INTERNATIONAL MONETARY SYSTEMS: GOLD STANDARD, BRETTON WOODS, EUROPEAN

INTERNATIONAL
MONETARY SYSTEMS
Gold Standard, Bretton Woods System,
European Monetary System
Gold Standard
• India import more from USA than it export.
Exports are not sufficient to pay for the imports. If
so India is said to have trade deficit with USA.
HOW TO SETTLE THE ACCOUNTS:
• Trade was being done even before the invention
of modern currency. Currencies of each other are
not acceptable, when they could be available.
• Need for an acceptable medium to settle
international payments.
• Gold became the most acceptable medium of
settlement of international transactions.
INTERNATIONAL FINANCE RAJIV SRIVASTAVA 2

Why Only Gold
• Gold was most convenient way of determining the
value of the currency because of following 5 unique
properties which no other commodity had:
– Durability: No loss of value with time, weather etc.,
– Storability: Ease of storing,
– Portability: Ease of carrying from one place to
another,
– Divisibility: Breaking up in smaller denomination,
– Standardisability: Ease of measurement of purity.
• The oldest monetary system for determining the value
of the currency was how much gold one unit of a
currency could buy.
Price Specie Flow Mechanism
• Settlement was to be done with actual flow of
gold. In order to pay for imports gold must be
shipped out. In terms of balance of trade
Gold will flow from DEFICIT COUNTRY to the
SURPLUS COUNTRY.
• Internal trade could take place in local currency
(Could be gold coins too).
• Local currency should be capable of buying a fixed
amount of gold.
• Exchange rate of two currencies would be decided
by the quantity of gold each currency could buy.
• Hence GOLD content decides the exchange rates.

Mint Parity of Gold
Mint parity of gold must prevail:
– Local currency that can be issued must be proportional
to the amount of gold the country has.
– Country that exports more will have more gold and
therefore can issue more local currency.
– A country that imports more will have to reduce the
money supply.
– BOP surplus will cause increased money supply and
deficit will cause decreased money supply.

Quantity Theory of Money
Quantity theory of money
– Price changes are proportional to the changes in the
quantity of money available.
– Increased supply of money leads to an increase in the
levels of price.
– Decreased supply of money causes a decrease in the
levels of price.

Offsetting Mechanism
Increased productivity  Reduced prices of goods/
services  Exports become more competitive
 Imports become less attractive  Increased
export and reduced import  Inflow of gold 
Issue of more currency  Increase in prices 
Exports become more expensive  Imports
become more attractive
(OFFSETS THE EARLIER EFFECT)
Under Flexible Exchange Rate System, the exchange
rate of two currencies will change.
BOP Adjustment
• India faces BOP deficit: (imports > exports)
Implies excess demand for foreign currency; also
implies excess supply of local currency
– Central bank sells gold from its reserves: reduces supply of
local currency  reduction in prices  makes imports
less attractive and exports more attractive  correction
in BOP deficit situation.
– Reduced money supply means reduced credit in the
economy and higher interest rates  reduced investment
reduced employment and reduced income levels 
reduced consumption (depends upon income investment
multiplier, propensity to import and propensity to save).
• India faces BOP surplus: Reverse process takes place.

How Gold Standard Works
Increased productivity leading to
increased production and reduced prices
Balance of payment Exports become more

corrects automatically competitive and gold inflow
increases
Increased prices make import

attractive and cause the reversal of Increased stock of gold leads to
gold flow back restoring gold level to increased supply of local money
the original
Increased money supply causes prices of

the goods to rise eroding the export
competitiveness

Virtues – Gold Standard
Gold standard leads to price stability:
– Self-correcting mechanism: Any event that changes
the level of prices gold standard would restore the
original price level through international flow of gold.
– There would be periodic bouts of inflation and
deflation.
Gold standard contains inflation:
– Since quantity of gold available worldwide is limited,
therefore money in circulation at global level can not
be expanded. World supply of money of all currencies
shall be constant.
– Limits scope of financial mismanagement by
politicians, economists and policy makers.

Pre-requisites – Gold Standard
• Rest on three pillars – actual flow of gold, mint parity to
prevail, and quantity theory of money to hold.
• Free flow of gold,
• No barriers to trade,
• Fix rate of conversion of paper money in to gold. (Mint
parity)
• Deficit country must have enough Gold Reserve to pay
for the deficit.
• Ratio of currency to the quantity of gold available in the
reserve must be maintained. (Reserve Ratio) (25% for US
$)

Review – 1821 - 1914
• By 1880 most nations were on gold standard.
• The world supply of gold remained constant, after
all gold was mined.
• Thereafter, gold was difficult to locate, mine and
mint, Nations faced periodic bouts of inflation and
deflation.
• This period is characterised by
– rapid expansion of international trade,
– stable exchange rates,
– free flow of capital and labour.

Pre and Post Gold Standard
• The price level of 1914 (Start of World War I) was same
as that of late 1700s (Pre Napoleonic Wars);
• As compared to 200 years of stable prices under gold
standard there was several times increase in price
levels from 1950 to 1985 (Post gold standard).
• 4.66 times in USA,
• 10.12 times in France,
• 10.56 times in Britain,
• 13.69 times in Italy.
• Britain maintained the price of the gold at £ 4.2474 per
ounce and USA priced gold at $ 20.67 per ounce
providing a fixed exchange rate of $4.867/£.

Pure Vs Managed Gold Standard
• PURE GOLD STANDARD
– As trade increased settlement of international
transactions in gold with physical movement of gold;
became tedious.
• MANAGED GOLD STANDARD

– England was a major economic, political and military
force and enjoyed a very dominant position.
– Balance of payment transactions were allowed to be
made in British pounds in markets of London, Paris
and New York.
Gold Standard - Variants
• GOLD SPECIE (Gold coins) STANDARD
– The oldest system of exchange rate; was in effect till World War I and a
few years thereafter. International settlements were done with
physical movement of gold.
• GOLD BULLION STANDARD
– Basis of money remains the fixed quantity of gold. The paper currency
is in circulation with issuing authority guaranteeing the exchange of
currency into fixed amount of gold.
• GOLD EXCHANGE STANDARD
– Authority issuing the currency stands guarantee to convert the
currency into another currency that is on Gold Specie or Gold Bullion
e.g. rupee convertible into fixed quantity of British pound which in turn
is on gold bullion.

Failure of Gold Standard
• Abandonment of Minimum Reserve Requirement:
– Deficit countries did not reduce the money supply
for
• Fear of rising interest rates, and
• Increase in unemployment
– Surplus countries did not increase money supply for
• Fear of inflation
• Abandonment of promise to convert paper currency in
to gold.

Fiat Money
• Nations resorted to currency controls, protectionism,
and fiscal indiscipline.
• FIAT MONEY
– Gold standard prescribed issue of currency backed
by promise of its conversion into gold. Issue of
money was constrained by availability of gold.
• Tendency to issue paper currency beyond the reserves
of gold was too great  All nations issued currency
beyond the gold reserve  a misleading belief that
promise of its conversion into gold will be honoured.
• Fear developed that promise to convert paper currency
into gold could be abandoned.
Changed Balance of Gold
• Money supply doubled in Britain, tripled in France and
quadrupled in Germany leading to similar inflations.
• Money supply in USA too doubled but was backed by
increasing reserves of gold.
• At the end of WW I USA had about 75% of the gold of
the world (worth $ 4.5 billion of total $ 5.80 billion).
• All nations had resorted to inflationary finance to
varying degrees.

Choices to Restore Gold Standard
To restore gold standard
1. Deflation (redeeming gold for paper currency, tight
credit, high interest rates) could cause recession and
unemployment, or
2. Devaluation in terms of gold.
• USA and Britain opted for deflation by raising interest
rates and balanced budgets, while Germany and France
opted for the softer route of devaluation.
• Germany: deflation was ruled out due to excessive
money supply.
• Britain: ruled out devaluation as most countries were
keeping reserves in sterling deposits in London.
British Approach
• Gold standard was suspended in Germany and France in
August 1914.
• Britain adhered but could not control money supply. At
start of war it had 15% of gold for money supply but by
the end it was only 7%.
• War could be funded by
– Imposing taxes: Would rise to confiscatory levels.
– Borrowings: (Public debt/external debt): Internal as well
as external and there were upper limits.
– Printing money; would be inflationary.
$ billion Taxes Borrowing Printing Total
Britain 9 27 8 44
Germany’s Approach
Exchange Rates in Germany: Currency: Reichsmark
4.20 per $ in 1914 at the start of World War I, 65/$ in 1920,
190/$ in early 1922
7,600 /$ by the end of 1922, Price rose 40 times
620,000/$ in August 1923,
630 billion/$ Nov 1923
4.2 trillion/$ Nov 23, went as high as 11 trillion/$ on Nov 26
but came back to 4.2 trillion/$ on Dec 10.
– “Cipher stroke”, Economy went back to barter: Getting rid
of money as fast as possible.
– Professors turned beggars and gentle aristocratic ladies
turned prostitutes.
Germany’s Approach
• Created new parallel currency Rentenmark to be backed by land and not
gold by mortgage on agricultural and industrial land.
• Land is a non-transferable, illiquid asset. It could not have issued
currency backed by gold.
• Rate fixed by new parallel currency;
1 Rentenmark = 4.2 trillion Reichsmark.
• Both German currencies continued to fall.
• Germany had US $ 1 billion worth of gold for $1.5 b issued currency at
start of war. At the end, it had gold worth $150 million only.
Source Slides 20-22: “Lords of Finance” by Liaquat Ahamed

Failure of Gold Standard
• Depression of 1930s led to
– successive competitive devaluations (26),
– increased protectionism, and
– unlimited money supply (fiat money)
leading to continuing inflation.
• Pressure of conversion of £ in to gold caused
– Abandonment of commitment of conversion into gold
by British government,
– Other countries too followed Britain and withdrew the
commitment of conversion.
– Only US $ survived because USA had enough gold.
BRETTON WOODS SYSTEM
A GOLD EXCHANGE STANDARD

Bretton Woods Conference
• Total chaos prevailed in the monetary system till World War II.
Gold standard had broken down due to a) increased
protectionism, b) competitive devaluations, and c) inflation.
• Gold faced the problems of confidence and liquidity (limited
supply) and hence fiat money.
• Gold was considered an anachronism in modern society.
• Conference of allied nations (40 countries) took place at
Bretton Woods, NH, in 1944.
• Delegation of Britain was led by Lord John Keynes, and that of
USA by Harry White.

Bretton Woods - Rationale
• Completely free exchange rate system was considered
too volatile and detrimental for trade.
• System of “Adjustable Peg” was proposed to retain the
stability of exchange rates and yet provide the fiscal
and monetary independence to the nations.
• An agreement was reached by all nations to maintain a
fixed exchange rate with respect to US dollar or gold.
• World Bank and IMF were created.
• It was a Gold Exchange Standard with some flexibility
given to nations, and only few currencies at gold
bullion.
Bretton Woods - Features
• US Government undertook to convert US dollar in to
gold at a fixed rate of $35 per ounce.
• Only US dollar was convertible in to gold.
• Members of the IMF agreed to fix the parity of their
currency with respect to dollar with variation within a
band of ± 1%.
• Outside the band of ± 1%, central banks were required
to intervene in the foreign exchange markets.
• Within 1 year of initial exchange rate, 10% revision was
possible with the permission of IMF.
Bretton Woods - Implications
• All members needed to accumulate dollars for
intervention.
• Gold was pledged by nations to IMF for supply of dollars.
• USA had seigniorage gains (USA could acquire
goods/services by printing as many dollars as long as
others were willing to hold dollars).
• Barring USA who had to maintain the Dollar Gold Parity
at $ 35/ounce, other could devalue or revalue by more
than 5% with prior permission of IMF;
(in order to prevent chain devaluation of 25 countries in 1930s)

BW Intervention Mechanism
Demand for $ increases from D to D’
Rs/$ D’ taking the value of $ beyond Rs
68.68 68.68 (> ± 1% ): Intervention
S required to bring back the value
within the band. RBI needs to supply
$ (Q4 – Q3).
68.00 D
Demand for $ decreases from D to
D” D” taking the value of $ below Rs
67.32 67.32(> ± 1% ): RBI needs to mop up
the excess supply of $ (Q2 – Q1).
Q1 Q2 Q3 Q4
Intervention by Central Banks
• Parity and support points: If the parity value is Rs 68/$ then
support points are Rs 67.32 and Rs. 68.68. As long as demand
and supply curve intersected within ± 1% of parity value, no
action is required.
• If demand for more imported goods shift the demand curve
beyond the permissible band, then RBI was obliged to supply
dollars from its reserves to support parity. Therefore supply
curve becomes infinitely elastic (flat).
• A country following inflationary policies faces BOP deficit as
domestic goods are expensive and imported goods are
attractive. The increased supply of local currency leads to its
depreciation forcing intervention. This necessitates buying own
currency from reserves.
Cracks in Bretton Woods
• System ran well till 1962. In 1962 France became doubtful
of ability of USA to honour exchange of gold at $ 35/ounce.
Started converting dollar reserves into gold. Few other
nations followed.
– Political reason of dominance of USA, and
– Economic reason of seigniorage gains
• By 1968 run on the gold was heavy. 2-tier gold policy was
initiated. Unofficially gold was floating but official price was
maintained at $ 35.
• In 1968 President Nixon suspended convertibility of
privately held gold; Prohibited US citizens to hold gold and
restricted capital outflows by MNCs.
Cracks in Bretton Woods
• By 1971 USA owed $ 88 billion in ST liquid liabilities to
foreigners due to heavy and consistent BOP deficit.
– 50% held by foreign central banks
– 25% held by MNCs
– Remaining 25% ($ 22 billion) was with speculators who
could demand gold at $35. US FED had gold reserve
worth $ 12 billion only.
• System of Gold Pool was devised by UK, France, Germany,
Italy, Belgium, Netherlands, and Switzerland. They tried to
sell gold to maintain value of US dollar at USD 35/oz, while
USA was supposed to restrict trade balance. This could not
hold as USA could not contain BOP deficit.
US Approach to BW System
• USA had the sole responsibility to maintain
exchange rate. It did not follow financial
discipline and kept issuing dollars.
– Issued T – bills as substitute for gold for those
redeeming,
– Eliminated private redemption,
– Prohibited US citizens to hold gold at home as well
as abroad,
– Pressurised nations not to convert their dollars,
– Continued issue the currency rather than raising
taxes, and
– Funded Vietnam war.
Explaining Failure – Triffin Paradox
Bretton Woods system had inherent
contradiction.
• The system depended on dollar performing its role as
key currency, a reserve currency.
• Increased levels of income and international trade
demanded increased supply of gold or its equivalent.
• For other countries to accumulate dollars USA had to
run a persistent and large BOP deficit. Mounting deficit
would cause confidence crisis of the reserve currency
itself.
– Therefore BW system was inherently unstable.
Explaining Failure – Triffin Paradox
• The paradox was also well anticipated by Lord Keynes
at the time of formulation of Bretton Wood System in
1944 itself.
• He had proposed a new currency called BANCOR (A
basket) for international settlement, so as i) not to let
the world economy hinge on performance of single
currency, as also ii) to have monitoring mechanism in
place.
• The idea was however rejected.

Smithsonian Agreement
• December 1971: Fall of Bretton Woods
System was imminent. Top 10 nations met.
– It was an attempt to revive Bretton Woods system.
– Dollar was devalued to 38 per ounce of gold, other
currencies were revalued by 10%, and some were
revalued by as much as 16%.
– Fluctuation margin of ±2.25% was allowed instead
of ±1%. (also known as Wider Band), to reduce
pressure on dollar.
– Dollar was devalued another time in 1973.

Failure of Smithsonian Agreement
• It was no more a fixed rate system (adjustable peg
punctuated by sharp revaluation/devaluation)
inasmuch as of 22 major currencies
– 12 devalued by more than 30%,
– 4 were revalued,
– 2 did not change ($ and ¥), and
– 4 were floating.
• Political pressures to regain independence of
monetary policies of nations too was mounting.

Jamaica Agreement – The End of BW
• In 1976 Jamaica Agreement was signed legalising the
floating rate system and demonetisation of gold as currency
of reserves (IMF quota could be paid in foreign currencies).
• Henceforth gold became like any other commodity though
could be termed as Reserve Asset.
• IMF returned 50% of gold reserves to respective nations
and, also sold 1/3rd to aid poor nations completed by 1980.
• The role of IMF changed from regulators of exchange rates
to that of financial institution and global “bank of last
resort”.

EUROPEAN MONETARY SYSTEM
THE BEGINNING OF EURO

‘Snake in the Tunnel’
• Failure of Smithsonian Agreement to revive dollar gave
rise to another system among the trading nations of
EEC.
• Except England all EEC countries joined to have
monetary and exchange rate stability.
– Referred as “Snake in the tunnel” the system proposed
maintaining parity with US dollar and other currencies in the
± 2.25% band as per Bretton Woods,
– but among themselves they decided to maintain ± 1.125%
band, except Italian Lira (± 3%).
– Also devised ECU as “a basket of currency”

Hypothetical Currency: The ECU Basket
• ECU “a basket of currency”: value was determined by 12
currencies with heavy weights to DM, FF and British £
(despite Britain not being a member)
PROPERTIES OF CURRENCY BASKET:
• Changes in the value of a currency w.r.t a basket better indicates the
strength than changes w.r.t one currency.
• When bilateral rates change the weights in the basket also change.
• Appreciation of one currency with respect to all will increase its
weight in the basket.
• Basket tends to follow the stronger currencies.
• Changes in the value of the basket is equal to the proportionate
changes in the bilateral rates.
EMS Intervention Mechanism
• Parity Grid:
– Violation of specified band warrants intervention from central
banks of both the nations. If FF appreciated w.r.t DM beyond the
band of ± 1.125% then France will buy DM and Germany will sell FF
to restore the parity. Both affected countries will intervene
simultaneously, making correction easier, quicker and less painful.
• Divergence Indicator:
– Breaching the band with ECU would imply strengthening or
weakening of one currency w.r.t. to all. Hence the corrective action
will be taken by only one country.
• Failure of repeated interventions will cause realignment. (12 realignments
took place).
• Initially a failure but later succeeded in narrowing the inflation differential
in EEC countries.
Maastrich Treaty 1991
• Objective of single currency and single Central Bank by
1999
Five conditions – ECONOMIC CONVERGENCE
1. Inflation rate must not exceed more than 1.5% of the
best three performing nations.
2. Budget deficit must not exceed 3% of the GDP.
3. Public Debt must not exceed 60% of the GDP.
4. Long term interest rate must not exceed by more
than 2% of the best three performing nations.
5. Should have maintained the exchange rate band for
at least 2 years.

Economic Convergence – 2001 Status

Sweden Rejects Euro
• In a referendum in September 2003 Swedish voted
against joining Euroland.
• Reasons:
1. Budget deficit would force Sweden to cut taxes, Most
Euroland nations had budget deficits.
2. Sweden is budget surplus with high tax rates and elaborate
social security spending; They may have to cut expenditure
on public spending.
3. Swedish economy was perceived stronger than Euroland.
4. Unemployment in Sweden was lesser than Euroland.
5. ECB had higher interest.

Britain’s Dilemma
Reasons against joining:
1. Ceding control over monetary policies and interest rates for
one seat in ECB in Frankfurt.
2. ECB cannot find the right interest rates for the whole
region. Four large economies of Euro; Germany, France,
Spain and Italy are growing at substantially different rates.
3. Britain’s higher deficit than Euroland meant cutting public
expenditure and raising taxes, which were lower than the
levels in Euroland.
4. Unemployment, inflation was lower in Britain than in
Euroland, while growth was higher.
5. Lower taxes in Britain are considered sufficient incentive
for attracting foreign investment.

Britain’s Dilemma
Reasons for joining:
1. Britain is paying high price for isolation by losing trade in
Europe.
2. Foreign investment critical to development is in jeopardy,
as it gets diverted to Euroland for reasons of larger market.
3. British MNCs have to bear higher transaction cost for trade
and exchange rate risks.
4. Trade (50% of total) with Euroland is stagnating while those
in Euroland have seen increasing trade in the Euroland
SHOULD BRITAIN AND SWEDEN JOIN EUROLAND??

Unresolved Issues of “Euro”
• COMMON MONETARY POLICY HARD TO FIND
– Finding common interest rate for region (2% in 2009 currently ??)
consistent with different fiscal policies of different nations is difficult
to find.
– Germany wanted stable prices and lower interest rates, Italy (under
recession) required interest rates close to zero. Booming Spain could
afford higher interest rates at 4% in 2009.
– France needed expansionary monetary policy for reducing
unemployment while Germans believed in contraction.
• Can fiscal policy be independent of monetary policy and vice-
versa??
• Who gets the seigniorage gains??

THANK YOU
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49
EXCHANGE RATE SYSTEMS
Flexible, Fixed and Combinations
Pure Exchange Rate Systems
• Fixed Exchange Rate System: Where the exchange
rates are fixed and determined by governments based
on various factors; they change rather infrequently
with deliberate efforts to guide the direction of change.
Gold Standards, Bretton Woods System were Fixed.
• Flexible Exchange Rate System: Where the exchange
rates are allowed to change as per the market forces
and there is no/little interference by Govt. Market
forces that impact supply and demand of foreign
currency alone determine the exchange rate.

Exchange Rate Regimes - Spectrum
• Popular exchange rate regimes as
classified by IMF are
Pegging
to a Crawling Clean
Dollarisation currency Pegs Float
Currency Pegging to Managed

Board a Basket Float

Exchange Rate Regimes in India
1966: Devaluation of 57.5% with £
Was pegged to £ in Bretton Woods era.
1971: Pegged to $ at Rs. 7.50; Re-pegged to £ with Rs. 18.97 ± 2.25%
1972: £ was floating (Rs. 18.95/ £)
1975: pegged to an undisclosed basket with £ as intervention
currency and ± 2.25%
1979: Band increased to ± 5%, IMF classified under “Managed Float”
category.
1991: Devaluation by 22%
1992: Introduced dual rate (40:60); $ intervention currency
1993: Abolished dual rates and had unified market rate
Almost fully convertible on current account.
Gradually moving towards capital account convertibility.

IMF Classification April 2018
ANCHOR NO ANCHOR
Aggregate/Inflation
Nos. CLASSIFICATION US Dollar Euro Other Composite
Targeting
13 NO SEPARATE LEGAL Panama, Kosovo, Kiribati
TENDER Ecuador, El Montenegro
Salvador
11 CURRENCY BOARDS Hong Kong, Bosnia, Brunei
Grenada, Bulgaria, St
Antigua Lucia
43 CONVENTIONAL PEG Bahrain, Denmark, Bhutan,
UAE, Oman, Congo, Togo, Nepal
Iraq, Jordan, Senegal, Namibia,
Qatar, Saudi Gabon, Mali, Lesotho
Arabia Cameroon
27 STABILISED Guyana, Croatia, N Singapore, Angola, Bolivia,
ARRANGEMENT Maldives, Macedonia Vietnam Ethiopia, Pakistan,
Lebanon Kenya, Egypt,
Indonesia
3 CRAWLING PEG Honduras Botswana
IMF Classification April 2018
ANCHOR NO ANCHOR
Aggregate/Inflation
Nos. CLASSIFICATION US Dollar Euro Other Composite
Targeting
15 CRAWLING LIKE Iran Afghanistan,
ARRANGEMENT Bangladesh, China,
Serbia, Sri Lanka, PNG,
Tunisia
1 PEGGING WITH Tonga
HORIZONTAL BAND
13 OTHER MANAGED Cambodia, Syria Sudan, Venezuela
ARRANGEMENT Zimbabwe
35 FLOATING Argentina, Brazil, Czech Rep, Israel, India, Korea, NZ, Switzerland, Thailand,
Turkey, Ukraine, Malaysia
31 FREELY FLOATING Australia, Japan, UK, USA, Mexico, Sweden, Norway, Russia, Canada, Euro
Nations

IMF DEFINITIONS
• Conventional Peg: Announced de jure exchange rate with
commitment for direct intervention.
• Stabilised: Not floating but maintain ± 2% margin for at least 6
months.
• Crawling: Adjusted in small amounts periodically with a
quantitative indicator e.g. inflation differential.
• Crawling Like: Same as Crawling; Within ± 2% margin for at
least 6 months.
• Floating: No predictable path is ascertainable, and stability is not
maintained officially.
• Freely Floating: Intervention limited to less than 3 in 6 months’
time with no intervention lasting for more than 3 days.
Dollarisation
• Dollarisation means adoption of currency of other nation as
official/legal tender, having no currency of its own.
• Few small countries such as Panama, El Salvador have done
so officially while some had to do so due to economic
necessity.
• Dollarisation means that the nation does not have any
monetary policy as the supply of the currency cannot be
controlled by them. (Zimbabwe)
• The inflation rate in such a nation would necessarily be same
as that of currency adopted.

Dollarisation
Advantages Disadvantages
• No administrative expenses (suits • Forfeiture of monetary
small and poor nations) freedom,
• Sound financial sector as complete • No lender of last resort
integration with financial system of • POLITICAL : Loss of
the currency adopted. national identity
• Reduction in interest rates, low • No source of state
inflation rate, and more fiscal revenue
responsibilities

Pegging - Features
As per IMF pegging is defined as:
• The country pegs its currency at a fixed rate to another
currency or a basket of currencies.
• No commitment to keep the parity irrevocably and exchange
rate may fluctuate within narrow margins of less than ±1
percent around a central value.
• The monetary authority stands ready to maintain the fixed
parity through direct intervention.
• Flexibility of monetary policy, though limited, is greater than
in the case of currency boards.

Pegging - Features
• Under pegging the nation fixes the value of its currency
to another or a basket of currencies.
• The anchor is chosen based on proportion of trade
denominated in that currency.
• The value remains fixed with respect to anchor
currency only while it changes by the same amount as
the anchor currency appreciates/depreciates.
• Large number of nations have adopted such pegging
either to US dollar or euro.

Pegging - Features
• Though nation has independent monetary policy under
pegging but for the system to succeed and be effective
it must align interest rate to that prevailing in anchor
currency and/or control the foreign capital flows.
• Failure to adhere to the monetary discipline under
pegged exchange rate system is attributed as the cause
of several currency crises such as Asian currency crisis
and Mexican peso crisis.

PEGGING
MEXICAN PESO CRISIS

Mexican Peso Crisis – Just Before it
Began
• Mexico signed NAFTA on 1 Jan 1994 generating lots of
confidence amongst already enthused international
investors.
• Mexico had received about $ 45 billion as foreign
capital during 1990-93 as a result of growing investors’
confidence, and falling interest rates in USA.
• With strong capital inflows, consumption and GDP had
been on the growing path.

Mexican Peso Crisis
• Banco de Mexico (Mexican Central Bank) provided support to
maintain overvalued peso by frequent interventions (selling US
dollar).
• Supply of US dollars was provided by issue of ST securities
denominated in US dollar, called “tesobonos” that guaranteed
higher fixed returns in US dollar terms than available in USA.
• The central bank used these dollars to buy pesos in foreign
exchange market lifting the value of peso.
– Mexico had large trade deficit as peso was overvalued making
imports cheaper and exports expensive.
– CAD rose from $ 6 billion in 1989 to $ 20 billion in 1992. CAD
became dangerously high at 7% of GDP in 1994.
Causes of Capital Inflows
• Foreign investment, FDI as well as portfolio investments,
was funding the trade deficit.
• Mexico assumed that mounting CAD was not an outcome of
expansionary monetary and fiscal policies (a folly).
• Market forces were confident that overvalued peso could
not be sustained, and ultimately would have to be
devalued.
• Such belief was also adding to capital flight hoarding dollars
now to be sold later. (Peso was a convertible currency).
The Tesobonos
• Mexico's central bank deviated from standard central
banking policy.
• It pegged peso to the dollar in 1988.
• Instead of allowing its monetary base to contract and its
interest rates to rise, the central bank purchased treasury bills
to prop up its monetary base, and prevent rise in interest
rates.
• Servicing the tesobonos (Mexican securities issued in US
dollar) with US dollar repayments further drew down the
central bank's foreign exchange reserves.

Political Chaos
• New government after elections came to power on 1
Dec 1994.
• 20 Dec 1994 substantial downward pressure on peso
caused devaluation by 13-15% despite earlier promises
by political classes not to do so. Stock prices
plummeted.
• Investors became sceptical of government, FIIs sold
shares, converted to dollars anticipating further
devaluation.

Pegging to Float
• Only 2 days later, 22 Dec: Mexico allowed peso to float
and it declined further by 15%.
• US $ 4.6 b leaves the country in two days (50% of FE
Reserves).
• As pesos were converted to dollar reducing supply of
pesos, government feared increase in interest rates.
They put back these pesos by redeeming T - Bills.

The Trap
• As ST securities issued in dollar matured for payment, Govt used
pesos to obtain dollar to repay, increasing supply of peso. Dollar
reserves sank by 50% in a single day.
• When the time came for Mexico to roll over its maturing dollar
debt obligations, few investors were interested in purchasing new
debt.
• To repay tesobonos, the central bank had little choice but to
purchase dollars with its severely weakened pesos, which proved
extremely expensive.
• The Mexican government faced an imminent sovereign default.
Tequila Effect
• The value of the Mexican peso depreciated roughly 50%
from 3.4 MXN/USD to 7.2 MXN, recovering to 5.8
MXN/USD four months later.
• Prices in Mexico rose by 24% over the same four months,
and by the end of 1995 Mexico's hyperinflation had
reached 52%, due to heavy and unchecked supply of
pesos.
• The impact of Mexico's crisis on the Southern
Cone and Brazil became known as the "Tequila effect”.

Peso Crisis – Major Causes
POLITICAL INSTABILITY
• Assassinations of precedential candidate Mr Colosiso and
many others caused political instability raising risk premium.
PEGGING
• Mexico pegged its currency peso to US dollar with a rather
small band, and frequent interventions aimed at keeping the
peso value higher. Foreign inflows too had been contributing
to the raised value of peso.
CAD
• Current account deficit was rising (as imports were cheaper)
rapidly indicating that peso overvaluation was unsustainable.
The crisis was considered to have been ignited by devaluation
and capital flight.

The Bail-Out
• To mitigate the spread of investors' lack of confidence in the United States
coordinated a $50 billion bail-out package in January 1995 aimed at
alleviating its growing risk premia and boosting investor confidence. Of the
$50 billion,
– $20 billion was contributed by the United States,
– $18 billion by the IMF,
– $10 billion by the BIS,
– $1 billion by a consortium of Latin American nations, and
– $1 billion by Canada.
• The bail-out required the Mexican government to institute
new monetary and fiscal policy controls, although the country refrained
from balance of payments reforms such as trade protectionism and
strict capital controls to avoid violating its commitments under NAFTA.

The Impact
• The Mexican economy faced a severe inflation and the peso's value
deteriorated substantially despite the bail-out's package in preventing a
worse collapse.
– GDP declined by 6.9% in 1995.
– Hyperinflation to in excess of 50%.
– Real wages plummeted and unemployment nearly doubled.
– Unemployment climbed to 7.4% in 1995 from its pre-crisis level of 3.9%
in 1994.
– Mexico's extreme poverty grew to 37% in 1996 from 21% in 1994,
undoing the previous ten years of successful poverty reduction
initiatives.
– Overall household incomes plummeted by 30% in the same year.

PEGGING
ASIAN CURRENCY CRISIS

Thailand – The East Asian Tiger
• July 1997: Started with Thailand when Baht was suddenly
devalued by 17%.
• Fastest growing economy, characterised by
– high spending,
– low savings,
– literate and skilled work force.
• Upward pressure on prices of real estate, stocks.
• Thai baht was linked/pegged to US dollar.
• High interest rates and pegging were attractive.
• During 1996 the inflow to the region (Thailand, Malaysia,
Indonesia, Korea & Philippines) was $ 93 b.
Excessive Inflows - Crony Capitalism
• Large inflow of foreign funds resulted in careless and
excessive lending, especially to real estate developers.
(crony capitalism)
• Large inflow of funds also makes country susceptible to
large outflows if investors lose confidence.
• Large inflow of funds should have caused decrease in
interest rates but did not because demand for loans too
was high.
• Thai Govt too was also borrowing heavily to improve
infrastructure, and financing the fiscal deficit.

Intervention through Swap
• Thai Govt. intervened to offset the sale of baht by FIs, FX
reserves depleted to a level to force de-pegging of baht.
• Later intervention came by swapping its baht reserves for dollar
reserves at other central banks and then using these dollars to
buy baht.
• The swap arrangement required replacement of swapped dollars
at future date. Market forces overwhelmed making Govt’s effort
ineffective.
• Central Bank used US $ 20 b to support baht. With depreciation
the loan defaults exceeded $ 30 b.
• Borrowing in other currencies though at lower interest became
expensive due to depreciation.

Pegging and Export Competitiveness
• Stronger yen had made Japanese exports expensive and
caused Japanese firms to set up production facilities in
SE Asia.
REDUCTION IN EXPORT COMPETITIVENESS:
• When US dollar appreciated against yen, DM etc.,
pegging of baht to dollar made Thai exports expensive
and imports attractive.
• Also, yuan depreciation by > 20% increased export
competitiveness of China, hitting SE Asian economies,
leaving production capacities in Thailand under-utilised.

Credit Boom to Credit Crunch
• Thai baht was potentially weak, investors withdrew funds
converting bahts to their home currencies, as they estimated
that devaluation was inevitable.
• Large scale sale of baht to buy of dollar resulted in delinking
of baht on July 2, 1997.
• Lenders did not renew dollar loans and pressed their claims.
The value of collaterals declined as real estate prices and
stock prices fell.
• Credit boom turned into credit crunch.
• Borrowers of dollar defaulted, and those wanting to pay
faced high cost as dollar appreciated, also created high
demand for dollar.

The Contagion Effect
• The spread to other countries took place due to strong
trade links, and financial similarities among 5 nations
• Investors started withdrawing funds from other Southeast
Asian nations too. Each of these nations had to abandon
pegging and let their currencies float.
• Direct interventions by respective central banks resulted in
weakened position of FX reserves only.
• Indirect intervention to raise interest rates to prevent
outflow of foreign funds too did not work.
Rupiah, Won, Baht, and Ringgit fell by 80%, 50% 45%, and
40% respectively.
The Bail-Out
• IMF bail-out package was $ 118 billion, criticised for
“privatising profit and socialising losses”. Japan
contributed significantly

Impossible Trinity
Pegged
Exchange
Rate
CANNOT
CO-EXIST
Independent
Free Flow of
Monetary
Capital
Policy

Impossible Trinity
Lessons for Pegging
• Impossible trinity says that all three of
1. pegged exchange rate,
2. independent monetary policy, and
3. free flow of capital
cannot exist simultaneously,
• While any two of them can be followed.

Currency Board
• Country has its own currency but its issuance is
completely backed by foreign exchange reserves.
• Governments have only fiscal tools to adjust to achieve
their growth and developmental plans.
• Currency boards are characterised by
a) anchor currency,
b) full convertibility at fixed pre-determined exchange rate,
c) absence of capital control measures,
d) 100% back up of reserves in anchor currency, and
e) absence of monetary policy (interest rate is aligned with
anchor).
Currency Board - Argentina Crisis
• 50 years of economic mismanagement of high spending financed by
monetary expansion, the country faced hyper inflation (>3000% in 1989)
1991: Measures taken
1. Austral 10,000 = 1 $ (fixed);
Later 1 peso = Austral 10,000 = US $ 1
2. Money supply had to be backed by 100% Forex Reserves and Gold.
– If govt required to sell $ it must buy back the equivalent local
currency by OMO. Money supply shrank.
– Locked monetary policy to that of USA (US Inflation was 4% then)
– Pegging Austral to $ coupled with straight-jacket monetary policy
contained inflation; fell to 170% in 1991 and to 4% in 1994 (similar
to that of USA)
RESTORED CONFIDENCE, REVERSED CAPITAL FLIGHT, INCREASED
INVESTMENT.

Managed Float or Dirty Float
• Briefly describe by IMF a managed float is an attempt to
influence the exchange rate without having a specific
exchange rate path or target.
• Indicators for managing the rate are broadly judgmental
(e.g., balance of payments position, international reserves,
parallel market developments etc), and adjustments may
not be automatic.
• Intervention may be direct or indirect.
• Currently IMF categorises India under “Floating
Arrangement”, after a long stint under “Managed Float”.

Managed Float or Dirty Float
Managed float is different in following two aspects:
– There is neither a declared or a pre-announced exchange
rate of pegging or policy for the crawl nor a band, and
– The band under managed float is also usually much larger
than what is associated with pegging or crawling peg.
– The band remains confidential so as to avoid speculation.
– The usual bands in pegging or crawling peg is ±1% around
central rate.

Operating Managed Float
• Managed float is characterised by intervention by central
bank with the objective of influencing the exchange rate.
• Intervention can be
– Direct : buying or selling of foreign currency in the foreign
exchange market, i.e. selling foreign currency to lift the
value of local currency and buying the foreign currency to
lift the value of foreign currency to aid exports, or
– Indirect : influencing interest rates to affect the desired
changes in the exchange rate, or imposing/relaxing capital
controls.

MANAGED FLOAT
Exchange
Rate SUPPLY S’
(Rs./$) DEMAND D’
P1
SUPPLY S
DEMAND D
P0
Q2 Q0 Q1 Q3 Quantity (Nos. of $)
QUANTITY OF $ SUPPLIED BY RBI = Q3 – Q2
Rajiv Srivastava International Financial Management 40
Benefits – Managed Float
Prevent speculative attacks
• The central bank can defend if any speculative attacks in the
exchange rate are made
Smoothen the exchange rate changes
• Without declaring the optimum level, the exporters and
importers can be assured a level of exchange rate and its
directional changes.
Preserve FE Reserves
• Since there is no committed exchange rate or path an no undue
pressure is created in maintaining adequate foreign exchange
reserves level.

Sterilised Intervention
• Intervention in foreign currency markets inadvertently affects
domestic money supply.
• If central bank buys foreign currency to lift its value with the
intention of promoting exports, it would imply infusing local
money supply causing inflation.
• Sterilised intervention
– Inflationary conditions → Need to mop up the increased
supply of domestic currency → Issue the government
securities (called open market operations) → Get back the
additional domestic currency equal to the amount released by
intervention

Sterilised Intervention
• Similarly, if central bank sells foreign currency to
reduce its value with the intention of promoting
growth and capital expenditure, it would imply
mopping local money supply causing deflation.
• Sterilised intervention
– Deflationary conditions → Need to increase supply
of domestic currency → Redeem the government
securities → Infuse back the domestic currency
equal to the amount mopped up by intervention

Advantages – Fixed Exchange Rates
Nations that pursue fixed exchange rate policy perceive
following advantages:
– Increased international trade,
– Convergence of economic policies,
– Controlling inflation (to the anchor),
– Reduced volatility of exchange rate, etc

Advantages - Flexible Exchange Rates
• The adjustment process in flexible rate is continuous one as
the gradual decline/rise in value of the currency takes place.
Under fixed system changes are large and abrupt.
• Better liquidity: No need to have FX reserves for the Central
Banks (RBI) in order to intervene; thereby the problem of
insufficient liquidity does not arise.
• Benefits of free trade: With fixed exchange rate system the
current account deficit (CAD) is corrected by imposition of
tariff and restrictions on free trade. Flexible rates avoid such
regulatory measures and save monitoring costs thereof. Also
allow gains from free trade.

Disadvantages – Flexible Rates
• Cause uncertainty & inhibit international trade and
investment:
– Are fixed rates really fixed (When they change, it is dramatic)
and are flexible rates really volatile (though flexible but have not
changed much)?
– Hedging alternatives of forwards, futures and options are
available.
• Flexible rates will not work for small economies:
– Nations that are small and do not produce all but import most
commodities can not have depreciation taking place as it will
reduce real income of the public.

Fixed Exchange Rate System
• Fixed exchange rate system forces the nations to follow
same economic policies as that of its major trading
partners.
• Avoiding PESO problem: In 1980s Mexico maintained a
fixed rate with US $ and in order to prevent the capital
flow out of the country. Mexico maintained very high
rates of interest. This stifled investment and
employment opportunities. It only delayed the
eventual devaluation of peso. If flexible rates were
there, the change would have been smoother allowing
economy to adjust to small changes.
Fixed Exchange Rate System
Importing Inflation
• If USA follows expansionary policy  Increased money supply 
Increase prices of US goods  US interest rates will also come
down in short run  Deficit in USA as well as deterioration on
capital account  Deficit in USA implies surplus in Canada 
Can $ will start appreciating  Bank of Canada needs to sell Can
$ and buy US $ to offset the pressure of appreciation of the Can.
$  increased supply of Canadian money (IMPORTING
INFLATION)
• If flexible rates prevailed the Canadian dollar would appreciate
and US dollar depreciate; It will lead to correction of BOP surplus
of Canada making exports more expensive and imports cheaper.

Importing Inflation
USA expands money supply; Prices of US goods rise
USA exports become expensive and

imports attractive
BOP deficit in USA and BOP

Fixed surplus in Canada Floating
Bank of Canada buys US dollars Canadian dollar appreciates

to maintain exchange rate and US dollar depreciates
Canadian imports become

Results in increased money
cheaper and exports expensive
supply of Canadian dollars;
correcting the BOP surplus
Inflation is imported from USA
Clean or Free Float
• In the terminology of IMF it is described as
independently floating. It does assign some role for the
central bank. It describes independently floating as
“Exchange rate is market-determined, with any official
foreign exchange market intervention aimed at
moderating the rate of change and preventing undue
fluctuations in the exchange rate, rather than at
establishing a level for it.”

Choosing Exchange Rate System
Selection of exchange rate regimes depends on many
macroeconomic factors such as
– Need to pursue sound and credible macroeconomic policies
so as to avoid the build-up of major macro imbalances.
– Improve the flexibility of their products and factor markets to
cope with shocks arising from the volatility of currency
markets.
– Develop and strengthen the financial systems in order to
enhance resilience to shocks. This warrants a sound and
efficient banking system together with deep and liquid
capital markets.

Choosing Exchange Rate System
• Efficient intermediation of financial flows and
minimising unsound lending practices that lead to the
build-up of excessive leveraging in the corporate sector
and exposure to foreign currency borrowings.
• Build regulatory and supervisory capabilities to keep
pace with financial innovations and the emergence of
new financial institutions’ activities, and new products
and services, which have complicated the conduct of
exchange rate policy.
• Promote greater disclosures and transparency.

THANK YOU
rms1234@gmail.com
54
FOREIGN EXCHANGE
MARKETS AND RATES
FE Markets and Participants
• Foreign Exchange market permits transfer of purchasing power
denominated in different currencies. Currencies are bought and
sold against each other.
• US $, Euro, Japanese Yen account for over half the volume of FE
transactions worldwide.
• Biggest market: As per BIS estimated daily turnover $ 1.5 trillion
(April 2000), $ 4 trillion (April 2010), $ 5.1 trillion (April 2016) : $
6.59 trillion (April 2019) PARTICIPANTS
– Large Commercial Banks through their dealers acting on behalf of their
clients engaged in exports and/or imports.
– Central Banks of various countries to execute Government orders to
influence the market within certain range.
– Individual brokers and corporate bodies

FE Markets Volumes APRIL 2019
BIS Triennial Survey Report
FX Market Turnover (USD billions/day)
3,500
3,202
3,000
TOTAL:
2,500 USD 6.590 billion/day
1,987
2,000
1,500
999
1,000
500 294
108
-
Spot Outright Forwards FX Swaps Currency Swaps Options

Currencywise Distribution of FX Turnover, %
100.0
88.3 Base: 200
90.0
CNY Ranked 8
80.0 INR Ranked 16
70.0
60.0
50.0
40.0 32.3
30.0
20.0 16.8
12.8
10.0 4.3 1.7
-
USD EUR JPY GBP CNY INR

Location Wise Distribution of INR Turnover,
USD billion/day
50.0 46.8
45.0
40.0
34.5
35.0
30.0
25.0
20.0 18.0
15.0
15.0 12.0
10.0
5.0
-
London Mumbai Singapore USA Hong Kong

Features of FE Markets
• Operates all the time, unlike domestic market, which closes
business every day and re-opens.
• Major centres: New York, London, Tokyo, Zurich, Frankfurt, Hong
Kong and Singapore.
• Over the Counter Market as no specific single market or organised
exchange exists.
• Communication medium is Telex, Telephone. Banks have dealing
rooms.
• Most transactions are done on SWIFT (Society for Worldwide
Interbank Financial Telecommunication; a non-profit Belgian
Cooperative having communication lines around the world)
• About 60% of the FE trades involve US $.

Features of FE Markets
• Inter-bank and retail market: 85-90% market is inter-
bank market
• International Standard Org: developed a 3 letter
abbreviation for each currency e.g. USD, EUR, CHF, JPY,
AED, INR, ZAR, CNY
• UCP 600: Standardised terminology
• Market makers vs. Brokers: Forex rates are market
makers rates.
• Quotes in PIPs for Inter-bank transactions, full quote in
the retail markets
Features of Indian FE Markets
• From Jan 2020 RBI has allowed Category I FX ADs to offer
FX rates round-the-clock for effective hedging and
reducing attractiveness of offshore markets.
• FX transactions can be done through Authorised Dealers
Category I: All kinds of capital and current account transactions
Category II: Only current account transactions
Category III: Only for specific product (factoring etc.)
Category IV: Only money changing
• Exporters must realise payment within 9 months

• Importers must pay for import within 6 months.
INTERNATIONAL FINANCE sRAJIV SRIVASTAVAoo 8
Types of Rates
• Spot vs. Forward
– SPOT: Rate for immediate delivery (in two business days)
– FORWARD: Rate for delivery on future date.
• American vs. European
– AMERICAN: Nos. of US $ per unit of foreign currency
– EUROPEAN: Nos. of foreign currency units per US $; prevalent
except for UK Pound.
• Bid vs. Ask
– BID:Rate at which bank buys foreign currency.
– ASK:Rate at which bank sells foreign currency.

Direct and Indirect Rates
• Direct vs. Indirect
– DIRECT: Number of units of home currency per unit of
foreign currency. Rs. 63.50 per $ in India, US $ 1.022 per Euro
in USA.
– Effective August, 1993 all quotations in India are Direct.
– INDIRECT: Number of units of Foreign Currency per unit of
home currency. US $ 1.41 per Rs. 100 in India, US $ 1.21 per
UK Pound in England.
– England, and now Euro follows Indirect Quote.
• Few currencies like Indonesian Rupiah, Japanese Yen, are quoted
for 100 units. Members of Asian Clearing Union are also quoted
for 100 units of their currency.
Cross Rates
• Bulk of trading in convertible currencies like Euro Yen,
Pound, takes place against US$. If yens is to be traded
against euros then a cross rate base on yen dollar rate
and euro dollar rate will be worked out.
• In n convertible currencies are to be traded the nos. of
quote required are n(n-1)/2, while use of a vehicle
currency and mechanism of cross rates reduce the nos.
of quotations to (n-1).

Value Date
• The date on which the money is ACCOUNTED FOR paid
is known as Value date. Used when there are chances
of variation in value due to timing.
– Spot: Settlement two business days from transaction.
– Cash rate: Settlement on the same date
– TOM rate: Settlement on next day.
– Forward rates are given in whole number of months and
value date is arrived at by adding same number of calendar
months to the value date of spot transaction. For 1-m
Forward transactions the value date is determined by adding
one month to the value date of spot transaction of the same
date.
INTERNATIONAL FINANCE 12
Forward Contract
• Forward Contract is a contract to buy or sell an
asset (currency) at a future date at a price
determined/negotiated today.
• The actual transaction (exchange of asset with
cash) will take place at agreed date.
Examples:
• The export proceeds of say US $ 10,000 receivable after 6
months can be sold today at a price quoted today.
• An importer can buy Euro today that is payable by him after 3
months at a price quoted today.

Swap Points
• A combination of SPOT and FORWARD contracts such
that they offset the quantity of asset bought and sold is
known as SWAP.
• Spot Purchase with Forward Sell, and
• Spot Sale with Forward Buy.
• Forward Contracts without accompanying SPOT deals
are “Outright Forwards”.
• SWAP quotes are given as points e.g.
SPOT ($ - Euro) 1.1265 - 1.1275;
1m SWAP 15/8

Swap and Forward Deals
SWAP quotes are given as points e.g.
SPOT ($ - Euro) 1.1265 - 1.1275;
1m SWAP 15/8
 To arrive at outright forward rates swap points are added or
subtracted depending upon premium or discount on the
currency. If SWAP points
Low/High: Add to Spot Rates
High/Low: Subtract from the Spot Rates
ASK rate must always be greater than BID rate
As one goes into the future the ASK - BID Spread must increase
• SWAP DEALS ARE ALWAYS CHEAPER THAN SPOT AND
OUTRIGHT FORWARD DEAL

Why Swaps
• Why SWAP: It is always difficult to find a matching opposite
position, while SWAP can do this by having offsetting
positions.
• Interbank deals are normally SWAPS, while deals for
customers are ‘Outright’.
– Bank buys 1m-forward dollar from an exporter outright,
but in the interbank market bank may do as follows:
• Enter a SWAP where it sells $ 1 m forward and buys
spot
• Sell $ spot to offset the long position

Merchant Rates
• Merchant rates are the rates quoted by banks to their clients.
• They are derived from inter-bank markets.
• These rate (known as card rates) do not change over a day
unless merchant transactions are large enough.
• Normally transactions of the bank with merchants are
covered in the inter-bank market i.e.
– If it buys foreign currency from the exporter it sells in the
inter-bank market, and
– If it sells foreign currency to the importer it buys the
same in the inter-bank market.
– The rate at which bank covers the transaction in the
inter-bank market becomes the base rate for arriving at
merchant rate.

Merchant Rates
• Since banks would cover their position in the inter-bank
market, where the lot size is large.
• Merchant transaction is normally small, the bank has to wait
for other customers to make the lot size, by which time the
exchange rate may move adversely.
• To cover the risk of adverse price movement in the inter-bank
market banks add margin to the BASE Rate.
• The margins over the base rate depends upon a) value of
merchant transaction, b) relationship with the customer, c)
trends in the market etc.
– for buying rate the profit margins are deducted, and
– for selling rates the margins are added.

Merchant Rates
• TT Buying Rate
 Base Rate – Exchange Margin
• Bill Buying Rate
 Base rate buy – Forward discount for transit plus usance
plus forward period (r/o higher month) less Exchange
margin; or
 Base rate buy + Forward premium for transit + usance
plus forward period (r/0 lower month) less exchange
margin
• TT Selling Rate
 Base Rate (spot sell) + Exchange Margin
• Bill Selling Rate
 Base rate TT Selling Rate + Exchange Margin
TT Merchant Rate - Example
• Inter-bank spot rate Rs/$ 65.2525 – 65.2600
TT Buying Rate TT Selling Rate
Spot bid rate 65.2525 Spot ask rate 65.2600
Less: Adjustment 0.0600 Add: Adjustment 0.0800
margin (ad-hoc) margin (ad-hoc)
Base Rate 65.1925 Base Rate 65.3400
Less: Exchange 0.0652 Add: Exchange 0.0980
margin (0.10%) margin (0.15%
TT Buying Rate 65.1273 TT Selling Rate 65.4380
65.12 (r/o) 65.44 (r/o)
Bill Merchant Rate - Example
• Inter-bank spot rate Rs/$ 65.2525 – 65.2600
• Swap points 3-m 75/125
Bill Buying Rate
Spot bid rate 65.2525
Less: Adjustment margin (ad-hoc) 0.0600
Base Rate 65.1925
Add: Swap points 0.0075
Outright forward 65.2000
Less: Exchange margin (0.10%) 0.0652
TT Buying Rate 65.1348 65.13 (r/o)
Traveller Cheques and Currency
BUYING SELLING
Interbank spot bid Interbank ask rate
LESS: Adjustment Margin ADD: Adjustment Margin
to get base rate to get base rate
LESS: Exchange margin ADD: Exchange margin
to get TT rate to get TT rate
Add: premium/deduct discount for Add: premium/deduct discount for
1-m 1-m
LESS: Commission to get TC rate ADD: Commission to get TC rate
LESS: Margin for handling cash ADD: Margin for handling cash
Currency note buying rate Currency note selling rate
PARITY RELATIONSHIPS
Absolute PPP, Relative PPP, IRP,
Fisher Effect, International Fisher Effect
Arbitrage
• Arbitrage is profit derived without taking any risks. (due to
different rates in different places)
Bid Ask
Trader A in HK (per $) HK $ 7.7500 7.7550
Trader B in NY (per HK $) US $ 0.1286 0.1287
Convert one of them to indirect quote
• For Trader B (per $) HK $ 7.7700 7.7760
– A customer buys US $ 10,000 from Trader A in Hong Kong by
paying HK $ 77,550.
– These US $ 10,000 are sold at HK $ 7.7700 per $ to get HK $
77,700 from Trader B in New York
– Earns a profit of HK $ 150 without any risk.
No Arbitrage Condition
• Banks/Dealer operate on the basis of BUY LOW & SELL HIGH
• Clients and arbitrageurs also operate on the same principle
for profit. This implies that the Ask Rate at one place/dealer
must be lower than the Bid Rate at another place/dealer. For
arbitrage to exist Bid of one must exceed Ask of another.
Bid 1 Ask 1 Bid 2 Ask2
ARBITRAGE
Bid 1 Bid 2 Ask 1 Ask2
NO ARBITRAGE

Cross Rates
Bid Ask
• A dealer in London offers
– Japanese Yen (JY)/$ 110.25 111.10
– Singapore $ (S$)/$ 1.6520 1.6530
• A dealer in Tokyo offers
– Japanese Yen (JY/SG) 68.30 68.50
FIND BID AND ASK RATES OF JAPANESE YENS PER

SINGAPORE DOLLAR

Chain Rule – Cross Rates
• Cross multiply the rates of Japanese Yen to $ and
Singapore $ to US $ to obtain Yen to Singapore $ rate
Bid (Yen/S$) =
Bid (Yen/$)/Ask (S$/$)= 66.6969 Y/S$
Ask (Yen/S$) =
Ask (Yen/$)/Bid (S$/$)= 67.2518 Y/S$
• The cross rates in London and the rates in Tokyo offer
arbitrage opportunities as Bid in Tokyo is higher than
Ask in London.

Law of One Price
• In competitive markets characterised by
– numerous buyers and sellers
– With free access to information
– no barriers to trade
– nominal or zero transaction cost, and
– rationale behaviour.
• Only one price must prevail. If not so, the arbitrageurs will
force different markets to converge through buying in
cheaper market at a lower price and selling in expensive
market at a higher price.

Purchasing Power Parity (PPP)
• Attributed to Swedish Economist Gustav Cassel;
• The cost of a common basket of goods must cost same in
different countries, and therefore they will determine the
exchange rate of two currencies.
• If a basket of goods in India costs Rs 6,000 and the same
basket of goods costs $ 100, then the exchange rate
should be Rs 60 per $.
• If the basket of goods in India can be purchased at a price
of less than Rs 60 (say Rs 58) then arbitrageurs will buy
goods in India, sell in USA for $ 1, convert to Rs 60 making
a profit of Rs 2.
• Hence the law of one price forms the basis of PPP.
PPP Exchange Rate
Price of common basket of goods at home
Spot Exchange Rate 
Price of common basket of goods abroad
• Each country has price index, and the ratio of the price
indices can be used to determine the spot exchange rate.
ASSUMPTIONS
• Based on the concept that demand for a country’s
currency is determined by the demand and supply factors
related to the goods produced by that country.
• Exchange rates will adjust to keep the purchasing power
constant.
• Arbitrage of goods and commodities will force the prices
to be equal across international borders.
PPP - Limitations
• Definition of basket of goods, weights in indices
• Relative utility of goods in different countries
• Difference in styling
• Quality differences
• Transportation cost
• Trade restrictions
• Tariff barriers
• Exchange controls
• Non tradable goods (land, construction, services like
transportation, consultancy etc)

PPP Expectations
• With the switch over from Fixed (Gold Standard & Bretton
Woods) to Flexible Exchange Rate System, it was expected
that changes in exchange rate will follow inflation rates, as
per PPP. It did not happen for variety of reasons.

Validity of PPP
• Prices changes are slow and trading based on prices is
slower. The changes in exchange rates have been very
frequent, large and persistent, which is not the pattern of
inflation rates.
– For developed nations about 50% of GNP comes from
non-traded goods not subject to arbitrage.
– Purchasing powers of currencies in different countries
are different.
– Exchange rates respond to factors other than goods
arbitrage, (Price levels in different countries), like
interest rates and portfolio considerations for return
on investment.
PPP – Absolute and Relative Versions
• Absolute form of PPP is relationship between the average
price levels and the expected equilibrium exchange rates.
– Nominal exchange rate at any point of time is ratio of
relative prices for a representative basket of goods.
– Inflation rates derive the exchange rates; Differences in
exchange rates are governed by inflation rates.
• Relative form of PPP deals with the percent change in the
spot rates over a period rather than absolute spot rates at
any given point of time.
• Absolute PPP may not hold for several reasons; yet
Relative PPP may still hold.
Relative PPP
• Let the actual exchange rate is not same as given by PPP.
Instead of Rs 60/$ the rate is Rs 65.
• If the rate of inflation in India is 10% the same basket of
goods in India will now cost Rs 6,600, while with 2%
inflation rate in USA the same basket would cost $ 102.
P1d  P0d ( 1  Id ); P1f  P0f ( 1  I f )
P1d P0d ( 1  Id ) ( 1  Id )
S1  f  f  S0
P1 P0 ( 1  I f ) (1  I f )
S1  S0 Id  I f
% change in spot rate  
S0 1  If
Relative PPP
• Even though actual exchange rate may deviate from
Absolute PPP, the
– Changes in relative price levels will determine the
appreciation/depreciation of exchange rate.
– Country/currency with higher inflation will witness depreciation
by an amount almost equal to the inflation rate differential.
– Relative PPP is based on tradable goods only.
– Non tradable goods and capital account transactions are ignored.
If price indices of only internationally traded good are chosen
then only Relative PPP may hold very accurately.

Interest Rate Parity (IRP)
• Like changes in the exchange rate can be explained by
Relative Purchasing Power Parity, interest rate
differential of two countries can explain the difference
in SPOT and FORWARD rates.
• Let the current rate of exchange is Rs 65 per $, and the
interest rates prevalent in India and USA are 10% and
5% respectively.
• Depending upon the forward rate the arbitrageurs will
work the following way:

Arbitrage - Spot and Forward Markets
If 6m forward rate is Rs 66/$
• Today:
– Borrow $1 at 5% for 6m (Repay: $1.025)
– Convert it into rupee at SPOT Rs 65/$
– Invest for 6 months in India
– Buy $ 6 m forward ($1.025 at Rs 66.00/$)
• After 6 months;
– Get Rs 65*(1 + 0.10/2) = Rs 68.25
– Pay Rs 67.65 (1.025 x 66) to buy required $ 1.025
– Pay debt of $ 1.025
– Profit of Rs 0.60 (Rs 68.25 – Rs 67.65)
Arbitrage - Spot and Forward Markets
If 6m forward rate is Rs 67/$, then
• Today:
– Borrow Rs 65 at 10% for 6 m (Repay: Rs 68.25)
– Convert them into $1 at spot rate of Rs 65/$
– Invest the $ in USA market at 5%
– Sell a 6m-forward contract for $1.025 (the maturity value) at Rs 67
• 6 months later:
– Get $ 1.025
– Convert in rupees under forward and get Rs 68.675 (67 x 1.025)
– Pay debt of Rs 68.25
– Profit Rs 0.425 (68.675 – 68.25)
Covered Interest Parity Theorem
• The gains made in the investment must exactly offset the gains
made by speculation in the conversion of currency at different
times.
• In efficient markets investment in either currency must result in
same returns. The investment climate in two countries must
determine the exchange rates over a period of time.
• There will not be any arbitrage opportunity
– If at maturity the liability equals asset.
– If not so it will provide arbitrage opportunity by borrowing in
one currency and investing in another currency.

Forward Premium/Discount
• Approximate IRP can be written as
F S
Forward premium or discount   Rd  R f
S
Assumed: No transaction costs i.e. no bid ask spread, and
No difference in lending and borrowing rates.
It implies that
– Premium/discount on a currency will be equal to the differential
on the interest rates in two countries.
– If interest rates in domestic markets are higher, then domestic
currency will be at discount (F > S).
– Interest rate differential can be used to forecast the
appreciation/depreciation of the currency in short term.
– Forward rates are unbiased indicator of future spot rates.

Interest Rate Parity – Graphical View

Fisher Effect
• Nominal interest rates vary directly with inflation rate.
• Nominal rates of interest express the rate of exchange
between current money and future money.
• Investors value money in terms of purchasing power.
Therefore the returns on investment have to be valued in
terms of how rich one gets after providing for purchasing
power of the time at which the investment was made.
Fisher Effect: (1 + R) = (1 + a) x (1 +I)
Real rates of return are same across borders.
Implies ad = af Or Rd – Rf ≈ Id – If
Nominal interest rate differential must equal inflation differential
International Fisher Effect
• Nominal interest rates reflect expected inflation rates.
• Arbitrage through capital flows would ensure that interest
differential between two countries will be compensated
by future change in the spot rate.
Combining PPP and Fisher Effect
• Expected return from investing at home must equal that
of investing abroad.
• Interest rates provide relationship between spot rates and
future spot rates.

Assumptions of Parities
• Financial assets in different countries are perfect
substitute. (No difference in quality of financial assets of
various nations).
• No restriction on capital flows across nations i.e. full
capital account convertibility with no end-use restrictions.
• Uniform taxes and tax credits passed for parent investors
in their countries.

Forecasting Exchange Rates
Forecast in
changes of spot
rates
Forward Rates as unbiased Relative Purchasing
Predictor of Spot rates Power Parity
Forward premium International Difference in

or discount Fisher Effect inflation rates
Interest Fisher
Rate Parity Difference in Effect
nominal interest
rates

EXPOSURES (RISKS) IN
FOREIGN CURRENCY
Transaction, Translation
and Economic Exposures
Kinds of Exposures
• Exchange rates change continuously which affects
performance of multinational corporations.
• Risk emanating from changes in exchange rates is referred
as exposures.
• Impact of changing exchange rates in the income
statement, values of assets and liabilities or business
outlook are of three distinct types:
• Translation Exposure
• Transaction Exposure
• Economic Exposure

Exposures Defined
Translation Transaction Economic
Exposure Exposure Exposure
Changes in the Changes in the
Changes in the
income amount of
amount of
statement, and future cash
future cash
values of flows, for
flows
assets and contracts
determined by
liabilities; entered in
future
denominated foreign
competitive
in foreign currency but
position.
currency not settled

Features of Exposures
Translation Transaction Economic
Exposure Exposure Exposure
Real
Real
Notional Retrospective
Prospective;
Retrospective as well as
prospective Concerns
Concerns
both local
only foreign Concerns only
and foreign
currency foreign
currency
currency

Managing Exposures
• Of the three exposures transaction exposure is most
important because
– It impacts the immediate cash flows,
– Translation exposure is notional and not real, and
– Economic exposure has long term implications and deals with
rather uncertain future affecting one and all and not one.
• Objectives are not well defined:
– “Eliminate all exchange rate risks”: Shall we do business in
foreign countries in foreign currencies.
• Managing translation and economic exposure create
transaction exposure.
Managing Transaction Exposure
Tactical Strategic
Forward
Hedge Invoicing
Money
Market Risk Sharing
Hedge
Futures Exposure
Hedge Netting
Options Leading and

Hedge Lagging

Forward Hedge
Selective Hedging: Because hedging has cost.
Account Receivable:
• Depreciating local currency (Appreciating foreign currency);
DO NOT HEDGE
• Appreciating local currency (Depreciating foreign currency);
SELL FORWARD
Account Payable:
• Depreciating local currency (Appreciating foreign currency);
BUY FORWARD
• Appreciating local currency (Depreciating foreign currency);
DO NOT HEDGE
Forward Hedge – Account Receivable
INFOSYS expects to receive US $ 10 M after 6 months.
Spot rate: Rs 65/$; 6-m Forward Rate: Rs 63/$
(Indicates depreciating US dollar/appreciating rupee)
Hedging Decision:
– Hedge only if future spot rate is expected to be lower than
the forward rate of Rs 63/$.
If yes:
– Sell $ 10 M forward at Rs 63,
– INFOSYS realises Rs 630 M after 6 months; irrespective of
future spot rate.
– INFOSYS realises a fixed rate that is known today.
Forward Hedge – Account Payable
TISCO needs to pay US $ 10 M after 6 months.
Spot rate: Rs 65/$; 6-m Forward Rate: Rs 67/$
(Indicates depreciating rupee/appreciating US dollar)
Hedging Decision:
– Hedge only if future spot rate is expected to be higher
than the forward rate of Rs 67/$.
If yes:
– Buy $ 10 M forward at Rs 67,
– TISCO pays Rs 670 M after 6 months; irrespective of
future spot rate.
– TISCO fixes liability at a fixed rate that is known today.
Cost of Forward Hedge
• Normally reckoned by the forward premium/
discount over spot rate.
(F1 – S0)/S0
True cost of forward hedge:
(F1 – S1)/S0
• True cost of forward hedge cannot be calculated
in advance.
• Would be dependent upon the future spot rate.

Money Market Hedge
• Does not use forward market at all.
• Uses spot market and money markets in two
currencies.
• Involves simultaneous actions of a) borrowing in
one currency, b) its spot conversion, and c)
investing in another currency, using money
markets of the two currencies.
• Enables locking-in of a fixed exchange rate for
receivable/payable.
Money Market Hedge
Account Receivable
INFOSYS expects to receive $ 10 M after 6 months.
Spot rate: Rs 65/$; Interest Rates Rupee: 10%, $: 14%
(Indicates depreciating US dollar/appreciating rupee)
Hedging:
– Borrow US dollar 10/1.07M at 14%; matures to $10M in 6-m
– Convert in rupees at spot rate to realise Rs 65x10/1.07 M,
– Invest rupees for 6 months at 10%;
Maturity value = 65 x 1.05 x 10/1.07 M.
Effective rate realised = Rs 63.7850
– Pay US dollar borrowed from the receivable.
Money Market Hedge
Account Payable
TISCO needs to pay US $ 10 M after 6 m.
Spot rate: Rs 65/$; Interest Rates Rupee: 14%, US $: 10%
(Indicates appreciating dollar/depreciating rupee)
Hedging:
– Borrow rupees at 14% for 6-m,
– Convert rupees at spot rate to US dollar,
– Invest US dollar for 6-m at 10% so as to mature to $10 M.
Effective Exchange Rate:
– US dollar needed for investment = 10/1.05 M
– Rupees needed to be borrowed today = 65 x 10/1.05 M
– Rupees loan to be repaid = 65 x 1.07 x 10/1.05 M
Effective exchange rate = Rs 66.2381/$
Money Market Vs Forward Hedge
• Money market is a home-made forward rate.
• If IRP holds money market and forward market will
give identical results.
• If IRP is distorted, there would be different rates.
Hence a corporate manager has a choice between
money market & forward market hedges.
• For receivable: choose the hedge that gives higher rate.
• For payable: choose the hedge that give lower rate.

Money Market Vs Forward Hedge
• Cost associated with money market
• Bid - Ask spread in the spot market
• Difference in lending and borrowing rates
• Use appropriate rates.

Money Market & Forward Hedge
ITC expects to receive £ 10,000 in 6 months. Following scenario exists
Spot: 80.20 – 80.50; 6-m Forward: 81.50 – 82.00
Interest Rates Rs: 10.00 – 10.50; £: 5.50 – 6.00
Forward Hedge:
Sell £ forward at Rs 81.50 (forward bid rate)
Money Market Hedge:
• Borrow £ at 6% (£ borrowing rate) for 6-m (£ borrowed = 10,000/1.03)
• Convert spot; Get Rs 10,000 x 80.20/1.03 (spot bid rate)
• Invest Rupees for 6-m; realise 10,000 x 80.20 x 1.05/1.03
Effective rate = Rs 81.76 (higher than forward)
CHOOSE MONEY MARKET HEDGE

Invoicing/Risk Sharing
• No invoicing in foreign currency will eliminate foreign
exchange risk altogether.
• The foreign exchange risk shifts from one party to another.
(from seller to buyer for receivable, from buyer to seller
for payable).
• Depends upon relative position of customer and supplier,
and will be accepted by the counterparty only if it feels
benefited.
CAUTION:
• Not to use spot rate but use forward rate for analysis of
such negotiations.

Invoicing/Risk Sharing
• Invoicing transfers entire risk of foreign exchange rates on the
counterparty.
• Foreign currency risk between buyer and seller can be shared by
linking payment to the exchange rate prevailing at the time of
payment (suitable for long term contracts).
EXAMPLE
If exchange rate is between Payment (% of invoice)
Rs/$ 61.00 and 62.99 102%
63.00 and 64.99 101%
65.00 and 66.99 100%
67.00 and 68.99 99%
69.00 and 66.99 98%

Exposure Netting
• Hedging need not be done for entire amount
outstanding. Netting to be done by:
– Adjusting receivable against payable in the same
currency, Receivable and payable provide natural hedge.
– Combining exposure across all subsidiaries, and
– Treating similar currencies as one.
• Receivable in euro and payable in dollar provide natural hedge if
euro and dollar are positively correlated with rupee.
• Receivable in euro and receivable in dollar provide natural hedge if
euro and dollar are negatively correlated with rupee.
• Reduces cost of hedging.
Cross Hedge
• When no forward contract is available in currency of exposure.
• Cross Hedge: When positions in spot and forward are on
different assets, one needs to hedge with spot and forward
positions on related and not on identical assets. Hedge through a
currency having linkage with the currency of exposure, and on
which forward contract is available.
(Exposure in Chinese Yuan pegged to dollar can be hedged with forward in
dollar)
• Need to establish the relationship and find degree of correlation
using past data.
• Greater the value of R2 (explains the fraction of variation
explainable) in the regression, better is the cross hedge.
Leading and Lagging
• Decision to avail or extend credit terms.
• When tools of hedging are not available:
• If foreign currency appreciating:
– Lead the payable (pay as low as possible)
– Lag the receivable (receive as much as possible)
• If foreign currency depreciating:
– Lag the payable
– Lead the receivable
• Must compare with cost of funds.
• Also use forward rate instead of spot rate.
From One Currency to Another
TRANSLATION EXPOSURE

Need for Translation
• Also called Accounting exposure.
• The impact of the changes in the exchange rates on the
consolidated accounts with respect to profitability,
assets and liabilities of the MNCs.
• MNCs are required to consolidate accounts of all its
subsidiaries in the domestic currencies.
• The accounts of each subsidiary are drawn in the
currency of the host, and therefore need to be
translated from the foreign currency to domestic
currency.

Does Translation Exposure Matter?
It does not because
• As long as profits of the subsidiary are not remitted it
does not matter irrespective of its depreciation or
appreciation.
• Cash flows will go to meet the asset and liabilities in that
currency.
• If position worsens in one year it may improve in the
next period.
• Cash flows to the parent are not affected unless parent
opts to remit profit/cash back to parent.
Does Translation Exposure Matter?
It may matter because
• Can affect earnings:
 Impact on share price since markets are driven by
earnings and the PE ratio.
• Value of assets and liabilities would change and
therefore various ratios such a debt equity ratio,
current ratio, profitability ratio may change.
 Affects ability to generate financial resources
either by debt or by equity.
• Cash flows????
Impact of Translation
• Impact is governed by
– Extent of dependence of parent on
subsidiary (Suzuki-Maruti).
– Strength of foreign currency
(Subsidiary in Africa vs. Europe, Currency
crisis of South East Asia)
– Accounting/Translation method

Translation Rates/Methods
• Many rates are available
– Opening Rate
– Closing Rate
– Average Rate
– Historical (Actual) Rate
• At what rate to translate the accounts??

Defining Exchange Rates
Closing Rate
• The rate prevailing at the time of translation.
• Would change from period to period.
Historical Rate
• The rate that prevailed on the date when transaction
actually took place.
• Would not change from one period to another, and
instead remains constant.
Equity
• Irrespective of method of translation equity would always
be translated at the historical rate.
Translation Methods
Current • Current items at closing rate.
Non-Current • Non-Current items at historical rates.
Monetary • Monetary items at closing rate.

Non-Monetary • Non-Monetary items at historical rate
• Same as Monetary/Non-Monetary except

Temporal Inventories at current rates.
All Current • All items at current rate.

Specifying Translation Rates
Current/ Monetary/ Temporal All
Non-Current Non-Monetary Current
Cash C C C C
Receivable C C C C
Payable C C C C
Inventory C H C C
Fixed Assets H H H C
LT Debts H C C C
Equity Always historical

Choosing Translation Method
• No method can be said to be superior/inferior to
another. All have some merits.
• Consistency of method used period after period is
more important than the method itself.
• The method used once must be followed
subsequently, else effect of changed method must
be quantified and highlighted in the financial
statements.
• Indian accounting standards allow translation
using Monetary/Non-Monetary method.

Handling Translation
• Balance sheet of subsidiary is denominated in
currency of the host nation and is balanced.
• Different items of balance sheet are translated at
different rates giving rise to mismatch of assets and
liabilities upon translation in local (parent’s)
currency.
• The difference in the balance sheet upon
translation is adjusted in a separate reserve account
“Reserves on account of Translation” in the equity.
– If asset > liabilities : Equity increases
– If asset < liabilities : Equity decreases

Handling Translation - Example
Ex Rate: Closing and stock: Rs 70/€, Current/ Monetary/ All Current
Equity & Fixed assets: Rs 60/€, LT Debt: Non Current Non Monetary
Rs 65/€
Equity 800 H 48,000 H 48,000 H 48,000
LT Debt 600 H 39,000 C 42,000 C 42,000
Current Liabilities 600 C 42,000 C 42,000 C 42,000
Total 2,000 129,000 132,000 132,000
Fixed Assets 900 H 54,000 H 54,000 C 63,000
Stocks 600 C 42,000 H 42,000 C 42,000
Account Receivable 400 C 28,000 C 28,000 C 28,000
Cash 100 C 7,000 C 7,000 C 7,000
Total 2,000 131,000 131,000 140,000
Translation Reserve in Equity + 2,000 - 1,000 + 8,000
Measuring Translation Exposure
Liabilities and Assets Foreign Current/ Monetary/ All Current
of subsidiary currency Non Current Non Monetary
Equity 800
LT Debt 600 C 600 C 600
Current Liabilities 600 C 600 C 600 C 600
Total 2,000 600 1,200 1,200
Fixed Assets 900 C 900
Stocks 600 C 600 C 600
Account Receivable 400 C 400 C 400 C 400
Cash 100 C 100 C 100 C 100
Total 2,000 1,100 500 2,000
Translation Exposure A 500 L 700 A 800

What Affects Translation Exposure
• Items translated at historical rates do not give
rise to translation exposure as the value
remains constant period after period.
• Only items that are translated at current rate
give rise to translation exposure as their value
changes period after period.
• Assets and liabilities translated at current rate
provide natural hedge, and therefore are can
be netted for assessing quantum of exposure.

Impact of Translation
Exposure Exchange Rate IMPACT ON NET WORTH
If Assets > Subsidiary currency Increase in value of assets is larger

Liabilities appreciates than liabilities (Net worth increases)
If Assets > Subsidiary currency Increase in value of assets is smaller

Liabilities depreciates than liabilities (Net worth decreases)
If Assets < Subsidiary currency Increase in value of assets is smaller

Liabilities appreciates than liabilities (Net worth decreases)
If Assets< Subsidiary currency Increase in value of asset is smaller

Liabilities depreciates than assets (Net worth increases)

Managing Translation Exposure
• Balance Sheet Hedge:
– Matching exposures on the asset and
liability sides that are translated at current
rates i.e. (so that they nullify each other).
– Assets and liabilities provide natural hedge.
– Not always feasible, and desirable.

Managing Translation Exposure
Derivatives Hedge:
– Would create transaction exposure; Not advisable to have
cash flow implications for what is notional.
– Means taking speculative position on the foreign exchange
rate movements.
• Need to hedge only the translation difference of the net profit
amount. Can be covered by a forward contract.
• Example: A subsidiary of Indian firm is expected to earn $ 10,000
in profit for the coming year. Current exchange rate is Rs 65. If $
depreciates to Rs 60 by next year the profit would be Rs 6 lacs
instead of Rs 6.5 lacs. The Indian firm can sell $ 10,000 forward.
Not To Hedge Translation Exposure
• Inaccuracy of forecast of profit
• Availability of forward contract??
• Translation exposure is transformed to transaction
exposure. (Changing notional exposure into cash flow)
• Taxability: Gain/loss on translation doesn’t affect tax.
Gains on forward contract will be taxed.
• If cash flows of subsidiary to be retained for future use by
the subsidiary then managing translation exposure
seems irrelevant.
• Not managing saves cost.

Changing Exchange Rates and Competitive Position
ECONOMIC EXPOSURE

Defining Economic Exposure
• Economic exposure is concerned with impact of
changes in exchange rates on the
– Value of the firm referred as Economic Exposure
– Cash flows of the firm referred as Operating
Exposure
• Value of the firm is reflected in stock price.
• Economic exposure refers to unanticipated changes in
the value of firm. Anticipated changes are already
discounted in the stock price.

Economic Exposure Affects All
• Appreciation/depreciation of the local currency has impact on all
firms irrespective of their national status (MNC or domestic).
• All firms face competition: domestic as well as foreign
firms/products.
• Change in exchange rate alters the competitive position of the firm
due to change in prices of the product from foreign suppliers.
• The degree of impact will be different for different firms depending
upon:
– Reliance on inputs/outputs from foreign suppliers
– Level of competition from foreign products.

Impact of Economic Exposure
• Distinct from transaction exposure: results from the fixed
contract obligations denominated in foreign currency.
• Pure domestic firms do not have translation and
transaction exposures but do have economic exposure.
– If rupee depreciates: Domestic firms face less
competition from foreign products as they become
relatively dearer
– If rupee appreciates: More competition as foreign
products become relatively cheaper.
• For MNCs the degree of economic exposure is relatively
high as compared to domestic firm.

Transaction Vs Economic Exposures
Transaction Exposure Economic Exposure

Contract specific Economy specific
Relates to transaction costs Relates to opportunity costs
Tactical Strategic
Changes in nominal exchange Changes in real exchange rates
rates

Economic Exposure and PPP
• Change in real exchange rate and not in nominal
exchange rates causes economic exposure.
• Any change in exchange rate consistent with inflation
rates should have no impact on the relative
competitive position of the firm with respect to foreign
competition.
• Changes in exchange rate consistent with inflation
changes nominal exchange rate but not the real
exchange rate.
• If PPP holds the real exchange rate remains constant.

Nominal and Real Exchange Rates
• Assume rupee is devalued by 5% and inflation rates in
India and UK are 3% and 2% respectively. If nominal
exchange rate was F0 the nominal rate at the end of 1 year
shall be 0.95 F0.
• If actual rate changed by 1% there is no change in the
relative purchasing power of the currencies. The change in
real exchange rate is 4% and not 5%.
• The real exchange rate is given by
Actual rate  PPP rate
Change in real rate 
PPP rate

Only Changes in Real Rates Matter
– US firm has an Indian subsidiary currently earning Rs 6,500
equivalent to $ 100 at current exchange rate of Rs 65/$.
– Inflation in India and USA are 10% and 0% respectively. As per PPP
the exchange rate after a year should be Rs 71.50/$ (Rupee
depreciating by 10%). The comparative position is as below:
Now A year later
Sales in Rupees 16,500 18,150
Cost in Rupees 10,000 11,000
Profit 6,500 7,150
Equivalent $ 100 100
– All sales and cost will increase in India by 10% and so will the
profit. Position of US parent remains unaffected.

Pegging – No Solution
• Exchange Rate pegged to a currency (China)
• Would it cause economic exposure?
• Exporter from China (fixed rate Yuan 10/$)
• Inflation 10% in China 0% in USA
Now Later
Selling Price $ 10 Yuan 100 Yuan 100
Cost in Yuan 40 44
Profit 60 ($ 6) 56 ($5.60)
• Profit declines despite no change in nominal
exchange rate, because real rate has changed.

Measuring Economic Exposure
• Measure the sensitivity of cash flow with
respect to exchange rate.
• Operating cash flows, Assets and Liabilities
all change the value of the firm.
– Impact on operating cash flows: Operating
exposure
– Impact on assets and liabilities: Economic
exposure
• Most people regard both as same

• Scenario Analysis:
– Concerned with forecast of changes in cash
flows with changing exchange rates.
– Classify items of revenue and expenses, and
– project subjectively the cash flows with varying
exchange rate scenario.
– Need to have a) access to internal information
about costing and pricing, b) be domain expert
to know impact on costing and pricing of the
products.

Managing Economic Exposure
• Marketing
– Diversifying markets
– Pricing strategy
– Product differentiation
• Production
– Input mix
– Shifting production
– Plant Locations
– Raising productivity
• Financial
• Regression analysis
R=a+bF+e
R = Value of cash flow,
F = Exchange rate,
a, b are regression coefficients, and e = error
• Use stock price as proxy to cash flow.
• Stock price is available in public domain.
• Can be done by people external to the firm.

What Can Be Managed
What can be hedged:
R = a+bF+e
Var (R) = b2 Var (F) + Var (e)
Can be hedged
Cannot be hedged

Manage or Not to Manage
Not to manage at all because:
• Economic hedge is superset of transaction exposure,
• Manage transaction exposure well to manage economic exposure.
Financial hedge:
Advantage:
– Marketing and Production related hedges are extremely
strategic.
– Financial hedge is easy to implement, forward, futures and
options provide easy solutions.
Disadvantage:
– Amounts to taking a speculative position in FE market.
– Converts economic exposure to transaction exposure.

Forward and Economic Exposure
• One rupee change in exchange rate effects the
cash flow by Rs 5,700. Depreciation of rupee
leads to increased cash flow while appreciation
reduces the cash flow.
• Protection required against appreciation of
rupee (depreciation of $)
THE STRATEGY:
• Sell $ forward equivalent to beta coefficient i.e.
Sell forward $ 5,700

Sensitivity of Cash Flow
Scenario Prob $ Cash flow Ex Rate R
1 1/3 1,000 45 45,000
2 1/3 1,100 46 50,600
3 1/3 1,200 47 56,400
Average 46 50,667
Var (F) = 1/3{(45 - 46)2+(46 - 46)2+(47 - 46)2} = 2/3
Cov (R,F) = 1/3{(45,000 – 50,667)(45 – 46) + (50,600 –

50,667)(46 – 46) +(56,400 – 50,667)(47 – 46)}
= 11,400/3 = 3,800
Beta Coefficient 
Cov (R , F)

 p(R  R )(F  F)
Var(F)  p(F  F)2
Beta coefficient = 3,800/2/3= 5,700

Forward and Economic Exposure
• Assumed forward rate = Rs 46/$
• Profit/Loss on the forward contract
Exchange Rate Profit/Loss -
45 5,700 x 1 = 5,700
46 5,700 x 0 = 0
47 5,700 x -1 = - 5,700

Sensitivity with Forward
• Variance of cash flow with and without the forward
contract
Ex Rate R CFforward Total
45 45,000 5,700 50,700
46 50,600 0 50,600
47 56,400 -5,700 50,700
Variance of CF 216,62,222 2,222
• Variance of the cash flow reduces drastically. The
remaining variance (2222) can not be diversified away or
eliminated.

INTERNATIONAL CAPITAL
BUDGETING
Cross-Border Acquisitions
NPV Framework
• Golden rule of net present value (NPV) of capital
budgeting is represented as
N
CFn
NPV   (1  r ) n
 CF0
Where 1
CFn represents free cash flows for period n over the life of
the project on N years and r is the discount rate.
• And the rule of acceptance is
– Accept projects with positive NPV and reject those
with negative NPV.

Cash Flows and Discount Rate
1. Whose cash flows: Subsidiary vs. Parent
2. Whose discount rate
SUBSIDIARY:
• Responsible for administering and managing the
project.
• What is good for subsidiary is also good for parent
PARENT
• Capital budgeting exercise is viewed from the
perspective of investor.
Parent being investor the cash flow should be
viewed from parent’s perspective.
Debatable if subsidiary is not wholly owned ??
Cash Flow – Subsidiary Vs Parent?
• In case of international projects while it is the subsidiary
that generates the cash flows but ownership lies with the
parent.
• There are often several items that are included in the cost
of subsidiary reducing the cash flows but actually are
sources of cash inflows to the parent such as
– Royalty payments, technical or management fee etc. that are
the cash outflows for the subsidiary but are actually cash
inflows for the parent.
– Inputs provided by parent in the form of supplies are cash out
flows for the subsidiary but the profit adds to the parent.

Domestic Vs International Projects
• The capital budgeting decision in another country involves
situations that are often absent in the domestic environment,
such as
– Political risk of operating in different country,
– Uncertainties with respect to culture, norms,
– Working conditions and labour laws and minimum wages,
– Level of protections based on nationalities of stakeholders,
– Availability of technical manpower and expertise,
– Red tape,
– Different legal and administrative environments,
– Commitments with respect to export, remittances, local
procurement,
– Availability of incentives like as taxes, loans, etc.
Causes for Differential in Cash Flows
• Insist on local participation (FDI policy) to guide capital
structure.
• Higher rates of corporate taxes for MNC than domestic
companies.
• Ceilings on royalty and technical fee payments.
• Lock-in period for remittances.
• Additional taxes on remittances.
• Export obligations/commitments.
• Specify minimum level of local procurement.

Parent’s Cash Flow From Subsidiary
Subsidiary’s Cash Flow
Less: Host country’s Taxes Less: Cannibalisation
Less: Retained by subsidiary Add: Sales creation
Remitable cash flow Add: Technical fees and royalty
payments (net of host’s taxes)
Less: Dividend withholding tax Add: Opportunity costs for non
cash based services/resources.
Remittance to parent Convert to parent’s currency
Parent’s cash flow in parent’s
currency

When Debt is from Host Country
• When debt is availed in host nation, add equivalent
loan in parent’s nation to make NPVs comparable.
Debt in Host Equivalent debt in
Country Parent’s country
EBIT 200 200
Interest, 10% on 100 (4 years) 10 -
EBT 190 200
Tax, 30% 57 60
PAT 133 140

When Debt is from Host Country
Debt in Host Eq debt
PAT (Previous slide) 133 140
Less: Repayment 25 -
Remitted cash flow 108 140
Expected Ex Rate 0.5 0.5
Cash flow in Parent’s currency 54 70
Less: Parent’s interest on equivalent loan (at - 3
ex rate of 0.6 debt is 60 @ 5%)
Add: Tax shield, 33% - 1
Less: Principal repaid parent’s debt - 15
Cash flow in parent’s currency (discount at re) 54 53

Cash Flow Differentials
• Differences in the cash flows of subsidiary and parent may
make projects abroad
– Positive NPV project from the perspective of
subsidiary, but negative NPV project for parent, and
– Negative NPV project at the level of subsidiary, but
positive NPV project at parent’s level.
• If subsidiary is a joint venture with local shareholder
(51:49), whose perspective must be considered?
• Conflicting opinions????
(Suzuki in Maruti, Airtel and Walmart, Hero Honda and
Honda, Royalties to Nestle, Suzuki, Unilever……)

Discount Rate
If cash flow in foreign currency for period t is CFt, the projected
spot exchange rate is St, the discount rates in subsidiary’s
(country abroad) currency and parent’s (Home) currency are ra
and rh respectively, then the discounted value of the cash
flows would be
Discounting home Discounting foreign

currency cash flow at host currency cash flow at
country discount rate parent’s discount rate
CFt x St
Present Value 
(1  rh ) t

The Discount Rate
• Cash flows measured in foreign currency or in
home currency must lead to same NPV as long
as we use the appropriate discount rate i.e.
CFt CFt x St
x S0 
(1  ra ) t
(1  rh ) t
• For this to happen relative PPP must hold:
St (1  rh ) t

S 0 (1  ra ) t
PROJECTING CASH FLOWS
Who Generates And Whom It Belongs To

Operating Cash Flows - Parent
• Operating cash flows are generated by the subsidiary
and denominated in the currency of the host nation.
• Operating cash flows of the subsidiary is the starting
point for projecting the cash flows for the parent.
• These operating cash flows in the currency of the host
nation need to be converted into the parent’s currency.
• Therefore forecasting of exchange rate is essential.

Projecting Operating Cash Flows
Item Basis of Projection
A Quantity Project in numbers
B Selling price Project at t = 0 and then increase by inflation
rate of the host nation
C Revenue (A X B) Would rise because of rising production/sales
and inflation rate of host nation incorporated in
D Variable Cost the price and all costs.
E Fixed Cost Project fixed cost and a rate of increase
modified by inflation rate
F Licence and Normally specified as % of sales and hence
Technical Fees automatically rise by increased sales and
inflation of the host nation.
Projecting Operating Cash Flows
H Depreciation As per policy; Mostly SLM: No adjustment of
inflation.
I Interest Ignored; Would be incorporated in the discount rate
as is done in domestic capital budgeting exercise.
J EBIT
K Taxes Corporate tax rate and tax rules of host country.
L Changes in Working capital of first year in the initial outlay.
working capital Normally taken as % of sale. Only increase of working
capital to be deducted from profit.
M Net repatriable J – K – L + H
profit

Operating Cash Flows

N Exchange rate Assuming Relative PPP holds project exchange rate
for each year, or use any alternate method.
O Cash flows MxN
from
Operation to
the parent
P Present Value Use all-equity discount rate of parent’s

Treatment of Royalty and Supplies
• The royalty payments which are considered as
cost in the cash flows of the subsidiary are cash
inflows for the parent and must be valued
separately and added, net of host nation’s tax.
• In foreign project the proprietary items are
supplied by parent that are incorporated as cost
in the foreign project. The contribution derived
from supply of such items must be valued
separately and added to the NPV of the project.
METHODS TO FIND NPV
What Is The Right Discount Rate

Properties of Discount Rate
• The discount rate is a function of several factors
and would be different for
– different risk profiles,
– different capital structures,
– changing preferences and expectation of
equity and debt suppliers, and
– constraints of tax and remittances affecting
dividend decision.
FTE and WACC Approaches to NPV

Requirements for NPV Approach
For several reasons WACC or FTE approach are appropriate for
evaluating domestic projects because;
1. Market values of debt & equity are readily available.
2. Cost of equity incorporating the business risk and financial risk
and cost of debt are directly observable.
3. These projects often relate to expansions in the same line of
business letting existing cost of capital serve as appropriate
discount rate.
4. Expansion projects are small relatively and keeping capital
structure constant.
5. Since financial risk and the business risk are same the existing
cost of capital is best discount rate.
NPV Approach & MNCs Projects
For several reasons WACC or FTE approach cannot be used for
international projects:
1. International projects do not have same business risk as they
operate in economic environments different than domestic.
2. International projects often have incentives and concessionary
loans that make the capital structure different.
3. International expansion projects are normally large compared to
the existing business warranting a change in capital structure
making WACC inappropriate as discount rate.
4. Since financial risk and business risk are different than existing
business and environment, existing WACC may NOT be the best
discount rate.
Limitations of WACC/FTE
• WACC is conceptually easy to apply: But can be used only when
business risk and financial risk faced by the project is similar to
that of the existing operations.
• It is a difficult assumption to fulfill in the international scenario,
where business risk and financial risk become substantially
different.
• Business risk alters the required rate of return (cost of equity).
• Due to change in the capital structure (financial risk) the cost of
equity too changes because there exist a claim of debt suppliers
that is prior to the claims of the shareholders,

Need to Use All-Equity Rate
• WACC and FTE approaches use single discount rate for all the
cash flows treating all operating cash flows bear the same risk.
• All cash flows do not carry the same risk (e.g. depreciation) and
therefore cannot have same discount rate.
• International projects have several funding options than local
and hence these funding option may
a) require different discount rate, and
b) force the MNC to alter the capital structure (financial risk)
because it has more financing options in the host country
than in the home country.
ADJUSTED PRESENT VALUE (APV)
A Method Best Suited to MNCs Project Appraisal

Adjusted Present Value (APV) Method
• Adjusted Present Value (APV) approach attempts
to address the issues of changes in business risk
and financial risk complementing conventional
NPV approach and is imminently suitable for
evaluation of international capital budgeting
proposals.
• It is based on MM Proposition II.

Adjusted Present Value (APV) Method
• MM Position
VL = VU + Value of Tax Shield
= VU + T x Debt (for perennial debt)
– VL and VU are the values of the levered and
unlevered firm.
– VU needs to be found using all equity discount
rate
– Value of the tax shield for the debt to be found
using cost of debt.
Advantage of APV Approach
• APV provides flexibility for the adjustment of
different means of financing to the NPV of all equity
cash flows e.g. project specific funding, including
subsidised loans that may be available to the MNC.
• Allows measurement of benefits of each financing
option.
• Allows use of different discount rates to different
kinds of cash flows appropriate to their risk.

APV Example – Does Debt Add Value?
• A firm ABCL is up for sale. ABCL is a profitable debt free
company generating cash flows of Rs 5 million a year at
present that are expected to grow at 2%. The owner of
the firm wants Rs 30 million. The cost of equity for
ABCL is reckoned to be 20%.
– You are a professional and can generate Rs 2 million
only. A bank is prepared to lend the remaining Rs
28 million at 10% (Leveraged Buy Out) repayable in
10 equal annual installments.
– What is the worth of the firm?
– Would the worth change if a loan is taken?
Applying APV Method
• Under Adjusted Present Value (APV) approach:
– We find NPV assuming all-equity financing. With all-
equity financing only business risk is incorporated.
– Value each of the financing alternatives separately and
adjust the net present value accordingly.
– The value of debt is found using MM proposition that
value of levered firm is greater than the value of
unlevered firm by the amount of tax shield of debt.
• Each component of financing permits the use of separate
discount rate as befitting the cash flow.
Obtain All-Equity Rate of Return
• WACC is conceptually easy to apply: But can be used
only when financial risk faced by the project is similar
to that of the parent. Difficult assumption to fulfill in
the international scenario.
• Use all equity approach to discount the operating
cash flows. o
e 
1  (1 T )D / E
where βe and β0 are all equity beta and observed beta
respectively, T is marginal tax rate, and D/E is the debt equity
ratio using market values.
• Can be used only when D/E ratio is constant. For
LBOs D/E changes substantially from year to year.
NPV with All-Equity Discount Rate
• Find out NPV assuming no leverage (100% equity
financing)
NPV = 5 x 1.02/(0.20 - 0.02) - 30 = - 1.667 m
• With financing by debt the value will increase by
the amount of tax shield the debt provides.
Therefore present value adjusted for tax shield
of debt
APV = NPV (all equity) + PV of debt tax shield

Value of Interest Tax Shield on Debt
Year O/S Interest Tax saved Repayment PV Of Tax Saved
10% 35% at 10%
1 28.000 2.800 0.980 2.800 0.891
2 25.200 2.520 0.882 2.800 0.729
3 22.400 2.240 0.784 2.800 0.589
4 19.600 1.960 0.686 2.800 0.469
5 16.800 1.680 0.588 2.800 0.365
6 14.000 1.400 0.490 2.800 0.277
7 11.200 1.120 0.392 2.800 0.201
8 8.400 0.840 0.294 2.800 0.137
9 5.600 0.560 0.196 2.800 0.083
10 2.800 0.280 0.098 2.800 0.038
PRESENT VALUE OF TAX SHIELD 3.778
APV = -1.667+3.778 = Rs 2.111 million

Value of Subsidised Loan
• A loan of 125 million is available to IBM for setting up a
plant in Sikkim at interest of 8% with bullet repayment
after 10 years. What is the value of the loan if debt
otherwise is available at 15% and the tax rate is 40%.
• The value of the subsidised loan comes from a) interest
tax shield provided, and b) concessionary rate of
interest instead of commercial rate.
• The value can be found by discounting the cash flow of
the concessionary loan at commercial rate of interest.

Value of Subsidised Loan
Interest on subsidised loan = 125 x 0.08 x 0.6 = 6.00
Interest saved = (0.15 – 0.08) x 125 = 8.75
Tax Saved = 0.4 x 0.08 x 125 = 4.00
10
6 125
NPV = 125  (1.15)n 1.15 10
= 63.99
1
Consists of two parts i) Interest subsidy and

ii) Tax shield
10
8.75
PV of Interest Subsidy = ∑ = 43.91
1 (1.15)n
10
4.0
PV of Tax Shield = ∑ n
= 20.07
1 (1.15)
Obtaining Discount Rate
• These are discounted at all-equity capitalization rate.
Normally all-equity capitalization rate is available in
home country. This must be converted to an
equivalent all-equity capitalization rate in foreign
currency using inflation rates in the foreign and
home country.
• Depreciation tax shield must be discounted at cost of
debt. The known cost of debt in home currency again
must be converted to equivalent cost of debt in
foreign currency using inflations rates in two
currencies.
Applying APV Method
Blocked Funds and Borrowing Capacity
• Concessionary loan if available may be valued at
commercial rate of interest.
• In case of blocked funds that are not remitted due to
higher rates of taxes payable the value must be
reckoned as the difference between the tax payable
and tax paid.
• Foreign project usually affects the borrowing
capacity in the home nation. If it enhances the debt
capacity of the parent the value of additional debt
must be added as benefit of the project, and valued
at market rate of debt.
Determining Discount Rates
• Operating Cash flows = EBDIT to be discounted at cost of
equity assuming no debt.
• Tax shields on depreciation and interest are discounted at
cost of debt.
• Restricted funds released must be viewed before tax as
MNC saves taxes if funds are retained for funding the
project.
• All rates used for discounting: parent’s home land.
• ADJUSTING FOR RISK: All equity beta to be used for
arriving at appropriate discount rate.
Unlever beta of competing firm if project is not of the
same risk class to arrive at all-equity discount rate.
INTERNATIONAL
TRANSFER PRICE
Tax Evasion Vs. Tax Planning
What is Transfer Price
• Transfer price is the price at which an MNC sells goods to an
associate concern.
• It can be used as a tool to allocate profit amongst the
associated firms, so as to minimise the incidence of the tax.
• Tax structures in different countries are different which
include
– the rates of tax on the profits earned,
– benefits of tax holidays,
– rebates and concessions,
– permissible/ deductible expenditure,
– recognition of income etc.
MNCs Vs Domestic Firms
• MNCs usually have a control of supply chain in
the manufacture of a product where the output
of one becomes the input for another
enterprise.
• MNCs have extra leverage to adjust the profits
of each firm in the group to a certain extent,
through the mechanism of transfer price which
domestic firms do not have.

How Transfer Price Works
1. Country A supplies material at cost lower than fair price
reducing its profit being taxed at higher rate.
2. Country B receives material from Country A at lower cost
increasing profit, and therefore paying taxes at lower rate.
Firm in Associated Firm in
Country A Country B
• High Tax Rate • Low Tax Rate

• Transfer Profit • Transfer Profit
from High Tax to Low Tax
Jurisdiction Jurisdiction

How Transfer Price Enriches
Shareholder
Savings in tax will increase the cash flows to the MNC in
aggregate and hence increase valuation.
These savings in tax would accrue to shareholders of the
parent, at the cost of revenue lost by the government.
• If Country B also happens to impose lower tariff
there is added advantage in reducing the price.
• Besides tax evasion (planning) the tool of transfer
pricing can also be used for money laundering too.

OECD and Transfer Price
• At what price the firm supplies to its associate in
another country is the prerogative of the parent firm,
and perhaps cannot be challenged.
• The fairness of the price is difficult to establish
• This is a global concern and more so for developed
economies where MNCs belong to.
• OECD has done some pioneering work related to
fairness of the transfer price, and has provided a
framework to establish fairness of price, referred as
“Arm’s Length Price”.
• OECD does not have any jurisdiction over any country
and hence each member country must pass the
relevant laws conforming to the OECD guidelines.
India and Transfer Price
• Section 92 of Income Tax Act dealt with the issue of transfer
pricing. It empowered the department to determine
“reasonable profit” and the “connected enterprises”. Both
the issues remained undefined.
• Finance Act 2001 clarified the issue in detail.
• A need was felt for a detailed and separate regulation for
administering transfer pricing with globalisation of Indian
economy. Absence of such regulations
– results in litigation and loss of revenue to the exchequer.
– India was losing its legitimate share of revenue.

Issues in Transfer Price
There are three issues in the transfer pricing:
1. What kind of transactions need to be covered by transfer
pricing regulation.
Transaction in revenue account and capital account.
2. How to determine/establish the connection (related
party)?
Parameter to establish who influenced the price?
3. How to determine the fair price of the goods traded
amongst the related parties?
If the transfer price is inappropriate how to replace it
with true price and tax profits on that basis.

Transaction Covered
Section 92 D
• Sale/purchase of goods and services
• Sale/purchase of fixed assets
• Agency arrangements
• Leasing arrangements
• Licence arrangements
• Loans/Guarantees
• Management contracts
• Deputation of personnel
Establish Relationship of Firms
Section 92 A (directly or indirectly)
a) By management control
b) By holding shares > 26%
c) By lending/borrowing > 90% of total borrowed amount
d) By control of board of directors > 50% appointment
e) By control of supply chain
> 90% of raw materials and consumables
> 90% of sales
f) By control through relatives

Arm’s Length Price (ALP)
• The term "arm’s length price" is defined as price applied
in uncontrolled conditions. In other words it refers to the
market value of a particular transaction ignoring the
impact on pricing due to existence of special relationship
between associated enterprises.
• Arm’s length principle would avoid the creation of tax
advantages or disadvantages that would otherwise distort
the relative competitive position of either type of entity.
• By separating tax considerations from economic decisions
the arm’s length principle promotes the growth of
international trade and investment.
Methods to Determine ALP
• Not applied to individual transactions; they
can be accumulated/clubbed together for a
period.
Five methods:
• Comparable Uncontrolled Price (CUP) Method
• Resale Price Method
• Cost Plus Method
• Profit Split Method
• Transactional Net Margin Method

Comparable Uncontrolled Price (CUP)
• Compare price of the related party with that of the
uncontrolled transaction.
• Most direct and most reliable.
• Need obtain comparable uncontrolled transaction.
• Differences in products are minor and reliable method
exists to account for differences
• Adjustments allowed:
Differences in terms of trade
Differences in volume of trade
Differences in the credit period

CUP Method - Example
LNM – Trinidad supplies ingots to Arcelor in France as well as to its
subsidiary LNM - France. The price paid by Arcelor is US $ 150 per MT
in June with credit period of 45 days and volumes aggregating 100
MT. LNM France gets 90 days credit and the volume is 500 MT in
December. What would be the Arm’s Length Price for LNM Trinidad.
Comparable Uncontrolled Price : 150.00
Add: Differences in timing of trade 7.50
(Assuming price in Dec was 5% higher)
Less: Quantity Discount 3% 4.50
Add: Differences in the credit period 2.25
(@1% pm as interest for 45 days)
Arm’s Length Price 155.25
Cost Plus Method
• Find out the cost of production
• Add appropriate margin as % of cost of
production, determined by sale to unrelated
parties.
• Need to have gross margin in uncontrolled
transactions
• Applicable for contract manufacturing
• Useful for semi finished goods

Cost Plus Method - Illustration
Production (Tons) - CHIPS 44,000
Rs. in Lacs Rs. Per Kg.
Raw Material Consumption 24,579.26 55.86

Manufacturing Expenses 3,645.16 8.28
(Power, Repairing & Maintenance,
Consumables, Packaging & Job Works
Wages 940.32 2.14
Depreciation 2,726.52 6.20
Cost of Production 31,891.26 72.48

Add : Gross Profit Margin 24.68% 17.89
ARM'S LENGTH PRICE (Rs. per Kg) 90.37
Less : DEPB availed for export 1,187.84 11.52
Quantity for DEPB Availment (Tons) 10,314
ARM'S LENGT H PRICE (Rs. per Kg) 78.85

Resale Price Method
• Find out the resale price
• Deduct the appropriate margin of the reseller
• Margin should be consistent with the activities performed
by the reseller
• Use gross margin of the competing reseller
• Need to consider level of costs, value addition at each
stage, time of sale etc.
Gucci supplies shoes to its subsidiary in Brazil. Sale made by the
subsidiary are US $ 100 M. On an average the traders in shoe earn
a margin of 15% in Brazil. The Arm’s Length Price for Gucci would
be 100 – 15 = $ 85 M.

Profit Split Method
• Determine aggregate profit of the two associated
enterprises
• Split the profit for the two in ratio of the jobs/functions
performed.
• Ratio of profit sharing could also be in terms of capital
employed or cost incurred.
• Dependent upon availability of reliable external data.

Profit Split Method - Illustration
• ‘A’ sell goods to its subsidiary ‘B’ for a price of 100
A B Total
Sales 100 155 155
Cost of sales 70 100 70
Gross Profit 30 55 85
Other Cost 10 35 45
Operating Profit 20 20 40
Capital Employed 80 20
Profit Apportionment 32 8
Transfer Price 112

Transactional Net Margin Method
• Net profit realised by the firm in an international
transaction is computed on a base like cost, sales,
capital employed.
• Net profit realised by the firm in domestic transaction
(comparable uncontrolled transaction)
• This is adjusted for the differences in the international
transaction and comparable uncontrolled transaction.

Choice of Method
• Each method may be deployed with data from
internal or external sources.
• External sources are always preferred over
internal sources of data.
• Any method can be used by the firm and
• IT department too can ask for application of any
method.

Pre-requisites
• Records need to be maintained.
• Results in an administrative burden for both the tax
administrations and firms.
• Also verification of such transactions takes place for
some years later at the time of assessment and
therefore, it becomes all the more difficult to assess
conditions prevailed at the time the transactions.
• Far placed geographical locations and confidentiality
cause difficulty in obtaining comparable data.

Avoiding Litigation
• Determination of the ALP has sufficient scope for
controversies in terms of method chosen, non-availability of
accurate/reliable information, subjectivity in the data, etc.
• This may lead to an expensive and lengthy litigation with no
advantage to the tax payer as well as tax collector.
• To avoid unnecessary litigations there exist following
guidelines (may vary from country to country).
– No Adjustment
– Advance Pricing Agreements
– Safe Harbour Rules
Need for Recalculating the Profit
• No Adjustment: No adjustment to the ALP computed
by the taxpayer would be made if the price computed
by the tax department is within ± 5%.

Advanced Pricing Agreements (APAs)
Advance Pricing Agreements (APAs) introduced in Finance Act,
2012,
• An agreement in advance between the tax authority and
taxpayer is reached for determining the transfer price/ALP.
• It is binding of both parties for specified transactions.
• APAs are likely to
– provide certainty to the pricing in advance,
– eliminate tax leakages arising due to double taxation,
– proactively avoid transfer pricing controversies, and
– eliminate/reduce risk of economic double taxation.
Advanced Pricing Agreement (APA)
• The maximum period for which advance pricing agreements
can be entered is five years.
• There is no threshold minimum either for duration or
monetary value for APAs.
• These APAs can be unilateral (agreement between taxpayer
and tax authority in India), bilateral, (agreement between
tax authorities in two countries where associated
enterprises are located) or multilateral (agreement
involving several tax authorities and associated
enterprises).

Safe Harbour Rules
Safe Harbour Rules
• Introduced in September 2013 to reduce transfer pricing
audits and prolonged disputes.
• They intend to provide certain standards for profitability.
• If the profit is within specified standards the transfer pricing
as determined by the taxpayer would remain valid and
unchallenged.
• These rules would a) increase transparency, b) help improve
investment climate, and c) make revenue authorities
business friendly.
TRADE FINANCE
Letters of Credit (LCs)

Trade Dilemma
• Exporters want money before despatch
• Importers want to defer the payment as much as possible
• Credibility gap/distrust between buyer and seller
• Larger is the gap in the international transactions of export
and import due to:
• Distances involved
• Different legal environments and legal recourse
• Jurisdiction and place of arbitration
• Exorbitant cost of litigation

Trade Dilemma
• Despatch of goods and payment is not possible
simultaneously in international transactions
• Banks help resolve the trade dilemma by serving
as intermediary and reduce credibility gap
• Intervention by the bank in international trade
transactions helps in
1. Reducing risk of non-completion,
2. Reducing foreign exchange risk,
3. Providing means of financing

Contract Completion
• Banks facilitate decide the terms of trade
including the payment terms
– Sellers like to retain title till paid/or assured
– Buyers like to pay only after receipt of goods
• Banks hold “title of the goods in the interim” till
fulfillment of commitments from both sides
• The risks of non completion of the contractual
obligation are defined meticulously at every
stage of the transaction till it is complete
Managing Exchange Rate Risk
• Once paid the amount needs to be
converted from one currency to another
– Exporter – need to convert foreign currency in local
currency
– Importer – need to convert local currency to foreign
currency
• Exchange rates change so does the cash flow
in local currency causing risk of cash flow
– Exchange rate risk depends upon the whether
country had fixed or floating rate system

Financing Trade
• Time lag involved in international trade also
provides business opportunities to the bank for
lending and financing the trade.
• Parties to the trade also need to find means of
raising finance for the time lag in international
trade.
– Exporters need funds/credit to produce
goods
– Importers need funds/credit to buy
• Banks fulfill credit needs for both.
LC Mechanism

Meaning of Letter of Credit
• Commitment on part of a bank to place agreed
amount as per the applicant (buyer/importer) at
the disposal of other (seller/exporter) party.
• Tripartite agreement:
– Contract between buyer and seller
– Contract between buyer and Issuing bank
– Contract between issuing bank and
beneficiary’s bank

Benefits of LC
Benefits/Need for Letter of Credit:
• Assures payment and delivery
• Eliminates mistrust between buyer and seller
• Eliminates commercial credit risk
• Eliminates political risk
• Provides legal protection: Governed by UCP 600
PARTIES TO LETTER OF CREDIT
• Applicant: Buyer
• Beneficiary: Seller

Banks and Their Roles in LC
• Issuing Bank: Bank opening the LC
• Advising Bank: Advising the beneficiary bank
• Confirming Bank: Bank adding confirmation is liable to
pay in addition to opening bank
• Paying Bank: Authorised to make on-behalf payment
• Negotiating Bank: Nominated to negotiate the
documents; must add confirmation
• Accepting Bank: Negotiate drafts of the beneficiary
• Reimbursing Bank: Reimburse the paying bank

Types of Letters of Credit
• According to risk:
– Revocable
– Irrevocable
– Irrevocable and confirmed
• According to tenor of payment:
– Sight
– Deferred/Usance
– Revolving
• Part shipment and transhipment allowed or
not allowed.
Types of Letters of Credit
• Revolving: Where original credit is restored upon
negotiation of part amount.
• Back-to-back: Another LC established on the strength of
first LC on similar terms and conditions as that of original
LC
• Transferable: Beneficiary can transfer to another party.
• Stand-by: Financial guarantee to repay the money
advanced. Utilisation is on ‘non-performance’ rather than
‘performance’.
• Anticipatory credit: For part amount to be adjusted at the
time of final submission of documents. Used for providing
advance. Also referred as Red clause LC
Documents Under Letter of Credit
FIVE DIFFERENT TYPES OF DOCUMENTS
• Financial: Bill of Exchange
• Commercial: Invoice, Packing List, Inspection certificate,
• Transport: Bill of Lading,
• Insurance: Insurance Cover Note
• Regulatory: Certificate of origin

Advantages and Disadvantages of LCs
• Reduces risk for both exporter and importer
– Exporter supplies on the strength of the bank rather
than on the promise of the unknown customer,
– Customer pays upon bank confirming the evidence
of shipment
• Exporter can avail credit facilities on the strength of LC
• Importer is reasonably sure that the terms of the
contract have been met.

Bill of Exchange
• Negotiable instrument : Four Conditions:
1. In writing and signed by drawer (exporter)
2. Unconditional promise to pay a definite sum
3. Payable on demand
4. Payable to order or bearer
• Drawn in multiple set (usually two), Nos. of Bills drawn are
mentioned
• All sets are negotiable.
• Can be SIGHT or USANCE (DP and DA basis)
• Evidences trade transaction, receipt of payment or
promise to pay (if usance)

Negotiability
Nemo dat quod non habet
• No one can give what he does not own
• Does not apply to negotiable instruments
• Transferee can acquire better title than transferor
• Transferability by delivery alone or by delivery
and endorsement

Typical Bill of Exchange - Sight

Bill of Exchange
• A non-interest-bearing written order used in international
trade that binds one party to pay a fixed sum to another party
at a predetermined future date.
• Investopedia Commentary: Bills of exchange are generally
transferable by endorsements. The difference between a
promissory note and a bill of exchange is that BE is
transferable and binds one party to pay a third party that was
not involved in its creation.
• Bank Draft vs Trade Draft; BoE also called draft.
– Bank draft: When issued by a bank,
– Trade draft: When issued by issued by individuals

Types of Bills of Exchange
• Sight draft and Usance (time) draft
– When usance – acceptance required
1. by drawee (trade acceptance)
2. by Bank (Bankers’ acceptance)
– If accepted by bank it is extremely liquid
• Clean vs Documentary
– Clean – Not accompanied by any other document –
used for advance payments
– Documentary - Payment requires documents of
underlying trade with BoE
Parties To Bill of Exchange
• Bill of Exchange is a written promise of payment from one
person to another that is legally binding. Initially, there are
3 parties:
1. the drawer (usually exporter)
2. the drawee (usually importer or importer’s bank) –
the person to whom the bill is addressed - becomes
the acceptor when he signs the bill. (usually a bank)
3. the payee: Should the bill be negotiated (i.e.
transferred) then anyone holding or endorsing it
becomes a party to the bill and liable upon it.
(holder in due course)
Features of Bill of Exchange
• Acceptance by the drawee is indicated by his /her
signature. BoEs are widely used in internationally trade. In
domestic trade they are replaced by cheques.
• Order in writing – instruction must be an order and not a
request. Cheque is pre-printed ‘Pay…………………. or order’
• It is a means of payment

Features of Bill of Exchange
• Requiring the person to whom it is addressed to pay on
1. demand or at a fixed or determinable date.
On demand – expressed to be payable on demand,
at sight,
or on presentation
2. or when time for payment is not stated it must be
determinable.
3. Fixed future date – pay on January 10, 2009.
Determinable future date – 60 days from the date the
goods are dispatched, 30 days after sight.

Bill of Lading
Purposes:
1. Evidence of execution of contract:
BL contains detailed terms and conditions of the carrier
on which it has accepted the goods
2. Receipt for the goods:
Carrier declares that the goods mentioned are received
for delivery to specified person.
3. Document to the title of goods:
Carrier delivers to the person specified or his orde

Types of Bill of Lading
“CLEAN” “ON BOARD” BILL OF LADING
• Clean vs. Claused:
Clean:
Bears no super imposed clause which declares defective
condition of the goods. Shipper is a bailee and has to deliver
the goods in the same condition as received by them.
Claused:
Also called Dirty/Foul BL contains super imposed clause
explicitly declaring the defective condition of the goods
received.

Types of Bill of Lading
• On Board vs. Received for shipment:
Received for shipment : “Received in apparent good condition…..” No
guarantee that the goods will be carried by the vessel named.
On Board: Acknowledges goods have been put on board a ship. “Shipped on
Board” must bear the name of the vessel.
• Short Form vs. Long Form:
It is contract with the shipper and must have terms/conditions of the
contract.
Short form: where terms and conditions are not stated: Charter parties and
not shippers issue such bills of lading.
Long Forms: Terms and conditions are printed on the BL

Straight or Order Bill of Lading
• Requires delivery to  Directs carrier to deliver
consignee only – goods to the order
typically of exporter –
• Not a title of goods –  Negotiable – can be traded
Not a good instrument with endorsement and
for financing – delivery
• Used when payment  Good for financing
already received or
financed by exporter
Official Documents
• For compliance of laws of the land
• Consular Invoice/Legalised Invoice:
Issued or stamped by consular by the embassy of importer
nation. For statistical purposes, for determination of duty etc.
• Certificate of Origin:
– Issued by authorised independent agency certifying
country of manufacture.
– Facilitates determination of status of exporting
country, applicability of concessional rate of duty
• Certificate of sea-worthiness
Issued by Llyod chamber.

INTERNATIONAL MONETARY SYSTEMS: GOLD STANDARD, BRETTON WOODS, EUROPEAN

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INTERNATIONAL

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Balance of payment Exports become more

Increased prices make import

Increased money supply causes prices of

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• MANAGED GOLD STANDARD

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Source Slides 20-22: “Lords of Finance” by Liaquat Ahamed

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