Investment Management

in International Business Session-9 Date: 15.09.2011 By Prof. Rakhi R. Shrivastava

Foreign Exchange Dealings and Numericals in Business. •Resource Mobilization through portfolio / GDR / ADR •Other Options of Funding in venture

Sub Topic - 1 Foreign Exchange Dealings
Foreign exchange Transaction Exchange Rate Mechanism FEMA on International Trade

Sub Topic - 1 Foreign Exchange Dealings It is a part of International Finance. Domestic business agreements are concerned with the basic issues like price, quantity and delivery date, but international business agreements are concerned with other issues, in addition to the issues involved in domestic trade. These issues are: Currency to be used in the international Business transactions Creditworthiness of the importer Acceptable methods of payment Arranging Finance

Sub Topic – 1 Foreign Exchange Dealings IF: Currency to be used Selection of currency to settle international transactions is very important: Exporter prefers to have his home or hard currency while the importer prefers to pay in his home currency. If the currency of importing country is weak the exporter prefers payment in strong currencies like USD, UK Pound, Japanese Yen and Euro. Hard currencies are choice of exporter fpr settling transactions in international business. Hence the iporter face struggle to earn hard currencies in order to meet their import bills

Sub Topic – 1 Foreign Exchange Dealings IF: Creditworthiness of importer

The exporter is interested to know the creditworthiness of the importer because he first arranges for the shipment of the goods and receives the money at later stage. There is an amount of risk involved in the payment of money by the importer. EXIM Bank of USA, EXIM Bank of India and such other organization provide credit rating information to the exporters for a fee. After evaluating the creditworthiness of the importer, the exporter and importer should come to an understanding regarding the method of payment.

Sub Topic - 1 Foreign Exchange

All currencies other than home currency are foreign currencies for a particular country while settling international transactions. There foreign currencies are known as foreign exchange. The exchange of foreign currencies into home currency is carried out by exchanging some units of the home currency for some units of foreign currency. The ratio of exchange between the two currencies is known as the foreign exchange rate and expression of this ratio or the rate of foreign exchange is known as the foreign exchange quotation.

Sub Topic - 1 Foreign Exchange

The importing country pays money to the exporting country in return of goods either in its domestic currency or in hard currency. This currency which facilitates the payment to complete the transaction is called foreign exchange. Foreign exchange includes foreign currency, foreign cheques, foreign drafts. FOREX is bought and sold in foreign exchange markets. The components of FOREX are: The buyers The sellers and The intermediaries

Exchange rate Determination Methods of Exchange rate Quotations Foreign Exchange Rate is defined as the rate of one currency in terms of another currency. In yester years, these rates used to be stable as these were controlled by government agencies now a days these are determined by market forces (demand and Supply). So these keep on fluctuating. Foreign exchange trading is defined as the sale or purchase of one currency that is traded with another currency. There are three types of quotes: Direct Quote Indirect Quotes

Exchange rate Determination Methods of Exchange rate Quotations Direct Quotation: This method expresses the number of units of domestic currency required to buy one or 100 units of foreign currency: Direct quotes in India are: 1$ = Rs. 43.5125 or Rs. 43.5125 / 1US$ 1£ = Rs. 82 or Rs. 82 / 1£ 1Euro = Rs. 54 or Rs. 54 / 1Euro To calculate Direct Quote: Direct Quote = 1 / Indirect Quote

Exchange rate Determination Methods of Exchange rate Quotations

Indirect Quotation: This method expresses the number of units of foreign currency that can be bought with one or 100 unit of the home currency one. Indirect quotes of above motioned examples in India are: Re. 1 = 0.02298 US$ or Re. 1 / 0.02298 US$ Re. 1 = £ 0.01219 or Re. 1 / £ 0.01219 Re.1= 0.01851Euro or Re.1/ 0.01851Euro To calculate the Indirect quote: Indirect quote = 1/Direct Quote

Exchange rate Determination Methods of Exchange rate Quotations

International Quote or Cross Currency Quote: Exchange rates are readily available for currencies which are frequently transacted. Exchange rates may not be available for currencies which have only limited transactions. In such situation, the home currency can be converted into common currency such as US$ or EURO and then common currency can be converted into desired currency. This is referred to as cross rate trading. It involves three way transaction involving three currencies: The home Currency

Exchange rate Determination Methods of Exchange rate Quotations: Problem Set: 1 Calculate how many rupees Shri Ras Bihari Ji Lid. a New Delhi based firm, will receive or pay for its following four currency transactions: The firm receives dividend amounting to Euro 1,12,000 from its French Associate Company. The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese Bank. The firm exported goods to UISA and has just received US$ 3,00,000. The firm has imported goods from Singapore amounting to Singapore Dollars (SGD) 4,00,000

Given: $1 = Rs. 40.00/40.05 Euro 1 = Rs. 56.00 / 56.04 SGD = Rs. 24.98 / 25.00 100 Yens = Rs. 44.00 / 44.10

Exchange rate Determination Methods of Exchange rate Quotations: Problem Set: 2 Calculate how many British pounds a London based firm will receive or pay for its following four currency transactions: The firm receives dividend amounting to Euro 1,12,000 from its French Associate Company. The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese Bank. The firm exported goods to USA and has just received US$ 3,00,000. The firm has imported goods from Singapore amounting to Singapore Dollars (SGD) 4,00,000

Types of settlements (Transactions): Ready of Cash: refers to transaction to be settled on the same day i.e transaction done on 4th June to be settled on 4th June. TOM: refers to transactions where the delivery of foreign currency is to be done on the next day (tomorrow) transaction done of 15th July to be settled on 16th July. Spot: refers to a transaction where the delivery of foreign currency is to be done on the second working day (day after tomorrow). Forward: refers to a transaction where the delivery of foreign currency is to take place on a date later than the spot date e.g. A transaction done on June 3rd to be

Types of Exchange Rate Cover Rate and Base rate: The rate at which the banks can cover the merchant transactions in the interbank market without any profit or loss is called the Cover Rate. That is the rate at which the bank can buy dollars to cover import transactions in USD and the rate at which it can sell the US dollar to cover an export transaction in Dollars. The base rate is deduced from the cover rate after allowing a cushion for the adverse movement of rates. In practice, there are instances in which the cover rate and the base rate are the same. Fixed and Floating Exchange rate

Bid (Buying) and Offer (Selling) Rates Foreign Exchange dealers usually quote two prices: For buying foreign currency (Bid rate) For selling the foreign currency (Ask or Offer Rate) The difference between bid rate or price and offer rate or price is termed as the bid-offer Spread. For example: In direct method, the first rate quoted will be buying rate and second rate will be offer rate. The two rates for dollar rupee exchange are: 1US $=Rs. 43.35 – 43.66. Difference between these two rates is the spread showing profit of Re.0.31 or 31 paisa per dollar traded.

What is spread? The difference between the Bid Price and the Ask price is called a Spread. The spread percentage is calculated using the following formula: [(Ask-Bid)/Ask] x 100 If a foreign exchange dealer looks at the following quote: EUR/USD = 1.3700/05, the spread could be 0.0005 or 5 pips also known as points. The pip is the smallest amount a price can move in any currency quote.

Types of Exchange Rate Purchase and sale of one currency against other currency may be either on spot basis or for future delivery. In spot transaction, the currencies are delivered either immediately (the same day) or on the second day from the date of transaction. The exchange rate of the spot transaction is called “Spot Rate”. A future delivery transaction is one in which a contract is made between two parties for the purchase and sale of one currency against other at a stipulated future date at an agreed rate. Such future delivery transactions is called as “Forward Rate.”

Forward Premium and Discount Let us consider the following spot and forward exchange rates: Situation 1: Spot Rate: 1US$ = Rs.43.51 3 Month forward: 1US$ = Rs. 43.96 Forward rate differential (higher) by Re. 0.45 or 45 paise. (Forward premium) Situation 2: Spot rate £ 1 = Rs. 70.45 3 – month forward: £ 1 = Rs. 69.75 Forward rate differential (Lower) Re. 0.70 or 70 paise. (Forward discount)

Some More Examples of Forward Rate at premium and at Discount Spot: = $ 1=Rs.40. 44 Six month Forward: $ 1= Rs. 42.38 $ is at premium If a currency is cheaper in future as compared to Spot, it is said to be at discount. Forward Premium and Discount The forward premium or discount can be expressed as an annualized percentage deviation from the spot rate by using the following formula:

Problem set A person has to pay $ 13750 after three months today. Spot Rate: Re. 1 = $0.0275. Rupee is likely to depreciate by 5% over three months. What is likely forward rate?

Forward Rate Quotations As per forex market convention, spot rates and forward rate differentials (premium or discount) are quoted separately. To arrive at the forward rates the spot rate has to be adjusted for the forward points. Forward premium points are added to the spot rate while forward discount pointed are deducted from the spot rate to arrive at the forward rate Forward Rate Quotations: Example: The dollar- Rupee exchange rate is 1US dollar = Rs. 43.30 – 43.73 The table below gives some forward premiums for the USD in paise per US dollar in the forward market

Risk in Foreign Exchange
FOREX risk is defined as the possibility of adverse movement in foreign exchange rates If one has to sell the foreign currency in future, the possibility of decline in the rate / price of that currency is foreign exchange rate risk. If one has to buy some foreign currency, the possibility of increase in the rate / price of that currency is foreign exchange rate risk. To conclude: Foreign exchange rate risk refers to such movements in foreign exchange rate which result in loss.

Resource Mobilization through Portfolio, ADR and GDR

Foreign Institutional Investors Foreign Institutional investors (FIIs) are foreign institutions like pension funds, mutual funds, investment trusts and portfolio managers. As per the regulation issues by GOI, FIIs, NRIs and PIOs are allowed to invest in the primary and secondary capital markets in India through the portfolio investent scheme. Under this scheme, FIIS/ NRIs can acquire shares and debentures of Indian Companies through the stock exchanges in India.

Foreign Institutional Investors The ceiling for overall investment for FIIs is 24% of the paid up capital of the Indian company and 1o% for NRIs/PIOs. The imit is 20% of paid up capital in case of PSBs including the State Bank of India. Regulation on FIIs were issued in November 14, 1995. According to this regulation FIIs may invest only in : Securities in the primary and secondary markets including shares, debentures and warrants of companies listed in a recognized stock exchange in India. Units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed on

Depository Receipts A depository receipt (DR) is a negotiable certificate that represents a company’s publically traded equity or debt. It is a negotiable certificate, denominated in US$ that represents a non US company’s publically traded local currency equity shares or dept instruments. Depository receipts are created when local currency shares of Indian company are delivered to the depository ‘s local custodian Bank, against which the Depository Bank (like the Bank of America) issues DR in US$. The depository receipts may trade freely in the overseas markets like any other dollar denominated security, either on a foreign stock exchange or over the

American Depository Receipts A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction. This is an excellent way to buy shares in a foreign company while realizing any dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency and economic risks for the underlying shares in another country. For example, dividend

Global Depository Receipts In order to enable the Indian companies to mobilize funds from foreign countries, the Govt. of India allowed Indian companies satisfying certain conditions to access foreign capital market through Euro issue of Global depository Receipts (GDR) and Foreign Currency Convertible Bonds. The term global depository receipts indicates that the depository receipts are marketed globally rather than in ant specific country or market.

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