOM and Cash

FX Settlement volumes February 3rd 2006

Trade Type # of US$ INR
TradesMillion Rs.Cr
Cash 55 844 37332
TOM 136 1467 64931
Spot 1790 3558 157104
Forward 32 180 8073
• Imports and exports or trade flows (including services)
• Borrowing and lending or financial flows
• Investment flows
• Speculation

Earlier Business Line used to report on FX volumes for the day

 FX Markets –Some more practices
• Bill rate and TT rate
– Bill rate further processing required in the bank
(includes processing charges)
– TT rate –further work required is minimal
– Since the difference is a service charge, can be
negotiated based on the bargaining position of the
customer
– In the SBI quote, difference between Bill rate and TT
rate is
• For exports Re.0.01, for $100,000 you pay Rs.1000
• For imports Re.0.03, for $100,000 you pay Rs.3000
– For transactions where you have forward cover, the forward
cover rate applies and not the bill rate or TT rate

Potential for smart risk less profit in negotiating costs

 Factors considered in selecting FX
banker
• Trust: will give your the best rate and make your profit from volumes
instead of margin; banks fix spread over inter bank rate
• Infrastructure: Communication facilities, do you have access to your
dealing room, can you execute large value transactions, are you
reachable 25 by 7, 365 days; SBI –Pound sterling Nov 1988
• For cross currencies: Do you have overseas offices, can you execute
overnight orders, keep client informed on markets moves
• Can you innovate new instruments and structures; most foreign banks
• FX banking goes with other banking facilities like borrowing, investments
and Non fund based business; integrated approach; share of fund
businesss
• Provides access to your research views and are able to add value to
customers trading strategy: Most foreign banks get their economist to
visit large clients and discuss their view with the treasury teams

Often the person makes the difference

INTERNATIONAL FINANCE

FX Market Players and Instruments

J Shankar
IISc, MBA –Second Semester
January 2007
 FX Market Players

• Hedgers

• Speculators

• Arbitrageurs

• Central Bank “as a player”

 Hedgers
• Have an exposure
• Enter market for risk reduction
• Will take delivery
• Incidental to their primary business
• Affected by market liquidity
• May or may not have a view on price
movements
• Examples –Consumers & Investors

Need: Price that will be traded in the future

 Speculator
• Create an exposure
• Increases risk; risk-reward critical
• Will not take delivery
• Benefits from low liquidity
• Enters market because of price view
• Primary business is market operations
• Examples -Hedge Funds, Margin players,
• Banks play this role to provide liquidity to their
customers: Difference between inter-bank rate and card
rate is the reward for this

A price that he expects will trade in the future

 Arbitrageurs
• No primary exposure
• Minimal exposure taken
• Risk-free profits; source of profit market
information
• Does not take delivery
• Exist because of illiquidity
• No view on price
• Primary Business is market operations

Looks out for differences in Prices in different markets

 What is a derivative
• A cost effective method of finding a trade-
able future price
• Derivatives name arises from the fact that
the price is derived from the spot market
• Fundamental basis for derived price is the
cost of holding

Key is cost effective method

 Cost of holding

• Spot price
+ cost of holding
- interest cost
- holding cost (warehousing cost)
- transaction cost
 Methods of finding the future
price or Derivative instruments

• Forward Contract

• Futures

• Swaps

• Options
 Forward Contract
• A contract for sale or purchase of for delivery and
payment beyond the market norms / conventions
• Difference between spot & forward price is
discount or premium
• Premium = Forward price minus spot price
• Discount = Spot price minus forward price
• Over the counter market
• Settlement mainly through delivery
• No margin or immediate payment required

Most popular instrument in the Indian FX market

 Forward Rate
Forward rate = S ((1+(rdxt) / )+C
(1+rf xt )

S = Spot rate
rd = Domestic interest rate
rf = Foreign currency interest rate
t - the life of the forward contrac
C = transaction cost of bid-ask spread in FX markets
and bid ask spread in Money markets
• Since Indian Rupee is not fully convertible, the forward
rate is not determined only by interest rate differential but
also expectation of spot movement
 Example of Forward Contracts
Period Forward Price (INR Premium / (discount)
-US$) (bid rates)
Spot price 1/12/06 44.6550
1 month premium 0.0791 2.09%
3 month premium 0.2333 2.12%
6 month premium 0.4688 2.11%

Interest Rates Source: Mecklai Financial & Commercial Services

Period INR US$ Differential

6 month 6.80% 5.33% 1.47%

Indian Rupee is not a convertible currency

 Example of Forward Contracts
Period Forward Price (US$- Premium / (discount)
Euro) Bid price

Spot price 1/12/06 1.3257

1 month premium 0.0020 1.78%
3 month premium 0.0056 1.71%
6 month premium 0.0104 1.57%
Interest Rates
Period Euro US$ Differential
6 month 3.74% 5.33% 1.49%

Euro and US$ are convertible currency

 Futures
• Traded in an Exchange
• Standardised terms
Quantity
Delivery period
Terms of settlement
Trading through members
Margin stipulation
 Terms in Futures Markets
• Basis = difference between cash price
and future price
• Contango =Future prices > cash price
• Backwardation =Future price < cash price
or Future price < cash price plus cost of
carry
• Cost of Carry = cash price + financing
cost + carrying cost
 Evolution of Futures Market

• 1919 -Eggs
• 1921 commodities -corn, wheat, oats, rye
• 1947 metals -copper
• 1972 currencies -DM, Yen
• 1975 Gold
• 1977 Treasury Bonds
• 1983 Crude oil

Future market in Indian rupee not yet introduced in India

 Difference between Forward Contract &
Futures
• FEATURE FORWARD FUTURE
Size Tailor-made Standard
Delivery -do- -do- Price
OTC Exchange Commission
Spread Broking fee Margin
Optional Mandatory Settlement by
Delivery over 90% <
1%
 Where to use Future and Forward

• Forward contract for known cash flows;

• For uncertain cash flows Futures
• Futures prices can be different from forward prices due
to
– Credit risk priced in forward contract, risk in futures covered
through margin
– Since forward contract is not marked mark to market, cash
flow is not influenced till the date of the expiry
INTERNATIONAL FINANCE

Derivative Instruments in FX markets

J Shankar
IISc, MBA –Second Semester
February 2007
 What is a derivative
• A cost effective method of finding a trade-
able future price
• Derivatives name arises from the fact that
the price is derived from the spot market
• Fundamental basis for derived price is the
cost of holding

Key is cost effective method

 Cost of holding

• Spot price
+ cost of holding
- interest cost
- holding cost (warehousing cost)
- transaction cost
 Methods of finding the future
price or Derivative instruments

• Forward Contract

• Futures

• Swaps

• Options
 Option
A contract obtained for a price paid that gives the holder the right but not
the obligation to conduct a trade with the counterparty, on terms
specified in the contract

Writer of option –receives premium and undertakes the obligation

Buyer of option –pays premium and buys the right but not the obligation

Put Option –right to sell

Call option –right to buy

Similar to a general insurance contract

 Inputs to Option Pricing

• Current Price or Spot price

• Strike Price or price for exercise
• Tenor or period for which option required
• Interest rate –risk free rate of interest of both
domestic
• Dividend yield of the stock, benefit from holding the
asset; for FX options risk free rate of interest of
foreign currency
• Volatility –computed as standard deviation of daily
percentage changes in spot prices
 Specific components of Option

• Premium –consideration paid to the writer of option

• Strike Price – price for exercise at the point of exercise,
• Tenor –life of option
• Exchange traded options are of short duration normally less
than one year
• In Indian markets
- Stock Index Option is an European Option
- Individual stock options are an American Option
- INR options are European Option

Some terminologies explained

 Value of an option
• Intrinsic value of an option
– Gain to holder on immediate exercise of option
– = Market price – Exercise price for Call option
– = Exercise price – Market price for Put option
• Does a option have value if it has no intrinsic value?
• Where does this value come from?
– Time value of option
• Volatility value
• Interest value or Risk free rate
• Dividends
– Fair value of an option considers both the Intrinsic value + the
time value of an option
• Option premium value can never exceed spot price
 Classification of options based
on exercise price
Classification based on Intrinsic value
• At the Money option
– Exercise price = Spot price
• In the Money option
– Call option: Spot price > Exercise price
– Put option: Exercise Price > Spot price
• Out of Money options
– Call option: Exercise price > Spot price
– Put option: Spot price > Exercise Price
• Zero price options are typically Out of Money
Options
 Typical Option quotes for FX
OPTION PRICES (US$/INR)
Months 1 month 3 month 6 month 12 month
ATM 44.32 44.59 44.90 44.54
Call 0.21 0.38 0.53 0.74
Put 0.21 0.38 0.53 0.74

Quote of Mecklai Financial & Commercial Services Ltd

February 20, 2007
 Option specific terms used
• Delta = Change in Option price to change in spot price
– Used by writers of option to determine the amount for
hedging in spot market
– Call options have delta in the range 0 to +1
– Put options have delta in the range 0 to -1
– Higher the delta, greater the probability of option expiring ITM
• Gama =rate of change in Delta to change in spot price
• Theta =rate of change in Option value w.r.t. time
– For the holder indicates the rate at which option looses value
over time, or decay value; for the writer of the option it is
value accruing to him;
– theta does not have a linear relationship with time but square
root of time;
– The loss is more closer to the date of expiration (Slog over)
 Option specific terms used
• Lamda :Change in premium to change in volatility

• Volatility is an input that is person dependent

• 3 types of volatility
– Historical volatility: computed based on daily price moves
– Forward looking volatility: computed by adjusting
historical volatility by an amplifier or reducer
– Implied volatility: is worked back from premium
• Writers of Options believe volatility will decrease going
forward compared to implied volatility in their option
pricing model
 Benefits of using option
• Cost paid upfront, no further cost involved for buyer of options,
hence can be factored in by the hedgers
• Potential for upside not capped, hence benefit unlimited
• Option strategy based on view
- Bullish (believes prices will increase)- buy call option

- Bearish (believes prices will fall) –buy put option

 Writer of option has an unlimited liability
 Writer benefits only if the option expires without being exercised or
the difference between exercise price and spot market on date of
exercise is lower than the premium received by him
 Use of a call option or right to buy

• Hedgers will buy call options, if they are

- Bullish or expects prices to go up or
wants to cap their costs
• Speculators will write call options, if
- If they are bearish or expects market to
be flat; collects premium upfront for a risk
that he is taking
 Uses of a Put option or right to sell

• Hedgers with an uncertain sales price

- Will buy put option to protect against price
drop
 Speculators will write put option

- if he is bullish or expects price to go up

Forward to Forward (combination of two
forward contracts)

• A simultaneous purchase and sale of forward

contract for different periods
• To fix the premium without fixing the spot rate,
Spot rate fixed before the expiry of first contract
• Used in Indian markets before it was banned in
1990’s
• To take a view on interest rate / expectation
down the line without fixing spot rate
 Exotic forwards (combination of
forwards with Options)

• Range Forwards
defines a range, with high and low
(European)
• Layered Forwards
defines a range, with high and low
(American)

Instrument variants to reduce the forward premium cost

 What is a Swap?
• Swap is an exchange of benefits derived from
holding an assets
• Two types of swaps –Currency swap and Interest
swaps
• Intermediary –Market maker
• Assumes credit risk for a spread
• Swaps are settled by payment / receipt of difference
• Reference to a specific public rate
• Documentation format is ISDA prescribed
(International Securities Dealers Association)
 The first Swaps

• First Currency swap in 1981 between

World Bank and IBM
– Exchange principal and fixed interest for interest
and fixed interest in another currency
– Value of swap priced through interest
– Interest rates used –T Bill, LIBOR, CP rates
 Variants

• CAPS –for lender Upside is fixed or for

borrower downside is fixed

• Floors – for lender downside is fixed or for

borrower upside is fixed

• Collar –that has both a Cap and a floor

 Pricing for a Swap
• Based on NPV
• Initial NPV of a Swap is Zero
• Exchange rate is determined by the Yield Curve
• If the yield curve is flat, fixed interest will be close
to floating interest rates
• If the yield curve is normal, sloping up left to right,
swap rate is fixed such that
- Fixed interest is higher than floating
- Steeper the curve, higher the rate fixed