MF0015 | Fixed Exchange Rate System | Futures Contract

Master of Business Administration- MBA Semester 4 MF0015 –International Financial Management- 4 Credits (Book ID: B1316) Assignment Set- 1 (60 Marks

) Note: Answer all questions (with 300 to 400 words each) must be written within 6-8 pages. Each Question carries 10 marks 6 X 10=60 Q1. What are the goals and functions of the World Bank, the IDA and the IFC? Answer: The goals and functions of the World Bank, the IDA and the IFC are following: The World Bank The World Bank group is a multinational financial institution established at the end of World War II (1944) to help provide long-term capital for the reconstruction and development of member countries. The group is important to multinational corporations because it provides much of the planning and financing for economic development projects involving billions of dollars for which private businesses can act as contractors and suppliers of goods and engineering related services. The World Bank is the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD has two affiliates, the international Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). The Bank, the IFC and the MIGA are sometimes referred to as the “World Bank Group”. International Development Association (IDA) The IDA was formed in 1960 as a part of the World Bank Group to provide financial support to LDCs on a more liberal basis than could be offered by the IBRD. The IDA has 169 member countries, although all members of the IBRD are free to join the IDA. IDA’s funds come from subscriptions from its developed members and from the earnings of the IBRD. Credit terms usually are extended to 40 to 50 years with no interest. Repayment begins after a tenyear grace period and can be paid in the local currency, as long as it is convertible. Loans are made only to the poorest countries in the world, those with an annual per capita gross national product of $480 or less. More than 40 countries are eligible for IDA financing. International Finance Corporation (IFC) The IFC was established in 1956. There are 182 countries that are members of the IFC and it is legally and financially separate from the IBRD, although IBRD provides some administrative and other services to the IFC. The IFC’s main responsibilities are (i) To provide risk capital in the form of equity and long-term loans for productive private enterprises in association with private investors and management (ii) To encourage the development of local capital markets by carrying out standby and underwriting arrangements and (iii) To stimulate the international flow of capital by providing financial and technical assistance to privately controlled finance companies. Loans are made to private firms in the developing member countries and are usually for a period of seven to twelve years.

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service trade. Capital account transactions can be divided into two categories foreign direct investment and portfolio investment. Portfolio investments are of two types – short-term and long-term. Table: Transactions Rules in Current Account Debit (Outflow) Goods Services Investment Income Unilateral Transfers Buy Buy Pay Give Credit (Inflow) Sell Sell Receive Receive The Capital account in the BOP records the capital transactions – purchases and sales of assets between residents of one country and those of other countries. Table: Transactions Rules in Capital Account Debit (Outflow) Portfolio (short-term) Credit (Inflow) Receiving a payment from aMaking a payment to a foreigner foreigner Selling a domestic Buying a short-term asset short-term asset to a foreigner Buying back a domestic asset foreign owner Portfolio (long-term) short-termSelling a short-term foreign from itsasset acquired previously Buying a long-term foreignSelling a domestic long-term asset (not for purpose ofasset to a foreigner (not for control) purpose of control) Buying back a long-termSelling a long-term foreign domestic asset from itsasset acquired previously (not foreign owner (not forfor purposes of control) purpose of control) Foreign direct Buying a foreign asset forSelling a long-term foreign investment purpose of control asset acquired previously (not for purposes of control) Buying back from its foreignSelling a owner a domestic assetpreviously foreign acquired asset for -2- . investment income and unilateral transfers and reflects the country’s current competitiveness in international markets. The Current account measures the net balance resulting from merchandise trade. What is a credit transaction and a debit transaction? Which are the broad categories of international transactions classified as credits and as debits? Answer: The Balance of Payment of a country is classified into three well-defined categories – the Current Account. the Capital Account and the Official Reserves Account. The rules for recording a transaction as debit and credit in the current account are given in Table.Q2.

5 billion US dollars a day. At times. Foreign Exchange Market in India The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. Exchange rate regime has often been likened to monetary policies and it may be concluded that both the processes are actually dependent on a lot of similar factors. about 80% of the total transactions. The entire exercise is performed in a controlled manner. the pegged float exchange rate and the fixed or pegged exchange rate. a self regulatory association of dealers. There are some basic exchange rate regimes that are used nowadays – the floating exchanges rate. Write a note on exchange rate regime and foreign exchange market in India. Since 2001. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. The foreign exchange market is pretty important in this case as well. In case the rates are pegged with horizontal bands the rate would be allowed to move within a specified limit or band. This is because the governments always step in to address any excesses in the changes of value. In case of the crawling pegs the rates of exchange stay fixed. The floating exchange rate regime is also known as a dirty float or a managed float. This central value is adjusted at definite periods. In case of the floating exchange rate regime. which is 1% more than the band. clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3. The floating rates are extensively used in most countries of the world. in case of the pegged exchange rate. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day.previously acquired purposes of control forpurposes of control Q3. the values of the currencies are influenced by the movements in the financial market. There are three types of pegged floats – the crawling bands. Answer: Exchange Rate Regime The concept of exchange rate regime may be explained as the method that is employed by the governments in order to administer their respective currencies in the context of the other major currencies of the world. the currency may be attached to a group of currencies or even precious metals like gold. Japanese Yen and Euro. Some common examples of the floating exchange rates would be the British pound. In case of the fixed exchange rate regimes or the pegged exchange rate. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and -3- . In case of the crawling bands the rate is permitted to fluctuate within a particular band or limit and the movements are based on a particular central value. pegging with horizontal bands and crawling bands. the rates are meant to be converting directly to some other currency. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI). United States dollar. as it is also known.

The Sodhani Committee set up in 1994 recommended greater freedom to participating banks. according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. -4- . In March 2006.corporations greater flexibility in holding and trading foreign currencies. About twothirds of all transactions had the rupee on one side. while swap transactions (essentially repurchase agreements with a one-way transaction – spot or forward – combined with a longer-horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. from 2000-01 to 2005-06. interest rates on FCNR deposits and the use of derivative products. trading volume in the foreign exchange market (including swaps. about half (48%) of the transactions were spot trades. In 2004. The growth of the foreign exchange market in the last few years has been nothing less than momentous. forwards and forward cancellations) has more than tripled. allowing them to fix their own trading limits. growing at a compounded annual rate exceeding 25%. In the last 5 years.

000 or FF 20.000 = FF (4.) = 40% The interest differential between US and France is 5%.000 for 90 days. $1 = 5FF $4. Present spot rate $ 0.000 worth of perfume (FF 20. Amount to be repaid after 90 days ii) Convert $4. how can an arbitrageur take advantage of the situation? Assume i) The arbitrageur is willing to borrow $4. (b) The arbitrageur can take advantage of the situation in the following manner.a.2000 US interest rate 15% 90 day forward rate 0. -5- .500 = $ (20. there is an incentive for CIA (outflow of trends from US) as interest differential in favour of France is – 5% or 5% in favour of US.Q4.. would an opportunity still exist for CIA? Answer: (a) Forward premium on FF (in % p.a. An American firm purchases $4. (a) What is the premium or discount on the forward French francs? What is the interest differential between US and France? Is there an incentive for covered interest arbitrage? (b) If there is a CIA.000 × 5) = FF 20.000 iii) Invest FF 20. for 90 days.000) from a French firm.e.000 and ii) There are no transaction costs. The following quotation and expectations exist for the FF.000 in France @ 10% p. (c) If transaction costs are $50.2200 French interest rate 10% Your expectation of the SR 90 days hence 0. Amount received at the end of 90 days = FF 20.000 into FF at current SR. opportunity still exists for CIA.2400. Yes.22 Amount received in US dollars after 90 days by selling FF 20. The American distributor must make the payment in 90 days in French francs. i) Borrow $ 4.500 iv) Sell investment proceeds forward at rate FF 1 = $.22) = $4510 v) Amount received $4510 Amount to be paid $4150 Profit $ 360 (c) As the profit of $360 > transaction cost of $50.500 × . i.

Long position when the buyer of a futures contract agrees to purchase the underlying asset. The next three days’ settlement prices are $0.700.217.147 17. Futures contract represents an institutionalised. The undertaker in a futures market can have two positions in the contract. standardised form of forward contracting. to protect farmers from the risk of price fluctuation in the commodities they produced. Each contract also specifies the delivery month. Futures on commodities evolved.700 + [($0. A future contract represents a contractual agreement to purchase or sell a specified asset in future for a specified price that is determined today.1: Global Listed Derivatives Volume Jan-Dec 2008 Futures Options Total Volume 8.9716 – $0. While only two million contracts were traded in 1978. the figure was nearly 30 million contracts in 1994. trading first began at the International Money Market (IMM) of the Chicago Mercantile Exchange (CME) in the currency of futures contract.000 = $2.9702) + ($0. 1.902.Q5.477 8.627 15. principally.078.837.0 million contracts per day. Where EUR 125. The modern day futures markets originated in the USA in the 19th century to facilitate grain trade.703.291.104 % Change 14. The Table 5. a treasury bill or any number of other assets. Calculate the changes in the margin account from daily marking-to-market and the balance of the margin account after the third day. -6- .621 Jan-Dec 2007 7.652. The data of March 2010 indicates that the CME group volume average contract is 11. Much of the early history is directly linked to the city of Chicago and the needs of farmers and grain merchants. trading in future contracts on commodities has been going on for many years. Solution: $1.526.1 shows the growth of futures and option market of the world: Table 5. You have a short position in one contract. which may be nearby or more deferred in time.9709.50. Short position when the seller agrees to sell the asset.9709) + ($0.9709 – $0.9625.9716/EUR.000 is the contractual size of one EUR contract.625.9% 12.308. a stock index.7% Although trading in futures contracts as financial instruments is relatively a recent phenomenon. The underlying asset could be a foreign currency. $0. Example Assume today’s settlement price on a CME EUR futures contract is $0.361. Define a futures contract.9702.9702 – $0.9625)] x EUR125.474 9.729.632. Your margin account currently has a balance of $1. 2. Trading activity in currency futures has expanded rapidly at the CME. What are the different types of futures contracts? What are the advantages of using stock index futures? Answer: Future Contracts In 1972. and $0. They are traded on an organised exchange which is a physical place or trading floor where listed contracts are traded face to face.7% 13. The specified price is known as the future price.

the Japanese yen. forest products. the Canadian dollar.Types of Futures Contracts Futures contracts that are traded fall into five categories. Stock index futures permit investment in the stock market without the trouble and expense involved in buying the shares themselves. textiles and foodstuff. Contracts are also listed on French francs. i) Agricultural futures contracts. The margin levels may allow leverage of up to 30-40 times. These contracts are traded in grains. 3. crude oil and gasoline are traded. iii) Interest rate futures contract. Among the metals. Actual purchases are not involved. silver. the changing nature of the futures market has meant new types of market participants. Today. In the United States. contracts are traded on gold. platinum and copper. Dutch guilders and the Mexican peso but these have met with only limited success. these contracts trade on several market indices like Standard and Poor's 500. There is high leverage due to margin system. livestock. and the deutsche mark. This category includes genuine metal and petroleum contracts. bonds. These contracts are traded in the British pound. The contract months depend on the seasonality and trading activity. Thus. oil and meal. Hedging of share portfolio. These contracts are traded on treasury bills. pension funds. Several different contracts and months for delivery are available for different grades or types of commodities in question. The transaction costs are typically many times lower than those for share transactions. the largest and most prestigious financial institutions like banks. bank certificates of deposit. v) Stock index futures contract. the Swiss franc. 4. the NYSE Index and the Value Line Index. notes. insurance companies. Eurodollar deposits and single family mortgages. -7- . Portfolio managers for large share portfolios can hedge the value of their investment against bear moves without having to sell the shares themselves. mutual funds all around the world use futures and futures markets have become an integral part of how these institutions manage their risks and portfolio of assets. Advantages of using Stock Index Futures The various advantages of using stock index futures are: 1. iv) Foreign exchange futures contract. 2. Numerous contracts on industry indices are now trading as well. a major market index. These futures contract without actual delivery were introduced only in 1982 and are the most recent major futures contract to emerge. Of the petroleum products. stock index allows for full participation in market moves without significant commitment of capital. Operating under a margin system. Lower transaction costs. ii) Metallurgical futures contract. only heating oil.

As the forward rate will be the market expectation of the change in rates. -8- .Q6. expressed as a basic algebraic identity that relates interest rates and exchange rates. Convert the cash at spot rates 3. Covered Interest Rate Parity:Assuming the arbitrage opportunity described above does not exist. 2. Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency. Borrow in the currency with the lower rate 2.  r$ is the dollar interest rate. and usually follows from assumptions imposed in economic models. The identity is theoretical. Invest the money at the higher rate 5. and is therefore called covered interest rate parity. Uncovered Interest Rate Parity:Assuming uncovered interest arbitrage leads us to a slightly different relationship: r = r2 + E[?S] Where E[?S] is the expected change is exchange rates. Define Interest Rate Parity. than investors would: 1. The evidence on uncovered interest rate parity is mixed. exchanging that currency for another currency and investing in interest-bearing instruments of the second currency. should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. this is a very good approximation:  r£ = r$ + f  Where f is the forward premium: (£/$f)/(£/$s) –1 The above relationship is derived from assuming that covered interest arbitrage opportunities should not last. What are the different types of IRP? Answer: Interest Rate Parity (IRP) Interest rate parity is an economic concept. this is equivalent to covered interest rate parity – unless one is speculating on market expectations being wrong. This is called uncovered interest rate parity. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different. Convert back through the forward contract Types of interest rate parity 1. Enter into a forward contract to convert the cash plus the expected interest at the same rate 4. while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period.  £/$s is the spot sterling to dollar rate  Unless interest rates are very high or the period considered is long.  £/$f is the forward sterling to dollar rate. According to interest rate parity the difference between the (risk free) interest rates paid on two currencies should be equal to the differences between the spot and forward rates. then the relationship for US dollars and pounds sterling is: (1 + r£)/(1 + r$) = (£/$f)/(£/$s)  where r£ is the sterling interest rate (till the date of the forward).

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