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ROLLNO. 1208005653
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Exchange rates respond quickly to all sorts of events - both economic and noneconomic. The movement of
exchange rates is the result of the combined effect of a number of factors that are constantly at play. Economic
factors, also called fundamentals, are better guides as to how a currency moves in the long run. Short-term
changes are affected by a multitude of factors which may also have to be examined carefully. n recent years,
global interdependence has increased to an unprecedented degree. !hanges in one nation"s economy are
rapidly transmitted to that nation"s trading partners. These fluctuations in economic activity are reflected
almost immediately in fluctuations of currency values. These changes in exchange rates expose all those firms
having export import operations as also multinationals with integrated cross border production and marketing
operations. t is useful to be aware of the various factors that influence exchanges rates.
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1. /"+( "# t!e De,&#2-S(3314 M"2e1$
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#t the most primary level, a change in the price of a currency will occur because of more or less demand for it.
$igh demand signifies a higher price experience of the currency pair. %ess demand signifies fall in the price of
the currency pair. #n increased demand for a currency suggests a strong economy, while a currency"s demand
can go down if the central bank lowers the rates of interest. The movement of price is based on the demand for
the currency. #ctually, currencies rally when the demand for it goes up.
T!e (3314 i2e 0&+t"r
# basic economic principle of supply says that a currency"s value will change with the rise and fall of the
levels of supply. The value and price of a currency will diminish if there is a higher supply of a currency.
Similarly, the value and price of a currency will increase when there is a lower supply of a currency. Even
though the supply side is important, the demand factor is the primary moving force that determines the value
and price of a currency.
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# number of factors affect the rates of exchange. #t the end, costs of currency result from the supply of
currency. The currency markets all over the world can be considered a huge melting pot. The supply and
demand ingredients constantly change in relation to the changing mix of current events and the cost of one
currency in relation to another change accordingly.
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These include the economic policy of the government which is made known through various government
agencies and the central bank of the country, and economic conditions, generally revealed through economic
reports. Economic conditions include&
• I#01&ti"# 1e-e1 &#2 tre#2: f there is a high level of inflation in the country, or if the inflation level
seems to be rising, typically a currency will lose value because inflation brings down the purchasing power
and thus the demand for that particular currency.
• E+"#",i+ )r"6t! &#2 !e&1t!: The economic growth and health of a country can be known through a
country"s gross domestic product '()*+, level of employment, capacity utili,ation, retail sales and other
indicators. (enerally, a currency will perform better and there will be more demand for it if the economy
of the country is healthy and robust. The better the economic performance, the higher will be the
currency"s demand.
• G"-er#,e#t .(2)et 2e0i+it "r (r31(e$ -idening government budget deficits lead to a negative
reaction in the market, whereas the market reacts positively in case of narrowing budget deficits. The
impact of budget deficit or budget surplus is reflected in the value of the currency of a country.
• B&1&#+e "0 tr&2e 1e-e1 &#2 tre#2: The flow of trade from a country to other parts of the world shows
the demand for goods and services of the country, which in turn indicates the demand for a country"s
currency for conducting trade. The competitiveness of a country"s economy is reflected by the surpluses
and deficits in trade of goods and services
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There are three broad functions that are performed by the money market.
.. /or the demand and supply of short term funds, the money market provides an equilibrating mechanism.
0. t helps the lenders and the borrowers of the short term funds in fulfilling the borrowing and investment
requirements at a competent market clearing price.
1. t offers an avenue to the central bank to intervene in influencing the cost of liquidity and the quantum in
the financial system which in turn transmits monetary policy impulses to the real economy.
%.' I#ter#&ti"#&1 i#teret r&te$
2oney market rates are interest rates used by banks for operations among themselves. 2oney market enables
the banks to trade their surpluses and deficits. This rate is also commonly known as inter-bank rate. The rates
for various countries vary substantially. The reason for this substantial difference in rates is due to the
interaction of supply or availability of short term funds 'bank deposits+ in a particular country versus the
demand by borrowers for short term funds in that country.
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3egulations contribute to the development of international money markets because these impose restrictions
on local markets. %ocal investors and borrowers try to circumvent the restrictions in local markets. )ifference
in regulations among countries puts banks in some countries to advantageous position compared to banks in
other countries. 4ver a period of time, international banking regulations have been standardi,ed, which permit
competitive global banking. Three most significant regulatory events for creating more competitive global
level playing field are given below&
.. The Single European #ct
0. The 5asel #ccord
1. The 5asel #ccord
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"0 ,"#e4 !&2 #"t e-"1-e2. E*31&i# "# +"(#ter tr&2e 6it! e*&,31e.
Thousands of years ago, the concept of bartering between parties was prevalent, when the concept of money
had not evolved. # person could give say .66 bags of wheat and get wood or coal, a certain quantity for
cooking. These bartering contracts were between individuals or small kingdoms. 5artering exists today
also but at different level. Today, most business is transacted with money as medium. Trading between
countries is through respective currencies using international exchange rate. !ountertrade means all types of
foreign trade in which the sale of goods to another country is associated with parallel purchase of some other
goods from that country.
There is exchange of goods between two parties in different countries under two separate contracts in money
terms. )elivery and payment of the two contracts are independent transactions. !ountertrade deals are mostly
negotiated and executed either at government to government level or between organi,ations with approval of
respective governments. !ountertrade takes many different forms as explained below&
'i+ B&rter$ t is exchange of goods without the use of money.

Typical examples are&
'a+ 4man exchange oil for air conditions with Taiwan
'b+ Sri %anka exchange fish for mobile handsets with (ermany
'ii+ B(4 .&+7$ n this part, the payment of the price of contract is through supply of related products.
Typical examples are&
'a+ # firm in !hina purchases plant 7 technology for manufacture of high precision bearings from (ermany,
and the firm in (ermany agrees to buy a part of bearings produced by the plant in !hina.
'b+ #n ndian aerospace firm sets up production facility for manufacture of executive 8ets under technical
collaboration from an #merican firm who in turn agrees to provide a part of worldwide business of
overhauling of executive 8ets to the ndian firm.
'c+ # firm establishes gas pipeline for another firm to transport gas and produce electricity and in turn agrees
to buy a portion of electric power for prolonged period at predetermined terms.
'iii+ 5"(#ter 3(r+!&e$ n such cases, there is direct purchase of items as exchange deals.
Typical examples are&
'a+ # firm in 9S sold soft drinks to 3ussian counterpart and imported vodka in exchange.
'b+ !anada sold wheat to ndonesia in exchange for import of rubber.
'c+ # (erman firm sold machine tools to a firm in 3omania in exchange for import of hosiery items.
Examples of countertrade are many and in a variety of forms. Though countertrade is existing to create win-
win situation between parties involved, it has its own ills: typically following issues are existing&
.. The exporting country sells high technology items at inflated prices and the items which they import are
disposed off to other countries at a discount, using a part of high premium charged on their exports.
0. The middlemen in the countertrade agreements are usually shrewd traders who exploit the political and
social circumstances to obtain large gains for themselves.
1. The goods that are offered in countertrade are not the required items, because the desirable items have
already been exported.
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M&#&)i#) Tr&#&+ti"# E*3"(re$
Transaction exposure calculates gains or losses which occur after the current financial compulsions according
to terms of reference are resolved. Taken that the deal would lead to a future inflow or outflow of foreign
currency cash, any unprecedented alterations in rate of exchange amid the period in which transaction is
entered and the time taken for it to settle in cash would guide to a change in worth of net flow of cash in terms
of the home currency.
/or example a transaction exposure of an ndian company will be the account receivable which is associated
with a sale denominated in 9S dollars or the compulsion of an account payable in Euro debt. *resume an
ndian firm sells goods with an open account to a (erman buyer for ;.,<66,666 payment of which is to be
done in 0 months. The current exchange rate is = >6?;, and the ndian seller expects to exchange the euros
received for = @6,666,666 when payment is received. f euro weakens to =A>?; when payment is received, the
ndian seller will receive only =<.,666,666, or some =@,666,666 less than anticipated. 4pposite will be the case
should euro strengthen. Thus exposure is a chance of either gain or loss.
A1ter#&ti-e 1$ nvoice the (erman buyer in rupees: but the ndian firm might not have obtained the sale in the
first place.
A1ter#&ti-e 2$ nvoice the (erman buyer in dollars: both the parties are exposed should an unanticipated
change in exchange rate between dollar and the respective home currency.
M&#&)i#) O3er&ti#) E*3"(re$
4perating exposure is alternatively known as economic exposure. t evaluates the changes that occur in the
current value of the firm. The change in the current value may be a result of the change that takes place in
predicted operating cash flows on account of fluctuations in exchange rates. They are similar in that they both
deal with future cash flows. They differ in terms of which cash flows management considers. Transaction
exposure deals with the predicted cash flows for future that have already been contracted and hence accounted
for. #t the same time, the operating exposure focuses on the predicted-but not yet contracted-cash flows in
future. These future cash flows may undergo changes in case of a ma8or fluctuation in the exchange rate,
resulting in changes in the overall competitiveness at international level.
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.(2)eti#) &#2 t!e te3 t" 2eter,i#e +&! 01"6.
Te+!#i:(e "0 5&3it&1 B(2)eti#)$
There are many techniques which can be used to analy,e the pro8ects. These techniques can be broadly
classified into discounted cash flow techniques, which include net present value 'B*C+, internal rate of return
'33+, profitability index '*+ and discounted payback methods, and non-discounted cash flow techniques
which include payback and accounting rate of return '#33+ methods.
Net ;ree#t V&1(e %N;V'$
n this method all future cash flows occurring in different time periods are discounted to present value using
opportunity cost of capital as discount rate. -henever there is a cash inflow, we take it with positive sign and
cash outflow, we take it as negative sign. f present value '*C+ of cash inflows is greater than present value
'*C+ of cash outflows the pro8ect can be accepted. $owever, if there are more than one pro8ect and only one
can be accepted then the pro8ect with highest difference of *C of all cash inflow and *C of cash outflows is
accepted. The difference of *C of all future cash flows and initial investment is known as B*C.
I#ter#&1 R&te "0 Ret(r# %IRR'$
nternal rate of return is defined as that discount rate at which B*C is equal ,ero. This internal rate of return is
compared with opportunity cost of capital. f 33 is greater than opportunity cost of capital the pro8ect can be
accepted: if 33 is less than opportunity cost of capital the pro8ect cannot be accepted as in such a case, the
pro8ect will not be able to generate even the opportunity cost of capital. f 33 is equal to opportunity cost of
capital the pro8ect will not generate any extra returns so it can either be accepted or re8ected. The greater the
magnitude by which 33 exceeds the opportunity cost of capital the greater will be the profitability, so ranking
of pro8ects can be done based on the magnitude of difference.
;r"0it&.i1it4 I#2e* %;I'$
t is defined as the ratio of present value of all cash inflows divided by the initial cash outflow. t is similar to
B*C in the sense that it also uses discounted cash flows and initial outflow but instead of subtracting initial
cash outflow from discounted cash flows, here we divide the discounted cash flows by initial cash outflow. -e
accept the pro8ect if * is greater than one, re8ect it if * is less than one and may or may not accept it if * is
equal to one.
;&4.&+7 ;eri"2$
This is a non-discounted cash flow technique. t finds out the time in years in which the initial investment
would be recovered. t is the easiest method as far as computation is concerned but drawback being that it does
not consider time value of money. 2athematically, it is calculated by dividing initial cash outflow by annual
constant cash inflows. )iscounted payback period is a better method than payback period in the sense that it
considers the time value of money and discounts all future cash flows.
Deter,i#i#) +&! 01"6$
#ny expenses which are already incurred will not be included in cash flows. Such expenses are called sunk
costs. The step of determining cash flows with accuracy is the most important step in capital budgeting
analysis as further process is dependent on it, but it is a difficult task due to the following reasons&
.. /uture is uncertain, and uncertainty gives rise to risks.
0. #ccounting information which is based on various assumptions is used as basis to determine cash flows
1. Economic conditions may change suddenly due to some event
n any capital investment pro8ect there will be three main cash flows&
• nitial cash outflow
• !ash flows during the pro8ect. t may be inflow or a mix of inflow and outflow
• /inal period cash flow: generally referred to as terminal cash flow
Though cash flows 'not profits+ are used as basis for evaluation of capital pro8ects, both are important. These
are connected by the following equation&
Cash Flow = Profit (P) + Depreciation (D) – Capital Expenditure (CAPEX)
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%&'A,eri+&# De3"it"r4 Re+ei3t %ADR'$
t represents ownership in the shares of a non-9S company and trades in the #merican stock markets. #)3s
enable #merican investors to buy shares in foreign company without any issue of cross-border and cross-
currency transactions. #)3s carry price in #merican dollar, pay dividend in the same currency and can be
traded like any other share of 9S-based companies. Each #)3 is issued by a 9S depository bank and can
represent one share. The owner of #)3 has the right to obtain the foreign stock it represents, but 9S investors
are more interested in owning #)3 as they can diversify their investments across the globe. #)3 falls within
the regulatory framework of the 9S and requires registration of the #)3s and the underlying shares with the
%.'G1".&1 De3"it"r4 Re+ei3t%GDR'$
They are used in (lobal Equity offering to international investors. t can be considered as global finance
instrument that allows an investor to raise capital at the same time from two or more markets. )epositing
receipts helps in cross border trading and settlement helps to reduce transaction costs and increases the
investment base among the institutional investors. ()3 is a negotiable certificate that represents a companyDs
publicly traded equity or debt. They are created when a broker purchases the companyDs shares on domestic
Stock market and deliver them to the depositoryDs local custodian bank who instructs the depository bank to
issue ()3s. They are traded on a stock exchange where they are listed and in 4T! market.