Ans.

1 Components of balance of Payments The balance of payment statement records all types of international transactions that a country consummates over a certain period of time. It is divided into three sections: 1. The Current Account 2. The Capital Account 3. The Official Reserve Account.

1. The current account The current account is typically divided into three sub-categories; the merchandise trade balance, the services balance and the balance on unilateral transfers. Entries in this account are current in value asd they do not give rise to future claims. A surplus in t he current account represents an in flow of funds while a deficit represents an outflow of funds. a. The balance of merchandise trade refers to the balance between exports and imports of tangible goods such as automobiles, computers, machinery and so on. b. Services represent the second category of the current account. Services include interest payments, shipping and insurance fees, tourism, dividends and military expenditures. These trades in services are sometimes called invisible trade. c. Unilateral transfers are gifts and grants by both private parties and governments. Private gifts and grants include personal gifts of all kinds and also relief organization shipments. For example, money sent by immigration workers to their families in their native country represents private transfer. Government transfers include money, goods and services sent as aid to other countries. For example, if the United States government provides relief to a developing country as part of its

drought-relief programme, government transfer.

this

would

represent

unilateral

2. The Capital Account The capital account is an accounting measure of the total domestic currency value of financial transactions between domestic rersidents and the rest of the world over a period of time. This account consists of loans, investments, other transfers of financial assets and the creation of liabilities. It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. The capital account can be divided into three categories: direct investment, portfolio investment and other capital flows. a. Direct investment occurs when the investor acquires equity such as purchases of stocks, the acquisition of entire firms, or the establishment of new subsidiaries. For example, many US firms are engaged in direct investment in foreign countries. Coca-Cola has built bottling facilities all over the world. b. Portfolio investments represent sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors. International portfolio investments have specifically boomed in recent years due to investors desire to diversify risk globally. c. Capital flows represent the third category of capital account and represent claims with a maturity of less than one year. Such claims include bank deposits, short-term securities, money market investments and so forth.

3. The official reserve account Official reserves are governments assets. The official reserve account represents only purchases and sales by the central bank of the country (e.g, the Reserve Bank of India). The change sin official reserves are necessary to account for the deficit or surplus in the balance of payments. For example, if a country has a BOP deficit, the central bank will have to either run down its official reserve assets such as gold, foreign exchange and SDRs or borrow fresh from foreign central banks. However, if a country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.

Ans. 2 Swap Contracts A swap is a contract between two counter-parties to exchange two streams of payments for an agreed period of time. These may be fixed or floating interest rate of commitment (plain vanilla swap), one currency for another currency (currency swap) and both of these (cocktail swap). Also, these may be basis swap and asset swap. Swaps are not debt instruments to raise capital, but a tool used for financial management. Some other derivatives commonly used are: An over-the-counter: A derivative that is not traded on an exchange but purchased from, say, an investment bank. These can be more flexible than exchange-traded contracts and sometimes involve more unusual risk-transfers, achieved by the bank bundling together assorted swaps, forwards and exchange-traded futures and options to meet the precise needs of the buyer.

 Leverage: The amount of money put at risk by a derivative is far bigger than the down payment made when it was traded. The extent of leverage in a derivative is not always obvious. Exotics: derivatives that are either complex or are available in emerging economies. These tend to be contrasted with plainvanilla derivatives, which are typically exchange-traded, relate to developed economies and are (relatively) uncomplicated.

1. Interbank forward dealing Interbank quotations are given a bid and ask (also referred to as offer) price. A bid is the price (i.e., the exchange rate) in once currency at which a dealer will buy another currency. An offer or ask is the price at which a dealer will sell the other currency. Dealers generally bid (buy) at one price and offer (sell) at a slightly higher price, making their profit from the spread, i.e., the difference between the buying and selling prices.

Example All foreign exchange dealers are interested in making a profit out of each transaction. Therefore, when a dealer in India tries to sell foreign currency he will try to get as high a price as is possible for every unit of foreign currency sold. But when the dealer is buying foreign currency, his aim will be to get the most reasonable price for every unit of the foreign currency he buys. A dealer in New Delhi may give the following quotation US $1 = Rs. 43.3000-43.7300 E1 = RS. 69.9200-71.3100

This means that the dealer will buy dollars from the exporter at US $1 = Rs. 43.3000 and sell dollars to an importer at US $ = Rs. 43.7300. Similarly, he will buy pounds at E1 = Rs. 69.9200 but sell punts at E1 = Rs.71.3100. The lower rate in the quotation is the bid (buy) rate while the higher rate is the ask (selling) rate. The difference between the banks bid and ask rate is the spread. The spread fluctuates in accordance with the level of stability in the market, the currency in question and the volume of the business. Spread can be expressed in percentage as Percentage spread = Ask price Bid price/Ask price x 100 = 43. 7300 43.3000/43.7300 x 100 = .9833

Generally, in transaction among dealers, only the last two digits are quoted and the rest is understood. This is done to save time. 2. Forward swaps A swap transaction (not to be confused with the swap rate) is a double-leg deal, in which one buys spot currency x selling currency Y and simultaneously sells forward currency X buying currency Y. Let us give an example to show the rationale of such a transaction. Assume that an American investor has a future receipt in DM. In Addition, assume that he thinks that German bonds are presently a good investment. So he has dollar assets abut does not hold cash in DM. In plain words, he needs Dm right now and cannot wait for the future receipt DM to come. One solution would be to sell dollars and buy DM in the spot market. However, suppose he does not wish to block money in a foreign exchange adventure for he cannot forecast the exchange value of the future receipt. In this case he sells dollars against DM spot getting his DM and buying his bonds. Simultaneaously he buys dollars forward against DM matching the value date of the receipt. Upon expiration of the forward period, the investor

cashes the receipt, pays back the DM that he owes and gets his original dollars. Hence, he has been able to overcome the time lag problem.

Ans. 3 The cost of equity capital The cost of equity capital is the required rate of return needed to motivate the investors to buy the firms stock. Calculation of th cost of equity is a difficult process and needs more approximations than calculating the cost of debt. For established firms, the dividend growth model may be used for computing the cost of equity. This model is also called the Gordon model. Ke= D1/Pq+ g Where, Ke is the cost of equity capital D1 are Dividends expected in year one. Pq is the current market price of the firms stock G is the compounded annual rate of growth in dividends or earnings

Alternatively, the cost of equity capital may be calculated by using the modern capital market theory. According to this theory, and equilibrium relationship exists between an assets required rate of return and its associated risk which can be calculated by the Capital Assert Pricing Model (CAPM) The cost of equit5y may be calculated by the CAPM by using the following formula E(Rj) = Rf + Bj(E (Rm) Rf)

Where E (Rj) is the expected rate of return on asset j. Rf is the rate of return on a risk free asset measured by the current rate of return or yield on treasury bonds.

E (Rm) is the expected rate of return on a bond market index such as the standard and poor index of industrial stocks.

Bj is the beta of stock j, measured by the relative variability or volatility of the rate of return on the stock compared to the variability of the return on a broad market index. A beta of 1 (unity) denotes a risk equivalent to the one entailed in an investment in a diversified portfolio of stocks. Both, the Gordon Model and the CAPM, yield a risk adjusted rate of return on equity. The major difference is that the latter utilizes beta which is a measure of the market related or systematic risk rather than total risk which is traditionally measured by the standard deviation. Both methods yield acceptable and conceptually defensible estimates of the rate required by the investors given the degree of risk inherent in the investment. For firms with no established track record and for which beta coefficients are not available, the cost of equity may be derived by adding an arbitrary risk premium (ranging between four to six percentage points) to the firms recent borrowing rate.

Ans. 5 Comparison of Purchasing Power Parity and International Fisher Effect. Table below compares two related theories of international finance, namely (i) Purchasing Power Parity (PPP) and (ii) the International Fisher Effect. The two theories relate to the determination of exchange rates. Yet, they differ in their applications . This relates to a specific point in time . The, PPP theory and IFE theory focus on how a currencys spot rate will change over time. While PPP

theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differential. Comparison of PPP and IFE Theories Purchasing Percentage Inflation rate Power Parity change in differential (PPP) spot exchange rate The spot rate of one currency with respect to another will change in reaction to the differentials in inflation rates between the two countries. The purchasing power for conscious in home country will be similar to their purchasing power when importing goods from the foreign country. The spot rate of one currency with respect to another will change in accordance with the differential in interest rates between the two countries. The return on uncovered foreign money market securities will be no higher than the return on domestic money market securities from the perspective of investors in the home country.

International Percentage Interest rate Fisher Effect change in differentials (IFE) spot exchange rate

Ans. 6 Benefits of American Depository Receipts Depository Receipts are negotiable certificates issued by a US commercial bank, referred to as the depository, which represent shares of a non-US company that ar5e deposited with the depositorys overseas custodian. Depository receipts are registered with the US Securities and Exchange Commission and trade like any other US security in the over-the-counter market or on a national exchange. Depository Receipt investors enjoy rights which are comparable to those of holders of the underlying securities, plus they have the benefits, convenience and efficiency of trading in the US securities market.

1. Benefits to the issuing company For issuers, there are several reasons for launching and managing an ADR programme: An ADR programme can stimulate investor interest, enhance a companys visibility, broaden its shareholder base, and increase liquidity. By enabling a company to tap US equity markets, the ADR offers a new avenue for raising capital, often at highly competitive costs. For companies with a desire to build a stronger presence in the United States, an ADR programme can help finance US initiatives or facilitate US acquisitions. ADRs can provide enhanced communications with shareholders in the United States. ADRs provide an easy way for US employees of non-US companies to invest in their companies employee stock purchase plans. Features such as dividends reinvestment programmes can help ensure a continual stream of investment into an issuers programme. ADR ratios can be adjusted to help ensure that an issuers ADRs trade is in a comparable range with those of its peers in the US market. May increase local prices as a result of global demand/trading through a more broadened and a more diversified investor exposure.

2. Benefits to the investors Given below are the principal advantages to the investors: 1. Depository receipts are US securities: Depository receipts are registered with the US securities and Exchange Commission and trade like any other US security in the over-the-counter market or on a national exchange. Depository receipt investors enjoy rights which are comparable to those of holders of the underlying securities, plus they have the benefits, convenience and efficiency of trading in the US securities markets. 2. Depository receipts are easy to buy and sell: Investors purchase and sell depository receipts through their US brokers in exactly the same ways they purchase or sell securities of US companies. Many regional NASD brokers/dealers, and virtually all New York brokers/dealers, make markets in and know how to create depository receipts. Alternatively, investors can deposit their non-US securities directly with a depositorys custodian and request the issuance of depository receipts. Investors may also return depository receipts to the depository for cancellation and have the underlying securities released back into the local market. 3. Depository receipts are liquid : Depository receipts are as liquid as their underlying securities because they are interchangeable. For example, if a US broker/dealer cannot purchase or sell a depository receipt in the US, it can always create a depository receipt by purchasing the underlying nonUS securities for deposit with the depository, which will then issue depository receipts for the securities. Alternatively, the broker/dealer can sell the underlying non-US securities, surrender the depository receipts and instruct the depository to deliver the underlying securities. Liquidity and ease of execution are major reasons why many institutions invest in depository receipts. 4. Depository receipts are global: Investors can choose from more than 1500 different equity depository receipts and several debt depository

receipts from 50 countries , including Australia, Brazil, United Kingdom, France, Germany, Hongkong, Italy, Japan, Mexico, Singapore, Spain, Sweden and Thailand. Most of the companies are researched by US analysts, while others have a local following. 5. Depository receipts are convenient to own: Depository receipt trades clear and settle through standardized US clearance systems within three business days; while direct investments in non-US shares are subject to complicated and varied standards for international trades. Depository receipts are negotiable US securities. They are quoted in dollars, pay dividends or interest in dollars, and trade exactly like any other US security. Unlike many non-US securities, which are issued in bearer form, depository receipts are issued in registered form, thus protecting the holder in the event the certificates are lost. Depository receipts overcome the obstacles that many mutual funds, pensions and other institutions may have in purchasing and holding securities abroad. 6. Depository receipts are cost-effective: Global custodian safe keeping charges are eliminated, saving depository receipt investors up to 30 basis points annually. Dividends and other cash distributions are converted into dollars at competitive foreign exchange rates. The standard three-day settlement for depository receipts significantly lowers the fail rate on traders and consequently the costs associated with financing failed trades. Investors enjoy both market liquidity and arbitrage opportunities. Depository receipts may be bought and sold in the US or the depository receipts can be cancelled and the underlying securities released into their home market. Holding depository receipts may facilitate the process of reclaiming excess withholding on dividends and reduce transfer taxes.