International Finance

Contents

 Introduction To International Finance

 Rewards & Risk of International Finance
 International Business Methods
 International Monetary System
 International Flow of Funds
Balance of Payments (BOP)
 Spot Rates & Quotation
 Interbank Arbitrage
 Business Exposures - Types
Management of Business Exposures
Internal Hedging Techniques
 International Financial Markets – OTC & Forward Contracts
 Purchasing Power Parity
Fisher Effect, International Fisher Effect
 Nominal & Real Exchange Rates
  Forward Contract & Futures Contract
 International Capital Markets
Domestic & Offshore Markets
 EURO Markets - Evolution of EURO Markets
Interest Rates In Global Markets
 ADRs & GDRs
 Intermnational Bond Markets
 Forwards Currency Markets & Rates in India
 Option Forwards
 Financial Swaps
Interest Rate Swaps & Currency Swaps
 External Hedging Tools – Forward, Futures & Options
 Numerical for Cross – Currency Rates / Forward Contracts & Option Forwards are conducted in
the Class-Room
- Not included in soft copy - Refer the same.

 Introduction To International Finance

 After IInd World War, World’s International Trade, growing rapidly.
 International Institutions & Organizations has established like (World Bank, IMF, WTO), reduced levels

of international tensions.
 International trade agreements have contributed to international trade.
 Therefore, we are witnessing huge increase in:
a) International Capital flows
b) Foreign Direct Investment (FDI)
c) Global Capital Raising
d) Outsourcing & International Competition
e) Cross-border Mergers & Acquisitions
 A firm that is engaged in cross-border business is defined as (MNC) Multinational Corporation
 Many companies’ foreign sales exceeded their domestic sales & the percentage of profits generated

by foreign activities was often higher than the percentage of sales on domestic level.
 We consume, invest, produce, work & sell in global economy. Therefore, financial managers &

investors have to understand international dimensions of finance.

Distinguishing factors: “International Finance & Domestic Finance”

1. Many MNCs obtain raw material from one nation, finance capital from another, produce goods with

labor & capital equipments in a third country sell in other countries.

Example:
GENERAL MOTORS –
Produces Cars in 50 countries---------Sell in almost 200 countries
IBM Computers –
Assembled in Malaysia / Taiwanese Monitors / Korean Keyboard / US made microchips
Software developed by US & Indian Engineers
 Advertising services of UK company
Financing from Banks in Holland & Germany

2. MNCs have their shares cross-listed in foreign stock exchanges.

3. Distinguishing factors are due to exchange rate. Cross – border barriers & financing opportunities in
global markets.
4. Companies ( MNCs ) consider”
Foreign Risk ---------------------- Currency Risk
Political Risk ---------------------- Political Climate
Barrier to trade ----------------- Protectionist legislation / dumping laws / tariffs / Quotas

Rewards & Risk of International Finance

Risks
1. MNCs have liability in host country.
2. Because of non native status, there is an inherent disadvantage to foreign firms in host countries.
3. They face number of differences – regulations, language & cultural difference.
 Rewards
1. Marginal returns on MNC projects are above than domestic firms.
2. MNCs can obtain capital funding at a lower cost around the world.

Goals of MNCs
1. Global brands like “Coca – Cola”, “Canon”, “BMW” influence global markets.
They can be defined as MNC on following factors:
a) Degree of foreign sales
b) Degree of foreign assets
c) Source of labor & production
d) Source of capital funding
2. MNCs are a recent phenomenon (after IInd World War ). They affect all the sectors of activity.
3. There are about 60,000 MNCs in the world. They account for about 10% of World GDP.
4. MNCs expand their business because
- To broaden markets
- To seek raw materials
- To seek new technologies
- To seek production efficiencies
- To avoid political hurdles
- To diversify by geography.
  International Business Methods
A firm contemplating foreign expansion take 3 decisions
a) Which market to enter
b) When to enter these markets
c) What is the scale of entry
1. Exporting
a) It minimizes direct investments in foreign countries
b) Avoids the cost of establishing manufacturing operations
c) Helps to achieve experience curve
d) Minimize risk & capital requirements.
Export strategy is vulnerable when manufacturing cost in home country is higher than other company’s

in other countries.
2. Turnkey projects
a) In this contractor agrees to handle every detail of projects.
b) Advantages are that a company can earn a return on a knowledge asset.
c) It is less risky than conventional FDI
d) Disadvantages of Turn-key project – there is no long term interest.
3. Licensing
a) Licensing allows a firm to provide its technology in exchange for fees.
b) It carries the risk of providing valuable technological know-how to foreign firms & losing control

over its use.

4. Franchising
a) This method is most suited to global expansion
b) Advantage is that franchisee bears most of the costs
c) Franchiser only has to expend the resources to train franchisee
d) Disadvantage – Responsibility for maintaining cross country quality control

5. Joint Ventures
a) It allows firms to quickly gain control over foreign operations as well as share of the foreign

market.
b) Firms can also penetrate foreign markets by establishing new foreign subsidiaries.

 EXPOSURE TO INTERNATIONAL RISK

a) There are three types of risk to ‘International Business’
a) Exchange Rate movement
b) Foreign Economies
c) Political Risk
b) In International context, firms, finance managers, investors & Government, consider risk due to:
1. Different Currencies 6. Different Regulations
 2. Different Inflation Rates 7. Different Tax Systems
3. Different Interest Rates 8. Different Legal Systems
4. Different Financial Markets 9. Different Tastes, preferences & cultures
5. Different Banking Systems

 INTERNATIONAL MONETARY SYSTEM

a) It is a system where foreign exchange rates are determined
b) It accommodates international trade & capital flows
c) Also Balance of payments are made
There are following exchange rate regimes:
a) Floating Exchange Rate System
It is a system where the value of the currency is not officially fixed – but varies according to supply &

demand for the currency.

b) Fixed Exchange Rate System
It is a system where the value of currency is set by official Government policy.

HISTORY OF INTERNATIONAL MONETARY SYSTEM

a) Gold Standard ( Until 1914 )

a) It was a system of fixed exchange rate under UK dominance.

b) Up to 1914 ( World War I ), the world was on Gold Standard.
c) Under this system countries, fixed the value of their currency relative to Gold.

b) Inter-War Period ( Between two world wars 1914-1944 )

a) Gold standard was suspended in 1914 – beginning of World War I.

b) To gain advantage in world exports, countries fluctuated their exchange rates.
c) This had an adverse impact on International Trade & Investment.
d) The 1920s – 1930s were characterized by recessions, banking crisis & Great Depression.

c) Bretton Woods System ( 1945 – 1971 )

a) It is a system established after the end of IInd World War, and it was a US – Centered fixed rate
system.
b) Under this system, the US Dollar was pegged to Gold at $ 35 per ounce & other currencies were
pegged to US Dollar.
c) As all other nations pegged to dollar, a dollar standard exchange rate system was created.
d) US dollar was the reserve currency used to settle International debts.
e) US Dollar was convertible to Gold by official holders (Central Banks& Treasuries) only. This ystem
collapsed in 1971.
f) After transition period of 1971-73, major currencies started to float.
Agencies that Facilitate International Flows

INTERNATIONAL MONETARY FUND ( IMF )

 After IInd World War, world’s international trade started growing steadily.\
 International Institutions & Organizations were established like ( IMF, Wolrd Bank, WTO ) reduced
the levels of International tensions.
Responsibilities of IMF
 To promote international monetary co-operation: prevent or manage financial crisis.
 To facilitate expansion and balanced growth of international trade.
 To promote exchange rate stability.
 To assist in establishing multilateral system of payments.
 To lend to member countries experiencing balance of payments difficulties.

Origin of IMF

 IMF was established for promoting International Economic Stability by promoting balance of Free
International Trade & Multi-convertibility of national currencies.
 The fund is a pool of Central Bank Reserves & National currencies which are made available to
fund members.

Objectives of IMF

 The fundamental objectives of IMF was the avoidance of competitive devaluation & exchange
controls that had characterized by the era of 1930.

There are 3 general objectives:

a) Elimination or reduction of existing exchange controls.

b) Establishment & maintenance of currency convertibility with stable exchange rate.
c) The widest extension of multilateral trade & payments.

Objectives of the fund stated in Article I of the fund Agreement

 To promote International Monetary Co-operation through permanent Institution.

 To facilitate the expansion of balanced growth of International Trade.
 To promote exchange rate stability to avoid exchange rate depreciation.

Functions:

 The fund functions as a short term credit Institution.

 It provides a machinery for orderly adjustment of exchange rates.
 It is a reservoir of the currencies of all the member countries.
 It is sort of lending institution in foreign exchange.
 It provides a machinery for international consultation.
  The fund is an autonomous organization affiliated to UNO.

 Its main office is in Washington.

IMF Resemblance to Gold Standards

 Gold occupies an important place in the scheme of the fund, as the par values of the currencies of
member countries are expressed in terms of Gold.
 Gold is designed to operate as a common denominator of the currencies of member nations.
 Member countries are prohibited from buying & selling Gold at prices other than those

corresponding to the par values of their currencies.
 Under IMF Scheme – GOLD continues to serve as a reserve of International currency. It is a most
liquid asset internationally.
 Thus, the fund may purchase the currency of any country by making payment of GOLD.
 Under the GOLD standard, every country balances its external debt account with rest of the world
and not with the countries individually.

IMF & India

 India’s economic policy until now was largely at odds with free enterprise, free market & free trade
philosophy of IMF & World Bank
 Though the socialist pattern oriented plan strategy did not allow free flow of foreign capital into the
country, Indian Industrial strategy has always remain dependent on foreign capital inflows.
 This is because India has never made any serious efforts in developing indigenous technologies.
 Following the soviet model planning, the country had intended to become closed economy. This
was never appreciated by IMF & World Bank.
 Whenever India experienced a foreign exchange crisis, there international authorities tried their
level best to dilute Indian Industrial & Trade policies.
 Changes towards process of liberalization attributed by IMF pressure.
 A very patent, calculated & long run campaign was launched by IMF & World Bank to see it that
Indian opens up its door to Western private investment & technology.

WORLD BANK

 It is a sister organization of IMF

 Its primary objective is to fight poverty & assist developed countries to improve their standard of
living.

 World Bank consists of five institutions

1) IBRD ( International Bank for Reconstruction & Development )

2) IDA ( International Development Association )
3) IFC ( International Finance Corporation )
4) MIGA ( Multilateral Investment Guarantee Agency )
5) ICSID ( International Center for Settlement of Investment Disputes )
  International Flow of Funds
 Introduction & Objectives
 Open economy interacts freely with other economies. Interaction is by two ways
a) It buys & sells, goods and services in world markets
b) It buys & sells, capital assets in world financial markets
 BOP ( Balance of payments )
a) It is a country’s record of all transactions between its residents & residents of all foreign
countries.
b) Inflows of funds generate credits for country’s balance. And outflow of funds generate debits.
c) If all the transactions are recorded correctly, the sum of all credit items necessarily equals to
the sum of all debit items.
d) Thus, the BOP entries are always balanced; the entries add up to zero.
 The three sub-account of the Balance of Payments are:
a) Current Accountb) Capital Account c) Official Reserve Account
 Current Account summarizes the flow of funds between one specified country & all other countries
due to purchases of goods & services.
 The capital account measures all international economic transactions of financial assets.
 The official reserve account is the total reserves held by official monetary authorities
(central banks).

DISTINGUISH BETWEEN – “CURRENT ACCOUNT & CAPITAL ACCOUNT”

 Current Account
a) It is that BOP account in which all short term flows of payments are listed.
b) It is the sum of net sales from trade in goods & services, net investment income
(Interest and Dividend) and net unilateral transfers ( Private transfer payments & Government
Transfer )
 c) Investment income for a country is the payment made to its residents who are holders of
foreign financial assets. And payments made to its citizens who are temporary workers
abroad.
d) Unilateral transfers are official Government grants in aid to foreign Governments.
e) Current account surplus indicates positive net exports or trade surplus.
f) Current account deficit indicates negative net exports or trade deficit.

 Capital Account
a) It is the BOP in which all cross-border transactions involving financial assets are listed.
b) All purchases or sell of assets, including FDI, Securities & Bank claims & Liabilities are listed
in Capital account.
c) When Indian citizens buy foreign securities or when foreigners buy Indian securities – they are
listed as Outflows & Inflows respectively.
d) When domestic residents purchase more financial asset, there is net capital out flow. If
foreigners purchase more in Indian Financial asset, there is net capital inflow.
e) Capital account surplus indicates Net Capital Inflows and
Capital account deficit indicates Net Capital Outflows.

 Official Reserve Account ( ORA )

a) It records the total reserves held by official monetary authorities (Central Banks) within the
country.
b) These reserves are normally composed of major currencies used in International trade &
financial transactions.
c) These reserves consists of “HARD” currencies ( such as $, €, Pound, Yen )
d) The reserves are held by central banks to cushion against instability in international markets.
 Summary
The Balance of Payments identity states that:
Current Account + Capital Account = Change in Official Reserve Account
 If a country runs a current account deficit & it does not run down its official reserve to cover deficit,
then current account must be balanced by Capital Account surplus.

INTERNATIONAL TRADE FLOWS

 Since 1960, global trade has grown twice as fast global GDP.
 The share of International trade in national economies, in most cases increased dramatically over
past few decades.
Factors Affecting International Trade Flows:
1. Impact of Inflation:
Inflation rate decreases current account as import increases & export decreases.
2. Impact of National Income:
Relative increase in a country’s income level will decrease its current account, as import increases.
3. Impact of Government Restrictions:
Government may reduce its country’s import by imposing tariff in imported goods.
4. Impact of Exchange Rate:
If a country’s currency begin to rise in value, its current account balance will decrease as imports
increases & export decreases.

INTERNATIONAL CAPITAL FLOWS

International Capital inflows consists of FDI & FPI
 Factors affect FDI
 1. Change in restrictions
2. Privatization
3. Potential Economic Growth
4. Tax Rates
5. Exchange Rates
6. Foreign Portfolio Investment
7. Tax Rates on Interest or Dividends
8. Interest Rates
9. Exchange Rates

Trade Deficits
1. A trade deficit occurs when a nation imports more goods & services than it exports. Trade surplus
occurs when nation exports more goods & services than it imports.
2. Trade deficit must be financed by foreign income or transfers. (Selling of FOREX Reserves by
Central Bank)
3. An example where a trade surplus was not beneficial for the country is Japan in the 1990s. The
positive trade balance that Japan had was partly due to the protectionist measures that were
adopted by the Japanese Government.
These measures caused the price of goods in Japan to be much higher than what they would
have been, had imports been freely allowed.
The foreign currency that the Japanese companies earned overseas were kept abroad and not
converted into YEN in order to keep the value of the YEN also prevented Japanese consumers
from importing goods from abroad and benefitting from trade surplus.

 Spot Rates & Quotations

Base Currency
1. Base currency is the currency that is bought or sold.
Terms currency is the pricing currency.
Example:
EURO – DOLLAR -------Quote
$ 1.2120
In this base currency is EURO
Terms currency is Dollar
Therefore, price of € 1 is $ 1.2120
2. Every forex transaction involves two currencies
Base currency ( Quoted / Underlying / Fixed Currency )
 Terms currency ( Counter currency )
3. The Terms currency is Numerator and
The Base currency is Denominator
 Numerator increases --- Base currency strengthens
 Numerator decreases – Base currency weakens

4. In oral communication, the base currency is always stated first.

Dollar – Yen / Dollar – Swiss / Sterling – Dollar

Currency Codes
1. Each currency is assigned a three letter code
US DOLLAR ---------------------- USD
EURO ---------------------- EUR
SWISS FRANK ------------------- CHF
JAPANESE YEN ------------------ JPY
BRITISH POUND ---------------- GBP

BID PRICE & ASK PRICE

1. The Bid Price is the price at which market is willing to buy the base currency.
2. The Ask Price is the price at which the market maker is willing to sell the base currency.

DIRECT Quotes
1. Direct quotation is the amount of domestic currency per unit of foreign exchange currency
Rs. 77.30 Pound in India / $ 1.7676 Pound in US
INR 44.00 Per USD Direct Quote in India
USD 1.2950 Per EUR Direct Quote in US
INDIRECT Quotes

Indirect quotation is the amount of foreign currency per unit of domestic currency.
Swedish Kroner 0.1763 / Rs in India
0.8251 Euro / $ in US
USD 2.2500 Per INR

 A quotation Consists of two prices

- The price shown on the left of the oblique or hyphen is the “BID PRICE”, the one on the right is
the “Ask” or “Offer Price”

Example: US / CHF Spot: 1.4550 / 1.4560

In this dealer will buy 1 Dollar & Pay CHF 1.4550

He will sell one USD & want to be paid CHF 1.4560

 For most countries, quotations are given in European Terms i.e. the base currency is US Dollar
Major exceptions are EUR, GBP, AUD & NZD
 In market “Cross Rate” is a quotation between two non-dollar currencies
GBP / CHF is a “Cross Rate”
EUR / INR is a “Cross Rate”
PIP
1. Prices are always quoted using five numbers.
Example: JPY 134.85 / USD
The final digit of which is referred to as a Point or PIP.
2. PIP is the smallest price change that a given exchange rate can make.

 Spot Rate Quotations:

 There are quotations in European Terms & American Terms

 The former are the quotes given as number of units of a currency per US Dollar

EUR 0.8110 Per USD

CHF 1.4500 Per USD Quotes in European Terms
INR 40.75 Per USD

USD 0.8040 Per CHF Quotes in American Terms

USD 1.3545 Per GBP

 The prevalence of this terminology is due to the common practice mentioned above of quoting all
exchange rates against dollar.

 Interbank Arbitrage
 Arbitraging between Banks
 It is not true that all banks will have identical quotes for a given pair of currencies at a given point
of time.
Let’s explore the possible relationship between quotes offered by different banks.

Bank A & B are quoting

Bank A Bank B
GBP / USD 1.4550 / 1.4560 1.4538 / 1.4548
Bid / Ask Bid / Ask

Such a situation gives rise to arbitrage opportunity. Pounds can be bought from Bank B @$1.4548
& sold to Bank A @$1.4550 ----------- for a net profit of $0.0002 per pound
 FOREIGN EXCHANGE EXPSOURE
 Forex exposure is the possibility that a company will gain or lose because of changes in exchange
rates.
 Changes in exchange rate can affect not only companies that are directly engaged in International
business, but also those companies that sell only in the domestic market.
 There are 3 types of Foreign Exchange Exposures:

a) Translation exposure
b) Transaction exposure
c) Economic exposure

A) Translation Exposure ( Accounting Exposure )

 It measures the effect of an exchange rate change on published financial statements of a

company.
 Need to “translate” foreign currency financial statements of foreign subsidiaries into a single
reporting currency.

B) Transaction Exposure

 It refers to the potential change in the value of obligations due to changes in exchange rate.

C) Economic Exposure ( Operating Exposure )

 It measures the impact of an exchange rate on the NPV ( Net present value ) of expected future
cash flows; from a foreign investment project.
 Company can reduce its exposure by restructuring its operations to balance its exchange rate
sensitive cash flows.

 Management of Transaction Exposure

 A firm can hedge its transaction exposure using external & internal methods.
 An external hedge involves a financial instrument, such as a forward contract or currency option.
 Internal hedge involves organizing pricing policies to transfer currency risk to a customer or
supplier.

 Management of Translation Exposure

 Translation gains & losses, have no direct impact of cash flows, because this type of exposure is
related to balance sheet – Assets & Liabilities.
 MNCs translation exposure affects its consolidated earnings & investors tend to use earnings
when valuing companies.
 To hedge translation exposure forward or future contracts can be used.
 Management of Economic Exposure

 It can be defined as the extent to which the value of the firm would be affected by unanticipated
changes in exchange rate.

 MNC can manage economic exposure by using following methods:

a) Selecting low cost production site
b) Flexible sourcing policy
c) Diversification of markets
d) R & D product differentials
e) Financial Hedging

 Management of Political Exposure

1. Political action has a direct connection when political actors change laws & regulations can directly
affect the business.
2. Indirect effect of political action occurs when political actors change economic environment.
Example of Political Risk
1. Nationalization
2. Creeping Expropriation ------ Dictate to control profitability of company
3. Contract Repudiation
4. Political Pressure in a Democratic System
5. Threat from local business

 Management of Interest Rate Exposure

1. Fixed rate investors have an interest rate exposure as the value of their assets is determined by
the present value of the future stream.
2. As interest rate rises, the discounting rate used to calculate the present value of their investments
fall.
3. Interest rate exposure can be minimized using interest rate swap or futures.

 Internal Hedging Strategies

 An internal hedge involves organizing the firm in such a way that transaction exposure is
minimized.
 Leading & Lagging involve shifting the timing of exposures by payables or receivables.

 Leading & Lagging

 It involves accelerating or decelerating the timing of payments that must be made or received in
foreign currencies.
 A foreign subsidiary that is expecting its local currency to fall in value, may try to speed up or lead
its payments.
 If the local currency is expected to rise, subsidiary may want to wait or lag payments.

 Netting
  In a MNC family of companies there are large number of intra-corporate transactions between
subsidiaries & the parent.
 If all the resulting cash flows are executed on pair wise basis, a large number of currency
conversions would be involved with substantial transaction costs.
 With a centralized system, netting is possible whereby the cash management center, nets-out
receivables against payables.

 Re-Invoicing center

 It is a separate corporate subsidiary that serves as an intermediary between the parent and all
foreign subsidiaries.
 The title ownership & invoices pass through the center but the physical movement of goods is
direct.

 International Financial Markets

 Foreign Exchange Markets – Foreign Exchange Trading

1. It is the largest & most liquid market in the world.

2. The largest amount of foreign exchange trading takes place in UK.
3. Forex trading, London benefits from its geographical location & time zone.
4. Forex market is a 24 Hr market. Asia Pacific / Sydney / Tokyo / Hong Kong / Singapore / Bahrain /
Middle East / Europe / New York
5. 24 Hr market means that the exchange rates & market conditions can change at any time.
6. The forex market consists of both OTC (Over The Counter ) & Exchange traded.
7. The OTC market is an international OTC network of major dealers – mainly Banks – trading via
computers / telephone & other means.
8. OTC market accounts for well over 90% of total foreign exchange market activity covers ( Spot,
Outright forwards, FX Swaps )
9. On the organized exchanges, foreign exchange products traded are currency futures & currency
options.

OTC Market Forward Market

 It is an exchange of one currency for another * Outright forward is similar to spot
Spot rate is current market price transaction
 This transaction do not require immediate * Difference – this is settled on any
Settlement pre-agreed date
 By convention, the settlement date is the second * Currency exchange may be there
Business day after the deal date on settlement day

 Purchasing Power Parity

 The absolute version of purchasing power parity states that the price levels adjusted for exchange
rates should be equal between countries. Thus one unit of currency has some purchasing power
globally.

Example:
If a loaf of bread costs $ 1 in USA and $ = 0.75 Pound
Then a loaf of bread should cost 0.75 Pound in UK
 1. The absolute version of PPP ignores transportation cost, tariffs, quotas, and product
differentiation, etc., therefore imprecise & does not hold in most cases.
 The relative version of PPP states that changes in relative inflation between two countries must
cause change in exchange rates. “ If domestic inflation rate is lower than that in foreign country,
the domestic currency should be stronger than the foreign currency.”

et ( 1 + in )
---- = --------------
e0 ( 1 + if )

Where,
et = expected future spot rate in = home inflation
e0 = spot rate if = foreign inflation

This equation can be approximated by following equation

et - e0
---------- = in - if
e0

 The exchange rate change during a period is equal to the inflation differential for the same period.
Thus, if the inflation in the home country is 3% & inflation in foreign country is 7% then home
currency will appreciate by approximately 4% (=7%-3%) relative to the foreign currency.

 The Fisher Effect ( FE )

1. The Fisher effect links inflation & interest rates.

2. According to the Fisher effect, countries with higher inflation have higher interest rates.
3. It states that nominal interest rate ( r ) is a function of real interest rate ( r* ) & a premium for
inflation expectations.
4. The nominal interest rate in a country is the real interest plus inflation ( r = r* + I )

5. Fisher postulated that the expected real rates if return are equal in different countries in the
absence of government intervention as Arbitrage would drive them towards equality
everywhere. Therefore, nominal interest rate differential between two countries should reflect
the inflation rate differential:

r = r* + I
rh = r*h + in
rf = r*f + if

Since,
r*h = r*f
rh –rf = in – if

6. Fisher effect therefore states that. With no government interference, nominal interest rates
vary by inflation differential. Thus, if inflation in UK is 5% and inflation in USA is 3% & if
government if two countries do not take any action to affect interest rates, then nomial interest
rate in UK will be 2% (=5%-3%) higher than in the USA.
  The International Fisher Effect ( IFE )
1. It links the PPP & Fisher effect. If the inflation differential is equal to the interest rate
differential then equation for PPP can be written as:
et ( 1 + rh )
---- = --------------
e0 ( 1 + rf ) ----- Equation of IFE
This equation can be approximated by following equation:
et - e0
---------- = rh - rf
e0
2. It states that spot rate adjusts to the interest rate differential between two countries.

In equilibrium, the expected change in the spot exchange rate should be equal in magnitude
but opposite in sign to the interest rate differential.

3. Thus, for investors to put money into a lower yielding security they have to be convinced that
they will be equally well off after adjusting for exchange rates. The implication of IFE is that the
currency with lower interest rates is expected appreciate relative to one with a higher rate.

 Nominal & Real Exchange Rates

 Nominal exchange rates are established on currency financial markets called “FOREX” markets;
which are similar to stock exchange markets.

 Rates are usually established in continuous quotation, with newspaper reporting daily quotation.

 Central Bank may also fix the nominal exchange rates.

 Real Exchange Rates

 Real exchange rates are nominal rate corrected somehow by inflation measures.

Example:
If a country A has an inflation rate 10%, country B an inflation of 5% and no changes in the
nominal exchange rate took place; then country A has now a currency whose real value is
10% - 5% = 5% ------- higher than before.

 Futures Contract Forward Contract

 Contract is entered on the centralized * Contract is OTC in nature

Trading platform of the exchange

 Contract is standardized in term of * Contract is customized as

per Quantity specified by the exchange agreement between buyer
& seller
 Contract is transparent- available on * Contract price is not
transparent

 Centralized trading screen of exchange * It is not publicly disclosed

 Contract is more liquid * Contract is less liquid

 Mark – to – market is applicable * No Mark – to – market is

applicable

 Contracts are regulated by exchange * Contracts are not

regulated.

 No Possibility of counterparty default * Possibility of counterparty

default

 International Capital Markets

 Massive cross border capital flows are always ins search of high returns to those seeking for low
cot funding.

 The phenomenon of borrowers, including governments accessing the financial markets of another
country is not new; what is new is the degree of mobility of capital, global dispersity of finance
industry and enormous diversity of markets and instruments which a firm seeking funding can tap.

 Major OECD countries had began deregulating and liberalizing their financial markets towards the
end of seventies.

 Exchange and capital controls were gradually removed, non – residents were allowed freer access
to national capital markets and foreign banks and financial institutions were permitted to establish
their presence in various national markets.

 The process of liberalization & integration continued in to 1990s with many of the developing
countries carrying out substantive reforms in their economies & opening up their financial markets
to non – resident investors.

 A series of crisis – Mexican Crisis of 1995, East Asian Collapse in 1997 & Russian meltdown in
the following year – threatened to stop the process in its tracks, but by the end of 1999 some of
the damage had been repaired & the trend towards greater integration of financial markets
appears to be continuing.

 A truly international financial market has already been born in Mid-fifties & gradually in size &
scope during sixties & seventies. This is well known “EURO-CURRENCIES MARKET”.
Wherein a borrower (investor) from country A could raise (place) funds in currency of country B
from (with) financial institutions located in country C.
Example:
 1) A Mexican Firm can get US Dollar loan from a Bank located in London.
2) An Arab Oil Sheik can deposit hi Oil Dollars with a Bank in Paris.

 During eighties & first half of nineties, this market grew further in size, geographical scope &
diversity of funding instruments.
It is nor more a “ EURO” Market but a part of general category called “Offshore Markets”.

 Developments have give rise to a globally integrated financial marketplace in which entities
needing short or long term funding have a much wider choice than before in terms of choice of
market segment, maturity, currency of denomination, interest rate basis & so on.

 The same flexibility is available to investors to structure their portfolios in line with their risk return
trade-offs & expectations regarding interest rates, exchange rates, stock markets & commodity
prices.

 Domestic & Offshore Markets

 Financial assets & liabilities denominated in a particular currency – say US Dollar are traded
primarily in a national financial markets of that country.

 Bank deposits, loans, promissory notes, bonds denominated in US Dollar are bought & sold in US
money & Capital markets such as NEW YORK as well as financial markets in London, Paris,
Singapore & other centers outside USA.
The former is domestic market while the latter in offshore market, in that currency.

 Major segments of domestic markets are usually subject to strict supervision & regulation by
relevant national authorities such as SEC, US Federal Reserve, Ministry of Finance in Japan, etc.

These authorities regulate the access of non – resident entities to the public capital markets in
their countries by laying down eligibility criteria, disclosure & accounting norms & registration &
rating requirements.

 The offshore markets on the other hand have minimal regulation, often no registration formalities
and varied importance of rating.

Euro-currencies market is the oldest & largest offshore markets.

 EURO Markets

 Prior to 1980, Eurocurrencies market was the only truly international market of any significance.
It is mainly an interbank market trading in time deposits & various debt instruments.

 A “EURO-Currency Deposit” is a deposit in the relevant currency with a Bank outside the home
country of that currency.
Thus
1. A US Dollar Deposit with a Bank in London is EURO-Dollar Deposit.
2. Sterling deposit with a Bank in Luxembourg is a EURO-Sterling Deposit

What matters is the location of the Bank – neither the ownership of the bank nor ownership of
deposit.
 Thus, a Dollar Deposit belonging to an American company held with Paris subsidiary of an
American Bank is still a EURO-Dollar Deposit.

 Similarly, a “EURO-Dollar Loan” is a Dollar loan made by a Bank outside the US to a customer or
another bank.
The prefix “EURO” is now outdated, since such deposits & loans are regularly traded outside
Europe.

 Over the years, these markets have evolved a variety of instruments other than time deposits &
short term loans. Among them are CDs (Certificate of Deposits), Euro Commercial Papers (ECPs),
medium to long term floating rate loans, Eurobonds, Floating Rate Notes (FRNs)
 Evolution of EURO Markets

 Eurocurrency markets, specifically Euro-Dollar market, is said to have originated, ironically

enough, with Russian Authorities seeking Dollar denominated deposits with Banks in Britain &
France.

 During the 1950s, USSR was earning dollars from the sale of Gold & other commodities and
wanted to use them ti buy grain & other products from the West, mainly US.

However, they did not want to keep these dollars on deposit with Banks in NEW YORK as they
were apprehensive that US Government might freeze the deposits if the cold war intensified.

 They approached Banks in Britain & France who accepted these Dollar deposits & invested them
party in US.

 The impetus for growth was derived from various restrictions imposed by the US Authorities on
domestic banks & capital markets.

 Throughout 60s & 70s – American Banks & other depository institutions had to observe ceiling on
the rate of interest they could pay on deposits.

 This absence of regulation continues to be a factor in favor of Euro Markets.

Due to importance of the Dollar as a Vehicle currency in International Trade & Finance, many
European corporations have cash flows in Dollars & hence temporary dollar surpluses.

 Due to the distance & time zone problems as well as their greater familiarity with European Banks,
these companies preferred to keep their surplus dollars in European Banks, a choice made more
attractive by the higher rates offered by Euro-Banks.

 These supply side factors were reinforced by demand for Euro-Dollar loans by Non-US entities &
by US multinationals to finance their foreign operations.

 The main factor behind the emergence & strong growth of Euro-Dollar markets were the
regulations on borrowers & lenders imposed by the US authorities which motivated both – Banks
& Borrowers to evolve Euro-Dollar deposits & loans.

 The ability of Euro Banks to offer better rates both to depositors & borrowers & the convenience
with a Bank closer to home which is familiar with the business culture & practices in Europe.

 Interest Rates In Global Markets (LIBOR)

 In a Eurocurrency market, which is primarily an interbank deposit market, the benchmark is
provided by the interbank borrowing & lending rates.
The most widely known benchmark is “LONDON INTERBANK OFFER RATE” abbreviated LIBOR.

 This is an Index of the rate which a “First Class Bank” in London will charge another first class
bank for a short term loan.

LIBOR is not necessarily the rate charged by any particular bank; it is only for an indicator of
demand supply conditions in the Interbank Deposit Market in London.

 Another rate often referred to as the LIBID – London Interbank Bid Rate; the rate which a bank is
willing to pay for deposits accepted from another bank.

 Financial press normally provides quotations for 3 & 6 month LIBOR. LIBOR also varies according
to the currency in which the loan or deposit is denominated.

 International Equity Investment

 The twentieth century has seen massive cross-border flows of capital. Till the 80s, it was
predominantly debt capital in the form of bank loans & bond issues.

 The international new issues equity market with globally syndicated offerings emerged during the
eighties & grew rapidly.

 The years 1991-96 saw a substantial increase in the flow of equity investment in emerging
markets.

 The Asian Currency Crisis of 1997 followed by the Russian Debacle in 1998 & an almost – crisis in
Brazil put a damper on the enthusiasm shown by rich country investors towards emerging stock
markets for much 1998 and early 1999.

 The long feared slowdown in the US Economy appeared to have finally struck during the closing
days of 2000.

However, emerging economies got on to a rapid growth trajectory in 2001 & have continued to
grow.

 The initial thrust to cross-border flows of equity investments came from the desire on the part of
institutional investors to diversify their portfolios globally in search of both – higher returns and risk
reduction.

 Financial deregulation & elimination of exchange controls in a number of developed countries at

the beginning of eighties permitted large institutional investors to increase their exposure to
foreign equities.

 The decade of 1990’s witnessed opening up of equity markets of developing countries like South
Korea, Taiwan, Indonesia & India tor foreign investors with some restrictions.

 A number of companies from these countries have raised equity financing in developed country
stock markets.
  The trend towards global integration of equity markets is unmistakable though it is punctuated by
intermittent crises and consequent regulatory interventions & investor retreat.

 It has been agreed that an investor can “Globalize” his portfolio without necessarily having to
invest in the foreign countries’ equity markets.

 Equity capital can flow to a developing country in one or more of the following three ways.

1) Developed country investors can directly purchase shares in the stock market of developing
country.

2) Companies from developing countries can issue shares in the stock market of developed
countries.

3) Indirect purchase can be made through a mutual fund which may be a specific country fund or
a multi country regional fund.

 Stock markets in developing countries are quite small in size compared to major developed
markets – US, Japan & UK.

 ADRs & GDRs

 ADR ( AMERICAN DEPOSITORY RECEIPT )

1. ADR represents ownership in the shares of non – US company that trades in US financial

markets.

2. ADRs enable US investors to buy shares in foreign companies without the hazards or in

convenience of cross border & cross currency transactions.

3. ADRs carry prices in US Dollars, pay dividends in US Dollars

4. Each ADR is issued by US depository bank can represent fraction of share, single share or

multiple shares of foreign stock.

5. The price of ADR often tracks the price of foreign stock in its home market, adjusted for the

ratio of ADRs.

6. Individual shares of foreign corporation represented by an ADR are called “American

Depositary Shares ( ADS ).

LEVEL – I ADR
 1. They are lowest level of sponsored ADRs that can be issued. When a company issues

sponsored ADRs, it has one designated depositary who also acts its transfer agents.

2. Majority of ADR currently trading through LEVEL – I program. This is the most convenient way

for a foreign company to have its equity traded in United States.

3. LEVEL – I shares can only be traded on OTC market has minimal reporting requirements with

US - Securities & Exchange Commission ( SEC )

LEVEL – II

1. When a foreign company wants to set up LEVEL II program, it must file registration with US

SEC. It is required to file a Form 20F.

2. Advantage that the company by upgrading their LEVEL II, is shares can be listed o n US Stock

Exchange – NYSE, NASDAQ, AMEX.

LEVEL – III ( Offering )

1. It is the highest level a foreign company can sponsor.

2. It is actually issuing shares to raise capital.

3. New shares are issued by the company & will have to follow all the rules of SEC, stock is

listed on NYSE & NASDAQ

Indian ADRs Trading in US

1. Dr. Reddy’s Lab - NYSE 4. Infosys Tech - NASDAQ

2. HDFC Bank - NYSE 5. Rediff.com - NASDAQ

3. ICICI Bank - NYSE 6. SIFY - NASDAQ

 GDR ( Global Depositary Receipts )

1. It is a certificate issued by a depositary bank which purchases shares of foreign companies

and deposits it on the account.

 2. GDR represents ownership of an underlying number of shares.

3. Prices of GDR are often close to values of related shares, but they are traded & settled

independently of the underlying share.

4. Several International Banks issue GDRs & are listed in Frankfurt Stock Exchange,

Luxembourg Stock Exchange, London Stock Exchange where they are traded – normally

1 GDR = 10 shares, but not always.

5. Indian GDRs

ARVIND MILLS ASHOK LEYLAND BAJAJ AUTO

CROMPTON GREAVES RELIANCE IND DR. REDDY’S LAB

GE SHIPPING GAIL HINDALCO SBI

 International Bond Market

 Phenomenal changes in European markets swept financial markets around the world during

1980s & 1990s.

 The financial revolution has been characterized by both tremendous quantitative expansion & an

unprecedented qualitative transformation in the institutions, instruments & regulatory structures.

 Prior to 1980, national markets were largely isolated from each other & financial intermediaries in

each country operated principally in that country.

 The foreign exchange market & the Eurocurrency & Euro Bond markets based in London were the

only markets that were truly global in their operations.

 Financial markets everywhere serve to facilitate the transfer of resources from surplus units

(savers) to deficit units (borrowers) the former attempting to maximize the return on their savings

while the latter looking to minimize their borrowing costs.

 Healthy financial markets also offer the savers a wide range of instruments enabling them to

diversify their portfolio.

 Globalization of financial markets which began in 1980s, has been driven by two underlying

forces.

 Growing imbalance between savings & investments within individual countries, reflected in their

current account balances.

 During nineties, developing countries as a group have experienced huge current account deficits

and have also had to resort to international financial markets to bridge gap between their incomes

& expenditures as the volume of concessional aid from official bilateral & multilateral sources has

fallen far short of their perceived needs.

 The other motive force is the increasing preference on the past of investors for international

diversification of their asset portfolios.

 Several investigators have established that significant risk reduction is possible via global

diversification of portfolios.

 In virtually all the major industrial economies, elimination or significant relaxation of regulations

governing the operations of financial markets has been already underway.

 Exchange controls, functional & geographical restrictions on financial institutions, foreign financial

intermediaries offering various types of financial services have been already dismantled or

gradually eased away.

 Markets themselves have proved to be highly innovative, responding rapidly to changing investor

preferences & increasingly complex needs of the borrowers by designing new instruments &

highly flexible risk management products.

 It is clear that for developing countries, as far as debt finance is concerned, external bonds &

syndicated credits are the two main sources of funds.

 Indian entities began accessing external capital markets towards the end of seventies as gradually

the amount of concessional assistance became inadequate to meet the increasing needs of the

economy.
 By & large, India’s borrowings have been by way of syndicated bank loans, buyers’ credits & lines

of credits.

 Throughout eighties, there was a steady improvement in the markets perception of the

creditworthiness of Indian borrowers. The 1990-91 crisis sent India’s sovereign rating below

investment grade & foreign debt markets virtually dried up only to be opened up again after 1993.

 Major Market Segments:

a) Bonds:

1) Straight Bonds

2) Floating Rate Notes ( FRNs)

3) Zero coupon & deep discount bonds

4) Bonds with embedded options.

b) Syndicated Credits:

Bank loans arranged by one or more banks

c) Medium Term Notes (MTNs)

Instruments which fill gap between short term MMI (Money Market Instrument) & Longe Term

Bonds.

d) Money Market Instruments (MMIs)

Commercial Papers (CPs), Certificate of Deposits (CDs), Call Money

 Forward Currency Markets & Rates in India

 During last few years, a forward Rupee-Dollar market with banks offering two way quotes has

evolved in India.

 The Rupee Dollar spot forward margin is not entirely determined by interest rate differentials.
 During 2005 an active interbank call money market has emerged.

The call money market occasionally becomes extremely volatile with call rates climbing as high as

60% p.a. In such situations, banks with access to Euro-Dollars can arbitrage the money markets

even if forward premium on dollars goes as high as 20% p.a.

 Therefore, to some extent, the call money market drives the forward rupee dollar margins.

 Forward contracts in the Indian market are usually option forwards through banks do offer fixed

date forwards if the customer so desires.

 All forward transactions are for the purpose of hedging an underlying exposure such as trade

related payables and receivables.

 Many forward transactions in the Indian market between banks & their non-bank customers tend

to be of the option forward type.

Therefore, swap margins are commonly quoted from spot to end of the current & future calendar

month.

 Most of forward transactions in Indian market are for a maximum maturity of six months.

 Forwards contracts can be cancelled, extended or early delivery can be arranged by paying a

small cancellation fee & any settlement payments.

 NDF – Non Deliverable Forward Contracts

 Not all currencies have feely tradable forward contract markets. This is especially true in emerging

markets’ currencies such as Argentina, Brazil, China, Taiwan.

 NDF provide an efficient method to protect the dollar value of foreign currencies & reduce the

inherent uncertainty of exchange rates.

 NDF user is economically protected from exchange rate fluctuations as there is no delivery of

foreign currency.
 Option Forwards

There are situations in which the exact timing of a foreign currency inflow or outflow is not certain

though the amount is known.

 Banks offer a contract known as “Option Forwards” in which the rate of exchange between the two

currencies is fixed but delivery date is not fixed.

 One of the parties (usually corporate customer) an take delivery on any day between two fixed

dates. The interval between these dates is the option period.

*-------------------------------------- * -------------------------------- *

t0 t1 t2

 t t
The contract is entered into at 0, it will expire at 2 – but buyer has the option of demanding

settlement on any day between 1 & 2. t t

 In fixing the rate, the bank assumes that the customer firm will settle the contract at a time most
favorable to itself.

 Accordingly, bank gives the customer the worst rate ruling during the option period.

Calculation with some examples:

On a particular day following rates ruling in the market.

USD / CHF Spot: 1.6200 / 10

3 Months Forward: 250 / 240

6 Months Forward: 500 / 480

Therefore, 3 Months & 6 Months outright forward rates are:

 3 Months: 1.6200 – 0.0250 = 1.5950 (Bid)
1.6210 – 0.0240 = 1.5970 (Ask)

Quoted as 1.5950 / 70

6 Months: 1.6200 – 0.0500 = 1.5700 (Bid)

1.6210 – 0.0480 = 1.5730 (Ask)
Quoted as: 1.5700 / 30

 Financial Swaps

 Introduction:

 Financial swaps are an asset liability management technique which permit a borrower to access
one market and then exchange the liability for another type of liability.

 Investors can exchange one types of asset for another with a preferred income stream in terms of
currency and interest rate fixed or floating.

 Swaps are not funding instruments or an investment vehicle. They are a device to obtain the
desired form of financing or asset indirectly which otherwise might be inaccessible or too
expensive.

 Major Types of Swap Structures

 All swaps involves exchange of series of periodic payments between two parties usually through
an intermediary which is normally a large international financial institution which runs a :Swap
Book’.

 The two payment streams are estimated to have identical present values at the outset when
discounted at the respective cost of funds in the relevant primary financial markets.
So like a forward contract, the value of a swap at the start is zero.

 The two major types are:

a) Interest Rate Swaps ( also known as coupon swaps)
b) Currency Swaps

When two are combined - give a cross currency interest rate swap.

 Interest Rate Swaps

 A standard fixed to floating interest rate swap known in the market jargon as plain vanilla coupon
swap.
It is an agreement between two parties in which each contracts to make payments to the other on
particular dates in future till a specified termination date.

 One party know as the fixed rate payer & other party know as the floating rate payer – will make
payments the size of which depends upon the future evolution of a specified interest rate Index
(6 Month LIBOR)

 Features of Interest Rate Swap

 The notional principal
The fixed & floating payments are calculated as if they were interest payments on a specified
amount borrowed or lent.

 It is notional because the parties do not exchange this amount at any time.
It is only used to compute the sequence of payments.
In a standard swap the notional principal remains constant through the life of the swap.

 The fixed rate

The rate applied to the notional principal to calculate the size of the fixed payment.

 Where the transaction is a straight forward “Plain Vanilla” fixed / floating interest are swap with the
principal amount remaining constant throughout the transaction.

 Swap dealers openly display the rates at which they are willing to pay or receive fixed rate
payments.

 Floating Rate
In a standard swap at market rates, the floating rate is one of market indices such as LIBOR,
prime rate, T-Bill rate, etc.

 Currency Swaps:

 In this, the two payment streams being exchanged are denominated in two different currencies.

 Usually, exchange of principal amounts at the beginning and re-exchange at termination are also a
feature of currency swap.

 A typical fixed – to – fixed currency swap works as follows:

 One party raises a fixed rate liability in currency X (Say US Dollar) while other raised fixed rate
funding in currency Y (Say EUR).
The principal amounts are equivalent at the current market rate of exchange.

 At the initiation of the swap contract, the principal amounts are exchanged with the first party
handing over US to the second & getting EUR in return.

 Subsequently, the first party makes periodic EUR payments to the second, computed as interest at
a fixed rate in the EUR principal while it receives payments from second party in dollars again
computed as interest on dollar principal.

 At maturity, the dollar & EUR principals are re-exchanged.

 A fixed to Floating Currency Swap:

It is also know as cross – currency coupon swap.

In this one payment say in Currency X calculated at a floating interest rate while the other in
currency Y is at a fixed interest rate.

 It is a combination of a fixed to floating currency swap & fixed to floating interest rate swap.
  It is also possible to have both payments at floating rate but in different currencies.

 Contracts without the exchange & re-exchange of principals do exist.

 External Hedging Tools – Forward, Futures & Options

There are four instruments multinational companies can use for hedging their foreign exchange
exposures (transaction exposures): Forwards, Futures, Options and Swaps

Forwards:
Forwards are custom made contracts to buy or sell foreign exchange in the future at a specific
price. Maturity and size of contracts can be determined individually to almost exactly hedge the
desired position. The hedging method uses up bank credit lines even two forward contracts
exactly offset each other.

Futures:
Futures are ready made contracts to buy or sell foreign exchange in the future at a specific price.
A firm that buys a currency futures contract is entitled to receive a specified amount in a specified
currency for a stated price on a specified date.

Options:
Options are the contracts that offer the right, but not the obligation, to buy or sell foreign
exchange in the future at a specific price. A currency option hedge involves the use of currency or
put options to hedge transaction exposure. Hence, the firm can be insulated from adverse
exchange rate movements, but may benefit from favorable movements. However, the firm must
assess whether the advantages are worth the premium paid for the option.

Swaps
Swaps are contracts which involve two counter parties exchange over an agreed period, two
streams of payments in different currencies. Currency swaps involve an exchange of cash flows in
two different currencies. A currency swap is a contract which commits two counter parties to an
exchange over an agreed period, two streams of payments in different currencies. These payments
are each calculated using a different exchange rate agreed at the start of the contract.