International Finance - Part II International Financial Markets & Instruments
Content
INTERNATIONAL FINANCIAL MANAGEMENT
PART II
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1
Structure of Foreign Exchange Market
Exchange Rate Quotation
Types of Transaction and Settlement
Dates
Intl.fin.
Exchange Rate Quotations
Existence of a number of currencies gives rise to
transactions in these currencies for settlement of
international transactions.
Two parties may exchange their respective domestic
currencies in settlement of export – import
transaction.
Or both parties may agree to settle the transaction in
a third country currency.
In the absence of an organized market It would be
difficult to find buyers and sellers of currencies to find
each other.
This has given rise to the development of a foreign
exchange market.
2
Intl.fin.
Factors That Influence Exchange Rates
The following equation summarizes the factors that
influence the exchange rates (the spot rate of a
currency):
e=ƒ(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP), where
e = change in the spot rate
ΔINF = change in the inflation rates between two
countries
ΔINT = change in the interest rates between two
countries
ΔINC = change in the differential in the income levels
of two countries
ΔGC = change in the government controls and
ΔEXP = change in expectations of future exchange
rates
3
Intl.fin.
>> Factors That Influence
Exchange Rates
1. Changes in the relative inflation rates
Changes in inflation rates can affect the
international trade activity
that in turn affects the demand and supply of
a currency
that in turn affects the exchange rates.
S1
Equilibrium rate:
S
R
a
t
e
e
D1
D
Quantity supplied
4
Intl.fin.
>> Factors That Influence
Exchange Rates
2. Changes in in relative interest rates
(concept of real interest rates)
Changes in relative interest rates can affect
investment in foreign securities
That affects the demand and supply of
currencies
Which in turn can affect the exchange rates
3. Relative income levels
Income can affect the amount of imports
demanded
Changes in demand can affect the exchange
rates
5
Intl.fin.
>> Factors That Influence
Exchange Rates
4. Government controls
influence the exchange rates in
many ways including imposition
of:
1. Foreign exchange barriers
2. Trade barriers
3. Market interventions etc.
6
Intl.fin.
Foreign Exchange Market
No physical market
It is a virtual market consisting of a network of
banks, brokers and dealers across various
financial centers around the world.
Linked with each other by telephone, telefax,
computer and other electronic network like
SWIFT system etc.
Information on the quotes of major
international banks, money markets, interest
rates etc. are continuously fed to the dealers
by service providers like Reuters, Telerate
Systems, Bloom Berg etc.
>>
7
Intl.fin.
>>Foreign Exchange Market
Informal code of moral conduct – a forex
dealers’ word is their bond!
Transactions done on telephone are
followed by mail confirmations.
It assists international trade and
investment by enabling currency
conversion. It also supports direct
speculation in the value of currencies.
8
Intl.fin.
Uniqueness of Forex Market
1. Huge trading volumes leading to high liquidity
(Average daily turnover is in excess of US$4
trillion)
2. Wide geographical dispersion
3. Round the clock operation, except weekends
4. The variety of factors that affect exchange rates
5. Razor-thin margins of profit
6. Use of leverage to enhance profit
.Because of these factors, forex market is referred
to as the market closest to the ideal of perfect
competition.
9
Intl.fin.
Structure of Foreign Exchange Market
85% of the transactions are speculative and only 15% are
trade-related or commercial transactions (According to the
BIS, the average forex trading volume in 2004 was $1.9
trillion per day – nearly 20 times the daily turnover of N.Y.
Stock Exchange!)
Theoretically, it is a zero-sum game. Presence of hedgers
and interventions by central banks result in speculative
gains or losses.
Main players:
Large commercial banks (Interbank Market) (≈40% of the
turnover)
Large MNCs
Hedge Funds, Pension Funds, Insurance Companies, Mutual Funds
etc.
Forex brokers
Central Banks
>>
11
Intl.fin.
Structure of Foreign Exchange Market
Large commercial banks deal in forex on their
own account as well as on behalf of their
customers.
They act as market makers.
There are numerous market makers in the
market and all of them would be giving different
quotes for a pair of currencies.
The market-making activities of commercial
banks along with speculation makes the market
extremely liquid and volatile.
Main trading centers: New York, London, Tokyo,
Hong Kong, Singapore.
>>
12
Intl.fin.
Structure of Foreign Exchange
Market
Brokers do not actually buy or sell any currency.
They are a link and match-makers between
different players in the market.
Brokers help the prospective buyer or seller to keep
their identities secret till the deal is struck.
Brokers also help the players to get a feel of the
market (direction of quotes)
Large corporations also bet on the markets to make
exchange profits.
The inter-bank market is called the Wholesale
Market whereas the market in which the banks
deal with their customers is called the Retail
Market. >>
13
Intl.fin.
Major Participant Groups & Their Motives
1. Non-banking entities simply exchange
2.
3.
4.
5.
14
currencies to honour their obligations or to get
the desired currency.
Traders use the forex market for hedging their
exposures o/a changes in the exchange rate.
Banks operate on behalf of their customers and
also engage themselves in proprietary trading.
Arbitrageurs change currencies to take
advantage of varying rates in different markets.
Speculators buy and sell currencies for the sake
of profit when they expect movement in the
exchange rate in a particular direction.
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A major structural change – Introduction
of Electronic Trading System (ETS)
In April 1992, Reuters introduced a new service
that added automatic execution to the process.
Traders enter buy and sell orders directly into
their terminals on an anonymous basis and
these prices are visible to all market
participants.
Another trader, anywhere in the world, can
execute the trade simply by hitting two buttons.
ETS has reduced the cost of trading by
eliminating the brokers and the number of
transactions.
15
Intl.fin.
Financial Instruments In Forex
Market
Spot – has the shortest time frame, involves cash rather than a
contract and interest not included in the agreed upon transaction.
Forward – rate is fixed on the day of the transaction itself for a
future transaction but money does not change hands until an
agreed future date.
Swap – currency swap & interest rate swap
Future – standardized forward contracts traded on exchange.
Options – an exchange traded derivative where the option holder
has the right to buy/sell currency but no obligation to do so.
Whereas the option writer has the obligation to stick to the
contract.
Speculation – ‘speculators have a stabilizing influence on the
market providing market for hedgers and transferring risk from
those who don’t wish to bear it to those who do’ – Milton
Friedman.
16
Intl.fin.
Structure of Foreign Exchange
Market
Being a virtual market, it is a round-the-clock
market.
N.Y C.T: 3
p.m.
London will
L.A.
remains
open
still be open
when
Frankfurt &
Zurich close
When
Singapore
closes,
Frankfurt &
Zurich
open
When Hong
Kong
closes,
Singapore
is still open
When L.A.
closes
When
Tokyo
closes,
Hong Kong
is still open
It is
opening
time at
Sydney and
Tokyo
London, New York and Tokyo markets are the
17
biggest
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THE WORLD OF FOREIGN EXCHANGE DEALING
Frankfurt
Chicago
London
Tokyo
New York
Bahrain
San Francisco
Hong Kong
Singapore
Sydney
Hong Kong
Foreign Exchange Dealing
Times: GMT
Tokyo & Sydney
Bahrain
Singapore
Frankfurt
London
New York
Chicago
San Francisco
GMT 2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 0900 0800 0700 0600 0500
0400 0300intl.financing
0200 0100
18
-10
-09
-08
-07
-06
-05
-04
-03 -02 -01
-00 +01 +02 +03 +04 +05 +06 +07 +08 +09
+10 +12
Attributes of Banks That Provide
Foreign Exchange
1. Competitiveness of quote: A saving of 1
cent per unit on an order of one million units of
currency is worth $10,000
2. Special relationship with the bank: The
bank may offer cash management services or
may be willing to make special efforts to obtain
hard-to-find currencies for the customer.
3. Speed of execution: Banks vary in efficiency
with which they handle an order. A corporate
needing the currency will prefer a bank that
handles the paper work properly and puts
through the transaction speedily. >>
19
Intl.fin.
>> Attributes of Banks That Provide
Foreign Exchange
4. Advice about currency market conditions:
Some banks may provide assessment of foreign
economies and relevant activities in the
international financial environment that relate to
corporates.
5. Forecasting advice: some banks may provide
forecasts of exchange rates to the corporates.
In view of the above advantages a corporate
needing a foreign currency should not automatically
choose a bank that will sell a currency at the lowest
price; It pays to develop a close relationship with a
major bank in case they need a favour from a bank.
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Intl.fin.
Settlement of Trades
Settlement of trades take place by transfer
of money to the Nostro Accounts of the
respective currencies held with a
correspondent bank.
Nostro, Vostro and Loro accounts.
Clearing House Inter-bank Payment
Systems: CHIPS & CHAPS
Over Bought / Over Sold positions
Competition between the market makers
ensures that the divergence in quotes are
not wide.
21
Intl.fin.
Indian Foreign Exchange
Market
Three-tired market.
Tier I : Transactions between ADs and RBI
Tier II : Inter-bank transactions
Tier III : Retail segment – transactions between ADs
and Money Changers and customers.
Market is regulated by the provisions of FEMA,
1999
RBI is the regulator under the powers vested by
FEMA.
Players:
Authorized Dealers (Categories A, B & C) and
Money Changers >>
22
Intl.fin.
Indian Foreign Exchange
Market
In the first tier, RBI buys and sells foreign
exchange from/to ADs.
The second tier is the inter-bank market where
ADs transact business among themselves.
Since the amounts transacted are large, they
form the ‘wholesale market’.
Transactions in the third tier are generally small
and deal with exporters, importers and
individuals. It is called ‘retail market’.
Most of the transactions take place in hard
convertible currencies like US dollar, Pound
Sterling, Euro and Japanese Yen.
23
Intl.fin.
Clearing Process
A majority of forex transactions in India involves dollar as one
leg;
A multilateral netting mechanism has been created through the
CCIL (Clearing Corporation of India Ltd.) for settlement of all
dollar denominated transactions.
As a central counterparty CCIL guarantees trade settlement.
ADs pass the dollar-related transactions through CCIL for
netting and settlement.
CCIL in turn settles the dollar leg through its correspondent in
the USA.
The rupee leg is settled through the member banks’ account
with RBI.
Advantage: Substantial cost and time benefit for the ADs.
Transactions in currencies other than dollar are settled directly
by ADs through their respective Nostro bank accounts.
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Intl.fin.
Exchange Rate Quotations
Currencies are traded in pairs like xxx/yyy. Currency xxx is the base
currency and yyy is the counter currency (or quote currency). E.g.,
USD/JPY, USD/CAD, USD/INR etc
Remember: The value of the base currency is always 1
The three exceptions to this rule are the British pound (GBP), the
Australian dollar (AUD) and the Euro (EUR). For these pairs, where
USD is not the base currency, a rising quote means the US dollar is
weakening and buys less of the other currency than before.
Direct Quote: Exchange Rate is expressed in terms of number of units
of domestic currency per unit of foreign currency.
E.g., 1USD = INR55.42
Indirect Quote: Domestic currency fixed and foreign currency variable.
E.g., Rs.100/$
Market quotes: DM/$ : 1.6688 / 93
Inter-bank quote: DM / $ : 88 / 93
A few currencies are quoted in 100s rather than 1s or 2s. E.g.,
Japanese Yen ($/100Y: 0.9150/52)
25
Intl.fin.
Direct & Indirect Quotes
Example:
1. If direct quote is Rs.45/US$, how to
present it in indirect quote?
.US$1/Rs.45 = US$0.0222/Re.
2. If indirect quote is US$0.025/Re, how can
this exchange rate be shown under direct
quote?
.Re.1/US$0.025 = Rs.40/US$
26
Intl.fin.
Inverse Quotes
For every quote A/B there is an inverse quote B/A
E.g., Euro / $ : 1.6688 / 93 is a quotation in Frankfurt.
The quote on the left side is called the Bid (purchase)
rate and that on the right is called the Ask (sale) rate.
Bid always precedes the ask rate.
Bid is the rate at which the bank is prepared to buy
dollars (also means the rate at which it is ready to sell
Euro) and Ask is the rate at which it is prepared to sell
dollars (also means the rate at which it is prepared to
buy Euro).
Hence the Euro / $ bid rate would correspond to $ /
Euro ask rate.
27
Intl.fin.
Inverse Quotes
For the above example,
The implied ($/Euro)bid = 1 / (Euro/$)ask
The implied ($/Euro)ask = 1 / (Euro/$)bid
So the implied inverse rate is:
$ / Euro : 0.5990 / 0.5992
The above equations can be generalized
as:
Implied (B/A) quote:
1/(A/B)ask Divided by 1/(A/B)bid
28
Intl.fin.
Inter-Bank and Merchant Quote
In an inter-bank transaction,
The bank requesting the quote is the customer and
The bank giving the quote is the market maker.
Example of a market quote:
Euro/$ : 1.6688 / 1.6693
It is the market practice to quote the same rate as Euro/$ :
1.6688/93
The rate on the left side is the bid (buying) rate and that on the
right side is the ask (selling) rate.
A few currencies like Japanese Yen are quoted in units of 100
($/100Y=0.9150/52)
The quote after the decimal points is called basis points.
According to FEDAI Regulations, all rates have to be quoted
to four decimal points, with the last two being multiples of 5
(this rule is ignored for the sake of simplicity and learning)
29
Intl.fin.
Inter-Bank and Merchant Quote
The spread between bid and ask prices is
influenced by:
Spread = ƒ(Order costs + Inventory costs –
Competition – Volume + Currency risk)
Order costs are costs of processing orders, clearing costs
etc.
Inventory costs are costs of maintaining inventory of a
particular currency. Holding an inventory involves an
opportunity cost.
Competition: Higher the competition, the lower the spread.
Volume: Higher the volume, lower the spread.
Currency risk: Higher the volatility of the currency, higher
the spread as the intermediaries dealing in these currencies
could incur large losses due to abrupt change in the values
of these currencies.
30
Intl.fin.
Rate Spreads in Forex Quotes
Example:
1. Consider the following bid-ask prices:
Rs.40 – 40.50/ US$. Find the bid-ask
spread.
Spread = 40.50 – 40.00 = 00.50p
% spread = (0.50 / 40.50) x 100 = 1.23%
2. Find out the bid rate if ask rate is
Rs40.50/US$ and the bid-ask spread is
1.23%.
(40.50 – x)/40.50 = 0.0123 or
40.50 – x = 0.0123 x 40.50 or
40.50 8*0.50 = x or x = Rs40.00
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Intl.fin.
Cross Rates (Synthetic Rates)
Cross Rates (also called Synthetic Rate):
Many currency pairs are only inactively traded,
so their exchange rate is determined through
their relationship to a widely traded third
currency (generally the USD)
Suppose we want to find out the cross rates
between SFR and CND with the following market
quotation: SFR/USD: 5.5971/78 and USD/CND:
0.7555/62
Synthetic (Sfr/Can$)bid rate = (Sfr/$)bid x
($/Can$)bid = 5.5971 x 0.7555 = 4.2286
32
Intl.fin.
Cross Rates (Synthetic Rates)
Synthetic (Sfr/Can$) ask rate = (Sfr/
$)ask x ($/Can$) ask i.e., 5.5978 x .
7562 = 4.2330
Therefore, the synthetic quote of
Sfr/Can$ will be: Sfr/Can$ = 4.2286 /
4.2330
The rates can be generalized as:
Synthetic (A/C)bid = (A/B)bid x
(B/C)bid and Synthetic (A/C)ask =
Intl.fin.
(A/B)ask x (B/C) ask, where A, B & C
33
Cross Rates (Synthetic Rates)
Suppose Currency A is Swiss Francs, Currency
B is Canadian Dollars and Currency C is US
Dollars, then a chain formula for cross rate
between Sfr and Can$ would be: How many
Sfr = 1Can$,
if 1Can$ = 0.7555US$ and
if 1US$ = 5.5971Sfr
The
numbers on the right hand side will form the
numerator and those on the left will form the
denominator. On simplifying,
(Sfr/Can$)bid
= 0.7555 x 5.5971 = 4.2286
(Sfr/Can$)ask = 5.5978 x 0.7562 = 4.2330
34
Intl.fin.
Forward Rates
A forward rate in a Forward Contract is an
agreement between a commercial bank and its
customer to exchange a specified amount of a
currency at a specified exchange rate (called the
forward rate) on a specified date in the future.
The most common forward contracts are for 30, 60,
90, 180 and 360 days. However, contracts for
periods in between (Broken period contracts) are
also available (discussed elsewhere).
The difference between the forward rate (FR) and
the spot rate (SR) at a given time is measured by
the premium (Pm) or discount (- ): FR = SR(1 + Pm)
35
Intl.fin.
Examples of Buying & Selling Rates
1. Mr. X presents a foreign draft for US$5,000 for
2.
3.
4.
5.
36
credit to his account.
Mr. X wants a foreign draft for US$200 to
subscribe to a foreign magazine.
ABC Ltd. has lodged an export bill for US$50,000
which is realized and credited to the Nostro
account of the A.D.
Mr. Dutta is visiting his children in USA. He
requests for a Vishwa Yatra Card for US$3,000.
Mr. Mishra, an Indian citizen working in US has
remitted US$10,000 to an AD for opening a
foreign currency term deposit account.
Intl.fin.
Different Types of Buying
Rates
TT Buying Rate
i.
a)
b)
c)
d)
e)
Payment of foreign draft issued by a
correspondent bank.
Realization of foreign cheques / bills sent
on a collection basis.
Cancellation of outward remittances.
Payment of FCNR Deposit
Cancellation of Forward Sale Contract
.Computed as: Interbank Spot Buying Rate
– Exchange Margin.
37
Intl.fin.
Different Types of Selling
Rates
TT Selling Rate
i.
a)
b)
Issue of drafts/TTs and all clean instruments for
remittance outside India.
Cancellation of forward purchase contracts
.Spot TT Selling Rate = Interbank Spot Selling Rate +
Exchange Margin.
i. Bills Selling Rate
a)
b)
Payment of import bills
Advance payment for imports
.Spot Bills Selling Rate = Interbank Spot Selling Rate +
Exchange Margin.
i. Travellers cheques (TC) selling rate (TT Selling + 0.5%
towards handling charges)
ii. Foreign currency notes selling rate (TC selling + 0.5%)
38
Intl.fin.
Different Types of Buying
Rates
iii. TC Buying Rate
iv. Bills Buying Rate
a)
b)
Purchase of export bills
Purchase of travelers cheques and currency
notes
iii. FC Buying Rate
39
Intl.fin.
Notional Rates
An assumed rate which is used for
40
notionally converting foreign currency
deposits into Rupees is called Notional
Rate.
Banks are required to report rupee value of
all foreign currency deposits and loans as
on 31st March at the prevailing notional rate
only.
All banks are fixing the notional rate in line
with the weekly average of daily rates
for different currencies advised by
FEDAI on every Friday.
Intl.fin.
Nominal, Real and Effective exchange rates
The exchange rates quoted by the market are nominal
exchange rates.
Real exchange rate is price-adjusted nominal exchange rate.
The relation between nominal and real exchange rate can
be written as:
er = eP/P* , where P and P* are domestic and foreign price
indices.
Suppose the WPI in India and USA rises from 100 in 1998 to
120 and 110 respectively in 2001and if the nominal exchange
rate between the two currencies between the two dates remain
at Rs40/$, the real exchange rate will move to:
40 x 120/110
= Rs43.64/$
In a floating rate system the nominal rate moves automatically
with the change in the price level, but it does not happen so in
a fixed exchange system because of the administered rate. As
a result there will be a gap between the two.
41
Intl.fin.
Effective Exchange Rate
(EER)
EER is the measure of the average value of a
currency relative to two or more other currencies ,
normally shown in the form of an index.
It is possible that Indian Rupee depreciates against
US dollar but appreciates against Japanese Yen.
It is also possible that Rupee depreciates vis-à-vis
different currencies at different rates.
Therefore it is essential to develop an index to
measure how rupee fares, on an average, in the
foreign exchange market.
Such an index is called an effective exchange rate.
42
Intl.fin.
More on EER
Process of construction of an EER index:
Step 1: Select the basket for the currency (only those
currencies are included that matter significantly in the
country’s trade)
Step 2: Find out the weight of different currencies in the
basket in the following way:
Assuming that India has trade links with only USA and Japan
Indian exports to them are $6000 and $4000 and
Imports from them are $7000 and $3000 respectively,
Then, the weights for these two countries will be:
USA=(6000 + 7000) ÷ [(6000 + 7000) + (4000 + 3000)] =
0.65.
Japan=(4000 + 3000) ÷ [(4000 + 3000) + (6000 + 7000)] =
0.35
43
Intl.fin.
More on EER
Step 3: Find out the exchange rate index as
follows:
Suppose in 1998, the exchange rate was Rs40/$ and
Rs50/Yen100;
In 2001the exchange rate changed to Rs44/$ and
Rs60/Yen100;
If 1998 is the base year the exchange rate index in
2001 will be 110 (100 + 10% increase) for US$ and
120 (100 + 20% increase) for Yen.
EER 1998 = [(0.65 x 100)+ (0.35 x 100)] = 100
EER 2001 = [(0.65 x 110) + (0.35 x 120) = 113.5
This means that rupee depreciated on an average
by 13.5% during the period 1998 – 2001.
44
Intl.fin.
Problems in foreign exchange
45
Intl.fin.
Problems in foreign exchange
1. If direct quote is `45/US$, show how this exchange
rate can be presented under the indirect quote?
Solution: US$1 / `45 = US$ 0.0222 / `
2. If indirect quote is US$ 0.025 / `, how can this
exchange rate be shown under direct quote?
Solution: `1/US$0.025 = `40 / US $
3. Consider the following bid – ask prices: `40 – 40.50
/ US$. Find the bid–ask spread in percentage terms.
Solution: Spread
= [(Ask price – Bid price) ÷ Ask
price] x 100
= [(40.50 – 40.00) / 40.50] * 100 = 0.0123 or
1.23%
46
Intl.fin.
Problems in foreign exchange
4. Find out the bid rate if ask rate is `40.50 / US$
and the bid-ask spread is 1.23%.
Solution: [(40.50 – x) ÷ 40.50 = 0.0123 or
40.50 – x = 40.50*0.0123 = 40.50 – 0.50 = x or
x = `40.00
5. Find out the forward rate differential if spot rate
of US $ is `45.00 and one month forward rate is
`45.80.
Solution: Forward premium (discount) = [(n-day
forward rate – spot rate) / spot rate] * (360 / n)
(360/30)*{(45.80 – 45.00) / 45.00} * 100 =
21.33%
47
Intl.fin.
Problems in foreign exchange
6. Find the one month forward rate of US dollar if
spot rate is `45.00 and the forward premium is
12%.
Solution: (360 / 30){(x – 45.00) / 45.00} = 0.12
Or (x – 45) = 0.12 x 45 x 30 / 360
Or x = 45 + 0.45
Or x = `45.45
7. Suppose a newspaper quotes `35.00–
35.20/US$ and at the same time it quotes
Canadian$0.76 – 0.78/US$, find out the rates
between Rupees and Canadian dollars. >>
48
Intl.fin.
Problems in foreign exchange
Solution: Buying Rate: `35.00/US$1 X
US$1/C$0.78 = `44.87/C$
Selling Rate: `35.20/US$1 X US$1/C$0.76 =
`46.32/C$
Or combining the two, ` / C$ rates are:
`44.87 – 46.32 / C$
8. Suppose one month forward US$/` rate is
`34.50 – 34.80 and US$/C$ is C$0.79 –
0.83, find out the forward rate of C$/`.
49
Intl.fin.
Problems in foreign exchange
Solution: `34.80 / C$0.79 = `44.05/C$
34.50/C$0.83 = `41.57
Combining the two, we get `41.57 – 44.05 / C$
9.Find `/€ exchange rate if the two exchange
rates are: `43.93 – 43.95 and €0.83 – 0.84 / US$.
Solution:
Bid rate: `43.93 / 0.84 = `52.30
Ask rate: `43.95 / 0.83 = `52.95
Combining the two we get: ``52.30 – 52.95 / €
50
Intl.fin.
Problems in foreign exchange
10. The following are the middle rates reported
by Reuters for Canadian dollars on a particular
day. Fill up the blanks with suitable cross rates:
Country / Currency
Canada
Euro Area
Great Britain
Japan
Solution:
Country / Currency
Canada
Euro Area
Great Britain
Japan
51
Intl.fin.
USD
EUR
GBP
JPY
1.2341
0.8247
0.5488
108.83
USD
1.2341
0.8247
0.5488
108.83
EUR
1.4965
0.6655
131.96
GBP
2.2485
1.5026
198.28
-
JPY
0.0113
0.0076
0.005
-
Problems in foreign exchange
11. Consider the following data:
Spot Pound = $1.9510/20
3-month forward: $1.9257/70
3-month forward premium is = 2.53/2.50 cents (Spot – forward)
Calculate the rate of dollar premium against sterling (Sterling
discount against the dollar)
Answer:
For seller of sterling:
0.0253/1.9510 x 4 x 100 = 5.19% p.a.
b. For buyer of sterling:
0.0250/1.9520 x 4 x 100 = 5.12% p.a.
c. For mid-price quote:
0.02515*/1.9515^ x 4 = 5.16% p.a. [ *(0.0253 + 0.0250)/2,
^(1.9520 + 1.9510)/2]
52
Intl.fin.
Problems in foreign exchange
12. A foreign exchange dealer quoted the following rates for Pounds
Sterling on Friday, November 30, 1995.
Spot $1.4710/810
ii. 30-day forward
65/44
iii. 90-day forward
145/123
iv. 180-day forward 290/222
v. Determine the outright quotations for the Pound Sterling.
vi. Was Pound Sterling selling at a forward premium or a forward discount
on that date? Calculate the forward premium (or discount) on the 90day forward contract. Use ask rate to answer the question.
vii. How many US dollars would it cost you to buy £1,000,000 on November
30 1995?
viii. If you expect to receive £1,000,000 in 180 days from the quotation
date, how many US dollars would you expect to realise by selling them
forward?
ix. Assuming that the yield on a 6-month CD of major banks in the US is
9%, what should be the yield on a comparable CD in UK to insure
interest parity between the two countries?
i.
53
Intl.fin.
Solution
Spot
I Month
3 Months
6 Months
$1.4710–
1.4810
$1.4710–
1.4810
- 0.00650.0044
$1.4710–
1.4810
- 0.0145–
0.0123
$1.4710–
1.4810
- 0.02900.0222
Outright
quotes
$1.4645–
1.4766
$1.47651.4687
$1.4420-1.4588
vi. Forward discount = (forward rate – spot rate)/spot rate x
12/nx100 = (1.4687 – 1.4810)/1.4810 x 12/3 x 100 = 3.32%
vii. 1,000,000 x 1.4810 = $1,481,000
viii. 1,000,000 x 1.4220 = $1,442,000
ix. Forward discount=(1.4588 – 1.4810)/1.4810 x 12/6 x100
= -3%
Therefore the yield on a UK CD should be 12% (9% +
3%)
54
Intl.fin.
Problems in foreign exchange
13. You have called a foreign exchange
dealer and asked for Euro-dollar quotation for
spot, 1-month, 3-month and 6-month. The
trader responded with the following quotes:
$0.2479/81, 3/5, 8/7 and 13/10 respectively.
What does this mean?
If you wish to buy spot Euros how much
would you pay in dollars?
If you wished to buy dollars how much
would you pay in Euro?
55
Intl.fin.
Problems in foreign exchange
Answer:
Spot €/$ rate
Forward rate
Outright quote
1-month
0.2479 –
0.2481
0.0003 –
0.0005
0.2482 –
0.2486
3-month
0.2479 –
0.2481
0.0008 –
0.0007
0.2471 0.2474
6-month
0.2479 –
0.2481
0.0013 –
0.0017
0.2466 –
0.2464
We can buy spot euros at the bank’s spot selling
rate of $0.2471 per Euro.
€/$ Bid rate = $/€ Ask rate.
We can buy spot dollars at 1 ÷ 0.2479 =
€4.0339
56
Intl.fin.
Exchange Rate Forecasting
• To explain how firms can benefit
from forecasting exchange rates;
• To describe the common techniques used
for forecasting; and
• To explain how forecasting performance
can be evaluated.
57
Intl.fin.
Why Firms Forecast Exchange
Rates?
Forecasting exchange rates is a very difficult
task, and it is for this reason that many
companies and investors simply hedge their
currency risk.
MNCs need exchange rate forecasts for their:
hedging decisions,
short-term financing decisions,
short-term investment decisions,
capital budgeting decisions,
earnings assessments, and
long-term financing decisions.
Why?
58
Intl.fin.
Corporate Motives for Forecasting
Exchange Rates
Decide whether to hedge foreign
currency cash flows
Decide whether to invest in foreign
projects
Decide whether foreign subsidiaries
should remit earnings
Decide whether to obtain financing in
foreign currencies
In short, to minimize risks and maximize
returns
59
Intl.fin.
Forecasting Techniques
The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
Technical,
Fundamental,
Market-based, and
Mixed.
None of the above methods is superior
to others. This speaks to the difficulty of
generating a quality forecast.
60
Intl.fin.
Technical Forecasting
Technical forecasting involves the use of
historical data to predict future values –
E.g. time series models.
Speculators may find the models useful
for predicting day-to-day movements.
However, since the models typically
focus on the near future and rarely
provide point or range estimates, they
are of limited use to MNCs.
61
Intl.fin.
Fundamental Forecasting
In general, fundamental forecasting is
limited by:
the uncertain timing of the impact of the
factors,
the need to forecast factors that have an
immediate impact on exchange rates,
the omission of factors that are not easily
quantifiable, and
changes in the sensitivity of currency
movements to each factor over time.
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Intl.fin.
Market-Based Forecasting
Market-based forecasting uses market
indicators to develop forecasts.
The current spot/forward rates are often
used, since speculators will ensure that the
current rates reflect the market expectation
of the future exchange rate.
For long-term forecasting, the interest rates
on risk-free instruments can be used under
conditions of IRP.
63
Intl.fin.
Mixed Forecasting
Mixed forecasting refers to the use
of a combination of forecasting
techniques.
The actual forecast is a weighted
average of the various forecasts
developed.
64
Intl.fin.
Comparison of Forecasting Methods
The different forecasting methods
can be evaluated:
graphically
by visually comparing the deviations
from the perfect forecast line, or
Statistically
by computing the forecast errors for
all periods.
65
Intl.fin.
Purchasing Power Parity (PPP)
(PPP) is perhaps the most popular method due to
its indoctrination in most economic textbooks.
It is based on the theoretical Law of One Price,
which states that identical goods in different
countries should have identical prices.
The exchange rate may however change to offset
price changes due to inflation.
Suppose prices in the U.S. are expected to
increase by 4% over the next year while prices in
Canada are expected to rise by only 2% and the
inflation differential between the two countries is
2%, >>
66
Intl.fin.
>>Purchasing Power Parity (PPP)
It means prices in the U.S. are expected to rise
faster relative to prices in Canada.
In this situation, the purchasing power parity
approach would forecast that the U.S. dollar would
have to depreciate by approximately 2% to keep
prices between both countries relatively equal.
If the current exchange rate was 90 cents U.S. per
one Canadian dollar, then the PPP would forecast
an exchange rate of US$91.8 Cents/1C$, meaning
it would now take 91.8 cents U.S. to buy one
Canadian dollar.
67
Intl.fin.
Big Mac Index
One of the most well-known applications of
the PPP method is illustrated by the Big
Mac Index, compiled and published by The
Economist. This light-hearted index
attempts to measure whether a currency is
undervalued or overvalued based on the
price of Big Macs in various countries. Since
Big Macs are nearly universal in all the
countries they are sold, a comparison of
their prices serves as the basis for the
index.
68
Intl.fin.
Big Mac Index (BMI)
The concept behind the BMI is that
prices will eventually equalize over time.
While this simple formula may serve as
a theoretical guide to determine under
and overvalued currencies, practicality
says many limitations exist in the short
and long term for measuring evaluations
and achieving successful trades.
69
Intl.fin.
Relative Economic Strength Approach
The relative economic strength approach looks
at the strength of economic growth in different
countries in order to forecast the direction of
exchange rates.
The idea being that a strong economic
environment and potentially high growth is more
likely to attract investments from foreign
investors.
In order to purchase investments in the desired
country, an investor would have to purchase the
country's currency - creating increased demand
that should cause the currency to appreciate.
>>
70
Intl.fin.
>>Relative Economic Strength Approach
Another factor that can draw investors
to a certain country is interest rates.
High interest rates will attract investors
looking for the highest yield on their
investments, causing demand for the
currency to increase, which again would
result in an appreciation of the currency.
>>
71
Intl.fin.
Relative Economic Strength Approach
Unlike the PPP approach, the relative
economic strength approach doesn't
forecast what the exchange rate should be.
Rather, this approach gives the investor a
general sense of whether a currency is
going to appreciate or depreciate and an
overall feel for the strength of the
movement.
This approach is typically used in
combination with other forecasting
methods to develop a more complete
forecast.
72
Intl.fin.
Econometric Models
The factors used in econometric models are
normally based on economic theory, but any
variable can be added if it is believed to
significantly influence the exchange rate.
If interest rate differential between the U.S.
and Canada (INT), the difference in GDP growth
rates (GDP), and income growth rate (IGR)
differences between the two countries are
found to be the most important factors in
forecasting the exchange rates, the
econometric model could be: USD/CAD (1-year)
= z + a(INT) + b(GDP) + c(IGR) >>
73
Intl.fin.
Econometric Models
The coefficients a, b and c in the formula
will determine how much a certain factor
affects the exchange rate and direction of
the effect (whether it is positive or
negative).
This method is probably the most complex
and time-consuming approach of all.
However, once the model is built, new data
can be easily acquired and plugged into the
model to generate quick forecasts.
74
Intl.fin.
Time Series Model
One of the more popular time series approaches
is called the autoregressive moving average
(ARMA) process.
The rationale for using this method is based on
the idea that past behavior and price patterns
can be used to predict future price behavior and
patterns.
The data you need to use this approach is
simply a time series of data that can then be
entered into a computer program to estimate
the parameters and essentially create a model
for you.
75
Intl.fin.
Bottom Line Approach (BLA)
Since bottom line is most valuable for a
business a finance manager would see
which parameter affects the bottom line
most.
The result from this method is limited by
focusing only on one parameter i.e., profit.
A combination of different factors will lead
to better forecasting of exchange rates.
76
Intl.fin.
Managing Foreign Exchange
Reserves
77
Intl.fin.
Motives for holding foreign
exchange reserves
Can be classified under:
Transaction
ii. Speculative and
iii. Precautionary
.Transaction motive arise because of
international trade handled by banks.
.Speculative motive arise because of
individuals or corporates engaging themselves
in speculation for profit.
.Central bank reserves however arise as a
precaution against unpredictable flows. >>
i.
78
Intl.fin.
Objectives of maintaining reserves
i.
ii.
iii.
iv.
v.
79
Intl.fin.
Maintaining confidence in monetary and
exchange rate policies.
Enhancing capacity to intervene in the
foreign exchange markets.
Limiting external vulnerability by maintaining
foreign currency liquidity to absorb shocks
during times of crises including national
disasters or emergencies.
Providing confidence to the markets and
Adding to the comfort of the market
participants by demonstrating the backing of
domestic currency by external assets.
Implications of reserve
accumulation
Portfolio inflows are temporary
Whereas current account surpluses tend to endure and have positive
effect on the exchange rate.
Persistent current account surpluses are identified with appreciation of
long-term equilibrium exchange rate.
Resisting current account surpluses may cause larger capital flows with
potential appreciation pressure.
In many emerging market economies there is a wide gap between forex
reserves and the currency in circulation.
The central bank can finance this gap by issuing domestic monetary
liabilities.
If the increased reserves put downward pressure on short- term interest
rates, bank credit would tend to expand and inflationary pressure will
mount.
Central banks would try to control the inflationary pressure by selling
govt. security (Sterilized intervention)
Build up of reserves may sometimes be inimical for economic growth.
80
Intl.fin.
Fiscal cost of intervention
Large currency appreciation against anchor
currency(ies) may result in considerable valuation
losses.
It is however debatable how far valuation losses
might matter for the sustainability of intervention
policy.
Intervention to prevent a rise in exchange rate can
accentuate macroeconomic and financial imbalances.
Increased bank lending resulting from partial or
ineffective sterilization could finance excessive
investment in certain sectors like property markets or
equity market with adverse effects.
81
Intl.fin.
Questions
Discuss the motives for holding foreign exchange
reserves. Is foreign exchange reserves buildup
inimical to growth?
What are the challenges posed by the surge in
capital flows to the conduct of monetary and
exchange rate policy?
Critically examine the renewed interest in recent
times in foreign exchange reserves in the context of
increasing globalization, acceleration of capital flows
and integration of financial markets.
Explain why it would be virtually impossible to set an
exchange rate between Indian Rupee and U.S. dollar
and to maintain a fixed rate of exchange.
82
Intl.fin.
>> Questions
Assume that the Federal Reserve believes that dollar
should be weakened against Chinese Yuan. Explain how
the Fed can use direct and indirect intervention to
weaken the dollar value with respect to yuan. Assume
that future inflation in the U.S. is expected to be low
regardless of Fed’s actions.
Explain briefly why the Federal Reserve may attempt to
weaken the dollar?
How can a central bank use indirect intervention to
change the value of a currency?
What is the impact of a weak home currency on the
home economy, other things being equal? What is the
impact of a strong home currency on the home
economy, other things being equal?
83
Intl.fin.
>> Questions
How can a central bank use direct
intervention to change the value of a
currency? Explain why a central bank may
desire to smooth exchange rate
movements of its currency?
Compare and contrast the fixed, floating
and managed float exchange rate systems.
What are some advantages and
disadvantages of a freely floating exchange
rate system versus a fixed exchange rate
system?
84
Intl.fin.
Types of Transactions
Transactions can be classified based on the time
between entering into a transaction and its
settlement.
Ready or Cash transaction: Settled the same day
or ‘value today transaction’.
TOM transaction: Settled the next day
Spot transaction: Settled 2 business days from
the date of the contract.
Forward transaction: Parties to the transaction
agree to buy or sell a currency or commodity at a
predetermined future date at a particular price
decided on the date of transaction.
85
Intl.fin.
Forex
Transactions
Forwar
d
Spot
Ready
(Today)
86
Intl.fin.
Tom
(Next
working
day)
Spot
(Two
working
days)
(Any
time
after two
working
days)
Value Dates
The settlement date of a forex transaction is called
its value date.
A Spot transaction is settled 2 nd business day from
the date of transaction.
Neither day should be a holiday either in any of the
settlement locations or in the dealing location of
the market making bank.
The settlement date for a forward contract
depends on:
1. The settlement date for the spot transaction entered
on the same date as the forward contract and
2. the maturity of the forward contract in months.
87
Intl.fin.
Value Dates
For example,
If a 3 months (or 90 days) is entered into on
July 20, the spot value date is July 23
(assuming that July 21 is a holiday).
The settlement date for the forward contract
will be Oct 23 (by adding 3 calendar months).
If it is a holiday that day, then the settlement is
shifted to the next day.
Suppose the spot settlement date is the last
day of the month, then the settlement date of
the forward contract will be the last day of the
relevant month irrespective of the number of
days in the two months.
88
Intl.fin.
Value Dates
Example: If one month forward contract is
entered to on Jan 29, then the spot
settlement will be Jan 31 and forward
settlement will be on Feb 28 or 29.
If the forward settlement date of a contract
is say Oct 31, and if it happens to be a
holiday, then the settlement cannot be
done on Nov 1. In such a case the
settlement will be shifted to the previous
day i.e., Oct 30.
89
Intl.fin.
Forward Quotes – Premium & Discount
A currency is said to be at premium it its
forward rate is higher than its current spot
rate.
Conversely, a currency is at a discount, if
the forward rate is lower than the current
spot rate.
Example 1:
INR/USD : 45.42/44 and 3m INR/USD :
46.62/70
USD/GBP : 1.6721/26 and 3m USD/GBP :
1.6481/92
The spread between the bid and the ask
90
rates increases as one goes into the future.
Intl.fin.
Forward Quotes – Premium &
Discount
The difference between the spot rates and forward
rates can be expressed in terms of swap points.
In the rupee-dollar example, the swap points are
120/126 (46.62 – 45.42 and 46.70 – 45.44).
In the dollar-pound example, the 3-month swap
points are 240/234 (1.6721-1.6449 and 1.67261.6492).
Rules:
1. When swap points are low/high, currency B is at a
premium and A is at discount:
Premium: Add swap points to spot rate to get the outright
forward rate or
Deduct swap points from the outright forward rate to get the
spot rate.
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Intl.fin.
Forward Quotes – Premium & Discount
Forward rates can be expressed in two ways.
Commercial customers are usually quoted the
actual price (outright rate). In the interbank
market, however, dealers quote forward rate
only as a premium or discount on the spot rate.
Example:
Spot sale JPN/USD Feb.6 1990: $0.006879 (A)
90 days forward Yen
: $0.006902 (B)
Swap rate for 90 days Yen: 23 points (B – A)
Alternatively, the premium or discount can be
expressed as annualized percentage as follows:
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Intl.fin.
Forward Quotes – Premium &
Discount
Forward premium/discount = (Fwd. Rate – Spot
Rate)/Spot Rate x 12 (or 360)/forward months (or
number of days)
Thus, the annualized premium in the above
example is:
(0.006902 – 0.006879)/0.006879 x 12/3 = 0.0134 or 1.34%
Out of two margins given for a month, the first
one relates to the buying rate and the second
rate to the selling rate
If the forward margins for a month are in
ascending order it indicates premium and if it is
in the descending order it is at a discount.
93
Intl.fin.
Forward Quotes – Premium & Discount
If the forward rate is in premium the forward rate is
found out by adding the margin to the spot rate and
deduct it for discount.
Example: The following quotes are received for spot,
one month, 3 months and 6 months SFR and GBP:
Spot
Intl.fin.
3
month
s
6
months
£/$
2.0015–
30
19-17
26-22
42-35
SFr/$
0.6963–
68
4-6
9-14
25-38
>>
94
1
mont
h
Pound Sterling
The
outright rates
Maturity
Bid are: Ask
Spread
Swiss Francs
Bid
Ask
Spread
(%)
(%)
Spot
$2.001
5
$2.003
0
0.075
$0.696
3
$0.6969
0.086
%
1 Month
1.9996
2.0013
0.095
0.6972
0.6982
0.143
3 Months
1.9989
2.0008
0.095
0.6972
0.6982
0.143
6 Months
1.9973
1.9995
0.110
0.6988
0.7006
0.257
Swiss Francs are selling at a premium against the dollar and
Pound is selling at a discount.
The wider percentage of the spread between the bid and the
offer of SFr compared to £/$ is due to broader market in Pounds.
The widening spreads by maturity for both the currencies is
caused by the greater uncertainty surrounding the future
exchange rates.
95
Intl.fin.
Forward Quotes – Premium &
Discount
2. When the swap points are high/low,
currency B is at a discount and currency A
is at premium.
Deduct the swap points from the spot rate to arrive
at the outright forward price or
Add them to the outright forward rates to get the
spot rate.
3. The bid side swap points are to be added
96
to or subtracted from the spot bid rate
(depending on the currency is at a
premium or discount) to arrive at the
forward bid rate. The ask-side swap
points are added to or subtracted from
the spot ask rate to get the forward ask
Intl.fin.
rate.
Forward Quotes – Premium &
Discount
Rolling over a forward contract: When the
maturity of a forward contract is extended
by cancelling the existing contract and
entering into a new contract for the
extended duration, it is called rolling over a
forward contract.
In India rolling over forward contracts for
over one year is not permitted.
A party with an exposure longer than one
year can initially hedge for the maximum
maturity available and roll over at maturity
for further periods.
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Intl.fin.
Broken date Forward Contracts
A broken date forward contract is a contract
which is not a whole month or for which a
quote is not readily available.
The rate for a broken period contract is
calculated by interpolating between the
available quotes for the preceding and the
succeeding maturities.
Example: What will be the forward rate for
1month and 10 days (broken date contract)
if$/` Spot :40.00 – 40.101month fwd.:
40.50 – 40.703month fwd.: 40.80 – 41.10
>>
98
Intl.fin.
Broken date Forward
Contracts
Solution:
For 1month and 10 days, swap points are:
Buying Rate: 50 + (80-50) x 10/60 = 55
Selling Rate: 70 + (110–70) x 10/60=77
The forward rate for 1 month and 10 days
will therefore be `40.55 – 40.77/$
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Intl.fin.
Broken date Forward Contracts
A customer wants a quote from the bank for
purchasing dollars from the bank on Sept. 29.
Dollar is at a premium and the swap points
are 29/35 between Aug and Oct maturity.
On the ask side, the premium is 35 points which is
spread over 61(30+31) days. The required
maturity is 29 days away from Aug maturity .
Hence the premium charged by the bank over
and above the Aug rate will be 35x29/61=17
points. The rate charged will be 5.5885 + 0.0017
= Sfr5.5902/$ Similarly, the buy and sell rates
can be calculated for any intervening rates
between two given maturities.
>>
100
Intl.fin.
Option Forwards
Customer of a bank has the option to ask
101
for settlement of the contract anytime
during a particular period called the option
period.
Giving quotes for this kind of contract is not
as straight forward as a quote for an
outright forward contract because while the
exchange rate is fixed the timing of the
exchange is not fixed.
If the exchange takes place at an
unfavorable time the bank would incur a
loss.
Intl.fin.
To avoid a loss, banks adopt the following
Option Forwards
1. When the bank is buying a currency:
Will add the minimum premium
102
possible (when it is at a premium) to
the spot rate and
Will deduct the maximum discount
from the spot rate (when it is at a
discount).
The bank quotes a rate applicable to
the beginning of the option period
when the currency is at a premium
and that applicable to the end of the
Intl.fin. option period when it is at a discount.
Option Forwards
2. When the bank is selling a currency:
Will add the maximum premium possible (when
it is at a premium) to the spot rate
Will deduct the minimum discount possible
(when it is at a discount) from the spot rate.
This would result in the bank quoting the rate
applicable to the end of the option period when
the currency is at a premium and to the
beginning of the option period when it is at a
discount.
. Example1: Euro/Sfr rate: Spot: 1.2245/49, 3m
fwd.: 10/15, 4m fwd.: 15/25, Option 4 months
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Intl.fin.
Option Forwards
Sfr is at a premium
If the bank is selling Sfr, it will load the maximum
premium to the spot rate (on the implicit
assumption that the customer will demand delivery
when the currency is most expensive). So it will
quote a rate Euro 1.2274/Sfr (1.2249 + 0.0025)
If the contract is to buy SFr, the bank would assume
that the customer would choose to exercise his
option when SFr is at its cheapest i.e., at the
beginning of the fourth month. So it will load a
minimum premium to the spot rate and quote
Euro1.2255/SFr (1.2245 + 0.0010)
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Intl.fin.
Option Forwards
Example 2. Currency is at a premium at the
beginning of the option period and at a
discount during the option period.
SFr/Aus$ : 3.4925/30
1month : 3.4935/45
2months
: 3.4930/42
Customer Option to buy Aus$ any time
during the second month, the bank would
quote the rate of SFr3.4945/Aus$ and if the
option were to sell Aus$, the quotation would
be SFr3.4930/Aus$.
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Intl.fin.
CURRENCY ARBITRAGE &
INTEREST RATE PARITY
i. Conditions that will result in
international arbitrage.
ii. The concept of interest rate parity and
how it prevents arbitrage opportunities
106
Intl.fin.
International Arbitrage
Definition: Capitalizing on a discrepancy in the quoted
prices by making a risk-less profit.
Three forms:
1.
2.
3.
107
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage
1. Locational arbitrage:
Example: Two coin shops A & B are in the business of
buying and selling coins. Shop A is prepared to sell a
particular coin at Rs.120 and shop B is prepared to buy
the same coin for Rs.130.
A coin collector can buy the coin at Rs.120 from shop A
and sell the same to shop B for Rs.130 and thus earn a
risk-free profit of Rs.10 in the transaction.
Prices in the shops may vary because of their different
locations. Demand conditions also vary if the two shops
are not aware of each other’s prices. These factors give
Intl.fin.
rise for arbitrage opportunities. Gains from locational
Triangular Currency Arbitrage
Exchange dealers are continually alert to the
possibility of taking advantage through
triangular currency arbitrage.
These transactions involve buying a currency in
one market and simultaneously selling it in
another market, to take advantage of exchange
inconsistencies in different money centers.
Suppose the Pound Sterling is bid at $1.5422 in
New York and Euro is offered at $0.9251 in
Frankfurt; At the same time London banks are
offering Pound Sterling at €1.6650.
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Intl.fin.
Triangular Currency Arbitrage
New York quote: ₤/$ Bid - $1.5422/pound
Frankfurt quote: €/$ Ask - $0.9251/Euro
London quote:
₤/€ Bid - €1.6650/pound
If $1.5422 = 1₤ and
If 1₤ = €1.6650
How many Euros = 1$
i.e. (1.5422/1) x (1/1.6650) = €0.9262 or 1€ = $1.0796
Since euro is available in Frankfurt at a cheaper rate of
$0.9251 (as against a cross rate of $1.0796) there is an
arbitrage opportunity.
109
Intl.fin.
Currency Arbitrage
Let us assume that the trader begins in
New York with $1 million.
Acquire €1,080,964.22 (1,000,000/0.9251) in
Frankfurt,
Sell these euros for ₤649,277.76
(1,080,964.22/1.6650) in London and
Resell the Pounds in New York for $1,001,239.05
(649,227.76 x 1.5422), making a profit of $1,239.05.
This sequence of transactions is known as triangular
currency arbitrage. >>
110
Intl.fin.
Currency Arbitrage
In the preceding example, the arbitrage
transactions would tend the euro to appreciate
vis-à-vis the dollar in Frankfurt and to depreciate
against Pound Sterling in London.
At the same time, sterling would tend to fall in
New York against the dollar.
Acting simultaneously, these currency changes
will quickly eliminate profits from this set of
transactions, thereby enforcing the no-arbitrage
condition.
Otherwise, a money machine would exist, opening
the prospects of unlimited risk-free profits.
111
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Currency Arbitrage - Exercise
Your forex trader has given the following cross currency quotes. The
quotes are expressed as one unit of currency on the left side per unit
of currency shown at the top row.
Curr
ency
SFr
DKr
GBP
JPN
SFr
DKr
Pound Stg.
Japanese
Yen
US $
0.295702.4256-67
0.1276-78
1.5780-86
3.3818-25
76 8.2031-41
0.4315-19
5.3021-33
0.41227- 0.00526-29
0.6502-10
35
0.12381190.121123.56978.38190
390
707
496arbitrage
23.178Do any triangular
opportunities exist among these
251deviations from the theoretical cross
currencies? (Assume that any
rates of 5 points or less are due to transaction costs).
How much profit could be made from a $5 million transaction
associated with each arbitrage opportunity?
112
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Questions
1. Discuss the forex market structure in India.
2. What risks confront the forex dealers and how
3.
4.
5.
6.
113
do they cope with those risks?
Suppose a currency increases in volatility, what
is likely to happen to its bid – ask spread? Why?
Who are the principal users of the forward
market?
How does a company pay for the foreign
exchange services of a commercial bank?
The $/€ exchange rate is €1=$0.95 and €/SFr rate is SFr1 =
€0.71, what is the SFr/$ exchange rate? >>
Intl.fin.
Questions
6. An investor wishes to buy euros spot @ $0.9080
and sell euros forward for 180 days @ 0.9146,
what is the swap rate on euros and what is the
forward premium or discount on 180 days euros?
7. Suppose Credit Suisse quotes spot and 90 days
forward rates on the Swiss Franc of $0.7957 – 60,
8 – 13,
What are the outright 90 day forward rates that
Credit Suisse is quoting?
b. What is the forward discount or premium
associated with buying 90-day Swiss Francs?
c. Compute the percentage bid-ask spreads on spot
and forward Swiss Francs.
a.
114
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Questions
8. As a foreign exchange dealer at Sumitomo Bank
you have a customer who would like spot and 30day forward Yen quotes on Australian Dollars.
Current market rates are:
Spot 30-day
¥101.37-85/US$1 15–13
A$1.2924 – 44/US$1
20–26
a) What bid and ask Yen cross rates would you quote
on spot Australian dollars?
b) What outright Yen cross rates would you quote on
30-day forward Australian dollars?
c) What is the forward premium or discount on buying
30-day Australian dollars against yen delivery?
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Part II – Unit 6 - International Financial
Markets & Instruments
Origin
Instruments
Players
Decision
116
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THE ASIAN CRISIS OF THE 90s
Causes
Governments’ intervention for controlling
their exchange rates
Consequences of intervention efforts
117
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Crisis in Thailand
World’s fastest growing economy till 1997
Grew faster than any other country over 1985 –
94
Thai consumers spent freely and saved less
Result – upward pressure on local interest rates
and prices of real estate and products
Thai Baht was linked to U.S. dollar till July 1995
and therefore attracted foreign investments
because of high interest rates.
More funds available to Thai banks were lent to
the real estate sector based on the previous
success of the developers
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>>Crisis in Thailand
Thailand was a “house of cards waiting to collapse”
Large inflow of funds led to lower interest rates
Thai government borrowed heavily to improve
country’s infrastructure at high rates of interest.
In 1997 foreign investors recognized Thailand’s
potential weakness and started withdrawing their
investments
Baht started depreciating against all major
currencies
On July 2 1997 baht was delinked from dollar and
Thailand’s central bank started intervening in the
market
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>> Crisis in Thailand
The market intervention didn’t help
In July 1997 baht plummeted
The defaulted bank loans were over $30
120
billion
On August 5 1997 IMF and other countries
agreed to provide a $16 billion rescue
package
In return Thailand agreed to reduce its
budget deficit, prevent inflation from rising
above 9% and increase taxes
Many banks folded up
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The crisis spread throughout Southeast
Effects On Other Currencies
In July – August 1997 the malaise spread to Malaysia,
Singapore, Philippines, Taiwan and Indonesia
Their currency values depreciated fast
Efforts by central banks to intervene and stabilize
their currencies failed
The Southeast Asian Countries gave up their fight to
contain depreciation of their currencies
Many restrictions on forwards and futures market
speculation did not bear fruit
Investors had no confidence in the markets and that
resulted in flight of capital
The currencies were allowed to float
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>> Effects On Other
Currencies
Due to integration of Southeast Asian economies the
excessive cross-border lending by local banks turned bad
Finally, what began as the ‘Thailand crisis’ became the
‘Asian Crisis’
The Asian Crisis had impact on many other countries
across the globe - Hong Kong, Russia, South Korea, Japan,
China, India, Latin American countries as well as Europe
and United States
Lessons learnt: The Asian Crisis demonstrated the degree
to which currencies could depreciate in response to lack
of confidence by investors and the inability of central
banks to stabilize their local currencies in such a crisis.
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How Exchange Rates Changed
Ruble depreciated - IMF package of $22.6
billion
S.Korea
-41%
Chaebols
collapsed,
Currency
depreciated
IMF rescue
package of $55
billion
- 0%
41%
Hong
Kong 0%
-
38%
-37%
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Singapore
- 15%
-84%
Taiwan
-20%
-37%
How Interest Rates Changed between June 1997(.) and June 1998
S.Korea
(14)/17%
(7)/12%
(11)/24%
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Singapore
(3)/7%
Indonesia
(16)/47%%
(7)/8
%
(7)/11%
%
Taiwan
(5)/7%
Hong Kong
(6)/10%
Philippine
s
(11)/14%
Sources of International
Liquidity
Monetary gold held by the authorities as a
125
financial asset
SDRs – (Value of SDR determined daily by the
IMF on the basis of a basket of currencies, with
each currency assigned a weight)
Reserve position in the fund (difference
between each member’s quota plus other
claims on the fund less the Fund’s holdings of
that member’s currency).
Foreign exchange comprising monetary
authorities claim on non-residents in the form
of bank deposits, Treasury Bills, Short and longterm government securities, without regard as
Intl.fin.
to whether the claim is denominated in the
International Financial Markets &
Instruments
126
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Origin of International Financial Markets
Demand for high quality dollar denominated bonds
who wished to hold their assets outside their own
countries.
Concerns of these investors:
Avoiding registration of ownership of investments and
taxes in their home countries and
Protecting themselves against falling values of domestic
currencies.
Euro bonds were designed to address these concerns.
Major changes have taken place in the international
markets since 1970s:
Removal of exchange controls in countries like U.K.,
France and Japan
Application of technology to financial services etc.
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International Financial Markets &
Instruments
The integration of financial markets across
countries has opened up the international
markets.
The financial intermediaries have developed a
large variety of financial instruments to suit the
needs of international investors for both equity
and debt investments.
Instruments in the bond market:
Foreign Bonds: Yankee Bonds, Samurai Bonds,
Bulldog Bonds,
Euro Bonds: Euro dollar, Euro Yen and Euro Pound
Bonds
Instruments in the Equity Market: ADR / GDR
128
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International Financial Markets &
Instruments
Foreign Bonds: Bonds floated in domestic market
denominated in domestic currency by non-resident
entities.
Euro Bonds: Bonds issued and sold outside the
home country of the currency.
Syndicated Euro Credits are available in euro
markets by way of Club loans and Syndicated loans.
Club loans are private arrangement between
lending banks and a borrower.
Syndicated Euro Credit is a full-fledged public
arrangement for organizing a loan transaction.
Wide network of participation by banks
Loan maturity of 3 to 7 years.
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History of International Financial
Markets & Instruments
Until the end of 1970s there were
130
restrictions on cross-border equity
investments.
Investors too preferred domestic equity
markets because of perceived risks in
foreign currency exposures.
Early 80s witnessed liberation of many
domestic economies and globalization.
Issuers from developing countries were
able to access international equity markets
through issue of Depository Receipts –
GDRs, ADRs and IDRs
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American Depository Receipts (ADRs)
In April 1990 SEC allowed non-US
companies to rise capital in the US market
without having to register the securities
with SEC or without having to change the
financial statements according to US GAAP
requirements.
QIBs are permitted to invest in ADRs
It represents non-US company’s publicly
traded equity.
Well-known intermediaries: Goldmann
Sachs & Co., Merrill Lynch Intl. Ltd., J P
Morgan etc.
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International Financial Markets &
Instruments
A Depository Receipt is a negotiable certificate
issued by a depository bank which represents the
beneficial interest in shares issued by the company.
These shares are deposited with a local custodian
appointed by the depository that issues the receipts
against the deposit of shares.
In countries with capital account convertibility, DRs
and domestic equity shares are mutually
convertible.
Until the DRs are converted into equity shares, the
holder will not have any voting rights and also there
is no foreign exchange risk for the company.
The company will be listed at the prescribed stock
exchanges providing liquidity for the instrument.
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International Financial Markets &
Instruments
Borrowers / Issuers: Mostly, corporates,
banks, FIs, govt. and quasi-govt. bodies
who need forex funds.
Corporates borrow foreign currencies for
expansion of their operations abroad or
because of dull and saturated domestic
markets.
Govts. Borrow for adjusting their BOP
mismatches, for keeping sufficient inventory
of currency reserves.
FIs like IMF, World Bank, ADB etc. borrow
long term funds for financing diversified
financing.
133
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International Financial Markets &
Instruments
Lenders / Investors:
Euro loans: The lenders are mostly
international banks.
For GDRs, the investors are mostly
institutions and high net worth individuals.
For ADRs, it is the institutional investors or
HNIs through the Qualified Institutional
Buyers.
Intermediaries:
Lead Managers, Co-lead Managers,
Underwriters, Lawyers and Auditors, Stock
Exchanges, Depository Banks and
Custodians.
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Functions of Intermediaries
1. Lead and Co-lead Managers:
Undertaking due diligence
Preparing the offer memorandum
Marketing the issues, including the road
shows
Sometimes there could be more than one
lead manager to ensure successful launch.
One of the lead manager will ‘run the books’
(sending out invitations, allotting Bonds / DRs
etc.) for the issue.
2. Underwriters: Taking on the risk of
under subscription and thus giving
support to the issue.
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Functions of Intermediaries
3. Agents & Trustees: The issuer of the Bonds
should appoint ‘paying agents’ in different financial
centers for payment of interest and principal due to
investors. These paying agents will be banks.
4. Lawyers and auditors:
Lawyers will draw up the legal documentation and
The auditors will provide comfort letters to the lead
managers on the financial health of the issuer.
5. Listing Agents and Stock Exchanges:
Listing Agents facilitate documentation and listing of
the issue and
Stock Exchanges will review the application and
provide comments on the issue prior to accepting the
securities for listing.
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Functions of Intermediaries
6. Depository Bank: Responsible for
issuing DRs, facilitating exchange of
DRs into underlying shares when
presented for redemption.
7. Custodian: The custodian holds the
shares underlying the shares on behalf
of the depository.
8. Printers: Responsible for printing and
delivery of the offer memorandum as
well as the DRs / Bond certificates.
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The Decision Criteria
1. Competitive cost
2. Currency requirement
3. Pricing:
Pricing of an international issue should consider the interest
rates and market value of the stock in the domestic market,
the exchange rate movements, hedging the risk, level of
premium etc.
4. Depth of the market in which the issue is being offered.
5. International positioning: Long term perspective of the
company.
6. Regulatory aspects: Various approvals required from
different authorities.
7. Disclosure requirements.
8. Investment climate – International liquidity, country risk.
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Indicative Time Schedule for
GDR/ADR Issue
139
Stage
Admn. Work involved
a. Initial
decision
i. Meeting between
issuer and lead
manager planning the
issue.
ii. Issue structure
finalized in
conformity with the
domestic regulatory
environment.
iii. Draft documentation
iv. Due diligence process
v. Board meeting and
share holders’
approval
vi. Fixing various parties
to the issue.
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Time in
weeks
1 and 2
Indicative Time Schedule for GDR/ADR Issue
Stage
b. Approvals and drafts
finalization
Admin. Work involved
i.
Official approvals – steps
initiated
ii. Comfort and consent letters
finalized with auditors
iii. Legal opinion formats
drafted and finalized
iv. Approvals obtained
Time in
weeks
3 and 4
c. Pre-launch formalities
d. Launch of issues
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v. Road show preparations and 7 and 8
presentations
vi. Pathfinder prospectus
finalized
vii. Listing preparations in final
stages
viii.Road shows organized
ix. Documentation circulated
among syndicate
x. Investors contracted
Indicative Time Schedule for GDR/ADR
Issue
Stage
e. Pricing and
closing
GDR Issue: Fees &
Expenses
141
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Admn. Work involved
i. Final terms fixed
ii. Allocation of securities to
investors
iii. Final prospectus to be kept
ready
iv. Final listing documents lodged
with stock exchange
v. Subscription agreement signed
vi. Delivery of global certificate
vii. Closing documents signed
viii.Payments to issuer
ix. Tombstone advertisement
Underwriting fee (%)
: 0.60 –
1.00
Management fee (%) : 0.60 –
1.00
Selling commission (%) :1.80 –
3.00
Time in
weeks
INTERNATIONAL DEBT
MARKETS
Debt markets and instruments
142
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International Debt Markets &
Instruments
143
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International Debt Market
(IDM)
The International Debt Market offers a
borrower:
A variety of different maturities,
Repayment structures and
Currencies of denomination.
Three original factors in the evolution of the
Eurobond market are still of importance:
Absence of regulatory interference,
Less stringent disclosure practices and
Favourable tax treatment.
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Debt Instruments – Euro Bonds (EBs)
EBs are bonds that are sold in countries other than
the country of the currency denominating the bonds.
Issuing EBs became easier with no exchange controls
and no govt. restrictions on transfer of funds in
international markets.
All EBs, through their features, can appeal to any
class of issuers or investors. The unique
characteristics that make them flexible are:
No withholding taxes of any kind on interest payments
Bonds are in bearer form with interest coupons attached
Listed on one or more stock exchanges (Usually on the
Luxembourg Stock Exchange) but issues are traded on
OTC market.
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Debt Instruments – Euro Bonds
Fixed Rate / Straight Debt Bonds:
Fixed interest bearing securities redeemable
at face value.
These are unsecured bonds
Bonds issued in the Euro-market are called
Euro Bonds.
Interest on the bonds are benchmarked to
LIBOR
Redemption of Straights is done by bullet
payment
No tax deduction at source on the income
from these bonds.
Can also be issued as Zero Coupon Bonds
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Debt Instruments – Floating Rate Notes (FRNs)
FRNs are Bonds with maturity of 5 – 7
years.
Conventionally the Bonds are called the
Notes and the margin will be above 6
months LIBOR for euro dollar deposits.
Procedure for issue:
The mandated bank forms a syndicate group
The lead bank is responsible for credit
appraisal, preparing a prospectus,
documentation etc.
Pricing is generally done by the book-building
route
147
Bought-out deal: Pre-priced issue is
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presented to the market
Debt Instruments – Euro Bonds
Listing:
Euro Bonds are generally listed in London / Luxembourg
stock exchanges.
Bond issue procedures generally end with tombstone
advertisements.
Clearing arrangements:
Euro Bonds are generally handed over to either
Euroclear system (Brussels) or Cedel (Luxembourg).
Euroclear and Cedel follow two distinct practices viz.
fungible
(Details regarding the identity of the owners and location of
and non-fungible
accounts for concluding transactions between parties.
Euroclear handles trades on fungible basis, whereas
Cedel permits both procedures.
individual securities are not provided)
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Debt Instruments – Foreign Bonds
Bonds issued by foreign entities for raising
medium to long term financing.
1. Yankee Bonds:
US Dollar denominated bond issues by
foreign borrowers in the U.S bond markets.
SEC regulates these issues and requires:
149
Intl.fin.
Complete disclosure documents in more detail
than what is available in the prospectus.
To adopt U.S accounting practices and
U.S credit rating agencies will have to provide
rating for these bonds.
Debt Instruments – Foreign Bonds
2. Samurai Bonds: Bonds issued by non-
Japanese borrowers in the domestic
Japanese markets.
Maturities: 3 – 20 years
As this is issued for public, arrangements
for underwriting and selling have to be
made and involves large documentation.
However, documentation and formalities
are friendly and hospital.
Expensive in terms of issuing cost
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Debt Instruments – Foreign Bonds
3. Bulldog Bonds: Sterling denominated foreign bonds
raised in UK domestic market.
Maturities: 5 to 25 years.
Generally redeemed on bullet basis
Will have to be listed on London Stock Exchange.
.Euro Notes:
Euro Notes (EN) are different from syndicated bank
credits and euro bonds in its structure and maturity
periods.
Pricing could be sub-LIBOR or a few basis points above
LIBOR.
Documentation formalities are minimal.
Euro Notes possess flexibility and can be tailored to suit
the specific requirements of different borrowers.
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Debt Instruments – Euro Notes
a. Euro Commercial Paper:
Short-term unsecured promissory notes that repay a
fixed amount on a certain future date.
Maturity: 3 months, 6 months and 1 year paper.
Even though the maturities are small, the overall funding
programme could be for medium to long term.
Procedure:
Select a dealer and an issuing and paying agent.
No mandatory rating. However, borrowers seek rating for
successful launching of CP programmes.
Documentation: Simple – An Information Memorandum, Dealer
Agreement, Issuing and Paying Agency Agreement and the actual
notes.
No separate disclosure requirements.
A variation of the ECP is the Asset-backed CP that is
backed by financial assets such as mortgages or credit
card receivables.
152
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Debt Instruments – Euro Notes
Note Issuance Facilities (NIFs): A medium-term legally
binding commitment under which a borrower can issue
short-term paper of up to one year.
Currency: Mostly US $
Margin: A spread over LIBOR or built into the NIF pricing
itself.
Underwriting: Yes, by banks. Could be a revolving
underwriting facility
NIFs can be reissued periodically.
Investors: Mostly commercial banks, insurance companies,
provident funds etc.
Medium-term Notes (MTNs):
Sequentially issued fixed interest securities
Maturity: Over one year, up to the desired level of
maturity
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Euro Credit Syndication
Syndicated Euro Credits are in existence since the late
60s.
Period: 7 to 15 years
RoI: Floating rate linked to 3 or 6 months LIBOR.
Currency: Denominated generally in US$, JPY, Euro, SFR .
Amortization: Half-yearly installments with 2 – 3 years
grace period.
Simplest way of raising foreign currency resources.
Documentation: Information Memorandum and loan
agreement from the lead manager.
Underwriting: Yes, by a management group assembled by
the lead bank, including itself.
Comparative Analysis of Global Financial Markets.xlsx plu
s Comparative Analysis of Financial Instruments.xlsx
154
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Glossary of Market Terms
American
Depository Receipt (ADR): A certificate of ownership issued by a
U.S. bank as a convenience to investors in lieu of the underlying foreign
corporate shares it holds in custody.
Arbitrage: Locking in a riskless profit from price disequilibria or distortions in
different markets
Arm’s length price: Price at which a willing buyer and willing unrelated seller
would freely agree to transact
Basis Point: The last decimal in the quotation of an exchange rate and 0.01%
when referring to interest rates or yields.
Bid Rate: The price at which a market maker is prepared to buy a currency or
borrow money.
CHIPS (Clearing House Inter-bank Payment System): Inter-bank payment
and settlement system in New York. Records all payments and receipts and
gives the net position at the end of the day. The system has enabled member
banks to substitute electronic payment in place of paper cheques.
CHAPS (Clearing House Automated Payment System): Exists in London.
Counterpart of CHIPS.
CHATS (Clearing House Automated Transfer System): Operational in Hong
Kong for automated inter-bank transactions.
155
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Glossary of Market Terms
Eurocurrency: A deposit or a borrowing domiciled
outside the home country of the currency.
EDI (Electronic Date Interchange): Transfer of data
between computers (Airline Reservation, SWIFT,
Customs Clearance of exports / imports)
Fixed date forwards: Standard maturity (or value)
dates for contracts like one, three or six months.
Forward Margin: Difference between spot and
forward rates, also known as swap price or points.
Fed Wire: A computer network that connects about
7000 banks around USA to the Federal Reserve Bank.
Follows gross settlement system, unlike CHIPS. Used
for payment and settlement of large value transactions.
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Glossary of Market Terms
Forward Rate: Price of a currency for
value date beyond the spot date. If more
expensive, the currency is at a premium, if
cheaper, then at a discount.
Market Making: Quoting rates for both
buying and selling a currency.
Middle Rate: Mean of Bid and Offered
rates.
Nostro Account: A bank’s account with a
correspondent bank / branch abroad, in the
home currency of that country.
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Glossary of Market Terms
Offer Rate: The price at which a market maker is
prepared to sell (a currency) or lend (money).
Option Forwards: One of the two parties to a forward
contract has the option of choosing the delivery date
within a specified period.
Position: The net commitment in a currency. It is square
if sales equal purchases, long, if purchases are more than
sales and short if sales exceed purchases.
Rollover: Similar to badla in the share market. Extending
or postponing delivery.
Reuter System: A computer based data bank that
provides real-time data on forex rates of various markets
all over the world.
Spread: Price difference between bid and offer rates.
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Glossary of Market Terms
Swap: Simultaneous sale and purchase of identical amounts
of one currency against another, for different maturities. A
swap could be spot (purchase or sale) against forward (sale or
purchase), or forward against forward.
Swap price or points: The difference in prices of the two (or
points) legs of a swap.
Straight Through Processing (STP): complete end-to-end
automated processing of transactions from inception to
settlement without any manual intervention.
Telerate: It is another company like Reuters that provides
information on global financial markets.
Value Date: The date of exchange of currencies. Also
referred to as delivery date or maturity date.
Vostro Account: A local currency account of a foreign bank /
branch.
159
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External Commercial
Borrowings (ECBs)
160
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Meaning of ECBs
ECB refers to commercial loans in the form
of:
Bank loans,
Buyers’ credit,
Suppliers’ credit,
Securitized instruments (e.g. floating rate
notes and fixed rate bonds, non-convertible,
optionally convertible or partially convertible
preference shares)
Availed of from non-resident lenders with a
minimum average maturity of 3 years.
Routes to ECBs
ECB can be accessed under two routes:
(i) Automatic Route and
(ii) Approval Route
Automatic Route (AR):
What is Automatic Route?
Who can borrow under the AR?
(a) Corporates, including those in the hotel, hospital,
software sectors (registered under the Companies Act,
1956) and Infrastructure Finance Companies (IFCs)
except financial intermediaries, such as banks, financial
institutions (FIs), Housing Finance Companies (HFCs)
and Non-Banking Financial Companies (NBFCs) are
eligible to raise ECB.
Who can borrow under the AR? .. Contd.
(b) Units in Special Economic Zones (SEZ)
(c) Non-Government Organizations (NGOs)
engaged in micro finance activities
(d) Micro Finance Institutions (MFIs)
engaged in micro finance activities
>>
Who can be the lenders for ECBs
under the AR?
(a) International banks,
(b) International capital markets,
(c) Multilateral financial institutions (such
as IFC, ADB, CDC, etc.) / regional financial
institutions and Government owned
development financial institutions,
(d) Export credit agencies,
(e) Suppliers of equipment,
(f) foreign collaborators and
(g) foreign equity holders
Amount & Maturity of ECB Under AR
A corporate other than those in the hotel, hospital and
software sectors: USD 750 million or its equivalent
during a financial year.
Corporates in the services sector viz. hotels, hospitals
and software sector : Up to USD 200 million or its
equivalent in a financial year for meeting foreign
currency and/ or Rupee capital expenditure for
permissible end-uses. The proceeds of the ECBs should
not be used for acquisition of land.
ECB up to USD 20 million or its equivalent in a financial
year with minimum average maturity of three years.
C:\Users\SESHU\Documents\Average Maturity Period on
ECBs.xlsx
Amount & Maturity of ECB Under AR
ECB above USD 20 million or equivalent and
up to USD 750 million or its equivalent with a
minimum average maturity of five years.
NGOs engaged in micro finance activities
and Micro Finance Institutions (MFIs): Up to
USD 10 million or its equivalent during a
financial year.
ECB up to USD 20 million or equivalent can
have call/put option provided the minimum
average maturity of three years is complied
with before exercising call/put option.
Pricing?
All-in-cost ceilings:
Average Maturity All-in-cost Ceilings over 6 month
Period
LIBOR*
Three years and
350 basis points
up to five years
More than five
500 basis points
* for
the respective currency of borrowing or applicable benchmark
years
In the case of fixed rate loans, the swap cost plus margin should be the equivalent of the floating rate plus the applicable margin.
All-in-cost includes rate of interest, other fees and expenses in
foreign currency except commitment fee, pre-payment fee, and
fees payable in Indian Rupees. The payment of withholding tax in
Indian Rupees is excluded for calculating the all-in-cost.
The all-in-cost ceilings for ECB are reviewed from time to time.
Ceilings applicable up to September 30, 2012 and subject to review
thereafter:
Purpose of ECBs
ECB can be raised for import of capital goods for new
projects, modernization/expansion of existing
production units in:
a) Industrial sector including small and medium
enterprises (SME),
b) Infrastructure sector [power, telecommunication,
railways, roads including bridges, sea port and
airport, industrial parks, urban infrastructure
(water supply, sanitation and sewage projects),
mining, exploration and refining and cold storage
or cold room facility] and
c) Specified service sectors, like hotel, hospital,
software
Purpose of ECBs
d) Overseas Direct Investment in Joint
Ventures (JV)/ Wholly Owned Subsidiaries
(WOS).
e) Acquisition of shares in the disinvestment
process and also in the mandatory
second stage offer to the public under the
Government’s disinvestment programme
of PSU shares.
f) For lending to self-help groups or for
micro-credit or for bonafide micro finance
activity.
Infrastructure Finance Companies (IFCs) i.e.
Non Banking Financial Companies (NBFCs)
categorized as IFCs by the Reserve Bank, are
permitted to avail of ECBs, including the
outstanding ECBs, up to 50 per cent of their
owned funds, for on-lending to the
infrastructure sector as defined under the
ECB policy,
g) Maintenance and operations of toll systems
for roads and highways for capital
expenditure provided they form part of the
original project
f)
End-uses not permitted
Other than the purposes specified hereinabove,
the borrowings shall not be utilized for any
other purpose including the following:
(a) For on-lending or investment in capital market
or acquiring a company (or a part thereof) in India
by a corporate [investment in Special Purpose
Vehicles (SPVs), Money Market Mutual Funds
(MMMFs), etc., are also considered as investment
in capital markets].
(b) for real estate sector,
(c) for working capital, general corporate purpose
and repayment of existing Rupee loans.
Security for the ECBs
Guarantees
Issuance of guarantee, standby letter of
credit, letter of undertaking or letter of
comfort by banks, Financial Institutions and
Non-Banking Financial Companies (NBFCs)
from India is not permitted.
No-objection from ADs
Before according ‘no objection’ under FEMA, 1999, AD
Category - I banks should ensure and satisfy
themselves that:
(i) the underlying ECB is strictly in compliance with
the extant ECB guidelines,
(ii) there exists a security clause in the loan
agreement requiring the borrower to create charge on
immovable assets / financial securities / furnish
corporate or personal guarantee,
(iii) the loan agreement has been signed by both the
lender and the borrower and
(iv) the borrower has obtained Loan Registration
Number (LRN) from the Reserve Bank.
Parking of ECB proceeds
Borrowers are permitted to either keep ECB proceeds
abroad or to remit these funds to India, pending
utilization for permissible end-uses.
The proceeds of the ECB raised abroad meant for Rupee
expenditure in India, such as, local sourcing of capital
goods, on-lending to Self-Help Groups or for micro credit,
payment for spectrum allocation, etc. should be
repatriated immediately for credit to the borrowers’
Rupee accounts with AD Category I banks in India.
In other words, ECB proceeds meant only for foreign
currency expenditure can be retained abroad pending
utilization. The rupee funds will not be permitted to be
used for investment in capital markets, real estate or for
inter-corporate lending.
Borrowers are permitted to either keep ECB proceeds
Parking of ECB proceeds
abroad or to remit these funds to India, pending
utilization for permissible end-uses.
ECB meant for Rupee expenditure in India, such as
local sourcing of capital goods, on-lending to Self-Help
Groups or for micro credit, payment for spectrum
allocation, etc. should be repatriated to India
immediately.
In other words, ECB proceeds meant only for foreign
currency expenditure can be retained abroad pending
utilization.
The rupee funds, however, will not be permitted to be
used for investment in capital markets, real estate or
for inter-corporate lending.
Investment of ECBs Parked Abroad
ECB proceeds parked overseas can be invested in the
following liquid assets:
(a) Deposits or Certificate of Deposit or other
products offered by banks rated not less than AA (-)
by Standard and Poor/Fitch IBCA or Aa3 by Moody’s
(b) Treasury bills and other monetary instruments of
one year maturity having minimum rating as
indicated above, and
(c) Deposits with overseas branches / subsidiaries of
Indian banks abroad. The funds should be invested in
such a way that the investments can be liquidated as
and when funds are required by the borrower in
India.
ECB Pricing
•The all-in-cost ceilings for ECB are reviewed from time to
time.
•The following ceilings are applicable up to September 30,
2012 and subject to review thereafter:
•* for the respective currency of borrowing or applicable
benchmark
•In the case of fixed rate loans, the swap cost plus the
margin should be the equivalent of the floating rate plus
the applicable margin.
Prepayment of ECBs
Prepayment of ECB up to USD 500 million
may be allowed by AD banks without prior
approval of Reserve Bank subject to
compliance with the stipulated minimum
average maturity period as applicable to
the loan.
Refinancing of an existing ECB
The existing ECB may be refinanced by
raising a fresh ECB subject to the condition
that the fresh ECB is raised at a lower all-incost and the outstanding maturity of the
original ECB is maintained.
An existing ECB may, however, be
refinanced by raising a fresh ECB at a
higher all-in-cost under the approval route.
APPROVAL ROUTE
ECB with minimum average maturity of 5
years by Non-Banking Financial Companies
(NBFCs) from multilateral financial
institutions,
Reputable regional financial institutions,
Official export credit agencies and
International banks to finance import of
infrastructure equipment for leasing to
infrastructure projects.
APPROVAL ROUTE
Eligible borrowers:
On lending by the EXIM Bank for specific purposes
Banks and financial institutions which had
participated in the textile or steel sector
restructuring package as approved by the
Government are also permitted to the extent of
their investment in the package and assessment by
the Reserve Bank based on prudential norms. Any
ECB availed for this purpose so far will be deducted
from their entitlement.
Infrastructure Finance Companies (IFCs) i.e. NonBanking Financial Companies (NBFCs), categorized
as IFCs, by the Reserve Bank,
Approval Route – Eligible Borrowers
Foreign Currency Convertible Bonds (FCCBs) by Housing
Finance Companies satisfying the following minimum
criteria: (i) the minimum net worth of the financial
intermediary during the previous three years shall not be
less than Rs. 500 crore, (ii) a listing on the BSE or NSE, (iii)
minimum size of FCCB is USD 100 million and (iv) the
applicant should submit the purpose / plan of utilization of
funds.
Special Purpose Vehicles, or any other entity notified by the
Reserve Bank, set up to finance infrastructure companies /
projects exclusively, will be treated as Financial Institutions
and ECB by such entities will be considered under the
Approval Route.
Multi-State Co-operative Societies engaged in manufacturing
activity
Approval Route – Eligible Borrowers
SEZ developers for providing infrastructure
facilities within SEZ, as defined in the extant
ECB policy like (i) power, (ii)
telecommunication, (iii) railways, (iv) roads
including bridges, (v) sea port and airport, (vi)
industrial parks, (vii) urban infrastructure
(water supply, sanitation and sewage
projects), (viii) mining, exploration and refining
and (ix) cold storage or cold room facility,
including for farm level pre-cooling, for
preservation or storage of agricultural and
allied produce, marine products and meat.
Approval Route – Eligible Borrowers
Developers of National Manufacturing
Investment Zones (NMIZs) for providing
infrastructure facilities within SEZ, as
defined in the extant ECB policy like (i)
power, (ii) telecommunication, (iii) railways,
(iv) roads including bridges, (v) sea port
and airport, (vi) industrial parks, (vii) urban
infrastructure (water supply, sanitation and
sewage projects), (viii) mining, exploration
and refining and (ix) cold storage or cold
room facility
Approval Route – Eligible Borrowers
Corporates in the services sector viz. hotels, hospitals
and software sector can avail of ECB beyond USD 200
million or equivalent per financial year
Service sector units, other than those in hotels, hospitals
and software, subject to the condition that the loan is
obtained from foreign equity holders. This would facilitate
borrowing by training institutions, R &D, miscellaneous
service companies, etc
Corporates which have violated the extant ECB policy and
are under investigation by the Reserve Bank and / or
Directorate of Enforcement are allowed to avail of ECB
only under the approval route.
Cases falling outside the purview of the automatic route
limits and maturity period guidelines.
Pricing of ECB under the Approval
Route
The all-in-cost ceilings for ECB are reviewed from time to time.
The following ceilings are applicable upto September 30, 2012
and subject to review thereafter:
Average Maturity
Period
All-in-cost Ceilings over 6
month LIBOR*
Three years and up to
five years
350 basis points
More than five years
500 basis points
* for the respective currency of borrowing or applicable
benchmark
In the case of fixed rate loans, the swap cost plus the margin
should be the equivalent of the floating rate plus the applicable
margin.
Investment in foreign countries
Investment decisions
187
Intl.fin.
What is a company’s motivation to
invest capital abroad?
Revenue-related motives:
1.
2.
3.
4.
5.
Attract new sources of demand
Enter profitable markets
Exploit monopolistic advantage
React to trade restrictions
Diversify internationally
Cost-related motives:
1.
2.
3.
4.
5.
188
Intl.fin.
Benefit from economies of scale
Use foreign factors of production
Use of foreign raw materials
Use foreign technology
React to exchange rate movements
International project details
A firm is considering an
189
investment in Freedonia, and the
initial cash outlay is 1.5 million
marks.
The project has 4-year project life
with cash flows given on the next
slide.
The appropriate required return for
repatriated U.S. dollars is 18%.
The appropriate expected
exchange rates are given on the
Intl.fin.
next slide.
International Capital Budgeting
Example
End
of
Year
Expected
Cash Flow
(marks)
Exchange
Rate (marks
to U.S. dollar)
Expected
Cash Flow
(U.S. dollars)
0
-1,500,000 2.50
-600,000
1
500,000
2.54
2
800,000
2.59
3
700,000
2.65
4
600,000
2.72
Net Present Value
190
Intl.fin.
Present Value
of Cash Flows
at 18%
-600,000
196,850 166,822
308,880 221,833
264,151 160,770
220,588 113,777
=
63,202
How does a firm make an international
capital budgeting decision?
1. Estimate expected cash flows in the
foreign currency.
2. Compute their US dollar equivalents
at the expected exchange rate.
3. Determine the NPV of the project
using the US required rate of return,
with the rate adjusted upward or
downward for any risk premium effect
associated with the foreign
investment.
191
Intl.fin.
More on capital budgeting
Only consider those cash flows that can be “repatriated”
(returned) to the home-country parent.
Discounting methods:
1. NPV method
2. Payback period
3. Internal Rate of Return method
4. Profitability index method
1. Payback period is the expected number of years
required to recover a project’s cost.
Example: year Project L Project S
0(Rs.100 lacs) (Rs.100 lacs)
110 30
260 30
380 80
>>
192
Intl.fin.
More on capital budgeting
Payback for L = 2+30/80 years = 2.375 years or
2years and 4.5 months.
Payback for S=2+40/80 years = 2.5 years or 2
years and 6 months.
Weakness of Payback method:
1. Ignores the time value of money. This weakness is
eliminated with the discounted payback method.
2. Ignores cash flows occurring after the payback
period.
2. NPV method: In this method, projects are
accepted if the net cash inflow during the lifespan
of the project is greater than the initial investment.
193
Intl.fin.
NPV Method
The
equation used for determining the
NPV is:
NPV = Where:
= expected after-tax cash flow from to
= initial investment
k = risk-adjusted discount rate and
n = life span of the project
194
Intl.fin.
NPV Calculation
Example: A project involves initial
195
investment of $5000,000. The net
cash flow during the first, second
and third years is expected
respectively at $3000,000,
$3,500,000 and $2,000,000. At the
end of the third year the scrap
value is indicated at $100,000.
The risk-adjusted discount rate is
10%.
Calculate
the
NPV.
>>
Intl.fin.
NPV Calculation
+ + - = {(3,000,000/1.10)} + {3,500,000/} + {(2,000,000 +
1,000,000)/} – 5,000,000 = $2,873,778
The project would be accepted because NPV is positive.
Note: NPV declines as k increases and NPV rises
as k decreases.
2. Profitability index (PI): It is the ratio between the
present value of the future cash flows and the initial
investment.
PI = } ÷ ]
Substituting the figures given in the previous example,
we get: 7,873,778 / 5,000,000 = 1.57
The project may be accepted because PI is more than 1
196
Intl.fin.
3.Internal Rate of Return
(IRR)
IRR
is the discount rate equating the present value
of future cash flows and the initial investment.
For accepting a project, IRR should be greater
than the hurdle rate.
Expressed as an equation:
] - = 0
The project will be acceptable if IRR is greater
than the required rate of return.
Based on the previous example, IRR is 40%. Since
the required rate of return is 10% the project
would be acceptable.
197
Intl.fin.
Advantages & Disadvantages of NPV and IRR
Advantage: IRR is more popular than NPV
because it is straight forward as it uses cash
flows and recognizes the time value of money.
Disadvantage:
It often gives unrealistic rates of return. Suppose
the cutoff rate is 11% and the IRR is 40%, the
management need not blindly accept the project.
An IRR of 40% assumes that a firm has the
opportunity to reinvest future cash flows at 40%
which is too good to be true! Unless the
calculated IRR is a reasonable rate for
reinvestment of future cash flows, it should not be
used as a yardstick to accept or reject a proposal.
198
Intl.fin.
Advantages & Disadvantages of NPV and
IRR
Another disadvantage of IRR method is
that it may give different rates of return –
suppose there are two discount rates
(two IRRs) that make the present value
equal to the initial investment.
Which rate should be used for
comparison with the cutoff rate?
The IRR method, despite its popularity in
the business world, entails more
problems than a practitioner may think.
199
Intl.fin.
Foreign Direct Investment (FDI)
Motivations behind making FDI
Cost-benefits of FDI for home country and
host country
Various FDI strategies
200
Intl.fin.
Foreign Direct Investment
(FDI)
Reasons for FDI:
Investment for establishment of a new enterprise
in a foreign country either as a branch or as a
subsidiary
Acquisition of an overseas business enterprise
Some of the questions that arise in an MNC
before making a FDI:
1. What are the motivating factors for an FDI?
2. What should be the mode of investment?
3. Which country should it move to?
4. Is the project viable in terms of cash flow?
5. How much risk is involved in the operation?
201
Intl.fin.
NPV & IRR sometimes select different projects
When comparing two projects, the use of NPV and IRR
methods may give different results.
A project selected according to the NPV method, may be
rejected if the IRR method is used! Reasons:
The selection will change depending on the discount rate
that is chosen.
Project size and life
Differences in cash flows
When are the NPV & IRR reliable?
1. If projects are compared using the NPV , a discount rate
that fairly reflects the risk of each project
2. If the IRR method is used, the project must not be
accepted only because the IRR is high; the firm must be
convinced that the IRR is realistic. Otherwise the project
must be re-evaluated by the NPV method, using a more
realistic discount rate.
202
Intl.fin.
Theories of FDI
1. FDI moves from capital-rich countries to capital-scarce countries
2.
3.
4.
5.
6.
7.
8.
203
till the marginal productivity of capital is equal in both the
countries.
An MNC with superior technology moves to different countries to
supply innovated products making in turn ample gains.
FDI moves to a country with abundant raw material and cheap
labour.
FDI takes place only when the product achieves a specific stage
in its life cycle.
It is the combination of three advantages – ownership, location
and internalisation – that motivates a firm to make FDI.
A firm moves from a strong currency country to a weak currency
country.
A firm moves from a politically unstable country to a politically
stable country.
Developing country firm too possess firm-specific advantages on
account of modification of technology.
Intl.fin.
Benefits and Costs of FDI
Benefits to host country:
• Availability of scarce factors
of production
• Improvement in the BoP
• Building of economic and
social infrastructure
• Fostering of economic
linkages
• Strengthening of the
government budget
Benefits to the home
country
• Availability of raw material
• Improvement in BoP
• Employment generation
• Revenue to the government
• Improved political relations
204
Intl.fin.
Cost to the host country:
• Strained BoP following
reverse flow
• Dependence on import of
technology
• Employment of expatriates
• Inappropriate technology
• Unhealthy competition
• Cultural and political
interference
Cost to the home country:
• Undesired outflow of factors
of production
• Possibility of conflict with the
host country government
Strategies for FDI
Firm-specific strategy: offering new kind of
product or differentiated product.
Cost-economising: cost can be lowered through
moving firm to a raw material abundant or
labour abundant location.
Cross investment: to avoid price cuts by
competing firms.
Joint venture with a rival firm: when a rival firm
in the host country is so powerful that it is not
easy for an MNC to compete, the MNC prefers to
join hands with it to penetrate the host country
market.
205
Intl.fin.
Conflicts with the home country and host country
The home country government may:
1. Prohibit investment in a particular host country
2. Design fiscal and monetary disincentives and strict
approval rules
3. Introduce extra territoriality provisions to interfere with
foreign subsidiaries
The host country government may insist on:
1. Appointing government representatives on the
management board and on manning senior positions with
local personnel.
2. Domestic participation in the equity share capital.
3. Purchase of inputs from local sources and
4. Checking unwarranted activities.
Code of conduct drafted at the international level by
the Group of 77 are only suggestive and not binding on
MNCs, with the result that they are not very effective.
206
Intl.fin.
IV. International Trade
World Trade Organization
International Cartels
Organization of Petroleum Exporting Countries (OPEC)
GATT (General Agreement for Tariff & Trade)
EC (European Community)
NAFTA (North American Free Trade Area)
UNCTAD (United Nations Conference on Trade & Development)
207
Intl.fin.
WTO (World Trade
Organization)
Successor to GATT
Began operations in 1995
WTO is a chartered organization with a legal status and
enjoys the same privileges and immunities of IMF &
World Bank.
India is one of the founder members of WTO.
Based in Geneva, its main functions are administering
and implementing the multilateral trade agreements
To limit harmful trade practices
Acting as forum for multilateral trade negotiations
Overseeing national trade policies
To administer the understanding on rules and procedures
governing settlement of disputes
208
Intl.fin.
Structure of WTO
209
Intl.fin.
WTO
The Ministerial Conference (MC) is the supreme
authority.
Its secretariat is headed by a Director General
appointed by the MC.
Takes decisions on all matters under any of the
multilateral trade agreements.
The General Council, composed of
representatives of all the members is a trade
policy review body and also a dispute settlement
body.
The three sub-councils operate under the General
Council.
210
Intl.fin.
WTO Agreement
I.
Multilateral Agreement on trade in goods:
Understanding on BoP
Agreement on agriculture
Domestic and export subsidies
Sanitary and Phytosanitary Measures
Agreement on textiles and clothing
Agreement on trade related aspects on investment measures
(TRIMS)
II.
General Agreement on Trade in services
Agreement on trade related aspects of Intellectual Property
Rights
Copy rights and other rights
Trademarks
Geographical indications
Industrial designes
Patents
Integrated circuits and
Trade secrets
211
Intl.fin.
WTO Dispute Settlement
System
Encourages countries to settle their
differences through consultations.
If consultations fail, then a stage-bystage procedure is followed. It may
include:
Ruling by a panel of experts
Chance to appeal against the
ruling etc.
212
Intl.fin.
International Cartels
Formation of a cartel is an attempt to reap
greater profits by acting as a single profitmaximising monopolist.
The cartel members agree to supply or restrict
production of the cartalised commodity.
Conditions necessary for a cartel:
The elasticity of demand for total consumption for
the rest of the world must be low
The cartel must control a very large share of the
world market for the cartalised commodity
The elasticity of supply of the cartalised
commodity by the rest of the world must be low.
213
Intl.fin.
OPEC
Has 11 oil producing countries as members
(Saudi Arabia, Iraq, Kuwait, UAE, Iran, Venezuela, Libya,
Nigeria, Algeria, Indonesia & Qatar, in the decending
order of crude reserves)
Head quarter in Vienna, Austria.
They possess about 78% of the world’s
proven crude oil reserves
Supply more than 40% of the world’s
consumption
Meet twice a year to review the status of
international oil market
214
Intl.fin.
European Community (EC)
European Economic Community or European Common
Market was founded in 1957 under the Treaty of Rome.
Founder members: France, Germany, Italy, Belgium,
Luxembourg and Netherlands.
Denmark, Ireland, U.K., Greece, Portugal & Spain joined later.
Objectives of EC:
Elimination of custom duties and quantitative restrictions on
exports and imports
Establishment of common customs tariff and common
commercial policy
Removal of obstacles to movement of persons, services and
capital
Common policy in agriculture & transport
Remedial of disequilibrium in BoP of member states
Establishment of a European Investment Bank to promote
economic expansion of community
215
Intl.fin.
European Community (EC)
The European Council decided to establish the
European Monetary System (EMS) in 1978.
EMS has created a EC Currency Zone to unify the
European economies.
The EMS established the European Currency Unit
(ECU) for settlement between the EC currencies
and the central banks
Euro as unified currency was introduced on Jan
1999 and the national currencies of the members
ceased to exist.
Euro became the successor to the ECU.
New notes and coins were introduced on Jan 1 2002
216
Intl.fin.
North American Free Trade Area (NAFTA)
Initiated by President George Bush but
concluded by the Clinton administration on
Jan 1 1984.
Members: USA, Canada and Mexico.
It is a trade and investment agreement
entered into with a view to reduce the
barriers to the flow of goods, services and
people among the three countries.
A company that is based in any one of the
three countries can freely conduct its
business across all the three borders.
217
Intl.fin.
UNCTAD (United Nations Conference
on Trade and Development)
An organ of UN formed in 1964 to provide a
forum for developing countries to discuss
problems relating to their economic
development.
Objectives: To formulate policies relating to
developmental aspects including trade, aid,
transport, finance and technology.
The Conference ordinarily meets once in
four years. >>
218
Intl.fin.
Doha Conference
13th session of UNCTAD held from 21- 26
April 2012 at Doha, Qatar.
Issues:
Agriculture
Market access for non-agricultural products
Transparency in govt. procurement
Trade facilitation
Dispute settlement system
Electronic commerce
Trade, debt & finance etc.
End without consensus
219
Intl.fin.
Financing of Foreign Trade
Different modes of finance
Purpose of finance
Documentation
Regulations
220
Intl.fin.
Financing of Foreign Trade
An efficient financial system helps
promotion of international trade and
maintain liquidity to meet international
financial commitments.
Purpose:
To facilitate international trade i.e., import
and export.
Sources of finance: Banks and Fis.
Mode of finance:
Fund-based and
Non fund-based
221
Intl.fin.
Export Finance
Export of goods and services play an
important part in the economy of a country
irrespective of whether it is a developed or
developing country.
Therefore export financing assumes an
important role.
Exporters expect that export finance should
be:
Adequate
Timely
222
Cheap and
Intl.fin.On liberal terms
Export – Import finance in
India
Export finance:
RBI has introduced the following measures to encourage
exports:
Finance at concessional rates of interest (not exceeding 2.5%
below the prime rate on rupee finance and 50 basis points
over LIBOR in foreign currency loans)
It is mandatory for banks to extend 12% of their net bank
credit to the export sector.
Interest subsidy
Refinance
Credit guarantee from ECGC for bank loans
Loans against Duty Drawback Entitlement
Retention of export proceeds in foreign currencies in EEFC
accounts
Concessional tax on export earnings
223
Intl.fin.
Export Finance
Pre-shipment and Post-shipment credit
Pre-shipment credit:
Packing credit
Advance against cheques / drafts received as advance payment.
Packing Credit:
Loan or advance granted to exporter for purchase of raw materials /
processing / packing based on confirmed orders or letters of credit
Quantum of finance: Generally up to fob value of goods.
Exception: Exports covered by incentives and backed by Export
Production Guarantee from ECGC.
Period of finance: Up to 180 days but can be extended up to 360
days if necessary.
Interest rate: Bank’s base rate minus 2.5% up 180 days and
normal rate thereafter.
Liquidation: By submission of export bills or from EEFC balances
Packing Credit is also available in foreign currency for cash exports
at internationally competitive interest rates.
224
Intl.fin.
Export Finance
Post-shipment finance:
Need for post-shipment finance?
Mode of finance:
Purchase/Discount/Negotiation of bills
Advance against export bills sent for collection
Advance against cash incentives / Duty Drawbacks etc.
Can be availed by exporters against submission of export
documents to a bank within 21 days from the date of
shipment of goods.
Quantum of finance: Up to 100% of the value of invoice.
Period of finance: Short-term or long-term depending on
the agreed payment terms between the exporter and the
importer.
Rate of interest: Depends on the tenor
225
Intl.fin.
Export Finance
Forfaiting
A mechanism of discounting export
receivables (medium & long term maturities)
supported by Bills of Exchange or Promissory
Notes, without recourse to the exporter.
Benefits to the exporter:
Can covert his credit sales into cash sales on
without recourse basis
Can improve his cash flows
Can transfer currency, credit and political
risks to the forfaiter
226
Intl.fin.
Export Finance
Rediscounting export bills abroad:
An additional source of finance available to
exporters
Envisages banks rediscounting export bills in
the overseas market by making
arrangements with overseas agency / banks
by way of a line of credit
Interest rate: Linked to 6 months LIBOR rate
for the currency concerned.
227
Intl.fin.
EXIM BANK OF INDIA
(eximbank)
228
Intl.fin.
EXIM BANK OF INDIA (eximbank)
A public sector financial institution established
in 1982 by an Act of Parliament.
Main activities:
229
Export Credit
Services:
1. Projects:
•. Suppliers /
Buyers credit
•. Pre-shipment
credit
•. Guarantees
2. Products:
•. Line of credit
•. Pre-shipment
credit
•. Post-shipment
credit
Intl.fin.
3.
Services:
•. Suppliers credit
Finance for exportoriented units:
1. Term loans
2. Working capital
3. Export market /
product
development
4. Export
fecilitation
5. Overseas
investment
finance
Value added
services:
1. Export
marketing
services
2. Multilateral
funded projects
3. Joint-venture
fecilitation
4. Consultancy
support
5. Workshop /
seminars
Advisory
services
Documents Used in Foreign
Trade
Purpose of documentation
Various types of documents used
International Regulations
230
Intl.fin.
Documents Used in Foreign Trade
1. Bill of Exchange
2. Invoice
3. Packing List
4. Documents of Title to goods:
Bill of Lading
2. Airway Bill
3. Post Parcel Receipt
1.
5. Insurance Policy / Certificate
6. Regulatory documents for customs / central bank.
7. Others: Letters of Credit (LCs), Bank Guarantees,
Acceptances
231
Intl.fin.
Bill of Exchange
232
Intl.fin.
Export Invoice
233
Intl.fin.
Packing List
234
Intl.fin.
Bill Of Lading Specimen.docx
DOC._CREDIT.ppt
C:\Users\SESHU\International Finance\GR
FORM SPECIMEN.docx
235
Intl.fin.
INTERNATIONAL CASH
MANAGEMENT SYSTEM
236
Intl.fin.
International Cash Management
(ICM) System
Introduction:
Important aspect of working capital
management
Effective and fast collection of cash resources and
Optimum utilization and conversion of funds
Same objective as that of domestic cash
management but wider in scope.
Factors in ICM:
Exchange Control Regulations in different countries
Multiple tax jurisdictions and currencies
Good reporting systems
237
Intl.fin.
Centralization of Cash Management
Benefits of centralization:
Maintaining minimum cash balance throughout the
year
Generate maximum possible return by investing all
the cash resources optimally
Judicious management of liquidity requirements
Minimize transaction costs and currency exposures
Optimally use the hedging techniques to minimize
the foreign exchange exposure
Achieve maximum utilization of transfer pricing
mechanism to enhance the profitability and
growth of the firm.
238
Intl.fin.
Objectives of effective ICM
1. Minimize currency exposure risk
2. Minimize country and political
239
risks
3. Minimize the overall cash
requirements of the company as a
whole without disturbing the
smooth operations of the
subsidiaries
4. Minimize transaction costs
Intl.fin.
5. Achieve full benefits of economies
Techniques of optimizing cash flows
1. Accelerating cash inflows
2. Managing the blocked funds
3. Leading and lagging
strategy
4. Netting
5. Transfer Pricing
240
Intl.fin.
Techniques of optimizing cash flows
1. Accelerating cash inflows
Quicker recovery of receivables i.e., minimize
float
Objective: Reduce investment in accounts receivable
Lower banking fees and other transaction costs.
Save interest expense on working capital borrowing
Means adopted:
Remittance through SWIFT
Same day value credits
Monitoring through corporate treasury workstations
Pre-authorised payment up to a certain limit
241
Intl.fin.
Techniques of optimizing cash flows
2. Managing the blocked funds
.In some cases the host countries
may block funds that a subsidiary
may attempt to remit to the parent.
.The parent may ask the subsidiary to
obtain finance from the local banks
rather from them.
.Unexpected blockages are however
a political risk.
242
Intl.fin.
Techniques of optimizing cash flows
3. Leading and Lagging
.Refers to adjustment in timing of payment that are
made in foreign currencies.
.Expediting payment is ‘leading’ and deferring
payment is ‘lagging’.
.It is a highly favoured means of shifting liquidity
among the subsidiaries.
.If the home currency is expected to:
(a) depreciate against a foreign currency – Expedite
the payment (leading)
(a) appreciate against a foreign country - Defer the
payment (lagging)
243
Intl.fin.
Techniques of optimizing cash flows
MNCs can lead or lag the timings of foreign
currency payments by modifying the credit
terms.
Companies generally accelerate payments
of hard currency payables and delay
payments of soft currency payables so as
to reduce the foreign exchange exposure.
Governments are less likely to interfere
with payments on inter-company accounts
than on direct loans.
244
Intl.fin.
Case Study
Multinational Industries Co. is an
Indian firm conducting financial plan
for the next year. It has no foreign
subsidiaries but a significant portion of
its sales are from exports. Its foreign
currency cash flows to be received
from exporting and cash outflows to be
paid for imported supplies for the next
year are given below: >>
245
Intl.fin.
Case Study – Contd.
Currency
246
Total Inflow
Total
Outflow
US
dollars
$42,000,000
$20,000,000
German
Marks
DM15,000,00
0
DM10,000,00
0
French
Francs
FFr.10,000,00
0
FFr.80,000,00
0
British
Pounds
£24,000,000
£15,000,000
Intl.fin.
Case Study – Contd.
The current spot rates and one year forward rates are:
Currency
US Dollars
German
Marks
French
Francs
British
Pounds
247
Intl.fin.
Spot Rate
(``)
42.50
22.50
One year
forward
rate(``)
43.20
23.25
6.60
6.00
66.90
67.10
Case Study – Contd.
On the basis of the above information determine the
net exposure of each foreign currency in rupees.
Are any of the exposure positions offsetting to some
extent?
Using the current spot rates as a forecast of the US
dollar in 90 days, would you hedge the US dollar
position?
If inflows of the British Pound range from £20 million
to £30 million for the next year, what will be the risk
of hedging £25 million in net inflows? How can the
company avoid such a risk?
Explain in brief the strategy which MNCs should adopt
for each of the four currencies?
248
Intl.fin.
Solution to Case Study
Net exposure of each foreign currency in
rupees:
USDoll
ar
D.
Marks
French
Frs.
British
£
249
Intl.fin.
(Amounts in millions)
Inflo
w
Outflo
w
Net
flow
Rate
Sprea
d
42
20
22
0.70
Net
Exp
osur
e in
```
15.4
15
10
5
0.75
3.75
10
80
(70)
(0.6)
42
24
15
9
0.2
1.8
Solution to Case Study – Contd.
Yes, the French Franc position of `42 million is
being offset by a better forward rate.
Yes. The US dollar position of `15.4 million can be
hedged by ‘leading and lagging’ techniques – since
one year forward rate is at a premium, speed up
payments for goods and services reflected by the
outflows so that the Re.0.70 spread can be
eliminated at the date of settlement.
If £25 million is left un-hedged, there is a
possibility of lower rate than the spot rate existing
at the time of settlement. Therefore, it is better to
take a forward contract. >>
250
Intl.fin.
Solution to Case Study –
Contd.
Strategies to be adopted:
US Dollars: Take a forward contract and sell
$20 million at the spot rate or delay
collections.
D. Marks: Take a forward contract for inflows
or delay collections.
French Frs.: Speed up or request for advance
payment of receivables while delaying
payments and creditors for goods and
services supplied.
Pound Stg.: Pre-pay for goods and services
but delay collection from sales or services.
251
Intl.fin.
Techniques of optimizing cash flows
4.
Netting:
Involves highly coordinated
international interchange of raw
materials, parts, subassemblies, and
finished parts among the various
units of an MNC, with many affiliates
both buying and selling to each other.
They are accompanied by heavy
volume of inter affiliate fund flows.
252
Intl.fin.
Techniques of optimizing cash flows
Advantages of a netting system:
Reduces the number of cross-border
transactions
Reduces the need for foreign exchange
conversion and the exchange loss.
Besides administration costs, transaction
costs on these fund flows may vary from
0.25% to 1.5% of the volume of funds
involved.
Helps in improved cash flow forecasting
Netting cash flows is a means of reducing
credit exposure to counter parties.
253
Intl.fin.
Techniques of optimizing cash flows
Two types of netting – Bilateral and
multilateral.
Bilateral: Only two parties - parent and the
subsidiary
Multilateral: Parent and several affiliates
Multilateral system requires centralized
system of communication and discipline on
the part of the subsidiaries.
By multilateral netting big MNCs can
eliminate 50% or more of their inter
company transactions.
254
Intl.fin.
Techniques of optimizing cash flows
Example of multilateral netting:
A U.S. parent company has subsidiaries in
France, Canada, UK and Japan. The amounts
due to and from the affiliated companies are
converted into US dollars. The French
subsidiary owes the Canadian subsidiary
$60,000, the UK subsidiary $80,000 and the
Japanese subsidiary $100,000. For the same
period, the French subsidiary is due to receive
$40,000 from the Canadian subsidiary,
$60,000 from the UK subsidiary and $100,000
from the Japanese subsidiary.
255
Intl.fin.
Techniques of optimizing cash flows
Inter-subsidiary Payments Matrix (US
dollars in thousands)
Paying affiliate
France Canad
U.K.
Japan
Total
a
France
40
60
100
200
Canad
60
40
80
180
a
U.K.
80
60
70
210
Japan
100
30
60
190
Total
240
130
160
250
780
256
Intl.fin.
Techniques of optimizing cash flows
NETTING SCHUDULE
Receipt
257
Payment
Net
Receipt
France
200
240
Canada
180
130
50
U.K.
210
160
50
Japan
190
250
Net
Payment
(40
60
Without netting, the total payments would
amount to $780 thousands. Mutual
netting reduces these transfers to $100
thousand (-87%). Consolidation and net
payments can be determined in both
directions.
Intl.fin.
Techniques of optimizing cash flows
5. Transfer Pricing (TP):
One of the most controversial and often least
understood issues in a MNC’s operation is TP.
When a parent or one subsidiary of an MNC in one
country transfers / sells goods, services or knowhow
to another subsidiary in another country, the price
charged for these goods / services is called TP.
A strategy to adjust the profits of a subsidiary by the
transfer price charged.
The transfer prices at which goods and services are
traded internally can significantly distort the
profitability.
Higher the transfer price, the larger will be the gross
profit of the transferring division and vice-a-versa.
258
Intl.fin.
Transfer Pricing in an MNC
Transfer pricing in an MNC depends upon:
The difference in tax rates between the two
countries (higher TP for countries with relatively
higher taxation)
Inflation differentials (high TP for countries
experiencing higher inflation and currency
devaluation.
Import duties and quotas imposed by the host
country etc.(low TP for goods and services
subjected to high import duties in a particular
country)
High TP for goods and services for countries that
restrict repatriation of income.
259
Intl.fin.
Example of Transfer Pricing
Strategy
ABC Company has a subsidiary in country x
that produces computer components and sells
them to another subsidiary in country y where
the production process is completed. The tax
rate in country x is 50% while that in country y
is 20%. The proforma income statement of
ABC is given below. Assume that ABC adjusts
its transfer pricing policy so that sales by
subsidiary x are reduced from $400,000 to
$320,000. Determine the change in the total
tax payments of the consolidated subsidiaries
as a result of this revised transfer policy. >>
260
Intl.fin.
Example of Transfer Pricing Strategy
(Amounts in thousands of $)
Subsidiar
yx
Subsidia
ry y
Consolidated
subsidiaries
Sales
400
700
1100
Less cost of goods sold
220
400
620
Gross profit
180
300
480
Less operating expenses
80
100
180
EBIT
100
200
300
Interest expense
10
30
40
EBT
90
170
260
Taxes (50% for X and 20% for
45
34
79
Y)
45
136
181
EAT
The sales level of X matches the cost of goods sold of Y and hence it
can be inferred that the entire sales of X are to Y. When sales of X
are reduced from $400,000 to $320,000, this would affect the cost of
goods sold of subsidiary Y by the same amount and the EAT would
respectively be $5,000, $200,000 and $205,000. As a result, the
incidence of tax would come down from $79,000 to $55,000!
261
Intl.fin.
Questions
1. How can a MNC implement leading and
lagging techniques for optimizing cash
flow movements?
2. How can centralized cash management
system be beneficial to a MNC?
3. What is netting and how can it improve a
MNC’s performance?
4. How can a MNC use transfer pricing
strategies? Elucidate.
262
Intl.fin.
FEMA (Foreign Exchange
Management Act)
Objectives
Difference between FERA & FEMA
Salient features of FEMA
263
Intl.fin.
Introduction
BoP crisis in 1991
Process of liberalization
Article Viii of IMF – Convertibility of current
account transactions w.e.f August 1994
Tarapore Committee road map on capital
account convertibility in June 1997.
Repeal of FERA and introduction of FEMA in
1999 (implemented w.e.f 1 June 2000)
264
Intl.fin.
Objectives of FEMA
Consolidate and amend the law relating
to foreign exchange:
To facilitate external trade and
payments
Promoting orderly development and
maintenance of foreign exchange
markets in India.
Approach of FEMA is radically different
from FERA – change from conservation
to facilitation and control to regulation.
265
Intl.fin.
Differences between FERA & FEMA
FERA
• FERA was a draconian
criminal law.
• Conserve foreign exchange
to prevent its misuse.
• Violation of FERA was a
criminal offence.
• Offences under FERA were
not compoundable.
• Citizenship was a criteria to
determine the residential
status of a person.
• Provisions in respect of
business travel, export
commission, gifts, donations
etc. were rigid.
266
Intl.fin.
FEMA
• FEMA is a civil law.
• Facilitate external trade and
payments and maintenance
of forex markets in India
• Violation of FEMA is a civil
offence.
• Offences under FEMA are
compoundable.
• Stay of more than 182 days
is the criteria for determining
the residential status of a
person.
• These provisions have been
considerably liberalized in
FEMA.
• Almost all current account
tractions are free.
Salient features of FEMA
Free transactions on current account;
RBI control over capital account
transactions;
Control over realization of export proceeds;
Dealing in foreign exchange through
‘Authorized Dealers’;
Adjudication of offences;
Appeal provisions including special director
(appeals) and appellate tribunal; and
Directorate of Enforcement
267
Intl.fin.
Country Risk Analysis
To define what a country risk means?
Identify key indicators of country risk
To describe the economic and political factors that
determine a country’s ability and willingness to
repay its foreign debts
268
Intl.fin.
What is Country Risk Analysis
(CRA)?
Following the rapid growth in international debt of LDCs
in the 70s and increasing incidence of debt rescheduling
in the 80s CRA has become a topic of major concern for
the financial community.
CRA is the assessment of potential risks and rewards
associated with making investments and doing business
in a country.
Essentially, an assessment whether sensible economic
policies are being followed by a country.
A country following sensible economic policies will
generally have good business environment where
businesses can flourish.
However, the focus of CRA cannot be restricted to only
economic policies.
269
Intl.fin.
What is Country Risk Analysis (CRA)
Political considerations often lead countries to
pursue economic policies that are detrimental to
business and their own economic health.
Significant Political Risks:
Expropriation or nationalization (most extreme
form)
Currency or trade controls
Changes in tax or labor laws
Regulatory restrictions etc.
International economic environment is heavily
dependent on the policies that individual nations
pursue.
270
Intl.fin.
Purpose of Country Risk
Analysis
Non-bank MNCs undertake CRA in order to
determine the investment climate in
various countries.
Banks do CRA to know:
A country’s ability to service its foreign debts
Which countries to lend to
The currencies in which to denominate their
loans and
Interest rates to demand on these loans.
271
Intl.fin.
Country Risk Analysis
There is close linkage between a country’s
economic policies and the degree of
exchange risk, inflation risk, interest rate
risk etc. that MNCs and investors face.
Therefore, no one can intelligently make a
CRA without comprehending its political
and economic policies.
Attempts to forecast exchange rates,
inflation rates or interest rates are helped
immensely by CRA.
272
Intl.fin.
Measuring Political Risk
There is no unanimity as to what constitutes PR
and how to measure it?
Some of the more common forms of political risk
indicators include:
Stability of the local political environment:
Frequency of changes in government (extent to which the
existing political status can be expected to continue)
Level of violence in the country
Internal and external conflict
Consensus regarding priorities:
Degree of agreement and unity on the fundamental objectives
of government policies and
The extant to which the consensus cuts across party lines.>>
273
Intl.fin.
Measuring Political Risk
Attitude of host government:
MNCs may satisfy the local people, but may
face a hostile attitude from the government.
Government may impose additional
corporate taxes, blockages of funds, funds
transfer restrictions etc. which affect MNC’s
cash flows.
War:
In the event of war, safety of MNC’s
employees
Volatile business cycles
Uncertain cash flows
274
Intl.fin.
Economic Risk Indicators
Inflation rate:
A measure of economic instability
Disruption and government mismanagement
Lower purchasing power of consumers and hence
lesser demand for MNCs goods
Current and potential state of country’s economy:
Level of external debt
Foreign exchange reserves
Current account
Balance of payments
GDP growth
Exchange and interest rates>>
275
Intl.fin.
Economic Risk Indicators
Resource base:
National, human and financial resources (‘other things’ remaining the
same, a nation with more natural resources is a better bet than one
without natural resources. But ‘other things’ are not always the same.
This is due to the quality of human resources and the degree to which
these resources are put to their most efficient use – South Korea and
Taiwan Vs Mexico or Argentina).
Adjustment to external shocks:
Ability of a country to withstand unforeseen shocks.
Vulnerability of external shock varies from country to country with some
dealing successfully and others succumbing to them.
Others:
Capital flight
Level of corruption
High tax rates
Vast state-owned firms
Imports and exports as a proportion of GDP
Vulnerability of exports for changing prices
Compressibility of imports
276
Intl.fin.
Techniques to assess CR
1. Debt-related factors:
Debt / GDP
Debt / foreign exchange receipts (Important ratio –
277
Intl.fin.
solvency)
Interest payments / foreign exchange receipts (liquidity)
Debt-service ratio (relates debt-service requirements to
export income)
Short-term debt to total exports
Imports / GDP (sensitivity of domestic economy to
external development)
Net interest payment / exports
Current account balance / GNP (countries with large
current account deficit are usually less creditworthy)
Techniques to assess CR
2. Balance of Payments (BoP)
Under or over valuation of exchange rate (on
purchasing power parity basis)
Current account / GNP ( a measure of the country’s
net external borrowings relative to country size)
Imports / GDP
Non-essential consumer goods and services / total
exports
Exports to 10 – 15 main customers / total exports
Exports of 10 – 15 main items / total exports
External reserves / imports
Reserves as a % of imports
Exports as a % if imports
278
Intl.fin.
Techniques to assess CR
3. Economic Performance:
GNP or GDP / Per capita (measures the level of
development of a country)
Gross investment / GDP (called propensity to invest
ratio, captures the country’s prospects for future
growth. Higher the ratio, higher the potential
economic growth)
Inflation (change in consumer prices as an annual
average in % - measures the quality of economic
policy)
Money supply (serves as an early indicator for
future inflation)
Gross domestic savings / Gross National Product
279
Intl.fin.
Techniques to assess CR
4. Political Instability:
Political protest, demonstrations, strikes, riots,
assassinations etc.
Successful / unsuccessful coups
Raters of CR:
Two magazines – Institutional Investor and Euromoney
have been publishing the CR since 1981/82.
Weights are attached to each risk depending upon
their importance.
Countries are graded on a scale of 0 to 100, with 100
representing least chance of default.
A fair amount of subjectivity is also involved in the
analysis.
280
Intl.fin.
Applications for Country Risk
Analysis
Can be incorporated in capital budgeting analysis.
The required rate of return is adjusted to account for the
country risk (high risk, high discount rate and vice-aversa).
If there is a probability of temporary blockage of
subsidiary’s funds to the parent or host country take over
of a project, the NPV under these circumstances should be
determined.
Further involvement in politically tense countries can be
avoided.
Avoid FDI in that country and withdraw current operations
before the crisis intensifies.
However, it is difficult to predict major troubles in various
countries.
281
Intl.fin.
Questions
1. What are the indicators of country risk? Of
2.
3.
4.
5.
282
country health?
What are the applications of country risk
analysis? Give examples to illustrate your
answers.
Briefly explain the various techniques to assess
country risk.
Why is country risk analysis is important for a
MNC?
How can exposure to country risk be reduced by
a MNC in the long run? Why country risk
analysis is not always accurate?
Intl.fin.
PART II
•
•
•
1
Structure of Foreign Exchange Market
Exchange Rate Quotation
Types of Transaction and Settlement
Dates
Intl.fin.
Exchange Rate Quotations
Existence of a number of currencies gives rise to
transactions in these currencies for settlement of
international transactions.
Two parties may exchange their respective domestic
currencies in settlement of export – import
transaction.
Or both parties may agree to settle the transaction in
a third country currency.
In the absence of an organized market It would be
difficult to find buyers and sellers of currencies to find
each other.
This has given rise to the development of a foreign
exchange market.
2
Intl.fin.
Factors That Influence Exchange Rates
The following equation summarizes the factors that
influence the exchange rates (the spot rate of a
currency):
e=ƒ(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP), where
e = change in the spot rate
ΔINF = change in the inflation rates between two
countries
ΔINT = change in the interest rates between two
countries
ΔINC = change in the differential in the income levels
of two countries
ΔGC = change in the government controls and
ΔEXP = change in expectations of future exchange
rates
3
Intl.fin.
>> Factors That Influence
Exchange Rates
1. Changes in the relative inflation rates
Changes in inflation rates can affect the
international trade activity
that in turn affects the demand and supply of
a currency
that in turn affects the exchange rates.
S1
Equilibrium rate:
S
R
a
t
e
e
D1
D
Quantity supplied
4
Intl.fin.
>> Factors That Influence
Exchange Rates
2. Changes in in relative interest rates
(concept of real interest rates)
Changes in relative interest rates can affect
investment in foreign securities
That affects the demand and supply of
currencies
Which in turn can affect the exchange rates
3. Relative income levels
Income can affect the amount of imports
demanded
Changes in demand can affect the exchange
rates
5
Intl.fin.
>> Factors That Influence
Exchange Rates
4. Government controls
influence the exchange rates in
many ways including imposition
of:
1. Foreign exchange barriers
2. Trade barriers
3. Market interventions etc.
6
Intl.fin.
Foreign Exchange Market
No physical market
It is a virtual market consisting of a network of
banks, brokers and dealers across various
financial centers around the world.
Linked with each other by telephone, telefax,
computer and other electronic network like
SWIFT system etc.
Information on the quotes of major
international banks, money markets, interest
rates etc. are continuously fed to the dealers
by service providers like Reuters, Telerate
Systems, Bloom Berg etc.
>>
7
Intl.fin.
>>Foreign Exchange Market
Informal code of moral conduct – a forex
dealers’ word is their bond!
Transactions done on telephone are
followed by mail confirmations.
It assists international trade and
investment by enabling currency
conversion. It also supports direct
speculation in the value of currencies.
8
Intl.fin.
Uniqueness of Forex Market
1. Huge trading volumes leading to high liquidity
(Average daily turnover is in excess of US$4
trillion)
2. Wide geographical dispersion
3. Round the clock operation, except weekends
4. The variety of factors that affect exchange rates
5. Razor-thin margins of profit
6. Use of leverage to enhance profit
.Because of these factors, forex market is referred
to as the market closest to the ideal of perfect
competition.
9
Intl.fin.
Structure of Foreign Exchange Market
85% of the transactions are speculative and only 15% are
trade-related or commercial transactions (According to the
BIS, the average forex trading volume in 2004 was $1.9
trillion per day – nearly 20 times the daily turnover of N.Y.
Stock Exchange!)
Theoretically, it is a zero-sum game. Presence of hedgers
and interventions by central banks result in speculative
gains or losses.
Main players:
Large commercial banks (Interbank Market) (≈40% of the
turnover)
Large MNCs
Hedge Funds, Pension Funds, Insurance Companies, Mutual Funds
etc.
Forex brokers
Central Banks
>>
11
Intl.fin.
Structure of Foreign Exchange Market
Large commercial banks deal in forex on their
own account as well as on behalf of their
customers.
They act as market makers.
There are numerous market makers in the
market and all of them would be giving different
quotes for a pair of currencies.
The market-making activities of commercial
banks along with speculation makes the market
extremely liquid and volatile.
Main trading centers: New York, London, Tokyo,
Hong Kong, Singapore.
>>
12
Intl.fin.
Structure of Foreign Exchange
Market
Brokers do not actually buy or sell any currency.
They are a link and match-makers between
different players in the market.
Brokers help the prospective buyer or seller to keep
their identities secret till the deal is struck.
Brokers also help the players to get a feel of the
market (direction of quotes)
Large corporations also bet on the markets to make
exchange profits.
The inter-bank market is called the Wholesale
Market whereas the market in which the banks
deal with their customers is called the Retail
Market. >>
13
Intl.fin.
Major Participant Groups & Their Motives
1. Non-banking entities simply exchange
2.
3.
4.
5.
14
currencies to honour their obligations or to get
the desired currency.
Traders use the forex market for hedging their
exposures o/a changes in the exchange rate.
Banks operate on behalf of their customers and
also engage themselves in proprietary trading.
Arbitrageurs change currencies to take
advantage of varying rates in different markets.
Speculators buy and sell currencies for the sake
of profit when they expect movement in the
exchange rate in a particular direction.
Intl.fin.
A major structural change – Introduction
of Electronic Trading System (ETS)
In April 1992, Reuters introduced a new service
that added automatic execution to the process.
Traders enter buy and sell orders directly into
their terminals on an anonymous basis and
these prices are visible to all market
participants.
Another trader, anywhere in the world, can
execute the trade simply by hitting two buttons.
ETS has reduced the cost of trading by
eliminating the brokers and the number of
transactions.
15
Intl.fin.
Financial Instruments In Forex
Market
Spot – has the shortest time frame, involves cash rather than a
contract and interest not included in the agreed upon transaction.
Forward – rate is fixed on the day of the transaction itself for a
future transaction but money does not change hands until an
agreed future date.
Swap – currency swap & interest rate swap
Future – standardized forward contracts traded on exchange.
Options – an exchange traded derivative where the option holder
has the right to buy/sell currency but no obligation to do so.
Whereas the option writer has the obligation to stick to the
contract.
Speculation – ‘speculators have a stabilizing influence on the
market providing market for hedgers and transferring risk from
those who don’t wish to bear it to those who do’ – Milton
Friedman.
16
Intl.fin.
Structure of Foreign Exchange
Market
Being a virtual market, it is a round-the-clock
market.
N.Y C.T: 3
p.m.
London will
L.A.
remains
open
still be open
when
Frankfurt &
Zurich close
When
Singapore
closes,
Frankfurt &
Zurich
open
When Hong
Kong
closes,
Singapore
is still open
When L.A.
closes
When
Tokyo
closes,
Hong Kong
is still open
It is
opening
time at
Sydney and
Tokyo
London, New York and Tokyo markets are the
17
biggest
Intl.fin.
THE WORLD OF FOREIGN EXCHANGE DEALING
Frankfurt
Chicago
London
Tokyo
New York
Bahrain
San Francisco
Hong Kong
Singapore
Sydney
Hong Kong
Foreign Exchange Dealing
Times: GMT
Tokyo & Sydney
Bahrain
Singapore
Frankfurt
London
New York
Chicago
San Francisco
GMT 2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 0900 0800 0700 0600 0500
0400 0300intl.financing
0200 0100
18
-10
-09
-08
-07
-06
-05
-04
-03 -02 -01
-00 +01 +02 +03 +04 +05 +06 +07 +08 +09
+10 +12
Attributes of Banks That Provide
Foreign Exchange
1. Competitiveness of quote: A saving of 1
cent per unit on an order of one million units of
currency is worth $10,000
2. Special relationship with the bank: The
bank may offer cash management services or
may be willing to make special efforts to obtain
hard-to-find currencies for the customer.
3. Speed of execution: Banks vary in efficiency
with which they handle an order. A corporate
needing the currency will prefer a bank that
handles the paper work properly and puts
through the transaction speedily. >>
19
Intl.fin.
>> Attributes of Banks That Provide
Foreign Exchange
4. Advice about currency market conditions:
Some banks may provide assessment of foreign
economies and relevant activities in the
international financial environment that relate to
corporates.
5. Forecasting advice: some banks may provide
forecasts of exchange rates to the corporates.
In view of the above advantages a corporate
needing a foreign currency should not automatically
choose a bank that will sell a currency at the lowest
price; It pays to develop a close relationship with a
major bank in case they need a favour from a bank.
20
Intl.fin.
Settlement of Trades
Settlement of trades take place by transfer
of money to the Nostro Accounts of the
respective currencies held with a
correspondent bank.
Nostro, Vostro and Loro accounts.
Clearing House Inter-bank Payment
Systems: CHIPS & CHAPS
Over Bought / Over Sold positions
Competition between the market makers
ensures that the divergence in quotes are
not wide.
21
Intl.fin.
Indian Foreign Exchange
Market
Three-tired market.
Tier I : Transactions between ADs and RBI
Tier II : Inter-bank transactions
Tier III : Retail segment – transactions between ADs
and Money Changers and customers.
Market is regulated by the provisions of FEMA,
1999
RBI is the regulator under the powers vested by
FEMA.
Players:
Authorized Dealers (Categories A, B & C) and
Money Changers >>
22
Intl.fin.
Indian Foreign Exchange
Market
In the first tier, RBI buys and sells foreign
exchange from/to ADs.
The second tier is the inter-bank market where
ADs transact business among themselves.
Since the amounts transacted are large, they
form the ‘wholesale market’.
Transactions in the third tier are generally small
and deal with exporters, importers and
individuals. It is called ‘retail market’.
Most of the transactions take place in hard
convertible currencies like US dollar, Pound
Sterling, Euro and Japanese Yen.
23
Intl.fin.
Clearing Process
A majority of forex transactions in India involves dollar as one
leg;
A multilateral netting mechanism has been created through the
CCIL (Clearing Corporation of India Ltd.) for settlement of all
dollar denominated transactions.
As a central counterparty CCIL guarantees trade settlement.
ADs pass the dollar-related transactions through CCIL for
netting and settlement.
CCIL in turn settles the dollar leg through its correspondent in
the USA.
The rupee leg is settled through the member banks’ account
with RBI.
Advantage: Substantial cost and time benefit for the ADs.
Transactions in currencies other than dollar are settled directly
by ADs through their respective Nostro bank accounts.
24
Intl.fin.
Exchange Rate Quotations
Currencies are traded in pairs like xxx/yyy. Currency xxx is the base
currency and yyy is the counter currency (or quote currency). E.g.,
USD/JPY, USD/CAD, USD/INR etc
Remember: The value of the base currency is always 1
The three exceptions to this rule are the British pound (GBP), the
Australian dollar (AUD) and the Euro (EUR). For these pairs, where
USD is not the base currency, a rising quote means the US dollar is
weakening and buys less of the other currency than before.
Direct Quote: Exchange Rate is expressed in terms of number of units
of domestic currency per unit of foreign currency.
E.g., 1USD = INR55.42
Indirect Quote: Domestic currency fixed and foreign currency variable.
E.g., Rs.100/$
Market quotes: DM/$ : 1.6688 / 93
Inter-bank quote: DM / $ : 88 / 93
A few currencies are quoted in 100s rather than 1s or 2s. E.g.,
Japanese Yen ($/100Y: 0.9150/52)
25
Intl.fin.
Direct & Indirect Quotes
Example:
1. If direct quote is Rs.45/US$, how to
present it in indirect quote?
.US$1/Rs.45 = US$0.0222/Re.
2. If indirect quote is US$0.025/Re, how can
this exchange rate be shown under direct
quote?
.Re.1/US$0.025 = Rs.40/US$
26
Intl.fin.
Inverse Quotes
For every quote A/B there is an inverse quote B/A
E.g., Euro / $ : 1.6688 / 93 is a quotation in Frankfurt.
The quote on the left side is called the Bid (purchase)
rate and that on the right is called the Ask (sale) rate.
Bid always precedes the ask rate.
Bid is the rate at which the bank is prepared to buy
dollars (also means the rate at which it is ready to sell
Euro) and Ask is the rate at which it is prepared to sell
dollars (also means the rate at which it is prepared to
buy Euro).
Hence the Euro / $ bid rate would correspond to $ /
Euro ask rate.
27
Intl.fin.
Inverse Quotes
For the above example,
The implied ($/Euro)bid = 1 / (Euro/$)ask
The implied ($/Euro)ask = 1 / (Euro/$)bid
So the implied inverse rate is:
$ / Euro : 0.5990 / 0.5992
The above equations can be generalized
as:
Implied (B/A) quote:
1/(A/B)ask Divided by 1/(A/B)bid
28
Intl.fin.
Inter-Bank and Merchant Quote
In an inter-bank transaction,
The bank requesting the quote is the customer and
The bank giving the quote is the market maker.
Example of a market quote:
Euro/$ : 1.6688 / 1.6693
It is the market practice to quote the same rate as Euro/$ :
1.6688/93
The rate on the left side is the bid (buying) rate and that on the
right side is the ask (selling) rate.
A few currencies like Japanese Yen are quoted in units of 100
($/100Y=0.9150/52)
The quote after the decimal points is called basis points.
According to FEDAI Regulations, all rates have to be quoted
to four decimal points, with the last two being multiples of 5
(this rule is ignored for the sake of simplicity and learning)
29
Intl.fin.
Inter-Bank and Merchant Quote
The spread between bid and ask prices is
influenced by:
Spread = ƒ(Order costs + Inventory costs –
Competition – Volume + Currency risk)
Order costs are costs of processing orders, clearing costs
etc.
Inventory costs are costs of maintaining inventory of a
particular currency. Holding an inventory involves an
opportunity cost.
Competition: Higher the competition, the lower the spread.
Volume: Higher the volume, lower the spread.
Currency risk: Higher the volatility of the currency, higher
the spread as the intermediaries dealing in these currencies
could incur large losses due to abrupt change in the values
of these currencies.
30
Intl.fin.
Rate Spreads in Forex Quotes
Example:
1. Consider the following bid-ask prices:
Rs.40 – 40.50/ US$. Find the bid-ask
spread.
Spread = 40.50 – 40.00 = 00.50p
% spread = (0.50 / 40.50) x 100 = 1.23%
2. Find out the bid rate if ask rate is
Rs40.50/US$ and the bid-ask spread is
1.23%.
(40.50 – x)/40.50 = 0.0123 or
40.50 – x = 0.0123 x 40.50 or
40.50 8*0.50 = x or x = Rs40.00
31
Intl.fin.
Cross Rates (Synthetic Rates)
Cross Rates (also called Synthetic Rate):
Many currency pairs are only inactively traded,
so their exchange rate is determined through
their relationship to a widely traded third
currency (generally the USD)
Suppose we want to find out the cross rates
between SFR and CND with the following market
quotation: SFR/USD: 5.5971/78 and USD/CND:
0.7555/62
Synthetic (Sfr/Can$)bid rate = (Sfr/$)bid x
($/Can$)bid = 5.5971 x 0.7555 = 4.2286
32
Intl.fin.
Cross Rates (Synthetic Rates)
Synthetic (Sfr/Can$) ask rate = (Sfr/
$)ask x ($/Can$) ask i.e., 5.5978 x .
7562 = 4.2330
Therefore, the synthetic quote of
Sfr/Can$ will be: Sfr/Can$ = 4.2286 /
4.2330
The rates can be generalized as:
Synthetic (A/C)bid = (A/B)bid x
(B/C)bid and Synthetic (A/C)ask =
Intl.fin.
(A/B)ask x (B/C) ask, where A, B & C
33
Cross Rates (Synthetic Rates)
Suppose Currency A is Swiss Francs, Currency
B is Canadian Dollars and Currency C is US
Dollars, then a chain formula for cross rate
between Sfr and Can$ would be: How many
Sfr = 1Can$,
if 1Can$ = 0.7555US$ and
if 1US$ = 5.5971Sfr
The
numbers on the right hand side will form the
numerator and those on the left will form the
denominator. On simplifying,
(Sfr/Can$)bid
= 0.7555 x 5.5971 = 4.2286
(Sfr/Can$)ask = 5.5978 x 0.7562 = 4.2330
34
Intl.fin.
Forward Rates
A forward rate in a Forward Contract is an
agreement between a commercial bank and its
customer to exchange a specified amount of a
currency at a specified exchange rate (called the
forward rate) on a specified date in the future.
The most common forward contracts are for 30, 60,
90, 180 and 360 days. However, contracts for
periods in between (Broken period contracts) are
also available (discussed elsewhere).
The difference between the forward rate (FR) and
the spot rate (SR) at a given time is measured by
the premium (Pm) or discount (- ): FR = SR(1 + Pm)
35
Intl.fin.
Examples of Buying & Selling Rates
1. Mr. X presents a foreign draft for US$5,000 for
2.
3.
4.
5.
36
credit to his account.
Mr. X wants a foreign draft for US$200 to
subscribe to a foreign magazine.
ABC Ltd. has lodged an export bill for US$50,000
which is realized and credited to the Nostro
account of the A.D.
Mr. Dutta is visiting his children in USA. He
requests for a Vishwa Yatra Card for US$3,000.
Mr. Mishra, an Indian citizen working in US has
remitted US$10,000 to an AD for opening a
foreign currency term deposit account.
Intl.fin.
Different Types of Buying
Rates
TT Buying Rate
i.
a)
b)
c)
d)
e)
Payment of foreign draft issued by a
correspondent bank.
Realization of foreign cheques / bills sent
on a collection basis.
Cancellation of outward remittances.
Payment of FCNR Deposit
Cancellation of Forward Sale Contract
.Computed as: Interbank Spot Buying Rate
– Exchange Margin.
37
Intl.fin.
Different Types of Selling
Rates
TT Selling Rate
i.
a)
b)
Issue of drafts/TTs and all clean instruments for
remittance outside India.
Cancellation of forward purchase contracts
.Spot TT Selling Rate = Interbank Spot Selling Rate +
Exchange Margin.
i. Bills Selling Rate
a)
b)
Payment of import bills
Advance payment for imports
.Spot Bills Selling Rate = Interbank Spot Selling Rate +
Exchange Margin.
i. Travellers cheques (TC) selling rate (TT Selling + 0.5%
towards handling charges)
ii. Foreign currency notes selling rate (TC selling + 0.5%)
38
Intl.fin.
Different Types of Buying
Rates
iii. TC Buying Rate
iv. Bills Buying Rate
a)
b)
Purchase of export bills
Purchase of travelers cheques and currency
notes
iii. FC Buying Rate
39
Intl.fin.
Notional Rates
An assumed rate which is used for
40
notionally converting foreign currency
deposits into Rupees is called Notional
Rate.
Banks are required to report rupee value of
all foreign currency deposits and loans as
on 31st March at the prevailing notional rate
only.
All banks are fixing the notional rate in line
with the weekly average of daily rates
for different currencies advised by
FEDAI on every Friday.
Intl.fin.
Nominal, Real and Effective exchange rates
The exchange rates quoted by the market are nominal
exchange rates.
Real exchange rate is price-adjusted nominal exchange rate.
The relation between nominal and real exchange rate can
be written as:
er = eP/P* , where P and P* are domestic and foreign price
indices.
Suppose the WPI in India and USA rises from 100 in 1998 to
120 and 110 respectively in 2001and if the nominal exchange
rate between the two currencies between the two dates remain
at Rs40/$, the real exchange rate will move to:
40 x 120/110
= Rs43.64/$
In a floating rate system the nominal rate moves automatically
with the change in the price level, but it does not happen so in
a fixed exchange system because of the administered rate. As
a result there will be a gap between the two.
41
Intl.fin.
Effective Exchange Rate
(EER)
EER is the measure of the average value of a
currency relative to two or more other currencies ,
normally shown in the form of an index.
It is possible that Indian Rupee depreciates against
US dollar but appreciates against Japanese Yen.
It is also possible that Rupee depreciates vis-à-vis
different currencies at different rates.
Therefore it is essential to develop an index to
measure how rupee fares, on an average, in the
foreign exchange market.
Such an index is called an effective exchange rate.
42
Intl.fin.
More on EER
Process of construction of an EER index:
Step 1: Select the basket for the currency (only those
currencies are included that matter significantly in the
country’s trade)
Step 2: Find out the weight of different currencies in the
basket in the following way:
Assuming that India has trade links with only USA and Japan
Indian exports to them are $6000 and $4000 and
Imports from them are $7000 and $3000 respectively,
Then, the weights for these two countries will be:
USA=(6000 + 7000) ÷ [(6000 + 7000) + (4000 + 3000)] =
0.65.
Japan=(4000 + 3000) ÷ [(4000 + 3000) + (6000 + 7000)] =
0.35
43
Intl.fin.
More on EER
Step 3: Find out the exchange rate index as
follows:
Suppose in 1998, the exchange rate was Rs40/$ and
Rs50/Yen100;
In 2001the exchange rate changed to Rs44/$ and
Rs60/Yen100;
If 1998 is the base year the exchange rate index in
2001 will be 110 (100 + 10% increase) for US$ and
120 (100 + 20% increase) for Yen.
EER 1998 = [(0.65 x 100)+ (0.35 x 100)] = 100
EER 2001 = [(0.65 x 110) + (0.35 x 120) = 113.5
This means that rupee depreciated on an average
by 13.5% during the period 1998 – 2001.
44
Intl.fin.
Problems in foreign exchange
45
Intl.fin.
Problems in foreign exchange
1. If direct quote is `45/US$, show how this exchange
rate can be presented under the indirect quote?
Solution: US$1 / `45 = US$ 0.0222 / `
2. If indirect quote is US$ 0.025 / `, how can this
exchange rate be shown under direct quote?
Solution: `1/US$0.025 = `40 / US $
3. Consider the following bid – ask prices: `40 – 40.50
/ US$. Find the bid–ask spread in percentage terms.
Solution: Spread
= [(Ask price – Bid price) ÷ Ask
price] x 100
= [(40.50 – 40.00) / 40.50] * 100 = 0.0123 or
1.23%
46
Intl.fin.
Problems in foreign exchange
4. Find out the bid rate if ask rate is `40.50 / US$
and the bid-ask spread is 1.23%.
Solution: [(40.50 – x) ÷ 40.50 = 0.0123 or
40.50 – x = 40.50*0.0123 = 40.50 – 0.50 = x or
x = `40.00
5. Find out the forward rate differential if spot rate
of US $ is `45.00 and one month forward rate is
`45.80.
Solution: Forward premium (discount) = [(n-day
forward rate – spot rate) / spot rate] * (360 / n)
(360/30)*{(45.80 – 45.00) / 45.00} * 100 =
21.33%
47
Intl.fin.
Problems in foreign exchange
6. Find the one month forward rate of US dollar if
spot rate is `45.00 and the forward premium is
12%.
Solution: (360 / 30){(x – 45.00) / 45.00} = 0.12
Or (x – 45) = 0.12 x 45 x 30 / 360
Or x = 45 + 0.45
Or x = `45.45
7. Suppose a newspaper quotes `35.00–
35.20/US$ and at the same time it quotes
Canadian$0.76 – 0.78/US$, find out the rates
between Rupees and Canadian dollars. >>
48
Intl.fin.
Problems in foreign exchange
Solution: Buying Rate: `35.00/US$1 X
US$1/C$0.78 = `44.87/C$
Selling Rate: `35.20/US$1 X US$1/C$0.76 =
`46.32/C$
Or combining the two, ` / C$ rates are:
`44.87 – 46.32 / C$
8. Suppose one month forward US$/` rate is
`34.50 – 34.80 and US$/C$ is C$0.79 –
0.83, find out the forward rate of C$/`.
49
Intl.fin.
Problems in foreign exchange
Solution: `34.80 / C$0.79 = `44.05/C$
34.50/C$0.83 = `41.57
Combining the two, we get `41.57 – 44.05 / C$
9.Find `/€ exchange rate if the two exchange
rates are: `43.93 – 43.95 and €0.83 – 0.84 / US$.
Solution:
Bid rate: `43.93 / 0.84 = `52.30
Ask rate: `43.95 / 0.83 = `52.95
Combining the two we get: ``52.30 – 52.95 / €
50
Intl.fin.
Problems in foreign exchange
10. The following are the middle rates reported
by Reuters for Canadian dollars on a particular
day. Fill up the blanks with suitable cross rates:
Country / Currency
Canada
Euro Area
Great Britain
Japan
Solution:
Country / Currency
Canada
Euro Area
Great Britain
Japan
51
Intl.fin.
USD
EUR
GBP
JPY
1.2341
0.8247
0.5488
108.83
USD
1.2341
0.8247
0.5488
108.83
EUR
1.4965
0.6655
131.96
GBP
2.2485
1.5026
198.28
-
JPY
0.0113
0.0076
0.005
-
Problems in foreign exchange
11. Consider the following data:
Spot Pound = $1.9510/20
3-month forward: $1.9257/70
3-month forward premium is = 2.53/2.50 cents (Spot – forward)
Calculate the rate of dollar premium against sterling (Sterling
discount against the dollar)
Answer:
For seller of sterling:
0.0253/1.9510 x 4 x 100 = 5.19% p.a.
b. For buyer of sterling:
0.0250/1.9520 x 4 x 100 = 5.12% p.a.
c. For mid-price quote:
0.02515*/1.9515^ x 4 = 5.16% p.a. [ *(0.0253 + 0.0250)/2,
^(1.9520 + 1.9510)/2]
52
Intl.fin.
Problems in foreign exchange
12. A foreign exchange dealer quoted the following rates for Pounds
Sterling on Friday, November 30, 1995.
Spot $1.4710/810
ii. 30-day forward
65/44
iii. 90-day forward
145/123
iv. 180-day forward 290/222
v. Determine the outright quotations for the Pound Sterling.
vi. Was Pound Sterling selling at a forward premium or a forward discount
on that date? Calculate the forward premium (or discount) on the 90day forward contract. Use ask rate to answer the question.
vii. How many US dollars would it cost you to buy £1,000,000 on November
30 1995?
viii. If you expect to receive £1,000,000 in 180 days from the quotation
date, how many US dollars would you expect to realise by selling them
forward?
ix. Assuming that the yield on a 6-month CD of major banks in the US is
9%, what should be the yield on a comparable CD in UK to insure
interest parity between the two countries?
i.
53
Intl.fin.
Solution
Spot
I Month
3 Months
6 Months
$1.4710–
1.4810
$1.4710–
1.4810
- 0.00650.0044
$1.4710–
1.4810
- 0.0145–
0.0123
$1.4710–
1.4810
- 0.02900.0222
Outright
quotes
$1.4645–
1.4766
$1.47651.4687
$1.4420-1.4588
vi. Forward discount = (forward rate – spot rate)/spot rate x
12/nx100 = (1.4687 – 1.4810)/1.4810 x 12/3 x 100 = 3.32%
vii. 1,000,000 x 1.4810 = $1,481,000
viii. 1,000,000 x 1.4220 = $1,442,000
ix. Forward discount=(1.4588 – 1.4810)/1.4810 x 12/6 x100
= -3%
Therefore the yield on a UK CD should be 12% (9% +
3%)
54
Intl.fin.
Problems in foreign exchange
13. You have called a foreign exchange
dealer and asked for Euro-dollar quotation for
spot, 1-month, 3-month and 6-month. The
trader responded with the following quotes:
$0.2479/81, 3/5, 8/7 and 13/10 respectively.
What does this mean?
If you wish to buy spot Euros how much
would you pay in dollars?
If you wished to buy dollars how much
would you pay in Euro?
55
Intl.fin.
Problems in foreign exchange
Answer:
Spot €/$ rate
Forward rate
Outright quote
1-month
0.2479 –
0.2481
0.0003 –
0.0005
0.2482 –
0.2486
3-month
0.2479 –
0.2481
0.0008 –
0.0007
0.2471 0.2474
6-month
0.2479 –
0.2481
0.0013 –
0.0017
0.2466 –
0.2464
We can buy spot euros at the bank’s spot selling
rate of $0.2471 per Euro.
€/$ Bid rate = $/€ Ask rate.
We can buy spot dollars at 1 ÷ 0.2479 =
€4.0339
56
Intl.fin.
Exchange Rate Forecasting
• To explain how firms can benefit
from forecasting exchange rates;
• To describe the common techniques used
for forecasting; and
• To explain how forecasting performance
can be evaluated.
57
Intl.fin.
Why Firms Forecast Exchange
Rates?
Forecasting exchange rates is a very difficult
task, and it is for this reason that many
companies and investors simply hedge their
currency risk.
MNCs need exchange rate forecasts for their:
hedging decisions,
short-term financing decisions,
short-term investment decisions,
capital budgeting decisions,
earnings assessments, and
long-term financing decisions.
Why?
58
Intl.fin.
Corporate Motives for Forecasting
Exchange Rates
Decide whether to hedge foreign
currency cash flows
Decide whether to invest in foreign
projects
Decide whether foreign subsidiaries
should remit earnings
Decide whether to obtain financing in
foreign currencies
In short, to minimize risks and maximize
returns
59
Intl.fin.
Forecasting Techniques
The numerous methods available for
forecasting exchange rates can be
categorized into four general groups:
Technical,
Fundamental,
Market-based, and
Mixed.
None of the above methods is superior
to others. This speaks to the difficulty of
generating a quality forecast.
60
Intl.fin.
Technical Forecasting
Technical forecasting involves the use of
historical data to predict future values –
E.g. time series models.
Speculators may find the models useful
for predicting day-to-day movements.
However, since the models typically
focus on the near future and rarely
provide point or range estimates, they
are of limited use to MNCs.
61
Intl.fin.
Fundamental Forecasting
In general, fundamental forecasting is
limited by:
the uncertain timing of the impact of the
factors,
the need to forecast factors that have an
immediate impact on exchange rates,
the omission of factors that are not easily
quantifiable, and
changes in the sensitivity of currency
movements to each factor over time.
62
Intl.fin.
Market-Based Forecasting
Market-based forecasting uses market
indicators to develop forecasts.
The current spot/forward rates are often
used, since speculators will ensure that the
current rates reflect the market expectation
of the future exchange rate.
For long-term forecasting, the interest rates
on risk-free instruments can be used under
conditions of IRP.
63
Intl.fin.
Mixed Forecasting
Mixed forecasting refers to the use
of a combination of forecasting
techniques.
The actual forecast is a weighted
average of the various forecasts
developed.
64
Intl.fin.
Comparison of Forecasting Methods
The different forecasting methods
can be evaluated:
graphically
by visually comparing the deviations
from the perfect forecast line, or
Statistically
by computing the forecast errors for
all periods.
65
Intl.fin.
Purchasing Power Parity (PPP)
(PPP) is perhaps the most popular method due to
its indoctrination in most economic textbooks.
It is based on the theoretical Law of One Price,
which states that identical goods in different
countries should have identical prices.
The exchange rate may however change to offset
price changes due to inflation.
Suppose prices in the U.S. are expected to
increase by 4% over the next year while prices in
Canada are expected to rise by only 2% and the
inflation differential between the two countries is
2%, >>
66
Intl.fin.
>>Purchasing Power Parity (PPP)
It means prices in the U.S. are expected to rise
faster relative to prices in Canada.
In this situation, the purchasing power parity
approach would forecast that the U.S. dollar would
have to depreciate by approximately 2% to keep
prices between both countries relatively equal.
If the current exchange rate was 90 cents U.S. per
one Canadian dollar, then the PPP would forecast
an exchange rate of US$91.8 Cents/1C$, meaning
it would now take 91.8 cents U.S. to buy one
Canadian dollar.
67
Intl.fin.
Big Mac Index
One of the most well-known applications of
the PPP method is illustrated by the Big
Mac Index, compiled and published by The
Economist. This light-hearted index
attempts to measure whether a currency is
undervalued or overvalued based on the
price of Big Macs in various countries. Since
Big Macs are nearly universal in all the
countries they are sold, a comparison of
their prices serves as the basis for the
index.
68
Intl.fin.
Big Mac Index (BMI)
The concept behind the BMI is that
prices will eventually equalize over time.
While this simple formula may serve as
a theoretical guide to determine under
and overvalued currencies, practicality
says many limitations exist in the short
and long term for measuring evaluations
and achieving successful trades.
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Intl.fin.
Relative Economic Strength Approach
The relative economic strength approach looks
at the strength of economic growth in different
countries in order to forecast the direction of
exchange rates.
The idea being that a strong economic
environment and potentially high growth is more
likely to attract investments from foreign
investors.
In order to purchase investments in the desired
country, an investor would have to purchase the
country's currency - creating increased demand
that should cause the currency to appreciate.
>>
70
Intl.fin.
>>Relative Economic Strength Approach
Another factor that can draw investors
to a certain country is interest rates.
High interest rates will attract investors
looking for the highest yield on their
investments, causing demand for the
currency to increase, which again would
result in an appreciation of the currency.
>>
71
Intl.fin.
Relative Economic Strength Approach
Unlike the PPP approach, the relative
economic strength approach doesn't
forecast what the exchange rate should be.
Rather, this approach gives the investor a
general sense of whether a currency is
going to appreciate or depreciate and an
overall feel for the strength of the
movement.
This approach is typically used in
combination with other forecasting
methods to develop a more complete
forecast.
72
Intl.fin.
Econometric Models
The factors used in econometric models are
normally based on economic theory, but any
variable can be added if it is believed to
significantly influence the exchange rate.
If interest rate differential between the U.S.
and Canada (INT), the difference in GDP growth
rates (GDP), and income growth rate (IGR)
differences between the two countries are
found to be the most important factors in
forecasting the exchange rates, the
econometric model could be: USD/CAD (1-year)
= z + a(INT) + b(GDP) + c(IGR) >>
73
Intl.fin.
Econometric Models
The coefficients a, b and c in the formula
will determine how much a certain factor
affects the exchange rate and direction of
the effect (whether it is positive or
negative).
This method is probably the most complex
and time-consuming approach of all.
However, once the model is built, new data
can be easily acquired and plugged into the
model to generate quick forecasts.
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Intl.fin.
Time Series Model
One of the more popular time series approaches
is called the autoregressive moving average
(ARMA) process.
The rationale for using this method is based on
the idea that past behavior and price patterns
can be used to predict future price behavior and
patterns.
The data you need to use this approach is
simply a time series of data that can then be
entered into a computer program to estimate
the parameters and essentially create a model
for you.
75
Intl.fin.
Bottom Line Approach (BLA)
Since bottom line is most valuable for a
business a finance manager would see
which parameter affects the bottom line
most.
The result from this method is limited by
focusing only on one parameter i.e., profit.
A combination of different factors will lead
to better forecasting of exchange rates.
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Intl.fin.
Managing Foreign Exchange
Reserves
77
Intl.fin.
Motives for holding foreign
exchange reserves
Can be classified under:
Transaction
ii. Speculative and
iii. Precautionary
.Transaction motive arise because of
international trade handled by banks.
.Speculative motive arise because of
individuals or corporates engaging themselves
in speculation for profit.
.Central bank reserves however arise as a
precaution against unpredictable flows. >>
i.
78
Intl.fin.
Objectives of maintaining reserves
i.
ii.
iii.
iv.
v.
79
Intl.fin.
Maintaining confidence in monetary and
exchange rate policies.
Enhancing capacity to intervene in the
foreign exchange markets.
Limiting external vulnerability by maintaining
foreign currency liquidity to absorb shocks
during times of crises including national
disasters or emergencies.
Providing confidence to the markets and
Adding to the comfort of the market
participants by demonstrating the backing of
domestic currency by external assets.
Implications of reserve
accumulation
Portfolio inflows are temporary
Whereas current account surpluses tend to endure and have positive
effect on the exchange rate.
Persistent current account surpluses are identified with appreciation of
long-term equilibrium exchange rate.
Resisting current account surpluses may cause larger capital flows with
potential appreciation pressure.
In many emerging market economies there is a wide gap between forex
reserves and the currency in circulation.
The central bank can finance this gap by issuing domestic monetary
liabilities.
If the increased reserves put downward pressure on short- term interest
rates, bank credit would tend to expand and inflationary pressure will
mount.
Central banks would try to control the inflationary pressure by selling
govt. security (Sterilized intervention)
Build up of reserves may sometimes be inimical for economic growth.
80
Intl.fin.
Fiscal cost of intervention
Large currency appreciation against anchor
currency(ies) may result in considerable valuation
losses.
It is however debatable how far valuation losses
might matter for the sustainability of intervention
policy.
Intervention to prevent a rise in exchange rate can
accentuate macroeconomic and financial imbalances.
Increased bank lending resulting from partial or
ineffective sterilization could finance excessive
investment in certain sectors like property markets or
equity market with adverse effects.
81
Intl.fin.
Questions
Discuss the motives for holding foreign exchange
reserves. Is foreign exchange reserves buildup
inimical to growth?
What are the challenges posed by the surge in
capital flows to the conduct of monetary and
exchange rate policy?
Critically examine the renewed interest in recent
times in foreign exchange reserves in the context of
increasing globalization, acceleration of capital flows
and integration of financial markets.
Explain why it would be virtually impossible to set an
exchange rate between Indian Rupee and U.S. dollar
and to maintain a fixed rate of exchange.
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Intl.fin.
>> Questions
Assume that the Federal Reserve believes that dollar
should be weakened against Chinese Yuan. Explain how
the Fed can use direct and indirect intervention to
weaken the dollar value with respect to yuan. Assume
that future inflation in the U.S. is expected to be low
regardless of Fed’s actions.
Explain briefly why the Federal Reserve may attempt to
weaken the dollar?
How can a central bank use indirect intervention to
change the value of a currency?
What is the impact of a weak home currency on the
home economy, other things being equal? What is the
impact of a strong home currency on the home
economy, other things being equal?
83
Intl.fin.
>> Questions
How can a central bank use direct
intervention to change the value of a
currency? Explain why a central bank may
desire to smooth exchange rate
movements of its currency?
Compare and contrast the fixed, floating
and managed float exchange rate systems.
What are some advantages and
disadvantages of a freely floating exchange
rate system versus a fixed exchange rate
system?
84
Intl.fin.
Types of Transactions
Transactions can be classified based on the time
between entering into a transaction and its
settlement.
Ready or Cash transaction: Settled the same day
or ‘value today transaction’.
TOM transaction: Settled the next day
Spot transaction: Settled 2 business days from
the date of the contract.
Forward transaction: Parties to the transaction
agree to buy or sell a currency or commodity at a
predetermined future date at a particular price
decided on the date of transaction.
85
Intl.fin.
Forex
Transactions
Forwar
d
Spot
Ready
(Today)
86
Intl.fin.
Tom
(Next
working
day)
Spot
(Two
working
days)
(Any
time
after two
working
days)
Value Dates
The settlement date of a forex transaction is called
its value date.
A Spot transaction is settled 2 nd business day from
the date of transaction.
Neither day should be a holiday either in any of the
settlement locations or in the dealing location of
the market making bank.
The settlement date for a forward contract
depends on:
1. The settlement date for the spot transaction entered
on the same date as the forward contract and
2. the maturity of the forward contract in months.
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Intl.fin.
Value Dates
For example,
If a 3 months (or 90 days) is entered into on
July 20, the spot value date is July 23
(assuming that July 21 is a holiday).
The settlement date for the forward contract
will be Oct 23 (by adding 3 calendar months).
If it is a holiday that day, then the settlement is
shifted to the next day.
Suppose the spot settlement date is the last
day of the month, then the settlement date of
the forward contract will be the last day of the
relevant month irrespective of the number of
days in the two months.
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Intl.fin.
Value Dates
Example: If one month forward contract is
entered to on Jan 29, then the spot
settlement will be Jan 31 and forward
settlement will be on Feb 28 or 29.
If the forward settlement date of a contract
is say Oct 31, and if it happens to be a
holiday, then the settlement cannot be
done on Nov 1. In such a case the
settlement will be shifted to the previous
day i.e., Oct 30.
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Intl.fin.
Forward Quotes – Premium & Discount
A currency is said to be at premium it its
forward rate is higher than its current spot
rate.
Conversely, a currency is at a discount, if
the forward rate is lower than the current
spot rate.
Example 1:
INR/USD : 45.42/44 and 3m INR/USD :
46.62/70
USD/GBP : 1.6721/26 and 3m USD/GBP :
1.6481/92
The spread between the bid and the ask
90
rates increases as one goes into the future.
Intl.fin.
Forward Quotes – Premium &
Discount
The difference between the spot rates and forward
rates can be expressed in terms of swap points.
In the rupee-dollar example, the swap points are
120/126 (46.62 – 45.42 and 46.70 – 45.44).
In the dollar-pound example, the 3-month swap
points are 240/234 (1.6721-1.6449 and 1.67261.6492).
Rules:
1. When swap points are low/high, currency B is at a
premium and A is at discount:
Premium: Add swap points to spot rate to get the outright
forward rate or
Deduct swap points from the outright forward rate to get the
spot rate.
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Intl.fin.
Forward Quotes – Premium & Discount
Forward rates can be expressed in two ways.
Commercial customers are usually quoted the
actual price (outright rate). In the interbank
market, however, dealers quote forward rate
only as a premium or discount on the spot rate.
Example:
Spot sale JPN/USD Feb.6 1990: $0.006879 (A)
90 days forward Yen
: $0.006902 (B)
Swap rate for 90 days Yen: 23 points (B – A)
Alternatively, the premium or discount can be
expressed as annualized percentage as follows:
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Intl.fin.
Forward Quotes – Premium &
Discount
Forward premium/discount = (Fwd. Rate – Spot
Rate)/Spot Rate x 12 (or 360)/forward months (or
number of days)
Thus, the annualized premium in the above
example is:
(0.006902 – 0.006879)/0.006879 x 12/3 = 0.0134 or 1.34%
Out of two margins given for a month, the first
one relates to the buying rate and the second
rate to the selling rate
If the forward margins for a month are in
ascending order it indicates premium and if it is
in the descending order it is at a discount.
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Intl.fin.
Forward Quotes – Premium & Discount
If the forward rate is in premium the forward rate is
found out by adding the margin to the spot rate and
deduct it for discount.
Example: The following quotes are received for spot,
one month, 3 months and 6 months SFR and GBP:
Spot
Intl.fin.
3
month
s
6
months
£/$
2.0015–
30
19-17
26-22
42-35
SFr/$
0.6963–
68
4-6
9-14
25-38
>>
94
1
mont
h
Pound Sterling
The
outright rates
Maturity
Bid are: Ask
Spread
Swiss Francs
Bid
Ask
Spread
(%)
(%)
Spot
$2.001
5
$2.003
0
0.075
$0.696
3
$0.6969
0.086
%
1 Month
1.9996
2.0013
0.095
0.6972
0.6982
0.143
3 Months
1.9989
2.0008
0.095
0.6972
0.6982
0.143
6 Months
1.9973
1.9995
0.110
0.6988
0.7006
0.257
Swiss Francs are selling at a premium against the dollar and
Pound is selling at a discount.
The wider percentage of the spread between the bid and the
offer of SFr compared to £/$ is due to broader market in Pounds.
The widening spreads by maturity for both the currencies is
caused by the greater uncertainty surrounding the future
exchange rates.
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Intl.fin.
Forward Quotes – Premium &
Discount
2. When the swap points are high/low,
currency B is at a discount and currency A
is at premium.
Deduct the swap points from the spot rate to arrive
at the outright forward price or
Add them to the outright forward rates to get the
spot rate.
3. The bid side swap points are to be added
96
to or subtracted from the spot bid rate
(depending on the currency is at a
premium or discount) to arrive at the
forward bid rate. The ask-side swap
points are added to or subtracted from
the spot ask rate to get the forward ask
Intl.fin.
rate.
Forward Quotes – Premium &
Discount
Rolling over a forward contract: When the
maturity of a forward contract is extended
by cancelling the existing contract and
entering into a new contract for the
extended duration, it is called rolling over a
forward contract.
In India rolling over forward contracts for
over one year is not permitted.
A party with an exposure longer than one
year can initially hedge for the maximum
maturity available and roll over at maturity
for further periods.
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Intl.fin.
Broken date Forward Contracts
A broken date forward contract is a contract
which is not a whole month or for which a
quote is not readily available.
The rate for a broken period contract is
calculated by interpolating between the
available quotes for the preceding and the
succeeding maturities.
Example: What will be the forward rate for
1month and 10 days (broken date contract)
if$/` Spot :40.00 – 40.101month fwd.:
40.50 – 40.703month fwd.: 40.80 – 41.10
>>
98
Intl.fin.
Broken date Forward
Contracts
Solution:
For 1month and 10 days, swap points are:
Buying Rate: 50 + (80-50) x 10/60 = 55
Selling Rate: 70 + (110–70) x 10/60=77
The forward rate for 1 month and 10 days
will therefore be `40.55 – 40.77/$
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Intl.fin.
Broken date Forward Contracts
A customer wants a quote from the bank for
purchasing dollars from the bank on Sept. 29.
Dollar is at a premium and the swap points
are 29/35 between Aug and Oct maturity.
On the ask side, the premium is 35 points which is
spread over 61(30+31) days. The required
maturity is 29 days away from Aug maturity .
Hence the premium charged by the bank over
and above the Aug rate will be 35x29/61=17
points. The rate charged will be 5.5885 + 0.0017
= Sfr5.5902/$ Similarly, the buy and sell rates
can be calculated for any intervening rates
between two given maturities.
>>
100
Intl.fin.
Option Forwards
Customer of a bank has the option to ask
101
for settlement of the contract anytime
during a particular period called the option
period.
Giving quotes for this kind of contract is not
as straight forward as a quote for an
outright forward contract because while the
exchange rate is fixed the timing of the
exchange is not fixed.
If the exchange takes place at an
unfavorable time the bank would incur a
loss.
Intl.fin.
To avoid a loss, banks adopt the following
Option Forwards
1. When the bank is buying a currency:
Will add the minimum premium
102
possible (when it is at a premium) to
the spot rate and
Will deduct the maximum discount
from the spot rate (when it is at a
discount).
The bank quotes a rate applicable to
the beginning of the option period
when the currency is at a premium
and that applicable to the end of the
Intl.fin. option period when it is at a discount.
Option Forwards
2. When the bank is selling a currency:
Will add the maximum premium possible (when
it is at a premium) to the spot rate
Will deduct the minimum discount possible
(when it is at a discount) from the spot rate.
This would result in the bank quoting the rate
applicable to the end of the option period when
the currency is at a premium and to the
beginning of the option period when it is at a
discount.
. Example1: Euro/Sfr rate: Spot: 1.2245/49, 3m
fwd.: 10/15, 4m fwd.: 15/25, Option 4 months
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Intl.fin.
Option Forwards
Sfr is at a premium
If the bank is selling Sfr, it will load the maximum
premium to the spot rate (on the implicit
assumption that the customer will demand delivery
when the currency is most expensive). So it will
quote a rate Euro 1.2274/Sfr (1.2249 + 0.0025)
If the contract is to buy SFr, the bank would assume
that the customer would choose to exercise his
option when SFr is at its cheapest i.e., at the
beginning of the fourth month. So it will load a
minimum premium to the spot rate and quote
Euro1.2255/SFr (1.2245 + 0.0010)
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Intl.fin.
Option Forwards
Example 2. Currency is at a premium at the
beginning of the option period and at a
discount during the option period.
SFr/Aus$ : 3.4925/30
1month : 3.4935/45
2months
: 3.4930/42
Customer Option to buy Aus$ any time
during the second month, the bank would
quote the rate of SFr3.4945/Aus$ and if the
option were to sell Aus$, the quotation would
be SFr3.4930/Aus$.
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Intl.fin.
CURRENCY ARBITRAGE &
INTEREST RATE PARITY
i. Conditions that will result in
international arbitrage.
ii. The concept of interest rate parity and
how it prevents arbitrage opportunities
106
Intl.fin.
International Arbitrage
Definition: Capitalizing on a discrepancy in the quoted
prices by making a risk-less profit.
Three forms:
1.
2.
3.
107
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage
1. Locational arbitrage:
Example: Two coin shops A & B are in the business of
buying and selling coins. Shop A is prepared to sell a
particular coin at Rs.120 and shop B is prepared to buy
the same coin for Rs.130.
A coin collector can buy the coin at Rs.120 from shop A
and sell the same to shop B for Rs.130 and thus earn a
risk-free profit of Rs.10 in the transaction.
Prices in the shops may vary because of their different
locations. Demand conditions also vary if the two shops
are not aware of each other’s prices. These factors give
Intl.fin.
rise for arbitrage opportunities. Gains from locational
Triangular Currency Arbitrage
Exchange dealers are continually alert to the
possibility of taking advantage through
triangular currency arbitrage.
These transactions involve buying a currency in
one market and simultaneously selling it in
another market, to take advantage of exchange
inconsistencies in different money centers.
Suppose the Pound Sterling is bid at $1.5422 in
New York and Euro is offered at $0.9251 in
Frankfurt; At the same time London banks are
offering Pound Sterling at €1.6650.
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Intl.fin.
Triangular Currency Arbitrage
New York quote: ₤/$ Bid - $1.5422/pound
Frankfurt quote: €/$ Ask - $0.9251/Euro
London quote:
₤/€ Bid - €1.6650/pound
If $1.5422 = 1₤ and
If 1₤ = €1.6650
How many Euros = 1$
i.e. (1.5422/1) x (1/1.6650) = €0.9262 or 1€ = $1.0796
Since euro is available in Frankfurt at a cheaper rate of
$0.9251 (as against a cross rate of $1.0796) there is an
arbitrage opportunity.
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Intl.fin.
Currency Arbitrage
Let us assume that the trader begins in
New York with $1 million.
Acquire €1,080,964.22 (1,000,000/0.9251) in
Frankfurt,
Sell these euros for ₤649,277.76
(1,080,964.22/1.6650) in London and
Resell the Pounds in New York for $1,001,239.05
(649,227.76 x 1.5422), making a profit of $1,239.05.
This sequence of transactions is known as triangular
currency arbitrage. >>
110
Intl.fin.
Currency Arbitrage
In the preceding example, the arbitrage
transactions would tend the euro to appreciate
vis-à-vis the dollar in Frankfurt and to depreciate
against Pound Sterling in London.
At the same time, sterling would tend to fall in
New York against the dollar.
Acting simultaneously, these currency changes
will quickly eliminate profits from this set of
transactions, thereby enforcing the no-arbitrage
condition.
Otherwise, a money machine would exist, opening
the prospects of unlimited risk-free profits.
111
Intl.fin.
Currency Arbitrage - Exercise
Your forex trader has given the following cross currency quotes. The
quotes are expressed as one unit of currency on the left side per unit
of currency shown at the top row.
Curr
ency
SFr
DKr
GBP
JPN
SFr
DKr
Pound Stg.
Japanese
Yen
US $
0.295702.4256-67
0.1276-78
1.5780-86
3.3818-25
76 8.2031-41
0.4315-19
5.3021-33
0.41227- 0.00526-29
0.6502-10
35
0.12381190.121123.56978.38190
390
707
496arbitrage
23.178Do any triangular
opportunities exist among these
251deviations from the theoretical cross
currencies? (Assume that any
rates of 5 points or less are due to transaction costs).
How much profit could be made from a $5 million transaction
associated with each arbitrage opportunity?
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Intl.fin.
Questions
1. Discuss the forex market structure in India.
2. What risks confront the forex dealers and how
3.
4.
5.
6.
113
do they cope with those risks?
Suppose a currency increases in volatility, what
is likely to happen to its bid – ask spread? Why?
Who are the principal users of the forward
market?
How does a company pay for the foreign
exchange services of a commercial bank?
The $/€ exchange rate is €1=$0.95 and €/SFr rate is SFr1 =
€0.71, what is the SFr/$ exchange rate? >>
Intl.fin.
Questions
6. An investor wishes to buy euros spot @ $0.9080
and sell euros forward for 180 days @ 0.9146,
what is the swap rate on euros and what is the
forward premium or discount on 180 days euros?
7. Suppose Credit Suisse quotes spot and 90 days
forward rates on the Swiss Franc of $0.7957 – 60,
8 – 13,
What are the outright 90 day forward rates that
Credit Suisse is quoting?
b. What is the forward discount or premium
associated with buying 90-day Swiss Francs?
c. Compute the percentage bid-ask spreads on spot
and forward Swiss Francs.
a.
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Questions
8. As a foreign exchange dealer at Sumitomo Bank
you have a customer who would like spot and 30day forward Yen quotes on Australian Dollars.
Current market rates are:
Spot 30-day
¥101.37-85/US$1 15–13
A$1.2924 – 44/US$1
20–26
a) What bid and ask Yen cross rates would you quote
on spot Australian dollars?
b) What outright Yen cross rates would you quote on
30-day forward Australian dollars?
c) What is the forward premium or discount on buying
30-day Australian dollars against yen delivery?
115
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Part II – Unit 6 - International Financial
Markets & Instruments
Origin
Instruments
Players
Decision
116
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THE ASIAN CRISIS OF THE 90s
Causes
Governments’ intervention for controlling
their exchange rates
Consequences of intervention efforts
117
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Crisis in Thailand
World’s fastest growing economy till 1997
Grew faster than any other country over 1985 –
94
Thai consumers spent freely and saved less
Result – upward pressure on local interest rates
and prices of real estate and products
Thai Baht was linked to U.S. dollar till July 1995
and therefore attracted foreign investments
because of high interest rates.
More funds available to Thai banks were lent to
the real estate sector based on the previous
success of the developers
118
Intl.fin.
>>Crisis in Thailand
Thailand was a “house of cards waiting to collapse”
Large inflow of funds led to lower interest rates
Thai government borrowed heavily to improve
country’s infrastructure at high rates of interest.
In 1997 foreign investors recognized Thailand’s
potential weakness and started withdrawing their
investments
Baht started depreciating against all major
currencies
On July 2 1997 baht was delinked from dollar and
Thailand’s central bank started intervening in the
market
119
Intl.fin.
>> Crisis in Thailand
The market intervention didn’t help
In July 1997 baht plummeted
The defaulted bank loans were over $30
120
billion
On August 5 1997 IMF and other countries
agreed to provide a $16 billion rescue
package
In return Thailand agreed to reduce its
budget deficit, prevent inflation from rising
above 9% and increase taxes
Many banks folded up
Intl.fin.
The crisis spread throughout Southeast
Effects On Other Currencies
In July – August 1997 the malaise spread to Malaysia,
Singapore, Philippines, Taiwan and Indonesia
Their currency values depreciated fast
Efforts by central banks to intervene and stabilize
their currencies failed
The Southeast Asian Countries gave up their fight to
contain depreciation of their currencies
Many restrictions on forwards and futures market
speculation did not bear fruit
Investors had no confidence in the markets and that
resulted in flight of capital
The currencies were allowed to float
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Intl.fin.
>> Effects On Other
Currencies
Due to integration of Southeast Asian economies the
excessive cross-border lending by local banks turned bad
Finally, what began as the ‘Thailand crisis’ became the
‘Asian Crisis’
The Asian Crisis had impact on many other countries
across the globe - Hong Kong, Russia, South Korea, Japan,
China, India, Latin American countries as well as Europe
and United States
Lessons learnt: The Asian Crisis demonstrated the degree
to which currencies could depreciate in response to lack
of confidence by investors and the inability of central
banks to stabilize their local currencies in such a crisis.
122
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How Exchange Rates Changed
Ruble depreciated - IMF package of $22.6
billion
S.Korea
-41%
Chaebols
collapsed,
Currency
depreciated
IMF rescue
package of $55
billion
- 0%
41%
Hong
Kong 0%
-
38%
-37%
123
Intl.fin.
Singapore
- 15%
-84%
Taiwan
-20%
-37%
How Interest Rates Changed between June 1997(.) and June 1998
S.Korea
(14)/17%
(7)/12%
(11)/24%
124
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Singapore
(3)/7%
Indonesia
(16)/47%%
(7)/8
%
(7)/11%
%
Taiwan
(5)/7%
Hong Kong
(6)/10%
Philippine
s
(11)/14%
Sources of International
Liquidity
Monetary gold held by the authorities as a
125
financial asset
SDRs – (Value of SDR determined daily by the
IMF on the basis of a basket of currencies, with
each currency assigned a weight)
Reserve position in the fund (difference
between each member’s quota plus other
claims on the fund less the Fund’s holdings of
that member’s currency).
Foreign exchange comprising monetary
authorities claim on non-residents in the form
of bank deposits, Treasury Bills, Short and longterm government securities, without regard as
Intl.fin.
to whether the claim is denominated in the
International Financial Markets &
Instruments
126
Intl.fin.
Origin of International Financial Markets
Demand for high quality dollar denominated bonds
who wished to hold their assets outside their own
countries.
Concerns of these investors:
Avoiding registration of ownership of investments and
taxes in their home countries and
Protecting themselves against falling values of domestic
currencies.
Euro bonds were designed to address these concerns.
Major changes have taken place in the international
markets since 1970s:
Removal of exchange controls in countries like U.K.,
France and Japan
Application of technology to financial services etc.
127
Intl.fin.
International Financial Markets &
Instruments
The integration of financial markets across
countries has opened up the international
markets.
The financial intermediaries have developed a
large variety of financial instruments to suit the
needs of international investors for both equity
and debt investments.
Instruments in the bond market:
Foreign Bonds: Yankee Bonds, Samurai Bonds,
Bulldog Bonds,
Euro Bonds: Euro dollar, Euro Yen and Euro Pound
Bonds
Instruments in the Equity Market: ADR / GDR
128
Intl.fin.
International Financial Markets &
Instruments
Foreign Bonds: Bonds floated in domestic market
denominated in domestic currency by non-resident
entities.
Euro Bonds: Bonds issued and sold outside the
home country of the currency.
Syndicated Euro Credits are available in euro
markets by way of Club loans and Syndicated loans.
Club loans are private arrangement between
lending banks and a borrower.
Syndicated Euro Credit is a full-fledged public
arrangement for organizing a loan transaction.
Wide network of participation by banks
Loan maturity of 3 to 7 years.
129
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History of International Financial
Markets & Instruments
Until the end of 1970s there were
130
restrictions on cross-border equity
investments.
Investors too preferred domestic equity
markets because of perceived risks in
foreign currency exposures.
Early 80s witnessed liberation of many
domestic economies and globalization.
Issuers from developing countries were
able to access international equity markets
through issue of Depository Receipts –
GDRs, ADRs and IDRs
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American Depository Receipts (ADRs)
In April 1990 SEC allowed non-US
companies to rise capital in the US market
without having to register the securities
with SEC or without having to change the
financial statements according to US GAAP
requirements.
QIBs are permitted to invest in ADRs
It represents non-US company’s publicly
traded equity.
Well-known intermediaries: Goldmann
Sachs & Co., Merrill Lynch Intl. Ltd., J P
Morgan etc.
131
Intl.fin.
International Financial Markets &
Instruments
A Depository Receipt is a negotiable certificate
issued by a depository bank which represents the
beneficial interest in shares issued by the company.
These shares are deposited with a local custodian
appointed by the depository that issues the receipts
against the deposit of shares.
In countries with capital account convertibility, DRs
and domestic equity shares are mutually
convertible.
Until the DRs are converted into equity shares, the
holder will not have any voting rights and also there
is no foreign exchange risk for the company.
The company will be listed at the prescribed stock
exchanges providing liquidity for the instrument.
132
Intl.fin.
International Financial Markets &
Instruments
Borrowers / Issuers: Mostly, corporates,
banks, FIs, govt. and quasi-govt. bodies
who need forex funds.
Corporates borrow foreign currencies for
expansion of their operations abroad or
because of dull and saturated domestic
markets.
Govts. Borrow for adjusting their BOP
mismatches, for keeping sufficient inventory
of currency reserves.
FIs like IMF, World Bank, ADB etc. borrow
long term funds for financing diversified
financing.
133
Intl.fin.
International Financial Markets &
Instruments
Lenders / Investors:
Euro loans: The lenders are mostly
international banks.
For GDRs, the investors are mostly
institutions and high net worth individuals.
For ADRs, it is the institutional investors or
HNIs through the Qualified Institutional
Buyers.
Intermediaries:
Lead Managers, Co-lead Managers,
Underwriters, Lawyers and Auditors, Stock
Exchanges, Depository Banks and
Custodians.
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Intl.fin.
Functions of Intermediaries
1. Lead and Co-lead Managers:
Undertaking due diligence
Preparing the offer memorandum
Marketing the issues, including the road
shows
Sometimes there could be more than one
lead manager to ensure successful launch.
One of the lead manager will ‘run the books’
(sending out invitations, allotting Bonds / DRs
etc.) for the issue.
2. Underwriters: Taking on the risk of
under subscription and thus giving
support to the issue.
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Functions of Intermediaries
3. Agents & Trustees: The issuer of the Bonds
should appoint ‘paying agents’ in different financial
centers for payment of interest and principal due to
investors. These paying agents will be banks.
4. Lawyers and auditors:
Lawyers will draw up the legal documentation and
The auditors will provide comfort letters to the lead
managers on the financial health of the issuer.
5. Listing Agents and Stock Exchanges:
Listing Agents facilitate documentation and listing of
the issue and
Stock Exchanges will review the application and
provide comments on the issue prior to accepting the
securities for listing.
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Intl.fin.
Functions of Intermediaries
6. Depository Bank: Responsible for
issuing DRs, facilitating exchange of
DRs into underlying shares when
presented for redemption.
7. Custodian: The custodian holds the
shares underlying the shares on behalf
of the depository.
8. Printers: Responsible for printing and
delivery of the offer memorandum as
well as the DRs / Bond certificates.
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The Decision Criteria
1. Competitive cost
2. Currency requirement
3. Pricing:
Pricing of an international issue should consider the interest
rates and market value of the stock in the domestic market,
the exchange rate movements, hedging the risk, level of
premium etc.
4. Depth of the market in which the issue is being offered.
5. International positioning: Long term perspective of the
company.
6. Regulatory aspects: Various approvals required from
different authorities.
7. Disclosure requirements.
8. Investment climate – International liquidity, country risk.
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Indicative Time Schedule for
GDR/ADR Issue
139
Stage
Admn. Work involved
a. Initial
decision
i. Meeting between
issuer and lead
manager planning the
issue.
ii. Issue structure
finalized in
conformity with the
domestic regulatory
environment.
iii. Draft documentation
iv. Due diligence process
v. Board meeting and
share holders’
approval
vi. Fixing various parties
to the issue.
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Time in
weeks
1 and 2
Indicative Time Schedule for GDR/ADR Issue
Stage
b. Approvals and drafts
finalization
Admin. Work involved
i.
Official approvals – steps
initiated
ii. Comfort and consent letters
finalized with auditors
iii. Legal opinion formats
drafted and finalized
iv. Approvals obtained
Time in
weeks
3 and 4
c. Pre-launch formalities
d. Launch of issues
140
Intl.fin.
v. Road show preparations and 7 and 8
presentations
vi. Pathfinder prospectus
finalized
vii. Listing preparations in final
stages
viii.Road shows organized
ix. Documentation circulated
among syndicate
x. Investors contracted
Indicative Time Schedule for GDR/ADR
Issue
Stage
e. Pricing and
closing
GDR Issue: Fees &
Expenses
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Intl.fin.
Admn. Work involved
i. Final terms fixed
ii. Allocation of securities to
investors
iii. Final prospectus to be kept
ready
iv. Final listing documents lodged
with stock exchange
v. Subscription agreement signed
vi. Delivery of global certificate
vii. Closing documents signed
viii.Payments to issuer
ix. Tombstone advertisement
Underwriting fee (%)
: 0.60 –
1.00
Management fee (%) : 0.60 –
1.00
Selling commission (%) :1.80 –
3.00
Time in
weeks
INTERNATIONAL DEBT
MARKETS
Debt markets and instruments
142
Intl.fin.
International Debt Markets &
Instruments
143
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International Debt Market
(IDM)
The International Debt Market offers a
borrower:
A variety of different maturities,
Repayment structures and
Currencies of denomination.
Three original factors in the evolution of the
Eurobond market are still of importance:
Absence of regulatory interference,
Less stringent disclosure practices and
Favourable tax treatment.
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Debt Instruments – Euro Bonds (EBs)
EBs are bonds that are sold in countries other than
the country of the currency denominating the bonds.
Issuing EBs became easier with no exchange controls
and no govt. restrictions on transfer of funds in
international markets.
All EBs, through their features, can appeal to any
class of issuers or investors. The unique
characteristics that make them flexible are:
No withholding taxes of any kind on interest payments
Bonds are in bearer form with interest coupons attached
Listed on one or more stock exchanges (Usually on the
Luxembourg Stock Exchange) but issues are traded on
OTC market.
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Debt Instruments – Euro Bonds
Fixed Rate / Straight Debt Bonds:
Fixed interest bearing securities redeemable
at face value.
These are unsecured bonds
Bonds issued in the Euro-market are called
Euro Bonds.
Interest on the bonds are benchmarked to
LIBOR
Redemption of Straights is done by bullet
payment
No tax deduction at source on the income
from these bonds.
Can also be issued as Zero Coupon Bonds
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Debt Instruments – Floating Rate Notes (FRNs)
FRNs are Bonds with maturity of 5 – 7
years.
Conventionally the Bonds are called the
Notes and the margin will be above 6
months LIBOR for euro dollar deposits.
Procedure for issue:
The mandated bank forms a syndicate group
The lead bank is responsible for credit
appraisal, preparing a prospectus,
documentation etc.
Pricing is generally done by the book-building
route
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Bought-out deal: Pre-priced issue is
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presented to the market
Debt Instruments – Euro Bonds
Listing:
Euro Bonds are generally listed in London / Luxembourg
stock exchanges.
Bond issue procedures generally end with tombstone
advertisements.
Clearing arrangements:
Euro Bonds are generally handed over to either
Euroclear system (Brussels) or Cedel (Luxembourg).
Euroclear and Cedel follow two distinct practices viz.
fungible
(Details regarding the identity of the owners and location of
and non-fungible
accounts for concluding transactions between parties.
Euroclear handles trades on fungible basis, whereas
Cedel permits both procedures.
individual securities are not provided)
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Debt Instruments – Foreign Bonds
Bonds issued by foreign entities for raising
medium to long term financing.
1. Yankee Bonds:
US Dollar denominated bond issues by
foreign borrowers in the U.S bond markets.
SEC regulates these issues and requires:
149
Intl.fin.
Complete disclosure documents in more detail
than what is available in the prospectus.
To adopt U.S accounting practices and
U.S credit rating agencies will have to provide
rating for these bonds.
Debt Instruments – Foreign Bonds
2. Samurai Bonds: Bonds issued by non-
Japanese borrowers in the domestic
Japanese markets.
Maturities: 3 – 20 years
As this is issued for public, arrangements
for underwriting and selling have to be
made and involves large documentation.
However, documentation and formalities
are friendly and hospital.
Expensive in terms of issuing cost
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Debt Instruments – Foreign Bonds
3. Bulldog Bonds: Sterling denominated foreign bonds
raised in UK domestic market.
Maturities: 5 to 25 years.
Generally redeemed on bullet basis
Will have to be listed on London Stock Exchange.
.Euro Notes:
Euro Notes (EN) are different from syndicated bank
credits and euro bonds in its structure and maturity
periods.
Pricing could be sub-LIBOR or a few basis points above
LIBOR.
Documentation formalities are minimal.
Euro Notes possess flexibility and can be tailored to suit
the specific requirements of different borrowers.
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Debt Instruments – Euro Notes
a. Euro Commercial Paper:
Short-term unsecured promissory notes that repay a
fixed amount on a certain future date.
Maturity: 3 months, 6 months and 1 year paper.
Even though the maturities are small, the overall funding
programme could be for medium to long term.
Procedure:
Select a dealer and an issuing and paying agent.
No mandatory rating. However, borrowers seek rating for
successful launching of CP programmes.
Documentation: Simple – An Information Memorandum, Dealer
Agreement, Issuing and Paying Agency Agreement and the actual
notes.
No separate disclosure requirements.
A variation of the ECP is the Asset-backed CP that is
backed by financial assets such as mortgages or credit
card receivables.
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Debt Instruments – Euro Notes
Note Issuance Facilities (NIFs): A medium-term legally
binding commitment under which a borrower can issue
short-term paper of up to one year.
Currency: Mostly US $
Margin: A spread over LIBOR or built into the NIF pricing
itself.
Underwriting: Yes, by banks. Could be a revolving
underwriting facility
NIFs can be reissued periodically.
Investors: Mostly commercial banks, insurance companies,
provident funds etc.
Medium-term Notes (MTNs):
Sequentially issued fixed interest securities
Maturity: Over one year, up to the desired level of
maturity
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Euro Credit Syndication
Syndicated Euro Credits are in existence since the late
60s.
Period: 7 to 15 years
RoI: Floating rate linked to 3 or 6 months LIBOR.
Currency: Denominated generally in US$, JPY, Euro, SFR .
Amortization: Half-yearly installments with 2 – 3 years
grace period.
Simplest way of raising foreign currency resources.
Documentation: Information Memorandum and loan
agreement from the lead manager.
Underwriting: Yes, by a management group assembled by
the lead bank, including itself.
Comparative Analysis of Global Financial Markets.xlsx plu
s Comparative Analysis of Financial Instruments.xlsx
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Glossary of Market Terms
American
Depository Receipt (ADR): A certificate of ownership issued by a
U.S. bank as a convenience to investors in lieu of the underlying foreign
corporate shares it holds in custody.
Arbitrage: Locking in a riskless profit from price disequilibria or distortions in
different markets
Arm’s length price: Price at which a willing buyer and willing unrelated seller
would freely agree to transact
Basis Point: The last decimal in the quotation of an exchange rate and 0.01%
when referring to interest rates or yields.
Bid Rate: The price at which a market maker is prepared to buy a currency or
borrow money.
CHIPS (Clearing House Inter-bank Payment System): Inter-bank payment
and settlement system in New York. Records all payments and receipts and
gives the net position at the end of the day. The system has enabled member
banks to substitute electronic payment in place of paper cheques.
CHAPS (Clearing House Automated Payment System): Exists in London.
Counterpart of CHIPS.
CHATS (Clearing House Automated Transfer System): Operational in Hong
Kong for automated inter-bank transactions.
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Glossary of Market Terms
Eurocurrency: A deposit or a borrowing domiciled
outside the home country of the currency.
EDI (Electronic Date Interchange): Transfer of data
between computers (Airline Reservation, SWIFT,
Customs Clearance of exports / imports)
Fixed date forwards: Standard maturity (or value)
dates for contracts like one, three or six months.
Forward Margin: Difference between spot and
forward rates, also known as swap price or points.
Fed Wire: A computer network that connects about
7000 banks around USA to the Federal Reserve Bank.
Follows gross settlement system, unlike CHIPS. Used
for payment and settlement of large value transactions.
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Glossary of Market Terms
Forward Rate: Price of a currency for
value date beyond the spot date. If more
expensive, the currency is at a premium, if
cheaper, then at a discount.
Market Making: Quoting rates for both
buying and selling a currency.
Middle Rate: Mean of Bid and Offered
rates.
Nostro Account: A bank’s account with a
correspondent bank / branch abroad, in the
home currency of that country.
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Intl.fin.
Glossary of Market Terms
Offer Rate: The price at which a market maker is
prepared to sell (a currency) or lend (money).
Option Forwards: One of the two parties to a forward
contract has the option of choosing the delivery date
within a specified period.
Position: The net commitment in a currency. It is square
if sales equal purchases, long, if purchases are more than
sales and short if sales exceed purchases.
Rollover: Similar to badla in the share market. Extending
or postponing delivery.
Reuter System: A computer based data bank that
provides real-time data on forex rates of various markets
all over the world.
Spread: Price difference between bid and offer rates.
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Intl.fin.
Glossary of Market Terms
Swap: Simultaneous sale and purchase of identical amounts
of one currency against another, for different maturities. A
swap could be spot (purchase or sale) against forward (sale or
purchase), or forward against forward.
Swap price or points: The difference in prices of the two (or
points) legs of a swap.
Straight Through Processing (STP): complete end-to-end
automated processing of transactions from inception to
settlement without any manual intervention.
Telerate: It is another company like Reuters that provides
information on global financial markets.
Value Date: The date of exchange of currencies. Also
referred to as delivery date or maturity date.
Vostro Account: A local currency account of a foreign bank /
branch.
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External Commercial
Borrowings (ECBs)
160
Intl.fin.
Meaning of ECBs
ECB refers to commercial loans in the form
of:
Bank loans,
Buyers’ credit,
Suppliers’ credit,
Securitized instruments (e.g. floating rate
notes and fixed rate bonds, non-convertible,
optionally convertible or partially convertible
preference shares)
Availed of from non-resident lenders with a
minimum average maturity of 3 years.
Routes to ECBs
ECB can be accessed under two routes:
(i) Automatic Route and
(ii) Approval Route
Automatic Route (AR):
What is Automatic Route?
Who can borrow under the AR?
(a) Corporates, including those in the hotel, hospital,
software sectors (registered under the Companies Act,
1956) and Infrastructure Finance Companies (IFCs)
except financial intermediaries, such as banks, financial
institutions (FIs), Housing Finance Companies (HFCs)
and Non-Banking Financial Companies (NBFCs) are
eligible to raise ECB.
Who can borrow under the AR? .. Contd.
(b) Units in Special Economic Zones (SEZ)
(c) Non-Government Organizations (NGOs)
engaged in micro finance activities
(d) Micro Finance Institutions (MFIs)
engaged in micro finance activities
>>
Who can be the lenders for ECBs
under the AR?
(a) International banks,
(b) International capital markets,
(c) Multilateral financial institutions (such
as IFC, ADB, CDC, etc.) / regional financial
institutions and Government owned
development financial institutions,
(d) Export credit agencies,
(e) Suppliers of equipment,
(f) foreign collaborators and
(g) foreign equity holders
Amount & Maturity of ECB Under AR
A corporate other than those in the hotel, hospital and
software sectors: USD 750 million or its equivalent
during a financial year.
Corporates in the services sector viz. hotels, hospitals
and software sector : Up to USD 200 million or its
equivalent in a financial year for meeting foreign
currency and/ or Rupee capital expenditure for
permissible end-uses. The proceeds of the ECBs should
not be used for acquisition of land.
ECB up to USD 20 million or its equivalent in a financial
year with minimum average maturity of three years.
C:\Users\SESHU\Documents\Average Maturity Period on
ECBs.xlsx
Amount & Maturity of ECB Under AR
ECB above USD 20 million or equivalent and
up to USD 750 million or its equivalent with a
minimum average maturity of five years.
NGOs engaged in micro finance activities
and Micro Finance Institutions (MFIs): Up to
USD 10 million or its equivalent during a
financial year.
ECB up to USD 20 million or equivalent can
have call/put option provided the minimum
average maturity of three years is complied
with before exercising call/put option.
Pricing?
All-in-cost ceilings:
Average Maturity All-in-cost Ceilings over 6 month
Period
LIBOR*
Three years and
350 basis points
up to five years
More than five
500 basis points
* for
the respective currency of borrowing or applicable benchmark
years
In the case of fixed rate loans, the swap cost plus margin should be the equivalent of the floating rate plus the applicable margin.
All-in-cost includes rate of interest, other fees and expenses in
foreign currency except commitment fee, pre-payment fee, and
fees payable in Indian Rupees. The payment of withholding tax in
Indian Rupees is excluded for calculating the all-in-cost.
The all-in-cost ceilings for ECB are reviewed from time to time.
Ceilings applicable up to September 30, 2012 and subject to review
thereafter:
Purpose of ECBs
ECB can be raised for import of capital goods for new
projects, modernization/expansion of existing
production units in:
a) Industrial sector including small and medium
enterprises (SME),
b) Infrastructure sector [power, telecommunication,
railways, roads including bridges, sea port and
airport, industrial parks, urban infrastructure
(water supply, sanitation and sewage projects),
mining, exploration and refining and cold storage
or cold room facility] and
c) Specified service sectors, like hotel, hospital,
software
Purpose of ECBs
d) Overseas Direct Investment in Joint
Ventures (JV)/ Wholly Owned Subsidiaries
(WOS).
e) Acquisition of shares in the disinvestment
process and also in the mandatory
second stage offer to the public under the
Government’s disinvestment programme
of PSU shares.
f) For lending to self-help groups or for
micro-credit or for bonafide micro finance
activity.
Infrastructure Finance Companies (IFCs) i.e.
Non Banking Financial Companies (NBFCs)
categorized as IFCs by the Reserve Bank, are
permitted to avail of ECBs, including the
outstanding ECBs, up to 50 per cent of their
owned funds, for on-lending to the
infrastructure sector as defined under the
ECB policy,
g) Maintenance and operations of toll systems
for roads and highways for capital
expenditure provided they form part of the
original project
f)
End-uses not permitted
Other than the purposes specified hereinabove,
the borrowings shall not be utilized for any
other purpose including the following:
(a) For on-lending or investment in capital market
or acquiring a company (or a part thereof) in India
by a corporate [investment in Special Purpose
Vehicles (SPVs), Money Market Mutual Funds
(MMMFs), etc., are also considered as investment
in capital markets].
(b) for real estate sector,
(c) for working capital, general corporate purpose
and repayment of existing Rupee loans.
Security for the ECBs
Guarantees
Issuance of guarantee, standby letter of
credit, letter of undertaking or letter of
comfort by banks, Financial Institutions and
Non-Banking Financial Companies (NBFCs)
from India is not permitted.
No-objection from ADs
Before according ‘no objection’ under FEMA, 1999, AD
Category - I banks should ensure and satisfy
themselves that:
(i) the underlying ECB is strictly in compliance with
the extant ECB guidelines,
(ii) there exists a security clause in the loan
agreement requiring the borrower to create charge on
immovable assets / financial securities / furnish
corporate or personal guarantee,
(iii) the loan agreement has been signed by both the
lender and the borrower and
(iv) the borrower has obtained Loan Registration
Number (LRN) from the Reserve Bank.
Parking of ECB proceeds
Borrowers are permitted to either keep ECB proceeds
abroad or to remit these funds to India, pending
utilization for permissible end-uses.
The proceeds of the ECB raised abroad meant for Rupee
expenditure in India, such as, local sourcing of capital
goods, on-lending to Self-Help Groups or for micro credit,
payment for spectrum allocation, etc. should be
repatriated immediately for credit to the borrowers’
Rupee accounts with AD Category I banks in India.
In other words, ECB proceeds meant only for foreign
currency expenditure can be retained abroad pending
utilization. The rupee funds will not be permitted to be
used for investment in capital markets, real estate or for
inter-corporate lending.
Borrowers are permitted to either keep ECB proceeds
Parking of ECB proceeds
abroad or to remit these funds to India, pending
utilization for permissible end-uses.
ECB meant for Rupee expenditure in India, such as
local sourcing of capital goods, on-lending to Self-Help
Groups or for micro credit, payment for spectrum
allocation, etc. should be repatriated to India
immediately.
In other words, ECB proceeds meant only for foreign
currency expenditure can be retained abroad pending
utilization.
The rupee funds, however, will not be permitted to be
used for investment in capital markets, real estate or
for inter-corporate lending.
Investment of ECBs Parked Abroad
ECB proceeds parked overseas can be invested in the
following liquid assets:
(a) Deposits or Certificate of Deposit or other
products offered by banks rated not less than AA (-)
by Standard and Poor/Fitch IBCA or Aa3 by Moody’s
(b) Treasury bills and other monetary instruments of
one year maturity having minimum rating as
indicated above, and
(c) Deposits with overseas branches / subsidiaries of
Indian banks abroad. The funds should be invested in
such a way that the investments can be liquidated as
and when funds are required by the borrower in
India.
ECB Pricing
•The all-in-cost ceilings for ECB are reviewed from time to
time.
•The following ceilings are applicable up to September 30,
2012 and subject to review thereafter:
•* for the respective currency of borrowing or applicable
benchmark
•In the case of fixed rate loans, the swap cost plus the
margin should be the equivalent of the floating rate plus
the applicable margin.
Prepayment of ECBs
Prepayment of ECB up to USD 500 million
may be allowed by AD banks without prior
approval of Reserve Bank subject to
compliance with the stipulated minimum
average maturity period as applicable to
the loan.
Refinancing of an existing ECB
The existing ECB may be refinanced by
raising a fresh ECB subject to the condition
that the fresh ECB is raised at a lower all-incost and the outstanding maturity of the
original ECB is maintained.
An existing ECB may, however, be
refinanced by raising a fresh ECB at a
higher all-in-cost under the approval route.
APPROVAL ROUTE
ECB with minimum average maturity of 5
years by Non-Banking Financial Companies
(NBFCs) from multilateral financial
institutions,
Reputable regional financial institutions,
Official export credit agencies and
International banks to finance import of
infrastructure equipment for leasing to
infrastructure projects.
APPROVAL ROUTE
Eligible borrowers:
On lending by the EXIM Bank for specific purposes
Banks and financial institutions which had
participated in the textile or steel sector
restructuring package as approved by the
Government are also permitted to the extent of
their investment in the package and assessment by
the Reserve Bank based on prudential norms. Any
ECB availed for this purpose so far will be deducted
from their entitlement.
Infrastructure Finance Companies (IFCs) i.e. NonBanking Financial Companies (NBFCs), categorized
as IFCs, by the Reserve Bank,
Approval Route – Eligible Borrowers
Foreign Currency Convertible Bonds (FCCBs) by Housing
Finance Companies satisfying the following minimum
criteria: (i) the minimum net worth of the financial
intermediary during the previous three years shall not be
less than Rs. 500 crore, (ii) a listing on the BSE or NSE, (iii)
minimum size of FCCB is USD 100 million and (iv) the
applicant should submit the purpose / plan of utilization of
funds.
Special Purpose Vehicles, or any other entity notified by the
Reserve Bank, set up to finance infrastructure companies /
projects exclusively, will be treated as Financial Institutions
and ECB by such entities will be considered under the
Approval Route.
Multi-State Co-operative Societies engaged in manufacturing
activity
Approval Route – Eligible Borrowers
SEZ developers for providing infrastructure
facilities within SEZ, as defined in the extant
ECB policy like (i) power, (ii)
telecommunication, (iii) railways, (iv) roads
including bridges, (v) sea port and airport, (vi)
industrial parks, (vii) urban infrastructure
(water supply, sanitation and sewage
projects), (viii) mining, exploration and refining
and (ix) cold storage or cold room facility,
including for farm level pre-cooling, for
preservation or storage of agricultural and
allied produce, marine products and meat.
Approval Route – Eligible Borrowers
Developers of National Manufacturing
Investment Zones (NMIZs) for providing
infrastructure facilities within SEZ, as
defined in the extant ECB policy like (i)
power, (ii) telecommunication, (iii) railways,
(iv) roads including bridges, (v) sea port
and airport, (vi) industrial parks, (vii) urban
infrastructure (water supply, sanitation and
sewage projects), (viii) mining, exploration
and refining and (ix) cold storage or cold
room facility
Approval Route – Eligible Borrowers
Corporates in the services sector viz. hotels, hospitals
and software sector can avail of ECB beyond USD 200
million or equivalent per financial year
Service sector units, other than those in hotels, hospitals
and software, subject to the condition that the loan is
obtained from foreign equity holders. This would facilitate
borrowing by training institutions, R &D, miscellaneous
service companies, etc
Corporates which have violated the extant ECB policy and
are under investigation by the Reserve Bank and / or
Directorate of Enforcement are allowed to avail of ECB
only under the approval route.
Cases falling outside the purview of the automatic route
limits and maturity period guidelines.
Pricing of ECB under the Approval
Route
The all-in-cost ceilings for ECB are reviewed from time to time.
The following ceilings are applicable upto September 30, 2012
and subject to review thereafter:
Average Maturity
Period
All-in-cost Ceilings over 6
month LIBOR*
Three years and up to
five years
350 basis points
More than five years
500 basis points
* for the respective currency of borrowing or applicable
benchmark
In the case of fixed rate loans, the swap cost plus the margin
should be the equivalent of the floating rate plus the applicable
margin.
Investment in foreign countries
Investment decisions
187
Intl.fin.
What is a company’s motivation to
invest capital abroad?
Revenue-related motives:
1.
2.
3.
4.
5.
Attract new sources of demand
Enter profitable markets
Exploit monopolistic advantage
React to trade restrictions
Diversify internationally
Cost-related motives:
1.
2.
3.
4.
5.
188
Intl.fin.
Benefit from economies of scale
Use foreign factors of production
Use of foreign raw materials
Use foreign technology
React to exchange rate movements
International project details
A firm is considering an
189
investment in Freedonia, and the
initial cash outlay is 1.5 million
marks.
The project has 4-year project life
with cash flows given on the next
slide.
The appropriate required return for
repatriated U.S. dollars is 18%.
The appropriate expected
exchange rates are given on the
Intl.fin.
next slide.
International Capital Budgeting
Example
End
of
Year
Expected
Cash Flow
(marks)
Exchange
Rate (marks
to U.S. dollar)
Expected
Cash Flow
(U.S. dollars)
0
-1,500,000 2.50
-600,000
1
500,000
2.54
2
800,000
2.59
3
700,000
2.65
4
600,000
2.72
Net Present Value
190
Intl.fin.
Present Value
of Cash Flows
at 18%
-600,000
196,850 166,822
308,880 221,833
264,151 160,770
220,588 113,777
=
63,202
How does a firm make an international
capital budgeting decision?
1. Estimate expected cash flows in the
foreign currency.
2. Compute their US dollar equivalents
at the expected exchange rate.
3. Determine the NPV of the project
using the US required rate of return,
with the rate adjusted upward or
downward for any risk premium effect
associated with the foreign
investment.
191
Intl.fin.
More on capital budgeting
Only consider those cash flows that can be “repatriated”
(returned) to the home-country parent.
Discounting methods:
1. NPV method
2. Payback period
3. Internal Rate of Return method
4. Profitability index method
1. Payback period is the expected number of years
required to recover a project’s cost.
Example: year Project L Project S
0(Rs.100 lacs) (Rs.100 lacs)
110 30
260 30
380 80
>>
192
Intl.fin.
More on capital budgeting
Payback for L = 2+30/80 years = 2.375 years or
2years and 4.5 months.
Payback for S=2+40/80 years = 2.5 years or 2
years and 6 months.
Weakness of Payback method:
1. Ignores the time value of money. This weakness is
eliminated with the discounted payback method.
2. Ignores cash flows occurring after the payback
period.
2. NPV method: In this method, projects are
accepted if the net cash inflow during the lifespan
of the project is greater than the initial investment.
193
Intl.fin.
NPV Method
The
equation used for determining the
NPV is:
NPV = Where:
= expected after-tax cash flow from to
= initial investment
k = risk-adjusted discount rate and
n = life span of the project
194
Intl.fin.
NPV Calculation
Example: A project involves initial
195
investment of $5000,000. The net
cash flow during the first, second
and third years is expected
respectively at $3000,000,
$3,500,000 and $2,000,000. At the
end of the third year the scrap
value is indicated at $100,000.
The risk-adjusted discount rate is
10%.
Calculate
the
NPV.
>>
Intl.fin.
NPV Calculation
+ + - = {(3,000,000/1.10)} + {3,500,000/} + {(2,000,000 +
1,000,000)/} – 5,000,000 = $2,873,778
The project would be accepted because NPV is positive.
Note: NPV declines as k increases and NPV rises
as k decreases.
2. Profitability index (PI): It is the ratio between the
present value of the future cash flows and the initial
investment.
PI = } ÷ ]
Substituting the figures given in the previous example,
we get: 7,873,778 / 5,000,000 = 1.57
The project may be accepted because PI is more than 1
196
Intl.fin.
3.Internal Rate of Return
(IRR)
IRR
is the discount rate equating the present value
of future cash flows and the initial investment.
For accepting a project, IRR should be greater
than the hurdle rate.
Expressed as an equation:
] - = 0
The project will be acceptable if IRR is greater
than the required rate of return.
Based on the previous example, IRR is 40%. Since
the required rate of return is 10% the project
would be acceptable.
197
Intl.fin.
Advantages & Disadvantages of NPV and IRR
Advantage: IRR is more popular than NPV
because it is straight forward as it uses cash
flows and recognizes the time value of money.
Disadvantage:
It often gives unrealistic rates of return. Suppose
the cutoff rate is 11% and the IRR is 40%, the
management need not blindly accept the project.
An IRR of 40% assumes that a firm has the
opportunity to reinvest future cash flows at 40%
which is too good to be true! Unless the
calculated IRR is a reasonable rate for
reinvestment of future cash flows, it should not be
used as a yardstick to accept or reject a proposal.
198
Intl.fin.
Advantages & Disadvantages of NPV and
IRR
Another disadvantage of IRR method is
that it may give different rates of return –
suppose there are two discount rates
(two IRRs) that make the present value
equal to the initial investment.
Which rate should be used for
comparison with the cutoff rate?
The IRR method, despite its popularity in
the business world, entails more
problems than a practitioner may think.
199
Intl.fin.
Foreign Direct Investment (FDI)
Motivations behind making FDI
Cost-benefits of FDI for home country and
host country
Various FDI strategies
200
Intl.fin.
Foreign Direct Investment
(FDI)
Reasons for FDI:
Investment for establishment of a new enterprise
in a foreign country either as a branch or as a
subsidiary
Acquisition of an overseas business enterprise
Some of the questions that arise in an MNC
before making a FDI:
1. What are the motivating factors for an FDI?
2. What should be the mode of investment?
3. Which country should it move to?
4. Is the project viable in terms of cash flow?
5. How much risk is involved in the operation?
201
Intl.fin.
NPV & IRR sometimes select different projects
When comparing two projects, the use of NPV and IRR
methods may give different results.
A project selected according to the NPV method, may be
rejected if the IRR method is used! Reasons:
The selection will change depending on the discount rate
that is chosen.
Project size and life
Differences in cash flows
When are the NPV & IRR reliable?
1. If projects are compared using the NPV , a discount rate
that fairly reflects the risk of each project
2. If the IRR method is used, the project must not be
accepted only because the IRR is high; the firm must be
convinced that the IRR is realistic. Otherwise the project
must be re-evaluated by the NPV method, using a more
realistic discount rate.
202
Intl.fin.
Theories of FDI
1. FDI moves from capital-rich countries to capital-scarce countries
2.
3.
4.
5.
6.
7.
8.
203
till the marginal productivity of capital is equal in both the
countries.
An MNC with superior technology moves to different countries to
supply innovated products making in turn ample gains.
FDI moves to a country with abundant raw material and cheap
labour.
FDI takes place only when the product achieves a specific stage
in its life cycle.
It is the combination of three advantages – ownership, location
and internalisation – that motivates a firm to make FDI.
A firm moves from a strong currency country to a weak currency
country.
A firm moves from a politically unstable country to a politically
stable country.
Developing country firm too possess firm-specific advantages on
account of modification of technology.
Intl.fin.
Benefits and Costs of FDI
Benefits to host country:
• Availability of scarce factors
of production
• Improvement in the BoP
• Building of economic and
social infrastructure
• Fostering of economic
linkages
• Strengthening of the
government budget
Benefits to the home
country
• Availability of raw material
• Improvement in BoP
• Employment generation
• Revenue to the government
• Improved political relations
204
Intl.fin.
Cost to the host country:
• Strained BoP following
reverse flow
• Dependence on import of
technology
• Employment of expatriates
• Inappropriate technology
• Unhealthy competition
• Cultural and political
interference
Cost to the home country:
• Undesired outflow of factors
of production
• Possibility of conflict with the
host country government
Strategies for FDI
Firm-specific strategy: offering new kind of
product or differentiated product.
Cost-economising: cost can be lowered through
moving firm to a raw material abundant or
labour abundant location.
Cross investment: to avoid price cuts by
competing firms.
Joint venture with a rival firm: when a rival firm
in the host country is so powerful that it is not
easy for an MNC to compete, the MNC prefers to
join hands with it to penetrate the host country
market.
205
Intl.fin.
Conflicts with the home country and host country
The home country government may:
1. Prohibit investment in a particular host country
2. Design fiscal and monetary disincentives and strict
approval rules
3. Introduce extra territoriality provisions to interfere with
foreign subsidiaries
The host country government may insist on:
1. Appointing government representatives on the
management board and on manning senior positions with
local personnel.
2. Domestic participation in the equity share capital.
3. Purchase of inputs from local sources and
4. Checking unwarranted activities.
Code of conduct drafted at the international level by
the Group of 77 are only suggestive and not binding on
MNCs, with the result that they are not very effective.
206
Intl.fin.
IV. International Trade
World Trade Organization
International Cartels
Organization of Petroleum Exporting Countries (OPEC)
GATT (General Agreement for Tariff & Trade)
EC (European Community)
NAFTA (North American Free Trade Area)
UNCTAD (United Nations Conference on Trade & Development)
207
Intl.fin.
WTO (World Trade
Organization)
Successor to GATT
Began operations in 1995
WTO is a chartered organization with a legal status and
enjoys the same privileges and immunities of IMF &
World Bank.
India is one of the founder members of WTO.
Based in Geneva, its main functions are administering
and implementing the multilateral trade agreements
To limit harmful trade practices
Acting as forum for multilateral trade negotiations
Overseeing national trade policies
To administer the understanding on rules and procedures
governing settlement of disputes
208
Intl.fin.
Structure of WTO
209
Intl.fin.
WTO
The Ministerial Conference (MC) is the supreme
authority.
Its secretariat is headed by a Director General
appointed by the MC.
Takes decisions on all matters under any of the
multilateral trade agreements.
The General Council, composed of
representatives of all the members is a trade
policy review body and also a dispute settlement
body.
The three sub-councils operate under the General
Council.
210
Intl.fin.
WTO Agreement
I.
Multilateral Agreement on trade in goods:
Understanding on BoP
Agreement on agriculture
Domestic and export subsidies
Sanitary and Phytosanitary Measures
Agreement on textiles and clothing
Agreement on trade related aspects on investment measures
(TRIMS)
II.
General Agreement on Trade in services
Agreement on trade related aspects of Intellectual Property
Rights
Copy rights and other rights
Trademarks
Geographical indications
Industrial designes
Patents
Integrated circuits and
Trade secrets
211
Intl.fin.
WTO Dispute Settlement
System
Encourages countries to settle their
differences through consultations.
If consultations fail, then a stage-bystage procedure is followed. It may
include:
Ruling by a panel of experts
Chance to appeal against the
ruling etc.
212
Intl.fin.
International Cartels
Formation of a cartel is an attempt to reap
greater profits by acting as a single profitmaximising monopolist.
The cartel members agree to supply or restrict
production of the cartalised commodity.
Conditions necessary for a cartel:
The elasticity of demand for total consumption for
the rest of the world must be low
The cartel must control a very large share of the
world market for the cartalised commodity
The elasticity of supply of the cartalised
commodity by the rest of the world must be low.
213
Intl.fin.
OPEC
Has 11 oil producing countries as members
(Saudi Arabia, Iraq, Kuwait, UAE, Iran, Venezuela, Libya,
Nigeria, Algeria, Indonesia & Qatar, in the decending
order of crude reserves)
Head quarter in Vienna, Austria.
They possess about 78% of the world’s
proven crude oil reserves
Supply more than 40% of the world’s
consumption
Meet twice a year to review the status of
international oil market
214
Intl.fin.
European Community (EC)
European Economic Community or European Common
Market was founded in 1957 under the Treaty of Rome.
Founder members: France, Germany, Italy, Belgium,
Luxembourg and Netherlands.
Denmark, Ireland, U.K., Greece, Portugal & Spain joined later.
Objectives of EC:
Elimination of custom duties and quantitative restrictions on
exports and imports
Establishment of common customs tariff and common
commercial policy
Removal of obstacles to movement of persons, services and
capital
Common policy in agriculture & transport
Remedial of disequilibrium in BoP of member states
Establishment of a European Investment Bank to promote
economic expansion of community
215
Intl.fin.
European Community (EC)
The European Council decided to establish the
European Monetary System (EMS) in 1978.
EMS has created a EC Currency Zone to unify the
European economies.
The EMS established the European Currency Unit
(ECU) for settlement between the EC currencies
and the central banks
Euro as unified currency was introduced on Jan
1999 and the national currencies of the members
ceased to exist.
Euro became the successor to the ECU.
New notes and coins were introduced on Jan 1 2002
216
Intl.fin.
North American Free Trade Area (NAFTA)
Initiated by President George Bush but
concluded by the Clinton administration on
Jan 1 1984.
Members: USA, Canada and Mexico.
It is a trade and investment agreement
entered into with a view to reduce the
barriers to the flow of goods, services and
people among the three countries.
A company that is based in any one of the
three countries can freely conduct its
business across all the three borders.
217
Intl.fin.
UNCTAD (United Nations Conference
on Trade and Development)
An organ of UN formed in 1964 to provide a
forum for developing countries to discuss
problems relating to their economic
development.
Objectives: To formulate policies relating to
developmental aspects including trade, aid,
transport, finance and technology.
The Conference ordinarily meets once in
four years. >>
218
Intl.fin.
Doha Conference
13th session of UNCTAD held from 21- 26
April 2012 at Doha, Qatar.
Issues:
Agriculture
Market access for non-agricultural products
Transparency in govt. procurement
Trade facilitation
Dispute settlement system
Electronic commerce
Trade, debt & finance etc.
End without consensus
219
Intl.fin.
Financing of Foreign Trade
Different modes of finance
Purpose of finance
Documentation
Regulations
220
Intl.fin.
Financing of Foreign Trade
An efficient financial system helps
promotion of international trade and
maintain liquidity to meet international
financial commitments.
Purpose:
To facilitate international trade i.e., import
and export.
Sources of finance: Banks and Fis.
Mode of finance:
Fund-based and
Non fund-based
221
Intl.fin.
Export Finance
Export of goods and services play an
important part in the economy of a country
irrespective of whether it is a developed or
developing country.
Therefore export financing assumes an
important role.
Exporters expect that export finance should
be:
Adequate
Timely
222
Cheap and
Intl.fin.On liberal terms
Export – Import finance in
India
Export finance:
RBI has introduced the following measures to encourage
exports:
Finance at concessional rates of interest (not exceeding 2.5%
below the prime rate on rupee finance and 50 basis points
over LIBOR in foreign currency loans)
It is mandatory for banks to extend 12% of their net bank
credit to the export sector.
Interest subsidy
Refinance
Credit guarantee from ECGC for bank loans
Loans against Duty Drawback Entitlement
Retention of export proceeds in foreign currencies in EEFC
accounts
Concessional tax on export earnings
223
Intl.fin.
Export Finance
Pre-shipment and Post-shipment credit
Pre-shipment credit:
Packing credit
Advance against cheques / drafts received as advance payment.
Packing Credit:
Loan or advance granted to exporter for purchase of raw materials /
processing / packing based on confirmed orders or letters of credit
Quantum of finance: Generally up to fob value of goods.
Exception: Exports covered by incentives and backed by Export
Production Guarantee from ECGC.
Period of finance: Up to 180 days but can be extended up to 360
days if necessary.
Interest rate: Bank’s base rate minus 2.5% up 180 days and
normal rate thereafter.
Liquidation: By submission of export bills or from EEFC balances
Packing Credit is also available in foreign currency for cash exports
at internationally competitive interest rates.
224
Intl.fin.
Export Finance
Post-shipment finance:
Need for post-shipment finance?
Mode of finance:
Purchase/Discount/Negotiation of bills
Advance against export bills sent for collection
Advance against cash incentives / Duty Drawbacks etc.
Can be availed by exporters against submission of export
documents to a bank within 21 days from the date of
shipment of goods.
Quantum of finance: Up to 100% of the value of invoice.
Period of finance: Short-term or long-term depending on
the agreed payment terms between the exporter and the
importer.
Rate of interest: Depends on the tenor
225
Intl.fin.
Export Finance
Forfaiting
A mechanism of discounting export
receivables (medium & long term maturities)
supported by Bills of Exchange or Promissory
Notes, without recourse to the exporter.
Benefits to the exporter:
Can covert his credit sales into cash sales on
without recourse basis
Can improve his cash flows
Can transfer currency, credit and political
risks to the forfaiter
226
Intl.fin.
Export Finance
Rediscounting export bills abroad:
An additional source of finance available to
exporters
Envisages banks rediscounting export bills in
the overseas market by making
arrangements with overseas agency / banks
by way of a line of credit
Interest rate: Linked to 6 months LIBOR rate
for the currency concerned.
227
Intl.fin.
EXIM BANK OF INDIA
(eximbank)
228
Intl.fin.
EXIM BANK OF INDIA (eximbank)
A public sector financial institution established
in 1982 by an Act of Parliament.
Main activities:
229
Export Credit
Services:
1. Projects:
•. Suppliers /
Buyers credit
•. Pre-shipment
credit
•. Guarantees
2. Products:
•. Line of credit
•. Pre-shipment
credit
•. Post-shipment
credit
Intl.fin.
3.
Services:
•. Suppliers credit
Finance for exportoriented units:
1. Term loans
2. Working capital
3. Export market /
product
development
4. Export
fecilitation
5. Overseas
investment
finance
Value added
services:
1. Export
marketing
services
2. Multilateral
funded projects
3. Joint-venture
fecilitation
4. Consultancy
support
5. Workshop /
seminars
Advisory
services
Documents Used in Foreign
Trade
Purpose of documentation
Various types of documents used
International Regulations
230
Intl.fin.
Documents Used in Foreign Trade
1. Bill of Exchange
2. Invoice
3. Packing List
4. Documents of Title to goods:
Bill of Lading
2. Airway Bill
3. Post Parcel Receipt
1.
5. Insurance Policy / Certificate
6. Regulatory documents for customs / central bank.
7. Others: Letters of Credit (LCs), Bank Guarantees,
Acceptances
231
Intl.fin.
Bill of Exchange
232
Intl.fin.
Export Invoice
233
Intl.fin.
Packing List
234
Intl.fin.
Bill Of Lading Specimen.docx
DOC._CREDIT.ppt
C:\Users\SESHU\International Finance\GR
FORM SPECIMEN.docx
235
Intl.fin.
INTERNATIONAL CASH
MANAGEMENT SYSTEM
236
Intl.fin.
International Cash Management
(ICM) System
Introduction:
Important aspect of working capital
management
Effective and fast collection of cash resources and
Optimum utilization and conversion of funds
Same objective as that of domestic cash
management but wider in scope.
Factors in ICM:
Exchange Control Regulations in different countries
Multiple tax jurisdictions and currencies
Good reporting systems
237
Intl.fin.
Centralization of Cash Management
Benefits of centralization:
Maintaining minimum cash balance throughout the
year
Generate maximum possible return by investing all
the cash resources optimally
Judicious management of liquidity requirements
Minimize transaction costs and currency exposures
Optimally use the hedging techniques to minimize
the foreign exchange exposure
Achieve maximum utilization of transfer pricing
mechanism to enhance the profitability and
growth of the firm.
238
Intl.fin.
Objectives of effective ICM
1. Minimize currency exposure risk
2. Minimize country and political
239
risks
3. Minimize the overall cash
requirements of the company as a
whole without disturbing the
smooth operations of the
subsidiaries
4. Minimize transaction costs
Intl.fin.
5. Achieve full benefits of economies
Techniques of optimizing cash flows
1. Accelerating cash inflows
2. Managing the blocked funds
3. Leading and lagging
strategy
4. Netting
5. Transfer Pricing
240
Intl.fin.
Techniques of optimizing cash flows
1. Accelerating cash inflows
Quicker recovery of receivables i.e., minimize
float
Objective: Reduce investment in accounts receivable
Lower banking fees and other transaction costs.
Save interest expense on working capital borrowing
Means adopted:
Remittance through SWIFT
Same day value credits
Monitoring through corporate treasury workstations
Pre-authorised payment up to a certain limit
241
Intl.fin.
Techniques of optimizing cash flows
2. Managing the blocked funds
.In some cases the host countries
may block funds that a subsidiary
may attempt to remit to the parent.
.The parent may ask the subsidiary to
obtain finance from the local banks
rather from them.
.Unexpected blockages are however
a political risk.
242
Intl.fin.
Techniques of optimizing cash flows
3. Leading and Lagging
.Refers to adjustment in timing of payment that are
made in foreign currencies.
.Expediting payment is ‘leading’ and deferring
payment is ‘lagging’.
.It is a highly favoured means of shifting liquidity
among the subsidiaries.
.If the home currency is expected to:
(a) depreciate against a foreign currency – Expedite
the payment (leading)
(a) appreciate against a foreign country - Defer the
payment (lagging)
243
Intl.fin.
Techniques of optimizing cash flows
MNCs can lead or lag the timings of foreign
currency payments by modifying the credit
terms.
Companies generally accelerate payments
of hard currency payables and delay
payments of soft currency payables so as
to reduce the foreign exchange exposure.
Governments are less likely to interfere
with payments on inter-company accounts
than on direct loans.
244
Intl.fin.
Case Study
Multinational Industries Co. is an
Indian firm conducting financial plan
for the next year. It has no foreign
subsidiaries but a significant portion of
its sales are from exports. Its foreign
currency cash flows to be received
from exporting and cash outflows to be
paid for imported supplies for the next
year are given below: >>
245
Intl.fin.
Case Study – Contd.
Currency
246
Total Inflow
Total
Outflow
US
dollars
$42,000,000
$20,000,000
German
Marks
DM15,000,00
0
DM10,000,00
0
French
Francs
FFr.10,000,00
0
FFr.80,000,00
0
British
Pounds
£24,000,000
£15,000,000
Intl.fin.
Case Study – Contd.
The current spot rates and one year forward rates are:
Currency
US Dollars
German
Marks
French
Francs
British
Pounds
247
Intl.fin.
Spot Rate
(``)
42.50
22.50
One year
forward
rate(``)
43.20
23.25
6.60
6.00
66.90
67.10
Case Study – Contd.
On the basis of the above information determine the
net exposure of each foreign currency in rupees.
Are any of the exposure positions offsetting to some
extent?
Using the current spot rates as a forecast of the US
dollar in 90 days, would you hedge the US dollar
position?
If inflows of the British Pound range from £20 million
to £30 million for the next year, what will be the risk
of hedging £25 million in net inflows? How can the
company avoid such a risk?
Explain in brief the strategy which MNCs should adopt
for each of the four currencies?
248
Intl.fin.
Solution to Case Study
Net exposure of each foreign currency in
rupees:
USDoll
ar
D.
Marks
French
Frs.
British
£
249
Intl.fin.
(Amounts in millions)
Inflo
w
Outflo
w
Net
flow
Rate
Sprea
d
42
20
22
0.70
Net
Exp
osur
e in
```
15.4
15
10
5
0.75
3.75
10
80
(70)
(0.6)
42
24
15
9
0.2
1.8
Solution to Case Study – Contd.
Yes, the French Franc position of `42 million is
being offset by a better forward rate.
Yes. The US dollar position of `15.4 million can be
hedged by ‘leading and lagging’ techniques – since
one year forward rate is at a premium, speed up
payments for goods and services reflected by the
outflows so that the Re.0.70 spread can be
eliminated at the date of settlement.
If £25 million is left un-hedged, there is a
possibility of lower rate than the spot rate existing
at the time of settlement. Therefore, it is better to
take a forward contract. >>
250
Intl.fin.
Solution to Case Study –
Contd.
Strategies to be adopted:
US Dollars: Take a forward contract and sell
$20 million at the spot rate or delay
collections.
D. Marks: Take a forward contract for inflows
or delay collections.
French Frs.: Speed up or request for advance
payment of receivables while delaying
payments and creditors for goods and
services supplied.
Pound Stg.: Pre-pay for goods and services
but delay collection from sales or services.
251
Intl.fin.
Techniques of optimizing cash flows
4.
Netting:
Involves highly coordinated
international interchange of raw
materials, parts, subassemblies, and
finished parts among the various
units of an MNC, with many affiliates
both buying and selling to each other.
They are accompanied by heavy
volume of inter affiliate fund flows.
252
Intl.fin.
Techniques of optimizing cash flows
Advantages of a netting system:
Reduces the number of cross-border
transactions
Reduces the need for foreign exchange
conversion and the exchange loss.
Besides administration costs, transaction
costs on these fund flows may vary from
0.25% to 1.5% of the volume of funds
involved.
Helps in improved cash flow forecasting
Netting cash flows is a means of reducing
credit exposure to counter parties.
253
Intl.fin.
Techniques of optimizing cash flows
Two types of netting – Bilateral and
multilateral.
Bilateral: Only two parties - parent and the
subsidiary
Multilateral: Parent and several affiliates
Multilateral system requires centralized
system of communication and discipline on
the part of the subsidiaries.
By multilateral netting big MNCs can
eliminate 50% or more of their inter
company transactions.
254
Intl.fin.
Techniques of optimizing cash flows
Example of multilateral netting:
A U.S. parent company has subsidiaries in
France, Canada, UK and Japan. The amounts
due to and from the affiliated companies are
converted into US dollars. The French
subsidiary owes the Canadian subsidiary
$60,000, the UK subsidiary $80,000 and the
Japanese subsidiary $100,000. For the same
period, the French subsidiary is due to receive
$40,000 from the Canadian subsidiary,
$60,000 from the UK subsidiary and $100,000
from the Japanese subsidiary.
255
Intl.fin.
Techniques of optimizing cash flows
Inter-subsidiary Payments Matrix (US
dollars in thousands)
Paying affiliate
France Canad
U.K.
Japan
Total
a
France
40
60
100
200
Canad
60
40
80
180
a
U.K.
80
60
70
210
Japan
100
30
60
190
Total
240
130
160
250
780
256
Intl.fin.
Techniques of optimizing cash flows
NETTING SCHUDULE
Receipt
257
Payment
Net
Receipt
France
200
240
Canada
180
130
50
U.K.
210
160
50
Japan
190
250
Net
Payment
(40
60
Without netting, the total payments would
amount to $780 thousands. Mutual
netting reduces these transfers to $100
thousand (-87%). Consolidation and net
payments can be determined in both
directions.
Intl.fin.
Techniques of optimizing cash flows
5. Transfer Pricing (TP):
One of the most controversial and often least
understood issues in a MNC’s operation is TP.
When a parent or one subsidiary of an MNC in one
country transfers / sells goods, services or knowhow
to another subsidiary in another country, the price
charged for these goods / services is called TP.
A strategy to adjust the profits of a subsidiary by the
transfer price charged.
The transfer prices at which goods and services are
traded internally can significantly distort the
profitability.
Higher the transfer price, the larger will be the gross
profit of the transferring division and vice-a-versa.
258
Intl.fin.
Transfer Pricing in an MNC
Transfer pricing in an MNC depends upon:
The difference in tax rates between the two
countries (higher TP for countries with relatively
higher taxation)
Inflation differentials (high TP for countries
experiencing higher inflation and currency
devaluation.
Import duties and quotas imposed by the host
country etc.(low TP for goods and services
subjected to high import duties in a particular
country)
High TP for goods and services for countries that
restrict repatriation of income.
259
Intl.fin.
Example of Transfer Pricing
Strategy
ABC Company has a subsidiary in country x
that produces computer components and sells
them to another subsidiary in country y where
the production process is completed. The tax
rate in country x is 50% while that in country y
is 20%. The proforma income statement of
ABC is given below. Assume that ABC adjusts
its transfer pricing policy so that sales by
subsidiary x are reduced from $400,000 to
$320,000. Determine the change in the total
tax payments of the consolidated subsidiaries
as a result of this revised transfer policy. >>
260
Intl.fin.
Example of Transfer Pricing Strategy
(Amounts in thousands of $)
Subsidiar
yx
Subsidia
ry y
Consolidated
subsidiaries
Sales
400
700
1100
Less cost of goods sold
220
400
620
Gross profit
180
300
480
Less operating expenses
80
100
180
EBIT
100
200
300
Interest expense
10
30
40
EBT
90
170
260
Taxes (50% for X and 20% for
45
34
79
Y)
45
136
181
EAT
The sales level of X matches the cost of goods sold of Y and hence it
can be inferred that the entire sales of X are to Y. When sales of X
are reduced from $400,000 to $320,000, this would affect the cost of
goods sold of subsidiary Y by the same amount and the EAT would
respectively be $5,000, $200,000 and $205,000. As a result, the
incidence of tax would come down from $79,000 to $55,000!
261
Intl.fin.
Questions
1. How can a MNC implement leading and
lagging techniques for optimizing cash
flow movements?
2. How can centralized cash management
system be beneficial to a MNC?
3. What is netting and how can it improve a
MNC’s performance?
4. How can a MNC use transfer pricing
strategies? Elucidate.
262
Intl.fin.
FEMA (Foreign Exchange
Management Act)
Objectives
Difference between FERA & FEMA
Salient features of FEMA
263
Intl.fin.
Introduction
BoP crisis in 1991
Process of liberalization
Article Viii of IMF – Convertibility of current
account transactions w.e.f August 1994
Tarapore Committee road map on capital
account convertibility in June 1997.
Repeal of FERA and introduction of FEMA in
1999 (implemented w.e.f 1 June 2000)
264
Intl.fin.
Objectives of FEMA
Consolidate and amend the law relating
to foreign exchange:
To facilitate external trade and
payments
Promoting orderly development and
maintenance of foreign exchange
markets in India.
Approach of FEMA is radically different
from FERA – change from conservation
to facilitation and control to regulation.
265
Intl.fin.
Differences between FERA & FEMA
FERA
• FERA was a draconian
criminal law.
• Conserve foreign exchange
to prevent its misuse.
• Violation of FERA was a
criminal offence.
• Offences under FERA were
not compoundable.
• Citizenship was a criteria to
determine the residential
status of a person.
• Provisions in respect of
business travel, export
commission, gifts, donations
etc. were rigid.
266
Intl.fin.
FEMA
• FEMA is a civil law.
• Facilitate external trade and
payments and maintenance
of forex markets in India
• Violation of FEMA is a civil
offence.
• Offences under FEMA are
compoundable.
• Stay of more than 182 days
is the criteria for determining
the residential status of a
person.
• These provisions have been
considerably liberalized in
FEMA.
• Almost all current account
tractions are free.
Salient features of FEMA
Free transactions on current account;
RBI control over capital account
transactions;
Control over realization of export proceeds;
Dealing in foreign exchange through
‘Authorized Dealers’;
Adjudication of offences;
Appeal provisions including special director
(appeals) and appellate tribunal; and
Directorate of Enforcement
267
Intl.fin.
Country Risk Analysis
To define what a country risk means?
Identify key indicators of country risk
To describe the economic and political factors that
determine a country’s ability and willingness to
repay its foreign debts
268
Intl.fin.
What is Country Risk Analysis
(CRA)?
Following the rapid growth in international debt of LDCs
in the 70s and increasing incidence of debt rescheduling
in the 80s CRA has become a topic of major concern for
the financial community.
CRA is the assessment of potential risks and rewards
associated with making investments and doing business
in a country.
Essentially, an assessment whether sensible economic
policies are being followed by a country.
A country following sensible economic policies will
generally have good business environment where
businesses can flourish.
However, the focus of CRA cannot be restricted to only
economic policies.
269
Intl.fin.
What is Country Risk Analysis (CRA)
Political considerations often lead countries to
pursue economic policies that are detrimental to
business and their own economic health.
Significant Political Risks:
Expropriation or nationalization (most extreme
form)
Currency or trade controls
Changes in tax or labor laws
Regulatory restrictions etc.
International economic environment is heavily
dependent on the policies that individual nations
pursue.
270
Intl.fin.
Purpose of Country Risk
Analysis
Non-bank MNCs undertake CRA in order to
determine the investment climate in
various countries.
Banks do CRA to know:
A country’s ability to service its foreign debts
Which countries to lend to
The currencies in which to denominate their
loans and
Interest rates to demand on these loans.
271
Intl.fin.
Country Risk Analysis
There is close linkage between a country’s
economic policies and the degree of
exchange risk, inflation risk, interest rate
risk etc. that MNCs and investors face.
Therefore, no one can intelligently make a
CRA without comprehending its political
and economic policies.
Attempts to forecast exchange rates,
inflation rates or interest rates are helped
immensely by CRA.
272
Intl.fin.
Measuring Political Risk
There is no unanimity as to what constitutes PR
and how to measure it?
Some of the more common forms of political risk
indicators include:
Stability of the local political environment:
Frequency of changes in government (extent to which the
existing political status can be expected to continue)
Level of violence in the country
Internal and external conflict
Consensus regarding priorities:
Degree of agreement and unity on the fundamental objectives
of government policies and
The extant to which the consensus cuts across party lines.>>
273
Intl.fin.
Measuring Political Risk
Attitude of host government:
MNCs may satisfy the local people, but may
face a hostile attitude from the government.
Government may impose additional
corporate taxes, blockages of funds, funds
transfer restrictions etc. which affect MNC’s
cash flows.
War:
In the event of war, safety of MNC’s
employees
Volatile business cycles
Uncertain cash flows
274
Intl.fin.
Economic Risk Indicators
Inflation rate:
A measure of economic instability
Disruption and government mismanagement
Lower purchasing power of consumers and hence
lesser demand for MNCs goods
Current and potential state of country’s economy:
Level of external debt
Foreign exchange reserves
Current account
Balance of payments
GDP growth
Exchange and interest rates>>
275
Intl.fin.
Economic Risk Indicators
Resource base:
National, human and financial resources (‘other things’ remaining the
same, a nation with more natural resources is a better bet than one
without natural resources. But ‘other things’ are not always the same.
This is due to the quality of human resources and the degree to which
these resources are put to their most efficient use – South Korea and
Taiwan Vs Mexico or Argentina).
Adjustment to external shocks:
Ability of a country to withstand unforeseen shocks.
Vulnerability of external shock varies from country to country with some
dealing successfully and others succumbing to them.
Others:
Capital flight
Level of corruption
High tax rates
Vast state-owned firms
Imports and exports as a proportion of GDP
Vulnerability of exports for changing prices
Compressibility of imports
276
Intl.fin.
Techniques to assess CR
1. Debt-related factors:
Debt / GDP
Debt / foreign exchange receipts (Important ratio –
277
Intl.fin.
solvency)
Interest payments / foreign exchange receipts (liquidity)
Debt-service ratio (relates debt-service requirements to
export income)
Short-term debt to total exports
Imports / GDP (sensitivity of domestic economy to
external development)
Net interest payment / exports
Current account balance / GNP (countries with large
current account deficit are usually less creditworthy)
Techniques to assess CR
2. Balance of Payments (BoP)
Under or over valuation of exchange rate (on
purchasing power parity basis)
Current account / GNP ( a measure of the country’s
net external borrowings relative to country size)
Imports / GDP
Non-essential consumer goods and services / total
exports
Exports to 10 – 15 main customers / total exports
Exports of 10 – 15 main items / total exports
External reserves / imports
Reserves as a % of imports
Exports as a % if imports
278
Intl.fin.
Techniques to assess CR
3. Economic Performance:
GNP or GDP / Per capita (measures the level of
development of a country)
Gross investment / GDP (called propensity to invest
ratio, captures the country’s prospects for future
growth. Higher the ratio, higher the potential
economic growth)
Inflation (change in consumer prices as an annual
average in % - measures the quality of economic
policy)
Money supply (serves as an early indicator for
future inflation)
Gross domestic savings / Gross National Product
279
Intl.fin.
Techniques to assess CR
4. Political Instability:
Political protest, demonstrations, strikes, riots,
assassinations etc.
Successful / unsuccessful coups
Raters of CR:
Two magazines – Institutional Investor and Euromoney
have been publishing the CR since 1981/82.
Weights are attached to each risk depending upon
their importance.
Countries are graded on a scale of 0 to 100, with 100
representing least chance of default.
A fair amount of subjectivity is also involved in the
analysis.
280
Intl.fin.
Applications for Country Risk
Analysis
Can be incorporated in capital budgeting analysis.
The required rate of return is adjusted to account for the
country risk (high risk, high discount rate and vice-aversa).
If there is a probability of temporary blockage of
subsidiary’s funds to the parent or host country take over
of a project, the NPV under these circumstances should be
determined.
Further involvement in politically tense countries can be
avoided.
Avoid FDI in that country and withdraw current operations
before the crisis intensifies.
However, it is difficult to predict major troubles in various
countries.
281
Intl.fin.
Questions
1. What are the indicators of country risk? Of
2.
3.
4.
5.
282
country health?
What are the applications of country risk
analysis? Give examples to illustrate your
answers.
Briefly explain the various techniques to assess
country risk.
Why is country risk analysis is important for a
MNC?
How can exposure to country risk be reduced by
a MNC in the long run? Why country risk
analysis is not always accurate?
Intl.fin.
