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2 a.

Write a note on emerging challenges in the area of international finance
concerning a firm I-29 to 31 3 marks
• Emerging challenges:
• A firm as a dynamic entity has to continuously adapt to changes in its
operating environment and in its goals and strategy
• During 1980’s and 1990’s there was unprecedented environmental
changes for most of Indian firms
• Political uncertainties at home and abroad, economic liberalisation at
home, greater exposure to international markets, increase in
exchange rates and interest rates, increased competition, threat of
hostile takeover have forced firms to rethink their strategic posture
• 21st century saw even greater acceleration of environmental changes
and increase in uncertainties facing the firm
• As we approach WTO deadlines pertaining to removal of trade
barriers firms have to face even more competition at home and abroad
• Capital account convertibility of the rupee is expected any time
• Ceilings on foreign portfolio investment are being revised upwards
and barriers for foreign direct investment are being steadily lowered
• Indian banking sector is being opened up to significant increase in
foreign stake
• On the whole integration of India in the global economy is expected to
accelerate hence exposure of Indian firms to global financial markets is
certainly going to increase in future.

b. Write a note on foreign exchange exposure and risk II-6 to 12 7 marks

• Classification of foreign exchange exposure and risk:
• Firms around the world are aware that fluctuations in exchange rates
expose their revenues, costs, operating cash flows and hence their
market value to substantial fluctuations
• Firms which have cross-border transactions- exports and imports of
goods and services, foreign borrowing and lending, foreign portfolio
and direct investment are directly exposed
• Purely domestic firms which have no cross-border transactions are
also exposed because their customers, suppliers and competitors are
exposed

• An unanticipated change in the exchange rate has an impact-favorable or adverse-on its cash flows which is known as transactions exposures • The foreign currency values of assets and liabilities are contractually fixed they do not vary with exchange rate. • Two Important points. which are settled within in an year. • 2. operating cash flows are affected • The other short-term exposure is known as translation exposure also called accounting exposure • A firm may have assets and liabilities denominated in a foreign currency . transactions exposure usually have short time horizons. • 1. export receivables etc. interest payable on foreign currency loans. accounting exposure and operating exposure • Consider a Firm that has certain contractually fixed payments and receipts in foreign currency as import payables..• Efforts are devoted to identify and categorize currency exposure and developing methods to quantify it • In currency exposure. firms are faced with two types of exposures in short term viz.. hence also called as contractual exposure • Transaction risk can be defined as a measure of variability in the value of assets and liabilities when they are liquidated.

consumer finance is disappearing and ‘everybody does everything’ . Europe and Japan are being tapped by non-resident borrowers • Non resident investment banks are allowed to access national bond and stock markets • In addition to geographical integration across markets. investment banking. the transaction exposure has impact on cash flows and translation exposure has no direct effect on cash flows • Accounting treatment of transaction and translation exposure: • The transaction and translation exposure give rise to exchange gains and losses. real or notional c Write a note on recent changes in the global financial markets I-37 to 46 10 marks Recent changes in global financial markets: • 1980’s witnessed unprecedented changes in financial markets around the world • The emergence of Euromarkets in 1960’s which were free from regulations. led to internationalization of banking business • These markets grew in 70’s and pioneered a number of innovative funding techniques • The outstanding feature of changes during 1980’s was integration • The boundaries between national markets and those between national and offshore markets blurred leading to emergence of global unified financial market • Banks in major industrialized countries have increased their presence in each other countries • Major markets such as US. there has been a strong trend towards functional unification across various types of FIs within individual markets • The traditional segmentation between commercial banking. • These are not going to be liquidated in foreseeable future • Accounting standards require the firm must translate these values into home currency and report in balance sheet • Translation risk is the related measure of variability • The key difference is that.

Germany. UK and Japan (US. a number of non-resident firms are listed on major stock exchanges like New York and London • Liberalisation and deregulation has led competition with in financial service industry. Holland were already free from most controls) • Withholding taxes on interest paid to non-residents were removed. Permitting foreign FIs to enter national markets and compete on an equal footing with domestic institutions in offering services to borrowers and investors • Because of liberalisation and deregulation. assets denominated in various currencies became nearly substitutable • Investors could optimise their portfolios considering estimates of return. Spreads on loans. eliminating the segmentation of markets for financial services with specialised services and fostering greater competition such as abolition of fixed brokerage charges. Switzerland.• The driving force behind this functional integration were i. underwriting commission. swaps. futures and their innumerable combinations comes from both demand side and supply side .. domestic financial markets were opened to foreign borrowers and domestic borrowers were allowed access to foreign financial markets • Thus in the portfolios of investors around the world. and fees of various kinds have become thin • The attainment of the Economic and Monetary Union (EMUabout 12 countries same currency) and birth of Euro at end of 1990’s have led to emergence of large capital market competing with US financial markets which is provider of capital to firms and governments around the world • The financial innovations from last 15 years resulted in options. liberalisation in cross-border transactions and ii. risk and their own risk preferences • Borrowers could optimise their liability portfolios considering estimates of funding costs. breaking up bank cartels etc. Deregulation within the financial systems of major industrial nations • The most significant liberalisation measure was lifting exchange controls in France. • ii. interest rate and exchange rate risks and their risk preferences • Deregulation involved action on two fronts • i.

9 to 11 7 marks • Accounting principles in Balance of Payments (BOP): • The BOP is a standard double entry accounting record and as such is subject to all the rules of double entry book keeping • Viz.. • Many of these new products are not even understood by the bankers themselves • Liberalisation and deregulation are ongoing process giving rise to re- composition of some controls and barriers to cross border capital movements • The quality and rigor of banking system in many developing countries needs improvement • US and most Europe have more or less free financial markets 5. one credit (+) and one debit (-) and leaving aside errors and omissions. These assets are used by monetary authority of the country to settle the deficit and surplus that arise on the other two categories taken together • Reserve assets are financial assets acceptable as a means of payment in international transactions and are held by and exchanged between the monetary authorities of trading countries.13 3 marks • The BOP is a collection of accounts conventionally grouped into three main categories with subdivisions in each.reserve account: in principle this is capital account. Explain the components of balance of payments III-12. Explain Accounting principles in Balance of Payments (BOP) III. • 1. capital account: transactions leading to changes in foreign financial assets and liabilities of the country are included • 3. current account: imports and exports of goods and services and unilateral transfer of goods and services are included • 2. assets denominated in foreign currencies. • They consist of monetary gold*. a. special rights and reserve positions in the IMF • Deficits and surpluses on the other two categories lead to decumulation and accumulation of reserves respectively b. the total credits must exactly match total of debits . for every transactions two entries must be made. However only “reserve assets” are included in this category.

BOP figures indicate excess demand or supply of currency and possible impact on exchange rate • Taken in conjunction with past data they confirm or indicate a reversal of perceived trends • They may signal a policy shift on the part of monetary authorities of the country. or tighten credit and money supply and make it difficult to borrow money to make investments abroad • It may force exporters to realize export earnings quickly and bring home foreign currency • Movements in a country’s reserves have implications for the stock of money and credit circulating in the economy . Write a note on importance of BOP statistics III. unilaterally or in concert with trading partners • For instance a country facing a current account deficit may rise interest rates to attract short-term capital inflows to prevent depreciation of its currency.. in most cases. the average exchange rate for the month is used • The two sides of transaction are to be recorded in the same period of time • For this purpose conventions have been established such as: • Exports are recorded when cleared by customs • Imports are recorded when payment is made etc. • That is balance of payment must ‘balance’ • Valuation and timing: • IMF recommends the use of “market prices” i. c. where they are two independent parties • IMF recommends FOB price for valuation • In India exports are valued on FOB and imports on CIF basis • Theoretically exchange rates prevailing at the time of transaction to be used. for transactions during a a particular month.39 to 42 10 marks • Importance of BOP statistics: • In BOP deficits or surpluses may have an immediate impact on the exchange rate • BOP records all transactions that create demand for and supply of a currency • When exchange rates are market determined. price paid by the ‘willing buyer’ to a ‘willing seller’..e. however in practice.

we have forward- forward swap • Thus a 1-3 month dollar-sterling swap will consist of purchase (sale) of sterling versus dollar one month forward coupled with a sale (purchase) of sterling versus dollar three months forward. Describe swap transaction. delivery can be 73 days from the date of transaction • Such contracts are called “broken date” or “odd date “ contracts • For some currency pairs forward contracts extending to five years are available b. . a.. outright forward contract. forward-forward swap. in foreign exchange market IV-64 to 67 7marks • A swap transaction in the foreign exchange market is a combination of a spot and a forward in the opposite direction • Thus a bank will buy Euros against US dollar and simultaneously enter into a forward transaction with the same counterparty to sell Euros against US dollar • A spot 60-day Dollar-Euro swap consist of a spot purchase (sale) of dollars against the Euro coupled with a 60-day forward sale (purchase) of dollar against Euro • When both the transactions are forward transactions. Explain “broken date” or “odd date “ contracts IV.64 3 marks • Though standard forward maturities are in a whole number of months. which in turn will affect the exchange rates and interest rates in the country 10. banks routinely offer forward contracts for maturities which are not whole months • For ex. • Central bank’s purchases of foreign exchange in the market will add to the money supply and vice versa unless the central bank “sterlises” the impact by compensatory actions such as open market sales and purchases • Countries suffering from chronic deficit may find their credit ratings being down graded • Finally BOP accounts are intimately connected with over all saving- investment balance in a country’s national account • Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalance.

banks in the countries of the two currencies involved must be open for business • The relevant countries are called settlement locations • The locations of the banks involved in the trade are dealing locations which need not be the same as settlement locations • Thus a London bank can sell Swiss francs against US dollar to a Paris bank • Settlement locations may be New York and Geneva. foreign exchange transaction can be categorised into spot and forward transactions • A third category called swaps are combination of a spot and a forward transaction (or forward-forward swap i.. Write a note on Types of transactions and settlement dates IV-53 to 63 10 marks • Types of transactions and settlement dates: • The settlement of a transaction takes place by transfer of deposits between the two parties • The day on which these transfers are effected is called settlement date or the value date • To effect the transfers. while dealing locations are London and Paris • The transaction can be settled only on a day on which both US and Swiss banks are open • Depending upon the time elapsed between the transaction date and the settlement date. a combination of two forward transactions) • In a spot transaction the settlement or value date is usually two business days ahead for European currencies and Asian currencies traded against dollar . • Forward contracts without an accompanying spot deal are know as “outright forward contracts” to distinguish them from swaps • It s estimated that about 40% of the turnover in the market is in the spot segment.. 50% in swaps and the rest in outright forward contracts • Outright forwards are most often used by corporations to cover their transactions exposures c.e. • As the term “swap” implies. it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date.

if the following Wednesday happens to be a bank holiday in either Japan or US.. while deals done on Friday will have Tuesday of the following week as the value date if. both transfers should take place on the same day • In Dollar-Yen trade between the London and Paris banks done on Monday. deals done on a Thursday will be cleared on the following Monday.• Thus if a London bank sells yen against dollar to a Paris bank on Monday. settlement day is again postponed to Thursday • What if Tuesday is holiday in UK but not in France? • Then “two business days” would mean Wednesday for the Paris bank but Thursday for London Bank • In such cases the normal practice is.e. the rate of exchange is fixed on the transaction date. London bank called for a quote. the London bank will turn over a yen deposit to the Paris bank on Wednesday and the Paris bank will transfer a dollar deposit to the London bank on the same day • If SBI sells dollars against Rupee to HDFC bank on a Tuesday. if the Paris bank “made the market” i. the value date is shifted to the next available business day. on the following Thursday SBI will turn over a dollar deposit to HDFC and HDFC will turn over a Rupee deposit to SBI • The time gap is necessary for conforming and clearing the deal through the communication network such as SWIFT (note that by the two business days ahead rule. in this case Thursday • What about holidays in the dealing location? If Wednesday is a holiday in either UK or France. the value date would be Wednesday while if London made the market it would be Thursday • The settlement is reduced to one day for trades between currency pairs such as US dollar and Canadian dollar and US dollar and Mexican Peso • Value dates for forward transactions: in a 1-month (or 30 days) forward purchase of say pounds against rupees. the value date is arrived as follows: • First find the value date for a spot transaction between the same currencies done on the same day and add one calendar month to arrive at the value date ..e. Saturday and Sunday are bank holidays as they are in most financial centers) • To reduce credit rate risk (i. one of the parties failing to deliver on its side of the trade).

• Ex. 9 and 12 months • The value dates are obtained by adding the relevant number of calendar months to the appropriate spot value date • If the value date arrived at in such a manner is ineligible because of bank holidays. spot date is November 28. banks routinely offer forward contracts for maturities which are not whole months • For ex. one business day ahead when a spot deal would be settled two business days later b. it must be rolled back to February 27 • Though standard forward maturities are in a whole number of months.67 3 marks • Short date transactions are transactions which call for settlement before the spot date • “cash” transactions are for settlement same date while some deals will involve settlements “tomorrow” i. • Standard forward contract maturities are 1 week.. delivery can be 73 days from the date of transaction • Such contracts are called “broken date” or “odd date “ contracts • For some currency pairs forward contracts extending to five years are available 11. a. 1. the corresponding spot value date is June 22 and one month forward value date is July 22. 2 weeks. Explain short date transactions IV. government interventions and speculation IV- 47 to 52 7 marks • Finally there are price takers who take the prices quoted by primary makers and buy or sell currencies for their own purposes but do not make a market themselves .e. 6. 3. in which case you must shift backward. Discuss price takers. two months forward would be August 22 etc. 3. if February 28 is holiday (not a leap year). then like in spot deal it is shifted forward to the next eligible business day • Important difference... Suppose 3-month forward contract struck on November 26. • Thus for a one month forward transaction entered into on say June 20.months takes you to February 28. roll forward must not take you into the next calendar month.

9810 per EUR is direct quote in US • Indirect quotes: indirect or reciprocal quotes are stated as number of units of a foreign currency per unit of home currency • thus USD 2. conversion of export receipts.4575 per CHF. MEP: Mexican Peso • CAD: Canadian Dollar. CHF 1.3542 per GBP • Direct quotes: are those that give units of the currency of that country per unit of a foreign currency • Thus INR 46. • Corporations use the foreign exchange market for a variety of purposes related to their operations • Among these are payments for imports. Discuss Exchange rate quotations and arbitrage IV.70 to 80 10 marks • Codes of selected currencies given below: • USD: US dollar . hedging of receivables and payables. INR 46.75 per USD (CHF=swiss franc) • American Terms: quotes given as number of US dollars per unit of currency • Thus USD 0. NZD:New Zealand Dollar • EUR: Euro • IEP: Irish Pound (Punt) Spot Rate Quotations: • European Terms: quotes given as number of units of a currency per US Dollar. payment of interest on foreign currency loans.00 per USD is direct quote in India. USD 1. USD 0..2560 per INR 100 is an indirect quote in India (note unit for rupee is 100). AUD: Australian dollar • JPY: Japanese Yen . similarly Japanese Yen. SAR: Saudi Riyal • SEK: Swedish Kroner • INR: Indian rupee.4500 per USD. CHF: Swiss Franc • GBP: British pound . placement of surplus funds etc. Indonesian Rupiah may be in terms of 100 (reason is other wise we have to deal with small numbers) • The inter-bank market uses quotation conventions adopted by Association Cambiste International . • Thus EUR 1. c.0275 per USD.

quotation are given in European terms i.e.Swiss Franc • GBP/JPY: Great Britain Pound – Japanese Yen • The first currency in the pair is the “base” currency. the one on the right is the “ask” or “offer” price • The bid price is the price at which the dealer is giving the quote is prepared to buy-is “bidding for” one unit of the base currency against the quoted currency • In other words it is the amount of quoted currency the dealer will give in return for one unit of the base currency • For most currencies.4550/1. Swiss Franc is the quoted currency. • The exchange rate quotation is given in number of units of the quoted currency per unit of the base currency • Thus a USD/INR quotation will be given as a number of rupees per dollar.0050 CHF . the base currency is the US dollar • The major exception are EUR.e..4560 the last two digits viz “50” correspond to 0. a “cross rate” or just a “cross” is a quotation between two non-dollar currencies • Thus GBP/CHF is a “cross rate” and so is EUR/INR • In the US financial press gives quotations in both European and American terms • Quotations in interbank markets are usually given up to five or six significant digits or four decimal places • The last digit thus corresponds to (1/100)th of (1/100)th unit of the quoted currency • Thus in USD/CHF bid rate 1. a GBP/USD quote will be given as number of dollars per pound • A quotation consists of two prices • the price shown on the left of the oblique or hyphen is the “bid” price. USD/CHF: US Dollar. USD becomes the quoted currency against these • In market parlance.• The currency pair is denoted by three letter SWIFT (Society for Worldwide International Financial Telecommunication) codes for the two currencies separated by oblique or hyphen • Ex.. US Dollar is the base currency. the second is the “quoted” currency • Thus in USD/CHF. • These are quoted in American terms i. AUD and NZD. GBP.

4550/60 • When two dealers are conversing with each other this may be further shortened to 50/60 • The first three digits viz.4575 per CHF.01 or (1/100) of the quoted currency • The quotations are usually shortened as follows: • USD/CHF:1.4560 given as 1.45 are known as “big figure” and professional dealers are supposed to know what the big figure is at all times • GBP/USD: 1.5365/72 means 1. USD 0.00 per USD is direct quote in India.0275 per USD..3542 per GBP • Direct quotes: are those that give units of the currency of that country per unit of a foreign currency • Thus INR 46.5365/1.71. a.9810 per EUR is direct quote in US • Indirect quotes: indirect or reciprocal quotes are stated as number of units of a foreign currency per unit of home currency .4550/1.75 per USD (CHF=swiss franc) • American Terms: quotes given as number of US dollars per unit of currency • Thus USD 0. we say USD has moved three pips • For small denominations currencies like JPY quotes are given up to 2 decimals only • In such cases a point or pip has the value 0.5372 • This may further abbreviated to “65/72” • Remember offer rate must always exceed bid rate 12.72 3 marks Spot Rate Quotations: • European Terms: quotes given as number of units of a currency per US Dollar. USD 1. • Thus EUR 1. • The last two digits are called “points” or “pips” • The difference between the offer rate and the bid rate is called the “bid- offer spread” or the “bid-ask spread” • We say the bid –ask spread in USD/CHF rate is ten points or ten pips • If the USD/CHF rate moves to 1. Explain spot rate quotations IV.4553/63. INR 46. CHF 1.4500 per USD. 1.

1595 • Means.2560 per INR 100 is an indirect quote in India (note unit for rupee is 100).5685 • GBP/USD 1-month forward: 1.5677/1. Discuss forward quotations IV-90 to 94 7 marks • Forward quotations: • Outright Forwards: quotations for outright forward transactions are given in the same manner as spot quotations • Thus quote like. (SEK=Swidish Krone) • USD/SEK 3-month Forward.5681) x 12months x 100 % / 1. as in the case of a similar spot quote.5585 • The pound is cheaper for delivery one month hence compared to spot pound • The pound is said to be at a forward discount in relation to dollar or equivalently. similarly Japanese Yen. • NOTE: This usage is not universal . delivery 3 months from the corresponding spot value date • Discounts and premiums in the forward market: consider the following pair of spot and forward quotes: • GBP/USD spot : 1.73% • With this definition.5580-1.1595 to sell a dollar. the dollar is at a forward premium in relation to the pound • With two-way quotations there is no unique way to quantify the discount or premium • Let us define the annualized percentage discount on the pound implied in the above quotations as: • [forward (GBP/USD)mid.9.1570 to buy a USD and require SEK 9.• thus USD 2. for any quotation (A/B).1570/9.5575/1.5681= • = ( -)7.Spot(GBP/USD)mid x 12 x 100/ Spot(GBP/USD)mid • (1. Indonesian Rupiah may be in terms of 100 (reason is other wise we have to deal with small numbers) b. a negative answer would indicate that currency B is at a forward premium vis-à-vis currency A whereas a positive answer would imply that B is at a forward discount against A • The practitioners terminology may differ across markets • When dealer says “GBP on USD is at a premium” it is usually interpreted to mean that the USD is at premium. the bank will give SEK 9.

on Eurosterling deposits of maturity n years • iUSD: Annualised interest rate.• Option forwards • a standard forward contract calls for delivery on a specific day. invest the S dollars in n-Eurodollar deposit will have grown to $[(S)(1+niUSD)] • 3. banks offer what are know as optional forward contracts or option forwards • Here the contract is entered into at some time t0 .10(90/360)] at the end of 90 days • For some currencies.2. stated as a fraction. convert sterling into dollars spot.3 months) • iGBP=Annualised interest rate. at maturity the value will be = GBP(1+niGBP) • If the investor chooses to invest in Eurodollar and eliminate all exchange risk he must do the following: • 1. 1/6. ¼ etc. for 1. stated as a fraction. Eurodollar n-year deposits • If the investor puts GBP 1 in a n-year Eurosterling deposit.. with the rate and quantities being fixed at this time but buyer has option to take or make delivery on any day between t1 and t2 with t2>t1>t0 c. Each sterling sold will give S dollars • 2. • In the inter-bank market. the settlement date for the contract. simultaneously enter into a n-year forward contract to sell the dollar proceeds of the deposit for sterling . the basis is 365 and not 360 (for Euro dollar it is 360) • Consider a Britisher who is choosing between Eurodollar deposits and Eurosterling deposit to place some surplus funds • The investor does not want to incur any exchange rate risk • To begin with we will assume there are no transaction costs • This means that in foreign exchange market there are no bid-ask spreads and in the money market there is no difference between borrowing and lending rates • We use following notation: • S: the GBP/USD spot rate • Fn: the GBP/USD forward rate for n-year maturity (n=1/12. Write a note covered interest arbitrage V-2 to 10 10 marks • Covered Interest Arbitrage: • All interest rates in Euromarkets are given as “annualised” rates and interest calculations are done on as simple interest basis • Thus an interest rate of 10% on 90-day Euro dollar deposit means that $1 put in such deposit gives $[1+0.

would fall • 4. S would increase • 3.. dollar would rise against the sterling in the n-year forward market i. the dollar interest iUSD will tend to rise • 2. the Eurosterling interest rate iGBP. and there are no restrictions on funds flow a large number of arbitragers would want to: • 1. • There are no riskless arbitrage profits to be had • This is the famous Covered Interest Parity Theorem . Fn would fall • these changes would continue till eqn-y hold equality • In reverse case i. Enter into forward contracts to sell the sterling in their deposit accounts against dollars • The resulting market forces give rise to one or more of the following: • 1. covered investment in either currency would give the same return. which sold forward at Fn dollar per GBP yields the maturity value in sterling • Suppose these are unequal.eqn.• For sterling invested in this fashion. specifically suppose • (1+niGBP)>(S/Fn)(1+niUSD) ----.e. y • Then British investor would find it profitable to invest in Eurosterling • Not only that. dollar will tend to depreciate against sterling in the spot market i. sell dollars and buy sterling in the spot market • 3. S(1+niUSD) is the maturity value of the dollars... [(1+ni GBP) (Fn/S)] > (1+niUSD)]----eqn. x • ie.e. all investors would find it profitable to liquidate dollar deposits or borrow dollars and invest in Euro sterling with forward cover • To see this in Eurodollar deposit gives $(1+ni USD) at maturity while the same dollar invested on a covered basis in Eurosterling deposit gives $[(1/S)(1+niGBP)(Fn)] • If Eqn y holds the Eurosterling exceeds • If the rates are such that eqn.y holds. invest sterling so acquired in Eurosterling deposits • 4. the maturity value is: GBP[(S)(1+niUSD)/(Fn)] • S=amount of dollars obtained by converting GBP 1 spot.. liquidate dollar deposits or borrow dollars • 2. if (1+niGBP)<(S/Fn)(1+niUSD) • Then covered investment in Eurodollar is more attractive and opposite forces will be initiated till again equality is stored • Thus in efficient markets..e.