2018

1. Critically evaluate purchasing power parity theory.

Ans. https://www.slideshare.net/DrMohamedKuttyKakkakunnan/purchasing-power-parity-
theory

2. What is future contract? Explain the salient features of future contract.

Ans. Futures contracts are similar to forward contracts, where two parties agree to buy or sell an
underlying asset at a predetermined price on a pre-specified date.

The six major features of futures contracts. The features are: 1. Organized Exchanges 2.
Standardization 3. Clearing House 4. Margins 5. Marking to Market 6. Actual Delivery is Rare.

Feature # 1. Organised Exchanges:

Unlike forward contracts which are traded in an over-the-counter market, futures are traded on
organised exchanges with a designated physical location where trading takes place. This provides
a ready, liquid market in which futures can be bought and sold at any time like in a stock market.

Feature # 2. Standardisation:
In the case of forward currency contracts, the amount of commodity to be delivered and the
maturity date are negotiated between the buyer and seller and can be tailor-made to buyer’s
requirements. In a futures contract, both these are standardised by the exchange on which the
contract is traded.

Feature # 3. Clearing House:

The exchange acts as a clearing house to all contracts struck on the trading floor. For instance, a
contract is struck between A and B. Upon entering into the records of the exchange, this is
immediately replaced by two contracts, one between A and the clearing house and another
between B and the clearing house.

In other words, the exchange interposes itself in every contract and deal, where it is a buyer to
every seller and a seller to every buyer. The advantage of this is that A and B do not have to
undertake any exercise to investigate each other’s creditworthiness. It also guarantees the
financial integrity of the market.

Feature # 4. Margins:
Like all exchanges, only members are allowed to trade in futures contracts on the exchange.
Others can use the services of the members as brokers to use this instrument. Thus, an exchange
member can trade on his own account as well as on behalf of a client. A subset of the members

1
is the “clearing members” or members of the clearing house and non- clearing members must
clear all their transactions through a clearing member.

The exchange requires that a margin must be deposited with the clearing house by a member
who enters into a futures contract. The amount of the margin is generally between 2.5% to 10%
of the value of the contract but can vary. A member acting on behalf of a client, in turn, requires
a margin from the client. The margin can be in the form of cash or securities like treasury bills or
bank letters of credit.

Feature # 5. Marking to Market:

The exchange uses a system called marking to market where, at the end of each trading session,
all outstanding contracts are reprised at the settlement price of that trading session. This would
mean that some participants would make a loss while others would stand to gain. The exchange
adjusts this by debiting the margin accounts of those members who made a loss and crediting
the accounts of those members who have gained.

This feature of futures trading creates an important difference between forward contracts and
futures. In a forward contract, gains or losses arise only on maturity. There are no intermediate
cash flows.

Whereas, in a futures contract, even though the gains and losses are the same, the time profile
of the accruals is different. In other words, the total gains or loss over the entire period is broken
up into a daily series of gains and losses, which clearly has a different present value.

Feature # 6. Actual Delivery is Rare:

In most forward contracts, the commodity is actually delivered by the seller and is accepted by
the buyer. Forward contracts are entered into for acquiring or disposing off a commodity in the
future for a gain at a price known today.

In contrast to this, in most futures markets, actual delivery takes place in less than one per cent
of the contracts traded. Futures are used as a device to hedge against price risk and as a way of
betting against price movements rather than a means of physical acquisition of the underlying
asset. To achieve this, most of the contracts entered into are nullified by a matching contract in
the opposite direction before maturity of the first.

3. Why the fixed rate system was replaced by the floating exchange rate exchange?

Ans. More than $5 trillion is traded in the currency markets on a daily basis, as of 2018. An
exchange rate is the rate at which one currency can be exchanged for another. In other words, it
is the value of another country's currency compared to that of your own. If you are traveling to

2
another country, you need to "buy" the local currency. Just like the price of any asset, the
exchange rate is the price at which you can buy that currency.

 Floating Rates:

Unlike the fixed rate, a floating exchange rate is determined by the private market through
supply and demand. A floating rate is often termed "self-correcting," as any differences in
supply and demand will automatically be corrected in the market. Look at this simplified
model: if demand for a currency is low, its value will decrease, thus making imported goods
more expensive and stimulating demand for local goods and services. This, in turn, will
generate more jobs, causing an auto-correction in the market. A floating exchange rate is
constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also
influence changes in the exchange rate. Sometimes, when a local currency reflects its true
value against its pegged currency, a "black market" (which is more reflective of actual supply
and demand) may develop. A central bank will often then be forced to revalue or devalue the
official rate so that the rate is in line with the unofficial one, thereby halting the activity of
the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure
stability and to avoid inflation. However, it is less often that the central bank of a floating
regime will interfere.

 Fixed Rate:

A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the
official exchange rate. A set price will be determined against a major world currency (usually
the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of
currencies). In order to maintain the local exchange rate, the central bank buys and sells its
own currency on the foreign exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a single unit of local currency is equal to
US$3, the central bank will have to ensure that it can supply the market with those dollars. In
order to maintain the rate, the central bank must keep a high level of foreign reserves. This
is a reserved amount of foreign currency held by the central bank that it can use to release
(or absorb) extra funds into (or out of) the market.

Key Differences
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment.
With a peg, the investor will always know what his or her investment's value is and will not have
to worry about daily fluctuations.

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4. What do you understand by foreign exchange risk? What are the different external exposure
management techniques which are used by importers and exporters?

Ans. Foreign exchange risk describes the risk that an investment’s value may change due to
changes in the value of two different currencies. It is also known as currency risk, FX risk and
exchange-rate risk.

Foreign exchange risk sometimes also refers to risk an investor faces when they need to close
out a long or short position in a foreign currency and do so at a loss due to fluctuations in
exchange rates. Some types of exposure associated with foreign exchange risk include economic
exposure, translation exposure and contingent exposure.

Foreign exchange risk most often affects businesses engaged in exporting and importing products
or supplies. It also applies to businesses that offer services in multiple countries and individuals
who invest internationally.

Any time an investor must convert money into another currency to make an investment, that
face potential changes in the currency exchange rate between their home currency and the
currency of their investment. These changes will affect the investment's value or the business’
bottom line.

For example, an American liquor company signs a contract to sell a French retailer 100 cases of
whiskey for a 50 euros per case, or 5,000 euros total. The American company agrees to this
contract at a time when the euro and the dollar are of equal value. Thus, the American company
expects that when they deliver the whiskey, the agreed upon payment of 5,000 euros will equal
roughly $5,000.

However, it may take a few months for the whiskey company to deliver the goods. In the
meantime, Europe undergoes an economic crisis and the value of the euro goes down sharply.
By the time the whiskey is delivered, one euro is worth only $.75. Thus, though the French
company still pays the agreed upon 5,000 euros, that amount is now equal to only $3,750.

Exposure management techniques:

http://www.businessmanagementideas.com/foreign-exchange-2/risk-foreign-exchange-
2/techniques-to-manage-foreign-exchange-risk-forex-management/16844

5. Differentiate between accounting exposure and economic exposure. Discuss the principal
translation methods of “Foreign subsidiaries accounts”.

Ans. Accounting exposure is the exposure to exchange gains and losses resulting from translating
foreign-currency-denominated financial statements into U.S. dollars. Basically, it is the result of

4
translating various items at different exchange rates and usually does not affect cash flows. For
example, if a building was purchased by long-term debt and the building was translated at
historical exchange rates while the debt was translated at current exchange rates, accounting
exposure would equal the amount of the difference. If both were translated at current exchange
rates, there would not be an accounting exposure. Economic exposure is the exposure to cash
flow changes resulting from dealings in foreign-currency-denominated transactions and
commitments, e.g., the necessity to use more U.S. dollars to settle a foreign-currency-
denominated debt.

Translation methods:

A firm's translation exposure is the extent to which its financial reporting is affected by exchange
rate movements. As all companies generally must prepare consolidated financial statements for
reporting purposes, the consolidation process for multinationals entails translating foreign assets
and liabilities or the financial statements of foreign subsidiaries from foreign to domestic
currency. While translation exposure may not affect a firm's cash flows, it could have a
noteworthy impact on a firm's reported earnings and therefore its stock price. Translation
exposure is distinguished from transaction risk as a result of income and losses from various types
of risk having different accounting treatments.

6. Discuss the role and functions of IFM.

Ans. https://www.slideshare.net/shibapmohanty/role-and-function-of-imf

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation has been made, the capital
structure has to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

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4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision has to be made by the finance manager. This
can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits
like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

7. Distinguish between currency trading and currency arbitrage.

Ans. https://www.investopedia.com/ask/answers/12/arbitrage-speculation-difference.asp

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2017

1. State the function of IMF.

Ans. http://www.yourarticlelibrary.com/international-trade/international-monetary-fund/top-
10-functions-of-international-monetary-fund-imf/63295

2. Discuss the impact of BOP and inflation on exchange rate.

Ans.

 BOP: A change in a country's balance of payments can cause fluctuations in the exchange
rate between its currency and foreign currencies. The reverse is also true when a fluctuation
in relative currency strength can alter the balance of payments. There are two different and
interrelated markets at work: the market for all financial transactions on the international
market (balance of payments) and the supply and demand for a specific currency (exchange
rate)

These conditions only exist under a free or floating exchange rate regime. The balance of
payments does not impact the exchange rate in a fixed-rate system because central
banks adjust currency flows to offset the international exchange of funds.

The world has not operated under any single rules-based or fixed exchange-rate system since
the end of Bretton Woods in the 1970s.

To explain further, suppose a consumer in France wants to purchase goods from an American
company. The American company is not likely to accept euros as payment; it wants U.S.
dollars. Somehow the French consumer needs to purchase dollars (ostensibly by selling euros
in the forex market) and exchange them for the American product. Today, most of these
exchanges are automated through an intermediary so that the individual consumer doesn't
have to enter the forex market to make an online purchase. After the trade is made, it is
recorded in the current account portion of the balance of payments.

 Inflation: Inflation not only creates problems within the economy, but also in the sphere of
external trade of a country, that is, country’s trade balances with the rest of the World.
Exchange rate of a currency, among other factors, is influenced by the domestic inflation.
Under flexible exchange rate system, though the exchange rate is determined by the demand
and supply of the currency, what operates from behind the demand and supply are the
factors like inflation.

Though India was part of the fixed exchange rate regime that prevailed in the post-world war
II period, it had to devalue its currency thrice in the post-independence period, largely owing
to the downward pressure exerted on it by the factors like high domestic inflation. To
understand the impact of domestic inflation on the exchange rate of rupee, one has to see

7
 what happens to the real effective exchange rate (REER), which is calculated as a weighted
average of nominal exchange rates adjusted for relative price differential between the
domestic and foreign countries. Real effective exchange rate is constructed as a weighted
index using export-based weights or trade-based weights for six countries and thirty-six
countries.

3. Explain the concept of parallel loans and currency swaps.

Ans.

 A parallel loan is a four-party agreement in which two parent companies in different

countries borrow money in their local currencies, then lend that money to the other's local
subsidiary.

The purpose of a parallel loan is to avoid borrowing money across country lines with possible
restrictions and fees. Each company can certainly go directly to the foreign exchange
market (forex) to secure their funds in the proper currency, but they then would
face exchange risk.

The first parallel loans were implemented in the 1970s in the United Kingdom in order to
bypass taxes that were imposed to make foreign investments more expensive.
Nowadays, currency swaps have mostly replaced this strategy, which is similar to a back-to-
back loan.

Example: For example, say an Indian company has a subsidiary in the United Kingdom and a
U.K. firm has a subsidiary in India. Each firm's subsidiary needs the equivalent of 10 million
British pounds to finance its operations and investments. Rather than each company
borrowing in its home currency and then converting the funds into the other currency, the
two parent firms enter into a parallel loan agreement.

The Indian company borrows 909,758,269 rupees (the equivalent of 10 million pounds) from
a local bank. At the same time, the British company borrows 10 million pounds from its local
bank. They each then loan the money to the other's subsidiaries, agreeing on a defined period
of time and interest rate (most loans of this type come due within 10 years). At the end of
the term of the loans, the money is repaid with interest, and the parent companies repay that
money to their home banks. No exchange from one currency to the other was needed and,
therefore, neither the two subsidiaries nor their parent firms were exposed to currency risk
due to fluctuations in the rupee/pound exchange rate.

 A currency swap is an agreement in which two parties exchange the principal amount of a
loan and the interest in one currency for the principal and interest in another currency. At
the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

8
Examples of Currency Swaps:
Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan.
On trade date, Company A exchanges $100 million USD with Company B in return for 74 million
pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD).

During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for
USD six-month LIBOR.

The USD interest is calculated on $100 million USD, while the GBP interest payments are
computed on the 74-million-pound amount.

At maturity, the notional dollar amounts are exchanged again. Company A receives their original
$100 million USD and Company B receives 74 million pounds.

Company A and B might engage in such a deal for a number of reasons. One possible reason is
the company with US cash needs British pounds to fund a new operation in Britain, and the British
company needs funds for an operation in the US. The two firms seek each other and come to an
agreement where they both get the cash they want without having to go to a bank to get loan,
which would increase their debt load. As mentioned, currency swaps don't need to appear on a
company's balance sheet, whereas taking a loan would.

4. Compare and contrast GDR and ADR.

Ans. https://keydifferences.com/difference-between-adr-and-gdr.html

5. Explain how a firm can manage its economic exposure.

Ans. https://efinancemanagement.com/international-financial-management/economic-
exposure

6. Critically review the explanations offered for the emergence and popularity of financial
swap.

Ans.

9
2016

1. What are the reasons for MNC’s to expand internationally.

Ans. http://choosewashingtonstate.com/wp-
content/uploads/2013/06/10_Reasons_to_go_International.pdf

2. Why should a finance manager study BOP of a country.

Ans. https://www.coursehero.com/file/21287418/Balance-of-payments/

3. Give an overview of foreign exchange market.

Ans. The foreign exchange market is an over-the-counter (OTC) marketplace that determines the
exchange rate for global currencies. Participants are able to buy, sell, exchange and speculate on
currencies. Foreign exchange markets are made up of banks, forex dealers, commercial
companies, central banks, investment management firms, hedge funds, retail forex dealers and
investors.

The foreign exchange market – also called forex, FX, or currency market – was one of the original
financial markets formed to bring structure to the burgeoning global economy. In terms of
trading volume it is, by far, the largest financial market in the world. Aside from providing a venue
for the buying, selling, exchanging and speculation of currencies, the forex market also enables
currency conversion for international trade settlements and investments. According to the Bank
for International Settlements (BIS), which is owned by central banks, trading in foreign exchange
markets averaged $5.1 trillion per day in April 2016.

Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative
to the value of the other. This determines how much of country A's currency country B can buy,
and vice versa. Establishing this relationship (price) for the global markets is the main function of
the foreign exchange market. This also greatly enhances liquidity in all other financial markets,
which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float". Free
floating currencies are those whose relative value is determined by free market forces, such as
supply / demand relationships. A fixed float is where a country's governing body sets its
currency's relative value to other currencies, often by pegging it to some standard. Free floating
currencies include the U.S. Dollar, Japanese Yen and British Pound, while examples of fixed
floating currencies include the Chinese Yuan and the Indian Rupee

Benefits of Using the Forex Market:

There are some key factors that differentiate the forex market from others, like the stock market.

10
 There are fewer rules, which means investors aren't held to the strict standards or regulations
found in other markets.
 There are no clearing houses and no central bodies that oversee the forex market.
 Most investors won't have to pay the traditional fees or commissions that you would on
another market.
 Because the market is open 24 hours a day, you can trade at any time of day, which means
there's no cut-off time to be able to participate in the market.
 Finally, if you're worried about risk and reward, you can get in and out whenever you want
and you can buy as much currency as you can afford.

4. Explain the different theories of exchange rate determinations.

Ans. http://www.economicsdiscussion.net/foreign-exchange/theories-foreign-
exchange/theories-of-exchange-rate-determination-international-economics/30637

5. compare and contrast of transition exposure and economic exposure.

Ans. https://efinancemanagement.com/international-financial-management/transaction-vs-
economic-exposure

6. Explain Letter of credit and global depositary receipt.

Ans. For GDR: https://www.slideshare.net/RanjanSethi1/global-depository-receipt

For LC: https://www.slideshare.net/dswanand/letter-of-credit

7. Explain the term currency swap and interest rate swaps.

Ans. https://www.investopedia.com/ask/answers/051215/what-difference-between-currency-
and-interest-rate-swap.asp

11
2015

1. Explain the objective of IMF.

Ans. Repeated answer.

2. Discuss the importance of BOP to a finance manager.

Ans. Repeated answer.

3. What is translation exposure? How do you manage it?

Ans. Repeated answer.

4. Explain the different techniques of managing transaction exposure of a company.

Ans.
https://www.tutorialspoint.com/international_finance/international_finance_transaction_expo
sure.htm

5. Discuss the interest rate parity theory and purchasing power parity theory?

Ans. https://www.slideshare.net/DrMohamedKuttyKakkakunnan/purchasing-power-parity-
theory

And The economic theory of interest rate parity states that the difference between the interest
rate in two countries is equal to the differential between the forward rate and the spot rate of
those two countries. This equality does not always exist, and thus allows traders to arbitrage
option positions to earn riskless returns. For interest rate parity to exist, there must be easy
capital mobility between countries, along with complete substitutability of assets. For instance,
a deposit in a foreign bank is considered the same as a deposit in a domestic bank. If the nominal
returns were different between the domestic and foreign deposits, investors would move their
money to the bank paying the higher nominal return. Interest rate parity exists when the
expected nominal rates are the same for both domestic and foreign assets. Any difference is due
to expected appreciation or deprecation in the foreign or domestic currencies. For instance, if
the domestic interest rate is 8%, and the foreign interest rate is 5%, this means that the market
expects the foreign currency to appreciate by 3%, or conversely, investors expect the domestic
currency to depreciate by 3%. In that scenario, it doesn’t matter if an investor invests in a timed
foreign deposit and then converts the foreign currency to his domestic currency, or invests in a
timed domestic deposit and then converts the domestic currency to the foreign currency. With
interest rate parity, either option produces the exact same cash flow.

12
6. What are the objectives of an ideal exchange rate regime? Which exchange rate regime
satisfy all the objectives?

Ans. An exchange-rate regime is the way an authority manages its currency in relation to other
currencies and the foreign exchange market.

Objectives:

i. Reduce volatility in exchange rates, ensuring that the market correction of exchange rates is
affected in an orderly and calibrated manner.

ii. Help maintain an adequate level of foreign exchange reserves.

iii. Prevent the emergence of destabilization by speculative activities and

iv. Help eliminate market constraints so as to assist the development of a healthy foreign
exchange market.

And https://www.slideshare.net/anshusindhu1/exchange-rate-regimes-43345290

13
2014

1. Explain the role of participants in foreign exchange market.

Ans. Participants in Foreign Exchange Market:

Participants in Foreign exchange market can be categorized into five major groups, viz.;
commercial banks, Foreign exchange brokers, Central bank, MNCs and Individuals and Small
businesses.

1. Commercial Banks:

The major participants in the foreign exchange market are the large Commercial banks who
provide the core of market. As many as 100 to 200 banks across the globe actively “make the
market” in the foreign exchange. These banks serve their retail clients, the bank customers, in
conducting foreign commerce or making international investment in financial assets that require
foreign exchange.

These banks operate in the foreign exchange market at two levels. At the retail level, they deal
with their customers-corporations, exporters and so forth. At the wholesale level, banks maintain
an inert bank market in foreign exchange either directly or through specialized foreign exchange
brokers.

The bulk of activity in the foreign exchange market is conducted in an inter-bank wholesale
market-a network of large international banks and brokers. Whenever a bank buys a currency in
the foreign currency market, it is simultaneously selling another currency.

A bank that has committed itself to buy a certain particular currency is said to have long position
in that currency. A short-term position occurs when the bank is committed to selling amounts of
that currency exceeding its commitments to purchase it.

2. Foreign Exchange Brokers:

Foreign exchange brokers also operate in the international currency market. They act as agents
who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers
and do not put their own money at risk.

They actively and constantly monitor exchange rates offered by the major international banks
through computerized systems such as Reuters and are able to find quickly an opposite party for
a client without revealing the identity of either party until a transaction has been agreed upon.
This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a
currency quote to many other dealers.

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3. Central banks:

Another important player in the foreign market is Central bank of the various countries. Central
banks frequently intervene in the market to maintain the exchange rates of their currencies
within a desired range and to smooth fluctuations within that range. The level of the bank’s
intervention will depend upon the exchange rate regime flowed by the given country’s Central
bank.

4. MNCs:

MNCs are the major non-bank participants in the forward market as they exchange cash flows
associated with their multinational operations. MNCs often contract to either pay or receive fixed
amounts in foreign currencies at future dates, so they are exposed to foreign currency risk. This
is why they often hedge these future cash flows through the inter-bank forward exchange
market.

5. Individuals and Small Businesses:

Individuals and small businesses also use foreign exchange market to facilitate execution of
commercial or investment transactions. The foreign needs of these players are usually small and
account for only a fraction of all foreign exchange transactions. Even then they are very important
participants in the market. Some of these participants use the market to hedge foreign exchange
risk.

2. Discuss the importance of SDR’s to member countries of IMF.

Ans. The SDR is an international reserve asset, created by the IMF in 1969 to supplement its
member countries’ official reserves. So far SDR 204.2 billion (equivalent to about US$291 billion)
have been allocated to members, including SDR 182.6 billion allocated in 2009 in the wake of the
global financial crisis. The value of the SDR is based on a basket of five currencies—the U.S. dollar,
the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling.

And https://www.slideshare.net/GopikaKondath/special-drawing-rights-52995249

3. Why is FDI is important to developing countries like India.

Ans. https://www.tradingbells.com/blog/role-of-fdi-in-the-economic-development-of-india/

4. Explain the different way on which foreign exchange dealer can hedge a forward transaction.

Ans. https://www.investopedia.com/articles/forex/020414/money-market-hedge-how-it-
works.asp and http://accounting-financial-tax.com/2009/07/6-ways-to-control-foreign-
exchange-risk/

15
5. Discuss the global benefits from a well – functioning IFM.

Ans.

6. “Derivates are sometimes deliberately mispriced in order to conceal losses or to make profit
by fraud”, Discuss.

Ans. Derivatives are sometimes deliberately mispriced in order to conceal losses or to make
profits by fraud.
Mispriced options were used by NatWest Capital Markets to conceal losses and the British
Securities and Futures Authority concluded its disciplinary action against the firm and two of its
employees, Kyriacos Papouis and Neil Dodgson, in May 2000.
In March 2001 a Japanese court fined Credit Suisse First Boston 40 million yen because a
subsidiary had used complex derivatives transactions to conceal losses.
In Seeing Tomorrow: rewriting the rules of risk by Ron S. Dembo and Andrew Freeman, a case in
which "clever but criminal staff got inside an options pricing model and used tiny changes to skim
off a few million dollars of profits for themselves" is described on page 23. The culprits were not
prosecuted because the bank feared that the revelation could wipe out hundreds of millions of
dollars of its overall value. This case is reminiscent of the plot of Into the Fire.
Another possible case came to light in January 2006 when Anshul Rustagi, a London-based
derivatives trader at Deutsche Bank was suspended after allegedly overstating profits on his own
trading book by £30 million. He was subsequently dismissed.

7. Briefly identify the procedure for an initial issue of GDR. Explain the steps involved in issuing
GDR.

Ans. https://efinancemanagement.com/sources-of-finance/depository-receipts

16
2013

1. What are the functions of IMF?

Ans. Repeated answer.

2. Explain the functions of foreign exchange market.

Ans. https://www.wisdomjobs.com/e-university/forex-management-tutorial-353/functions-of-
foreign-exchange-market-10968.html

3. Explain the steps involved in money market operations.

Ans.

4. What are the methods of hedging interest rate exposure.

Ans. Interest rate hedges are flexible tools that allow companies to reduce their vulnerability
to changes in interest rates. First American Bank provides innovative strategies and products to
help our customers manage interest rate exposure and reduce uncertainty.

 Interest Rate Cap: a separate contract that puts an upper limit on the interest rate of a
customer's floating rate loan. Caps provide protection from rising rates, while still permitting
a customer to benefit from falling rates. Customers pay an upfront fee for this protection.
 Interest Rate Floor: a separate contract that puts a lower limit on the interest rate of a
customer's floating rate loan. Customers receive an upfront fee for giving up the benefit of
falling rates.
 Interest Rate Collar: a combination of a Cap and a Floor that puts both an upper and lower
limit on the interest rate of a customer's floating rate loan. Collars are often structured as
"Costless," so that the fee paid for the Cap is equal to the fee received for the Floor.
 Interest Rate Swap: a separate contract that allows a customer to effectively convert a
floating rate loan to a fixed rate for a period of time. There is no upfront cost to a Swap. The
cost is built into the rate.
 Forward: a hedge executed today with an effective starting date some specific date in the
future. For example, a customer with a balloon payment on a loan due in 6 months could use
a Forward Swap to lock in an interest rate for the renewal of the loan, and eliminate their risk
of rates rising during the interim period.

5. Explain the merits and demerits of fixed rate and floating rate exchange system.

Ans. Repeated question

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6. Discuss the impact of inflation and interest rate on exchange rate.

Ans. Repeated question

7. write a brief note about commercial paper.

Ans.

8. Explain the features of option contract.

Ans. An options contract is an agreement between a buyer and seller that gives the purchaser of
the option the right to buy or sell a particular asset at a later date at an agreed upon
price. Options contracts are often used in securities, commodities, and real estate transactions.

1. Highly flexible: On one hand, option contract are highly standardized and so they can be
traded only in organized exchanges. Such option instruments cannot be made flexible according
to the requirements of the writer as well as the user. On the other hand, there are also privately
arranged options which can be traded ‘over the counter’. These instruments can be made
according to the requirements of the writer and user. Thus, it combines the features of ‘futures’
as well as ‘forward’ contracts.

2. Down Payment: The option holder must pay a certain amount called ‘premium’ for holding
the right of exercising the option. This is considered to be the consideration for the contract. If
the option holder does not exercise his option, he has to forego this premium. Otherwise, this
premium will be deducted from the total payoff in calculating the net payoff due to the option
holder.

3. Settlement: No money or commodity or share is exchanged when the contract is written.

Generally, this option contract terminates either at the time of exercising the option by the
option holder or maturity whichever is earlier. So, settlement is made only when the option
holder exercises his option. Suppose the option is not exercised till maturity, then the agreement
automatically lapses and no settlement is required.

4. Non – Linearity: Unlike futures and forward, an option contract does not posses the property
of linearity. It means that the option holder’s profit, when the value of the underlying asset
moves in one direction is not equal to his loss when its value moves in the opposite direction by
the same amount. In short, profits and losses are not symmetrical under an option contract. This
can be illustrated by means of an illustration:

Mr.X purchase a two month call option on rupee at Rs. 100=3.35 $. Suppose, the rupee
appreciates within two months by 0.05 $per one hundred rupees, then the market price would
be Rs. 100=3.40 $. If the option holder Mr.X exercises his option, he can purchase at the rate
mentioned in the option ie., Rs. 100=3.53 $. He gets a payoff at the rate of 0.05 $ per every one
hundred rupees. On the other hand, if the exchange rate moves in the opposite direction by the

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same amount and reaches a level of Rs. 100=3.30 $. the option holder will not exercise his option.
Then, his loss will be zero. Thus, in an option contract, the gain is not equal to the loss.

5. No Obligation to Buy or Sell: In all option contracts, the option holder has a right to buy or sell
an underlying asset. He can exercise this right at any time during the currency of the contract.
But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will
be simply lapsed.

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