CHAPTER 1 NATURE AND SCOPE OF INTERNATIONAL

FINANCE

Course Overview:
Theory of Trade

MNC

Gold Standard

Monetary Union

Understanding Exchange Rate Regimes

Exchange Rate Regimes

Currency Crisis

Fixed vs. Floating

Macro-Economic
Determinants
Laws Binding
Spot Rates

Market Types

Financial Market Structure

Instruments

Players &
Organization
Bonds

Forward
s

Exchange Rate Behavior

PPP, CIPC
Fisher Eqn.

Implications for future rates

FX Derivatives and Use in Hedging

Futures, Options,
Swaps

Strengths & Weaknesses

FX Risk Types and Hedging

Limitations
Alternative Hedging
Techniques
Netting, Counter-trade,
Transfer Pricing

Transaction Risk
Operating Risk
Translation Risk

Limitations

Other FX Management Issues

Introduction:
1. International Finance
a. Corporate Finance for management of international investments
b. More than just corporate finance with exchange rates:
Currency Riskuncertainty surrounding future exchange rates
Risk from non-financial factors such as nationalization, failure to
enforce patent & copyright laws, foreign legal risks
Capital Barriers and Differential Taxes
Financial hedges (Derivatives) to reduce currency risk
Pricing structures to reduce taxes or circumvent capital controls
World-wide alternatives for raising/employing capital
2. Multinational Corporations (MNC)
a. Firm that has production and sales in more than one country.
b. Permits efficient distribution of manufacturing and has access to a broader
customer base.
c. Is able to shift both production and sales activities in response to market
shifts.
d. More than 60,000 MNCs world wide producing 25% of global output
e. By country of origin: US, Japan, France, Germany, and UK have the
largest MNCs.
f. Over 1990s FDI by grew at 3 times the growth rate of international trade
g. Examples: GE, Exxon, Shell, Ford, Toyota, Daimler-Chrysler, etc.
3. Market Imperfections
a. MNCs exist to take advantage of market imperfections:
Minimizing labor costs
Minimizing corporate taxes
Taking advantage of Tariffs, Quotas, and other trade restrictions
Circumventing Capital Restrictions
Pricing in accordance with a countrys wealth
Moving production to countries with the VAT (reduces taxes on
exports)
b. Additional Risks:
Future Foreign Exchange rate uncertainty
Political (e.g. nationalization) and Legal Risks

4. WHY COUNTRIES TRADE:

Theory of Comparative Advantagecountries should specialize
in the goods they produce efficiently, and trade.
Increases total world production.
Example: Suppose there are only two countries and two goods in the world.
- Australia can produce 800,000 rifles or 300,000 computers
- Singapore can produce 500,000 rifles or 250,000 computers
- Australia needs 300,000 computers, the rest can be rifles
Without
Trad
e

Rifles

Computer
s
0

300,000

Singapore
Total:

500,000
500,000

0
300,000

With Trade
Australia
Singapore
Total:

666,667
0
666,667

50,000
250,000
300,000

Austr
alia

5. Events/Trends leading to Globalization

a. Deregulation of International Financial Markets
Japan opened FX markets to foreign brokerages in 1980
London (LSE) opened to foreign bank membership in 1986
Repeal of Glass-Steagall in 1999
Opening of developing markets via the easing of investment
restrictions to facilitate FDIforeign ownership
Multinational Corporations issuing globally traded shares
International Trade growing (exceeds 20% of World GDP)
Merger of NYSE and EuroNext Stock Markets 2006
b. Introduction of the EURO and the formation of the European Union in
1999.
b. Privatization
Globally, developing countries divesting state owned industries
Provides capital to payoff external debts

Increases production efficiency by as much 20% (more?)

Provides foreign investment opportunities

History of the International Monetary System:

1. Bimetallism/Gold Standard
a. Originally coinage in silver and gold
b. Bimetallism fell out of favor and Gold Standard created (where notes
were backed by a certain ratio of gold)
c. Suspended by most nations in 1914 (WW I)
d. Restored in 1928, but dropped by most economies in 1931-36 because of
inability to control gold outflows during financial crises.
2. Drawbacks of Gold Standard
a. Fixed amount of goldCurrency does not grow with economy
b. Leads to deflation in growing economies
c. Exchange rates fixed:
i. Prices of goods must adjust to compensate for trade imbalances
ii. Problem is that prices are sticky. Sticky prices in a deflationary
economy result in lower demand levels and thus, unemployment
UK
MS
Prices

UK has a trade
deficit with France

Gold Transferred

France
French MS
Prices

Because of rising
prices in France,
trade imbalance
disappears.

3. Bretton Woods (1944)the last Gold Standard:

a. Reinstituted Gold Standard
b. Pegged the US dollar at $35/oz. goldUS would hold worlds gold
c. Other central banks to hold US dollar as reserve currency in lieu of gold
d. Exchange rates fixed against US dollar
e. Problemfixed amount of gold when growing economies require
increasing currency reserves
i. Increasing Reserves devalues the US dollar against gold
ii. Because of fixed exchange rates, the Dollar becomes over-valued
in terms of the other currencies (Frank, Deutschmark, Pound)
f. In late 60s and early 70s, US government loosened monetary policy to
pay for Vietnam conflict
i. Foreign central banks forced to purchase excess US dollars to
maintain fixed rate parities
ii. Exported inflation to other nations through fixed exchange rates
g. Attempted to salvage system by revaluing dollar to $38/oz. (Smithsonian)
h. System collapsed to floating rates (1973)

4. Flexible Exchange Rates (Present System)

a. Floating rates that are supply/demand based
b. Central banks may intervene to calm transient disturbances (e.g. 9/11)
c. Gold officially abandon as reserve assetcurrency now represents a
claim on the economy
d. Drawbacks:
i. Greater exchange rate volatility
ii. Uncertainty surrounding the future exchange rateinterferes with
financial planning
e. Louvre Accord (1987)
i. Coordination among G-7 countries to coordinate monetary policies
to achieve greater exchange rate stability
ii. Louvre Accord is de-facto a managed-float arrangement
5. Exchange Rate Arrangements:
a. DollarizationUsing another countries currency as legal tender
b. Currency BoardPeg with a legal obligation
c. Fixed Rate (Peg)
d. Pegged with horizontal bands
e. Crawling Peg
f. Crawling Bands
g. Managed Float
h. Independent Float

No Freedom to conduct
Monetary Policy

Complete Freedom to conduct

Monetary Policy

6. EU and the European Monetary System

a. Originally 6 nations, now 27 (Croatia, Macedonia, Turkey are candidates)
b. Purpose: facilitate trade and labor flows, and economic development
c. Creates a Common Market exceeding the population of the US
d. Effectively creates a United States in Europe with:
- Ease of cross-border transactions
- Ability of labor to move where needed
7. Introduction of the EURO
a. Common currency binding 15 nations (Not all EU members use the
EURO, notably UK, Sweden, and Denmark)
b. Facilitates Cross-border Transactions and Investment by eliminating
exchange rate risk
c. Consistent Monetary and Fiscal Policy for members
d. Compete as a Reserve Currencycreates currency stability
e. Countries wishing to adopt the Euro must meet convergence criteria:
i. Deficits and Public Debt
ii. Price Stability (Inflation)
iii. Keep individual currencies within prescribed exchange rate bands
f. European Central Bank solely responsible for of monetary policy, National
Central Banks in each country behave like regional FEDs
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Appreciation of the Euro:

Pacific FX Plot 2009 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada

8. Benefits of Monetary Union

a. Facilitate Cross-border Transactions and Investment
i. Eliminate exchange rate risk and need for forecasting
ii. Permit Business Decisions to be made solely on economic grounds
iii. Increase Price Competition
iv. Eliminate costs of currency exchange
b. Benefits of a Major Reserve Currency
i. Stable exchange value
ii. Major holdings in Central Banks
iii. Simplify exchange with US and other countries
iv. Facilitate Capital Market Development for all members
9. Drawbacks
a. Limitations on Fiscal Policy for member nations (deficit spending)
b. No ability to use Monetary Policy
c. Example: France has 10% unemployment, it cannot use stimulative fiscal
or monetary policy
d. Free flow of labor may not correct problem

Balance of PaymentsNet Demand for a Currency:

10. Balance of Payments
a. Net Difference between the Supply and Demand for a Currency
b. BOP = 0 for a floating rate regime (why?)
Rates adjust so that Supply Equals Demand
The currency in Demand Appreciates vs. the other currency
c. Under Fixed Rates a Deficit or Surplus can persist
Deficits must be financed through borrowing or
The central bank will hemorrhage currency
d. BOP = Current Account + Capital Account
11. Current Account
a. Exports Imports (Net Exports or NX)
b. Reflects imbalances in Trade
c. For instance if the US imports 200 million in goods, and exports 160
million, it has a trade deficit of 40 million (a negative balance)
12. Capital Account
a. Capital Inflows Capital Outflows
b. Capital Inflows are investment from foreign entities
Used to purchase factories, real property, and other productive
resources
Composed of Direct and Portfolio Investment
c. A positive balance:
More capital is entering the country than leaving
Foreign investors are purchasing more of our productive
resources than we are purchasing of theirs
13. Implications of a Trade Deficit
a. Exports < Imports Current Account < 0
b. Since BOP = 0, then Capital Account > 0
c. Thus:
i. We are selling our productive resources to pay for consumption of
foreign goods
ii. Selling our future to consume in the present
d. This will eventually lead to a currency depreciationcurrently occurring
e. Deviation from this rule is when we are selling over-valued assetse.g.
Japanese purchase of real-estate in 1980s

Budget Deficits and Implications for Currency Value (Exchange Rates):

14. Excessive Government Spending
a. Governments finance spending via two meanstaxes and debt
b. Deficit Spending means that Spending exceeds Tax Revenues, or we must
issue debt to finance spending
c. Noteit does not matter what the spending is for; e.g. Social Programs,
Medicare, Education, Infrastructure, Military, War, Catastrophic Events
d. To attract purchasers for our debt, we must increase Treasury ratesthis
can result in an immediate appreciation of the currency
e. However, over the long-run, higher interest rates mean higher inflation
our currency devalues
f. Moreover, to continue deficit spending, we will have to continue raising
interest rates currency will continue to depreciate
Graphic Model:
Prices

AD = C+G+I+NX

AS = f(I(r), L)

CConsumption
GGovernment
ICapital investment
NXNet Exports
LCost of labor

Real GDP

If Government Increases Spending: G

Prices

AD

AS

G means AD shifts out

GDP and Prices
Prices means inflation, therefore
currency ultimately depreciates

Real GDP

Crowding out of Investment:

10

Interest Rates (r)

As Government borrows more
money, interest rates rise and
capital investment falls

Prices
AD

Capital Investment (I)

AS
Because of declining
investment, and
increasing wages, AS
shifts backward.

Real GDP

Crowding out of Net Exports:

Prices

AD

AS
NX and Investment Falls as Prices Rise, thus AD
also gets shoved backward. The result is higher
prices than we started with (inflation), higher wage
rates, and less investment (economic growth)

Real GDP

15. What if foreign investors cease buying our debt?

a. Treasury rates skyrocket Interest rates sky rocket
b. Capital Investment collapses
c. The currency plummets
d. Note: there is a binding relationship between the current spot, a countrys
risk-free rate (Treasury rate for the U.S.), and expected future spot (also
known as the forward)
Economic Shocks:
16. Economic Shocks
a. Can make a country richer or poorer
b. Improve or reduce productivity
c. Negative Shocks such as the destruction of a major oil field, will reduce a
countrys exports, its productivity, and reduce its productive capacity
d. Hence, demand for its currency will fall, and the currency will depreciate

11

Prices

AD

AS
Effect of a negative supply shock,
reduces productive capacity and
results in higher prices.

Real GDP

Depreciation:
17. What causes a currency to Depreciate???
a. Persistent Trade Deficits will cause a depreciation
b. Foreign Borrowing to finance Government Deficit Spending
c. Major Negative Economic Shocks reducing productive capacitye.g.
9/11, Hurricane Katrina
18. Mexico January 1995
a. Facts
40% Devaluation against US dollar
Loss of 30 Billion in Foreign Reserves
Financial Bail-out Package
Crawling Band (Peg) arrangementessentially fixed exchange
rates
b. Mexico losing reserves, why?
Political assassinations and Perceived Political Instability
Huge early influx of foreign investment financing consumption
c. De-regulation of Banks Zero reserve requirement/Easy Credit Policies
Excessive incentives to lend
Lending increasing lower credit borrowers (high defaults)
d. Short term management of government debt
Began issuing bonds in Denominated in US dollars (dangerous?)
Lowered interest rates, but resulted in skyrocketing debt when
Peso devalued
e. The result for the Mexican economy was a massive recession
19. Asian crisis 1997-98
a. ThailandIndonesiaKoreaMalaysiaPhilippines
Thai Baht devalues 20%, July 1997 (40% by December)
Other currencies follow, Rupiah devalues by 80%
b. What was the cause of the crisis?

12

High levels of foreign currency debt by firms and governments

Excessive government spending
Excessive investment beyond economically justified levels
Lack of a Credit Culture at banks
Political lending decisions
Fixed exchange rates

c. Devaluation meant financial disaster

Value of foreign denominated debt sky rockets
Flight of investment capital
Skyrocketing unemployment
20. Other Financial CrisesCommon Components (The Big Picture)
a. Fixed rate arrangements have been a feature in most crisis
b. Excessive government spendingblossoming government debt
c. Large Amounts of Foreign Currency Debtexacerbates crises
d. IMF typically provides a bailout package
e. Brazil, Argentina, Russia
21. The International Banking and Financial Crisis of 2008
a. There are several contributing factors to the crises:
i. Increased issuance of Sub-prime and Creative Mortgage Contracts
creating a real estate bubble
ii. Excessive Government Spending
iii. Excessive Consumerism driven by Loose Credit Policies, Lack of
Consumer Discipline, and Asset Overvaluation
iv. The Increased Footprint of Speculators in Financial Markets
v. The Decline of the US Industrial/Manufacturing Base
b. Creative Mortgage Contracts and The Real Estate Bubble
Interest Only, Variable Rate, and Negative Amortization Loans
beginning 2000
Extensive Sub-Prime Lending encouraged by Democrats in
Congress
Resulted in home-buyers being able to borrow far more than with
Traditional Fixed Rate Mortgages
Housing Prices climbed beyond long-run values
Pyramid Scheme Collapses when Interest Rates Increase, and
borrowers are forced to refinance
Risk Spread throughout Financial System when risky mortgages
used in normally sound CMOs
c. The Role of Government Spending
Increased Wartime Spending by Bush Administration, did not cut
other Govt Spending to compensate (LBJ)
Deficit spending compounded by tax cuts
13

The Result: Burgeoning Federal Deficits, exhausting access to

world credit
Deprives the US of Credit to recapitalize of our banks
Excessive Spending also Stimulates Excessive Consumerism

d. Excessive Consumerism and Easy Credit

Strengthening of Bankruptcy Laws combined elimination of
Usury Laws has resulted in increased credit card issuance
Likewise, the US consumer has become increasing predisposed
to living on credit
Result is a negative savings rate, again reducing the countrys
potential credit reserve
And, exacerbates the real-estate crises because of insufficient
household savings to make mortgage payments if laid off

e. The Stock MarketThe Worlds Newest Casino

Stock Market trades increasingly characterized by speculative
trading (technical trading)
The result is increasing market volatility
Inhibits traditional capital raising function of the market, crucial
to recovery from a recession
Due to the decline in trading costs and increased use of program
trading/speculative strategies
Further encouraged by real-estate bubble, in which consumers
borrowed against fictitious equity
f. Decline of US Manufacturing Base
US has ceded much of its manufacturing base to China, India,
and several developing countries
Result of economic specialization arguments that we pursue high
return services
Problem is that services means we provide capital, and we are
now a debtor nation
Will impede recovery because we have little to export, yet it is a
trade surplus that is needed to pay off US debt
While this is not a direct cause, it threatens our recovery, and
contributed vastly to our trade deficit and exhaustion of world
credit

14

g. Contagion to Foreign Marketswhy did it spread?

UK/Europe had its own real-estate crises
Foreign institutions held large quantities of US CMOs
The US is the chief export market for Asia and many developing
nations

CHAPTER 2 FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE MARKET AN OVERVIEW:

In todays world no economy is self sufficient, so there is need for exchange of goods and
services amongst the different countries. So in this global village, unlike in the ancient
age the exchange of goods and services is no longer carried out on barter basis. Every
sovereign country in the world has a currency that is legal tender in its territory and this
currency does not act as money outside its boundaries. So whenever a country buys or
sells goods and services from or to another country, the residents of two countries have to
exchange currencies. So we can imagine that if all countries have the same currency then
there is no need for foreign exchange.
The Foreign Trading Market is regarded as the biggest financial market. It is this market
that is responsible for the trading of currencies. Very large amounts of currency are traded
by large organizations such as financial institutions, multinational corporations, currency
speculators, central banks and government. The foreign exchange market is regarded as
the most suitable market for this trade and superior to the New York Stock Exchange
(NYSE). US $ 2 trillion is handled each day by the foreign exchange market. The New
York Stock Exchange handles US $ 50 billion each day. As soon as one kind of currency
is traded for another kind then it regarded as foreign exchange market. This market
allows for the trading of any kind of currency.
There are currencies as different from one another as the US dollar and the Swiss franc
and the Japanese yen. The foreign exchange market does not cater only to the needs of

15

the biggest institutions as was the case in previous years. Nowadays, smaller enterprises
also take advantage of the foreign exchange market. In fact there are many people who
use this market because it has the potential to yield good profits. This has become
apparent to thousands of individuals who are taking part in the buying and selling of
currencies. But it is always a good idea to have as much background information as
possible in order to make informed decisions. Everybody wants to be successful.
The foreign exchange market one that is unique. This is a market that has an enormous
diversity of traders situated around the globe.
The foreign exchange market is unique because of following:

trading volume results in market liquidity

geographical dispersion

continuous operation: 24 hours a day except weekends, i.e. trading from 20:15
UTC on Sunday until 22:00 UTC Friday

the variety of factors that affect exchange rate

the low margins of relative profit compared with other markets of fixed income

the use of leverage to enhance profit margins with respect to account size

NEED FOR FOREIGN EXCHANGE:

Let us consider a case:
Where Indian company exports cotton fabrics to USA and invoices the goods in US
dollar. The American importer will pay the amount in US dollar, as the same is his home
currency.

Exports Cotton
Fabrics
Exporter

Importer

16

USA

Indian

Co.

US $

However the Indian exporter requires rupees means his home currency for procuring raw
materials and for payment to the labor charges etc. Thus he would need exchanging US
dollar for rupee.
If the Indian exporters invoice their goods in rupees, then importer in USA will get his
dollar converted in rupee and pay the exporter.
Exports

$ convert
USA

Rs.

Indian Co.

Exporter is paid in Rs.

From the above example we can infer that in case goods are bought or sold outside the
country, exchange of currency is necessary. Sometimes it also happens that the
transactions between two countries will be settled in the currency of third country. In that
case both the countries that are transacting will require converting their respective
currencies in the currency of third country. For that also the foreign exchange is required.
OVER-THE-COUNTER TRADING:

17

Foreign exchange market there is no for market place called the foreign exchange market.
It is mechanism through which one countrys currency can be exchange i.e. bought or
sold for the currency of another country. The foreign exchange market does not have any
geographic location.
Foreign exchange market is described as an OTC (over the counter) market as there is no
physical place where the participants meet to execute the deals, as we see in the case of
stock exchange. The largest foreign exchange market is in London, followed by the New
York, Tokyo, Zurich and Frankfurt. The market is situated throughout the different time
zone of the globe in such a way that one market is closing the other is beginning its
operation. Therefore it is stated that foreign exchange market is functioning throughout
24 hours a day. In most market US dollar is the vehicle currency, viz., the currency sued
to dominate international transaction.

18

OTC PRODUCT PERMITTED IN INDIA

OTC
DERIVATIVES

INTEREST
RATE
DERIVATIVES

FORWARD
RATE
AGREEMENT

INTEREST
RATE
SWAPS

FOREIGN
CURRENCY
DERIVATIVES

FOREIGN
EXCHANGE
FORWARDS

CROSS
CURRENCY
FORWARDS

FOREIGN
CURRENCY
RUPEE
SWAPS

CROSS
CURRENCY
OPTIONS

FOREIGN
CURRENCY
RUPEE
OPTIONS

Why Hold Forex Reserves?

Technically, it is possible to consider three motives i.e., transaction, speculative and
precautionary motives for holding reserves. International trade gives rise to currency
flows, which are assumed to be handled by private banks driven by the transaction
motive. Similarly, speculative motive is left to individual or corporate. Central bank
reserves, however, are characterized primarily as a last resort stock of foreign currency
for unpredictable flows, which is consistent with precautionary motive for holding
foreign assets. Precautionary motive for holding foreign currency, like the demand for
money, can be positively related to wealth and the cost of covering unplanned deficit, and
negatively related to the return from alternative assets.

19

From a policy perspective, it is clear that the country benefits through economies of scale
by pooling the transaction reserves, while sub serving the precautionary motive of
keeping official reserves as a war chest. Furthermore, forex reserves are instruments to
maintain or manage the exchange rate, while enabling orderly absorption of international
money and capital flows. In brief, official reserves are held for precautionary and
transaction motives keeping in view the aggregate of national interests, to achieve
balance between demand for and supply of foreign currencies, for intervention, and to
preserve confidence in the countrys ability to carry out external transactions.
Reserve assets could be defined with respect to assets of monetary authority as the
custodian, or of sovereign Government as the principal. For the monetary authority, the
motives for holding reserves may not deviate from the monetary policy objectives, while
for Government; the objectives of holding reserves may go beyond that of the monetary
authorities. In other words, the final expression of the objective of holding reserve assets
would be influenced by the reconciliation of objectives of the monetary authority as the
custodian and the Government as principal. There are cases, however, when reserves are
used as a convenient mechanism for Government purchases of goods and services,
servicing foreign currency debt of Government, insurance against emergencies, and in
respect of a few, as a source of income.

FACTORS AFFECTING FOREIGN EXCHANGE MARKET RATE

Although exchange rates are affected by many factors, in the end, currency prices are a
result of supply and demand forces. Supply and demand for any given currency, and thus
its value, are not influenced by any single element, but rather by several. These elements
generally fall into three categories: economic factors, political conditions and market
psychology.

20

II. 1. Economic factors

Government budget deficits or surpluses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country's currency.

Balance of trade levels and trends: The trade flow between countries illustrates
the demand for goods and services, which in turn indicates demand for a country's
currency to conduct trade. Surpluses and deficits in trade of goods and services
reflect the competitiveness of a nation's economy. For example, trade deficits may
have a negative impact on a nation's currency.

Inflation levels and trends: Typically, a currency will lose value if there is a high
level of inflation in the country or if inflation levels are perceived to be rising.
This is because inflation erodes purchasing power, thus demand, for that
particular currency.

Economic growth and health: Reports such as gross domestic product (GDP),
employment levels, retail sales, capacity utilization and others, detail the levels of
a country's economic growth and health. Generally, the more healthy and robust a
country's economy, the better its currency will perform, and the more demand for
it there will be. Internal, regional, and international political conditions and events
can have a profound effect on currency markets.

2. Political conditions:
All exchange rates are susceptible to political instability and anticipations about the new
government. For example, political or financial instability in Russia is also a flag for the
Rupee to US Rupee exchange because of the substantial amount of German investments
directed to Russia.

21

3. Market psychology and trader perceptions

They

influence

the

foreign

exchange

market

in

variety

of

ways

Flights to quality: Unsettling international events can lead to a "flight to quality," with
investors seeking a "safe haven". There will be a greater demand, thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts.
How to predict market movements?
There are two types of analysis which are generally used to keep a track of the Exchange
markets.Theseare:
Fundamental Analysis
Fundamental analysis includes a detailed study of the basic and primary elements which
have and can potentially manipulate the financial system of a certain thing. This type of
technique is often used to study and forecast the various trends like price action and
market trends. These predictions are done mainly through evaluating the following
indicators:
1. Activity Indicators relating to GDP, Production, Sales, Income, Spending,
Housing.
2. Inflation Indicators comprising of CPI, WPI etc.
3. External Sector Indicators which include Trade Balance, Current account balance.
Technical Analysis
Technical analysis is a method of evaluating currencies by analyzing statistics generated
by market activity, such as past prices and volume. It attempts not to measure a security's
intrinsic value, but instead uses charts and other tools to identify patterns that can suggest
future activity.
Some of the techniques used are:

22

1. Candlestick Charts
2. Moving Averages (Simple and Exponential)
3. Bollinger Bands
4. Relative Strength Indicator
5. Oscillators
What is a hedge?
Hedge is an investment position taken in order to protect oneself from the risk of an
unfavorable price move in a currency.
Why one must hedge his Foreign currency Risk?
1. To mitigate Exchange rate risk:

Fluctuations in the exchange rate of currencies give rise to exchange rate risk.

As the time gap between finalizing an export/import order and receiving/making

payment against it widens, the possibility of fluctuation of exchange rate rises. A
hedge helps in protecting businesses from unfavorable fluctuations.

2. To avail the following benefits:

1. It brings certainty in business- you would know the precise exchange rate at
which your receivables/ payables will be converted.
2. Helps in estimating receipts and payments-once you are aware of one side on the
P/L you can plan the other.
3. Business is immune to any further movement in currency markets, thus relieving
itself of the exercise of tracking currency markets.
Hedging Products

23

1) Forwards:
It is a foreign currency contract to buy or sell a foreign currency at a fixed rate for
delivery on a specified future date or period.
Forwards contract is used as a foreign currency hedge when a person/business has an
obligation to either make or take a foreign currency payment at some point in the future.
If the date of the foreign currency payment and the last trading date of the foreign
currency Forwards contract are matched up, the investor has in effect "locked in" the
exchange rate payment amount.
Advantages:
1. Helps in hedging the exchange rate risk.
2. Brings the certainty of converting foreign exchange at a fixed rate.
3. Provides for early or part settlement.
Disadvantages:
1. Creates an obligation to settle the contract and does not allow the buyer to make
use of better market rates, if available.
1) What is maturity date?
The date on which the forward contract expires.
2) What is a strike price?
This is also called Exercise Price. This is the rate booked by an exporter or importer on
the date of the contract.
For Example: On 31 March, 2008, an exporter buys and Forward contract, maturity date
for 30 September 2008
USD/INR rate on 31 March, 2008 = 39.50

24

Forward rate booked by the exporter= 40.00= Strike price /Strike Rate
2 Options:
It is a financial Foreign currency contract giving the buyer the right, but not the
obligation, to purchase or sell a specific foreign currency contract (the underlying) at a
specific price (the strike price) on or before a specific date (the expiration date). The
amount paid for the contract is called "premium."
In other words, buy paying a premium the buyer can stay protected from unfavorable
market movements and at the same time make use of better market rates when available.

Advantages:
1. Unlike a forwards contract, it does not create an obligation to settle, the buyer can
make use of better market rates when available.
2. Provides protection against loss; however the option to make use of favorable
market rate exists.
3. Provides the flexibility of choosing the strike price and maturity period,
accordingly the option price can be arrived to suit the buyers needs.

25

4. Tax Benefit-Premium paid can be claimed under expenses for tax benefit as per
Income Tax Act (India), 1961.
1) What is maturity date?
The date on which the FXFlexi contract expires.
2) What is strike price?
This is also called Exercise Price. This is the rate booked by an exporter or importer on
the date of the contract.
For Example: On 31 March, 2008, an exporter buys and Options contract, maturity date
for 30 September 2008
USD/INR rate on 31 March, 2008 = 39.50
Options booked by the exporter for 30 September 2008
Options rate booked by the exporter= 40.00= Stike price /Strike Rate
3) What are the types of Options contract?
Options for importers
Importers have to pay in foreign currency for their imports. As such importers buy
foreign currency and sell rupees. Hence, Importers can book an Options contract and
book the rate at which they will buy foreign currency. On the maturity date, importers can
buy foreign currency at the rate booked or the market rates whichever is lower. This is
also known as a call option contract.
For e.g. an importer books an Options contract on 31 March, 2008, maturity date 30
September 2008 at the rate of 39.00.
Scenario analysis:
Market rate on 30 September, 2008= 39.50

26

The importer will convert the foreign exchange at the rate booked by him i.e. 39.00 as
that is lower than the market rate and hence more favorable for an importer.
Options for exporters
Exporters receive payment in foreign currency. As such exporters sell foreign currency
and buy rupees. Hence an exporter can book an Options contract and book a rate at which
they will sell foreign currency. On the maturity date, exporters can sell foreign currency
at the rate booked or the market rates whichever is lower. This is also known as a put
option

contract.

For e.g. an exporter books an Options contract on 31 March, 2008, maturity date 30
September 2008 at the rate of 40.00.
VIII. Forex Channels
The various channels through which to avail Forex Services are
1. Dealer- To a select group of clients, banks offer the service of directly contacting
the foreign exchange dealers to take quotes and/or book deals with them.
2. Relationship/Treasury Manager- Clients can contact the relationship/treasury
manager assigned to them for rates and deals.
3. Forex over the PHONE-Some banks offer the facility whereby clients who do not
have access to banks dealing room or dealers, can call up centralized treasury
offices where the services of taking quote and deal booking is made available.
4. Forex over the INTERNET- Some banks offer the facility whereby clients can
also avail the benefit of viewing streaming currency exchange rates over their
computer screens and at the same time book deals over it. This platform has the
following advantage.

Real time platform of forex rates

27

Transaction through a secure network

No need to call up Branch/ dealer for rates

Participants in foreign exchange Market

The main players in foreign exchange Market are as follows:
1. CUSTOMERS The customers who are engaged in foreign trade participate in v foreign
exchange Market by availing of the services of banks. Exporters require converting the
dollars in to rupee and importers require converting rupee in to the dollars, as they have
to pay in dollars for the goods/services they have imported.
2. COMMERCIAL BANK: they are most active players in the forex Market. Commercial
bank dealing with international transaction offer services for conversion of one currency
in to another. They have wide network of branches. Typically banks buy foreign
exchange from exporters and sells foreign exchange to the importers of goods. As every
time the foreign exchange bought or oversold position. The balance amount is sold or
bought from the Market.
Top 10 currency traders of overall volume, May 2010 Rank Name Market Share
Germany Deutsche Bank
Switzerland UBS AG
United Kingdom Barclays Capital
United States Citi
United Kingdom Royal Bank of
Scotland
United States JPMorgan
United Kingdom HSBC
Switzerland Credit Suisse
United States Goldman Sachs
United States Morgan Stanley

18.06%
11.30%
11.08%
7.69%
6.50%
6.35%
4.55%
4.44%
4.28%
2.91%

28

3. CENTRAL BANK In all countries Central bank have been charged with the
responsibility of maintaining the external value of the domestic currency. Generally this
is achieved by the intervention of the bank.
4. Exchange BROKERS
Forex brokers play very important role in the foreign exchange Market. However the
extent to which services of foreign brokers are utilized depends on the tradition and
practice prevailing at a particular forex Market center. In India as per FEDAI guideline
the Ads are free to deal directly among themselves without going through brokers. The
brokers are not among to allowed to deal in their own account allover the world and also
in India.
5. OVERSEAS FOREX Market Today the daily global turnover is estimated to be more
than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 %
of this total turnover. The rest of trading in world forex Market is constituted of financial
transaction and speculation.
TIMINGS:
As we know that the forex Market is 24-hour Market, the day begins with Tokyo and
thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris,
London, New York, Sydney, and back to Tokyo.
5. SPECULATORS the speculators are the major players in the forex Market Bank dealing
are the major speculators in the forex. Market with a view to make profit on account of
favorable movement in exchange rate, take position i.e. if they feel that rate of particular
currency is likely to go up in short term. They buy that currency and sell it as
Corporations particularlysoon as they are able to make quick profit. Multinational
Corporation and transnational corporation having business operation beyond their
national frontiers and on account of their cash flows being large and in multi currencies
get in to foreign exchange exposures. With a view to make advantage of exchange rate
movement in their favor they either delay covering exposures or do Individual like share
29

dealingnot cover until cash flow materialize. Also undertake the activity of buying and
selling of foreign exchange for booking short term profits. They also buy currency
foreign stocks, bonds and other assets without covering the foreign exchange exposure
risk. These also result in speculations.

F.E.R.A . and F.E.M.A.

(Foreign Exchange Regulation Act AND Foreign Exchange Management Act)

Historical Background :

Historical Background The Foreign Exchange Regulation Act of 1973 (FERA)

Enacted in 1973

In the backdrop of acute shortage of Foreign Exchange in the country.

FERA had a controversial 27 year stint during

which many bosses of the

Indian Corporate world found themselves at the mercy of the Enforcement

Directorate (E.D.).
Foreign Exchange Regulation Act

The Foreign Exchange Regulation Act (FERA) was legislation passed by

the Indian Parliament in 1973 by the government of Indira Gandhi

It came into force with effect from January 1, 1974.

FERA imposed stringent regulations on certain kinds of payments.

It deals in foreign exchange and securities and the transactions which had an
indirect impact on the foreign exchange and the import and export of currency.

The purpose of the act, inter alia, was to "regulate certain payments, dealings in
foreign exchange and securities, transactions indirectly affecting foreign exchange
and the import and export of currency, for the conservation of foreign exchange
resources of the country".

30

FERA was repealed in 1999 by the government of Atal Bihari Vajpayee.

It replaced by the Foreign Exchange Management Act,which liberalised foreign

exchange controls and restrictions on foreign investment.

Foreign Exchange Management Act

The Foreign Exchange Management Act(FEMA) was an act passed in the

winter session of Parliament in 1999 which replaced Foreign Exchange
Regulation Act.

This act seeks to make offenses related to foreign exchange civil offenses.

It extends to the whole of India.

FEMA, which replaced Foreign Exchange Regulation Act(FERA).

It had become the need of the hour since FERA had become incompatible with the
pro-liberalisation policies of the Government of India.

FEMA has brought a new management regime of Foreign Exchange consistent

with the emerging framework of the World Trade Organisation(WTO).

It is another matter that the enactment of FEMA also brought with it

the Prevention of Money Laundering Act 2002, which came into effect from 1
July 2005.

Objective Of F.E.R.A &F.E.MA

1) To help RBI in maintaining exchange rate stability.

2) To conserve precious foreign exchange.

3) To prevent/regulate Foreign business in India.

31

4) To consolidate and amend the law relating to foreign exchange with the object
to facilitating external trade and payments and for promoting the foreign
exchange market in India.

5) So the new law is for the management of foreign exchange instead of

regulation of foreign exchange.

6) The draconian provisions were droped out in new enactment.

7) The size of the bare act got reduced to 49 sections in place of 81 sections in
FERA

Objectives

8) To facilitate external trade and payments

9) To promote the orderly development and maintenance of foreign exchange

market

DIFFERENCE BETWEEN FERA AND FEMA :

1)-The objective of FERA was to conserve forex and to prevent its misuse.
The objective of FEMA is to facilitate external trade and payments and
maintenance of forex market in india.
2-Violation of FERA was a criminal offence
whereas violation of FEMA is a civil offence.
3- Offences under FERA were not compoundable
Offences under FEMA are compoundable.
4- Citizenship was a criteria to determine the residential status of a person under
FERA.
32

while stay of more than 182 days in India is the criteria to decide residential status
under FEMA.
5- Almost all current account transactions are free, except a few.
FERA & FEMA
Object to conserve and prevent misuse
Violation was Criminal Offence and was non compoundable
It was a draconian police law
To facilitate external trade and payments
Violation is a civil offence and is compoundable
It is a civil law

Current Account and Capital Account transactions

Under the FEMA regime, the thrust was on regulation and control of the scarce
foreign exchange, whereas under the FEMA, the emphasis is on the management
of foreign exchange resources.
Under FERA it was safe to presume that any transaction in foreign exchange or
with a non-resident was prohibited unless it was generally or specially permitted.
FEMA has formally recognised the distinction between current account and
capital account transactions.

Two golden rules or principles in FEMA are mentioned as follows:

all current account transactions are permitted unless otherwise prohibited.
all capital account transactions are prohibited unless otherwise permitted.

Current Account Transactions

33

Any person may sell or draw foreign exchange to or from an authorized person if
such sale or drawal is a current account transaction.

The Central Government may, in public interest and in consultation with the
Reserve Bank, impose such reasonable restrictions for current account
transactions as may be required from time to time.

CHAPTER 4 INTERNATIONALBOND MARKET

Definition of 'Bond Market'

The environment in which the issuance and trading of debt securities occurs. The bond
market primarily includes government-issued securities and corporate debt securities, and
facilitates the transfer of capital from savers to the issuers or organizations requiring
capital for government projects, business expansions and ongoing operations.
What is bond?The bond market (also known as the credit, or fixed income market) is a
financial market where participants can issue new debt, known as the primary market, or
buy and sell debt securities, known as the Secondary market, usually in the form of
bonds. The primary goal of the bond market is to provide a mechanism for long term
funding of public and private expenditures. Traditionally, the bond market was largely
dominated by the United States, but today the US is about 44% of the market [1]. As of
2009, the size of the worldwide bond market (total debt outstanding) is an estimated
$82.2 trillion,[2] of which the size of the outstanding U.S. bond market debt was $31.2
trillion according to Bank for International Settlements (BIS), or alternatively $35.2
trillion as of Q2 2011 according to Securities Industry and Financial Markets Association
(SIFMA).[2]Nearly all of the $822 billion average daily trading volume in the U.S. bond
market[3] takes place between broker-dealers and large institutions in a decentralized,
over-the-counter (OTC) market. However, a small number of bonds, primarily corporate,
are listed on exchanges.References to the "bond market" usually refer to the government
bond market, because of its size, liquidity, relative lack of credit risk and, therefore,
34

sensitivity to interest rates. Because of the inverse relationship between bond valuation
and interest rates, the bond market is often used to indicate changes in interest rates or the
shape of the yield curve. The yield curve is the measure of "cost of funding".
Definition of 'International Bond'
Debt investments that are issued in a country by a non-domestic entity. International
bonds are issued in countries outside of the United States, in their native country's
currency. They pay interest at specific intervals, and pay the principal amount back to the
bond's buyer at maturity.
International Bond:-A bond issued in a country or currency other than that of the investor
or broker. They include Eurobonds, which are issued in a foreign currency, foreign bonds,
which are issued by a foreign government or corporation in the domestic market, and
global bonds, which are issued in both domestic and international markets. Unlike
domestic bonds, international bonds are usually subject to currency risk. Caution is
required when investing international bonds because they may be subject to different
regulatory and taxation requirements than the ones with which the investor or broker is
familiar.
Investopedia explains 'International Bond':=International bonds include eurobonds,
foreign bonds and global bonds. A different type of international bond is the Brady bond,
which is issued in U.S. currency. Brady bonds are issued in order to help developing
countries better manage their international debt. International bonds are also private
corporate bonds issued by companies in foreign countries, and many mutual funds in the
United States hold these bonds.
INTERNATIONAL BOND IS FURTHER CLASSIFIED IN TWO TYPES
A. Eurobond
B. Foreign bond
Definition of 'Eurobond'-A bond issued in a currency other than the currency of
the

country

or

market

in which

it is

issued.
35

Usually, a eurobond is issued by an international syndicate and categorized

according to the currency in which it is denominated. A eurodollar bond
that is denominated in U.S. dollars and issued in Japan by an Australian company
would be an example of a eurobond. The Australian company in this example
could issue the eurodollar bond in any country other than the U.S.Eurobonds are
attractive financing tools as they give issuers the flexibility to choose the country
in which to offer their bond according to the country's regulatory constraints.
They may also denominate their eurobond in their preferred currency. Eurobonds
are attractive to investors as they have small par values and high liquidity
'Foreign Bond':-A bond that is issued in a domestic market by a foreign entity, in
the domestic market's currency. A foreign bond is most often issued by a foreign
firm to raise capital in a domestic market that would be most interested in
purchasing the firm's debt. For foreign firms doing a large amount of business in
the domestic market, issuing foreign bonds is a common practice. Types of
foreign bonds include bulldog bonds, matilda bonds and samurai bonds.
FEATURES OF INTERNATIONAL BOND
It is a fund raising market
It is debt market
Fixed income instrument
Issued in foreign currency
THE PROCESS OF BRIGING A NEW INTERNATIONAL BOND TO THE
MARKET
Step 1:-A borrower will contact an investment banker ask it to serve as
lead manager of an underwriting syndicate that will bring the

bonds

to

market.
Step 2:- The lead manager will usually invite other banks to form a
managing group to help negotiate terms with the borrower, ascertain

market

conditions, and manage the issuance.

36

Step 3:-The managing group, along with other banks, will serve as underwriters for the
issue, i.e., they will commit their own capital to

buy the issue from the borrower at a

discount from the issue price.

Step 4:-The various members of the underwriting syndicate receive a
spread (usually in the range of 2 to2.5 percent of the
the number and type of functions they

portion of the

issue size), depending upon

perform.

Step 5:-The lead manager receives the full spread, and a bank serving as only

member of the selling group receives a smaller portion.

RISK OF INVESTING IN BOND

1. Inflation Risk
2. Interest rate Risk
3. Default Risk
4. Downgrade Risk
5. Liquidity Risk
6. Reinvestment Risk
7. Rip-off Risk
ADVANTAGES & DISADVANTAGES OF INTERNATIONAL BOND

ADVANTAGES :
Diversify your portfolio
International fund raising instrument
Fixed income market

37

 Investment avenue(short term as well as long term

Disadvantages:- Investing in international bond funds can help you diversify your
portfolio. However, there are some potential drawbacks that you need to know about.
Here are four disadvantages of investing in international bond funds.
1. Outperformed by Mutual Funds:-When you invest money into an indexed bond
ETF, you are going to run the risk of being outperformed. Many actively managed
mutual funds can outperform these types of funds. Therefore, you may not be
choosing the best place to put your money.
2.

Fees:-Many people that invest in these types of funds like to buy and sell shares
frequently. When you do this, you are going to incur fees. These fees can
significantly cut into the amount of return that is made from the international

bond fund.
3. Risk:-By investing in this type of fund, you are taking on extra risk. You have to
be aware of international market concerns as well as geopolitical and economic
risks.
4. Limited SelectioN:-If you want to invest in international bond funds, you are
going to find that you have a very limited selection to choose from. While there
are hundreds of ETFs to choose from, those that specialize in international bond
funds are a little more difficult to come by.
INSTRUMENTS OF INTERNATIONAL BOND MARKET
FIXED RATE BONDS (71% of market in 2003) - Fixed maturity date (long term),
fixed coupon rate (% of face value), issued in , , , or $. Interest only bonds (nonamortizing). Coupon pmts are usually made annually, not semi-annually as for most
domestic bonds, more convenient for bondholder, less costly for issuer (bondholders are
scattered). Eurobonds are bearer bonds and owners hold a physical bond certificate.
How does bearer receive interest pmts? Owner clips bond coupons and presents to bank
for annual payment.

38

FLOATING-RATE NOTES (FRN), 26% of Market- Started in 1970. Usually

medium term (1-10 year) bonds with a quarterly or semi-annual floating/variable coupon
rate, like an ARM, issued mostly in $ and . Indexed to some reference interest rate like
6 month LIBOR (CH 11). Semi-annual pmt (reset at the beginning of each 6 month
period) would be .50 ( LIBOR + Risk Premium) of face value, risk premium usually 1/8
percent (.125%) for firm's with very good credit rating. Example: Rate is: LIBOR + .
125%, and LIBOR = 6.6%. Semi-annual coupon pmts for every $1000 face value would
be: .50 (6.6% + .125%) ($1000) = $33.625. In six months if LIBOR is 5.7%, the
payment would be: .50 (5.7% + .125%) ($1000) = $29.125. Advantage of FRNs compared to fixed rate bonds, very little interest rate risk (capital or price risk), i.e., the
price of the bond will fluctuate between reset dates, but will adjust back to par ($1000)
after the quarterly or semi-annual reset date. Why might the FRN not sell at par, even at
the reset date?? Example: National Bank of Kuwait issued $450m of 3-year FRNs in
2002, indexed to LIBOR + 25 bp (1/4%).
EQUITY-RELATED BONDS (3% Market)
Bonds with Warrants - Fixed rate bond with call options (warrants) on the company's
stock. The warrant allows the bondholder to buy a certain number of equity shares at a
predetermined price on or before a fixed date. Why issue? When would you exercise?
ZERO COUPON BONDS - Bonds that do not pay interest over their life. Sold at a deep
discount off face value ($1000), with one payment only, at maturity. Advantages?
Company can borrow money, have no debt payments. It can actually deduct interest as a
taxable expense. Investors avoid reinvestment rate risk (fixed duration). In countries like
Japan (and Europe) with no long term capital gains tax, zero coupons have a tax
advantage over coupon bonds. Coupon payments are taxable as interest income, but the
long-term capital gain (Face Value - Price) is non-taxable. Example: 10-year zero coupon
DM bonds, sold at 50% of face value, 15-year zero coupon DM bonds sold at 33 1/3% of
face value. YTM: _______ for 10 year, _________ for 15 year.

39

DUAL-CURRENCY BONDS :-Started in mid-80s. Fixed rate coupon pmts are made in
one currency (SF or ), maturity value (principal) is paid in another currency ($). The $
maturity value is fixed, so a dual-currency bond includes a long term forward contract. If
dollar appreciates (depreciates), the value of the bond rises (falls). Dual-currency bonds
are riskier for investors, so the yield (coupon rate) is higher. Japanese MNCs have issued
Yen/$ dual currency bonds, coupons paid in Yen, principal paid in $, to finance FDI in
U.S. Example: Honda might issue dual currency Yen/Dollar bonds to expand or establish
factory in U.S. Long-term investment, may not be profitable for 10 years. The loan can
be serviced in Yen from Japan, and the principal can be paid with long-term dollar profits
earned in the U.S. bond instruments and currency distribution: $ and bonds account for
84% of the market. has grown in importance, SF and C$ have declined.
WHAT IS EUROBOND ?
(1) Underwritten by an international syndicate,
(2) Offered at issuance simultaneously to investors in a number of countries
(3) Issued outside the jurisdiction of any single country.
Definition of 'Eurobond'-A bond issued in a currency other than the currency of
the

country

or

market

in which

it is

issued.

Investopedia explains 'Eurobond':-Usually, a eurobond is issued by an international

syndicate and categorized according to the currency in which it is denominated. A
eurodollar bond that is denominated in U.S. dollars and issued in Japan by an Australian
company would be an example of a eurobond. The Australian company in this example
could issue the eurodollar bond in any country other than the U.S.Eurobonds are
attractive financing tools as they give issuers the flexibility to choose the country in
which to offer their bond according to the country's regulatory constraints. They may also
denominate their eurobond in their preferred currency. Eurobonds are attractive to
investors as they have small par values and high liquidity. Examples of eurobonds.1)
Wal-Mart issues bonds denominated in U.S. dollars on the German financial markets.2.

40

The French government issues euro-denominated bonds on the Japanese financial

markets.
The Procedures for the Eurobond Issuance Process:Select a Lead Manager:-Eurobonds are issued by underwriting syndicates. These
syndicates are made up of investment and merchant banks and may be formed in different
ways.
Generally, the borrower chooses one investment bank to be the lead manager of the bond
issue. The lead manager then negotiates with other banks to form the syndicate.
Borrowers may also use existing syndicates or ask a particular investment banker to act
as lead manager.
Organize a Syndicate:-The lead manager negotiates with other banks to form a
managing group. This group then negotiates the terms of the bond issue with the
borrower. Members of the managing group will also form another group to act as
underwriters in the bond issue. The underwriters will commit their own money to buy the
bond issue from the borrower -- at a set minimum price. They then sell the bonds on to
secondary markets at an agreed profit. The managing group will also negotiate with other
banks to form a selling group -- this is the group of banks that will actually sell the bonds
to investors.
Selling the Bonds:-Once the syndicate is formed and the terms of the issue are agreed
upon, the managing group buys the bonds from the borrower. The managing group then
sells the eurobonds to the underwriters, and the underwriters sell the bonds to the selling
group. The banks that make up the selling group then sell the bonds on to investors. One
thing to keep in mind is that although there are several roles -- managers, underwriters
and sellers -- these roles usually overlap, so that managers may also be underwriters and
sellers.
Principal Paying Agent:-A principal agent is chosen. This is the bank that is responsible
for receiving interest payments from the borrower and passing them on to the investors

41

who buy the bonds. A fiscal agent or trustee may also be appointed by the borrower to
handle the paperwork and legal aspects of the eurobond issue and act as principal agent.
The trustee will also represent the purchasers of the bond if the borrower defaults.
Trustees and fiscal agents are generally banks, and not individuals.
UNIQUE CHARACTERISTICS OF EUROBOND

1 FACEVALUE/PARVALUE: Thefacevalueisthe amount of money a holder will get back,once a

bond matures.
2) COUPON (THE INTEREST RATE):The couponis the amount the bondholder will
receive asinterest payments. Its called coupon becausein early days there were physical
couponsattached to the bond certificate
3) MATURITY: It is the date in the future onwhich the investors principal will be repaid.
4) ISSUER: Eurobonds are mostly issued bycorporate
5)DENOMINATIONS: various currencies arecommonly used the US $ is used the
most,denominating 70-75 % of Eurobonds.
6)SECONDARY MARKET: Eurobonds have asecondary market which is different fromcommon
stock market/exchange.
7) RATINGS: The bond rating system helpsinvestors determine a companys credit risk.
8 TAXATION: Eurobonds are not subject to taxlargely free from government regulation.

ADVANTAGES

&

DIS

ADVANTAGES

FOR

COMPANIES

TO

ISSUE

EUROBONDS

42

There are several advantages for companies to issue Eurobonds:

Large amounts
Freedom and Flexibility
Lower cost of issue
Lower interest cost
Longer maturities

Against these advantages, there are some disadvantages to consider:

there are issue costs to take into account

if the debt is not matched against a foreign currency asset, the Eurobond issuing
firm may be open to foreign exchange risk.

ADVANTAGES & DISADVANTAGES FOR INVESTOR TO ISSUE

EUROBONDS
There are several benefits to an investor who does put its money into Eurobonds:
Tax free income
Low Risk investment
Convertible to Equity
Liquid investment

As for disadvantages to the investor:

43

Investing in a Eurobond is not a good idea for investors who may need a
repayment of the investment at short notice.

There is always the risk of the issuing company going under and the maturity
value of the Eurobond not being paid.

Definition of 'Foreign Bond':-A bond that is issued in a domestic market by a foreign

entity, in the domestic market's currency. A foreign bond is most often issued by a
foreign firm to raise capital in a domestic market that would be most interested in
purchasing the firm's debt. For foreign firms doing a large amount of business in
the domestic market, issuing foreign bonds is a common practice. Types of
foreign bonds include bulldog bonds, matilda bonds and samurai bonds.
Investopedia explains 'Foreign Bond':-Foreign bonds are regulated by the domestic
market authorities and are usually given nicknames that refer to the domestic
market in which they are being offered. Since investors in foreign bonds are usually
the residents of the domestic country, investors find them attractive because they
can add foreign content to their portfolios, without the added exchange rate
exposure.
A debt security issued by a borrower from outside the country in whose currency the
bond is denominated and in which the bond is sold. A bond denominated in U.S. dollars
that is issued in the United States by the government of Canada is a foreign bond. A
foreign bond allows an investor a measure of international diversification without
subjection to the risk of changes in relative currency values.
Three characteristics of foreign bonds
A foreign bond has three distinct characteristics:

The

bond

is

issued

by

foreign

entity

(such

as

government, municipality or corporation)

The bond is traded on a foreign financial market

The bond is denominated in a foreign currency.

44

Bond markets
Bond markets in India have witnessed a sea change since the early 1990s. The
government securities market has practically emerged since the mid-1990s. Trading
platforms and settlement mechanisms have improved and new instruments have been
experimented with, with varying degrees of success. In comparison, with practically no
new primary market issuance of corporate bonds (except in the private placement
segment), the current state of the corporate bond market in India is till nascent although
in the last 2-3 years it has witnessed significant reform activities. The package of
regulatory and infrastructural changes recommended by the Patil committee in 2005,
partly implemented already, is likely to increase the primary and secondary market
activity.The market for asset securitization in India is relatively small but has
demonstrated significant growth in recent years. Asset-backed securities have led the
market with mortgage-backed securities lagging. Corporate loan securitization is also
considerable but mostly in the form of single loan sell-offs rather than pools of loans as in
Collateralized Debt Obligations (CDOs) as securities. Securitization of trade credit or
receivables is yet to develop.
Bonds are debt securities in which an investor purchases a bond from a government or a
corporation and holds that bond until it comes due. At that time, the issuer of the bond
will pay the interest earned by the bond in full. In India, there are several types of bonds
available to investors, including ones that are only sold privately and a tax-savings bond
that releases the investor of a tax burden.

DEFINITION : Bonds issued

and traded within the internal market of a country and denominated in the currency of
that country.
Bonds issued in the country and currency in which they are traded. Unlike international
bonds, domestic bonds are not subject to currency risk. They usually carry less risk, as
the regulatory and taxation requirements are usually known to investors in domestic
bonds, or at least to their brokers and accountants.

45

Public Sector Undertaking Bonds

If you're looking for a medium- to long-term investment in the Indian

bond market, a Public Sector Undertaking bond can be a good choice.
PSUs are issued and backed by the government of India, but they're
usually sold on a private basis. In other words, the Indian government
targets investors themselves and offers the bonds to these investors at
fixed rates. An investment banker usually only serves as a middleman in
this situation.

Corporate Bonds
o

These are more traditional bond instruments, which are offered by private
corporations in India for terms that can last up to 15 years. Unlike the
government bonds mentioned earlier, anyone can purchase a corporate
bond. However, there is a higher risk of default and that can depend upon
the corporation backing the bond, market conditions, the company's
industry and its investment rating. But the risk comes with a higher return
on the investment.

Financial Institutions and Banks

o

Bonds issued by financial institutions and banks in India are a vibrant

financial instrument and make up more than 80 percent of the bond market
in that country. The reasons are simple. Bonds issued by financial
institutions and banks are regulated well and come with good bond ratings.
Large-scale investors are some of the most important investors in this
category.
46

Emerging Markets Bonds

o

These bonds, issued by the Indian government, are issued abroad as hard
currency to raise capital for economic development in third-world
countries. What's different about these bonds is that they are usually issued
in U.S. dollars or the Euro, which can make them more attractive to
investors in those countries. Also making these EM bonds attractive is the
interest rate, which while high is typically paid by the issuer. The risk
comes in that countries like India have a lower credit rating and the
success of the bonds is tied to the success of the country's economic
development.

Tax-Savings Bonds
o

The Indian government issues special bonds that allow its citizens to be
either partially or fully released from paying taxes. Most of them are
issued by India's Reserve Bank. These five-year bonds are sold at an
interest rate of 6.5 percent and interest is paid off every half-year. The
upside for the investor is that by purchasing this bond, they are released
from paying taxes on the related interest income, as long as they hold the
bond until it matures.

LOAN SYNDICATION
The size of loan is large, individual banks cannot or will not be able to finance. They
would prefer to spread risk among a number of banks or a group of banks is called as
Syndication of loans. These days there are large group of banks that form syndicates to
arrange huge amount of loans for corporate borrowers the corporate that would want a
loan but not be aware of those banks willing to lend. Hence, syndication pays a vital role
here. Once the borrowers has decided upon the size of the loan, he prepares an
information memorandum containing information like the amount he requires, the

47

purpose, business details of his country and its economy. Then he receives bids (after this
the borrower and the lender sit across the table to discuss about the terms and conditions
of lending this process of negotiations is called syndication.) The process of syndication
starts with an invitation for bids from the borrower. The mandate is given to a particular
bank or institution that will take the responsibility of syndicating the loan while arranging
the financing banks. Syndication is done on a best effort basis or an underwriting basis. It
is usually the lead manager who acts as the syndicator of loans, the lead manager has dual
tasks that is, formation of syndicate documentation and loan agreement. Common
documentation is signed by the participation banks or common terms and conditions.
Thus, the advantages of the syndicated loans are the size of the loan, speed and certainty
of funds, maturity profile of the loan, flexibility in repayment, lower cost of fund,
diversity of currency, simpler banking relationship and possibility of
renegotiation.
"Syndication is an arrangement where a group of banks, which
may not have any other business relationship with the borrower,
participate for a single loan."
Typically, syndicated loans are structured as term loans or
operating revolvers. However, they may also include tranche or segmented
structures, letters of credit, acquisition facilities, construction financing,
asset-based structures, project financing and trade finance. The standard
theory for why banks join forces in a syndicate is risk diversification.
FOR EXAMPLE: If a company wants a huge amount as a loan for
expansion or any other purpose, say when Reliance or ITC wants money,
loans are got from the banks. But generally, it got from a single bank and
that single bank alone shares the risk. Take the case of funding a rocket
launch - if the launch is a failure, then the bank which funds for it may
become bankrupt. But in syndication, many banks come together and fund

48

a single project. Loan syndication is basically done to share the total loss
or liability.
TYPES OF LOANS SYNDICATION
Globally, there are three types of underwriting for syndications: an underwritten deal,
best-efforts syndication, and a club deal. The European leveraged syndicated loan market
almost exclusively consists of underwritten deals, whereas the U.S. market contains
mostly best-efforts.

UNDERWRITTEN DEAL
An underwritten deal is one for which the arrangers guarantee the entire commitment,
and then syndicate the loan.
If the arrangers cannot fully subscribe the loan, they are forced to absorb the difference,
which they may later try to sell to investors.
If it is not get sold than the arranger may be forced to sell at a discount and, potentially,
even take a loss on the paper.
Arrangers underwrite loans for several reasons. First, offering an underwritten loan can
be a competitive tool to win mandates.

49

 Second, underwritten loans usually require more lucrative fees because the agent is on
the hook if potential lenders balk.
BEST-EFFORTS SYNDICATION
A best-efforts syndication is one for which the arranger group commits to underwrite
less than the entire amount of the loan, leaving the credit to the vicissitudes of the market.
Traditionally, best-efforts syndications were used for risky borrowers or for complex
transactions.
Since the late 1990s, however, the rapid acceptance of market-flex language has made
best-efforts loans the rule even for investment-grade transactions.

CLUB DEAL
A club deal is a smaller loan usually $25100 million, but as high as $150 millionthat
is pre marketed to a group of relationship lenders. The arranger is generally a first among
equals, and each lender gets a full cut, or nearly a full cut, of the fees.
STAGES AND PROCESS OF LOAN SYNDICATION
PRE - MANDATE PHASE
The prospective borrower may liaise with a single bank or it may invite competitive bids
from a number of banks. The lead bank identifies the needs of the borrower, designs an
appropriate loan structure, develops a persuasive credit proposal, and obtains internal
approval. The mandate is created. The documentation is created with the help of
specialist lawyers.
PLACING THE LOAN

50

The lead bank can start to sell the loan in the market place. The lead bank needs to
prepare an information memorandum, term sheet, and legal documentation and approach
selected banks and invite participation. The lead manager carries out the negotiations and
controversies are ironed out. The syndication deal is closed, including signing of the
mandate.
POST - CLOSURE PHASE
The agent now handles the day-to-day running of the loan facility.
CHAPTER 4 GLOBAL CAPITAL MARKET
Indian companies are permitted to raise foreign currency resources through two main
sources:

Issue of Foreign Currency Convertible Bonds (FCCBs)

Issue of Ordinary equity shares through depository receipts, namely, Global
Depository Receipts/ American Depository Receipts to foreign investors i.e.
institutional investors or investors residing abroad.

A Depository Receipt (DR) is any negotiable instrument in the form of a certificate

denominated in US dollars. The certificate is issued by an overseas depository bank
against certain underlying stocks/shares. The shares are deposited by the issuing company
with the depository bank. The depository bank in turn tenders DRs to the investors. A DR
represents a particular bunch of shares on which the receipt holder has the right to receive
dividend, other payments and benefits which company announces from time to time for
the shareholders. However, it is non-voting equity holding. DRs facilitate cross border
trading and settlement, minimize transaction cost and broaden the potential base,
especially among institutional investors. More and more Indian companies are raising
money through ADRs and GDRs these days.
WHAT ARE ADRs OR GDRs?
American Depositary Receipts (ADRs) are securities offered by non-US companies who
want to list on any of the US exchange. Each ADR represents a certain number of a
company's regular shares. These are deposited in a custodial account in the US. ADRs
allow US investors to buy shares of these companies without the costs of investing
directly in a foreign stock exchange. ADRs are issued by an approved New York bank or
trust company against the deposit of the original shares. When transactions are made, the
ADRs change hands, not the certificates. This eliminates the actual transfer of stock
certificates between the US and foreign countries.
Global Depositary Receipts (GDRs) are negotiable certificate held in the bank of one
51

country representing a specific number of shares of a stock traded on the exchange of

another country. This is a financial instrument used by the companies to raise capital in
either dollars or Euros. GDRs are also called European Depositary Receipt. These are
mainly traded in European countries and particularly in London.
However, ADRs and GDRs make it easier for individuals to invest in foreign companies,
due to the widespread availability of price information, lower transaction costs, and
timely dividend distributions.
WHY DO COMPANIES GO FOR ADRs OR GDRs?
Indian companies need capital from time to time to expand their business. If any foreign
investor wants to invest in any Indian company, they follow two main strategies. Either
the foreign investors can buy the shares in Indian equity markets or the Indian firms can
list their shares abroad in order to make these shares available to foreigners.
But the foreign investors often find it very difficult to invest in India due to poor market
design of the equity market. Here, they have to pay hefty transaction costs. This is an
obvious motivation for Indian firms to bypass the incompetent Indian equity market
mechanisms and go for the well-functioning overseas equity markets. When they issue
shares in forms of ADRs or GDRs, their shares commanded a higher price over their
prices on the Indian bourses.
Another problem faced by the foreign investors is restrictions on equity ownership by
foreigners. Only foreign institutional investors can buy shares in India whereas in case of
ADRs or GDRs, anyone can buy this. FIIs face restrictions of ceilings or stakes in Indian
companies. In contrast, there is no such restriction on GDRs or ADRs, and hence GDRs
or ADRs generally enjoy a premium.
WHICH INDIAN COMPANIES ARE LISTED ABROAD?
Infosys Technologies was the first Indian company to be listed on NASDAQ in 1999.
However, the first Indian firm to issue sponsored GDR or ADR was Reliance industries
Limited. Beside, these two companies there are several other Indian firms are also listed
in the overseas bourses. These are Satyam Computer, Wipro, MTNL, VSNL, State Bank
of India, Tata Motors, Dr Reddy's Lab, Ranbaxy, Larsen & Toubro, ITC, ICICI Bank,
Hindalco, HDFC Bank and Bajaj Auto.
WHAT ARE THE PRICES OF INDIAN ADRs & GDRs?
The ADR and GDR prices of the Indian companies are much higher compared to the
prices on the Indian bourses. While, Infosys trades at $72.14 at NASDAQ, it quotes at Rs
2,245 on the BSE. Satyam at $24.25, Wipro at $21.50, Tata Motors at $10.20, MTNL at
$6.34, Dr Reddy's Lab at $16.27, HDFC Bank at $41.94, Bajaj Auto at $28.14, RIL at
$24.83 and ITC at $35.30 were all quoting at a higher price than their Indian peers.

52

HOW TO TRADE IN ADRs?

ADRs can be traded either by trading existing ADRs or purchasing the shares in the
issuer's home market and having new ADRs created, based upon availability and market
conditions.
When trading in existing ADRs, the trade is executed on the secondary market on the
New York Stock Exchange (NYSE) through Depository Trust Company (DTC) without
involvement from foreign brokers or custodians. The process of buying new, issued
ADRs goes through US brokers, Helsinki Exchanges and DTC as well as Deutsche Bank.
WHAT ARE THE NORMS FOR INDIAN ADRs AND GDRs?
There are no ceilings on investment in ADRs or GDRs. An applicant company seeking
the government's approval in this regard should have a consistent good track record for a
minimum period of 3 years. This condition can be relaxed for infrastructure projects such
as power generation, telecomm, petroleum exploration and refining, ports, airports and
roads.
There is no restriction on the number of GDRs or ADRs to be floated by a company or a
group of companies in a financial year. The government has also relaxed the conversion
and re-conversion (i.e. two-way conversion or fungibility) of shares of Indian companies
into depository receipts listed in foreign bourses.
The companies have been allowed to invest 100 per cent of the proceeds of ADR or GDR
issues for acquisitions of foreign companies and direct investments in joint ventures.
BASIS FOR
COMPARISON

ADR

GDR

Acronym

American Depository Receipt

Global Depository Receipt

Meaning

ADR is a negotiable instrument

GDR is a negotiable instrument

issued by a US bank, representing issued by the international

non-US company stock, trading

depository bank, representing

in the US stock exchange.

foreign company's stock trading

globally.

Relevance

Foreign companies can trade in

Foreign companies can trade in

53

BASIS FOR

ADR

COMPARISON

US stock market.

GDR

any country's stock market other

than the US stock market.

Issued in

United States domestic capital

European capital market.

market.
Listed in

American Stock Exchange such

Non-US Stock Exchange such as

as NYSE or NASDAQ

London Stock Exchange or

Luxemberg Stock Exchange.

Negotiation

In America only.

All over the world.

Disclosure

Onerous

Less onerous

Retail investor market

Institutional market.

Requirement
Market

External Commercial Borrowings

Any money that has been borrowed from foreign sources for financing the commercial
activities in India are called External Commercial Borrowings. The Government of India
permits ECBs as a source of finance for Indian Corporates for expansion of existing
capacity as well as for fresh investment. The ECBs are defined as money borrowed from
foreign resources including the following: Commercial bank loans Buyers credit and
suppliers credit Securitised instruments such as Floating Rate Notes and Fixed Rate
Bonds etc. Credit from official export credit agencies and commercial borrowings from
the private sector window of Multilateral Financial Institutions such as International
Finance Corporation (Washington).
Objective of ECB
Government permits the ECBs as an additional source of financing for expanding
the existing capacity as well as for fresh investments. The ECB policy of the
Government seeks to emphasize the priority of investing in the infrastructure and
core sectors such as Power, telecom, Railways, Roads, Urban infrastructure etc.
54

There is also emphasis on the need of capital for Small and Medium scale
enterprises.

How ECB is different from FDI?

ECB means any kind of funding other than Equity. If the foreign money is used to
finance the Equity Capital, it would be termed as Foreign Direct Investment. The
ECB should satisfy the ECB regulations stipulated by the Government or its
agencies such as RBI. The Bonds, Credit notes, Asset Backed Securities,
Mortgage Backed Securities or anything of that nature are included in ECB.
Please note that the following are not included in the ECBs:

Any Investment made towards core capital of an organization such as equity

shares, convertible preference shares or convertible debentures. We should note
here that those instruments which can be converted into equity are called
convertible. The convertible instruments are covered under the FDI Policy. Any
other
direct
capital
is
not
allowed
in
ECB.

CHAPTER 5 INTERNATIONAL FINANCIAL REPORTING STANDARDS

[I.F.R.S.]
Accounting Standards issued by the ICAI
Accounting Standards are written documents, policy documents issued by expert
accounting body or Govt., or other regulatory body covering the aspects of recognition,
measurement, treatment, presentation and disclosure of accounting transaction in the
financial statement. Accounting Standards in India are issued by the ICAI.
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 Net Profit or Loss for the period, Prior Period Items and Changes in
Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts (revised 2002)
AS 8 Accounting for Research and Development
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003)

55

Withdrawal of the Announcement issued by the Council on Treatment of

exchange differences under Accounting Standard (AS) 11 (revised 2003), The
Effects of Changes in Foreign Exchange Rates vis--vis Schedule VI to the
Companies Act, 1956
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 (revised 2005) Employee Benefits
Limited Revision to Accounting Standard (AS) 15, Employee Benefits (revised
2005)
AS 15 (issued 1995)Accounting for Retirement Benefits in the Financial Statement of
Employers
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18, Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income.
AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Joint Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent` Liabilities and Contingent Assets
AS 30 Financial Instruments: Recognition and Measurement and Limited
Revisions to
AS 2, AS 11 (revised 2003), AS 21, AS 23, AS 26, AS 27, AS 28 and AS 29
AS 31, Financial Instruments: Presentation
Accounting Standard (AS) 32, Financial Instruments: Disclosures, and limited
revision to Accounting Standard (AS) 19, Leases

International Accounting Standards

IAS 1 Presentation of Financial Statements

This Standard prescribes the basis for presentation of general purpose financial
statements to ensure comparability both with the entitys financial statements of
previous periods and with the financial statements of other entities. It sets out

56

overall requirements for the presentation of financial statements, guidelines for

their structure and minimum requirements for their content.

IAS 2 Inventories
The objective of this Standard is to prescribe the accounting treatment for
inventories. A primary issue in accounting for inventories is the amount of cost to
be recognised as an asset and carried forward until the related revenues are
recognised. This Standard provides guidance on the determination of cost and its
subsequent recognition as an expense, including any write-down to net realisable
value. It also provides guidance on the cost formulas that are used to assign costs
to inventories.

IAS 7 Statement of Cash Flows

The objective of this Standard is to require the provision of information about the
historical changes in cash and cash equivalents of an entity by means of a
statement of cash flows which classifies cash flows during the period from
operating, investing and financing activities

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

The objective of this Standard is to prescribe the criteria for selecting and
changing accounting policies, together with the accounting treatment and
disclosure of changes in accounting policies, changes in accounting estimates and
corrections of errors. The Standard is intended to enhance the relevance and
reliability of an entitys financial statements, and the comparability of those
financial statements over time and with the financial statements of other entities.

IAS 10 Events after the Reporting Period

The objective of this Standard is to prescribe:
(a) when an entity should adjust its financial statements for events after the
reporting period; and
(b) the disclosures that an entity should give about the date when the financial
statements were authorised for issue and about events after the reporting period.
The Standard also requires that an entity should not prepare its financial
statements on a going concern basis if events after the reporting period indicate
that the going concern assumption is not appropriate

IAS 11 Construction Contracts

The objective of this Standard is to prescribe the accounting treatment of revenue
and costs associated with construction contracts. Because of the nature of the
57

activity undertaken in construction contracts, the date at which the contract

activity is entered into and the date when the activity is completed usually fall into
different accounting periods. Therefore, the primary issue in accounting for
construction contracts is the allocation of contract revenue and contract costs to
the accounting periods in which construction work is performed.

IAS 12 Income Taxes

The objective of this Standard is to prescribe the accounting treatment for income
taxes. For the purposes of this Standard, income taxes include all domestic and
foreign taxes which are based on taxable profits. Income taxes also include taxes,
such as withholding taxes, which are payable by a subsidiary, associate or joint
venture on distributions to the reporting entity.
The principal issue in accounting for income taxes is how to account for the
current and future tax consequences of:
(a) the future recovery (settlement) of the carrying amount of assets (liabilities)
that are recognized in an entitys statement of financial position; and
(b) transactions and other events of the current period that are recognized in an
entitys financial statements.

IAS 16 Property, Plant and Equipment

The objective of this Standard is to prescribe the accounting treatment for
property, plant and equipment so that users of the financial statements can discern
information about an entitys investment in its property, plant and equipment and
the changes in such investment. The principal issues in accounting for property,
plant and equipment are the recognition of the assets, the determination of their
carrying amounts and the depreciation charges and impairment losses to be
recognised in relation to them

IAS 17 Leases
The objective of this Standard is to prescribe, for lessees and lessors, the
appropriate accounting policies and disclosure to apply in relation to leases.
The classification of leases adopted in this Standard is based on the extent to
which risks and rewards incidental to ownership of a leased asset lie with the
lessor or the lessee.
A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incidental to ownership.

IAS 18 Revenue

58

The primary issue in accounting for revenue is determining when to recognize

revenue. Revenue is recognized when it is probable that future economic benefits
will flow to the entity Tand these benefits can be measured reliably. This Standard
identifies the circumstances in which these criteria will be met and, therefore,
revenue will be recognized. It also provides practical guidance on the application
of these criteria.
Revenue is the gross inflow of economic benefits during the period arising in the
course of the ordinary activities of an entity when those inflows result in increases
in equity, other than increases relating to contributions from equity participants.
IAS 19 Employee Benefits
Employee benefits are all forms of consideration given by an entity in exchange
for service rendered by employees. The objective of this Standard is to prescribe
the accounting and disclosure for employee benefits. The Standard requires an
entity to recognise:
(a) a liability when an employee has provided service in exchange for employee
benefits to be paid in the future; and
(b) an expense when the entity consumes the economic benefit arising from
service provided by an employee in exchange for employee benefits.

IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance
This Standard shall be applied in accounting for, and in the disclosure of,
government grants and in the disclosure of other forms of government assistance.

IAS 21 The Effects of Changes in Foreign Exchange Rates

An entity may carry on foreign activities in two ways. It may have transactions in
foreign currencies or it may have foreign operations. In addition, an entity may
present its financial statements in a foreign currency.
The objective of this Standard is to prescribe how to include foreign currency
transactions and foreign operations in the financial statements of an entity and
how to translate financial statements into a presentation currency. The principal
issues are which exchange rate(s) to use and how to report the effects of changes
in exchange rates in the financial statements.
This Standard does not apply to hedge accounting for foreign currency items,
including the hedging of a net investment in a foreign operation. IAS 39 applies to
hedge accounting.
This Standard does not apply to the presentation in a statement of cash flows of
the cash flows arising from transactions in a foreign currency, or to the translation
of cash flows of a foreign operation (see IAS 7 Statement of Cash Flows).
59

IAS 23 Borrowing Costs

Core principle
Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset form part of the cost of that asset. Other
borrowing costs are recognised as an expense.
Borrowing costs are interest and other costs that an entity incurs in connection
with the borrowing of funds.

IAS 24 Related Party Disclosures

The objective of this Standard is to ensure that an entitys financial statements
contain the disclosures necessary to draw attention to the possibility that its
financial position and profit or loss may have been affected by the existence of
related parties and by transactions and outstanding balances with such parties

IAS 26 Accounting and Reporting by Retirement Benefit Plans

This Standard shall be applied in the financial statements of retirement benefit

plans where such financial statements are prepared.
Retirement benefit plans are arrangements whereby an entity provides benefits for
employees on or after termination of service (either in the form of an annual
income or as a lump sum) when such benefits, or the contributions towards them,
can be determined or estimated in advance of retirement from the provisions of a
document or from the entity's practices.
Some retirement benefit plans have sponsors other than employers; this Standard
also applies to the financial statements of such plans.
IAS 27 Consolidated and Separate Financial Statements
The objective of IAS 27 is to enhance the relevance, reliability and comparability
of the information that a parent entity provides in its separate financial statements
and in its consolidated financial statements for a group of entities under its
control. The Standard specifies:
(a) the circumstances in which an entity must consolidate the financial
statements of another entity (being a subsidiary);
(b) the accounting for changes in the level of ownership interest in a
subsidiary;
(c) the accounting for the loss of control of a subsidiary; and
(d) the information that an entity must disclose to enable users of the financial
statements
to evaluate the nature of the relationship between the entity and its
subsidiaries.

60

Consolidated financial statements are the financial statements of a group

presented as those of a single economic entity. A group is a parent and all its
subsidiaries. A subsidiary is an entity, including an unincorporated entity such as a
partnership, that is controlled by another entity (known as the parent). Control is
the power to govern the financial and operating policies of an entity so as to
obtain benefits from its activities.

IAS 28 Investments in Associates

This Standard shall be applied in accounting for investments in associates.
However, it does not apply to investments in associates held by:
(a) Venture capital organisations, or
(b) mutual funds, unit trusts and similar entities including investment-linked
insurance funds that upon initial recognition are designated as at fair value
through profit or loss or are classified as held for trading and accounted for in
accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Such investments shall be measured at fair value in accordance with IAS 39, with
changes in fair value recognized in profit or loss in the period of the change.
Significant influence is the power to participate in the financial and operating
policy decisions of the investee but is not control or joint control over those
policies.

IAS 29 Financial Reporting in Hyperinflationary Economies

This Standard shall be applied to the financial statements, including the
consolidated financial statements, of any entity whose functional currency is the
currency of a hyperinflationary economy

IAS 31 Interests in Joint Ventures

This Standard shall be applied in accounting for interests in joint ventures and the
reporting of joint venture assets, liabilities, income and expenses in the financial
statements of venturers and investors, regardless of the structures or forms under
which the joint venture activities take place. However, it does not apply to
venturers interests in jointly controlled entities held by:
(a) venture capital organisations, or

61

(b) mutual funds, unit trusts and similar entities including investment-linked
insurance funds that upon initial recognition are designated as at fair value
through profit or loss or are classified as held for trading and accounted
for in accordance with IAS 39 Financial Instruments: Recognition and
Measurement.

A joint venture is a contractual arrangement whereby two or more parties

undertake an economic activity that is subject to joint control. Joint control is the
contractually agreed sharing of control over an economic activity, and exists only
when the strategic financial and operating decisions relating to the activity require
the unanimous consent of the parties sharing control (the venturers). Control is the
power to govern the financial and operating policies of an economic activity so as
to obtain benefits from it.
A venturer is a party to a joint venture and has joint control over that joint
venture.
Joint ventures take many different forms and structures. This Standard identifies
three broad typesjointly controlled operations, jointly controlled assets and
jointly controlled entitiesthat are commonly described as,and meet the
definition of, joint ventures.

IAS 32 Financial Instruments: Presentation

The objective of this Standard is to establish principles for presenting financial
instruments as liabilities or equity and for offsetting financial assets and financial
liabilities. It applies to the classification of financial instruments, from the
perspective of the issuer, into financial assets, financial liabilities and equity
instruments; the classification of related interest, dividends, losses and gains; and
the circumstances in which financial assets and financial liabilities should be
offset.
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right
(d) a contract that will or may be settled in the entitys own equity
instruments
A financial liability is any liability that is:
(a) a contractual obligation
(b) a contract that will or may be settled in the entitys own equity
instruments

62

An equity instrument is any contract that evidences a residual interest in the assets
of an entity
after deducting all of its liabilities.

IAS 33 Earnings per Share

The objective of this Standard is to prescribe principles for the determination and
presentation of earnings per share, so as to improve performance comparisons
between different entities in the same reporting period and between different
reporting periods for the same entity. The focus of this Standard is on the
denominator of the earnings per share calculation.
This Standard shall be applied by entities whose ordinary shares or potential
ordinary shares are publicly traded and by entities that are in the process of
issuing ordinary shares or potential ordinary shares in public markets. An entity
that discloses earnings per share shall calculate and disclose earnings per share in
accordance with this Standard.
An ordinary share is an equity instrument that is subordinate to all other classes of
equity instruments.
A potential ordinary share is a financial instrument or other contract that may
entitle its holder to ordinary shares.

IAS 34 Interim Financial Reporting

The objective of this Standard is to prescribe the minimum content of an interim
financial report and to prescribe the principles for recognition and measurement in
complete or condensed financial statements for an interim period. Timely and
reliable interim financial reporting improves the ability of investors, creditors, and
others to understand an entitys capacity to generate earnings and cash flows and
its financial condition and liquidity.
This Standard applies if an entity is required or elects to publish an interim
financial report in accordance with International Financial Reporting Standards.
Interim financial report means a financial report containing either a complete set
of financial statements (as described in IAS 1 Presentation of Financial
Statements (as revised in 2007)) or a set of condensed financial statements (as
described in this Standard) for an interim period. Interim period is a financial
reporting period shorter than a full financial year.

IAS 36 Impairment of Assets

The objective of this Standard is to prescribe the procedures that an entity applies
to ensure that its assets are carried at no more than their recoverable amount. An
63

asset is carried at more than its recoverable amount if its carrying amount exceeds
the amount to be recovered through use or sale of the asset. If this is the case, the
asset is described as impaired and the Standard requires the entity to recognize an
impairment loss.
The Standard also specifies when an entity should reverse an impairment loss and
prescribes disclosures
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
The objective of this Standard is to ensure that appropriate recognition criteria and
measurement bases are applied to provisions, contingent liabilities and contingent
assets and that sufficient information is disclosed in the notes to enable users to
understand their nature, timing and amount.
IAS 37 prescribes the accounting and disclosure for all provisions, contingent
liabilities and contingent assets, except:

(a) those resulting from financial instruments that are carried at fair value;
(b) those resulting from executory contracts, except where the contract is onerous.
Executory contracts are contracts under which neither party has performed any of
its obligations or both parties have partially performed their obligations to an
equal extent;
(c) those arising in insurance entities from contracts with policyholders; or
(d) those covered by another Standard.
IAS 38 Intangible Assets
The objective of this Standard is to prescribe the accounting treatment for
intangible assets that are not dealt with specifically in another Standard. This
Standard requires an entity to recognise an intangible asset if, and only if,
specified criteria are met. The Standard also specifies how to measure the carrying
amount of intangible assets and requires specified disclosures about intangible
assets.
An intangible asset is an identifiable non-monetary asset without physical
substance

IAS 39 Financial Instruments: Recognition and Measurement

The objective of this Standard is to establish principles for recognizing and

measuring financial assets, financial liabilities and some contracts to buy or sell
non-financial items. Requirements for presenting information about financial
instruments are in IAS 32 Financial Instruments: Presentation. Requirements for
disclosing information about financial instruments are in IFRS 7 Financial
Instruments: Disclosures.
IAS 40 Investment Property

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The objective of this Standard is to prescribe the accounting treatment for

investment property and related disclosure requirements
IAS 41 Agriculture
The objective of this Standard is to prescribe the accounting treatment and
disclosures related to agricultural activity.
IAS 21
The Effects of Changes in Foreign Exchange Rates

as issued at 1 January 2012. Includes IFRSs with an effective date after 1 January 2012
but not the IFRSs they will replace.
This extract has been prepared by IFRS Foundation staff and has not been approved by
the IASB. For the requirements reference must be made to International Financial
Reporting Standards.
An entity may carry on foreign activities in two ways. It may have transactions in foreign
currencies or it may have foreign operations. In addition, an entity may present its
financial statements in a foreign currency. The objective of this Standard is to prescribe
how to include foreign currency transactions and foreign operations in the financial
statements of an entity and how to translate financial statements into a presentation
currency. The principal issues are which exchange rate(s) to use and how to report the
effects of changes in exchange rates in the financial statements. This Standard does not
apply to hedge accounting for foreign currency items, including the hedging of a net
investment in a foreign operation. IAS 39 applies to hedge accounting. This Standard
does not apply to the presentation in a statement of cash flows of the cash flows arising
from transactions in a foreign currency, or to the translation of cash flows of a foreign
operation (see IAS 7 Statement of Cash Flows).
Functional currency
Functional currency is the currency of the primary economic environment in which the
entity operates. The primary economic environment in which an entity operates is
normally the one in which it primarily generates and expends cash. An entity considers
the following factors in determining its functional currency: (a) the currency: (i) that
mainly influences sales prices for goods and services (this will often be the currency in
which sales prices for its goods and services are denominated and settled); and
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(ii) of the country whose competitive forces and regulations mainly determine the sales
prices of its goods and services. (b) the currency that mainly influences labour, material
and other costs of providing goods or services (this will often be the currency in which
such costs are denominated and settled). Reporting foreign currency transactions in the
functional currency Foreign currency is a currency other than the functional currency of
the entity. Spot exchange rate is the exchange rate for immediate delivery. Exchange
difference is the difference resulting from translating a given number of units of one
currency into another currency at different exchange rates. Net investment in a foreign
operation is the amount of the reporting entitys interest in the net assets of that operation.
A foreign currency transaction shall be recorded, on initial recognition in the functional
currency, by applying to the foreign currency amount the spot exchange rate between the
functional currency and the foreign currency at the date of the transaction. At the end of
each reporting period: (a) foreign currency monetary items shall be translated using the
closing rate; (b) non-monetary items that are measured in terms of historical cost in a
foreign currency shall be translated using the exchange rate at the date of the transaction;
and (c) non-monetary items that are measured at fair value in a foreign currency shall be
translated using the exchange rates at the date when the fair value was measured.
Exchange differences arising on the settlement of monetary items or on translating
monetary items at rates different from those at which they were translated on initial
recognition during the period or in previous financial statements shall be recognised in
profit or loss in the period in which they arise. However, exchange differences arising on
a monetary item that forms part of a reporting entitys net investment in a foreign
operation shall be recognised in profit or loss in the separate financial statements of the
reporting entity or the individual financial statements of the foreign operation, as
appropriate. In the financial statements that include the foreign operation and the
reporting entity (eg consolidated financial statements when the foreign operation is a
subsidiary), such exchange differences shall be recognised initially in other
comprehensive income and reclassified from equity to profit or loss on disposal of the net
investment. Furthermore, when a gain or loss on a non-monetary item is recognised in
other comprehensive income, any exchange component of that gain or loss shall be
recognised in other comprehensive income. Conversely, when a gain or loss on a non-

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monetary item is recognised in profit or loss, any exchange component of that gain or
loss shall be recognised in profit or loss

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