You are on page 1of 13

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College; gundupagimanjunath@gmail.

Q) What are the factors which influence the foreign exchange rate? May/June 2007 5Marks.
The more important factors that influence exchange rates are discussed below:
Strength of the Economy :The strength of the economy affects the demand and supply of foreign
currency. If an economy is growing fast and is strong it will attract foreign currency thereby
strengthening its own. On the other hand, weaknesses result in an outflow of foreign exchange.
Political and Psychological Factors: Political or psychological factors are believed to have an
influence on exchange rates. whenever there is a political crisis anywhere in the world. Exchange
rates can also fluctuate if there is a change in government. Some time back, Indias foreign
exchange rating was downgraded because of political instability and consequently, the external
value of the rupee fell.
Economic Expectations: Exchange rates move on economic expectations. After the 1999 budget
in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations
affect the external value of the rupee, all economic data the balance of payments, export growth,
inflation rates and the likes are analyzed and its likely effect on exchange rates is examined. If
the economic downturn is not as bad as anticipated the rate can even appreciate. The movement
really depends on the market sentiment the mood of the market and how much the market
has reacted or discounted the anticipated/expected information.
Inflation Rates : It is widely held that exchange rates move in the direction required to
compensate for relative inflation rates. The underlying reasoning behind this conviction is that a
relatively high rate of inflation reduces a countrys competitiveness and weakens its ability to sell
in international markets.
Capital Movements : Capital movements are one of the most important reasons for changes in
exchange rates. Capital movements of foreign currency are usually more than connected with
international trade. This occurs due to a variety of reasons both positive and negative. When
India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to
purchase equity shares in Indian companies, billions of US dollars came into the country
strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the
country weakening the currency.
Speculation : Speculation in a currency raises or lowers the exchange rate.
Balance of Payments : A net inflow of foreign currency tends to strengthen the home currency
vis--vis other currencies. This is because the supply of the foreign currency will be in excess of
demand. If the balance of payments is positive and foreign exchange reserves are increasing, the
home currency will become stronger.
Governments Monetary and Fiscal Policies : Governments, through their monetary and fiscal
policies affect international trade, the trade balance and the supply and demand for a currency.
Monetary and fiscal policy support the currency through a reduction in inflation. These also affect
exchange rate through the capital account. Net capital inflows supply direct support for the
exchange rate. Central governments control monetary supply and they are expected to ensure that
the governments monetary policy is followed. To this extent they could increase or decrease
money supply.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small
measure, by expectation of change in regulations relating to exchange markets and official
intervention. Official intervention can smoothen an otherwise disorderly market. Intervention is
the buying or selling of foreign currency to increase or decrease its supply. Central banks often
intervene to maintain stability. It has also been experienced that if the authorities attempt to halfheartedly counter the market sentiments through intervention in the market, ultimately more steep
and sudden exchange rate swings can occur.
Interest Rates : An important factor for movement in exchange rates in recent years is interest
rates, i.e. interest differential between major currencies. In this respect the growing integration of
financial markets of major countries, the revolution in telecommunication facilities, the growth of
specialized asset managing agencies, the deregulation of financial markets by major countries, the
emergence of foreign trading as profit centres and the tremendous scope for squaring effects on
the rates, etc. have accelerated the potential for exchange rate volatility.
Tariffs and Quotas : Tariffs and quotas exist to protect a countrys foreign exchange by reducing
demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports.
Very few items were permitted to be freely imported. Additionally, high customs duties were
imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not
popular internationally as they tend to close markets. When India lifted its barriers, several
industries such as the mini steel and the scrap metal industries collapsed (imported scrap became
cheaper than the domestic one). Quotas are not restricted to developing countries. The United
States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese
Exchange Control : The purpose of exchange control is to manage the supply and demand
balance of the home currency by the government using direct controls basically to protect it.
Currency control is the restriction of using or availing of foreign currency at home/abroad
Q) Discuss the role of MNCs in FDI? May/June 2007 15Marks
FDI is investment that directly leads to productive activity within the host country
Clearly growing importance of MNCs and FDI though some debate how important
It would seem that to prosper many firms need to produce and sell in a number of countries
Indeed, MNCs now outweigh exports as dominant means of servicing foreign markets.
Top 100 MNCs control about 20% world production (UNCTAD, Held). MNCs on some
estimates control around 70% world trade
Many firms are multinational and some have a high proportion of their assets overseas:
Changes over time marked both in terms of firms and industries
While FDI is one useful indicator of the growth of international production, but is an
underestimate Held et al
o Accounts for only 25% total invest in international production. MNCs raise money from a
variety of sources
o Global production not just ownership and control but cross border production networks between
firms systematic data on this not available
When considering the option of moving abroad companies have a number of channels available:
-Exports of goods and services
-Direct investment in wholly owned subsidiaries
-Licensed production
-Joint ventures

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

-Strategic Alliances between number of firms
-Portfolio investment/cross equity holdings
The economic role of multinational corporations (MNCs) is simply to channel physical and
financial capital to countries with capital shortages. As a consequence, wealth is created, which
yields new jobs directly and through crowding-in effects.
In addition, new tax revenues arise from MNC generated income, allowing developing countries
to improve their infrastructures and to strengthen their human capital. By improving the efficiency
of capital flows, MNCs reduce world poverty levels and provide a positive externality that is
consistent with the United Nations (UN) mission countries are encouraged to cooperate and to
seek peaceful solutions to external and internal conflicts.
The role of MNCs is underappreciated they have provided developing countries with much
needed capital, jobs, and environmentally friendly technologies. Through free market initiatives,
MNCs create wealth, which provides the income flow necessary for welfare improvements. If the
desideratum of developing countries is to escape severe conditions of poverty, they need to
privatize, deregulate, protect private property rights, and establish a rule of law the MNCs will
then provide the capital.
Q) Discuss the significance of Inernational Financial Management? May/june 2007 15Marks
Importance of International Financial Management:
-International financial management deals with the financial decisions taken in the area of
international business. The growth in international business is, first of all, evident in the form of
highly inflated size of international trade. In the immediate post-war years, the general agreement
on the Trade and Tariffs was set up in order to boost trade. It axed the trade barriers significantly
over the years, as a result of which international trade grew manifold. Naturally, the financial
involvement of the trader's exporters and importers and the quantum of the cross country
transactions surged significantly.
-All this required proper management of international flow of funds for which the study of
International Financial Management came to be indispensable. When the product becomes mature
in the importing countries, the exporter starts manufacturing the product there so as to evade tariff
and to supply it at the least cost.
-The two way flow of funds, outward in the form of investment and inward in the form of
repatriation divided, royalty, technical service fees, etc., required proper management and so the
study of International Finance Management become a real necessity.
-With growing operation of Multinational companies, a number of complexities arose in the area
of their financial decisions. Apart form the considerations of where, when and how much to
invest, the decision concerning the management of working capital among their different
subsidiaries and the parent units become more complex especially because the basic polices varied
from one Multinational companies to the other. Those Multinational companies that were more
interested in maximizing the value of global wealth adopted a centralized approach while those
not interfering much with their subsidiaries believed in a decentralized approach.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

-The vast magnitude of lending y international and regional development asks and different
governmental and non-governmental agencies. The movement of funds mostly to the developing
world and the reverse movement of funds in form of interest and amortization payments needed
proper management. Besides, there were big changes in the character of the international financial
market with the emergence of Euro banks and offshore banking center and of various instruments,
such as Euro bonds, Euro notes and Euro commercial papers.
-The nature of the movement of funds become so complex that proper management become a
necessity and the study of International Finance Management become highly relevant. In fact,
International Finance Management suggests the most suitable technique to be applied at a
particular moment and in a particular case in order to hedge the risk.
International finance is a distinct field of study and certain features set it apart from domestic
financial management. MNC has got operations around the world and thus have to deal with
international customers, shareholders and other suppliers.
Foreign Exchange Risk: An understanding of foreign exchange risk is essential for managers and
investors in the modern day environment of un foreseen changes in foreign exchange rates. When
different national currencies are exchanged for each other there is a definite risk of volatility in
foreign exchange rates.
Political Risk: Political risk ranges from the risk of loss or gain from unforeseen government
actions or other event of political character such as acts of terrorism to outright expropriation of
assets held by foreigners. MNCs must assess the political risk not only in countries where it is
currently doing business but also where it expects to establish subsidiaries.
Expanded Opportunity sets: when firms go global they also tend to benefit from expanded
opportunities which are available now. They can raise funds in capital markets where cost of
capital is the lowest. In addition firms can also gain from greater economies of scale when they
operate on a global basis.
Market Imperfections: The final feature of international finance that distinguishes it from
domestic finance is that would markets today are highly imperfect. There are profound differences
among nations law, tax systems, business practices and general cultural environment.
Imperfections in the world financial markets tend to restrict the extent to which investors can
diversify their portfolios.
Q) Explain the role of IMF? June 2008 5 Marks
The IMF was created to promote internatioal monetary cooperation; to facilitate the expansion and
balanced growth of internatioal trade; to promote exchange stability; to assist in the establishment
of a multilateral system of payments; to make its general resources temporarily available to its
members experiencing balance of payments difficulties under adequate safeguards; and to shorten
the duration and lessen the degree of disequilibrium in the international balances of payments of
1. Surveillance:The IMF oversees the international monetary system and monitors the financial
and economic policies of its members. It keeps track of economic developments on a national,

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

regional, and global basis, consulting regularly with member countries and providing them with
macroeconomic and financial policy advice.
2. Lending: The IMF provides loans to countries that have trouble meeting their international
payments and cannot otherwise find sufficient financing on affordable terms. This financial
assistance is designed to help countries restore macroeconomic stability by rebuilding their
international reserves, stabilizing their currencies, and paying for importsall necessary
conditions for relaunching growth. The IMF also provides concessional loans to low-income
countries to help them develop their economies and reduce poverty.
3. Technical Assistance: To assist mainly low- and middle-income countries in effectively
managing their economies, the IMF provides practical guidance and training on how to upgrade
institutions, and design appropriate macroeconomic, financial, and structural policies.
Q) Bring out the features of Forex Market? June 2008 5 Marks
The features of the FOREX market which contributes to its growth are:
Liquidity - Higher the liquidity, the more powerful will be from the investor side as it gives them
the choice to open or close a position of any size.
Promptness and Availability - The FOREX market need not have to wait to give any certain
respond to any given occasion due to its 24 hour work schedule and likelihood to trade round the
Value - Except for the natural bid market spread between the supply and demand price the
FOREX market has usually incurred no service charge.
Market trend - Each currency reveals its own typical temporary modifications which represents
investments managers with the chances to manipulate in the FOREX market.
Margin - Widespread credit leverages or margins in conjunction with highly variable currency
quotations makes this market a highly gainful but also very chancy.
1. The forex market operates worldwide and non-stop for five and a half days a week, every day it
moves along with the sun.
2. one would need access to electronic communication networks (ECN) for pre-market trading.
3. The wide availability of sophisticated technology has spawned a whole new level of foreign
exchange, where self-directed (so-called retail) traders can easily buy and sell currencies
through on interact connection with a click of the mouse, dealing with invisible counter-parties on
the other side of the transaction.
4. The forex market is the planets most liquid market. With more than $2 trillion changing
hands every day, traders have no worries about liquidity when it comes to trading any of
the big-economy currencies: USD, GBP, EUR, CHF, JPY, CAD, AUD and NZD.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

5. The unparalleled liquidity of forex translates into very little or almost no slippage when
you trade during normal market conditions (not during news); there is rarely any
discrepancy between the displayed price and the execution price.
Q) Distinguish between futures and Forwards? June 2008 5Marks
Q) Distinguish between a forward and futures contract. Which of the two is more popular?
Why? May/June 2007 15Marks.
Fundamental Differences Between Futures and Forwards:
The fundamental difference between futures and forwards is that futures are traded on exchanges
and forwards trade OTC. The difference in trading venues gives rise to notable differences in the
two instruments:
Futures are standardized instruments transacted through brokerage firms that hold a "seat"
on the exchange that trades that particular contract. The terms of a futures contract including delivery places and dates, volume, technical specifications, and trading and
credit procedures - are standardized for each type of contract.
In contrast, forwards are entirely customized and all the terms of the contract are privately
negotiated between parties. They can be keyed to almost any conceivable underlying asset
or measure. The settlement date, notional amount of the contract and settlement form (cash
or physical) are entirely up to the parties to the contract.
Forwards entail both market risk and credit risk. Those who engage in futures transactions
assume exposure to default by the exchange's clearing house. For OTC derivatives, the
exposure is to default by the counterparty who may fail to perform on a forward. The profit
or loss on a forward contract is only realized at the time of settlement, so the credit
exposure can keep increasing.
With futures, credit risk mitigation measures, such as regular mark-to-market and
margining, are automatically required. The exchanges employ a system whereby
counterparties exchange daily payments of profits or losses on the days they occur.
Through these margin payments, a futures contract's market value is effectively reset to
zero at the end of each trading day. This all but eliminates credit risk.
The daily cash flows associated with margining can skew futures prices, causing them to
diverge from corresponding forward prices.
Futures are settled at the settlement price fixed on the last trading date of the contract (i.e.
at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the
Futures are generally subject to a single regulatory regime in one jurisdiction, while
forwards - although usually transacted by regulated firms - are transacted across
jurisdictional boundaries and are primarily governed by the contractual relations between
the parties.
In case of physical delivery, the forward contract specifies to whom the delivery should be
made. The counterparty on a futures contract is chosen randomly by the exchange.
In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.
Future Contracts are more popular and the reasons are:
A Futures Contract is a unique investment among alternative investments. It has several
characteristics that make it attractive to the investors.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

Simple and uncomplicated - Futures contract are very easy to follow - based on whether
you believe prices are going to rise or fall, you sell and buy.
There is no paper work involved or any high financial requirements to be met. When
Futures Contract prices go up you sell, and when they go down, you buy. It is a very
logical strategy to follow.
Easy entry and exit - In such a liquid market, it is very easy to enter and exit a transaction,
especially now that it can be done online. If you so wish, it need involve only a low
Direct investment opportunities - A Futures Contract helps you to invest directly in the
market. In other forms of investment you have to consider a lot of other factors like
management issues, market shares, and other company-related matters that would pose
risks to your investments. But since the Futures move one-for-one with the underlying
prices, you have a direct investment opportunity.
Capital Efficiency - A Futures contract is the most capital efficient investment choice you
have since you can make a larger investment with actually a much smaller amount. The
Futures ties up only 20% of the full contract value, freeing the remaining 80% for other
investments. So, your capital can be put to very effective use through this marginal
Volatile - Since speculators like markets that move, they make a good investment choice
since the Futures Contract prices are highly mobile.

Q) Explain the various methods of making payment in International Trade? June 2008
Getting paid for providing goods or services is critical for any business. However, getting paid for
an international transaction (also commonly known as "export receivables") can be a very
different experience from securing payment on business with other UK entities, due to the number
of extra factors that can influence the process.
The main factor in considering how an exporter expects to be paid for a transaction is the potential
risk that they and their customer are willing to face between them - don't forget, there are always
two sides to any situation. There are different types of risk that you will face as an exporter, this
briefing will consider the payment risk.
Open Account
This is the least secure method of trading for the exporter, but the most attractive to buyers. Goods
are shipped and documents are remitted directly to the buyer, with a request for payment at the
appropriate time (immediately, or at an agreed future date). An exporter has little or no control
over the process, except for imposing future trading terms and conditions on the buyer. Clearly,
this payment method is the most advantageous for the buyer, in cash flow and cost terms. As a
consequence, Open Account trading should only be considered when an exporter is sufficiently
confident that payment will be received.
It should be noted that in certain markets, such as Europe, buyers will expect Open Account terms.
The financial risk can often be mitigated by obtaining a credit insurance policy to cover the
potential insolvency of a customer that provides reimbursement up to an agreed financial limit.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

There are a number of commercial insurers who specialize in this market - contact your insurance
representative for details.
Advance Payment
The most secure method of trading for exporters and, consequently the least attractive for buyers.
Payment is expected by the exporter, in full, prior to goods being shipped. As one might imagine,
having covered the two extremes on the Payment Risk Ladder, commercial decisions have to be
made and this usually results in selecting one of the middle rungs of the ladder. This is where
banking products such as Bills for Collection and Letters of Credit come in to play.
Bills for Collection
More secure for an exporter than Open Account trading, as the exporter's documentation is sent
from a UK bank to the buyer's bank. This invariably occurs after shipment and contains specific
instructions that must be obeyed. Should the buyer fail to comply, the exporter does, in certain
circumstances, retain title to the goods, which may be recoverable. The buyer's bank will act on
instructions provided by the exporter, via their own bank, and often provides a useful
communication route through which disputes are resolved.
There are two types of Bill for Collection, which are usually determined by the payment terms
agreed within a commercial contract. Different benefits are afforded to exporters by each and they
are covered separately below:
Documents against Payment (D/P)
Usually used where payment is expected from the buyer immediately, otherwise known as "at
sight". This process is often referred to as "Cash against Documents".
The buyer's bank is instructed to release the exporter's goods only when payment has been made.
Where goods have been shipped by sea freight, covered by a full set of Bills of Lading, title is
retained by the exporter until these documents are properly released to the buyer. Unfortunately,
for airfreight items, unless the goods are consigned to the buyer's bank no such control is available
under an Air Waybill or Air Consignment Note, as these documents are merely "movement
certificates" rather than "documents of title"
Documents against Acceptance (D/A)
Used where a credit period (e.g. 30/60/90 days - 'sight of document' or from 'date of shipment')
has been agreed between the exporter and buyer. The buyer is able to collect the documents
against their undertaking to pay on an agreed date in the future, rather than immediate payment.
The exporter's documents are usually accompanied by a "Draft" or "Bill of Exchange" which
looks something like a cheque, but is payable by (drawn on) the buyer. When a buyer (drawee)
agrees to pay on a certain date, they sign (accept) the draft. It is against this acceptance that
documents are released to the buyer. until the point of acceptance, the exporter may retain control
of the goods, as in the D/P scenario above. However, after acceptance, the exporter is financially
exposed until the buyer actually initiates payment through their bank.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

Bills for Collection are used in certain markets (particularly Asian) to fulfil Exchange Control
Regulations. They are a cost-effective method of evidencing a transaction for buyers, where
documents are handled (and reported) via the banking system.
Letters of Credit (L/Cs)
A Letter of Credit (also known as a Documentary Credit ) is a bank-to-bank commitment of
payment in favour of an exporter (the Beneficiary), guaranteeing that payment will be made
against certain documents that, on presentation, are found to be in compliance with terms set by
the buyer (the Applicant). Like Bills for Collections, Letters of Credit are governed by a set of
Standby Letters of Credit (SBLCs) or Bank Guarantees
SBLCs are similar to Bank Guarantees, in that they sit behind a transaction and are only called
upon if the buyer fails to pay in the normal course of business (which is often Open Account).
They can be particularly useful to cover an underlying financial risk where multiple payments are
to be made, possibly as part of an agreed schedule. However, they do not offer the documentary
control of Letters of Credit to buyers and, as such they are an unconditional guarantee.
Main Types of Money Transfers
SWIFT Inter-Bank Transfer - now firmly established as standard practice in the major trading
nations. The buyer will instruct their bank to make payment to any bank account specified by the
exporter. It is good practice, therefore, for the exporter to include their account details on their
invoice heads.
Buyer's Cheque - an unsatisfactory method of settlement for the exporter as it carries the risk of
dishonour upon presentation as well as the added inconvenience of being slow to clear. There is
also the very real danger of the cheque being lost in transit as well. A cheque is also unsatisfactory
if it is in the currency of the buyer, as this will take longer to clear and will involve additional
bank charges.
Banker's Draft - this is arranged by the buyer who asks their bank to raise a draft on its
corresponding bank in the exporter's country. Provides additional security to a buyer's cheque, but
they can be costly to arrange and they do run the risk of getting lost in transit.
International Money Orders - these are similar in nature to postal orders. They are pre-printed
therefore cheaper to obtain than a Banker's Draft, although again there is the risk of loss in transit.
Q) What is BOP? Bring out the constituents of BOP? June 2008 5Marks
Balance of Payment (BOP) of a country is a systematic record of all economic transactions,
between the residents of the country and the rest of the world in a given period of time, generally
one year.
Residents:Persons are residents of a country in which they normally reside.

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

Economic Transactions: It is an exchange or transfer of value. This transfer/exchange can take
the form of goods or services, or it can take form of the donations, gifts or reparations, which are
called unilateral transfers.
Systematic record: Records prepared by classifying all items as per their nature, are systematic
Transactions inside the balance of payments can be classified in two broad categories: transactions
on the capital account, and those on the current account.
The current account: The current account is a record of all transactions relating to trade in goods
and services, net interest and dividend payments and any transfers in the form of foreign aid.
Therefore, the three component of the current account are:
1. The trade balance: This is the difference between the exports and imports of goods and
services. The excess of exports over imports is called the trade surplus, and likewise if the imports
exceed exports, there is a trade deficit. Often, a distinction is made between goods and services by
calling them visible and invisible trade. The trade balance is the most significant element of the
current account. Often, a worsening balance of payments refers to an increase in the trade deficit.
2. Net foreign income: Income is earned by residents on assets held abroad and likewise
foreigners earn income on the domestic assets. Net foreign income is the difference of the two.
3. Unilateral transfers include transfers such as foreign aid that are made without consideration.
Capital Account:The capital account is a record of all transactions that represent flow of money
for investment and international loans. It is different from the current account in that it does not
include settlements for current transactions. To illustrate with an example, while the purchase of a
machinery would feature in the current account, its financing with an international loan would be
an entry in the capital account. Investments by foreigners in our stock markets, raising of capital
by Indian companies in markets abroad, foreign direct investments in Indian industry are all
inflows on the capital account.
Long and short-term capital flows
A very important characteristic of the capital account is the nature of the capital flow, i.e. whether
it is short term or long term in nature. When a punter puts money in Indias stock markets hoping
to make a quick gain, it will be regarded as a short-term capital flow. Similarly, when an investor
eyeing high Indian interest rates deposits money with an Indian bank, it too is a short-term capital
flow. On the other hand, when a large international financial investor lends long-term money to an
Indian company so that it can buy plant and machinery, it is an example of long term, also called
stable capital flows. The difference is crucial because only long term capital flows can make any
significant impact on the economy. Short term capital flows can be quite destabilising, for instance
as they were in the recent South Asian crisis when all the hot money was pulled out at the first
signals of trouble and eventually led to the melt down.
The current account and the capital account are complementary to each other. The net total of the
two decides the net increase or decrease in the countrys forex reserves. For the past many years,
the Indian economy has witnessed a steady worsening of the current account deficit, but large
capital inflows in the form of foreign direct investment and portfolio investment and taken

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

together, the reserves have been building up. A deficit in the current account is not necessarily a
negative indicator, so long as the deficit is used to augment productive capacity. This can take the
form of investments in infrastructure that make economic expansion possible and increase the
capacity of the country to export in the future. At the same time, a surplus in the current account
does not necessarily imply prosperity, for instance Russia has a large current account surplus from
its export of commodities and arms, which is offset by large-scale capital flight and therefore a
deficit on the capital account.
I. Current Account
(A) Goods

General merchandise, goods for processing,

repairs on goods produced in ports by carries and
non-monetary gold.

(B) Services

construction, financial and computer services,
royalties and license fees, other professional and
business services.

(C) Income

Direct investment income, portfolio investment

income, and compensation of employees

(D) Current Transfers

remittances and other current transfers.

II. Capital and Financial Account

1. Capital Account
(A) Capital transfers
(B) Non-produced and Non-financial assets
2. Financial Account
(C) Direct Investment


Government and private transfers of fixed assets

and forgiveness of liabilities.
Land and subsoil assets, patents, copyrights,
trademarks, franchises.
External investments with lasting interest in

(D) Portfolio Investment

External investments in securities and financial


(E Other investment

External investments other than reserves, direct

and portfolio investments. For example, short- and
long-terms loans, trade credits, currency holdings
and deposits, other accounts receivable and

(F) Reserve Assets

Monetary gold, foreign exchange assets and other


Q) Explain the types of options, highlighting their pros and cons? June 2008 15Marks
There are various types of options available for trading in derivative securities. This article
explains how the put and call options work and also what the difference between American,
European and Asian types of options are
Options, like futures and forward contracts, are types of derivative contracts that allow you to
buy/sell an asset at a future date. They are called derivatives because the value of the option is

Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

derived from an underlying asset. Different types of options give the buyer the right, but not the
obligation to buy or sell the underlying asset at a predecided price on a future date. In contrast, a
futures contract forces the buyer/seller to carry out the transaction on the future date at the
specified price.
The option buyer pays a premium (option price) in order to get that right to decide whether or not
to conduct that transaction in the future.
Types of Options
Based on how they are exercised, options can be divided into two types
1. European Options:These are options that can be exercised only on the expiration date, not
before it. They are generally based on indices.
2. American Options:These are options that can be exercised at any time before or on the
expiration date. The holder of these options can use them whenever he sees fit, before the
settlement date. They are generally used for individual stocks.
3. Asian Options:Asian options are a type of exotic options. In these, the payoff price is
determined not by the spot price at the time of maturity, but by the average price over some period
of time before expiry. They are used in highly complex derivatives.
The key difference between American and European options relates to when the options can be

A European option may be exercised only at the expiry date of the option, i.e. at a single
pre-defined point in time.
An American option on the other hand may be exercised at any time before the expiry

For both, the pay-off - when it occurs - is via:

Max [ (S K), 0 ], for a call option
Max [ (K S), 0 ], for a put option:
(Where K is the Strike price and S is the spot price of the underlying asset)
Option contracts traded on futures exchanges are mainly American-style, whereas those traded
over-the-counter are mainly European.
Expiration date: American options expire the third Saturday of every month. They are closed for
trading the Friday prior. European options expire the Friday prior to the third Saturday of every
month. Therefore they are closed for trading the Thursday prior to the third Saturday of every
Difference in value: European options are typically valued using the Black-Scholes or Black
model formula. This is a simple equation with a closed-form solution that has become standard in
the financial community. There are no general formula for American options, but a choice of


Gundupagi Manjunath, Asst. Prof., SRN Adarsh College;

models to approximate the price are available (for example Whaley, binomial options model, and
others - there is no consensus on which is preferable).
An investor holding an American-style option and seeking optimal value will only exercise it
before maturity under certain circumstances. Any option has a non-negative time value and is
usually worth more unexercised. Owners who wish to realise the full value of their option will
mostly prefer to sell it on, rather than exercise it immediately, sacrificing the time value.
Where an American and a European option are otherwise identical (having the same strike price,
etc.), the American option will be worth at least as much as the European (which it entails). If it is
worth more, then the difference is a guide to the likelihood of early exercise. In practice, one can
calculate the Black-Scholes price of a European option that is equivalent to the American option
(except for the exercise dates of course). The difference between the two prices can then be used
to calibrate the more complex American option model.