International Finance 315 v1

INTERNATIONAL FINANCE
Sub Code - 315
Developed by
Prof. Rahul Shah
On behalf of
Prin. L.N. Welingkar Institute of Management Development & Research
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Advisory Board
Chairman
Prof. Dr. V.S. Prasad
Former Director (NAAC)
Former Vice-Chancellor
(Dr. B.R. Ambedkar Open University)
Board Members
1. Prof. Dr. Uday Salunkhe  2. Dr. B.P. Sabale  3. Prof. Dr. Vijay Khole  4. Prof. Anuradha Deshmukh 
Group Director  Chancellor, D.Y. Patil University, Former Vice-Chancellor  Former Director 
Welingkar Institute of Navi Mumbai  (Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)
Program Design and Advisory Team
Prof. B.N. Chatterjee Mr. Manish Pitke

Dean – Marketing Faculty – Travel and Tourism
Welingkar Institute of Management, Mumbai Management Consultant
Prof. Kanu Doshi Prof. B.N. Chatterjee

Dean – Finance Dean – Marketing
Welingkar Institute of Management, Mumbai Welingkar Institute of Management, Mumbai
Prof. Dr. V.H. Iyer Mr. Smitesh Bhosale

Dean – Management Development Programs Faculty – Media and Advertising
Welingkar Institute of Management, Mumbai Founder of EVALUENZ
Prof. B.N. Chatterjee Prof. Vineel Bhurke

Dean – Marketing Faculty – Rural Management
Prof. Venkat lyer Dr. Pravin Kumar Agrawal

Director – Intraspect Development Faculty – Healthcare Management
Manager Medical – Air India Ltd.
Prof. Dr. Pradeep Pendse Mrs. Margaret Vas

Dean – IT/Business Design Faculty – Hospitality
Welingkar Institute of Management, Mumbai Former Manager-Catering Services – Air India Ltd.
Prof. Sandeep Kelkar Mr. Anuj Pandey

Faculty – IT Publisher
Welingkar Institute of Management, Mumbai Management Books Publishing, Mumbai
Prof. Dr. Swapna Pradhan Course Editor

Faculty – Retail Prof. Dr. P.S. Rao
Welingkar Institute of Management, Mumbai Dean – Quality Systems
Welingkar Institute of Management, Mumbai
Prof. Bijoy B. Bhattacharyya Prof. B.N. Chatterjee

Dean – Banking Dean – Marketing
Mr. P.M. Bendre Course Coordinators

Faculty – Operations Prof. Dr. Rajesh Aparnath
Former Quality Chief – Bosch Ltd. Head – PGDM (HB)
Welingkar Institute of Management, Mumbai
Mr. Ajay Prabhu Ms. Kirti Sampat

Faculty – International Business Assistant Manager – PGDM (HB)
Corporate Consultant Welingkar Institute of Management, Mumbai
Mr. A.S. Pillai Mr. Kishor Tamhankar

Faculty – Services Excellence Manager (Diploma Division)
Ex Senior V.P. (Sify) Welingkar Institute of Management, Mumbai
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1st Edition (July-2006). 2nd Edition (Jan-2011). 3rd Edition (Jan-2013)
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CONTENTS
Contents
Chapter No. Chapter Name Page No.
1 Overview of International Business 3-18

2 Fundamentals of International Finance 19-39
3 International Foreign Exchange Markets 40-60
4 Foreign Exchange Management in India 61-72
5 Foreign Exchange Quotations 73-123
6 Foreign Exchange Calculations 124-177
7 Exchange Rate Regimes 178-199
8 Euro Currency (Offshore) Market 200-220
9 International Equity Market 221-243
10 Risk Management and Derivatives 244-260
11 International Institutions 261-273
12 Appendix 274-279
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OVERVIEW OF INTERNATIONAL BUSINESS
Chapter 1
Learning Objectives
After completing this chapter, you should be able to understand:
• What is International Business (IB)

• How Globalization Impacts the Economy on the Backdrop of IB
• International Bank for Reconstruction and Development (IBRD) and its
Impact
• Role and Importance of World Bank
• Components of International Business
• Contribution of International Finance
Structure:
1.1 Introduction
1.2 Introduction of International Business
1.3 Growing Importance of International Business
1.4 International Bank for Reconstruction and Development (IBRD) and its
impact
1.5 Drivers of International Business
1.6 Nature of International Finance
1.7 Significance of International Finance
1.8 Summary
1.9 Self Assessment Questions
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1.1 INTRODUCTION
One of the most significant trends in past two decades has been the rapid
and sustained growth of international business in the world. Markets have
become truly global for most of the goods, services and financial
instruments. World trade has expanded by more than six per cent per year
since 1950. The most dramatic increase in globalization has occurred in
financial markets. Global markets are characterized by competition. More
and more companies are going international and a growing percentage of
their overall sales is coming from overseas markets. There are new
opportunities and pressures to utilize them. The opening of markets
creates new geographical space for companies to expand in and access
tangible and intangible resources. It also permits wider choice in the
methods like trade, FDI, licensing, sub-contracting, franchising and
partnering to operate in different locations.
Today, more and more companies from many countries are investing
abroad through mergers and acquisitions or through various forms of non-
equity relationships. The fragmentation and production processes across
international borders are an important new trend for developing
economies. Global trade rules have fostered global production networks
and an associated rise in intra firm trade by progressively lowering trade
barriers. Foreign capital has played a catalytic role in pushing policies in
the right direction and controlling number of resources to the development
effort. Globalization is praised for the new opportunities such as access to
new markets and technology transfer, increased production and higher
living standards. There is wide spread reduction and removal of trade
barriers, deregulation of internal markets, privatization and liberalization of
technology and investment flows at national level. Thus, it appears that in
the changing economic scenario, global business is a fact of like. The global
corporations have become the central players of the world economy and in
linking foreign direct investment, trade technology and finance. They are a
driving force of world growth. Managing business is the new millennium
means some global interactions. The companies may succeed or fail on the
basis of their ability to deal with the dynamic global environment. Their
impact on the economic and the social welfare of developing countries is
both widespread and critical.
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1.2 INTRODUCTION OF INTERNATIONAL BUSINESS
International business is the process of focusing on the resources of the

World and objectives of the organizations on World business opportunities
and threats. The term international business has emerged from the term
export marketing. A company that fails to go global is in the danger of
losing its domestic business to competitors with lower costs, greater
experience better products and, in a nutshell MORE VALUE for the
customer.
Globalization makes the business environment increasingly global even for

domestic firms. The major competition which many firms encounter in the
home market now, for instance, is from foreign firms - they now face a
substantially growing competition from goods produced in India by MNC
and imports.
For the sake of simplicity, one may be tempted to define international

business as any business activity or transaction that transcends the
national border. It is however, doubtful whether some of the business
transactions which cross national border can be regarded as real
international business. For example, consider the case of a firm which
imports a minor item, which is not available domestically and is required
for manufacturing from a foreign country. The nature and reason/purpose
of business activities which cross national borders differ, and therefore, the
extent of real internationalization or international orientation also differs. It
may also be noted that there may be real internationalization in certain
transactions which would outwardly appear to be purely domestic business.
For example, take the case of a firm which sells all its output domestically
and procures all the raw materials, parts, components and other industrial
inputs domestically. There is real internationalization, if the procurement
from the domestic market is the result of global sourcing, i.e., the decision
to source them domestically is the result of the realization that the current
global sourcing destination is globally the best source. Some other facets of
internationalization of what may appear to be domestic business is
indicated in the definition of international marketing.
It may be noted that many seemingly domestic products are truly

international products in the sense that several of the parts and
components which make up these products are manufactured in different
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countries as mentioned earlier and explained in this section on global

sourcing and production sharing.
1.3 GROWING IMPORTANCE OF GLOBALISATION OF

INTERNATIONAL BUSINESS
The importance of international business is due to following driving forces:
Liberalization
One of the most important factors which have given a great impetus to
internationalization since the 1990s, is the almost universal economic
policy liberalisations which are fostering a borderless business world. While
a lot of the liberalizations owe it to the GATT/WTO, substantial
liberalizations have been occurring outside the GATT/WTO as well for
example, the revolutionary economic policy changes in China and other
Socialist/ Communist nations. It may be noted that it has become quite
common to describe the global trend as LPG (Liberalization, Privatization
and Globalization) is indicating the mutually interdependent and reinforcing
nature of these forces.
Multinational Companies
Multinational enterprises which link their resources and objectives with

world market opportunities have been a powerful driving force targeting
globalization. Taking advantage of the liberalization trend, there has been a
fast growth of the number of MNCs and their global network of affiliates.
Accordingly to the World Investment Report, 1997, there were about
44,500 MNCs (it would definitely be more than 70,000 in the year 2007).
According to World Investment Report, 2002, the MNCs were 65,000. The
MNCs leverage their strengths to link global resources and opportunities
and thereby, strengthen the globalization trend.
Technology Development
Technological advances have tremendously fostered globalization.

Technology has in fact been a very important facilitating factor of
globalization, with its rising costs and risks, which makes it imperative for
firms to tap world markets and to share these costs and risks on the other
hand, falling transport and communication costs — the death of distance
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have made it economical to integrate distant operations and ship products

and components across the globe in the search of efficiency. Technology is
a universal factor that crosses national cultural boundaries. Technology is
truly STATELESS, there are no cultural boundaries limiting its application.
Once a technology is developed, it soon becomes available everywhere in
the world. Monopoly of technology, like possession of patented technology,
encourages internationalization because the firm can exploit the respective
demand without any competition. For example, a hospital in the U.S.
performs the required diagnostics - an Xray and assorted scans. In the
next three minutes, a radiologist in Bengaluru (India) receives the scanned
images and sends back his report (teleradiology). The entire process from
the time the patient got admitted, takes 20 minutes. The cost of this work
is over 30% lower in India compared to U.S.A and the time difference
makes it easier for them to look for India (an article on long range X-ray,
published in Business Today, Oct 13, 2002).
Transportation and Communication Revolution
The IT revolution has made an enormous contribution to the emergence of

the global village. Indeed the microprocessor, which enabled the explosive
growth of high power, low cost computing, vastly increasing the amount of
information that can be processed by individuals and firms, has been doing
wonders. The microprocessor also underlies many recent advances in
telecommunications technology. The development in satellite, optical fiber,
wireless technologies and Internet and world wide web (www) has been
revolutionized. The cost of microprocessors continues fall, while their
power increases (doubles) and its cost of production falls in half every 18
months (this is known as Moore's Law). The internet and web have
increased the volume of global business from fewer than one million users
in 1990, connected to the Internet and increased to 1.12 billion users or
about 18% of the world population by the end of the year, 2005.
Global sourcing was increased not only by trade liberalization but also by
technological developments which reduced transport costs. Advent of
containerization and super tonnage cargo ships drastically reduced
transport costs.
Product Development Costs and Efforts
The cost of new product development is very huge in several industries

such as pharmaceuticals. To recoup such high costs an international market
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is required. Further, because of the huge investment and diverse

requirements of skill associated with new product development, cross
border alliances in research and development are becoming more and
more popular.
Quality and Cost
The two most important determinants of demand are the quality and price
of the offering.These are better achieved when the firm/company is
international in its operations.
Rising Aspirations and Wants
Due to increasing level of education and exposure to the electronic-media,

the aspirations of people all around the world are rising. The customer
today is by and large international he/she wants a world-class products of
a desired attributes at international price. He/She may desire a product
available anywhere in the world.
Competition
Another factor for importance of international business is increasing

competition.Heightened competition compels firms to explore new ways of
increasing their efficiency, including by extending their international reach
to new markets at an early stage. With new ownership and contractual
arrangements, and new activities being located in new sites abroad.
World Economic Trends
One of the important trends is the difference in the growth rates of the
economies/markets. The comparative slow growth of the developed
economies or the stagnation of some of their markets and the fast growth
of a number of developing countries, prompt firms of developed-countries
to turn to the expanding markets, elsewhere.
The domestic economic growth and the outside opportunities reduce the
opposition to international business.
Another driving force of internationalization is the economic liberalization,

characterised by DEREGULATION and PRIVATISATION.
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Regional Integration
The proliferation of regional integration schemes, like the European Union

(EC), North American Free Trade Agreement (NAFTA), SAARC, ASEAN, EEC,
EFTA (European Free Trade Association), etc. by creating a borderless
world between the members of such trade blocs, foster the
internationalization trend. Many of these regional blocs also give a fillip to
the cross border investments and financial flows.
Development of Leverages
Leverage is simply some type of advantage that a company enjoys by

virtue of the fact that it conducts business in more than one country any
international company posseses the four important leverages.
a. Experience transfer for expanding or strengthening its

international operations: It can draw on management practices,
strategies, products, advertising,appeals or sales or promotional ideas
that have been tested in actual markets and apply them in other
comparable markets
b. Scale economies: The cost is one of the important determinants of

success. Cost advantage, in many cases, derives out of scale
economies. To realize scale economies, it is often essentital to go after
the global market. Technological breakthroughs are substantially
increasing the scale economies and the market scale required to break-
even.
c. Resource utilization: Another strength of an international company is

its competence of sourcing the resources internationally.
d. International strategy: A global strategy built on an information

system that scans the world-business environment to identify
opportunities, trends, threats and resources. The international strategy
is a design to create a winning offering on an international scale.
To Achieve Higher Rate of Profits
When the domestic markets do not promise a higher rate of profits,

business firms search for foreign markets which promise for higher rate of
profits.
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Expansion of Production
Many of the domestic companies expanded their production capacities that

was more than the domestic demand. These companies in such cases are
forced to sell their excess production in foreign developed countries. Toyota
Motors of Japan is an example
Limited Home Market
When the size of the home market is limited either due to the smaller size
of population or due to lower purchasing power of the people or both, the
companies internationalise their products. ITC entered the European
market due to lower purchasing power of the Indians with regard to high
quality cigarettes.
Similarly, merely 60 lakh population of Switzerland forced Ciba-Geigy to

internationalise its operations. In fact, this company was forced to
concentrate on international market and establish manufacturing facilities
in foreign countries including India.
Political Stability
Political stability does not simply mean that continuation of the same party
in power, but that continuation of the same policies of the Government for
a quite longer period. Business firms prefer to enter the politically stable
countries and are restrained from locating their business operations in
politically instable countries.
Nearness to Raw Materials
The source of highly qualitative raw materials and bulk raw materials is a
major factor for attracting the companies from various foreign countries.
Most of the U.S.-based and European-based companies located their
manufacturing facilities in Saudi Arabia, Bahrain, Qatar, Oman, Iran and
other middle-east countries due to the availability of petroleum.
Quality of Human Resource Availability
This is a major factor for software, high technology and telecommunication

companies to locate their operations in India. Importing human resources
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from India by these companies is costly rather than locating their

operations in India.
Imposition of Tariffs and Quotas
Before deregulation and globalization there were various governments

which imposed tariffs or duty on imports to protect the domestic company.
Government had also fixed import quotas in order to reduce the
competition to the domestic companies from foreign companies. These
practices are still prevalent not only in the developing countries but also in
advanced countries. For example, Japanese companies are competent
competitors to the US companies. U.S.A., imposed tariffs and quotas
regarding import of automobiles and electronics from Japan. Harley-
Davidson of U.S.A., sought and got 5 years of tariffs protection from
Japanese imports. To avoid high tariffs and quotas, companies prefer direct
investment to go to internationally. For example, companies like Sony,
Honda, and Suzuki preferred direct investment in various countries by
establishing subsidiaries or through joint ventures.
1.4 INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT (IBRD)
The World Bank originated as a result of the Bretton Woods Conference of

1944, is one of the World's largest sources of development assistance and
its extended assistance to more than 100 developing nations, bringing a
mix of finance and ideas to improve living standards and eliminate the
worst forms of poverty. For each of its clients, the IBRD works with
government agencies, non-governmental organizations and the private
sector to formulae assistance strategies.
The World Bank group comprises of five closely associated institutions,

each institution playing a distinct role in the mission to fight poverty and
improve living standards for people in the developing world. The term
World Bank refers specially to two of the five institutions. The IBRD, IDA
(International Development Association), other institutions are the
International Finance Corporation (IFC), the Multilateral Investment
Guarantee Agency (MIGA) and the International Centre for Settlement of
Investment Disputes (ICSID)
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Mission and Role of World Bank
• To fight poverty with passion and professionalism for lasting results.
• To help people, help themselves and their environment by providing

resources sharing knowledge, building capacity and forging partnerships
in the public and private sectors.
• To be an excellent institution, able to attract, excite and nurture diverse

and committed staff with exceptional skills who know how to listen and
learn.
• To assist in the reconstruction and development of the territories of the

members, by facilitating the investment of capital for productive
purposes, including the restoration of economies destroyed or disrupted
by war, the reconversion of productive facilities to peace time needs and
the encouragement of the development of the productive facilities and
resources in less developed countries.
• To promote private foreign investment by means of guarantees or

participation in loans and other investments made by private investors,
and when private capital is not available on reasonable terms to
supplement private investment by providing, on suitable conditions,
finance for productive purposes out of its own capital funds raised by it
and other resources.
• To promote the long-range balanced growth of international trade and

the maintenance of equilibrium in the balance of payments by
encouraging international investment of the productive resources of
members, thereby, assisting in raising productivity, the standards of
living and conditions of labour in the territories.
• To make sure of availability of funds in the market.
• To provide funds to the borrowers at the possible lowest cost through

manipulating the currency mix and opting the time when the interest rate
in the market is low.
• To control volatility in net income and overall charges of the loan.
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• To promote an appropriate degree of maturity transformation between

borrowings and lending.
• It borrows in the international capital market both on medium and long-

term basis, on currency swaps and under the discount net programme.
Implications
• Funds contribute directly to productive capacity projects.
• Indirectly promotion of local private enterprises.
• Investments directly affect the well-being of the masses of poor people

of developing countries.
• Energy development through oil and gas.
• Contribution to a more sustainable balance of payments in the medium

and longterm and to the maintenance of growth in the face of severe
constraints.
• Through high priority projects needed to restore credit worthiness and

growth.
1.5 DRIVERS OF INTERNATIONAL BUSINESS
International business is not a new phenomenon. Trade across the globe is

as old as business itself. However, the volume of international trade and
the number of players in it have increased dramatically over the last
decade. Today every nation and an increasing number of companies buy
and sell goods in the international marketplace. A number of developments
around the world have helped to fuel this activity. The key drivers of
international business are as follows:
International Production and Operations Management
The globalization process with its borderless network of operations has

created a complex system of manufacturing and operations management
that is indifferent to where goods are manufactured, where services are
offered and where these goods and services are distributed. The dynamic
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shift in the world over in the last decade has resulted in China becoming
the manufacturing center of the world and India becoming the information
technology hub of the world. As international companies seek cost
advantages to compete successfully in the international marketplace, they
constantly look for countries that have lower input costs. In addition, the
technological advances achieved during the late twentieth century have
helped companies adopt more advanced manufacturing systems, including
lean manufacturing. Lean manufacturing improves productivity through
cost and time management. The growth in globalization has opened
opportunities for small entrepreneurs in many countries. Many of these
small entrepreneurs use modern management and operations concepts and
extended value chain management practices to be competitive.
International Marketing
International marketing includes the marketing of goods and services

across national boundaries and the marketing operations of an organization
that sells or produces within a given country when that organization is part
of an enterprise which also operates in other countries and there is some
degree of influence or control of the organizations marketing activities from
outside the country in which it sells and produces the goods. On other
hand,international marketing is simply an attitude of mind and the
approach of a company with a truly global outlook, seeking its profits
impartially around the world. It includes, home market also on a planned
and systematic basis. Thus, developing marketing programs for
international markets is useful to know the various regulations that govern
the activities.
International Human Resource Management
Managing a modern day international company with its dynamic

competitive environment requires a strong internal governance process
that starts with the people that administer it. As more and more companies
embrace the resources- based view (RBV) of strategy, the employees offer
the core competencies for sustainable competitive advantage. Moreover,
research studies have shown that the companies most effective in
conducting business globally must excel in people management among
other factors. Human resources also referred to as human capital are
probably the most important resource the international companies possess.
Thus, as companies grow the need to staff this growth requires that an
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international company recruit and train new employees. Many of the larger
international companies plan their staffing needs well in advance to
coincide with their expansion plans into overseas markets.
International Financial Management
When a company expands its business beyond its national borders by

exporting or importing goods or services, the company's financial manager
has to deal with additional variables such as exchange rates, tariffs, and
regulatory, legal and cultural issues. The financial manager's
responsibilities increase further when the company establishes subsidiaries
abroad, as he or she must deal with additional issues such as borrowing
and lending in local markets and interacting with foreign governments,
agencies and institutions. The international finance manager takes major
decisions about sourcing and investment of funds from various institutions
in the market place such as banks, insurance, stocks, debt markets and
regulatory agencies. Understanding the roles and structures of these
institutions, which are integral to overseas business transactions that help
international financial managers appreciate the decision making challenges
facing them.
1.6 NATURE OF INTERNATIONAL FINANCE
The term "foreign exchange" basically refers to buying the currency of one
country while selling the currency of another country. All nations have their
own, different kinds of money (currency). This has existed throughout the
ages, probably since the time of the Babylonians. As trading developed
between nations, the need to convert one kind of money to another also
developed. This is how a formal system of foreign exchange arose.
As trade between nations developed, Britain, as the nation with the largest
and the strongest navy could spread its commercial interests far and wide.
It therefore, became the most active trading nation, with a vast empire of
colonies. As a result, Britain's currency, the pound sterling, became
benchmark to other currencies that were compared (and exchanged) for
most of the seventeenth, eighteenth and nineteenth centuries. Today, most
currencies are compared to the U.S. Dollar, currently the most active and
commercially strong trading nation; many currencies are still "pegged" to
the U.S. Dollar for their exchange rate.
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Thus, Foreign Exchange refers to money denominated in the currency of

another nation or group of nations. Any person who exchanges money
denominated in one nation’s currency for money denominated in another
nation's currency is conducting foreign exchange. That holds true whether
the amount of the transaction is equal to a few dollars or to billions of
dollars; whether the person involved is a tourist cashing traveler's check in
a restaurant abroad or an investor exchanging hundreds of millions of
dollars to acquire a foreign company. In other words, a foreign exchange
transaction is a shift of funds from one country and currency to another.
The Forex (short for Foreign Exchange) market is the 24 hour cash market
where currencies are traded, typically via brokers. Foreign currencies are
constantly and simultaneously bought and sold across local and global
markets and traders' investments increase or decrease in value based on
currency movements.
Foreign exchange market operates by trading one type of currency against

another. Unlike other financial markets, the market has no physical location
and no central exchange. It operates through a global network of banks,
financial institutions and individuals. The Forex market is emerging as the
world's largest financial market, operating round the clock with enormous
amounts of money traded on a daily basis.
Forex market exists because people and corporate transact internationally.

They travel, export, import goods and services, raise capital abroad and
merge acquire international businesses.
1.7 SIGNIFICANCE OF INTERNATIONAL FINANCE
International Finance is an important input in the decision making process

of different entities. It affects all aspects of economic activity. The activity
can be in the form of individuals making asset selection decisions, firms
taking financial management decision, fund managers deciding on which
markets to deploy funds in and when to exit the markets, governments
deciding to raise funds, central banks dealing with a consistent decline in
foreign exchange reserves, a financial crisis, a surplus of foreign exchange
reserves, or commercial banks making asset liability decisions. In other
words International Finance is also meant as a subset of International
Business.
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1.8 SUMMARY
International Business is the process of focusing on the resources of the

world and the objectives of the organization on world business
opportunities and threats. The term International Business has emerged
from the term international marketing which in turn, emerged from the
term export marketing. A company that fails to go global is in danger of
losing its domestic business to competitors with lower costs, greater
experience, better products and in a nutshell more value for the customer.
1.9 SELF ASSESSMENT QUESTIONS
1. What do you mean by International Business?
2. Explain the growing importance of International Business.
3. Write a note on World Bank and its objectives.
4. Explain the factors responsible for the growth of International Business.
5. Explain the concept of International Finance with its significance to the

economy. 
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture - Part 1
Video Lecture - Part 3 
! !19
FUNDAMENTALS OF INTERNATIONAL FINANCE
Chapter 2
FUNDAMENTALS OF INTERNATIONAL
FINANCE
Learning Objectives
• What do you mean by International Finance

• Scope of International Finance
• Factors affecting Foreign Exchange Rates
• Balance of Payment and its Components
• Elements of Foreign Exchange Transaction
Structure:
2.1 Meaning of International Finance

2.2 Scope of International Finance
2.3 Factors Influencing Foreign Exchange Rates
2.4 Balance of Payment
2.5 Features of Balance of Payment
2.6 Components of Balance of Payment
2.7 Methods to Identify Surplus or Deficit in BOP
2.8 Elements of Foreign Exchange Transaction
2.9 Devaluation/Depreciation of Exchange Rate
2.10 Summary
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2.1 MEANING OF INTERNATIONAL FINANCE
• The study of International Finance essentially involves the study of

different mechanisms by which money can be raised in international
market.
• The main areas through which monetary resources are raised are:
a. International equity market

b. International debt market
c. International loan syndication
d. International trade credit
• All these mechanisms in different proportions involve two additional

variables beyond those applicable to raising resources domestically.
These additional variables are:
1. The rate of conversion between currencies is called the exchange

rate.
2. The rates of interest applicable to the two currencies being
exchanged.
• Thus, the study of International Finance, therefore, involves an

understanding of international economics and the mechanisms of foreign
exchange arithmetic.
2.2 SCOPE OF INTERNATIONAL FINANCE
• International Trade: International trade helps to achieve the following:
1. Transfer of efficiency from one geographical area to another.

2. Improvement in the standard of living of both communities.
3. Provides for better utilization of resources at a universal level.
• Foreign Exchange Market: The transactions which get executed

through the intermediation of banks where one currency gets converted
into another. This process is called 'Foreign Exchange’.
• International Financial Economics: It is concerned with causes and

effects of financial flows among nations.
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• International Financial Management: It is concerned with how

individual economic units, especially MNCs, cope with complex financial
environment of international business.
• International Financial Markets: It is concerned with international

financial/investment instruments, foreign exchange markets,
international banking, international security markets, financial
derivatives, etc.
2.3 FACTORS AFFECTING FOREIGN EXCHANGE RATES
Foreign Exchange rates are influenced by several factors in the

international market.These can be summarized as follows:
Gross Domestic Product (GDP)
GDP is the broadest measure of aggregate economic activity in a country

and represents the total value of final goods and services produced in a
country. GDP is the primary indicator of the strength of economic activity.
So, the growth in the GDP positively influences the foreign exchange price
of the currency. A fast growing economy will reflect strength in the
exchange rate and vice versa.
Trade Balance
This represents the difference between imports and exports of tangible

goods. The changes in exports and imports are recorded in the current
account of the BOP and therefore, have a ready immediate effect on the
demand-supply equation. This data is, thus, widely followed by the foreign
exchange market.
Inflation
Inflation is the rate of change in the price level of a fixed basket of goods
and services in an economy. In most countries the most widely followed
measure of inflation is the Consumer Price Index (CPI) i.e., the rate of
change in the price level of a fixed basket of goods and services purchased
by consumers. Inflation reduces the purchasing power of the currency.
! !22
Employment Levels
Employment levels in an economy reflect the development and stability in

the economy. An expanding economy would result in greater investments
which would result in more employment generation. This increases income
within the economy resulting in higher consumption and savings.
Exchange Rate Policy
In many countries, the exchange rate policy is decided by the Finance

Ministry. However, the execution of the exchange rate policy is always
managed by the Central Bank.The central bank of the country participates
in the local foreign exchange market by way of intervention to stabilize the
exchange rate or maintain it in a particular range.
Political Factors
Some of the common political developments such as elections, public

announcements by central bank or government officials, military takeovers,
political instability, etc. All such factors affect the exchange rate.
View of Speculators
More than 90% of the turnover in international foreign exchange markets

represents speculative activity. The view or perception of the likely value of
the currency of these participants in the market has a critical effect on the
exchange rate.
2.4 BALANCE OF PAYMENTS (BOP)
• International trade plays a major role in the economic development of a

country. The world is becoming an integrated market place and trade
equations are changing rapidly. Realizing the importance of private
capital inflow-outflow for the development of a country, many countries
are taking numerous measures to attract foreign investors.
• Balance of Payment is a term included in international trade.
! !23
IMF definition
Balance of payments is a statistical statement that summarises

transactions between residents and non-residents during a period.
"The balance of payments of a country is a systematic record of all

economic transactions between the residents of a country and the rest of
the world. It presents a classified record of all receipts on account of goods
exported, services rendered and capital received by residents and
payments made by them on account of goods imported and services
received from the capital transferred to non-residents or foreigners”.
— Reserve Bank of India
The above definition can be summed up as following:- Balance of Payments

is the summary of all the transactions between the residents of one
country and rest of the world for a given period of time, usually one year.
The definition given by RBI needs to be clarified further for the following
points:
A. Economic Transactions
An economic transaction is an exchange of value, typically an act in which

there is transfer of title to an economic good, the rendering of an economic
service or the transfer of title to assets from one economic agent
(individual, business, government, etc) to another. An international
economic transaction evidently involves such transfer of title or rendering
of service from residents of one country to another. Such a transfer may be
a requited transfer (the transferee gives something of an economic value to
the transferor in return) or an unrequited transfer (a unilateral gift). The
following are the basic types of economic transactions that can be easily
identified:
1. Purchase or sale of goods or services with a financial quid pro quo —

cash or a promise to pay. [One real and one financial transfer].
2. Purchase or sale of goods or services in return for goods or services

or a barter transaction. (Two real transfers)
! !24
3. An exchange of financial items, e.g., purchase of foreign securities

with payment in cash or by a cheque drawn on a foreign deposit.
[Two financial transfers]
4. A unilateral gift in kind [One real transfer].
5. A unilateral financial gift. [One financial transfer]
B. Resident
The term resident is not identical with "citizen" though normally there is a
substantial overlap. As regards individuals, residents are those individuals
whose general centre of interest can be said to rest in the given economy.
They consume goods and services; participate in economic activity within
the territory of the country on other than temporary basis.
• This definition may turn out to be ambiguous in some cases. The

"Balance of Payments Manual" published by the "International Monetary
Fund" provides a set of rules to resolve such ambiguities. As regards
non-individuals, a set of conventions have been evolved, e.g.,
government and non-profit bodies serving resident individuals are
residents of respective countries, for enterprises, the rules are somewhat
complex, particularly to those concerning unincorporated branches of
foreign multinationals.
• According to IMF rules these are considered to be residents of countries

in which they operate, although they are not a separate legal entity from
the parent located abroad. International organizations like the UN, the
World Bank, and the IMF are not considered to be residents of any
national economy although their offices are located within the territories
of any number of countries.
• To certain economists, the term BOP seems to be somewhat obscure.

Yeager, for example, draws attention to the word "payments" in the term
BOP; this gives a false impression that the set of BOP accounts records
items that involve only payments. The truth is that the BOP statements
records both payments and receipts by a country. It is, as Yeager says,
more appropriate to regard the BOP as a “balance of international
transactions" by a country.
! !25
• Similarly, the word "Balance" in the term BOP does not imply that a
situation of comfortable equilibrium; it means that it is a balance sheet of
receipts and payments having an accounting balance. Like other
accounts, the BOP records each transaction as either a plus or a minus.
• The general rule in BOP accounting is the following:-
(a)If a transaction earns foreign currency for the nation, it is a credit

and is recorded as a plus item.
(b)If a transaction involves spending of foreign currency it is a debit and

is recorded as a negative item.
• The BOP is a double entry accounting statement based on rules of debit

and credit similar to those of business accounting and book-keeping,
since it records both transactions and the money flows associated with
those transactions.
• Also, in case of statistical discrepancy the difference amount is adjusted

with errors and omissions account and thus, in accounting sense the BOP
statement always balances.
2.5 FEATURES OF BALANCE OF PAYMENTS (BOP)
Systematic Record
It is a systematic record of receipts and payments of a country with other

countries.
Fixed Period of Time
It is a statement of a account pertaining to a given period of time, usually

a year.
Comprehensiveness
It includes all the three items, i.e., visible, invisible and capital transfers.
The balance of payments is a comprehensive record of economic
transactions of the residents of a country with the rest of the World during
a given period of time. The aim is to present an account of all receipts and
! !26
payments on account of goods exported, services rendered and capital by

resident of a country and goods imported, services received and capital
transferred by residents of the country.
Double Entry System
Receipts and payments are recorded on the basis of double entry system.
The basic convention applied in constructing a balance of payments
statement is that every recorded transaction is represented by two entries
with equal values. One of these entries is designateda credit with a positive
arithmetic sign; the other is designated a debit with a negative sign. In
principle, the sum of all credit entries is identical to the sum of all debit
entries and the net balance of all entries in the statement is zero.
Self-balanced
From the point of view of accounting, double entry system automatically

keeps debit and credit sides of the accounts in balance.
Adjustment of Differences
Whenever there are differences in actual total receipts and payments, need
is felt for necessary adjustment.
All Items — Government and Non-government
Balance of Payments includes receipts and payments of all items

government and non-government.
2.6.COMPONENTS OF THE BALANCE OF PAYMENTS

ACCOUNT (BOP)
As it is evident, balance of payment is a collection of accounts of all such

eligible transaction that have bearing on the Forex position of the economy.
This BOP, the collection of accounts is conventionally grouped into three
main accounts with subdivisions in each. 
! !27
The major components in the BOP are:
A. Current Account
B. Capital Account
C. Reserve Account
D. Errors and Omissions Account
(A) Current Account
a. The current account of the BOP is made up of three balances namely

- Merchandise (Visible) balance, Services (Invisible) balance and
Unilateral Transfer Balance.
! !28
b. Effectively, it reflects the net flow of goods, services and unilateral

transfers (gifts,donations, legacies, etc.).
c. Balance on current account can be defined as the net value of the

balances of the visible trade, invisible trade and unilateral transfer
d. BOP on current account covers all receipts and payments arising out
of trade and personal remittances. It thus, has a direct impact on the
exchange rate of the domestic currency.
e. Following items are mainly included under current account:
1. Export and Import of Visible goods  

 
Import and Export of visible material goods and precious metals. In
other words, all goods included in balance of trade are the main items of
current account.
2. Invisible Items — Services 

 
Import and Export of invisible goods, i.e., different kinds of services
included in current account. Main Invisible services are:-
(i) Services Rendered by Commercial Undertakings: Commercial

undertakings like shipping companies, insurance companies, banks,
etc., belonging to a given country or different countries, exchange
their services among different countries. Exchanges of such services
are included in current account.
(ii)Services of Experts: Every country avails mostly the services of the

foreign experts like doctors, engineers, soldiers, etc. and also puts
the services of its experts at the disposal of the other countries. The
services received from abroad are imports and the services rendered
to foreign countries are exports.
3. Travelling 
 
One of the main invisible items of the balance of payments is travels.
These travelling may be of any account for instance, these may be in
connection with business, education, health, conventions or pleasure
! !29
trip, etc., the country visited to, for it these travels constitute exports
and use of foreign transport by the natives amounts to imports.
4. Transportation 
 
Movement of goods from one country to the other. Use of domestic
transport by the foreigners amounts to exports and use of foreign
transport by the natives amounts imports.
5. Investment Income 
 
Interest, rent, dividend and profit also form an invisible item of balance
of payments.  
 
When a country gets income from its investment abroad it is recorded
under the head 'Receipts'. 
 
On the other hand, when foreign investors earn income from the
country where they make investment, then it is recorded under the
head ‘Payments'.
6. Governmental Transactions 
 
Each government establishes its embassies, offices of high
commissioners and other missions abroad and spends a lot on their
maintenance. Such a expenditure is treated as payments. Besides
subscriptions, etc., made to international institutions are also included in
this category.
7. Donations and gifts 

 
Donations are gifts, etc., received from abroad are included under
'Receipts' and donations and gifts, etc., given to other countries are
included under ‘Payments'.
8. Miscellaneous  
 
These include such invisible items as commission, advertisement, rent,
patent fees, royalties, membership fees, etc., the amount received from
! !30
abroad on this count constitutes credit item and amount paid to other
countries in this respect constitutes debit item.
(B) Capital Account
a. The capital account records all international transactions that involve

creation of assets and liabilities in foreign currencies.
b. The capital account, thus, records all 'receivables and payables' which
would impact the demand-supply equilibrium in the future.
c. The classification of a transaction is either current or capital

therefore, does not depend on the nature of asset but on the nature
of the transaction.
d. The main items of capital account are as follows:
1. Private Foreign Loan Flow  

 
Foreign loans received by the private sector are counted as credit item
and repayments of these loans is counted as debit item.
2. Movement in Banking Capital 

 
Beside central bank, inflow of banking capital is counted as credit item
and outflow as debit item.
3. Official Capital Transactions 

 
Loans received by the public sector from abroad or International
Monetary Fund constitutes credit items and loans repaid debit items.
(C) Reserve Account
a. Reserve account forms a special feature of the capital account. This

account records the changes in the part of the reserves of other
countries that is held in the country concerned.
b. These reserves are held in three forms: in foreign currency, as gold

and as Special Deposit Receipts (SDRs).
! !31
c. The change in the reserves account measures a nation's surplus or

deficit on its current and capital account transactions by netting
reserve liabilities from reserve assets.
d. The main items of Reserve accounts are as follows:
1. Reserves, Monetary Gold and SDRs 

 
Foreign currency assets of the government, gold reserves of the central
bank, SDRs of IMF and similar capital transactions, etc., are included
under credit items and all kinds of payments under debit items
2. Gold Movements 
 
When the central bank of a country buys gold from abroad, it makes
payment to foreign sellers. It is reflected under debit items. On the
contrary, when it sells gold it is reflected under credit items.
3. Miscellaneous 
 
Beside the above items, all other kinds of governmental capital receipts
which also include receipts of the central bank are shown on credit side
and all kinds of payments are shown on debit side.
(D) Errors and Omissions Account
a. Errors and omissions account is a "statistical residue." It is used to

balance the statement because in practice it is not possible to have
complete and accurate data for reported items and because these
cannot, therefore, ordinarily have equal entries for debits and credits.
b. The entry for net errors and omissions often reflects unreported flows
of private capital, although the conclusions that can be drawn from
them vary a great deal from country to country, and even in the
same country from time to time, depending on the reliability of the
reported information.
c. The changes in the country's reserves must reflect the net value of all
the other recorded items in the balance of payments. These changes
are to be recorded accurately, and it is the discrepancy between
! !32
these changes in reserves and the net value of the other recorded
items that allows us to identify the errors and omissions.
d. For e.g., A remittance by an Indian working abroad to India may not

yet be recorded or a payment of dividend abroad by an MNC
operating in India may not yet be recorded or so on. The errors and
omissions amount equals to the amount necessary to balance both
the sides.
Balance of Payments Account
Receipts (Credits) Payments (Debits)
1. Export of goods Imports of goods
2. Export of services. Import of services.

3. Interest, profit and dividends received. Interest, profit and dividends paid.
4. Unilateral receipts. Unilateral payments.
Current Account Balance (1 to 4)
5. Foreign investments. Investments abroad.

6. Short-term borrowings. Short-term lending.
7. Medium and long-term borrowings. Medium and long-term lending.
Capital Account Balance (5 to 7)
8. Errors and omissions. (+) Errors and omissions.

9. Change in reserves. Change in reserves (-)
Total Receipts = Total Payments
! !33
2.7 METHODS TO FIND OUT SURPLUS OR DEFICIT IN BOP

ACCOUNT
1. Autonomous and Accommodating Capital Flows Concept
No. Autonomous Tansactions Accommodating Transactions
1 These transactions are undertaken in These transactions are

the normal course of business without undertaken considering the
considering the equilibrium and no equilibrium and intention of
specific intention of balancing BOP. balancing the the BOP.
2 These transactions effectively represent These transactions effectively

Current and Capital account represent Reserve account
transactions. transactions.
3 Classified as 'Above the Line’ Classified as 'Below the Line’

transactions. transactions.
4 These transactions are normally These transactions are

undertaken by market participants undertaken by the Central
other than the Central Bank. Bank.
5 BOP are surplus if net balance of A surplus BOP result in an

autonomous transactions are positive increase in reserves whereas, a
BOP are deficit if net balance of deficit BOP result in a decrease
autonomous transactions are negative. in reserves account.
2. The Official Settlement Concept
I. Another approach for indicating, a deficit or surplus in the BOP is to

consider whether the net monetary transfer that has been made by
the monetary authority is positive or negative.
II. This means that the transfer to or from the Reserves Account
represents the extent of accommodation being provided by the
monetary authority for balancing surplus/ deficit in the autonomous
transactions.
III.Effectively, the monetary authority settles the disequilibrium in the

BOP and hence,such actions are called 'Official Settlements'.
! !34
3. Current Account Monetary Model
I. This model is based on the Purchasing Power Parity theory and on the
assumption that flexible exchange rates keep the balance of
payments in continuous equilibrium.
II. Consequently, it is implied that there are no changes in foreign

exchange reserves.
III.Nominal domestic money supply is determined by domestic credit

creation which is controlled by domestic monetary authorities.
IV. The monetary authority is not bound by any compulsion to intervene

in markets for protecting the exchange rate.
4. Capital Account Monetary Model
I. This Model was developed by economist Frankel in 1979. The Frankel

model suggests (like the current account monetary model) that an
increase in domestic money supply will, in the long run depreciate
the domestic currency, while an increase in demand for the domestic
currency will lead to of foreign currency appreciation.
II. The interest rate of a currency also has an impact on the appreciation
or depreciation of the domestic currency.
III.If interest rates increase due to tight monetary conditions, i.e.,

greater demand for the domestic currency, then the currency would
appreciate whereas, if the interest rate increase as a consequence of
higher inflation then the currency would depreciate.
2.8 ELEMENTS OF A FOREIGN EXCHANGE TRANSACTION
FIAT Currencies
FIAT currencies are paper currency notes issued by the Central Monetary
Authority of the respective countries, incorporating promise to redeem
these notes at face value. The intrinsic value of these notes is always less
than the face value.
! !35
Foreign Currency
The Foreign Exchange Management Act, 1999, defines:
"Foreign Exchange means foreign currency and includes-
(i) Deposits, credits and balances payable in any foreign currency.
(ii)Drafts, travellers cheques, letter of credit or bills of exchange,

expressed or drawn in Indian currency but payable in any foreign
currency; and
(iii)Drafts, traveller's cheques, letter of credit or bills of exchange drawn by

banks, institutions or persons outside India, but payable in Indian
currency".
NOSTRO accounts
Demand deposit accounts, denominated in foreign currencies maintained

by domestic banks with banks overseas are called NOSTRO accounts.
Nostro means 'our account with you'. Ex: If State Bank of India, Mumbai
has a US Dollar account with American Express Bank, New York then such
an account would be called a NOSTRO account.
VOSTRO accounts
Demand deposit accounts denominated in domestic currency maintained by

overseas banks with domestic banks are called VOSTRO accounts. Vostro
account means ‘your account with us'. Ex: If Standard Chartered Bank,
London has an INR account with Syndicate Bank, New Delhi then such an
account would be called a VOSTRO account.
LORO accounts
The term LORO is used when the NOSTRO/VOSTRO account is referred to,
by a bank other than the account maintaining bank and the bank with
which the account is maintained. In other words, it is used when referring
to third party accounts. Ex: If Canara Bank, Mumbai has an account with
Citibank, New York denominated in US Dollars then when Bank Of Baroda
! !36
has to refer to this account while corresponding with Citibank, it would

refer to it as LORO Account, meaning 'their account with you’.
Correspondent Banks
The bank with whom a nostro or vostro a/c relationship is established is

called correspondent bank. This bank essentially acts as an agent of the
domestic bank (principal) and undertakes various functions as follows:
1. Maintaining the foreign currency a/c

2. Providing temporary overdrafts as and when necessary.
3. Providing credit reports on companies located in the country of the
correspondent bank.
4. Assisting the principal bank in all agency functions.
5. Providing trade-related data and product data to help the principal bank.
Foreign Exchange
It can be defined as a transaction or mechanism which facilitates the

exchange between one legal tender and another. It involves transfers
through demand deposit accounts at both ends of an international
transaction. The actual conversion takes place through the use of Nostro/
Vostro accounts between international banks.
Foreign Exchange Market
The foreign exchange market can be defined as an electronically connected

network of international banks, brokers and service providers. The main
characteristics of this market are:
(a) This market does not involve any physical transfer of currencies.
(b) This market does not have any physical structure.
(c) This market helps to establish the rate of conversion between
currencies.
Other Elements
Favourable Balance of Payments — Value of total receipts more than total

payments.
! !37
Adverse Balance of Payments — Value of total receipts less than total

payments.
Balanced Balance of Payments — Value of total receipts equals total

payments.
Unrequited Receipts — Receipts for which nothing has to be paid in return.
Unrequited Payments — Payments for which nothing is received in return.
2.9 DEVALUATION / DEPRECIATION OF EXCHANGE RATE
1. Economies which operate on either a fixed exchange rate system or a

managed float system use the exchange rate to achieve equilibrium in
international trade.
NO. DEVALUATION DEPRECIATION
1 Represents reduction in the value of Represents reduction in the value of

the currency through official action. the currency through market
action.
2 It is one time action. It is a continuous process.
3 It cannot be predicted. It can be anticipated.
4 Associated with the fixed exchange Associated with the flexible

rate system. exchange rate system.
!
!
 
! !38
2.10 SUMMARY
BOP is a standard double entry accounting record to all the transactions of

an economy with Rest of the World (ROW). It is a regular double entry
accounting statement of economic transactions between the residents of a
country and the non-residents. For our reference, it may be enough to
interpret 'non-residents' as 'residents of foreign countries'.The term
'economic transactions' denotes any transaction wherein, something of
economic value is provided by one party to another. Balance of Payments is
a record of payments and receipts of the country. Hence, in strict sense, it
is a calculation of Balance of Payments and Receipts.
1. Balance of Payments as representative of demand and supply factors for

foreign currencies.
2. Factors affecting demand for and supply of foreign currencies.
3. Factors influencing exchange rates.
4. Benefits of BOP Analysis.
5. Nostro/Vostro/Loro. 
! !39
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !40
INTERNATIONAL FOREIGN EXCHANGE MARKETS
Chapter 3
INTERNATIONAL FOREIGN EXCHANGE
MARKETS
Learning Objectives
• Foreign Exchange Control

• Foreign Exchange Control in India
• International Foreign Exchange Market in India
• Dealing Room Operations
• MIBOR
Structure:
3.1 Introduction of Foreign Exchange Control

3.2 The Origin or Evolution of Exchange Control
3.3 Meaning of Exchange Control
3.4 Characteristics of Exchange Control
3.5 Merits of Exchange Control
3.6 Demerits of Exchange Control
3.7 Origin of Exchange Control in India
3.8 Objectives of Exchange Control in India
3.9 Features of Exchange Control in India
3.10 Foreign Exchange Market Introduction
3.11 Participants in Foreign Exchange Market
3.12 Features of International Foreign Exchange Market
3.13 Dealing Room Operations
3.14 Distinction between Merchant and Interbank Transactions
3.15 Mumbai Inter-Bank Offer Rate (MIBOR)
3.16 Summary
3.17 Self-assessment Questions
! !41
3.1 INTRODUCTION OF FOREIGN EXCHANGE CONTROL
• Foreign Exchange Control refers to the control of international monetary

and economic transactions involving foreign exchange either by
government directly or a centralized agency like central bank.
• There are various forms of controls imposed by a government on the

purchase/sale of foreign currencies by residents or on the purchase/sale
of local currency by non-residents. Common foreign exchange controls
include:
➡ Banning the use of foreign currency within the country

➡ Banning locals from possessing foreign currency
➡ Restricting currency exchange to government-approved exchangers
➡ Fixed exchange rates
➡ Restrictions on the amount of currency that may be imported or
exported
• Countries with foreign exchange controls are also known as "Article 14

countries,"after the provision in the International Monetary Fund
agreement allowing exchange controls for transitional economies.
• Such controls used to be common in most countries, particularly poorer

ones, until the 1990s, when free trade and globalization started a trend
towards economic liberalization. Today, countries which still impose
exchange controls are the exception rather than the rule.
• In this exchange control, free play of market forces is restricted by

certain regulative measures in the exchange market. The rate of
exchange under this system will naturally be different from one that will
exist in the absence of such control.
• In today's world economy, almost all the countries in the world have
adopted some form of exchange control or other. In some, it exists in its
extreme form with all its complexities. The control extends over all
transactions of international receipts and payments which are centralized
and all payments are rationed.
! !42
• The countries proclaiming to abolish the exchange control also have

some forms of control. Thus, it is difficult in present times to conceive an
economy which is absolutely free from all sorts of exchange control.
• Regulation at government level of money-flows in and out of a country.

Exchange controls are usually maintained in the belief that they help to
protect a country’s currency and its foreign-exchange reserves.
• The controls may restrict investments by residents overseas and non-

residents’ investments and participation in the local market. Big
international currency movements tend not to obey such controls.
• Sometimes individuals are limited in the amount of currency they may

take abroad for holidays. The UK abandoned exchange controls in 1979.
In Australia, exchange controls which had persisted in one form or
another since 1939, were virtually abolished in December 1983, when
the AUD was floated.
• Types of controls that governments put in place to ban or restrict the

amount of foreign currency or local currency that is allowed to be traded
or purchased. Common exchange controls include banning the use of
foreign currency and restricting the amount of domestic currency that
can be exchanged within the country.
• Typically, countries that employ exchange controls are those with weaker
economies.These controls allow countries a greater degree of economic
stability by limiting the amount of exchange rate volatility due to
currency inflows/outflows.
• The International Monetary Fund has a provision called Article 14, which
only allows countries with transitional economies to employ foreign
exchange controls.
3.2 THE ORIGIN OR EVOLUTION OF EXCHANGE CONTROL
• The origin of the foreign exchange control can be traced back to thirties.
After World War I, the Germany adopted exchange control to stabilize its
continuously depreciating Mark.
! !43
• After it in the same contemporary period, almost all the European

countries resorted to this technique and after World War II almost all the
countries of the world have adopted this technique of exchange control.
• There is hardly any country today which has not adopted in one form or
the other, the system of exchange control.
3.3 MEANING OF EXCHANGE CONTROL
• The foreign exchange control is a system in which a country introduces

some regulatory measures to curb the free play of market forces in the
foreign exchange market.
• The government imposes control on the purchase and sale of foreign

currencies in that system. The term exchange control is used in two
different senses, in the wide sense as well as the narrow sense.
• In the wide sense, the term exchange control refers to all those
intervening activities of government which are intended to influence the
rate of exchange or the business connected with the foreign exchange
and also includes such things as the imposition of control on exchange
rate, exchange equalization accounts as well as the conclusion of trade
and payment agreements with other countries.
• In narrow sense, the exchange control refers to these restrictions which

are imposed by the government on foreign exchange business.
3.4 CHARACTERISTICS OF EXCHANGE CONTROL
1. All types of international transactions involving foreign exchange are

centralized.
2. State has full control over the foreign exchange business in the market.
3. Only those possessing licences can deal in foreign exchange.
4. The government fixes the priorities for distribution of foreign exchange.
5. The whole foreign exchange is deposited with central bank which gives
the exporters domestic currency in return.
! !44
6. The importers get foreign currency from the central bank.
7. Rate of exchange is determined officially by the government and it is

also managed.
3.5 MERITS OF EXCHANGE CONTROL
• It maintains exchange rate stability.
• It is aimed to keep exchange rate in the economy different from the

market exchange rate.
(i) Under Valuation: This policy is adopted for curing the depression.
Under this system, the country fixes rate lower than it would be in a
free exchange market. It will give stimulus to export and domestic
industries and import will be discouraged. As the result, balance of
trade and payments turn in favour of the country.
(ii) Over Valuation: In this objective, a country fixes the value of its
currency at a level higher than it would be if there was no
intervention in foreign exchange. It is adopted when the country is
suffering from inflation and to meet the large debt payments
expressed in foreign currency and the country is in need of foreign
goods.
• It intends to iron out temporary ups and downs and this is done through
exchange equalization account.
• It also aims to correct persistently adverse balance of payments.
• It helps in conserving country's depleting gold reserves and foreign

exchange reserves.
• With exchange control, country also regulates capital movement in order

to prevent the flight of capital from the country.
• Country with exchange control aims objective for its economic growth
with stability.
! !45
• Exchange control done with a view to encourage trade with a particular

country or group of countries (trade block), this is called bilateralism.
• Exchange control provides protection against the tough foreign

competition.
• Exchange control helps in proper execution of the economic plans and

developmental planning in the country.
• It removes the imbalance and deficit in the international trade by

restricting foreign exchange to the importers for importing goods.
• The Government may prohibit the import of certain commodities

altogether with the help of exchange control.
• It could be utilized to earn profit by keeping a wide margin between

buying and selling rates of foreign exchange.
• Through exchange control, a country can adjust the domestic demand of

export and import. By this adjustment a country can maintain internal
price stability.
• Through exchange control, a country tries to escape from the abuses of

international economic crises.
• Exchange control facilitates in making orderly and timely international

debts and other payments.
• Exchange control also maintains the fixed and stable relations with
important currencies to which they have more transactions.
3.6 DEMERITS OF EXCHANGE CONTROL
• As all control gives birth to the dichotomy in the economy and encourage
political and administrative corruption in the country.
• Under exchange control, a country puts an end to the working of a

principle of comparative cost. In this, a country also produces those
commodities in which it does not enjoy advantages.
! !46
• A country has to employ an army of competent officials which is not

feasible for underdeveloped countries.
• It generates the feeling of fulfilling national interest at all costs and this
ultimately creates tension among international community.
• Due to exchange control, there are more fluctuations in the international

economy which encourages the working of business cycles.
• It is against the consumer's interest.
• It obstructs economic cooperation internationally.
• It discourages multilateral trade.
• In the long run, exchange control results in the creation of fundamental

disequilibrium which is more harmful for the economy.
• The criteria laid down for the various types of control are arbitrary in
nature.
• Exchange control puts several restrictive measures in the way of free

trade; it will reduce the volume of international trade
• It also presents several hurdles and obstacles in establishing

specialization in production of several commodities because of imposing
of several restrictions on free trade.
• Exchange control is also not conducive for free flow of capital movement
and investment and that is not in the interest of the economy.
3.7 ORIGIN OF EXCHANGE CONTROL IN INDIA
• In India, exchange controls were first introduced on September 3, 1939,

by government of India. Immediately, after the outbreak of Second World
War No exchange controls were administered before this introduction,
though during first war there were fluctuations in the exchange rate of
Indian Rupee in terms of Sterling and it encouraged speculative activities
and produced adverse repercussions on the country's trade.
! !47
• With the introduction of exchange control in 1939, the government

empowered the Reserve Bank of India under the Defence of India Rules
(DIR), to administer the exchange control of India.
• The RBI, then set up a separate 'Exchange Control Department' for the
proper administration of the exchange control. In 1939 itself, RBI
enunciated its exchange control policy for the benefits of exporters and
importers and to conserve the non Sterling area currencies to utilize
them for essential purposes.
• Due to these developments, it became clear that foreign exchange

control would have to continue in some form or the other in the post war
period, also in the interest of making the most prudent use of the foreign
exchange resources.
• It was felt necessary to continue the exchange control on a systematic

and longterm basis. It was, therefore, decided to place the exchange
control on a statuary basis and the FOREIGN EXCHANGE REGULATION
ACT of 1947, was enacted.
• This Act since been replaced by the Act of 1973 and then after
liberalization of the economy with many modifications with a new name.
It was further replaced by Foreign Exchange Management Act, 1999,
(FEMA).
• Over the years, the scope of exchange control has been substantially
widened and the regulations have become more progressive in view of
the increasing demand of foreign exchange for the planned development.
• It became an integral part of the planned process of development. Its

scope was so further extended to Sterling area and after 1951, Pakistan
and Afghanistan also came into its fold.
• Exchange control in India is administered by the RBI. It is related to and

supplemented by trade control and the responsibility of which has been
entrusted to chief controller of imports and exports now re- designated
as Director General Foreign Trade (DGFT), under the ministry of
commerce.
! !48
• For trade control in our country, we enact the Imports and Exports
Control Act 1947, which has been replaced by the Foreign Trade
Development & Regulation Act (FTDRA), 1992.
• Under the exchange control, the RBI had empowered selected

commercial banks to deal in foreign exchange. In other words, the sale
and purchase was to be conducted by these banks only.
• A major portion of foreign exchange dealings is dealt with these banks in

India which have been authorized by RBI to deal in foreign exchange as
‘Authorized Dealers' in foreign exchange.
3.8 OBJECTIVES OF EXCHANGE CONTROL IN INDIA
(i) Protection of Balance of Payments
One of the important objectives of exchange control is protection of

balance of payments. When the balance of payments deficit of a nation
becomes large and chronic and its automatic correction is not possible,
certain active measures have to be adopted. In normal times, the adverse
balance of payments caused value of country's currency to fall and helps in
restoring equilibrium.
(ii) Reducing Burden of Foreign Debt
The exchange value of a currency is sometimes fixed and maintained at

higher level to lighten the burden of foreign debts contracted in terms of
foreign currencies. By overvaluing currency, the foreign exchange earnings
of the country from exports are increased in cases where the demand is
inelastic and the prices in terms of the home currency to be paid for
essential imports get reduced.
(iii)Raising the Level of Prices
Sometimes, the currency is undervalued to help in raising certain

conditions that are desirable to stabilize the exchange rate at what can be
called the equilibrium level, i.e., the level determined by market forces.
Short-term fluctuations are eliminated by deliberate action of authorities.
! !49
(iv) Elimination of Short-term Fluctuations in Exchange Rate
Exchange regulation in certain conditions is thought desirable to stabilize

the exchange rate at what can be called the equilibrium level, i.e., the level
determined by market forces.
(v) Prevention of Export of Capital
When the country suffers from exceptionally heavy outflow of capital

caused by loss of confidence on the part of nationals of the country or
foreigners in the economy of the country or its currency, certain exchange
controls over remittances from and to the country are necessary
(vi) Economic Planning
Exchange control is an important part of economic policy in any planned

economy. Planning involves a very careful use of foreign exchange
resources of the country, so that only those goods are imported which are
essential for the implementation of the plans. Exchange controls are
resorted to regular the exports and imports in the light of plans.
(vii)Encouragement of Certain Economic Activities
One of the objectives of exchange regulations is to encourage certain

economic activities in the country. Certain industries can be developed by
reducing the imports of commodities produced by them and restricting the
availability of foreign exchange to pay for them.
3.9 FEATURES OF EXCHANGE CONTROL IN INDIA
1. Authority of Control: The main authority in this field is entrusted to

Finance Ministry of Government of India and Reserve Bank of India. For
smooth implementation of the exchange control, RBI takes the help of
several authorized dealers and authorized money changers, etc.
2. Foreign Currency Receipts: Any person earning foreign exchange

from any source has to surrender it before authorized dealer. He can
keep upto $500 with him. A foreign tourist can bring foreign money
without any limit. Any person residing abroad can remit up to $5000 as
! !50
gift instead of previously $1000 to the relative or friend in India. NRIs

can remit money without any limit.
3. Foreign Currency Payments: In making foreign payment for various

purposes like imports of goods and services, education, tourism and
travel, transportation, insurance for all these payments liberal rules
have been framed in comparison to previous rules of FERA. A person
can remit the amount of $25000 without permits of RBI for foreign visit.
4. Administration: The FEMA has assigned more powers to RBI in the

administration of exchange control in the country. RBI has its own
foreign exchange control department under the direct control of the
governor of the bank. There are several other deputy controllers to look
after its sub-offices at Mumbai, Kolkata, New Delhi, Chennai and
Kanpur. The FEMA provides for appointment of director enforcement for
taking up investigations of the contraventions under this act
5. Exchange Rates: After delinking of Indian Rupee with pound sterling,

the exchange rate of Indian Rupee is fixed in accordance with a basket
of selected currencies. Now the value of rupee floats according to the
relative demand and supply of foreign exchange. In emergent
situations, the RBI has power to manage the fluctuations.
6. Convertibility of the Rupee: Free convertibility of a currency means

that the currency can be exchanged or converted for any other currency
without any restrictions at the market determined exchange rate.
Convertibility of the rupees thus means that the rupee can be freely
converted into dollar, pound, and euro, yen, etc. and vice versa at the
rates of exchange determined by the market forces of demand and
supply.
7. Enforcement of Money Laundering Prevention Act 2002: The

government of India enacted an Act in 2002, the Money Laundering
Prevention Act to prevent entry of unlawful money into the country.
8. Superiority of FEMA over FERA: FERA to FEMA marks a positive shift

from control to management of foreign exchange. There are several
grounds on which, we can conclude that the FEMA is superior in
comparison to FERA. Some of the grounds are —
! !51
a) Many provisions of FERA like the ones relating to blocked accounts,

Indians taking up employment abroad, employment of foreign
technicians in India, vexations search, etc., have no appearance in
FEMA.
b) There is lot of deregulation as FEMA only regulates foreign exchange

and FERA controls everything that has to do with foreign exchange.
c) FEMA is much smaller enactment having only 49 sections against 81

of FERA
d) FEMA has more liberal and transparent rules regarding foreign

investment in comparison to FERA.
e) Contravention under FEMA is liable only for penalty up to thrice the

amount involved, while it is was five times in FERA with provision of
imprisonment.
f) The contravention in the FERA is dealt as a criminal offence and

there are provisions of imprisonment also in addition to penalties
while in FEMA violations, it is dealt as civil matters and there is
provision of only penalty.
g) The liability of proving the crime is on the party in FERA but in FEMA
it lies on the enforcement agency
3.10 FOREIGN EXCHANGE MARKET INTRODUCTION
• In today's world no economy is self-sufficient, so there is need for

exchange of goods and services amongst the different countries. So in
this global village, unlike in the primitive age the exchange of goods and
services is no longer carried out on barter basis.
• Every sovereign country in the world has a currency that is legal tender
in its territory and this currency does not act as money outside its
boundaries. So whenever a country buys or sells goods and services from
or to another country, the residents of two countries have to exchange
currencies.
! !52
• So we can imagine that if all countries have the same currency then
there is no need for foreign exchange. Foreign exchange market is
described as an OTC (over the counter) market as there is no physical
place where the participants meet to execute the deals, as we see in the
case of stock exchange.
• The largest foreign exchange market is in London, followed by the New

York, Tokyo, Zurich and Frankfurt. The markets are situated throughout
the different time zone of the globe in such away that one market is
closing the other is beginning its operation.
• Therefore, it is stated that foreign exchange market is functioning

throughout 24 hours a day. In most market US dollar is the vehicle
currency, viz., the currency used to dominate international transaction.
In India, foreign exchange has been given a statutory definition.
• Section 2 (b) of Foreign Exchange Regulation Act, 1973, states: 

 
Foreign exchange means foreign currency and includes:
➡ All deposits, credits and balance payable in any foreign currency and
any draft, traveller's cheques, letter of credit and bills of exchange,
expressed or drawn in Indian currency but payable in any foreign
currency.
➡ Any instrument payable, at the option of the drawee or holder thereof

or any other party thereto, either in Indian currency or in foreign
currency or partly in one and partly in the other.
• In order to provide facilities to members of the the public and foreigners

visiting India, for exchange of foreign currency into Indian currency and
vice versa.
• RBI has granted to various firms and individuals, licence to undertake

moneychanging business at seas/airport and tourism place of tourist
interest in India.
• Besides certain authorized dealers in foreign exchange (banks) have also

been permitted to open exchange bureaus.
! !53
3.11 PARTICIPANTS IN FOREIGN EXCHANGE MARKET
The main players in foreign exchange market are as follows:
1. Customers: The customers who are engaged in foreign trade

participate in foreign exchange market by availing of the services of
banks. Exporters require converting the dollars into rupee and importers
require converting rupee into the dollars, as they have to pay in dollars
for the goods/services they have imported.
2. Commercial Bank: They are most active players in the Forex market.
Commercial bank dealing with international transaction offer services for
conversion of one currency into another. They have wide network of
branches. Typically banks buy foreign exchange from exporters and sells
foreign exchange to the importers of goods. As every time the foreign
exchange bought or oversold position. The balance amount is sold or
bought from the market.
3. Central Bank: In all countries, Central bank have been charged with
the responsibility of maintaining the external value of the domestic
currency. Generally, this is achieved by the intervention of the bank.
4. Exchange Brokers: Forex brokers play very important role in the

foreign exchange market. However, the extent to which services of
foreign brokers are utilized depends on the tradition and practice
prevailing at a particular Forex market centre. In India, as per FEDAI
guidelines the Authorised Dealersare free to deal directly among
themselves without going through brokers. The brokers are not among
to allowed to deal in their own account all over the world and also in
India.
5. Overseas Forex Market: Today the daily global turnover is estimated

to be more than US $ 1.5 trillion a day. The international trade,
however, constitutes hardly 5 to 7% of this total turnover. The rest of
trading in world Forex market is constituted of financial transactions and
speculations. As we know that the Forex market is 24-hour market, the
day begins with Tokyo and thereafter, Singapore opens, thereafter India,
followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and
back to Tokyo.
! !54
6. Speculators: The speculators are the major players in the Forex

market.
• Bank dealers, are the major speculators in the Forex market with a
view to make profit on account of favorable movements in exchange
rates. They take position, i.e., if they feel that rate of particular
currency is likely to go up in short-term. They buy that currency and
sell it as soon as they are able to make quick profit.
• Corporation's, particularly multinational and transnational corporations

having business operations beyond their national frontiers and on
account of their cash flows being large and in multi currencies get into
foreign exchange exposures. With a view to take advantage of
exchange rate movement in their favour, they either delay covering
exposures or do not cover until cash flow materialize.
• Individuals, like share dealers also undertake the activity of buying and
selling of foreign exchange for booking short-term profits. They also
buy foreign currency stocks, bonds and other assets without covering
the foreign exchange exposure risk. This also result in speculations
3.12 FEATURES OF INTERNATIONAL FOREIGN EXCHANGE

MARKET
(1) The primary objective of the foreign exchange market is to facilitate

international trade and investment, by allowing end-users to convert
one currency into another.
(2) The modern foreign exchange market started with the introduction of
the ‘Flexible Exchange Rate System' during the 1970s.
(3) The principle characteristics of this market are:
a) It is decentralized, over-the-counter (OTC) market, engaged in

negotiated transactions.
b) It enjoys the highest trading volume which results in high liquidity.
c) International foreign currency transactions do not involve transfers of

currencies in cash form
! !55
d) All transactions in this market get routed through the banking

system.
e) The actual settlement of transactions is done through a network of

‘NOSTRO' and 'VOSTRO' accounts maintained by banks worldwide.
f) It is geographically dispersed across all countries which makes it a

universal market. However, in each country there is a domestic
foreign exchange market governed by individual regulations.
g) It operates 24 hours a day, except weekends, across all times zones.
h) It operates on very fine (low) profit margins compared to other

markets.
i) The International Foreign Exchange Market provides for a "BARTER"

of currencies, i.e., there is exchange of one currency against another.
j) It has no physical existence and operates as an electronically

connected network of end-users, banks, brokers and service
providers.
k) The most modern communication systems are used thereby, reducing

transaction costs, eliminating interest loss factor and the problem of
idle funds.
3.13 DEALING ROOM OPERATIONS
The Dealing Room Operations are classified as follows:
A. Foreign Exchange Dealing Room Operations
1. It is a profit centre for the bank and functions as a centralized service

branch to meet the needs of all other branches to buy/sell foreign
currencies.
2. It is managed by specially trained personnel called 'dealers or

traders', who undertakes all foreign currency operations.
! !56
3. The primary function of the Dealing Room is to provide rates for

various transactions which get reported to the Dealing room.
4. Rates provided by a bank to its customers are called 'Merchant

Rates'. These rates can be explained as follows:-
(I) Card Rates
1. The card rates are the rates at which the dealer quotes the rates to
their customers, i.e., at the start of every trading day the market first
establishes the vehicle currency quotation.
2. The dealers then prepare cross rates for currencies normally used by
their customers.
3. Profit margins are loaded for different categories of transactions and

tabulated under eight heads: TT Buying, Bills Buying, TC Buying, CN
Buying, TT Selling, Bills Selling, TC Selling and CN Selling.
4. These rates are collectively called as Card Rates and all transactions
are undertaken at branches involving amounts less than $5000 or
equivalent during the day are put through at card rates.
(II)Ready Rates
When branches receives transactions involving amounts in excess of

USD 5000 or equivalent, a transaction specific rate is provided by the
Dealing Room and this rate is known as Ready Rates.
(III)Conclusion
Thus, card rates are standardized whereas, ready rates are

customized.
B. Dealing Room Transactions
All transactions in the Dealing Room are classified as follows:
(I) Merchant Transactions
! !57
1. Customers of the bank continuously approach the bank for rates, i.e.,
either card or ready rates are applied depending on the volume of
each transaction.
2. Every deal is reported to Dealing Room where it is recorded into

respective currency position.
(II)Inter Bank Transactions
Transactions that are undertaken either to 'cover' merchant

transactions to lock the profit margins or represent proprietary trading
or speculative transactions done in keeping with the view of the
dealers regarding anticipated rate movements. All such transactions
are conducted at interbank rates and are standardized in nature.
Interbank deals are classified in terms of their settlement maturity,
i.e.: Cash, Tom, Spot or Forward.
Conclusion
Thus, merchant transactions apply more focus on customer's of the banks

whereas,Interbank transactions deals with banks or institutions.
3.14 DISTINCTION BETWEEN MERCHANT AND INTER BANK

TRANSACTIONS
Merchant Transactions Interbank Transactions
Represent transactions between the Represent transactions between the

bank and its customers. bank and other banks or institutions.
Transactions are initiated by the Transactions are initiated by the bank

customers (end-users). to cover merchant deals or acquire
speculative positions.
Customized deals. Standardized deals.
Do not involve brokers. May or may not involve brokers.
! !58
Conducted at merchant rates which are Conducted at interbank rates which are
quoted to nearest 0.0025 paisa. quoted to nearest 0.0005 paisa.
Transactions classified as per rate Transactions classified in terms of
types: TT, Bills, TC and CN. settlement types: Cash, Tom, Spot and
Forward.
Represents the retail segment of the Represent, the wholesale segment of

market and are governed by Exchange the market and are subject to RBI
Control Regulations of RBI. rules and guidelines of the Foreign
Exchange Dealers Association of India.
3.15 MUMBAI INTER BANK OFFER RATE (MIBOR)
1. The Committee for the Development of the Debt Market had studied and
recommended the modalities for the development of a benchmark rate
for the ‘Call Money Market' in India.
2. Accordingly, the National Stock Exchange of India Limited had

developed and launched the NSE Mumbai Inter-Bank Bid Rate and NSE
Mumbai Inter-Bank Offer Rate (MIBOR) for the overnight money market
on June 15, 1998.
3. The Fixed Income Money Market and Derivatives Association of India

(FIMMDA) and NSEIL now provide co-branded reference rates renamed
as ‘FIMMDA-NSE MIBID/MIBOR’.
4. Rates are provided for 1 Day, 3 days (only on Fridays), 14 days, 1

month & 3 months maturity.
5. These rates represent the interest rates at which banks can borrow
funds, in market lots, from other banks in the Indian inter-bank market.
6. These rates are used as benchmark rates for Interest Rate Swaps,
Forward Rate Agreements, Floating Rate Debt instruments, Term
Deposits and calculation of swap points for foreign exchange forward
market.
! !59
3.16 SUMMARY
The foreign exchange market is an over-the-counter market. This means

that there is no single physical or electronic marketplace or an organised
exchange (like a stock exchange) with a central trade clearing currency
mechanisms where traders meet and exchange currencies. The market
itself is actually a worldwide network of inter bank traders, consisting
primarily of banks, connected by telephone lines and computers. The
markets span all the time zones of the world and functions virtually round
the clock enabling a trader to offset a position created in one market by
using another market. Of course, of the dozen or so market centres, the
really major ones are London, New York and Tokyo. Other important
centres are Zurich, Frankfurt, Hong Kong and Singapore.
1. Describe in detail the characteristics of the International Foreign

Exchange Market
2. Describe the operations of a Foreign Exchange Dealing Room.
3. Explain the Foreign Exchange Market in India.
4. How did the origin or evolution of Exchange Control occur?
5. Who are dealers? What role do they play in Dealing Room operations? 
! !60
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !61
FOREIGN EXCHANGE MANAGEMENT IN INDIA
Chapter 4
FOREIGN EXCHANGE MANAGEMENT IN
INDIA
Learning Objectives
• Foreign Exchange Management in India

• Retail v/s Wholesale Foreign Exchange Market
• Capital Account Convertibility
• Reserve Management
• Foreign Exchange Dealers Association of India (FEDAI)
Structure:
4.1 Introduction to Indian Foreign Exchange Market

4.2 Structure of Indian Foreign Exchange Market
4.3 Management of Foreign Exchange in India
4.4 The Components of the Indian Foreign Exchange Market
4.5 Retail v/s Wholesale Foreign Exchange Market
4.6 Capital Account Convertibility
4.7 Reserve Management
4.8 Role of FEDAI in the Foreign Exchange Market
4.9 The Liberalized Exchange Rate Management System (LERMS)
4.10 The Unified Exchange Rate Management System
4.11 Pros And Cons of Currency Convertibility
4.12 Summary
4.13 Self-assessment questions
! !62
4.1 INTRODUCTION TO INDIAN FOREIGN EXCHANGE

MARKET
1. The Foreign Exchange Management Act, 1999 (FEMA), provides the

Central Government the powers to execute the provisions of the Act,
and provides the RBI the powers to make regulations for executing the
provisions of the Act in terms of Sec. 46 and Sec. 47 of the Act
respectively.
2. Section 41 provides that the Central Government may direct or instruct

the RBI who shall comply with such directions or instructions.
3. The RBI therefore has the sole authority as well as the responsibility to
administer the foreign exchange business in the country.
! !63
4.2 STRUCTURE OF INDIAN FOREIGN EXCHANGE MARKET
The above structure of Indian Foreign exchange market can be explained

as follows:-
1. Authorized Person 
 
The Reserve Bank provides licences to three categories of persons called
Authorized Dealers, Money Changers and Offshore Banking Units (OBUs)
to transact with the public at different levels. All such transactions, with
end-users are governed by the Exchange Control Regulations provided
by the Reserve Bank of India.
2. Authorized Dealers 
 
The bulk of the foreign exchange transactions undertaken in the country
involve endusers and banks. Banks and select entities licensed by the
Reserve Bank to undertake these transactions are called 'Authorized
Dealers' (ADs). They are permitted to undertake all categories of
transaction pertaining to both the Current and Capital accounts of the
Balance of Payments.
3. Authorized Money Changers 

 
Authorized money changers are sub-classified as full-fledged money
changers and restricted money changers. Full-fledged money changers
are permitted to undertake both purchase and sale transactions with the
public, e.g., Travel agencies. Restricted money changers are permitted
only to purchase foreign currency notes and traveller's cheques, e.g., 5
star hotels.
4. Offshore Banking Units 

 
Branches of banks in India established in Special Economic Zones
(SEZs) are accorded the status of Offshore Banking Units (OBUs). The
OBUs are allowed to undertake banking operations only in designated
foreign currencies essentially with non-residents. Each such OBU has a
minimum start-up capital of USD 10 million and its balance sheet is
prepared in designated foreign currencies.
! !64
4.3 MANAGEMENT OF FOREIGN EXCHANGE IN INDIA
1. Foreign exchange is a scarce commodity and was subject to strict

control in almost all countries till the 1970s.
2. In India, in keeping with the policy of liberalization the focus has

changed to exchange management and not exchange control.
3. The term 'exchange control' can be described as the quantitative

control, by the government or a centralized agency of transactions
involving foreign currencies.
4. Effectively, any directive or regulation which restricts the free play of

demand - supply forces in the foreign exchange market can be termed
as exchange control.
4.4 THE COMPONENTS OF THE INDIAN FOREIGN

EXCHANGE MARKET
The Foreign Exchange Market in India may be broadly classified into Retail
market and Wholesale market.
I. Retail Market
1. In this segment end-users of foreign currencies which includes

individuals, exporters and importers and travellers and tourists
approach ADs for their requirements.
2. ADs provide committed rates for such transactions. These rates are
called ‘Merchant Rates’.
3. Total turnover and individual transaction size is very small, i.e.,

transactions are customized in terms of amount and maturity to meet
the requirement, of individual customers.
4. All transactions undertaken in this segment are governed by the

Exchange Control Regulations of RBI. ADs also need to maintain
tariffs and commissions as per FEDAI guidelines.
5. Brokers and other intermediaries are not allowed in this segment.
! !65
II.Wholesale Market
1. The wholesale market is also referred to as inter bank market. It

includes transactions between ADs as also operations between ADs
and the RBI.
2. Transactions in this segment are conducted in standard market lots

and the average transaction size is large.
3. Transactions are conducted at 'Inter Bank' rates, i.e., this is the

segment in which exchange rates are determined.
4. A large proportion of inter bank transactions are conducted through

approved/authorized foreign exchange brokers.
5. All transactions are conducted in accordance with the code of conduct

established by RBI and FEDAI in this regard.
4.5. RETAIL V/S WHOLESALE FOREIGN EXCHANGE

MARKET
Retail Segment Wholesale Segment
This segment covers transactions This segment covers transactions

between Authorized Dealers/Money between Authorized Dealers and
Changers and customers. Central Bank.
Rates quoted in this segment are Rates quoted in this segment are
called ‘Merchant Rates’. called ‘Interbank Rates’.
No brokers are permitted in this Authorized brokers operate between

component of the market. Authorized Dealers
Transactions are governed by Dealing operations are conducted

Exchange Control Regulations. according to the Code of Conduct
issued by FEDAI and RBI.
This segment 'uses' exchange rates. This segment ‘determines’ exchange

rates.
Transactions are customized. Transactions are standardized.
! !66
4.6 CAPITAL ACCOUNT CONVERTIBILITY
1. In 1997, a committee headed by Mr. S.S. Tarapore, the Deputy

Governor of RBI, was constituted to recommend step-wise
implementation of capital account convertibility (CAC).
2. The recommendations of this committee could not be implemented

because of international developments such as the South East Asian
Crisis, currency failures in Brazil and Russia and events such as 11th
September, 2001 in the US.
3. The committee under the chairmanship of S.S. Tarapore defined CAC as

the freedom to convert local financial assets into foreign financial assets
and vice versa at market determined rates of exchange.
4. It is associated with changes of ownership in foreign/domestic financial

assets and liabilities in the form of Receivables and Payables and
involves the creation and liquidation of claims on or by non-resident
entities.
5. A second committee to suggest a road map for achieving fuller CAC was
constituted.
6. The recommendations of this committee received in 2006, will be

implemented by RBI in phased manner so as to achieve desired level of
CAC by 2011-12.
7. In the interim period, the RBI has progressively allowed greater

freedom in capital transactions which were as follows:
(a) Individual residents are permitted to invest upto USD 100,000 in

international securities.
(b) Individual residents are permitted to establish non-interest bearing

accounts in specified currencies with banks in India.
(c) In gradual manner, the RBI has allowed Indian Corporate entities to
raise resources and invest overseas in higher quantities.
! !67
(d) Branches of Indian banks located in SEZs (Special Economic Zones)

are permitted to conduct banking operations, i.e., accept deposits
and give loans in non-resident currencies.
8. The current status of the INR is that, it is fully convertible for current
account transactions and partially convertible for capital account
transactions.
9. The prerequisites for CAC are as follows:
(i) Maintenance of domestic economic stability.

(ii) Adequate foreign exchange reserves.
(iii) Restrictions on inessential imports.
(iv) Comfortable current account position.
(v) An appropriate industrial policy and a friendly investment climate.
4.7 RESERVE MANAGEMENT
1. Foreign Currency Reserve Management can be described as a process

that ensures that adequate foreign assets are readily available to the
authorities for meeting identified liabilities and a defined range of
objectives for a country.
2. These objectives are as follows:
(i) Exchange rate management represented by the capacity to

intervene in support of the domestic currency.
(ii) Maintaining adequate foreign currency liquidity to absorb shocks

during times of crisis.
(iii) Providing confidence to the international community that the

country can meet its external obligations/liabilities.
(iv) Ensuring that the domestic currency is largely backed by external

assets.
(v) Managing Foreign Currency Lines of Credit for promoting high value
exports.
! !68
3. Thus, adequate foreign currency reserves, appropriate portfolio

management policies, sound reserve management policies and practices
are responsible for management in reserves.
4.8 ROLE OF FOREIGN EXCHANGE DEALERS ASSOCIATION

OF INDIA IN THE FOREIGN EXCHANGE MARKET
1. The FEDAI was set up in 1958, as an association of banks dealing in

foreign exchange in India (called Authorized Dealers - AD’s).
2. It is a self-regulatory body and is incorporated under Section 25 of the

Companies Act, 1956.
3. The major activities include the framing of rules governing the conduct
of foreign exchange business between banks, transactions between
banks and the public and liaison with RBI for reforms and development
of the foreign exchange market. 
 
The main functions of FEDAI are as follows:
(a) Frame guidelines and rules for foreign exchange business.
(b) Training of bank personnel in the areas of foreign exchange

business.
(c) Accreditation of foreign exchange brokers and periodic review of

their operations.
(d) Advising/Assisting member banks in settling issues/matters in their

dealings.
(e) Represent member banks in discussions with Government/RBI/

Other Bodies and provide a common platform for ADs to interact
with the Government and RBI.
(f) Announcement of daily and periodical rates to member banks.
(g) Announcement of 'spot date' at the start of each trading day to

ensure uniformity in settlement between different market
participants.
! !69
(h) Circulate guidelines for quotations of rates, charging of

commissions, etc.
4. Thus, FEDAI plays a catalytic role for smooth functioning of the markets
through closer coordination with the RBI, organizations like FIMMDA
(Fixed Income Money Market and Derivatives Association), the Forex
Association of India and various market participants.
5. FEDAI also helps to maximize the benefits derived from synergies of

member banks by way of innovation in areas like new customized
products, benchmarking against international standards on accounting,
market practices, risk management systems, etc.
4.9 THE LIBERALIZED EXCHANGE RATE MANAGEMENT

SYSTEM (LERMS)
1. In March 1992, India adopted a dual exchange rate system called

'LERMS'. In this system, exporters were required to sell 40% of all
export proceeds to the RBI at a fixed price.
2. The balance component of 60% was permitted to be sold at the market-

driven prices through the domestic foreign exchange market.
3. This system was introduced because the country's foreign exchange

reserves had depleted.
4. The component of 40% sold to the RBI ensured a corpus of foreign

currency at a fixed cost which guaranteed availability of foreign currency
resources for purchase of essential imports such as petro-products,
defence equipment, agro-products, etc.
5. LERMS represents the first step towards floating of INR which is a pre-
condition for currency convertibility.
4.10 THE UNIFIED EXCHANGE RATE MANAGEMENT

SYSTEM
1. As the foreign exchange reseores position gradually improved, LERMS

was discontinued from March 1993. From this period on wards, the
! !70
Indian Rupee has always been valued on market-related basis. This is

known as "The Unitied Exchange Rate Management System.”
2. It representated full floatation of the INR which means that the

Government and the RBI are no longer participants in the currency
Naluation process.
4.11 PROS AND CONS OF CURRENCY CONVERTIBILITY
PROs:
1. It represents confidence of the country in maintaining a stable Balance

of Payments position.
2. It assures international investors about being able to exit their

investments without any restrictions.
3. It provides domestic entities with access to international financial

markets and wider avenues for investments.
4. It ensures that the forward market is in conformity with the Interest

Parity Condition.
5. It promotes Foreign Direct and Portfolio Investments
6. It provides greater depth to both the domestic foreign exchange market

and derivatives market.
CONs:
1. It makes the economy vulnerable to withdrawal of capital by both

residents and non-residents.
2. Exchange rates tend to be more volatile due to larger volume of

transactions.
3. The economy becomes susceptible to international 'Hot Money'.
! !71
4.12 SUMMARY
Foreign exchange market in India is totally structured, well regulated both

by RBI and also by a voluntary association (Foreign Exchange Dealers
Association). Only dealers authorized by RBI can undertake such
transactions. All inter bank dealings in the same centre must be effected
through accredited brokers, who are the second arms in the market
structure. However, between the authorized dealers and the RBI and also
between the ADs and overseas banks are effected directly without the
intervention of the brokers.
1. Enumerate the role of participants in the Indian foreign exchange

market.
2. Discuss the issue of convertibility of INR.
3. Describe the role of FEDAI in the Indian Forex market.
4. What do you mean by LERMS?
! !72
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !73
FOREIGN EXCHANGE QUOTATIONS
Chapter 5
Learning Objectives
• What do you mean by Exchange Rate Quotations

• Types of Rates in Terms of Settlement
• Conceptual Understanding of Vehicle Currency
• Significance of Cross Rates
• Mechanism of Different Types of Foreign Exchange Quotations
Structure:
5.1 Meaning of Exchange Rate Quotations

5.2 Foreign Exchange Rate Convention
5.3 Classification of Rates: Direct, Indirect and Cross Currency
5.4 Distinction between Direct Rates and Indirect Rates
5.5 Characteristics of Exchange Rates
5.6 Factors Influencing the Spread
5.7 Significance of Spread
5.8 Exchange Rates Quotes
5.9 Direct Rates to Indirect or Vice Versa:
5.10 Vehicle Currency
5.11 Concept of Cross Rates
5.12 Method of % Spread and Cross Rates
5.13 Arbitrage, Speculation and Trading
5.14 Bulls v/s Bears
5.15 Arbitrage and Speculation:
5.16 Arbitrage Hunt
5.17 Classification of Rates in Terms of Settlement
5.18 Summary
! !74
5.1 EXCHANGE RATE QUOTATIONS
• The Forex market comprises of commercial banks, brokers, central bank

providing services
➡ Interbank Messaging service providers: SWIFT, CHIPS, CHAPS, etc.

➡ Information service providers: Bloomberg, Dow Jones Newswires,
Thomson,Reuters, etc
• The foreign exchange market provides the environment for establishing

the demand supply equilibrium between currencies based on which the
rate of conversion is established. These conversion rates are called
'Foreign Exchange Rates' or 'Exchange Rates'. Thus, the rate of exchange
for a currency is known from the quotation in the foreign exchange
market. As seen earlier, all foreign exchange transactions operate
through banking system and therefore, banks operating at a financial
centre, and dealing in foreign exchange, constitute/represent the foreign
exchange market. The rates in foreign exchange market are determined
by interaction of forces of demand for and supply of the commodity dealt
in market
Some Important Currencies Regularly Quoted in India
Country Currency Abbreviation Symbol
USA US Dollar USD $
UK Pound Sterling GBP £
Japan Japanese Yen JPY ¥
Euro-Area Euro EUR €
India Indian Rupee INR

!
Switzerland Swiss Franc CHF SFr
Canada Canadian Dollar CAD C$
Australia Australian Dollar AUD A$
Singapore Singaporean Dollar SGD S$
Sweden Swedish Kroner SEK SKr
! !75
Germany Deutsche Mark DEM Dm
France French Franc FRF FFr
Deutsche Marks and French Francs are not in use now. The different
abbreviations have been used for all numerical examples.
5.2 FOREIGN EXCHANGE RATE CONVENTION
• A foreign exchange rate is method which provides a relationship between

two currencies, i.e., 1 USD = INR 46.0625 - 46.0675 is conventionally
written as USD/ INR 46.0625 - 46.0675. (USD = base currency and INR
= variable currency)
• A rate, therefore, represents the value of the base currency expressed in

terms of the variable currency. Currencies are bought and sold against
one another. Each currency pair therefore constitutes an individual
product.
• ISO 4217, provides unique three letter abbreviations (codes) for each
currency which are internationally used.
• A rate expressed as EUR/USD is the price of the Euro expressed in US

Dollars, as in 1 Euro = 1.2835 US dollars.
• The L.H.S (Left hand side) currency in the pair is the base currency,
whereas the R.H.S (Right Hand Side) currency is the counter, quoted or
variable currency.
• Representation of rates in this form is called as the ACI Convention.
Note:
Exchange rates are represented under different conventions. Some

patterns are as follows:
INR 56.2750 – 56.3400 = 1 USD

INR 56.2750 – 56.3400 per USD
1 USD = INR 56.2750 – 56.3400
INR 56.2750 – 56.3400/USD
! !76
Book contains the ISO 4217, abbreviations for currencies and the ACI
convention for exchange rates will be followed, i.e., base currency/variable
currency.
5.3 CLASSIFICATION OF RATES: DIRECT, INDIRECT AND

CROSS CURRENCY
• A foreign exchange rate which provides relationship between fixed

numbers of units of foreign currency against variable number of units of
domestic currency is called a direct rate. (Format of expressing exchange
rates is operative in India since August, 1993). In such rates foreign
currency acts as base currency whereas domestic currency acts as
variable currency
• A foreign exchange rate that provides relationship between fixed

numbers of units of domestic currency against variable number of units
of foreign currency is called an Indirect Rate. (Form of expressing
exchange rates prevailed in India prior to August, 1993). In such rates
domestic currency acts as base currency and foreign currency acts as
variable currency
• A foreign exchange rate which provides a relationship between two non-

domestic currencies is called a cross currency rate. For example:
Quotation India USA Japan
USD/INR Direct Indirect Cross Currency
INR/USD Indirect Direct Cross Currency
• Direct, Indirect and Cross Currency rates are, therefore, a function of

location and the location of the quotation must always be indicated when
classifying rates.
! !77
5.4 DISTINCTION BETWEEN DIRECT RATES AND INDIRECT

RATES
DIRECT RATES INDIRECT RATES
Foreign exchange rates which Foreign exchange rates which

represent a relationship between a represent a relationship between a
fixed numbers of units of foreign fixed numbers of units of domestic
currency against variable number of currency against variable number of
units of domestic currency are called units of foreign currency are called
Direct Rates. Indirect Rates.
An example of a direct rate in India An example of a indirect rate in India

would be: 1 USD = INR 54.3825 – would be: 100 INR = USD 1.8605 –
54.3875 1.8610
Direct rates were introduced in India Indirect rates were used in India from
effective from 2nd August, 1993. 1971, upto 2nd August, 1993.
When trading in foreign currency with When trading in foreign currency using
the use of direct rates, the strategy indirect rates, the strategy used is 'Buy
used is - Sell Low'. 'Buy Low – Sell High Low.
High'.
Direct rates are generally expressed in Indirect rates in India were expressed
India to the base of 1 unit of foreign to the base of 100 INR.
currency except Japanese Yen whose
relationship is expressed to the base of
100 units.
In the US market, direct rates are In the US market, indirect rates are
called Rates on American terms'. called 'Rates on European terms'.
An example of a quotation on An example of a rate on European

American terms would be: 1 GBP = terms would be: 1 USD = CHF 1.4950
USD 1.6675 – 1.6685 – 1.4960
In the case of direct rates, the base In the case of indirect rates, the base
currency is always a foreign currency currency is always domestic currency
while variable currency is always the while variable currency is always a
domestic currency. foreign currency.
! !78
5.5 CHARACTERISTICS OF EXCHANGE RATES
1. Forex rates are quoted by banks on two-way basis, e.g.: USD/INR

54.0625 – 54.0675
2. The LHS rate in the quotation is called BID rate and represents the rate
at which the bank would buy one unit of the base currency (USD).
3. The RHS rate in the quotation is called ASK or OFFER rate and
represents the rate at which the bank would sell one unit of the base
currency (USD).
4. The difference between the Ask and the Bid rates, in a given quotation
is called spread. Therefore spread is denoted as (ASK–- BID). Since ASK
> BID, the spread is always positive.
5. Foreign exchange rates are normally quoted upto two or four decimal
places. In India the general practice in the inter-bank market is to quote
rates upto four decimal places.
6. Foreign exchange rates are always expressed to the base of 1, 10, 100
or 1000 units of base currency. In India, rates are expressed either to
the base of 1 unit or 100 units of base currency.
7. Unless otherwise specified, an inter-bank quotation in India is usually

valid for USD 1 million.
8. Percentage spread = Spread

—————— × 100
Mean rate
ASK - BID
———————- × 100
= (ASK+BID)
—————————
2
ASK - BID
= ——————— × 200
ASK+BID
! !79
5.6 FACTORS WHICH INFLUENCE THE SPREAD ARE
• Transaction cost (It includes brokerage, operating expenses and

correspondent bank charges).
• Volatility in the market (Higher the volatility, wider will be the spread and
vice versa).
• Depth of the market (Depth of the market is associated with volume

available for covering the transaction. Greater the depth, narrower will be
the spread and vice versa.)
• Exchange control regulations (The RBI does not specify any minimum or
maximum spread for quotations in India.)
5.7 SIGNIFICANCE OF SPREAD TO END-USERS
• For end-users this means that the correctness of a foreign exchange

quotation decreases when the transaction is undertaken in any currency
other than the vehicle currency.
• The spread, therefore, represents a level of safety for the person making
the quotation whereas, it represents cost to the person using the
quotation.
• Thus, the spread represents the nominal difference between the Àsk'
and `Bid’ rates of a quotation whereas, the %age spread helps to
compare the correctness of different quotation.
5.8 EXCHANGE RATES IN SHORT FORMAT
• Rate quoted as USD/INR 54.1225 – 75 = 54.1225 – 54.1275

Effectively only the àsk' side of the quote is expressed in short form. The
two numbers replace the last two decimal places in the `bid' rate and if the
resultant rate is equal or less than the bid rate then 1 is added to the
previous decimal place.
! !80
5.9 CONVERSION OF DIRECT RATES TO INDIRECT OR

VICE VERSA
Consider the quotation: USD/INR 54.8850 – 54.8900
This is direct quotation in India. To convert this quotation to Indirect we
need to take the reciprocal of this quotation: !
Therefore, indirect quotation would be: INR/USD 0.018220 – 0.018218
If we use the convention of quoting the rate upto four decimal places then
both bid and ask rates would be identical. It therefore becomes necessary
to increase the base quantity of the quotation to make it meaningful.
Therefore: 100 INR / USD 1.8220 – 1.8218 (multiplying both sides by 100)
We now find that the bid rate > ask rate which is not logical. By
interchanging their places we get: 100 INR/USD 1.8218 – 1.8220
Effectively when converting a direct quotation to Indirect or vice versa take

the reciprocal and interchange sides. Algebraically, it can be represented
as;
1
—————- = (B/A)Ask
(A /B) Bid
1
—————— = (A/B)Bid
(A /B) Ask
This is called the Direct/Indirect Rule or Inverse Rule.
Ex: Direct quotation in New York: GBP/USD 1.9835 – 1.9845. Calculate its
indirect
form.
! !81
1 1
(USD/GBP)Bid = ———————- = ——————— = 0.5039
(GBP/USD)Ask 1.9845
1 1
(USD/GBP)Ask = ——————— = ———————- = 0.5042
(GBP/USD)Bid 1.9835
(USD/GBP) Quotation: 0.5039 – 0.5042
5.10 VEHICLE CURRENCY
• The International Foreign Exchange Market is an aggregate of individual

markets operating in each country.
• At start of every trading day, value of domestic currency in each country

is locally established against any one major universally accepted,
international/foreign currency such as USD, GBP, and EUR. The currency
is called 'vehicle currency' for that domestic currency
• In India, effective from August 1991, the USD is considered as Vehicle

currency for INR. This means that Indian Foreign Exchange Market
establishes only the USD/ INR quotation.
• When any quotation is required for a currency other than USD, say EUR/
INR, then the domestic market provides the EUR/USD cross-currency
quotation. These two quotations are crossed so as to eliminate USD and
provide the required EUR/INR quotation.
• Rates obtained in this manner are called 'Cross Rates' and the method or
mechanism is called 'Crossing'. In each such calculation the vehicle
currency gets eliminated and provides the means to connect the
domestic currency with all international currencies.
• Sometimes transactions are done in currencies for which the bank may
not be maintaining any 'Nostro" account. In such instances the vehicle
currency is used to pay a correspondent who arranges the required
currency for the principal bank.
! !82
• Effectively, the Nostro accounts are not maintained in particular currency,

then the vehicle currency is used to pay or receive equivalent amount of
that currency. Since, the vehicle currency is normally a universally traded
currency; quotation of this currency against most international currencies
is easily available.
• This currency, therefore, acts as a vehicle to help establish value of the

domestic currency against any desired international currency. The factors
which influence the choice of vehicle currency are:
(a) Composition of foreign currency reserves of the country.

(b) Pattern of invoicing import export trade of the country.
(c) Ready acceptability of the vehicle currency.
(d) Ready availability of cross currency quotations against the vehicle
currency.
(e) Proportion of use of vehicle currency in invoicing of international
trade.
• The vehicle currency mechanism is necessary because if rates for various

currencies are established against the domestic currency through market
forces then the crossing mechanism could be used to create cross
currency quotes in the local market providing arbitrage opportunities
against international markets. This would defeat the fundamental
purpose of the foreign exchange market which is to connect the domestic
currency to all international currencies.
5.11 CONCEPT OF CROSS RATES
• The cross-currency rates are, therefore, used in combination with the

vehicle currency rate against the domestic currency to establish the value
of the domestic currency against all international currencies. As
mentioned earlier, this process is called 'Crossing' and the resultant
exchange rates are called 'Cross Rates’.
• Calculation of cross rate quotation would involve two calculations for

establishing the bid and the ask rates. If two given quotations are 
a b a 
—- and —— then the cross quotation ——- would be calculated by 
b c c 
eliminating the common currency b;
! !83
! The product of these would factor would eliminate

Y to provide the desired value.
!
(Chain Rule)
Example:
USD/INR 44.7250 – 44.7300
GBP/USD 1.9675 – 1.9685
Calculate GBP/INR quotation?
(GBP/INR)B = (GBP/USD)B X (USD/INR)B
= 44.7250 X 1.9675
= 87.9964
(GBP/INR)A = (GBP/USD)A X (USD/INR)A
= 44.7300 X 1.9685
= 88.0510
GBP/INR = 87.9964 – 88.0510
Explanation:
Bid Rate Calculation
The bank would buy 1 GBP for USD 1.9675 since it would be possible for
them to dispose the same at this price in the market. Similarly, the bank
would buy 1 USD for INR 44.7250. Therefore, it would be willing to buy
! !84
1.9675 USD for (1.9675 X 44.7250) INR. Effectively, it would buy 1 GBP
for INR (1.9675 X 44.7250)
Thus: (GBP/INR)Bid = (GBP/USD)Bid X (USD/INR)Bid
= (1.9675 X 44.7250)
This is known as `The Chain Rule'
Ask Rate Calculation
Similarly, it can be seen that
(GBP/INR)Ask = (GBP/USD)Ask X (USD/INR)Ask
= (1.9685 X 44.7300)
5.12 CALCULATION OF % SPREAD AND CROSS RATES
1. Given: USD/INR 44.7250 – 44.7300 

 
Calculate % spread
Solution:
ASK - BID
% spread = ——————— X (200)
ASK + BID
44.7300 - 44.7250
= ———————————- X (200)
44.7300 + 44.7250
0.0050
= —————— X (200)
89.4550
= 0.0112 %
! !85
2. Given: GBP/USD mid rate 1.9697 

 
GBP/USD spread 0.0012 
 
Calculate % spread
Solution:
Spread
% spread = ———————- X (100)
Mean rate
0.0012
= ——————— X (100)
1.9697
= 0.0609%
Note: Mean rate, mid rate, average rate, flat rates are all the same.
3. Given: USD/CHF spread = 0.0016 

 
USD/CHF average rate 1.3996 
Calculate (a) % spread
(b) USD/CHF quotation
Solution:
Spread
% spread = ———————- X (100)
Mean rate
0.0016
= ——————— X (100)
1.3996
= 0.1143%
ASK + BID
Mean rate = ———————- = 1.3996
2 
! !86
Thus, ASK + BID = 2.7992 … (1)
Spread = ASK – BID = 0.0016 … (2)
Therefore, 2 ASK = 2.8008 …… Adding (1) & (2)
Therefore, ASK = 1.4004 ……. (A)
Substituting in equation (2), we get:
1.4004 – BID = 0.0016
So, BID = 1.4004 – 0.0016
= 1.3988 … (B)
USD/CHF quotation 1.3988 – 1.4004 …….. From (A) & (B)
Alternate Method: For part (b)
SPREAD 0.0016
BID RATE = MEAN RATE – —————— = 1.3996 - —————
2 2
= 1.3996 – 0.0008
= 1.4004
Therefore, Quotation USD/CHF 1.3988 – 1.4004
4. Given: FRF/SEK spread = 40 pips 

 
FRF/SEK flat rate = 1.4030 
 
Calculate: (i) % age spread of FRF/SEK
(ii) FRF/SEK quotation
(iii) SEK/FRF quotation 
! !87
Solution:
Spread
(i) % spread = ———————- X (100)
Mean rate
0.0040
= ——————— X (100)
1.4030
= 0.2851% ……(1)
(ii)Mean rate = ASK + BID = 1.4030
Thus, ASK + BID = 2.8060 .… (a) 

 
Spread = ASK – BID = 0.0040 .… (b) 
 
Therefore, 2 ASK = 2.8100 … Adding (a) & (b) 
 
Therefore, ASK = 1.4050 … (A) 
Substituting in equation (2), we get, 

 
1.4050 – BID = 0.0040 
 
Therefore, BID = 1.4050 – 0.0040
= 1.4010 ….. (B) 
FRF/SEK quotation: 1.4010 – 1.4050 ….. (2)
1 1
(SEK/FRF)Bid = ———————- = —————- = 0.7138
(FRF /SEK)Ask 1.4050
1 1
(SEK/FRF)Ask = ———————- = —————-
(FRF /SEK)Bid 1.4010
Therefore, SEK/FRF quotation: 0.7117 – 0.7138 
! !88
5. Identify countries in which following are 'Direct' quotations and convert

them into Indirect form
(a)1 GBP = USD 1.9693 - 1.9708
(b)1 USD = CHF 1.3688 - 1.3698
Solution:
1 1
(USD/GBP)Bid = ———————- = ————— = 0.5074
(GBP/USD)Ask 1.9708
1 1
(USD/GBP)Ask = ———————- = ————— = 0.5078
(USD/CHF)Bid 1.3698
1 1
(CHF/USD)Bid = ———————- = ————— = 0.7300
(GBP/USD)Ask 1.9693
1 1
(CHF/USD)Ask = ———————- = ————— = 0.7306
(GBP/USD)Bid 1.3688
Given Quotation Country where direct Indirect form
GBP/USD 1.9693 - 1.9708 USA USD/GBP 0.5074-0.5078
USD/CHF 1.3688 - 1.3698 Switzerland CHF/USD 0.7300-0.7306
Note:
(a) Identification of country in 'Direct form is done by identifying country

of variable currency.
(b) The term 'PIPS' and 'POINTS' can be used interchangeably in the
context of exchange rates. They represent the last decimal place of a
conventionally expressed exchange rate. They represent the smallest
increase/decrease in the rate. In the Indian foreign exchange markets
rates are expressed upto four decimal places. Thus, one 'PIP' would be 
1 
1 % of the small currency unit = ——— of the small currency unit =
100
! !89
1 1 1
——— X ——— X ——— major currency unit.
100 100 100
Therefore, INR 46.3825 can be interpreted as Rupees 46, 38 paise, 25

pips.
(c) A 'Basis Point' can be defined as the last decimal of a conventionally
written interest rate. Interest rates are quoted upto two decimal
places. 1 basis point = of the rate. If rate changes from 2.25% to
2.50% then change = 25 basis points.
6. Given: USD/CAD 1.1595 – 1.1605 

 
USD/CHF 1.3690 – 1.3700 
 
Calculate CAD/CHF quotation
Solution:
(CAD/CHF)Bid = (CAD/USD)Bid X (USD/CHF)Bid ……Chain rule

1
= ———————— X (USD/CHF)Bid ……Inverse rule
(USD/CAD)Ask
1
= ———————— X 1.3690
1.1605
= 1.1797
(CAD/CHF)Ask = (CAD/USD)Ask X (USD/CHF)Ask ……Chain rule
1
= ———————— X (USD/CHF)Ask ……Inverse rule
(USD/CAD)Bid
1
= ———————— X 1.3700
1.1595
= 1.1815
CAD/CHF quotation: 1.1797 – 1.1815 
! !90
7. Given: USD/SGD 1.5432 – 1.5433
……SGD/GBP 0.3323 – 0.3333
……Calculate GBP/USD quotation
Solution:
(GBP/USD)Bid = (GBP/SGD)Bid X (SGD/USD)Bid ……Chain rule
1 1
= ——————— X ————————- ……Inverse rule
(SGD/GBP)Ask (USD/ SGD)Ask
1 1
= ——————— X ———————-
0.3333 1.5433
= 1.9441
(GBP/USD)Ask = (GBP/SGD)Ask X (SGD/USD)Ask ……Chain rule

1 1
= ——————— X ————————- ……Inverse rule
(SGD/GBP)Bid (USD/ SGD)Bid
1 1
= ——————— X ———————-
0.3323 1.5432
= 1.9512
GBP/CHF quotation: 1.9441 – 1.9512
8. Given: USD/FRF 5.9970 – 6.0020 

 
USD/SEK 7.0110 – 7.0160
I. Calculate FRF/SEK quotation

II. Establish relation between the given and derived quotations in terms
of %age spread 
! !91
Solution:
(FRF/SEK)Bid = (FRF/USD)Bid X (USD/SEK)Bid ……Chain rule
1
= ———————— X (USD/SEK)Bid ……Inverse rule
(USD/FRF)Ask
1
= ———————— X 7.0110
6.0020
= 1.1681
(FRF/SEK)Ask = (FRF/USD)Ask X (USD/SEK)Ask ……Chain rule

1
= ——————— X (USD/SEK)Ask ……Inverse rule
(USD /FRF)Bid
1
= ——————— X 7.0160
5.9970
= 1.1699
FRF/SEK quotation: 1.1681 – 1.1691 ….. (I)
Ask - Bid
USD/FRF % spread = ——————- X (200)
Ask + Bid
6.0020 - 5.9970
= —————————- X (200)
6.0020 + 5.9970
0.0050
= —————- X (200)
11.9990
= 0.0833% 
! !92
Ask - Bid
USD/SEK % spread = ——————- X (200)
Ask + Bid
7.0160 - 7.0110
= —————————- X (200)
7.0160 + 7.0110
0.0050
= —————- X (200)
14.0270
= 0.0713%
Ask - Bid
FRF/SEK % spread = ——————- X (200)
Ask + Bid
1.1699 - 1.1681
= —————————- X (200)
1.1699 + 1.1681
0.0018
= —————- X (200)
2.3380
= 0.1540%
Therefore, % spread USD/FRF + % spread USD/SEK
(Approx.) = % spread FRF/SEK
Therefore, sum of % spread of given quotation is (approx.) equal to
% Spread of derived quotation ….. (II)
! !93
9. Given: Identify the countries in which the following are 'Indirect'

quotations and convert them into direct form:
(a)1 USD = CAD 1.1610 – 1.1620

(b)1 EUR = USD 1.3113 – 1.3123
Solution:
1 1
(CAD/USD)Bid = ———————- = ————— = 0.8606
(USD/CAD)Ask 1.1620
1 1
= ———————- = ————— = 0.8613
(USD/CAD)Bid 1.1610
1 1
= ———————- = ————— = 0.7620
(EUR /CAD)Ask 1.3123
1 1
= ———————- = ————— = 0.7626
(EUR /USD)Bid 1.3113
Given Quotation Country where direct Direct form
USD/CAD 1.1610 – 1.1620 USA CAD/USD 0.8606 – 0.8613
EUR/USD 1.3113 – 1.3123 Euro-Area USD/EUR 0.7620 – 0.7626
Note:
Identification of country in 'Indirect' form is done by identifying the country

of the base currency.
10.The following quote is given:

1 USD = INR 44.3630/80
a. Identify the country in which this is a direct quote
b. Find the mid rate, spread and the spread percentage
c. Calculate the Inverse quote 
! !94
Solution:
The given quote reconstructed as per ACI convention:
USD/INR 44.3630 – 44.3680
(a)The quote would be classified as direct in India.
ASK + BID 44.3680 + 44.3630

(b) Mid rate = ——————— = ——————————— = 44.3655
2 2
Spread = ASK – BID = 44.3680 – 44.3630 = 0.0050
ASK – BID
% spread = ——————- X (200)
ASK + BID
44.3680 - 44.3630
= ——————————- X (200)
44.3680 + 44.3630
0.0050
= —————— X (200)
88.7310
= 0.0113%
100 X 1 100 X 1
(c) (100 INR/USD)Bid = ———————— = —————— = 2.2539
(USD/ INR)Ask 44.3680
100 X 1 100 X 1
(100 INR/USD)Ask = ———————— = —————— = 2.2541
(USD/ INR)Bid 44.3630
Inverse Quote: 100 INR/USD 2.2539 – 2.2541
(Note: When INR is base currency, base units should be 100)
! !95
11.USD/INR MID RATE of Bank of India is 44.3825 

 
Required Spread = 0.0040 
 
Bank of Baroda quotes: GBP/INR 73.3500/00
(a) Calculate USD/INR Quotation for Bank of India.

(b) Calculate GBP/USD cross rate from quotations of Bank of India and
Bank of Baroda.
Solution:
SPREAD 0.0040
(a) BID RATE = MID RATE – —————— = 44.3825 – —————
2 2
= 44.3825 – 0.0020
= 44.3805
SPREAD 0.0040
ASK RATE = MID RATE + —————— = 44.3825 – —————
2 2
= 44.3825 + 0.0020
= 44.3845
Therefore, Bank of India USD/INR Quotation: 44.3805 – 44.3845
(b) (GBP/USD)Bid = (GBP/INR)Bid X (INR/USD)Bid ….. Chain Rule
1
= (GBP/INR)Bid X ———————— ….. Inverse Rule
(USD / INR)Ask
73.3500 X 1
= ————————
44.3845
= 1.6526 
! !96
(GBP/USD)Ask = (GBP/INR)Ask X (INR/USD)Ask ….. Chain Rule
1
= (GBP/INR)Ask X ———————— ….. Inverse Rule
(USD / INR)Bid
73.3600 X 1
= ————————
44.3805
= 1.6530
Therefore, Cross Quotation: GBP/USD 1.6526 – 1.6530
12.Swiss Bank Corporation Zurich offers 100 INR at CHF 2.7400 –10
whereas Union Bank of Switzerland Zurich offers USD at CHF 1.2192 –
02. 
 
Calculate the effective USD/INR quote using these two quotations.
Solution:
Given quotations reconstructed as per ACI Convention would be:
100 INR/CHF 2.7400 – 2.7410 for SBC Zurich
USD/CHF 1.2192 – 1.2202 for UBS Zurich
(USD/INR)Bid = (USD/CHF)Bid X (CHF/INR)Bid ….. Chain Rule
1
= (USD/CHF)Bid X ———————— ….. Inverse Rule
(INR /CHF)Ask
1 x 100
= (USD/CHF)Bid X ————————— ….. Adjust for
(100INR /CHF)Ask Base units
! !97
1.2192 X 1 X 100
= ——————————-
2.7410
= 44.4801
(USD/INR)Ask = (USD/CHF)Ask X (CHF/INR)Ask ….. Chain Rule
1
= (USD/CHF)Ask X ———————— ….. Inverse Rule
(INR /CHF)Ask
1 x 100
= (USD/CHF)Ask X ————————— ….. Adjust for
(100INR /CHF)Ask Base units
1.2192 X 1 X 100
= ——————————-
44.4801
= 44.5328
Therefore, Effective USD/INR Quotation: 44.4801 – 44.5328
5.13 ARBITRAGE, SPECULATION AND TRADING
Arbitrage
• Arbitrage can be defined as an operation which involves simultaneous

purchase and sale of equal quantity of asset or currency with the
intension of deriving risk free profit out of imperfect quotations in one or
more markets.
• An arbitrageur is an entity who identifies an opportunity for arbitrage and

derives profit from it. Arbitrageur are not market makers and therefore,
do not provide any quotations. They only utilize quotations made by
others and profit from them.
• Arbitrage operations help to equalize prices and remove imperfections.

There are no arbitrage possibilities in a perfect market. The volume and
! !98
profit of arbitrage transactions is market dependent. The arbitrageur

does not use his/her assessment in this operation.
• Factors which lead to arbitrage opportunities are:
(a) sudden imbalance in demand-supply equilibrium

(b) time zone factors
(c) information arbitrage
(d) exchange control regulations
• The various types of arbitrage can be classified as follows:
2- Point Arbitrage is also called as Geographical Arbitrage and it

involves 2 currencies.
3- Point Arbitrage is also called as Triangular Arbitrage and it involves
3 currencies.
Speculation:
• Speculation can be defined as an operation which involves buying and

selling of equal amounts of base currency, security or asset at two
different times, so as to derive profit from favourable rate movement in
the interim period.
! !99
• Speculation involves a deliberate acceptance of risk since the anticipated

rate movement may not materialize. Speculation may therefore result in
either profit or loss depending on the accuracy of the speculators view or
judgment.
• Entities who undertake such operations are called speculators. These

entities normally operate contrary to market views and therefore help to
provide liquidity in the market when critically needed.
• While the volume of arbitrage operations depends on the opportunities

provided by the market, the volume of speculative transactions depends
on the resources of the speculators and the conviction of their view on
rate movements. Speculation requires a high level of technical knowledge
of the underlying asset.
Trading
• Trading can be defined as an operation involving buying and selling of

currencies,securities, assets, etc., through a process of continuously
quoting two-way prices to provide an instant entry-exit opportunity to all
other participants in the market.
• Entities who undertake such operations are called traders or dealers.

They are market makers since their presence ensures availability of
entry-exit prices at all times during market hours.
• These entities help to make the market liquid and generally deliver the
largest volume of operations in the market.
• Traders are therefore both buyers and sellers at all times and act as
'buyer' for all sellers and as 'seller' for all buyers coming to the
market.They provide continuity to the price discovery process.
! !100
5.14 BULLS V/S BEARS: (COMPARATIVE FEATURES)
Bulls Bears
Bulls can be described as market Bears can be described as market

participants who are optimistic about participants who are pessimistic about
the performance of the currency. the performance of the currency.
Bulls always anticipate an appreciation Bears always anticipate a fall in the

in the currency value of the currency.
Bulls always initiate trading Bears always initiate trading

transactions by first buying currency transactions by first selling currency
and thereafter, selling it. and thereafter, buying it.
Bulls require monetary resources for Bears require commodity resources for
their activities. (to first buy) their trading activities. (To first sell).
5.15 ARBITRAGE AND SPECULATION
Arbitarge Speculation
It is a risk-free activity. There is a conscious acceptance of

risk.
Profit per transaction is normally very Profit/Loss per transaction is

small dependent on the take profit/stop-loss
levels set by the speculator.
The volume is market dependent, i.e., The volume of transactions is

it dependson the opportunities dependent on the risk taking capacity,
provided by the market. These financial resources be and conviction of
transactions cannot initiated by the the speculator regarding rate changes.
arbitrageur.
Arbitrage operations always result in Speculation may or may not result in

profit. profit.
Arbitrage transactions remove market Speculative transactions provide

imperfections. critical liquidity to the market and
reduce volatility.
Personal analytical skill of the Personal assessment of the speculator

arbitrageur is not required. plays an important part in this activity.
! !101
Arbitrage operations usually take place In most cases speculative operations

with the flow of the market. take place contrary to market trends.
Entities undertaking such transactions Entities undertaking such transactions

are called 'Arbitrageur'. are called 'Speculators'.
5.16 ARBITRAGE HUNT
1. Given — SBI Bank quotes USD/INR 40.2350 – 40.2400
ICICI Bank quotes USD/INR 40.2425 – 40.2475
Identify and Calculate arbitrage gain
Solution:
The Bid price of ICICI Bank is more than the Ask price of SBI Bank which
means that SBI Bank is selling USD at a rate lower than the buying rate of
ICICI Bank. The arbitrageur would exploit this imperfection by buying rate
of ICICI Bank. The arbitrageur would exploit this imperfection by buying
USD from SBI Bank and selling the same to ICICI Bank.
Arbitrage calculations therefore involve two steps:
1) Identifying the rates between which arbitrage is possible and
2) Quantifying the arbitrage gain on an assumed or given amount of

capital.
Bid 40.2425 > Ask 40.2400 

 
Therefore, arbitrage exists 
 
Assume capital USD 1 million
(Principal X Identified Bid rate)

Arbitrage gain = ————————————————— - Principal
Identified Ask rate
! !102
(1,000,000 X 40.2425)
= —————————————— - (10,00,000)
40.2400
= USD 62.13 per USD 1 million
Note: Assumption of capital can be in either of the two currencies. In

case the assumed capital was INR then the resultant gain/profit would
be in INR.
Derivation of Formula for calculating arbitrage:
In the above example the arbitrageur would first sell USD 1,000,000 to
ICICI Bank @ 40.2425 and acquire equivalent INR = 1,000, 000 x
40.4025. He would simultaneously sell these INR to SBI Bank @ 40.2400
(1,000,000 40.2425)
and reconvert to USD = ———————————— Since the multiplier is
40.2400
more than the divisor, the arbitrageur would now have more than USD
1,000,000. The balance left with him after withdrawing the capital used
would reflect the gain made in the transaction. Therefore gain
(1,000,000 40.2425)
= ———————————— – (1,000,000)
40.2400
Mathematically it can be presented as:
Principal X Identified Bid rate)

————————————————— - Principal
Identified Ask rate
2. Given – GBP/USD 1.9378 – 1.9388 (Bank X)
GBP/USD 1.9398 – 1.9404 (bank Y)
Identify and calculate arbitrage profit.
! !103
Solution:
Bid 1.9398 > Ask 1.9388 

 
Therefore, arbitrage exists. 
 
Assume, capital GBP 1 million
(Principal X Identified Bid)

Arbitrage profit = ————————————————— - (Principal)
Identified Ask
(1,000,000 X 1.9398)
= —————————————— – (1,000,000)
1.9388
= GBP 515.78 per GBP 1 million.
Note: The assumed capital should always be reflected in the answer

since the net gain would change with any change in the capital amount.
3. Given – USD/CHF 1.3725 – 1.3735

CHF/USD 0.7215 – 0.7225
Identify and calculate arbitrage gain.
Solution:
When the two given quotations are in different forms, it is necessary to

convert any one of them to make it comparable with the other. In the
above case if quotation (2) is converted, then:
1 1
Derived USD/CHF ————- − —————— = 1.3841 – 1.3860
0.7225 0.7215 
Given USD/CHF 1.3725 – 1.3735 

Therefore, Bid 1.3841 > Ask 1.3735 
! !104

 
Assume, capital CHF 1 million.

Identified Ask
(1,000,000 X 1.3841)
= —————————————— – (1,000,000)
1.9388
1,000,000
= —————————————— – (1,000,000)
(0.7225 X 1.3735)
= CHF 7705.17 per CHF 1 million.
Note: An arbitrage operation involves using imperfections in market

quotations. The arbitrageur does not quote and derived quotations are to
be used only for identifying arbitrage possibilities. Calculation of gain/
profit in such transactions should involve only given market quotations.
Hence it is necessary to substitute the derived rate with the original
market rate from which it is derived. (1.3841 = 1/0.7225)
4. Given – Bank A USD/INR 40.1625 - 40.1665

Bank B USD/INR 40.1695 - 40.1735
Identify and calculate arbitrage gain if both quotations are valid for USD
1 million only.
Solution:
In real market conditions quotations are valid for specific base currency
amounts. When this fact is specified the formula to be used for calculating
the gain is:
Arbitrage gain=(principal X identified bid)–(principal X identified ask) 
Bid 40.1695 > Ask 40.1665
! !105
Therefore arbitrage exists. 

 
Assume capital USD 1 million since both quotations are valid for this
amount. 
 
Arbitrage gain=(principal X identified bid)–(principal X identified ask)
= (1,000,000 X 40.1695) – (1,000,000 X 40.1665)
= INR 3000 per USD 1 million.
Note: The gain is computed in variable currency whereas, capital

assumed is in base currency.
Capital Gain Formula
(Principal × Bid)
Base currency Base currency —————————- – (Principal)
Ask
Base currency Variable currency (Principal x Bid) – (Principal × Ask)
(Principal × Bid)
Variable currency Variable currency —————————- – (Principal)
Ask
Principal Principal
Variable currency Base currency —————— – ——————
Ask Bid
5. Given – USD/CHF 1.3705 – 1.3715

GBP/USD 1.9355 – 1.9365
GBP/CHF 2.6500 – 2.6510
Identify and quantify triangular arbitrage.
Solution:
In such cases use any two of the given quotations to derive a quotation
comparable to the third quotation. Taking quotes (1) and (2) above, we
can derive a GBP/CHF quotation:
! !106
Derived (GBP/CHF)Bid = (GBP/USD)bid X (USD/CHF)bid
= 1.9355 X 1.3705 = 2.6526
Derived (GBP/CHF)ask = (GBP/USD)ask X (USD/CHF)ask
= 1.9365 X 1.3715 = 2.6559
Therefore, derived GBP/CHF 2.6526 – 2.6559 

 
And the given GBP/CHF 2.6500 – 2.6510 
Therefore, Bid 2.6526 > Ask 2.6510 

 
 
Assume, capital GBP 1 million.

Identified Ask
(1,000,000 X 2.6526)
= —————————————— – (1,000,000)
2.6510
(1,000,000 X 1.9355 X 1.3705)

= ————————————————- – (1,000,000)
2.6510
= GBP 604.58 per GBP 1 million.
Note: The result would be the same irrespective of the combination of

quotations taken for identifying the existence of an arbitrage opportunity.
! !107
6. Given – USD/CAD 1.1685 – 1.1695

USD/CHF 1.3785 – 1.3795
CAD/CHF 1.1885 – 1.1895
Identify and calculate triangular arbitrage profit.
Solution:
Derived (CAD/CHF)Bid = (CAD/USD)Bid x (USD/CHF)Bid
1
= ————————- × (USD/CHF)Bid
(USD / CAD)Ask
1.3785
= ——————
1.1695
= 1.1787
Derived (CAD/CHF)Ask = (CAD/USD)Ask x (USD/CHF)Ask
1
= ————————- × (USD/CHF)Ask
(USD / CAD)Bid
1.3795
= ——————
1.1685
= 1.1806
Derived CAD/CHF 1.1787 – 1.1806
And given quotation 1.1885 – 1.1895
Therefore, Bid 1.1885 > Ask 1.1806
Therefore, arbitrage exists and Assume, capital CAD 1 million.
! !108

Arbitrage gain = ————————————————— - (Principal)
Identified Ask
(1,000,000 X 1.1885)
= —————————————— – (1,000,000)
1.1806
(1,000,000 X 1.1885 X 1.1685)

= ————————————————- – (1,000,000)
1.3795
= CAD 6714.21 per CAD 1 million.
7. Given EUR/USD 1.3132

USD/SGD 1.4733
EUR/SGD 1.9332
Identify if triangular arbitrage exists and calculate the same.
Solution:
Derived EUR/SGD = EUR/USD X USD/SGD
= 1.3132 X 1.4733
= 1.9347
Given EUR/SGD = 1.9332
When only mid-rates are given then, as per the identifying mechanism, the
arbitrageur would sell at the higher price treating it as the market bid rate
and buy at the lower price treating it as the market selling (ask) rate.
Therefore, Bid 1.9347 > Ask 1.9332
Therefore, arbitrage exists.
Assume, capital EUR 1 million.
! !109

Arbitrage gain = ————————————————— - (Principal)
Identified Ask
(1,000,000 X 1.9347)
= —————————————— – (1,000,000)
1.9332
(1,000,000 X 1.3132 X 1.4733)

= ————————————————- – (1,000,000)
1.9332
= EUR 795.34 per EUR 1 million.
8. Following quotes are provided by three different traders: 

 
Trader A: 1.6818 - 28 USD per GBP 
Trader B: 6.0025 - 25 SEK per USD 
Trader C: 10.0800 - 00 SEK per GBP 
 
Establish if opportunity for arbitrage exists and if yes, calculate the
profit on capital USD 1 million; using synthetic mechanism.
Solution:
Note:
(1) When currency of capital is specified that currency cannot be

eliminated when deriving the quotation comparable to the third
quotation.
(2) The establishing of arbitrage opportunity by converting 3-currency

comparison into a 2-currency comparison is called "Synthetic
Mechanism" and the derived quotation is called the "Synthetic
Quote"
Reconstructing the given quotations as per ACI convention, we get: 

 
GBP/USD 1.6818 – 1.6828 … (1) 
! !110
USD/SEK 6.0025 – 6.0125 … (2) 
GBP/SEK 10.0800 – 10.0900 … (3) 

 
Using quotations (1) & (3) we can derive USD/SEK quotation
comparable to quotation (2) 
 
Derived (USD/SEK)Bid = (USD/GBP)Bid X (GBP/SEK)Bid ….. Chain rule
1
= ———————— × (GBP/SEK)Bid ….. Inverse
(GBP /USD)Ask rule
1×10.0800
= ————————
1.6828
= 5.9900
Derived (USD/SEK)Ask=(USD/GBP)Ask X (GBP/SEK)Ask ….. Chain rule
1
= ———————— × (GBP/SEK)Ask ….. Inverse
(GBP /USD)Bid rule
1×10.0900
= ————————
1.6818
= 5.9995
Therefore, Derived USD/SEK 5.9900 – 5.9995
Given USD/SEK 6.0025 – 6.0125
Therefore, BID 6.0025 > ASK 5.9995
Therefore, arbitrage exists
Assume, capital USD 1 million ….. (Given)
! !111
B 6.0025
Profit = P X —— − p = 1,000,000 × ————- – 1,000,000
A 5.9995
1,000,000 × 6.0025
= ————————————- × 1.6818 – 1,000,000
10.0900
= 496
Therefore, Profit on capital of USD 1 million = USD 496
9. A dealer in Frankfurt quotes:
GBP per EUR 0.7330 – 40 and

JPY per EUR 102.50 – 50
What is the expected rate for GBP in terms of JPY in London? If actual
quote in London is JPY per GBP 142 – 143 identify and calculate
arbitrage gain, if any.
Solution:
Reconstructing quotations as per ACI convention, we get:

EUR/GBP 0.7330 – 0.7340
EUR/JPY 102.50 – 103.50
Estimated:
(GBP/JPY)Bid = (GBP/EUR)Bid X (EUR/JPY)Bid ….. Chain rule
1
= ———————— × (EUR/JPY)Bid ….. Inverse rule
(EUR /GBP)Ask
1×102.50
= ————————
0.7340
= 139.65
! !112
(GBP/JPY)Ask = (GBP/EUR)Ask X (EUR/JPY)Ask ….. Chain rule
1
= ———————— × (EUR/JPY)Ask ….. Inverse rule
(EUR /GBP)Bid
1×103.50
= ————————
0.7330
= 141.20
Therefore, Derived GBP/JPY 139.65 - 141.20 (Estimated)
Given GBP/JPY 142.00 – 143.00 (Actual)
Therefore, BID 142.00 > Ask 141.20
Therefore, Arbitrage opportunity exists
Assume, capital GBP 1 million
Identified Bid
Arbitrage gain = Principal X —————————— - (Principal)
Identified Ask
142.00
= 1,000,000 X —————— – (1,000,000)
141.20
1,000,000 X 142.00 X 0.7330

= ————————————————- – (1,000,000)
103.50
= GBP 5662 per GBP 1 million.
! !113
10.A bank in Mumbai offers to sell USD against INR at USD/INR 44.3800
whereas a bank in the US offers to sell INR against USD at 100 INR/
USD 2.2535. Would you undertake the transactions?
Solution:
Note: When comparing rates, the base currency should be identical.
As per given data:
We can buy USD @ INR 44.3800
100 X 1
We can sell USD @ INR ————— = 44.3754
2.2535
Therefore, by undertaking the transaction we would incur a loss since

our buying rate for USD would be higher than our selling rate for USD.
11.Bank in Mumbai quotes USD/INR 44.6300 – 50 whereas Bank in USA

quotes 100 INR/USD 2.2410 –15. Identify if any advantage can be
derived from these quotes.
Solution:
Quotation (1) USD/INR 44.6300 – 44.6350
Quotation (2) 100 INR/USD 2.2410 – 2.2415

Quotation (2) can be inversed to make it comparable to Quotation (1).
Derived:
1 1 X 100
(USD/INR)Bid = ———————— = ——————————
(INR/USD)Ask (100INR /USD)Ask
1 X 100
= ——————-
2.2415
= 44.6130
! !114
1 1 X 100
(USD/INR)Ask = ———————— = ——————————
(INR/USD)Bid (100INR /USD)Bid
1 X 100
= ——————-
2.2410
= 44.6229
Therefore, Derived USD/INR 44.6310 – 44.6229
Given USD/INR 44.6300 – 44.6350
Therefore, Arbitrage exists.
Assume, capital USD 1 million
Identified Bid
Arbitrage gain = Principal X —————————— - (Principal)
Identified Ask
44.6300
= 1,000,000 X —————— – (1,000,000)
44.6229
2.2410
= 1,000,000 X 44.6300 X ————- – (1,000,000)
100
= USD 158 per USD 1 million.
12.The following quotations are available in New York: 

 
1 USD = GBP 0.5880 – 90 
1 USD = CAD 1.1003 – 13 
 
Calculate the cross currency quotation for 1 GBP in terms of CAD. 
The following quotation is available in Toronto: 
! !115
1 GBP = CAD 1.8685 – 95 

 
Compare this with the cross currency quotation and identify if any
arbitrage opportunity exists.
Solution:
Reconstructing the quotations as per ACI convention, we get:
USD/GBP 0.5880 – 0.5890
USD/CAD 1.1003 – 1.1013
Derived: (GBP/CAD)Bid=(GBP/USD)Bid X (USD/CAD)Bid ..Chain Rule
1
= ———————- X (USD/CAD)Bid .. Inverse
(USD/GBP)Ask Rule
1
= ———————-
(USD/GBP)Ask
= 1.8681
(GBP/CAD)Ask =(GBP/USD)Ask X (USD/CAD)Ask ..Chain Rule
1
= ———————- X (USD/CAD)Ask .. Inverse Rule
(USD/GBP)Bid
1 X 1.1013
= ———————-
0.5880
= 1.8730
Therefore, Derived GBP/CAD 1.8681 – 1.8730

Given GBP/CAD 1.8685 – 1.8695
! !116
Therefore, Arbitrage opportunity does not exist as there is no BID >

ASK situation which is required for deriving arbitrage.
13.The following quotations are available at a given time: 

 
Bank A: 1.3995 – 05 SGD/USD 
Bank B: 31.53550 – 00 INR/SGD 
Bank C: 2.2628 – 33 USD/100 INR 
 
Identify and calculate arbitrage gain.
Solution:
Reconstructing the quotations as per ACI convention, we get
USD/SGD 1.3995 – 1.4005 ….. (1)
SGD/INR 31.5350 – 31.5400 ….. (2)
100 INR/USD 2.2628 – 2.2633
= INR/USD 0.022628 – 0.022633 ….. (3)
Derived:
(USD/SGD)Bid = (USD/INR)Bid x (INR/SGD)Bid ….. Chain Rule
1 1
= ———————— X ———————— ….. Inverse Rule
(INR/USD)Ask (SGD/INR)Ask
1 1
= ———————— X ———————
0.022633 31.5400
= 1.4009
(USD/SGD)Ask= (USD/INR)Ask x (INR/SGD)Ask ….. Chain Rule
! !117
1 1
= ———————— X ———————— ….. Inverse Rule
(INR/USD)Bid (SGD/INR)Bid
1 1
= ———————— X ———————
0.022628 31.5350
= 1.4014
Therefore, Derived USD/SGD 1.4009 – 1.4014
Given USD/SGD 1.3995 – 1.4005
Therefore, Arbitrage exists.
Assume, capital USD 1 million
Identified Bid
gain = Principal X —————————— - (Principal)
Identified Ask
1.4009
= 1,000,000 X —————— – (1,000,000)
1.4005
1,000,000 1 1
= ———————X—————- X ————- – (1,000,000)
1.4005 0.022633 31.5400
= USD 260 per USD 1 million
14.A Bank in New York is quoting USD/CHF 1.2193- 03 whereas a Bank in

Zurich is quoting CHF/USD 0.8197 -07. If you are a buyer for CHF, from
which bank would you buy?
! !118
Solution:
Purchase and sale should always be viewed from the perspective of the
Base currency. Since the decision is to be taken for CHF, both quotations
should be made comparable with CHF as Base Currency.
Therefore, Derived CHF/USD: (using Inverse Rule)
1 1
(CHF/USD)Bid = ———————— = ————— = 0.8195
(USD/CHF)Ask 1.2203
1 1
(CHF/USD)Ask = ———————— = ————— = 0.8201
(USD/CHF)Bid 1.2193
Therefore, Derived CHF/USD 0.8135 – 0.8201 (New York)
Given CHF/USD 0.8197 – 0.8207 (Zurich)
The selling rate for CHF is lower in the case of the Bank in New York, which
means we should buy CHF in New York.
5 . 1 7 C L A S S I F I C AT I O N O F R AT E S I N T E R M S O F
SETTLEMENT
• All the exchange rates indicated so far are those that are exchanged and
dealt with between banks and are therefore, called Inter-bank Rates.
• Rates quoted by banks to their customers are called Merchant Rates and
involve an addition or subtraction of exchange margin which represents
the profit margin. (That is, it which represents the profit margin,
transaction handling commission and overhead expenses.)
• Interbank contracts are settled at inter-bank rates. Inter-bank Foreign

exchange transactions do not involve any pre/post payment of either
currency. In all sale/ purchase transactions the two currencies are always
exchanged on the same calendar date but at two different times. The
time difference is due to time - zone factors. This concept is called the
Principle of Compensated Value.
! !119
• Contract date - the date on which the two counter parties to a foreign
exchange contract agree to the currencies to be bought/sold, the rate of
conversion, the amount and the settlement date called the contract date
represented as ‘C'.
• The settlement of any transaction takes place through transfers of

deposits between the two contracting parties. The date on which the
actual transfer/exchange of currencies takes place is called the
settlement date or the value date.
• To effect the transfers, the correspondent banks in the countries of the

two currencies involved must be open for business. The concerned
countries are called settlement locations.
• The locations of the two principal banks involved in the trade are called
dealing locations, which need not be the same as the settlement
locations.
Therefore, four different settlement maturities possible in

interbank contracts
Contract date Settlement date Classification
C C+0 Cash or value today
C C+1 Tom or value tomorrow
C C+2 Spot
C C + 3 Onwards Forward
(C = contract date)
Cash Contracts
Foreign exchange contracts which provide for settlement on contract date

itself are called 'cash' or 'value today' contracts and the rate applicable to
them are called 'cash' or 'ready' rates. Such contracts are represented as C
+ 0. The rates for such transactions are derived from ongoing spot rates. It
is not possible to deal on `cash' basis in all currencies due to time zone
limitations.
! !120
Tom Contracts
Foreign exchange contracts which provide for settlement on the first

working day after the contract day are called Tom or value tomorrow
contracts and are represented as C + 1. The rates applicable to such
contacts are called Tom rates. Rates for such transactions are derived from
the ongoing Spot rate. It is possible to deal on `Tom' basis in all
currencies.
Spot Contracts
A foreign exchange transaction which involves settlement of currencies on

the second working day after the contract date is called a spot contract and
the rate applicable to such contracts is called the spot rate. The spot rate
represents the standard conversion value between a given pair of
currencies which is indicative of the relative strength and weakness of the
respective currencies. Rates for all other settlement maturities are derived
from the spot rate by adding or subtracting a factor called swap margin.
The increase or decrease in the spot rate indicates the appreciation or
depreciation in the base currency. Such contracts are represented as C +
2.
Forward Contracts
Foreign Exchange transactions in which the counter parties agree to a

settlement beyond the spot date are called `forward transactions' or
`forward contracts'. Rates applicable to such transactions are called
`forward rates'. Forward rates are derived from the Spot Rates by adding
or subtracting a factor called Forward Margin. Forward Margin represents
the interest differential between the two currencies for the given maturity.
Forward margins are also referred to as SWAP POINTS or SWAP MARGINS.
Forward Margins
• They can be classified as either PREMIUMS or DISCOUNTS. When the

interest rate of the variable currency is more than the interest rate of the
base currency, the forward margin is added to the spot rate to arrive at
the forward rate. Such margins are called PREMIUMS on base currency.
When the interest rate of the variable currency is less than the interest
rate of the base currency, the forward margin is subtracted from the spot
! !121
rate to arrive at the forward rate. Such margins are called DISCOUNTS
on base currency.
• The value of a currency is represented by the spot rate. The forward rate
being higher or lower than the corresponding spot rate does not signify
appreciation or depreciation of the currency. The difference between the
forward and the spot rate signifies the compensation being exchanged
between the two parties for the difference in the interest rates for the
given forward period. Effectively it compensates the net opportunity cost
in terms of interest rates.
Holgate's Principle:
This principle states that —
1. Premium on base currency is always added whereas, discount on

base currency is always subtracted from the spot rate to arrive at the
corresponding forward rate.
2. Premium on base currency implies discount on variable currency and

discount on base currency implies premium on variable currency.
5.18 SUMMARY
The rates quoted in the foreign exchange markets are described in this
chapter. Guidelines followed in the banks while quoting in foreign and local
currencies are described. FEDAI has issued guidelines on methods of
expressing rates of exchange for certain currencies like sterling pounds, US
dollars, French francs, etc. If equivalent amounts of two currencies are
known exchange rate of the currencies is calculated using rule of three.
The buying and selling rates are loaded with interest for transit period; re-
discount charges, bank's own discount charges plus both banks'
commission while opening documentary letter of credit.
! !122
1. Define Forward Rates. Explain the concept of premiums and discounts in

the context of Holgate's principle.
2. The term 'Cash Contracts' does not refer to currencies in physical cash
form. Discuss.
3. A market is imperfect without the presence of market makers. Explain

the importance of Foreign Exchange Traders.
4. What is Vehicle Currency?
5. Explain the concept of Arbitrage, Speculation and Trading.
6. Bulls v/s Bears and their comparative features.
! !123
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !124
FOREIGN EXCHANGE CALCULATIONS
Chapter 6
Learning Objectives
• What is Forward rate?

• How do you Calculate Forward Rate Based on Formula and Schedule
• Swap Points
• Annualized Forward Margin
• Interest Rate Arbitrage
• Borrowing and Investment Decision
Structure:
6.1 Abstract
6.2 Calculation of Forward Rates Through the Use of Formula
6.3 Calculation of Swap Points
6.4 Features of Forward Rates
6.5 Calculation of Forward Rates through Schedules Method (Tables)
6.6 Annualized Forward Margin (AFM)
6.7 Relationship between Exchange Rates, Interest Rates and Commodity
Prices
6.8 Interest Rate Arbitrage
6.9 Borrowing and Investment Decisions
6.10 Japanese Yen Carry Trade
6.11 Summary
! !125
6.1 ABSTRACT
Assume that a forward rate is required to be created for an import

transaction of USD 1 maturing one year forward. Assume, spot USD/INR =
50, INR interest rate = 6% p.a. and USD interest rate = 3% p.a. Assume,
borrowing of INR 50 for one year.
Liability at the end of one year would be:
!
= INR 53
The borrowed INR can be used to purchase 1 USD at the spot price and
invested at 3% p.a. for one year. The USD available at the end of one
year would be:
!
= USD 1.03
Thus, USD 1.03 can be created against a liability of INR 53 one year
forward. This means that 1 USD gets created at a cost of INR (53/1.03)
one year forward. Therefore, 1 year forward USD/INR:
53
= ———
1.03
= 51.4563
Thus, forward rate `F':
! !126
= 51.4563
53
= ———
1.03
This formula would therefore, enable computation of a forward rate `n'

months forward.
Where:
F = forward rate
S = spot rate
Rv = interest rate on variable currency
Rb = interest rate on base currency
n = number of months
In case, rate is required in terms of days then replace n/12 by d/365.
In case, days are in multiple of 30 then assume year to be 360 days.
! !127
6.2 CALCULATION OF FORWARD RATES THROUGH THE

USE OF FORMULA
1. If spot USD/SEK is 5.2425, USD interest rate is 4.00% p.a. and SEK
interest rate is 6.5% per annum then calculate USD/SEK rate 3 months
forward.
Solution:
Forward rate
! !128
2. If 6 month forward USD/SEK rate is 6.8525, SEK interest rate is 7.35%

p.a. and USD interest rate is 3.65% p.a. Calculate the USD/SEK spot
rate.
Solution:
3. Given, 
 
1 EUR = USD 1.3485 spot 
 
1 EUR = USD 1.3502 two months forward 
 
USD interest rate = 4% p.a. 
 
Calculate EUR interest rate.
! !129
Solution:
1.3485 X 604
Therefore, (600 + Rb) = ————————-
1.3502
= 603.24
Therefore, Rb = 3.24% p.a. i.e.: EUR interest rate = 3.24% p.a.
4. Given, 
 
Spot GBP/CAD 1.9213 
 
73 days forward 1.9187 
 
GBP interest rate = 3.50% p.a. 
 
Calculate CAD interest rate.
Solution:
! !130
6.3 CALCULATION OF SWAP POINTS
1. Given, 
 
Spot GBP/USD 1.9845 – 1.9855 
 
USD interest rate 4.1250 – 4.3750% p.a. 
 
GBP interest rate 5.8750 – 6.1250% p.a. 
 
Calculate swap points (forward margins) for three months.
! !131
Solution:
For `bid side' swap points use deposit rate of Variable currency and lending
rate of Base currency.
Therefore, swap points = F - S = 1.9747 - 1.9845 = (-) 0.0098 …… (1)
For àsk side' swap points use deposit rate of Base currency and lending
rate of Variable currency.
404.1250
= 1.9855 X ———————
406.1250
! !132
= 1.9782
Therefore, swap points = F – S = 1.9782 – 1.9855 = (–) 0.0073 … (2)
Since the swap points are negative they represent discount on base
currency. In all discount situations the swap points are always in
descending order (left to right)
Therefore, three month forward margins: 98-73
1. Positive swap points represent premium on base currency. In such cases

the swap points are always in ascending order (left to right).
2. When a transaction is postponed beyond the spot date, the seller

continues to hold the base currency on which it is possible to earn the
market deposit rate whereas, he is deprived of the variable currency
which would have to be borrowed at the market lending rate. Therefore,
the forward ask rate would get calculated using the base currency
deposit rate and the variable currency lending rate. The opposite would
hold true for calculating the forward bid rate when two-way interest
rates are provided.
3. Swap points are always represented in the form of `pips'. Therefore, no

decimals are indicated. Factors are presented without positive or
negative signs. It is understood that factors in ascending order (Left to
Right) are positive (premium on base currency) whereas, factors in
descending order (Left to Right) are negative (discount on base
currency).
2. Given, 
 
Spot USD/CAD 1.0985 - 1.0995 
 
CAD Deposit rate: 4.75% p.a. 
 
USD Deposit rate: 4.00% p.a. 
 
3 month swap points: 14 - 27 
 
Calculate the arbitrage free lending interest rates for the two currencies.
! !133
Solution:
Spot USD/CAD 1.0985 – 1.0995
(+) 3 months premium 14 – 27

———-—-—————
3 months USD/CAD 1.0999 – 1.1022
CAD Lending rate: 4.99% p.a.
USD Lending rate: 4.23% p.a.
! !134
3. Given, 
 
Spot GBP/AUD 2.2950 – 2.2960 
 
AUD Lending rate: 2.25% p.a. 
 
GBP Lending rate: 3.50% p.a. 
 
6 months swap points: 169 –113 
 
Calculate the arbitrage free deposit rates for the two currencies.
Solution:
Spot GBP/AUD 2.2950 – 2.2960
(–) 6 Months discount 0.0169 – 0.0113

—————————-
2.2781 – 2.0847
(200 + Rv) = 202.00
Rv = 2.00
AUD deposit rate = 2.00% p.a. .....(1)
! !135
2.2960 X 202.25
(200 + RB) = ——————————-
2.2847
= 203.25
RB = 3.25
GBP deposit rate = 3.25% p.a. ….. (2)
4. Given 
 
Spot EUR/SGD 1.7480 – 1.7490 
 
3 months swap points: 33 – 54 
 
SGD Deposit rate: 3.00% p.a. 
 
EUR Deposit rate: 2.00% p.a. 
 
Calculate the arbitrage free lending rates for the two currencies.
Solution:
Spot EUR/SGD 1.7480 – 1.7490
(+) 3 months premium 33 – 54
3 months EUR/SGD 1.7513 – 1.7544
! !136
EUR Lending rate = 2.24% p.a. ….. (1)
SGD lending rate = 3.24% p.a. ….. (2)
! !137
6.4 FEATURES OF FORWARD RATES
• When forward rates are quoted by banks to their customers, the

premium or discount for the forward maturity is included when quoting
the final rate to the customer. The Exchange Margin representing the
profit of the bank is also factored into the base rate. Such rates are
called òutright forward rates’.
• When forward rates are quoted by banks in the inter-bank market, a

schedule of forward margins is provided along with the spot quotations.
Spot USD/INR 41.0625 – 41.0675 Spot USD/CHF 1.3625 – 1.3635

1 month forward 650 – 700 1 month forward 35 – 25
• In a given schedule of forward margins, if LHS factors are less than the
RHS factors, they represent premium on base currency whereas, if LHS
factors are greater than the RHS factors, then they represent discount on
base currency.
• In a given schedule of forward margin, LHS factors are added or

subtracted to the bid rate in the spot quotation whereas, the RHS factors
are added or subtracted to the ask rate of the spot quotation.
• The forward margin factors are added or subtracted from the extreme
right hand decimal place of the spot rate, because the factors are
presented in the form of pips.
• Forward margins are always presented in terms of the variable currency

and therefore they represent premium or discount per unit of the base
currency.
• Each factor in the schedule of forward margins represents a standalone

calculation and there is no cumulative addition or subtraction when
arriving at forward rates.
! !138
• The spread of a forward quotation arrived at using the schedule of

forward margins can never be finer than the spread of the spot
quotation.
• The schedule of forward margins is presented in two different ways. The

forward margins are either calculated for standard forward maturities
such as 1, 3, 6 months or in terms of calendar months as spot/Jan, spot/
Feb, etc. (In India, forward margins are normally presented in terms of
calendar months).
• When forward margins are presented in terms of standard maturities,

assume 1 month = 30 days and 1 year = 360 days, whereas, when the
margins are presented in terms of calendar months, the calculations
represent the actual days for that month. In such cases 1 year = 365
days.
Broken Date Forward Quotations
• From a given schedule of forward margins, if a quotation is required to

be calculated for a date falling between two standard maturities then,
such quotations are calculated using the `Principle of Interpolation'. This
means that a quotation is first obtained for the first standard maturity
and pro rata premium or discount for the balance number of days
between the first and the second standard maturity is calculated to
obtain the required quotation.
Rules Regarding Forward Dates
• Forward maturities are always calculated in relation to the spot date.

Example, 1 month forward contract dated 25th January, maturity date
would be 27th February, i.e., 1 month from the spot date of 27th
January.
• If a conventionally calculated maturity date falls on a holiday, at either of

the locations then the next working day is treated as maturity date.
Example, in the above case, if 27th February is a Sunday, then the
maturity would be on 28th February.
• The conventionally calculated forward date in terms of months must tally

with the number of calendar months. For example, in the above case, if
! !139
28th February is a holiday either in India or at the foreign centre then,

the forward maturity date would be 25th February. Foreign exchange
markets are closed over week-ends, thus, Saturday 26th February cannot
be considered.
• If a conventionally calculated forward date does not exist in a particular

month,then the last working date of that month is considered as the
maturity date. Example, a 3 month forward contract dated 29th January
would conventionally mature on the 31st April. Since no such date exists,
the contract would mature on 30th April.
6.5 CALCULATION OF FORWARD RATES THROUGH THE

USE OF FORWARD SCHEDULES (TABLES)
1. From the following data calculate the one, two and three month USD/
INR and USD/CHF rates.
Spot USD/INR 41.0625 – 41.0675 Spot USD/CHF 1.3625 – 1.3635

Solution:
Spot USD/INR rate 40.0625 – 40.0675 Spot USD/CHF rate 1.3625 – 1.3635
(+) 1 month premium 0.0650 – 0.0700 (-) 1 month 0.0035 – 0.0025
1 month rate ————————— discount 1.3590 – 1.3610
40.1275 – 40.1375
1 month rate
40.1900 – 40.2000
2 month rate
40.2500 – 40.2600
3 month rate
! !140
2. Based on the above data calculate the one month and three month CHF/
INR quotations. 
 
Note: When calculating forward cross rates, both quotations must be of
the same maturity
Solution: One month quotation:
(CHF/INR)Bid =(CHF/USD)Bid X (USD/INR)Bid
1
= ———————- X (USD/INR)Bid
(USD/INR)Ask
(1 X 40.1275)
= ————————
1.3610
= 29.4838
(CHF/INR)Ask =(CHF/USD)Ask X (USD/INR)Ask
1
= ———————- X (USD/INR)Ask
(USD/INR)Bid
(1 X 40.1375)
= ————————
1.3590
= 29.5346
One month CHF/INR 29.4838 – 29.5346
Three month quotation:
(CHF/INR)Bid =(CHF/USD)Bid X (USD/INR)Bid
1
= ———————- X (USD/INR)Bid
(USD/CHF)Ask
! !141
(1 X 40.2500)
= —————————
1.3555
= 29.6938
(CHF/INR)Ask =(CHF/USD)Ask X (USD/INR)Ask
1
= ———————- X (USD/INR)Ask
(USD/CHF)Bid
(1 X 40.2600)
= ————————
1.3535
= 29.7451
Three month CHF/INR 29.6938 – 29.7451
3. From the above data determine the quotation for:
(a) 50 days forward USD/INR

(b) 70 days forward USD/CHF
(c) 70 days forward CHF/INR
Spot USD/INR rate 40.0625 – 40.0675
(+) 30days premium 0.0650 – 0.0700 1 month = 30 days

30 days rate —————————-
40.1275 – 40.1375
(+) 20days premium 0.0417 – 0.0417 Proportional basis

——————————
50 days quotation 40.1692 – 40.1792
Spot USD/CHF rate 1.3625 – 1.3635
(-) 60 days discount 0.0065 – 0.0055 2 month = 60 days

60 days rate —————————-
1.3560 – 1.3580
(-) 10days discount 0.0008 – 0.0008 Proportional basis

——————————
10 days quotation 1.3552 – 1.3572
! !142
Spot USD/INR rate 40.0625 – 40.0675
(+) 60days premium 0.1275 – 0.1325 2 month = 60 days

60 days rate —————————-
40.1900 – 40.2000
(+) 10days premium 0.0200 – 0.0200 Proportional basis

——————————
10 days quotation 40.2100 – 40.2200
The 70 days quotations for USD/INR and USD/CHF when crossed would
give:
70 days CHF/INR 29.6272 – 29.6783.
Calculation of proportional forward margin:
= 8.33
= 8 (rounded off to nearest integer)
= 417 (rounded off to nearest integer)
= 200
! !143
FM1 = forward margin of first standard maturity
FM2 = forward margin of second standard maturity
SM1 = first standard maturity
SM2 = second standard maturity
Note: If the forward margins for two consecutive maturities change

from premium to discount or vice versa then use the formula:
4. Given spot USD/INR 48.8125 – 48.8175 

 
One month forward 75 – 25 
 
Two month forward 135 –185 
 
Calculate USD/INR quotation for 40 days forward.
Solution:
Spot USD/INR 48.8125 – 48.8175
(–) 30 days discount 0.0070 – 0.0025

30 days USD/INR 48.8050 – 48.8150
(+) 10 days premium 0.0070 – 0.0070

40 days USD/INR 48.8120 – 48.8220
Calculation:
(135 + 75)
= ——————- X 10
(60 - 30)
! !144
= 70
Note: It is not necessary that calculation of proportionate forward

margin for both bid and ask sides be identical. Therefore, in such cases
separate calculations need to be done for both sides.
5. If the quotations provided in Ex.1 above pertain to bank `X', then

indicate the rates at which deals would be done in response to the
following enquiries from other banks:
(a) Bank À' wishes to purchase INR against USD 1 month forward.
(b) Bank `B' wishes to purchase USD against CHF 2 months forward.
(c) Bank `C' wants to sell INR against CHF 3 months forward.
(d) Bank `D' wants to sell USD against INR 50 days forward.
(e) Bank È' wants to sell CHF against INR 70 days forward.
Solution:
(a) Quotations always pertain to the base currency. Bank À' wants to
purchase INR effectively means it wants to sell USD. Therefore Bank
`X' would be a buyer for USD 1 month forward and would quote:
40.1275
(b) Bank `B' wants to purchase USD means Bank `X' would be a seller
of USD 2 month forward and would quote: 1.3580
(c) Bank `C' wants to sell INR effectively means it wants to buy CHF.
Bank `X' would be a seller of CHF 3 months forward and would
quote: 29.7451.
(d) Bank `D' wants to sell USD therefore Bank `X' would be a buyer of
USD 50 days forward and would quote: 40.1692.
(e) Bank È' wants to sell CHF so Bank 'X' would be a buyer of CHF 70
days forward and would quote: 29.6272.
! !145
6. Given: 
 
Spot USD/INR 46.0525 – 46.0575 
 
Spot/August 425 – 475 
 
Spot/September 1050 – 1100 
 
Spot/October 1850 – 1900 
 
Calculate quotations for 31 August, 30 September and 31 October.
Solution:
Spot USD/INR 46.0525 – 46.0575

(+) Premium 0.0425 – 0.0475
31 August USD/INR 46.0950 – 46.1050

Spot USD/INR 46.0525 – 46.0575
(+) Premium 0.1050 – 0.1100
30 September USD/INR 46.1575 – 46.1675

Spot USD/INR 46.0525 – 46.0575
(+) Premium 0.1850 – 0.1900
31 October USD/INR 46.2375 – 46.2475
In premium situations, the forward margins are calculated upto the last
day of the calendar month whereas in the case of forward discount margins
are calculated upto the first day of the calendar month.
7. Given: The following data on 4 October, 2010 

 
Spot USD/INR 45.8830-80 
 
Spot October 850-900 
 
Spot November 1750-1800 
 
Spot December 2680-2730
Calculate quotations for: 1 month, 10 days forward and 2 months, 3
days forward.
! !146
Solution:
(A) The Spot date on 4 October, 2010 is 6 October, 2010 

 
1 month 10 days forward would be 16 November, 2010
Spot USD/INR 45.8830 – 45.8880

(+) Premium 31 October 0.0850 – 0.0900
31 October USD/INR 45.9680 – 45.9780

(+) Premium for 16 days 0.0480 – 0.0480
16 November USD/INR 46.0160 – 46.0260
Calculation of proportionate premium:
Bid side calculation:
Note: (SM2 X SM1) = November which has 30 days
! !147
(B) The Spot date on 4 October, 2010 is 6 October, 2010 

 
2 month 3 days forward would be 9 December, 2010
Spot USD/INR 45.8830 – 45.8880

(+) Premium 30 November 0.1750 – 0.1800
30 November USD/INR 46.0580 – 46.0680

(+) Premium 9 days 0.0270 – 0.0270
9 December USD/INR 46.0850 – 46.0950
Calculation of proportionate premium:
Bid side calculation:
Ask side calculation:
Note: (SM2 – SM1) = December which has 31 days
! !148
8. A Bank in Mumbai is quoting: 

 
Spot USD/INR 45.0265 –15 
 
1 month forward 485 – 535 
 
 
A Bank in New York is quoting: 
 
Spot USD/CHF 1.2190-00 
 
 
2 month forward 22 – 14
A customer of the bank in Mumbai wants to purchase CHF against INR, 2
months forward. What rate would the bank quote?
Solution:
Only the 2 months forward quotation is required.
Spot USD/INR 45.0265 – 45.0315
(+) 2 month premium 0.0985 – 0.1060

——————————
2 month USD/INR 45.1250 – 45.1375
Spot USD/CHF 1.2190 – 1.2200
(–) 2 month discount 0.0022 – 0.0014

——————————
2 month USD/CHF 1.2168 – 1.2186
2 month forward:
(CHF/INR)Ask =(CHF/USD)Ask X (USD/INR)Ask ..... Chain Rule
1
= ———————- X (USD/INR)Ask ..... Inverse Rule
(USD/CHF)Bid
(1 X 45.1375)
= ————————
1.2168
= 37.0952
! !149
The Bank would quote: 1 CHF = INR 37.0952
(Note: Since the customer is buyer for CHF, the bank needs to indicate
only its selling rate)
9. Based on the following data; calculate 20 days forward GBP/AUD

quotation:
Spot BP/USD 1.6636/45 USD/AUD 1.1803/13
1 month forward 15/9 6/12
Solution:
Spot GBP/USD 1.6636 – 1.6646
(–) 20 days discount 0.0010 – 0.0006

—————————-
20 days forward 1.6626 – 1.6640
Spot USD/AUD 1.1803 – 1.1813
(+) 20 days premium 0.0004 – 0.0008

—————————-
20 days forward 1.1807 – 1.1821
20 days forward
(GBP/AUD)Bid = (GBP/USD)Bid X (USD/AUD)Bid ... Chain Rule
= 1.6626 X 1.1807 = 1.9630
(GBP/AUD)Ask = (GBP/USD)Ask X (USD/AUD)Ask ... Chain Rule
= 1.6640 X 1.1821 = 1.9670
20 days forward GBP/AUD 1.9630 – 1.9670
! !150
Calculations: (GBP/USD)
Bid Side Ask Side

(FM2 – FM1) (FM2 – FM1)
———————- X D ——————- X D
(SM2 – SM1) (SM2 – SM1)
(20 – 0) (12 – 0)
= ————- X 20 = ————— X 20 = 6
(30 – 0) (30 – 0)
Calculations: (USD/AUD)
Bid Side Ask Side

(FM2 – FM1) (FM2 – FM1)
———————- X D ——————- X D
(SM2 – SM1) (SM2 – SM1)
SM2 – SM1 SM2 – SM1
(6 – 0) (12 – 0)
= ————- X 20 = ————— X 20
(30 – 0) (30 – 0)
=4 =8
6.6 ANNUALISED FORWARD MARGIN (AFM)
AFM can be described as arithmetical difference between the interest rates

of the variable and base currencies in annualised percentage terms. Thus,
AFM = (Rv -Rb). It is calculated as:
(F – S) 12
AFM = ———— X —— X 100
S n
F = Forward rate
S = Spot rate
N = Number of months
! !151
Unless otherwise specified, annualised forward margin is conventionally

calculated on the àsk' rates.
1. Using the above data (Calculation of forward...Ex. (1) Calculate the

annualised forward margin for USD/INR quotation for three months.
What is the significance of your result?
Annualised Forward Margin
Interpretion:
The positive result indicates that the interest rate on INR > interest rate of
USD by 1.9218% for three months maturity. One can therefore conclude
that USD would be at premium against INR.
Note: If annualized forward margin = 0 then it indicates that Rv – Rb = 0

which means that Rv = Rb, i.e.: the interest rate of both currencies are
equal for the given maturity. If AFM is negative then it indicates that Rv <
Rb which means that base currency would be at a discount.
2. Given, 
 
Spot GBP/SGD 2.6813 
 
3 months AFM = Discount 1.50% 
 
Calculate 3 months forward GBP/SGD rate.
! !152
Solution:
(F – S) 12
AFM = ———— X —— X 100
S n
F – 2.6813 12
(-) 1.50 = ——————- X ——- X 100
2.6813 3
(-) 1.50 F
———— X ————— - 1
400 2.6813
1 - 1.50 F
————— X ————-
400 2.6813
398.50 F
————— X ————-
400 2.6813
398.50 X 2.6813
F = —————————
400
= 2.6712
3 months forward GBP/SGD rate = 2.6712
3. Given, 
 
4 months forward EUR/CHF rate = 1.5745 
 
4 months forward AFM = (–) 2% 
 
Calculate Spot EUR/CHF rate
Solution:
! !153
(F – S) 12
AFM = ———— X —— X 100
S n
1.5745 – 4 12
(- 2) = ——————- X ——- X 100
S 4
(- 2) 1.5745
= ———— X ————— - 1
300 S
(1- 2) 1.5745
= ———— X —————
300 S
1.5745 X 300
S = —————————
298
S = 1.5851
Spot EUR/CHF rate =1.5851
4. Given, 
 
Spot USD/CAD 1.1305 
 
6 months forward AFM = Premium 1% 
 
Calculate 6 months forward USD/CAD rate. 
 
If CAD interest rate = 3.25% p.a. Calculate USD interest rate.
Solution:
(F – S) 12
AFM = ———— X —— X 100
S n
! !154
F – 1.1305 12
(1) = ——————- X ——- X 100
1.1305 6
1 F
———— X ————— - 1
200 1.1305
1+1 F
———— X —————
200 1.1305
201 F
———— X —————
200 1.1305
201 X 1.1305
F = ———————
200
F = 1.1362.
6 months forward USD/CAD rate = 1.1362 ..... (1)
AFM = RV – RB
1 = 3.25 – RB
RB = 3.25 – 1
RB = 2.25
USD interest rate = 2.25% p.a. ..... (2)
5. Given 
 
Spot = EUR/JPY 115.2000 
 
3 months forward rate = 114.6950 
 
Calculate AFM. Interpret the result.
Solution:
! !155
(F – S) 12
AFM = ———— X —— X 100
S n
114.6950 – 115.2000 12
= ———————————- X ——- X 100
115.2000 3
(–) 0.5050 400

= —————————
115.2000
= (–) 1.7535
3 month forward AFM = (–) 1.7535% ..... (1)
The negative result indicates that base currency is at a discount. Thus,

interest rate of base currency EUR is more than interest rate of
variable currency JPY by 1.7533% for 3 months maturity. ..... (2)
6. A Bank in India is quoting Spot USD/INR 44.8325 and is offering USD at

an annual forward premium of 2%. 
 
Calculate the Banks 6 month forward USD/INR rate.
Solution:
(F – S) 12
AFM = ———— X —— X 100
S n
F – 44.8325 12
(+2) = ——————— X ——- X 100
44.8325 6
2 F
(+) ———— X —————
200 44.8325
! !156
1+1 F
———— X —————
200 44.8325
200 F
———— X —————
200 44.8325
200
F = ——— X 44.8325
200
F = 45.2808.
6 months forward USD/INR rate = 45.2808
6 . 7 R E L AT I O N S H I P B E T W E E N E X C H A N G E R AT E S ,
INTEREST RATES AND COMMODITY PRICES
1. Purchasing Power Pairty Theory (PPP): 

 
The `Law of One Price' forms the basis for the development of the PPP
theory. Gustav Cassel, a Swedish economist, evolved this theory by
applying the `Law of One Price' to commodity markets. The theory
states that, "The ratio of the price of a basket of goods and services
expressed in terms of the variable currency to the price of the same
basket expressed in terms of the base currency should represent the
spot exchange rate between the two currencies".
In its absolute form, the theory can be represented as,
Pv b
——- = S ——-
Pb V
Where,
Pv = price index in variable currency

Pb = price index in base currency
S = Spot rate
! !157
In most cases, this equality did not work because the underlying
assumptions were impractical. By studying the relationship over a
long time frame, the following equality was established —
!
Where,
S = percentage change in the spot rate over 1 year

Pv = percentage change in price index in variable currency country
Pb = percentage change in price index in base currency country
This relationship proved to be a reasonably accurate estimation of the

expected change in spot rate in relation to the inflation rates. (Change
in price index effectively indicates inflation rate).
When this equality was studied for developed economies having very
small inflation rates, then the denominator, (1 + Pb) became
approximately equal to 1 and the equality was represented as,
The theory, therefore, concluded that the rate of change in the spot
exchange rate between two currencies was equal to the difference in
their corresponding inflation rates. Effectively, the rate of change in the
spot rate = Iv – Ib
This theory has been used in developing currency valuation system like
the Crawling Peg mechanism.
Application of the Theory: “Crawling Peg Mechanism”
When the flexible exchange rate system was introduced in 1978, member
countries of the IMF were allowed to introduce independent currency
valuation systems. One of the mechanisms developed and extensively used
(mainly by South American countries) was the Crawling Peg Mechanism.
Under this system, the currency would be pegged to a major international

currency but the peg would be reviewed and revised at fixed intervals
based on the inflation rate difference between the two currencies. The
! !158
system ensured that the change in the `peg’ reflected change in the
economy and also prevented loss of reserve since it reduced the need for
intervention for protecting a fixed peg. Thus, a change in the purchasing
power of a currency in the domestic economy got reflected in the external
value of the currency.
2. Covered Intrerest Parity Theory(CIP): 

 
The CIP theory is the financial market equivalent of ‘The Law of One
Price’. The theory states that “When steps have been taken to eliminate
exchange rate risk, by fixing the forward rate on the date of the
transaction, then the cost of borrowing in one currency is equal to the
return on financial investment in the other currency, irrespective of the
currency 
!  
On simplification of this equality we get: 
 
!  
 
When this equality holds, there is no opportunity for arbitrage. However,
if the equality is violated, then a profit can be derived by borrowing in
one currency and investing in the other. Since the forward rate is fixed
on the day of initiating the transaction, all variables are locked in and
risk-less profits can be earned. Such gains are, therefore, called
Covered Interest Arbitrage.
Conclusion:
Interest rate theories as applied to exchange rates help us to conclude that

the profit or loss gained by the difference in interest rates between two
currencies is offset by the profit or loss on account of the difference
between the spot and forward exchange rates.
3. Interest Rate Arbitrage 

 
The equilibrium condition in terms of the CIP theory is represented by
the relation, 
! !159
F–S (Rv – Rb) n 

———— = —————— X ——— 
S 100 12 
 
When this equality is satisfied, the cost of borrowing in one currency is
equal to investment yield earned on the other currency. Therefore, no
arbitrage opportunity would exist. 
 
When this equality is violated, it provides opportunity to earn arbitrage
profit by borrowing in one currency and investing in the other. 
 
When ———— > —————— X ——— arbitrage profit is derived by 
S 100 12 
borrowing in variable currency and investing in base currency 
 
Similarly, When ———— < —————— X ——— arbitrage gain is  
S 100 12 
derived by borrowing in base currency and investing in the variable
currency. 
 
Since the Forward rate in such transaction is fixed at the time of
initiating the transaction, the profit earned in this manner is called
`Covered interest arbitrage' or Interest rate arbitrage. The `Covered
Interest Parity' theory is widely used for investment and borrowing
decisions in a risk-free form when multi-currency options are available. 
 
The existence of the Euro currency market means that in making
hedged or covered investment and borrowing decisions, there is no
need to actually go to the different currency centres to arrange
transactions. For example: A Swiss investor could compare covered
yields on dollars, sterling, euro, yen and various other currencies in
Frankfurt offshore market and arrange for investment or borrowing in
the currency of his or her choice in that market.
4. Uncovered Interest Parity (UIP) 

 
This theory is an extension of the CIP theory. It presents the interest
parity condition without the forward rate being hedged. Algebraically it
can be 
! !160
!  
where Sn = spot rate after ‘n’ months. 
 
It, therefore, assumes that the spot rate on the forward date would be
the same as the forward rate on the spot date. Because this assumption
is not practical, this theory is not actively used for decision making.
However, simplification of this equality helps to establish the following
relationship, S = Rv - Rb, i.e., the rate of change in the spot rate
between two currencies is equal to the difference in their interest rates.
5. Fischer's Theory on International Interest Rates 

 
Irving Fischer combined the PPP theory and UIP theory to arrive at the
following conclusion, 
 
!  
Where, 
 
R = Nominal Interest Rate 
I = Inflation rate 
 
The difference between the nominal interest rate and the inflation rate
for a given currency is defined as, the Real Rate of Interest. This theory
helps to conclude that, the real ROI in all currencies is equal. If there is
inequality, then international funds would move into the currency
providing a higher real return. The extra supply would eliminate the
inequality.
! !161
6.8 INTEREST RATE ARBITRAGE
1. Given, 
 
USD/CAD 1.1620 spot 
 
USD/CAD 1.1640 3 months forward 
 
 
CAD interest rate 5% p.a. 
 
Identify and calculate interest rate arbitrage
Solution: 
(F - S) (1.1640 - 1.1620) 0.0020

———— = —————————- = ————— = 0.0017 .... (a)
S 1.1620 1.1620
 
(F - S) n (5 - 4) 3 1
———— = —— ———— X —— = ———- .... (b)
S 12 100 12 400
Since (b) > (a) we can derive arbitrage by borrowing in Base currency
(USD) and investing in Variable currency (CAD).
Assume borrowing USD 1 million for 3 months.

4 3
Cost of borrowing = 1,000,000 X —— X —— .... (PTR/100)
12 12
= USD 10,000 ..... (1)
Benefit on Investment:
Conversion to CAD= (1,000,000 X 1.1620)
Re-conversion into USD = (1,000,000 Å~ 1.1620) 1.1640
! !162
= USD 10,760.31
Arbitrage gain = net benefit – cost of borrowing
= USD 10,760.31 – USD 10,000

= USD 760.31 per USD 1 million.
When investing the currency, the amount received at the end of the
investment period would include the interest element. Therefore:
Amount = Principal + Interest
When converting and re-converting currencies, base to variable

currency conversion involves multiplication operation whereas variable
to base currency conversion involves division operation.
2. Given, 
 
CHF 1.3615 per USD spot 
 
CHF 1.3595 per USD 6 months forward 
 
CHF interest rate 2% p.a. 
 
USD interest rate 4% p.a. 
 
Identify and calculate interest rate arbitrage.
Solution:
! !163
(F - S) (1.1395 – 1.3615)
———— X —————————— = (-) 0.0015 .... (a)
S 1.3615
(Rv – Rb) n (2 - 4) 6 1
————— X —— = ———— X —— (-) ———- = (–) 0.0100 ..… (b)
S 12 100 12 100
Since (a) > (b) we will borrow in variable currency (CHF) and invest in
base currency (USD) to derive arbitrage gain.
Assume borrowing CHF 1 million.

2 6
Cost of borrowing = 1,000,000 X ——- X ———
100 12
= CHF 10,000 .... (1)
1,00,000
Conversion to USD = —————
1.3615
= CHF 18,501.65 ..... (2)

Arbitrage gain = Net benefit – cost of borrowing
= CHF 18,501.65 – CHF 10,000 ..... From (1) & (2)
= CHF 8,501.65 per CHF 1 million.
! !164
3. Given, 
 
Spot 1 USD = INR 44.3950 
 
6 months forward 45.2400 
 
Annualised interest rate on INR 7% 
 
Annualised interest rate on USD 3% 
 
Calculate the possible arbitrage gain on 1 million units of capital.
Solution:
(F - S) 45.2400 – 44.3950 0.8450

———— X —————————— = ————— = 0.0190 .... (a)
S 44.3950 44.3950
(Rv – Rb) n (7 - 3) 6 1
————— X —— = ———— X —— (-) ———- = 0.0200 ..… (b)
S 12 100 12 100
Since (b) > (a) we will borrow base currency (USD) and invest in
variable currency (INR)
Assume borrowing USD 1 million

3 6
100 12
= USD 15,000 .... (1)
Conversion to INR : 1,000,000 X 44.3950
! !165
= USD 15,668 ..... (2)
Arbitrage gain = Net benefit – Cost of Borrowing
= USD 15,668 – USD 15,000 ..... From (1) & (2)
= USD 668 per USD 1 million
(Note: The term 'Annualised Interest Rate' means rate of interest per
annum)
4. Given, 
 
USD/SGD 1.4815 – 1.4825 spot 
 
USD/SGD 1.4840 – 1.4850 three months forward. 
 
 
SGD interest rate = 5% p.a. 
 
Calculate arbitrage gain, if any.
Note: When two-way quotations are given, it is not possible to use the
formula method, for identifying the currency to be borrowed.
Solution:
Case I: Assume borrowing SGD 1 million.

5 3
100 12
= SGD 12,500.00 .... (1)
1,00,000
Conversion to USD = ——————
1,4825
! !166
= SGD 8,519.39 ..... (2)
As cost of borrowing > net benefit there is no arbitrage gain.
Case II: Assume borrowing USD 1 million

3 3
100 12
= USD 7,500.00 .... (1)
Conversion to SGD = 1,000,000 X 1.4815
= USD 10,113.64 .... (2)
! !167
Arbitrage gain = Net benefit – Cost of borrowing
= USD 10,113.64 – USD 7,500.00 ..... From (1) & (2)
= USD 2,613.64 per USD 1 million.
Note: If arbitrage gain is established in case I, it is not necessary to

undertake, Case II because arbitrage is possible in any one situation
only.
5. Given, 
 
Spot GBP/SGD 2.6315 – 2.6325 
 
6 months forward GBP/SGD 2.6282 – 2.6292 
 
GBP interest rates: 3.60 – 3.80% p.a. 
 
SGD interest rates: 2.40 – 2.60% p.a. 
 
Calculate covered interest arbitrage.
Solution:
Case I: Assume borrowing GBP 1 million

3.80 6
Cost of borrowing = 1,000,000 X ——— X ———
100 12
= GBP 19,000 .... (a)
Benefit on investment:
Convert to SGD = 1,000,000 X 2.6315
! !168
Since Net benefit is less than the Cost of borrowing there is no

arbitrage gain.
Case II: Assume borrowing SGD 1 million
2.60 6
Cost of borrowing = 1,000,000 X ——— X ———
100 12
= SGD 13,000 .... (a)
Benefit on investment:
!
Arbitrage = Net Benefit – Cost of Borrowing = SGD 3,337 per
SGD 1 million ...By (a) & (b)
Note: When interest rates are provided on two-way basis, the Bid side
rate represents the rate at which the bank would accept deposits
whereas, the Ask side rate represents the rate at which the bank
would lend which means the arbitrageur can borrow at the Ask side
rate and invest at the Bid side rate.
! !169
6.9 BORROWING AND INVESTMENT DECISIONS
(Based on CIP Theory)
1. The following data was available to decide on the best alternative for
borrowing INR 12 million for a temporary period of three months on a
risk-free basis (ignore transaction costs). Exchange rates are against
INR.
Currency Spot rate 3 months forward rate Interest rate
USD 40.1245 40.2765 4.25% p.a
EUR 54.1650 54.2000 5.50% p.a
GBP 80.0650 80.0350 6.00% p.a
Solution:
Borrowing would be done in EUR since the liability is the lowest.
! !170
2. From the following data decide on the best alternative for investing INR
8 million for a temporary period of six months on a risk-free basis.
(Ignore transaction costs)
Currency Spot rate Forward quote Interest rate
INR 5.65 – 5.90% p.a
USD/INR 48.8830 – 48.8860 49.2330 – 49.2360 4.25 – 4.50% p.a
EUR/INR 65.2545 – 65.2575 65.5545 – 65.5575 4.75 – 5.00% p.a
GBP/INR 90.4750 – 90.4780 90.6750 – 90.6780 5.25 – 5.50% p.a
Solution:
! !171
Investment would be made through USD since the return is the maximum.
Note:
(a) The amount to be invested in the foreign currency is arrived at by

dividing with the spot ask rate because this amount of foreign currency
would be received from the bank on delivery of the investible surplus
in INR. The bank would sell at the market ask rate.
(b) When interest rates are provided on two way basis, the LHS rate
represents the deposit rate and the RHS rate represents the lending
rate. The accepting bank would therefore give the market deposit rate.
(c) At the end of the specified period the maturity amount in foreign
currency would be sold to the bank at its buying (bid) rate.
3. From the following data decide on the best alternative for borrowing INR
5 million for a temporary period of six months on a risk-free basis.
(Ignore transaction costs)
Currency Spot rate Forward quote Interest rate
INR 5.75 - 6.00% p.a
USD/INR 48.8830 – 48.8860 49.2330 – 49.2360 4.25 – 4.50% p.a
EUR/INR 65.2545 – 65.2575 65.5545 – 65.5575 4.75 – 5.00% p.a
GBP/INR 90.4750 – 90.4780 90.6750 – 90.6780 5.25 – 5.50% p.a
Solution:
! !172
Borrowing would be done in EUR since the liability is the lowest.
Note:
(a) The amount to be borrowed in the currency is arrived at by

dividing with the spot bid rate because this amount of foreign
currency when sold to the bank would yield the amount required
to be borrowed. The accepting bank would purchase at the
market bid rate.
(b) When interest rates are provided on two way basis, the LHS rate
represents the deposit rate and the RHS rate represents the
lending rate.The lending bank would therefore charge the
market lending rate.
(c) At the end of the specified period the borrower would be

required to buy the maturity amount in foreign currency at the
selling banks ask rate.
! !173
6.10 JAPANESE YEN CARRY TRADE: (BASED ON UIP

THEORY CONCEPT)
• The "carry" of an asset can be described as the difference between the

appreciation in the asset (from purchase to sale date) and the cost of
holding the asset. Such transactions in the Foreign Exchange Markets are
called "Currency Carry Trades”. The transaction would involve borrowing
a currency with low interest/appreciation rate to derive profit through the
interest rate differential.
• The steps in a Carry Trade are:
1. Arrange borrowing in a low interest rate currency.

2. Convert to desired currency and acquire identified asset.
3. Sell asset and reconvert funds to original currency.
4. Adjust loan obligation with interest.
• A Carry trade transaction is not an arbitrage. It does not involve

simultaneous buysell deals in two different markets. The transaction is
done with the intension to make profit by holding the asset for some
time.
• It therefore represents a double speculation that the benefit of

appreciation of the acquired asset (which may or may not happen) would
be greater than the exchange rate differential between the conversion
and reconversion dates and interest on borrowed funds.(which again may
or may not be the case).
• Effectively, this concept is fundamentally based on the 'Uncovered

Interest Parity Theory' where expectation of future spot exchange rate is
in-built into the transaction.
• Among the currency carry trade, Japanese Yen carry trade is the most
popular because other than Swiss francs, it is the only major currency
which offers both:
1. Capital account convertibility, and

2. Very low interest rates for borrowing.
! !174
• Since 1992, the Japanese economy has reflected low inflation which has
enabled their monetary authority to maintain low interest rates over the
past two decades. (This coincides with Fischer's theory on international
interest rates).
• They also prefer to maintain an undervalued currency so as to ensure

export competitiveness to achieve a surplus Balance of Trade. The
sustained undervaluation reduces the probability of loss on account of
exchange rate differential.
1. Assume borrowing JPY 1,000,000 @ 0.50% for one year. 

 
Amount repayable at the end of one year = JPY 1,005,000 
 
Convert JPY to GBP at spot rate GBP/JPY 208 and invest @ 4.50% for
one year. 
 
At the end of the period reconvert to JPY at spot rate GBP/JPY 221 =
JPY 1,110,313 
 
Profit on transaction = JPY (1,110,313 – 1,005,000) = JPY 105,313 =
approx. 10.5% profit. 
 
!  
 
The profit on account of interest rate differential = 4% and the balance
represents profit on account of exchange rate differential. (The
depreciating nature of the JPY has thus played a significant role in the
popularity of such transactions.)
2. Amount repayable at the end of one year = JPY 1,005,000 

 
Convert JPY to GBP at spot rate GBP/JPY 208 and invest @ 4.50% for
one year. 
 
At the end of the period reconvert to JPY at spot rate GBP/JPY 200 =
JPY 1,004,808 
 
Loss on the transaction = JPY (1,005,000 – 1,004,808) = JPY 192 
! !175
!  
 
The profit on account of interest rate differential = 4% has been offset
by the loss on account of exchange rate differential. 
 
It is thus evident that for such transactions to succeed, the currency to
be borrowed should not only have a low interest rate but should have a
depreciating tendency. 
 
International studies have shown that when the DOW JONES - WORLD
STOCK INDEX falls, the JPY depreciates. This shows that international
traders use the Japanese Yen Carry Trade process to fund acquisition of
securities when international stock markets fall.
6.11 SUMMARY
A forward exchange contract in foreign currency is a contract for buying or

selling a foreign currency for delivery on a specified future date, at a rate
of exchange fixed at the time of entering the contract. This contract
reduces exchange rate risk faced by importers and exporters. Authorised
Dealers can enter into forward contracts for purchase of foreign currencies
against goods exported or to be exported against a firm order. Such
contracts can be made for export orders in accordance with schedule of
deferred payments approved by the RBI. Long-term forward purchase
contracts can be made for export of capital or engineering goods under
suppliers' credit scheme approved by the RBI.
Authorised Dealers can enter into forward contracts for sale of foreign
exchange to importers provided letter of credit is opened by the importer
or firm order placed by importer has been accepted by the supplier and the
import is covered by either OGL or valid import license. Forward exchange
rates are affected by factors like interest rate differentials,confidence in the
currency, official intervention, exchange control regulations and attitude
and fancies of foreign exchange dealers.
! !176
1. Discuss the connectivity between exchange rates, interest rates and

commodity prices.
2. Explain the PPP Theory.
3. Elaborate the CIP Theory.
4. Bring about the features of Covered Interest arbitrage.
5. Express the rules involved in the Borrowing and Investment Decisions.
! !177
REFERENCE MATERIAL
chapter 
Summary
PPT
MCQ
! !178
EXCHANGE RATE REGIMES
Chapter 7
Learning Objectives
• What do you mean by Exchange Rate and its Regimes

• Gold Standard system
• Fixed Exchange Standard System
• Flexible Exchange Rate System
• Central Bank Measures to Balance the Exchange Rate
Structure:
7.1 The Exchange Rate Regimes

7.2 The Gold Standard System
7.3 Mint Par of Exchange
7.4 Gold Points
7.5 Bretton Woods System
7.6 Triffin Paradox
7.7 Smithsonian Agreement
7.8 Snake in the Tunnel System
7.9 Special Drawing Rights
7.10 Fixed Exchange Rate System
7.11 Flexible Exchange Rate System
7.12 Currency Intervention
7.13 Methods of Control
7.14 Clean Float
7.15 Dirty Float
7.16 Adjustable Peg System
7.17 Crawling Peg System
7.18 Neutralization of Reserves
7.19 Fixed Exchange System vs. Flexible Exchange System
7.20 The Gold Standard vs. Bretton Woods System
7.21 Summary
7.22 Self Assessment Questions 
! !179
7.1 THE EXCHANGE RATE REGIMES
Over the past 140 years, several systems have been used for valuing
currencies. Four such systems were used universally for significant periods
and had a profound impact on how exchange rates between currencies
were to be established. These systems are called 'Exchange Rate Regimes'.
They are:
1. The Barter System which provided for valuation based on goods

against goods.
2. The Gold Standard (1870 to 1932) which provided for valuation

against gold on fixed basis.
3. The Bretton Woods System (1946 to 1971) also called the fixed
exchange rate system of the IMF - which provided for valuation against
the USD on a fixed basis.
4. The Flexible Exchange Rate System (From 1978 to still in

operation) - which provided for variable valuation through market
demand/supply forces.
7.2 THE GOLD STANDARD
The Gold Standard was the first universally implemented exchange rate
system. It was promoted by the Bank of England and established
worldwide in 1870. The main features of this system were as follows:
1. Every country was required to establish a Central Bank to function as

the custodian of the country's monetary gold reserves.
2. Every Central Bank was to be provided the sole (exclusive) authority to

issue paper money (Bank Notes) within the area under its jurisdiction.
3. Each Central Bank was required to establish a fixed official price for gold
in terms of the domestic currency.
4. Every Central Bank was required to provide an irrevocable promise on

each paper note to redeem the same on demand in terms of specified
quantity of gold.
! !180
5. Each Central bank was required to provide an unconditional guarantee

to buy and sell unlimited to quantity of gold at the fixed official price.
6. The total amount of money supply in circulation by way of Bank Notes

was required to be limited to the extent of the monetary gold reserves
with the Central Monetary Authority.
7.3 MINT PAR OF EXCHANGE
The mechanism for establishing exchange rates between currencies under

the Gold Standard was called the 'Mint Par of Exchange'. The exchange
rates between two currencies were represented by the ratio of the official
gold prices for the two currencies. Thus, exchange rates established in this
manner were called 'CENTRAL EXCHANGE RATES ' or ‘MINT PARITIES’.
7.4 GOLD POINTS
The Gold Standard provided for fixed exchange rates. However, imbalance
of trade between two countries on a day to day basis resulted in the
exchange rate in the domestic market moving on either side of the central
exchange rate providing opportunities for arbitrage between the two rates.
The extreme points of this zone are called the upper and lower gold points.
Each currency pair had a unique set of gold points. Thus, the inbuilt
mechanism for balancing trade in the gold standard was called as Price
Specie Adjustment Mechanism.
A. Advantages:
1. It was an easy system to introduce and operate.
2. It provided for a very high level of stability in exchange rates.
3. The Price Specie Adjustment Mechanism provides in-built system for

achieving trade equality
4. It provided a fully secured system for settlement on international

transactions.
! !181
B. Disadvantages:
1. The cost of manufacturing gold gradually increased to levels beyond

the official prices.
2. Countries with persistent trade deficit suffered from recessions

resulting in reduced investments and unemployment.
3. The system had no flexibility to adjust money supply in times of

economic crisis.
4. To avoid the negative effects of reduced money supply, countries

would break the equality between gold reserves and money supply,
thereby, diluting the system. (This was called 'Neutralization' of
reserves). This resulted in the failure of the system in 1932.
7.5 THE BRETTON WOODS SYSTEM/IMF'S EXCHANGE RATE

SYSTEM
A. Bretton Woods System
1. The continuing Second World War made any cooperation on the

economic front impossible.
2. In this kind of scenario, there was a need for an economic system

which would again make international trade and investments
possible.
3. To make this type/kind of scenario, stable exchange rates were

required and also some arrangement that would help countries to
overcome their short-term balance of payments problem and help
them remain within the system without causing downfall in the
economies.
4. Post World War, the trends in international monetary system had

gradually started revealing imbalances in the monetary resources.
5. Representatives of 45 major economies met at Bretton Woods, USA,

in July, 1944, to finalize a new Exchange Rate System based on
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stability and flexibility to be universally implemented after the Second

World War.
6. The Conference in 1945, saw birth of two leading world institution,

i.e.,
➡ International Monetary Fund (IMF)
➡ International Bank of Reconstruction and Development (IBRD) -

known as the World Bank. With the objective of financing and
assisting the need-based nations with monetary assistance enabling
them to overcome their balance of payments deficits.
7. The IMF was given the mandate to establish a suitable exchange rate
system. The fixed exchange rate system proposed by them was
implemented in 1946. The main features of the system proposed by
IMF were as follows:
(i) In this system, all members were to fix par value of their
currency either in terms of Gold or in US Dollar. The par value in
dollar was fixed at 35 dollar per ounce, i.e.,1 ounce of gold = $
35
(ii) The monetary authorities (US Federal Reserve Bank) provided an

unconditional guarantee to buy and sell unlimited quantity of gold
at this price and thus, support their exchange rate. This system
was called as Gold Convertibility Clause.
(iii) The member countries were required to fix a PARITY VALUE for
its currency against USD.
(iv) Even though the member countries had an option of pegging

their currencies to either gold or dollar, the only reserve
mentioned in the agreement establishing the system was gold.
Thus, effectively, every currency was redeemable in terms of
USD and only USD was redeemable in terms of gold. Hence USD
therefore, became the means of international settlements.
! !183
(v) Variation in the exchange rate was permitted on either side parity
in the range of (+/-) 1%. The end points of the variation zone
were called as ‘support points' OR 'intervention points’
(vi) This system introduced the concept of Central Bank intervention

as a means of ensuring protection of parity rates.
(vii) The IMF also provided a commitment to the member countries to

provide financial assistance to countries facing temporary balance
of payment deficits.
(viii)In case, there are some structural imbalances, member countries

could devalue the currencies in consultation with IMF. Thus, this
system was also called as 'The Adjustable Peg System’.
(ix) Finally, all the member countries accepted the supervisory

authority of the IMF with regards to the exchange rate
management system and the domestic foreign exchange market.
B. Reasons for the failure of Bretton Woods System
The reasons involved in making the failure of Bretton woods system are as
follows: -
1. There was an excessive demand of USD in the international financial

markets.
2. There was continuous deficit on USA's Balance of payments (trade

deficit) as countries such as Japan and West Germany enjoyed export
benefits against US economy.
3. The system did not provide for a revision in the price of gold in terms
of USD. Due to this, it was not possible to devalue the USD despite
continued trade deficit.
4. Another problem with this system was that it had become too rigid.
In 1967, Britain devalued its currency pound. In 1968, there was
outflow of capital from France due to political disturbances. In 1969,
Franc was devalued. Germany followed suit
! !184
5. All these had compelling effect in the form of either creating

worldwide illiquidity or devaluation of dollar thereby, leading way to
breakdown of Bretton Wood System by 1970.
7.6 TRIFFIN'S PARADOX
1. Professor Triffin, an economist, predicted that the continuous deficit in

balance of trade incurred by the US would reduce its acceptability in the
international markets since, supply would keep increasing without a
downward revision in the value of USD.
2. He predicted the system would disintegrate due to this basic weakness

in the system that it did not provide for a periodic review of the value of
the USD.
3. In 1968, the Gold Convertibility Clause was invoked but the US Federal
Reserve Bank could not honour its commitment.
4. The formal withdrawal from the system was announced by the US on

15th August, 1971, thus resulting in the collapse of the system as
predicted by Professor Triffin.
7.7 SMITHSONIAN AGREEMENT
1. The G-10 countries (USA, UK, West Germany, France, Japan, Canada,
Italy, Sweden, Belgium and Holland) met at the Smithsonian Institute in
Washington in December, 1971 and reached an agreement to re-
introduce the Bretton Woods System with certain modifications.
2. The main amendments agreed in this agreement were as follows:
(a)The US was exempted from the Gold Convertibility Clause.

(b)The US Dollar was devalued upto 1 ounce of gold = USD 38.
(c)The remaining countries in the G-10 revalued their parities by 10%.
(d)The variation zone on either side of parity rates was increased from,
(+/–) 1% to (+/–) 2.25%.
(e)All other countries were required to revise and fix new parities
against the USD.
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3. The basic idea behind these amendments was to provide greater export
competitiveness to the US economy to help them to reduce their trade
deficit and re-introduce a fixed price for gold for conversion.
4. However, the US suffered a record deficit in 1972, resulting in further

devaluation of the US Dollar upto 1 ounce of gold = USD 42.22.
5. In February 1973, the OPEC Group of Countries increased crude oil

prices by several hundred percentage points which resulted in all major
economies simultaneously running into deficit. The Smithsonian
Agreement was consequently abandoned in March 1973.
7.8 SNAKE IN THE TUNNEL
1. The Smithsonian Agreement of December 1971, provided for wider

variation zone of (+/-) 2.25% from revised parity rates.
2. The member countries of the European Economic Community (ECC)

were in favour of greater stability in their exchange rates and therefore,
voluntarily accepted a smaller variation zone of (+/–) 1.125% for their
currencies.
3. This required a higher degree of financial discipline. The rates of these

countries thus, moved in a narrower band (The EEC Snake) within the
wider Smithsonian tunnel.
4. After the Smithsonian agreement was abandoned in 1973, the 'Snake'

concept was incorporated into the 'Parity Grid' mechanism which was
the basis for the European Monetary System introduced in 1979.
5. This helped to achieve economic convergence between members of the

European Union which led to the introduction of the common currency
'Euro' in 1999.
7.9 SPECIAL DRAWING RIGHTS (SDRs)
1. Special drawing rights (SDRs) are an international reserve asset created

by the IMF in 1969. It is also known as Paper Gold as SDRs is expected
! !186
to replace the gold which is the most important international monetary

asset.
2. They were allotted to the members in 1970. Since 1970, a total SDRs
21.4 billion have been allotted to members.
3. SDRs created by the IMF were allocated to all member countries in the
same ratio as the quotas (subscriptions) paid by them for their
membership. The main features are as follows:
(i) SDR is a creation of the IMF.
(ii)It is not linked to any single currency nor does its creation depend on
supply/ stock of gold
(iii)It does not belong to any single country.
(iv)All member countries have a claim on the created SDR.
(v)It is not tangible but only a book entry.
(vi)Its value is determined by a basket of currencies such as USD, GBP,

EUR and JPY and the value is usually expressed in US Dollar and its
basket is revised every 5 years.
(vii)The currencies selected belonged to the countries with the largest

export of goods and services. The weightage given to each currency
may change depending on their relative importance in international
trade and reserves.
(viii)At present SDRs are used for transactions between the

governments.
(ix)It is the unit of account of the IMF and used as an unit of account or
as a basis unit of account by a number of international organizations.
(x)Besides the members, SDRs are also held by 'prescribed'

international institutions. There are 15 such institutions at present.
! !187
(xi)One of the major features of the IMF is to provide adequate levels of

reserves to facilitate the expansion and growth of international trade.
The IMF has the authority to create unconditional liquidity by
allocating SDRs to all member countries in proportion to their quotas.
4. Thus, IMF undertook an experiment of creating an artificial currency unit

to function as supplementary reserve asset which would also augment
international liquidity.
7.10 FIXED EXCHANGE RATE SYSTEM
A. Meaning, Introduction of Fixed Exchange Rate System:
1. The fixed exchange rate or the 'pegged' exchange rate system is a

system in which the central bank which is the monetary authority of a
country pegs (fixes the value of) the domestic currency to a foreign
currency or a basket of currencies or SDRs or bullion (gold and/or
silver).
2. The process of expressing one currency in terms of another is called

pegging and the multiple used for the peg is called parity. The
currency against which parity rates are calculated is generally a fully
convertible currency. The most widely used currency for pegging by
countries following this model is the U.S. Dollar (USD).
3. Only small economies follow this system today. China is the only
major economy which currently uses the fixed exchange rate system.
The Chinese Yuan is pegged to the U.S. Dollar.
B. Merits of Fixed Exchange Rate System:
1. Stability in Exchange: The fixed exchange rate system provides for

stability in exchange rates and does not expose the importers and
exporters of the country to exchange rate risk.
2. Currency Valuation Process: The central bank can effectively

ensure that the exchange rate reflects underlying changes in
economy since it directly controls the currency valuation process.
! !188
3. Helps the government: It helps government to control inflation and

in long run helps to maintain low interest rates.
4. Lesser operating cost: It is an easier system for importers and

exporters and has lesser operating cost since hedging is not required.
C. Demerits of Fixed Exchange Rate System:
1. Inefficient resource management: In order to successfully utilize

this system, the central bank must hold substantial amounts of
foreign currency to participate in the domestic market. This results in
inefficient resource management.
2. Real Value: At times, the real value of the currency may become
unacceptable to foreign entities. This may call for a revaluation or
devaluation in the currency.
3. Self-balancing mechanism: The fixed exchange rate system does

not automatically regulate the inflow and the outflow of foreign
currency investments to counterbalance trade imbalances. Thus,
there is no self-balancing mechanism.
4. Competitive advantage: The central bank could use this system to

gain a competitive advantage in international trade by not revaluing
the currency despite consistent trade surplus.
7.11 FLEXIBLE EXCHANGE RATE SYSTEM
A. Meaning, Introduction of Flexible Exchange Rate System
1. The Flexible Exchange Rate System or the floating exchange rate

system can be described as a system of exchange rate management
where the relative value of the domestic currency as against foreign
currencies is determined by market forces of demand and supply.
2. Under this system, the central bank of the country does not
participate in the currency valuation process. It neither sets a target
rate nor does it participate in the domestic foreign exchange market.
! !189
3. Most of the major economies of the worlds employ these system

variations of this system. Today the currencies of the world can be
broadly classified as:
(i) Freely floating currencies such as US Dollar, British Pound Sterling,

etc. (not controlled through intervention).
(ii)Pegged currencies such as the Chinese Yuan, etc. (held stable

through intervention within fixed variation zone) and
(iii)Currencies subject to managed float such as the Indian Rupee,

etc., where volatility eliminated through intervention without any
target level.
B. Merits of Flexible Exchange Rate System
1. Determination of the Currency Values: The Flexible Exchange Rate

System provides for determination of currency values based on market
forces of demand and supply. Such rates reflect the true economic
fundamentals of the currency.
2. High Degree of Transparency: Rates under this system are

independent of any overt influence by either the government or the
central bank. It is, therefore, possible to take logical investment
decisions when using such rates. Thus, there is a high degree of
transparency in exchange rate management.
3. Efficient Reserve Management: Regular intervention by the central

bank is not permitted. It is, therefore, possible for countries to invest
their reserves in an optimum manner without having to maintain large
liquid reserves for intervention. It, therefore, promotes efficient reserve
management.
4. Exchange Rates: Exchange rates are market established. Thus,

exchange rates depreciate or appreciate gradually and domestic
importers and exporters are able to factor such changes into their
business costs.
! !190
5. Current Account deficits: It has a built in mechanism which helps

countries to deal with their current account deficits, i.e., exports and
imports are properly monitored.
C. Demerits of Flexible Exchange Rate System:
1. Destabilization of the Currency: It may expose the country's

currency to speculative pressures and could lead to destabilization of
the currency.
2. Inflationary Pressures: It may lead to inflationary pressures on

economy causing interest rates to rise in the long run.
3. Variable Exchange Rates: The Flexible Exchange Rate System

provides for variable exchange rates. Variability means uncertainty.
Thus, often inhibits international trade and investments.
4. Balance of Payments Problem: Countries with inelastic import

demands incur repeated deficit balance of payments problem which
lead to high inflation, poverty and unemployment.
5. Exchange Rate: Heavy capital inflows and outflows could distort the
exchange rate leading to an inaccurate representation of the
underlying economy.
7.12 CENTRAL BANK INTERVENTION/CURRENCY

INTERVENTION
1. The Flexible Exchange Rate System, by definition provides for variability

in exchange rates. Such rates become volatile due to speculative
activities.
2. To avoid the adverse impact of instability, most small and medium

countries have opted for the 'Managed Float System’.
3. This implies that the respective Central Banks would actively participate
in the domestic markets to maintain stability and guide exchange rates
to desired levels.
! !191
4. The forms of intervention undertaken by the Central Banks are as

follows:
(i) Verbal intervention 

 
In this system, senior officials of the Central Bank or the Government
make public announcements of their views regarding the ongoing
exchange rates. Such announcements influence the trading strategies
of market participants thereby, having the desired effect on the
exchange rate.
(ii)Money market intervention 

 
Instability of exchange rates is generally due to speculative activity.
By changing the CRR, SLR or the bank rate, the Central Bank alters
the volume and cost at which funds are available to speculators.
(iii)Securities market intervention 

 
Through selling or repurchasing government securities, the Central
Bank changes the amount of money supply in the system. This
directly affects the volume of funds in the economy.
(iv)Active intervention 
 
In this case, the Central Bank directly buys or sells foreign currencies
in the domestic market to achieve pre-decided results. This is the
most potent form of intervention in the Managed Float System and
has been successfully used by Central Banks all over the world. 
 
Conclusion: Thus to sum up, intervention plays critical role in the
success of this system.
7.13 METHODS OF CONTROL
The problem to control and check violent and adverse fluctuations in the
rate of exchange and for getting stability in the rate largely depends upon
the equilibrium in the demand and supply forces of foreign exchange or in
the different items of balance of payment. Some of the important
measures of control a country could resort to are mentioned below:-
! !192
1. Minimization of trade deficit
A country should take all possible efforts to boost export and control
import to remove trade imbalance or at least minimize it. This trade
imbalance can be removed or minimised by taking such steps:
• Imposition of import duties

• Export incentives and other
2. Correcting all causes of adverse effects
Whatever causes which have been discussed should be corrected

favourably for better position.
3. Depreciation or Devaluation of currency
For good results in external sector of the economy, a country can

depreciate or devalue its currency in terms of other foreign currencies.
4. Monetary and currency measure
By making appropriate changes in the monetary policy and taking some

monetary measures like change in bank rate may help a country to achieve
stability in the rate.
5. Curbing speculative activities
Speculation gives birth to high fluctuations. All efforts should be made to

curb speculative activities in the foreign exchange market.
6. Control on capital movement
A country can introduce various control measure, to control the capital

movement particularly the outflow of capital.
7. Introduction of exchange control
Through various methods of exchange controls like intervention,

restrictions and agreements a country can improve the situation and
ensure greater stability in the exchange rate.
! !193
8. Creation of foreign exchange reserve
For stability in the rate and for other purposes a country should create
sufficient reserve of clear foreign currencies in order to meet the emergent
need and overcome the uncertain circumstances.
9. Freedom from political and economic crisis
A country by all means should make itself free from all political and
economic crisis in order to have positive results in its favour in the field of
foreign exchange market.
7.14 CLEAN FLOAT
1. It is also called as 'Free Float' and is a model under which there is no

official participation in establishing currency values.
2. The Central Bank does not set any target range or price and the value of
a currency is determined by market forces of demand and supply.
3. The Central Bank or the Government does not participate in

establishment of exchange rate.
4. The disadvantage of this system was that currencies of weaker

economies became vulnerable to speculative attacks but most major
economies floated their currencies.
7.15 MANAGED OR DIRTY FLOAT
1. Most medium and small economies, adopted the system of PEGGING

their currency either to one of the major international currencies or
SDRs or a basket of currencies.
2. A managed float or a dirty float is a form of exchange rate management

where the country's central bank does not set a target price nor does it
set a target range.
3. Whenever the currency exhibits volatility the central bank intervenes by

participating in the domestic foreign exchange market. It does so in
! !194
order to ensure stability and also to ensure that the exchange rate
reflects the underlying status of the economy.
4. The concept means the currency is floated, but central Bank participates
in domestic market to influence exchange rate movement in such a way
as to reflect true fundamentals of the currency.
5. The Managed Float concept, therefore, effectively combined the best

features of both the fixed and flexible exchange rate systems.
7.16 THE ADJUSTABLE PEG SYSTEM
1. As the name suggests the Adjustable Peg System provides for revision
in the Parity Rate based on specific economic parameters.
2. The Bretton Woods System itself is also viewed as an Adjustable Peg
System because it provided for parity rate changes in consultation with
the IMF.
7.17 CRAWLING PEG MECHANISM
1. One of the systems developed under the Adjustable Peg Concept was
the ‘Crawling Peg’
2. The revision in the parity rates was connected to inflation rates and
thus, this system relied substantially on the Purchasing Power Parity
Theory which provided a relationship between exchange rates and
inflation rates.
3. Under this system the exchange rate would be pegged to a major
international currency, the parity rate would be revised at fixed intervals
based on the inflation rate differential between the domestic currency
and the host currency to which it was pegged.
4. The benefits of this system were:
(a)The exchange rate reflects the changes in underlying economy vis-à-

vis the host currency.
(b)The need for interventions was reduced.
(c)Provided for better utilization of foreign currency reserves.
! !195
7.18 STERILIZATION (NEUTRALIZATION) OF RESERVES
Active interventions in the form of actual purchase/sale of foreign

currencies by the Central Bank result in altering both the foreign currency
reserves of the country and the money supply in the economy. Such
interventions are of two types:
A. Sterilized Intervention
Sterilized intervention can be described as the purchase or sale of foreign

currency, offset by a corresponding sale or purchase of domestic
government securities to minimize/eliminate the effect of the intervention
on domestic money supply.
B. Non-sterilized interventions
Non-sterilized intervention can be described as the purchase or sale of

foreign currency, against domestic currency, without any offsetting
operation, thereby influencing the exchange rate through the monetary
system.
7.19 FIXED EXCHANGE SYSTEM V/S FLEXIBLE EXCHANGE

SYSTEM
No Fixed Exchange System Flexible Exchange System
1 Provides for stable exchange rates. Provides for variable exchange rates
2 Exchange rates are officially Exchange rates are market

controlled determined
3 Fixed Exchange Rate system Flexible Exchange Rate system

promoted trade and investment promoted transparency in price
discovery.
4 Rates are artificially controlled & Market established rates reflect the
hence may not reflect the correct true state of the economic changes.
state of the underlying economy.
5 Subject to devaluation/revaluation Subject to depreciation/appreciation

by the monetary authority. through market demand/supply
forces.
! !196
6 Devaluation/Revaluation are one Depreciation/Appreciation are

time effects which cannot be gradual effects which can be
factored into trade negotiations reasonably predicted and hence can
since they are unpredictable. be factored into trade negotiations.
7 It provided for greater control over The monetary authority has lesser
inflation by the monetary authority. control over inflation.
8 Risk management systems are not Variability of rates increases risk

needed, hence, cost of operations is hence there is a need for risk
lower. management systems.
9 Greater need for keeping reserves in Does not provide for any mandatory
liquid form for intervention. This intervention therefore reserves can
reduces the return on reserves. be invested for better yields.
10 In the long run the system helps to In the long run the system is
maintain low interest rates and susceptible to higher interest rates
achieve a higher per capita income. and lower growth in terms of per
capita income.
7.20 THE GOLD STANDARD VS BRETTON WOODS SYSTEM
No Gold Standard Bretton Woods System
1 The Gold Standard promoted by The Bretton Woods System was

Bank of England and introduced in introduced by the IMF in 1946 and
1870, was first universally rate represented the first semi-fixed
implemented Exchange exchange rate determination
Determination System. system. (Adjustable Peg System)
2 Only gold was used as reserve Gold/US Dollars were accepted as

asset. reserve.
3 The Central Bank of each country Only the Federal Reserve Bank of
was required to announce an official the US was required to fix the price
price for gold in terms of domestic of gold in terms of US Dollars.
currency.
4 Each Central Bank gave an The Federal Reserve Bank gave an

unconditional guarantee to buy or unconditional guarantee to buy or
sell unlimited quantity of gold at the sell unlimited quantity of gold at 1
official price. ounce gold = US Dollars 35.
! !197
5 Every currency note carried an Every currency note carried

irrevocable promise of redemption anirrevocable promise of
against specific quantity of gold. redemption against specific amount
of US Dollars.
6 The system failed because it lacked Oversupply of US Dollars reduced

flexibility for changing money the acceptability of the currency.
supply.
7 Each currency pair had an unique Each currency pairs had a

gold point standardized variation range.
8 International settlements were done International settlements were

in terms of gold. done in terms of US Dollars.
9 Mechanism for calculating exchange Mechanism for calculating exchange

rates was Mint Par of Exchange rates was The Par Value
system mechanism.
10 In the gold standard the reserves Under Bretton Woods System, USD
did not earn any interest. reserves could be invested to get
return on reserves.
11 There was no commitment In the Bretton Woods System the

mechanism in gold standard as IMF functioned as supervisor of the
there was no support to monitor Par Value Mechanism.
Mint parities.
7.21 SUMMARY
An exchange rate is just the value of one currency in terms of another. The
term exchange rate regime relates to the mechanism, procedures and
institutional framework for determining exchange rates at a point in time
and changes in them over time, including factors which induce the
changes. At one end of the spectrum we have rigid or fixed exchange rates
and at the other end, perfectly flexible or floating exchange rates.
Spanning them are hybrids with varying degree of limited flexibility.
! !198
1. Explain the salient features of Gold Standard system.
2. Describe the characteristics of Bretton Woods System and explain the

reasons of failures.
3. What are SDRs and describe their attributes in details.
4. Bring out the various exchange rate mechanisms available under

currency valuation.
! !199
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !200
EURO CURRENCY (OFFSHORE)MARKET
Chapter 8
Learning Objectives
• Euro Currency Market
• Origin of Euro Currency Market
• Euro Currency Deposit and Credits Market
• Types of International Bonds
• Tax Havens
• LIBOR/SIBOR
Structure:
8.1 Definition/Introduction of Euro Currency Market

8.2 Origin of Euro Currency (Offshore) Market
8.3 Factors Contributing Towards Growth of Euro-Currency (Offshore)
Market
8.4 Characteristics of Euro Currency Markets
8.5 Components (Compositions) of Euro Currency Markets
8.6 Euro Currency Deposits Market
8.7 Euro Currency Credit (Loans) Market
8.8 Types of Euro Currency Bonds
8.9 Types of Foreign Bonds
8.10 Euro Currency Notes Market
8.11 External Commercial Borrowings (ECB)
8.12 Syndication of Loans
8.13 Offshore Banking
8.14 Tax Havens
8.15 Petrodollars
8.16 Libor (London Interbank Offered Rate)
8.17 Sibor (Singapore Interbank Offered Rate)
8.18 Euro Bonds Vs. Euro Credits
8.19 Euro Currency Bonds Vs. Euro Currency Notes
8.20 Euro Currency Market Vs. Foreign Exchange Market
8.21 List of Some Important Central Banks
8.22 List of Some Important Regulatory Authorities
8.23 Summary
! !201
8.1 DEFINITION/INTRODUCTION OF EURO CURRENCY

MARKET
1. Euro Currency market can be described as an international financial

market which specializes in borrowing and lending of currencies from/to
non-residents outside the country of issue, of the currencies.
2. This market consists of specific banking operations of accepting deposits

and giving loans in non-resident currencies.
3. Such deposits and loans are called euro-currency deposits/credits and

the banks undertaking the transactions are called Euro-banks. The
locations where Euro banks undertake such transactions are called Euro
currency markets.
4. In other words, don't confuse Euro with Euro currencies. Euro is a

currency and Eurocurrency is deposits and loans in various currencies
including Euro.
8.2 ORIGIN OF EURO CURRENCY (OFFSHORE) MARKET
1. During the Bretton Woods era, the USD was the primary means of
international settlements. Most countries had reserves in USD invested
in financial assets in the US.
2. There were certain governments that were not politically sync with the
US government and were always apprehensive about their USD assets
being frozen by the US administration in case of adverse developments
between the governments.
3. Such governments needed a mechanism by which they would have

access to their USD resources without the US regulators being able to
identify and freeze such accounts.
4. Thus, the need for developing such a market came from the desire to
disguise ownership of foreign currency deposits while continuing to have
claim on such deposits.
! !202
5. Therefore, this market provides an environment where assets and

liabilities in the form of deposits and credits can be created outside the
regulatory supervision of the monitoring authority pertaining to a
currency.
Conclusion: Thus, a deposit in USD created outside USA becomes a Euro-

dollar deposit; a deposit in GBP created outside UK would be called a Euro
sterling deposit, etc.
8.3 FACTORS CONTRIBUTING TOWARDS GROWTH OF

EURO CURRENCY (OFFSHORE) MARKET
The factors contributing to the growth of Euro currency (Offshore) market

are as follows:
1. Regulation Q 
 
The Regulation Q of the Federal Reserve Act imposed a ceiling on
interest rates that could be given on deposits by banks in the US. This
enabled European banks to attract US dollar deposits by offering better
interest rates.
2. Regulation M 
 
The Regulation M of the Federal Reserve Act which stipulated reserves
to be maintained against deposits accepted by banks in US, this
increased the cost on deposits for banks in USA. This feature was
! !203
exploited by European banks since they were not subject to reserve

requirements on Euro-Dollar deposits.
3. Insure Deposits 
 
There was a mandatory requirement on all banks in the US to insure
deposits accepted by them from the public; on the other side Euro
currency market is unregulated which means that Euro banks were
under no obligation to insure Euro deposits and thereby, reducing the
cost on deposits leading to growth of Euro currency market.
4. Interest Equalization Tax 

 
An interest equalization tax introduced by US monetary authority in
1963, resulted in increasing cost of borrowing in US for non-resident
entities. They therefore, approached offshore market for their funding
needs since Euro - banks were not subject to Interest Equalization Tax,
which brought the development of Euro currency market.
5. International Borrowing 
 
The Voluntary Restraint Program was introduced in the US in 1965, in
terms of which, borrowing in the US for financing international projects
was restricted which made US banks reluctant to provide loans to
international borrowers thereby, ensuring that US Multinationals would
also look upon for borrowing funds from the Euro currency market.
Conclusion:
Thus, these developments resulted in American depositors and borrowers

undertaking banking transactions in US Dollars outside the regulatory
jurisdiction of the US monetary authority leading to the development of
Euro-Currency (Offshore) Market.
8.4 CHARACTERISTICS OF EURO CURRENCY MARKETS
The various characteristics of Euro Currency Markets are:
1. Unregulated Market: 
 
! !204
It is a cross border market. Hence, no government has full control over

the transactions, i.e., government interference is minimal. Thus, it is an
unregulated market.
2. Short-term Deposits and Long-term Loans: 

 
Deposits in Euro currency markets are primarily for short-term.
Eurocurrency loans however are for longer period of time. This leads to
asset-liability mismatch problem for the banks.
3. Largely Wholesale Market: 

 
Transactions in Euro currency markets are very large. They are mostly
within Banks and Governments, Public Sector Organizations and large
MNCs. This makes the market a wholesale rather than a retail market.
4. Time Deposits: 
 
The Euro currency market exists for savings and time deposits, fixed
deposits and recurring deposits.
5. Eurodollar and LIBOR based market: 

 
Euro currency interest rates are tied to a variable rate base such as the
London Interbank Offer Rate (LIBOR). Thus, this reduces interest rate
risk.
8.5 COMPONENTS (COMPOSITIONS) OF EURO CURRENCY

MARKETS
Compositions of Euromarkets are described in 3 areas, viz., (a) Market

participants, (b) Euro Financial-instruments and (c) Transactional structure.
The market participants include:
(a) Market Participants: 

 
Commercial Banks, Corporate Banks, Governments and central banks,
Private Individuals.
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(b) Euro Financial-instruments: 

 
The members involved under these markets are: - Eurodeposits,
Euroloans, Eurobonds, Euro commercial papers, Euro certificates of
deposits, etc.
(c) Transactional Structure of Euro Markets: 

 
The Euro currency market is entirely a wholesale market. Transactions
in the market are telephone linked or telecommunication linked and is
focused upon London, which has a share of around one third of the
Euro currency market. All Euro currency transactions are unsecured
credits, hence, lenders pay particular attention to borrowers, status
and name.
8.6 EURO CURRENCY DEPOSITS MARKET
The features of these deposits are:
1. These deposits are placed with banks in currencies outside their home
country;Deposits are accepted only in freely convertible currencies.
2. Deposits are normally accepted for periods from one day to one year.
85% of the deposits are for six months maturity. This is the standard
maturity for Euro-currency deposits.
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3. Generally the minimum size of deposits in these markets is USD 50000

or equivalent in other currencies.
4. These deposits are unsecured and uninsured.
5. These deposits are not subject to any regulatory control in the form of
reserve requirements, interest rate ceilings/limitations, etc.
8.7 EURO CURRENCY CREDIT (LOANS) MARKET
1. Eurocredits are generally provided for short to medium-term, i.e., 5-8

years.
2. This component of the market operates on a wholesale basis and

individual Eurocredits are, therefore, provided for very large amounts.
3. Euro credits are always provided on a syndicated basis so as to

distribute the credit risk over a large number of participants.
4. These loans are assessed on the basis of the credit rating of the
borrower and the financial viability of the project.
5. Euro credits are provided both as revolving credits and as term loans.
6. Euro credits provide the flexibility of borrowing with multi-currency

option.
7. Euro-credits are always given on a floating rate basis and are rolled over
normally on 6 monthly basis, i.e., the interest rate is reviewed and reset
based on the ongoing applicable LIBOR plus specified mark-up.
8. Euro loans agreements may provide for pre-payment of the loan without
commitment charges at the time of the periodic roll-overs.
8.8 TYPES OF EURO CURRENCY BONDS
1. Fixed Rate Bonds/Straight Debt Bonds:
(a) It is a debt instrument which has a fixed majority and a fixed

maturity rates. Its face value or principal is repaid in one go at
maturity. This form of repayment is called Bullet re-payment.
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(b) A straight debt bond may have a maturity of as long as 50 years.

Bonds in shorter maturities are known as “NOTES".
(c) These Euro bonds are listed on London, Luxembourg, Singapore

stock exchange’s. An investor may purchase bonds either in
primary/secondary markets.
2. Floating Rate Notes (FRN):
(a) Bonds having varying interest rates or coupon rates over their life
are called as floating rate notes.
(b) They are issued with maturity period varying from 5 - 7 years and
their rates are linked to 6 months LIBOR rates.
(c) There are various types of FRNs and they are as follows:
i) Flip Flop FRNs: The investors have the option to convert into flat
interest paying instrument at the end of the particular period.
ii) Mix-match FRNs: These notes have semi-annual interest

payments though the actual rates are fixed monthly. This enables
the investors to benefit from arbitrage arising out of differential
interest rates from different maturities.
iii) Mini Max FRNs: These notes include both minimum and
maximum coupons. The investors will earn a minimum rate as well
as maximum rates on these notes.
iv) Capped FRNs: An interest rate capd is given over which the
borrower is not required to service the notes even if LIBOR moves
above that level.
3. Sinking Fund Bonds: These bonds provide for repayment of the

principal in instalments during the lifetime of the bond. Such bonds are
issued by companies with average credit rating. The repayment in
instalments assures the investors about the solvency and credit-
worthiness of the issuer. It also helps to progressively reduce the
interest liability of the issuer.
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4. Junk Bonds: Companies with very poor credit rating or entering into
high risk business ventures issue such bonds. These bonds carry coupon
rates of atleast 3-4% above the normal rates. A characteristic feature of
these bonds is the high turnover of investors. Such bonds are used by
corporate entities and individuals to make short-term gains on
temporary surplus liquidity.
5. Zero Coupon Bonds: Zero coupon bonds do not carry any interest and
are issued at a discount to face value when the redemption takes place
on maturity at face value. The difference between the issue price and
the redemption price provides the return to the investor by way of
capital gains.
6. Deep Discount Bonds: These bonds are also issued at a discount to

face value and redeemed at face value on maturity. The difference
between the issue price and the redemption price represents cumulative
interest at a specified rate of interest. The difference, therefore,
represents interest income to the investor unlike Zero coupon bonds
where it represents capital gains.
8.9 TYPES OF FOREIGN BONDS
1. Yankee bonds: These are US Dollar denominated issue (bonds) by

foreign borrowers in the US bond markets. Or Dollar denominated bonds
issued in US markets by non US companies is known as Yankee bonds.
Foreign issuer has to adapt US accounting practices and the US credit
rating agencies will have to rate these bonds. These bonds are
sponsored by US domestic underwriting syndicate and requires
securities, exchange board registration prior to selling them in the
domestic US markets. Example: Reliance Industries Ltd. has been the
most successful Indian Corporate to tap this instrument with a 50 years
50 million dollar Yankee bond issue.
2. Samurai Bonds: Yen denominated bond issued in the Japanese

domestic markets by the non-Japanese companies are known as
Samurai bonds. The borrowers have a minimum investment grade rating
(Grade A). The maturities range between 3-20 years. The issuing costs
are one of the highest in case of the samurai bonds as this instrument is
for the public and the arrangements for underwriting and selling
involves large documentation. There are two parties to this issue:
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(a)The securities, house which acts as lead arranger.

(b)The bank which acts as chief commissioned company.
3. Bull Dog Bonds: Pound denominated bonds issued in UK domestic

markets by the non UK companies are known as the Bull Dog bonds.
The tenure ranges between 5-25 years. These bonds are subscribed by
long-term institutional investors such as Pension funds and LIC's which
have redemption on bullet basis.
4. Kangaroo Bonds: A type of foreign bond that is issued in the

Australian market by non-Australian firms and is denominated in
Australian currency. The bond is subject to Australian laws and
regulations. Also known as a "Matilda Bond”
5. Maple Bonds: A bond denominated in Canadian dollars that is sold in

Canada by foreign financial institutions and companies. The maple bond
gives domestic investors (in this case, Canadian investors) the
opportunity to invest in foreign companies without worrying about the
effects of currency exchange fluctuations. Foreign companies can use
maple bond issues to raise Canadian dollars for setting up operations in
Canada.
6. Panda Bonds: A Panda bond is a Chinese renminbi-denominated bond

from a non-Chinese issuer, sold in the People's Republic of China.
Eventually, it was agreed that funds raised from sales of panda bonds
would have to remain in China; issuers would not be permitted to
repatriate such funds
7. Matador Bonds: A term used to identify a foreign bond issued in Spain

by a company that is not domiciled in Spain. Matador bonds were bonds
denominated in pesetas, and were usually corporate bonds. The name
matador originated from the bullfighters in Spain. Spain followed a
systematic approach when accepting new foreign issuers. Spain initially
only allowed AAA-rated supranationals to issue matador bonds, then a
few years later allowed other sub-AAA multinationals access to Spain's
debt markets, and eventually it allowed non-investment grade
sovereigns to issue bonds.
8. Rembrandt Bonds: A foreign bond denominated in Euros and traded in

the Netherlands are called Rembrandt Bonds. In order to raise capital
! !210
from Dutch investors, a non-Dutch company may choose to sell the

bond in the Netherlands for this purpose.
9. Matrioshka Bond: Matrioshka bond, a Russian rouble-denominated

bond issued in the Russian Federation by non-Russian entities. The
name derives from the famous Russian wooden dolls, Matrioshka,
popular among foreign visitors to Russia.
10.Arirang Bond: An Arirang bond is a won-denominated bond issued by

a foreign entity in South Korea. The name refers to Arirang, a Korean
folk song. The market for Arirang bonds is extremely small, constituting
less than 0.2% of corporate bond issuance in South Korea. The Asian
Development Bank was the first to issue Arirang bonds, with a 1995
issue of won 80 billion worth of 7-year bonds.
11.Kauri Bond: A Kauri bond is a bond denominated in New Zealand

dollars that is issued by a foreign (i.e., non New Zealand) issuer. The
first issue took place in 2004. The name "kauri" comes from one of the
New Zealand's large native trees.
8.10 EURO CURRENCY NOTES MARKET
1. Euronotes are instruments of borrowing issued by borrowers directly to

investors without using banks as intermediaries, with or without the
underwriting support for the issue.
2. They have shorter maturities than bonds. Maturities normally range

from 15 days to 5 years.
3. Instruments generally used in this market are as follows:
(a) Commercial Paper (CP): This is a short-term security issued for

maturity of less than one year without underwriting support from
banks. These instruments are, therefore, issued by borrowers with
very good credit rating wishing to leverage the same to raise
resources at rates lower than lending rates of banks.
(b) Notes Issuance Facility (NIF):
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i) In situations where borrowing entity requires resources for the

medium, term but investors desire to invest on short-term basis,
the reconciliation is achieved through this mechanism.
ii) The borrower issues short-term notes supported by underwriting

from banks. The notes are redeemed on maturity by issue of fresh
notes.
iii) Shortfalls in subscriptions are covered by the underwriters. The

borrower is thus assured of requisite finance for the required
duration while simultaneously fulfilling the needs of the investors.
(c) Medium-term Notes (MTN):
i) These represent medium-term, fixed interest rate instruments

issued without underwriting support from banks.
ii) These instruments are issued for periods ranging from one to ten
years with standard maturity being five years.
iii) These instruments are very popular with Euro-market investors.

They are normally listed so as to provide liquidity.
(d) Bankers Acceptance (BA):
i) This is an instrument widely issued in the US money market to

finance domestic as well as international trade.
ii) The exporter (seller) draws a time or issuance draft on the buyers
(importer’s bank).
iii) On completing the shipment, the seller hands over the shipping
documents and L/C issued by his bank to the exporter's bank
discounts the same and lends to the seller.
(e) Repurchase Obligations (REPO):
i) In these transactions the borrower 'sells' securities to the lender

with the commitment to 'repurchase' the same at a predetermined
rate on a fixed future date.
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ii) The difference between the sale and repurchase prices represents
the return to the lender as interest. Effectively it represents the
most secured form of lending in the Euro currency market.
8.11 EXTERNAL COMMERCIAL BORROWINGS (ECB)
• ECBs are the loans or equity raised in any convertible foreign currency
from individual investors, banks, and investment institutions in
international financial markets.
• ECB Policy is a policy where ECB can be raised by borrowers in terms of

prevailing ECB policy in the country, which is formulated by the Govt.
from time to time keeping in view the external debt management
priorities of the country prescribing the quantum, maturity, and use of
funds raised in foreign convertible currencies.
• ECB policy envisages sectoral approach for raising external finance and
preference is given to infrastructure sector.
8.12 SYNDICATION OF LOANS
• As the size of the individual loans increased, individual banks found it

difficult to take the risk single handedly, regulatory authorities in most
countries also limit the size of the individual exposures. Hence, the
practice of inviting other banks to participate in the loan, to form a
syndicate, came into being; thus the term ‘syndicated loans'. A loan
syndicate refers to the negotiation where borrowers and lenders sit
across the table to discuss about the terms and conditions of lending.
• When borrower's requirement for loan is large a bank may seek to attract
other banks to make the loan jointly as a syndicate using common loan
documentation. This process is known as "syndication". Syndication
works on the principle of risk spreading i.e. the credit risk is diversified
amongst the lenders. Syndication benefits the lenders and the borrowers.
8.13 OFFSHORE BANKING
1. In today's highly integrated global network, international offshore

centers are playing a vital role in facilitating investment worldwide. An
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offshore center exists by usage and is known as Offshore Financial

Centers (OFCs).
2. Offshore Banking Centers are also known as Offshore Bank Centers,

which conduct a wide range of business activities such as banking,
insurance, securities transactions, trusts and some non-financial
activities such as shipping, registries, etc.
3. An Offshore Banking Unit (OBU) of a bank is a deemed foreign branch of

the parent bank situated within India, and shall undertake International
Banking business involving foreign currency denominated assets and
liabilities.
4. Offshore banking is thus, an extension of the Euro currency concept

used in offshore financial centers.
5. Offshore Banking has taken a great shape in India since 2002. The
seeds for OFCs were sown in the EXIM Policy 2002-07, where the
Government has targeted to achieve the growth in export target from
the present 0.67% to 1.00% of the world trade.
6. The Government of India has introduced the Special Economic Zone

(SEZ) scheme with a view to provide an internationally competitive and
a hassle free environment for export production.
7. As per the Government's policy, SEZs will be a specially made duty free
enclave and deemed to be a foreign territory for the purpose of trade
operations and duties/ tariffs so as to usher in export-led growth of the
economy. Offshore banks are the foreign branches of Indian Bank
located in India.
8.14 TAX HAVENS
• A country that offers foreign individuals and businesses little or no tax

liability in a politically and economically stable environment. Tax havens
also provide little or no financial information to foreign tax authorities.
• Individuals and businesses that do not reside in a tax haven can take
advantage of these countries' tax regimes to avoid paying taxes in their
home countries. Tax havens does not require that an individual reside in
! !214
or operate a business out of that country in order to benefit from its tax
policies.
• Both residents and non-residents enjoy very low income tax rates. They
provide a very high degree of financial freedom combined with limited
regulations where enforcement is less stringent.
• They offer limited wholesale banking services to non-residents with near

zero tax on income. The non-resident financial institutions located at
such centers are not integrated with the financial system of the host
country.
• They promise strict secrecy regarding financial transactions of non-

resident bank customers which means there is a lack of effective
exchange of financial information with foreign tax authorities.
• Alaska, the Bahamas, Belize, Bermuda, the British Virgin Islands, the
Cayman Islands, the Channel Islands, United Arab Emirates, the Cook
Islands, Hong Kong, the Isle of Man, Mauritius, Lichtenstein, Monaco,
Panama, Switzerland and St. Kitts and Nevis are all considered tax
havens.
8.15 PETRODOLLARS
• The Organization of Petroleum Exporting Countries (OPEC) was formed in

1960, at the Baghdad Conference in Iraq. This group has had a
significant influence on crude oil/petroleum prices. The first major hike in
petroleum prices was introduced in 1973.
• This event had a major impact on the flow of international funds. Since
petroleum trading was invoiced in USD, these surplus funds generated
out of petroleum sales and recycled between exporters and importers,
were called Petro dollars.
8.16 LIBOR (LONDON INTERBANK OFFERED RATE)
1. The LIBOR is interest rate at which prime bank offers dollar deposit to
other prime bank in London. This rate is used as the basis for pricing
Eurodollar and other Eurocurrency loans. The lender and the borrower
agree to a markup (specific percentage or basis percentage, i.e., 1% =
! !215
100 basis points) over the LIBOR, and the total of LIBOR plus the
markup is the effective interest rate for the loan.
2. It represents the average rate at which bank can obtain unsecured

funding in a given currency for a given period.
3. A panel 8 to 16 Euro-banks in the London market have been designated

by the British Bankers' Association (BBA) based on scale of market
activity, credit rating and perceived expertise in the currency, contribute
to the rates at which they would be willing to transact funds in the
interbank mark
8.17 SIBOR (SINGAPORE INTERBANK OFFERED RATE)
SIBOR stands for Singapore Interbank Offered Rate and is a daily reference
rate based on the interest rates at which banks offer to lend unsecured
funds to other banks in the Singapore wholesale money market (or
interbank market). Using SIBOR is more common in the Asian region and
set by the Association of Banks in Singapore (ABS).
8.18 EUROBONDS V/S EUROCREDITS
No. Eurobonds Euro Credits
1 Eurobonds are medium to long-term Euro credits are short to

instruments issued for periods from medium-term transactions
5-40 years. provided for 5-8 years.
2 Eurobonds often provide for fixed Euro credits are always given on
coupon /interest rates. floating rate basis.
3 Liability for interest on the entire Interest liability on each

amount begins from day of receipt. component begins from the date
of drawing.
4 Bonds cannot be issued in multiple Loans can be availed of in

currencies. different currencies.
5 Coupon rates on bonds are based on Euro credit interest rates are
deposit rates and are therefore lower based on borrowing rates and
than rates payable for loans. are therefore higher than bond
rates.
! !216
6 Bonds have to be marketed to Loan syndications can be

international investors; raising completed in a very short span
finance through issue of bonds is a of time.
slower process.
8.19 EURO CURRENCY BONDS V/S EURO CURRENCY

NOTES
No. Euro Currency Bonds Euro Currency Notes
1 Bonds are sold by the borrower to a Notes are sold by the borrower
syndicate of underwriting banks. without any underwriting
support.
2 Borrower sells the issue to the under- Borrower sells the instruments
writers who thereafter sell the directly to retail investors
instruments to retail investors. without any intermediation.
3 Issue risk is assumed by the The sale of notes is based on the

underwriters and credit rating of the credit rating of the borrower and
borrower is of limited importance. hence is critical to the issue.
4 Price discovery takes place through Since there is no intermediation,

demand/supply. the cost of acquiring the notes is
the same for all investors.
8.20 EURO CURRENCY MARKET V/S FOREIGN EXCHANGE

MARKET
No. Euro Currency Market Foreign Exchange Market
1 This market deals with borrowing and This market deals with purchase
lending of currencies. and sale of currencies.
2 It is an unregulated market. These markets are regulated by

the respective national monetary
authorities.
3 This market functions on interest This market functions on

rates. exchange rates.
! !217
4 It is essentially a wholesale market. It operates at both retail &

wholesale levels.
5 Transactions are mainly done in Transactions at retail level are

standard quantities. customized.
6 Lending is not security-oriented. Security-based approach to

lending.
7 Euro banks face a permanent asset No such limitations.

liability mismatch problem.
8.21 LIST OF SOME IMPORTANT CENTRAL BANKS:
Country Name
USA Federal Reserve Bank
UK Bank of England
Japan Bank of Japan
Switzerland Swiss National Bank
Euro Area European Central Bank
China People's Bank of China
Australia Reserve Bank of Australia
Norway Bank of Norway
India Reserve Bank of India
8 . 2 2 L I S T O F S O M E I M P O RTA N T R E G U L AT O R Y
AUTHORITIES
Country Agency
USA Securities and Exchange Commission (SEC)
UK Financial Services Authority (FSA)
Japan 1. Financial Services Agency

2. Securities and Exchange Surveillance Commission (SESC)
! !218
Switzerland Federal Department of Finance
Canada 1. Canadian Securities Administrators (CSA)

2. Investment Industry Regulatory Organization of Canada
(IIROC)
Australia 1. Australian Prudential Regulation Authority (APRA)

2. Australian Securities and Investments Commission (ASIC)
Germany Federal Financial Supervisory Authority
France Autorite Des Marches Financiers (AMF) - Financial Markets

Authority
India Securities and Exchange Board of India (SEBI)
8.23 SUMMARY
The Euro currency market is entirely a wholesale market. Transactions are

rarely for less than $1 million and sometimes they are for $100 million.
Like foreign exchange markets, the vast bulk is confiried to interbank
operations. The largest non-banking companies have to deal via banks.
Borrowers are the very highest pedigree corporate names carrying the
lowest credit risks. The market is telephone linked or telecommunication
linked and is focused in London, which has a share of around one third of
the Euro currency market. All Euro currency transactions are unsecured
credits, hence the fact that lenders pay particular attention to borrowers,
status and names.
! !219
1. What is Euro Currency market? What factors have contributed to its

growth?
2. Define Euro Currency market. Enumerate its characteristic features.
3. Define Bond. Explain different types of bonds.
4. Trace the origin of Tax Havens and factors contributing to their growth.
5. Bring out the progress of offshore financial centers.
! !220
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !221
INTERNATIONAL EQUITY MARKET
Chapter 9
Learning Objectives
• What do you mean by Foreign Capital
• International Equity Capital
• Global Depository Receipt
• American Depository Receipt
• Indian Depository Receipt
• Foreign Direct Investment
• Foreign Portfolio Investment
• Hot Money
• Participatory Notes
Structure:
9.1 Introduction to Foreign Capital
9.2 Need for Foreign Capital
9.3 International Equity Market
9.4 Concept of Depository Receipt
9.5 Global Depository Receipt (GDR)
9.6 American Depository Receipt (ADR)
9.7 Comparison Between Different Levels of ADR
9.8 Advantages of ADRs and GDRs
9.9 Distinction between GDR and ADR
9.10 Indian Depository Receipt (IDR)
9.11 Foreign Currency Convertible Bonds (FCCB)
9.12 Foreign Currency Exchangeable Bonds (FCEB)
9.13 Distinction Between FCCB and FCEB
9.14 Distinction Between FDI & FPI
9.15 Hot Money
9.16 Participatory Notes
9.17 Fungibility
9.18 Foreign Direct Investment in India
9.19 Factors Contributing to the Slow Flow of FDI into India
9.20 Foreign Investment Promotion Board (FIPB)
9.21 Foreign Investment Promotion Council (FIPC)
9.22 Summary
9.23 Self Assessment Questions 
! !222
9.1 INTRODUCTION TO FOREIGN CAPITAL
Foreign Capital refers to the investment of capital by a foreign government,

institution, private individual and international organization in a country.
Foreign Capital includes foreign aid, commercial borrowing and foreign
investment. Foreign aid includes foreign grants, concessional loans, etc.
Foreign Capital is invested in the form of foreign currency, foreign
machines and foreign technical know-how. Foreign Capital has many forms,
that is foreign collaborations, loan in the form of foreign currency,
investment in equity capital, etc. Many foreign institutions and
governments give grants. The main difference between foreign grants and
loans is that loans are repaid with interest, whereas grants are not repaid.
9.2 NEED FOR FOREIGN CAPITAL
In the early stage of Industrialization in any country foreign capital plays

an important role. The need for foreign capital is as follows:
1. Increase in Resources: Foreign capital not only provides an addition

to the domestic savings and resources, but also an addition to the
productive assets of the country.The country gets foreign exchange
through FDI. It helps to increase the investment level and thereby,
income and employment in the recipient country.
2. Risk Taking: Foreign capital undertakes the initial risk of developing

new lines of production. It has with it experience, initiative, resources to
explore newlines. If a concern fails, losses are borne by the foreign
investor.
3. Technical Know-how: Foreign investor brings with him the technical

and managerial know-how. This helps the recipient country to organize
its resources in most efficient ways, i.e., the least cost of production
methods are adopted. They provide training facilities to the local
personnel they employ.
4. High Standards: Foreign capital brings with it the tradition of keeping

high standards in respect of quality of goods, higher real wages to
labour and business practices. Such things not only serve the interest of
! !223
investors, but they act as an important factor in raising the quality of

product of other native concerns.
5. Marketing Facilities: Foreign capital provides marketing outlets. It

helps exports and imports among the units located in different countries
financed by same firm,
6. Reduces Trade Deficit: Foreign capital by helping the host country to

increase exports and reduce trade deficit. The exports are increased by
raising the quality and quantity of products and by lower prices.
7. Increases Competition: Foreign capital may help to increase

competition and break domestic monopoly. Foreign capital is a good
barometer of world's perception of a country's potential.
9.3 INTERNATIONAL EQUITY MARKET
1. Until the end of 1970s, international capital markets mainly focused on

debt financing but equity financing were raised only by corporate in the
domestic markets. As there were restrictions on cross border equity
investments.
2. Early 1980s witnessed, liberalization and globalization of many domestic

economies. This gave a boost to the developing countries where issue of
dollar or foreign currency denominated equity shares were not
permitted, now they are able to access the international equity markets
through the issue of an intermediate instruments called Depository
receipt.
9.4 CONCEPT OF DEPOSITORY RECEIPT
1. A Depository Receipt is a negotiable certificate issued by a depository

bank that represents the beneficial interest in shares issued by a
company.
2. These shares are deposited with a local custodian appointed by the

depository, which issues receipts against the deposit of shares.
3. According to the placements planned depository receipts are broadly

classified into 3 types.
! !224
(i) Global Depository Receipt (GDR) - which can be simultaneously

issued to investors in two or more countries.
(ii)American Depository Receipt (ADR) - which are issued only to

investors in America
(iii)Indian Depository Receipt (IDR) - which are issued only to investors

in India. Each of these depository receipts represents a specified
number of shares in the domestic market.
4. The main purpose by a company going for an international capital

market is because of the size of the fund that can be raised, currency
choice, large shareholder base and international brand image or
presence that emerges out of the issue.
9.5 GLOBAL DEPOSITORY RECEIPT (GDR)
1. GDR is a negotiable instrument in the form of depository receipts or

certificates created by the overseas depository bank outside India and
issued to non-resident investor against the issue of ordinary shares of
Foreign Currency Convertible Bonds (FCCB) of the issuing company.
A. The Characteristic features as follows:
1. GDRs are issued to investors in more than one country and may be
denominated in any acceptable freely convertible currency.
2. The equity shareholder may deposit the specified number of shares

and obtain the GDR and vice versa.
3. A typical GDR is denominated in any foreign currency whereas the

underlying shares would be denominated in the local currency of the
issuer. The holder of GDR is entitled to the dividend, bonus on the
value of share underlying the GDR.
4. GDR may, at the request of the investor can get converted to equity
shares by cancellation of GDRs through the intermediation of the
depository and the sale of underlying shares in the domestic market
through the local custodian. This provision can, however, be used
! !225
only after a "Cooling off" period of 45 days from the date of the
issue.
5. GDRs are considered as common equity of the issuing company. The

company effectively transacts with only one entity, i.e., the overseas
depository for all the transactions.
6. The foreign currency funds acquired by the company through a GDR

issue are permitted to be used for any normal business activity, but
cannot be used for trading in international securities or real estate.
7. Indian companies with a good financial track record of three years

are readily allowed access to international markets through such
issues. Clearances are required from the Foreign Investment
Promotion Board (FIPB) and the Ministry of Finance.
B. Advantages of a GDR Issue:
1. GDR holders do not acquire voting rights, and therefore, the

promoters are not in danger of losing management control.
2. Companies having international operations are able to build a brand

image which helps in their marketing efforts.
3. Investors have the benefit of having access to good quality

companies in other countries without political risk, operational risk
and excessive regulatory control.
4. Through a GDR issue the company is able to create a potential

demand for its shares at the international level which results in
higher valuation for its shares in the domestic market. This results in
a higher PE ratio which reduces the cost of capital.
! !226
C. Mechanism of Issue:
The above diagram of GDR Issue can be explained with the help of
following steps:
Step 1: The domestic company wishing to issue equity shares favouring

international investors is called 'The Issuing Company'.
Step 2: The issuing company appoints an international merchant bank to

act as lead managers, are required to market the issue to international
investors by conducting ‘road shows' with respect to background, financial
status and future prospects of the issuing company.
Step 3: After the road shows the lead manager arranges 'book runners',
who are specialized agencies for establishing and analyzing investor
response to the issue, the purpose being to help the issuing company to
price the issue at an appropriate level.
! !227
Step 4: After issue price is decided, the lead manager collects subscription
money from potential investors and after deducting their fees transfers the
collected amount to the depository bank.
Step 5: The issuing company now issues physical shares in favour of the
depository bank.
Step 6: These shares issued in favour of depository Bank are submitted

with the domestic bank of the issuing company which is also called
Custodian Bank.
Step 7: The Custodian Bank then confirms the receipt of underlying shares
issued by issuing company in favour of Depository bank.
Step 8: As soon as Depository Bank receives the confirmation from the

custodian bank. It issues GDRs to the investors/depository receipt holders.
Step 9: The issuing company helps the depository bank to arrange listing
of the GDRs. Most Indian companies list the GDRs on the international
stock exchanges in London and Luxembourg. This helps investors to freely
trade in GDRs.
Note: In the case of over-subscribed issues the lead manager is normally

entitled to a 'green shoe' option which means they are allowed to place
additional GDRs beyond the specified GDR issue size. (Normally 15%).
D. Participants involved in GDR Issue:
! !228
The market participants in GDR Issues are as follows:

1. Issuing Company:
i) Determine financial objective
ii) Appoint depository bank, lawyer, investment bank and accountants
2. Lawyer:
i) Advise on applicable securities laws and related matters
ii) Advise on GDR program (legal) structure
3. Investment Bankers:
i) Lead underwriting process
ii) Establish syndicate of participating banks
4. Depository Bank:
i) Advise on GDR program structure
ii) Appoint local custodian
5. Custodian Bank:
i) Act as local market agent for the depository
ii) Receive and hold deposits of underlying ordinary shares for GDR
issuances
6. Accountants:
i) Prepare financial statements in accordance with relevant
international accounting standards, review and audit offering
circular financial disclosure.
7. Brokers:
i) Make GDRs available to qualifying investors.
9.6 AMERICAN DEPOSITORY RECEIPT (ADR)
1. Till 1990s, the companies had to issue separate depository receipts, i.e.,
in US,ADRs were issued and in Europe, EDRs were issued. These
depository receipts were issued to access both these markets.
2. The weakness of this system was that there was no cross border trading
possible as ADRs had to be traded, settled and cleared through the
! !229
Depository Trust Company (DTC) in US and EDRs had to be traded,

settled and cleared through the Europe clearance in the Europe.
3. However, since April 1990, changes in the US had been introduced, i.e.,
non-US companies could raise capital in the US market with registration
with SEC (Securities Exchange Commission).
4. ADR is a dollar denominated negotiable certificate. It represents a non

US company in US market. ADRs were designed in 1920, to help
American invest in overseas securities and to assist non US companies
wishing to trade their stocks in American markets.
A. Unsponsored ADR:
Unsponsored ADR are those ADRs that are issued by one or more
depository banks based on market demand. Unsponsored ADRs are issued
without the cooperation of the foreign company, but it has to be a
reporting company as per the US Exchange Act of 1934.
ADRs can be diagrammatically represented as follows:
B. Sponsored ADR:
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1. Sponsored Level 1 ADR program:
This is the first step for an issuer. In this instrument only minimum
disclosure is required by the SEC. The issuer is not allowed to raise fresh
capital or list itself on any of the National Stock Exchanges.
2. Sponsored Level 2 ADR Program:
The Company is allowed to enlarge the investor base for existing shares to
greater extent. But significant disclosure has to be made. The company is
now allowed to test itself on American Stock Exchange or New York Stock
Exchange.
3. Sponsored Level 3 ADR Program:
This level is to raise fresh capital through public offering in the US capital
market.
4. Restricted ADR:
In addition to the sponsored ADR issues a company can also access the US
and other capital markets through ADR program falling under rule 144A or
regulation 'S' of the SEC. These issues have certain limitations in terms of
target investors, etc.
a) Rule 144A: This rule provides for raising capital through private
placement of ADRs with large institutional investors called qualified
institutional bodies (QIB's). Such issues operate at Level 1 status and
do not require disclosures or fulfilment of GAAP standards.
b) Regulation 'S': Regulation 'S' provides for raising capital through the
placement of ADRs to offshore non US investors. Section 'S' of the
SEC regulations permits ADRs to be issued to individuals and
corporate entities without any restrictions outside the US.
! !231
9.7 COMPARISON BETWEEN DIFFERENT LEVELS OF ADR
Particulars Level 1 Level 2 Level 3
Trading Pattern Only on OTC Listing allowed Listing allowed on on

market. stock exchanges in
USA.
Registration with ADRs are Both ADRs and Both ADRs and
SEC. registered but underlying shares underlying shares
underlying are registered. are registered
shares are not
registered.
Adherence to Only nominal Partial Full compliances

GAAP norms fulfillment. compliances
Disclosure norms Limited Stringent Very stringent
Capital raising No public issue. Public issue Public issue with

Only private without fresh fresh capital
placement capital.
9.8 ADVANTAGES OF ADRs AND GDRs
Advantages to the issuing companies:
1. Provides access to more liquid markets.

2. Provides funds at lower costs and better terms.
3. It expands the investor base for the issuing company.
4. Establishes name recognition for the company in new capital markets.
5. Provides marketing advantages due to improved brand image.
6. Source for foreign currency resources for overseas acquisitions, joint
ventures,import financing, project funding, etc.
Advantages to the investors:
1. Access to the best investment possibilities across the world.
! !232
2. It is an easy and cost effective way for individuals to hold and own
shares in a foreign company.
3. The mechanism helps investors to avoid foreign procedural hurdles and

clearances.
4. Means of wealth protection and investment diversification.
5. Hedge against adverse developments in domestic economy.
9.9 DISTINCTION BETWEEN GDR AND ADR
No. Global Depository Receipt American Depository Receipt
1 Can be denominated in any freely Can be denominated only in US

convertible currency. Dollars.
2 Can be issued to investors in one Can be issued only to investors

or more markets simultaneously. resident in the US.
3 Depository bank can be any Depository bank needs to be located

international investment bank. in the US.
4 Issue does not require foreign Issue requires approval from the
regulatory clearances. Securities and Exchange Commission
(SEC) of the US
5 There is no sub-classification in They are sub-classified in terms of

this instrument. the level of clearance of the SEC.
6 GDRs are normally co-related to In many cases ADRs are co-related to

equity shares of the issuing equity shares of the company
company expressed in whole expressed as a fraction.
numbers.
9.10 INDIAN DEPOSITORY RECEIPT (IDR)
1. IDRs are financial instruments that allow foreign companies to mobilize

funds from Indian markets by offering entitlement to foreign equity and
getting listed on Indian Stock Exchanges.
! !233
2. This instrument is similar to the GDR & ADR. The IDRs need to be
registered with SEBI.
3. The Government opened this avenue for the foreign companies to raise
funds from the country, as a step towards globalizing the Indian capital
market and to provide local investors exposure in global companies.
9.11 FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB)
FCCB is a type of Eurobond which can be exchanged for equity shares at

some later date after the issue of the Bond.
I. Features of FCCB:
1. It is a type of convertible bond issued in a currency different than the

issuer’s domestic currency.
2. A convertible bond is mix between a debt and equity instrument, i.e.,

these bonds give the bondholder the option to convert the bond into
stock.
3. Investors have the option to convert them into GDRs or underlying

shares. If investors prefer to hold the Bonds till maturity date, the
Corporate has to redeem the Bonds on that date.
4. The Coupon rate on the FCCB would be nominal.
5. FCCBs are denominated typically in US$ thousand each.
6. FCCBs can be converted at the pre-determined conversion price, at

any time by the investor, into GDRs or underlying shares.
7. FCCBs in India cost at upto 3 years Tenure: 150 bps over 6 months
LIBOR and between 3 to 5 years: 250 bps over 6 months LIBOR.
II.FCCB advantages:
1. The company gains higher leverage, as debt is reduced and equity

capital is enhanced upon conversion.
! !234
2. FCCB does not dilute ownership immediately, as the holders of ADR/

GDR do not have voting rights.
3. Conversion premium adds to the capital reserves.
4. FCCB carries fewer covenants as compared to a syndicated loan or

debenture, hence, more convenient to raise funds for Mergers and
Acquisitions.
III.FCCB Disadvantages:
1. In a falling stock market, there is no demand for FCCB.
2. FCCB, when converted into equity, brings down the earnings per
share, and eventually, dilutes the ownership.
3. In the long run, equity is costlier than debt, and hence, when interest
rates are falling, FCCB are not preferred.
4. Book value of converted shares depends on prevailing exchange

rates.
9.12 FOREIGN CURRENCY EXCHANGEABLE BONDS (FCEB)
FCEB is a type of Eurobond (issued by issuing company) which can be

exchanged for equity shares of another company (called as Offered
Company) at some later date after the issue of the Bond.
I. Features of FCEB:
1. FCEB is a bond expressed in foreign currency, the principal and

interest in respect of which are payable in foreign currency.
2. It is issued by an Issuing Company and subscribed to by a person

who is resident outside India in foreign currency.
3. The Issuing Company has to be part of the promoter group.
4. Prior approval of Foreign Investment Promotion Board, wherever

required under the Foreign Direct Investment policy, should be
obtained.
! !235
II.FCEB Advantages:
1. It provides an additional avenue for Indian companies raising funds

from overseas.
2. It helps companies unlock the value of their holdings in other

companies.
3. It helps companies raise finance without further dilution.
III.FCEB Disadvantages:
1. It is permissible only in certain areas and to the extent that ECBs and
FCCBs are permitted.
2. Proceeds of FCEBs cannot be used for investment in real estate

sector/in capital markets
9.13 DISTINCTION BETWEEN FCCB AND FCEB
Particulars FCCB FCEB
Conversion FCCBs are issued by a FCEBs are issued by a

company to non-residents company which are
giving them the option to exchangeable for the shares
convert them into shares of of the specified group
the same company at a company at a
predetermined price. predetermined price.
Issuing A proper Indian firm issues FCEBs are issued by

Company FCCBs. investment or holding
company of group to
nonresidents
Issue of shares/ In an FCCB, when the fresh In case of FCEBs, when the
existing holder exercises the option to option is exercised, there is
convert, the issuer company no issuance of fresh shares.
will issue fresh shares to the
holder in exchange
Default Risk FCCB possesses low risk. FCEB possesses high risk.
! !236
9.14 DISTINCTION BETWEEN FDI & FPI
Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)
FDI can be defined as investment FPI can be defined as investment by

made by Non-resident investors in the non-resident investors in the equity of
equity shares domestic company with a of a company with the intention of
the intention of participating in the getting quick capital gains.
management of the company.
FDI normally involves a long-term FPI normally involves a short-term

association between and the investors investment in the target company.
and the target company.
FDI normally takes place through a FPI does not involve any interaction
direct transaction between existing between the investor and the target
promoters and the investors by private company for any such investments
placement. made through the stock exchange.
FDI is usually a primary market FPI is usually a secondary market

transaction. transaction.
FDI has an impact on the balance FPI has no direct impact on the
sheet of the company since it involves balance sheet of the company since a
introduction of fresh capital, secondary market investment only
technology, etc. involves an exchange between
investors.
FDI normally involves introduction of FPI does not involve any direct linkage
new technology, markets, financing between the new investor and the
arrangements, etc., since the new management. There is no intention of
investor actively participates the in participating in the management
management process. process.
FDI leads to economic growth since it FPI does not directly create economic
increases employment. growth.
FDI is normally desired by all Due to the problem of HOT MONEY

Governments as a catalyst for associated with FPI most Governments
economic growth. impose restrictions/limitations on such
investments.
FDI involves investment in physical FPI involves investment in financial

assets. assets.
! !237
9.15 HOT MONEY
1. FDI provides the host country with foreign currency resources which are
in most cases permanent whereas, FPI provides short-term foreign
currency resources helping to reduce the use of existing reserves for
meeting BOP deficits.
2. FPI contributors include a diversified set of investors with different risk

profiles and investment horizons.
3. Macroeconomic fundamentals do not play a critical role in such

investment. The intention is to make quick profits out of opportunities
provided by emerging markets.
4. Movements of such funds distort the exchange rates and disrupt the
capital market both when entering and exiting a market.
5. These monetary flows are called 'Hot Money’.
6. Operations of domestic entities gets adversely affected therefore, to

safeguard against the ill effects of such fund movements, most
governments introduce exchange control regulations.
9.16 PARTICIPATORY NOTES
1. In India, generally stated, investments by non-residents under the

Portfolio Investment Scheme are permitted only as foreign institutional
investments.
2. For purpose of eligibility for investment under this route, a non-resident

has to register with the Securities and Exchange Board of India (SEBI)
as a Foreign Institutional Investor (FII) or as a sub-account of an
existing FII.
3. Registration as an FII requires fulfilment of various conditions prescribed

by SEBI.
4. Further, SEBI requires that any sub-account can be registered under an

FII, only if the FII is the investment manager for such sub-account. 
! !238
5. Indian stocks, like those of other emerging market economies, are in

great demand by overseas investors.
6. Some of these investors do not want to register themselves with SEBI

or, due to the conditions prescribed for FII registration, are unable to
register themselves as such.
7. It is in this context that the practice of FIIs issuing Participatory Notes,

Equity Linked Notes, etc., to such overseas investors has become
prevalent in the recent years.
8. Thus, Participatory Notes (PN or P-Notes) are instruments used by

foreign funds, not registered in the country, for trading in the domestic
market.
9. Participatory notes are like contract notes and are issued by foreign
institutional investors, registered in the country, to their overseas clients
who may not be eligible to invest in the Indian stock markets
10.Foreign institutional investors invest funds on behalf of such investors,

who prefer to avoid making disclosures required by various regulators.
The associates of these FIIs generally issue these notes overseas.
9.17 FUNGIBILITY
1. Fungibility means an asset can be interchanged into another asset of

the same class. Such transactions provide for equalization of prices in
different markets.
! !239
2. In the case of Depository Receipts, Fungibility provides for conversion of

the Drs into underlying shares.
3. This provides investors with two exit options: they can sell DRs on the
international stock exchanges or arrange cancellation of the DRs and
sell the underlying shares on the domestic stock exchanges depending
on price benefit.
4. On February 13, 2002 the Reserve Bank of India issued guidelines

permitting 'Dual Fungibility’.
5. This means DRs converted into local shares could be re-issued by

repurchasing the underlying shares in the local market.
6. Thus, the underlying shares representing the re-issuable Drs are called
‘Headroom'. Dual or Two-way Fungibility therefore represents a form of
capital account convertibility.
9.18 FOREIGN DIRECT INVESTMENT IN INDIA
1. FDI is a matter of special interest in developing countries because such

countries are continuously in competition to attract foreign capital for
enhancing availability of investible funds in their economies as also to
acquire new technology and managerial skills.
2. This competitive environment results in developing countries providing

several financial incentives such as tax concessions, liberal regulations
and permissions for repatriation of profits.
3. However, FDI also has adverse side effects due to which governments of
developing countries need to control the quantity of such inflows, their
end utilisation and the investment agreements between the contracting
parties.
4. Despite a very liberal and transparent FDI mechanism and sound

macroeconomic fundamentals. India has not been able to achieve the
expected level of FDI inflows.
! !240
5. This is due to the slow process of policy and regulatory changes.

Economic reforms were introduced in India in 1991, with the
Liberalization, Privatisation and Globalisation (LPG) model.
9.19 FACTORS CONTRIBUTING TO THE SLOW FLOW OF

FDI INTO INDIA
Despite attractiveness of the Indian market in terms of size, demographics

of the population, the liberalised terms for inward FDI, etc., the record of
the country in this regard has been poor. The factors which have
contributed to this are as follows:
1. India has a highly regulated business environment in terms of controls

and procedures.
2. The government enjoys a monopoly in several key sectors of the

economy.
3. There are limitations on acquisition of real estate.
4. The labour laws require reframing in an environment of market

economics.
5. The infrastructure especially in terms of transportation is inadequate.
6. The modern communication systems available in urban India need to

percolate to rural areas.
7. The fiscal deficit arising out of government borrowing is too large

resulting in very high debt.
9.20 FOREIGN INVESTMENT PROMOTION BOARD (FIPB)
1. The FIPB mechanism was specially designed to permit FDI proposals not
falling under the automatic route.
2. There are no specific pre-established parameters for deciding on such

proposals.
! !241
3. Each proposal is considered on merit based on potential for economic

benefit to the country.
4. Each proposal is considered in totality and the outcome is advised within

30 days of submission.
5. The recipient company, however, needs to intimate to the concerned

Regional Office of RBI regarding the receipt of the investment amount
within 30 days of receipt and file the necessary documents within 30
days of issuing equity to the foreign entity.
9.21 FOREIGN INVESTMENT PROMOTION COUNCIL (FIPC)
1. Despite efforts and a progressive liberalization of investment norms

both in terms of quantitative ceilings for various sectors and the
conditions/terms of investment, the country has failed to attract the
expected level of FDI.
2. The government therefore, constituted the Foreign Investment

Promotion Council to promote and market India as an investment
destination.
3. The FIPC is expected to play a proactive role in identifying both

domestic entities which can benefit from and absorb FDI and the foreign
counterparts and countries which can be tapped for such partnerships.
4. While the FIPB only comes into the picture when there is an actual
proposal for evaluation, the FIPC would actively pursue generation of
such proposals.
5. The FIPC is set up under the Industry Ministry to ensure greater co-
ordination of efforts towards the desired objective.
! !242
9.22 SUMMARY
The international financing decision has several dimensions which must be

weighed against each other before choosing a particular mode of funding.
The all-in cost of funding and the various risks remain the guiding
principles but regulatory issues and accessibility often takes precedence
over cost and risk considerations. Since the start of 1990s, equity financing
on global markets became accessible to firms in developing countries.
Portfolio investments by foreign investors in the stock markets of
developing countries and the depository receipts mechanism have been the
dominant form of equity financing by firms in emerging markets.
1. Explain the mechanism of a GDR issue.
2. What is ADR and explain its different types?
3. Distinguish between FDI v/s FPI.
4. Bring out the concept of Petrodollars and Hot Money.
5. Discuss the concept of Participatory Notes in the Indian context.
! !243
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !244
RISK MANAGEMENT AND DERIVATIVES
Chapter 10
Learning Objectives:
• Risk Management
• Risk faced by Corporate Entities
• Risk faced by Commercial Banks
• Hedging Process
• Foreign Currency Derivatives
• Non-deliverable Forwards
Structure:
10.1 Risk Management

10.2 Exposure (Limit)
10.3 Risk vs. Exposure
10.4 Risk Faced By Corporate Entities
10.5 Risk Faced By Commercial Banks
10.6 Hedging Process
10.7 Internal Hedging Method
10.8 External Hedging Methods
10.9 Foreign Currency Derivatives as Instruments of Risk Management
10.10 Forward Contract v/s Futures Contracts
10.11 Futures Contracts v/s Option Contracts
10.12 Limitations of Derivatives
10.13 Uses of Derivatives
10.14 Non-deliverable Forwards Market
10.15 Summary
! !245
10.1 RISK MANAGEMENT
1. A risk can be defined as an unanticipated event with adverse financial

consequences by way of loss or reduced earnings.
2. Risk represents uncertainly or unpredictability of the future.
3. From financial perspective risk may generate profit/loss depending on

the way in which it is managed.
4. Risk thus, can be described as the variability of the potential outcome.
5. Risk management is traditionally seen as a process designed to avoid or

eliminate risk.
6. Thus, a risk management system must allow the management to

deliberately accept the risk, such that the risk return profile is consistent
with its overall objectives.
7. It should encourage the management to focus on its profitability goals

vis-à-vis its risk taking capacity and the associated worst case loss.
10.2 EXPOSURE (LIMIT)
1. Exposure can be described as the gross volume of the transaction which

is subject to risk. It is normally estimated in terms of foreign currency.
2. T h e r e f o r e , a l t h o u g h t e r m s , r i s k a n d e x p o s u r e a r e u s e d
interchangeabley, there is a fundamental difference between the two.
3. Further, risk is a subject matter of control whereas, exposure is not

because that would involve reduction in business volume.
! !246
10.3 RISK vs. EXPOSURE
Risk Exposure
Risk can be defined as the possibilities Exposure can be defined as a gross

of financial loss due to future value of the transaction amount on
uncertainties. which loss can be incurred.
It is normally calculated in terms of It is normally calculated in terms of

domestic currency. foreign currency.
It should and can be controlled or Limiting exposure may adversely

managed through appropriate hedging impact the volume of the business
transaction. growth and is therefore not normally
attempted.
Risk may be positive or negative. Exposure is always negative.
10.4 RISK FACED BY CORPORATE ENTITIES
Foreign currency risks and the attendant risks arise whenever a business
has an income or expenditure or an asset or liability in a currency other
than the balance sheet currency. The volatility of the exchange rates and
the exchange rate movements destabilise the cash flows of a business
significantly. Such destabilization of cash flows which affects the
profitability of a business is the risk from foreign currency exposures.
Types of Risks:
1. Transaction Risks
2. Translation Risks
3. Economic Risks
1. Transaction Risks
These risks are the most common. For e.g, a company is exporting to USA
goods worth USD 1,00,000 and the rate prevailing on the date of contract
is 43.50. In this case on the date of payment, the rate moves above 43.50
say to 46.00, it will result in creating a loss say to the tune of 2.50 per
dollar. The risk is an adverse movement of the exchange rate from the time
transaction was undertaken till the time it is executed.
! !247
2. Translational Risks
Translational Risks arise from the need to 'translate' foreign currency

assets or liabilities into the home currency for the purpose of finalizing the
accounts for any given period. For e.g., consider that a company has
borrowed dollars to finance the import of capital goods worth USD 10,000
@ ` 43 per dollar, The entry was booked at this rate. The depreciation on
the asset would be provided accordingly assuming that the forex rate has
not changed. However, if at the time of finalization of the accounts, the
exchange rate moves to say ` 48 per Dollar, it would involve translational
loss of ` 50,000/-.
3. Economic Risks
Transaction and Translation are accounting concepts that affects the

bottom lines of the companies directly. Whereas, an economic risks is a
managerial concept. Economic risk to an exchange rate is risk "that change
in the rate that affects the company's competitive position in the market
and hence, indirectly affects the bottom line.
10.5 RISK FACED BY COMMERCIAL BANKS
1. Transaction Risk
a) Banks continuously quote rates for different transactions and

currencies to their customers. After the rates are accepted by the
customer, the bank dealers cover their transactions to lock in the
profit or loss.
b) Covering means undertaking any opposite transaction in the

interbank market so as to square of the currency exposure arising
out of transaction with the customer.
c) Between the quotation to the customer and the covering of the

transaction, and adverse exchange rate movement may result in loss.
Such a risk is called transaction risk.
2. Open Position Risk
! !248
a) Exchange Control guidelines in India require banks to maintain at the

close of every working day a square position in currencies. But in
practice, absolute square positions are impossible to maintain.
b) Therefore, some open position either overbought or oversold is
unavoidable in the very nature of foreign exchange operation.
c) Also, it may happen that the dealer may be expecting the dollar to
weaken during the day might square the deal later.
d) Hence, the bank makes profit out of such open position which is a
deliberate attempt. However, such uncovered positions may result in
a loss for the banks.
3. Pre-settlement Risk
a) Banks contract with each other and with customers for various
forward maturities. Such contracts being Over the Counter (OTC)
contracts, they carry a credit risk for both parties.
b) If a counter party fails, i.e., becomes bankrupt or otherwise incapable
of fulfilling the contract, on any day from the contract date upto one
day before the settlement date, then the other party is required to
replace the counterparty with a third party.
c) The replacement contract rate may be adverse as compared to the

original contract rate. Such a loss which represents the cost of
counterparty replacement is called pre-settlement risk.
4. Settlement Risk
a) On the day of settlement, if one of the parties to the contract fails

after the other party has delivered under the contract, then in
addition to the loss of the principal, the other party would also face
the cost of counterparty replacement and minimum one day's
overdue interest.
b) This is because corrective action can be taken only after 'cash'

transactions timing. Settlement day risks occur due to time zone
factors and may exceed the principal value of the contract. (This risk
attracted greater attention of risk managers after the Bank Herstatt
case of 1974).
! !249
10.6 HEDGING PROCESS
• The objective of the company in managing its transaction exposure is to

avoid losses that may occur due to exchange rate variations. A Company
which wishes to minimize, eliminate or avoid the risk may go in for
hedging each of its exposure.
• Hedging can be defined as a process or mechanism of reducing,

minimizing or eliminating risk from a given transaction. A foreign
exchange exposure is hedged or covered, when the company takes
certain steps to insulate itself from the adverse effects of exchange rate
movement.
• The basic objective in hedging is to create the position in the foreign

currency, in the direction opposite to the one that exists so that
ultimately the balance or net effect becomes zero. Hedging may be
achieved through internal or external mechanism.
10.7 INTERNAL HEDGING METHOD
1. Exposure netting
a) Companies having multi currency transaction, has exposure netting

that can take different forms. The currencies are grouped into two:-
(i) Currencies whose value is likely to appreciate.

(ii)Currencies whose values are likely to depreciate.
b) The exposure due to receivable in a currency which is expected to

appreciate may be offset by a payable in another currency which is
also expected to appreciate. The mechanism is called NETTING
MECHANISM.
2. Denomination in local currency
a) The exchange risk can be completely avoided if the transaction is

denominated in local currency. In such case exchange risk will be
borne by the opposite party to the transaction.
! !250
b) In international trade, the invoicing of the transaction is decided

between the parties based on the acceptability of the currency and
negotiating capacity of the parties.
c) Invoicing of the transaction in either the currency of the importer or

the exporter shifts exchange risk on to the other parties.
d) Sometimes, to make the things equitable, the invoicing value is

spilt, i.e., half the transaction is denominated in importers currency
half in the currency of the exporter.
3. Foreign currency accounts
a) In the case of a trader engaged in both exports and imports and a

manufacturer exporter who has an import component in his
manufacturing process; the exchange risk can be minimized by
maintaining foreign currency account, through which all transactions
can be rotated.
b) The arrangement has a dual advantage as follow:-
(i) Since export proceeds can be used to pay for imports the entity is
exposed to exchange risk only for the net balance.
(ii)In the normal course the bank will apply buying rate for exports
and selling rate for imports with the applicable exchange margin in
both cases. The loss in terms of exchange margin for covering
foreign currency into local currency and vice versa is avoided. This
reduces transaction cost.
4. Leads and lags
a) Exporters and importers keep making forecasts as to whether the

transaction currency will weaken or strengthen in future.
b) According to this expectation, they may like to prepone or postpone

the time of receipt or payment of the foreign currency.
! !251
c) The manipulation of the timing of receipts and the payments of

foreign currency depending upon the expectation of change in
currency values is known as Leads and Lags.
10.8 EXTERNAL HEDGING METHODS
1. External transactions or instruments undertaken or used with the

specific intention of hedging risks arising out of internal business
operations represent external hedging. Such products are called
derivatives.
2. Hence to manage risk derivatives are used because, they help the user
to reduce or eliminate foreign exchange risks through various
instruments.
3. A derivatives can be defined as "a transaction or a financial instrument

which derives its value through some other asset or security”.
4. Foreign currency derivatives derive their values from the value of the
underlying currency.
5. Derivatives can be used for,
➡ Hedging exchange rate risk

➡ Speculation
➡ Maximization of profits
➡ Adjusting liquidity and hedging mismatched maturity risk (interest rate
risk)
6. The different types of foreign currency derivatives are as follows: -
i) Foreign currency forward contracts.

ii) Foreign currency swaps.
iii) Foreign currency futures contracts.
iv) Foreign currency option contracts.
! !252
10.9 FOREIGN CURRENCY DERIVATIVES AS INSTRUMENTS

OF RISK MANAGEMENT
I. Foreign Currency Forward Contracts
1. A Foreign Currency Forward Contract can be described as an over-

the-counter agreement between two parties in which they agree to
exchange a definite amount of foreign currency at an agreed
conversion rate either on a fixed future date or during a fixed future
period.
Characteristic features of Foreign Currency Forward Contracts
1. These contracts represent privately arranged agreements which are

therefore negotiated on 'over the counter' (OTC) basis.
2. Such contracts are customized contracts, both in terms of amount

and maturity.
3. Banks normally do not demand any margin money and hence, there
is no interest cost.
4. There is a commitment to exchange specified currency at an agreed

price in future.
5. Both parties to the contract are exposed to credit risk.
6. These are bilateral contracts with no brokers or intermediaries

involved and therefore, there are no overhead expenses.
7. Profit or loss on forward contracts gets crystallised only on maturity.
8. Under-utilization, non-utilization or late utilization of the contract

leads to cancellation of contract on maturity at customers, cost.
II.Foreign Currency Futures Contracts
A futures contract can be defined as an agreement between the buyer and

the seller, standardized in regard to both amount and maturity, settled
! !253
through an organized exchange, in terms of which the seller is obliged to

deliver a specified currency.
Characteristic features of Foreign Currency Future Contracts
1. These contracts are standardized both in terms of contract value and

maturity.
2. Since real time contract values are customized, use of futures does
not always provide 100% hedging.
3. A special characteristic of such contracts is the elimination of credit

risks i.e., the Clearing House associated with the Exchange provides a
settlement guarantee to both buyers and sellers.
4. The Clearing House protects itself through margin money recovered

from both buyers and sellers.
5. The margin Money is recovered through designated brokers through

whom all futures contracts are undertaken.
6. Both purchase and sale contracts, are 'Marked to Market' at the

closing price of the trading day, thereby, crystallizing the profit/loss
daily.
7. It is necessary to hold such contracts to maturity. They enjoy the right

of ‘set-off' which means that purchase and sale contracts cancel each
other.
III.Foreign Currency Options Contracts
1. An option is a derivative instrument which gives the buyer the right

but not the obligation to buy or sell specified amount of foreign
currency on or before a standardized future maturity date at a pre-
described strike price (also called exercise price).
2. The buyer of the option pays a specific premium to the seller for
getting the right. This represents the consideration for the contract.
! !254
3. Options which provide the buyer with the right to buy the specified
foreign currency are called "Call Options”.
4. Whereas contracts which provide the buyer the right to sell the
specified foreign currency are called "Put Options”.
5. Options contracts which can be exercised on any date upto the

maturity date are called 'American Options’.
6. Whereas contracts which can be exercised only on maturity date are

called 'European Options’.
7. An Option contract can thus be viewed as a combination of two

contracts:
(a) An agreement between the buyer and seller involving transfer of

a right for which consideration by way of premium is paid by the
buyer to the seller, and
(b) On exercising the right, buyer of the option is entitled to either

buy or sell specific amount of currency at a pre-decided strike
price which represents consideration for the transaction.
IV.Foreign Currency Swap Contracts
1. A Foreign Currency Swap can be defined as simultaneous purchase

and sale of identical amounts of base currency for two different
maturities. It therefore involves an exchange of cash flows in both
base and variable currencies.
2. A swap can also be viewed as a simultaneous and equivalent lending

or borrowing in two currencies for a defined period expressed as buy
and sell transactions.
3. The difference in the rates applied for the two legs of the transaction
represents the interest rate differential between the currencies for
the given period.
! !255
10.10 FORWARD CONTRACT vs. FUTURE CONTRACTS
Forward Contracts Future Contracts
A Forward Contract can be defined as a A Future Contract can be defined as a

contract between a bank and the the contact between an exchange and
customer in which bank agrees to buy/ an operator in which the operator
sell a specific amount of foreign agrees to buy/sell standardized
currency on a fixed forward date or amount of foreign currency for delivery
within a fixed forward period, at a rate on a standard maturity date in the
decided on date of contract. future, at a specified rate.
Forward Contracts are customized in Future Contracts are standardized in

terms of amount and settlement date. terms of amount and settlement date.
Settlement date of a Forward Contract All Future Contracts maturing in a

can be any forward date. particular calendar month are settled
on the last working day of the month
in
India.
A Forward Contract can provide 100% A Future Contract do not provide 100%
hedge to the customer. hedge to the operator.
A Forward Contract is a rigid A Future Contract is a flexible

transaction whose terms cannot be instrument which can be cancelled
changed except with the original through an opposite transaction with
counterparty. the exchange.
Both parties to a forward contract Future Contracts do not involve credit

carry credit risk risk because for both buyers and
sellers, the counterparty is the
exchange which guarantees the
transaction. This is called the ‘Principle
of Novation'.
A Forward Contract does not involve Future Contract involves maintenance

payment of any margin money deposit, of initial and minimum margins with
therefore, there is no cost of funds. the exchange. All Futures Contracts
are marked-to-market on a daily basis
by corresponding debit or credit to the
margin money account. If balance of
this account falls below the minimum
margin level, then the operator is
called upon to restore the margin
! !256
money account up to the initial margin

level.
Crystallization of profit or loss takes Addition to the margin money account

place on maturity date. is allowed to be withdrawn and it is
therefore possible to draw the profit
element before maturity date.
There are no intermediaries in forward Future Contracts with the exchange

contracts are possible only through recognised
brokers.
10.11 FUTURE CONTRACTS vs. OPTION CONTRACTS
Future Contracts Option Contracts
Both buyers and sellers are subject to Both buyers and sellers are subject to
symmetrical obligations. asymmetrical obligations.
Delivery of underlying asset is Delivery of underlying asset is

mandatory optional.
Performance commitment is implied in The contract needs to be specifically

the contract. exercised or lapses on maturity.
These contracts are only traded on These contracts may be traded both on
exchanges exchanges and on OTC basis.
Difference between contract and spot Favourable difference between contract

price represents time value/cost of and spot market price represents
carry. intrinsic value.
Involves payment of consideration only Involves payment of premium for

on delivery. purchasing the contract and exchange
of consideration if the contract is
exercised.
Delivery can be demanded only on Contracts can be exercised on any day

maturity. upto maturity.
Trading strategies are restricted to only Multiple option trading strategies are
buy/sell operations. available based on market view.
! !257
Both buyers and sellers are subject to Only sellers (option writers) are
daily marked-to-market. subject to daily marked-to-market
since they are exposed to unlimited
losses.
10.12 LIMITATIONS OF DERIVATIVES
1. Leveraging increases risks

2. Need for Regulatory Supervision
3. Need for Institutional Infrastructure
10.13 USES OF DERIVATIVES
1. They enhance liquidity in the market for underlying assets.
2. They help to control, reduce, eliminate or manage efficiently various

types of risks.
3. They represent a form of insurance against risks.
4. They help individuals and managers of large funds to design strategies

for proper asset allocation, increasing returns and achieving their
portfolio objectives.
5. They reduce price volatility.
6. They encourage wider participation in the currency market.
10.14 NON-DELIVERABLE FORWARDS MARKET
A. Introduction:
1. A Non-deliverable Forward (NDF) is an outright forward contract in

which counterparties settle the difference between the contracted
NDF price or rate and the prevailing spot price or rate of maturity
date on an agreed notional amount.
! !258
2. It is used in various markets such as foreign exchange and

commodities.
3. NDFs are prevalent in currencies of countries where forward currency

trading has been banned by the government (usually as a means to
prevent exchange rate volatility) or in currencies of emerging nations
with convertibility limitations.
4. NDFs have become popular derivative instruments catering to the

offshore investors’ demand for hedging.
5. NDF markets develop in currencies where non-domestic players have

no access to the local forward market.
6. NDFs are therefore derivative instruments used for trading in non-

convertibility or restricted currencies without delivery of the
underlying currency.
7. The trading takes place in offshore centers and does not involve
exchange of principal amount. The settlement takes place in a
convertible foreign currency, normally USD.
B. The features of an NDF include:
1. The notional amount

2. The fixing date
3. The settlement or delivery date
4. The contracted NDF rate
5. The prevailing spot rate
C. Advantages:
1. No sovereign/convertibility risk.
2. No onshore balance sheet/tax consequences.
3. No dependence on local markets, except for fixing.
4. No regulatory supervision since transactions takes place offshore.
D. Disadvantages:
1. Limited liquidity
! !259
2. Market sentiment factored into pricing.

3. Minimum contract size (usually $ 250,000 per transactions) is large.
4. Traded on OTC basis therefore price discovery through negotiations.
10.15 SUMMARY
Foreign Exchange dealing is a business that one gets involved in, primarily
to obtain protection against adverse rate movements on their core
international business. Foreign Exchange dealing is essentially a risk-
reward business where profit potential is substantial but it is extremely
risky too. Hedging refers to risk management strategy used in limiting or
offsetting probability of loss from fluctuations in the prices of commodities,
currencies or securities. In effect, hedging is a transfer of risk without
buying insurance policies. It employs various techniques but, basically,
involves equal and opposite positions in two different markets (such as
cash and future markets). Hedging is used also in protecting one's capital
against effects of inflation through investing in high yield financial
instruments (bonds, notes, and shares), real estate, or precious metals.
1. Explain the risks faced by commercial banks in foreign exchange

market.
2. What do you mean by risk management and bring out different types of
risk faced by corporate entities?
3. Explain in detail the internal hedging mechanisms that a corporate

entity can use to minimize the risk.
4. How would you use the external hedging mechanisms for risk
management tools?
! !260
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !261
INTERNATIONAL INSTITUTIONS
Chapter 11
Learning Objectives
• Bank for International Settlement

• Basel Norms
• European Central Bank
• International Institutions
Structure:
11.1 Contribution of Bank for International Settlements In Risk

Management System
11.2 Contribution of BIS for Risk Management System
11.3 Basel Norms
11.4 Basel I vs. Basel II Norms
11.5 European Central Bank (ECB)
11.6 International Monetary Fund Objectives
11.7 International Bank for Reconstruction and Development (IBRD).
11.8 International Finance Corporation (IFC)
11.9 International Development Association (IDA)
11.10 Asian Development Bank
11.11 Summary
11.12 Self-assessment Questions
! !262
11.1 CONTRIBUTION OF BANK FOR INTERNATIONAL

SETTLEMENTS IN RISK MANAGEMENT SYSTEM
A. History
1. The Bank for International Settlements (BIS) was formed in 1930.

The Bank was originally intended to facilitate money transfers arising
from settling obligations under the Versailles treaty.
2. Post World War II there were allegations that the BIS had acted
inappropriately during World War II.
3. As a result, at the Bretton Woods Conference in July, 1944, there was

a demand for liquidation of the BIS. However, this was never
undertaken. The decision to liquidate the BIS was officially reversed
in 1948.
4. The BIS was originally owned by both governments and private

individuals, but in recent years the BIS has bought back all shares
held by private investors, and is now wholly owned by its member
central banks.
B. Objectives
1. The primary objective of BIS is to set capital adequacy requirements

because from an international point of view, speculative lending
based on inadequate underlying capital and inconsistent risk
assessment strategies result in economic crises.
2. To make banking operations safer for customers and reduce risk for
technical insolvency, banks are required to set aside a proportion of
their deposits as “reserve"
3. Thus, the overall objective is to strengthen the International Financial

Architecture with specific focus on International Banking Supervision.
C. Features
1. It is an International organization of central banks which promotes

international monetary and financial cooperation.
! !263
2. It coordinates regulations pertaining to financial services.
3. It promotes international financial stability.
4. It provides banking services only to central banks helping with

management of foreign currency reserves of the central banks.
5. It is based in Basel, Switzerland, and was established under the

Hague Agreements of 1930. The BIS has 57 members.
11.2 CONTRIBUTION OF BIS FOR RISK MANAGEMENT

SYSTEM
1. The BIS promoted the Basel Committee on Banking Supervision which

has played a central role in establishing the Basel Capital Accords of
1988 and 2004.
2. The Basel Committee on Banking Supervision provides a forum for

international cooperation on banking supervisory matters.
3. The objective is to enhance understanding of important supervisory

issues and improve the quality of banking supervision worldwide.
4. This is achieved by exchanging information on national supervisory

issue, approaches and techniques, with a view to promoting common
understanding.
5. The committee uses this common understanding to develop guidelines

and supervisory standards in areas where they are considered desirable.
6. In this regard, the Committee is known for its international standards on

capital adequacy; effective banking supervision; and the agreement on
cross border banking supervision.
7. To ensure risks are managed effectively the following techniques were

adopted:
➡ Banking is the art and science of measuring and managing risks in

lending and investment activities. As banks throughout the world are
! !264
highly Leveraged Entities their failure will cause significant distress to

the depositors and deprive borrowers of loan funds.
➡ Hence, Basel I norms were introduced aiming at capital adequacy for

banks as proportion of risk weighted assets. It was criticized by the
people as it lacked sophisticated measurement and management of
risks. Thus, there was a need for a set of new regulations.
➡ Basel I norms were announced by Basel committee in 1988 and were

adopted by Banks by the end of 1992. The norms mainly focused on
credit risk. In 1996, the committee amended the norms to include the
market risk.
➡ Following the South-East Asian crises, the Basel Committee in June

1999, proposed a new set of norms. To reinforce the soundness of the
global financial systems. These norms were called Basel II, which were
sought to better align the regulatory capital with underlying risk and
replace the current broad brush approach with a preferential broad-
based risk weighing approach.
➡ Basel II were able risk management techniques that made capital

adequacy, sound supervision, regulation and transparency of
operations.
➡ Thus, Basel norms came into existence in response to the

unprecedented growth in financial intermediation in the aftermath of
the world oil prices hike in 1970, with consequent risk in financial risk
of failure.
➡ Banks embarking on Basel II programs would find it advantageous to

set up a committee with representatives throughout the banking
fraternity. This committee should provide guidance throughout the
project lifecycle. There were seven steps that board decided on the
approach to be adopted and set time lines for complying with Basel II
recommendations. These steps are as follows:
Step 1: Analyzing the methods of the given banks and Basel II.
Step 2: Drawing and implementation of road map.
Step 3: Implementing or enhancing the internal rating system.
Step 4: Creating infrastructure for data management.
! !265
Step 5: Building Data Analysis.

Step 6: Testing the solutions, infrastructure and procedure.
Step 7: Preparing for supervisory certification.
11.3 BASEL NORMS
1. Basel I Norms
• Basel I is the round of deliberations by central bankers from around the

world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland,
published a set of minimum capital requirements for banks. This is also
known as the 1988 Basel Accord, and was enforced by law in the Group
of Ten (G-10) countries in 1992.
• Basel I is now widely viewed as outmoded. Indeed, the world has

changed as financial conglomerates, financial innovation and risk
management have developed. Therefore, a more comprehensive set of
guidelines, known as Basel II are in the process of implementation by
several countries.
2. Basel II Norms
• Basel II, initially published in June 2004, was intended to create an

international standard for banking regulators to control how much
capital banks need to put aside to guard against the types of financial
and operational risks, banks (and the whole economy) face.
• One focus was to maintain sufficient consistency of regulations so that

this does not become a source of competitive inequality amongst
internationally active banks. Advocates of Basel II believed that such
an international standard could help protect the international financial
system from the types of problems that might arise should a major
bank or a series of banks collapse.
• In theory, Basel II attempted to accomplish this by setting up risk and

capital management requirements designed to ensure that a bank has
adequate capital for the risk, the bank exposes itself through its
lending and investment practices.
! !266
• Generally speaking, these rules mean that the greater risk to which the
bank is exposed, the greater the amount of capital the bank needs to
hold to safeguard its solvency and overall economic stability.
• Politically, it was difficult to implement Basel II in the regulatory

environment prior to 2008, and progress was generally slow until that
year's major banking crisis caused mostly by credit default swaps,
mortgage-backed security markets and similar derivatives
3. Basel III Norms
• Basel III (or the Third Basel Accord) is a global regulatory standard on
bank capital adequacy, stress testing and market liquidity risk agreed
upon by the members of the Basel Committee on Banking Supervision
in 2010-11, and scheduled to be introduced from 2013 until 2018.
• The third installment of the Basel Accords was developed in response to

the deficiencies in financial regulation revealed by the late-2000s,
financial crisis. Basel III strengthens bank capital requirements and
introduces new regulatory requirements on bank liquidity and bank
leverage.
• The OECD estimates that the implementation of Basel III will decrease
annual GDP growth by 0.05-0.15%. Critics suggest that greater
regulation is responsible for the slow recovery from the late-2000s,
financial crisis, and that the Basel III requirements will increase the
incentives of banks to build the regulatory framework and further
negatively affect the stability of the financial system
11.4 BASEL I V/S BASEL II NORMS
Basel I Norms Basel II Norms
Introduced in 1988. Introduced in 2004.
These norms covered assessment of These norms covered assessment of

only credit risk. credit, market operational and residual
risks.
! !267
They involved 'one size fits all' They involved wider approach
approach with fixed risk weights for providing for standardized external
five asset classes. rating methods as well as internally
developed risk assessment processes.
A more rigid approach with focus only A more flexible approach with focus on
on provisioning for risk. liquidity and solvency on an on-going
basis.
These norms did not cover financial These norms have a more
innovations such as comprehensive approach and provide
securitization,derivatives, etc. for a changing environment.
No protection against over-trading. Provisions for a leverage ratio to avoid

excess leveraging.
Disclosure norms less comprehensive. Stringent disclosure norms to ensure

greater discipline.
11.5 EUROPEAN CENTRAL BANK (ECB)
A. Introduction / Background
1. The Bretton Woods Agreement provided the US Dollars with the

status of Universal Reserve Asset and simultaneously reduce the
importance of European currencies.
2. The idea of Monetary Union arose out of the need to establish a

currency to effectively compete with US Dollars.
3. The European nations formed a club called the 'European Union' (EU)
and achieved integration of trade and convergence of economies.
4. The intention was to create a single barrierless market with a

common currency and a common central bank. 16 of the 27
participating members have adopted a common currency called
'EURO' (EUR).
5. During the course of these developments, it was essential to create a

common institution which would monitor and implement a common
monetary policy.
! !268
6. The European Monetary Institute (EMI), was established to handle

transitional issues of countries adopting the EURO and to prepare for
creation of the ECB and the European System of the Central Banks
(ESCB).
7. In keeping with the terms of the Amsterdam Treaty (2, October,

1997) the ECB replaced the EMI effective 1, June, 1998. The bank
assumed full powers effective 1, Jan, 1999, when the EURO was
introduced.
B. Role of ECB
The ECB has the mandate to administer the monetary policy of the 16
EU member countries who have adopted the common currency EURO.
These nations are collectively called 'EUROZONE'.
C. Objectives of ECB
1. To ensure price stability within the Eurozone through low inflation

rates.
2. To define and implement a common monetary policy.
3. To take care of the foreign currency reserves of the ESCB.
4. To promote smooth operation of the financial markets
5. To maintain an exclusive right over issuances of Eurobank notes and

coins.
6. To maintain a stable financial system and monitor the banking sector.
11.6 I.M.F. OBJECTIVES
(i) To promote international monetary cooperation
(ii) To facilitate the expansion and balanced growth of international trade

and employment, and development of productive resources.
! !269
(iii) To promote exchange stability and maintain exchange arrangement

among member.
(iv) To eliminate foreign exchange restrictions and establish multilateral

system of payment in current transactions.
(v) To give confidence to members by making general resources of the

fund temporarily available to them under adequate safeguards,
providing them an opportunity to correct balance of payments without
resorting to destructive measures.
(vi) To shorten the duration and lessen the degree of disequilibrium in

international balance of payments of members. India is also a member
of the fund.
Thus, the main resource for IMF is the members, quotas, etc.
11.7 INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT (IBRD)
The World Bank is group of three institutions- the IBRD, The International
Finance Corporation (IFC) and the International Development Association
(IDA). However, the IBRD is generally referred to as the World Bank. The
headquarters of these institutions are at New York. USA.
Objectives
1. To assist in reconstruction and development of the territories of its

member governments by facilitating investment of capital for productive
purposes.
2. To promote foreign private investment.
3. Where private capital is not available on reasonable terms, to make

loans available for productive purposes out of its own sources or
borrowed by it.
4. To promote the long-range growth of international trade and the

maintenance of equilibrium in the balance of payments.
! !270
Features
• The World Bank makes loans for agriculture and rural development
power, industry, transport, etc. The total amount of loan granted by the
Bank should not exceed 100% of its total subscribed capital and surplus.
• The Bank renders a variety of technical assistance involving full scale

economic survey of the development potential of member countries or
advice on particular projects.
• The World Bank extended its loan to six commercial Banks in Public
Sector such as, Bank of India, Dena bank, Indian Bank, Indian Overseas
Bank, Allahabad Bank and Syndicate Bank.
11.8 INTERNATIONAL FINANCE CORPORATION (IFC)
• It is multilateral development institution, having 184 members on June,

2002, of which 163 are the developing countries. India is a member of
the IFC, having subscribed to the tune of 4.13% of the total capital with
3.57 % of voting power.
• Though the IFC and the IBRD are legally and financially separate entities,
membership of the IFC is open only to the members of the IBRD.
• IFC seeks to promote the economic development of its less developed

member countries, especially through the growth of the private sectors
of their economies, and also promotes private foreign investment in the
less developed countries. IFC has assisted a number of projects in India.
• IFC has identified five priority areas in India where it plans to beef up its
activities, such areas are capital market, direct foreign investment, and
access to foreign markets, equity investment in new and expanding
companies and infrastructure.
11.9 INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)
• It is also a multilateral development institution, though legally and

financially distinct from IBRD, is managed by the Bank's staff. It is also
called as "Soft Loan Window” of the World Bank. It has members of two
categories.
! !271
• The funds come mostly from the subscription from its member countries.
The object is to promote economic development of the less developed
countries by enabling the IBRD to supplement its bankable loans payable
in 50 years in U.S. dollars or in any convertible currency. IDA loans are
called credit to distinguish from IBRD loans.
11.10 ASIAN DEVELOPMENT BANK
It has been established under the auspices of the United Nations. The
authorised capital stock consists of (i) callable capital stock, and (ii) paid-in
capital stock.
Objectives
i) To promote the investment of the public and private capital for

development purpose in the ESCAFE region
ii) To utilize the available resources for financing development with

special reference to the requirement of the smaller and less
developed countries
iii) To assist in the coordination of development policies and plans
iv) To provide technical assistance in the preparation, financing and

execution of development projects.
11.11 SUMMARY
The world of business is in an environment of borderless finance. The

volume of international finance transactions has increased significantly
during the past few decades. World trade and investment are now
measured in trillions. Banks are now getting larger and more sophisticated
as a result of cross border merger and acquisition activity and innovations
in electronic technology. All of this growth has produced four developments
which have significantly affected international commerce. The Bank of
International Settlements (BIS) is an international organisation which
develops international monetary and financial corporation and serves as a
bank for central banks.
! !272
1. Elaborate on the role of the BIS in the current international financial

architecture.
2. Discuss the operational issues pertaining to the ECB as regulator for

EURO- Zone.
3. Bring out the important features of Basel I & Basel II on the backdrop of
Basel III.
4. What is the objective of International Monetary Fund?
5. How is Asian Development Bank important to the growth of India?
! !273
REFERENCE MATERIAL
chapter
Summary
PPT
MCQ
! !274
APPENDIX
Chapter 12
APPENDIX
Country Currency Code ISO 4217
Albania Lek ALL
Afghanistan Afghani AFN
Argentina Peso ARS
Aruba Guilder AWG
Australia Dollar AUD
Azerbaijan Manat AZN
Bahamas Dollar BSD
Barbados Dollar BBD
Belarus Ruble BYR
Belize Dollar BZD
Bermuda Dollar BMD
Bolivia Boliviano BOB
Bosnia & Herzegovina Convertible Marka BAM
Botswana Pula BWP
Bulgaria Lev BGN
Brazil Real BRL
Brunei Darussalam Dollar BND
Cambodia Riel KHR
Canada Dollar CAD
Cayman Dollar KYD
Chile Peso CLP
China Yuan Renminbi CNY
! !275
APPENDIX
Colombia Peso COP
Costa Rica Colon CRC
Croatia Kuna HRK
Cuba Peso CUP
Czech Republic Koruna CZK
Denmark Krone DKK
Dominican Republic Peso DOP
East Caribbean Dollar XCD
Egypt Pound EGP
El Salvador Colon SVC
Estonia Kroon EEK
Euro Member Euro EUR
Falkland Islands Pound FKP
Fiji Dollar FJD
Ghana Cedis GHC
Gibraltar Pound GIP
Guatemala Quetzal GTQ
Guernsey Pound GGP
Guyana Dollar GYD
Honduras Lempira HNL
Hong Kong Dollar HKD
Hungary Forint HUF
Iceland Krona ISK
India Rupee INR
Indonesia Rupiah IDR
Iran Rial IRR
Isle of Man Pound IMP
! !276
APPENDIX
Israel Shekel ILS
Jamaica Dollar JMD
Japan Yen JPY
Jersey Pound JEP
Kazakhstan Tenge KZT
Korea (North) Won KPW
Korea (South) Won KRW
Kyrgyzstan Som KGS
Laos Kip LAK
Latvia Lat LVL
Lebanon Pound LBP
Liberia Dollar LRD
Lithuania Litas LTL
Macedonia Denar MKD
Malaysia Ringgit MYR
Mauritius Rupee MUR
Mexico Peso MXN
Mongolia Tughrik MNT
Mozambique Metical MZN
Namibia Dollar NAD
Nepal Rupee NPR
Netherlands Antilles Guilder ANG
New Zealand Dollar NZD
Nicaragua Cordoba NIO
Nigeria Naira NGN
Norway Krone NOK
Oman Rial OMR
! !277
APPENDIX
Pakistan Rupee PKR
Panama Balboa PAB
Paraguay Guarani PYG
Peru Nuevo Sol PEN
Philippines Peso PHP
Poland Zloty PLN
Qatar Riyal QAR
Romania New Leu RON
Russia Ruble RUB
Saint Helena Pound SHP
Saudi Arabia Riyal SAR
Serbia Dinar RSD
Seychelles Rupee SCR
Singapore Dollar SGD
Solomon Islands Dollar SBD
Somalia Shilling SOS
South Africa Rand ZAR
Sri Lanka Rupee LKR
Sweden Krona SEK
Switzerland Franc CHF
Suriname Dollar SRD
Syria Pound SYP
Taiwan New Dollar TWD
Thailand Baht THB
Trinidad and Tobago Dollar TTD
Turkey Lira TRL
Tuvalu Dollar TVD
! !278
APPENDIX
Ukraine Hryvna UAH
United Kingdom Pound GBP
United States Dollar USD
Uruguay Peso UYU
Uzbekistan Som UZS
Venezuela Bolivar Fuerte VEF
Viet Nam Dong VND
Yemen Rial YER
Zimbabwe Dollar ZWD
! !279
APPENDIX
REFERENCE MATERIAL
chapter
PPT
! !280

International Finance 315 v1

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International Finance 315 v1

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INTERNATIONAL FINANCE

Sub Code - 315

Program Design and Advisory Team

Prof. B.N. Chatterjee Mr. Manish Pitke

Prof. Kanu Doshi Prof. B.N. Chatterjee

Prof. Dr. V.H. Iyer Mr. Smitesh Bhosale

Prof. B.N. Chatterjee Prof. Vineel Bhurke

Prof. Venkat lyer Dr. Pravin Kumar Agrawal

Prof. Dr. Pradeep Pendse Mrs. Margaret Vas

Prof. Sandeep Kelkar Mr. Anuj Pandey

Prof. Dr. Swapna Pradhan Course Editor

Prof. Bijoy B. Bhattacharyya Prof. B.N. Chatterjee

Mr. P.M. Bendre Course Coordinators

Mr. Ajay Prabhu Ms. Kirti Sampat

Mr. A.S. Pillai Mr. Kishor Tamhankar

COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Research.

NOT FOR SALE. FOR PRIVATE CIRCULATION ONLY.

1st Edition (July-2006). 2nd Edition (Jan-2011). 3rd Edition (Jan-2013)

Chapter No. Chapter Name Page No.

1 Overview of International Business 3-18

After completing this chapter, you should be able to understand:

• What is International Business (IB)

1.2 INTRODUCTION OF INTERNATIONAL BUSINESS

International business is the process of focusing on the resources of the

Globalization makes the business environment increasingly global even for

For the sake of simplicity, one may be tempted to define international

It may be noted that many seemingly domestic products are truly

countries as mentioned earlier and explained in this section on global

1.3 GROWING IMPORTANCE OF GLOBALISATION OF

The importance of international business is due to following driving forces:

Multinational enterprises which link their resources and objectives with

Technological advances have tremendously fostered globalization.

have made it economical to integrate distant operations and ship products

Transportation and Communication Revolution

The IT revolution has made an enormous contribution to the emergence of

Product Development Costs and Efforts

The cost of new product development is very huge in several industries

is required. Further, because of the huge investment and diverse

Quality and Cost

Rising Aspirations and Wants

Due to increasing level of education and exposure to the electronic-media,

Another factor for importance of international business is increasing

World Economic Trends

Another driving force of internationalization is the economic liberalization,

The proliferation of regional integration schemes, like the European Union

Leverage is simply some type of advantage that a company enjoys by

a. Experience transfer for expanding or strengthening its

b. Scale economies: The cost is one of the important determinants of

c. Resource utilization: Another strength of an international company is

d. International strategy: A global strategy built on an information

To Achieve Higher Rate of Profits

When the domestic markets do not promise a higher rate of profits,

Many of the domestic companies expanded their production capacities that

Limited Home Market

Similarly, merely 60 lakh population of Switzerland forced Ciba-Geigy to

Nearness to Raw Materials

Quality of Human Resource Availability

This is a major factor for software, high technology and telecommunication

from India by these companies is costly rather than locating their

Imposition of Tariffs and Quotas

Before deregulation and globalization there were various governments

1.4 INTERNATIONAL BANK FOR RECONSTRUCTION AND

The World Bank originated as a result of the Bretton Woods Conference of

The World Bank group comprises of five closely associated institutions,

Video Lecture - Part 3 