ASSIGNMENT Course Code : MS-45 Course Title i] INTERNATIONAL FINANCIAL MANAGEMENT Assignment Code: MS-45/TMA/JULY/2022 Coverage : All Blocks Note: Attempt all the questions and submit this Assignment to the’Coordinator of your Study Centre. Last date of submission for January 2022 session is 30" April, 2022. 1. What are the different kinds of Intemational Fiftmcial Flows. Explain the structure of Balance of Payments and discuss the basic prinéiples governing recording of these flows. 2. What do you understand by Purchasing Power Parity (PPP)vand Interest Rate Parity? Explain the reasons for deviation of these parity conditions. 3. Discuss the various types of exchange rate exposures aind.explain the techniques used to manage these exposures. 4. Explain the role and servieés offered by the Export Credit Guarantee Corporation (ECGO). Discuss the factors peculiar to the international operations of Firms and explain the issues involved in foreign intvestinent analysiss Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given inthe Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance of the student/to_get an_idea_of how he/she can answer the Questions given the Assignments. We do not claim 100% accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample answers may be seen as the Guide/Help for the reference to prepare the answers of the i iv ii ignm i wers are pre re the private Teacher/Tutor so the chances of error or mistake cannot be denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample _Answers/_ Solutions. Please consult _ your _own Teacher/Tutor before you prepare _a Particular Answer and for _up-to-date_andexact information, data _and solution. Student should must _read_and refer the 1. What are the different_kinds of International Financial Flows. Explain the structure of Balance of Payments and discuss the basic principles governing recording of these flows. ANS: different kinds of International Financial Flows: International Capital Flows (Financial flows) means the inflow and outflow of capital from one nation to another nation. Following are «the different types (forms) of International Capital Flows: 1, Foreign investment can be of two types. One is direct and the other is portfolio. Foreign direct investment (FDI) takes place when a company moves in,another country for the production of goods or services and takes /part/in the mamagement of that company. Foreign Direct Investment (FDI) is generally regardedjas the most stable type of capital flows, both during normal and turmoil times.Foreign direct investment is composed primarily of fixed assets and is highly illiquid and hard to sell during crises. FDI is also influenced more by long term profitability expectatiéhs associated with a country’s fundamentals rather than speculative foreesand interest rate differentials. 2. Trade Flows: Trade could possibly be associated with goods. On the other hand, it maybe linked to services. The mer¢handise trade has two sides. While the first is export, the opposite is import. If a ‘country exports different goods, it will get convertible currencies which will be an inflow of funds»On the other hand, it has to make payments in convertible currencies for the importsit makes. Hence export and import of items result in international finaneial flows. 3. Invisibles consist of trade in seryices, investment income and unilateral transfers. If a shipping company has products of a foreign exporter/importer and receives the freight charges, it will likely, be treatedyas iniflow of funds because of trade in services. In the same way, if a foreign shipping company carries merchandise of an Indian exporter, it will be outflow, of~funds in form of freight charges. There are plenty of examples of international flow of funds resulting from trade in services. 4, External assistance and external commercial borrowings are different. While External assistance normally flows from an official institution, external commercial borrowings flow from international banks or other private lenders. The rate of interest in the former is generally minimal as well as a longer maturity period. The latter has market interest rate and a faster maturity. 5. Private loan flows include all kinds of bank loans as well as other sector loans such as loans to finance trade, mortgages, financial leases, repurchase agreements, etc. They've been a fairly ignored category.structure of Balance of Payments: The BOP structure depends on the concepts of the double-entry book-keeping. This implies that all the inflows of funds are placed on the credit side and all sorts of outflows of funds are debited. The balance of payments accounting differs from the business accounting in one aspect. In the BOP accounting the credits are on the left side and debits on the right side. 1. Trade Balance It is the difference between exports and imports'of items, typically referenced as visible or tangible items. In case the exports are higherycompared to imports, you will see trade surplus and if imports are more than exports, you will have trade deficit. Trade balance shows whether a nation/enjoys a sutplus or deficit. Developing countries usually have trade deficit. The trade balance is a part of current account. 2. Current Account In the current account, merchandise trade is entered first. There are actually a large number of distinct items which belong to the goods category. Export receipts are shown on the credit side and the imports are shown on the debit side. The second item that is recorded in the current account is invisibles. The current account consists of trade in services, dividends, unilateral receipts, investment income, etc. After entering the details, balancing is performed for the current account. This balance is referred to as the balance of current account. When debits are more than credits deficit occurs. Current account surplus will take place when credits are higher than debits. Current account balance is extremely important. It exhibits a country’s earning and payments in foreign currency. A surplus balance improves the country’s financial position. It may be utilized for growth and development of the country.3. Capital Account The Capital account includes all the short-term and long-term transactions between a country and the world. Usually, these types of flows of money are related to saving and investment, but speculation has turned into a major component of the account in recent times. In the capital account, both direct and portfolio foreign. investment is recorded. External assistance and commercial borrowing are. presented net repayment. Direct investment identifies the money which moves across national boundaries with the intention of investing in a business. Portfolio investment moves across national boundaries with the intention of purchasing shares and bonds. The Official reserves means the reserves of gold and foreign éxchange kept by the Reserve Bank of India to be used by the government. 4. Errors and Omission According to double entry book - keeping concept for every credit, there exists a matching debit and thus, there must be a balancein BOP as/wellyIn reality BOP may not balance. Once various types of international financial flows are recorded, the statistical discrepancy, referred to as errors and omissions, is also, recorded. The statistical discrepancy occurs due to complications associated with collecting balance of payments data. You can find different sources of data which occasionally differ in their approach. For instance, merchandise»is shipped (in, March, however the payments are received in April. If statistics are compiled on the 31st March, the numbers will differ. The errors and omissions amount is.equal.to the amount required to balance both the sides. It is useful to keep in mind that whenever past figures for the BOP are adjusted as time passes by, the figures for ‘net ‘errors and Omissions’ get smaller and smaller as the errors are located and fixed. 5, Foreign Exchange Reserves Foreign exchange. reserves exhibits the reserves that are kept in the form of foreign currencies. If the overall balancesis surplus, it is moved to the official reserves account which raises the foreign exchange reserves. It may be in form of dollar, pound, gold and Special Drawing Rights (SDRs). basic principles governing recording of these flows: International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world. 2. What do you understand by Purchasing Power Parity (PPP) and Interest Rate Parity? Explain the reasons for deviation of these parity conditions.ANS:PPP: According to this concept, two currencies are in equilibrium—known as the currencies being at_par—when a basket of goods is priced the same in both countries, taking into account the exchange rates. Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries’ currencies through a "basket of goods" appioach. Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries. Some countries adjust their gross domestic product (GDP) figures to reflect PPP. 0 seconds of 2 minutes, 10 secondsVolume 75% Calculating Purchasing Power Parity ‘The relative version of PPP is calculated with the following formula; Pi s= Py where: S = Exchange rate of currency 1to currency 2 P, = Cost of good X incurrency 1 Py, = Cost of good X in currency 2 Pairing Purchasing Power Parity With Gross Domestic Product In contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of the goods and services produced within one country. Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation. However, some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies. To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. Ifthe exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5. In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro. Purchasing power parity (PPP) (assuming 50% of income is spent on tradeables) u PPP compares prices across 140% countries PPP 120% | | Ba/bt = 2/3 100% + a In the general case A if the price of of ae tradeables is 7. equalised — 0% 20% 40% 60% ppp = ia x Per cent of labour force in 1/(i + en/et bn/bt) tradeable sectors Interest Rate Parity: Interest rate)parity (IRP) is a theory according to which the interest rate_differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of their interest rates. Parity is used by forex traders to find arbitrage opportunities. Interest rate parity (IRP) plays an essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of IRP is that hedged returns from investing in different currencies should be the same, regardless of their interest rates. IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate. The formula for IRP is: 1+i Fo = So x a 1+ 4% where: Fo = Forward Rate Spot Rate te = Interest rate incountry c ty = Interest rate in country b REASONS FOR DERIVATION: It should be noted that, often inflation rates are calculated by using price indices rather than taking prices of individual goods or services. Generally, all countries have developed some price index series which are readily available from economie databases and can be used to calculate inflation rates. There are several reasons why exchange rates predicted by using inflation rates do not match with the actual rates prevailing in the market. These include (a) inappropriate price indices to calculate inflation rates, (b) capital flows, (c) government intervention in the currency market and (d) speculative activity in the foreign exchange market etc. The difference between the actual market rates and those based on PPP is referred to as real appreciation or depreciation. Linkage between exchange rates and interest rates is referred to as interest rate parity (IRP) relationship. Deviations from IRP relationship give rise to arbitrageopportunities. Level of foreign exchange reserves can have an impact on the value of currency. It has been generally seen that the reserves are at comfortable (optimum) level if a country can meet easily the foreign exchange needs of 3-4 months. Reduction in the reserves from the optimum level is likely to causes greater depreciation than the appreciation that an identical increase in the reserves would cause. A piesident in BOP of a. country can have an adverse impact on the value of the currency. Technical analysis can also be used for estimating future exchange rate. Technical analyst (or chartist) uses the past data to make patterns and extends them to future, believing that these patterns are likely to repeat themselves. 3. Discuss the various types of exchange rate exposures _and_explain_the techniques used to manage these exposures. ANS: TYPES OF EXCHANGE RATE EXPOSURE: Transaction Exposure: This exposure arises when a company has asséts and liabilities the value of which is contractually fixed in foreign currency and these items are to be liquidated in the near future. For example; the walue of assets in the form of foreign currency receivables or liabilities in the form of foreign currency payables will be sensitive to the exchange rate. Likewise, currency rate fluctuations would impact loans, interest, dividend and royalty etc. to be paid to the foreign entities or to be received from them. Translation Exposure: Translation exposure arises from the variability of the value of assets and liabilities as they appear.in.the balance sheet and are not to be liquidated in near future. Translation of the balance sheet items from their value in foreign currency to that in domestic currency is done to consolidate the accounts of various subsidiaries. Therefore, translation exposure is also known.as Consolidation Exposure or balance sheet exposure. Economic Exposure :Economic expostire results from those items which have an affect on cash flows but the valueiof which is not contractually defined, as is the case of transaction exposure. Some examples of operating exposure are given below; a) Tender submitted for a contract remains an item of operating exposure until the award of contract. Once the contract is awarded, it becomes transaction exposure. b) A deal for buying or selling of goods is under negotiation. The price of goods being negotiated may be affected by fluctuations in the exchange rate. c) If a part of raw material is imported, the cost of production will increase following a depreciation of the home currency. d) Interest cost on working capital requirements may increase if money supply is tightened following a depreciation of the home currency.e) Domestic inflation will increase input costs of the firm even if there is no change in the exchange rate. This will adversely affect its competitiveness vis-a-vis the firms of other countries. Management of Transaction Exposure The most common methods for hedging transaction exposures are + Forward Contracts — If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes.a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value. Futures Contracts ~ These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure. Money Market Hedge - Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless-returns. It is also a form of financing the foreign currency transaction. It converts the obligationsto a domestic-currency payable and removes all exchange risks. Options — A foreign currency options a contract that has an upfront fee, and offers the owner the right, but not an obligation, to tradé currencies in a specified quantity, price, and time period. Translation Exposure Management ‘The following are the ways to manage or hédge translation exposure: Currency Swaps Currency swaps are a settlement between two entities to exchange cash flows denominated fora particular currency for a fixed time frame, Currency amounts are swapped for a predetermined period and interest is paid during that time span. Curreney Options The Currency option gives the right to the party to exchange the amount of a particular currency at an agreed exchange rate. However, the party is not obligated to do so. Nevertheless, the transactions must be conducted on or before a set date in the future. Forward ContractsUnder the forward contracts, two entities fix a specific exchange rate for the interchange of two currencies for a future date. The settlement for the agreed amount of currencies is conducted on the particular future date which is pre-decided. Managing Economic Exposure The risk of economic exposure can be hedged either by operational Strategies or currency risk mitigation strategies. Operational Strategies The following are the operational strategies which can be used to alleviate the risk of economic exposure: Diversifying Production Facilities and Markets for Products Diversifying the production facilities and sales toa number of markets rather than concentrating on one or two markets would mitigate the risk inherent. However, in such cases, the companies have to forgo the advantage earned by economies of scale. Sourcing Flexibility Companies may have alternative sources for acquiring key inputs. The substitute sources can be utilized in case the exchange rate fluctuations make the inputs expensive from one region. Explain the_rol ffer he _Exj rant Corporation (ECGC). Ans: ECGC) functions under the ministry of commerce and industry, Department of Commerce, Government of India. It is a Central government undertaking body to provide export credit guarantee//insurance to,thesexporters in the case of the default of payments by the buyer. If a situation arises wherein, the buyer fails to make the payment to the seller (exporter), the ECGC acts’as an insurance firm who guarantees the payment to the exporter. It is managed by a Board of Directors comprising representatives of the Government, Reserve! Bank of India, banking, and insurance and exporting community It was initially registered as Export Risk Insurance Corporation (ERIC) on 30th July 1957 in Mumbai as a Private Ltd. Company. Later ERIC’s name was changed to Export Credit & Guarantee Corporation Ltd in 1964 and to Export Credit Guarantee Corporation of India in 1983. With effect from August 8th, 2014, it was renamed as ECGC limited. What does ECGC do?In case of loss of export of goods and services, it provides credit risk insurance covers to exporters Export Credit Insurance covers are offered to banks and financial institutions to enable exporters to obtain better facilities from them. It assists exporters in recovering bad debts. It provides information regarding different countries with its own eredit ratings For Indian companies investing in joint ventures abroad ingthe form of equity or loan, Overseas Investment Insurance is provided. It offers insurance protection to exporters in the case of any payment risks. It provides guidance to activities related to export. It Provides information regarding creditworthiness of overseas buyers Why do we need insurance for export credit insurance? Insurance of the exports is important even at the best times. There can be a risk of default payments for the exports and these tisks depend on political and economic changes around the world. For example, there can be blockage or delay of delivery of the exports due to a civil war. Any disturbance in the economy of the export or import company can also provide these risks. There could be restrictions imposed on either payment of the export or import of the goods due to instability in the nation. This can result in default buyers, There can be a'¢ase of the’buyef” going bankrupt due to political and economic uncertainties. To avoid the risk of such default payments and default buyers insurance of the exports is necessary. Procedures with ECGC to cover insurance: A purchasé order is issued to the seller by the buyer. The purchase order contains complete détails about the buyer who has to make payment. The seller (exporter) approaches ECGC to get approval on the buyer and the amount which can be shipped. The ECGC with the help of overseas network provides details regarding the creditworthiness of the buyer. ECGC collects some amount on the export and issues insurance policy. Credit Insurance Policies: Some of the important credit insurance policies are discussed below:i) Standard Policy: The Shipments (Comprehensive Risks) Policy is the most important policy issued by ECGC. It covers the risks in respect of goods exported on short term credit i.e. credit not exceeding 180 days. This policy covers both commercial and political risks from the date of shipment. It is issued to those exporters whose estimated export turnover is more than Rs.5o lakh during the next 12 months. The policy covers the following commercial and political risks: (a) Commercial Risks: Insolvency of the buyer Default by the buyer to make payment for the goods accepted by them within a specified period Buyer's failure to accept the goods (when such non-acceptance is not due to exporter's actions. (b) Political Risks: Imposition of restriction on remittance by the government of the buyer's country or any Government. action blocking of delaying transfer of funds by the buyer; War, civil war, revolution or civil disturbances in the buyer's\country; New import restrictions or cancellation of a valid import licence; Additional handling, transport or insurance charges due to interruption or diversion, of voyage, which cannot be recovered from the buyer; Any other cause of loss occirting outside India not normally insured by general insurers and beyond the control of both the exporter and the buyer. (c) Risks Not Covered: The following risks are not covered by the Standard Policies of ECGC: Commercial disputes including quality disputes raised by the buyer, unless the Exporter obtains a decree from a competent court of law in the buyer's country in his favour; Causes inherent in the nature of the goods; Buyer's failure to obtain necessary import or exchange authorization from authorities in his country. Dis he fe i he i ional rations of Firms and explain the issues involved in foreign investment analysis. Ans: factors peculiar to the international operations of Firms: Political factors: Various political factors affect the international factors. Political factors such as changes in tax rates, policies and actions,of government, political stability of country, foreign trade regulations etc. affects the working of an international business firm. Lack of political stability in the country directly impacts the operations of business firm. Also, various tax policies and government initiatives sometimes hinders the expansion of business in other countries. Thus, effective political environment of business influences the growth of business firm (Shaw, 2018). Economic factors: Economic factors relates to the economic system of the country where the firm has its operations. Various econocmi factors such as inflation rate, interest rate, income distribution, employment level, allocation of government budget, etc., directly impactsthe operations of business firm (NDUNGU, 2012), Various economic factors such as purchasing power of customers also determines the demand of various products and services. Legal factors: Legal factors relate to the legal environment of the country in which firm operates. Different laws prevail in different countries and international business firms have to abide by the laws of each country. Laws relating to age and disability discrimination, wage rates, employment and environment laws affects the working of business firms. Along with this, various international lending agencies affects the legal culture and working policies of business firm Social factors: Social factors such as education, awareness and trends and status of people in the society affects the consumer behavior to purchase, vatious goods and) services. Also, Social environment and culture such as customs, lifestyles andyvalues differs from country to country which further directly impacts the international business. Environmental factors: Environment factors such as weather, climate change, temperature etc. affects the business firm and the demand pattern of various goods and services. increasing environment awareness has made this’ external environment factor a significant issue to be considered by business firms. Move towards environment friendly products and services also has affected the demand pattern of various goods and services. Technical factors: Technological changes in the industry has both positive and negative impacts on the working of business fitms. Technological changes and development of automated work processes helps in'inéteasing the éfficiency of business processes. However, technological changes also threaten the demand of various products and services in the industry. issues involved in foreign investment analysis: Parent Vs. Project Cash Flows :The first specific issue that arises in respect of the overseas project is as to which cash flows should be considered for evaluating the project, the cash flows available to the project, or cash flows accruing to the parent company or both. Evaluation of an overseas project on the basis of project's own cash flows provides insight into its competitive status vis-a- vis domestic or regional firms. The project is expected to earn a risk-adjusted rate of return higher than that on its local competitors. Otherwise the MNC should invest money in the equity of local firms. This approach has theadvantage of avoiding currency conversions, thus eliminating the margin of error involved in forecasting exchange rates over the life cycle of the project. Such approach is appreciated by local manager, local joint venture partners and host governments. However, the parent MNC is generally keen to evaluate a foreign project from the viewpoint of net cash flows available to it because on it depends the level of earnings per share and dividends distributed to the stockholders. It is these funds'that actually make it possible to pay dividends to shareholders and make interest and principal payments to lenders. Further, project evaluation from the parent's viewpoint furnishes the basis for raising funds from the market to finance overseas operations. Tax Issue: In capital budgeting, only after-tax cash flows are relevant. This is true both for domestic and overseas projects. The tax issue for multinational capital budgeting purposes is complicated by the existence of host country and home country taxes as well as a number of factors. Thus, earnings on foreign projects, first of all) fall in host country tax net. Then on distribution, it is subjected to witholding tax and»finally, in the home country the earnings are further taxed. Multinationals Exchange Control: Exchange. control ,restricting the repatriation of earnings to the parent country is another reason that causes discrepancy between the project value, from the parent's perspective and from the local perspective. When an MNC is contemplating investment in a country shaving exchange control, the present value calculation from the parent's point of view will be based on the following facts: The pattern of financing investment by MNC-debtor equity or both. In case of investment to be funded via debt, cash generated by the project is returned to the home country to the extent of debt repayment and interest. However, this will not be possible in case of equity funded investment. Remittances of net cash flows expected to be generated by the foreign projects. Not all remittances under exchange restrictions are permissible. Hence, forecasts of the proportion of the cash flows that can be remitted to the parent company will have to be made, Remittances expected back to the parent company by way of debt service and management fees and royalties. Of course, these are subject to ceilings by exchange control regulations. Lost Exports: Another issue relating to direct foreign investment decision is the issue of lost exports arising out of engaging in a project abroad. Profits from lost exports represent a reduction from the cash flows generated by foreign project for each year of its duration. This downward adjustment in cash flows may be total, partial or nil depending upon whether the project will replace projected exports or none of them.