CA.CS.CMA.MBA: Naveen.

Rohatgi

TYBMS: International Finance

Q1)THE LIABERALISED EXCHANGE RATE MANAGEMENT SYSTEM (LERMS):

In march 1992, India adopted a dual exchange rate system called LERMS (liberalized
exchange rate management system). In this system, exporters were required to sell 40% of all
export proceeds to the RBI at a fixed price. The balance component of 60% was permitted to
be sold at the market driven prices through the domestic foreign exchange market. This
system was introduced because the countrys foreign exchange reserves had depleted
substantially. The component of 40% sold to the RBI was used for purchase of essential
imports such as petro products, defence equipment, agro- product, etc. LERMS represents
the first step towards floating of INR which is a pre- condition for currency convertibility.
Q2) FOREIGN CURRENCY CONVERTIBLE BONDS
Convertible debenture bond (or convertible debenture) is a debt instrument that can be
converted into equity shares of the issuing company, usually at a pre specified ratio on a predecided future date. It is a hybrid security with both debt and equity features. Although it
normally has a low coupon rate, the holder/ investor is compensated with the right to convert
the bond into equity shares at a premium to the market value of the shares on the conversion
date.
From the issuers perspective, the benefit of raising money by selling convertible bonds is a
reduced cash interest payment since the debt gets converted to equity in future. However, in
exchange for the benefit of reduced interest cost, the value of shareholders equity is reduced
due to the capital dilution taking effect when bondholders equity is reduced due to the
capital dilution taking effect when bondholders convert their bonds into new shares.
Foreign currency convertible bonds (FCCBs) are debt instruments issued in a non- resident
currency that is in a currency other than the issuers domestic currency with an option to
covert them into shares of the issuer company. Its a quasi debt instrument to raise foreign
currency funds at beneficial rates. FCCB acts like a bond by making regular coupon and
principal payments; and also provides the bondholder an option to convert the bond into
shares.
Like any typical bond, convertible bonds have an issue size, issue date, maturity date,
maturity value, face value and coupon (interest rate). They also have the following additional
features:
Conversion price: The nominal price per share at which conversion takes place.

Conversion ratio: The number of shares each convertible bond converts into.

Call features: The right of the issuer to call a bond early for redemption, subject to
certain performance criteria.

Put features: The right of the investor to seek early for redemption, subject to certain
performance criteria.

ADVANTAGES
Low cost debt It allows the issuer to acquire long term financing at coupon rates less than
market rates)
Sales of equity at a premium Equity is sold at a premium to prevailing share price there
by minimizes dilution cost. (future appreciation is factored into conversion price)

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBMS: International Finance

Diversification of investor base Instruments are sold to a distinct non- equity specialist
investor base
Flexibility Instruments can be tailored to issuers needs.
Q3) FACTORS CONTRIBUTING TOWARDS GROWTH OF
EUROCURRENCY(OFFSHORE MARKET)/ Features of EURO CURRENCY MARKET
The decline in the US economy during the Vietnam War phase prompted the US administration
to introduce various regulation with a view to prevent outflow of capital and increase in domestic
interest rates. These regulations however, contributed to Euro- banks generating substantial
offshore business in US Dollars, because the Euro- Currency concept provided them with the
mechanism to provide banking facilities to their customers outside the regulatory environment in
the country of any particular currency. The factors which contributed to the growth of this market
were:
1 Regulation Q of the Federal Reserve Act which imposed a ceiling on interest rates that
could be given on deposits by banks in the US. This enabled European banks to attract
US Dollar deposits by offering better interest rates.
2

Regulation M of the Federal Reserve Act which stipulated reserves to be maintained

aginst deposits accepted by banks in the US. This increased the cost on deposits for banks
in USA which widened the spread between deposit and lending rates. This feature was
exploited by European banks, since they were not subject to reserve requirements on
Euro- Dollar deposits.

The mandatory requirement on all banks in the US to insure deposits accepted by them
from the public. The Euro- Currency market is unregulated which means Euro- Currency
deposits. This reduced their cost on deposits.

The interest equalization tax introduced by the US monetary authority in 1963 resulted in
increasing the effective cost of borrowing in the united states for non- resident entities.
They therefore approached the offshore market for their funding needs since Euro- banks
were not subject to the Interest Equalization Tax.

The voluntary restraint program was introduced in the US in 1965 in terms of which,
borrowing in the US for financing international projects was restricted. The US for banks
were discouraged from making loans to international borrowers. The guidelines were
replaced by mandatory restrictions on outbound direct investments in 1968. Effectively,
US Multinationals were also, now constrained to borrow in the offshore market for their
international projects.

Persons not resident in the US have unequal cash flows in USD. They acquire USD by
exporting to the Us and need the same to pay for imports from the US. At both times,
conversion into/ from domestic currency is involved. Such entities deposited their export
proceeds with Euro- bank and withdrew them when needed to pay for imports. It became

CA.CS.CMA.MBA: Naveen. Rohatgi

TYBMS: International Finance

possible for such entities to maintain foreign currency resources, without incurring
conversion cost, without exchange rate risk, earn the higher deposit rates available in the
Euro- Currency market and have the convenience of dealing with local banks.
These developments resulted in American depositors and borrowers undertaking banking
transaction in US Dollars outside the regulatory jurisdiction of the US monetary authority.
Although this market began with offshore banking transaction in US Dollars, it gradually
encompassed other major international currencies
Q4) An offshore bank is a bank located outside the country of residence of the depositor,
typically in a low-tax jurisdiction (or tax haven) that provides financial and legal advantages.
These advantages typically include:

greater privacy (see also bank secrecy, a principle born with the 1934 Swiss Banking Act)

little or no taxation (i.e. tax havens)

easy access to deposits (at least in terms of regulation)

protection against local, political, or financial instability

While the term originates from the Channel Islands being "offshore" from the United Kingdom,
and most offshore banks are located in island nations to this day,
Q5)Types of order in foreign exchange market.
Q6)What is arbitrage ? Explain geographical and triangular arbitrage.