PPS Le) ———_— International Financial Management Se a 2 ded SiddaiahLibrary of Congress Cataloging-in-Publication Data Siddaiah, Thoremuluri, 1951- International financial management / Thummuluri Siddaiah. p.em, Includes index. ISBN 978-8131717202 (pbk) 1. International finance. 2. Foreign exchange market. 3. Balance of payments 4, Investments, Foreign. 5. international trade. 1. Tile HG3881.$526 2009 658.15°99-de22 2009033189 Copyright © 2010 Dorling Kindersley (India) Pvt. Ltd. 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ISBN 978-81-317-1720-2 Head Office: 7th Floor, Knowledge Boulevard, A-8(A), Sector 62, Noida 201 309, India Registered Office: Id Local Shopping Centre, Panchsheel Park, New Delhi 110 017, India ‘Typeset by Chennai Publishing Services Printed in India at Baba Barkha Nath Printers Pearsoa Education Inc., Upper Seddle River, NJ. Pearson Education Ltd., London Pearson Education Australia Pty, Limited, Sydney Pearson Education Singepore, Pre, Ltd Pearson Education North Asia Ltd, Hong Kong Pearson Education Canada, Ltd., Toronto Pearson Educacion de Mexico, S.A. de CV. ‘Pearson Education-lapan, TokyoBrief Contents Foreword iti Preface v 1 The Foreign Exchange Market: Structure and Operations 1 2__ The Intemational Monetary System 3 3 The Balance of Payments: Implications for Exchange Rates 61 4__ Intemational Parity 85 5. Management of Foreign Exchange Exposure and Risk 123 6 Currency Forwards and Futures 151 7__Currency Options 181 8 Financial Swaps 29 9 Cross-border Investment Decisions 259 10 Financing Decisions of MNCs 289 11 Management of Working Capital: An International Perspective 307 12__Intemational rade 13 Foreign Investments 351 14 Portfolio Theory: An International Perspective 381 15 The Indian Accounting and Taxation System 401 16 Mulilateral Financial Institutions 2s Andee gesContents Foreword xiii Preface xv 1 The Foreign Exchange Market: Structure and Operations 1 1.1 Introduction 1 1.2 Money asa Medium of Exchange 2 1.3 __ The Foreign Exchange Market _3 14 Arbitrage 14 1.5 Nostro, Vostro, and Lor Accounts 18 1 Forward Rates and Future Spot Rates _19 17 The US. Dollar as a Vehicle Currency 21 1.8 Trends in Foreign Exchange Trading 22 1.9 Networks for international Transactions 22 1.10 __ The Indian Foreign Exchange Market _23 ‘Summary 30 ‘Questions and Problems 30 Further Reading 31 2___ The International Monetary System. 33 21.___Intraduction 33 2.2___The Gold standard 34 2.3 The Gold Exchange Standard _36 2.4 ‘The Bretton Woods System _37 2.5 Post-Bretton Woods Systems _38 2.6 Alternative Exchange Rate Regimes _40 2.7 The IMF Classification of Exchange Rate Regimes 45 2.8 Selection and Management of Exchange Rate Regimes 47 2.9 Exchange Rate Policy and Monetary Policy 47 2.10 The Par Rate of Exchange 48, 2.11 Emergence of the Euro 48 2.12 Exchange Rate of the Indian Rupee 49 2.13 Depreciation, Appreciation, Devaluation, and Revalvation 51 2.14 — Convertibility of Currency 93 2.15 International Liquicity and International Reserves 55 2.16 Sterilization 58 Summary 58 ‘Questions and Problems 39 Further Reading 59CONTENTS The Balance of Payments: Implications for Exchange Rates 61 3.1 Introduction 61 3.2 The Balance of Payments Manual 61 3.3. Functions ofthe BOP 62 3.4 Principles of BOP 62 35 BOP Accounting 63 3.6 National Income and International Transactions 70 3.7 The BOP and Exchange Rates 71 3.8 The BOP and Money Supply _74 3.9 India’s BOP. 76 Summary 61 Questions and Problems 81 Case Swidy 62 Further Reading 83 Intemational Parity 85 41 Ioueduction 85 4.2 Exchange Rate Determination 85 4.3, Factors Affecting Exchange Rates 87 44 The BOP Theory of Exchange Rates 89 4.5 The Purchasing Power Parity (PPP) Theory 90 4.6 The Real Exchange Rate 97 4.7 The Real Effective Exchange Rate (REER) 98 4.8 Interest Rates and Exchange Rates _100 4.9 Forward Rate Parity 109 4.10 The Fisher Fffect 110 4.11 The Intemational Fisher Relation 113 4.12 _Interelationship of Parity Conditions _114 4.13 Exchange Rate Forecasting 116 Summary 119 Questions and Problems 120 Further Reading 121 Management of Foreign Exchange Exposure and Risk 123 S.1___Introduction 123, 5.2 Foreign Exchange Exposure and Risk: A Comparison 124 5.3. Real and Nominal Exchange Rates 128 5.4 Types of Exposure 128 Summary 147 ‘Questions and Problems _147 Case Study 148 Further Reading 148CONTENTS x Currency Forwards and Futures 151 6.1 Introduction 151 6.2 Currency Forward Contacts 151 6.3 Currency Futures Contracts _153 6.4 Traders and Trading Operations 158 6.5 A Glimpse of Two Major Futures Exchanges 162 6.6 Forwards and Futures: A Comparison 163 6.7 Relationship Between Spot Rates and Futures Prices 166 6.8 Pricing of Currency Futures _168 6.9 The Hedge Ratio 170 6.10 Cross Hedging and Delta Cross Hedging 172 6.11 The US. Dollar Index (USDX) 173 6.12 Interest Rates: Basic Concepts 174 6.13 Currency Futures in India 178 Summary 179 Questions and Problems 179 Further Reading _180 Currency Options 181 ZA___Intioduction 181 7.2 __Fowms of Options_182 7.3 Inhe-Money, Outof-the-Money, and Athe-Money 188 7.4 Disposing of Options 189 7.5 The Chemistry of Options 189 7.6 Option Value 193 7.7 Bounds for Option Prices 194 7.8 Determinants of Option Price _197 7.9 Trading Strategies _199 7.10 __ The Binomial Option Pricing Model_202 7.A1 The Black-Scholes Valuation Model 210 7A — Put-Call Parity 213 7.13 The Greeks 215, 7.14 — Forwards/Futures and Options: A Comparison 222 7.18 Futures Options 224 7.46 Currency Options Trading in India 224 Summary 225 Questions and Problems 226 Case Study 227 Further Reading 227 Financial Swaps 29 8.1 Introduction 229 8.2 Parallel Loans 230CONTENTS ul 8.3 Back-to-Back Loans 231 8.4 Types of Swaps 231 8.5 A Swapas a Series of Forward Contracts 253, B.6 Market Quotations for Swaps 254 8.7 Derivatives Trading in India 2: Summary 256 Questions and Problems 257 Case Study 257 Furher Reading 258 Cross-border Investment Decisions 259 9.1 Introduction 259 9.2 Capital Budgeting 260 9.3. Approaches to Project Evaluation 265 9.4 Risks in Cross-borcler Investment Decisions 277 9.5 Incorporating Risk in Investment Decisions 279 9.6 Real Options 283 Summary 285 Questions and Problems 285 Case Sudy 286 Furher Reading 287 Financing Decisions of MNCs 289 10.1 Introduction 289 10.2. The Cost of Capital 269 10.3 Capital Structure 295 10.4 Methods of Raising Capital 300 Summary 304 Questions and Problems 305 Furher Reading 305 Management of Working Capital: An International Perspective 307 Introduction 307 14.2 Cash Management 308 14.3 Marketable Securities 115 11.4 Management of Receivables 316 11.5 Inventory Management 320 11.6 Financing Current Assets 322 Summary 324 Questions and Problems 324 Case Study 325 Further Reading 325CONTENTS: xi 12__Intemational Trade 2 38T 13 14 15 124__Introduction 327 12.2 Theories of International Trade 328 12.3. The World Trade Organization 329 124 Trends in World Trade 332 125 India's International Trade 333 12.6 International Trade Finance 335 12.7 Documents Used in International Trade Finance 339 128 Institutional Credit 340 129 Imports into India: Guidelines for Trade Credits 343 12.10 Forfaiting 344 1241 Countertrade 344 12.12 The Expor-import Bank of india 345, 12.13 The Export Credit Guarantee Corporation 347 Summary 349 Questions and Problems 349 Further Reading 350 Foreign Investments 351 13.1 Inroduction 351 132 Foreign Direct Investment 352 133 Foreign Investments in India 362 134 Indian Depository Receipts 371 135 Foreign Investments by Indian Companies 372 13.6 The Bilateral Investment Promotion and Protection Agreement 374 137 — Trends in FDL 374 13.8 Causes of Low FDI in India 379 Summary 379 Questions 380 Further Reading 380 Portfolio Theory: An International Perspective 381 14.1 Introduction 381 142 The Markowite Portfolio Model 382 143 The Capital Asset Pricing Model 388 144 Intemational Portfolio Diversification 393, Summary 399 Questions and Problems 399 Further Reading 400 The Indian Accounting and Taxation System 401 15.1 Iniroduction 401 15.2 The Accounting Standards Board 402 15.3 Accounting Standard 11. 402xii CONTENTS 16 15.4 Global Tax Rates 405 15.5 The Taxation System in India 407 15.6 India’s Double-taxation Avoidance Agreements 416 Summary 419 Questions and Problems 420 Case Study 420 Further Reading 421 Appendix 15.1 421 Multilateral Financial Institutions 425 16.1. Introduction 425 16.2 The International Bank for Reconstruction and Development 425 16.3 The International Development Association 427 16.4 The International Finance Corporation 429 16.5 The Asian Development Bank 431 16.6 The International Monetary Fund 433 Summary 438 Questions and Problems 439 Further Reading 439 441aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.PREFACE ait Dealing with Corporate Finance from the International Perspective The phenomenal growth of international trade, cross-border investments, and the recent eco- nomic crisis have made it necessary for finance managers and students of finance to under- stand the dynamics of financial decisions, especially those that invelve foreign exchange rates and markets. faternational Financial Management seeks to provide finance managers and students with the knowledge and skills required for managing business operations in the international arena. The book also aims to help them take advantage of the opportunities available in the global environment and, at,the same time, protect their businesses from the vagaries of exchange rates. The framework of intemational finance will also be useful for policymakers and executives in government and non-governmental (not-forprofit) orga- nizations. With its numerous solved examples, practice problems, and case studies and its focus on financial practices and poliey, the book is designed to help students who aspire to become finance managers, executives, financial analysts, ot financial consultants to apply the con- cepts of international finance to real-world events and situations. As the book provides the ‘conceptual framewerk and analytical tools necessary to make financial decisions from an international perspective, it is also suitable for executive development programmes and ‘management development programmes. Organization of the Book ‘This book is organized into 16 chapters. The topics in each chapter are discussed from the perspective of the finance manager in the internationel context. with a special focus on India, ‘Chapter 1, “The Foreign Exchange Market: Structure and Operations,” discusses the structure and operations ofthe foreign exchange market and introduces the reader to foreign exchange rates. This chapter acts as the foundation for the concepts dealt with in the fol- lowing chapters Chapter 2, “The Intemational Monetary System,” focuses on different exchange rate regimes in the world and their implications. The chapter also highlights the developments in the exchange rate system of India, Chapter 3, “The Balance of Payments: Implications for Exchange Rates,” deals with the balance of payments and discusses its impact on exchange rates. Students of intemational finance usually find it difficult to understand how intemational transactions are recorded and what their implications for exchange rates are. This chapter deals with these issues by providing various solved examples, and it also discusses the convertibility of curreney and its implications. Chapter 4, “Intemational Parity,” discusses various parity conditions such es purchasing power parity, interest rat parity, forward rate parity, and the intemational Fisher effect. The basic concept of exchange rate determination leads the discussion on intemational parity ‘Chapter 5, “Management of Foreign Exchange Exposure and Risk,” highlights different kinds of foreign exchange exposures and risks faced by firms and discusses how such risks can be managed. Chapter 6, “Currency Forwards and Futures,” Chapter 7, “Currency Options,” and Chapter 8, “Financial Swaps,” deal with derivatives. Chapter 6 highlights how the forward and futures ‘markets operate and elaborates on the trading strategies associated with futures, The chapter also introduces the concept of interest rate funures to readers. Chapver 7 explains various currency option trading strategies. Option pricing is the focus of this chapter. A comparison of options, forwards, and futures provides an overview of the various currency derivatives. Chapter 8 discusses financial swaps as rsk-management tools and profit-generating strategiesaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.PREFACE xt JPY in place of ¥. Table 1.1 in Chapter | provides a list of the major currencies in the world and their symbols avd ISO 4217 codes ‘+ As far as possible, million and billion have heen used to represent large numbers in place of lakh and crore, which are commonly used in Indian books. However, where the primary data was available in lakh and crore (most of the RBI data, for instance), the information has been retained in the original style, The following table will help, readers convert amounts in lakh/crore to amounts in million/billion in the same curteney ‘Amountin lakhicrore Amount in fgures__Amount in milionibillion 1 lakh 100,000 100 thousand To bkh 1,000,000 1 milion 1 erore 10,000,000 10 million VO crore 100,000,000 100 milion 100 crore 1,000,000,000 bition Acknowledgements {Lam grateful to my guru, Professor B. M. Lall Nigam, who initiated me into the subject of finance and has been a constant source of inspiration and encouragement. 1 thank my famiiy members, Ms Usha Rani, Dr Harini, Dr Mruthyunjaya, Dr Alekhya, and Ch Guru Sai, for their endurance through the years that 1 spent in writing this book. Special thanks are due to my daughter, Dr Alekhya, who has helped me in keying in the ‘manuscript and in formatting the equations, charts, and tables in this book. She spared many hhours on this work despite the fact that, as an MBBS student, she had her own load of assignments to deal wit, T would like to thank Shabnam Dobutia, Development Euitor at Pearson Education, for hr editorial support. I have gained the knowledge and skills required for writing this book by reading the works of many great authors and through interactions with my students. Towe a great deal to them, Thuramuiuri Siddoiahaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.The institutional secup that facilitates the trading (of currencies is known as the foreign exchange market. ts also referred to.asthe forex market, or the FX market. Table 1.1 List of select currencies with codes and symbols THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS 3 paddy could be expressed in terms of say, pulses; the value of apples could be measured in terms of a certain number of oranges: and s0 of. In the monetary world, however, the value of every commodity or service is expressed in terms of money. Money is a measure of value for all goods and services. By convention, the value of money is measured in terms of its purchasing powor of goods and services, Money is thus @ medium of exchange for most things in the werld, Different countries have different currencies as their monetary unit. For example, the Indian rupee is tne currency or monetary unit in Indie, and the value ofall goods and services in India is measured and expressed in terms of Indian rupees. Similarly, the U.S, dollar isthe ‘currency in the United States and the value of all goods and services in the United States is ‘measured and expressed in terms of this currency. Although the terms money and currency have different connetations in economic terms, no distinction is observed between them in ‘common parlance, People in different counitics can use their respective currencies as the medium of exchange for all goods and services within the geographical borders of their countries. How- ever, when people from one country buy goods made in a foreign country or engage in financial transactions abroad, they usually need the eurreney of that county. In such situa tions, it should be possible to acquire the required amount of the foreign currency by ‘exchanging a specific amount of domestic currency for it. There would be no need for for- ney and a foreign exchange market if all the nations in the workd were to have a ingle currency. However, since it is not practical to have a single currency for all nations {although the introduction of the euro is a step in this direction), it is imperative to have a foreign exchange market The International Organization for Standardization (ISO) has developed a system of three-letter codes or abbreviations for all the currencies in the world to facilitate easy and efficient currency trading, The codes under this standarg, referred to as ISO 4217, indicate the name of the country and its currency. An illustrative list of some currencies and their ‘codes is presented in Table 11 1.3. The Foreign Exchange Market A foreign exchange trancaction isa trade of one currency for another currency. The institt- tional set-up that facilitates the trading of currencies is known as the foreign exchange market, or the forex market ot FX marker. The foreign exchange market is not located in a physical space and does not have a central exchange. Rather, itis an electronically linked network of a large umber of individual foreign exchenge trading centres, in which the market paricipants deal directly with each other. Thus the forex market provides e single, Countryiregion Currency Currency code Currency symbol United States of America U.S. dollar usd 8 United Kingdom British pound cep £ European Union European Union euro EUR é Switzerland Swiss franc CHF CHF Australia Australian dollar AUD 5 Cenada Canadian dollar cAD 8 Japan Yen wy v Malaysia Malaysian ringgit MYR RM Mauritius Mauritius rupee MUR Rp Pakistan Pakistan rupee PKR Ro Singapore Singapore dollar scD 5 Sri Lanka Sri Lanke rupee uKR. Rp India Indian rupee INR. INR, Rs, or Reaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.Table 1.2 Extent of RBI intervention in the foreign exchange market (USD billion) The price of one. ‘currency in terms of another currency is known as the foreign ‘exchange rate. ‘THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS 7 Year Purchase Saleof. Net offoreign foreign intervention currency currency 2001-02 22.8 158 70 2002-03 30.6 149 157 2003-04 55.4 249 305 2004-05 31.4 10.6 208 2005-06 15.2 74 8 2006-07 26.8 00 26.8 2007-08 79.7 1.49 78. Source: Reserve Bank of India, Report an Currency and Finance 2005-06 and 2006-08, ‘exchange rate. Central banks may also use their forcign exchange reserves to intervene the foreign exchange market ‘The Reserve Bank of India (RBI) intervenes in the foreign exchange market, especially to arrest violent fluctuations in exchange rates due to demand-supply mismatch in the domestic foreign exchange market, Sale/purchase of foreign exchange by ihe RBI is gener~ ally guided by excess demand/supply. The extent of intervention by the RBI can be assessed from the data presenied in Table 1.2. It is evident from the table that intervention by the RBI is not uniform over time. However, in all the years presented in the table, the RBI was the net purchaser of foreign currency. This may be because of an excess supply of foreign exchange due to a surge in capital inflows. The purchase of foreign currency by the RBI was ‘meant to absorb excess supply inthe foreign exchange market and assuage the strong upward pressure on the foreign exchange rate, The RBI also intervenes in the derivatives market to prevent sharp changes in the exchange rate. In the imerbank market, currency notes and coins rarely change hands. The buying/sell- ing of a particular currency is actually the buying/selling of a demand deposit denominated in that currency. Thus, the exchange of currencies is, in reality, the exchange of a bank ‘deposit denominated in one currency for a bank deposit denominated in another currency. For example, a dealer buying yen, no matter where the transaction tekes place, is actually buying a yen-denominated deposit in a bank located in Japan or the claim of a bank located ‘outside Japan on a yen-denominated ceposit ina bank located in Japan, The retail segment of the foreign exchange market consisis of tourists, restaurants, hotels, shops, banks, and other bodies and individuals. Travellers and other individuals exchange one currency for another in order to meet their specific requirements. Currency notes, traveller's cheques, and bank drafts are the common instruments in the retail market ‘Authorized restaurants, hotels, shops, banks, and other entities buy and sell foreign curren cies, bank drafis, and traveller’s cheques to provide easy access to foreign exchange for individual customers, and also to convert their foreign currency into their home currency. Individuals who receive foreign remittances and those who send foreign currencies abroad ‘may also participate in the retail segment of the foreign exchange market. ‘Although the foreign exchange needs of ret for a small fraction of the turnover in the foreign exchange market, the retail market assumes ‘great importance, especially for people of small means. This isthe reason behind the grow- ing importance of the retail segment. The transaction costs, however, are higher because of the small size of the retail segment. customers are usually small and account 1.3.4 Foreign Exchange Rates Depending on the perspective of the participant, a currency is identified as the domestic or home currency, or ss a foreign currency. For example, from the perspective of an Indianaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.The rate of exchange between any two currencies as determined through the medium of some other currency is known as 2 cross rate. THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS i ‘currencies, The currencies that are traded in Asian NDF markets are the Chinese yuan ren- minbi, the Korean won, the Taiwan dollar, the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, the Thai baht, the Pakistan rupee, and the Indian rupee. 1.3.7 Cross Rates ‘There are thousands of pairs of exchange rates with more than 150 currencies in the world, but one does not need to know all these pairs of exchange rates when there is parity in the exchange rates. ‘A foreign currency can be purchased with the home currency or with another forei currency. For example, the U.S. dollar can be purchased directly with Indien rupees, but it can also be purchased indirectly by using Indian rupees to buy British pounds and thea using British pounds to buy U.S. dollars. When there are no transaction costs, there is no differ- ence between buying a foreign currency with the home currency directly and buying it indi- rectly through another foreign currency. However, to buy a currency indirectly, there should be parity in cross-exchange rates between currencies. That is, in the present example, the market should offer exchange rates between the U.S. dollar and the Indian rupee, between the Indian rupee and the British pound, and between the British pound and the U.S. dollar such thet one receives the same amount in U.S. dollars whether they are purchased directly with Incian rupees, or indirectly vie British pounds. With zero transaction cost, his implics that (USD/INR) = (GBP/INR) x (USD/GBP), The rate of exchange between any two currencies (say, ‘and j) as determined through the medium of some other currency (say, &) is known as a cross rate. This can be expressed as follows (iL Gk) x (kl) au) From Eq. 1.1, since (k//)= 1/(/&), the cross rate of (iif) can be calculated from the follow- ing equation (wk) iy -§® 1.2) Gi) ui (2) Analogously, Ae U9 = Gy Now, if stands for USD, j stands for INR, and k stands for GBP, then from Eq. 1.1, (USDIGBP) COSDIINR) (INRIGBP) oa Analogs, nnvusp) -(98"USD) (GBPIINR) Ifthe GBP/INR end the GBP/USD exchange rates are known, the INR/USD exchange rates ccan be calculated, For example, if GBP/INR: 78.69 and GBPUSD: 1.8279, we can calcu- late the spot exchange rate between the Indian rupee and the U.S. dollar using Eq, 1.3 in the following way: 11.8279) (1778.69) (USD/INR)aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.14 INTERNATIONAL FINANCIAL MANAGEMENT Example 1.2 Solution Arbitrage refers to the selling and buying of the same currency to profit fom exchange rate discrepancies within a market centre of across market centres ‘The USD is quoted at AUD 1.1197/1.2135 and the GBP is quoted at AUD 2.1920) What is the direct quote be:weea the USD and the GBP? The following steps may be followed to obtain the direct quote: |. Sell one USD for AUD 1.1197. 2. Convert AUD 1.1197 into GBP (1.1197/2.2500~0.4976). Thus, the bid rate for the USD is GBP 0.4976. 3. Buy AUD 1.2135 with GBP 0.5125 (i, 1.123512.1920). Buying AUD with GBP is equivalent to selling GBP for AUD at the bid rate of AUD 2.1920. 4. Buy one USD with AUD 1.2135, Thus, the direct quote for USD is GBP 0.4976/0.5125, . 1.4 Arbitrage Arbitrage refers to the selling and buying of the same currency to profit from exchange rate discrepancies within a market centre or across market centres. Arbitrage transactions are carried out without any risk or commitment of capital. A market participant may therefore buy a currency in one market centre and simultaneously sell it in another market centre, thereby making a profit. Ths is called two-point simple arbitrage or direct arbitrage. 1.4.1 Two-point Arbitrage Let us consider an example to understand the concept of two-point arbitrage ‘Assume Bank X quotes the rates USD/INR: 45.50/45.65. At the same time, the quote from Bank Y is: USD/INR: 45.25/45.40. This scenario provides an arbitrage opportunity. A market participant can buy U.S. dollars at INR 45.40 from Bank Y and sell them to Bank X at INR 45,50. These two transactions pro- vide a profit of INR 0.10 per U.S. dollar involved in the transactions. This profit is known a arbitrage profit, and it's made without any risk or commitment of capital While discussing two-point arbitrage, it is important to understand the concept of implied inverse quotes. Let us consider an example to understand this. Assume that the quote berween two currencies, say, USD/INR, is 43,3821/43.9560. In other words, INR 43.5821 is the rate at which the bank is ready to buy U.S, dollars and INR. 43.9560 is the rate at which the bank is ready to sell U.S. dollars. It is implied that the bid rate is also the rate at which the bank is ready to sell Indian rupees. That is, the bid rate would correspond to the ask rate in the INRUSD quote. The ask rate in the quote INRUSD is 1/43.5821, which is equal to USD 0.0229. Similarly, the (USD/INR) ask rate would correspond to the (INR/USD) bid rate. In the example, the ask rate INR 43.9560 is equal 10 the bid rate 143.9860 (i.c., 0.0227) in the INR/USD quote. Thus, it ean be stated that: Implied (INR/USD),,= I(USD/INR),., Implied (INR/USD),,, = 1/(USD/NR),. ‘The implied inverse quote (synthetic) in this example is INRUSD: 0.0227/0.0229 ‘The implied inverse quote can also be stated as: LU USDANR) ae T/(USDINR),Solution THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS 15 If the actual quote in the foreign exchange market differs from the implied inverse quote, it may result in arbitrage opportunity. For exampie, suppose the exchange rate quote in New York is INR/USD: 0.0197/0.0200. A market participast can buy Indian rupees at USD (0.0200 in New York and sell them in Mumbai for USD 0.0227, thus making a riskless profit, of USD 0.0027 for every Indian rupee. Such arbitrage opportunities, however, will son ds- ‘appear as arbitrageurs continue to eam profits. Ttiwbitnge opportnties ae fo be avelded, the ok id of he sahil USBI gue should be higher than the bid rate of the implied USDYINR quote, and the bid rate of the actual USDAINR quote should be lower than the ask ate of the implied USD/INR quote. The same can be stated as follows: Actual (USD/INR),,,< Synthetic (USD/INR),x. and, Synthetic (USDVINR),,,< Actual (USD/INR) ‘The actual quote and the synthetie inverse quote must overlap (ie. the bid rate in one ‘quote should be lower than the ask rate in another) in order t avoid arbitrage opportunity Consider another example: The spet quotation in Mumbai is USD/INR: 45.25/35. Atthe same time, the quotation of a bank in New York is INR/USD: 0.021525. In this ease, (USDANR iy VANR/USD) =vo022s =INK 44.4448 (USDINR 4. = MINRUSD) 0.0215 =INR 465116 Thus, the synthetic inverse quote for USD/INR is 44.444445.5116, Since actual (USD/INR) gy < synthetic (USDVINR}, and synthetic (USEYINR),,,< actual (USD/INR),q, there is n0 arbi- trage opportunity ‘The inverse quote isthe reciprocal of the direct quote between two currencies. For exam- pile, the inverse quote for USD/INR is INR/USD. The actual inverse quotes may differ from. snthetic inverse quotes by the amunt of transaction costs. In the absence of transaction casts and spread (difference between bid and ask rates), the exchange rate in one country would have to be the exact reciprocal of the exchange rate in another country forthe same pair of curren- cies. For exemple, if the exchange rate in New York is INR/USD 0.0234, then the exchange rate in Mumbai would be 1/0.0234, or INR 42.735. Otherwise, an arbitrage opportunity may arise. A firm in England has to make a payment of SGD 1 million to its supplier in Singapore. The currency quotes available are as follows: GBP 0.0117/0.0119 for INR SGD 0.03510/0.03520 for INR ‘What is the amount o be paid in British pounds by the importer? It's given that INR/GBP: 0.0117/0,0119 and INR/SGD: 0.03510:0.03520. The ex0ss rates will be as follows: (SGD/GBP),,~ (INR/GBP),,, x (SGD/INR),., = (INRIGBP)yg X IAINR/SGD), = 0.0117 x 1/0,03820 a = 0.332416 INTERNATIONAL FINANCIAL MANAGEMENT Figure 1.1 Triangular trading and (SGD/GBP),, = (INR/GBP),..X (SGDINR),4 (INRIGBP),.. X I(INR/SGD)j, = 0.0119 1/0.03510 = 0.3390 ‘SGD/GBP =0.3324/0,3390 Therefore, the importer has to pay GBP 339,000 to get SGD | million to settle the dues to its supplier in Singapore. . 1.4.2 Triangular Arbitrage {fee currencies are involved in an arbitrage operation, it is called a three-point arbierage or a triangular arbitrage. in a triangular arbitrage. one currency is traded for another cur- rency, which is traded for a third currency, which, in turn, is traded for the first currency. For example, assume a firm wants to conver: INR to GBP. It can do so directly. The num- ber of British pounds to be received per unit of INR is given as INRIGBP. The firm can also get pounds indirectly from INR to USD and then from USD to GBP. This is diagrammati- cally represented in Figure 1.1. For arbitrage profit in triangular trading to be zero, the product of the exchange rates should be equal to 1. For example, the following are exchange rate quotations in the market with zero transaction cost: USD/INR: 39.7925 GBP/USD: 2.0592 INR/GBP: 0.0122 The product of these exchange rates is equal to 1. That is, (USD/INR) x(GBP/USD) x (ENF/GBP) = 1. For instance, assume a market participant buys USD | million by paying INR 39.7925 million, with the USD 1 million he or she buys GBP 0.4856 million and uses these British pounds to get almost the same amount of INR. which he or she had used orig- inally to buy the USD. The exchange rates in this ease are in equilibrium, ‘When the exchange rates of the given currencies are in equilibrium (i. their product is 1, the product oftheir reciprocal rates must also be equal to 1. The reciprocals of the exchange rates in this example are as follows: INR/USD: 0.0251 USDIGBP: 0.4856 GBPANR: 81,9672 ‘Therefore, (INK/USD) x (USDIGBP) x (GBP/NR). Triangular arbitrage opportunity arises when the curtency direct quotes are not in alignment with the eross Boy uso exchange rates. Taking another example, . three currencies are quoted as follows: Fn uy IWR wth GBP GBP/USD: 2.0592 coe +} AUD/GBP: 0.4256 wth USD USD/AUD: 1.1310Solution THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS M7 If te rates are to be in equilibrium, the product of these rates should be equal to 1. But the product of the above rates is less than one. In other words, there is an arbitrage opportunity. ‘When there is an arbitrage opportunity, what can be done to make an arbitrage profit? That i, which currencies should be purchased and which ones should be sold to make a profit? In the current example, the aritrageur should buy GBP with U.S. dollars at a spet rats of 2.0592, buy ‘Australien dollars with pounds at 0.4256, and then buy U.S. dollars with Australian dollars at the spot te of 1.1310. By doingso, the arbitrageur makes a rskless profit of[1 - (GBP/USD) (AUDIGBP) x (USD/AUD] per cent= 0.88 per cent. Ifsuch a situation were to exist in reality, the arbitrage transactions would tend to cause the GBP to appreciate against the USD and to depreciate against the AUD. Further, the AUD would fall against the U.S. collar. Thus, the exchange rates would ultimately be in equilibrium and provide little scope for arbitrage profit. In the example we just discussed, the product of the exchange rates is less than I. If the product is greater than 1, which is also possible, then the arbitrigeur should engage in trian- gular arbitrage by selling the currencies in the numerator for respective currencies in the dcnominator at their respective spot rates. For example, consider the following exchange rates: GBP/USD: 2.1620 AUDIGBP: 0.4240 USD/AUD: 1.1425 Here, the product ofthe exchange rates is greater than 1. In such a situation, one can sell the numerator currencies to make an arbitrage profit. An astute investor can sell, say, GBP 1,000 to get USD 2,162, sell the U.S. dollars to get AUD 2,470, and finally sell the Australian dollarsto get GBP 1,047.32. Thus, the investor can make a riskless profit of GBP 47.32 by simultaneously executing the trades. If the product of the cross rates is less than 1, at least one of these rates should rise and if the product is greater than 1, atleast one of the rates must fall. The arbitrageurs will bring the exchange rates back into equilibrium through the buying and selling of currencies. Buy- ing a currency raises the exchange rate of that currency and selling a currency lowers the exchange rate of that currency. Therefore, arbitrage activities continue to effect changes in exchange rates until equilibrium is restored. In these days of highly advanced communication networks, arbitrage opportunities very rarely exist. Ifatall they exist, they will disappear very scon as every market participant is vigilant and would revise the rates as frequently as necessary. Further, in view of the trans- action costs, market participants may not bother about small variations in the quotes of dif- ferent banks as the trading of currencies on such small differences in exchange rates will not yield a net profit. Nevertheless, the role of arbitrageurs is very important, particularly in ensuring equilibrium or parity in exchange rates. ‘The following quotes are available in the foreign exchange market: GBP/INR: 85.16 USDANR: 45 GBP/USD: 1.85 ‘Are there any arbitrage gains possible fiom the spot exchange rates quoted in the three for c'ign exchange trading centres? ‘The arbitrageur can make a profit through the following steps: 1. Buy Indian rupees with, say, GBP 1 mil 2. Convert the Indian rupees into U.S. doll 85.16 million 45 USD 1.8924 millionaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.The forward exchange tate is the rate at which the actual exchange of currencies takes place at 2 specified date in the future. Ifa forward rate in home currency is more than the spot rate, the foreign correney is at @ forward premium, and i Itis less than the spot ‘ate, the foreign currency {s at a forvard discount ithe forward rate is equal to the spot rate, the foreign currency is said 10 be flat ‘THE FOREIGN EXCHANGE MARKET: STRUCTURE AND OPERATIONS: 19 1.6 Forward Rates and Future Spot Rates ‘The forward exchange rate is the rate at which the actual exchange of currencies takes place ata specified date in the future. The gain or loss from a forward contract depends on the actual future spot rate ofthe currency. In this section, we shall look at forward exchange rates and future spot rates in greater tail 1.6.1 Forward Premium and Forward Discount ‘The forward contract calls for the delivery of specified amounts of currencies at a specified rate of exchange on a specified future date. Ifa forward rate in home currency is more than the spot rate the foreign currency is said to be at a forward premium, and if itis less than the spot rate, the foreign currency is at forward discount. Ifthe forward rate is equal to the spot rate, the foreign currency is said to be flat. As stated earlier, a swap transaction between any two currencies consists of a spot pur- chase (or sale) and a forward sale (or purchase) ofa foreign currency. In other words, a swap ‘transaction combines a spot and a forward in opposite directions. For example, consider a trader who buys U.S. dollars spot against INR and simultaneously enters into a forward trans- ‘action with the same counterparty to sell U.S. dollars against INR. The amount of the foreign. ‘currency is the same in both transactions. The difference between the spot and the forward. ‘exchange rates is known as the swap margin, and this margin corresponds to the forward pre- rium or discount. A forward contract without an accompanying spot transaction is called an ‘owiright forward contract. Forward rates are either quoted as outright rates or «8 a discount/premium on the spot rate. The forward premium or discount is knowa as the forward differential or swap rate. It is also common to state the premium or discount in points known as swap points. Usually, outright rates are qucted in the retail segment of the foreign exchange market. In the whole- sale or interbank market, the forward rates are quoted asa discount or premium on the spot rate. The forward premium or discount can be expressed as follows: ‘onward: Spot rate Forward premium/discount =" Spot rate as) The forward premium or discount can also be expressed as an annualized percentage devi- ation from the spot rate: Annualized percentage forward premium/discount Forward rate—Spot rte 360 Spot rate Number of days of forward contract Let us assume that the spot exchange rate between INR and USD is 43/USD and the one- month forward rate is 43.75/USD. The forward premium or discount as per Eq. 1.5 is: 4375-43 B ¥12= 0.2093 ‘The U‘S. dollar is thus at an annualized forward premium of 20.93 per cent. “The spot and forward quotations for INR/USD can be stated as follows: Spot: 43.75/43.80 90-days forward: 202520 INTERNATIONAL FINANCIAL MANAGEMENT As amatier of convention, the swap points are added to the spot bid-ask ratesif the swap points are in ascending order, and subwracted from the spot rate if the swap points are in descending order. In this example, as the swap points are in ascending onder (20/25), the ‘90-days forward outright quotations can be represented as 43.95/4.05, This implies thatthe bank is ready to buy 90-days forward USD at INR 43.95 and sell at INR. 44.05. Similarly, assume that the U.S. dollar is quoted as follows: Spot: INR 43,75/43,80 90-days forward 25/20 In tis case, the swap points are in descending order and should therefore be subtracted from the spot bid-ask rates. The 90-days outright forward quotation shall be INR. 43.50143.60. This implies thatthe bank is willing to buy U.S. dollars at INR 43.50 and sell at INR 43.60, ‘Thus, the interbank forwerd rates may be quoted as the spot rate plus or minus the swap points The convention of adding or subtracting swap points is followed in direct quotations as well as indirect quotations. Ina direet quotation (expressed in terms of the number of units ‘of home currency per unit of foreign currency), if the swap points are added to the spot bid-ask rates, it will result ins forward premium (i.e, the foreign currency will be ata for- ‘ward premium). If, however, the swap points are subtracted from the spot bid-ask rates in a direct quotation, it will result in the foreign currency being at a forward discount. In the case of indirect quotations (expressed in terms of the number of units of foreign currency per unit of home currency), the foreign curreney will be at a forward discount if the swap points are added to the spot bid-ask rates: itwill be ata forward premium if the swap points are subtracted from the spot bid-ask rates. ‘The (indirect) spot and forward quotations between INK (unit of 190) and USD stated as follows: be Spot: 2.2857/2.2831 90-days forward: 2025 The outright forward quotations can be stated as follows: 90 ER xC+K This is because, inthis case, the domestic investment would give a higher return than the foreign investment. Alternatively, the investor will prefer an investment in foreign cur- rency-denominated securities if and only if: EAB) 5)(47B) +k, y< x(k, ‘Third, the investor will be indifferent between a home currency-denominated security and a foreign currency-denominated security if and only if: EAB) 5948) (+k, (1+ Kp In this case, the return on both the investments is the same. From the above discussion, itis clesr that an investor may have an option to invest in either home currency-denominated assets or foreign currency-denominated assets. How- ever, the retum on foreign currency-denominated investments will depend on two fectors: the interest rate and the foreign exchange rate. Since foreign exchange rates change from time to time due to various factors, the investor is exposed to foreign exchange risk. In order to hedge such a risk, the investor may enter into a forward contract for the relevant period. By having a forward contract on hand, the investor knows the amount of his or her retum ‘upon maturity of the foreign currency-denominated investment. ‘situation may also arise in which the investor has to decide whether to borrow in home ‘currency ot in foreign curtency. The decision, of course, will depend on the cost of bor- rowing. For every unit of home currency borto wed, the borrovter has to pay (1+K,,¥ units of home currency at the end of period r. Borrowing one unit ofhome currency is equivalent to borrowing 1/S,A/B) units of foreign currency, Therefore, the units of foreign currency the borrower has io pay at the end of period fare (1+ Kop) Or If these are converted into home currency atthe forward rate, this gives the following units of home currency: FAAIB) XC Ky)! ‘scarey “C+ Kor? ‘Therefore, borrowing in home currency is profitable if and only if: 1 < FAAB) ‘ Ce Ran < Fp Ot Kinaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.106 INTERNATIONAL FINANCIAL MANAGEMENT Table 4.4 Cash flows in INR at varying interest rates in India Figure 4.4 Interest rate parity EXE Solution Indian interest Inerest rate Cash flows rate (%) diferential in ater one year favour of India (%) (INR millon) 5 = 10.50 6 0 10.60 7 1 10.70 8 2 10.80 8 3 10.99 40 4 11.00 w It should be noted that interest rate parity holds only when there are no covered interest arbitrage opportunities. In other words, (1+K,V(1+K) must equal F/S, so that there is a no-arbitrage situation, Thus, interest rate parity can be represented by the following equation: ‘idoreciraia Parity ine differential (%) w Forward differential (%) 1K, A IFK, Sp ‘The same can be approximated as: 0 F,-So Ss This meaas that the interest rate differential is approximatsly equal fo the forward rate differential. If interest parity holds, the forward rate is an unbiased predictor of the future spot rate. In such a case, the above equation can be expressed as: Ky-K, E(S,)—~Sy Ke Eo a aaa Here, E(S) = Expected spot rate at time 1 ‘Thus, the interest rate differential equals the expected spot rate differential. Such a rela- tionship is called an uncovered interest party relationship. Ifthe interest rate is 9 per cent per ‘annum in Incia and 6 per cent per annum in Australia, the uncovered interest parity relation- ship would imply that the AUD is expected to appreciste against the INR by about 3 per cent. ‘The interest rates in India and the United States are 8 per cent per annum and 6 per cent por annum, respectively. The current spot rate is USD/INR 39 4354, If interest rate parity holds, ‘what isthe three-month forward rate? ‘The three-month forward rate (Fyp) will be: Fyq= 39.4354 [(1 + 0.08/4)(1 + 0.0614] =39.6297 ‘The USD has a forward rate (90 days) of INR 39.6297, resulting in an annualized premium of about {[(39.6297 ~ 39.4354y/39.4354] x4} per cent, or 1.97 per cent. This forward rate can also be taken as the expected spot rate in three months. .aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.110 INTERNATIONAL FINANCIAL MANAGEMENT Figure 4.6 Forward rate and future spot rate parity # sell the same at INR 45 tomake a profitof INR I on each U.S. dollar traded. In the course of buying the USD forward, part {pants will dive up the forward rate unt is no longer lower than the expected future spot rate, () ‘The buying and selling of foreign cur- rency in the forward market will also have implications for future spot rates. The squaring of forward contracts at maturity will put pressure on the future spot mar- ket In other words, pressure from the for- ward market is transmited to the spot 0° market, and thus influences the spot rates. Similarly, pressure from the future spot ‘market is also transmitted to the forward market, which influences the forward rates. ‘When the forward rate is ro longer greater or lower than the expected future spot rate, the forward rate and expected future spot rate are in equilibrium. In other words, $). ‘There is no incentive to tuy ot sell the currency forward in this scenario. A graphical rep- resentation of this relationship is shown in Figure 4.6. The vertical axis measures the ‘expected future spot rate and the horizontal axis measures the forward rate differential. The parity line joins the points where the forward premium or forward discount on foreign cur- rency is in equilibrium with the expected percentage change in the home currency value of the foreign currency. That is, the forward rate differential should equal the expected rate of change of the spot exchange rate: Expected change In the spot rato (%) Patlly ine Forward rate ditierertal (7) F-Sy _ ES)~So So So For example, an expected 3 per cent depreciation (appreciation) of foreign currency should be matched by the 3 per cent forward discount (premium) on the foreign currency. Further, considera situation where the market expects 4 per cent depreciation of foreign car- rency, but speculators are selling the foreign curtency at 3 percent forward discount. In this situation, the forward differential and the expected future spotrate will be in disequilibrium. This will ultimately be set right inthe course of buying and selling of foreign currency. ‘When the forward rate and the expected future spot rate sre in equilibrium, the interest rate differential between two currencies is equal to the expected rate of change in the spot rate. This relationship is known as uncovered interest rate parity. For example, the interest rate is 4 per cent in the United States and 6 per cent in India. In this situation, the Indian rupee would be expected to depreciate against the U.S. dellar by about 2 per cent. However, in reality, the forward rate may not exactly reflect the expectation of the future spot rate because of the risk premium on the forward contract, In other words, forward market par- ticipants would demand a risk premium for bearing the risk of the forward contract, This ‘would make the forward rate different trom the expected future spot rate, resulting in d ation from the parity line ‘The forward rate and the future spot rate are influenced by current expectations of Future events. As people get new information, they update their expectations about future events, leading to changes in exchange rates. Therefore, the forward rate parity is also known as forward expectation parity (FEP), 4.10 The Fisher Effect Interest rates can be classified as nominal interest raies and real interest rates. The nominal interest rateis the rate of exchange between current money and future money. For example,aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.114 INTERNATIONAL FINANCIAL MANAGEMENT Solution Exner Solution Figure 4.8 ‘The international Fisher efiect 14k pL 1+006) 45 on, K,=10.7 per cent So, the interest rate in India should be 10.7 por cont per annum. . ‘The interest rate in India is 12 per cent and the interest rate in the United States is 6 per cent. ‘What should be the percentage change in the value of the USD according tothe international Fisher effect? Percentage change in the value of USD=(1+0.12)(i+0.06)—1 (0.0566 or 5.67 per cent ‘Thus, the value of the USD should appreciate by 5.67 per cent. This would make the retum ‘on investment in India equal to the retum on investment in the United States. . ‘The international Fisher effect in the expectation form of relative PPP can be represented ‘graphically, 2s shown in Figure 4.8, The vertical axis in the Figure 4.8 shows the expected change in the exchange rate (in per cent) and the horizontal axis measures the interest rate differential (in per cent) between ‘wo countries for the same period. The parity line is arrived at by joining the points where: ES)~S0 KK, a To This is an approximated form of the intemationel Fisher relation. In other words, the interest rate differential between any two nations is an unbiased predictor of the future change in the spot rate of exchange between the two currenci The parity line shows that an interest differential of, say, 2 per cent in favour of the home country should be offset by the expected 2 per cent appreciation in the home cur- rency value of the foreign currency. If they are not in equilibrium, funds would flow from one country to another until real retums ere equal in both countries. Investors usually invest in countries where the real returns are the highest. This will tend to reduce the returns in these countries because of greater supply of funds. Simultaneously, this will also tend to increase the returns in the countries from which the funds are withdrawn because of reduced supply of funds. 4.12 Interrelationship of Parity Conditions © “The parity conditions described in this chapter are interrelated. For example, inter- Expected change ‘est rates cause and are caused by changes in spot rate (%) Pariy tine in forward rates of forcign exchange, which, in tum, depend on the expected future spot rate of foreign exchange. The infation differemial between the countries a © influences interest rates, forward rates, and Inerest intl Oo) tag fe ners ste party (RP), UE ky # atk Seaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.118 INTERNATIONAL FINANCIAL MANAGEMENT According to the portfolio balance model, investors would adjust their portfolios, consisting of domestic ‘money, foreign money, domestic bonds, and foreign bonds, keeping in View their rsk-return Characteristics The portfolio balance model ‘The portfolio balance model is based on the premise that people divide their total wealth between domestic and foreign money, and domestic and foreign bonds, depending on their expected return and risk. Three assets are involved in the portfolio balance model: money (M), domestic bonds denominated in the home currency (B), and foreign currency bonds (FB). ‘The domestic bonds are the sum of bond holdings of households and the monetary authority. Iris assumed that there is a fixed net supply of domestic bonds. Foreign bend holdings are elso held by the public and the monetary authority. These holdings can increase or decrease over time, via the current-account surplus or deficit. The monetary base (money) isthe sum of the domestic bond holdings and the foreign tond hold- ings (in domestic currency terms) of the monetary authority. Foreign currency bond hold- ings ean be converted into the domestic currency by multiplying them with the exckange rate. An increase in financial wealth in a country can be held as money, domestic bonds, or foreign bonds. The change in the demand for the three assets must sum to one. The mone- tary autherity of a country can increase the money supply in the economy (an inerease in the monetary base) by buying either domestic bonds (an open market operation) or foreign bonds (a non-sterilized foreign exchange operation). A sterilized foreign exchange operation rofers to keeping the money supply in the economy at its original level (the level before the foreign exchange operation). The monetary authority can sell or buy domestic bonds from the pablie so that the money supply held by the public returns to its intial level. Thus, the public holds less (more) forcign bonds and more (less) domestic bonds. A sterilized foreign exchange operation can influence the exchange rate without changing the money supply. AA detailed discussion on sterilization is presented in Chapter 2. Acconding to the portfolio balance model, the total financial wealth (TW) in a country is distributed as: TW=M+B,+SF, =Byy+ SFy +B, + SF Here, ‘orcign bond holdings of the monetary authority jomestic bond holdings of house holds ‘oreign bond holdings of house holds a function of the interest rate, the expected change in the exchange sate, and the output and financial wealth in a country. It is inversely related to the interest rate and the expected change in the exchange rate, and positively related to domestic income and financial wealth, The demand for bonds (domestic and foreign) to be held by house- holds is also function of the interest rate, the expected change in the exchange rate, and the output and financial wealth ofthe country. The demand for domestic bonds is inversely related to the expected change in the exchange rate and domestic income, and positively related to the interest rate and financial wealth. However, the demand for foreign bonds is inversely related to the domestic intrest rate and domestic income, and positively related to the expected change in the exchange rate and financial wealth Risk-averse investors diversify their investments across assets so that risk-adjusted retum is the same for all assets. Bonds are not perfect substitutes and, therefore, there is always portfolio diversification in terms of bonds between countries. The proportion of ‘wealth allocated to any bond is positively related to its retum. Investors may choose to allo- cate a larger proportion of their wealth to domestic bonds when domestic interest rates are rising. This implies thatthe proportion of investment in foreign bonds veries inversely withaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.Chapter 5 Management of Foreign Exchange Exposure and Risk LEARNING OBJECTIVES ‘After studying this chapter, you should be able to: ‘© Discuss the concepts of foreign types of transaction and operating exchange exposure and foreign exposures. exchange risk, and understand how ‘Discuss the management of ansaction exposure and highlight various hedging Define real exchange rte and nominal techniques. Setshes ae. ‘© Describe the management of operating Classy foreign exchange exposure into exposure. ‘economic and transation exposure, ard understand how economic exposure can be further categorized into various they are measured, ‘© Gain an overview of different currency translation methods, 5.1 Introduc Foreign exchange rates never remain constant, At times, they may change widely and vio- lently. However hard a currency is, its value is subject to change relative to other currencies. ‘As economies in the world become more and more integrated. a significant change in the value of any one currency will affect business the world over. For instance, if the Japanese ‘yen substantially appreciates against the U.S. collar, it will adversely affect the competitive position of Japanese firms in the world market, particularly in the U.S. market. This in turn, ‘will have implications for world trade and significant economic consequences for many ‘countries in the world. It s important to note that changes in foreign exchange rates can affect not only firms engaged in international business, but also those engaged in domestic business. Even if ‘domestic firms buy raw materials and other components in the domestic market and sell their products exclusively in the domestic market, they may face competition from imports Further, any change in exports caused by a change in the exchange rate would influence ‘domestic sales as well. In other words, any change in the foreign exchange rate would influ- ence both exports and imports, which in turn will affect the domestic market. ‘The economic consequences of changes in foreign exchange rates may be direct or indi- rect, Many entities are affected by changes in foreign exchange rates. Along with firms or ‘corporations engaged in different kinds of businesses, governments and individuals are also affected by exchange rate fluctuations. Further, changes in foreign exchange rates may affect not only operating cash flows, but also the home currency values of the essets and lia~ bilities of a firm. For example. consider 2 firm in India that has borrowed USD 1 million from a firm in the United States. The INR value of the loan changes with changes in the ‘exchange rate between the Indian rupee and the U.S. dollar. Similarly, a firm engaged in ‘expor'- or import-oriented business would be exposed to exchange rate movements. Thus.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK 127 rate is USD/INR 43.75, and the three-months forward rate is INR 44, After three months, the spot rate is INR 44.50. In this case, the unexpected depreciation of the INR is INR 0.50 per USS. dollar. The gain in the INR value of the deposit is INR 5 million. The exposure is USD 10 million (i¢., INR 5 rillion/0.50). This is the amount that is subject to unanticipated changes in the exchange rate, As the forward rate is an unbiased estimate of the future spot rate, the forward rate is used to calculate the unexpected change in the exchange rate. That is, the forward rate of a particular duration can be compared to the actual spot rate on the date of the maturity of the forward contrast, and the difference, if any, i taken as unex- pected change in the exchange rate. ‘Sometimes, firms may have certain assets or liabilities with zero exposure. For example, considera firm that had a USD-denominated investment whose value was USD 2 million. At the exchange rate of USD/INR 44, the investment in terms of Indian rupees was INR 88 mil- lion. In view of inflation in the United States atthe rate of 3 per cent, the investment value subsequently inereased to USD 2.06 million. On the other hand, the US. dollar depreciated to INR 42.718, at which the investment in terms of Indian rupees was again INR 88 million. It may be observed from this example that though the foreign exchange rate has changed, the investment value in terms of domestic currency has rot changed. This is because the domes tic currency value of the investment hss gone up in the same proportion. Therefore, the for- eign exchange exposure on the investment is zero. In other words, the domestic currency value of the assct is insensitive to exchange rate changes. Though zero exposure is an idcal situation, in realty itis difficult to find such assets and liabilities. The values of assets or lia bilities and foreign exchange rates may not change in the same proportion or may not move ‘concurrently to give rise 1o zero exposure, Unanticipated exchange rate fluctuations can affect not only domestic assets, liabilities, and operating incomes of firms, but also their foreign assets, liabilities, and operating incomes. For example, a firm's domestic borrowings are affected by domestic interest rate ‘changes, which, in tum, are influenced by unanticipated exchange rate changes. Even though there isno conversion from foreign currency into domestic curency, the domestic liability is ‘exposed to exchange rate movements. The foreign exchange exposure of suppliers may also influence the exposure ofa firm even if it does not have any cross-border transections. 5.2.2 Foreign Exchange Risk ‘The terms foreign exchange exposure and foreign exchange risk are used interchangeably although they are conceptually different, Maurice D. Levi defines foreign exchange risk as “the variance of the domestic currency value of assets, liabilities, or operating incomes that is attributable to unanticipated changes in foreign exchange rates.” By definition, foreign exchange risk depends on the exposure, as well as the variability of the unanticipated changes in the relevant exchange rate. Formally stated, ‘Var( ARV) = B? Var(AS), where ‘Var( ARV) = Variance of the change in value of a business item caused by ‘unanticipated changes in the foreign exchange rate B= Regression coefficient which describes the systematic relation between (ARV) and (AS) ‘Var( AS) = Variance of unanticipated changes in the foreign exchange rate ‘This model implies that foreign exchange rate risk isa function of the exposure and vari- ance of exchange rates. The exposure or the unpredictable nature of exchange rates alone ‘cannot result in foreign exchenge risk. For example, let us assume that the operating cash flows of a British firm are highly sensitive to the exchange rate between GBP and JPY. In this case, the firm has a very high foreign exchange exposure. However, itis predictable thataa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.Transaction exposure can bbe managed by hedging techniques as well as ‘operational techniques. ‘Hedging techniques include forwards, money ‘market hedges, futures, ‘options, and swaps Operational techniques include exposure netting, leading and lagging, and Currency of invoicing. Figure 5.2 Managing transaction exposure MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK 131 ‘Many firms generally have financial contracts denominated in foreign currencies. The ‘number of such firms has increased phenomenally in recent years as a result of globaliza- tion of trade and investments. Therefore, firms should manage their transaction exposure judiciously by adopting appropriate techniques or strategies. ‘There are many techniques by which the firms can manege their transaction exposure. These techniques can be broadly divided into hedging techniques and operational tech- niques. Hedging refers to taking an offsetting position in order to lock in the home currency value for the currency exposure, eliminating the risk arising from changes in the exchange rate, The important hedging techniques are forwards/futures, money market hedges, ‘options, and swaps. Operational techniques include exposure netting, leading and lagging, and currency of invoicing, Figure 5.2 illusrates the various techniques of managing trans- action exposure Hedging with forwards and futures A forward contract is a legally enforceable agreement to buy or sella certain amount of for- ‘eign currency on a specified date at an exchange rate fixed at the time of entering the con- ‘tract. Firms may hedge their transaction exposure by entering into forward contracts. That isa firm may buy or sell the foreign currency forward and thereby avoid fiuctuations in the hhome currency value of the foreign currency-denominated fixed future cash flows. For ‘example, assume an Indian trader has three-month receivables of USD 1 million. in order to eliminate the currency risk, the trader signed a forward contract witha bank, which agrees to buy that amount in three months at a forward rate of USD/INR 40. The current spot rate is USD/INR 39.75. By entering the forward contract, the Indian tracer has fixed the INR value of his three-month receivables. Regardless of what happens to the exchange rat the future, the trader would get INR 40 million on the realisation of his receivables. In other ‘words, the Indian trader has effectively transformed ihe foreign currency-denominated asset (receivables) into home currency-denominated assets. As we discuss in the nex: chapter, the forward rate typically relects the current spot rate plus the interest differential between the two currencies involved. ‘Consider another example. Suppose that a firm in India hes imported goods from a US.- ‘based firm for USD 5 million on six-month credit. To hedge this transaction exposure, the firm has entered a forward contract to buy USD 5 million at e forward rate of USD/INR 45, ‘On the date of maturity of the forward contract, the firm will deliver INR 225 million to the ‘counter-party and in return receive USD 5 million. This happens regardless of the spot rate ‘on the date of maturity of the forward contract, Thus, the USD payable is exactly offset by the USD receivable, and the Indiaa firm’s transaction exposure is hedged by a forward con- tract. However, it may also happen that the payables in INR under the forward contract will ‘be lower (or higher) than those under the unhedged position if the future spot rate turns out Managing Transaction Exposure Hedging ‘Operational techniques techniques: Forwards] [ Money Netting Leading and || market || Swaps | | Options and) | [Ourrency off | and futures | |_hedge coftsetting | | ‘nveicing | | taggingaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.| 135 MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK ‘There is a direct relation between money market hedging and forward contract hedging, {In fact, money market hedging creates homemade forward market hedging. Borrowing at the home currency interest rate and investing at the foreign currency interest rate are simi- Jar to hedging foreign currency payables with the purchase of foreign currency forwards. On. the other hand, borrowing at the foreign currency interest rate and investing at the home- currency interest rate are akin to the hedging of foreign currency receivables with the sale of foreign currency forwards. ‘Money market hedging involves taking a money morket position to hedge exposure on foreign currency receivables or foreign currency payables. An exporter who wants to hedge receivables in a foreign currency may borrow a certain amount in the currency denominating tho receivables, get that forcign currency-denominated amount converted into home cur- reacy in the spot market, and then invest it for « period coinciding with the period of recziv- ables. Then the exporter pays off the foreign currency loan with the receivables amount, For ‘example, assume a firm in India has 90-dey roceivabies of USD 10 million. First, the firm ‘may borrow an amount such thatthe principal and interest after 90 days will be equal to the receivable amount. The annual rate of interest on the U.S. dollar-denominated loan is 8 per cat (or 2 per cent for 90 days). The firm initielly borrows USD 9.80 millon [ic., USD 10 million/(1 + 0.02)}. Then, the borrowed amount is converted into INR at the spot rate of, say, LUSD/INR 43. So the firm realizes an amount of INR 421.57 million, and invests that amount at 10 per cent per annum. On the day whea the firm realizes the receivables amount, it will hve its investment matured for INR 432.11 million. By using the receivables amount, the firm will pay off the USD-denominated loan of 10 million. Suppose the 90-day forward rate is USP/INR 43.25. The cash inflows under forward market hedge are INR 432.50 million. Thus, forward market hedging would yield higher amounts of receivables in home currency than money market hedging. This difference in cash flows arises because there is no parity between the forward rate and the interest rate differential (ie, no interest rate rarity). ‘The steps involved in money market hedging on receivables can be summed up as follows: 1. Borrow in the foreign currency in which the receivables are denominated at the pre- vailing interest rate. Convert the borrowed currency to domestic currency at the spot bid rate Invest that amount ai the prevailing interest rate for the peried of the receivables. Repay the foreign currency loan with the amouat realized through receivables. veer Realize the maturity value of the investment. Importers who want 10 hedge their payables may borrow a certain amount in their home ‘currency, conver tha! amount atthe spotrate into the currency in which the payables are denom- inated, and then invest that amount for a period matching the payables. For example, consider an Indian importer who has USD 50 million 90-day payables. The interest cate in the United States is 8 per cent per arnum or 2 per cent per 90-day period. This means an amount of USD 49.02 million invested or borrowed today will become USD 50 million at the end of a 90-day period at an interest rate of 8 per cent per annum, So the importer borrews an amount of INR. 2,108 million at an interest rate of 10 per cent per annum ot 2.5 per cent per 90-day period, and cconvers this into USD 49.02 million atthe current spot rate of USDINR 43. Then that amount (USD 49.02 million) is invested at 8 per cent per annam for 9° days, which will become USD ‘50 million at the end of the 90-day period. On the day when the importer has to pay off the ‘import bill, he or she will have an amount of USD 50 milion sufficient for clearing the dues. Further the importer has to pay back the loan of INR 2,160.7 million (principal plus interest). To draw a comparison between money market hedging and forward market hedging, assume the 90-day forward rate es USD/INR 43.75. The cash outflows using the forward ‘market hedge amount to INR 2,157.50 million (50 million43.15) and the cash outflows under the money market hedge are INR 2,160.7 million. Thus the importer could save INR 3.2 million by using the money market hedge instead of the forward market hedge.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK 139 in the same or other currencies. For example, suppose that a firm has receivables of USD 1 jon and at the same time payables of USD | million. So the USD receivables cancel out the USD payables, leaving no net exposure. In case both the amounts are different, the firm can use the receivables to settle the payables and hedge the residual or net amount of receiv ables or payables. A firm can hedge the residual exposure (exposure remaining after netting) rather than hedging each currency exposure separately when it has a portfolio of currency exposures. A long position in one currency, say, USD, can be offset by a short pesition in the same currency. If two currencies are positively eorrelated,a firm ean offset s long position in ‘one currency with a short position in the other currency. Thus, a gain (Loss) on the receivables due to appreciation (depreciation) of a currency will be matched by a loss (gain) on the payables dus to eppreciation (depreciation) of another currency. This, in fue, provides a rat- ural hedge. However, if two currencies are negatively correlated, then a long (short) position in one currency can be offset by a long (short) pesition in the ether currency. A firm can have ‘mere stable cash flows if it has currency diversification, which can limit the potential impact of changes in any single currency on the cash flows of a firm, Currency of invoicing Importers and exporters can also shift foreign exchange exposure by getting their exports ot imports invoiced in their own currency. This method of hedging does not eliminate foreign exchange exposure but shifts it from one party to another. For example, ifa firm invoices its imports in its domestic currency, it need not face foreign exchange exposure on its payables, But the counter party (i.e. the exporter) will face the foreign exchange exposure. milarly, a firm can shift its entire exchange risk tothe importer by invoicing its exports in its domestic currency. Thus, if the importing firm can get the payables invoiced in its home currency, the exporter will face the exchange exposure, and ifthe exporting firm can invoice its exports in its home currency, the importer will face the foreign exchange exposure. Exports are often invoiced in the exporter’s currency. Since the amounts are received or paid some time after the invoice is made, the expected exchange rate is a significant considera- tioa. Ifa currency is more volatile, then invoieing in such a curreney is avoided. It is also a common practice for both parties—the exporter ard the importer—to agree to use a currency other than their respective currencies to invoice their transactions. For example, an Indian exporer and a Japanese importer may agree to use the U.S. dollar as the invoice currency, Further, in the case of some currencies, there may not be a regular market for currency derivatives like options and futures. Therefore, traders may use a third cur- rency, which is less volatile in value or whose country of origin has a developed currency derivative market Sometimes, exporters and importers agree (o share the foreign exchange exposure by getting a part of the trade invoiced in, say, the imporier’s home currency, and the rest of the trade invoiced in the exporter’s home currency. Such invoicing is known as mixed currency invoicing. Trade transactions may also be invoiced in one of the standard currency baskets such as euro or SDR, and thereby the foreign exchange exposure is reduced. Tride transac~ tions may also be expressed in terms of composite currency unit made of different curren cies. Such private currency baskets, also known as cockiails, ae designed to avoid violent fluctuations in individual exckange rates. ‘A firm may wish to have its exports invoiced in the currency in which itis required to pay forits impons. For example, an Indian firm may like to invoice its expors to the United King- dom in GBP so that it can use GBP receivables to pay off its future payables in GBP. But it ‘may be dificult to match foreizn currency inflows and outflows in terms of amount and time. A firm may not be able to invoice the amount ofits exports to match the amount of payables it has in the same currency, and it may also not be able to match the time of its foreign cur- tency inflows with the time of its foreign currency outflows. In such an eventuality, the firm will have some degree of foreign currency exposire, which can be hedged by other methods, “The patter of invoicing in Indias trade is presented in Table 5.7. As can be observed from Table 57, most of India’s trade is invoiced in LS. dollars. Thovgh India’s share in world tradeaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK 143 | by considering the price elasticity of demand and other factors. The following example will illustrate how such decisions are made, Assume that a firm in India is exporting its product to the United States at USD 2, equivalent to INR 86. When the exchange rate between INR and. USD changes from USD/INR 43 to USDYENR 45, the firm may maintain the product price at INR 86 and sell the product in the United States at USD 1.91. This may result in an increase in the market share of the Indian firm in the US market. As depreciation makes the Indian rupee cheaper to foreigners, the firm can also charge a higher Indian rupee price without altering the price denominated in the foreign currency. Thus the firm may increase the Indian rupee price to INR 90 and maintain the product price in U.S. dollar tems at USD 2. If the prices of com- petitors from otber countries and within the United States remvain at their previous level, the Indian firm can sell all it wishes without altering the U.S. dollar price ard thereby inerease its profit mangins in domestic currency terms. Now. suppose that the INR appreviates against the USD. The product cost goes up in U.S. dollar terms in such a scenario. I the Indian fim faces, competition from the local manufacturers whose USD costs did not rise, it will not be able t0 raise the US. dollar price of its product without risking a rechction in sales, In other words, the Indian firm cannot let the exchange rate pass through the U.S, dollar price. Exchange rate pass- ‘through refers to the extent to which exchange rate changes are absorbed inthe price of the product. Wit fall pass-through, the changes in exchange rate will not kave an impact on the traders’ profit margins ‘A firm cannot change its prices whenever there isa change in foreign exchenge rates. If it keeps adjusting prices in response to changes in exchange rates, the price of the product becomes unstable, ultimately leading to customer dissatisfaction. So, every firm should have a long-term pricing strategy to avoid frequent changes in its pricing, while atthe same time responding to exchange rate changes. Technology ‘Technological factors also play an important role in operating exposure management, The technology used by a firm should be flexible and capable of adjusting to changes in the sourcing of inputs, composition of inputs, production methods, and levels of production, In order to respond. exchange rate fluctuations, a firm may make efforts to reduce the domes- tic currency cost of its produets. Efforts may be aimed at increasing the productivity of the various factors of production. This may entail changing the technology through modemniza- tion oF uperades. Unlike other types of foreign exchange exposure, operating exposure is a complex phe- nomenon that cannot be measured or effectively controlled and managed. As exchange rate uctuations affect all facets of a firm, despite its best efforts, there remains at least some clement of operating exposure that can not be hedged or eliminated, This is why operating exposure is also called the residual foreign exchange exposue. ‘Though exchange rate fuctuations affect the revenues and cost structure of firms that are directly involved in international trade, firms that are not involved in imternational trace may also be affected by exchange rate fluctuations. For example, a firm which faces a decline in its exports following appreciation of its domestic cureney may concentrate on the domestic market and become a strong competitor to purely domestic firms, Asa result, the competitive environment in the domestic market changes, affecting input costs as well as ‘output prices. Even macroeccnomie changes that are brought about by exchange rate flue- tuations may influence the costs and revenues of a firm that may not be involved in export- ing or importing 5.4.2 Translation or Accounting Exposure An MNC may have subsidiaries located in different countries, with each subsidiary prepa: ing its financial statements in its local currency. These financial statements need to be con- solidated with that of the parent unit in order to present the overall performance of theaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE AND RISK 147 Summary 1. Foreign exchange rates are susceptible to several factors and, therefore, never remain constant. Changes in foreign exchange rates have «significant influence on the economies in the world, more so in these days af global- ization of trade and investment Business firms, especially those engaged in international trade and investment, are exposed to foreign exchange fluctuations. Foreign exchange exposure and foreign exchange risk are conceptually different, Foreign ‘exchange exposure is defined as the sensitivity of changes in the real domestic currency value of assets, liabilities, or ‘operating incomes to unanticipated changes in exchange rates. Foreign exchange risk, on the other hand, is mea- sured by the variance of the domestic currency value of assets, liabilities, or operating incomes that is atribulable to unanticipated changes in foreign exchange rates. 3. Foreign exchange exposure is broadly divided into eco- ‘nomic exposure and translation exposure. 4, Economic exposure refers to potential changes in alt future cash flows of a firm resulting from unanticipated changes Questions and Problems 1. Distinguish between foreign exchange exposure and for eign exchange tsk 2. Why do firms eed to manage forign exchange expone? 3. What is economic exposura? How can firms manage theie economic exposure! 4. What is transaction exposure? How is it different irom translation exposure and from operating exposure? 5. Explain the need for cross hedging. 6. What initiatives should a firm's management take to cope with operating exposurez 7. Explain the methods by which translation exposuze can he measured. 8, Explain the significance of real exchange rate 9. Explain the implications of PPP for operating exposure 10. What are the advantages of hedging foreign exchange exposure by a leadi/ag strategy? 11, Explain the process of exposure netting 12. What is hedging by invoice currency? 13. How do product and production strategies help a firm hedge its operating exposure? 14. What are the limitations of pricing as operational hedging? 15, 16, in exchange rates. There ate two types of economic expo- ‘sure: transaction exposure and operating exposure. Transaction exposure refers to potential changes in the value of contractual cash flows that arise due to unex- pected changes in the foreign exchange rate. Transaction fexgosure can be managed by hedging techniques or by ‘operational techniques. The principal techniques include currency forwards, currency futures, currency options, ‘currency swaps, currency of invoicing, exposure netting, and leading and lagging. Operating exposure refers to sensitivity of future operating, ‘cash flows to unexpected changes In the foreign exchange rate. The management of operating exposure involves deck sion making wit respect to production, produc, pricing etc. Translation exposure arises when the items of financial fatements prepared in foreign currencies are restated in the home currency of the MNC. The principal currency translation methods are currersinoncurrent methed, mon- etaryinonmanetary method, temporal method, and cur- rent rate method. ‘An Indian firm has imported machinery from an MNC in New York for USD 2 millon. The fim is permitted to pay the amount six months from now. The interest rate is 10 peer cent per annum in India and 8 per cent per annum in the United States. The current spot rate is USDIINR 45. ‘The sinmonth forward rate is USD/INR 46. How would, the firm hedge its foreign currency exposure? A U.S-basedl MNC has purchased goods worth JPY 700 mmiion from a Japanese firm, payable in three months. ‘The current exchange rate is USDIIPY 117 and the three month forward rate is USD/IPY 120. The interest rate is 8 per cent per annum in the United States and 4 per cent injapan. The MNC wants to use a money market hedge to hretge this yen account payable. Explain the process of ‘money market hedging in this case A firm based in the United Kingdom has a three-month account payable of INR 200 million. The current exchange rate is GBPIINR 82 and the three-month forward rate is GBFINR 83. The firm can buy the threemanth ‘option on INR with an exercise rate of GBP/INR 82.75 for the premium of 0.005 pence per INR, The interest rate is {6 per cent per annum in the United Kingdom and 10 per ccent per annum in India. Calculate the cash flows under different methods of hedging,aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.152 INTERNATIONAL FINANCIAL MANAGEMENT. EET Solution ‘may depreciate against the USD. To guard ageinst such an exchange rate risk, the Indian firm hhas entered a six-month forward contract with a local bank, at an exchange raic of USD/INR 43.50. As per the terms of the forward contract, the Indian company will pay the bank INR 217.5 million for USD 5 million to be paid by the bank to the company. The company will use this USD 5 million to pay for its import of equipment. The Indian company hes thus off set a short position in U.S. dollars by a long position in the forward contract, thus elimina!- ing all exchange rate risk. The net cost of the equipment when covered with a forward contract is INR 217.5 million, no matter what happets to the spot rate of USD/INR in six ‘months. But the forward contract may result in a gain or loss to the parties, depending on the spot rate of the underlying currency at the time the forward contract matures. Such gain ot loss, of course, is not related to dhe current spot rate. ‘The current spot exchange rate between INR and USD is USDIINR 47. The risk-free inter- est rates in India and in the United States are 7 per cent, and 5 per cent, respectively, What is the 90-day forward rate? ‘The 90-day forward rate will be Fygn AT e007 H0800555) ~INR 47.2324 . Apart from hedgers, speculators and arbitrageurs partici Speculators take positions in the forward market in order to profit fromm exchange rate fuc- tuations. Arbitrageurs seek to eam risk-free profit through covered interest differential Active forward markets exist only for a few currencies like USD, EUR, CAD, JPY, GBP, and SF. Forward markets do not exist for some currencies, particularly these of underde- veloped economies. The salient features of forward contracts are: © They are private deals between two parties to exchange future cash flows, They are not standardized contracts, and forward markets are self-regulated. © They have flexibility with respect to contract sizes and maturity periods or expiration cates. © The termsand conditions of forwards are all negotiable, Currency forward contracts can be customized to suit the needs of each party. As the size and maturity of a forward contract exactly matches thet of the underlying ‘ash flow exposure, a forward contract provides a perfect hedge [i.., the gain (loss) on ‘the underlying position is exactly offset by the loss (gein) on the forward position} © They are mostly interbank transactions, traded over-the-counter by telephone or telex. © Though there is no secondary market a5 such for forward contracts, banks that are involved in forward trading do make two-way forward markets in all major currencies at all times. © Sometimes forward contracts are transactions between banks and large corporate cents © As contracts are private deals, there is no insistence on margins. However, when the deal is between a bank and a corporate client, the bank may insist on margins when the bank's, relationship with the customer is not that good. In other words, banks exercise discre- tion when insisting on whether a margin account is to be established. (© As currency forward contracts are private deals, there isa strong possibility that any one of the parties may back out or fil to honcur the terms of the contract. Forward contracts are prone to default riskaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.156 INTERNATIONAL FINANCIAL MANAGEMENT Leverage relers to having Control over a large portion of a contract, with a small amount of Investment. Its the inverse ofthe percentage ‘margin requirement. Itis in this context the concept of leverage comes into effect. Leverage refers to having control over a large portion of a contract, with a small amount of investment. Futures con tracts are considered to be highly leveraged positions because the initial margins are rela- tively small. A market participant puts up a mere fraction (10 to 15 per cent in most situations) as margin, yet he or she has full control over the contract. Infact, the money one puts up is not actually to purchase a part of the contract; it isto act as a performance bond Leverage is the inverse of the percentage margin requirement. For example, if the notional contract value is USD 100,000 and the required margin is USD 2,000, then a mar ket participant can trade with 50 times leverage or “50-1.” The lower the initial margin, the higher is the leverage. Leverage is a double-edged sword as it can produce greater profits or ‘greater losses. It isthe possibility of excessive gains that sparks interest in futures contracts. ‘That possibility, however, comes with greater risk. 6.3.3. Marking to Market ‘The concept of marking to market can be better explained with an example, Assume that @ firm having a USD 20,000 account balance with the clearing house of CME purchases ten March Canadian dollar futures contracts at a rate of CAD/USD 0.9966. the contract size being CAD 100,000. The total U.S. dollar value of the futures contract is USD 0.996% 100,000%10, or USD 996,600, The current initial margin is, sey, USD 1,800 for one con- tract. So the total initial margin required is USD 18,000. Since the account balance is USD 20,000, the initial margin is met with the cash in the account. On the second day of trading, the settlement price declines to USD 0.9916. In other words, the value of one contract has dropped by 0.0050 or 50 ticks, resulting in a lass of USD 500 per contract and USD 5,000 ‘on ten contracts. The value of the futures contracts now is USD 991,600. The total value of the 10 contracts has declined from USD 996,600 to USD 991,600 ora loss in value of USD 5,000. This amount is deducted from the account as profits, and losses are continually marked to market throughout each trading day. Now, the total account balance of the firm is USD 20,000-USD 5,000, of USD 15,000. Suppose the maintenance margin on one CAD futures contract is USD 1,200. The total maintenance margin on the ten-contract position is USD 12,000. As the account balance is above the mainienance margin, no action is required on this account, Further, suppose that on the next day the settlement price is USD 0.9986 The value of the contract increases by 0.0070 or 70 ticks per contract, resulting ina gain of USD 700 per contract or USD 7,000 for the ten contract positions. The value of the contract is now USD (0.9986 100,000%10, or USD 998,600, The value of the account also increases to USD 15,000-+USD 7,000, or USD 22,000. As the account balance is above the maintenance mar- gin of USD 12,000, no action is required on this account. ‘On the fourth day, there is a drop in the settiement price to USD 0.9816 from USD (0.9986. The value of the furures contract decreases by USD 0.017 of 170 ticks, resulting in 8 loss of USD 1,700 per contract and USD 17,00) on the ten contract positions. Now, the value of all ten contract positions is USD 0.9816%100,000% 10, or USD 981,600. The value of the margin account decreases to USD 22,000—USD 17,000, or USD 5,000. This is lower than the maintenance margin of USD 12,000, Therefore, the firm is required to bring in at least USD 15,000 to meet the initial margin requirement to continue holding the ten futures contracts. ‘Thus, by marking to market at the end of each trading day, the margin account of each party to the currency futures contract is adjusted to reflect the counterparty’s gain or loss. ‘When the margin money according to the marking to market is received from the counter- party with a long position (ie, the party that has purchased the futures), the clearing house adds to the margin account of the counterparty with a short position (ie, the party that has sold the futures) by the same amount. In other words, when the long position’s account is adjusted up, the short position’s account is adjusted down by the same amount and viceaa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.160 INTERNATIONAL FINANCIAL MANAGEMENT This amount becomes bigger with a greater number of futures contracts. However, this profit will evaporate once other traders start cashing in on the price differential. In other words, the futures price and forward rate will move in such a way that arbitrage opportunity eventually disappears. 6.4.2 Spreads Market participants may assume short or long positions in order to cash in on the deprecia- tion or appreciation of a currency against another currency. Traders in futures contracts may also adopt spread strategies, which involve taking advantage of the exchenge rate difference between two different futures contracts of the same pair of currencies. The spreads may be calendar spreads, intemarket spreads, and inter-exchange spreads. A calendar spread refers to simultaneous buying and selling of two futures contracts of the same type, having ‘he same exchange rate but different maturity dates, In the case of inter-market spread, a ‘market participant may go long in one market and short in another market with contracts of the same period. The interexchange spread may be any spread in which each position is created in different futures exchanges. Spread strategies are les risky than naked positions. 6.4.3 Trading Platforms and Participants Every organized futures exchange provides the needed infrastructure and methods for trad- ing futures, The infrastructure inchides trading platforms through which trade is earried out Trading platforms are of two types: the physical trading floor and the electronic trading floor. Each of these platforms and methods of trading are briefly described bere. Physical trading Futures exchenges provide physical flocrs for trading in futures contracts. Physical floors are also known as (rading pits. A pit is « physical place earmarked for trading futures in a specific currency, and it has different sections corresponding to different contract expiration months. The trading on the floor takes place through the open outcry method. In open out- ry, brokers flail and stout in a pit. The buver-brokers, having decided ow much they are willing to pay, shout their bids (price and quantity) to other brokers in the pit. The seller- brokers do the same with their orders, The quantity and price are indicated through hand sig- nals and a vocat open outery. The price of a futures contract is determined in the trading pit ‘when the seller's quote and the buyer's quote match, Each action of the broker in a pit is recorded electronically. Though the whole process may look chaotic and confusing to an omlooker, the open outery method is in fact an accurate and efficient trading system. Its an age-old method of trading in futures contracts but is still in vogue. Nowadays, it i facie tated by modem electronic gadgets like display boards that display price quotes, including ‘quotes in other futures exchanges, and computers to record the transactions that take place through the open outery method. The trading floor of an exchange has two principal participants—floor brokers and floor traders. Floor brokers act as agents for the investing public and execute trades on their behalf. In other words, floor brokers execute orders for the accounts of clearing members and their customers. Floor traders, also known as locals, mostly trade for their own accounts, but can act as floor brokers as well. Diflereat coloured jackets are wom by floor brokers and floor traders who trade in the pits. Runners are responsible for passing on the customer's order to the floor traders. They communicate all matters relating to market orders to the floor tra¢er. They alse bring the filled orders to the brokerage firm's desk for confirmation to the customers. Runners, there- fore, are the link between the customers and the floor brokers in the trading pit. ‘The other professionals who are involved in futures trading are futures commission mer- chants, sealpers, day traders, and position traders. A ftures commission merchant (FCM)aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.aa You have either reached a page that is unavailable for viewing or reached your viewing limit for this book.164 INTERNATIONAL FINANCIAL MANAGEMENT expiration date ofa forward contract can be fixed to coincide with the date on which the for- cign currency cash flows are especied. Thus, the forward contract can be @ perfect hedge ‘against currency risk, by providing amounts that exactly match withthe size and timing of foreign currency cash flows. As futures contracts have standardized amounts of the under- lying foreign currency and also specific delivery months with a specific day of the month, the amount or timing of foreign currency cash flows may not match with the standardized funures contrects. There may be a mismatch between the amount of the currency exposure and the contract size ofthe futures, and also between the maturity ofthe futures contract and the timing of cash flows of the underlying exposure. However, currency futures provide a perfect hedge when the amount of exposure is an even multiple ofa standard futures con- tract and the timing of cash flows of the exposed curency matches with the delivery date of a standard futures contract. Another | Bank Firm UBOR + 0.25% 10% fixed 9% fixed rate LIBOR + 100 bp fixed, while paying a 9 per cent fixed rate to its creditors and LIBOR +25 bp to the inter- ‘mediating bank. So, the net benefit for Firm X is 0.5 per cent (a saving of 0.25 per cent rel- ative to borrowing directly at LIBOR + 0.50 per cent and a saving of 0.25 per cent relative to the fixed rate). Firm Y receives LIBOR + 0.50 per cent, while paying LIBOR + 100 bp and 10 per cent per annum fixed interest rate to the bank. The net benefit to Firm ¥ is 0.50 per cent (a saving of 1 per cent in fixed-rate interest relative to borrowing directly at II per cent minus an extra burden of 0.50 per cent in the floating rate). The intermediary bank receives LIBOR + 0.25 per cent trom Firm X, plus 10 per cent per annum fixed interest rate from Firm Y, and pays 9.25 per cent fixed interest o Firm X and LIBOR + 0.50 per cent to Firm ¥. So, the net benefit to the bank is 0.50 per cent for arranging the swap. ‘There are a number of alternative swap arrangements that can be used according to one’s own comparative advantage. As for as risks are concerned, the counterparty that is obliged to pay a floating rate will be at risk from a rising LIBOR, whereas the counterparty that receives the floating rate will be at risk from an opportunity loss in the event of a fall in LIBOR. Both counterparties are at risk from default by the other. Value of interest rate swaps ‘An interest rate swap can be viewed as a pair of bond transactions, as a serics of forward Tate transactions, or as pair of option contracts, and can be valued accordingly. fan interest rate swap is considered to be a pair of bond transactions, the swap value is the difference in the values between two bonds. Ifa bond is purchased, the holder of the bond receives interest, and if a bond is issued, the issuer pays interest. Much in the same way, in an interest rate swap of the plain vanilla variety, the counterparty pays a fixed cate of interest and receives a floating rate of interest, In other words, an interest rate swap involves the exchanging of cash flows associated with a fixed-rate interest bond and ‘cash flows associated with a floating-rate interest bond. For example, assume that Firm A thas lent Firm B USD | million at a three-month LIBOR rate, and Firm B has lent Firm A USD I million at a fixed interest rate of 6 per cent per annum, To put it differently, Firm Bhassold a USD | million floating-rate bond to Firm A, and purchased a USD | million fixed-rate bond from Firm A. So, the value of the swap to Firm B is the difference in the values of the two bonds. The value of the swap can be derived using the following formula: Here, ¥,= Value of interest rte swap ¥, = Value of fixed-rate bond underlying the swap ¥;,= Value of floating-rate bond underlying the swap ‘The initial value of a swap is zero because the counterparties negotiate the terms of the swap in such a way thatthe present value of the payments must be equal tothe present value