International Finance II

Overview of Forex:

What Factors influence Exchange Rates ?

We have understood, that in a floating exchange rate scenario, the
market forces (demand/supply) determines the exchange rates.

The contributory factors for such demand and supply are broadly
classified into

Determinants of
Exchange Rates

Fundamental Technical
Issues Issues
Balance of
Payments/Forex Economic Government
Reserves Growth Rate Controls

Fiscal/Monetary
Speculation
Policy

Interest
Rates

Political Issues
Fundamental Issues

 Balance of Payments - Surplus leads to stronger

currency, while a deficit weakens a currency

 Economic Growth Rate - Rise in Imports leads to fall

in the value of currency

 Fiscal Policy - Lower taxes can lead to higher

economic growth rate.

 Monetary Policy – The central bank’s policy to

control interest rates and money supply.

 Interest Rates - High interest rate attracts overseas

capital and appreciates currency in the short term, In
the longer term, however, high interest rates slow the
economy down, thus weakening the currency.

 Political Issues - Political stability is likely to lead to

economic stability.

Technical Issues
 Government Controls – The controls can lead to an
unrealistic value of currency resulting in volatility in
the exchange rate movements.

Speculation

 Speculative forces can have a major effect on

exchange rates.
Example :
There are expectations that a currency will be devalued.

Speculator will start selling the currency in preparation

for buying it back later at a cheaper rate, hence selling
pressure from speculators extends to other market
participants.

This activity creates liquidity in the Foreign Exchange

Market.

Model Questions:

Select the appropriate answer :

1) Bank A’s Mumbai branch maintains an Euro account with
Citi Bank,London, and Citi Bank, London mainatians a
Rupee account with Bank A’s Hyderabad branch. The
Rupee account of Citi London with Bank A is known as:
a) Vostro a/c
b) Nostro a/c
c) Loro a/c
d) Any one of the above

2) Bank J buys from Bank D US$ 2 MM on April 26/2009 to

be settled on January 27/2010 (January 25th and 26th being
holidays in USA). This is an example of ---------
a) Cash deal
b) Tom deal
c) Spot deal
d) Forward deal

3) Bharti Air Tel and MTN merger deal failed. The failure is
due to ------------ risk
a) Counter party risk
 b) Cross border risk
c) Interest rate risk
d) Exchange rate risk

4) In case of an integrated treasury who is responsible for

reconciliation of nostro accounts
a) front office
b) mid office
c) back office
d) none of the above

5) If the spot rate and three months forward rate is one and the
same it is called as:
a) swap
b) premium
c) discount
d) par
6) How the credit risk can be mitigated?
a) hedging in the forward markets
b) using a derivative called interest rate swap
c) fixing the counter party limits
d) squaring the open positions
7) Which of the following is current account transaction/s?
i)A NRI remits EUR 20,000.00 to be credited in
his NRE rupee account
ii)Indian Oil Corporation remits US$ 100,000.00
against import of oil (part payment)
iii) A FII remits US$ 150,000.00 though a custodial
bank for investment in BSE
iv)Bank A funds the nostro a/c with US$ 75,000.00
a) i,ii,iii
b) ii
c) iv
d) i,iiiiv
 8) Identify the exception:
a) ECGC
b) FEDAI
c) AMFI
d) EXIM Bank
9) A leading software exporter received EUR 250,000
from a Finland importer.
As the FX trader of your bank, what you would do:
a) Buy EUR 250,000.00 from the exporter
b) Sell EUR 250,000.00 to the exporter
c) Sell EUR 250,000.00 to the importer
d) Buy EUR 250,000.00 from the importer
10)In a bid bond guarantee, the issuer of the guarantee
is:
a) beneficiary’s banker
b) importer’s banker
c) exporter’s banker
d) banker’s banker

II) Identify the correct answer from the following questions:

(a)Citi Bank, New York maintains INR account with Citi
Bank,Mumbai. This account of Citi Bank,New York is
------------------- (Vostro/Nostro)
(b)The derivative forward exchange contract carries -------
risk ( exchange rate/credit)
(c) NRI investments in India, in INR is an example of
----------------- a/c transaction (current/capital)
(d)Letters of credit are issued by ---------- banker
(seller’s/importer’s)
(e)A forex trader can have a forex deal on T+7 basis-----
(correct/incorrect)
(f) put option and call option are not examples of derivatives
--------- (correct/incorrect)
(g)Indian Rupee is a ------------ convertible currency
 (partialy/fully)
(h)Outward remittance of forex funds results in --------
of forex reserves ( increase/decrease)
(i)Yankee bonds are denominated in EUR -------(true/false)
(j) An international investor borrows in London at a lower
Interest rate and invests in US markets at an higher
interest rate. This is an example of arbitrage --------
(true/false)

III) 1) Overbought position is exposed to exchange rate risk

Oversold position is exposed to ----EXCHANGE--risk
2)A confirmed letter of credit is confirmed by the
confirming bank.A confirmed letter of credit is issued
by ------OPENING OR ISSUING-----bank
3) Interest rate swap is an example of a derivative
Forward exchangecontract is an example of DERIVITIES
4) Bretton Woods conference led to the formation of
World Bank.The World Bank is also known as IBRD
5) Layering is the term used in MONEY LAUNDERING in
International markets

IV) A list of terms are given below.

(i)Appreciation - market forces
(ii)Spread - profit
(iii) mismatch - gap
(iv)Basel II - capital adequacy
(v) netting - hedging
(vi)MIBOR - FIMMDA
(vii)Pre shipment finance - exports
(viii)Airway bill - transport document
(ix) GDR - investment product
(x) FII - capital market
 From the following items, select the appropriate term
and match with the above terms.
(a) capital adequacy (b) FIMMDA (c) market forces
(d) transport document (e) profit (f) gap (g) exports
(h) capital market (i) hedging (j) investment product

Answers:
I Answers:
(1) a
(2) d
(3) b
(4) b
(5) d
(6) b
(7) b
(8) c
(9) a
(10) c

II) (a) Nostro a/c (b) credit (c) capital (d) importer’s
(e) correct (f) incorrect (g) partial (h) decrease (i) false
(j) true
III)
1) Exchange rate risk
2) Opening/issuing bank
3) Derivative
4) IBRD
5) Money laundering

IV)
(i)Appreciation (c) market forces
(ii)Spread (e) profit
 (iii) mismatch (f) gap
(iv)Basel II (a) capital adequacy
(v) netting (i) hedging
(vi)MIBOR (b) FIMMDA
(vii)Preshipment finance (g) exports
(viii)Airway bill (d) transport document
(ix) GDR (j) investment product
(x) FII (h) capital market

Trade (Export Import) Finance

1)What is the role of a factor?
• A factor combines both the activities of financing and
collecting of receivables
• A factor makes prepayment of about 80% of invoice value
after deducting the discount charges at normal interest rate to
the seller/exporter
• A factor is entitled to (a) Finance charge: for purchase of
invoices (b) Service charge: for collection, follow up, etc

2)You are an auditor of a bank’s Treasury activities. Which off

balance sheet items you would be reviewing?
 Letters
Other
of
Derivatives
Credit

Forward
Exchange Bank
Contract Guarantees

Interest
Rate
Swaps

3)What is a letter of credit?

• Letters of Credit (L/C) is an undertaking/commitment
given by the buyer’s/importer’s bank
• A L/C is issued, at the request of the importer,by the
importer’s banker in favour of the exporter
• The importer is called the applicant and the exporter as
the beneficiary of the L/C . The importer’s banker is
called as l/c opening/issuing banker.
• The commitment/undertaking given by the opening banker
will be valid only if the exporter performs as per the terms
and conditions of the l/c. The performance of the exporter
in the context of l/c is the submission of all the documents
 strictly as per the terms and conditions of the l/c (as per
UCPDC banks deal only in documents). If the exporter
Performs as referred above, then only the importer’s
Banker would honour his commitment of making payment.

4) State which of the following statement/s is/are correct?

a) The exporter is the beneficiary of a letter of credit
b) The Railway receipt is an example of commercial
document
c) A letter of credit is a non fund based line of credit
granted to an exporter by his banker
d) In a bank guarantee the issuing banker is the guarantor
e) Preshipment credit is granted to an exporter
f) C&F is an example of INCO terms
g) Negotiating banker receives payment from the
Importer’s bank
h) International infrastructure investments is an
example of capital account transaction
i) Country Risk and Cross Border Risk are one and the
same
j) SDR and GDR are one and the same
Answers:
Correct items: a,d,e,f,g,h,i
In correct items: b,c,j
5)Who are the parties to a letter of credit?

Importer
Buyer
Applicant
Importer’s
Banker
Reimbursing
Opening
Banker
Bank

Parties
to a
Letter of
Credit Advising
Bank
Confirming
Intermediary
Banker
Bank

Exporter’s
Banker Exporter
Negotiating Seller
Banker Beneficiary

{}Importer {}: The trader/corporate, imports goods/services

from another country, and needs to pay for such goods and
services. By establishing a l/c through his banker, the
importer involves the banker, which enables him to increase
his trade dealings with his overseas counterparties.
{}Exporter{}: The trader/corporate, exports goods/services
to another the country, and needs to receive payment for
such goods and services. The benefit for the exporter is
he takes the credit risk on the issuing banker rather than
 the importer. The risk for exporter, if he does not submit the
documents strictly as per the terms of the l/c he will not
receive the payment. Hence the exporter should ensure to
submit all the documents, as per l/c terms and conditions.

6)Which banks are involved in l/c transactions?

Opening
Banker

Reimbursing Advising
Banker Banker

Letters of
Credit

Negotiating Confirming
Banker Banker

7)Briefly explain the role of the banks, involved in l/c

transaction/s?
{}Importer’s banker{}: Issuance of l/c, as per the application
submitted by the importer (applicant). The importer’s banker
provides a facility (comfort level) to the importer, which is
called as non fund based line of credit.
 Importer’s banker, who issues the l/c is also known as the
Issuing/opening banker of the l/c. Opening banker gives an
undertaking/commitment to the exporter (beneficiary)
that if the exporter submits all the documents strictly as
per the terms and conditions of the credit,(letter of credit)
then the payment would be made by the importer’s banker to
the exporter’s banker or exporter. The importer’s banker is
entitled for l/c issuing commission and other incidental
charges. Subsequently, if any changes are made to the terms
of l/c(known as amendments) the opening banker is entitled
for amendment and other incidental charges

{}Advising Banker{} Once, the l/c is opened by the importer’s

banker, the l/c will be communicated to the exporter, through
an intermediary bank, in exporter’s country. This bank is
known as an “Advising bank”. The advising bank may be the
overseas branch of the importer’s banker and/or the
correspondent bank . The advising banker’s responsibility is to
ensure that the authenticity of the issuance of the l/c. For the
services of advising the l/c to the exporter, the advising
banker is entitled for commission as income.

{}Exporter’s Banker{}: Upon receipt of the l/c from the

importer, through the advising banker, the exporter would
prepare himself to export the goods (If he is a manufacturer and
exporter, the exporter would arrange to produce the goods and
export them). An exporter is entitled to two types of financial
support from his banker, who is known as exporter’s banker.
(Preshipment and post shipment credit)
After exporting the goods, the exporter would approach his
banker with the relevant documents (drawn strictly as per the
terms and conditions of the l/c), either to avail of loan against
documents or to get the export proceeds collected by his banker
on collection basis.
If the exporter’s banker finances against the export receivables
against the terms of a l/c,then he is known as the “negotiating
bank”.
The negotiating banker’s responsibility is to verify all the
documents submitted by the exporter against l/c details(terms/
Conditions) and grant export finance to the exporter.
Negotiating banker would get upfront discount as his income
and also entitled for negotiation charges and other incidental
charges.

{}Confirming banker{}: A confirming banker adds his name

to the already established l/c b another banker. In case the
beneficiary of the l/c (exporter) or (exporter’s banker) is not
comfortable with the credit risk on the importer’s banker,
they may insist that the l/c needs to be confirmed by a banker
In the exporter’s country to avoid country risk.

{}Reimbursing banker{}: The banker who is nominated as a

reimbursing banker in the l/c, is responsible to honour the
re imbursement of the amount claimed by the negotiating
banker.

8) Differentiate between a bank Letter of Credit and a bank

guarantee?

 Both letter of credit and guarantee are

undertaking/commitment in written form issued in
favour the beneficiary
 A letter of credit is valid against the performance of
an exporter (beneficiary). The performance is that the
exporter should submit all the required documents as
called for in the l/c. Only when the exporter submits
all the documents as per the terms and conditions of
credit, then only the importer’s banker (issuing banker
is responsible to honour his commitment)
  A guarantee is valid against the non performance of
an exporter in favour of the importer (beneficiary)
If the exporter, fails to deliver the goods or does not
Satisfy the importer as per the contact terms, the
Importer a beneficiary of the guarantee can invoke the
Guarantee. He can claim the amount as per the
guarantee issued by the exporter’s banker. (issuing
banker of the guarantee)

9)What are the different types of letters of credit

Letters of
Credit

Revolving
Revocable Confirmed Red Claused

Irrevocable Unconfirmed Back to back Green Claused

10) Briefly explain what is a bank guarantee?

• A guarantee is a contract to perform the promise or discharge
the liability of a third person in case of his default
• Three parties to guarantee are:
• Guarantor or Surety – who gives guarantee
 • Principal debtor – an applicant, on whose behalf the
guarantee is issued
• Creditor – beneficiary in whose favour the guarantee is
issued

At the request of the export customer, his banker issues

a guarantee in favour of the overseas counter party
(beneficiary). The issuing banker is the guarantor. In case the
exporter fails to perform, the banker as guarantor
should honour the commitment to pay the amount against
the guarantee
Financial
Guarantees

Performance
Guarantees

Deferred
Payment
Guarantees

11)Derivatives are used to hedge risks. What are the different

Derivative products/ Highlight the fetures of the derivatives:
The features of the International Markets are:
} Markets are operating on 24x7 basis in different time
zones
} Handles volumes in terms of forex trades/deals and other
trades/deals
} Vibrant markets supported by active participants like
banks, Financial Institutions, Fund Managers, Exporters,
Importers of goods and services, Investors, Stock and
Other Markets, Regulators, Speculators, Arbitragers, etc.,
} Mainly due to the demand and supply factors the
movement of prices/interest rates and foreign exchange
rates, makes the markets, financial centres exposed to
many risks.
} While risks can not be avoided, the impact of risks can
be minimized/mitigated by using different options and tools.
} One of the important risk management tool is the
derivative products.
 24x7
Basis
Different
Time Zones
Risks
Hedging
Speculators
Opportunities

Transfer of
International
Funds
Markets Arbitragers

Various
Investments
Financial
And
Products
Borrowings Export
Import of
Goods and
Services

As the future happenings can not be predicted with certainty,

in our daily life activities, we hedge ourselves by our pro active
methods to cover against future risks. Ex: Travel plans are made
and the journey tickets are booked well in advance to avoid risk.
Similarly, in financial markets to hedge against future uncertainties
the derivative products are used.
A derivative is a financial instrument, whose value is derived from
the value of the under lying asset. Derivatives are used to hedge
i.e., to protect/cover against the future uncertainty.

Derivatives

Forward
Exchange Futures
Swaps Options
Contract Contract

Interest
Currency Call Put
Rate
Swaps Option Option
Swaps

Forward Exchange Contract: To hedge against exchange rate risk a

forward exchange contract is booked by the exporter and or
importer with the banker. If an exporter, wants to hedge against
his future (3months) export receivables he can book a forward
exchange contract with his banker. On the date of the transaction
(T) the banker books a forward exchange contract as per the
agreed forward rate and delivery date (3months).

Future Contract: To hedge the credit risk, a futures contact

can be booked.
Forward Exchange Contract Furutres Contract

(a) Traded in the Over the (a) Traded in an

counter Market (OTC) exchange
(b) To hedge exchange rate (b) To hedge credit
risk risk
(c) No cash flow till delivery (c) Margin is required
date
(d) Exposed to default risk (d) Exchange acts as
intermediary

Options: Options are contracts that allows its holder/owner the

right but not the obligation to buy /sell a specified security at a
specified price on/before a given date.

Options are classified into: Call option and Put option.

Call option allows the right to buy an asset, and put option
allows the right to sell an asset.
Depending upon the price movements, these options can be
used to hedge the risks.

Swaps: A swap is an agreement between two parties to exchange

the cash flows in the future. The agreement defines the dates when
the cash flow are to be paid and the way it has to be calculated.
These swaps are used to hedge against
Interest rate movements and to avail of opportunities in
different markets.
The swaps are classified into (a) Interest Rate Swap and
(b)Currency Swap
{Hedgers use derivatives to reduce risk that they face from
potential future movements in market variables.

}Speculators use derivatives to bet on the future direction

of a market variable They can, for example, buy a put
 option on a stock if they think it will go down. If they think
that the price of the stock will go up they will buy a call option.

{}Arbitragers take offsetting positions in two or more

instruments to lock in a profit, if securities are inconsistently
priced.

12)Differentiate between ADRs,GDRs and IDRs

(i)What is a depository receipt?

+ A depository receipt is a transferable financial instrument
+ Traded in another country’s stock exchange
+ Backed by the security of domestic shares
+ If listed/ traded in US stock exchanges called as ADRs and if
listed/traded in European stock exchanges called as GDRs and
if listed/traded in Indian stock exchanges called as IDRs

(ii) Highlight the features of GDR:

+ Global Depository Receipt (GDR) is an international
financial instrument
+ GDRs are issued in US$, traded on a stock exchange in
Europe.
+A bank in Europe acquires shares of the foreign companies
and issues their own receipts or certificates to the investors.
The bank is called as a depository and the certificates so
issued are called GDRs
 Indian
American
Depository
Depository
Receipts
Receipts

Global
Depository
Receipts

(iii)Highlight the features of ADRs

+ American Depository Receipts (ADRs) are international
financial instruments.
+ ADRs are issued in the US capital markets.
+ADR is a receipt issued by a US bank, against a specified
number of shares of a non US company
+The US bank acts as a depository
+ADRs are traded in the US stock markets

• An Indian Pharma Company, SCB India Ltd (SCBIL)

company wants to issue ADR.The procedures are
• SCBIL, needs to comply with the requirements of the
overseas stock exchange (ex:NYSE)
• Upon compliance, an US broker buys the shares of SCBIL
from the Indian market and delivers the shares to the local
(Indian) custodian bank. The custodian bank verifies the
 delivery of shares to them and confirms to the US depository
bank.
• Upon receipt of confirmation from the Indian custodian bank,
the US depository bank issues ADRs to the US broker.
For example, ADRs are issued as in the ratio of 1 ADR
to one Indian share or 1 ADR = 20 Indian shares, as per
terms agreed and are traded in the US stock exchanges

All

The

Best